Budget Expectations: What mutual funds want?

22 Jan 2024 , 07:52 AM

WHY MUTUAL FUND EXPECTATIONS MATTER?

Over the last many years, the AMFI has been regularly putting up a list of expectations to the Union Finance Minister, ahead of each Union Budget. Ahead of Budget 2024-25, the expectations of mutual funds assume a lot of significance. Consider some of the statistics. As of the close of December 2023, mutual fund AUM stands at Rs50.78 trillion or $615 billion approximately. The average AUM is already above Rs51 trillion. That is not all. There are a total of 16.5 crore individual folios. Even if you assume duplications, that is a huge number. 

Systematic investment plans (SIPs) are bringing in Rs16,710 crore of gross flows a month and that figure is steadily growing. Today, there are about 7.64 crore SIP investor accounts and the SIP AUM has crossed Rs10 trillion as of the first week of January 2024. Clearly, mutual funds as an investment class have arrived in a big way. The time is ripe for Union Budget 2024-25 to hear out the demands of the mutual fund segment and make a close evaluation of the propositions that are feasible and can also add genuine value. Here is what the mutual funds expect from Union Budget 2024-25.

1. Facilitate tax-free transfer across mutual fund plans and options

Today if you own the dividend option of a scheme and want to transfer that to a growth option or a reinvestment option, then it is treated as a case of capital transfer. That means, it attracts capital gains tax implications. Even if an investor wants to shift from a regular plan to a direct plan (which carries much lower TER), that is also treated as a capital transfer and liable to capital gains tax. The contention of the mutual funds is that such a rule does not apply to ULIPs of insurance companies, although they are both risk products. 

It is possible to shift from one plan of a ULIP to another plan of the same ULIP without attracting capital gains tax. Hence the demand of mutual funds is to put these products at par with ULIPs in terms of tax-neutral transfer within the scheme. That means; if a person transfers from the regular option to direction option or from the dividend plan to growth plan of the same scheme, then it will be a tax neutral transaction and must not attract tax.

2. Easing the tax pressure on pure debt funds

It may be recollected that in the previous Finance Bill announced with the previous budget, there was a significant change made to the tax treatment of debt funds. Under the new rule, non-equity funds are now classified into two categories. You must be aware that a non-equity scheme is one where the equity component is less than 65%. Under the new rule, the old logic of treating gains on debt funds as long term capital gains and giving them benefit of indexation will only apply if the debt fund holds between 35% and 65% in equity. 

However, if the holding in equity is less than 35%, then it will be treated as a fixed income instrument, and the benefits of indexation will not be available. That means, even if you hold it for more than 3 years, it will still be treated as other income and taxed at your peak rates. Mutual funds feel this is unfair to debt funds where many retired and conservative investors rely on for regular income through SWPs. This spoils the entire equation for them.

3. Putting debt funds at par with listed debt

Even prior to the 35% rule, the AMFI had written to the government that the tax rules were biased against debt funds but favouring listed debt. Here is a classic case. Today, if your debt fund holds equity between 35% and 65%, then you are entitled to long term tax indexation benefits if held for 36 months or more. However, in the case of listed debt securities, this requirement is brough down to just 12 months to qualify as long term assets. This has been a persistent demand from the AMFI and other mutual fund AMCs also. They want the parity to be restored. Either, the debt instruments must also be held at 3 years for LTCG, or the definition for debt funds must also be reduced to 1 year, to put them at par.

4. Putting equity fund taxation at par with ULIPs

Another area where mutual funds have been demanding parity with ULIPs is on the tax treatment of equity funds. Today, equity funds are treated taxed even if they are long term equity assets. The tax is much lower at 10% over and above a capital gains threshold of Rs1 lakh per year. However, this is a flat tax and there is no benefit of indexation even if held for a long period of time. However, in the case of ULIPs, once the basic lock-in of 5 years is met, then any early surrender or partial withdrawal is treated as a tax-free yield to the investor. Here again the equity funds want to be put at par with the ULIPs, since the unit linked insurance plans appear to have an unfair advantage, despite being a similar product.

