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Remove tax arbitrage for debt schemes
February, 21st 2007

One may begin by commenting how escrowed the expectations and the debates on the budget are, in our country. The budget is awarded marks more on how much a person normally spending Rs.10000/- on an evening out, is going to pay by way of service tax or luxury tax rather than on what proportion of our GDP is being spent on primary health care or education.

Whether a tube of tooth-paste or a pack of cigarettes is going to be costlier or not is discussed more animatedly than what percentage of population has come up above the poverty line or what percentage is likely to have old age income security.

Capital Markets are very sensitive to news more so to bad news. While the market is always willing to factor economic, political or business developments, it hates surprises and is comfortable with long-term directions in policies.

Whether it is through the Common Minimum Programme or annual policy statement of the Government, broad contours of the policy about the market are fairly laid out i.e. to promote savings, to help infrastructure grow, to encourage the capital market to be more broad-based, to safeguard the interest of the retail investors and to encourage investment in the market so that growth momentum of the country can be sustained and even enhanced.

Given these broad contours, the directions, so far as tax is concerned, are fairly straight-forward. By and large, the tax regime for investment in the market is benign. Long term capital gain on equity investments is nil---whether it is made directly or through Mutual Funds, short-term capital gains is 10 per cent, dividend distribution tax for equity oriented schemes is nil and for debt oriented schemes, the rate is 20 per cent.

For every transaction on the Stock Exchanges or for redemption of units of Mutual Funds, securities transaction tax is applicable. The lack of clarity about definition of equity oriented schemes has also been removed in the previous budget. 
Some of the areas where action can, however, be taken include removal of incidence of double taxation of STT on mutual fund investors. Similarly, while infrastructure sector is generating lot of euphoria especially from the foreign investors, some concrete measures towards promoting the sector would be to help domestic Mutual Fund float close- ended infrastructure schemes investment in which would qualify for long-term capital gains and also be an eligible investment under Sec.80 C of the Income Tax Act within the overall cap.

On the other hand, there is a case for removing the tax arbitrage for debt-oriented schemes. The liquid funds or the Fixed Maturity Plans (FMP)of Mutual Funds are basically being utilised for parking short term corporate treasury money to gain advantage of tax arbitrage. It serves no policy objective to divert short-term corporate treasury money from the banking system to the MF system by allowing a tax concession.

It would be correct to estimate that almost Rs.1,00,000 crore in the MF industry is on account of such tax arbitrage. If the same is removed, the pressure on banks to offer higher rates for mobilising deposits would get reduced to that extent. The funniest part of the situation is that after receiving the corporate treasury money the MFs invest the same in short term deposit of the banks of course, at a higher rate of interest!

Section 80C is a good example of Governments intention of providing a long-term direction to the taxation policy. Several items have been included there. Inter-industry rivalry is resulting in pressure on the Government to place more and more instruments under the ambit of Section 80 C. One such example is the demand for placing FDs of banks of lesser duration, say 3 years and beyond, in the same category.

Government may have a genuine policy objective of encouraging people to invest in risk capital or to invest in infrastructure, in retirement plans or insurance plans. If temporarily, for a variety of reasons the deposits of banks are not keeping pace with the credit growth, it would be wrong to argue that tax concessions are required for encouraging bank deposits. Section 80C was not originally intended to help solve the operational problems of an industry segment. By the same logic, tomorrow the NBFC or Chit Fund industry may demand similar concession.!

Another demand being raised to the Government is to increase the ceiling from Rs.1 lakh to Rs.2 lakhs and also to provide a sub-ceiling for the insurance industry or the pension industry. Groups making such demands fail to appreciate the rationale behind simplification of tax laws, providing a long-term objective and certainty about taxation policy. If such demands are considered, it would lead to going back to the earlier system with different sub-ceiling for different types of investments permitted under the Income Tax Act.

Another area for Government to consider seriously is EET approach which was announced as a policy objective two years back and on which a committee set up by the Government has already submitted its report. PFs, insurance and pension investments qualify for Section 80C today where investment is exempt, income on that investment is exempt and when the amount is finally withdrawn the same is also exempt (EEE).

It makes rational sense to allow exemption on the first two stages of the transaction but on retirement when it is expected that the worker or the tax payee would not be having a regular income and hence be in a lower bracket, then the amount withdrawn needs to be taxed. It would be useful for the Government to make a time bound implementation plan of this policy but it may not be popular with majority of the tax paying public. In the euphoria of the high growth led tax buoyancy, one must not forget that no country can offer all the three stages to be completely exempt.

There is one area where I would seriously recommend urgent action i.e. the decision in the previous budget to ask the exempt PFs to come under the purview of EPFO. The Ministry of Finance has issued investment guidelines for PFs whereby an investment of up to 15 per cent (5 per cent directly into equity and 10 per cent through equity-oriented MFs) was permitted. The exempt funds were free to do so.

What the budget decision of 2006 has done is to force all the exempt funds to get registered with EPFO and to follow their guidelines. This decision needs to be re-visited as it is not synchronous with the efforts towards pension reforms.

U K Sinha
(The author is the CMD of UTI Asset Management Company Pvt Ltd)

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