Budget 2018 impact: Dividend distribution tax on equity funds

Budget 2018 imposed a 10% tax on long-term capital gains from equity funds. This apart, the budget also proposed that dividends paid out by equity funds be taxed at 10%. Remember that equity funds includes balanced funds as well. So how does this dividend distribution tax affect your decisions?

Dividend reinvestment takes a hit

Every mutual fund comes with two options, growth and dividend. When you choose the dividend option, you get two sub-options, payout and reinvestment. The dividend payout option, of course, has never been a prudent choice in equity funds, since it results in you effectively booking profits in your investments, reducing compounding and wealth building. It was also not an option for regular incomes, given unpredictability of dividend payouts. We’ve always recommended the growth option to our investors.

So that brings us to dividend reinvestment. In the reinvestment option, the dividend is used to buy more units of the fund. In effect, you get the dividend in the form of additional units rather than cash.

When mutual funds declare dividends, the NAV of the dividend option goes down by the amount of dividend. In the reinvestment option, the dividend amount is used to buy additional units at this reduced NAV. Therefore, the value of your investments would neither go up nor go down. So far, this meant that returns from the dividend reinvestment option would be the same as the growth option.

However, this no longer holds because of the dividend distribution tax of 10% imposed on equity funds in the budget. Along with surcharge and cess, it works out to 11.648%. This was done to prevent arbitrage as long term capital gains from equity funds now attract a tax of 10.4%. This tax will be applicable even if your dividend is reinvested.

Once this tax comes into effect, returns from dividend reinvestment option will be lower than the growth option of the same fund. This is because in addition to deducting the dividend amount, the tax will also be reduced from the NAV. But what is reinvested is only the dividend amount. So the reinvested amount is lower than what was deducted from the NAV. Thus, your investment value reduces to the extent of tax paid. The higher the frequency of dividends, the higher will be the impact of this tax.

Impact of Dividend Distribution Tax

The following graph shows how this tax could have impacted the value of your investments in the dividend reinvestment option of HDFC Prudence. If you had invested Rs. 10,000 on 31st January, 2013, it would have grown to Rs. 22,065. However, if this tax had been applicable, it would have grown to only Rs. 20,819.

The growth option, however, remains unaffected by this tax. Hence the value of your investment in this option will still be the same as before. The gains might be taxable, but one, you have an exemption of Rs. 1 Lakh which will bring down the effective rate. Two, you pay the tax only at the time of redemption while in the dividend reinvestment option, you’re indirectly forced to bear the tax each time dividend is declared which is out of your control.

Hence, while earlier the growth and reinvestment option would have yielded the same returns, due to the dividend distribution tax, the returns of dividend reinvestment option will now be lower. An investor, therefore, has no reason to choose the dividend reinvestment option anymore. If you have selected a reinvestment option, use the tax-free window up to March 31st to switch it into the growth option (switch between options amounts to a redemption in the eyes of the tax law).

We always recommend the growth option while investing in equity to derive the full benefits of compounding.