The unsolved mysteries of Budget 2004

This is being stood on its head by the budget proposals that remove the long term (longer than one year) capital gains tax and tax the short term (less than a year) gain at 10 per cent, down from the earlier tax at the marginal rate of income tax, on ‘listed securities on a recognised stock exchange’.

Now, mutual funds are not ‘listed securities’. A mutual fund is a money aggregator that pools money from many investors, makes a corpus and then buys and sells shares, bonds and government paper on the stock market. So, while a fund does trade on a stock market, its schemes need not be listed. These are bought and sold directly through agents, from the mutual fund.

This leaves mutual fund schemes subject to tax at the older rates of 10 per cent on long term capital gain without inflation indexation and 20 per cent after indexation. Short term capital gains are to be taxed at the marginal rate. If you have bought units at Rs 15 and sell, after a year at Rs 35, the Rs 20 profit per unit will be taxed at 10 per cent. Had you bought a share directly and transacted at the above prices, your tax liability would have been zero.

It is expected that the government will include mutual fund units in its definition of ‘securities’ but if it does not, then look at using a divided reinvestment plan to circumvent this problem. Another strategy is to look at two fund entities that are listed: closed end funds and exchange traded funds (ETF). A closed end fund, unlike an open end fund, has a date of redemption. These are not bought and sold directly but through a stock exchange.

An ETF is a mutual fund scheme that is like an index fund, except that it lists directly on the stock exchange and is bought and sold through brokers. Ask your broker for more details on this.

2.Why kill the debt market for the small investor?
The turnover tax at 15 basis points (a fancy way to say 0.15 per cent) is hard on the markets, but particularly harsh on the debt funds. A debt fund is a mutual fund product that buys into government and corporate bonds and gives a reasonable return at low risk to the investor. Debt funds, like monthly income schemes are favoured by the retired and the risk-averse. Since debt funds work on very thin margins, a rise in the cost of 15 basis points may impact the overall return and unwittingly push the risk averse investor towards riskier equity in search for higher return. If the government does not exempt debt from the turnover tax, you may find small savings products a better bet than a debt mutual fund today.

Once the small savings rates go down, equity remains the only other way to get better returns.

3.Why push the individual into using insurance as a saving product and not for protection?
Insurance has been sold as a tax-saving device by agents for many years in India. In the last three years some insurance companies had made headway in explaining the true nature of insurance to people. Life insurance is a product that a person should buy to protect his family to protect against his own untimely death. A pure risk cover, like a term policy, has a very low premium, unlike a hybrid product, like a unit-linked plan or a money-back policy which have higher premiums since a large part of the premium goes towards investment and growth and a small part towards protecting the life of the person using the insurance. By taxing the risk premium, that part of the premium that goes towards the risk cover, and not the savings part, the government is prodding the individual into using insurance for investment and not protection. This should have actually been the other way round, tax the savings part and make the risk component tax free. If this rule stays, you should still consider buying insurance that is geared more towards a higher protection component rather than higher savings.