There’s inequity in EET

The discussion paper on direct tax code lays down the rationale of EET as follows:
“In line with the best international practice in this regard, the code proposes to introduce the ‘Exempt-Exempt-Taxation’ (EET) method of taxation of savings. Under this method, the contributions are exempt from tax (this represents the first ‘E’ under the EET method), the accumulation/ accretions are exempt (free from any tax incidence) till such time as they remain invested (this represents the second ‘E’ under the EET method) and all withdrawals at any time are subject to tax at the applicable personal marginal rate of tax (this represents the ‘T’ under the EET method).”

A laudable intention, and an even more laudable action; EET is a fair and equitable basis for taxation and progressive in its impact. What has been proposed in the discussion paper has been tightly secured in the code; every effort has been made in the code to ensure that no one can escape that last ‘T’ of EET.

Nevertheless, the proposed EET framework in the code needs a second look as there are “slips twixt the cup and the lip” in it that make it inequitable and regressive. EET is not just what meets the eye; it is more than the first E, the second E and the last T; between the three lies a chasm of inequity.

The inequity in EET becomes obvious when we break down “the withdrawals” from the “the permitted savings intermediaries”, the term that the code uses for providers of long-term saving instruments. The code lists four such intermediaries: Approved provident funds, approved superannuation funds, life insurers and the New Pension System Trust.

Withdrawals from any of these savings instruments consist of two distinct parts: (a) the “contributions”, that is what the assessee contributes to the corpus from his current income, over a period of time (the first E); and (b) the “accumulation/ accretions”, that is what the corpus in these instruments earns over the period for which it remains invested (the second E). Under the EET regime, all withdrawals (including the pension received) from these savings instruments at any time are subject to tax at the applicable personal marginal rate of tax.

The accretions are obviously an income of the assessee, over and above what he has reported in his annual returns till date, and it is fair that it should be reported in the annual return in the year of withdrawal as income of current year and tax be paid on it. But what about the contributions?

Contributions come from the income already reported in annual returns of earlier years; they do not constitute income of the current year. The question that arises therefore is, is it fair to construe the entire withdrawal as the income of the current year as required by Section 56 of the code?

The logic that underlies bringing the entire withdrawal under the purview of the last T of EET is that contribution constitutes income of the earlier years on which no tax has been paid; therefore, EET logic requires that the contribution part of the withdrawal also be taxed.

But does this logic always hold good? No. To the extent that the assessee has deducted the contributions from his ‘gross total income from ordinary sources’ for the respective year under Sections 65 and 66, the logic holds good, and taxing the contribution part of the withdrawal is fair.

But if the assessee has not deducted the contributions from his ‘gross total income from ordinary sources’ for the respective year under Sections 65 and 66 for any reason,
the logic fails.

And the possibility of this happening is very real. The limit for deduction under Section 66 is Rs 3 lakh per annum. If the assessee contributes more than this limit to the permitted savings intermediaries — and there is no reason why he should not — then, to the extent that his contributions exceed this limit, the logic of EET fails.

Then EET results in double taxation; the assessee pays tax in current year on an income on which he has already paid tax in an earlier year.  The possibility of this happening, let me repeat, is real.

Let us take the example of a person who begins to contribute at age 44 with the intention of getting an annual pension of Rs 6 lakh at current prices, adjusted for inflation at 6% per annum.

That works out to an annual pension of little over Rs 16,15,000 when he begins to draw it at age 61; he hopes to draw it till about the age 94.  Let us assume a 12% return on his contribution. To put this plan into action, his annual contributions to the permitted savings intermediaries have to be Rs 5,20,000.

This exceeds the permissible deduction limit of Rs 3 lakh by Rs 2 lakh. Then, he will be paying double tax on about 42% of the contribution part of the withdrawal. That is where the inequity of EET lies. Can this inequity be removed? Yes. Simply do away with the limit on deductions under Section 66.

Will that not open the gates for a surge of tax avoidance? Make the long-term savings really, really long term; increase the lock-in period for the investments in permitted savings intermediaries to 15 years.

What about the loss in tax revenue? The loss in tax revenue will be more than offset by the long-term resource mobilisation: If one can raise capital which will not move out for fifteen years, why cry over tax?

The writer has been working in the retail financial products space for last 15 years,
both in the industry as well as a visiting faculty in the subject at Goa University.