With the Budget 2020 proposing that companies will not be required to pay Dividend distribution tax (DDT) and the dividend shall be taxed only in the hands of the recipients at their applicable rate, investors are wondering how to enjoy dividend cushion but reduce tax liabilities. Earlier, DDT was charged at 15% plus statutory levies, but now tax on dividend income can be as high as 30% if the investor falls in the highest-bracket plus 10% TDS. RupeeIQ discusses a few ways to manage the dividend conundrum..

Dividend play via mutual funds

Mutual funds are not taxed when they receive dividends from their investments (portfolio companies) as per the norms. So here is a strategy one can adopt to enjoy gains from dividends without paying too much taxes.

For instance, IT companies like TCS and Infosys are known to pay hefty dividends. Investors can use, for example, the theme based IT mutual funds to gain dividends benefit. If you invest in the growth plan (not the dividend plan) of any IT/technology mutual fund, you can potentially enjoy dividend benefits without paying tax on dividends. Use the systematic withdrawal plan (SWP) route for redemptions beyond one year so that you attract only Long Term Capital Gain (LTCG) tax at 10% over redemptions over Rs 1 lakh per financial year.

The MF growth plan route (including SWP) can be used by both taxpayers in lower and higher brackets without attracting tax liabilities that befall when funds pay you dividends.

In case you opt for dividend plans, there is a disadvantage: TDS on MF dividends, which has been announced in Budget 2020. TDS will be deducted at 10% for dividends above Rs 5,000 in a year. The low threshold of Rs 5,000 means that many investors will see their dividends getting paid after TDS. Of course, you can get the TDS refunded when you file the income tax return based on your tax liability.

The main disadvantages of investing in IT/technology funds is the concentration of a few stocks in the portfolio. Sectoral funds are fit for investors with high risk appetite only.

You can always use the direct equity route to hand pick IT stocks, but the strategy will not be effective for investors in highest tax slab when dividends are received.

Do note that there are some IT stocks with high promoter holding and they may not declare high dividends like in the past any longer. They could prefer paying returning cash to their promoters through buybacks instead of the dividend route.

PSU mutual funds

Government owned companies like PSUs, CPSEs etc. will continue to pay dividends to the parent i.e. the government. Government is comfortable with taking dividends from government owned firms. Even if there is any tax liability from dividends, its the government who gets the tax anyhow.

The propensity of PSUs like SBI or NTPC to pay dividends is a durable trend. There are a select mutual funds that exclusively focus on PSU funds. So, investors should latch on to them. CPSE ETF offers a ready portfolio of high dividend yield stocks.

Investors can use the PSU funds to gain dividends benefit, just like IT funds. Mutual funds are not taxed when they receive dividends due to norms, be it PSU funds or IT funds.

So, if you invest in the growth plan (not the dividend plan) of any PSU mutual fund, then you can potentially enjoy dividend benefits without paying tax on dividends.

Use the systematic withdrawal plan (SWP) route for redemptions beyond one year so that you attract only Long Term Capital Gain (LTCG) tax at 10% over redemptions over Rs 1 lakh per financial year.

The MF growth plan route (including SWP) can be used by both taxpayers in lower and higher brackets without attracting tax liabilities that befall when funds pay you dividends.

The main disadvantages of investing in PSU funds is that they are linked to government fortunes. Also, the fear of disinvestment hangs over PSU stocks. Dividends are only one way to earn profits. NAV movement is difficult to predict.

You can always use the direct equity route to hand pick PSU stocks especially in the BFSI space, but the strategy will not be effective for investors in highest tax slab when dividends are received.

MNC funds

Shares of MNC stocks like Nestle and HUL have seen demand, post the DDT move. MNCs are known to pay high dividends, which are taken by foreign parent.

A smart way to play the MNC theme is through the handful MNC mutual funds. Not only are MNC funds dependable, provide stability to your portfolio and can be a good substitute to large-caps, they also are a vehicle to get dividend benefits without getting taxed at your income tax slab.

Investors can use the MNC funds to gain dividends benefit, just like IT or PSU funds. Mutual funds are not taxed when they receive dividends due to norms, be it MNC funds or PSU funds or IT funds.

You invest in the growth plan (not the dividend plan) of any MNC mutual fund, then you can potentially enjoy dividend benefits without paying tax on dividends. MNCs will pay dividends and that will get absorbed in the NAV of growth plan.

To monetise the dividend boost, use the systematic withdrawal plan (SWP) route for redemptions beyond one year so that you attract only Long Term Capital Gain (LTCG) tax at 10% over redemptions over Rs 1 lakh per financial year.

By and large the DDT changes are negative for Indian shareholders and positive for foreign shareholders. The old question of dividend versus buyback looms again. do note that the choice will depend on the shareholder profile of the corporate in question. So, MNC companies can change track.

Flows now should get diverted to growth funds over dividend funds given LTCG/STCG tax is lower than marginal tax rate at which dividend will be taxed.

The MF growth plan route (including SWP) can be used by both taxpayers in lower and higher brackets without attracting tax liabilities that befall when funds pay you dividends.

The main disadvantages of investing in MNC funds is that the valuations of MNC stocks are at a premium to broader market due to perceived high corporate governance norms and better financial strength. Do note that MNC funds recently have shown the tendency to keep not so attractive dividend-paying stocks in their portfolio as well, which may dilute any exclusive dividend focus you may have.

You can also use the direct equity route to hand pick MNC stocks. But, this will not be effective for investors in highest tax slab when dividends are received as they will be taxed at highest rate.

Also Read

Budget 2020: TDS of 10% on your mutual fund dividends from April 1

Budget 2020: Dividend distribution tax scrapped, but shifts the burden to the recipients; high income earners to bear the brunt –

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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