Spraying DDT

To a corporate investor paying 35 per cent on interest income, the debt fund became a good ‘pass through’ vehicle. By 2000, banks began to cry hoarse, as they were losing customers to debt funds, and the minister increased the DDT to 20 per cent. Then in 2001, he went back, true to the ‘roll-back’ tradition, and reduced the DDT again to 10 per cent, this time in response to the technology led crisis and the need to bring the small investor back to the markets. In February 2002, the minister ‘troubled by the issues over the past four years’ decided to do away with tax exemptions for mutual fund dividends, and made them all taxable. The story thus kept changing every year, as you can see in the table alongside, with more tweaks and turns to the definition of which kind of fund should pay DDT and who should pay at what rates.

What is the problem with the DDT? And why is it contentious? First, to the extent that interest income remains taxable, there is no case for making it tax free only because it went through a debt fund. If an investor invested in the same securities that the debt fund invested in, and earned the interest income, he pays tax. But if the mutual fund bought the same securities and paid out the same income as dividend, it becomes exempt. Therefore a debt fund provides a better post tax return compared to direct investment in other comparable taxable interest yielding products. Second, there is an element of inequity in the way the DDT works, applying a uniform rate to all tax payers. An investor whose marginal rate of tax is lower than the DDT, ends up suffering a loss in return. For example, an investor who is not subject to tax, would receive his dividend after a DDT of 25 per cent, whereas a tax paying investor still enjoys a subsidy on the dividend income as long his marginal rate of taxation is higher than the DDT rate.

Why the experimentation with DDT? A mutual fund structure is not a simple one of receiving interest income and passing it off as dividend. There are some complications. First, the debt securities in the portfolio are valued at market price every day. This means, the NAV of a debt fund is not made up purely of interest, but also of some appreciation/depreciation in the value of the securities. Therefore, pure interest income cannot be separated and distributed. Second, the NAV itself will fluctuate based on the market situation, and there are times when the loss in the value of the portfolio can be higher than the interest income earned, or vice versa. Third, not all debt funds are equal, when it comes to their interest income and capital appreciation. Depending on the duration of their portfolio, these components can vary. As long as interest income that the fund earned has got entwined with the capital gains/losses, it is tough to put the debt fund on par with other pure interest earning instruments. Which is why debt and liquid funds remain products chosen by corporate and institutional investors — a segment that has to be separately recognised when it comes to the DDT.

The mutual fund industry clearly focuses on this segment for its debt and liquid fund products. Every debt/liquid product comes with a dividend and growth option, as well as the facility to reinvest the dividend. Therefore, depending on the investor’s tax situation a suitable option can be chosen to optimise taxes. About 40 per cent of the industry’s AUM is in liquid and debt funds, and this number was much higher before the equity boom of the last 3 years brought a large corpus of equity funds in. The opportunity provided by the DDT regime has been well optimised by the industry and the investors are not complaining. This time around the axe has fallen on liquid funds, though the 25 per cent DDT still leaves some room for tax arbitrage by corporate investors.

Not all debate about DDT should be about tax arbitrage. The other side of the story is that liquid funds today provide an efficient treasury option to several corporate investors and has emerged a niche product. Liquid funds enable investors access diverse markets for CPs, CDs, CBLOs and PTCs and offer liquidity intermediation. Liquid funds service investors in a 24-hour time frame. If a large investor is today looking for a market-linked return on his treasury funds, the liquid fund would wins hands down for competitiveness, efficiency, cost and service. Not everything about mutual funds needs to be about small investors. The industry needs large investments by corporate investors to be able to acquire size and cross subsidise small investors. Liquid funds that serve large investors and the other funds that serve retail investors have emerged as two equally important segments for the industry. It is then time to recognise these segments as such and look at DDT as the much required incentive, both for the industry and for the investor.

The author is managing director, Centre for Investment Education and Learning Pvt Ltd