CA. Pradip R Shah

Introduction:

1.0       As we all know, the process of reforms initiated in Nineties slowed down and was restricted to financial, insurance, industrial licensing sectors etc. only. For various reasons, it was almost put on hold and, particularly both the direct and indirect taxes were kept out of it. However, looking to the steps unfolded in the last one year, it appears that it is gathering momentum. Sales tax has been replaced with Value Added Tax (VAT). Discussion for replacing Central Excise and VAT with Goods and Service Tax (GST) is at an advance stage of finalization. With the release of the Discussion Paper (DP) and draft Direct Taxes Code (DTC), the process of reform in Direct Taxes (DT) has already been commenced. Thus, there appear to be a committed movement on the part of the policy-makers to initiate the reform process in both the types of taxes i.e. direct and indirect.

 

1.1       One of the major areas of reform under the Direct Taxes is with respect to pruning of exemptions and deductions granted while computing taxable income. During the last fifty years, number of exemptions and deductions has been increasing resulting into taxing artificial income. In the last five years, there has been increasing awareness amongst the policy-makers about the cost of such exemptions and deductions. It is being felt that the revenue foregone in the process of granting exemptions and deductions is nothing but an expenditure which is named as “Social Expenditure”. Since the last few years, the Budget Documents placed before the Parliament, contains a detailed list of various sections of Direct and Indirect taxes under which revenue foregone is quantified. The DP carries a detailed discussion about it and justifies the proposal for the removal of exemptions and deductions.  A glance at a table contained in the Budget Documents for the year 2008-09 will show that in the case of Individual tax-payers, total loss of revenue u/s 80-C of the Income Tax Act is Rs. 27,389 cr. This is a fairly large amount.

 

1.2       Each exemption and deduction has its objective. For example, in the case of deduction from gross total income granted under section 80-C of the IT, the objective is to give relief to the tax-payer for savings made for future, more particularly for his retirement age. Apart from that the savings so made was also providing resources for capital formation. In order to give greater push, the model followed so far was three-pronged viz. (a) to provide tax incentive in the year of investment, (b) not to levy tax on the income accruing on such investment, and (c) not to charge any tax when the investment matures in future. Thus, from the perspective of taxability, the entire process remains tax-free i.e. Exempt, Exempt and Exempt (EEE).

 

1.3       Attempts made so far in this direction were half-hearted and lacking specific direction, nor were any attempts made to create the required infrastructure for pooling the resources in a specific direction to ensure that a person having reached the age of 60 years should be in a position to get steady flow of secured income. With the increase in longevity the number of citizens living 70 years and above is also rising. Thus, with the change in composition of the demography, the problem of providing for pension or income from annuity is becoming acute.

 

Pension System and Income Tax

2.0       It is increasingly felt at global level that for economic stability of a nation, a robust Pension System (PS) is a must. In order to achieve the broader goal of social protection, it is necessary that ageing population of the society be provided with financial security. Politically all these may sound attractive, however, economically speaking it has to be carried out in a fiscally responsible manner. Under the PS, the role of the State is to focus on creating a system wherein steady income is provided to vulnerable elderly citizens. Any PS involves the problem of funding for the future liability. The easiest method is to keep funding of the liability open for the future generation. However, it can lead to disastrous results as the nation will have to honour the commitment for the future liability and not having sufficient resources for the same. Therefore, pre-funding of the pension commitments assumes importance. Economically speaking, it requires commitment of resources in the current period to improve the future requirements of the funds. Pre-funding enhances the capacity of the society to fulfill pension commitments as it ensures that liabilities are backed by assets.

 

2.1       So far the country has not taken any concrete steps for creating a system wherein a person after reaching the age of retirement, can earn steady income and maintain his standard of living. Although, both the Central and State Government are having the scheme of pension for its employees, it reaches to very small section of the society. In the case of private sectors, very few companies are having defined-benefit plan. For the people working in unorganized sectors, few options are available. With increase in longevity of the people, demographics changes are also taking place. Ratio of working people and retired persons is also changing very fast. Apart from that there is awareness amongst the people and the policy-makers to create a system wherein better care can be taken of the senior citizens. The Government has not been able to do much in this respect. It is increasingly felt that, as it has happened in other countries in the last twenty years, a system can be created wherein this problem can be taken care of by the people themselves. Role of the State should be to provide mechanism for pooling the resources in the form of savings, providing tax incentives, making available regulatory and administrative services. The funds accumulated from the tax-payers can provide vast resources for further developmental work and, in the process, raising the level of income.

 

2.2       Meanwhile, a major development in the area of pension sector has been alarming rise in future liability of the Central and State Governments with respect to payment of pension to its employees. Till January, 2004 all the Governments have been following defined-benefit plans exposing them to unlimited liability. However, in order to put an end to it, the said system was discontinued and New Pension System has been introduced. That was the first step of the process of reform in pension sector. Second step involved is to streamline the tax treatment of contribution for pension system, income earned thereon and withdrawal there from either in the form of annuity or lump sum. It has to be ensured that different types of investment options get the same tax treatment throughout its term. The third step involves setting-up of mechanism for administration of the funds raised and development of regulatory authorities. With the implementation of the second and third step, the process of establishing a structured pension system will commence. In view of this, the amendments as proposed u/s 56 and 65 of DTC should be viewed in the larger context of reforms in the pension system rather than revenue raising or amending the ITA.

 

Relevance of EEE

3.0       The existing structure of EEE i.e. exempt, exempt and exempt, was devised in early fifties and sixties wherein the country was in need of savings badly. In order to attract resources for development work, the Government provided substantial tax incentives under the DT. However, the scenario has changed since then and we have moved far ahead of the period of 50s and 60s. Nature and number of challenges have changed and, hence, the need for appropriate response. Meanwhile, at the global level, various countries which have experimented with this model i.e. EEE, also found it costly and moved to other models. The most common model which has appeared, and is prevalent today, is EET i.e. Exempt, Exempt and Tax.

 

Justification for Learning About EET

4.0       Every sane human being knows that a time will come when it will not be possible for him to earn for livelihood and, therefore, he will have to depend on savings made in the past. In India, savings of household sector forms more than 20.00% to 25.00% of the current earnings.  Since it forms such a major part, taxation thereof also assumes importance. If an individual has to part with substantial portion of the savings so made for taxes, there is no point in foregoing the present consumption. Therefore, the knowledge of the taxation structure and corresponding system of investment, affecting hard-earned savings, assumes substantial importance. If EET is going to come and we have to live under it, there is no alternative except learning to live with it.

