Tax Planning For Mf Schemes

Ever since the last quarter of 1994, when the share market started its downward slide, the merits of the open-ended, debt-based schemes of mutual funds (MFs) became evident. Debt funds could, of course, be either dividend paying or pure growth schemes. In a pure growth scheme, returns get reinvested in the fund instead of being paid out as dividends.

Debt funds have many pluses to it. First, the returns are not influenced by the vagaries of equity-based instruments and are usually higher than those that an individual investor can obtain from any other source. The fund manager has access to many avenues such as privately placed debentures and underwriting of primary instruments.

 

Second, most of these MF schemes come with no load, at entry or exit. Coupled with excellent liquidity and requests for withdrawals normally being settled within five working days, these schemes become comparable with bank savings accounts. And they offer much higher returns.

Third, concessional tax treatment on long-term capital gains makes pure-growth schemes attractive. But now, after the Finance Act 1997 has increased the ceiling, it makes more sense to invest in dividend-paying schemes till the limit is reached, as I have explained below.

This is the first time that the government is launching a fast-track project for reviving the share market in general and mutual funds in particular. The evidence for this, to my mind, lies in the two changes being effected in the investment climate:

No tax on equity dividend:

Dividend on shares of public companies formed a large part of Section 80L, which allows a deduction upto a ceiling of Rs 15,000 from aggregate income, chargeable to income tax, from some specified sources. The ceiling for the general categories like interest on deposits in banks, small savings schemes (NSC-VIII, POTD, NSS-92 and POMIS) and PSU bonds is Rs 12,000 whereas there is a special additional ceiling of Rs 3,000 for income from UTI/MFs (which is good) and interest from government securities. The general limit of Rs 12,000 is applicable to income from UTI/MFs also.

Now that the dividend is out of the tax net, the limit under Section 80L will have to be occupied by interest from debt-based schemes of MFs. One has to reach the limit to derive maximum benefit in terms of tax concessions. Pure-growth schemes should be reverted to only after one earns Rs 15,000 under Section 80L.

It is obvious that the only reasonable avenue left under the general and special provisions of Section 80L are debt-oriented schemes of MFs. The other avenue under the special category is securities of central or state government, which no individual would perhaps risk touching.

Reduction in tax rates:

Income tax rates have been slashed across the board. Now, the total income, arrived at by claiming deduction under Chapter VI-A (Section 80L, 80G etc.) will be taxed at the marginal rate of 10 per cent on income between Rs 40,000 and Rs 60,000, 20 per cent on income between Rs 60,000 and Rs 1,50,000 and 30 per cent thereafter.

It is obvious that those in the 10 per cent bracket will do well by opting for the regular income schemes of MFs rather than the pure-growth scheme. The same tenet applies to those in the 20 per cent bracket. Such assessees can save whatever little tax they are still required to pay by contributing to the Public Provident Fund, infrastructure bonds, ULIP and other avenues covered by Section 88.

To clarify this point further, let me assume that an assessee is earning Rs 10,000 over and above the limit of Rs 15,000 under Section 80L. An assessee in the 10 per cent bracket will have to contribute only Rs 5,000 to Section 88 and can have Rs 5,000 extra on hand for his day-to-day needs. An assessee in the 20 per cent zone will have to contribute the entire amount of Rs 10,000 and subsequently withdraw from these avenues, as soon as possible and as much as possible, according to the rules under these schemes and without incurring any additional tax liability.

Assessees in the 30 per cent tax bracket will have to contribute Rs 15,000, i.e., Rs 5,000 extra to save tax on an income of Rs 10,000. There is a small hitch though. The ceiling on contribution to Section 88 is Rs 70,000 out of which Rs 10,000 is specially reserved for infrastructure avenues.

For the assessee who has covered himself to the hilt under Section 80L and has also contributed under Section 88, it would be wise to turn to the pure-growth schemes.

Indexation on long-term capital gains

After the large-scale debacle of the share market, the investor, particularly the retail one, shifted his loyalty from MFs to public sector deep discount bonds which offer great flexibility along with assured returns. And most important, he has not yet mastered the art of saving taxes.

The Central Board of Direct Taxes has tried its level best to bring the investor on the right track by denying him the benefit of the cost inflation index on capital gains from these bonds and retaining it on units of UTI/MFs.

These units (the regular-dividend plan and the pure-growth plan) attract the same indexation which gives the dividend plan the sharper edge in slashing taxes. Let me explain with an example: Imagine that some MF had launched a scheme in 1990-91 with a dividend plan and a growth plan. It has been paying annual dividend of 15 per cent on the dividend plan throughout its term of six years and has achieved 5 per cent growth at the end of the term on the dividend plan and is redeemed at Rs 10.50. The growth plan is redeemed at Rs 23.63. You will find that the Internal Rate of Returns (IRR) for both the plans is identical. However, let us now examine the tax aspect (See box :Who wins in the tax game).

Thus, though the IRR of both the plans are identical, the dividend plan results in a long-term loss of Rs 6,258 whereas the growth plan yields a gain of Rs 6,872 for tax purpose. The long-term capital gains are taken as a separate block and charged to tax at a flat rate of 20 per cent. Neither the deductions under Sections 80L, 80G etc., nor the rebate under Section 88 are available on capital gains.

On the other hand, the capital loss can be set off against capital gains, long-term or short-term, earned during the same year. Even after such a set off, if there is any balance, it can be carried forward for eight successive years for a similar set off in future.

The monthly interest earned may be tax-free under Section 80L or come into the nil zone with contributions under Section 88. In effect the regular (monthly) income scheme distributes tax-free income regularly and at redemption, generates a capital loss; as against this the pure-growth scheme generates long-term capital gain which attracts tax, however small.

To sum up

For those who are not covered for Rs 15,000 under Section 80L as also those who can save tax by making additional contributions under Section 88, the monthly or regular income schemes of MF are far superior to the pure-growth schemes and will thus, hold good for a fairly large number of investors.