The segregation will be difficult in the case of exchange-traded funds as it is difficult to determine at what price investors traded the units | Illustration: Binay Sinha
The Securities and Exchange Board of India’s (Sebi’s) diktat to segregate dividend as income distribution (appreciation in net asset value, or NAV) and capital distribution (equalisation reserve) in the consolidated income statement from April 1 has put mutual fund (MF) houses in a bind.
When a unit is sold, and sale price (NAV) is higher than the face value of the unit, a portion of the sale price that represents realised gains has to be credited to an equalisation reserve account, which can be used to pay dividend, the new norms suggest.
This has put MFs in a peculiar situation. Income distributed by MFs is taxable in the hands of investors and liable to tax deducted at source (TDS). If MFs do not deduct TDS from the capital distributed among investors, the overall tax collection could fall, resulting in a revenue loss for the government.
Assets of dividend plans have seen a considerable drop over the past year with the Budget 2020 making dividends taxable in the hands of investors. Still, assets of dividend plans amounted to over Rs 1.79 trillion as of December 31, 2020, according to Value Research data.
If MFs choose to deduct tax on the entire quantum of distribution made, there may be TDS mismatches for investors, if it transpires that there is no tax to be paid on the capital distribution portion of the dividend paid.
The Association of Mutual Funds
in India (Amfi) has set up a committee that will take up the matter with Sebi, said a senior industry official. “The regulator hasn’t thought through the implications, especially with regard to investors’ taxation. What may be capital for investor A may not be capital for investor B. Also, at a fund level, the bifurcation between what is capital and what is income is very different. The Finance Bill, 2021, should have got a new law stating that in case of dividends, when there is a distinction between capital and income, TDS should be only on income,” the person said.
There is also uncertainty on whether investors will be able to adjust the cost of acquisition of the units and avail of indexation benefits. The segregation will be difficult in the case of exchange-traded funds as it is difficult to determine at what price investors traded the units.
“While income distributed is taxable in the hands of investors and subjected to TDS, there is ambiguity with respect to the tax treatment of capital returned to investors. Will such amount be regarded as a capital receipt or should it be adjusted against the cost of acquisition of units or will it trigger capital gains is not clear. Clarity on tax treatment of capital returned will mitigate TDS and taxability challenges for MFs and investors,” said Tushar Sachade, partner, PwC India.
Experts believe the new norms may be an indirect way for the regulator to apply the brakes on dividend option plans in MFs. In the past, several hybrid schemes have been mis-sold to investors on the promise of regular dividends. All dividends received on or after April 1, 2020, by MF investors are taxable. The Finance Act, 2020, also imposed TDS on dividend distribution by mutual funds
on or after April 1, 2020.
The standard rate of TDS is 10 per cent on dividend income paid in excess of Rs 5,000 from a company or mutual fund. This has been reduced to 7.5 per cent until March 31, 2021, against the backdrop of the pandemic.
Tale of two investors
Take a case of two investors who enter an MF scheme when the NAV is Rs 10 and Rs 20, respectively. Let's say the MF books profits and declares a dividend of Rs 5 when the NAV becomes Rs 22.
For the first investor, the entire Rs 5 would be treated as income distribution as it relates to the increase in NAV. For the other investor, Rs 2 would be considered as income distribution and Rs 3 would become capital distribution.
At present, the entire Rs 5 is being considered as income. But, this will change. In the above example, the first investor will pay tax on Rs 5, while the second will pay tax on Rs 2. The second investor may deduct Rs 3 (capital distribution) from the NAV to arrive at the cost of acquisition. It remains to be seen, however, whether s/he will lose out on indexation benefits while calculating total gains.