Last updated: March 25, 2012 7:38 am

Joy turns to worry over Indian tax break

When Pranab Mukherjee, India’s finance minister, earlier this month proposed to introduce a new tax advantaged saving scheme for equity investors, fund houses rubbed their hands in anticipation.

The Rajiv Gandhi Equity Savings Scheme raised hopes of a boost to the domestic capital market by encouraging as many as 15m eligible Indians to route their savings into the stock market.

Announced as part of the Indian national budget for 2012-13, the scheme would allow new retail investors earning less than Rs1m ($19,500) a year to claim a 50 per cent income tax deduction on investments of up to Rs50,000 in equities.

But with details still being finalised, fund houses’ initial excitement is giving way to worry at reports that only direct investments in equity will be eligible for tax deductions.

“If the intent is to encourage first time investors to participate in equity markets, a better route would be through well-managed equity funds with an established track record,” says Sunil Mehta, chief executive of AIG India Asset Management.

With less than 4 per cent of household savings invested in India’s fund industry, increasing the participation of new retail investors in the markets is seen as a key to counterbalancing volatile flows from foreign investors.

Foreign portfolio investors last year withdrew a net $357.8m, compared with inflows of $29.4bn in 2010, as the benchmark India Sensex index fell nearly 25 per cent.

India’s annual economic growth rate dipped to 6.1 per cent in December, buffeted by headwinds from Europe and the US and persistent inflation that forced the Reserve Bank of India to raise repo rates 13 times from March 2010 to October 2011.

The volatile market, together with regulatory changes to the industry’s distribution model in 2009, has led to stagnating inflows into equity mutual funds despite a rebound last month. Assets under management in equity funds stood at Rs1,600bn in February, up 4.9 per cent from a year earlier, according to the Association of Mutual Funds of India.

But while equity funds accounted for 24 per cent of total assets under management for the industry, Sankaran Naren, chief investment officer – equity at ICICI Prudential Asset Management, believes many more investors would move into equities under the RGESS.

“These models have worked in many parts of the world,” Mr Naren says. “In India I can see that there is a big potential because so many people enter this eligible tax bracket each year with an income less than 10 lakh rupees [Rs1m].”

Mr Naren says the RGESS, which would have a three-year lock-in period, is special because it offers tax deductions only for investments in shares.

Currently, many Indians choose alternative financial instruments because they can receive tax rebates on investments such as unit-linked insurance plans and New Pension Scheme plans.

“In a country like India where interest rates are high, people are comfortable investing in debt and they don’t invest in equity,” Mr Naren says.

But while other fund managers admit the scheme is likely to boost equity volumes, they worry the good work could be undone over the longer term if new investors are restricted to buying equities directly.

“Direct investing requires expertise and resources and there is a need to ensure that new retail investors’ experience with equity investing is positive,” says Jaya Prakash K, head of products at Franklin Templeton Investments India.

One safeguard reportedly being considered by the finance ministry is to limit investments to the top 100 companies listed on the BSE. But industry experts warn this does not go far enough.

Dhirendra Kumar, chief executive of Value Research, says: “We have had companies in the top 100 stocks based on capitalisation, which have lost 90 per cent in a year.”

AIG India’s Mr Mehta adds: “It is impossible for any retail investor in the current volatile markets to stay invested in [the] 100 top stocks ... [for the three-year] lock-in period. The mutual fund route provides a more structured and efficient investment process for retail investors.”

With final details on the scheme expected to be announced next month, Mr Mehta is also awaiting clarification on whether the tax benefit will be available only for one-time investments. He would like the scheme to offer rebates for investments and to see the investment limit raised from Rs50,000 to Rs100,000 to provide longer term incentives.

Until such details are revealed, many, such as Value Research’s Mr Kumar, worry that the RGESS could go from a potential game changer to a disheartening experience that might instead drive investors away, “never to come back to equity”.

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