 

What is EET?

5.0       EET is a system under which (a) deduction is permitted from gross taxable income while computing tax liability i.e. first limb “E”, (b) tax is not levied on income accruing on such investment i.e. second limb “E” and lastly (c) tax is levied on the amount withdrawn i.e. “T”.

 

Why EET?

6.0       Deductions granted under the first limb are considered as incentives. Tax incentives are of two types viz. exemptions and deductions. The DP in the Chapter XII para 12.2 refers to tax incentives as inefficient, distorting, inequitous, impose greater compliance burden on the tax payer and on the administration, result in loss of revenue, create special interest groups, add to the complexity of the tax laws, and encourage tax avoidance and rent seeking behaviour. In order to encourage net savings, it is proposed to rationalise tax incentives. For the said purpose, the DTC proposes EET method of taxation.

 

Methodology of introducing EET

7.0       Let us examine each limb of EET under the proposed scheme of taxation.

(a)The First Limb  – “E” – Deduction at the Time of Investment

7.1       The DTC provides for deduction in respect of contributions (both by the employee and the employer) to any account maintained with any permitted savings intermediary, during the financial year. This account will be required to be maintained with any permitted savings intermediary in accordance with the scheme framed and prescribed by the Central Government in this behalf. The permitted savings intermediaries will be approved provident funds, approved superannuation funds, life insurer and New Pension System Trust. The accretions to the deposits will remain untaxed till such time as they are allowed to accumulate in the account.

(b) The Second Limb – “E” – Exempting income accruing on Investment

7.2       Under the proposed scheme, the tax-payer will be having the option of making investment wherein income will be accruing periodically and appreciating in value as well. A question may arise about taxability of the income which has accrued and the right to receive has been crystalised in favour of the tax-payer. U/s 3(1)(a) such income becomes taxable as and when it accrues. However, one does not find any specific clause under Schedule VI exempting such income. As a concept, EET means not levying tax on the income accrued till it is withdrawn for consumption. DP refers to this principle and says that there will not be any tax on the income accruing till it is withdrawn. However, a specific cluse in this respect is missing in Schedule VI.

 

(c) The Third Limb – “T” – Taxing the withdrawals

7.3       As per the scheme laid down under DTC, any withdrawal made, or amount received, under whatever circumstances, from these accounts will be included in the income of the assessee under the head ‘income from residuary sources’, in the year in which the withdrawal is made or the amount is received.  Accordingly, it will be subject to tax at the appropriate personal marginal rate.

 

Impact of EET

8.0       To put it simply, in the first stage, tax deduction will be provided at the time of making investment in the prescribed manner. In the second stage, no tax will be levied on income accruing on such investment till they remain within the permitted system. Finally, in the third stage, tax is to be levied only when the investments are withdrawn, either fully or partly, in lump sum or periodically.

 

8.1       Tax impact, in the first stage, will be beneficial as, subject to the limits laid down, tax can be saved to the extent of investment made.

 

8.2       Tax impact, in the second stage, will also be beneficial as there will be no tax liability on income accruing to the investment made. A point to be remembered here is that rate of return will have compounding impact, as there will not be any outflow on account of tax. This will help in boosting the growth of the corpus at a faster rate.

 

8.3       Tax impact, in the third stage, will depend upon how the amount is withdrawn from the system. If the assessee opts for monthly withdrawals in the form of annuity, it will be treated as “Income from Residuary Sources” and taxed as income for the said year at the applicable rate of tax. Here, there may not be any tax impact if the withdrawals are within the threshold exemption limit.

 

8.4       If the assessee opts for the withdrawal of entire amount of savings made, tax may be payable at a higher rate. Since, the assessee will be withdrawing from the funds after reaching the age of retirement, benefit of higher threshold exemption limit will be available.

 

Transitional Impact

9.0       Before understanding it in detail, let us see what DP and DTC has to say about these issues. Clause 12.7 of DP addresses these briefly as follow:

12.7 Further, the Code also provides that the withdrawal of any amount of accumulated balance as on the 31st day of March, 2011 in the account of the individual in the Government Provident Fund (GPF), Public Provident Fund (PPF), the recognised provident funds (RPFs) and the Employees Provident Fund (EPF) under the Employees Provident Fund and Miscellaneous Act will not be subject to tax. In other words, only new contributions on or after the commencement of this Code will be subject to the EET method of taxation

 

9.1       As can be seen, the DP does not touch upon all the aspects as pointed out above. Therefore, we will have to refer to relevant provisions of DTC. After all, tax impact will be felt on the basis of the tax proposals contained therein.

Income Exempt under ITA – S. 10 Income Exempt under DTC- Schedule- VI
(12)the accumulated balance due and becoming payable to an employee participating in a recognised provident fund, to the extent provided in rule 8 of Part A of the Fourth Schedule 11. The amount of accumulated balance, as on the 31st day of March, 2011, in the account of an employee participating in an approved provident fund and any accretion thereto.
(11)      any payment from a provident fund to which the Provident Funds Act, 1925 (19 of 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; 

17. Any payment from a provident fund to which the Provident Funds Act, 1925 (19 of 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, of accumulated balance, as on the 31st day of March, 2011, in the account of the person.

 

9.2       A comparison of clause 11 and 17 of DTC will show that the former contains the words “and any accretion thereto” while the latter is silent about it. It means that interest accruing on and after 1-4-2011 of approved PF will be exempt. However, interest accruing to PF to which PF Act, 1925 applies and other PF set-up by the Central Government viz. PPF etc. will be taxable. It is difficult to digest such treatment to the same type of income. There is a major lacunae herein.

 

9.3       Reading the provisions of sub-clause 17 of DTC an interesting issue arises. It states that any amount withdrawn from the funds accumulated as on 31-3-2011 in a PF etc. will be exempt from tax. The point is whether they are taxable under DTC? The question of making an income exempt arises only when it is taxable. Balances in these PF are contribution made prior to 1-4-2011 and interest accrued thereon. DTC cannot levy tax thereon. If that is the case, where is the question of making it exempt?

