Ever since the Finance Minister presented the Union Budget proposals, there has been a lot of heartburn about dividends becoming taxable. Sit back and relax, nobody has moved your cheese. Let’s get the perspective on what is happening, and where you need to set the temperature to suit the new climate.
We will start with dividends from equity shares, then discuss dividends from Mutual Funds (MFs). The company paying dividends on its shares has to pay a dividend distribution tax (DDT) after which the dividends are tax-free in your hands. What the Union Budget has proposed is that the DDT be done away with. Rather, the dividend becomes taxable in your hands, at your rate.
Hence if you are in the 30% tax slab, you will now have to pay 30% tax on the dividends you receive. There are two issues in this. One, the numbers. The DDT paid by the company, to quote a round figure (giving up some decimals of correctness), is 20%. When DDT is no longer applicable, the company may bump up the dividend to that extent and pay a higher dividend as there is a relatively higher quantum at disposal. If you pay income tax at 30%, or higher including surcharge and cess, your net receipt is lower to the extent your taxation rate is higher than 20%. The other issue is psychological; something that is tax-free currently, becoming taxable.
Dividend yield
Let us now turn this issue on its head. There is a concept called dividend yield, which is the dividend received as a percentage of market price.
As an illustration, a company issues shares at a price of ₹10, which is the face value. Subsequently, the price goes up to ₹100 in the market, when you purchase it. The company earns a profit and declares a dividend of 15%. Now, this 15 is a percentage of the face value, hence you get a dividend of ₹1.5 per share.
However, as a percentage of the price you have paid for it, your yield is only 1.5%. In the new scenario, the company may pay a little higher than ₹1.5, as DDT would no longer be applicable. On the amount received, you will have to pay tax at 30%, depending on your income bracket. The crux of the matter is, most of the returns on equities come from price appreciation.
The dividend yield moving from 1.5% to say 1.4% does not make a material difference any which way.
In the equity market, this can be made up quickly from favourable price movement. As a reference point, the dividend yield on Nifty 50 stocks is only 1.3%. To be noted, (a) if you are in a lower tax bracket than 20%, you are better off in the new scheme of things (b) 30% is the marginal slab rate; your average tax rate is lower by virtue of the lower tax slabs (which are at less than ₹10 lakh as per current slabs) and (c) if you are holding significant equity and earn dividend of more than ₹10 lakh per year, you are anyway paying a tax of 10% on that.
Mutual funds
After dividend from equity stocks, comes the case of dividends from MFs. The Union Budget proposal is that DDT be done away with, and MF dividend becomes taxable in your hands at your rate. The difference with equity shares discussed above is that in MFs, there will be a TDS (tax deducted at source) of 10% in the dividend option.
What will change? Currently, in equity-oriented MF schemes, there is a DDT of 10% plus surcharge and cess. When this becomes taxable at your slab rate of say 30%, you pay 20% higher tax, or a little more than 20% if you are in a higher surcharge bracket. We said earlier, you have to re-set the temperature to suit the new climate.
In MF schemes, there are two options, dividend and growth. In the dividend option, the MF periodically declares dividend. In the growth option, there is no pay-out as such; the gains or accretions remain in the NAV, which you take home when you redeem.
In the growth option, it becomes long term if you hold for one year. After that, the gains from equity funds are taxable at 10% plus surcharge and cess. This does not change after the Union Budget. Moreover, up to ₹1 lakh of long-term capital gains per financial year is free from tax. Hence, you have to shift your investments off equity-oriented MF Schemes from dividend option to growth option and enjoy same / lower taxation.
There is a psychological aspect here as well. A dividend seems like an additional or bonus return. That is not the case. In the growth option, you have earned as much: it is there in the NAV. Rather, you earn a little higher in the growth option, as that component remains in the fund and continues to earn from the market for a longer period of time and gets the benefit of compounding.
For investors requiring regular cash flows, e.g. retired senior citizens, who are currently invested in the dividend option, they should switch to the growth option and take a Systematic Withdrawal Plan (SWP). In the dividend option, the quantum of dividend is decided by the AMC whereas in an SWP, you decide the quantum to be withdrawn regularly. Preferably, for tax efficiency, the SWP in the growth option should start after one year of investment for equity funds and three years for debt funds, for it to become long term from the tax perspective and enjoy a lower rate.
(The author is founder, wiseinvestor.in)
