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Direct Tax Code: No more a saving grace
August, 25th 2009

The proposed Direct Tax Code (DTC) 2009 seems to have brought cheer among equity investors. Sensex surged 500 points on Aug 14, thanks to proposed raise in tax slabs for individuals, cut in corporate tax rate and enhancement in the investment limit in saving schemes to Rs 3 lakh from the current level of Rs 1 lakh. Prima-facie, these proposals give an impression that Indian taxpayers will be able to save more.

However, a closer look at the draft suggests that it may curtail retail investor's participation in equities or equity-oriented funds. One of the major incentives for equity investors at present is tax exemption on capital gains earned on investments in equities or equity-oriented funds over long-term.

Long-term in this case is defined as one year. However, as per the proposed draft, long-term capital gains on equity shares could be taxable.

Actually, the bill has removed the distinction between long-term and short-term capital gains in case of capital assets.

Transfer of any financial or non-financial asset after one year from the end of financial year in which asset was acquired is subject to tax, but can enjoy indexation benefit, which means gains earned from such transaction will be adjusted for inflation before calculating tax liability. But the tax rate is not yet specified.

Investments in equity-linked saving schemes of Mutual Funds (ELSS), a major source of retail investors' participation in the equity market, are popular among taxpayers. However, the latest proposal denies this benefit to investments in ELSS. In the latest draft, the scope of investment subject to tax deductions is proposed to be restricted to investments in provident funds, pension schemes, bank deposits, life and health insurance. All other investments do not enjoy this incentive.

Considering the restricted scope of tax exempted savings, an Indian tax payers will be forced to invest in PPF, EPF and Pension schemes in order to reduce tax liability.

At present, a large chunk of salaried class earns a salary in the range of Rs 4-6 lakh per annum. As HRA, Medical and leave travel allowance are proposed to be clubbed with the gross salary, the taxable income will increase substantially. The rise could be two to three folds per annum considering the proposed tax slab for individuals. There will be hardly any deduction available after the removal of tax incentive on interest payment for home loans. (Most of the people belonging to this category currently enjoy this benefit).

So the individual would have two options - either to pay tax and make investments from the residual income as per his/her own wish or opt for investments in permitted saving schemes like EPF, PPF, life insurers for up to Rs 3 lakh and save tax.

But the story does not end here. One can save tax at the time of investment in such scheme, but could not escape from the tax liability at the time of maturity or withdrawal. Right now, interest earned on investment in EPF or PPF at the time of maturity or withdrawal does not attract any tax.

But according to the EET (Exempt-Exempt-Tax), method of taxation of savings introduced as per the latest proposal, these returns will be taxable at the time of withdrawal or maturity. In short, the avenues to save on tax have been dealt a hard blow in this proposed direct tax code. Postponement of tax liability is the only option available after the latest draft. So, tax liability of an individual will be the most influential factor while taking investment decisions.

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