Government to go slow on personal tax reforms

The finance ministry is hastening slowly on its radical proposals for changes in tax rules. Thanks to public resistance to giving up their pet tax exemptions, the ministry has put out a new discussion paper of the direct tax code (DTC) that, inter alia, will go slower in reducing tax rates while retaining a part of the exemptions available for long-term capital gains on shares, provident funds and pension payments.

The bad news is that unit-linked insurance plans (Ulips) will be taxed if the new DTC becomes law next year. Life insurance payments received on maturity will also be taxed. Payments received in case of death through a term insurance policy — which is a pure insurance policy with no investment component — will, however, not be taxed.

The good news is that the earlier proposal to abandon special tax treatment for long-term capital gains (LTCG) will be modified: now there will be a basic exemption on LTCG, which will make investment in shares and equity mutual funds more tax-friendly than other avenues.

The bottomline is that the DTC is not going to replace the complexity of the Income Tax Act, 1961, anytime soon. The new DTC discussion paper, put into the public domain on June 14, has sought further comments up to June 30, 2010. The idea is to move the legislation in the monsoon session of Parliament, though the changes may not be effective till the next financial year.

Under the latest DTC, there will be no big-bang changes in basic tax rates and slabs. Earlier, the basic exemption limit for men under 65 was Rs1.6 lakh (Rs1.9 lakh for women). For incomes between Rs1.6 lakh and Rs10 lakh, the code proposed tax at 10%.

A 20% rate was proposed for the Rs10-25 lakh range, and 30% for incomes above Rs25 lakh.

The latest discussion paper released by the Central Board of Direct Taxes suggests that the government will not make this shift in one leap. “The indicative tax slabs and tax rates and monetary limits for exemptions and deductions proposed in the DTC will… be calibrated while… finalising the legislation,” it says.

“There is now uncertainty on the rates. They (the government) will now draft the rates in law and directly present it in Parliament and there will be limited choice for recommendations then,” says Samir Kanabar, director, Ernst & Young India.

There  is something to cheer about though. Currently, interest paid on a home loan is available as a deduction subject to a maximum of Rs1.5 lakh per year. The earlier version of DTC had proposed to take this deduction away.  The revised discussion paper proposes to keep this deduction.

“The deduction for interest on capital borrowed for acquisition or construction of a self-occupied house property, up to a ceiling of Rs1.5 lakh, as available in the existing provisions of the Income-Tax Act, 1961, should be retained,” the paper says.

The code seeks to increase the deductions allowed for investing in tax-saving instruments up to Rs 3 lakh from the current Rs 1 lakh. These instruments include government provident fund, public provident fund, other recognised provident funds and the new pension scheme administered by the Pension Fund Regulatory and Development Authority.

But other deductions like  deduction for house rent allowance and leave travel allowance, and deductions on investments in tax-saving mutual funds and fixed deposits will go.    

A major change is the partial abandonment of the EET (exempt-exempt-taxed) idea. The revised discussion paper proposes an EEE(exempt-exempt-exempt) method of taxation for all provident funds and the new pension scheme administered by the Pension Fund Regulatory and Development Authority.

What this means is that investments made in any of the above modes of investing will be tax exempt at the point of investment, interest payment and the final corpus released at the time of maturity. The earlier version of the DTC had sought to shift such investment to the EET regime, where the amount received at the time of maturity would have been added to income for that year and taxed.

Over and above this approved pure life insurance products and annuity schemes will also be subject to EEE method of tax treatment. What this means is that Ulips, which are primarily investment plans with just a dash of insurance, will be taxed at maturity. This is not the case currently.

There will be some relief for those investing in shares as well as equity funds. Currently investors do not need to pay any tax on capital gains if they hold on to their investment for one year or more. The revised discussion paper makes the calculation of long-term capital gains a little complicated. Let us say you sell your shares in the stock market for Rs 1,000. You had bought these shares at Rs 400 nearly two years back. So you end up making a capital gain of Rs 600 (Rs 1000 - Rs 400). Under the current regulations there would be no tax on this gain.

In the previous DTC, the gain would have been added to your income after adjusting for inflation. The revised draft DTC allows for an unspecified deduction on the capital gain before adding the balance to your income for the year. What this means is that long-term capital gains will be taxed at rates lower than your bracket rate.

The revised paper does not specify the rate of deduction on capital gains. But let us say this rate is at 50%. So 50% of Rs 600 works out to Rs 300. The remaining Rs 300 (Rs 600 - Rs 300) will added to your income for the year and taxed accordingly. So if you come in the 30% tax bracket, this would mean a tax of Rs 90 (30% of Rs 300). This would mean an effective tax rate of 15% (Rs 90 expressed as a percentage of Rs 600).

“The discussion paper is effectively proposing 10-15% tax on long-term capital gains and 30% on short-term capital gains. It is certainly not favourable when compared to the present regime, but provides some relief if one compares it with the earlier version of the DTC. They have treaded the middle path,” says NC Hegde, tax partner and M&A tax leader at Deloitte.

Also, the earlier version of the direct tax code had proposed a tax even those living in their own houses on the basis of notional rent. That proposal has been done away with. Public sector employees can also breathe a sigh of relief. The earlier version had proposed to consider the value of rent-free or concessional accommodation, the value of leave travel concession, medical reimbursements, etc, as perks and taxed accordingly. That proposal has been done away with.