Govt must Revisit Capital Gain Rules else PMS churning to Begin

The Finance Ministry must think about capital gain taxation for the betterment of the financial industry. Yes, they have to relook at the same since the current mechanism will make Portfolio Management Services (PMS) less appealing than Mutual Funds or AIF.

If the Ministry of Finance does not bring any changes, then very soon we will witness a flight of investments moving from PMS to Mutual Funds or AIFs. The primary reason is the treatment of taxation in terms of churning of portfolios.

Let me highlight the difference to give you clarity on how this sudden change will happen:

Mutual Funds (MFs)

In the case of mutual funds, the churn or turnover within the fund does not directly impact the investor's tax liability. Here's why:

1. Fund-Level Transactions: When the fund manager buys or sells securities within the mutual fund, any gains or losses are retained within the fund itself. These transactions do not trigger tax events for individual investors.
2. Taxation Events for Investors: Investors are taxed only when they redeem (sell) their mutual fund units. The gains realized on redemption are subject to capital gains tax.
3. Types of Gains:
• Short-Term Capital Gains (STCG): If the units are held for less than one year (for equity-oriented funds), the gains are typically taxed at 15%.
• Long-Term Capital Gains (LTCG): If the units are held for more than one year (for equity-oriented funds), gains above a certain threshold (e.g., INR 1 lakh in India) are taxed at 10% without the benefit of indexation.

Portfolio Management Services (PMS)

In PMS schemes, the tax treatment is different because the assets are held in the investor's name and transactions are considered the investor's own transactions.

1. Direct Ownership: In PMS, the portfolio is managed on behalf of the investor, but the assets remain under the investor's ownership. Each buy or sell action executed by the portfolio manager is a transaction directly attributable to the investor.
2. Taxable Events: Every buy and sell transaction executed within the PMS portfolio can trigger a taxable event for the investor. This means that the investor might have to pay capital gains tax on each profitable sale.
3. Types of Gains:
• Short-Term Capital Gains (STCG): Similar to mutual funds, gains on securities held for less than one year are typically taxed at the standard rate for short-term gains.
• Long-Term Capital Gains (LTCG): Gains on securities held for more than one year are taxed as long-term gains, often with rates and conditions similar to those for mutual funds.

Churn does not get taxed in the case of MFs, but it gets taxed in PMS schemes. The current market is a bull market hence these matters might not impact but in a volatile market generating returns to beat Mutual Funds and AIFs under the 33% taxation markup will make it more cumbersome work for the fund managers. Further, the index might be on the higher side but the majority of the stocks are at 30% to 40% down hence there is a huge churning opportunity. Now with the current taxation framework, the PMS will find significant hurdles to generate returns.

The Finance Ministry needs to come up with a simplification of the process so that both the Mutual Funds and PMS are at par in terms of taxation on the churning of portfolios.  Now in case the government does not revisit the same then we will find significant profit books from the PMS segment and getting to AIFs and other products. Understanding these distinctions is crucial for investors to make informed decisions about their investment strategies and their potential tax implications. Further the growth of the Industry will get capped and small case type of PMS will get hit very strongly.  The govt should not  not forget that the total size- AUM  of the PMS industry including EPFO/PF investments stood  at Rs 32 lakh crore, the AUM of the PMS industry excluding EPFO/PF investments stood at Rs. 9 lakh crore on Jan 31, 2024