What is Dividend Distribution Tax (DDT) on Equity Mutual Funds and should one opt for Dividend or Growth option?

Capital Gains Tax, Dividend Distribution Tax had been in the news in early 2018. Union finance minister Arun Jaitley announced in the 2018 Union Budget that dividend income from equity mutual fund schemes would attract Dividend Distribution Tax (DDT) from April 1, 2018. What should you do as an equity mutual fund investor? Should you continue with the existing strategy or tweak it? Let us begin with what Dividend Distribution Tax means.

When a company announces dividends, it is liable to pay a tax on the amount paid as dividend. This tax is called the Dividend Distribution Tax (DDT). DDT is applicable to equity oriented mutual funds (which invest at least 65% of their assets in equity shares of domestic companies listed on a recognised stock exchange). Hence, if one chooses the Dividend Payout or the Dividend Reinvestment (Dividend option) instead of the Growth Option, one is impacted by DDT.

Prior to the 2018 Union Budget, DDT was only levied on dividends from debt mutual funds. Now, if you hold your equity oriented mutual funds for more than a year, the gains are taxed at 10% plus surcharge and health and education cess. While DDT is paid by the fund house and not by the investors, they would be impacted as the fund house will deduct the tax out of the dividends that are declared. Hence, the amount available for distribution as dividend gets reduced.

For example: if a fund house wants to distribute a surplus of Rs.10 per unit, then it has to pay Rs.1 per unit as DDT (excluding surcharge and cess) to the government and then can distribute only Rs. 9 per unit as dividend to the investor, which is then ‘tax-free’ in the hands of the investor.

So what should you do post DDT on equity mutual funds?

You have the following options:

1. Invest in the Growth option of an equity-oriented mutual fund
2. Switch from a Dividend Payout option to a Growth option

Let’s understand when and how these options should be used.

For existing investment:

If you currently have the Dividend option in your existing investment, you might want to consider changing this to the Growth option. A DDT of 10% (plus surcharge and health and education cess) is levied on all dividends in the Dividend option as opposed to the Growth option (gains upto Rs 1 lakh p.a are exempt for equity funds irrespective of dividend or growth plan). All you have to do is submit a written application to your fund house.

However, keep a few things in mind while considering the growth option:

• If you have invested in tax-saving schemes or equity-linked saving schemes (ELSS), you need to wait until the lock-in period gets over.
• The switch from one option to another is treated as redemption from one option and investment in the other option of the same scheme. It may, therefore, attract an exit load as well as short-term / long-term capital gains tax depending on the length of the investment.

For new investment:

If you need a regular cash flow, opting for a Dividend Payout option may not be the best option because the fund house will be paying 10% tax (plus surcharge and health and education cess) every time dividends are declared which will reduce the amount coming into your hands.

If you don’t need a regular cash flow, you may still consider the Growth option as mutual funds offer facilities like the Systematic Withdrawal Plan (SWP) in which investors can opt to withdraw specific amounts at predetermined time intervals i.e. monthly/quarterly and the use of this facility therefore suits the need. SWP is more tax efficient as ₹1 lakh of LTCG is exempt from tax, while dividends are taxed at a flat rate of 10%. An investor may also be able to avoid tax on his gains, if the LTCG accrued on the amount withdrawn under the SWP remains below the ₹ 1 lakh threshold.

This is why many financial advisors and distributors are now recommending the Growth Option along with a suitable-sized SWP as a good solution for those investors who want to benefit from the equity market but also seek regular income from their investments.

Therefore, all is not lost in the new tax regime post the Union Budget 2018. Some wise planning can help you make handsome returns on your investment. To guide you with your investments and in case you in mutual funds you should consult an investment advisor.

Note:

*Dividend payout – The dividends are declared and paid out to the investor.

** Dividend Reinvestment – The dividends are declared but not paid out to you. Instead they are reinvested at the NAV of the fund after dividend declaration.

***Growth option - No dividends are declared. The dividends remain invested in the fund; this is reflected in a rise in the NAV of the fund. In this case, the number of units you hold remains the same.