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Who is going to finally pay this Rs.700 crore bill?

Vijay Venkatram, Managing Director, Wealth Forum

14th September 2015

In a nutshell

There is a Rs.700 crore bill of service tax that is being passed around between fund houses, distributors and SEBI, with no resolution yet on who is going to finally pay it, although distributors in the interim are bearing it, much against their wishes

A potential solution starts off from first getting clarity from CBEC on the set off provisions, and then changing accounting treatment of commissions to avail the set off

To complete this loop however, SEBI will need to play a part, first in amending its guidelines on debiting different management fees for regular and direct plans and then allowing consequent incremental service tax to be charged to TER

Given SEBI's reluctance to increase TER, a possible solution currently at discussion stage is for SEBI to repeal / tinker with its B-15 incentive, which is anyway attracting criticism, and allow service tax incidence on distribution commissions to be charged to TER, thus ensuring no further increase in TER.

Even if the investor finally pays this service tax through all these twists and turns, one not-so-favourable implication for distributors could be widening the gap between NAVs of direct and regular plans.


No issue in recent industry history has caused as deep a wedge between distributors and fund houses as the ongoing service tax issue. At the heart of the conflict is who is going to finally pay the Rs.700 crores annual service tax bill (14% on Rs.5000 crs annual distribution commissions) - a bill that can only go up as service tax rates converge with GST rates and as business volumes continue to grow. And the root cause of the problem, in my humble opinion, is a rather ham-handed manner in which AMFI has handled this sensitive issue. We wrote on this subject in March 2015 (Click Here) arguing about the principle of service receiver bearing the incidence of service tax, and again in April 2015 (Click Here), suggesting healthy dialogue between stakeholders to resolve the issue by getting into specifics, rather than reaching hasty generic conclusions that seem arbitrary.

We now have a situation where the CBEC has clarified - and rightly so - that it had no business to put out an ad opining on who is to bear the service tax incidence. Its jurisdiction is restricted to who is supposed to pay the tax and how it has to be paid - not who will finally bear the tax. Who bears the tax is always a commercial decision between the service provider and the service receiver. AMCs bristled when they saw the infamous ad that got everybody excited and worked up - principally because they saw an unwarranted opinion from a Government body on what should be a commercial decision. If I understand the sentiment correctly, this was exactly the same feeling that distributors got when AMFI sent out a communication to all AMCs that since SEBI had refused to allow TER to be hiked to accommodate service tax, it has to be borne by the distributors. Somewhere AMFI missed the whole point of how a distributor would regard this communication. If SEBI expressed its reluctance to have investors bear this burden, perhaps AMFI should have restricted itself to communicating just the facts and leaving it to AMCs to figure out how they deal with the commercial arrangements with their distributors.

How is each stakeholder viewing this situation?

There are 3 stakeholders in the decision on who finally foots the service tax bill - and here is how each of them seems to be currently thinking:

Distributors: We are providing a service to investors and to fund houses. If a tax is being levied on our service, we must have the right to decide whether we want to pass it on to our customers or absorb it in part or whole. How can SEBI and AMCs decide that we must bear the entire burden? If we have to bear this tax, does it mean that we are the recipient of our own service? Why is it that we have to effectively shell out 47% tax on our income (33% income tax + 14% service tax)? And, why is it that although service tax is applicable only for businesses with more than Rs.8 lakhs of annual income, and the majority of IFAs earn less than that from MF commissions, they still have to bear this burden? And, when we compare with other financial products, why is it that the regulators think it is ok for the consumer to bear service tax on insurance premiums, on ATM withdrawal fees and on every other financial transaction including management fees of AMCs, but not on commissions on mutual funds?

AMCs: What is now introduced is exactly what was in force 3 years ago, before service tax on MF commissions was scrapped. All that we are doing is to go back to where we were, since service tax has now been re-introduced. In these 3 years, distribution commissions have gone up significantly, which distributors must bear in mind. Fund houses do not have the ability to bear this tax burden, and while we will continue our efforts to work with SEBI and CBEC on alternative solutions, we have no option but to ask distributors to bear the tax burden.

SEBI: We do not want TER of funds to be hiked to make investors absorb the service tax burden. As it is, we have allowed an increase in TER in 2012 as part of our MF reforms measures and we are under pressure since TERs in Indian mutual funds are now among the highest in the world. We have no appetite now to consider any further hikes to TER for whatever reason.

So, where do we go from here?

AMFI's team is presently engaging CBEC to understand what exactly can be set-off under the Cenvat credit provisions. The best case for the industry is if service tax on distribution commissions can be set off in total against service tax payable by fund houses. This would mean that effectively the Government gets no incremental revenue from this entire exercise, as it would have levied say Rs.700 crores as service tax on distribution commissions, but which would be offset against a much larger service tax that is levied on AMC management fee. If this happens, nobody really pays any additional tax - which perhaps is an outcome that may not please the revenue authorities in the Finance Ministry.

