The Hindu Business Line : MF must look beyond dividend plans

THE mutual fund industry is hoping the Government will remove distribution tax in the coming Budget. At present, dividends paid by mutual funds are tax-exempt for investors. Each fund instead pays a 12.5 per cent distribution tax, which is charged to the net asset value (NAV). In essence, the distribution tax acts as a dividend-tax deducted at source. Investors in growth plans, however, pay 20 per cent capital gains tax on an inflation-adjusted basis or 10 per cent tax on non-inflation adjusted basis.

The differential tax treatment for dividends and capital gains creates a fictitious demarcation between growth and dividend schemes. This is ironical because most funds manage one portfolio for growth and dividend plans. The differential tax treatment could lead to sub-optimal returns. Besides, it requires the portfolio manager to move a sizable proportion of the assets into cash each time the fund declares dividend. Finally, it attracts arbitrageurs who take advantage of the tax laws for dividend stripping. The mutual fund industry should, hence, take a concerted effort to do away with the dividend plans.

One portfolio, two plans: Growth and dividend plans are typically managed through one portfolio. This could theoretically lead to a cash drag for unit-holders of growth plan. The reason is that the portfolio manager has to maintain sufficient cash to pay dividends. Because of a single portfolio, it may be difficult for fund-houses to charge the implicit cost (impact cost and cash drag) of dividend payments to the dividend plan. Of course, proving that there is a cash drag on the growth plan is difficult. A portfolio manager may defend a fund's higher cash holding by stating that he holds it for normal asset allocation purpose.

Homemade dividends: In any case, investors need to buy large number of units for such dividends to provide sizable supplementary cash flows to fund monthly household budgets. Essentially then, the biggest beneficiary of dividend plans is high net worth investors. The reason is that these individuals pay just 12.5 per cent distribution tax as a charge on the NAV. They would have to pay 20 per cent inflation-adjusted capital gains tax for growth plans.

Retail investors can anyway redeem units to create cash flows when required. Fund-houses also provide a systematic withdrawal plan, where the unit-holders can redeem units at periodic intervals. Dividend plans are, hence, largely irrelevant for retail investors in much the same way as Modigliani-Miller argued in their dividend irrelevance theory.

Arbitrageurs: The tax laws also make it worthwhile to engage in dividend stripping. At present, unit-holders have to invest at least 90 days before the record date for dividend payments and thereafter hold the units for another 90 days to avail tax benefits. The tax benefit is this: investors will typically redeem the units at lower than the purchase price because of the dividend payout. The loss on redemption can be set off against capital gains, thus, providing a good tax shelter for investors.

The problem with dividend stripping is the cash drag on the common portfolio, and hence on the unit-holders of the growth plan. When sizable arbitrage money moves in and out of the fund, its portfolio composition will change. There is, therefore burden due to impact cost as well.

In the light of these factors, the mutual fund industry should seriously consider discontinuing the practice of offering dividend plans to unit-holders. Mutual fund investment is supposedly a long-term investment. Dividend plans could force portfolio managers to think short-term. Investors have to generate their monthly cash flow requirements from bond investments, not from dividend plans offered by equity mutual funds.

(Feedback can be sent to bvenky@thehindu.co.in)

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