The Federal Government in an amendment to Finance Bill 2006 has restored the tax exemption on the income of mutual funds. This decision accepts that without the 'pass through' concept there can be no even playing field in the capital market. Companies pay tax on their income and the dividend paid to shareholders is liable to tax in the hands of the shareholder.
If one was to tax mutual funds also it would act as a disincentive for investors. Since mutual funds are required to distribute 90 percent of their profit, the liability for the unit holder is the same as a shareholder's in a listed company.
Why did the government propose to impose tax on mutual funds in the first place? Since big brokers were better versed in share business, they were the first to launch private mutual funds. Hitherto, government managed funds NIT and ICP were the only players in the field.
There have been many complaints from brokers and individual investors that the mutual funds have become large players in the bourses. And, equity funds instead of being a long term investor in stocks and providing stability to the market, are using their mountains of cash to muscle their way into CFS and started lending to the detriment of other investors.
Income (mutual) funds, unlike equity funds, are ideally designed to lend in CFS and invest in bonds and government paper. Unfortunately the Securities and Exchange Commission of Pakistan did not draw a line between income and equity funds so that they stick to their core functions.
Did SECP make a mistake in giving permission to member/brokers to also have mutual funds? It does, of course, add to their power and the ability to control the market movement. But no one else had the requisite expertise in the private sector.
So the only institutional counter-check on the unbridled power of big brokers could be banks. But the big five banks were, until recently, in government hands - and their balance sheets were weak due to abnormally high non-performing loans.
The mutual fund industry has grown in the last couple of years. Intense competition among them, has led to improved returns and small investors in bigger numbers are flocking to invest in mutual funds instead of tracking share prices and taking undue risks themselves.
It is safer to pay a fee and let experts take care of your investment. Rather than taxing them through CBR, it is a better policy that they be regulated more closely by SECP. The regulator could impose a ban or place a cap on lending and restricting them to the core activity they are established for.