Today’s Economic Times has a very good article written by Anish Thacker, partner taxation at E&Y. It’s well written and addresses the issues from an Industry viewpoint.
It brings into focus the issues that the average person faces in their savings options that will be impacted under the proposed Direct Tax Code.
The government has historically tried to encourage savings by the SME entrepreneur and the Salaried Individual to provide for their old age, and the tax man has obliged. Under the tax code applicable today, there are some “real” benefits provided to customers in an effort to promote long term savings in the absence of any state provided or compulsory employee pension schemes.
The savings by individuals in Life Insurance, Pension Plans, Employee and Public Provident Funds, NSC, are currently enjoying various tax benefits as under:
- Contribution: The amount of contribution is exempt from tax in the year of contribution. The benefit is that the contributor can claim a tax deduction for the amount contributed (upto a maximum Rs 100,000 under Sec 80C). This is applicable to contributions made to Life Insurance, Pensions, Employee & Public Provident Funds.
- Income during the Tenure of Investment: The income earned by these Plans in the year of income is not taxed. This is applicable to all categories under Sec 80C. The benefit of compounding allows a higher accumulation for the customer.
- On Maturity: The amount accumulated by the customer under schemes specified in (1) above are exempt from tax for Insurance and Provident Funds. For Pensions only 2/3rd can be encashed on maturity with a minimum 1/3rd going towards purchasing an annuity.
Therefore, all three stages of the investment made in these specified categories are exempt from tax. This is generally referred to as the “EEE” regime.
In Life Insurance and Pensions, contributions can be made for more than the maximum exemption amount of Rs 100,000 – and many do contribute an overall higher amount annually when combining all their investments including EPF, PPF, Pensions and Insurance.
Although tax exemptions Sec 80C is limited to total contributions upto Rs 100,000, the annual income of the plans and the maturity amount is exempt under the current regime. This is currently a huge benefit to those who are accumulating their savings to provide meeting specific obligations of their children’s education or buying a house or their pensions.
The proposed Direct Tax Code seeks to move from the Exempt-Exempt-Exempt regime to an Exempt-Exempt-Tax regime.
What this amounts to is a deferment of tax, not an exemption from tax!
Essentially, this would mean that although Contributions to these long term savings products would continue to be exempt (proposed to increase to Rs 300,000) and the annual income generated by these investments would also be exempt.; the total amount paid on maturity would be taxed at the tax rates prevalent at that time.
In Life Insurance the full maturity amount will be taxable except where the Sum Assured is more than 20 times the annual Premium paid on the policy (an increase in requirement from the current 5 times the annual premium paid). Therefore some life insurance products with a significant risk cover will remain attractive avenues to accumulate funds; whilst investment oriented and short term insurance products will lose favour.
Investments in Mutual Funds will be taxed at the applicable short-term or long-term capital gains tax rate on withdrawal.
Investments such as in EPF and PPF today are attractive due to the tax arbitrage, even though the investments under EPF are mostly in debt securities and usually return c. 8-8.5%, nominally a positive return over inflation. Returns on such instruments will be impacted in real terms, considering the government’s efforts to link return to market returns; inflation; and the tax at maturity as proposed under the DTC.
The focus for investors will need to move towards investments that provide for a “real” wealth accumulation and not only a tax savings play.