Dividend reinvestment is taxed as additional principal amount

FUND QUERIES

I have opted for dividend reinvestment option in a liquid fund. What will be the tax liability when the capital appreciates due to dividend reinvestments? Will is be the same in case of equity?

- Manoj Pruthi

Let us understand the basic principle. From a tax point of view, taking a dividend reinvestment option is no different from receiving the dividend in your bank account and then making a fresh investment of the same. The dividend received will be taxed like any other dividend (under dividend distribution tax or DDT) and the resulting purchase of fresh units will be treated like any other fresh capital investment. Any capital gains when you sell will be treated as long-term or short-term depending on the duration of investment.

Therefore, what you refer to as principal amount is not a single principal amount but a separate principal amount for each individual dividend reinvestment. Each of these individual investments will therefore become long-term on a separate date 365 days after it was invested. This is a basic principle that is applicable to all types of funds.

In the liquid fund, there will definitely be a tax liability on the capital appreciation on the principal amount at the time of redemption. If you redeem the units within 365 days from the date of purchase, then any short-term gains would be added to your income and taxed as per your tax slab. If the redemption is made after 365 days from the date of purchase, one is liable to pay a long term capital gains tax. Dividends are irrelevant to capital gains tax.

The same principle applies to equity funds. But the actual tax paid will be different. In the case of equity funds, neither dividends nor long term capital gains are taxable. Tax is paid for short-term gains only.

If I hold an Fixed Maturity Plan (FMP), a liquid fund, or a debt fund for more than a year, what will be the tax treatment? Please consider dividend as well as growth plans.

- D Gupta

If debt funds, including FMP and liquid funds, are sold after 365 days from the date of purchase; then any capital gains/loss made would be treated as long-term in nature. The investor would be liable to pay long term capital gains tax at the time of the redemption of units. Following is the tax calculation for long term capital gains for both, dividend as well as growth.

For long-term investment in Liquid fund we can clearly see that the investors in the growth option would be better off than the Dividend option.
 

Debt Funds	Dividend	Growth
Initial Investment	100000	100000
Return @ 10%	10000	10000
Dividend @ 2%	2000	N.A.
Capital Appreciation	8000	10000
DDT @ 14.163%	248	N.A.
LTCG@11.33%	906	1133
Net Realisation	108846	108867

I want to know how is the income from Monthly Income Plan (MIP) is taxed?

- Shailesh Rawat

Tax Returns from MIPs are taxed depending on the way an investor derives them. If you opt for dividend plan, then all debt funds including MIPs are liable for dividend distribution tax (DDT) of 12.5% of the dividend amount.

If you choose the growth plan, all gains will be treated as short-term or long-term depending on your period of holding. Any short-term gain (for holding of less than 1 year) from debt funds is added to your income. Long-term gain from MIPs is taxed at 10 per cent without indexation and 20% with indexation.

Deriving gain from an MIP (growth option) through Systematic Withdrawal Plan (SWP) could be more tax-efficient than dividend plan. SWP is redemption of units worth a predefined amount and periodicity. Besides, you will also have a greater control on your cash inflows. However, you should be conservative in your regular withdrawal.

Else you run the risk of eating into your capital.

SWP entails a stable payout to investors at predetermined intervals. But this would make sense only if the investor starts withdrawing after a year.

Suppose you invest Rs 100,000 on June 1, 2006 in a fund. To keep matters simple we are assuming that you would receive a regular dividend of 0.9 per cent each month. Every month you would get Rs 788 in hand after deduction of dividend distribution tax. But in case of growth plan with monthly SWP of Rs 900, you would have to just pay the long term capital gains tax. And this long term capital gains tax is much lesser than the DDT.

The table provided below would help you understand this better.
 

	Rs
Initial Investment (June 1, 2006)	100000
Units Allotted at Rs 10	10000
Dividend Plan
Monthly Dividend at 0.9 per cent	900
Income in Hand	788
Total Income	9460

 

Growth Plan
Month	NAV Rs	SWP Rs	Post Tax  Return (Rs)
1-Jul-07	13.00	900	879.23
1-Aug-07	13.10	900	878.70
1-Sep-07	13.20	900	878.18
1-Oct-07	13.30	900	877.67
1-Nov-07	13.40	900	877.16
1-Dec-07	13.50	900	876.67
1-Jan-08	13.60	900	876.18
1-Feb-08	13.70	900	875.69
1-Mar-08	13.80	900	875.22
1-Apr-08	13.90	900	874.75
1-May-08	14.00	900	874.29
1-Jun-08	14.10	900	873.83
Total Income			10517.00