DDT may compel change in strategy for domestic funds

Domestic fund houses may have to realign their dividend distribution strategy following the introduction of the dividend distribution tax (DDT) on equity-oriented units, as investors may end up paying higher tax.

DDT, mutual funds (MFs) will force the industry to stop mis-selling of balanced funds that declare a monthly dividend, as the new tax regime will ensure there is no arbitrage between dividend and growth schemes.

In fact, there was a lot of mis-selling of balanced funds that declare a monthly dividend, which is evident from the fact that the average balanced fund size is now Rs 5,000 crore as against the average equity large-cap fund of Rs 2,000 crore.

Experts also feel that the introduction of 10 per cent tax on dividends would ensure there is no arbitrage between dividend and growth schemes.

The mutual fund industry feels that the LTCG tax introduced in the budget will not have any major impact on the inflows into equity schemes as the growth opportunity in the asset class is much better than any other assets.

The knee-jerk reaction in the market is only a short-term phenomenon and the market has overreacted to the government move.

Says Nilesh Shah, managing director, Kotak Mutual Fund, “I think we should not be blaming LTCG because it has been introduced with grand fathering. This is probably a function of two factors -- the cost of capital has started moving up and the other thing is that the valuations were also very high.”  The new LTCG tax has been introduced with grandfathering of gains till January 31, 2018, which minimises any potential short-term disruptions.

“While the tax is not conducive for the market, the fact that equity instruments still attract the lowest rate of tax means that the asset class will continue to see good flows. There, however, may be some knee jerk reaction in the short term,” notes Chandresh Nigam, MD & CEO, Axis Mutual Fund.

Experts point out that LTCG tax is only on gains and given the high growth potential of the Indian economy, the modest 10 per cent tax on LTCG tax should not be a big concern to investors.

The big negative surprise for the fund industry was the proposal to introduce a tax on distributed income by equity oriented mutual fund at the rate of 10 per cent, as the government tried to provide a level playing field across growth-oriented funds and dividend-distributing funds.

Some industry players predict that this will end mis-selling of products. “The biggest mistakes are made when something which embodies risk is presented as low risk under the garb of regular tax-free dividends. The tax on dividends will surely preclude one such misrepresented product. The funds may still continue to declare monthly dividend, it's just the attractiveness of the dividend will decline,” points out Aashish Somaiyaa, MD & CEO, Motilal Oswal AMC.

Mutual fund investments have seen a huge rise in inflows and were big drivers of the current rally. Domestic funds had invested a staggering over Rs 1 lakh crore in the stock market last year, much higher than over Rs 48,000 crore infused in 2016 and more than Rs 70,000 crore during 2015.

Deepak Jasani, head-retail research, HDFC Securities, says “What is relevant for investors in mutual funds is the net return earned on their investments. Even after the introduction of DDT, if the expected net return from these funds is higher than other alternatives on a post tax basis, they could continue to invest in these schemes (preferably in SIP mode).”

Industry experts said investors should be concerned with post tax return earned from Indian equities over their time horizon compared to other alternative avenues.