The Hindu Business Line : Are MFs asking for more?

THERE has been a strident demand for ushering in a scheme of pass-through while assessing unit-holders in respect of their income from mutual funds. Thanks to Section 10(23D) of the Income-Tax Act, 1961, approved mutual funds enjoy complete tax immunity. The proponents of the pass-through concept contend that while exempting the mutual fund from tax liability is the laudable first step in taxing an income in the hands of its ultimate beneficiary, the logical culmination lies in maintaining the identity of the income that has been passed through to the unit-holders.

To wit, if a growth fund earns income from long-term capital gains (LTCG), it is illogical to call such income distributed to the unit-holders by the omnibus name dividend. Ditto, they argue, is the position with regard to the interest income of an income-fund.

Taking this argument further, according to them, if a scheme of mutual fund has got interest, dividend from shares, short-term capital gain and long-term capital gains, it would be wrong to call the income passed on to the unit-holders by the catchall term dividend.

What is mistakenly called dividend, in such a scenario, is actually an amalgam of dividend, interest and capital gains, they aver. And their ire is precisely against the present tax dispensation that seamlessly merges distinct sources of income into a homogenous lot.

The clamour for maintaining the identity of income passed through is not a mere fad. There is a definite purpose behind it. Interest qualifies for deduction under Section 80L if it has been earned from investments in the prescribed modes mainly government securities and LTCG is overly pampered with soft rate of tax as well as with tax shelters.

Dividend too qualifies now for deduction from income up to a limit if it is from domestic companies in terms of Section 80L. The votaries of the pass-through school want to secure for the unit-holders all these exemptions and sops.

At first flush, the demand makes practical sense and indeed strikes a sympathetic chord. But the following arguments can be marshalled against it:

Mutual funds will have to attach with its dividend warrant a statement certified by its auditors detailing the source or sources of the distribution. While this may not pose any special problems for a scheme that does not stray away from the straight and narrow, schemes dallying with diverse investment avenues and thus earning income from more than one source may run to trouble with the tax administration over the manner of pigeonholing into various slots. At any rate such pigeonholing is inherently as cumbrous as it is litigation-prone;

There is an element of deceit in branding the profit from sale of shares and securities as capital gains because if one applies the litmus test established by the Supreme Court in CIT vs H. Holck Larsen (1986 160 ITR 67) rigorously, it would be clear that the mutual fund industry as well as financial institutions in this country by and large have been getting away with an unintended tax benefit — theirs is by no means capital gains (except when they invest as promoters or with similar permanent mission) because they are admittedly dealers in shares and when a dealer in shares makes profit by selling them, the resultant income is his business income and not capital gains.

If the tax administration wakes up to this reality, the growth funds in particular will have a tough time proving that what it has earned is LTCG. And if they fail, the pass through holds no great advantage to the unit-holders because business income is taxable at normal rates and enjoy no tax shelter;

If the pass-through concept were to be given cognisance while assessing unit-holders, it would be difficult and untenable to deny the same to others. For example, companies and their shareholders who are subjected to double taxation can justly contend that companies should be exempt from tax and tax should be collected from the shareholders, the ultimate beneficiaries of a company's income.

And the process of pigeonholing income into various slots would be even more cumbrous when it comes to the corporate sector.

In fine, acceding to the orchestrated chorus of according special treatment to unit-holders would open the proverbial Pandora's box. Let not the mutual fund industry press for more. As it is, there is a view that insulating the industry from double taxation even while subjecting the corporate sector to it smacks of discrimination.

Any further sops to the industry would only exacerbate this disgruntlement.

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