5. Reducing the burden of TDS on mutual fund dividends

Currently, as you must be aware, dividends earned on mutual funds are entirely taxed in the hands of the investor at the peak rates applicable. This applies to dividends on equity funds and on debt funds. However, the issue here is about the TDS limits for mutual fund dividends. Currently, under Section 194K of the Income Tax Act, TDS at 10% is deducted for resident Indian investors if the dividend amount across all schemes exceeds Rs5,000 per year. The limit is considered to be too low. One can argue that TDS is just a pre-emption of income and not a charge. However, it does force investors to go through the rigmarole of filing returns and waiting for the refund, which can take time. The demand from the Union Budget 2024-25 is to enhance the limit for all mutual fund investors to Rs50,000 dividend per year from Rs5,000. This is more so since bank interest to resident Indians is now tax-free up to Rs40,000 per annum. A similar change in the case of dividends on mutual funds would ease the compliance burden for mutual fund investors.

6. Putting equity FOFs on par with equity funds

This has been another anomaly in the taxation of mutual funds. For example, if the fund of funds (FOF) needs to qualify as an equity fund for tax purposes, it has to meet two criteria. Firstly, it has to invest up to 90% of its corpus in equity funds. Secondly, the Equity Funds in turn must also invest 90% or more in listed equities in India. It is the second criteria that most FOFs are facing a problem. As a result, the FOFs tend to be classified as non-equity funds and get unfavourable tax treatment. This has been a bottleneck for the growth of FOFs in India, a product that is so critical to financial planning in most of the Asian and Western economies. The answer is to insist that the FOF invests 90% in EOFs and the EOF in terms invests, at least, 65% in listed equities in the Union Budget 2024-25. That would make the attractiveness of FOFs a lot more intense for Indian investors.

7. Time for graded taxation of equity capital gains

This is a though process that has been in the works for a long time. Currently, if equity funds are held for more than 1 year, they are treated as long term funds and are taxed at 10% flat, after considering a base exemption of Rs1 lakh per annum. The problem with this piece of regulation is that it discourages long term financial planning. For example, when a person saves in an equity fund through SIP for 25 years, then out of the corpus  received, more than 80% is returns and less than 20% is the invested capital. The entire 80% becomes liable for gains at 10% and there is no indexation benefit available. The demand, therefore, is to either offer indexation benefit or make long term gains on equity funds tax-free, if held beyond 3 years, instead of 1 year. That is likely to encourage long term financial planning.

8. Reinvigorating tax saving schemes in the New Tax Regime

When the new tax regime (NTR) was simplified and made the default scheme in the last budget, it also meant a blow for ELSS schemes, which relied heavily on the attractiveness of the tax exemption. However, that remains relevant only for the old tax regime and not in the NTR. Here are some expectations. Firstly, a separate limit of Rs1.50 lakhs can be carved out of Section 80C only for ELSS schemes to encourage people to grow wealth with tax planning. Secondly, a nominal ELSS of Rs50,000 limit can be introduced in the NTR also, to ensure that retail and small tax payers do not lose out on the growth benefits of ELSS. A third proposal is to make the tax saving more rational by also including debt schemes under the banner of DLSS and subjecting them to a 3 year lock in. That will also encourage the entry of conservative investors into the fold.

9. Time to re-introduce LTCG reinvestment benefits in mutual funds

 Today, we are aware that one can save tax by reinvesting the long term capital gains in residential property entitles you to claim tax exemption on the capital gains under Section 54F of the Income Tax Act. However, you must be aware that prior to 2001, there were two sections viz. Section 54EA and 54EB, where investors could reinvest the long term capital gains in mutual funds and make the capital gains tax free subject to a minimum lock-in. However, these sections were scrapped in 2001 Union Budget and replaced with Section 54EC, which limited this exemption only to infrastructure bond investments in REC, NHAI, IREDA and such other approved institutions. It is not expected that Budget 2024-25 should bring back that benefit of Section 54EA and EB for mutual funds. That will ensure a lot of capital gains money come into mutual funds and also attract a lot of HNIs into that space.

Of course, this list can go on, but these are some of the key demands that mutual funds have ahead of Union Budget 2024-25. One thing to note is that mutual funds as a share of GDP is still very small in India at about 15% of GDP. In most developed the mutual fund AUM is around 75% of the GDP. That should be the target. For that, this Union Budget 2024-25 can make a start by smoothing out some of the creases in mutual fund regulation.