The core principle that drives the structure of MFs is that it is a pass-through entity. An MF is exempt from tax on its income, not because of explicit benevolence to the industry, but out of sheer logic. A fund simply earns an income, charges a fee for doing so, and passes it on to the investors, who in turn pay the taxes as applicable. It is the relative attractiveness of the MF industry that has attracted repeated tinkering of the advantages that flow out of its pass-through status. There have been several innovative ways in which this has been done, and this Budget proposes yet another version. The impact of these changes is a shifting competitive environment for the MF industry, with every policy change. A burden the industry can well do without.

The repeated tinkering with dividend distribution tax comes from the tax arbitrage in the debt fund. The complexity arises out of the differential rates of tax incidence in the hands of the investor, and the difficulty of choosing a single rate for distribution tax. By creating differential rates for individuals/HUFs and the others, apart from increasing operational costs, the relative attractiveness equation is disturbed yet again.

The biggest concern, though, is in the changes to the capital gains tax rates, which hurts the industry in two ways. The Budget has linked the new low rates of capital gains tax and the securities transactions tax, and seeks to balance revenue targets by foregoing capital gains tax, in cases where it can be recovered from the securities transaction tax. An MF is a tax exempt entity because it is a pass-through vehicle and, therefore, pays no capital gains tax on its investment transactions. But it will now be subject to the securities transaction tax, because the proposals define a “taxable securities transaction” as one entered into on a recognised stock exchange.

The investment transactions of an MF are not taxable, but since the entire portfolio has to have marketable securities by definition, these are entered into on stock exchanges. Since MFs offer liquidity, and are open ended, they have to buy and sell securities on a continuous basis. In products like the liquid fund, the tenor of the instrument is so low, that transactions to buy and sell have to be frequent, by design. A liquid fund with a maturity of, say, 30 days, will buy and sell assets, assuming it does not trade in the interim at all, about 12 times in a year. Therefore, on net assets of Rs 100, the turnover is Rs 1,200. At 0.15 per cent, the tax works out to 1.8 per cent. Given the average return of 4.8 per cent for the liquid fund, this is a 37.5 per cent reduction in return. Most debt funds will become unattractive if the transaction tax applies to MFs, which were in any case not paying any capital gains tax.

In one stroke, the Budget undermines all the process innovation and efficiency of the MF industry and makes direct investing in equity markets more attractive than investing through MFs

Even higher damage is in the proposed treatment of capital gains of the investor. His transactions are now easy, efficient, less expensive, and safe, only because he deals directly with the MF. The industry has moved a long way from the nightmares of lost and forged certificates and inordinate transfer delays. But he will now not have the benefit of the capital gains tax, because these transactions are “not entered into on a recognised stock exchange.” Since he would pay not transaction tax, he would continue to pay the capital gains tax at old rates. In one stroke, the Budget undermines all the process innovation and efficiency of the MF industry, and makes direct investing in equity markets more attractive than investing through MFs.

Even granting that the MF industry does enjoy a preferential tax regime, has there been a positive pay-off? MFs have created significant benefits to investors, corporate sector and the capital markets, a story not so widely told. From a time where investors had to apply for allotment of securities, face the peril of loss in transit, wait for 60 days to transfer, suffer risks of unscrupulous transfers, MFs have made investing easy, safe and flexible, and reduced transaction time to three days, or lower.

While the reduction in interest rates of debt instruments translated into direct reduction in income for most investors, MFs enabled millions of individuals and institutions to benefit from the capital gains that came along with the reduction in interest rates. If there were no mark-to-market products, like the debt fund, the benefits of the debt markets would have remained restricted to banks and wholesale players.

MFs have grown this segment to a Rs 90,000 crore, liquid, efficient and cost-effective choice for investors. Provident funds that have lately begun to invest in gilt funds see these benefits as significant. Even as the corporate sector began to see treasury management as a separate profit-centre function, but had limited investment opportunities beyond the risky ICD markets and the low-volume CP markets, MFs enabled efficient deployment of short-term funds of the sector, in liquid funds. At asset management fees of 60bps, liquid funds are efficient and low-cost mechanisms for managing short-term surpluses. MFs have extended the formal credit mechanism to the

NBFC sector, and virtually created a market for short-term lending to good quality credits in this sector. Much of the growth in the CP markets can be attributed to MFs.

The same is true for corporate bonds and private placements, where MFs have enabled significant improvements. By offering product choices that earn market returns, they have enabled investors to shift away from the yearning for an assured level of return, to a market-determined rate. They have done this maintaining a high level of transparency and disclosure, which helped build investor trust in options that did not necessarily come from the government. The Rs. 1,60,000 crore assets in the industry are a testimony to this.

If the government sees the merits of the MF choice for investors, one would expect that they would create an enabling environment that encourages investors to choose MFs over investing directly in the markets. Such special attention to MFs came in 1998, in a set of tax sops, though the primary intent was to bail out UTI. The benefits that spilt into other MFs can best be described as a happy, unintended consequence. What is disturbing, is that taxation of MFs and its investors seems to be driven so much by the need to alter its attractiveness in comparison with other products, and little else.

This time, the damage is deeper, as direct investing in risky markets is tax-efficient than choosing the MF route. The industry is high on energy and enthusiasm, but shifting the competitive grounds on which it works, year after year, is unkind. To play and to win are important — being in a fair game comes before that.

The writer is managing director, Prudential ICICI AMC Ltd.