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Will MF dividends continue to be tax-free?

Aabhas Pandya

The fund industry is keeping its fingers crossed as the budget draws closer. With talks abound of the government losing substantial revenue due to dividend stripping, the obvious question is whether the tax-free status on mutual fund (MF) dividends will be withdrawn.

Dividend payout from open-end funds with more than 50 per cent allocation to equities is tax-free for investors till 2002. The three-year tax-free status was bestowed upon this category of schemes in 1999 to encourage investments in equities through mutual funds. The move was also aimed at resurrecting the country's largest fund, US-64 that manages assets of over Rs 200 billion.

However, both corporates and high networth individuals (HNIs) are believed to have used this "loophole" to the hilt and converted a part of their earnings into tax-free income. Besides, the notional losses on account of redemption at a lower net asset value (NAV) are adjusted against any gains in that fiscal.

"This modus operandi is perfectly legal. Now, it is for the government to see how it can prevent loss of revenue,'' said the chief investment officer of a mutual fund.

Dividend stripping works to the advantage of the asset management company (AMC) as well, which earns a sizeable income on account of entry and exit loads. According to industry sources, around Rs 130 billion of "hot" money flowed into equity funds that doled out dividends last year.

"The government is estimated to have lost anywhere between Rs 40-50 billion on account of dividend-stripping, given the tax rate of 30 per cent for HNIs and 38.5 per cent for corporates,'' said an official with a leading mutual fund.

So, is the budget going to take away the tax-free status of dividends from equity funds? The fund industry thinks otherwise and expects the benefit to continue till 2002.

"We believe that the tax breaks on dividends will continue. However, even if the current status is withdrawn, money will flow into the growth option,'' said Prakash Dalal of Kotak Mahindra Mutual Fund.

Vivek Reddy, CEO, Kothari Pioneer Mutual Fund echoed Dalal's viewpoint.

"The Budget in 1999 exempted open end equity oriented schemes from distribution tax for 3 years, which means that investors in these funds will enjoy tax breaks till March 31, 2002. Tax-free dividends are good incentives for equity investments. This is necessary, especially, at this stage when the markets require broad-based participation from retail investors."

Nonetheless, the budget is largely expected to plug the loophole.

"The government may put a lock-in period in place for funds that dole out dividends. Even a seven-day lock-in will keep short-term investors at bay since that exposes them to vagaries of the market. Thus, while it will effectively kill dividend stripping, long-term investors will continue to earn a tax-free payout,'' said the head of a distribution company.

Prakash Dalal of Kotak said, "restrictions may be put on investors who enter on dividend record dates with the purpose of exiting immediately after the NAV is X-dividend.'' In fact, some AMCs like Alliance Capital already have a seven-day lock-in on investments in their funds.

Yet, amidst the raging debate on the tax status, million-dollar question is whether investors in equity funds need a dividend option at all?

Equity funds are a vehicle for long-term wealth creation and are not structured to facilitate frequent payouts.

"Ironically, the current scenario is such where debt funds with small payouts attract a 22 per cent tax while equity funds with hefty dividends do not attract any tax. Thus, investors are opting for growth option in bond funds, otherwise ideal for regular income,'' says the CEO of a mutual fund.

Courtesy the budget, investors' preferences have surely gone topsy-turvy!

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