KARACHI: The Federal Board of Revenue (FBR) on Thursday issued explanation to Finance Act 2014 regarding amendments in mutual funds taxation regime.
Relevant sections: clause (6lA) of Section 2, clause (99) of Part I of Second Schedule, Division I of Part III of First Schedule of Income Tax Ordinance, 2001.
According to the FBR, the income of Mutual Funds is exempt from income tax under clause (99) of Part I of Second Schedule to the Income Tax Ordinance, 2001, subject to the condition that ninety percent of their income is distributed to the unit holders. However, income distributed i.e. dividend income, is not exempt in the hands of the unit holders (except those specifically provided under the law). Mutual Funds are, therefore, required to deduct withholding tax at the time of distribution of dividend income.
To avoid the legal obligation to withhold tax on dividend income, open-ended Mutual Funds, had recently adopted a practice of issuing bonus units instead of cash dividend.
No tax was deducted on the said issuance and when the said units were disposed of by the unit holders, even capital gains tax was not paid because of FIFO and cost staggering rules.
Through Finance Act, 2014 the said anomaly has been removed by amending clause (99), and from now onwards, to claim exemption under the said clause, bonus shares, bonus units or certificates shall not be considered for the purpose of computing ninety per cent distribution of income.
In other words, to claim exemption, ninety per cent of the income must be distributed in the form of cash dividend.
Another amendment in taxation regime of mutual funds relate to tax deduction on dividend income distributed by them to the unit holders. At present, taxpayers can cam income from bank deposits, Government Securities, capital gains, dividend etc. either directly or through mutual funds~ However, if earned through mutual funds, its class or character changes to dividend income for all categories, despite the fact that mutual funds are only pass-through entities.
As a result, the rate as applicable to dividend is applied on the income distributed instead of respective rates for different heads/classes of income.
For example if a company invests directly in government securities, it will be taxed at a rate of 33 percent on interest income earned.
However, if the same investment is routed through mutual funds, the company will be taxed at a rate of 10 percent on the same income characterized as dividend income distributed by the mutual funds.
In order to bring tax neutrality in tax system and to discourage such tax avoidance tools, the rates for dividend income distributed by mutual funds have been amended accordingly. From tax year 2014 and onwards, in case of companies the rate of tax deduction for dividends distributed by mutual funds other than stock funds shall be 25 percent.
Stock Funds have also been defined through Finance Act, 2014 as collective investment scheme or mutual fund where investible funds are invested by way of equity shares in companies to the extent of 70 percent of the investment.
For Stock Funds the rate shall be l0 percent (if dividend receipts are more than capital gains receipts) or 12.5 percent (if receipts from capital gains are more than dividend received).
For individuals, since the rate of dividend and interest income is both l0 percent, the rate of 25 percent is applicable to companies shall not apply. However, in case of stock funds where capital gains receipts are higher than dividend receipts, the rate shall be 12.5 percent for individuals as well.