Ramesh had invested savings through his bank’s relationship manager in several below-par investments, including life insurance policies and mutual fund schemes. After reviewing his portfolio through an online analyser, he was advised to exit several investments but retain amounts in two mutual fund schemes, with one change: switch both from regular plans to direct plans to save the distributor commission paid to the bank.
Then came the surprise. One retained scheme had a substantial capital gain. Ramesh was told that switching from regular to direct would be treated as a sale, triggering capital gains tax. He was puzzled. He was not leaving the scheme, so why should there be tax?
The oddity becomes clearer because regular and direct plans of the same mutual fund scheme invest in the same underlying portfolio and are managed by the same fund manager. The key difference is that the regular plan carries distributor commission, while the direct plan does not. As a result, the direct plan generally delivers a higher return.
This does not mean every investor should choose direct plans. Many investors value the guidance and hand-holding offered by distributors and are willing to pay for it. But if they later decide that the service is no longer worth the cost, they should be free to stop paying the commission without tax becoming the deciding factor.
Strangely, an investor can change distributors without triggering tax because only the recipient of the commission changes. Yet stopping the commission altogether by moving to a direct plan can create a taxable event. The reverse is also true: a direct-plan investor moving to a regular plan can face the same issue.
Making switches between regular and direct plans tax-neutral should not result in revenue loss. The capital gain is not being forgiven; it remains embedded in the investment and can be taxed when the investor finally sells the units.
There is precedent. Earlier, when certain mutual fund schemes had separate institutional and retail plans with different expense structures, regulatory changes required these plans to be merged, and the Income-tax Act was amended to make that movement tax-neutral.
Truth be told, switching between different plans of the same mutual fund scheme should be tax-neutral. Investors should not have to pay tax merely to change how they manage the same investment. Until the law changes, tax will continue to influence a choice that should belong to the investor alone.
