The direct taxes code (DTC) is expected to be effective from 1 April 2011. The draft DTC has already been circulated and gives an idea of what to expect, though actual provisions may be different. DTC would have a major effect on the taxation of investment income. To get prepared for this, one would need to understand and factor in the likely effect.

The dividend on shares would continue to be exempt from tax and the company would continue to pay dividend distribution tax. However, capital gains on the sale of shares would neither be exempt nor subject to a concessional rate of tax. All types of capital gains, whether on shares held for a considerable period of time or for a short period, would attract tax at the slab rate which applies to each individual.

The only benefit available would be that of indexation of cost for shares held for a long period. This long period would not be 12 months, as is the case under the current law, but 12 months from the end of the year of acquisition of the shares. One may, therefore, consider selling shares that have appreciated considerably before DTC kicks in so that the gains thereon are not taxed or are taxed at lower rates. One can always buy these shares later and get the benefit of higher cost.

There seems to be a drafting mistake as far as mutual funds (MFs) are concerned because the discussion paper on DTC envisages taxation of investors on income distributed by an MF. However, the draft provisions indicate that income earned by investors in respect of MF units, including income distribution and capital gains on sale of units, would be exempt from tax.

There is also no provision for any income distribution tax in respect of incomes distributed by MFs, nor any tax on the MF itself. Therefore, the benefit of total exemption would be available not only on equity-oriented MFs, but for all types of MFsan unintended benefit indeed. Therefore, MFs would remain attractive.

The deduction for savings is being increased to Rs3 lakh, but restricted to only four types of investmentsprovident fund (PF) and superannuation fund approved by the Pension Fund Regulatory and Development Authority, life insurance and New Pension System (NPS).

Equity-linked saving schemes, home loan repayments, five-year term deposits with scheduled banks, National Savings Certificates (including interest accrued thereon), senior citizens savings scheme and five-year post office time deposits would no longer qualify for deduction.

Not only that, the proposed move to the EET (exempt exempt tax) method of taxation means that all investments eligible for deduction at the time of investment would be taxed at the time of withdrawal along with income thereon, irrespective of whether deduction was actually obtained or not.

All withdrawalsprincipal contribution and interestfrom a PF, superannuation fund, and NPS would be taxed at the time of withdrawal. The only saving grace is that the accumulated balance as on 31 March 2011 in a PF would not be taxable at the time of withdrawal.

In life insurance policies, the maturity proceeds would not be taxable only if the premium payable each year is less than 5% of the sum assured and the proceeds are received on the completion of the policy period or on death. Amounts received under money-back policies or endowment plans during the policy period would effectively get taxed. There is no provision for exemption for policies taken before DTC, and, therefore, one may end up paying taxes on the maturity of old policies.

So, all the carefully-designed investments plans would need a complete relook before these proposals come into effect. Fresh plans would need to be drawn up to factor in the changed tax effect on ones investments.