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Budget Hits Mutual Fund Investors With Ill-Thought Out Tax

Besides being applied retrospectively, the increased capital gains tax on non-equity fund is not carefully thought through

What irony! In his budget speech, Finance Minister Arun Jaitley promised so emphatically that he would never create a past liability by means of a retrospective change in the tax laws. And yet in the same budget, the tax that investors in non-equity mutual funds pay has been increased with retrospective effect. If you redeemed your investment in a fixed-income, gold, MIP, or international equity fund after April 1, then you have been hit with a retrospective tax--a fresh tax liability, for an action you took in the past.

In the previous sentence, I say ‘apparently’ because there’s an internal contradiction in the explanatory notes that accompany the finance bill. The note states that ‘This amendment will take effect from 1st April, 2015 and will, accordingly, apply in relation to the assessment year 2015-16 and subsequent years.’ If the assessment year is 2015-16 then the date has to be April 1, 2014, and not 2015. In the day after the budget, one newspaper first reported the revenue secretary had said that the tax would be with retrospective effect and then the next day it said that he had said that it wouldn’t. There’s no authoritative statement yet. Either way, this sort of a contradiction in the budget is hard to condone.

Anyhow, there are other issues with this tax, even if its implementation is not retrospective. In his speech, the FM said that the tax advantage that non-equity funds had over bank deposits had been intended for retail investors while it was being used mostly by corporates. One can’t blame Arun Jaitley for this, but the tax arbitrage should surely have been noticed at some point in the decade or so it has been around. By now, there are about Rs 8 lakh crore invested in such funds. This massive amount (almost 50 percent of this year’s budget!) is invested in government and corporate bonds and is the closest functional approximation that India has to ‘the vibrant bond market’ that every finance minister (including this one) wistfully asks for in his budget speech.

It’s easy to casually disrupt any business by throwing off a small change in the tax laws, and our rulers have always seemed to enjoy doing so. However, I seriously wonder if the powers that be have worked out how this will play out and understood all the implications. For one, if the tax changes come into effect on any particular date, then just before that date, practically every fixed income fund investor will want to sell off the old holdings and roll it over into new holdings. The funds will rush to sell the underlying bonds, practically overnight. The scale of chaos can’t actually be predicted but I guess it will be good training exercise for the officialdom on how cause and then try and contain a deliberate disruption to a huge financial market.

There’s yet another problem with this tax increase, and that’s of the damage that it will do to the financial planning of a large number of individual investors. In his budget speech, Arun Jaitley said that ‘This arbitrage has hardly benefited retail investors as their percentage is very small among such Mutual Fund investors’. This is not quite the point. The amount invested by retail investors may be small compared to corporates, but I wonder if he has looked at the actual number of retail investors affected. In fact, there’s a more subtle point here. The type of retail investor who invests in fixed-income funds tends to be the conservative, retired type whom this unexpected hit will harm the most. These are people who have made detailed long-term investment and redemption plans based on such types of funds as FMPs. And in any case, if corporates taking advantage of lower tax breaks is is so abhorrent, there’s no reason why the tax rules in such funds can’t be separate for individuals and corporates. After all, practically every other tax in the land is distinct between the two types of entities.

There’s yet another issue, ‘non-equity funds’ doesn’t just mean bond funds. There are MIPs (monthly income plans), gold funds, debt-oriented hybrid funds, international equity funds and other commodity funds which are mostly used by individual investors. Basically, in order to remove this so-called arbitrage (presumably, to please banks) a large class of mutual fund investors have been sold down the river, and avoidable risk has been created in the bond market.