The Hindu Business Line : Bringing about parity

Exemption to MFs from dividend distribution tax, and to unit-holders from long-term capital gains tax, will result in a shift in the investment pattern of balanced funds.

Financial sector reforms in India have meant accent on the capital market. Of late, the Government has even started monitoring the Sensex. Funds entering the capital market do not come from Indian investors alone. Measures taken in the past two years have broadened and strengthened the market.

In this year's Budget, the Finance Minister, Mr P. Chidambaram, enhanced FII investment limits in government securities from $1.75 billion to $2 billion and in corporate debt from $0.5 billion to $ 1.5 billion. The ceiling on aggregate investments by mutual funds in overseas instruments has been raised from $1 billion to $2 billion. The requirement of 10 per cent reciprocal shareholding has been removed. A limited number of qualified Indian mutual funds will hereafter be allowed to invest up to $1 billion in overseas exchange traded funds.

Close-ended equity funds

Section 10(38) of the Income-Tax Act, 1961 provides long-term capital gains tax exemption to certain securities. And some companies, such as open-ended equity-oriented funds (Section 115 R (2)), have been exempt from paying dividend distribution tax.

Explanation to Section 115T defines an open-ended equity-oriented fund as one where more than 50 per cent of its total proceeds are invested in equity shares of domestic companies. The percentage is computed based on the annual average of the monthly averages of the opening and closing figures.

To provide a level playing-field for close-ended funds, the Finance Act, 2006 removed the distinction between open-ended and close-ended funds by amending Sections 115R(2) and the Explanation to Section 115T. The result of the amendment is that all equity-oriented funds will hereafter not be liable to pay dividend distribution tax; a privilege hitherto enjoyed only by open-ended equity-oriented funds.

The Government has also thought it fit that the definition of "equity-oriented funds" in Section 115T conforms to SEBI norms. Therefore, as per the latest Finance Act, exemption from dividend distribution tax shall be available only to a fund where 65 per cent and more of its investable funds are invested in equity shares of domestic companies. Since October 2004, income by way of long-term capital gains arising out of transfer of equity shares in a company or a unit of an equity-oriented funds is not taxable if securities transaction tax (STT) is paid.

The change in definition of equity-oriented funds by the latest Finance Act means that if such funds invest 65 per cent of their resources in equity shares of domestic companies, transfer of units will not be liable for long-term capital gains tax.

If the transfer takes place within one year, there will be liability for short-term capital gains tax at 10 per cent. If, however, the investment in the domestic equity market by the mutual fund is less than 65 per cent of its resources, transfer of units of such funds will attract long-term capital gains tax.

The allurement of exemption from dividend distribution tax in the hands of mutual funds and from long-term capital gains tax in the hands of unit-holders will definitely result in a shift in the investment pattern of balanced funds. There will be more investment in equities of domestic companies. The risk profile of mutual funds will correspondingly go up.

What about debt market?

The emphasis on the equity share market has meant neglect of debt instruments. No economy can be sustained merely by a booming stock market. A healthy market for debt instruments is vital for even the corporate sector. Recently, the Reserve Bank of India introduced the anonymous electronic order matching trading module NDS-OM on its Negotiated Dealing System.

The Government has also appointed a high level expert committee on corporate bonds. There is a move to create a single, unified exchange-traded market for corporate bonds. These measures may result in the development of a healthy debt market alongside the growing equity cult.

(The author is a former Chief Commissioner of Income-Tax.)

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