FUND FULCRUM (contd.)

March 2015

Regulatory Rigmarole

It is normal to look towards a budget with some hopes and expectations of a direct tail wind to one’s areas of interest. From that perspective, the mutual fund industry, like any other industry, had hopes from Budget 2015 - the usual ones regarding higher tax exemptions for mutual funds investing or reduction in applicable tax rates on dividends and capital gains etc. Let alone, meeting these expectations, the budget has created some headwinds for mutual funds’ distribution by removing the service tax exemption for commissions paid out to distributors. Since the total expense to be charged on a scheme is capped by regulation, this charge will potentially result in reduced earnings for distributors and AMCs’ share of retention. But all said and done, mutual funds are capital market entities. Tax exemptions, commissions, surcharge on tax etc. are relevant if there are incomes and earnings in the first place. Equity markets produce returns based on the earnings of the corporate sector. How the budget is effective in managing the entire economy and what it does to corporate sector as a whole is more important than what it does directly for the mutual funds sector. Budget 2015 provides tailwinds for growth in top lines with the government highlighting a pro-growth approach. Increased outlay on infrastructure spends with thrust on infrastructure development from the government and capex from the public sector, will result in increased demand in the economy. Already we are witnessing reduced input costs and lower expected inflation. With the direction of reduction in corporate tax rates over the next four years, we now not only have growth in top line and reduction in costs, but we also have reduced tax on the earnings. Combination of these three working in tandem over the next few years could result in rerating for Indian equity markets over the years to come. If markets reward investors, their willingness to invest and allocation to equities will be higher.

Union Budget 2015 has proposed to hike the dividend distribution tax in debt funds by 40 bps to 28.75%. In the Budget document, Union Finance Minister Arun Jaitley has proposed to increase the surcharge by 2% from 10% to 12% on additional income-tax payable by fund houses on distribution of dividend. Debt funds currently pay DDT of 25%+ 10% surcharge + 3% cess or 28.325% on gross basis when they distribute income to resident individuals. Now, after factoring in the hike in surcharge, DDT will increase to 28.75%.  It does not make sense to opt for dividend payout option for individuals irrespective of their tax bracket. Investors should simply go with growth option. Firstly, they will have indexation benefit if they remain invested for over three years. In addition, they will be taxed on marginal rate of taxation in case of redemption within three years, just like bank deposit. In July 2014, Finance Minister had revised the computation method of DDT on gross basis which had increased the actual DDT payout by almost 5%. With the proposed revision in DDT, the dividend payout option in debt mutual funds has certainly become less attractive.

The mutual fund industry is likely to witness more scheme mergers after the government in its Budget proposed to change the tax treatment on such mergers. So far, merger of one scheme with another was treated as a normal transfer of units, which led to capital gains tax liability for an investor in the former fund, provided the NAV at the time of transfer of units was higher than at the time of purchase. From now on, such a merger of two or more schemes will be exempted from capital gains tax and will not be treated as a mere 'transfer' of the mutual fund units. This is likely to encourage fund companies to go in for further consolidation of schemes in their portfolio.  Scheme mergers will no longer be considered as fresh investments, allowing investors to make exits earlier without incurring taxes. For instance, long-term mutual fund investors were deemed fresh investors the moment a scheme was merged with another one. As a result, these investors ended up paying short-term capital gains (STCG) of 15% on equity products if they sold their units within a year of the scheme merger. The STCG is 20% on fixed income products if the investor exits the scheme before three years. This anomaly is now being rectified as the budget has offered tax neutrality for scheme mergers.

The budget has, however, brought mutual fund agents under the service tax net and has proposed a marginal increase in dividend distribution tax for debt funds. These moves would increase transaction costs for investors. Exemptions are being withdrawn on services provided by a mutual fund agent to a mutual fund or assets management company, according to the budget memorandum. This means that fund houses would deduct a service tax of 14% on commissions paid to distributors in the forthcoming financial year. The finance ministry had exempted mutual fund distributors from service tax, which stood at 12.36% in 2012. 

The budget has done away with a major uncertainty for the mutual fund industry, regarding offshore fund management. Domestic asset managers, who have been pining for the ability to manage foreign money can now take heart as the government has changed the taxation structure relating to domicile of the fund manager. So far, a foreign portfolio investor making use of local fund management expertise faced tax issues on account of 'permanent establishment' (PE) norms. Location of such a fund manager in India for managing offshore funds constituted permanent establishment of the fund in India, which exposed the fund profits to tax in India at a rate in excess of 40%. This prevented foreign portfolio investors from handing over money to local asset managers and instead provided the same to managers abroad. Now, the government has modified the norms to the effect that mere presence of a fund manager in India would not constitute PE of the offshore funds resulting in adverse tax consequences. This is expected to help local fund companies to attract more foreign money. 

