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Home >Mutual Funds >News >SBI Mutual Fund’s dividends on 2 ETFs may leave tax hole

MUMBAI : SBI Mutual Fund has declared dividends of a cumulative 2.5% on the net asset value (NAV) of its Nifty and Sensex exchange traded funds (ETFs) through February and March.

In absolute terms, the fund house paid out nearly 3,400 crore to all its unit holders on a combined asset size—of both exchange traded funds—of 137,533 crore.

While the dividends were declared to enable the Employees’ Provident Fund Organisation (EPFO) to realize some gains and pay out subscribers, retail investors may have to pay additional tax as dividends are taxed in the hands of shareholders, said a person with knowledge of the matter, seeking anonymity.

Institutions account for 90-95% of the assets under management (AUM) of the schemes, the person explained. Dividends have not been declared in the retail investor dominated schemes like the equity-linked savings scheme (ELSS) fund, he added, in order to protect investor interest.

Actively managed mutual funds have both growth and dividend options and investors can choose either. Investors can select the time and extent of profit booking through the growth plan (which offers no dividends), and can realize gains by simply selling the mutual fund units.

However, exchange traded funds do not have separate growth and dividend plans and, hence, as an industry practice, these plans do not declare dividends.

“This is probably the first instance of a manager inducing a tracking error," said Anubhav Srivastava, partner and fund manager, Infinity Alternatives.

Tracking error is the variance between the net asset value of an exchange traded fund and that of the benchmark it is tracking (say, the Nifty 50 index).

An efficient exchange traded fund will seek to minimize tracking error. “This has been done to favour the Employees’ Provident Fund Organisation at the cost of all other investors, who now have a tax incidence; that, too, at a higher rate," Srivastava added.

While most retail investors tend to be in the 10-30% tax brackets, some high net-worth individuals in the exchange traded fund may face tax rates as high as 42.7%.

Mutual funds are required to deduct tax at source (TDS) on dividends at 10%. However this rate has been reduced to 7.5% for fiscal year 2020-21.

Any investor in a higher tax bracket has to pay the difference between the tax deducted at source rate and his or her slab rate to the income tax department.

For instance, a person in the 20% bracket will have to pay 12.5% even after receiving the dividend with 7.5% TDS deducted.

The pension fund’s accounting policies may have prompted SBI MF to declare the dividend, the person mentioned above said.

If the Employees’ Provident Fund Organisation were to book gains by selling the exchange traded fund units, the amount realized would be considered as part principal repayment and part gains.

However, Employees’ Provident Fund Organisation rules require the organization to invest 15% of incremental flows in equities. Hence, a return of money in the form of principal repayment would cause the provident fund organisation to fall short of this 15% requirement.

When a dividend is declared in a mutual fund, its net asset value falls by a corresponding amount. For example, if a mutual fund with an net asset value of 10 declares a dividend of 1, its net asset value falls to 9 (adjusting for any market movements).

This makes mutual fund dividends different from dividends on stocks since they can involve some repayment of an investor’s own capital.

Taking note of this problem, in October 2020, markets regulator Securities and Exchange Board of India (Sebi) changed the name of dividend plans to ‘income distribution cum capital withdrawal option’, and required fund houses to adopt this name from 1 April 2021 for their dividend plans.

Srivastava said declaring dividends in exchange traded funds also creates a ‘reinvestment risk’, which implies that investors will not be able to reinvest the dividend at the same net asset value at which they received them, if they do not need the money.

This is because there is a time lag in payment and reinvestment and reinvestment risk causes investors to lose out on returns.

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