The proposed Direct Taxes Code (DTC) has finally been introduced in Parliament, to be effective from April 2012 instead of April 2011 as originally intended. This DTC version has seen substantial changes in relation to taxation of investments, from what was proposed in the earlier version. What are these changes and what modifications should you make to your investment strategy on account of such changes?
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While the dividend distribution tax (DDT) on equity shares is to remain unchanged, there would now be a DDT of 5% on income distributed by equity-oriented mutual funds (MFs), which was so far exempt from such tax. The dividend on equity shares and on income distribution received from equity-oriented MFs would continue to be exempt in the hands of investors. However, for other MFs, there is a significant change since income distribution tax of 25% for money market and liquid funds and 12.5% for other such funds is being removed. However, income from such funds received by the investor, which was so far exempt, would be taxable as the income of the investor at tax slab rates. This would benefit investors in lower tax brackets; investors in the highest tax bracket of 30% would end up paying more tax.
The good part is that the current exemption for long-term capital gains (LTCG) on the sale of equity shares on the stock markets and on sale of equity-oriented MFs would effectively continue under the DTC. Also, the concessional tax for short-term capital gains (STCG) on these would continue. In fact, STCG tax may be lower for those in lower tax slabs, as only half the STCG would be taxed at normal tax rates. The gains on sale of mutual funds (other than equity-oriented) would be taxable in the same manner as capital gains on the sale of other assets.
One needs to keep in mind that the LTCG tax rate would be the applicable slab rate and not the current concessional rate of 20% (with cost indexation) or 10% (without cost indexation). For computation of capital gains on other assets as opposed to the current 12-month period (for shares, MF units and listed securities) or the 36-month period for an asset to get cost indexation and other benefits as a long-term capital asset, the holding period would be one year from the end of the year in which the asset is acquired. For securities, the holding period is now longer if one wants the benefit of cost indexation. Therefore, fixed maturity plans (FMPs) with double indexation would still get tax benefits. Of course, for an asset such as land or buildings, the period of holding to qualify for the benefit would be lower than the current period of three years.
There is a sea change as far as taxation of life insurance policies are concerned. All life insurance policies would be taxed on maturity as normal income, unless received on death of the life insured, or on maturity at the end of the policy (only if the premium payable in any year does not exceed 5% of the sum assured). Therefore, only endowment policies that have a duration of 20 years or more would effectively be exempt from tax. The premium paid would be allowable as deduction against the proceeds of insurance policies. There would be a tax deduction at source at 10% on payment of such taxable proceeds. Unfortunately, the amended law would apply to all insurance policy proceeds after 1 April 2010, irrespective of when the policy was taken. All existing policies maturing after that date would be affected.
For unit-linked insurance policies, the concept of an approved equity-oriented life insurance scheme is being introduced. Distributions or payments made by such schemes to policyholders will be subject to a 5% income distribution tax payable by the insurance company. The amounts of such distributions or payments on which such income distribution tax is paid will not be taxable in the hands of the policyholders.
The deduction for investments and insurance premium is also being restructured, though the EEE (exempt, exempt, exempt) basis is being continued, instead of the originally proposed EET (exempt, exempt, taxable). There would be two types of deductions—one of Rs1 lakh for contribution to approved funds, which would consist of notified provident funds, pension funds and other funds. It is not clear whether Public Provident Fund would be notified for this purpose. The other deduction would be of Rs50,000 for life insurance premium, health insurance premium and education expenses of children. This would mean that certain types of investments and payments that are currently eligible for this deduction—National Savings Certificates, five-year bank fixed deposits, infrastructure bonds, equity-linked savings schemes and housing loan repayment—would no longer qualify for deduction. Also, if you are paying an annual life insurance premium and health insurance premium totalling at least Rs50,000, the deduction would be limited to Rs50,000 against the current available deduction limit of Rs1.15 lakh (1 lakh for life insurance premium and Rs15,000 for health insurance premium).
Fortunately, investments would continue to remain outside the purview of wealth tax, against the original proposal to tax them. Paintings, sculptures, works of art and watches having a value of at least Rs50,000 would be subject to wealth tax.
Given these tax provisions, what category of investments should one focus on? Direct investment in listed equities, of course, offers the best tax benefits in the form of exempt income if held for more than a year. The next best option is the growth option of equity-oriented MFs, where the capital gains is again exempt if held for at least a year. If one is looking at debt MF schemes, the growth option is preferable to the dividend option in the long term. Also, since the date for applicability of DTC is postponed, one-year FMPs maturing before April 2012 currently make sense for taxpayers in the highest tax slab. The attractiveness of life insurance as an investment would significantly diminish with the tax on maturity proceeds and the reduced limit for deduction of insurance premium.
Finally, a note of caution—the DTC is still in its draft stage and may undergo further changes before it is finally enacted.
Gautam Nayak is a chartered accountant. Your comments are welcome at email@example.com