Last week, I wrote about how tax-saving investments need to be investments first, and then tax-savers. Investors tend to choose their tax-saving investments carelessly. They invest in certain instruments that are not really suitable for them, solely because they will save on taxes. Of course, the tax-saving landscape of the country is set for a sweeping change from next year.
The new Direct Tax Code (DTC) severely limits the types of investments on which complete tax exemption will be available.
One of the tax-saving instruments that will no longer exist after the new code comes into effect is the equity-linked savings schemes (ELSS) of mutual funds. While this fits into the principal on which the DTC is based, it isn't by itself a great idea. Interestingly, just a couple of days ago, the Securities and Exchange Board of India (SEBI), somewhat uncharacteristically, asked the Central Board of Direct Taxes (CBDT) to keep the tax-saving status of ELSS unchanged. According to media reports, SEBI has written to the CBDT that these products are beneficial to small investors.
For investors as well as the mutual fund industry, ELSS is a very useful product. There are two reasons for this. One, these ELSS funds are unique in being the only tax-saving instrument, which bring the benefits of equity returns. Sure, there are two other options that give equity-linked returns - (unit-linked insurance plans) ULIPs and the New Pension System. However, ULIPs have long lock-in - five years, high costs and low transparency. The NPS is a great product but it is a retirement solution rather than a savings product with a lock-in that effectively extends till retirement age. ELSS funds actually have the best combination of low cost, 100 per cent equity as well as a shorter lock-in period of just three years.
Apart from these, ELSS funds have another hidden benefit. For many retailinvestors, it tends to be a gateway to investments in equity and other equity mutual funds. The tax-saving feature attracts people to these funds and the three-year lock-in ensures (most of the time) that investors get good returns even if their timing and choice of funds is less than optimal. This experience converts a certain proportion of these investors to investing in equity mutual funds over and above their tax-saving needs. The demise of ELSS will definitely be negative development in the Indian savings and investment landscape.
As such, it is good to see that SEBI is trying to prevent this from happening although anyone would have doubts about the timing. If SEBI has been trying to do so for a while and it has come to light only now then that's great. However, if this effort has commenced only now, then one would have to wonder if it hasn't already been too late. I hope I am wrong but as things stand, the changes in the DTC seem to be a done deal.
This article was originally published on August 23, 2010.
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