The Finance Minister has proposed to set up a common financial redressal agency which will address grievances against all financial services companies. Simply put, an investor can lodge his/her complaint against any financial service provider such as an insurance company, bank, mutual fund, stock broker and so on, at a single point. Though the Budget has not given clarity on how the government will take this forward, the proposal was in line with the recommendation of Financial Sector Legislative Reforms Commission (FSLRC), a committee headed by Justice BN Srikrishna. FSLRC had recommended creation of a new statutory body to redress complaints of consumers through a process of mediation and adjudication. The redressal agency will function as a unified grievance redressal system for all financial service providers. To ensure complete fairness and avoid any conflicts of interest, the redressal agency will function independently from the regulators.

The Finance Minister’s announcement to merge the commodity market regulator Forward Markets Commission (FMC) with capital market regulator SEBI may enable fund houses to come up with commodity mutual funds. Commodity funds invest in food crops, spices, fibers, copper, aluminium, oil, gold, silver, and platinum. In India, mutual fund houses are not permitted to invest in commodities other than gold. However, a few fund houses have thematic funds which invest in companies engaged in commodity business.

The Reserve Bank of India (RBI) is likely to adopt a zero tolerance policy on Know Your Customer (KYC) and Anti-Money Laundering (AML) norms. The move follows a series of violation of norms by banks, which were identified by the RBI in the recent past. The regulator also feels that the quantum of penalties for such violations is small. It is currently looking at a proposal to increase this. Another proposal is to put operational curbs such as not allowing a bank to disburse loans for three months or not allowing them to take part in treasury operations for a limited period. Branch expansion is another area where restrictions could be imposed. The central bank discussed these issues at a recent meeting with chief compliance officers of several south and western India-based banks. Association of Mutual Fund Industry in India said that upfront commission should not exceed 100 basis points (1%) for the first year. Further, upfront commission shall not exceed distributable TER (Total Expense Ratio) of the scheme if the same is below 100 basis points. The upfront commissions paid to distributors selling schemes would be capped at 1% from April 1, 2015. There is no cap on trail commission. These rules do not apply to applications sourced from B15 locations. The commission will be paid on distributable TER, which is gross TER minus operating expense. Assuming the distributable TER (net TER) of a scheme is 2% then maximum upfront commission will be 1%. This upfront commission will include expenses incurred on distributors in the form of junket, loyalty program etc. However, training has been reportedly excluded from such expenses. Gross TER on 15th of every month will be considered for such calculations. The decision comes against the backdrop of concerns raised by market regulator SEBI about high commissions being doled out to mutual fund agents. Introduction of cap on commissions would help ensure a level playing field and curb instances of exorbitant payments. At present, there is no limit on upfront commission and some fund houses pay upfront commissions of up to 8% to their distributors for selling a mutual fund scheme.

To attract retail investors, mutual fund houses are tapping social media platforms like WhatsApp and a host of other calling and messaging apps to facilitate transactions in mutual fund products. These new facilities will help investors in buying or selling mutual fund products in a simpler and faster manner. Mutual fund houses that have adopted digital modes such as internet and mobiles for increasing distribution of mutual fund products include Axis MF, Reliance MF, UTI MF, L&T MF, Quantum MF, and ICICI Prudential MF. Besides, several fund houses are allowing customers to invest, redeem, and switch funds using their mobile phones and a host of mutual funds are gearing up to adopt digital technology to tap investors. Quantum MF is offering WhatsApp facility to either transact or see mutual fund portfolios. L&T MF has introduced a new service--Goinvest--where customers can track their investments on Facebook. Besides, Axis MF's Easy Services that includes EasyCall, EasySms, EasyApp provide customers an option to invest in mutual fund schemes through an SMS, using a dedicated application or by calling up on a designated mobile number. At present, many fund houses are offering facility for online investment, but industry insiders say that there is a need to promote and make it more user friendly for investors by improving the infrastructure and efficiencies. Further, SEBI had also set up an expert panel to suggest measures for increasing distribution of mutual fund products through digital modes. According to an estimate, number of internet-enabled mobile phones in the country is expected to increase from 1-1.5 crore in 2010 to 30-40 crore in 2015. The Securities and Exchange Board of India is of the view that a greater use of internet as a distribution channel can help increase the penetration of mutual funds, especially among young investors. According to the regulator, the online phenomenon is growing rapidly as more and more people, especially the younger generation, prefer to carry out most of transactions online such as internet banking, shopping, and ticketing.