Direct Tax Code: Impact on mutual funds & capital gains

(Rajan Ghotgalkar is Managing Director of Principal Pnb Asset Management Company. The views expressed in this column are his own and do not represent those of his organisation or Reuters.)

Handout pic of Rajan Ghotgalkar - Managing Director of Principal Pnb Asset Management Company.

By Rajan Ghotgalkar

Before going ahead I believe the honourable Finance Minister deserves to be complimented on the manner in which he has managed this very intricate piece of legislation whilst ensuring transparency and more importantly reacting to suggestions with an open mind in keeping with the best traditions of democratic consensus building process.

Hopefully the legislation will be able to live up to its promise to impart Indian Tax laws the much required stability which is so very important for business investment especially when we seek to import the much required foreign capital to finance infrastructure needs.

(To read Rajan Ghotgalkar’s earlier columns on Reuters India, click here)

Simultaneously, there is a move away from the directive taxes which belong in the past when we were a closed and planned economy. Tax laws are not meant to push money into government coffers but only to motivate right investing behaviour.

There is no reason why the government should accept the onerous burden of assured returns as it presently does on PPF, etc. This of course is distinct from the need for affirmative action to improve the lot of the significant portion of our population which is below poverty levels.

In the absence of a social security system, it is heartening to see the government extending the EEE status to specified retirement accumulations.

The discussion paper (June 2010) has made changes which may result in a reduction in the tax base as proposed in the Direct Tax Code (August 2009) and has therefore, held in abeyance the tax rates and slabs stated in the DTC. It is expected that these will now form part of the Budget 2011-12 but may not be as liberal.

The more significant reversal has been on the Minimum Alternate Tax (MAT) which in its earlier form was to say the least retrograde. It would have been a significant disincentive for setting up heavy industry which is not only capital intensive but also suffers long gestation periods.

It would have been unfeasible to invest in a gas refinery or a computer chip plant or for that matter even infrastructure projects. Thankfully the damage has been avoided and the MAT will now be computed with reference to book profits.

We also have our government employees to thank for prevailing on the powers that be to retain the perquisite taxation structure. It was very wise not to introduce the Retirement Benefits Accounts Scheme keeping in with the move to get away from managing investments.

The other significant rethink has been on the proposal to determine notional rent on a presumptive basis at the rate of 6 percent, which is nowhere even near the rental returns in many urban areas especially Mumbai.

It has also done away with the proposal to tax house property not let out. Anyway capital gains through appreciation of property are taxed and tax as proposed would have been repressive and highly discouraging for investment into house property, an important source of legitimate financing for housing development.

It is to the government’s credit that, it has retained its position to do away with profit linked deductions for SEZs.

I would like to now touch upon the two significant changes proposed by the DTC.

First the taxation of mutual funds and secondly the changes in capital gains taxation whilst addressing the possible impact on the investing environment, especially FIIs.

Mutual Funds and Life Insurance companies have been called “pass through entities”. Income in their hands will not be subject to Dividend Distribution Tax (DDT) nor will they pay tax on income they receive on behalf of their investors.

However, the investors will be liable to tax on “any” income which accrues to them from investment with any of the pass through entities.

It is important to clarify what the DTC means when it says “any income which accrues to them”. Mutual funds can only pay dividends out of equalised and realised profits so the need to mention accruals seems out of place and needs to be remedied lest it results in chaotic accounting requirements for mutual funds and confusion for investors.

Therefore, whilst the dividend from corporates will be subjected to DDT as now, the dividends paid by Mutual funds it seems will be taxed as there seems to be no mention of DDT to be recovered by mutual funds. This also seems to hold true for debt funds as the DTC does not make any distinction between debt and equity funds.

Undoubtedly, this will place the already besieged mutual fund industry at a significant disadvantage.

On the other hand, any sum received under a life insurance policy (including any bonus) shall be exempt from tax provided it is a “pure insurance policy”; which is only if the premium payable for any of the years during the term of the policy does not exceed 5 per cent of the capital sum assured.

I would believe that in the interest of providing a level playing field to mutual funds the DTC should very clearly provide for investment income in products like ULIPs to be taxed like mutual funds. One would not expect this to prove too challenging a task.

Income under the head “Capital Gains” will be considered as income from ordinary sources in cases of all tax payers including non residents and taxed at the rate applicable to that tax payer. This includes short term capital gains which will be taxed as above without any indexation.

Long term capital gains arise on capital assets held for a period of more than one year from the end of the financial year in which they were acquired. This prevents ‘double indexation benefits’.

Long term capital gains are divided into; listed equity shares or units of an equity oriented fund and; from ‘other assets’, which would include house property, debt instruments and units of debt oriented funds.

Long term capital gains on equity shares and units of an equity oriented fund shall be computed after allowing a deduction at a specified percentage of capital gains ‘without any indexation’.

