The principle works only for long-term investors of non-equity schemes.

Given a choice between paying tax at a higher rate or a lower rate on the same instrument, what would you choose? Or, to rephrase the question: given a choice between paying tax at 30 per cent or at 12.5 per cent, what will you choose?

The obvious answer would be 12.5 per cent, since it is lower. However, one could benefit by paying tax at the higher rate.

This is no trickery with numbers; it's just plain mathematics and one can practically implement this tax manoeuvre.

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It is easy to guess the significance of the numbers. The maximum tax rate payable is 30 per cent and 12.5 per cent is the rate of dividend distribution tax applicable to non-equity schemes. (The education cess of three per cent is being ignored for simplicity purposes).

With equity schemes beckoning left, right and centre, coupled with the market exploring the stratosphere, why are we even talking of non-equity schemes? The reason is on account of asset allocation.

Every portfolio, irrespective of how aggressive the investor is, should contain a fixed income portion. It is possible to optimally operate this fixed income allocation in one's portfolio.

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Investment strategy

Let us understand the investment strategy by taking the example of two individuals. Naresh and Sachin, both belonging to the 30 per cent zone, have invested Rs 10 lakh in a non-equity scheme.

The scheme is a regular, run of the mill, assembly line income scheme. It has earned a distributable profit of 10 per cent. This works out to Rs 1 lakh on the originally invested capital of Rs 10 lakh.

Naresh has chosen the dividend option. His objective is to make the investment, sit back and enjoy the tax-free income.

On the other hand, Sachin has chosen the growth option and withdraws Rs 1 lakh just a day before completion of one year.

Note that this is the same amount as Naresh receives as dividend. However, for Sachin the withdrawn amount represents short-term capital gain.

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Going through a bit of number crunching - nothing serious, just some additions and multiplications, you will see the results are interesting.

Now, 10 per cent of Rs 10 lakh works out to Rs 1,00,000. But Naresh gets a dividend of only Rs  88,889. Why? The mutual fund  (MF) has to pay a distribution tax of Rs  11,111.

The math is simple: 11,111 is 12.5 per cent of 88,889 and 88,889 plus 11,111 equals 1,00,000.

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Tax liability

Let's see what happens in Sachin's case. Since he has chosen the growth option, in one year at 10 per cent, the NAV would have grown to Rs 11.

To redeem Rs 1,00,000, he would need to sell 9,091 units (100,000 divided by 11). Let's quickly calculate the tax.

Though Sachin has sold units worth Rs 1,00,000, the entire amount is not taxed. It is only the capital gain that will be taxed! The capital portion of Rs  1,00,000 is 1,00,000 into 10 divided by 11, around Rs  90,910 (rounded off).

Thus, the capital gain works out to just Rs 9,090 and the tax thereon at 30 per cent is Rs  2,727. Net take-home for Sachin is Rs 97,273, compared to Rs 88,889 for Naresh, almost Rs 10,000 higher.

In the end, both have their original investment intact. In other words, here, 30 per cent works out to be lower than 12.5 per cent.

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Looking at it another way - when the mutual fund pays you income, it is called dividend. Instead of dividend, if you withdraw the same amount of money from the mutual fund, it's short-term capital gains.

The objective of this exercise is to demonstrate that earning short-term capital gains is better than earning dividend income.

Suppose Sachin was in a lower tax zone, his take-home would be much higher.

But there would be no such benefit for Naresh. He would have to bear the same amount of tax, notwithstanding whatever tax slab he came under.

Also, if Sachin had been able to wait for only two additional days before applying for repurchase, he would be in a position to take advantage of the 10 per cent long-term rate, thereby still lowering his tax liability.

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In conclusion

The general misconception is that there is no advantage in earning short-term gain, since it is taxed at the normal rates.

However many do not realise  that, the advantage flows from the fact that a large portion of withdrawals is capital and, simultaneously, an equal amount from the income gets converted into capital.

In other words, you are consuming capital and investing income.

Obviously, this principle would work only for the long-term investor. If you have a short-term view and were to sell your entire holding at one go, this investing strategy will not work.

However, if your holding period is more than one year, then investing income and consuming capital is the way to go.

Look at it any which way, the only way to make the dividend truly tax-free is to avoid it altogether. The rule is simple - no dividend, no tax!!

The writer is director, Wonderland Consultants