 

9.4       In the process of switching over to a new system, transitional issues arise. So is the case from EEE to EET. Here the issues arising are:

a)      What will happen to investment already made so far i.e. will they be permitted to remain therein?

b)      Whether new contribution can be made after 1-4-2011 in the erstwhile scheme? Whether tax deductions will be available?

c)      What will happen to income accruing on such investments in future i.e. 1-4-2011 onwards? Will it be taxable?

d)      Whether any tax will be levied under the DTC for withdrawals from such investments after 1-4-2011?

 

9.5       Before examining these issues, it will be better to get an idea of various types of investments which are permitted under ITA for Tax deduction. They are:

  1. Life Insurance Premia
  2. Deferred Annuity
  3. Contribution to Provident Fund to which PF Act, 1925 applies
  4. Contribution to any PF set up by the Government i.e. PPF
  5. Contribution to a Recognised PF
  6. Contribution to an approved Super Annuation Fund
  7. Subscription to savings certificate as notified by the Government i.e. NSC
  8. Contribution to any plan under Unit Linked Insurance Plan, 1971
  9. Contribution to Annuity Plan of LIC or other insurer
  10. Subscription to any term deposit of a scheduled bank
  11. Any payment or part payment of loan for the purpose of construction or purchase of S O Property

Status of various options available under the existing scheme of taxation for investment for pension

Contribution Income Accrued Withdrawal
Life Insurance Policies E E E
Deferred Annuity E E T
PF to which PF Act applies E E E
Notified PF i.e. PPF E E E
Recognised PF E E E
Approved Super Annuation Fund E E T
NSC etc. E T E
Unit Linked Insurance Plan E E E
Annuity Plan of LIC or other insurer E E T
Term Deposit under Tax Saving Scheme of a scheduled bank E T E

 

9.6       Each one of these are having different terms and conditions for rate of return, withdrawal system and security aspect etc.  Let us examine each one of them from different perspective and see its tax implications.

 

What will happen to investment already made so far i.e. will they be permitted to remain therein?

Status under DTC
Life Insurance Policies It is a contractual payment by the policyholder to the insurance company. DTC has no role to play therein. Therefore, irrespective of tax implications under DTC, the assessee will have to honour his commitment to insurance companies.
Deferred Annuity As above
PF to which PF Act applies Yes, it will be permitted to remain therein.
Notified PF i.e. PPF The existing PPF Scheme will be discontinued. No more contributions can be made after 1-4-2011. (See para 12.8 of DP). It appears that amount accumulated therein will be permitted to continue with the facility of withdrawal periodically.
Recognised PF Balance in the account will continue to remain as they are.
Approved Super Annuation Fund As Above
NSC etc. NSC subscribed to will continue till the date of maturity.
Unit Linked Insurance Plan It is a contractual payment by the policyholder to the insurance company. DTC has no role to play therein. Therefore, irrespective of tax implications under DTC, the assessee will have to honour his commitment to insurance companies.
Annuity Plan of LIC or other insurer As Above
Term Deposit under Tax Saving Scheme of a scheduled bank It is as per the contract between the assessee and the Scheduled Bank. It will continue as per its term.
Repayment of loan for S O Property It is a contractual payment by the borrower to the lender. DTC has no role to play therein. Therefore, irrespective of tax implications under DTC, the assessee will have to honour his commitment to the lender.

 

Whether new contribution can be made after 1-4-2011 in the erstwhile scheme? Whether tax deductions will be available?

Status under DTC
Contribution after 1-4-2011 Tax Deductions under DTC
Life Insurance Policies It is a contractual payment to insurance company. Assessee will have to continue to make the payment of premium. At present, there is no clarity. However, it appears that some mechanism will be devised under which payment of premium on life insurance policies after 1-4-2011 are identified and the deduction be permitted.
Deferred Annuity As above No tax deduction permitted for contribution to the old scheme.
PF to which PF Act applies Contribution as per the provisions of PF Act will have to be made. Contribution after 1-4-2011 will be permitted as deduction from income. 

Balances accumulated till 31-3-2011 will be segregated and separate identity will be maintained.

Notified PF i.e. PPF No contribution permitted after 1-4-2011. Since there will be no contribution after 31-3-2011, the question does not arise.
Recognised PF Contribution as per the provisions of PF Act will have to be made. Contribution after 1-4-2011 will be permitted as deduction from income. 

Balances accumulated till 31-3-2011 will be segregated and separate identity will be maintained.

Approved Super Annuation Fund It will be as per the Scheme formulated. No tax deduction permitted for contribution to the old scheme. Deduction perm­i­tted for contribution through PSI only.
NSC etc. NSC can be subscribed to after 1-4-2011. No tax deduction permitted for subscription to NSC. Deduction permitted for subscription to Govt. securities through PSI only.
Unit Linked Insurance Plan It is a contractual payment to insurance company. Assessee will have to continue to make the payment of premium. Whether premium paid under the existing policies will form part of permitted securities or not is to be seen. At present, there is no clarity.
Annuity Plan of LIC or other insurer -do- -do-
Term Deposit under Tax Saving Scheme of a scheduled bank Not under the existing scheme. Investment can be made through intermediaries under the new system. Deduction will be permitted for investment made through PSI.
Repayment of loan for S O Property No No

 

 

What will happen to income accruing on such investments i.e. investment made prior to 1-4-2011 in future? Will it be taxable?

Status under DTC
Life Insurance Policies Bonuses which have already been declared till 31-3-2011 cannot be taxed under DTC as the right to income has already crystalised before 1-4-2011. Recently, the Ministry of Finance has also clarified that no tax will be payable for bonus which has already accrued till 31-3-2011. Of course, this will require devising a system under which such income can be identified. 

Here, it should be noted that the provisions of S. 56(2)(f) will apply. Therefore, the policies which do not qualify for exemption will be bearing the burden of taxation.

