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Taxation terms

While investors should consider several risk-return measures before investing, an important factor to take into account is the manner in which income or profits from investments are taxed.

twitter-logo Sameer Bhardwaj        Print Edition: September 4, 2008

While investors should consider several risk-return measures before investing in stocks, bonds, mutual funds and other financial instruments, an important factor to take into account is the manner in which income or profits from investments are taxed. As all financial instruments have varied tax structures, it would be prudent to consider the post-tax returns to compare their performances.

Take mutual funds. The dividend/income schemes of mutual funds are subject to dividend/income distribution tax, while the schemes in which the gain or profit comes from the sale of fund units (dividend/growth/bonus) are subject to capital gains tax. In the first of a two-part sub-series, let us consider the dividend distribution tax and the rates applicable to different mutual funds in 2008-9.

Dividend/income distribution tax

The income distributed by a mutual fund to the unit-holders is subject to a dividend/income distribution tax. The tax is levied on the fund, while the income/dividend received by unit-holders is tax-free. However, as the fund pays the tax from its resources, it impacts the unit-holders indirectly. This is reflected in the NAV, which is reduced by the amount of tax paid. The income distribution tax substantially affects the value of investments over a period of time due to the compounding effect. Let us look at the dividend/income distribution tax rates applicable to different fund categories:

Equity-oriented funds: These are the funds that invest more than 65% of their corpus in equity shares of domestic companies. The dividend distributed by such funds is exempt from the dividend distribution tax.

Dividend distribution tax: An example

 Equity oriented fundDebt fundLiquid or money market fund
Entry NAV (Rs)151515
Dividend/income (per unit) (Rs)222
Dividend/income distribution tax (effective tax rate)Nil0.2830.567
Ex-dividend/income NAV (Rs)1312.7212.43
Exit NAV# (Rs)16.2515.9015.54
Returns*21.67%19.31%16.95%
*Returns are calculated using the Total Returns formula (refer to Aug 7 issue of MONEY TODAY). Assuming dividends are not re-invested. # Assuming fund


Debt funds: These funds invest in medium-to-longterm debt securities like government bonds and corporate bonds/debentures. The income distributed by debt funds to individuals and HUFs are subject to an income distribution tax of 12.5%. The fund is also liable to pay a surcharge and a cess of 10% and 3%, respectively, on the tax. The effective tax rate comes to 14.16%.

Liquid or money market funds: These funds provide the benefit of liquidity and are least volatile among debt funds. These invest in short-term debt securities (which have a duration of less than a year) like commercial papers, certificates of deposit and call money. The income distributed by such funds is subject to an income distribution tax of 25%. The fund is also liable to pay a surcharge and cess of 10% and 3%, respectively, on the tax. The effective tax rate for liquid and money market funds is 28.32%.

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