The new Code may leave investors scrounging for options that would help build wealth with a limited tax impact.

Vidya Bala

Investors and laymen have greeted the first reading of the new Direct Taxes Code Bill, 2009 with relief, believing that it will ‘introduce moderate levels of taxation’ and ‘simplify the existing provisions’ by replacing the archaic Income-Tax Act, 1961.

However, a detailed reading of the Code suggests that while it may simplify matters for the taxman, the individual taxpayer may end up paying a high price over the long run.

For one, even as the Code has liberally raised the slabs of income that would be subject to tax, it has done away with a number of ‘expenses’ currently allowed as deduction for the individual. Two, it proposes to make no distinction between short term and long term capital gains as far as the tax rates go.

And, the third and most significant move that can have long-term ramifications on the savings and retirement kitty of the citizens is the introduction of the Exempt Exempt Tax (EET) regime on all investments, which is literally a sting in the tail for investors. We explain these three key aspects of the Code (as far as the personal taxes go) and their implications for a taxpayer/investor.

The most conspicuous change in the Code is in the rates and slabs for income-tax.

The new Code has raised the income to be taxed at 20 per cent to Rs 10 lakh (Rs 3 lakh at present). Only an income of Rs 25 lakh and above (at present, Rs 5 lakh) would suffer a 30 per cent tax rate.

While this may, on the face of it, seem like a liberal regime, it may end up increasing the tax suffered by many, especially those enjoying various deductions.

The Code seeks to do away with deductions such as house rent allowance, leave travel allowance, medical allowance, as well as interest paid on home loan, which usually offer substantial tax shelter to salaried taxpayers (interest on housing is now to be allowed as a deduction only against any rental income from let-out property). These deductions are currently a blessing for taxpayers who hover in the borderline between a lower and higher slab.

Ostensibly to counterbalance this, the Code increases the exemption limit for savings (currently under Section 80C) from Rs 1 lakh to Rs 3 lakh. However, two facts may prevent investors from reaping benefits of this.

One, it is highly unlikely that a person earning anywhere up to Rs 6 lakh would have surplus to lock 50 per cent or more of his earnings into tax-saving instruments.

Two, Section 66 (the substitute for the present Section 80C) restricts the scope of permitted tax-saving investments to far fewer options — approved provident funds, superannuation funds, the new pension scheme and pure life insurance plans.

This essentially means that tax-saving options such as five-year bank deposits, equity-linked savings schemes (ELSS) of mutual funds, unit-linked insurance plans (ULIPs) and principal on home loan, to name a few, would not qualify for the Rs 3 lakh limit under the proposed law.

This would leave investors with fewer tax-saving options that have the potential to beat inflation. Besides, money withdrawn from these options would also be taxed.

According to the Code, the amount invested in the tax-saving instruments mentioned above will be exempt at the time of investment (subject to Rs 3 lakh) and exempt when it earns interest and but fully taxed at your marginal rate of tax when the amount matures or is withdrawn. That is EET for you.

So provident and superannuation funds, insurance policies as well as accumulations under the new pension scheme would suffer tax when you withdraw the balance at retirement or otherwise.

Under the current law, savings in avenues such as provident fund were exempt at all levels (EEE), even at the time of withdrawal.

So EET merely postpones your tax burden to the time of withdrawal. For the salaried class, this typically means pushing the tax burden towards their retirement.

While accumulated amounts in provident funds up to March 2011 would not fall under the EET net, fresh investments post this date would.

However, a similar ‘grandfathering’ clause has not been stated for insurance policies. The Code has instead given some concessions for insurance policies, which may make very few policies eligible for exemption on withdrawal.

Unfortunately, the tax-saving instruments which fall under EET are the primary sources of saving for the Indian household.

According to RBI data life insurance policies, for instance, accounted for 20 per cent of the 2008-09 financial savings of the Indian household while provident/pension funds accounted for 9.5 per cent. Taxation of this significant component would result in poor yields for investors.

Let us take the case of PPF. The post-tax yield of a lumpsum invested in year 1 alone now yields 8.7 per cent after 15 years, assuming an 8 per cent return and a 10 per cent tax rate. Under the Code, the yield would drop to 7.9 per cent.

Unlike developed countries of the West which have social security systems provided by the government, the Indian household is dependent on savings to fend off post-retirement blues of inflation and medical expenses. According to Mr V. Ranganathan, Partner, Tax and Regulatory Services, Ernst & Young Pvt Ltd, the concept of EET, etc., is relevant for taxing the social security receipts (such as pension) and not saving schemes such as insurance products; savings products are not part of any such regime in other countries. The proposal causes worry on this front.

With the new Code likely to erode many of the tax-related reasons for investing in debt avenues, equities and real estate may remain the only asset classes that allow a reasonable post-tax return to investors.

However, their post-tax returns too could dip, given the re-jig in capital gains.

The Code proposes to do away with the distinction between short-term and long-term capital gains for all asset classes. Long-term capital gains would receive indexation benefit if held for over one year from the end of the financial year in which the asset was purchased. Capital gains are proposed to be taxed at the marginal rate of tax or in other words, the tax slab applicable to the individual.

What are the implications of this? Long-term investors in asset classes such as listed equities would suffer taxes on their investments. They do not currently attract any tax. They may nevertheless remain a superior asset class for those in the lower income bracket, provided the Indian equity markets continue to outperform.

Besides, there is some respite in the form of set-off of capital losses against capital gains before paying taxes.

All this suggests that, far from simplifying things for Indian investors, the new Tax Code, if implemented in its current form, may leave investors scrounging for options that would help build wealth with a limited tax impact.