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PRE BUDGET REPORTS

Mutual Funds: Include ELSS as an eligible tax saving instrument under DTC

Direct Tax Code (DTC) and Equity Linked Savings Schemes (ELSS) have been the hot discussion topic among the investors who had been using ELSS as a route for investing in equity markets and at the same time availing deductions under Section 80C of the Income Tax Act upto a limit of Rs 1 lakh. ELSS are a form of equity diversified mutual funds wherein units of these funds are eligible as a tax saving investment. Like any other equity diversified mutual funds, they have both growth and dividend options available. The key difference with normal equity diversified fund is that ELSS have a lock in period of three year from the date of allotment of units. So every systematic investment plan (SIP) that investors do in ELSS, gets locked in for 3 years.

Under the current eligible instruments for tax savings, ELSS and ULIPs are those which are providing investors the benefit to take exposure in equities. ELSS as a category has been the single biggest driver of the retail growth of MFs in India since its introduction. At Rs 23000 crore, ELSS is the fourth largest category of all fund types and continues to grow year on year. The factors that have contributed to the success story of ELSS are lowest lock-in amongst tax saving investment options and the opportunity to generate higher returns than traditional tax saving options such as Public Provident Fund, National Savings Certificate etc. has driven the growth of this category.

The biggest issues right now in front of the Mutual Fund (MF) industry, is the removal of the ELSS category with the roll out of the proposed DTC. This comes at the time when the industry's Assets Under Management (AUM) is not growing at a good pace as distributors are not showing much interest in selling mutual fund products due to lower commissions compared with other products such as insurance which provides life cover. In addition, this year is spoiled with the awaiting exit of a major international fund house. Last budget, QFI's were given a go ahead but that had little or no impact on the AUM of the MF industry.

Impact of DTC on MF investments 

There are four proposals under the DTC that could potentially impact the investors:

1. DTC proposes to introduce a 5% Dividend Distribution Tax on Equity-oriented schemes.
2. DTC proposes to remove the Dividend Distribution Tax on fixed-income schemes and instead treat the dividends received by the investor (which is currently tax-free) as taxable income.
3. Long-term capital gains tax post-indexation benefit arising out of fixed income investments, which is currently taxed at 20%, is proposed to be taxed at marginal rate.
4. Tax-deduction offered under Sec 80C for Equity Linked Savings Schemes is proposed to be removed.

Industry Expectations

• The industry seeks continuation of benefits U/s 80C of the Income Tax Act, for investments in ELSS schemes. This will boost the MF industry as well as equity markets.

• For all other equity schemes as well, the deduction U/s 80C of the Income Tax Act should be extended, if the investor remains invested for five years.

• Dividends of equity funds are currently tax free and the industry want the government to continue to be so.

• Security transaction tax (STT) can either be abolished or reduced. STT has to be paid at the time of redemption in case of equity oriented schemes. Reducing or abolishing STT will help to increase the liquidity and volumes in the stock markets.

• Include ELSS as an eligible tax saving instrument under DTC if it rolled out in the upcoming Union Budget.

• Currently, a Fund of Funds (FOF) scheme which invests in equity oriented schemes does not qualify for the tax exemptions available to equity oriented schemes.  An equity oriented fund of fund scheme invests only in the equity schemes of other Mutual Funds and therefore they should be treated as an equity oriented scheme provided the FOF invests 65 % or more of the corpus in equity oriented MFs schemes.

Analyst Expectations:

Direct Tax Code, in the current form, will force Mutual Fund industry to innovate. ELSS may cease to exist after the implementation of the DTC in the current form, and it may be replaced by pension funds for tax exemption.

If DTC is introduced in the current form, then the list of investment in the basket of section 80C of Income tax Act can be reduced. ELSS can become ineligible for deduction under the Income tax Act and this category will surely lose all interest amongst investors. This will be huge set-back for the mutual fund industry as well as equity markets. The industry hopes for suitable changes in the DTC code to accommodate ELSS schemes. This can turn the tide in the favour of an industry which is slowly but steadily facing its single biggest challenge.

The performance of the mutual funds industry would be closely aligned with the financial savings trend in the economy. In Financial Year (FY) 2011, the financial savings reduced from around 12.9% of the GDP to 10%. This was attributable to high inflation during that period that had led to increased household expenditure. However, while the inflation is tempering down, the real economic growth may continue to be the deciding factor in determining the future investment flow in the industry. Nonetheless, the likelihood of improved market circumstances will be significant for increased retail participation in the days to come.

The Indian MF industry has limited focus on building retail AUM and players have historically garnered AUM by targeting the institutional segment. Institutional AUM makes the industry vulnerable to the possibility of sudden redemption pressures. The DTC proposal in favour of ELSS would benefit the industry in building assets from retail investors who would focus on long term savings.