Mutual funds and the Budget 2000-2001

Important measures

Deletion of sections 54 EA and 54 EB of the Income Tax Act, 1961.

The above two sections provided relief from capital gains tax if investments were made in specified securities and locked in for a period of 3 years in the case of 54EA and 7 years in the case of 54EB. Mutual fund units were one of the specified securities and this resulted in a lot of money realised as profit from sale of securities being reinvested in the market through mutual funds.

With the withdrawal of the exemption to mutual funds, investors have lost out on a very viable alternative for tax saving and funds also would be faced with the problem of ‘hot money’ as there would no longer be any lock in period for investments. It is estimated that 54EA investments formed approximately 15% of the corpus.

Increase in dividend tax from 10% to 20% for debt funds.

The existing dividend tax payable by debt schemes has been doubled to 20%. This would lead to a reduction in returns available to investors by approximately 1.5% from the average of approximately 14%. This is expected to hurt retail investment in debt schemes and could lead to a pull out and reduced mobilisation. Two implications of this move could be:

Reinvestment of dividends by investors; since capital gains would be taxed at a lower rate as compared to dividend, investors would prefer to reinvest dividend and earn long-term capital appreciation.

Switch over from debt to equity schemes; since open ended equity schemes are free from paying dividend tax, these schemes could attract some of the investment that is pulled out from debt schemes.

Instead of taxing debt schemes so as to bring parity between the banks and mutual funds, it is widely felt that the finance minister could have simply extended some of the benefits enjoyed by mutual funds to banks and FIs. The experience with mutual funds has in any case shown that turning dividends tax free in the hands of investors has simply improved collections, widened the tax base and reduced procedural delays.