This adjusted amount will be included in the total income of the tax payer and taxed at the rate applicable. Losses can be carried forward.

The base for long term capital gains on ‘other assets’ will firstly be moved to 1st April 2000 (from 1st April 1981) and then subjected to indexation before being taxed at the applicable rate. The proposed Capital Gains Savings Scheme will not be introduced.

Significantly, the Discussion Paper leaves the ‘Securities Transaction Tax’ (STT) open to calibration to provide for the change in the taxation of capital gains as proposed in the DTC.

It is obvious that, the intention will be to make up tax lost in providing for deductions on capital gains by retaining all or part of the STT. We may have to await the Budget 2011-12 to see the actual position.

Closely associated with capital gains is the issue of FIIs when seen in conjunction with the Double Taxation Avoidance Agreements (DTAA). It was realised surprisingly later that, the manner in which the DTC had sought to unilaterally override DTAAs was against the spirit of the Vienna Convention and that it would adversely impact direct investment due to the resultant uncertainty regarding the cost of doing business in India.

Therefore, between the domestic law and the relevant DTAA, the discussion paper clarifies that; the one which is more beneficial to the tax payer shall apply.

Most FIIs invest in India through companies incorporated in tax havens like Mauritius covered by DTAAs and what this simply means is that such FIIs will continue to retain both short and long term capital gains tax free because most countries where they are incorporated do not tax capital gains.

In the case of the remaining few FIIs which are not covered by DTAAs, they will be subjected to capital gains tax as described above.

The discussion paper also clarifies that FII income from buying/selling shares will be treated as capital gains and not business income. Of course it will no longer be possible for them to claim ‘absence of permanent establishment in India’ and avoid tax (15 percent on short term capital gains) by treating their profits as business income.

The government will benefit from higher tax through normal rates on short term capital gains.

The FIIs will also benefit from the clarified rules on the ‘Test of Residence’ which state that, it will be determined by the place where the board of directors make or approve decisions (although, the domestic MNCs will need to now watch out).

The taxation for FIIs has therefore, now become much easier.

However, with the advent of stringent Anti Money Laundering requirements and the need to prevent inflow of funds from ‘unwanted’ sources, the government has been continuously making efforts to block FIIs which cannot demonstrate transparent corporate structures e.g. SEBI requirement for greater disclosures in participatory notes.

In a step to further this effort the government has empowered the Commissioner of Income Tax to invoke the ‘General Anti-Avoidance Rule’ (GAAR).

Undoubtedly, differentiating between tax avoidance and tax evasion leads us down the slippery slope of litigation and extensive apprehensions were expressed on the sweeping nature of this law.

The GAAR can now be invoked only if the arrangement besides obtaining tax benefit is also; not at arms length, represents abuse of the provisions of the DTC, lacks commercial substance or is not for bona-fide business purposes. Apart from the above safeguards to avoid arbitrary application of this potentially repressive provision, the discussion paper also provides for a ‘Dispute Resolution Panel’.

It seems to be a general expectation that, the changes to the taxation of capital gains would result in volatility in equity markets during the first quarter of 2011 because many would liquidate holdings to book profits prior to the implementation of the DTC on 1st April 2011. Also that, the tax on capital gains will prove to be a disincentive for holding stocks long term leading to added churn.

In my view the fears seems exaggerated. Firstly because most FIIs have invested through entities incorporated in tax havens sheltered by DTAAs (for whom things have only got better) and for the small minority, there is enough time to reorganise their structures so that, they can take advantage of DTAAs.

And for the obstinate remaining few, all it will require is to sell and buy in the nature of a ‘journal entry’ which at the most will involve the cost of transacting and STT.

Irrespective of the above, it is important to appreciate that, professional investors will not take investment decisions on the incidence of tax (albeit it could be one of the subsidiary factors) but on the underlying fundamentals within stated investment objectives.

FIIs are in India (and China) mainly because they possibly provide the most favourable risk reward ratio in markets they can influence whilst deploying the surplus liquidity at their command.

As for the domestic retail investors, the zero capital gains tax has hardly encouraged them to substantially increase participation in equity markets, which have left them on the sidelines whilst they have become increasingly dominated by FII flows.

I therefore, do not foresee that, the DTC will in anyway disadvantage them because it would more than likely exempt their capital gains through deductions at lower slabs, so as to also limit the administrative burden.

However, whilst in our country which harbours extreme economic inequalities, one can hardly grudge taxing of capital gains on equity investments; it is saddening to see that, the opportunistic FIIs will continue to get away without paying tax and domestic investors will be taxed on similar heads of income.

I would believe that, domestic investors who are really here to stay in the longer term and contribute to the domestic economy, may they be retail or institutional, surely deserve an equal playing field.

We may even be well advised to retain the STT as it is and make it a permissible deduction from the capital gains tax payable in India.

-- The above article is not intended to be a financial advisory. Readers must seek specific advice from experts before making investment decisions --