All types of incomes are taxable. For a lay investor, the going is good till the taxation process is simple. However, several problems may arise when the tax calculation becomes complex. The final tax implication depends upon the nature of the scheme in which investment is made.

Tax-free in your hands

When dividend is paid, an individual is affected in two ways. The first is the direct impact, which is in the form of the actual receipt of dividend. Direct impact refers to what happens when a dividend is received by the investor. All dividends received by an investor are tax-free.
Suppose an investor holds 500 units in a mutual fund scheme and the scheme decides to pay the investor Rs 5 per unit, then the investor will receive Rs 2,500, which will be tax-free. This holds for investments made in debt-oriented and equity-oriented funds. In this case, the type or nature of the scheme does not affect the taxability of dividend.

Dividend distribution tax

The second impact on the individual is indirect impact. This is the tax on distribution of dividend which has to be paid by the entity paying dividends. The company, which pays dividends has to pay this tax while a mutual fund pays this tax when its scheme declares its dividend.

In case of a mutual fund, the dividend distribution tax directly impacts the net asset value (NAV) of the fund. The fund does not bear the cost of the tax itself; it is passed on to the investor through an adjustment in the NAV. Hence, though investors may feel they are not paying any tax, there is an indirect impact because their overall returns fall.

Investors need to check whether the tax is applicable to their scheme. According to the current guidelines, equity-oriented schemes do not have to pay dividend distribution tax. This spells good news for equity fund investors because for them, even the indirect tax impact is absent and hence, they are not subject to any tax.

Investors need to distinguish between equity and debt schemes. In an equity scheme, 65% of the assets of the fund are invested in equities. This means that on an average, the scheme has to keep a certain proportion of its assets in equity. Schemes classified as equity-diversified schemes, equity-linked savings schemes, sector funds, index funds and most balanced funds come under this category.

Debt schemes, on the other hand, are subject to dividend distribution tax. This is why these schemes declare two dividend figures a gross dividend and a net dividend. There is a further classification here the tax rate for individuals and Hindu Undivided Families (HUFs) is 12.5% plus surcharge plus cess while that for other entities is 20% plus surcharge plus cess. Hence, debt scheme investors take a hit on the tax front, which affects the NAV and consequently, the overall returns earned.