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Commentary

New Tax Code: EET Regime and Tax Saving Schemes

The new Direct Tax Code is out (full draft) and proposed to cut taxes dramatically starting 2011. From a current slab of about 1.6 lakh, 3 lakh and five lakh (10%, 20% and 30% rates) – the new slabs will be 1.6 lakhs, 10 lakhs and 25 lakhs.

The flip side of it? Most deductions are out, and it’s a simplified bill. The lower rates will encourage compliance and weed out complex avoidance schemes.

But there are tons of online sites that talk about all the stuff in the code. Let me focus on one thing: the EET regime.

EET refers to Exempt-Exempt-Taxed. Upto 3 lakh a year starting 2011, certain investments – and I think by this they mean insurance, ELSS mutual funds, PPF and so on – will be exempt from tax in the year of investment. Then, as they grow in size, the growth is also exempt. Finally, when you withdraw the money the entire amount is added to your income and taxed.

Currently we have EEE – insurance and ELSS funds are exempt at entry, exempt on growth and exempt on exit. The limit is only 1 lakh a year.

Still, 2011 is hajaar far away – two more financial years away, in fact. Why should you bother? Because the EET regime changes a few things.

Investing money in tax saving instruments now will be taxed on exit – because they will exit only after 2011 (lock in is three years, minimum). So if an insurance agent tells you to buy an insurance policy because it’s tax-saving, he’s pfaffing – you will end up paying tax when you exit.

(This doesn’t apply for PPF apparently; the tax code has a grandfathering clause that lets any accumulated balance in PF accounts as of March 31, 2011, stay untaxed even afterwards)

But it may still be worth it. A person earning 8 lakhs today will pay 30% tax on the 1 lakh invested. Should he get scared of EET and ditch? Well, he will get 70K today, out of that 1 lakh. But if he held for three years, and say there was zero growth, he will get 1 lakh in 2012, at which time let’s say his income is 12 lakh. The 1 lakh he gets then will be charged at 20% only, a 10% saving. (It may not be much, but there is a saving)

But in all the participation in insurance and Mutual Funds should reduce today, even though the tax code only gets valid in 2011. At least till 2011, because one can get a better deal investing in a PF instead. Not very positive in the short term for MFs/Insurance companies.

Another impact of the tax code will be that interest on housing loans may no longer be exempt from tax. I’m not sure about this, though. And STT will go – which means long term cap gains tax is back.(sell all long held stocks and buy them back in March 2011!)

  • Anonymous says:

    >why not wait till mar 2011 and then sell all the investments(long one)? and then buy in apr 2011

    milind

  • Sunil says:

    >The position is not clear regarding instruments on which 80C may not have been claimed either by virtue of exceeding limit or simply that there was no taxable income to claim deduction. These instruments would have been out of taxed income in the former case and out of exempt income in the latter. Therefore this would be T. Now the interest accrued may not be taxed. That would be E. Now the withdrawal will be taxed. That would be T. This becomes TET,i.e the same income has been subjected to tax twice. Now suppose in the new regime you exceed 3 lakhs limit, assuming that you are not taxed on accumulation, you would be taxed twice on the investment at the time of withdrawal. One interesting point to see the honesty of the government will be the 80C deposits for 5 years with the bank. Currently bank is deducting TDS on the income accrued on these. They are taxed with your other income. We have to see what they do at maturity. Tax the whole thing or only the initial investment. The clarity seems to be only for PPF account and not for instruments on which investment is made with income already taxed (no deduction claimed). Currently 80C deposits are ETE. They may become ETT?

  • Anonymous says:

    >The exact language in the draft is:
    "The amount of accumulated balance, as on the 31st day of March, 2011, in the account of an employee participating in an approved provident fund and any accretion thereto."

    This means that amount accumulated upto end of FY 2011 is tax-exempt as well as the interest earned on such amount in future.

    But will this accumulated amount will contine to be tax-exempt when the PPF account is renewed after completion of 15 years? Or will a renewal make the previously-accumulated amount taxable?

  • Px says:

    >Isnt the lower limit a tad bit low

    plus i dont know how they will go about with ppfs without litigation, as it becomes especially unfair to people who have held their acs for above 15yrs especially because the rules are so inflexible

    plus would this not be a big boost to the markets as corporate tax would be axed to 25%

  • Deepak Shenoy says:

    >Sunil: I completely agree- the non 80C claimed investments are not mentioned – so anything about the 100K limit that was invested today and withdrawn after Apr 2011 is likely to be taxed again (insurance, ELSS etc).

    80C deposits will be ETT – all they have done is replaced the last letter (currently E) with "T". So EEE becomes EET and ETE becomes ETT.

  • Deepak Shenoy says:

    >Anon2: I'm sure it won't make the previous amount taxable, but it might end up making NEW accumulations (interest etc.) taxable; this will need clarity from the department.

