Equity Funds: Subjected To Unfair Tax

Updated: Jul 25 2004, 06:13am hrs
Ive been busy analysing and commenting about the Union Budgets mutual fund related measures for a couple of weeks now, and frankly, the experience has left me feeling like a professional opponent. Looking at the way fund-related issues in the Budget have been managed, I have no alternative but to behave like an ever-contrarian parliamentary opposition. As things stand now, mutual fund investors will be subject to a completely unjustifiable taxation structure.

In the Budget proposals on July 8, the finance minister introduced a Securities Transaction Tax (STT) of 0.15 per cent together with an abolition of the long-term capital gains tax (LTCGT) and imposition of a flat 10 per cent tax rate on short-term capital gains on all exchange traded securities. At that point of time, these measures were not applied to mutual funds.

The move had left those who invested in equity funds at a great disadvantage vis-a-vis those who played the stock markets directly. There were other problems with the transaction tax. Debt trading, day trading and various forms of arbitrage became unviable overnight. While the details of how these activities were conducted were not known to the Budget makers, their importance in the scheme of things meant that the government soon came out with some fixes.

These fixes were announced by the FM on July 21st. The new capital gains tax structure was made applicable to mutual funds as well. Given the fact that unlike many other taxes, the STT will be impossible to avoid, the government has persisted with it. However, the rate at which it will be applicable to different market participants has been calibrated. For normal stock transactions where the buyer takes delivery, the tax has been split evenly between buyers and sellers of securities, i.e. 0.075 per cent both at the time of purchase and sale of the security.

Heres the problem: henceforth, for purposes of taxation, equity-oriented mutual fund units would be treated at par with securities, and hence, the purview of the STT has been extended to include mutual fund units.

Consequently, unit-holders will also be able to enjoy the relaxation of capital gains taxation norms. However, this has given rise to a further complication. When a mutual fund unit is bought, the investor is the buyer and the fund is the seller, according both the parties are liable to pay the STT of 0.075 per cent. Similarly, when a unit-holder makes a sale, he is the seller and the fund is the buyer. This, to put it mildly, is a problem. The tax that the fund pays will eventually end up being paid by the investors. This means that fund investors will pay effectively pay a transaction tax of 0.30 per cent! In fact this is the way it will have to be. No tax brought upon by the transactions made by a single investor should be put in the general pool of a funds expenses.

Otherwise, it will have to be shared by other investors. But what makes this really unfair to fund investors is that when the fund is buying and selling shares on the stock markets to manage the portfolio, it is paying the transaction tax anyway. Mutual funds are supposed to be a pass-through vehicle for taxes. They are not taxed, while managing investors money because the investors will pay tax eventually. In the transaction tax, this is no longer true. Fund investors investments will attract 0.15 per cent transaction tax on the market and the investor himself will pay an effective 0.30 per cent on top of that.

The governments statement on these fixes made it appear that the capital gains tax breaks were being given to funds as a quid-pro-quo for the transaction tax. This is a strange way of looking at things. Equity mutual funds are not a parallel yet similar activity to buying stocks they are, instead, a way of buying stocks. If you apply the exact same tax on both youll end up levying double taxation. This is clearly illustrated by the way the government charges capital gains tax. There is no capital gains tax when a fund trades on behalf of investors; instead, the investors pay capital gains tax, when they sell their investments in a fund. Following the same principle, transaction tax too should be levied only at one point.

While reading the fixes statement, I observed something strange. This is what the statement said: Unit holders holding units in equity-oriented mutual funds: I propose to treat units as securities and extend the benefit of the new capital gains tax regime to such unit holders. However, like any other equities traded on the stock exchange, they would now have to pay STT at 0.15 per cent (i.e. 15 basis points), note the phrase like any other equities traded on the stock exchange. Is it possible that the Centre is still in a frame of mind that closed-end funds (which are traded on the stock markets and for which transaction tax is justified) are the main kind of funds If we werent living in a time when closed-end listed funds are just a historical curiosity then the above statement would have made perfect sense. I hope, Im reading too much into the words.

Value Research