While the Union Budget had no major surprises (pleasant or otherwise) for the mutual fund industry, there was some tinkering with regards to taxation. Also provisions were made permitting mutual funds to launch dedicated infrastructure funds and invest in overseas markets.
Let's first understand the taxation impact. The Budget has proposed that liquid and money market funds pay a dividend distribution tax (DDT) of 25%; at present, this rate is 12.5%. This marks a steep 100% increase in DDT on liquid/money market funds. DDT on all other debt funds have been maintained 12.5% for individuals; for corporates however, this rate is hiked to 20% (earlier 12.5%). DDT on equity funds remains unchanged at nil.
There is no change in the taxation of capital gains.
With these changes, this is how dividends declared by mutual funds will be taxed:
Taxation of dividends of mutual fund schemes
| Category | Tax rates for | |
| Individuals | Corporates | |
| Liquid funds | 28.3% | 28.3% |
| Other debt funds | 14.2% | 22.7% |
| Equity funds | Nil | Nil |
It is evident that with a 25% DDT, investments in liquid and money market funds are no longer remunerative for investors. In our illustration we have quantified the 'loss' to the investor under the new tax regime proposed in the budget.
DDT burns a hole in returns
| Investment in Liquid/Money Market Fund | At present | Proposed |
| Investment (Rs) | 100,000 | 100,000 |
| Yield | 9.0% | 9.0% |
| Pre-tax Return (Rs) | 9,000 | 9,000 |
| Distribution tax (incl surcharge and cess) | 14.0% | 28.3% |
| Net return | 7,738 | 6,451 |
| Effective return | 7.7% | 6.5% |
In our example, the liquid fund investor at present (DDT @12.5%) earns a net dividend of Rs 7,738. After the proposed budgetary provisions (DDT @25%), he will earn a net dividend of Rs 6,451.
The finance minister has permitted mutual funds to launch and operate dedicated infrastructure funds. It is not clear at this stage, the exact implications of this provision. There are close to a dozen dedicated infrastructure funds already; so it's not something novel. We will have to see exactly what the finance minister had in mind; when the implications are clear, we will come out with a note on the same.
Another proposal made by the finance minister with regards to mutual funds investing abroad is also something that is already happening. There is at least one dedicated mutual fund scheme that invests exclusively in global equities and there are several others that invest abroad partially. Again, at this stage it's not evident how this provision is different from existing provisions that allow mutual funds to invest abroad.
Overall, our view on the budget with regards to mutual funds is that it's rather subdued. It does not tackle the hard issues with regards taxation of gold ETFs, global funds, fund of funds (FoF) and launch of real estate funds, a much-anticipated event. One reason for this could be that the finance minister is sending out a message to investors that there are certain things that can and will happen outside the budget.
For the investor, the budget does not count as a turning point that should make him look at his portfolio all over again. Regardless of the budgetary provisions, the principles of financial planning remain unchanged. The investor must continue evaluating every investment opportunity based on his risk appetite and asset allocation.
While appraising mutual funds he must consider the track record of the mutual fund scheme, whether it has a team-based investment approach (as opposed to a fund manager-driven approach) and whether it has redeemed itself across market cycles, particularly the downturns.