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Budget and mutual funds

Withdrawal of section 54EA and 54EB
Budget 2000 has done away with sections 54EA and 54EB. Wide-ranging funds were available under Sections 54EA and 54EB plans, with a lock-in period of three years and seven years respectively, to take shelter from capital gains tax arising from long-term capital gains. The key implication of the withdrawal is:

1. This will prohibit a stream of patient capital flowing into the open-end funds and the equity markets. For some funds, the 54EA and 54EB plans accounted for upto 20 per cent of their net assets.

2. This also eliminates the only available equity investment alternative to investors for shelter from capital gains tax. All other alternatives now will divert gains to fixed-return bonds of NABARD and National Highway Authority of India.

Long-term capital gains
The budget has amended the provision to sub-section (1) of section 112, which so far was restricted only to long-term capital gains (LTCG) arising out of transfer of listed securities, to include mutual fund units and units of Unit Trust of India as well. As a result, the LTCG arising from transfer of these units will also not exceed 10 per cent (effectively 11 per cent after surcharge) of the capital gains before allowing adjustments for cost inflation index.

Earlier, the effective tax rate on LTCG on these units was 15 per cent (20 per cent less 5 per cent on account of cost of inflation). Besides, this amendment also enhances the appeal of systematic withdrawal plan, especially for the fixed return investors, thereby marginalising the effect of increase in dividend tax to 22 per cent in a debt fund.

Dividend tax
The dividend tax has been increased on the income distributed by all close-ended funds and open-ended fund with less than 50 per cent allocation to equities from 11 per cent to 22 per cent level (including the 10 per cent surcharge). This has reduced the attractiveness of the dividend plans of all debt funds. But the reduction in capital gains tax from 20 per cent to 10 per cent will increasingly find investors' favour.

All the monthly income plans (MIPs), with the exception of MIP 99(II) and MIP 2000, have little to bother about the dividend tax with their returns guaranteed for five years. However, the returns for MIP 99(II) and MIP 2000, which will be declared after the first year, would be after taking into account the additional expense of the 22 per cent dividend tax. Assuming the rate of 10.75 per cent for the subsequent years as well (which looks unlikely given the interest rate trends) the effective post-dividend tax rate would be 8.38 per cent.

The medium-term debt funds would now become less attractive. Considering an average return of 12 per cent a year, for an investor in the dividend option, the effective rate of return after discounting for the dividend tax would now be 9.36 per cent. But if investors choose the growth plan of a debt fund, then this impact can be easily circumvented.

If you choose the systematic withdrawal plan of an open-ended debt fund and start your regular withdrawal after the first year, and pay capital gains tax on the gains on the amount of withdrawal, this will entail a lower tax and yield more. Investors will pay 11 per cent towards LTCG for withdrawals after 12 months. The effective rate amounts to 10.68 per cent. This compares favourably against a one-year term deposit in a bank with better liquidity too. Fixed return investors should choose the growth plan of any debt fund to enhance their yield and reduce tax.

The new generation cash funds (short-term debt funds) would be the worst hit by the dividend tax. With an average return of 9.89 per cent, the effective post-tax yield will be 7.7 per cent after the 22 per cent dividend tax. The dividend tax makes them relatively less attractive but they retain their attraction with a marginally higher post-tax return than short-term deposits.

Budget implications on equity funds
We take a closer look at the budget implication on the information technology sector. For the past two years, technology funds have been on the forefront for a while and even a diversified equity fund today is loaded with tech stocks. Most funds owe their spectacular performance to the high allocation to tech stocks.

The positives for the information technology stocks handsomely outnumber the negatives, even though valuations look stretched on conventional basis. The key negative was the imposition of tax on the export income of software companies. As a result, 20 per cent of the export incomes of the companies in the current year, and an incremental 20 per cent every year over the next four years would be taxed. This will lead to a 7.7per cent slip in the bottom line in the earnings of a company with 100 per cent export income.

But companies in Software Technology Parks (STPs) will be exempt from such a tax. This effective means that all the leading software companies will be marginally hurt. Besides, the dividend tax will reduce dividend yield. But this is hardly a concern, given their high valuations which virtually yield nothing by way of dividend.

On the positive side, hardware prices will come down with reduction in customs duty. And the key factor that will drive the infotech stock prices will be the increase in FII limit from 30 per cent to 40 per cent of the company's equity capital. This will further drive stock prices of infotech pivotals.

However, as the Budget changes will affect different infotech companies differently, choosing the right stocks will become a more sophisticated game. This will bring about the crucial difference in fund performance, which is invisible today. Till now, the secret of tech investing success has been to just buy them, but this will increasingly become difficult. The evaluation of the fund manager will increasingly shift to his individual bandwidth than his courage or mandate to buy any tech stock.

Stock Strategy

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