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The Tax Axe

The Kelkar report on direct taxation, if implemented, will bring huge, unneeded complexities to the operations of mutual funds.

While the litany of complaints against the Kelkar report is long, the nature of its recommendations on the mutual funds industry is fundamentally different from those on other parts of the economy. In areas like housing loans and agricultural income, new tax norms may make a certain activity a little more or a little less attractive. However, in the case of the mutual funds, an implementation of the Kelkar recommendations will necessitate a fundamental change in the way the industry operates.

There are two parts of the report that impact mutual funds. One is a straightforward removal of tax exemptions that investors have enjoyed under Section 88, which includes NSC, NSS, EPF and PPF. The other is a structural change in the way mutual funds are taxed. Let's take a look at both separately and extrapolate the impact that each will have on investors.

Section 88 Changes
As things stand, the tax rebate provided by section 88 to instruments like NSC, NSS, EPF and PPF provide a much greater effective tax break than on mutual funds. The effective, post tax-break return NSC VII is 15.78 per cent and that on PPF is 16.89 per cent. Given that these instruments are fixed income investments that effectively carry a sovereign guarantee (they are loans to the government and have the highest possible safety level), these are extraordinarily high returns, specially in the current scenario of declining interest rates.

Many investors start out with a certain investable amount and then distribute that amount based on safety and tax concessions. Such investors are now likely to find that on a relative scale, mutual funds are a more attractive investment than these instruments. At the very least, you no longer have any reason to carry a tax-related bias against investing in funds.

Of course, you no longer have any tax-related bias in favour of any kind of investing, but perhaps that is the way it should be.

Structural Changes
These are potentially a far more serious matter. Dr Kelkar's reasoning is long and complex, but a careful reading of his recommendations (see box) reveals some potentially huge problems.

Mutual fund investors who invest in for more than a year—and thus are long-term investors—will end up paying short-term capitals gains tax whenever a fund manager trades. The fact that they themselves took a long-term view will not save them from paying short-term tax indirectly. Short-term investors on the other hand, may end up being taxed twice on the same income, in the hands of the funds as well in their own hands.

However, the biggest impact will be on how funds operate. Whenever a fund gets a large redemption request, it will have to sell assets that may attract tax. This itself will impact the NAV at which the redemption is being made. This in turn will create a pressure on funds to sell assets on the basis of their tax efficiency rather than their merit as investments. Not only that, the NAVs and investment quality of all investors will get impacted with every disinvestment.

Add to this the complexity of making daily tax adjustments for interest, and handling the jerks that NAVs will undergo every time a short-term asset is offloaded, and it becomes pretty clear that investing in funds as well as running funds is going to become a pretty hairy task under a Kelkarian tax regime. One can only hope that someone in the government sees that these recommendations need major surgery before they are implemented.

The Recommendations
1. The income of the mutual fund derived from short-term capital gains and interest should be taxed at a flat rate in the hands of the mutual fund.

2. Since most investors in units are generally smaller taxpayers, we recommend that the rate of tax should be the minimum marginal rate of personal income tax i.e. 20 per cent.

3. With a view to overcoming double taxation, the dividends received by the unit holders should be fully exempted since the distributable surplus would have suffered the full burden of the tax.

4. The short-term capital gain arising to the investor from sale of units of investment funds should be taxed at his level at the personal marginal rate of tax.

5. The long-term capital gain arising to the investor from sale of units of mutual fund should be exempt from income tax.

6. The tax treatment of mutual funds and their investors should also be extended to venture capital funds, private equity funds and hedge funds. However, the tax rate for these funds should be 30 per cent since their investors are likely to be those in the highest tax slab.