Consider conformity with DTC when investing for long term

As the Indian Income Tax Act (ITA) enters its last leg, making way for the Direct Taxes Code (DTC) effective from April 1, 2012, investors should be careful of overlapping investments.

Overlapping investments are those where the ITA is applicable while making the investment, whereas it is the provisions of the DTC that will apply at the time of maturity. For example, the currently popular fixed maturity plans (FMPs) of mutual funds.

The unique selling point of these schemes is the tax efficiency they offer over bank fixed deposits (FDs). While currently, both bank FDs and FMPs offer a similar rate of return, the interest on bank deposits is taxed at the normal rate, in the case of FMPs (over 1 year), the 10% (20% with indexation) capital gains tax rate applies. Consequently, on a post-tax basis, an FMP turns out to be much more advantageous.

However, there is a very significant issue that needs to be considered. If you were to invest in say any one-year FMP available currently, at the time of making the investment, the ITA is
applicable.

However, at the time of maturity (FY 11-12), it is the DTC that would apply. And did you know that under the DTC, the tax advantage that an FMP has may just not be available! Let’s understand how and why.

Basically, long-term capital gains from equity shares and equity oriented mutual funds (MFs) continue to be tax-free under the DTC. However, the current system of long-term capital gain taxation of non-equity MFs (10% without indexation or 20% with indexation) has been discontinued under the DTC.

Though indexation will apply, the resultant capital gain would be added to the other income of the taxpayer and be brought to tax at the slab rates applicable. (Note: Here that it is not indexation per se, but only the special rate of 20% after indexation that is discontinued - indexation itself continues to apply).

Also, under the DTC, there is a significant departure from the ITA with respect to method of determining whether a non-equity asset is long-term or not. For instance, under the ITA, a financial asset has to be held for over one year to qualify as long term.

Such holding period is calculated from the date of purchase to the date of sale. For example, if you invest in an FMP say today, it would qualify as a long-term asset with effect from July 13, 2012.

However, under the DTC, the asset has to be held for over one year from the end of the financial year in which it was acquired. So, taking the same example, an FMP purchased today, will qualify as long-term, under the DTC, only if held for over one year from March 31st, 2012 i.e. it will be considered as a long-term asset if and only if it is sold anytime from April 2013 onwards.

So let’s see what the above provisions mean for a typical 370-day FMP that is on offer today. First and foremost, it must be understood that since the maturity of this FMP will be in July 2013, it is the DTC provisions that will be applicable and not those of the ITA.

That being said, since an FMP is a non-equity asset, the current system of 10% (20% with indexation) will not apply and instead the income will be subjected to the marginal rate of tax. Even this one could have lived with, since at least the net income subjected to tax would be lower due to applicability of indexation.

However, in the above specific example, in order for the FMP to qualify as a long-term asset (and hence be eligible for indexation), it needs to be held for over one year from the end of the financial year in which it is purchased i.e. it needs to be held till April 2013.

However, the maturity of the FMP will fall in July 2013 and hence indexation too will not be applicable. Consequently, the income from such an FMP will be taxable just like interest from a bank deposit is - to be added to your other income and taxed at slab rates. The net effect would be that, given a similar rate of interest, there would be no difference whatsoever in the post tax return from a bank deposit and an FMP!

To Sum up
The DTC is just around the corner. It is time various stakeholders take cognizance of this and tweak their offers in such a way that would be most optimal for the consumer. For example, the FMP tenure could have been so adjusted that every investor would end up qualifying for indexation benefits. Many may have already invested not knowing (and not being warned either) that at the time of maturity, the tax efficiency that one has been used to all these years will not be available.

Investors on their part would do well to appreciate that this dual law applicability, at the time of entry and exit, will be applicable not only to mutual fund schemes, but also a host of other investments such as insurance plans, bonds and even to payments that earn tax deductions such as home loan installments and tuition fees. Therefore, before committing funds for the long-term, one should take care that the investments are tax efficient and in conformity with the provisions of the DTC, rather than the current ITA.

The writer is director, Wonderland Consultants, a tax and financial planning firm. He may be contacted at sandeep.shanbhag@gmail.com