The Hindu Business Line : Mutual funds as tax sanctuaries

Mutual funds in India do not pay income-tax, thanks to the almost blanket exemption conferred on them by Section 10(23D) of the Income- Tax Act, 1961. Contrary to the notion harboured in some quarters, this exemption isn't in deference to there being mutuality - contributors and participants to the profits of an association being the same set of persons.

The exemption, on the contrary, is evidently in deference to the fact that India has implicitly adopted the pass-through dispensation for taxing mutual funds, whereby the incidence of tax is on the ultimate beneficiaries, the unit-holders.

PASS-THROUGH EFFECT

With the abolition of tax on dividends in the hands of shareholders as well as unitholders in 1997 with a concomitant ushering in of the Dividend Distribution Tax (DDT) regime, the pass-through effect is felt vicariously rather than directly - the mutual fund pays DDT effectively on behalf of, and out of, the funds belonging to the unit-holders.

The DDT rates, as per Section 115R, are 25 per cent plus for money market and liquid funds and 12.5 per cent plus or 20 per cent plus according as one is an individual/HUF or others in respect of funds belonging to other species. Equityoriented funds, the ones investing at least 65 per cent of their investible funds in equity, however, have been exempted from DDT.

The genesis of mutual funds, as is widely known, was to afford an investment platform for the greenhorn and callow investors. But the indulgence shown to them by the I-T Act has resulted in a strange spectacle in this country - while those for whom it is intended haven't shown a very keen interest, those for whom it is not intended have latched on with alacrity enticed by the benign tax regime.

TIGHTENING THE SCREWS

The Finance Minister, Mr P. Chidambaram, very rightly therefore tightened the screws last year by introducing a regime of differential DDT with money market and liquid funds whose main beneficiaries are corporates and high net worth individuals (HNI) attracting a 25 per cent DDT. But he needs to do more. For example, exemption from DDT to equity-oriented funds has found adherents who stand to save huge amounts of taxes given the fact that such exemption is on even if the dividend distributed by such funds largely emanate from shortterm capital gains. These people left to themselves would have otherwise paid a 10 per cent tax. Now that this rate has been increased to 15 per cent, one is likely to witness a huge surge in HNI and others falling in the higher tax brackets clambering onto the mutual funds bandwagon.

In the interest of horizontal equity therefore equity-oriented funds should be spared from DDT only on dividend attributable to dividend and long-term capital gains both of which are in any case exempt from tax across the board.

Dividend attributable to short-term capital gains earned by equity-oriented funds should be subjected to DDT of 15 per cent plus, the rate at which they are taxed upfront in the hands of those who chose to have a direct interface with the stock market. If the composition of the membership of a scheme can be prised open so as to impose a differential DDT, a fortiori the composition of its income should also be vivisected so that no unmerited tax relief is given.

(The author is a Delhi-based chartered accountant.)

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