ADB says MF sponsor rule can be junked

Final report on reforms in the Mutual Fund sector

An Asian Development Bank (ADB) report to suggest reforms in the domestic mutual fund sector has said that the existing legal structure can be retained but the requirement of a sponsor can be done away with.

The report has been done on behalf of the ministry of finance.

According to the report the sponsor has a limited role to play after the fund is set up. "Indeed its controlling ownership of the asset management company and the trustee company might be seen as compromising the independence of the trustees and hence weakening investor protection."

It has suggested introducing the concept of a promoter which will be required to be scrutinised, as is the sponsor, to ensure that the promoter is fit and proper to hold a (recommended) minimum of 51 per cent of the equity capital of the AMC.

Over a period of time of five years the existing shell trustee companies would have to be replaced with professional trustee companies which are wholly independent of the AMC and its promoter.

The report has also suggested more direct supervision of the AMC by the Securities and Exchange Board of India (Sebi) from licensing to overseeing day-to-day activities.

The report says that changes to the Sebi Act are desirable but not critical and the regulator has the powers to discipline non-compliance.

The report has lambasted the tax regime with respect to the mutual funds pointing out that it was encouraging short-termism with a bias towards corporate investors. It has suggested that investments made through a mutual fund should by and large be tax neutral.

The consultants have suggested that all income in the form of dividends and interest as well as capital gains should be taxed at the applicable rate in the hands of the mutual fund investor, thus ensuring tax neutrality with direct investment.

Tax deduction in the hands of AMC or tax deducted at source by the issuer of the units of the mutual fund can also be passed on as a tax credit to the investor.

The capital gains can be retained in the mutual fund free of tax, with the investor paying tax on final disposal of the units at the relevant rate.

If the above is found administratively complex the report has also suggested al alternative whereby all issuers of securities should be allowed to distribute income to a mutual fund without any tax deducted at source or distribution tax.

The mutual fund, when it passes on this income to its unitholders by way of dividend, should pay a distribution tax at, the applicable rate to distribution of company dividends.

Capital gains, both short and long term, if not distributed and accumulated within the fund will suffer no tax at the mutual fund level; however if distributed will suffer distribution tax of 20 per cent (being the average of the long term and short term rates applicable to individual investors) and thereafter no further tax in the hands of the investors. This will not only be more equitable but will also discourage short-termism, says the report.

With regard to offer documents the report has said that disclosure requirements in the Offer Document should be rationalised and the information contained be brief and as comprehensive as possible for a small investor.

In the case of supervision the AMC should be more directly supervised by Sebi as opposed to the significant reliance now placed by Sebi on sponsors and trustees. Further a more hands on approach to supervision should be adopted.

Significantly, the report suggests that the supervising officer of Sebi should be present at the beginning and at the end of an inspection audit when queries are being discussed with the mutual fund.

A selective or risk based inspection routine should be adopted whereby the historically more compliant mutual funds are inspected less frequently than the less compliant, smaller or newer mutual funds.

Noting that the first steps of certifying distributors by requiring them to pass an exam have been taken. the report says, "the next step will be more direct licensing and monitoring."

With respect to distributors the report has pointed out that there should be a single unified licensing regime for broadly based financial advisers and distributors, who will be selling a whole lot of other financial products apart from mutual funds.

The report also recommends that the distinction now existing between AMC management fees and distribution fees should be eliminated and the two combined into a single recurring annual charge payable direct to the AMC.

The front-end load, which is charged to some schemes for meeting distributor commissions, is now accounted for within the mutual fund.

The consultants have recommended that it should be paid directly to the AMC, who should decide how much initial charge and how much trail fee should be paid to distributors from its own revenues.

"This would make it possible to make higher initial charges on retail sales, accompanied by higher up-front commissions, and perhaps lower or no trail commissions, so as to make mutual funds competitive with single premium life products that pay much higher up-front commissions."