The New Direct Tax Code (DTC) Bill has several provisions that will impact mutual fund investors and the manner in which they go about investing in mutual funds in the country. Since there is about a year and a half to go before this will be implemented, there is time available for the investors to adjust to the changes that are proposed. There are several implications of the changes that the new code will actually bring about and hence each one of them will need to be taken into consideration by the investors as they go about preparing for the changed environment. Here are a few areas with their important details.
There are several tax benefits that are available for investments into mutual funds and all except the zero per cent long term capital gains tax are not likely to be around in the DTC. The immediate impact will be felt on the deduction that is available currently under Section 80C for the investments made during the year into Equity Linked Savings Schemes (ELSS) and this will no longer be present. At the same time the equity-oriented funds that currently have no dividend distribution tax will find that they will need to pay the tax in the future which means an indirect impact for the investor though this will be very marginal. This removal of the tax benefit has to be considered in tune with the position of certain categories of funds and how they will exist in the future.
Equity linked savings schemes (ELSS) today form a part of the mutual fund universe and these funds have a specific role to play for investors in their portfolio. These are funds where investments up to Rs 1 lakh enables the investor to get a deduction from their taxable income under Section 80C which also includes a lot of other investment options like the provident fund contribution, PPF contribution, National Savings Certificate investment and so on. The presence of ELSS is important in this list because it is the only pure equity option that is available for investors under this section.
This option will no longer be available under the DTC as a means of getting deduction under the Rs 1 lakh limit proposed here and what this means is that it signals an end to the use of the ELSS funds. Today if one goes and looks at the nature of the funds, then ELSS are similar to the diversified equity funds that are offered by the fund houses. The only difference that is actually witnessed is that there is a lock-in period of 3 years that is present on these funds. The presence of the lock-in and the tax benefit means that these funds stand out as a separate category.
Once the tax benefit is not there, there would be no incentive for launching new funds by the industry and at the same time the investor interest in the existing funds for new investments will also dry up. That is obvious since there is no reason why someone would want a three-year lock-in for their investments without any tax benefit to follow. The moment the fund removes the lock-in for the new investments in these funds there is little that separates this category from the long list of other diversified funds in the market. This does not mean that the existing ELSS funds will close down overnight but these will continue as the investors who have already invested would wait for their lock-in to end and then slowly withdraw their investments.
A lot of investors do not even today know that there are pension funds that are offered by mutual funds for investors. These funds also have the same deduction under Section 80C as ELSS and hence also have the same three-year lock-in. Once again there is no direct mention of the continuation of the benefit for these funds under the new DTC and hence the investors will have to take a careful look at the manner in which the situation unfolds in this area over a period of time. Unlike equity-oriented funds that have the tax benefit, the situation here is a little better for these funds as the removal of the tax benefit will still leave the basic reason for the funds existence intact. There is a specific purpose for these funds which is to provide amounts for the investors at the time of their retirement and these funds are best positioned to undertake this goal. There are just a couple of these offerings in the market - one from Templeton Mutual Fund and the other from UTI Mutual Fund.
These funds have a specific goal in mind so even if the tax benefit is not present then there are investors who would want the specific need of earning pension to be completed and they can look at the pension funds for meeting their requirements. The idea is to build a corpus over the life of the individual in such a manner that there is a mix between debt and equity so that it can be used to generate a regular return in the later years of a person's life.
There is a change that will impact debt funds. Under the existing system, the dividend that is received on all funds, be it debt or equity, is tax free in the hands of the investor. There is an indirect impact in the debt funds through a dividend distribution tax that has to be paid by the fund house and this acts as an indirect cost for the investor in the fund as the figure is adjusted in the net asset value of the fund. Under the DTC, there is no dividend distribution tax that has been proposed on debt funds but the dividend received by the investor will be taxable as income from other sources in their hands.
This situation will also require some working for the investor because this will change the manner in which they will be treating dividend. There will also have to be a separate way in which they treat the dividend that is received from equity funds and debt funds since dividend received from equity funds will be tax free in their hands as dividend distribution tax will be paid on it. The impact in terms of the cost can also be high because someone who falls in the higher tax bracket will have a situation where they end up paying a higher amount on the dividend received when this gets totaled into the taxable income as compared to someone who falls into the lower tax bracket. This could prove to be a significant impact on the investor and hence will require individual workings to know the exact situation.
Capital gains on equity funds
There is relief that is available to the investors on the capital gains front for equity-oriented funds. This will come as a major ease for investors who have been thinking of the impact that the change will have on their finances. The terms for the short term and long term capital gains classification remains as before which means that any holding more than one year will classify for the long term category. The benefit of the short term capital gains transaction is that there will be a relief of 50 per cent on the gain so in effect the tax rate will become half of what the investor would have normally paid. The final tax rate depends upon the block that the individual falls under. So this would be 5 per cent, 10 per cent or 15 per cent as the case may be (since the tax rates proposed are 10 per cent, 20 per cent and 30 per cent for individuals).
The long term capital gains situation is the only one where mutual fund investors in equity-oriented schemes can smile as there is no tax that would have to be paid for the gains earned here. Full 100 per cent would be allowed as a deduction and hence there would not be any amount that would be liable to be taxed. This is a situation that is similar to what is prevailing at the current moment and hence it would ensure that there is adequate interest that remains for the investors to continue their investment for a longer time period.
(The writer is Chief Coach at FinCare Consulting)