Mutual funds: Taxation needs a re-look

You would think that with evolution, things get better (at least that is what Darwin proposed with regards to everything biological). So it comes as a surprise when you find that as the mutual fund industry evolves, certain aspects only get worse. Of course, all industries face teething problems, but we are sure there is a better way to handle many of these issues. And as usual, we always look forward to the budget to resolve them.

But first, a review of how mutual funds are placed at present in terms of taxation.

Dividends
Dividends on equity-oriented funds (open-ended and close-ended) are totally tax-free i.e. neither does the investor pay tax nor does the fund house pay a distribution tax.

Dividends on debt-oriented funds (open-ended and close-ended) are tax-free in the hands of the investor; however, the fund house pays a dividend distribution tax (@14.24 per cent).

Short-term capital gains
Short-term capital gains on equity-oriented funds are taxed at a flat rate of 10 per cent. Short-term capital gains on debt-oriented funds are added to income and taxed at the marginal rate of taxation.

Long-term capital gains
Long-term capital gains on equity-oriented funds attract a Securities Transaction Tax of 0.125 per cent. Long-term capital gains on debt-oriented funds are taxed at higher of the two i.e.10% without indexation and 20 per cent with indexation.

Apart from tinkering with the STT rate (this was revised last year from 0.15 to 0.125 per cent), it is unlikely that the budget will disturb the existing taxation structure.

However, there are several other issues for the budget to tackle:

There is considerable anticipation among investors for real estate/property funds (or REITs as they are popularly referred to in the US). It was in the budget that gold ETFs (exchange traded funds) were given the green signal; it is time investors were also given the opportunity to invest in real estate funds. The budget should speed up the process for the introduction of these funds.

At present, there is considerable scope to realign the mutual fund taxation structure. While mutual funds manage a range of assets (and this variety will only increase), on the taxation side, all mutual funds are lumped together under either equity funds or debt funds. So gold ETFs, which are a totally different asset class vis-à-vis debt, are classified as debt funds for the purpose of taxation.

This implies that investors in gold (physical asset) will incur long-term capital gains/loss only after holding it for 36 months, but investors in gold ETFs will incur long-term capital gains/loss only after 12

months. So ETFs are particularly attractive for long-term investors (with an investment horizon of 12 months depending on the gold price) who really aren't all that long-term (vis-à-vis the 36 month investment horizon).

Likewise, when real estate funds are launched, they are likely to be classified as debt funds. So long-term capital gains/loss on real estate funds will get triggered after 12 months of investment, while long-term capital gains/loss on real estate will come into effect only after 36 months.

Another negative of the dual taxation structure is that even certain equity assets are classified as debt funds. For instance, if an equity fund invests in global companies (which is happening already and dedicated global equity funds are expected to be launched as guidelines get clearer), this is classified as debt.

Since an equity fund must invest at least 65% in domestic equities, it cannot invest more than 35 per cent in global equities. For instance, Principal Global Opportunities Fund is an equity fund, but from a taxation perspective it is a debt fund! This is also one reason why fund houses have avoided launching equity funds that invest in global equities.

Another instance of the skewed taxation structure is equity FoFs (fund of funds). At present, equity FoFs are classified as debt funds. There is no reason why they should be excluded from the ambit of equity-oriented funds.

Reforms in the pension fund segment are long overdue. In the past, there was talk of allowing only insurers to manage pension monies. Given the limited 'investment experience' of insurance companies (most ULIPs have done well only because of the rally in stock markets), credible fund houses with superior investment track records must also be permitted to launch pension products.

There should be more stringent guidelines in place for the launch of new AMCs (Asset Management Companies). While guidelines at present may appear reasonable, you still have an AMC like Standard Chartered AMC that is exiting the mutual fund business because it is not a core business for the sponsor globally. In effect, the Indian mutual fund industry has served as a perfect laboratory for the AMC.

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