Mutual Funds with PSU theme: Are they more attractive now?

Post the abolition of the Dividend Distribution Tax as announced in the Union Budget 2020, the possibility of funds with PSU themes performing well and rewarding investors has become better. Our study points out how this will happen 

The Union Budget 2020 presented by Finance Minister Nirmala Sitharaman was one of the longest in history but the sheer volume did not do much to cheer the equity market, driving home the point that words don’t really matter but action does. On the budget day, the frontline equity index, BSE Sensex, dropped almost 1,000 points. Nevertheless, in the following week it recovered most of its fall and went on to close on a week’s high of 41,141.85. The budget had nothing for retail investors from an investment perspective. The signal was clear – most of the expectations were not met! However, the budget did propose to abolish Dividend Distribution Tax (DDT).

This might be a good news for some and bad news for others. DDT is bad news for people falling in the higher tax bracket as the dividend earned would be added to an individual’s income and be taxed as per the Income Tax slab rates. That being said, it would be good news for those in the lower tax bracket. Previously, any domestic company that was distributing dividend was required to pay DDT at the rate of 15 per cent on the gross amount of dividend as mandated under Section 115 O of the Income Tax Act 1961. Therefore, the effective rate of DDT becomes 17.65 per cent, excluding any surcharge and cess on the amount of dividend.

Case Study

Let us take an example to understand the calculation of DDT. Let’s assume that the dividend declared by a company is Rs 1 crore. Now to calculate DDT we need to determine what is grossed up dividend. This is calculated as 17.647 per cent of Rs 1 crore and adds the same to it. After adding it becomes Rs 1.18 crore i.e. Rs 1 crore plus Rs 17.647 lakhs. Next, we need to calculate DDT on grossed up dividend at the rate of 15 per cent. This amounts to Rs 17,64,706. The calculation excludes any surcharge and cess. Adding the surcharge and cess further, the effective DDT comes to around 20.56 per cent. This saving will be available for the companies to distribute to their shareholders.

The change, as proposed by the budget, will clearly have a few winners. First, for a retail investor whose salary is below Rs 10 lakhs and who pays Income Tax at the rate of 20 per cent or below, he or she will now pay only 20 per cent as tax instead of 20.56 per cent paid by companies earlier. The second set of major beneficiaries will be domestic mutual funds that enjoy pass-through status and pay no tax. Now they can pocket larger dividend incomes from their portfolios as they will no longer suffer the indirect incidence of the DDT.

Even within the mutual funds, those funds will be more benefited that hold a larger share of Public Sector Undertakings (PSUs) and Multinational Companies (MNCs). In the case of PSUs, given that their largest shareholder, the government, isn’t liable to Income Tax, it is very likely that the government will ask companies to pay out dividends on all the savings that such companies will make after scrapping of DDT. PSU stocks, some of which are already having high-dividend yields, may have a reason to increase their payouts in the future.

PSUs: Right Time to Invest?

Are the above changes likely to benefit funds with PSU theme? In the following paragraphs we would like to seek an answer to this question. To arrive at the right results, we carried out a study wherein based on the PSUs’ five-year Compounded Annual Growth Rate (CAGR) of net profit we computed the expected net profit for FY20. And to understand the dividend payout pattern, we took a five-year median of the dividend payout ratio of these PSUs. The five-year period is from 2015 to 2019. This helped us understand which PSU companies are expected to dole out increased dividend in the forthcoming year. Further, we went on to calculate the weighted benefit that an individual fund with PSU theme might receive.

Not just that, we also calculated the benefit that other funds holding PSUs would be getting in terms of increase in their Net Asset Value (NAV) due to increase in dividend payout. Below is the list of PSU companies whose shareholders might benefit from the abolition of DDT due to increase in dividend. These are the companies that are currently paying effective DDT of 20.56 per cent. These companies are likely to pass on the benefit to their shareholders and may increase the dividend payout. The data for the study is sourced from Accord Fintech and Dion Global. 

Following is the list of funds with PSU theme and the weighted effective benefit that they may have after abolition of DDT. It is assumed that the share price of the company will remain the same.

Thus, we can see that Nippon India CPSE ETF is likely to get the maximum benefit of 20.54 per cent followed by SBI PSU Fund, Invesco India PSU Equity Fund and Aditya Birla Sun Life PSU Equity Fund with weighted effective benefit of 15.07 per cent, 15.06 per cent and 13.37 per cent respectively. Not just funds with PSU theme but also those funds holding PSU companies might benefit from the same. Following is the list of top 10 funds with other than PSU theme to benefit from the abolition of DDT. 

As can be seen from the above table, Bharat 22 ETF might be at the top to sweep the benefit of abolition of DDT followed by DSP Natural Resources and New Energy Fund and Nippon India ETF Dividend Opportunities with weighted effective benefit of 10.22 per cent, 9.38 per cent and 6.30 per cent respectively. However, some of you might argue that the above changes might have been discounted in NAVs. But, that’s not the case. The below table is more than enough to clear your doubts. Moreover, the benefit to funds will start only in FY21 from when the change in taxation of dividend will come into effect. 

The above table shows the return of the funds with PSU themes post-budget. These returns are weighted returns of PSU stocks that might stand to benefit from abolition of DDT. Returns are for the period February 01, 2020 to February 14, 2020. This shows that still they have not discounted the complete benefit that they might get.

Conclusion

The above study clearly indicates that there is a possibility of funds with PSU themes to perform well with potential benefit of abolition of DDT. Even if we look at the returns of the funds from the date of the Union Budget, they are yet to discount the complete benefit. Therefore, this is an opportunity to invest in these funds. Look out for funds with the PSU theme. However, investors should note that this study is based on probability and holds no guarantee of occurring in the same way as stated. Therefore, only those who have all their financial needs taken care of and have moderately aggressive to aggressive risk appetite should consider investing in PSU theme funds.