Operational and compliance challenges foreseen for fund houses in deducting tax at source, resulting in possible TDS mismatches and disputes with investors.
The Securities and Exchange Board of India's (Sebi’s) dividend diktat that came into effect from April 1 may compel fund houses to declare dividends less frequently or eschew such declarations altogether.
The new norms require dividends doled out by fund houses to be segregated as income distribution (appreciation in net asset value, or NAV) and capital distribution (equalisation reserve) in the consolidated income statement.
This can result in operational and compliance challenges for fund houses in deducting tax at source (TDS), resulting in possible TDS mismatches and disputes with investors.
"As things stand, one can expect dividend declarations to reduce substantially. We (as a fund house) are under no compulsion to declare dividend and won't be doing so this year," said the chief executive of a fund house.
Dividend plans have become less popular with investors after the Budget 2020 made dividends taxable in the hands of investors.
Sebi's new dividend diktat will make it unattractive for fund houses to declare dividends, as well, the chief executive said.
Swarup Mohanty, CEO, Mirae Asset Management, echoed that dividends declared by MFs may come down drastically this year, as abiding by the new dividend diktat can be operationally cumbersome.
He said the genesis of the problem lies in the manner in which balanced hybrid funds were mis-sold in the past two years as products that could provide consistent dividends.
"Several investors were unaware that their income was returned to them as dividend," Mohanty said.
"Under the new regime, investors will know what part of the money coming back is part of the capital and what is the actual dividend."
Assets of dividend plans amounted to over Rs 3.98 trillion as of March 31, 2021, according to Value Research data.
Experts reckon the new dividend diktat will make systematic withdrawal plans (SWPs) more popular for investors who need regular income as it does away with the need for income declaration and calculating tax to be paid on it.
"We have been advocating growth plans over dividend plans for quite some time now.
"We also recommend SWPs over dividend plans for investors who need income as investors can control the amount they need from such plans.
"Also, redemptions under SWPs from equity schemes are exempt from tax up to Rs 1 lakh if they constitute long-term capital gains," said Amol Joshi, a distributor.
An SWP allows investors to set an amount they want to withdraw regularly and the frequency at which it needs to be withdrawn.
When a unit is sold, and the sale price (NAV) is higher than the face value of the unit, a portion of the sale price that represents realised gains has to be credited to an equalisation reserve account, which can be used to pay dividend, the new dividend norms suggest.
Income distributed by MFs is taxable in the hands of investors and liable to tax deducted at source (TDS).
If MFs do not deduct TDS from the capital distributed among investors, the overall tax collection can fall, resulting in a revenue loss for the government.
If MFs choose to deduct tax on the entire quantum of distribution made, there may be TDS mismatches for investors, if it transpires that there is no tax to be paid on the capital distribution portion of the dividend paid.
The MF industry has consulted tax experts and has been advised that capital distribution may be interpreted differently by tax authorities and pose challenges to investors.
While income distributed is taxable in the hands of investors and subject to TDS, there is ambiguity with respect to the tax treatment of capital returned to investors.
There is also uncertainty about whether investors will be able to adjust the cost of acquisition of units and avail of indexation benefits.
The segregation will be difficult in the case of ETFs as it is difficult to determine at what price investors traded the units.