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ELSS: Not that attractive?

Budget 2005 announced that you could save tax by investing Rs. 1,00,000 – one lakh – in any specified scheme, and the invested amount would be tax exempt for that year. Section 80C, they called it, and it contained a number of investment avenues – Insurance policy premium, NSCs, PPF, Equity Linked Savings Schemes (ELSS) etc.

ELSS is an offering by mutual funds that invests 80% or more of it’s money on Equity – i.e. Regular Shares, Convertible Preference Shares or Debentures/Bonds. Obviously most go through the stock markets. The money you invest is locked for three years (at least). Idea being, you must invest for the long term.

Assuming you invested 1,00,000 in ELSS, you save 30.6% (at the highest slab) – this equates to Rs. 30,600 saved. Additionally, you get price appreciation after three years, which adds to the yield – especially if you were planning to invest anyway.

What’s wrong then? Well, the IT department has issued a notification – no. 226 on 3.11.2005 – that changes a few things.

There’s a very good article by Sandeep Shanbhag at that tells you in more descriptive terms about the issues involved, but I’ll try to explain further.

ELSS is perhaps not a tax saving scheme it’s a tax deferring scheme. The government may not tax you this year, but may introduce a later notification to tax you on maturity or on withdrawal. This is the concept of EET (Exempt-Exempt-Exempt)

The EET concept is simply that

  • Investments are Exempt from tax (in the year of investment)
  • Accumulated gains are Exempt from tax (in the year of the gain itself)
  • Withdrawals or maturity benefits are Taxed (in the year of withdrawal/maturity)

(Note: The government hasn’t yet introduced EET, but it is likely to happen soon.)

Simply put, in ELSS, you don’t pay tax THIS year, you pay tax after three years or whenever you withdraw.

Now, few important concepts in the notification:
1) From 2005-06, plans must be closed ended – i.e. they have a fixed period of existence. A new plan must be introduced every year, which closes 10 years after introduction. So, each year you have a new “plan” or “series” of the mutual fund. This is not like regular Equity Mutual Fund units.

2) An ELSS plan must be open for a minimum of one month per year (three months from 2006-07 onwards). What does that mean? You can put in money now – November – and the MF can allot your units in February 2006. (The one month can be ANYTIME before March 31 of the financial year)

You are then locked in for three years from the date of allotment. This may be splitting hairs, but those extra three or four months of lock in could be a pain!

3) NAV is no longer transparent. Unlike Equity Mutual Fund units, ELSS schemes do not need to announce the NAV daily. No, not even weekly! A “series” – a particular year’s units – need not announce the NAV until one year elapses (after date of allotment). After that it only needs to announce the NAV twice a year. After three years, you get your NAV only once a month.

So, you can’t even know how your ELSS is performing, until a year elapses! How do you decide whether an ELSS scheme is worth investing in, next year? After all, we’re not one time investors – we need to regularly invest.

4) As Shanbhag says, an early repurchase may not be in your favour. Since NAVs aren’t daily, the difference between the day you invest and the NAV date may work against you. MFs can say they wont give you upto 50% of such gain. Remember, in a boom, fund NAVs can go up 1% to 1.5% every day, so even 15 days is a HUGE loss. And you can be sure that if there’s any loss, you’ll be made the loser.

Let’s now see, what is the ELSS Analysis?

1. Tax saving (in the year of investment) 1. Tax is paid on investment PLUS gains on year of withdrawal.
2. Amount locked in for three years
3. NAV is not transparent
4. You can get ripped off during repurchase.

Why bother with ELSS then? Invest in a regular mutual fund instead.