Liquid Funds: Distribution tax burden 20% and not 25%

As most investors know by now, Budget 2007 has hiked the rate of Dividend Distribution Tax (DDT) to 25% on money market mutual funds and liquid funds for all categories of investors. 

 

The enhanced rate of distribution tax has apparently been introduced to cut the arbitrage opportunity between income tax rates and distribution tax.

 

This has set the cat amongst the pigeons as far as mutual funds and investors are concerned. It is feared that investors, especially corporates, will pull out on a large scale and start favouring bank deposits instead.

 

But even after the enhanced rate, the arbitrage opportunity exists. The effective rate of DDT works out to be 20%, not 25%. Here's how.

 

I take a base DDT of 25% (surcharge and cess are not included for simplicity), and assume a Rs 100 dividend to be distributed. So the mutual fund (MF) concerned will pay Rs 80 to the investor and pay Rs 20 as distribution tax.

 

Rs 20 is 25% of Rs 80 (the dividend distributed). As far as the investor is concerned, he has borne a tax of Rs 20 on a gross income of Rs 100, which works out to just 20%.

 

Look at it the other way. Had the investor actually received Rs 100 in hand (which would be the case in the case of a bank deposit), he would have been asked to pay Rs 25 (25% of Rs 100) as tax. Because the MF pays tax on the investor's behalf, the effective rate works out lower. Basic mathematics.

 

Also read: Budget: What's in it for me and you?   

 

I left out surcharge and education cess above. If they were taken into account, the revised DDT rate as specified by the Budget climbs to 28.325% instead of 25%; the effective tax rate (as discussed above), climbs from 20% to 22.07%.

 

Note: This rate is only applicable to Liquid Funds and Money Market Mutual Funds. Detailed water tight definitions have been provided by SEBI for schemes to qualify as such.

 

Thus, by corollary, even if some investment instruments (or even one of the instruments in the portfolio), were to not satisfy the set norms, the scheme will not qualify as a money market or a liquid scheme and, hence, be liable for distribution tax at the old rate.

 

The following table summarises the changes in DDT:

 

DDT	Liquid Funds		Other Non-Equity Funds		Equity Funds
	Old Rates*	New Rates†	Old Rates*	New Rates †	Old Rates*	New Rates†
Individuals/HUFs	12.50%	25%	12.50%	12.50%	NIL	0%
Others	20%	25%	20%	20%	0%	0%

 

 

 

 

 

 

 

 

 

* Surcharge of 10% and Education Cess of 2% would apply over and above the base rate.

† Surcharge of 10% and Education Cess of 3% would apply over and above the base rate.

 

The writer, Sandeep Shanbhag, is Director, AN Shanbhag NR Group. He may be contacted at sandeep.shanbhag@gmail.com

 

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