While investing in mutual fund schemes, investors can choose from the dividend or growth option. When it comes to fixed income funds, both the options have certain advantages. But there are some factors to be considered before you make your choice. CASH FLOW NEEDS The primary criterion for choosing an option is cash flow requirements .
If there is no interim cash flow requirement, the growth option is better; in this option, the returns are reflected in the movement of the NAV. There are also no hassles in investing the interim cash flows. If there is requirement for interim cash flows from the investment , then the dividend option is better. The frequency of the dividends would be as per the requirements of the investor and the availability of the dividend frequency options (monthly, quarterly, etc) in the fund.
The asset management company (AMC) endeavours to maintain the stated dividend frequency, subject to availability of distributable surplus. TAX TREATMENT The other relevant parameter is the tax efficiency of the returns being taken home through the dividend and growth options. Dividends are tax-free in the hands of the investor, but there is a dividend distribution tax (DDT) that is deducted by the AMC on behalf of the investor and passed on to the government.
The rate of the DDT in case of liquid funds is 25% (plus surcharge/cess). For non-liquid fixed income funds, there are two rates of DDT: for individual /HUF investors, it is 12.5% (plus surcharge/cess) and for corporate investors, the rate is 20% (plus surcharge/cess). From June 1, the DDT rate for corporate investors has gone up to 30% for all categories of fixed income funds. In the growth option, the gains are taxable in the hands of the investor, ie, there is no distribution tax. As per the current tax laws, the growth option taxation depends on the holding period: returns from mutual fund units held for a period of less than a year are called short-term capital gains (STCG), and from holdings of more than a year are long-term capital gains (LTCG).
STCG is taxable at the slab rates for individuals; most investors nowadays are in the highest tax bracket of 30% (plus cess). In case of LTCG, the investor has the choice of paying the incometax either at 10% (plus cess) without taking the benefit of cost inflation index or at 20% (plus cess) after taking the benefit of cost indexation. As we see from the tax structure , as per the current tax laws, the choice of dividend/growth option should be based on the intended holding period.
For a horizon of less than a year, the dividend option is better as the individual DDT rate of 12.5% (plus surcharge/cess) is lower than the STCG rate of 30% (plus cess). The only exception to this would be an individual who is in the 10% tax slab, for whom the STCG tax rate would be lower, but that would be a rare case. For a horizon of more than a year, the growth option is preferable , as the 10% (without indexation ) rate is lower than the current DDT rates. The investor should opt for the 20% rate only if the net tax incidence (with indexation benefit) is lower than the 10% rate. EFFECTS OF DTC So far so good, in that the choice between dividend and growth options is based on cash flow requirements and tax efficiency.
The grey area comes with the proposed Direct Tax Code (DTC), scheduled to be implemented from April 1, 2012. It is a grey area because at this point of time, it is aproposalwhichisyettobemade into law and may undergo changes by the time it is implemented. As per the proposals, the returns from the dividend option will be clubbed with the income of the investor (ie, there would be no distribution tax) and would be taxable at the slab rates.
In the growth option, there would be no distinction between short-term and long-term holdings as such, but the benefit of indexation would be applicable for a holding period of one year from the end of the financial year in which the asset is acquired . The taxation on the growth option would be as per the slab rates, which means 30% for most investors. Since both dividend and growth options would be taxable at the hands of the investor, there would not be much of a difference in terms of taxation except where the intended holding period would be enough to be eligible for indexation benefit. In that case, the growth option would be more tax efficient.
Joydeep Sen
(CFP, Sr Vice-President - Advisory Desk BNP Paribas Wealth Management)
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