From April 1, SEBI’s new norms require dividend given by fund-houses to be segregated as income distribution (appreciation in net asset value, or NAV) and capital distribution (equalisation reserve) in the consolidated income statement. However, it seems that the MF industry finds it difficult to implement the rules at the investor level, and fears this could lead to taxation issues.
In the past, several hybrid funds were missold to investors with the promise of regular dividends and therefore the regulator is revamping the practice. But to understand the current situation, one needs to know the full picture.
SEBI has introduced labelling norms for the dividend options of mutual funds which came into effect from April 1, 2021. Under the new norms, mutual funds are renaming dividend options as income distribution cum capital withdrawal. Previously, the dividend options available were Dividend payout, Dividend reinvestment and Dividend transfer plan. Now, Dividend Payout will become Payout of Income Distribution cum capital withdrawal option. Dividend Reinvestment will become Reinvestment of Income Distribution cum capital withdrawal option. And, Dividend Transfer Plan will become Transfer of Income Distribution cum capital withdrawal option.
The bone of contention are terms such as capital distribution. This term, for example, may be interpreted differently by tax authorities and could pose challenges to investors. Also, fund-houses can face compliance challenges in deducting tax at source, which may cause disputes with investors.
Fund industry says segregation of income and capital distribution is done at the fund level in developed markets. Micro managing at investor level will lead to more issues.
Fund-houses want the terminology proposed by SEBI to be reviewed. They feel words such as ‘capital’ and ‘income’ should be replaced by something more appropriate so as to ensure that there are no adverse tax implications.
From a tax perspective, income distributed by MFs is taxed in the hands of investors and so TDS comes into play. So, its a Catch-22 situation. If MFs do not deduct TDS from the capital distributed among investors, the overall tax collection could fall. But If MFs choose to deduct tax on the entire quantum of distribution, there may be a TDS mismatch for investors.
There is some ambiguity with respect to the tax treatment of capital returned to investors. Plus, there is also uncertainty on whether investors will be able to adjust the cost of acquisition of the units and avail indexation benefit.