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Iniquitous tax regime for equity funds
August, 21st 2010

Transactions inopen-ended equity-oriented funds cannot be consummated in a stock exchange.

Section 10(38) of the Income-Tax Act, 1961 distinctly favours investments in close-ended funds by conferring exemption from tax on transfer of long-term units of equity-oriented funds through a recognised stock exchange in India. This is of a piece with the exemption conferred on sale of long-term shares through recognised stock exchanges in India.

The common thread running through both is routing of transaction through a recognised stock exchange in India on which Securities Transactions Tax (STT) is chargeable. STT is levied only on stock exchange transactions and hence willy-nilly transactions outside the stock exchanges would not get the tax exemption. Nothing wrong in encouraging transactions through an organised and regulated forum except that there are a couple of deals that simply cannot be consummated in a stock exchange.

One such is transactions in open-ended equity-oriented funds. By definition, an open-ended fund allows free entry and exit on the basis of Net Asset Value (NAV) without driving the investors into the stock exchange-fold.

In other words, it is not mandatory for an open-ended fund to list its units. The bottom line is the I-T Act's exemption made conditional upon one routing the sale through a stock exchange works against those unit-holders who make use of the services of the fund manager and exit through the fund itself based on the NAV transparently determined instead of through the exchange.

In a way the I-T Act unjustly favours a close-ended fund inasmuch as the units of such funds have to be mandatorily listed as it is the only exit route with the fund manager staying away from entertaining new entrants and those seeking to exit which is the unenviable lot of his open-ended counterpart.

It also has the effect of driving open-ended fund to provide an additional exit route, that is, through stock exchange as well which it is not strictly required to provide besides compelling the investor to exit through the stock exchange even if he is going to get a better deal if he exits through the fund manager.

Hijacked by well-heeled

In India, the mutual fund dispensation intended for the small investors has been hijacked by the well-heeled. Corporates, banks and financial institutions and high net worth individuals are the major investors in mutual funds.

The market regulator SEBI is aware of this but seems to have done precious little to undo this. It seems to be reluctant to ask the well-heeled to disembark from the mutual fun bandwagon because the space thus vacated should be capable of being filled in by the small investors who unfortunately are not coming forward in a big way to route their investments through mutual funds.

It perhaps fears that any stern action against them would precipitate a crisis in the mutual fund industry itself, a fledgling institution that needs to be propped up. It is not as if the well-heeled are adopting the mutual fund route for safety reasons.

What brings them in droves to the mutual funds fold is the tax dispensation that is kind to mutual fund investments.

An individual investing heavily in shares through a mutual fund ends up with minor bruises, a vicarious 12.5 per cent dividend distribution tax (DDT) as opposed to the vicarious 17 per cent DDT he has to pay had he invested upfront in a company without the intermediation of a mutual fund. What can be done forthwith is to bring about parity in the tax rates whether one invests through a mutual fund or directly.

Taxing investors directly

Better still, it would be appropriate to remove the same dispensation for both the forms of investments direct and through mutual funds. The system of DDT was introduced to end double taxation of dividend though admittedly even under the DDT regime companies are taxed twice, one with corporate tax and with DDT on the same amount.

Be that as it may, the point is a company and mutual fund is not on all fours. Unlike a company, a mutual fund is a tax-free entity. This being the case, there is no need to pamper its investors with a tax-free dividend income.

In other words, investors in mutual funds receiving dividend from them should be required to pay tax on the dividend income themselves and not vicariously which is the case now when the fund pays DDT virtually on their behalf.

This would not only be in keeping with the pass-through principle, the cornerstone of mutual funds investment but also end the tax advantage responsible for attracting high net worth investors and corporates to the mutual funds-fold.

There is a view that DDT should be abolished even for corporates because it is better to a have a double taxation regime that targets the ultimate beneficiaries with an even hand. Implied in this suggestion is the bottom-line that high net worth individuals would pay tax on dividend at the maximum marginal rate of 30 per cent and not get away with a slap on their wrists with a vicarious but soft DDT impost. While there is a considerable merit in this submission, a beginning can be made by removing the tax advantage for big ticket investors in mutual funds.

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