What is the problem with the DDT? And why is it contentious? First, to the extent that interest income remains taxable, there is no case for making it tax free only because it went through a debt fund. If an investor invested in the same securities that the debt fund invested in, and earned the interest income, he pays tax. But if the mutual fund bought the same securities and paid out the same income as dividend, it becomes exempt. Therefore a debt fund provides a better post tax return compared to direct investment in other comparable taxable interest yielding products. Second, there is an element of inequity in the way the DDT works, applying a uniform rate to all tax payers. An investor whose marginal rate of tax is lower than the DDT, ends up suffering a loss in return. For example, an investor who is not subject to tax, would receive his dividend after a DDT of 25 per cent, whereas a tax paying investor still enjoys a subsidy on the dividend income as long his marginal rate of taxation is higher than the DDT rate.

Why the experimentation with DDT? A mutual fund structure is not a simple one of receiving interest income and passing it off as dividend. There are some complications. First, the debt securities in the portfolio are valued at market price every day. This means, the NAV of a debt fund is not made up purely of interest, but also of some appreciation/depreciation in the value of the securities. Therefore, pure interest income cannot be separated and distributed. Second, the NAV itself will fluctuate based on the market situation, and there are times when the loss in the value of the portfolio can be higher than the interest income earned, or vice versa. Third, not all debt funds are equal, when it comes to their interest income and capital appreciation. Depending on the duration of their portfolio, these components can vary. As long as interest income that the fund earned has got entwined with the capital gains/losses, it is tough to put the debt fund on par with other pure interest earning instruments. Which is why debt and liquid funds remain products chosen by corporate and institutional investors — a segment that has to be separately recognised when it comes to the DDT.

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