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Does budget 2020 change your life as a mutual fund investor?

If you are a mutual fund investor, budget 2020 does change some things. There are three key items that have been announced in this budget. Taxation on dividends, removal of dividend distribution tax and changes in the tax treatment of side pocketing in Mutual fund portfolios.

You have possibly learnt all there is to know about the new tax regime and whether it makes sense for you to move to it or not. If you are earning over Rs 7.5 Lakhs a year, you would have probably come to the same conclusion most people in your shoes are coming to right now. Stick with the old because the deductions and exemptions truly make it gold.

 Now if you are a mutual fund investor, this budget does change some things. There are three key items that have been announced in this budget. Taxation on dividends, removal of dividend distribution tax and changes in the tax treatment of side pocketing in Mutual fund portfolios. 

 Dividends are now taxable as income in the hands of investors. Accordingly, TDS will be deducted at 10% for residents (dividend more than Rs 5000). This impacts dividend options of equity and hybrid funds that have garnered an AUM of Rs 2 lakh crore and satisfy the need for regular income.

This move also triggered some confusion on whether this move applied to all income or just dividend income. Capital gains were what experts were concerned about. As TDS on capital gains would have been quite a significant change. Fortunately, the finance ministry released a clarification stating that the TDS only applies to dividend income.

This value is 20% for NRIs on dividends more than Rs 5000 per year. NRIs will now also be taxed as a resident in India for any income that they earn in India if they are not paying tax on it in any other jurisdiction for reason of domicile or residency status.

Dividend options of mutual funds are now even more unattractive than they were before. Stick with growth or switch to it if you have not. However for regular income needs using Systematic withdrawal plans would be the wiser choice, as it had been before.

Dividend Distribution Tax has been abolished now. This could have been a welcome move but combined with taxation on dividend, this is akin to taxing the same economic activity twice. Dividends are now taxed in the hands of investors who hold the securities rather than at the company’s end. Those with significant dividend income will see a significant increase in the tax they now pay.

The decision to tax dividends in the hands of investors rather than at the company’s end makes issuing dividends a less attractive option for companies with larger promoter holdings. For those in the higher tax brackets, this might attract a high tax of 42.74% as opposed to 11.65% on equity and 29.21% on debt products.

SEBI has now pushed for AMCs to create segregated portfolios for the affected securities, also called side pocketing. A ‘side pocket’ option allows a mutual fund house to separate bad assets or risky ones from other liquid investments in a debt portfolio which could get impacted by the credit profile of underlying instruments. 

2019 saw many debt funds facing multiple rating downgrades of some of the securities held by them. DHFL, Vodafone Idea were some of the companies that saw their debt securities get hammered after a rating downgrade. Investors in certain debt funds which held these securities saw significant NAV crashes. A passive debt fund investor definitely doesn’t expect this and might be looking at heavy losses because they are not actively tracking the market.

SEBI has now pushed for AMCs to create segregated portfolios for the affected securities, also called side pocketing. A ‘side pocket’ option allows a mutual fund house to separate bad assets or risky ones from other liquid investments in a debt portfolio which could get impacted by the credit profile of underlying instruments. 

A segregated portfolio ensures that investors who wish to exit the fund can withdraw at least the healthy portion of the fund i.e the main fund without booking any loss while they continue to hold units in the segregated portfolio.

When a debt fund realises that the debt securities it had invested can be defaulted on, it is prudent to write off these securities. A side pocket puts these securities in a separate portfolio and if the fund recovers them at some point of time, then these units will have some definite value and the investors can sell their units at that time.

Such securities tend to be a small part of the fund. Fund managers create a segregated portfolio when the rating has become non-investment grade and the probability of recovery in a short time frame is low. This protects the existing investors by benefiting from the entire recovery as the portfolio for newer investors will not include these securities.

While the mutual fund companies have issued units in segregated portfolios at zero cost, the budget has specified that the cost of acquisition should be in proportion, and, the holding duration should also be in line with the holding duration of the original portfolio. The indexation benefits, if any, will be intact on the segregated portfolio. However, we also believe investors should be able to carry losses, in their tax returns, in case the segregated portfolio shows no recovery. It will be complex for SIP investors to calculate capital gains tax payable by them in case they withdraw from these funds. 

There are three things which would have been good to see in 2020 but didn’t see the light of the day. Many advisors were expecting parity in the treatment of insurance, and mutual funds under Sec. 80C and tax treatment of capital gains. LTCG does not make sense in a country with such low levels of retail participation in the financial markets. Doing away with LTCG can be combined with an increase in the LTCG duration. This is required to signal to investors that equity is an asset class that needs time. Given the risk-averse country we are, an introduction of a debt-based savings scheme under Sec 80c can support "financialisation" of savings. Hopefully, next year will be different.

This article was first published on livemint.com in February 2020

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