Change in ddt on debt mf schemes from june 2013 onwards – how to cope
Retail Research 1Change in DDT on Debt MF schemes from June 2013 onwards – How to cope (Revised) May 24, 2013From 1st June, 2013 onwards, the dividends declared by all the debt oriented mutual funds for Individual & HUF investors will beattracting a uniform rate of Dividend Distribution Tax (DDT) of 25% (plus surcharge and cess wherever applicable). Further, thesurcharge on Dividend Distribution Tax for all mutual fund schemes has also been hiked from 5% to 10%.As per the existing structure, Liquid Funds are liable to pay the DDT of 25% (plus surcharge and cess) for such investors while thefunds other than Liquid funds (such as Ultra Short term, Short Term, Income, Gilt, MIP and so on) are liable to pay DDT of 12.5% (plussurcharge and cess). The hike is proposed by the Finance Minister in the Union Budget FY14 to provide uniform taxation of DDT for alltypes of investors as far as debt oriented funds are concerned.On the other hand, partnerships and corporates have been paying DDT of 33.99% (30% plus surcharge and cess) from the dividendsfrom the investments in all debt funds (including Liquid funds).As per the tax provision on the distributed income, fund houses pay taxes on the dividend distributed to the investors. Fund housesdeduct DDT from the Dividend. So the net dividends are tax free in the hands of investors. It is to be noted that there is no tax levied onthe dividend distributed by Equity oriented mutual fund schemes for any investors.The below table summarizes the changes proposed in the Union Budget on DDT for the Individual & HUF investors.For Individuals and HUF investors:Classification Categories ExistingProposed(From June 01, 2013)Equity FundsEquity Diversified,Equity Sector,Hybrid - Equity Oriented (more than 65% equity),Arbitrage FundsNIL NILLiquid FundsLiquid Funds,Liquid ETF27.038% = 25%+ 5% (SurCharges) + 3% (Cess)28.325% = 25%+ 10% (Sur Charges)+ 3% (Cess)Debt Funds other thanLiquid FundsUltra Short Term Funds,Floating Rate Funds,Short Term Income,Dynamic Income,Income Funds andGilt Funds.Hybrid - Debt Oriented (less than 65% equity),MIP,FMPs,13.519% = 12.5%+ 5% (SurCharges) + 3% (Cess)28.325% = 25%+ 10% (Sur Charges)+ 3% (Cess)Impact: This move will make dividend option in Debt Mutual Funds less attractive for Individual & HUF investors. Because the net posttax return in the hands of the investors from dividend plans would be lower as the DDT charged on the debt funds has been increasedfrom 12.5% to 25% (plus surcharge and cess). Apparently, the categories MIP and Ultra Short Term Funds will also be affected due tothe move. Investors who depend on dividend income would have invested with MIP categories (in most of the cases). And, the UltraShort Term category is treated as substitute to liquid funds for their tax efficiencies (hence, both are having similar investment strategy).Effective tax rate: Interestingly, as far as effective tax rate on DDT is concerned, the effective rates are lower for investors as the DDTis calculated on actual dividend distributed and not on gross returns. But for an investor, the tax rate is calculated from the gross returnsof his investment.For instance, given in the one rupee of distributable income, the AMC has to pay DDT on the dividend of retail investors based on thefollowing formula. That is (x + 28.33% of x = 1). Here, “x” denotes the dividend portion for retail investors. The result becomes (0.7793paisa dividend + 0.2207 paisa DDT = Re. 1). Hence, the effective tax rate for retail investors (on the income distributed) will come closeto 22.07% and not 28.33%. In a nutshell, we can say that the AMC has to pay 28.33% on the dividend of retail investors which is thesame as 22.07% tax on the gross returns of the investment of the investors.ExistingProposed (From June 01,2013)Marginal Maximum Tax RateClassificationDDTEffectivetax rateDDTEffectivetax rateTaxableIncome uptoRs 1 croreTaxable Incomeexceeds Rs 1croreLiquid Schemes 27.04% 21.28% 28.33% 22.07% 30.90% 33.99%Funds other than Liquid Funds 13.52% 11.91% 28.33% 22.07% 30.90% 33.99%