Deferred Annuity Income arising under these policies will be taxable from 1-4-2011 onwards. Clause 284(128) is wide enough to cover the same.
PF to which PF Act,1925 applies Clause 17 of Schedule VI of DTC exempts withdrawal from the accumulated balance up to 31-3-2011. It means any amount accruing in such accounts after 1-4-2011 will be taxable.
Notified PF i.e. PPF There is no clarity in this respect. Assuming that Clause 17 of Schedule VI of DTC is applicable to PPF Account, interest accruing thereto after 1-4-2011 will be taxable. This is for the reason that the said clause exempts withdrawal of accumulated balance till 31-3-2011. Accumulated balance will include contribution by the depositor to such an account and interest accrued thereto.
Recognised PF Clause 11 of Schedule VI of DTC exempts the balance in these accounts as on 31-3-2011 and accretions thereto.
Approved Super Annuation Fund Annuity received under these schemes will be taxable.
NSC etc. Interest accruing on NSC has been taxable. It will continue to be taxable under DTC as well.
Unit Linked Insurance Plan As in the case of Life Insurance Policies, income accrued till 31-3-2011 will be exempt. However, this is subject to the provisions of S. 56(2)(f) of DTC.
Annuity Plan of LIC or other insurer Annuity received under these schemes will be taxable.
Term Deposit under Tax Saving Scheme of a scheduled bank Interest accruing on Fixed Deposit under tax saving scheme will continue to be taxable.

 

Whether any tax will be levied under the DTC for withdrawals from such investments after 1-4-2011?

Status under DTC
Life Insurance Policies This is a complex issue.  Proceeds of the life insurance policies having the premium – 

a) up to 5.00% of the sum assured will be exempt.

b) exceeding 5.00% of the sum assured will be taxable.

It should be noted that the DTC does not differentiate on the basis of the date of insurance policy taken. It means the insurance policies contracted prior to 1-4-2011 will also get covered under the proposed scheme of taxation.

Deferred Annuity Withdrawal of the principal amount will not be taxable under DTC as they are not part of PSI.
PF to which PF Act,1925 applies Withdrawal of accumulated balance till 31-3-2011 will not be taxable. Only withdrawal of contributions made to these accounts after 1-4-2011 will be subject to the EET method of taxation.
Notified PF i.e. PPF Withdrawal will not be taxable as the amount accumulated therein is not part of PSI. Provisions of DTC will not be applicable. Since the DP states that there will not be any contribution in these accounts after 31-3-2011, the question of taxation of contribution and withdrawal thereof after 1-4-2011 does not arise.
Recognised PF Only withdrawal of contributions made to these accounts after 1-4-2011 will be subject to the EET method of taxation.
Approved Super Annuation Fund Withdrawal of the principal amount will not be taxable under DTC as they are not part of PSI.
NSC etc. Principal amount received on maturity for NSC subscribed to before 31-3-2011will not be taxable.
Unit Linked Insurance Plan See comments in respect of Life Insurance Policies.
Annuity Plan of LIC or other insurer Withdrawal of the principal amount will not be taxable under DTC as they are not part of PSI.
Term Deposit under Tax Saving Scheme of a scheduled bank Principal amount received on maturity for Fixed Deposit subscribed to before 31-3-2011will not be taxable.

 

Structure of Investment Opportunities

10.0     The tax-payers are bound to be worried about the issues arising herein, particularly creation of infrastructure for organizing and administering funds and database at a massive level, network for pooling the funds etc. As per the DP, the Government will permit certain companies / organisation to act as PSI. These PSIs will be approved by Regulatory Authority i.e. Pension Fund Regulatory and Development Authority (PFRDA). PSI will collect the funds from the tax payers and shall make investment as per their direction. PSI will be making this investment in the following types of instruments / schemes etc.

a)         government securities

b)         term deposits of banks

c)         unit-linked insurance plans

d)         annuity plans

e)         bonds and securities of public sector companies, banks and financial institutions

f)          bonds of other companies enjoying prescribed investment grade rating

g)         equity linked schemes of mutual funds, debt oriented mutual funds, equity and debt instruments.

Who will decide the instruments?

11.0     In the case of some of the items, the tax payer, and in other schemes, it will be by the trustees of the schemes. However, the pattern of the investment by the trustees will be as per the guidelines issued by the Government.

 

Switchover from One Scheme to another

12.0     This is called “rollover”. It is permitted to rollover from one scheme to another. Any gain or income arising in the said process will not be taxable as no amount is being withdrawn from PSI. The question of paying tax will arise only when any amount is withdrawn from PSI.

 

How many PSI can one have?

13.0     No limits will be laid down with reference to PSI. Therefore, one can have PSI for investment where aggressive rate of return is available. Same tax payer can have another PSI for the purpose of getting recurring annuity or pension.

 

Rollover from one PSI to another

14.0     Yes, rollover from one PSI to another PSI will be permitted. Moreover, such a rollover will not attract any tax. In fact as long as the amount remains invested with any PSI the question of levying tax on such transactions will not arise.

 

Monitoring of the system

15.0     The Government proposes to design a system of central record keeping by an independent agency which will serve as a depository of all information relating to investment and withdrawal from the various accounts maintained by the assessee with the PSI.

 

Long Term Impact

16.0     As will be clear switching over from EEE to EET is not a short term issue. It will have wide implications for each tax-payer in the long term. What are they and how to cope with the issues arising therefrom?

 

16.1     Firstly, the tax payer will be left with the funds which have been invested under various schemes as permitted under the ITA so far. Since these schemes will not be part of the permitted scheme, the tax payer will have to find an alternative for its management. As the income derived from it will no longer be exempt; one will have to be on look-out for secured and sound investment fetching reasonable return.

 

16.2     Secondly, the tax payer will have to understand the nitty gritty of the new structure and procedural aspect of it.

 

16.3     Thirdly, the most important part is allocation of the investible funds amongst various schemes / instruments. This problem of selection of instruments will be of a recurring nature as the tax payer will have to opt for the instrument / scheme depending upon the prevailing rate of interest and potentiality of appreciation in value.

 

16.4     Fourthly, DTC provides for the limit of Rs. 3.00 lacs as permitted savings for each year as against Rs. 1.00 lac at present. The tax payer will have to be more cautious as in order to save taxes, he will be setting apart more liquid funds. He will have to tackle with more issues as against at present.

 

16.5     Fifthly, another area of uncertainty will be with respect to the total quantum of funds being available at the time of retirement. As on today, it is possible to quantify one’s requirements and opt for scheme like PPF and insurance policies where the rate of return are fairly stable. However, it may not be so under the proposed structure. As can be seen from the instruments proposed to be made available, the rate of return will vary with the market trend. So is the appreciation in the value of various other investments. Like tortoise, one will have to move slowly and steadily to achieve the desired amount of corpus at the point of retirement. Any attempt to derive high rate of return by opting for aggressive investment portfolio may land into serious problem. One will have to learn balancing the portfolio for the desired goal.

