Hike in Dividend Distribution Tax for money market funds is Positive for Banks

The BSE Bankex hit a three-month low at 6408.01 points on Budget day and though it has rebounded from those levels, it's still at a three-month low of 6584.56 points.

Besides, the index has underperformed the broader market: while the Sensex lost just under 5 per cent between December and February, the Bankex lost around 10 per cent.

That's not surprising because the recent hike in the Cash Reserve Ratio (CRR) by 50 basis points to 6 per cent meant less funds at banks' disposal at a time when liquidity is already tight.

Moreover, deposit rates have been moving up-five-year money now fetches depositors over 9 per cent compared with 6.5 per cent less than a year back.

While banks have increased lending rates, it's not always easy to pass on the increased borrowing costs, especially to retail borrowers.

Thus, the hike in dividend distribution tax for money market mutual funds from an effective 14.025 per cent to 28.325 per cent, comes as a positive for the sector.

Investors have been parking surpluses with liquid funds instead of bank deposits because interest from bank deposits is taxable whereas dividend from a debt mutual fund is not.

As such, the return post-tax was higher from these schemes. With investors likely to receive less as dividend from money market mutual funds, because of higher dividend distribution tax, they may prefer to save through fixed deposits. Besides, the lower fiscal deficit of 3.3 per cent should ease liquidity and bring further relief to banks.

The fringe benefit tax to be levied on employee stock option plans (ESOPs), however, is a negative for the sector especially for private sector banks such as ICICI Bank, UTI Bank and HDFC Bank, which have given their employees stock options.

While the rate at which the tax will be levied has not been specified, the benefits are expected to be taxed at 33.99 per cent.

Long-term financial institutions HDFC, IDFC and LIC Housing Finance (not in the Bankex), will have to pay more tax because the government proposes to reduce the tax benefit available against long-term funding business (loans with a maturity over five years).

At present, these lenders claim an exemption on 40 per cent of their profit from long-term loans; this now stands reduced to 20 per cent. As a result, the effective tax rate will rise to 27 per cent from 20.4 per cent impacting their earnings.