What exactly are fund of funds? They are essentially hybrid mutual funds that invest in other funds. For example, an international fund is typically structured as a fund of fund, wherein the Indian fund will invest in mutual funds issued by its global counterparts. For example, Templeton offers an international FOF where domestic investors can invest to get an indirect exposure to international stocks and indices. Such FOFs are also possible in the Indian domestic context and they do exist although they have not taken off in a big way.
Globally, FOFs are heavily in demand especially by financial planners. For example, if a financial planner is trying to create a retirement plan, then instead of going through specific funds, they will directly opt for retirement solution based FOFs. Such FOFs are structured as a combination of equity and debt funds with in-built insurance to take care of risk management needs. However, FOFs have not taken off in India due to the relatively unfavourable tax treatment of these FOF plans.
The current FOF taxation scenario in India
Currently, there is a skew in the treatment of fund of funds in India. All FOFs are treated as non-equity funds for the purpose of taxation. The Income Tax Act defines an equity mutual fund as a fund that invests more than 65% of the corpus in equity shares. As a result, even arbitrage funds and equity oriented balanced funds got classified as equity funds due to the preponderance of equity in them. However, FOFs were treated as non-equity funds even if the predominant investment was in equity funds. That restricted the popularity of FOFs in India. Treating all FOFs as non-equity funds has the following implications for FOFs.
- The benefit of Section 80C cannot be extended to ELSS schemes since it is only available for equity schemes and even equity oriented FOFs are classified as non-equity schemes.
- The period for long term classification is a holding period of 3 years and not 1 year. This worked against FOFs.
- Short term capital gains would be taxed at the peak tax rate of the individual rather than at the concessional rate of 15% in case of equity funds
- Long term capital gains will be taxed at 20% of index gains rather than at 10% with benefit of Rs.1 lakh tax free gains.
- Lastly, FOFs will have to pay DDT (dividend distribution tax) of 29.12% on dividends declared inclusive of surcharge and cess.
The big change in Budget 2019 for FOFs
In a bid to promote the CPSE-ETF (which is structured as an FOF), the government in its 2019 budget extended several benefits to the FOFs also. This is likely to make the FOFs more popular as is already evident from their inflows. Here are the key takeaways…
- Budget 2019 has proposed a change in the taxation rules for the fund of funds (FOFs). The proposal is to allow the concessional rate of tax for short-term capital gains on the transfer of units of FOF. On the long term front, the difference may not be substantial.
- Fund of Funds invest in other mutual fund schemes but do not directly invest the money into assets such as debt securities or equity shares. Effectively there are debts FOFs as well as equity FOFs and their taxation will now differ. This is contrary to the current situation where all FOFs irrespective of the underlying asset class get taxed as per debt fund taxation.
- Budget 2019 has proposed to tax equity-oriented FOFs in the same way as equity funds with respect to short term capital gains. The taxation will be at a concessional rate of 15 per cent. Effectively, short-term capital gains on equity FOFs will also attract concessional rate of taxation.
Will it really attract FOF flows?
The whole idea is to encourage FOFFs to invest CPSE ETF. But that is not clear if it would be really of interest to FOFs to buy them and whether there will be retail demand. If FOFs invest then investors can invest in CPSE ETFs indirectly without a demat account. That could be an advantage. However, the tax anomaly has been finally removed and that is the good news.
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