Draft code II favours equity MFs over Ulips

Looks like insurance companies are in for more trouble. The revised discussion paper on the direct tax code put out by the Central Board of Direct Taxes clearly seems to favour equity mutual funds over unit linked insurance plans (Ulips).

Ulips are essentially investment plans offered by insurance companies which come with a dash of insurance.

Currently Ulips come under the EEE (exempt exempt exempt) regime when it comes to taxation.

What this means is that the money invested in an Ulip is tax exempt, the returns earned during the tenure of the Ulip are tax exempt and the amount received at maturity is also tax exempt.
The revised discussion paper on the direct tax code suggests that Ulips will now come under the EET (exempt exempt tax).

This means that the amount invested in an Ulip will continue to be tax exempt, and so will the returns earned during the tenure of the Ulip. But the amount received at maturity will be taxable.

So let us say an investor invests Rs 1 lakh in a single premium Ulip and he gets Rs 3 lakh after ten years.

The entire amount of Rs 3 lakh will now be added onto his taxable income for the year and taxed according to the marginal tax bracket he falls into.

Let us say the investor’s taxable income is Rs 9 lakh for the year. So the Rs 3 lakh will be added onto the taxable income of Rs 9 lakh and the investor will be taxed at the top tax rate of 30% (as per current regulations).

This means he would have to pay a tax of Rs 90,000 (30% of Rs 3
lakh). This would mean his gain would be limited to Rs 1.1 lakh (Rs 3 lakh  - Rs 1 lakh of initial investment - Rs 90,000 paid as tax). Equity mutual funds on the other hand have been treated more favourably.  

Let us take the same example, where the investor invests Rs 1 lakh in an equity mutual fund and makes Rs 3 lakh at the end of 10 years.

This would mean a capital gain of Rs 2 lakh (Rs 3 lakh - Rs 1 lakh).

The revised discussion paper allows for a certain deduction on this capital gain of Rs 2 lakh. Let us say this rate of deduction is 60%, this means that 60% of Rs 2 lakh i.e. Rs 1.2 lakh will not be taxed. And the remaining Rs 80,000 (Rs 2 lakh - Rs 1.2 lakh) will only be taxed.

This means the investor who comes under the 30% tax bracket will pay a tax of Rs 24,000 (30% of Rs 80,000). So his overall gains will be Rs 1.76 lakh (Rs 2 lakh capital gain - Rs 24,000 paid as tax). This will be 60% more than the money made in case of an Ulip.

The government hasn’t decided on a rate of deduction as yet. But even if this rate is as low as 10%, investing in an equity mutual fund will make more sense. At a 10% deduction rate, 10% of Rs 2 lakh capital gain i.e. Rs 20,000 will not be taxed. This means Rs 1.8 lakh will be taxed (Rs 2 lakh - Rs 20,000).

The tax on this at the rate of 30% would work out to Rs 54,000 (30% of Rs 1.8 lakh). This will limit the total gain to Rs 1.46 lakh (Rs 2 lakh - Rs 54,000), or 33% more than the Rs 1.1 lakh gain in case of a single premium Ulip.