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DTC's Impact: Some Losses and Some Gains

How the Direct Tax Code to be ushered in from April 1, 2012 will affect your portfolio

While the initial draft of the Direct Tax Code (DTC) presented a grand vision of massive overhaul of the tax system, DTC in its final avatar appears to be nothing more than a modified version of the Income Tax Act of 1961. Nonetheless, it is a step forward, albeit a baby step. Without getting into the debate on whether DTC signifies an improvement in the tax system, we shall stick to our objective of finding out what impact DTC will have on your investment portfolio.

For a better understanding of its impact we have segregated this story into three broad sections.

Since investments can only be taxed at three stages - at the time of investment, when income derived from the investment is distributed, and lastly at the time of redemption - we shall examine the impact of DTC at each of these three stages.

At the time of investment
Equity. Currently among equity instruments only equity-linked saving schemes (ELSS) and unit-linked insurance plans (Ulips) are eligible for tax deduction under Section 80C of up to `1 lakh. DTC is till date silent on whether these exemptions will continue. But with no clarification forthcoming from the Ministry of Finance, investors are more or less reconciled to the fact that these instruments will no longer be eligible for Section 80C benefit. This is a big blow to investors since they will no longer enjoy the dual advantages of growth and tax benefit. Moreover, of all the tax-saving instruments, ELSS had the shortest lock-in period.

Investors can still have partial exposure to equity via investments in the New Pension Scheme (NPS), which will, however, be limited to 50 per cent of their investment if they choose E, the equity-oriented fund under NPS.

Debt. The list of debt instruments eligible for tax deduction at the time of investment has also been trimmed. Five-year bank fixed deposits, post office deposits like monthly income schemes and National Savings Certificate have all got the boot from the list of tax-saving instruments. Moreover, infrastructure bonds, which under the current regime entitle you to additional exemption of `20,000 over and above `1 lakh, will no longer enjoy that special treatment.

All instruments that are eligible for tax benefit are retirement savings accounts such as public provident fund, provident fund, new pension scheme and savings schemes as notified by the government. Except for NPS, which has the option of equity allocation, all the others are debt investments.

This again is a significant setback for investors as the best return that they can hope from these retirement instruments (entitled to tax benefits) is 8-9 per cent. After adjusting for inflation the most one can hope for is a return of 3-4 per cent, which is in no way enough.

Income distributed
Equity. At present only the dividend paid out by companies to their shareholders is subject to dividend distribution tax (DDT) at the rate of 15 per cent. While keeping this provision intact, the new tax code has proposed to tax the dividends distributed by equity mutual funds. The tax rate will be 5 per cent. This clearly puts dividend plans of equity mutual funds at a disadvantage vis-à-vis their growth plans. In a growth plan, you will only have to pay the Securities Transaction Tax (STT) at the time of redemption after one year. On the other hand, in a dividend plan you will have to pay DDT when dividend is paid out and STT at the time of withdrawal (after one year).

Debt. Under the current regime, most debt investments either come under the EEE (exempt, exempt, exempt) regime or the interest income from them is added to the taxpayer's income and taxed according to her income-tax bracket. But debt mutual funds receive special treatment under the current tax regime. The income derived from debt funds is subject to DDT. For liquid funds the rate for DDT is 25 per cent while for any other type of debt fund it is 12.5 per cent for individuals. Investors falling in the higher tax brackets deploy their cash surpluses in liquid and debt funds to enjoy a tax arbitrage.

Under DTC any income from non-equity funds will be added to the taxpayer's income and taxed at their respective tax rates. This removes the long-standing advantage that mutual funds have enjoyed over other forms of debt investments, namely bank fixed deposits. While this change will not be beneficial for anyone in the 20-30 per cent tax bracket, for anyone in the 10 per cent or zero tax bracket this is certainly welcome news. Small investors will henceforth find debt mutual funds a more attractive investment avenue.

Treatment of gains
The initial draft of DTC proposed to completely alter the treatment of capital gains, but what we have in the final avatar amounts to just minor tweaking.

Short-term capital gains
Equity. Currently short-term capital gains are taxed at a flat rate of 15 per cent. Under DTC this is set to change. Like dividend income from debt funds, short-term capital gains from equities will be taxed according to the investor's tax slabs. However, the tax rate applicable (STCG Rate) will be half the income-tax rate.

Again this development is positive for small investors as STCG rates have declined by 66.67 per cent for them. Even for taxpayers in the 20 per cent bracket there will be tax relief of 33.33 per cent. Even though short-term investment in equities is not something that we recommend, at least the lower tax bracket investors will not be taxed at as high a rate as before under DTC.

Debt. DTC has maintained the status quo in case of debt instruments. As is the case at present, under DTC as well short-term gains from debt investments will be added to the investor's income and taxed according to her tax slab.

Long-term capital gains
Equity. In the initial draft there was a proposal to tax long-term capital gains in equities. But much to the relief of equity investors, exemption on long-term capital gains has been retained.

Non-equity (Debt, Commodity ETF, foreign funds). Currently non-equity investment instruments, namely bonds and debt funds, are taxed at 10 per cent without indexation and 20 per cent with indexation benefit provided they have been held for over 12 months. DTC has maintained the same tax rates but has made a small change in holding period, for someone who wants to enjoy indexation benefit. Now indexation benefit will only be available if the investment is redeemed after one year from the end of the financial year of purchase.

Other assets. Currently assets like property and physical gold become eligible for indexation benefit only after a three-year holding period. Now these assets, if held for a period of 12 months or more from the end of the financial year in which they were purchased, they shall qualify for indexation benefit.

Impact of DTC on different tax brackets
The effective tax burden will decline for all tax brackets (All fig in Rs except where mentioned)
Income  4,00,000    8,00,000    12,00,000  
  Current  Post DTC  Current  Post DTC  Current  Post DTC
Exemption 1,35,000 1,50,000 1,35,000 1,50,000 1,35,000 1,50,000
80C 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000 1,00,000
80D 15,000 50,000 15,000 50,000 15,000 50,000
80CCF 20,000   20,000  20,000 
Taxable income 2,65,000 2,50,000 6,65,000 6,50,000 10,65,000 10,50,000
Tax rate (%) 10 10 20 20 30 30
Tax 26,500 25,000 1,33,000 1,30,000 3,19,500 3,15,000
Effective tax rate (%) 6.63 6.25 16.63 16.25 26.63 26.25