Retail Research 2The following are the some of other feasible options available for individual and HUF investors post the change in DDT structure in debtmutual funds:1. Dividend option is still attractive but less than earlier: Though there is an increase in the DDT, Dividend plans in the Debtschemes are still attractive for investors who fall under the higher tax slab of 30%. They still give higher post-tax returns than similarproducts such as bank fixed deposits. In the Dividend option of debt funds, the investor has to bear the tax of 22.07% while in BankFixed deposit, he pays 30.90% (if taxable income is upto Rs.1 crore) or 33.99% (if taxable income is more than Rs.1 crore).Taxable Income upto Rs 1 crore Taxable Income exceeds Rs 1 croreParticularFixed DepositDebt MF DividendOptionFixed DepositDebt MF DividendOptionAssumed rate of return from the investment (%) p.a 9% 9% 9% 9%Income tax rate 30.90% NA 33.99% NADividend Distribution Tax (Effective Tax) NA 22.07% NA 22.07%Effective post tax yields 6.22% 7.01% 5.94% 7.01%2. Long Term Capital Gain benefit in Growth option: Growth option in Debt Mutual Funds is attractive if the units are redeemed aftera year of purchase. Gains thereon are liable to be taxed as Long Term Capital Gains @ lesser of 10% without indexation or 20% withindexation (plus education cess). The option of 20% (with indexation) is available only if the mutual fund scheme is listed on the stockexchanges. Hence, the growth option of Debt funds continues to remain the best bet for anyone who wants to accumulate wealth tomeet long-term goals.As DDT is applicable for Dividend plans, Capital Gains tax is applicable to Growth plans. The gains from the debt mutual scheme(growth option) are taxed depending on the period the investments in the mutual funds are kept. If the debt mutual fund units areredeemed after a year, then the gains thereon are liable to Long Term Capital Gain tax while the proceeds from the investments whichredeemed before one year are taxed as Short Term Capital Gain. Short term Capital Gains are taxable at the normal tax slab rate of theinvestor. For long term capital gains in listed debt funds, the investor has to pay the tax @ lesser of 10% without indexation or 20% withindexation; (plus education cess). Short Term Capital Gain is taxed as per the normal slab of the investors.Income upto Rs 1 crore Income exceeds Rs 1 croreMutual Fund Mutual FundParticularFixedDeposit GrowthOptionDividendOptionFixedDeposit GrowthOptionDividendOptionAssumed rate of return from the investment (%) p.a 9% 9% 9% 9% 9% 9%Income tax rate 30.90% 10.30% NA 33.99% 11.33% NADividend Distribution Tax (Effective Tax) NA NA 22.07% NA NA 22.07%Effective post tax yields (lumpsum withdrawal after a year) 6.22% 8.07% 7.01% 5.94% 7.98% 7.01%3. Systematic Withdrawal Plans (SWP): Investors who need regular income can consider investing in debt mutual fund categories byopting for Systematic Withdrawal Plan (SWP). The SWP facility allows to withdraw a fixed sum in regular intervals for specified timeperiod or till the corpus becomes zero. SWP allows investors to withdraw from the funds after one year from the date of allotment of theunits. The 1 year lock in also results in concessional tax levy of Capital Gains tax (discussed in 2 above).Investors looking for income at periodical intervals usually invest in these funds. Often, a systematic withdrawal plan is used to fundexpenses during retirement. Under SWP, withdrawals can be fixed or variable amounts at regular intervals. These withdrawals can bemade on a monthly, quarterly, semi-annual or annual schedule. The holder of the plan may choose withdrawal intervals based on his orher commitments and needs.SWP is usually available in two options:• Fixed Withdrawal: Under this you specify amount you wish to withdraw from your investment on a monthly/quarterly basis.• Appreciation Withdrawal: Under this you can withdraw your appreciated amount on a monthly/quarterly basis.SWP in debt mutual funds is tax efficient option in comparison to other options such as Bank and Corporate Fixed Deposits. The taxliability in SWP is lower than that of bank FDs (with the caveat that withdrawals can begin only after a year to avail concessional taxtreatment). The applicable tax rate (for the investor who belongs to 30% tax bracket) on the income from SWP is 10.3% or 20% (withindexation), which is lower than the applicable tax rate of 30.9% in Bank FDs. The option of 20% (with indexation) is available only if themutual fund scheme is listed on the stock exchanges. A comparative study in the monthly withdrawals from the investments in debtfund (through SWP) and Bank FD for the period of three years clearly shows that SWP is more tax efficient than Bank FDs. Theeffective post tax yield (on 9% gross return bearing instruments) that an investor gets from SWP option is close to 8.02% while from theBank FD is around 6.40%. Further, no TDS is applicable in SWP withdrawals but it is applicable in Bank FDs for interest above acertain limit.
