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ShareA draft of the new direct tax code which seeks to replace the existing Income-Tax Act has been released by the government for public debate.
A key highlight of this new code is the transition into the much-hyped EET system of taxation. The blueprint has been put up for public comments and suggestions from the public would be taken into consideration by the government before enacting the draft into the final direct tax code.
However, before offering comments, we need to understand what exactly is EET and what are its consequences on the common taxpayer.
EET stands for Exempt-Exempt-Taxed and is a tax system where an investment in a savings plan is deductible from income. So also is the interest earned. However, the maturity amount is taxable. This is in contrast to the earlier EEE system (under Section 88) where investment, interest and the maturity amount remained tax-free. A case in point is public provident fund (PPF).
Difference between EET and EEE
Investors will remember that it was Budget 2005 that had dropped Section 88 and introduced Section 80C in is place. It is vital to understand the difference between the tax deduction offered by Section 80C as against Section 88 in order to understand the implications of EET.
As far as investments are concerned, there is really no difference. The instruments remain the same, which means we still use the same PPF, ELSS, NSC, etc to invest and claim deduction.
However, the main difference is that Section 88 offered a rebate (deduction) from the tax payable. Section 80C, on the other hand, offers a deduction from the income chargeable to tax. This difference is vital. Let's see how it manifests itself in terms of numbers.
Let's take the case of a certain Mr Shah, who is of 45 years of age and has an income of Rs 5 lakh. Now, as per the old rules, he would typically have invested Rs 70,000 in PPF and Rs 30,000 in say infrastructure bonds under Section 88. His tax liability would be worked out in this way:
Particulars
Income Rs5,00,000
Tax thereon Rs1,24,000
Less: Rebate u/s 88 @15% Rs15,000
Final tax liability Rs1,09,000*
*FY05 tax rates
Now, under Section 80C, he can invest the entire Rs 1 lakh in any of the avenues available. Let's say, he invests the money in an ELSS fund. On a similar income level, his tax liability would be:
Particulars
Income Rs5,00,000
Less: Deduction u/s 80C Rs1,00,000
Net taxable income Rs4,00,000
Tax thereon Rs35,000*
*FY09 tax rates
Earlier, when one invested under the Section 88 window, tax saving effected was permanent in nature. This meant that once the tax was saved for that particular year, it was saved per se. When the invested amount matured, it was tax-free.
However, when the EET system is put into place, permanent tax saving won't be possible. This is because, by making an investment, you will reduce the same from your income thereby lowering the tax liability. However, when the amount matures, it would be taxable in that year. In the above example, the ELSS fund, when he redeems it, will be taxable in Shah's hands.
The transition from Section 88 to Section 80C was essentially made in an effort to implement EET -- but so far it had not been done.
In any case, the EET system is a deferment of tax and not saving of tax. In other words, you will postpone the payment of tax depending upon the lock-in of the investment. However, some time or the other, the investment will mature. At that time, tax will be levied.
So, the long and the short of it is that permanent tax saving is not possible under EET.
EET and DTC
First of all, let's consider the tax deduction. Section 80C of the Income-Tax Act has been replaced by Section 67 in the code. The current Section 80C limit of Rs 1 lakh has been tripled to Rs 3 lakh under the new Section 67. This section, just like Section 80C did, provides for a deduction in respect of contributions made by both the employee and the employer to any account maintained with any permitted savings intermediary (PSI) during the financial year. PSIs mean approved provident funds, approved superannuation funds, life insurers and the New Pension System Trust. This is the first 'E' of EET where the investment made is exempted from tax.
The interest that such contributions earn will be exempted from tax till such time as it is allowed to accumulate in the account. This is the second 'E' of EET where the interest is also exempted.
Now comes the last part, the 'T'. Any withdrawal made or amount received from the above accounts will be taxable in the year in which withdrawal is made or amount received.
Existing investments
In this context, the most common apprehension expressed by investors was regarding taxability of existing investments. Existing investments are made with the express understanding that the withdrawal or maturity amount will not be taxed.
Thankfully, the new code respects this sentiment and provides that the withdrawal of any amount of accumulated balance as on March 31, 2011 in provident funds and PPF will not be subject to tax. In other words, only new contributions on or after the commencement of this code will be subject to the EET method of taxation.
Note that the carte blanche sunset clause exemption for balances up to March 31, 2011 is limited to existing investments in PPF and PF. Life insurance policy proceeds is a notable omission.
The code states that in case of a life insurance policy (other than Keyman Insurance), any sum received including any bonus will be exempt, only if the premium does not exceed 5% of the capital sum assured and such sum is received only upon completion of the original period of contract or upon the death of the insured. All other types of insurance proceeds will be taxed, notwithstanding the fact that the current Section 10(10D) offers a blanket tax exemption.
Moving on, the PSIs mentioned above would be required to be approved by the Pension Fund Regulatory and Development Authority (PFRDA). These intermediaries will, in turn, invest the amounts deposited with them in government securities, term deposits of banks, unit-linked insurance plans, annuity plans, bonds and securities of public sector companies, banks and financial institutions, bonds of other companies enjoying prescribed investment grade rating, ELSS, debt-oriented mutual funds, equity and debt instruments. The choice of instruments will, in some schemes, be with the investor and in some others, with the trustees of the schemes. The pattern of investment by the latter will be as prescribed.
Further, the rollover of any amount received, or withdrawn, from one account with any PSI to any other account with the same or any other PSI will not be treated as withdrawal. Hence, such rollover will not be subject to tax. For example, if a taxpayer were to withdraw funds from say an ELSS fund and reinvest the same in another ELSS fund, such withdrawal will not be subject to tax.
To sum
It remains to be seen how the government actually puts into practice this new way of investing where investments in the current common tax saving instruments is not done directly by the taxpayer but through the mechanism of a permitted savings intermediary. Centralised record capture and record keeping for a wide and diverse taxpayer and investor base is not an easy task as already has been evinced by the recent events (MAPIN, UTN etc). But as they say, tomorrow is another day. Watch this space for further developments.
The writer is director, Wonderland Consultants a tax and financial planning firm. He may be contacted at sandeep.shanbhag@gmail.com
