As the Income-Tax Act (ITA) enters its last lap, making way w.e.f. April 1, 2011 for the direct tax code (DTC), investors should be careful of overlapping investments. Overlapping investments are those where the ITA is applicable while making the investment whereas it is the provisions of the DTC that will apply at the time of maturity.

For example, take fixed maturity plans or closed-ended schemes of mutual funds i.e. where the term of the scheme is fixed.

A major selling point of such schemes nowadays is the benefit of double indexation. The scheme is structured in such a manner that the term overlaps two financial years, thereby affording the investor the tax advantageous double indexation benefit.

In cases where the scheme overlaps two financial years, even triple indexation is being offered. But did you know that under the DTC, this strategy of double indexation cannot be implemented?

In other words, any investment made today keeping in mind the double indexation benefit under the ITA will necessarily mature at a time when the DTC will be in force. And under DTC, double indexation is not available. Lets understand how and why.

Double indexation

Before discussing double indexation, it is necessary to understand the concept of indexation itself. For calculating capital gains, we reduce the cost from the sale value.

For calculating long-term capital gain, such cost can be enhanced by the inflation multiple. For this purpose, the central board of direct taxes (CBDT) releases the index figures for each financial year. Such declared index is applicable for the any transaction done during the entire year.

The base year is 1981-82, for which the index is 100. Then on, considering the inflation figure for the year, CBDT has been releasing indices for each year. Such an index is known as the cost inflation index (CII). The CII for FY10 is 632. Lets examine a simple example to illustrate the use of the CII.

Therefore, instead of paying tax on Rs 3 lakh just on account of the indexation benefit, you get the option of paying tax on Rs 2,56,455.

Now, how do we use this principle in the case of FMPs? Like mentioned last time, FMPs are nothing but non-equity funds. Long-term capital gains on non-equity funds are taxed at the lower of 10% without cost indexation or 20% with cost indexation (as detailed above).

As mentioned earlier, double indexation is a neat trick where you hold an investment for a little more than one year but get the benefit of the index multiple of two years. How is this done? Consider the table for the 370-day FMP.

The FMP is for 370 days, exactly 5 days more than one year. However, check out the date of investment and date of exit. The entry date is March 29, 2010 i.e. FY10. The date of sale is April 3, 2011, i.e. FY12.

By holding the investment a little into the next financial year, an investor can use the facility of the CII for two years. The rest of the table is self-explanatory. The CII usage boosts the cost beyond the sale price due to which, the investor suffers a notional capital loss. Consequently, the entire maturity value is rendered tax-free.

The net annualised return remains at 7% without any tax incidence whatsoever. Whats more, the long-term capital loss which is notional and not actual, can be set-off against any other taxable long-term gains of the investor thereby further reducing the overall tax liability.

Change as per the DTC

In the above example, note that the maturity date is April 3, 2011 i.e. FY12, when the DTC will be operational. So though at the time of investing, it was the ITA that was applicable, at the time of maturity, the DTC will apply. And this will change the tax impact.

Now, though the DTC too offers indexation facility, there is a significant departure from the ITA. Under the ITA, as can be seen above, the ratio of the CII of the year of sale to the CII of the year of purchase is to be taken for cost inflation purposes.

However, under the DTC, it is the ratio of the CII of the year of sale to the CII for the financial year immediately following the financial year in which the asset was acquired that has to be adopted! In other words, in the denominator, instead of the CII pertaining to the year of purchase, the CII pertaining to the year after the year of purchase has to be taken.

This small but significant modification basically makes the double indexation concept redundant. Let us see how DTC will change the tax impact in the above example.

Note how under the DTC, a notional capital loss turns into an actual capital gain. This is because the benefit of an extra years inflation index is lost. In other words, under DTC, double indexation turns into single indexation whereas triple indexation will get converted to double indexation. At all times, the extra years indexation benefit will remain unavailable.

To conclude

We are fast approaching the transitionary phase where one law gets discontinued, paving the way for a brand new one. This dual law applicability at the time of entry and exit will be applicable not only to mutual fund schemes, but also to a host of other investments such as insurance plans, bonds and even to payments that earn tax deductions such as home loan installments and tuition fees.

Therefore, before committing funds for the long-term, investors should ensure the investments are tax efficient in conformity with provisions of the DTC rather than the ITA.