Section 194K was introduced in the Budget 2020 by Finance Minister Nirmala Sitharaman through the Finance Act. This section has significantly changed the taxation landscape for dividends from mutual funds. Before its introduction, taxing dividends was challenging for both companies paying dividends and investors receiving them. The interplay between dividend income and the tax framework needed a review to simplify and clarify the process. Section 194K has established a new approach to TDS (Tax Deducted at Source) on mutual fund dividends. This change ensures greater transparency and compliance for everyone involved.
What is the 194K of the Income Tax Act?
Section 194K of the Income Tax Act, 1961, mandates a TDS deduction at a rate of 10% on dividend income from mutual funds. This means that the entity paying the income will deduct TDS from the income generated for the mutual fund schemes investor. Consequently, the investor will receive their income minus the TDS. Investors can claim a refund of the TDS when they file their income tax returns. This provision helps streamline the process of taxing dividend income from mutual funds.
Types of income from mutual funds investments
| Sl. no. | Income type | Chargeability to tax |
| 1. | Dividend | Under previous tax laws, the Dividend Distribution Tax (DDT) was paid by fund houses on behalf of investors. However, as per Budget 2020, DDT has been abolished, and dividend income is now taxable in the hands of the investors. With Section 194K, mutual funds must deduct TDS on dividends exceeding Rs. 5,000 per unitholder. |
| 2. | Capital gains | Capital gains are taxable in the hands of the investor. Long-term capital gains from equity-oriented mutual funds are taxed at 10% if they exceed Rs. 1 lakh per year. Short-term capital gains from these funds, subject to STT, are taxed at 15%. Section 194K does not require TDS on capital gains from the redemption of mutual fund units. |
Who is eligible for section 194K?
Any entity responsible for paying a resident any income related to mutual fund units, specific company units, or administrator units from a specified undertaking is required to deduct TDS while crediting the income to the payee's account or when making payments. This is to ensure that the right amount of tax is being deducted at the source.
Exceptions of section 194K
TDS under Section 194K is not required if the dividend income is less than Rs. 5,000 in a fiscal year. Additionally, income from capital gains is also exempt from TDS under this section. These exceptions are designed to simplify the tax process for smaller investors and those earning through capital gains, making it easier for you to manage your investments without worrying about complex tax implications.
Rate of section 194K
The TDS rate specified by Section 194K is 10%. This deduction will appear in Form 26AS, which helps in keeping track of the taxes deducted at source. If the final tax liability is less than the amount deducted, or if there is no tax liability, you can claim a refund when filing your income tax return. If you provide your PAN and Aadhaar number, the 10% rate applies. Without PAN or Aadhaar, the TDS rate is 20%. However, higher TDS cases are rare as PAN is required for mutual fund investments. This system ensures that the correct tax is deducted and credited appropriately.
Penalties for non-deposit of TDS
Mutual fund dividend payments must comply with Section 194K. Non-compliance incurs interest and penalties, which can be significant. If TDS is not deducted, 1% interest per month or part thereof is charged from the date it was deductible. If TDS is deducted but not paid, 1.5% interest per month or part thereof is charged from the deduction date to the payment date. Additionally, under Section 271C, a penalty equal to the unwithheld or unpaid TDS amount is levied. Non-deduction and non-payment of TDS also result in disallowance of expenses under Section 40(a). These penalties highlight the importance of compliance with the TDS provisions.
The purpose of section 194K TDS deduction on income
Before the introduction of Section 194K, dividends faced double taxation: first, when paid by companies to AMCs (Asset Management Companies), and again when AMCs distributed profits to unit holders. AMCs must now deduct 10% TDS on dividends, which is applicable if annual dividends exceed Rs. 5,000. This change aims to streamline and rationalise the process of taxing dividends in mutual funds. It helps reduce the tax burden on companies while ensuring a fair tax process for investors, thereby promoting a more efficient and transparent taxation system.
Income tax provision before section 194K
Previously, you as an individual investor were responsible for reporting your dividend income and capital gains. Dividend income from mutual funds was exempt under Section 10(35), and there was no provision for TDS on mutual fund income, except for NRIs. The Dividend Distribution Tax (DDT) was charged to the company distributing the dividends, but the dividends were tax-free for investors. This system was complex and required significant documentation and compliance from individual investors, making it cumbersome to manage.
How budget 2020 changed the taxation of dividends for mutual fund investors?
Earlier, dividends were subjected to double taxation: once when companies paid dividends to AMCs, and again when AMCs distributed these profits to unit holders. You had the option to reinvest your profits into the fund or receive dividends, with the latter being subject to Dividend Distribution Tax (DDT). The Budget 2020 abolished DDT, significantly simplifying the process by requiring AMCs to deduct 10% TDS on dividends exceeding Rs. 5,000 annually. However, TDS rate increases to 20% in case the PAN is not provided. For NRIs, TDS is deducted as per Section 195. This significant change has reduced the overall tax burden on investors, streamlined the taxation process, and enhanced compliance. The new approach has made it easier for you as an investor to manage your tax liabilities effectively and has brought more transparency to the system.
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What are the penalties for non-compliance of section 194K?
Non-compliance or delayed TDS payment results in penalties and interest. If TDS is not deducted as per the rules, 1% interest is charged from the date the tax was deductible until the deduction is made. If TDS is deducted but not paid to the government, 1.5% interest is charged from the deduction date to the payment date. Under Section 271C, a penalty equal to the unwithheld or unpaid TDS amount is levied. Non-compliance also results in the disallowance of expenses under Section 40(a)(ia). Therefore, all stakeholders must comply with these rules to avoid substantial penalties.
Conclusion
Mutual funds are a popular investment choice, offering tax benefits and good returns. However, understanding the tax implications is crucial to avoid penalties. Section 194K mandates a 10% TDS on dividend earnings exceeding Rs. 5,000 annually, ensuring that the tax process is clear and straightforward. Capital gains from the sale of mutual fund units are not subject to TDS under this section. By complying with Section 194K, you can ensure they meet your tax obligations and avoid penalties, promoting a streamlined and efficient taxation process for mutual fund investments. This clarity helps investors make informed decisions and manage your investments effectively.
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