The forward charge mechanism for service tax on MF distributor commissions introduced in this Budget has brought relief to small IFAs who earn less than Rs. 10 lakhs of annual commission income, as they will now not have to pay this tax. Life does not however change for larger distributors - they continue to suffer the incidence of service tax as they will now have to pay service tax to the Government directly (rather than having it deducted by fund houses), but are still unable to recover it from any end user of their service - whether that is an AMC or an investor.
Small IFAs associated with IFA platforms lose out on service tax relief
IFA platforms who operate a sub-broker model find themselves in a tight spot due to the turn of events. Several of their channel partners earn less than Rs.10 lakhs annual commission income. But because they earn it as a sub-brokerage from the platform, and since the platform pays service tax, they effectively continue to bear the burden of service tax. As a channel partner of a platform, a small IFA therefore sees a 15% haircut on his income which he would believe should not be levied as his income falls below the service tax threshold. This will understandably bring in some strain in the commercial arrangements between platforms and their channel partners, unless a fair and equitable solution can be worked out quickly.
Distribution development efforts of IFA platforms can be severely impacted
IFA platforms offer considerable value to small IFAs, with their practice management inputs and back office support. Leading IFA platforms like NJ India and Prudent are also the main catalysts for bringing in new IFAs into the industry (The "Gujarat model" of distributor development). Every new IFA who comes into the industry through platforms now has to take a 15% haircut on his income because he chooses to work with a platform. If he chooses to go it alone, he is denied the valuable initial and ongoing support that quality platforms deliver, which many find essential in their initial years, and even beyond. As it is, this profession is finding it difficult to attract new talent. We certainly don't want this handicap to further stymie our efforts on distribution expansion.
An accounting solution
Discussions are underway within the industry to find a solution to this situation. Large fund houses readily acknowledge that this is a genuine issue, which needs to be addressed through an industry-wide solution. All the accounting discussions that had commenced last year when service tax was introduced, are back on the discussion table (Who is finally going to pay this Rs.700 cr bill?).
Neeraj Choksi of NJ India, the country's largest IFA platform, believes that the simplest way to deal with this situation is to use the flexibility given under fungibility rules and pay all distributor commissions from the AMC's books rather than partly from scheme books and partly from AMC books. Since the AMC is a service provider as well as a service receiver (unlike a scheme), it can get a Cenvat setoff on service tax on distributor commissions paid by it. This will then allow AMCs to "gross up" commission payouts by 15%, to neutralize service tax impact on distributors. Grossing up will allow distributors to effectively recover service tax from AMCs. As Neerajbhai says, since all distribution agreements are anyway between AMCs and distributors and never between individual schemes and distributors, it is clear that the distributor is rendering a service to the AMC under his distribution agreement and therefore the distributor is entitled to recover service tax on his income from the AMC who is the beneficiary of his services.
As one of the senior AMC professionals put it, this is however easier said than done. If it was so simple, he asks, why haven't AMCs done this a year ago, when the issue first arose? The issues with this approach have been discussed in some detail in our earlier article, Who is finally going to pay this Rs.700 cr bill?. Whether AMCs can or cannot avail Cenvat credit for service tax on distribution commissions, seems to be linked with a past history of a different treatment that some AMCs adopted on service tax on distribution commissions, and which is currently being contested with the Service Tax Authorities. The other option of debiting a "grossed up" management fee to the scheme and recovering service tax on the enhanced management fee from the scheme does not find favour with the regulator, who does not want the incidence of service tax on distribution commissions to be effectively borne by investors.
Commission renegotiation as an interim measure
What may happen as an interim measure is for AMCs to renegotiate commission structures with some of the large IFA platforms, in a manner that reduces the impact of this service tax googly on platforms, and enables platforms to enhance their payouts to small channel partners, so that they get the service tax benefit that would normally be available for IFAs with less than Rs.10 lakhs of annual commission income.
This can however open up many more renegotiation requests from a number of large distributors and IFAs who are currently developing their own franchisee networks. Apart from the handful of leading IFA platforms, there are scores of other distributors who have small networks of say 10-20 sub-brokers, who will face the same issue as the large IFA platforms. AMCs will then need to deal with commission renegotiation requests from all of them.
But, has the core service tax issue been addressed?
Then of course you have the entire segment of distributors who earn more than Rs.10 lakhs commission income, who pull in the maximum business into the industry, but who are still denied the right to recover service tax from the recipient of their services. What the forward charge mechanism has achieved is to give relief to small IFAs, but it does not address the core issue which distributors have been raising for a year: why are we not allowed to recover service tax from the recipient of our services?
Who does a distributor serve?
Any resolution to this issue can happen only when there is clarity on who the distributor is serving. Is it the AMCs? Is it the schemes of fund houses? Or is it their investors? After all, if you want to recover service tax from the recipient of your service, you ought to first be clear on who that recipient is.
If it is the AMCs, then it is a simple bilateral negotiation process between distributor and AMC, like it happens with any other service. The service provider passes on service tax incidence onto his customer, to the extent market can bear. AMCs will hold a view that this process has already happened and that commission structures rolled out in July 2015 have taken into account this principle of what the market can bear. AMCs will also argue that their ability to bear service tax incidence is linked to their ability to pass it on to the ultimate beneficiary of their services - which is the investors. As long as SEBI is not willing for this to happen, there will remain a constraint in their ability to absorb the impact of service tax.
If distributors are serving the underlying schemes, it in effect means they are serving investors. In this case, they have a right to recover service tax from the investors. SEBI's decision not to allow this recovery from the schemes is in effect denying them this right - a right that has been permitted to all other service providers to the scheme including the AMC. If SEBI is denying this right only because they feel costs are already too high, then SEBI perhaps needs to reflect on why they became high in the first place. If SEBI decided to give a B-15 incentive and a further 20 bps incentive to AMCs, and that pushed up total investor costs too high, they need to look at those two elements rather than denying distributors their right to recover a statutory levy that can be rightfully passed on to the service recipient.
For IFA associations to either take this matter up with SEBI or with Ministry of Finance or indeed contemplate litigation, the core issue that needs to be resolved is whether they serve the investor in the first place. If not, there is no cause for action.
From a simple legalistic point of view, one can argue that a distributor earns commissions from fund houses he signs up with, as consideration for selling their schemes. He receives no consideration from his investors. An RIA on the other hand receives fees from investors, as consideration for advisory services rendered. It would therefore follow that a distributor serves the AMC and an RIA serves the investor. Extending this logic, distributors should not be looking at investors bearing the service tax incidence. Their limited focus ought to be on bilateral negotiations with AMCs on who will bear how much of the service tax on distribution commissions - a process that began same time last year. AMCs in turn will need to find ways of getting Cenvat credit on service tax on distribution commissions. To the extent they can get Cenvat credit, neither the distributor nor the AMC bears this cost.
The confusion arises when distributors are told that they ought to align themselves with their investors and work for their investors' interests rather than their own or fund houses interests. All sales process regulations introduced in recent years are aimed at ensuring that distributors serve investors better and protect their interests better. If a distributor is expected to serve the investor and shoulders increased compliance responsibilities towards this end, should he not be entitled to recover service tax from the true recipient of his services?
The answer to this key question - who does a distributor finally serve - can pave way for a final resolution to the service tax imbroglio. Until then, we will have more and more band-aid solutions coming up, to address one issue after another, one googly after another that is bowled by this statutory levy and its complex implementation.
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