June 02, 2019

Of Mutual Fund Investments And Income Tax Notices

This is a long post.

A few weeks ago, on an online investment forum, an individual reported receiving a notice from the Income Tax authorities, issued under sections 147/148 of the IT Act.  Without getting too technical, such a notice is supposed to be served when the Income Tax officer “has reason to believe” that you haven’t disclosed your income fully.  This is how that person described what he felt after receiving the notice (warning: contains expletives):

…when I did a quick read about the section under which the letter was sent (147/148)- I started shitting bricks. It's really scary stuff. What got me also worried was that this pertained to FY 2011-12 which was like 7-8 years ago. I started going nuts over whether I had missed out something and if I still had the records from back then.

There’s more.  The ITO required him to submit copies of bank accounts, credit card statements, investments etc. for 2011-12 within a period of 5 working days and to meet him in person.  By law, there are stiff penalties for not complying with this.

So what has this got to do with investing in mutual funds? 

The primary reason for this notice was a dubious interpretation of half-baked information supplied by mutual fund companies to the Income Tax authorities about this person’s investments.  If that statement surprises you, here’s a bit of background.

Mutual fund companies (and some other entities) are required by law, to report to Income Tax authorities, specific high value transactions made by their customers each year.  For each person, this information forms a part of what is known as his/ her Annual Information Report (AIR).  Notably, the type of information that is required to be reported, hasn’t been well thought through.  For instance, fund houses are expected to report only purchases (excluding switches) but not redemptions.  Consequently, Income Tax officers have been known to use this incomplete information to confront mutual fund investors with allegations of evasion of income, something that happened in the case of the abovementioned person as well.

Net of redemptions, this person had made negligible purchases of mutual funds during the year in question.  Unfortunately, his gross purchases were close to twice his salary income for that year.  It seems that the ITO pounced upon this fact to allege that this person had not fully disclosed his income.  Rather than cross-check this information with the person’s return (which was on record), the ITO preferred to issue him the notice.  The way I see it, the ITO was either incompetent and/ or had questionable motives.  Be that as it may, I can’t help thinking that had the AIR shown the complete details of purchases and redemptions, this notice might never have been issued.

That’s not the only aspect about the AIR that bothers me.  Fund houses are expected to report purchases for each individual, regardless of whether they are the first holder or the second holder, and without mentioning if a person is the first holder or the second holder.  To understand how this can cause its own problems, let me share with you the case of a lady whom I personally know. 

She is a housewife and has no independent income of her own.  Until now, she had never filed a return: in fact she never needed to.  In March this year, she received a similar notice from her ITO for undisclosed income because  according to her AIR, she made significant mutual investments in a certain year.  As it happens, those are all investments made by her husband, where she is the second holder. She tried to explain this fact but the ITO insisted that she first file her return and then submit copies of her bank accounts and mutual fund statements.  As in the earlier mentioned case, she was given 5 working days to do so.

While the purpose of the AIR may be to track those who shortchange on taxes, there is little doubt in my mind that honest tax payers as well as honest non-tax payers can end up being troubled, for no fault of theirs.  In the course of preparing this piece, I spoke to a few tax consultants.  All of them were of the view that such notices could come to anyone whose gross mutual fund purchases (reported in the AIR) are disproportionate to their other disclosed income, irrespective of the actual amount of investment.  What’s more, each of them confirmed experiences of honest clients being inconvenienced. 

From what they told me and showed me, my overarching takeaway is that being above-board, in itself, is not enough: there is a need to be smart.  It’s a broken system, so to speak, and there is little regard for your honesty or any general principle of fairness.   Being smart is about understanding the system and minimizing the chances of being screwed. 

While it is up to each one of us to decide what we’d like to do, here are some things that I would include as part of being smart.

  • Know what kind of information about your investments is required to be reported by mutual fund companies (and other entities).  Currently, each fund house is required to report purchase transactions (excluding switches) that add up to more than 10 lakh in a financial year.  Here is a link to the relevant section of the Income Tax Rules.  
  • In light of the previous point, decide how you would want to go about making investments (including mutual fund investments).  As an example, I have come across investors who go to great lengths to avoid the chance of their mutual fund investment information appearing in the AIR.  In the context of the current laws, they prefer to invest just enough in any single fund house to not trigger the reporting requirement. 
  • Be aware of what is actually reported in your AIR.  The list of transactions reported by fund houses for each year are available as part of Form 26AS which can be accessed via the Income Tax e-filing website.   It could help to check out this form diligently each year.  For one, I have seen instances of information being wrongly reported by fund houses.  For another, you will be better prepared for the possibility of a notice.
  • Keep copies of every document that can shed light on your income, including bank statements and investment statements.  In the event of receiving a notice, you may have to quickly produce documents pertaining to several years before.  In addition, consider keeping copies of credit card statements (including for corporate credit cards, if they are tagged to your PAN).  ITOs have been known to ask for these as well.
  • If you don’t already have a tax consultant, consider identifying one whom you can retain for help.  As indicated above, receiving a notice can be a harrowing experience as well as one that calls for swift action.  Additionally, it can necessitate several face-to-face interactions with the ITO.  Having a resourceful tax consultant can make things simpler.  He/ she will typically know what to do, and can take on the responsibility of tackling the ITO.  A truly resourceful (and genuine) tax consultant should be able to save an honest client much grief.

Before I close, here’s some food for thought for fund houses.  I am not aware of the lobbying efforts undertaken by the fund industry but I find it striking that while mutual fund investments are expected to be reported, ULIPs are not.  In any case, as mentioned earlier, in its current form, there is ample room for the information shared with the Income Tax authorities to be misused against the interest of mutual fund investors.  While the instances of such cases may currently not be much, it may be best not to underestimate the  potential magnitude of the problem.  Any investor who has to go through what the aforementioned individuals have gone through, could well decide to stay away from mutual funds for life.  Anyone who fears the possibility of something like that happening may well think likewise.

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