 

Strategy for Living with EET

Justification for having strategy

17.0     Investment pattern for majority of the tax payers, so far, was simple viz. to make maximum investment in Recognised / Approved PF, PPF A/c and Life Insurance policies. Considering the limit of Rs. 1.00 lac permitted, these items took substantial portion of the permitted amount u/s 80-C. Apart from that, practically there was no risk element for investment therein. Compared to the rate of interest prevailing in the market, rate of return on these investments was fairly stable and reasonable. Hence, it did not merit any long term strategy for investment. However, under DTC, things are going to change. As per the proposed scheme, level of security being available with the instruments, will be low. Moreover, yield on the investment to be made will vary with the market forces, so is the value of investment. The days of earning steady tax-free interest @8.00% p.a. will be over. The most important aspect is that the tax-payer is permitted to claim deduction for investment up to Rs. 3.00 lacs as against Rs. 1.00 lac today. Temptation to pay low tax will make them to go for higher amount of investment. The tax-payer will have wider choice of investment avenues for claiming tax deduction. Wide variety of choice will add to more exposures to insecurity.

 

17.1     Apart from that, the benefit of EEE will not longer be available. It should be remembered that there will not be one-to-one relationship between tax benefit claimed in the year of investment made and paying the tax in the year of withdrawal. It means that once an investment is made the tax-payer will be entitled to claim deduction u/s 66 of DTC. As far as the Government is concerned, whether the tax-payer claims the benefit of lower tax or not is not important. So is the case where the income of the assessee is lower than the amount of investment made. Once this amount is withdrawn, it will have to be included under the head “Income from Residuary Sources” and offer for tax. In fact, it appears that the system will be such that the amount of withdrawal will be reported to the concerned Assessing Officer through a reporting system. Alternatively, there may be provision of Tax Deducted at Source from such amount at a future point of time.

 

17.2     In nutshell, the worst scenario will be wherein there is a risk of getting stuck into the last-leg viz. “T” without availing the benefit under first “E”. As we shall see, in such cases, the tax implications can be high in future.  A question that arises is whether it is possible to keep away from such scenario? It is for these reasons strategy assumes substantial importance.

 

17.3     Before going into specific issues let us visualise the types of scenario which can create such problems. They are:

 

a)                  Having made the investment, the assessee not having the taxable income at all for the said year i.e. the assessee is having losses which are required to be carried forward.

b)                 In the second case, although there is positive income but it is not sufficient enough to justify the level of investment already made through PSI.

c)                  In the third case, investment already made through PSI, brings down the taxable income below the level of threshold exemption limit i.e. Rs. 1,60,000 as proposed.

 

17.4     There are, basically, two aspects to the issue viz. (a) timing of investment and (b) the quantum part of it. Let us examine each one in detail.

 

Time Aspect of the strategy

18.0     As per the DTC, the assessee is permitted to make investment at any time during the year. Generally, for convenience, the tax-payers, in order to avoid hassles arising at the last moment, make investment at an early point of time of the year i.e. in April, May or June. This is done under the assumption that there will be positive income and it will be sufficient enough to justify the said investment. At present, it does not make much difference as there is no tax at the time of withdrawal of such investment.

 

18.1     However, it may not be so. Consider the case of an assessee having proprietary business. As all of us know, no one can guarantee profit in the business. Having made the investment in April, 2011 to claim tax benefit, imagine the plight when in March, 2012 he finds having made the losses. Why should one wait till March, 2012? Even during the year at any time i.e. before 31st March 2012, he realizes that there are no chances of having any positive income till the end of the year. Since the tax payer is not having any taxable income the question of deriving any tax benefit does not arise. Secondly, at the time of withdrawal of these funds in future, it will be added to the income. Thus, amount invested through PSI which was from after-tax income will be subject to tax second time. The cost involved here in the form of tax will be prohibitive. Can anything be done about it? No. Once having made the investment, any withdrawal of it will be subject to tax. Such a scenario can arise with an individual deriving income from salary. He may loose his job at any point of time which may result into substantial loss of income.

 

Quantum Aspect of the Strategy

19.0     Associated with the timing is the quantum part as well. What will happen if the taxable income is lower than the amount of investment already made? It means that the assessee will not be able to derive any tax-benefit on the excess amount of investment made. For example, the assessee has already made investment of, say, Rs. 3,00,000 as permitted under DTC. However, at the time of compiling the data for filing the Return of Income, finds that the taxable income works out to Rs. 2,00,000 only. What will happen to Rs. 1,00,000? Whenever it is withdrawn in future, it will be subject to tax.

 

19.1     Another aspect associated with this is to what extent one should make an investment? One may be tempted to go to the full extent permitted i.e. Rs. 3,00,000. However, it may not be advisable to do so. This is for the reason that, in the said case, the assessee will not be making use of the threshold exemption limit. This will be clear from the following example:

Case- A Case – B Case – C
Rs. Rs. Rs.
Gross Total Income 3,00,000 3,00,000 4,60,000
Less: Investment u/s 66 of DTC 3,00,000 1,40,000 3,00,000
Net Taxable Income Nil 1,60,000 1,60,000
Total Tax Payable Nil Nil Nil
Cash Outflow 3,00,000 1,40,000 3,00,000

 

Note the following points in the above three cases:

a)      In the case of A and B taxable income remains the same, amount of investment is varied. Despite having low investment, tax liability in Case B is also Nil.

b)      Compare the Case A with C. In the Case of C the income is higher by Rs. 1,60,000. However, it is made use of making investment for reducing tax liability. As a result both C and A come to the same level of Nil tax despite having substantial difference in income.

c)      As far as Case B and C is concerned income is more by Rs. 1,60,00 which has been utilised for making tax deductible investment resulting into Nil tax.

d)      In all the cases, whenever Rs. 3,00,000 will be withdrawn in future, it will be subject to tax.  Hence, in the case of B and C tax impact will be low when compared to Case A. This is for the reason that A has not made use of tax benefit he was entitled for. Excess amount of Rs. 1,60,000 invested in the Case-A will get taxed twice resulting into extremely high cost of taxation.

