When exits are shut

Closing the option of premature redemption of units in

mutual funds is restrictive, says R. Mohan Lavi

,cf301,8.2,9>THE maxim, quilibet licet renuntiare juri pro

se introducte, translates as follows: ``Everyone has a
right to waive and to agree to waive the advantage of law
or rule made solely for the benefit and protection of the
individual in his privat e capacity which may be dispensed
with without infringing any private right or public policy.''

This was quoted by the Securities Appellate Tribunal in its

ruling in Kwality Ice-Creams (India) Ltd vs Securities &
Exchange Board of India (2001 30 SCL 107).

Kwality had invested Rs 2 crore in three open-ended

mutual fund schemes, providing tax benefits on capital
gains under Section 54EB of the Income-Tax (I-T) Act. As
per the terms, the investment was repurchasable after
seven years from the date of issue. After about two years
from the date of issue, Kwality wanted to redeem the
investment stating that it was willing to forego the benefits
under Section 54EB of the I-T Act. But the mutual funds
declined to redeem the units. Kwality filed a civil writ peti
tion in the Delhi High Court. During the course of the
hearing, Kwality stated that it was making a formal
application to SEBI. The court approved such a move.
After the hearing, SEBI too passed an order that the
redemption was not permissible. Kwality t hen approached
the Delhi High Court praying for setting aside the SEBI
order. As an alternative remedy was available before the
SEBI Appellate Tribunal (SAT), Kwality chose the same.
After a detailed hearing, SAT also confirmed that the
redemption was no t possible.

SAT's order raises questions about investment in mutual

funds. Confusion seems to have stemmed from the fact
that Kwality invested all its funds in open-ended funds. An
open-ended fund is one which offers units for sale without
specifying any duration fo r redemption. A close-ended
scheme means any scheme of a mutual fund in which the
period of maturity of the scheme is specified.

Section 54 EB (2) states that ``where the long term

specified asset is transferred or converted (otherwise than
by transfer) into money at any time within a period of
seven years from the date of its acquisition, the amount of
capital gains arising from the transfer of the original asset
not charged under Section 45 on the basis of the cost of
such long-term specified asset as provided in clause (a) or
as the case may be, clause (b) of sub-section 1 shall be
deemed to be the income chargeable under the head
capital gains relating to long-term capital assets of the
previous year in which the long-term specified asset is
transferred or converted (otherwise than by transfer) into
money.''

In fact, this is the basis on which the withdrawal of benefit

relating to all sections of income-tax on capital gains work.
During the course of the discussions, reference was made
to a Government Notification dated December 19, 1996,
specifying the asse ts for the purpose of investment under
Section 54EB, the text of which is as follows:

``In exercise of the powers conferred by sub-section (1)

of Section 54 EB of the I-T Act, 1961 (43 of 1961), the
Central Board of Direct Taxes hereby specifies the
following assets, referred to as the long-term specified
assets, for the purposes of the s aid section, namely:

i) Deposits for a period of not less than seven years with

the State Bank of India established under the State Bank
of India Act, 1955 (23 of 1955) or any subsidiary bank as
defined in the State Bank of India (Subsidiary Banks) Act,
1959 (38 of 1959), or any nationalised bank, that is to
say, any corresponding new bank, constituted under
Section 3 of the Banking Companies (Acquisition and
Transfer of Undertakings) Act, 1970 (5 of 1970) or any co-
operative society engaged in carrying on the business of b
anking (including a co-operative land mortgage bank or
co-operative land development bank);

ii) All bonds, redeemable after a period of seven years,

issued or to be issued by the Housing and Urban
Development Corporation Ltd, New Delhi;

iii) All units re-purchasable after a period of seven years,

issued or to be issued by any mutual fund (including the
Unit Trust of India) referred to in clause (23D) of Section
10 of the Income-Tax Act.''

It appears unlikely for SBI or HUDCO to refuse payment of

taxpayers' money if they are willing to pay the resultant
capital gains tax. One wonders why SAT has singled out
mutual funds for this special treatment.

The offer document of any open-ended scheme offering

the benefits of Section 54 EB generally reads thus:
``Investment of entire or part of capital gains arising out
of transfer of long-term capital assets in this scheme will
be eligible for capital gains tax exemption under Section
54EB subject to repurchase/switchover of units only after
seven years from the date of acceptance of application.''

If one extends this argument, it is obvious that if the

repurchase was made seven years before, then the capital
gains claimed as exempt earlier will now be taxed. The
emphasis is more on the exemption/loss of exemption
rather than on the redemption or o therwise of the units.

One of the arguments supporting the non-redemption was

that premature redemption would adversely affect the
interests of other investors, as the NAV of the fund would
suffer. It is submitted that protecting the NAV of the fund
is the duty of the mutual f und. It cannot prevent unit-
holders from choosing an option to exit just because the
interests of other investors would suffer.

This shows that more disclosure of information is needed

in the mutual fund industry. Gullible investors need to
know the manner in which the fund functions and the
options open to them.