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Scrapping tax benefit to have limited impact on MFs: Expert
January, 19th 2010

There is increasing pressure on the government to withdraw the tax benefits offered to corporates investing in mutual funds. Even the market regulator SEBI has taken a stance that this benefit needs to be scrapped. What are the implications on the mutual fund industry if the government agrees to play ball?

Q: For long, corporates have been using MFs to park money to make use of the tax benefit. Regulators have a view on putting an end to this tax arbitrage. How do you read this development?

A: I am not reading much into this because if you look at the direct tax code, the draft of which was debated and was put on table for discussion and if it ever comes into effect then that does away with all the tax arbitrage which we are talking about in the direct tax code. So I do not think this is actually about time to have a debate on this.

Mutual fund being used as a vehicle which is more tax efficient and there is a differential tax treatment which is recognised by the government. If you look at the dividend distribution tax applicable for companies on the liquid fund compared to an Individual it is different. There are different rates. In fact the taxation rate for individuals compared to companies is different. So I do not see that it has not been recognised.

One particular aspect which is going unknown is that in the absence of mutual fund without being an active investor in the fixed income market, I think the bond markets, which is still very shallow will be completely illiquid.

Q: If the government withdraws the benefit, what according to you will be the implications? Could you quantify the amount of money that corporates have parked in MFs? Do you expect that to come down or ebb considerably on the back of this possible withdrawal?

A: No. I do not see that there will be a complete disappearance of the fixed income investment by companies into mutual funds. There are two-three dimensions to it. One is the sheer absence of alternatives. In fact many small corporates and small companies or even mid-sized companies cannot participate in the fixed income market.

For them to have a diversified portfolio and derive a reasonable return or an optimal return on their cash assets or on their liquid assets with a defined time frame, they do not have anywhere to go. So mutual funds do provide a vehicle whether there is a tax advantage or not.

This is assuming that all the money coming into fixed income fund is entirely because of the tax advantage which may not be true. I visualise that mutual funds will become relatively less attractive but 90% of the business can still be protected because if you look at the liquid fund for example this is a sizable part of the industry and this could be almost a third of the total fixed income funds.

If you look at the liquid plus and the short term funds that could be the remaining part because we do not have any meaningful money in the income fund. I do not think companies can participate or build that portfolio, derive the kind of return in that fund. So it will become less attractive. But I think it will be premature to say the disappearance of the tax arbitrage and it will be the death of the fixed income funds.

Q: Will this also lead to banks becoming more cautious?

A: I think there can be an embargo on banks to be putting money. There is a fear of the cyclicality of this transaction because banks putting money in mutual fund, mutual fund buying short term instrument issued by banks. But this situation is created entirely because of the absence of credit offtake and the clutch of liquidity in the system. I do not know what kind of systemic risk it poses. But it is better to err on the side of caution when you are forced to face with such a situation.

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