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EETing into Your Returns

THE FINANCE MINISTER WANTS WITHDRAWALS FROM TAX-FREE AVENUES TO BE MADE TAXABLE. BUT HOW HE INTENDS TO DO IT IS NOT CLEAR.

Asset Managers Print Edition: January 25, 2007

Investors in small-savings schemes have long had their cake and eaten it too. A major chunk of small-savings schemes fall under the EEE umbrella. For the uninitiated, EEE represents Exempt, Exempt, Exempt. The first “E” denotes “contribution made in certain saving schemes exempt from tax”. The second “E” denotes “accruing income from such contributions being exempt” and the last “E” means “tax free maturity proceeds”.

 POINTS OF CONFUSION
  Will EET be from prospective or retrospective effect? Finance Ministry hints it will be prospective.
  How will the pre-EET and post-EET returns be segregated and calculated?
  At what rate will withdrawals be taxed? Will the income be treated as long-term capital gains?
  Will EET also apply to equity-based investments such as ELSS funds?
  In that case, would the tax benefits extended to other investments in the stock markets also go?
 Simply put, at no stage are these saving schemes taxable. But the Budget of 2005 gave a new twist to the issue of exemption to income from small-saving schemes when the finance minister announced that the last “E” in this lucrative trinity would be replaced by a “T”. What earlier was EEE would eventually become EET. In other words, he meant to remove the exemption given to withdrawals from these small savings. The invested amount would be taxable on maturity. The proposal is expected to be implemented from 1 April.

 Let me illustrate this with an example. If an investor deposits Rs 1,000 in his PPF account, the current interest rate of 8% will grow to Rs 3,172 on maturity after 15 years. In the current EEE regime, the Rs 1,000 contributed is the first “E” and therefore exempt. The Rs 2,172 interest earned during the 15-year term is the second “E” and is also tax free in the hands of the investor. The maturity proceeds of Rs 3,172 after 15 years is the third “E” and is alsotax free. Mr Chidambaram wants to replace this third “E” by a “T” and tax the proceeds on maturity.


 But this is not as simple as it sounds. There is confusion over whether the EET would be implemented from prospective or retrospective effect. There are indications from the Finance Ministry that the EET will be a prospective law and will therefore not hit the taxation of any contribution made before its implementation. But there still is uncertainty over how the pre- and post-EET returns will be segregated and calculated.

 Another area that requires clarity is the contributions made to tax-saving schemes over and above the Rs 1 lakh exemption limit under the Section 80C. Since such investments do not attract the first “E” they are not exempt from tax. In such a case, will the maturity proceeds be taxed as per the EET clause? Many investors, for instance, deposit money in PPF not to avail exemption under Section 80C but for the other attractive benefits it offers—such as tax-free interest income and tax-free withdrawals. These investors may have already exhausted their Section 80C limit through other investments.

Further, at what rate will these withdrawals be taxed? And how much of the withdrawal is going be taxable? There are two ways to look at this. Firstly, the income can be taxed like capital gains i.e. difference of sale proceeds and principal amount is the gains on which the investor needs to pay tax. The same rates and rules that govern capital gains would apply here. The other way is to include the proceeds in the individual’s total taxable income for the year on which the tax is payable at a predetermined rate. This aspect awaits further clarity.

 The EET regime will affect different types of taxpayers differently. An assessee currently in the lower tax slab will end up paying more as the years progress because his income level would go up and place him in a higher tax slab. On the other hand a person on the verge of retirement is expected to benefit because after retirement his income level will go down and therefore EET will not hit him hard.
 
The EET regime will also affect the attractiveness of tax-saving options and other investments. While some instruments will outright become redundant, the investment style in others will need to be tweaked to make them more tax efficient. For instance, PPF, which is one of the most attractive of small saving schemes, will lose its sheen once the maturity proceeds become taxable. Unit-linked insurance plans and traditional endowment policies, where the proceeds are totally tax free, too would lose their attractiveness.

 Equity-linked saving schemes will also be hit. But at least they offer investors a way out if they opt for the dividend option. Dividend is tax free in the hands of the investor. Even the maturity proceeds may not be too taxing. Besides, when EET becomes a reality, mutual funds may structure their dividend payments in a way that investors are not burdened with a tax liability.

 However better clarity will come once the rules governing the EET regime are framed and made public. Till that time, don’t stop or postpone your investments on the grounds that the proposed shift to EET regime will eat into your returns. Continue investing in small-savings schemes as they still offer you attractive returns and tax benefits.

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