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Exempt exempt tax will hit tax payers hard
June, 03rd 2010

In August 2009, the finance minister released for public comments, a draft of the new Direct Taxes Code (DTC), which is slated to replace the present direct tax laws. In response, various industry associations, trade bodies and consulting firms made representations regarding the concern areas, ambiguities, etc. A revised draft addressing certain identified core areas of concern is likely to be released soon for further public consultation.

One of the DTC proposals that has been most debated is Exempt-Exempt-Tax (EET) regime for taxation of insurance products and other savings instruments. The EET method allows exemption at the first two stages, but provides for a tax on withdrawals at the personal marginal rate. The concept of EET is primarily prominent in developed countries, which have comprehensive social security schemes, but in India, in the absence such schemes, EET, if implemented, would come as a big blow to the individual tax payer. Many representations were received regarding these provisions. This article discusses the key provisions proposed in the current draft of the DTC regarding the taxation of insurance products and mutual fund products.

Insurance Impact on holders

Contribution stage

Currently, a deduction from the total income up to a maximum of Rs 100,000 is available in the hands of individuals in respect of premium paid for self, spouse and children. Under DTC, this limit is sought to be raised to Rs 300,000 (in respect of premium for self) and the premium paid for spouse and children may not be deductible in the hands of the payer.

Accrual stage

As envisaged in the draft DTC, the policyholders would be exempt from tax at the accrual/accumulation stage as per the provisions of the current income tax law.

Further, under DTC, life insurance companies are sought to be treated as pass-thru entities. Accordingly, the surplus in policyholders account of the insurance companies is sought to be exempt from tax. ((Under the current law, the same is taxable at 12.5%,) (plus surcharge and education cess) as part of actuarial surplus in the hands of the life insurance companies.))

While the DTC seeks to exempt the policyholders surplus, the Minimum Alternate Tax (MAT) of 2% on gross assets proposed in the DTC could erode the policyholders surplus unless policyholders surplus is exempted specifically from the MAT provisions.

Withdrawal/ Maturity stage

Currently, any sum (including bonus) received under a life insurance policy, except policies where the premium paid for any of the years exceeds 20% of the capital sum assured, is exempt from tax. In case where the premium paid in any of the years exceeds 20% of the capital sum assured, an exemption is available only if the sum is received on the death of the insured.

Under the DTC, the entire proceeds from a life insurance policy are proposed to be made taxable. The proceeds are not taxable only if it is in respect of a policy, wherein the premium paid in any of the years does not exceed 5% of the actual capital sum assured and where the sum is received on completion of original contract period or upon the death of the insured.

Thus, various insurance products, including unit-linked products, may not enjoy the exemption at the withdrawal stage. Further, the death benefits of only qualified policies (i.e., those policies where the premium paid in any of the years does not exceed 5% of the capital sum assured) would be exempt from tax.

MFs Impact on unit holders

Currently, the entire income of Sebi-registered mutual funds is exempt from tax. All mutual funds (except equity-oriented funds) are liable to pay tax on income distributed to the unit holders at the prescribed rates (13.84% for individuals for debt funds and 27.68% for liquid/money market funds), i.e. income distribution tax (IDT). The income received by the unit holders in respect of the units of a mutual fund, is exempt from tax in their hands.

Under the DTC, it is proposed that the income of mutual funds would continue to be exempt from tax. Further, the mutual funds are also sought to be exempt from the payment of IDT, irrespective of the nature of their schemes. Also, the unit holders are also to be exempt from tax in respect of the income from units of a mutual fund.

The treatment proposed under DTC is inconsistent with the treatment discussed in the discussion paper on DTC and also the EET mechanism, according to which investors should be liable to tax on any income which accrues to them from any pass-thru entities (including mutual funds). This would result in complete non-taxation of income (other than gains on transfer of units), which does not appear to be the intent.

The DTC does not contain any comparable provision as exists in current tax laws, for deduction of up to Rs 100,000 in respect of subscription made to any mutual fund framed in accordance with equity-linked savings scheme, 2005.

Further, in respect of capital gains earned by individual investors on the sale of unit of mutual fund, there are differences in tax rates as per the current law and as proposed by DTC, as indicated in the table.

The provisions of DTC, as envisaged, for taxation of the insurance and mutual fund products would provide a competitive advantage to mutual fund products against insurance products. It is hoped that the tax advantage would be neutralised in the revised draft of DTC.

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