How MFs can multiply your money

Budget 2006 altered the tax treatment of mutual funds in a manner that affects balanced funds.

Under the new norms, at least 65 per cent of corpus must be invested in equities, (up from the earlier threshold of 50 per cent), to qualify as an equity-oriented fund for tax purposes. Many funds, which were receiving the tax benefits of equity-fund treatment, will have to raise their equity exposure to keep those tax benefits.

Implications

The change removes an anomaly. Earlier, the Income Tax Act's definition of an equity-oriented fund ran counter to Sebi's definition under which an equity fund required a minimum 65 per cent equity exposure. The IT Act kept this threshold at 50 per cent.

Budget 2006 has retained Sebi's definition. And from 1 June 2006, only those funds with 65 per cent or more in equities are exempt from dividend distribution tax (14.03 per cent including surcharges) and unit-holders are exempt from paying long-term capital gains tax.

This move places funds that invest 50-65 per cent in equities in limbo. Earlier, these funds enjoyed tax relief. Now they will have to push equity exposure above 65 per cent to claim benefits.

Balanced funds have two choices:

• Stay above 65 per cent in equities to enjoy tax relief. Your risk profile rises.
• Retain the option to drop below 65 per cent in a falling market and ignore the tax impact. Your tax outgo increases.

Plugging the loophole

It all began with the 1999 Budget abolishing dividend distribution tax on all Unit Trust of India and mutual fund open-ended schemes that had over 50 per cent in equities to spur investor interest in capital markets. UTI's US-64, with an equity component ranging over 50-70 per cent making it a balanced fund, qualified for this tax break.

That year it paid one of its lowest-ever dividends (13.75 per cent, down from 20 per cent the year before). After factoring in losses from the prevailing sale prices, US-64 investors made only 3.9 per cent in 1998-99.

The tax break helped all funds with the specified level of equity, but the timing, when US-64 had to hack its dividend, suggests it may have been designed to aid the ailing scheme. But it could not prevent US-64 from collapsing from poor fund management. Still, balanced schemes of Sebi-registered mutual funds enjoyed the exemption for many more years.

With no US-64 to protect now, Budget 2006 plugs this loophole. The finance minister still wants to egg equity investment on; hence, the hike in the equity threshold to 65 per cent.

MF strategies

Most mutual funds aren't really worried. We are in the middle of a big bull run. Balanced funds returned 33 per cent, 17 per cent and 63 per cent in 2005, 2004 and 2003 respectively, due to high equity allocations and aggressive management. They have been managing debt passively: buying and holding till maturity with limited trading.

Significant proportions of corpus are parked in cash and call securities. Some balanced funds like BOB Balanced Fund have their entire debt holdings (28.98 per cent) in cash and call markets.

As many as 12 of 22 balanced funds already have the mandate to invest over 65 per cent in equities, as specified in their offer documents But they also have the mandate to go down to 50 per cent. Expect some of these funds to stay above 65 per cent under all conditions. Some will need to change their mandate to drop below 65 per cent.

Most of the balanced funds we spoke to said they will maintain status quo. This means that they will not hesitate in cutting exposure if markets correct. "We would much rather pocket profits and pay taxes, than having excessive equities exposure and endanger returns and suffer losses, if markets take a downturn. Anyway, the dividend distribution tax is lower than the income tax rates," says S V Prasad, CEO, Birla Sun Life Mutual Fund.

Funds like Birla Sun Life and HDFC have an edge in owning two balanced funds owing to acquisitions. One possible strategy is to maintain one balanced fund above 65 per cent for the aggressive and the other below 65 per cent for the conservative.

Birla Sun Life 95 (earlier Alliance 95) fund has consistently stayed above 65 per cent in equities, Birla Balance Fund is usually below 65 per cent. Both have the mandate to go up to 75 per cent in equities.

Sanjay Sinha, head-equity, SBI MF, adds, "It's no good if we run behind equities now and change mandates. Say one or two years down the line, debt turns attractive. In that case, we'd like to have the leeway to increase debt allocation. Asset attractiveness and returns potential will continue to be our primary driver. If at all equity allocation is above 65 per cent, it will be incidental, not tax-driven."

Some funds are planning to alter their asset-allocation pattern, as prescribed in their offer documents. Sebi regulations say that if fund houses make changes in their offer documents, they must offer an exit option. If your balanced fund makes such changes, it will send you a letter telling you about the change and will also put out ads. Keep an eye out for such changes.

Says Pankaj Razdan, CEO, Prudential ICICI Mutual Fund: "Investors will be sent an official notification on changes, with an option to exit the scheme without any load until a certain date. Sufficient time will be given to the investors."

What you should do

If your balanced fund doesn't send you a notice, stay invested. Tax benefits can only be a secondary motive. Your primary objective is to beat inflation and maintain your risk profile. If markets do correct, you stand to lose more than you save by not paying dividend distribution tax.

If your fund informs you of changes in asset allocation, we suggest two steps:

• Assess your risk profile. If you're uncomfortable with a higher equity allocation, switch to a well-performing balanced fund that can reduce its equities exposure to 55-60 per cent. Read the offer document and see if you're comfortable with the stated equity-debt split.
• Look at track record. If you are comfortable with your fund remaining above 65 per cent in equities, check out the track record. If it has outperformed its peers in the last three years, the comfort is high. But make sure you're comfortable with the added risk. Although a fund will be required to maintain the 12-monthly average holding calculated at the end of every month (of the respective month's opening and closing AUM) at above 65 per cent in equities, your fund won't drop significantly below that mark. As and when markets correct, your fund stands to lose more than conservatively balanced funds.