By clarifying that all equity-linked savings schemes (ELSS) would be eligible for tax benefits under Section 80 C of the Income Tax Act, the Central Board of Direct Taxes (CBDT) has only brought in partial clarity as the bigger question on the structure of these schemes still remains unanswered.
Till 2005, the tax benefit on investment in ELSS was to the tune of Rs 10,000 per annum under Section 88. However, under Section 80 C one can claim deduction against an investment in ELSS up to Rs 1 lakh.
While this is good news for investors, by offering this benefit to only investments in existing and new close-ended ELSS, the CBDT has done great harm to both investors and floaters of open-ended schemes in particular, and the equity market in general.
The CBDT has also reversed its 1998 notification, which had made all such schemes open-ended. There are 33 ELSS schemes in operation with a total corpus of Rs 3,102 crore (Rs 31.02 billion). Out of these, Rs 2,033 crore (Rs 20.33 billion) belongs to 22 open-ended schemes and Rs 1,069 crore (Rs 10.69 billion) to 11 close-ended schemes which were floated before 1998.
In 1992, when the finance ministry gave its nod to the floatation of ELSS, the idea was to encourage retail investors' interest in equity funds, with a tax incentive thrown in.
These funds were close-ended, with a three-year lock-in period. They were made open-ended in 1998 and there was ample justification for doing so.
First, an open-ended fund encourages a steady flow of money into the scheme over a period of time, and this is required for the long-term development of the equity market. It also enables an investor to enter the market at different levels.
In stock market parlance, an investor can average his/her cost of acquisition of ELSS units by buying them at different points of time at different levels of net asset value (NAV).
A close-ended scheme, on the other hand, demands that an investor makes a payment at one go. This will encourage investors to time the market, which virtually nobody can actually do.
From the mutual funds' point of view also, open-ended ELSS are preferred schemes as they can keep their fund expenses in check.
For close-ended funds, they will need to float a new scheme every year and keep it open for a certain period, incurring issue expenses, which will ultimately be passed on to the investors in some form. Moreover, each time a close-ended scheme is floated, it will not have a proven track record. In other words, investors will be forced to invest in a scheme that has no history behind it.
This is against any principle of sound investment.
The only argument against open-ended schemes could be stray instances of divided stripping. A savvy investor can buy units of an open-ended ELSS before the record date and pocket the dividend. In this case, even if there is a three-year lock-in period, an investor is actually not locking in the entire investment as he is getting back a portion of the invested amount upfront in the form of dividend.
However, this alone cannot be a reason for rooting for closed-ended schemes as, considering all relevant aspects, open-ended schemes are more beneficial for retail investors as well as for the long-term development of the market.
The tax incentives are to cushion the risk an investor takes while putting in money in equity-linked instruments. Such schemes should be nurtured with utmost care if the government is serious about the long-term future of the capital market.
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