Mutual funds have gained huge popularity in recent years and have become a good investment option for investors over the period of time. Even during the nationwide lockdown last year there was an increase in the overall SIP contributions in India. The tax structure on mutual funds also has seen a change through the Finance Act of 2020 with the re-introduction of section 194K of the Income Tax Act, 1961.
Given below are a few details of section 194K and its impact on investors.
Comparison between old tax regime and new tax regime
Prior to the re-introduction of section 194K, mutual funds were subject to Securities Transaction Tax (STT) which was introduced in Finance Act 2004 by former Finance Minister Mr. Jaswant Singh. Under the old tax regime, investors were liable to pay STT on mutual fund transactions which served as an effective tool against evasion of tax on capital gains. Also, mutual fund houses were required to pay an additional tax (under section 115R of the Income Tax Axt, 1961) in the form of Dividend Distribution Tax (DDT) for income distributed to the unitholders as dividends.
As per the amendment in the Income Tax Act, 1961 through Finance Act 2020, Finance Minister Nirmala Sitharaman has revoked the levy of DDT applicable on mutual fund transactions. Under the new tax regime, mutual funds houses are not liable to pay DDT on the dividends declared. Such dividend income will be taxable at the hands of the taxpayers and will be taxed based on their applicable slab rates.
Mutual funds will have to deduct TDS at the rate of 10% for the dividends paid to the unitholders, provided that such dividend amount exceeds Rs. 5,000 for each recipient in any financial year.
It is also to be noted that such TDS will be deducted only on dividend payments and not on capital gains arising out of redemption of mutual funds.
Who can deduct TDS under Section 194K?
Section 194K not only specifies the rate of deduction but also the occasions of such TDS being deducted by the AMCs. According to section 194K, the responsibility to deduct TDS is on any person who is required to pay income to a resident Indian related to any of the following,
- Units of mutual funds
- Units from the Administrator of specified undertakings
- Units from the specified company
Applicability of Section 194K
The provisions of section 194K are applicable to all mutual fund schemes whether they are regular plans or direct plans. The investment options of the mutual fund schemes are available in either growth plans or dividend plans. The broad categories for such classification based on investment objective is,
- Dividend reinvestment option
- Dividend payment option
- Growth option
Section 194K will apply to all such schemes that require payment of dividends to the investors.
In the dividend payment option, AMC will have to deduct TDS at the rate of 10% before remitting the same to the investor (provided the total dividend for the year is more than Rs. 5,000). In the case of the re-investment option, it is to be noted that reinvesting the dividends is also considered the same as paying the dividend to the investor and hence is liable for deduction of TDS under section 194K.
Payment under the growth options is made to the investor at the time of redemption of the investment. The gains generated are capital gains of a short-term or long-term nature. Such capital gains are outside the scope of section 194K.
The other cases where the mutual funds will not be required to deduct TDS on payments made to the investor is when the dividend to be paid is less than Rs. 5,000. In such a case, provisions of section 194K do not apply. However, if the total dividend income increases over Rs. 5,000, TDS will be deducted on the entire dividend income and not just the excess.
Rate of TDS under Section 194K
The applicable rate of deduction prescribed under section 194K is 10%. After the deduction of TDS, the same will be reflected in Form 26AS. Investors can file their income tax return if the total tax liability is NIL or if the final tax to be paid is less than actually deducted.
The rate of 10% is applicable in a case where the investor has provided the PAN and Aadhar Number to the deductor. When there is no PAN or Aadhaar Number that is provided to the deductor, the applicable rate of TDS is 20%. As PAN is mandatory for opening a mutual fund, the case of higher TDS is quite rare.
Impact on investors
The introduction of section 194K has made dividend income taxable in the hands of the investors. This has resulted in a direct increase in the tax liability of the investors. Small investors may not be affected in a huge way (especially those who do not have dividend income of more than Rs. 5,000 in any financial year). However, for investors that have a significant chunk of investments in the dividend plans that lead to huge dividend income, this section can be a game-changer.
Re-introduction of section 194K will result in a reduction of their dividend income as well as increase their tax liability. The impact of the addition 194K will be significant for the taxpayers under the highest tax bracket as their dividend income will be taxed at the highest rate of tax when it was previously tax-free. This may turn them away from the dividend funds and make them move towards growth funds if the former no longer provides cost-effective returns.
Investors of equity funds or debt funds will be better off having their returns in the form of capital gains in the growth plan regardless of the gains being short-term or long-term. For equity funds, short-term gains will be taxed at 15% instead of the highest tax bracket whereas long-term gains will be taxed at 10% after the tax exemption up to gains of Rs. 1,00,000. In the case of debt funds, short-term funds will be taxed at slab rates whereas long-term funds will be taxed at 20% after the benefit of indexation.
Consequences of not deducting or delay in depositing TDS
The provisions of section 194K are mandatorily applicable on all the dividend payments from mutual fund schemes. Non-payment or non-deduction of the TDS will attract interest and penalty on the investor. The details of the same are mentioned below.
- Interest at the rate of 1% is charged in case of non-deduction of TDS. Such interest is charged from the date when the tax was deductible till the time it is actually deducted for every month or part of the month.
- Interest at the rate of 1.5% is charged in case of non-payment of TDS after the tax is dedicated. Such interest is charged from the date when the tax was deducted till the time the tax is paid to the government for every month or part of the month.
- penalty under section 271C along with the interest amount is also applicable for non-payment or non-deduction of TDS. The amount of penalty will be equal to the amount of TDS not deducted or not paid to the government.
- Non-deduction and non-payment of TDS will also result in disallowance of expenditure under section 40(a)(ia).
Section 194K is re-introduced in the Income Tax Act, 1961 to modify the incidence of tax on dividends from the AMC to the individual investors. This shift has resulted in the dividend being taxed at the slab rates of the investors.
The basic exemption limit for individuals under Income Tax Act is Rs.2,50,000 under old tax regime.
TDS on dividends received from mutual funds is taxed at the rate of 10%. However, if the investor has not furnished a PAN card then the applicable rate of tax is 20%. So in order to avoid the excess TDS, it is important to provide PAN to the deductor.
No. Sec 194K does not apply in the case of non-residents. Section 196A will be applicable in the case of non-residents. This section requires TDS to be deducted at the rate of 20% (excluding applicable cess and surcharge) for the dividend income paid or credited to non-resident unitholders. This section does not have any basic exemption limit like Rs, 5,000 in the case of section 194K.
Yes. A penalty equal to the amount not deducted or not paid will be charged as a penalty for non-compliance of provisions of section 194K.