    Px: Markets will react evenly – they've removed a lot of corp deductions, removed tax avoidance measures currently used, increased MAT base to be on assets, set up serious provisions in case even the spirit of an act is to avoid tax etc. That hurts the big companies more than the small ones (and is good – I don't see why they should avoid tax) I don't know for sure but this might mean Infy and co. will pay a little more tax to India also.

  • CharteredClub says:

    >The same had happened in the yr 1995. Even then they tried to change the Tax Laws But nothing happened. Finally after 7 years of Debate only a few of the provisions of the new proposed Bill were chosen and they were incorporated in the Existing Income Tax Act 1961.

  • Arpit says:

    >Section 66 of the new tax code ( which replaces section 80C ) does not specify instruments like ELSS MF, NSC and 5-year fixed deposit. So nobody has to worry about ETT.

    All four tax-savings instruments are EET, which are:
    1. Provident fund
    2. Pension fund
    3. Life insurance
    4. Superannuation fund

  • Bhagwad Jal Park says:

    >I believe the main question here is, will investments in regular equity MFs (Not tax savings) be exempt from tax on exit if they're long term savings?

    As the first commenter pointed out, since they're not tax saving schemes, we would already have paid tax our before investing. It doesn't make sense to tax it again.

    Also, if they are equity MFs, then the accumulation is not interest but dividend in nature and since companies have already paid their tax before doling out dividends, the extra accumulated amount should not be taxed either.

    I would appreciate some clarity on this from a knowledgeable person.

  • Deepak Shenoy says:

    >Bhagwad: THe principal won't be taxed. (since, as you rightly pointed out, it's been taxed already)

    Only gains will be – as they should be, because when you realize gains it is income; but you get inflation indexation benefits, of course.

  • Bhagwad Jal Park says:

    >I wonder if dividends will be taxed? Suppose I invest in an equity dividend scheme, then even though that's income, it's already been taxed on the corporate end.

    So if I have to pay tax on dividends received, it's double taxation.

  • Deepak Shenoy says:

    >NO mention of dividends being taxed (other than dividend tax itself – which is levied on the company/MF before you anyhow). So that may not change.

  • Bhagwad Jal Park says:

    >So to take the dividend logic one step further, instead of investing in an equity growth scheme, I can invest in a dividend scheme where the dividends get reinvested to buy more.

    Numerically they come to the same thing, but from a tax perspective, the gains on one will be taxed and the gains on the other will not?

    Any opinions on this idea?

  • Deepak Shenoy says:

    >Dividend reinvestment is accounted as fresh investment into the fund at the NAV on the date of dividend.

    That means only gains from that date (for the dividend units) will be taxed. For the primary units (pre-dividend) it will be gains from the NAV of date of original investment. FIFO logic applies so if you sell, the first units in are the first to go, and so on.

    Again, consistent with the philosophy of taxing only gains in the hands of the investor.

  • Bhagwad Jal Park says:

    >True, but what I'm saying is that with long term gains taxed, dividend reinvestment turns out to be much much cheaper than regular growth for equity funds.

    This is because the NAV drops when dividends are issued thereby limiting the growth and therefore the tax. So instead of having the same number of shares at a higher price, we now have many more shares at around the same price. This is much better from a tax point of view.

    However, with Dividend Distribution Tax being maintained in the DTC, I don't know how this will be affected. Do MFs have to pay DDT?

  • Deepak Shenoy says:

    >BJP: You're right, and that was the original reason of how dividend reinvestment used to be so popular. I had written about it at http://blog.investraction.com/2006/10/mutual-funds-dividend-option-or-growth.html – so when cap gains (or taxed returns) is back, that option will be useful again.

    Debt MFs get charged DDT. Not equity ones, though.

  • Bhagwad Jal Park says:

    >But (and here's the main point) suppose Dividend Distribution tax is applied to the dividends? You mentioned in one of your posts that DDT is not payable when dividends are given to equity MFs but then according to the new tax code, it'll have to be taxed at some other point.

    So the question now is – which is better? Growth with long term capital gains tax, or dividend redistribution with DDT?

  • Deepak Shenoy says:

    >AFAIK, Dividends of equity MFs have no DDT because they are supposed to redistribute the dividend they receive from companies, who have already paid DDT.

    Given DDT, is unlikely to be any tax in the hands of investors unless DDT is removed. (DDT Is applied at source, so the investor that gets dividend doesn't need to pay)

    Dividend reinvestment thus is still better – because of two factors: Equity MFs can capture capital gains and distribute that as dividend, which is not taxed at DDT level either (this is a legal loophole as of now). Second, the reason you specify, that it incurs lower long term cap gains tax when you exit.

  • ASHISH MANCHANDA says:

    >YES IT IS LIKELY TO CHANGE THE INVESTMENT PLANNING OF PEOPLE IN MY OPINION EET JUST RESULT IN POSTPONEMENT OF TAX ON YOUR INVESTMENT AND RETURNS YOU WON'T BE ABLE TO AVOID TAX NOW I.E. AFTER THE IMPLEMENTATION OF DIRECT TAX CODE, 2011