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Mutual Fund Dividends

Funds' dividends are just a way of distributing profits, but there are many tax advantages of receiving them. Dividends from equity mutual funds are fully tax-free. These dividends can also be used to offset short-term capital gains.

Dividends seem to have become a major theme in the marketing of mutual funds nowadays. Evidently, many investors have an inadequate appreciation of the fact that dividends are meaningless as indicators of fund performance-the money that is given to you as dividends is simply deducted from your account with the fund.

Let's look at an example. We make an investment of Rs 2000 at an NAV of Rs 20 per unit, getting us a 100 units of a fund. The fund then gains 20 per cent, bringing its NAV to Rs 24 and thus our investment is worth Rs 2400 (Rs 24 X 100 units). Now, the fund declares a dividend of 50 per cent, thus paying us Rs 500 (dividends are always a percentage of the face value). Now, the NAV will go down to Rs 19 and thus the value of our holdings will go down from Rs 2400 to Rs 1900. Basically, all that has happened has that a part of our holdings has been handed out to us as dividends. There was no extra benefit. While our investment had generated Rs 400, the 'extra' dividend of Rs 100 came from our initial capital.

But there is still an advantage to dividends. While you may not get any extra, you could end up saving some tax. Firstly dividends from equity mutual funds are fully tax-free for the current financial year. So neither does the mutual fund have to pay any tax on the dividends it distributes and neither does the investor. This is thus the most tax friendly way of receiving returns from equity mutual funds. These tax-free dividends can also be used to offset short-term capital gains. In the above example, we made a capital loss of Rs 100 (our initial capital investment of Rs 2400 is worth only Rs 1900 after we got Rs 500 as dividends). This loss can be used to set off other short-term capital gains that you may have made during the year. This is what the so-called 'dividend-stripping' is all about.

Tax provisions require that an investor who enters three months before the record date should remain invested for three months after the record date to claim a capital loss. As most funds are declaring the dividend payout day well in advance one can invest in such a fund with the intention of offsetting gains elsewhere. Of course if the fund's NAV rises substantially during the 90 day wait then there may be no short-term loss to claim. And then some funds charge an entry or exit load during such times. Nonetheless in situations where the quantum of dividend is high substantial benefits can accrue from this strategy of dividend stripping.

On the debt side a dividend distribution tax of 12.81 per cent (12.5 per cent plus 2.5 per cent surcharge) is levied on all dividends paid by a fund. This tax is levied on the net amount that a fund wishes to distribute as dividend. Thus if a fund wants to give investors a dividend of Rs 100 it will have to book profits of Rs 100 plus 12.81 per cent of Rs 100. So the fund will declare a gross dividend of Rs 112.81. Of this Rs 12.81 will go to the government, as dividend distribution tax while the investor will receive Rs 100 as dividend.

Contrary to popular perception for debt schemes, the systematic withdrawal plan (SWP), is the most tax efficient way of receiving payouts and not the dividend option. This happens because in the systematic withdrawal mechanism capital gains tax is paid. As capital gains tax is paid only on the gains component and this is a smaller portion of the withdrawal (especially during the early years) its effect is minimal. Dividend distribution tax on the other hand is paid on the full amount of the withdrawal. For cash funds and others, where no SWP is available, the dividend route becomes the most tax efficient way of receiving gains.