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DTC Effect: Should ELSS still be a part of your portfolio?
December, 06th 2011

Are you one of those who turn to equity-linked savings schemes (ELSS) to reduce your tax liability? What has been a popular tax-saving route for most investors, may not work any longer. Under the Direct Taxes Code (DTC), which is likely to come into effect from 1 April next year, the government has proposed to remove this tax benefit associated with ELSS funds. This has led to some confusion among investors about how to approach these funds. Can ELSS funds still be a part of your portfolio?

Will the ELSS funds be closed?

If the proposal is accepted, you will no longer be able to claim tax deduction for investment in these schemes. So what happens to the existing ELSS funds in the market? There are currently 28 such schemes, with nearly Rs 20,000 crore in assets under management. The fund houses have also failed to give any direction to its investors, probably because of the ambiguity over the implementation of the DTC, which might get delayed further.

Even if it is introduced by the start of the next fiscal year, most fund houses are hopeful that the government will extend the tax benefit. Says Harshendu Bindal, president, Franklin Templeton Investments (India): "If the government wants to encourage long-term savings flow into the capital market, ELSS is a good option." He points out that the mutual fund industry has made a representation to the government through the Association of Mutual Funds in India (Amfi) to consider continuing the tax benefits to ELSS.

Even if the ELSS funds lose their tax benefit, they are not likely to end overnight. They could be merged with other existing equity schemes, but this could be a tricky proposition. For one, many of these schemes have very high AUMs and it would be difficult to create synergies from the mergers. Secondly, since ELSS schemes come with a lock-in feature, investors cannot sell the units for three years after the purchase.

A merger essentially amounts to a redemption, or sale, from the scheme being merged. Under the current rules, this would not be possible for the investors whose lock-in period hasn't ended. Unless Sebi allows relaxation, fund houses will have to think of another way to treat these funds.

It is likely that these funds will continue to exist post-DTC, albeit without the tax benefit and lock-in period. Jayant Pai, VP and CFP, Parag Parikh Financial Advisory Services, says, "These funds could be subsumed into some other diversified equity fund within the same fund house. Or the fund house could change the name of the scheme to exclude the word 'tax'."

In the absence of the tax advantage, these funds will operate as normal equity schemes. As a result, investors may no longer put additional money into them. Since fresh inflows will be hampered, it will affect the funds' performance. Says Hemant Rustagi, CEO, Wiseinvest Advisors: "Fund managers may find themselves handicapped as fresh inflows will not come in if the tax benefit is removed. This will affect the performance of tax-saving funds."

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