Budget Should Bring Mutual Funds On Tax Parity With NPS

Finance Minister Nirmala Sitharaman has indicated that the government will continue to work for the middle class in the upcoming Budget. Towards this aim, the government is focusing on job creation, building infrastructure, and smart cities, among others, to fulfil the aspirations of India’s workforce. 

The past few years have been very challenging for the global economy as well as India. The country has emerged relatively well from the throes of the pandemic and global headwinds compared to other economies. Economists are predicting that the Indian economy is set to reach the $7 trillion mark in seven years. 

The mutual fund industry plays an important role in channelising savings towards the capital market. Indian households have embraced market-linked products like mutual funds in a big way post-demonetisation as we enter into an era of financialisation of savings. 

It is heartening to see that the mutual fund industry has grown at a CAGR (compound annual growth rate) of 14 per cent from Rs 21.26 lakh crore in December 2017 to reach Rs 40.76 lakh crore in December 2022. As of December 2022, the inflows from Systematic Investment Plans (SIPs) stand at Rs 13,573 crore with a record 6.12 crore SIP folios. Thus, it is clearly evident that Indians prefer the mutual fund route to meet their long-term goals. 

To help mutual funds penetrate further into smaller towns and cater to investors’ long-term goals like retirement, here are a few recommendations made by the Association of Mutual Funds in India (AMFI) for the Budget 2023, which I would like to reiterate: 

MF Retirement Products With Tax Benefits  

With the absence of any formal pension scheme for the private sector, many investors invest in mutual funds to meet their retirement goals. Currently, National Pension Scheme (NPS) is eligible for an additional tax exemption of Rs 50,000 under Section 80CCD. The mutual fund industry has long been demanding that the tax treatment for NPS and retirement/pension-oriented schemes launched by mutual funds should be aligned by bringing the latter under Sec 80CCD of the Income Tax Act, 1961. This will bring parity of tax treatment for the pension schemes and ensure a level playing field.

Mutual funds should be allowed to launch mutual fund-linked retirement plans (MFLRP) akin to a 401(k) Plan in the US, which would be eligible for tax benefits. Tax incentives are pivotal in channelising long-term savings. For instance, the US mutual fund industry saw rapid growth when tax incentives were announced for retirement savings. The Indian mutual fund industry has provided support to the domestic market when we have seen record outflows from foreign institutional investors. 

Pension funds can emerge as sources of funds in infrastructure and other projects with long gestation periods. Pension funds can provide depth to the equity market (absorbing stocks arising out of the government’s disinvestment programme). 

Remove Tax Arbitrage 

Furthermore, mutual funds offer many features like ‘Income Distribution cum Capital Withdrawal (IDCW), formerly a dividend plan, growth options, and direct and regular plans. 

Mutual fund investors sometimes switch from the growth option to the dividend option (or vice-versa) and from the regular plan to the direct plan and vice-versa. Currently, such switches are treated as “Transfer” under Sec. 47 of the Income Tax Act, 1961, and liable to capital gains tax. In such switches, the amount invested remains in the mutual fund scheme, and there are no realised gains as the underlying securities/portfolio remains unchanged. 

Unit Linked Insurance Plans, on the other hand, are not subject to capital gains tax for switching within a plan. To conclude, similar products should get similar tax treatment, and hence this tax arbitrage needs to be done away with. 

Flexible Limit On International Investing 

In addition to these recommendations by AMFI, another area that needs attention is that the government needs to provide clarity and some leeway in the international Fund of Funds (FoFs) category, which has gained immense traction lately. There is a cap of $7 billion on total investments by mutual funds in foreign funds. There is a separate limit of $1 billion to invest in foreign Exchange-Traded Funds (ETFs). The government should consider having an open limit to cap the total investments by mutual funds in foreign funds at 10 per cent of equity assets of the industry, given that demand for such funds is on the rise. International FoFs are an ideal vehicle for domestic investors to get international diversification, which can be up to 10 per cent of investors’ portfolio allocation.  

Lastly, Equity Fund of Funds should be treated on par with Domestic Equity Funds for taxation as equity FOFs (domestic and international) primarily invest in funds based in domestic or foreign countries where the underlying holdings are stocks. Currently, FOFs are treated as debt funds for taxation.

Disclaimer: The author is the CEO of PGIM India Mutual Fund. Views expressed are the author’s own