Readers would be aware that the new direct tax code proposes to adopt the Exempt-Exempt-Taxed (EET) regime.

The first leg (representing the first E) is covered by Section 66 of the code, which allows an individual or an HUF a deduction of up to Rs 3 lakh in aggregate in respect of any sums paid to, or deposited in, any account maintained with any permitted savings intermediary during the financial year.

The accretions to the deposits will remain untaxed till such time as they are allowed to accumulate in the account. This is the second leg representing the second E.

Finally, Section 56(2r) of the code states that the gross residuary income shall "include any amount received, or withdrawn, under any circumstances" from any account maintained with any permitted savings intermediaries representing the principal amount of the savings; or interest, dividend, bonus, capital appreciation or any other form of return on the investment, by whatever name called.

This is the third leg representing the last T. Accordingly, it will be subject to tax at the then existing personal marginal rate applicable to the assessee.

Analysis
The interesting thing about EET is that it is the same as TEE (Taxed-Exempt-Exempt). In other words, it makes no difference (financially) whether you claim the tax deduction or alternatively pay tax and invest the difference! To put it differently: TEE = EET since: (1-t)(1+i)n =(1+i)n(1-t) where t = Tax rate,i = Interest rate per annum, n = Number of years after which the amount is withdrawn The table (Upfront vs trailing tax) illustrates this point.

In the table, the amount of gross income is taken to be Rs 10,000. The left hand side illustrates the closing balance where tax is paid and the net amount is invested @ 9% pa. The right hand side illustrates what happens when tax deduction is claimed upfront, but the maturity amount is subjected to tax at the end of the term of five years. Of course, the interest rate is kept constant under both scenarios @ 9% pa.

Have a look at the last column which represents the after-tax closing balance of the EET System. You will notice that this column is the same as the closing balance of TEE system for each year. The conclusion is EET = TEE in respect of the take home of the taxpayer.

Note that this would be true only if the tax rate at the start of the deposit is the same as or lower than that at the end. The taxpayer will benefit if he finds himself in a lower tax zone at the time of withdrawal. On the other hand, there will be a colossal loss if the tax slab is higher at the time of maturity.

Now, on account of the structure of EET, the chances of the tax slab being higher are greater.

Let us take the instance of an employee in the 20% tax bracket with 30 years left for retirement. If he deposits only Rs 20,000 every year in any retirement benefits account maintained with any permitted savings intermediary, he will find that @ 9% pa, his retirement amount would grown to Rs 27.26 lakh. Now, if he were to withdraw this amount, he would migrate into the higher 30% tax slab since his income would be above Rs 25 lakh. In other words, his tax rate would be higher after he has retired than when he was working!

In view of this, the conclusion is that, unless the code is amended suitably, a taxpayer will do well by paying upfront taxes every year, rather than investing in any permitted savings intermediary.

Yet another anomaly
The sixth schedule of the code lists income not to be included in the total income.

Item-11 exempts the accumulated balance in the account of an employee participating in an approved provident fund as on the March 3, 2011, but more importantly, also exempts any accretion thereto. Note carefully that this means the interest earned and consequently any withdrawal made even after April 1, 2011 of this amount will not be taxable. EET would only be applicable to fresh contributions made and the accretions only on such fresh contributions. Unfortunately, the same is not true for other provident funds and PPF.

Item-17 exempts any payment from a provident fund to which the Provident Funds Act, 1925 applies, or from any other provident fund set up by the central government and notified by it in this behalf in the official gazette (i.e. PPF), so far as these payments relate to accumulated balances as on March 31, 2011. Consequently, contributions made from April 1, 2011 and the entire interest earned on the old balances as well as the fresh contributions are chargeable to tax! Life insurance premia also suffer similar, though not the same fate.

The authorities would have done well by applying unified rules to all balances as on March 31, 2011, thereby avoiding complexity. After all, this is the declared objective of the code.