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Budget 2011: Good news for mutual fund industry?

March 3, 2011

An employee counts rupees at a cash counter inside a bank in Mumbai June 21, 2010. REUTERS/Rupak de Chowdhuri/Files(The views expressed in this column are the author’s own own and do not represent those of either Principal Pnb or Reuters)

When it comes to the mutual fund industry, the 2011-12 budget has good news and not so bad news.

Let’s first take up the good news.

In his budget speech, our Finance Minister has said “Currently, only FIIs and sub-accounts registered with the SEBI and NRIs are allowed to invest in mutual fund schemes. To liberalise the portfolio investment route, it has been decided to permit SEBI-registered Mutual Funds to accept subscriptions from foreign investors who meet KYC requirements for equity schemes. This would enable Indian Mutual Funds to have direct access to foreign investors and widen the class of foreign investors in Indian equity market.”

After being at the receiving end of rapid regulatory changes, these indeed point to better times, especially because overseas investors are expected to be mature and therefore longer term in their orientation especially considering that the long-term India growth story remains intact.

However, I would stop just short of popping the champagne because aspects like KYC, income tax and investor caps have yet to be unravelled.

Having said that, the industry should begin with obtaining approvals from overseas regulators so that it can exploit this very substantial opportunity.

Now for the not-so-bad news which seems to have had wider coverage.

The Section 115(r) of the Income Tax Act has been amended so that with effect June 1, 2011 all ‘persons’ other than an individual or a Hindu Undivided Family (HUF) will now on be subjected to Dividend Distribution Tax (DDT) at 30 percent instead of 20 percent on income distributed by debt funds defined by SEBI as money market & cash funds and to DDT at 30 percent instead of 25 percent on other debt funds. This change therefore, only impacts investors in the dividend option.

However, with effect April 1, 2011 the surcharge of 7.50 percent has been reduced to 5.0 percent which reduces the impact to around 3 percent and 6 percent in the case of cash and other debt funds respectively.

There is no change in the position of individuals or HUFs (DDT at 12.5 percent on cash funds and 25 percent on other debt funds).

I do not believe that this tax law amendment is a game changer. All it does is take away the small tax arbitrage which existed between debt mutual funds and other competing investment products.

Liquid mutual funds will continue to score over bank demand and term deposits not only in terms of their returns but also because demand deposits do not earn a return (all money below 7 days maturity cannot get into a bank term deposit).

An employee arranges rupee at a cash counter inside a bank in Agartala, June 3, 2010. REUTERS/Jayanta Dey/FilesNo other investment avenue allows the no holds barred liquidity coupled with a higher return. Premature withdrawal of bank-term deposits is subjected to reduced interest rates and despite popular notion CDs and CPs invariably have to be held to maturity unless of course one is ready to take a hair cut when trading out.

Income distributed by mutual funds is tax free in the investor’s hands and does not attract Tax Deducted at Source (TDS).

I would, therefore, believe that our empowered corporate investors will now have to simply choose between cash funds and other debt funds by matching their investment horizon with the duration risk in the wide range of debt funds.

As per SEBI regulations, cash mutual funds cannot hold in their portfolio assets with  residual maturity in excess of 91 days which are not subjected to ‘mark to market’ norms.

On the other hand, all other debt funds can also hold assets beyond 91 days which are subjected to asset value volatility gains and losses which will get reflected in their returns proportionate with associated risks.

Mutual funds should ideally introduce debt products with specifically defined limits for assets subjected to mark to market valuations. This way, investors will know the extent of risks associated with their choice of debt funds — especially those to their capital.

Mutual funds, as the oft quoted regulatory disclaimer states, are subject to market risks and do not guarantee a return or capital.

I eagerly await the time when liquid funds are accepted by retail investors as an alternative to bank savings and current accounts.

Unfortunately, the margins of the mutual fund industry do not afford it the luxury of building a high street distribution infrastructure.

Finally it is important to note that, the position with regards equity-oriented funds (where equity is 65 percent or more) has not changed.

They continue to be exempt from long-term capital gains tax and DDT. All income distributed by them also stays tax free.

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