Budget 2011 wants foreign individual investors to invest in Indian equity-oriented mutual fund (MF) directly, just like us. Presently, foreign institutional investors can directly invest in Indian equity schemes. However, foreign individuals cannot directly put in their money. Typically, they can invest in foreign fund houses such as Templeton International Asset Management Co, Fidelity International Asset Management or BlackRock Investment Managers that have schemes dedicated to invest in emerging markets such as India or even in India-specific MF schemes.

But if foreigners, say, prefer to invest in schemes such as HDFC Top 200 or Reliance Vision, they cannot. Until now.

Says Milind Barve, managing director, HDFC Asset Management Co Ltd: “It’s a good move because obviously there has been a fair bit of interest amongst foreign investors towards Indian markets, not just for the past year or so, but the past three to four years." K. Ramanathan, chief investment officer, ING Investment Management Co. Ltd, adds: “At present, foreign investors have a limited number of India-dedicated funds to invest in India. This move will enable them to invest in Indian funds managed by Indian fund managers."

Finance minister Pranab Mukherjee announced in his Budget speech that such investors who wish to invest in Indian MFs will need to meet know-your-client (KYC) norms before investing. Effective 1 January 2011, KYC has been made compulsory irrespective of the amount you invest in an MF. Earlier, KYC was required only for investments worth Rs50,000 and more. The requirement is aimed at preventing money laundering as key documents and details —such as bank details, permanent account number (PAN), residence proof —are captured by way of the KYC process to ensure that the investor is genuine. While the finance minister has announced that foreign investors will also need to get their KYC done, further clarity will be required as to the kind of documents foreign investors will need to submit, since they would not have PAN cards.

Selling points...

Although the announcement has just come in and most fund houses will start preparing to draw up plans to tap foreign money, most market participants we spoke to told us that MF houses will need to tie up with foreign distributors to be able to push their schemes and attract investors.

For instance, HDFC Asset Management Co. Ltd has tied up with Credit Suisse’s Asset Management (a Switzerland-based fund house that has an international presence) for the latter to distribute the former’s schemes wherever Credit Suisse is present. “In our opinion, domestic fund managers sitting in India have performed better than offshore fund managers (sitting abroad and investing in India)," said Barve. “It will take some time before it translates into inflows as distribution platforms need to be robust. We need to talk to them and put our funds in their platforms. Initially, this will happen through online distribution platforms as people may not be too comfortable using fax and telephones" said Ramanathan.

...but concerns persist

Though the MF indistry seems to have welcomed the move, there are concerns. Allowing foreign individuals to invest may also lead to volatility, some fund managers said.

“The move to allow foreign investors might provide the much required depth but at the same time MF might see a lot of volatility in the inflows/outflows leading to underperformance. It could also impact the other retail/institutional investors. Therefore, the modality of its implementation will need to be discussed before it is formalized," said T.P. Raman, managing director Sundaram Asset Management Co. Ltd.

There are concerns on registration. Indian MFs that wish to solicit money abroad will need to register in countries that they wish to tap. “Registration could be a painful and a time-consuming process," said Hiresh Wadhwan, national director, financial services tax, Ernst and Young Pvt Ltd, a global consultancy firm. Not all agree though. Barve said that registration should not be a tough process but a mere formality.

Higher dividend distribution tax

Companies will no longer benefit by parking their surplus cash in liquid and debt MF schemes. Budget 2011 has increased the dividend distribution tax paid on dividends distributed by liquid and debt MF schemes to corporate investors. The dividend distribution tax (DDT) for corporate investors now stands at 32.45% (all rates including surcharge and cess), up from 27.68% a year back.

For a number of years, corporates have parked their surplus cash in liquid funds as against stashing it away in their bank account on account of better tax rates.

While interest earned on savings bank deposits have been taxed at 30% (corporate tax rate), companies prefer to invest in the dividend plan of liquid schemes because dividends are taxed at 27.68%, thereby earning an advantage of about 3 percentage points. What’s more, the budget has also increased the DDT on dividends distributed by debt MF schemes for corporates to 32.45%.

From 1 June 2011, corporates may not find liquid funds to be an attractive parking vehicle. Will existing corporate investors withdraw? Ramanathan said: “It is surely a negative because the arbitrage has practically vanished. The liquid scheme is still attractive because of the easiness to transact. I don’t see flows reducing. Incremental inflows in long bond funds will be affected."

Bhanu Katoch, CEO, JM Financial Asset Management Ltd, said the tax move may not have much impact on investments by banks in mutual funds. “Banks invest mostly in growth plans so this change will not affect them at all," Katoch said. “Corporates which invest in dividend plans will have to incur higher tax outgo. But corporates are not coming in to mutual funds because of tax alone. They come to MFs for higher liquidity. That advantage still remains."

The tax arbitrage offered to corporate investors have attracted its fair share of criticism to the MF industry.

Of the Rs3.86 trillion in debt funds (including liquid funds), industry estimates suggest that about 60% belongs to companies which invest in such schemes to take advantage of the prevailing tax arbitrage. Various Budgets over the years have tried to cover the loophole.

Budget 2004 increased the corporate DDT to 20.91%, up from 12.82% a year before. Budget 2007-08 further increased it to 28.325% (including surcharge and cess) for liquid schemes. That was when MFs floated ultra short-term funds (erstwhile liquid-plus schemes) to attract corporates; this year’s Budget has also plugged this loophole by including all debt schemes.

However, most of the fund houses Mint spoke to do not see a huge surge of outflows. They said that while liquid funds offer overnight liquidity, bank fixed deposits mandate a lock-in of seven days.

Sources from the fund industry though claim that distributors are concerned and expect corporates to withdraw money in the coming few months, once this diktat comes into force 1 June.