 

19.2     It should be remembered that, in both the cases i.e. A and B, whenever Rs. 3,00,000 are withdrawn in future, it will be subject to tax. In the former case the assessee will be paying the tax without availing any tax benefit in the past. In the latter case, tax impact will be lower as the assessee has availed tax benefit in the past. Therefore, it should always be remembered that the level of investment should not bring down gross total income below the level of threshold exemption limit permitted.

 

Basic principles to be followed

20.0     What are the basic principles to be followed? They are as under:

(a) Keep investment restricted to one’s Gross Taxable Income. Moreover, investment should not bring down gross taxable income below the threshold exemption limit. Always utilise the threshold exemption limit to the full extent.

 

(b) Avoid any investment scheme which requires long term commitment. Investment scheme requiring long term commitment may create serious issues. This is for the reason that there may not be taxable income or may not be sufficient enough to justify the level of commitment already made. Any breach or failure to honour the commitment may lead to financial losses, as such commitments are legal contractual commitments.

 

(c) As we have seen above, the investment opportunities offered are quite large. At one extreme, opportunities will be provided to the tax-payers to make investment in equity market through Mutual Funds making it possible to derive high yield or making the loss as well. At the other end, one will be permitted to invest in Government securities and debt instruments where there is steady rate of return though not in tandem with the prevailing market rate. But the chances of loosing money will be comparatively low. While one may be lured by the great opportunities offered by the equity market, it should be remembered that one is playing with hard-earned money which are meant for retirement age. Therefore, one has to move cautiously. It is for these reasons one will have to select a mixed portfolio i.e. consisting of both the equity and debt instruments. A portion of equity component will give the rate of return somewhat better than the prevailing rate of interest. There cannot be standard formula for the same as it will have to be decided based on ones’ capacity to bear the risk, age etc. No hard and fast rules can be laid down. However, it can be said that, if the assessee has already crossed the age limit of 40, it will be advisable to have lower quantum of equity exposure.

 

(d) As explained above, if the assessee has opted for mixed-portfolio of investment, it will be necessary to have a re-look at it periodically. With the opening of the financial markets, the rate of interest is bound to move in both the directions. Accordingly, the rate of yield on the investment and, value thereof, will also fluctuate.  In order to derive better benefits, one will have to reshuffle the portfolio periodically which reflects the prevailing market conditions.

 

Timing of Investment

21.0     As we have seen in the case above, how in the case of a businessman an early investment can pose serious problem. In the case of a salaried employee chances of such happenings are not high. However, as we know, now-a-days one cannot guarantee employment. Particularly in the private sector, an employee’s services may be terminated at any point of time. It may so happen that finding a new job may take considerable time as well. During the said period the employee will not be having salary income. If investment has already been made in PSI during the time of previous employment, it can cause serious problem as explained above. Thus, even in the case of salaried employee as well, timing of the investment in PSI will assume substantial importance.

 

Long Term Recurring commitment of Investment

22.0     At times, a person makes commitment for long time recurring investment. For example, in the case of Life Insurance Premia, one is committing to pay premium for 10, 15 or 20 years. This commitment survives irrespective of the fact whether the person is having any taxable income or not. These commitments are such that any withdrawals from it before completing the contractual term may entail substantial losses. Therefore, one is forced to fulfill the commitment. A businessman incurring losses or a salaried employee having no income due to loss of job may find it difficult to tackle such a situation. While on the one hand there may not be sufficient taxable income to claim tax deduction of the amount to be paid of such a nature, commitment of payment of insurance premium has to be fulfilled. Can there be any way out of such a situation?

 

23.0     As explained above, while making allocation of the funds for the purpose of investment in PSI, one has to keep in mind such commitments. In fact, one should have a mixed portfolio i.e. consisting of fixed commitment and certain portion in flexible scheme. The option for flexible scheme of investment should be exercised only when there is sufficient income which can absorb tax benefit arising out of fixed commitment investment.

 

Impact of EET on Tax-Payers

24.0     What will be the impact on the tax-payers of switch-over from EEE to EET? For a tax-payer the EET scheme per se will always be costly. This is for the reason that when compared the last leg “E” with the “T”, there is bound to be additional cost. However, therefore, one should not jump to conclude that EEE is better than EET as proposed under the DTC. We should remember that the DTC is proposing EET as a package of increased limit of Rs. 3,00,000 for investment. It means,

a)      there will be additional tax saving on additional amount invested of Rs. 2,00,000. Assuming the rate of tax of 30.00% it will be Rs. 60,000.  The tax-payer will have the option of making investment of it i.e. Rs. 60,000 or consuming it.

b)      income accruing on Rs. 2,00,000 will also be tax-free. This will help in faster growth of the corpus.

 

24.1     In view of this, while making comparison one will have to keep these factors in mind. An attempt has been made in the example given here below to compare both the systems.

 

25.0     CASE 1

Assumptions:

a)      tax-payer invests Rs. 1,00,000 through PSI and claim tax-benefit under EET.

b)      Rate of tax in the year of investment withdrawal is higher as compared to the year in which investment was made

c)      Tax benefit arising on account of tax deduction are also invested and not consumed.

Comparison of EEE with EET
EEE EET
Rs. Rs.
A Amount available for investment 100,000 100,000
B Rate of tax in the year of investment 10.00% 10.00%
C Rate of tax in the year of withdrawal of investment 30.00% 30.00%
D Tax benefit available in the year of investment (AxB) 10,000 10,000
Amount invested
E -in permitted instrument /through PSI (A) 100,000 100,000
F -through Open Market (i.e. tax benefit component) (D) 10,000 10,000
G Total Investment (E + F) 110,000 110,000
H Term considered for comparison 5 years 5 years
I Appreciation in value of investment 50% 50%
Amount realized after five years
J -in permitted instrument /through PSI (E x I) 150,000 150,000
K – Investment thru Open Market (F x I) 15,000 15,000
L Total Amount Realised (J + K) 165,000 165,000
Tax to be paid in the year of withdrawal of investment (fifth year)
M – At the normal rate of tax (J x C) (No tax under EEE) 45,000
Computation of Capital Gain Tax
N Rate of Inflation (compounded) Projected 5.00% 5.00%
O Inflation Index 127.63 127.63
P Investment (F) 10,000 10,000
Q Adjusted Capital Cost ( F x O) 12,763 12,763
R Taxable Capital Gain (K – Q) 2,237 2,237
S Rate of Tax on CG (under IT and DTC respy.) 20% 30%
T Tax Payable on CG (R x S) 447 671
U Total Tax Liability (M + T) 447 45,671
V Amount left after tax liability (L – U) 1,64,553 1,19,329
W Loss due to tax under EET (V under EEE less V under EET) (-)45,224

 

25.1     Additional tax liability of Rs. 45,224 is due to the last limb “T”. Now, it will be clear why DTC is offering investment limit of Rs. 3,00,000 as against Rs. 1,00,000 as at present. It also means that in order to reduce the burden, the tax-payer will have to go for additional investment of Rs. 2,00,000. In order to neutralize loss arising of Rs. 45,224, additional incentives have to be offered in the year of investment. To what extent it can compensate, see the Case 2 below.

