Oct 1, 2011

Impact of Direct Tax Code on investment strategy

The world of investments is about the future. It is about planning for tax-adjusted returns for future years. As investors do their math of investments today, they have to keep in mind that the income tax map is set for a substantial change in April 2012. This change will come if the new Direct Tax Code Law is passed by the Parliament in this winter session.

The new tax code will have an impact on most investment avenues such as insurance policies, home loans, PPF, mutual funds and stocks. Many tax exemptions in existence today will no longer be valid as the government slowly migrates from the exempt-exemptexempt (EEE) regime to a simpler and more straightforward tax structure.

The Direct Tax Code (DTC) is nothing but a step in that direction. Investors have to now get used to having fewer exemptions and plan their investments from a returns perspective rather than a tax perspective.

Impact on mutual funds

Equity-linked saving schemes (ELSS): The main reason why investors invest in ELSS funds is to save tax. At the end of every financial year there is a rush to subscribe to ELSS funds. The major change that will come under the new DTC is that tax exemptions for ELSS funds will no longer be valid. They are treated like any other equity mutual fund for tax purposes.

ELSS along with NSC and 5-year tax saving bank fixed deposits (FDs) will also be stripped off the Section 80C deduction.

Equity and equity-oriented funds: For equity-oriented funds, the tax benefits have been moved from an exemption-based mechanism to a deduction-based mechanism . Thus, in a case of transfer of units of an equity fund, there will be a deduction of 100 percent for long-term capital gains and a deduction of 50 percent for short-term capital gains.

Income subject to such deductions will be taxed at normal rates. Levy of securities transaction tax (STT) on the transfer of such units will continue. This may reduce the tax cost marginally for individual investors taxable in the 30 percent slab. Income distributed by equity funds continues to be exempt in the hands of investors. However, such distributions are now proposed to be subject to income distribution tax, payable by the mutual fund at the rate of five percent.

Debt funds: In the case of debt funds, investors will have to pay tax at the normal applicable rates for income received and short-term capital gains. Long-term capital gains on units of debt funds (other than equity funds) will be taxed at normal rates subject to indexation benefits , where applicable. Presently, such units are taxed at the rate of 20 percent (with indexation benefits ) and 10 percent (without indexation benefits) for holding periods of more than one year. Indexation takes into account inflation during the holding period and allows the investor to adjust his buying price.

However, to claim indexation benefits, the holding period has to be computed from the end of the financial year in which the units are purchased. This is a significant change and will impact the way investors invest in fixed monthly plans (FMPs). One issue, however, is that it puts investors investing early, at a disadvantage when compared with investors investing just before the end of the financial year.

Impact on insurance

The DTC will have a significant impact on insurance as it will apply to existing policies too. According to the code, any amount you receive at maturity from an insurance policy (including bonus) will be taxed. However, this rule will not apply to policies where premium paid in a year is less than five percent of sum assured each year and the policy is kept till maturity. The DTC aims to nudge policyholders to take a longterm view on investments. To be eligible for tax deduction under DTC, a policy should have a life cover of at least 20 times the annual premium.

Unit-linked insurance plans (ULIPs): The ULIPs will, therefore, lose their tax advantage when the DTC come into effect on April 1, 2012. Premature withdrawals from ULIPs too will be taxed. All insurance products will be eligible for a maximum deduction of Rs 50,000 for the current Rs 1 lakh if the life cover is 20 times the annual premium under Section 70 of the DTC.

Investment strategy

Investors should think twice before deciding on an insurance policy. They should look at insurance from a risk perspective rather than a returns perspective . Investors should plan their investments keeping the DTC in mind as investment horizons are usually three years or more and the change in tax regime in the interim can change the tax-adjusted returns.

 -Source (ET Bureau Sep 11, 2011, 05.47am IST)

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