This withholding tax has been kept in abeyance, for 3 years for those mutual funds which invest more than 50 per cent of their investible funds in equity shares. On the other hand, long term capital gains earned on sale of listed mutual funds is the lower of 10 per cent of the capital gains without indexation of the cost of acquisition or 20 per cent of the capital gain after indexation of the acquisition cost.

Now, let us take a look at the implications. A fear has been expressed that the tax free dividend from equity funds may make investors switch from safe, income oriented options to risky, equity oriented options. Even within the mutual fund industry, a non-level playing field has been established whereby income funds are subject to 11 per cent withholding tax on dividends whereas equity funds are not.

The fear is that equity funds will sell due to the tax sops and the investors may ignorethe attendant risks of investing in equity funds. The fear is not entirely unfounded, in my opinion.

While, the MFs and the market intermediaries may take the view that tax sops are not the sole rationale for investment, it would be but natural for a large number of small investors, who are otherwise risk averse to switch funds from safe, income oriented options to risky, equity oriented options. At what cost this switch will be made, only time will tell.

Another attendant issue is that, all of a sudden, equity funds have become attractive short term investments whereas all of us have been touting funds as long term investments. It makes eminent sense for investors to purchase units cum-dividend, receive the tax free dividend and sell the units net of dividend i.e., what is commonly referred to as 'dividend stripping'.

In view of prevailing investor service standards, this whole cycle can be accomplished within a week, with little risk of loss of principal. This means that 'hot' money could flow, in andout of the equity funds, thereby making the equity funds extremely volatile, at around dividendpayout time. This is bound to be injurious to the interest of long term investors. Do we desire such a situation ?

Yet another issue is that of the quantum of dividend payable by equity funds. As is commonly understood, dividend is paid out of realised income net of loss provisions.

In order to pay dividend, the equity funds will have to realise a part or the whole of the capital gains by resorting to sale of equity shares in the market. Since, all funds, except UTI have their year ending on March 31, would this not lead to a depressed market condition at year end ?In all this discussion, we have not considered the plight of the poor risk-averse investor such as a senior citizen or a widow who invests in income funds to realise regular income by way of dividends.

In order to make equity funds more attractive, the Budget proposals have, unfortunately taken away the hitherto tax-exempt nature of dividendincome in the hands of such investors. On the contrary, the dividend income of large investors, including corporates, in such income funds will be more attractive on post-tax basis, because for them the marginal tax rate has come down from 22 to 11 per cent.

Is this not contrary to the principles of social justice ? Having raised these questions, I have a few suggestions for the Finance Minister, the Mutual Fund industry and the retail investors at large.

I suggest an amendment to the Budget proposals so as to enable small investors in income funds to access the benefits, provided hitherto in terms of minimum TDS exemption limit of Rs. 10,000 and applicability of Form 15H. This will also partly restore the level playing field between equity funds and income funds.

In terms of revenue implication, this amendment would not amount to much.As far as the Mutual Fund industry is concerned, they should collectively take a view regarding "dividend stripping" and use the provision for exit loads skillfully toavoid flow of 'hot' money in and out of equity funds around dividend payout time.

Finally, a word of advice to the retail investors. I would strongly advise those investors who are, by nature risk averse, to take a well considered view of the risks and rewards of investing in equity before venturing into the same.

Tax sops should not be the sole rationale for investment in such funds.The author is vice-president and head, Escorts Asset Management