Do Mutual Funds Pay Dividends or Interest?

Published On: 23-May-2022

Mutual funds are investment products that create a portfolio of securities from the money invested by different investors. The investment decisions are made by professional fund managers and a team of research analysts. As compensation for the fund management services, mutual funds charge certain expenses to the scheme through Total Expense Ratio (TER) towards fund management fee, selling and distribution costs, investor awareness expenses, etc. As such, the investors can be benefited from professional fund management with relatively lower charges through mutual funds. The investors can invest in mutual funds by submitting the application form physically at any Official Points of Acceptance, through the website/ mobile app of the mutual fund house, or other digital options provided by Registrar & Transfer Agents, etc.

Mutual funds can invest in different asset classes, like equities, debt securities, gold, etc. Here is how the investors can expect returns from different asset classes:

  1. Equities – Equities represent the investment in the equity shares of different companies. Accordingly, the investment portfolio will reflect the changes in the valuation of equity shares depending upon the market prices.
  2. Debt – When one invests in debt, one is investing in debt and money market securities. Most debt securities provide fixed and guaranteed returns for the tenor of debt security. As such, the primary source of returns for a debt investor is through the accrual of interest income in the valuation of debt securities. Such accrual is reflected in the increase in the valuation of debt securities. Ceteris Paribas, the valuation of debt securities increases with each passing day, duly reflecting the interest income on such securities. However, the valuation of debt securities also changes due to changes in the issuer company's market interest rates and credit ratings. Since the debt securities are freely tradeable, the market price must reflect the prevailing interest rate scenario and not the interest rates prevailing at the time of issue of debt securities. For example, suppose the market interest rates increase after the issue of debt security. In that case, the existing debt securities issued at lower coupon rates become less favourable for the investors leading to lower valuations.
  3. Gold – When one has invested in Gold, the daily changes in the price of Gold will impact the valuation of such gold portfolio.

How are returns generated for Mutual Fund Investors?

The valuation of mutual fund units varies as per the valuation changes of the investment portfolio. Accordingly, mutual funds provide market-linked returns to the investors. While the debt portfolio of the investment portfolio may provide fixed income accrual to the investors, such portfolio is also impacted by the valuation changes due to the changes in market variables.

Here is how mutual fund investors earn returns:

  1. Capital Appreciation – Such returns can be measured by calculating the difference between the current NAV and NAV as on the date of investment. Alternatively, the difference can also be calculated between the current market valuation and the amount invested. Even when the underlying portfolio is earning returns through an interest in debt securities, the returns are considered capital appreciation only and not interest income.
  2. Dividend Income – Mutual funds must declare dividends only from the realized profits in the investment portfolio. If the portfolio has increased in valuation, but the profits are still unrealized, mutual funds cannot declare dividend. Still, the favourable changes in the portfolio valuation are reflected through capital appreciation. Further, mutual funds can declare a dividend in Income Distribution cum Capital Withdrawal plans and not under Growth plans. Once the dividend has been declared and distributed, the NAV of such plan decreases correspondingly by that amount and statutory levy, if any. As such, dividend income is not an additional income for the investors but effectively partial liquidation of the mutual fund NAV.

Taxation of Mutual Fund Returns

Here is a sneak peek into the tax provisions of mutual fund returns:

  1. Dividend Income – Dividend income is taxable in the hands of the investor at the regular tax rates applicable to the investor. As such, the investors falling in higher tax slabs, say 20%, 30%, etc. are at a loss when receiving dividend income against the tax incidence of capital appreciation. Further, the mutual fund houses must also deduct TDS @ 10% of dividend income if the dividend income exceeds Rs. 5,000 in a year.
  2. Capital Appreciation – The capital appreciation on mutual fund investments is taxed as capital gains at the time of redemption of mutual fund units, and the tax rates depend upon the portfolio composition of the mutual fund scheme. As per the Income Tax laws, an equity-oriented fund needs to invest a minimum 65% of its assets in equity securities and equity-related securities. The mutual fund schemes not complying with this asset allocation pattern are classified as non-equity oriented funds. Further, the cut-off holding period for classifying gains as Short Term Capital Gains (STCG) and Long Term Capital Gains (LTCG) differs between equity and non-equity funds. The cut-off period for equity funds is 12 months months are subject to STCG taxes in case of equity funds, while for non-equity funds, including debt funds, the specified cut-off period is 36 months. Gains from investments with shorter holding periods are classified as STCG, and gains with more extended investment periods are classified as LTCG. The tax rate for STCG from equity funds is 15% (plus applicable cess and surcharge), while the tax rate for LTCG is 10% (plus applicable cess and surcharge) without indexation benefit. Additionally, LTCG from equity shares and equity funds of Rs. 1 lakh in aggregate every year are taxed at a zero rate. In contrast, STCG from non-equity funds is taxed at regular tax rates applicable to the investor, while LTCG from debt funds is taxed at 20% (plus applicable cess and surcharge) with indexation benefit. 

As such, whatever be the source of income for the underlying securities and the corresponding changes in the valuation of the investment portfolio, the returns from mutual fund schemes are taxed as capital gains or dividend income. This depends upon whether the returns are triggered through redemption requests or the distribution of income by mutual funds.

Note: The tax provisions mentioned in the article are for illustrative purposes only and are updated as per the Union Budget 2022 presented in the Parliament in February 2022. The tax rates for capital gains will be as per the tax laws applicable on the date of redemption/ sale and not on the investment date.