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Tax Laws Hit Investors

Investors in mutual funds suffer from the inefficient and irregular application of tax rules which ultimately reduce the gains they book

Of the various tax-related rules and regulations that govern mutual fund investments in India, there are two that are deeply unfair to savers and investors. Strangely, more than one Budget has passed by and despite the reasons being widely known, the government has made no move to fix these issues. Interestingly, both these issues would have been resolved by the Direct Tax Code, but now that that it is almost officially in cold storage, one can only hope that something is done about them.

Both these issues impact investing in equity funds alone, which, unlike debt funds, are mostly used by retail investors and not corporates. Both these directly reduce the returns that investors get, and this reduction in returns is a direct result of tax rules that are inconsistently and unfairly applied.

The first issue is the imposition of the Securities Transaction Tax (STT) on investments made by equity mutual funds. The STT is applied on all equity transactions. This is also done for equity funds. In the case of stocks, STT is applied on both purchase and sale. For equity mutual funds, it is applied only on redemption, but at twice the rate (0.25%). So investors pay STT on their investments into equity funds. However, when mutual funds invest that money in stocks, STT is again deducted from those investments. This is completely against the principles on which the STT is based and serves no purpose, but to unfairly take out a chunk of money from savers’ pockets. For tax purposes, mutual funds in India are treated as pass-through vehicles. For example, in the case of capital gains on equity investments, it does not matter whether the fund itself is buying or selling stocks in the short-term or long-term. Whether investors’ gains are treated as long-term or short-term is decided by whether the investor is investing for the short- or the long-term. However, STT is applied without paying heed to this principle. 

Curiously, insurance products which invest in equity products are not subject to STT.

The other issue is conceptually similar. There is a type of mutual funds called fund-of-funds (FoFs). These are funds that are meant to invest in other mutual funds. These can be very useful in creating investment options that are suited to particular investment needs without the complexity of creating a mutual fund from scratch. Investment alternatives suited to different investors can be created by just mixing and matching other funds. However, the inconsistent application of the pass-through principle makes these funds extremely tax-inefficient in India. When an investor invests in an equity fund, his income gets taxed as equity because even though he may be investing in a fund, the eventual underlying investment is in stocks. This gets him the benefit of zero long-term capital gains tax. However, if his investments are in equity funds-of-funds, that investment is not treated as equity, even though the eventual investment is still in stocks. This makes FoFs a non-starter.

The mutual fund industry itself has asked the government to fix these two issues in this years’ Budget. I don’t know whether anything will actually be done because both these issues are older than a year and were raised before previous budgets too. As I said, the real solution is a simpler tax regime, which the Direct Tax Code would have ensured. 

The fund industry has another demand, where in which it is asking the government to treat closed-end funds as ELSS tax savers. I’m not sure whether this would be a great idea. It would just end up making closed-end equity funds more popular and that’s a problem. There shouldn’t be any such thing as a closed-end equity fund. The main input that goes into choosing a fund is its track record, something that closed-end funds don't have. Moreover, liquidity is an important component of what an equity fund delivers to the investor and closed-end funds would basically add another layer of illiquidity to tax-saving investments.