At this stage with equity markets poised within reach of 7,000 points, long-term capital gains on equity-oriented funds waived off and dividends tax-free, investors are wondering what can go wrong in this Budget to spoil the mutual fund party?

Frankly, at this point it is difficult to imagine why the finance minister would want any killjoys in the Budget to puncture the investor's mutual fund dream.

However, investors need to appreciate that measures are often introduced in the Budget to generate interest in a particular area (in this case mutual funds) and when that purpose is served, the measures need not necessarily be persisted with in the subsequent Budgets.

• Run-up to the Budget 2005-06

Right now this is how mutual fund investments fare on various tax benefits/sections:

Dividends

Dividends on equity-oriented mutual funds (equity funds and balanced funds) are tax-free in the hands of investors. Fund houses are not required to pay dividend distribution tax on equity/equity-oriented funds.

Dividends on debt funds (which includes monthly income plans) to individuals and HUFs attract 12.5% distribution tax plus 2.0% surcharge. In case of corporates, the distribution tax is levied at the rate of 20% plus 2% surcharge.

Capital gains

Long-term capital gains tax on tradable securities has been done away with completely and now such transactions will incur a 0.15% securities transaction tax (STT) on the cost of purchase.

While stocks were always included in the ambit of tradable securities, the last Budget saw the inclusion of equity-oriented funds to that category. This means that investments in equity-oriented funds do not attract long-term capital gains tax. However, debt funds are not tradable securities and attract long-term capital gains tax.

Short-term capital gains on equity-oriented mutual funds are charged at 10.0%, while those on debt funds are levied at the tax slab applicable to the investor.

Section 88

Investments in equity-linked saving schemes (ELSS) are eligible for tax rebate (subject to an upper limit of Rs 10,000) under Section 88 for investors whose gross total income is below Rs 500,000.

What is likely to happen?

Dividends: We believe dividends on equity and debt funds will continue to remain tax-free in the hands of investors. However, there could be some realignment in the dividend distribution tax for either or both fund categories (equity and debt).

Capital gains: Long-term capital gains tax waiver on mutual funds is likely to stay. Again, there could be some tinkering with the rate of STT from the existing 0.15%. Status quo on short-term capital gains is also likely to be maintained.

Section 88: If the finance minister is determined to implement the long-standing recommendations of the Kelkar Committee, Section 88 could soon become history.

While this process was initiated a couple of years ago, it was pushed on to the backburner over the last two Budgets for populist reasons. Now with the government a little more firmly (?) in the driver's seat, the process to 'dismantle' Section 88 could start all over again.

In other words, we could see Section 88 benefits being watered down. Either the rate could decline or it could be made eligible for a lesser number of taxpayers.

Investment Guide 2005. Get this latest issue of Money Simplified absolutely FREE! Click here!