Are mutual funds subject to corporate income tax @ 35 per cent on the gains made by them? Please clarify
—Dharmender Pasricha
We feel this question is at the heart of a lot of confusion in the minds of investors. We need to be very clear about one thing that mutual funds are tax-free entities. Any gain that a mutual fund makes out of trading in securities is accumulated in the fund and is reflected in the higher NAV of the fund.
Then how does a fund meet its expenses? All funds are managed by an AMC, which is a company, and so generates its income and bears its expenses and at the end of the financial year draws up its financial statements wherein it calculates its pre-tax profits. It then pays tax based on its pre-tax profits, at the corporate tax rate of 35 per cent plus the applicable surcharges. For the sake of simplicity, let us ignore advance tax issues.
Now, from where does the AMC earn its income? Every AMC charges what is known as investment management and advisory fee on all schemes under its management. This is disclosed in the half-yearly reports of an AMC and is a part of the expense ratio that a fund charges. There is a SEBI-mandated upper bound on the expense ratio — 2.5 per cent for equity funds and 2.25 per cent for debt funds, and from that a maximum of 1.25 per cent can be charged as investment management and advisory fee.
What are the expenses that the AMC meets out of this charge? The salaries of the fund managers are met out of the management fees and other costs such as marketing and selling expenses, audit fees, advertisement costs, trustee fees, custodian fees/ depository charges, etc. are met out of the remaining expense charge (stated as the expense ratio). Moreover, brokerage charges are not a part of these expenses as it is directly debited from the fund's corpus and the NAVs stated are already adjusted for brokerage fees.
Another crucial point is that while the management fee charged is at the discretion of the AMC (of course within the upper bound set by SEBI), the rest of the expense charge is based on actuals and is subjected to a statutory audit.
For the sake of illustration, let us look at Templeton India AMC, which manages 49 funds and on each of these there is an expense charge. Within this overall expense charge is an investment management and advisory fee, which is what the AMC earns. For example, the expense ratio for Franklin India Bluechip as on March '04 is 2 per cent. This includes an investment management and advisory fee of 1.02 per cent.
To sum it up, while the AMC pays tax, the fund that you have invested in does not. It only contributes to the AMC's earnings through the payment of the management fee.
Of course as an investor, you have to pay a long-term or a short-term capital gains tax (whichever is applicable, if at all) and now a securities transaction tax in case you have invested into equity-oriented mutual funds. But then that is a consequence of your own investment decisions.
This article was originally published on November 03, 2004.
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