The mutual fund industry is very disappointed with the latest budgetary provisions. With the replacement of sections 54EA/EB (of the Income Tax) and the imposition of higher dividend tax on debt-oriented schemes, Yashwant Sinha has dealt a double-whammy to the mutual fund industry.
There was very little by way of encouragement for the MF industry. In fact there was only disappointment. First was the replacement of Sections 54EA/EB of the Income Tax Act. Earlier investors with long-term capital gains could get relief under section 54EA/EB by investing in specified bonds/debentures, shares of a public limited company and units of a mutual fund.
Under the provisions of the budget, tax benefit can be derived by investing only in NABARD (National Bank for Agricultural and Rural Development) bonds and not in bonds/debentures, shares and/or units of a mutual fund.
This move has serious connotations for the MF industry. In an interview with equitymaster.com Anil Harish (son of the late D M Harish), leading tax consultant, gave his views on this move. He opined, 'The mutual fund industry is going to be affected very gravely, because the real flow of funds is coming in on account of capital gains. People were attracted to mutual funds out of tax benefits given to mutual fund industry and also by the phenomenal returns that the mutual funds were getting, and therefore it was beneficial both to the individuals and the mutual funds.'
Many MFs even had dedicated 54EA/EB options under each scheme for investors.
Anil Harish remarked further, 'It seems now to me that the finance minister has seen the mutual fund grow so fast that he doesn't like that, that he wants this to go to NABARD. This will make a very tangible difference to the equity markets because money is not going to come into mutual funds on account of capital gains tax exemption, and will go only to NABARD. While NABARD can do whatever it can, its objectives are limited because its funds cannot flow into different areas of equity and that can affect the capital markets. This lack of flexibility is going to be bad for the individuals and the markets.'
According JM Capital Management's Ashutosh Bishnoi, 'the removal of the two sections will impact inflows in MFs adversely - by as much as 25%.'
The imposition of 20% tax on dividends declared by debt-oriented schemes is another blow to the industry. This has increased the effective tax rate for debt schemes from 11% (earlier) to 22%. The industry's wishlist had a 15% tax imposition. According to AP Kurian, chairman of the Association of Mutual Funds of India (AMFI), the hike is too steep. The assured returns are most likely to be affected by this move.
Debt fund managers were already dealing with declining interest rates and now have to deal with higher dividend taxes. Speaking to leading financial daily, Ajay Srinivasan (managing director of Prudential ICICI AMC) opined, 'This is likely to increase their (debt fund managers) reliance on equity component of a monthly income scheme portfolio to generate incremental returns.'
However Ajay Srinivasan was of the opinion that this move would not stop higher income individuals from investing in debt schemes as this investment avenue is more attractive than other conventional avenues. It is going to be very difficult for MFs to convince retail (lower-income bracket) investors to invest in debt schemes and pay an effective tax rate of 22%.
The tax-free nature of dividends declared by equity schemes, combined with their excellent performance, are factors that will push more investors to equity schemes as opposed to debt schemes.