If an industry needs clarification on an issue that will affect its tax outgo in the future, should it seek the clarification from an independent tax expert or the Central Board of Direct Taxes - the division of the Ministry of Finance that is in charge of administration of direct tax laws in India? The Indian mutual fund industry is facing such a dilemma currently, but its apex body, the Association of Mutual Funds in India, has chosen to avoid CBDT and consult tax experts instead. But this could be dangerous.

The story so far

When Budget 2007 increased the dividend distribution tax that liquid funds pay while distributing dividends to 28.325 per cent (including surcharges), up from 14.025 per cent earlier, there was a minor confusion. MFs and investors wondered whether the hike in DDT applied to short-term fixed maturity plans that mature before one year.

While spelling out higher DDT for liquid funds, this year's Budget referred to the Securities and Exchange Board of India's definition of a liquid fund.

Sebi, in a circular issued on 11 October 2006, had defined a liquid fund as a scheme whose tenure (average maturity) is one year or less, among a host of other parameters.

In other words, Sebi has clearly laid down the guidelines for them and the way they should construct and manage their portfolios.

As short-term FMPs too have maturities less than a year, there was confusion whether FMPs fall under the definition of a liquid fund and attract the higher DDT.

Expert opinion

With FMPs being the flavour of the season, it was felt a clarification was needed. Amfi, on its part, has sought clarification from two tax experts, BSR & Company chartered accountants and Ernst & Young chartered accountants.

In its reply - which Amfi eventually circulated to MFs and a copy of which is with Outlook Money - BSR & Co. has said that FMPs are different from liquid funds and, therefore, do not attract the higher DDT.

BSR and Co says that liquid funds and FMPs serve different purposes. While the basic objective of a liquid fund is to provide and ensure liquidity at all times, an FMP aims to provide reasonable returns by investing in securities that mature before just before the FMP does.

Unlike liquid funds, FMPs are closed-end. Further, FMPs do not have a restrictive investment mandate like the one Sebi circular prescribed for liquid funds.

Ernst & Young is expected to submit its report soon.

The downside

There is no harm in consulting a tax expert. But certain MFs feel, and we agree, that Amfi would do better to seek an advance ruling - a tax lingo that stands for seeking a clarification from CBDT on a matter on which it has been silent so far.

When it comes to interpretation of tax laws, who is a better authority than CBDT? There's no guarantee that CBDT would agree with BSR & Co. and Ernst & Young interpretation, even if they make perfect sense.

If CBDT disagrees with the views of the tax experts, the onus for paying the differential DDT would fall on MFs and could burn a hole in their pockets. Says Amfi chairman A.P. Kurian: "I do not see that possibility. We have consulted tax experts; we do not need to ask CBDT."