Retail Research 34. Bonus stripping: Bonus stripping is one of the other ways to save tax. In this, an investor can set off his capital gains against thelosses arising out of bonus stripping. This involves transactions such as investing in bonus plan of a debt mutual fund schemes beforethe record date, selling the original units and bonus units at different timeframes resulting in short term capital loss and long term capitalgain.The Section 94(8) of the Income tax Act reads as under:“ Where—(a) any person buys or acquires any units within a period of three months prior to the record date;(b) such person is allotted additional units without any payment on the basis of holding of such units on such date;(c) such person sells or transfers all or any of the units referred to in clause (a) within a period of nine months after such date,while continuing to hold all or any of the additional units referred to in clause (b),then, the loss, if any, arising to him on account of such purchase and sale of all or any of such units shall be ignored for the purposes ofcomputing his income chargeable to tax and notwithstanding anything contained in any other provision of this Act, the amount of loss soignored shall be deemed to be the cost of purchase or acquisition of such additional units referred to in clause (b) as are held by him onthe date of such sale or transfer.Mutual Fund Units Stripping means after the units of a mutual fund are purchased, the mutual fund allots bonus units to the holder ofthe units, and after receiving the additional units, the original units are sold. Usually after the declaration of bonus units, the NAV of themutual fund will decline proportionately. Hence, on sale of the original units, short-term capital loss will arise. Subject to provisions ofsection 94(8) referred to above, that loss can be set off against the other short-term capital gains or against a taxable long-term capitalgain. This will thus result into no commercial loss but only tax loss and therefore there would be a tax benefit.On sale of bonus units of equity-oriented mutual fund after a period of 12 months, the gain, if any, will be treated as long-term capitalgains and the same is taxable @ 10% (without indexation) + surcharge/cess as may be applicable.The benefit of bonus stripping is apparent from the following table:ParticularsCalculation based on theassumption that the original unitsare sold post 9 months of recorddate of Bonus and the bonus unitsare sold after 1 yearCalculation based on theassumption that the original unitsare sold prior to 9 months ofrecord date of Bonus and thebonus units are sold after 1 yearDate 5-Feb-13 5-Feb-13Amount Invested 1,000 1,000Present NAV (bonus option) 18.0492 18.0492No. of Original Units 55 55Bonus Date 22-Feb-13 22-Feb-13Days Invested from date of acquisition 17 17Bonus proposed 3:5 3:5Rate of Return Assumed 9% 9%NAV on the date of Bonus 18.1218 18.1218No. of Bonus Units 33 33NAV post Bonus 11.3261 11.3261Redemption Date of original units 29-Nov-13 1-Mar-13Days Invested from date of bonus 280 7NAV as on date of Redemption 12.1002 11.3448Applicable Exit Load 0% 0%Applicable NAV post exit load 12.1002 11.3448Redemption of original units 670.4 628.55Loss created by sale of original units post Bonus 329.6 371.45Short-Term Capital Gains Rate 30.90% * -Amount Saved due to the exercise 101.85 * -Next Redemption for the bonus units 27-Feb-14 27-Feb-14No. of days bonus units are held 370 370NAV at time of redemption of bonus units 12.3601 12.3601Redemption value & Long-term Capital gains on the Bonus units 410.88 407.8833Loss created by sale of original units (cost of acquisition of bonusunits)- 371.45Capital Gain - 36.43Long-term capital gains rate 10.30% 10.30%Tax on long-term capital gains 42.32 3.75Cash-flow 1,140.80* 1,032.68XIRR (post tax) 15.86% * 7.47%
Retail Research 4*= assumed to be in the case where the investor has short term capital gains in the same year from sources other than listed equity shares or equity oriented mutual funds. Incase the investor has short term capital gains in the same year from listed equity shares or equity oriented mutual funds, the figure work out to 15.45%, Rs.50.92, Rs.1,089.88and 10.03% respectively (vs 30.90%, Rs.101.85, Rs.1,140.80 and 15.86% mentioned in the table above).Note:The above table is based on the assumption that:• The income earned by the scheme is 9% p.a.• Bonus is declared by the scheme in the ratio of 3:5. If the ratio is smaller the IRR will tend to fall as the tax benefit of short term capital loss will be smaller.• Bonus is declared soon after the investment in original units.• Bonus units are sold on completion of 1 year from allotment of Bonus units.• The calculation will remain the same whether the units of the scheme are listed on the stock exchange or not.• The calculation is made for an investor who earns taxable income of less than Rs.1 cr.In India, there are 19 Fund houses float bonus option on their debt category schemes. Fund houses like DWS, Franklin Templeton, JM,JP Morgan, Mirae Asset, PineBridge, Pramerica, Religare, Reliance and Sundaram have bonus option for most of their debt schemeswhile the rest have bonus option in one or two schemes. However there is no regular interval seen on declaring bonus on thoseschemes.Given the increase in the DDT on debt mutual fund schemes, more AMCs could come up with bonus options in their debt schemes andcould use this option more often and regularly going forward.Summary:To earn best tax efficient returns on debt mutual fund schemes;• Investors who are willing to hold on to their debt investments for a period of 1 year and above can opt for growth option.• Investors who have short term Capital gains in the same year from sources other than listed equity shares or equity orientedmutual funds) and who can wait for 3 and further 6 months from their investment date (which is closer to the record date) canopt for Bonus option.• Other investors can continue with dividend option.Analyst: Dhuraivel GunasekaranRETAIL RESEARCH Fax: (022) 3075 3435Corporate Office: HDFC Securities Limited, I Think Techno Campus, Building –B, ”Alpha”, Office Floor 8, Near Kanjurmarg Station, Opp. CromptonGreaves, Kanjurmarg (East), Mumbai 400 042 Fax: (022) 30753435 Website: www.hdfcsec.comDisclaimer: Mutual Funds investments are subject to risk. Past performance is no guarantee for future performance. This document has been preparedby HDFC Securities Limited and is meant for sole use by the recipient and not for circulation. This document is not to be reported or copied or madeavailable to others. It should not be considered to be taken as an offer to sell or a solicitation to buy any security. The information contained herein isfrom sources believed reliable. We do not represent that it is accurate or complete and it should not be relied upon as such. We may have from time totime positions or options on, and buy and sell securities referred to herein. We may from time to time solicit from, or perform investment banking, orother services for, any company mentioned in this document. This report is intended for non-Institutional Clients.