If you are a mutual fund investor, from April 1, 2020 there are key changes that have taken effect, which impact mutual funds. Let us explain them to you in detail so that you can take informed decisions. Read on.

Tax treatment of dividend received from MFs in the hands of unitholders

Earlier, dividend income received from mutual funds was exempt in the hands of the unitholders (resident as well as non-resident) under section 10(35) of the Income-tax Act, 1961. Also, the mutual fund was required to pay dividend distribution tax (DDT) on the amount of dividend under section 115R of the Act.

The Finance Act, 2020 has removed the levy of DDT in the hands of the mutual fund and adopted the classical system of dividend taxation under which the mutual funds would not be required to pay DDT. Instead, the dividend will be taxed only in the hands of the unitholders. The new change is applicable w.e.f. April 1, 2020 and applies from financial year 2020-21.

All types of mutual fund schemes are covered under the new tax regime, i.e. equity oriented and other than equity oriented mutual fund schemes under dividend payout and dividend reinvestment options. “For the reinvestment schemes whenever dividend is declared by MF, units will be allotted for the net amount post TDS (tax deducted at source) and the investor will be required to compute tax on the same and claim credit of the TDS,” Nippon India MF says.

This impacts dividend options of equity and hybrid funds that garnered huge AUMs by promising regular income via dividends. Shifting to growth plans of mutual funds will help you avoid this dividend and tax related issues.

Tax deducted at source on MF dividend income

The TDS only applies to dividend income. TDS or Tax Deducted at Source is required to be deducted at the time of credit of any income to the account of the unitholder or payment of any income to unitholder. As per section 194K of the Income tax Act, TDS at the rate of 10% should be deducted on dividend income credited/paid to resident unitholders. If PAN of unitholder is not available, then TDS rate is 20%.

Section 194K of the Act provides for a threshold of Rs 5,000 in aggregate for the financial year. In simple terms, this means if your dividend income is over Rs 5,000 in a financial year, TDS will be deducted ideally. It it is lower than Rs 5,000 in a financial year, no TDS will be deducted ideally. The threshold limit of Rs 5,000 is applicable for aggregate dividend credited /paid in a financial year. The same is computed at the individual PAN level.

But, some fund-houses are going to deduct TDS even if the threshold is not reached. “…on account of practical difficulties involved due to unique nature of mutual fund investments and different schemes involved, HDFC Mutual Fund shall deduct TDS from each dividend declared i.e. even without reaching Rs 5,000 threshold. In case of total TDS exceeding the actual tax liability of any investor, he/she can claim refund while filing income-tax return,” says HDFC MF. The TDS certificate shall be generated on the TRACES portal by the Mutual Fund and issued to the unitholders on a quarterly basis.

As per section 196A of the Income Tax Act, TDS at the rate of 20% (plus applicable surcharge and cess) should be deducted on dividend income credited / paid to non-resident unitholders (other than FII/FPI). There is no threshold limit applicable in case of dividend income credited / paid to non-resident unitholders.

If you don’t want TDS to be deducted, you can submit Form No. 15G to mutual fund provided that the tax on estimated total income (including such dividend received from mutual fund) of the financial year is nil, or submit Form No. 15H (for senior citizens) to mutual fund provided that the tax on estimated total income (including such dividend received from mutual fund) of the financial year is nil. Submit the applicable form on an annual basis at the start of the financial year.

Tax rationalisation for segregated portfolios in MFs

The year 2019 saw many debt funds facing multiple rating downgrades and were forced to create segregated portfolios for the affected securities, called side pocketing. A side pocket allows a mutual fund house to separate bad assets or risky ones from other liquid investments in a debt portfolio scheme.

Previously, units in the side pocket were considered created on the day the portfolio segregation, and not on the day the original investment was made for taxation purposes. This meant that investors could end up paying a higher tax for the gains made during recovery. With a side pocket, investors, who took the hit when the credit event happened, get the full upside of a future recovery. When recovery is made in the side pocketed portfolio, the same is distributed among investors on a pro-rata basis.

This tax anomaly for side pocket has been changed. While the mutual fund companies issued units in segregated portfolios at zero cost, the cost of acquisition will be in proportion, and, the holding duration will also be in line with the holding duration of the original portfolio. The indexation benefits, if any, will be intact on the segregated portfolio. This will take effect from 1st April, 2020 and will, accordingly, apply in relation to the assessment year 2020-21 and subsequent assessment years.

Kumar Shankar Roy

Kumar Shankar Roy is contributing editor with RupeeIQ. Kumar is a financial journalist, with a functional experience of 15 years. He tracks mutual funds, insurance, pension, PMS, fixed income/debt and alternative investments markets closely. He has worked for The Times of India, The Hindu Business Line, Deccan Chronicle Group, DNA, and Value Research, among others, across different cities in India. He is deeply interested in marrying data insights with actionable opinion. He can be contacted at [email protected].

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