What portion of service tax on commissions can actually be set off?

As it stands now, a portion of distribution commissions is debited to the scheme and the spillover is debited to AMC books. Service tax on commissions debited to the scheme cannot be set-off as the scheme is the ultimate recipient of services and is not a service provider. Only the service tax on the spillover commission that is absorbed in AMC books can be set off against service tax on management fees earned by the AMC. That doesn't solve much of the problem, though it's better than no set off. From the revenue authorities point of view, this set off of service tax on spillover commissions does not help their case, as there is no incremental revenue they earn from it.

There is an attempt to see whether CBEC will allow special dispensation to enable a complete set off of all service tax on commissions - whether debited to the AMC books or scheme books, against service tax on management fees charged by AMCs. If that were to happen, that would solve the problem for the industry, though it would provide no incremental revenue to the exchequer. There is clearly a legal hurdle here, which may be difficult to overcome. The scheme and the AMC are two distinct entities, which may make it difficult for CBEC to consider such a proposition.

For full set-off relief, ball will be back in SEBI's court

The other solution is to change the present accounting practice and start charging all distribution commissions to the AMC, and nothing to the scheme. This will then allow a full set off of service tax, but opens up other complications - which this time put the ball into SEBI's court. If distribution commissions are charged to AMC books, then the AMC will effectively be charging two different levels of management fees to the direct and regular plans of the same scheme.

Currently, here's how it works: Lets say there is a scheme where an AMC charges 1% as management fees (which is debited to the scheme) and in a full trail model, there is a 1% trail commission, which is also debited to the scheme's regular plan, but not to its direct plan. The NAVs of both plans now have a 1% differential, but the management fees are the same.

If the AMC were to instead debit this trail commission to AMC books, it would then have to charge 1% as management fees to the direct plan, but 2% as management fee to the regular plan. The net impact on NAVs is the same, but what is coming in the way is the fact that SEBI does not permit two different levels of management fees for regular and direct plans of the same scheme. Its logic is that within the current definition of management for which management fees are charged, there cannot be two levels of fund management attention given to direct and regular plans, and therefore there cannot be two different management fees charged.

SEBI would have to re-align its understanding of management to include distribution activities that the AMC outsources to its distributors, and then allow two different levels of management fees within the same scheme.

It's not over yet

But the matter doesn't really end here. Even if SEBI agrees to re-align its definition of management, there will now be a higher service tax amount that is charged to the scheme's regular plan. At present, in the example above, the scheme bears a service tax of 14% on the 1% management fee that the AMC charges to the scheme. Scheme TER is today increasing by this 0.14%, as SEBI has specifically allowed service tax on management fees to be charged over and above the TER cap. Now, if management fees of 2% were to be charged, service tax will now be 0.28% and not 0.14%, and effective cost to the investor will increase by 0.14%.

This incremental charge to the investor will ultimately accrue to the exchequer by way of incremental tax revenue - which was the purpose of the whole exercise anyway.

But, that's what SEBI doesn't like to see, given that it is already under pressure for allowing TERs to increase rather than decrease in recent years, as the fund industry's scale has grown. At the same time, there is also growing recognition that it is unreasonable to say that the consumer must bear service tax on every other financial service he avails, including that of an insurance agent, but should not bear the tax levied on the service of a mutual fund distributor. SEBI's reluctance to allow TER to increase as a consequence of this new tax is not coming from a view it has on the merit or otherwise of the service - it is primarily coming from the fact that it has tied its own hands up by increasing TER in its 2012 reforms, to an extent that is attracting adverse attention.

A sensible way forward therefore, which is currently being discussed in the industry, is that SEBI should unwind some of its "reforms" measures - in particular the B-15 incentive which is anyway coming in for a lot of criticism, and as a quid-pro-quo, allow TER to increase on account of service tax on distribution commissions. That way, overall TER will not increase, and a level playing field would have been created from all perspectives.

The principle must be upheld

In the final analysis, there is a simple principle that needs to be recognised. Today, an investor has a choice of investing through a direct plan or a regular plan. If he chooses a regular plan, he is consciously choosing to avail of the services of a distributor. The distributor is remunerated by way of commissions. If the Government decides to levy a service tax on this service, the investor will need to bear this tax incidence, just as he is currently bearing on all other financial services that he avails. Mind you, he always has a choice of not availing the service.

Service tax relief may spell other troubles for distributors

SEBI will need to find a way to reduce TER at least to an extent that allows this tax to be justifiably recovered from investors. Tinkering with or scrapping the B-15 provision seems to be the best bet as of now. While this can finally deliver the service tax bill to the doorstep of the ultimate recipient of the service, an unintended consequence will be that the NAV gap between direct and regular plans will only get wider. Distributors may well get some service tax relief, but may then have to contend with stiffer competition from more attractively priced direct plans.


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