26.0     CASE 2

Assumptions:

d)      Tax-payer invests additional amount of Rs. 2,00,000 permitted under EET through PSI and claims tax-benefit. Since, there is no tax deduction for Rs. 2,00,000 under EEE, there is outflow on account of tax and the balance amount is invested.

e)      Rate of tax in the year of withdrawal is higher as compared to the year in which the investment was made

f)        Tax benefit arising on account of tax deduction are invested.

Comparison of benefits under section 80-C of IT with S. 66 of DTC
EEE EET
Rs. Rs.
A Amount available for investment 200,000 200,000
B Rate of tax in the year of investment 10.00% 10.00%
C Rate of tax in the year of withdrawal of investment 30.00% 30.00%
D Tax benefit available in the year of investment (A x B) under EET [Rs. 20,000 Tax liability under EEE] -20,000 20,000
Amount invested
E -in permitted instrument /through PSI (A) 200,000
F -through Open Market  ( A – D) 180,000 20,000
G Total Investment (E + F) 180,000 220,000
H Term considered for comparison 5 years 5 years
I Appreciation in value of investment (Projected) 50% 50%
Amount realized after five years
J -in permitted instrument /through PSI ( E x I) 300,000
K – Investment thru Open Market (F x I) 270,000 30,000
L Total Amount Realised 270,000 330,000
Tax to be paid in the year of withdrawal
M – Normal rate of tax (J x C) [No tax under EEE] 90,000
Computation of Capital Gain Tax
N Rate of Inflation (compounded) Projected 5.00% 5.00%
O Inflation Index permitted 127.63 127.63
P Investment thru open market 180,000 20,000
Q Adjusted Capital Cost (P x O) 229,734 25,526
R Taxable Capital Gain ( K – Q) 40,266 4,474
S Rate of Tax on CG 20% 30%
T Tax Payable on CG (R x S) 8,053 1,342
U Total Tax Liability (M + T) 8,053 91,342
V Amount left after tax liability (L – U) 2,61,947 2,38,658
W Loss due to tax under EET (V under EEE less V under EET) (-)23,289

26.1     For the purpose of comparison of the two systems i.e. the one under existing IT and the DTC, if we combine final outcome of both the computations, it will be found that there is a loss of Rs. 68,513 (i.e. Rs. 45,224 of Case 1+ Rs. 23,289 of Case 2). These figures are indicative only and, in other cases, it may work out to be more. For example, in case the rate of tax is higher in the year of withdrawal under EET, outflow on account of tax will be more.

27.0     Case 3

Now let us consider the above facts with slightly different scenario wherein the rate of tax at the time of investment and withdrawal remains the same.

Comparison of benefits under section 80-C of IT with S. 66 of DTC
EEE EET
Rs. Rs.
A Amount available for investment 200,000 200,000
B Rate of tax in the year of investment 10.00% 10.00%
C Rate of tax in the year of withdrawal of investment 10.00% 10.00%
D Tax benefit available in the year of investment –  (A x B) under EET [Rs. 20,000 Tax liability under EEE] -20,000 20,000
Amount invested
E -in permitted instrument /through PSI (A) 200,000
F -through Open Market ( A – D) 180,000 20,000
G Total Investment (E + F) 180,000 220,000
H Term considered for comparison 5 years 5 years
I Appreciation in value of investment  (Projected) 50% 50%
Amount realized after five years
J -in permitted instrument /through PSI (E x I) 300,000
K – Investment thru Open Market (F x I) 270,000 30,000
L Total Amount Realised ( J + K) 270,000 330,000
Tax to be paid in the year of withdrawal
M – Normal rate of tax ( J X C) [ No tax under EEE] 30,000
Computation of Capital Gain Tax
N Rate of Inflation (compounded) – projected 5.00% 5.00%
O Inflation Index permitted 127.63 127.63
P Investment (F) 180,000 20,000
Q Adjusted Capital Cost (F x O) 229,734 25,526
R Taxable Capital Gain (K – Q) 40,266 4,474
S Rate of Tax on CG 20% 10%
T Tax Payable on CG (R x S) 8,053 447
U Total Tax Liability (M + T) 8,053 30,447
V Amount left after tax liability (L – U) 2,61,947 2,99,553
W Gain under EET (V under EET less V under EEE) 37,606

28.0     Case 4

Let us consider the case wherein the rate of tax at the time of withdrawal is lower as compared to when the investment was made. This is typically the case of employees who are drawing high salary and paying the tax at the maximum rate. However, when they retire salary discontinues and income in the form of annuity and interest is derived. These amounts may not be high enough to attract the maximum marginal rate of tax. Once can say that with the higher threshold limit of exemption as senior citizen and lower income, one may be in the second slab of tax as against the third when the investment was made.

