Regular to direct plan switch: Is a tax levy justified for investors?

My friend Ramesh had invested sizeable savings through the relationship manager of his bank in several below-par investments, including life insurance policies and mutual fund schemes. He eventually realised his mistake and put the investments through an online portfolio analyser. It recommended exiting several investments but retaining substantial amounts in two mutual fund schemes. There was just one change: it suggested switching both from the regular plan to the direct plan to save the distributor commission being paid to the bank.

 

Then came the surprise. One of the two retained schemes had a substantial capital gain. Ramesh was told that switching it from regular to direct would be treated as a sale, triggering a significant tax bill. He was puzzled. He was not leaving the scheme. So why should there be capital gains tax? 

The puzzle deepened when Ramesh looked at his other retained scheme, which showed a loss. Just by switching from regular to direct, he could book that as a tax loss. So, the rule can trigger tax on a gain and also allow a loss to be booked without exiting the investment. That shows how artificial the tax event is. 

To understand his confusion, think of a mutual fund scheme as a single jar with two compartments — regular and direct. Both compartments hold the same shares, bonds and other investments, managed by the same fund manager. Both also bear the same fund management expenses. The only difference is that the regular compartment pays out a little more every day as distributor commission. So, if a specific amount is invested in each, on the same day, the direct compartment will always end up with a higher return. It simply isn't paying that daily commission. 

That does not mean everybody should invest only in direct plans. Many investors value the hand-holding provided by distributors and are happy to bear the commission charges. But if they later feel that the hand-holding is no longer worth the commission, they should be free to stop paying it. Instead, tax treats a switch from regular to direct as a sale, which can trigger capital gains tax. 

The oddity becomes clearer if Ramesh simply wanted to change distributors — he could do that without any tax, since only the person receiving the commission changes. But stopping the commission altogether can trigger tax. That makes little sense. 

For investors like Ramesh, a large capital gain can become a kind of chakravyuh. The tax bill on moving to direct may be large enough to keep them in the regular plan, while commission continues to be paid. The problem can work in reverse too. A direct-plan investor who later wants the hand-holding of a distributor can face the same tax problem on moving to regular. 

So this is not really about regular versus direct. It is about investor choice. Investors should be free to use a distributor or switch to a direct plan, and to change that choice later without tax becoming the deciding factor. 

Making switches between regular and direct tax-neutral will not cause any revenue loss. The capital gain is not being forgiven or exempted; it remains in the investment and will be taxed when the investor finally sells the mutual fund units.

 

Nor would this be a new principle. Earlier, some mutual fund schemes had separate institutional and retail plans which, like regular and direct plans, had different expense structures. When the regulator required these plans to be merged, the Income-tax Act was amended to make the movement between them tax-neutral. The principle of tax-neutral movement between plans of the same scheme is already recognised in law. 

Truth be told, making the shift between the different plans of a mutual fund scheme tax-neutral is an overdue fix. Ramesh, like every investor, should never have to pay tax simply to change how he manages the same investment. Until this changes, tax will keep deciding a choice that should belong to the investor alone. 

The writer heads Fee-Only Investment Advisors LLP, a Securities and Exchange Board of India (Sebi)-registered investment advisor; X (formerly Twitter): @harshroongta