Dear FM, you have announced changes in the Dividend Distribution Tax and Capital Gains Tax in budget 2014. The DDT was changed to make actual tax rate lower than effective tax rate while the capital gains tax was changed to cut arbitrage between FMP (Fixed Maturity Plans) of mutual funds and bank fixed deposits. The DDT tax change was necessary as was change in capital gains tax on FMPs, however in removing FMP arbitrage, you have effectively penalised bond fund investors. Let us see how.
FMP are closed ended funds that aims to lock in returns for the investor. A FMP for 366 days would buy securities maturing in 13 months and lock in to yields. For example if FMP was floated today for 366 days, a AAA portfolio would yield around 9% and as it is close ended, at the time of redemption, the investor would get returns of 9% less expenses. It is similar to a bank deposit that pays 9% for one year except tax as FMP was taxed as a debt security that is eligible for long term capital gains of 10% without indexation or 20% with indexation if held for over 12 months. Bank deposits on the other hand were taxed at full tax and the FMP offered tax arbitrage apart from market yield on securities at the time of inception.
The new tax law has however clubbed all non equity schemes along with FMPs and is subjecting the investor to hold the schemes for 36 months to avail of only the 20% with indexation capital gains tax benefit. The tax is retrospective as it is applicable from Assessment year 2015-16. Investors who have invested in short term or long term income funds or gilt funds or other such funds that requires a holding period of at least one year and above to minimise interest rate and credit spread risk will be subject to new tax laws if they redeem their investments this year.
Corporate bonds and government bonds have been kept out of the new tax law and an investor would be better off buying bonds directly instead of mutual funds to avail of capital gains benefits over a one year holding period. The fact is that bond markets in India are still extremely illiquid for retail investors and do not even come anywhere close to equities in terms of costs or ease of transactions. Bond funds are ideal vehicles for investors looking to capture downward movement in interest rates and credit spreads in the economy.
The new capital gains tax on bond funds makes it compulsory for investors to hold the funds for three years to avail of long term capital gains tax, which the investor may not want. The fact is that the government is the biggest culprit in driving up bond yields in the economy as it borrows heavily to fund its fiscal deficit and no investor would want to hold bond funds if the government systematically takes up yields. Hence the need for liquidity in case the government transgresses the FRBM act, which it had done so six years back with heavy consequences.
It is true that your government is committing to lowering inflation and to fiscal consolidation that would make bonds attractive for investors but at this point of time the investor is bruised and hurt by inflation and poor fiscal policies and unless there is a long period of low inflation and better government finances, the investor would not put money in bonds for longer period of time.
Budget 2014 saw two changes in the tax applicable to mutual fund investments. One is the Dividend Distribution Tax (DDT) and the second is the Capital Gains Tax on non equity schemes i.e. all schemes other than pure equity schemes.
The FM has removed an anomaly in DDT where effective tax rate was lower than the actual tax rate. Simply put, if a fund paid a dividend of 8% and DDT is 28.33%, the tax paid was calculated as 28.33% = (x/(8-x)), where x is the tax paid on dividend. Solving for x, the tax paid on dividend is Rs 1.77 or 22.1%, which is lower than 28.33% DDT. All debt mutual funds pay DDT of 25% plus surcharge on dividends, which works out to 28.33%.
Equity mutual fund schemes do not have to pay DDT while companies paying dividend have to pay 15% plus surcharge as DDT.
Investors earning dividend income will receive lower dividend post the DDT amendment.This is applicable from 1st October 2014.
The FM has removed the benefit of a twelve month holding period for classification of short term capital assets on all non equity mutual fund schemes. The benefit of 10% capital gains before indexation has also been taken away. Hence all non equity mutual fund units are classified as short term capital asset if held for a period of less than thirty six months. This is applicable from 1st April 2015 and starts from Assessment Year 2015-16, which effectively means that investors redeeming bond fund investments this year will have to pay short term capital gains tax.
The ruling places mutual fund schemes at a disadvantage relative to bonds, as listed bonds would have the benefit of twelve months holding period with 10% non indexation capital gains benefits. However dividend paid out by mutual fund schemes would carry lower tax rate than interest on bonds due to DDT.
Finance Bill 2014
Dividend and Income Distribution Tax
Currently according to dividend distribution tax (DDT) a lower rate of 15% is applicable but this rate is being applied on the amount paid as dividend after reduction of distribution tax by the company.Therefore, the tax is computed with reference to the net amount. Similar case is there when income is distributed by mutual funds.
Due to difference in the base of the income distributed or the dividend on which the distribution tax is calculated, the effective
tax rate is lower than the rate provided in the respective sections.In order to ensure that tax is levied on proper base, the amount of distributable income and the dividends which are actually received by the unit holder of mutual fund or shareholders of the domestic company need to be grossed up for the purpose of computing the additional tax.
Consider following example
Thus, where the amount of dividend paid or distributed by a company is Rs. 85, then DDT under the amended provision
would be calculated as follows:
Dividend amount distributed = Rs. 85
Increase by Rs. 15 [i.e. (85*0.15)/(1-0.15)]
Increased amount = Rs. 100
DDT @ 15% of Rs. 100 = Rs. 15
Tax payable u/s 115-O is Rs. 15
Dividend distributed to shareholders = Rs. 85
It will take effect from 1st October, 2014
Long-term Capital Gains on debt oriented Mutual Fund
According to the existing provisions short-term capital asset means a capital asset held by an assessee for not more than thirty six months immediately preceding the date of its transfer. However, in the case of a share held in a company or any other security listed in a recognised stock exchange in India or a unit of the Unit Trust of India or a unit of a Mutual Fund or a zero coupon bond, the period of holding for qualifying it as short-term capital asset is not more than twelve months.
The shorter period of holding of not more than twelve months for consideration as short-term capital asset was introduced for encouraging investment on stock market where prices of the securities are market determined. Now it is proposed that an unlisted security and a unit of a mutual fund (other than an equity oriented mutual fund) shall be a short-term capital asset if it is held for not more than thirty-six months.
These amendments will take effect from 1st April, 2015 and will accordingly apply, in relation to the assessment year 2015-16 and subsequent assessment years.
Tax on long-term capital gains on units
According to existing provisions where tax payable on long-term capital gains arising on transfer of a capital asset, being listed securities or unit or zero coupon bond exceeds ten per cent. of the amount of capital gains before allowing for indexation adjustment, then such excess shall be ignored. As long-term capital gains is not chargeable to tax in the case of transfer of a unit of an equity oriented fund which is liable to securities transaction tax.
It is proposed to amend the provisions to allow the concessional rate of tax of ten per cent. on long term capital gain to listed securities (other than unit) and zero coupon bonds.
This amendment will take effect from 1st April, 2015 and will accordingly apply, in relation to the assessment year 2015-16 and subsequent assessment years.