Comparison of benefits under section 80-C of IT with S. 66 of DTC
EEE EET
Rs. Rs.
A Amount available for investment 200,000 200,000
B Rate of tax in the year of investment 30.00% 30.00%
C Rate of tax in the year of withdrawal of investment 20.00% 20.00%
D Tax benefit available in the year of investment –  (A x B) under EET [Rs. 20,000 Tax liability under EEE] -60,000 60,000
Amount invested
E -in permitted instrument / through PSI (A) 200,000
F -through Open Market (A – D) 140,000 60,000
G Total Investment( E + F) 140,000 260,000
H Term considered for comparison 5 years 5 years
I Appreciation in value of investment (Projected) 50% 50%
Amount realized after five years
J -in permitted instrument /through PSI (E x I) 300,000
K – Investment thru Open Market (F x I) 210,000 90,000
L Total Amount Realised ( J + K) 210,000 390,000
Tax to be paid in the year of withdrawal
M – Normal rate of tax (J x C) 60,000
Computation of Capital Gain Tax
N Rate of Inflation (compounded) – Projected 5.00% 5.00%
O Inflation Index permitted 127.63 127.63
P Investment (F) 140,000 60,000
Q Adjusted Capital Cost (P x O) 1,78,682 76,578
R Taxable Capital Gain (K – Q) 31,318 13,422
S Rate of Tax on CG 20% 20%
T Tax Payable on CG (R x S) 6,264 2,684
U Total Tax Liability M + T) 6,264 62,684
V Amount left after tax liability (L – U) 2,03,736 3,27,316
W Gain under EET (V under EET less V under EEE) 1,23,580

28.1     To summarise, EET can work at the best when the tax-payer act judiciously and chalk down the strategy well in advance. As can be seen from the Case 4, despite having “T” in the last leg, the benefit of additional investment limit of Rs. 2,00,000 can help in deriving greater benefit. Broad principles emerging from the above are as follow:

a)      Never make investment which can bring down total taxable income below threshold limit of exemption.

b)      It is better to have flexibility in determining the amount to be invested. Don’t make commitment for investment on long-term basis. One should have the flexibility of altering the amount of investment to be made through PSI.

c)      Additional cash flow arising through tax benefit of additional limit of Rs. 2,00,000 should also be invested through open market in sound securities as it will help in faster growth of capital.

d)      Don’t make mistake of withdrawing entire amount of investment made after retirement. Withdraw only the amount as per the requirement ensuring that one does not land into the higher tax bracket.

e)      On retirement or reaching the age of super-annuation, transfer certain portion of the investment from high growth but risky securities to the securities or the scheme wherein fixed income or annuity is received. Amount received in this respect will be taxable under DTC. However, as long as the tax bracket remains the same, there will not be losses on account of additional tax outflow

 

Options with the Tax-Payers

29.0     A question that will always baffle the tax-payers is whether it will be advisable to put additional amount of Rs. 2,00,000 and reduce the tax liability? This question can have answer only if the tax-payers are having the option of tax-free investment opportunities. As we all know, all the schemes having the feature of tax-free income have been discontinued. Therefore, the next best option will be to find out whether there can be any investment opportunity wherein the tax slab can be less than the maximum rate of tax i.e. 30.00%. One alternative can be to invest Rs. 2,00,000 in some capital asset for a long term and derive capital gain. In view of indexation benefits being available for capital assets, overall tax liability can be less than average rate of 30.00%. However, the tax deduction permitted in the year of investment under DTC can make substantial difference over a long period of time. Therefore, EET cannot be a loosing proposition.

 

Justification for EET

30.0     Although it is not part of the subject matter of this analysis to look into the justification for switching over from EEE to EET, it is necessary to at least have some idea about it. After all it affects all of us collectively. Having enjoyed the benefits under EEE, the “T” of EET is bound to create lots of heart-burn amongst the tax-payers. It will be difficult to reconcile to it. Most of us may not be aware the amount of debt the Central and state governments have created since independence. The most important aspect which has not been visible to all of us is pension liability of the retired employees which has not been provided for / funded so far. Apart from that the State has failed to make sufficient provision for the citizens who are not part of the organized sector. Secondly, looking to the size and population of the country, rate of growth has not been sufficient enough. There is shortage of resources.

 

30.1     Experience in the European countries has shown that EET is the best solution to tackle these issues. Data reveals that the countries having EET system have shown considerable progress in pooling the resources, rapid growth in industrial development and making it possible to provide steady income during the retirement age. There is hardly any country following the EEE model. All these factors must have weighed with the policy-makers to opt for EET. One may not like EET, but will have to learn to live under it.

Conclusion:

31.0     For the tax-payer, “T” in the EET will never look like preferable to EEE. However, looking to the fact of EET as certainty, one will have to learn to live under it. The only alternative for the tax payer is to organize the affairs in such a way that there is no additional burden due to tax-outflow.

 

31.1     Ever since the process of liberalisation and opening of the Indian economy was started, till date its impact was felt at the business and industrial level only. To a large extent tax-payer’s investment were safe as it had the backing of security of the Government. However, with the introduction of EET, the said comfort will become thing of the past. The tax-payers will have to be more alert and cautious; otherwise he will face serious problems during his retirement period. While the country is not yet ready to take care of all the retired people even partially, one will have to ensure that he is left with sufficient corpus when he reaches the age of 60.

 

31.2         With the introduction of EET, Goods and Service Tax as proposed w.e.f. 1-4-2010, open economy, free flow of funds on current account etc. we shall be moving with the other developed countries. All these are major moves in the process of reform. Since these are structural changes, they are bound to create uncomfortable conditions for large number of persons. Although, the cut-off date of 1st April, 2011 appears too far away, if the basics of living with EET are not learnt in time, its cost may be high for any one.

CA. Pradip R Shah

[email protected]

More Under Income Tax

0 Comments

  1. CA.N.VENKATESWARAN. says:

    DEAR SIR,
    THE SERIES OF ARTICLES ON DTC ARE THOGHT PROVOKING AND EXCELLENT. IT REQUIRES FURTHER ANALYSIS AFTER THE FRESH PROPOSAL OF AMENDMENTS PROMISSED. THE BASIC POINT IS THAT AVERY ONE SAVES FOR THE FUTURE LARGE COMMITMENTS LIKE HIGHER EDUCATION OF CHILDREN OR THEIR MARRIAGE OR HOUSE BUYINE ETC. THESE EXPENSES CANOT BE MET BY PART WITHDRAWALS. THEN WHAT WILL BE THE OUTFLOW ON TAXES AND THIS GAP ON ACCOUNT OF OUTFLOW CAN BE MET IS A MILLION DOLLAR QUESTION?
    CA.N.VENKATESWARAN.

  2. venkat says:

    what happens if investments under EET were NOT withdrawn during the life time of the investor but withdrawn only after his/her death by the successors?

Leave a Comment

Your email address will not be published. Required fields are marked *

Search Posts by Date

June 2021
M T W T F S S
 123456
78910111213
14151617181920
21222324252627
282930