Growth Versus Dividend Option - Tax Liability

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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 maneuver.

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.

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 `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 `1lakh on the originally invested capital of `10 lakh.

Naresh has chosen the dividend option. His objective is make the investment, sit back and enjoy the tax-free income. On the other hand, Sachin has chosen the growth option and withdraws `1lakh just aday before completion of one year. Note that this is the same amount as Naresh receives as dividend. However, for Sachin the withdrawn amount represents shortterm capital gain.

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

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 `11. To redeem `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 1,00,000, the entire amount is not taxed. It is only the capital gain that will be taxed! The capital portion of `1,00,000 is 1,00,000 into 10 divided by 11, around `90,910 (rounded off). Thus, the capital gain works take-home for Sachin is `97,273, compared to `88,889 for Naresh, almost 10,000 higher. The table summarises what we just discussed.

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.

Looking at it another way - when the mutual fund pays you income, it's 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 shortterm 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

TO CONCLUDE

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 ashort-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!!

 

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