Dividend Tax Rules Explained: What Investors Must Know Before Taking The Crucial Step

Before investing in the mutual fund world, any money market investor should have at least a basic understanding of equity fund strategies and how taxation of equities works. Equity investments generate two types of income: capital gains and dividend income.

While capital gains enter the equation when assets such as shares or equity mutual funds are sold at a profit in terms of the rate of acquisition, the dividend is the portion of the profits that a company distributes to its shareholders.

Taxation Of Dividends

The dividends are added to the total income of the resident shareholders and are taxed according to their applicable income tax slab rates. In a supportive structure for the shareholders, the taxes incurred on dividends by individuals in the lower

income brackets are naturally lower than those in the higher pay brackets. On paper, the dividends tax is put under the head ‘Income from other sources’.

The shareholders enjoy a specific deduction as permitted by the authorities. They may claim interest expenses incurred on borrowed funds used to purchase such shares. However, the claim can be made for only up to 20 per cent of the total dividend income. No such deduction applies to other expenses such as brokerage, commissions and service charges.

For example, consider that a resident shareholder receives Rs 1 lakh as dividend income and pays Rs 35,000 as interest on a loan taken to buy the shares. The maximum deduction allowed in this case will be Rs 20,000 (20 per cent of Rs 1 lakh). The taxable dividend income will thus be Rs 80,000, which is the dividend income (Rs 1 lakh) minus the maximum deduction (Rs 20,000).

Taxation of capital gains

The income generated by selling the listed shares above the value at the time of purchase amounts to capital gains. To compute such gains, authorities and chartered accountants categorise capital assets such as shares and equity mutual funds as short or long-term assets depending on the holding period.

What Is FIFO Strategy

Investors operate and acquire regularly in the mutual fund market and buy fruitful schemes depending on factors like income, expectations, future growth and risk appetite. While computing gains for tax for such investments, the First-In, First-Out (FIFO) method is applied as a guiding principle.

According to the FIFO method, the securities that are credited first to a demat account are also considered the first meant to be sold. “Indian tax regulations mandate that the cost of acquisition and the holding period for the dematerialised shares and mutual fund units be calculated on a FIFO basis,” explained Harsh Bhuta, Managing Partner at Bhuta Shah & Co LLP, as quoted by the Economic Times.

“This approach promotes uniformity and prevents investors from selectively liquidating the most advantageous lots within a single account.”