As reported by the Economic Times (ET), corporates and bank treasury managers are employing innovative tactics to reduce the effective tax rate on their interest income, from a high of 38.5% to a low of 11%. And the interesting part is, its perfectly legal.

Corporates follow a very simple method to effect the reduction of tax liability. They swap their debt investments with mutual fund (MF)units. While the income on debt instruments attracts corporate tax at 38.5%, that from units is tax-free. However, returns are lower at 11% and this is the rate at which the MF pays income tax.

While such swaps increase the inflows into debt MFs and protect the returns of banks and corporates, they eat into government revenues.

Kotak Mahindra MF offers banks and corporates a facility to swap their investments in government securities with units of K-Gilt, its dedicated Gilt Fund. JM MF also offers an automatic facility to swap gilts held by provident funds for units of its gilt fund. Most funds do not have an automatic facility like JM MF and have to follow the route adopted by Kotak.

According to Sundaram Newton Asset Management Company (AMC), managing director T. P. Raman, Bombay-based funds have been conducting such swaps in a big way. MFs gain as their corpus swell (more AMC fees) and get avenue to deploy money in a market where good debt paper, attractively priced, is hard to come by.

After having met with good deal of success in government securities, MFs are now exploring the possibility of widening the scope of the swap formula to the corporate debt segment.

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