What does the Budget have in store?

In our post-budget coverage last year, we had said that all the triggers were there for investors to take to mutual funds.

Dividends were tax-free, long-term capital gains were waived off for a period of 12 months and equity markets reigned at dismal levels.

As we said the triggers were there, but the investor had to bite. At 3,000 Sensex level equity funds were not seeing a lot of investor interest regardless of the capital gains waiver and tax-free dividends.

This was the proverbial calm before the storm. Everyone was saying that Indian markets were horribly undervalued, but notwithstanding that assessment, no one had anticipated the 100% surge in equity markets. When this happened, the triggers were activated. Mutual funds began falling over each other to declare dividends and investors began lapping it up with unbridled glee.

All in all, the last budget's provisions fructified and the mutual fund investor was a lot happier, not mention richer.

Now with Budget 2005 upon us, its time to make an evaluation of how things stand today so one can make an informed guess of what to expect going forward.

Dividends

With effect from April 1, 2004, dividends on mutual fund are taxable in the hands of investors at the tax slab applicable to them. To delve a little into how the situation was until March 31, 2004, when the provisions of the last budget were in force:

• Dividends on debt funds were tax-free in the hands of investors. However, debt funds incurred a 12.5% dividend distribution tax.

• Equity funds (including balanced funds with more than 51% equity component) did not pay the dividend distribution tax. So dividends were really 'tax-free' in the hands of investors.

Long-term capital gains

Fund managers for a while (from April 1, 2003 through March 31, 2004) did not have to pay long-term capital gains tax. This was a provision in the previous budget for all investors. Now investors, including fund managers, pay long-term capital gains tax.

Section 88

Investments in equity-linked saving schemes (ELSS) are eligible for tax rebate.

What should happen?

Dividends

Dividends should once again become tax-free in the hands of investors. In a way, we have come full circle from the last budget and the pessimism that dominated investor mindset before Budget 2004 has sneaked in once again.

The Kelkar Committee has recommended that dividend distribution tax on corporates be waived off and if that happens then equity funds should continue to get this benefit (right now corporates pay distribution tax and equity funds don't).

Dividend distribution tax on debt funds should also be waived off as debt funds have turned unattractive over the last 12 months and investors are looking at fixed deposits with renewed interest. If distribution tax is waived off, debt funds will be able to declare that much more dividend.

Capital gains

The Kelkar Committee has recommended that long-term capital gains tax on stocks be waived off completely. This was also the recommendation made by the committee last year.

Section 88

For the second year, the Kelkar Committee has recommended that Section 88 be done away with completely. If this happens, tax rebate on equity-linked tax saving schemes will go.

What is likely to happen?

Dividends

We believe dividends on equity and debt funds will continue to remain tax-free. There could be some realignment in the dividend distribution tax with both equity and debt funds getting the waiver.

Capital gains

Given the depressed mood in equity markets, the Budget is likely to be benevolent towards equity investors by allowing them some leeway in capital gains tax waiver. Whether it's a one-off like the previous budget or an absolutely final waiver is not very clear at this stage.

Section 88

The last Budget left Section 88 untouched as removing it (which was the recommendation) could have had some very sticky implications for the government, which was declaring its final Budget. The new government is also unlikely to phase it out at this stage given the rigours of a coalition government.