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No tax benefits for short-term MF investors, says Sebi panel
November, 21st 2008

The Securities and Exchange Board of India (Sebi) is considering a proposal to remove the short-term tax benefits on dividends paid by mutual funds.

At present, investors get tax advantages when they are paid dividends. In case of equities, there is no tax on short-term (less than a year) dividend payout. For debt funds, the tax is 22.66 per cent for companies and 14.16 per cent for individuals.

This is at variance with the short-term capital gains tax of 15 per cent for equities and 33 per cent on debt. But many firms and high networth individuals exit funds after they get interim dividend. These early redemptions mean a loss in the net asset value for long-term investors.

The move, recommended by Sebis advisory committee on mutual funds, is aimed at discouraging investors to exit funds after dividend payouts.

For example, an investor has put in Rs 1 crore in an equity fund and the value of the investment goes up to Rs 1.2 crore after three months. If the investor is paid this incremental Rs 20 lakh as dividend, the amount is tax-free. On the other hand, if this investor were to book profit by selling the unit, he would have to pay 15 per cent tax on capital gains.

In case of debt, suppose an investor puts in Rs 1 crore at a 10 per cent yield with a maturity of six months and a dividend option. Just before maturity, the fund house pays the investor the dividend, say Rs 4.5 lakh. The tax rate on the returns for institutions is 22.66 per cent. For individuals, the rate is 14.16 per cent. On the other hand, if they were to pay short-term capital gains, it would be 33 per cent.

Clearly in both the cases, short-term investors save significantly 15 per cent on equities and 11 per cent (corporate) and 19 per cent (individuals) on debt.

Financial experts say this leads to a lot of tax arbitrage between investing in bank fixed deposits and mutual funds. Both companies and high net-worth individuals move money from banks fixed deposits to mutual funds because the short-term tax on bank fixed deposits is 30 per cent. By investing in mutual funds, companies and individuals are able to save on taxes, said a financial planner.

Obviously, long-term investors in these funds stand to lose when funds have to sell papers at a loss to meet redemption pressures. The net asset values (NAVs) also dip sharply leading to further losses.The Sebi panels recommendation will have to be approved by the Central Board of Direct Taxes (CBDT) and the finance ministry.

Dividend payouts by funds have been a cause of concern in the past as well. Just a couple of years back, HNIs and corporate clients would invest in a fund just days before the dividend payout. Once the dividend was paid and the funds NAV fell, the investor exited the fund. So they got the twin advantage of a tax-free dividend and booking capital losses because of the fall in the investment value.

This anomaly was removed after the finance ministry made it mandatory that anyone who invests in an MF three months before the dividend payout would have to hold it for another nine months before they can book capital losses.

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