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Changes in Mutual Fund Tax Laws Shows Poor Understanding

Arun Jaitley may have fixed the obvious flaws in the mutual fund tax mess, but the entire episode is deeply disappointing

The Finance Minister has clarified in parliament that the new tax measures on non-equity funds will not apply to capital gains arising out of redemptions made before July 10, the day he presented the budget in the parliament. In the budget, he had increased the time limit for returns from non-equity funds to be considered as long-term from one to three years. This has meant a sharp increase in the tax that has to be paid for such investments if they are redeemed after an investment period of more than one year but less than three years.

The first problem was that this came into effect from April 1, 2014. Thus it was a tax with retrospective effect, something that Mr. Jaitley had promised he would not impose in the budget speech. Last week, the finance minister clarified that this date was being changed to July 10. This means that technically, the tax measures are no longer retrospective.

However, this is the minimum that the government could have done. There are other aspects of these tax measures--and the premise on which they are based on--that are wrong and unjust. Let's see what Mr. Jaitley gave as the justification during his budget speech, “...the capital gains arising on transfer of units held for more than a year is taxed at a concessional rate of 10% whereas direct investments in banks and other debt instruments attract a higher rate of tax. This allows tax arbitrage opportunity. This arbitrage has hardly benefited retail investors as their percentage is very small among such Mutual Fund investors.” He repeated this justification during the budget debate in the Lok Sabha on the 25th, “...was a facility which we had really given for retail investors. A bulk of it was being used by corporates and it was being used for arbitrage.”

This logic is seriously misguided, and on one important point, it is simply wrong. A majority of the amount invested in debt funds may be from corporates, but in terms of the number of investors, there are a huge number of individuals who use these products. It's just that individuals invest in thousands or lakhs and corporates do in crores or tens of crores so individuals are not easily visible at an aggregate level. In some types of funds, like liquid funds and short-term funds, the activity is almost all corporate, but others, like FMPs (fixed maturity plans), are primarily retail products. The data on which the budget argument is based is being interpreted in a highly biased way. What makes it worse is that individual investors who use debt funds (and specially FMPs) tend to be conservative, older and retired types. This would have been an easy problem to solve if the government was bothered. If the problem was that corporates were abusing a concession meant for individuals, then surely the new measure could have been made applicable only to corporate investors and not individuals. After all, practically every other part of our tax code differentiates between the two, so why not this too? I suspect the real reason is that the government has simply caved in to the bank lobby and sold individual investors down the river.

There's a further problem. Although the budget speech and the statement in the debate refers to debt products, the actual law applies to all non-equity funds. That's not the same thing. The new tax regime also applies to debt-oriented hybrid funds, equity funds-of-funds, gold funds, as well as international equity funds. None of these products have any conceivable arbitrage vis-a-vis bank products. The justifications stated by the FM in parliament simply do not apply to these types of investments by any stretch of imagination. It's lazy and unjust to not bother to differentiate these from pure debt products which might be competing with banks.

All in all, the whole episode is deeply disappointing in the poor understanding, knowledge and empathy displayed in making and changing laws that affect lakhs of people. In other words, it's business as usual for the Government of India.