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Friday, Mar 01, 2002

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Implications for MF industry

Aarati Krishnan

THOUGH the MF industry is bound to rue the withdrawal of tax concessions, the move to do away with the tax-free status for dividends distributed by funds may have positive implications for the industry in the long term.

  • Funds will be forced to use performance, rather than the tax-free status of their dividends, as the selling point for their products. Over the past three years, the dividend tax exemption has ensured that even insipid performers among debt funds have managed to garner large inflows, based on their high post-tax yield, relative to other instruments.

    With dividends from MFs now being put on par with those from other debt options such as company fixed deposits, bonds and term deposits from banks, with respect to the tax treatment, there will be greater pressure on debt funds to focus on returns from their investments.

    While they may have to benchmark their returns against other debt options, mutual funds could continue to attract fresh inflows on account of superior liquidity.

  • The proposal to introduce a 10 per cent tax on dividends from equity funds and the US-64, and this only for one year, could serve as a deterrent to the practise of using equity funds as vehicle for dividend stripping. Over the past three years, equity funds have attracted hot flows from corporates and high net worth individuals on the strength of their liberal dividend payouts. These tax-free payouts helped the investor to book notional "capital losses" on the NAV to set off against capital gains from other sources. Such short-term flows have the potential to force frequent churning of the portfolio, impacting returns for the staying investors in the fund.

  • The phase-out of the dividend tax exemption would also force equity funds to refrain from making generous dividend payouts as a marketing gimmick. Given that dividends from equity funds have to come from realised gains on the portfolio and are possible only in bullish equity market conditions, equity funds are not the best vehicles to deliver regular cash flows to investors. Dividend payouts can still be used judiciously to return cash to unit holders when a fund manager feels that recent returns on the portfolio may not be sustained over a long period.

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