Equal treatment

Govt should not tax two forms of debt differently

The Reserve Bank of India (RBI) has responded to the crisis across the debt segment of the mutual fund industry by opening a special window to support bank lending. The window, which is open until May 11, will help debt funds with sound portfolios to tide over the current crisis of confidence. Banks can lend to debt mutual funds (MFs) under the special liquidity facility for them up to a limit of Rs 50,000 crore, with their offer of collateral, which may also be swapped back after 90 days. MFs, which can offer acceptable collateral, will now be able to handle redemption pressure without fear of liquidating portfolios at a discount. However, this scheme is likely to benefit only funds that hold paper issued by the government or by AAA-rated firms. Lower-rated collateral is unlikely to be acceptable in the current climate. This means funds with large exposures to the high-risk, high-yield category of instruments will still have to cope with redemption pressure. The liquidity situation for lower-rated papers may only improve as the economy returns to normalcy.

But a key issue that has not been addressed for many years is the differential tax treatment for bank deposits and investment in debt MFs. Income from deposits is taxed above a low threshold at the marginal rate, while debt funds that are held for three years attract 20 per cent tax after indexation. Usually, this sort of differential is designed to encourage investment in a certain category of assets. For example, equity receives much more benign tax treatment than debt since equity investments are riskier and favourable treatment is supposed to encourage entrepreneurship. But in this case, banks and debt funds broadly hold the same range of assets, in the bond market, at least. While banks lend directly to companies, both debt funds and banks operate in the bond market, where they have access to the same range of assets. The debt funds, which are in trouble at the moment, are the ones that have dabbled most in risky, high-yield assets. It is likely that tax differential encourages the flow of household savings in risky businesses — something that they don’t properly understand. Fund managers accumulate risky bonds to show higher returns, which helps in attracting more flow.

There is no reason why the state should distinguish between two forms of debt when it comes to taxation, especially when it is the relatively well off who invest in MFs. Such tax arbitrage tilts the scales decisively in their favour, to no discernible public purpose, and perhaps to the public detriment when one considers the cases of fund mismanagement, default, and the like, as has just happened with Franklin Templeton and in the past with other fund managers. In the latest case, the fund house’s aggressive investment strategy and appetite for non-AAA corporate bonds was once feted for its ability to pay higher returns to investors. This penchant for taking unabated risk has now backfired in a spectacular fashion. The differential tax treatment must go.