Sunday, January 9, 2011

Let Mumbai compete with Mauritius

Policy needs to enable foreign capital investment in domestic funds and abandon policies that export the fund management industry to Mauritius. The Mauritius Fund industry primarily comprises alternative funds (AFs). Unlike mutual funds (MFs), AFs are privately raised ones targeting only qualified investors. AF mandates are diverse - invest in infrastructure, start-ups, listed or unlisted companies, create hedged portfolios or bet on market direction.

The only Indian AF industry, with a few domestic funds, is the small, policy-hobbled VC fund (VCF) industry. Sebi-registered VCFs are tax 'pass through vehicles', uncompetitive vis-Ã -vis 'tax-exempt' MFs. Policymakers fail to grasp the key challenge facing VCFs - they have to compete with MFs for raising domestic capital and with FIIs for raising foreign capital. Economic rationale to invest in a VCF (a concentrated portfolio of illiquid, unlisted businesses) exists only if post-tax risk adjusted returns are superior to a MF or FII.

Unlike VCFs, Indian MF investors enjoy tax arbitrage. Firstly, tax liability arises only when units are sold while in international regimes tax liability arises when the fund makes NAV gains. Secondly, NAV may increase through short-term capital gains (STCG) or interest income but can become long-term capital gains (LTCG) for the MF investor. Thirdly, tax differentials are high, jeopardising investment in VCFs: zero LTCG taxes on sale of equity MF units vs 22% LTCG taxes on sale of unlisted VCF investments.

Mauritius Funds gain marketshare due to two factors. One, asset side regulations on VCFs: one licence raj-style regulation restricts VCFs to nine sectors to qualify for the 'privilege' of a tax pass through. Other sectors (including infrastructure!) are off-limits but can be accessed as FDI by Mauritius Funds! Two, the world's biggest investors i.e., pensions and endowments, find economic rationale only for Mauritius Funds compared to investments at home where they enjoy tax-exempt status.

Policymakers need to recognise that investing in unlisted and listed businesses are two sides of the same coin and treat them on par. Innovative unlisted businesses are job creators. Mega infrastructure projects are done in unlisted startups. Unlisted investing - in all sectors - needs a competitive framework.

The new Direct Taxes Code incorporated two sterling provisions in the first draft - all equity funds will be tax pass through vehicles sans distinction between unlisted and listed investing. But, the draft was justifiably criticised for taxing capital gains at income-tax rates. The latest draft is proposing a half-right solution that takes us back to square one - low tax regime for listed equities only and tax-exempt status for MFs. While tax arbitrage on debt MFs remains plugged, it is illogical that LTCG taxes on unlisted investments have increased to 30% of gains.

We need to revert to the principles espoused in the first draft but adopt a low capital gains tax regime. Reverting also provides the platform for an AF industry framework that would add depth to the domestic fund industry.

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