8.3 Dividends and Distributable Reserves

The Name Change Was a Disclosure Fix

What used to be called a "dividend" from a mutual fund is now IDCW — Income Distribution cum Capital Withdrawal. The relabelling was deliberate.

Investors imported an assumption from company dividends: that a dividend is paid out of profits, on top of the value of the shareholding. A mutual fund distribution is nothing of the sort. It is paid out of the scheme's own net assets, so NAV falls by the amount distributed. Part of what an investor receives may be their own capital coming back.

The name now says so explicitly, and AMCs must disclose the split between income distribution and capital withdrawal.

What May Be Distributed

Distribution may be made only out of realised gains and distributable surplus.

• Realised gains only. Unrealised appreciation on holdings still in the portfolio cannot be distributed. A scheme with large paper profits and no realised gains cannot pay from those profits.
• Not from the unit premium reserve. When units are issued at a NAV above face value, the excess is credited to a unit premium reserve. That is subscription money, not income, and distributing it would mean paying investors with other investors' capital.

This restriction closes a genuine abuse. Without it, a scheme could attract subscriptions and pay them straight back out as "dividends" to create an appearance of income, funded entirely by new money.

What Happens on the Record Date

Before distribution:  NAV = INR 28.40
IDCW declared:              INR 2.00 per unit
After distribution:   NAV = INR 26.40

The investor holds units worth INR 26.40 and INR 2.00 in cash — a total of INR 28.40, exactly as before. No wealth has been created.

And the transaction is not neutral: the INR 2.00 becomes taxable in the investor's hands at their slab rate, with tax deducted at source where the threshold is crossed. Money that would have compounded untaxed inside the scheme has been converted into taxed income.

This is the reasoning behind a rule of thumb the syllabus supports: for an investor who does not need regular cash, the growth option is generally preferable, because gains compound and tax arises only on redemption, when the more favourable capital gains treatment applies.

The Equalisation Reserve

A problem arises when new investors join a scheme carrying accumulated distributable surplus.

Suppose a scheme has built distributable surplus over a year and a new investor subscribes the day before a distribution. Without an adjustment, the new investor would receive a share of surplus generated entirely before they arrived, diluting existing investors' entitlement.

The equalisation reserve solves this. When units are issued, the portion of the subscription price representing accumulated distributable surplus is credited to an equalisation account rather than treated as fresh surplus. On distribution, that amount is transferred back, so the surplus per unit available to existing investors is unaffected by new subscriptions.

The practical effect: the equalisation reserve makes the distributable surplus per unit independent of unit sales. For the new investor, the corresponding portion of any distribution received is effectively a return of their own subscription — which is exactly what "capital withdrawal" in the IDCW label refers to.

IDCW Sub-Options

IDCW reinvestment carries a trap. The investor receives no cash, but the distribution is still taxable as income in their hands, and stamp duty of 0.005% applies on the units issued. The investor pays tax on money they never saw. It is the least attractive option for most investors and is chosen surprisingly often.

Frequency and Disclosure

Schemes may offer daily, weekly, monthly, quarterly or annual IDCW frequencies. Distribution is never guaranteed — it depends on the availability of distributable surplus, and a scheme with none cannot pay regardless of its stated frequency.

AMCs must disclose the NAV before and after distribution and the split between income distribution and capital withdrawal, so the investor can see how much of the payout was genuinely income.

A distributor who presents a monthly IDCW scheme as producing "regular monthly income like a pension" has mis-sold, on two counts: the payments are not assured, and part of what is paid is the investor's own capital being returned.