How new tax code will hit savings schemes

It is a fact that tax incentives offered under the Income Tax Act, 1961 (the IT Act) have been instrumental in encouraging individuals to invest and save for their long-term retirement needs.

One of the key incentives in this respect has been that many of the savings instruments have been under the Exempt Exempt Exempt (EEE) model.

This means that if an individual taxpayer gets a tax deduction when he makes an investment, then the income that accrues in a particular savings instrument is tax-free, and so are the receipts from the tax-saving instrument.

Currently, under Sec 80C of the Act, an individual could claim deduction up to Rs 1 lakh (Rs 100,000). This is proposed to be revised to Rs 3 lakh (Rs 300,000) under the Direct Taxes Code (DTC). This has a big catch to it.

Under DTC, all the savings instruments are proposed to be brought under the Exempt Exempt Tax (EET) model. Therefore, the receipts from all the savings instruments will be taxed at the time of withdrawal. Hence, it needs careful re-consideration in terms of an individual's long-term retirement planning.

One of the main savings and investment avenues the DTC could impact are polices under unit-linked insurance plans (Ulips), money back and guaranteed return plans of insurance companies.

Under the Income Tax Act, any sum received under a life insurance policy, including the sum allocated by way of bonus, is generally exempt from tax if the annual premium doesn't exceed 20 per cent of the capital sum assured.

Under the DTC, it is proposed that any sum received under an insurance policy -- including the sum allocated by way of bonus -- shall be taxable, unless two conditions are satisfied.

First, the premium payable should not exceed 5 per cent of the capital sum assured and second, the sum is received only upon completion of the original period of the insurance contract, or upon death of the insured.

If any of these conditions are not satisfied, the sum received would be held as taxable under the code.

The other types of saving schemes to be hit by the DTC are investments in tax-saving mutual funds, bank fixed deposits, Senior Citizens Savings Scheme (SCSS), post office monthly income scheme (POMIS), provident fund schemes, Public Provident Fund among other schemes.

Under DTC, even though the limit for claiming deduction has been enhanced to Rs 3 lakh, the scope of the deduction has been considerably reduced.

The scope of deduction is proposed to be limited to the schemes offered by the permitted savings intermediary.

Now, schemes like five-year bank deposits and specified mutual funds are outside the ambit of the proposed deduction. Further, all the tax-saving instruments are now being brought under the EET model.

The only saving grace is that the balance in these funds, up to March 31, 2011, is proposed to be tax-exempt, and the EET model will apply only to new deposits made under these schemes.

The premise underlying the EET model is that an individual taxpayer has availed of the tax deduction while making the investment.

This, however, is not true in all cases. There are individuals whose income is currently below the taxable income level. Also, there are individuals who have exhausted their deduction limit under the IT Act or the DTC, and have still made investments in tax-saving instruments.

In both these cases, the presumed deduction has not been actually claimed. Still, the receipts from tax-saving instruments would be taxable.

One should re-examine one's tax-saving instrument portfolios and future investment options, as instruments like NPS may become more attractive.

The author is executive director, KPMG India.