In a bid to restore confidence among investors in the capital markets, the finance minister offered an unprecedented measure by way of tax breaks for open-ended equity oriented funds. The Finance Bill also proposes to exempt income distributed by Unit Trust of India and mutual funds from income tax and has subjected the investors to only a 10 per cent dividend tax. This is likely to translate into a free lunch for many corporates without any cash outflow for them, sources said.

Consider the example: Suppose a corporate invests Rs 100 in a mutual fund like UTI, which is entirely invested back when the corporate issues debentures at a coupon rate of 13 per cent. This effectively means that there is noreal cash outflow for the corporate as what is going out as investment is coming back as a loan from the MF.

The mutual fund earns Rs 13 on the debenture invested while the mutual fund pays a dividend of Rs 11.7 (13-1.3) at the end of the year. The corporate then gets a tax shield of Rs 5.005 (38.5%*13) for the investment made in the mutual fund. Thus the total money earned by the corporates is Rs 3.705 (11.7+5.005-Rs 13). "Since there is no net cash outflow initially this a free lunch for corporates", a mutual fund expert said.

According to him a lot of corporates can take advantage of the loophole by deciding the interest rate and the amount to invested in the mutual funds schemes to reduce its effective tax rate down to 10 per cent. "In practice every Indian corporate needs to pay only the minimum alternate tax (MAT)," he said.

The government charges 35 per cent tax from corporates which has gone up by 10 per cent in the new budget. "Through this new scheme they can plan their investments and get thebenefit of the tax-shield," a tax expert said. According to analysts, the government stands to lose substantially if every corporate exploits this loophole. The government which is expecting to get atleast Rs 25,000 crore through this route will get affected as exploiting this loophole will see corporates paying the barest minimum of taxes.

The tax breaks offered by the finance minister to the mutual fund industry is likely to affect the deposit collected by the banking system as there could be a shift towards mutual funds to take advantage of these tax breaks. Second, the banks themselves cannot invest in mutual funds beyond 5 per cent of the incremental deposits of the previous year limiting them from routing their investment to gain the tax advantage.

With all open-ended equity funds and US-64 exempt from dividend tax and lowering of tax to 10 per cent for other open-ended funds would adversely affect the banks, sources said.