Govt's latest tax-saver: Don't invest before reading this!

Should taxpayers invest in Rajiv Gandhi Equity Saving Scheme to save tax? How much tax will they actually save? And what are the pros and cons you should check out before going for this scheme?

Salil Dhawan offers his take.

With equity-linked saving scheme (ELSS) or tax-saving mutual fund (MF) schemes on their way out effective April 2013 if the proposed direct taxes codea (DTC) kicks in by then, Budget 2012 has provided some sort of an alternative.

However, unlike ELSS that is a mutual fund, the new option will in all probabilities solicit direct investments in equities.

About the scheme and its features

Right now there are about 3.5 crore equity investors in India, but over 10 crore people earn more than Rs 2 lakh a year. According to government, many of them will want to avail of this new exemption after they exhaust their Section 80C limit.

Termed as Rajiv Gandhi Equity Saving Scheme (RGESS), investors whose annual income is less than Rs 10 lakh can invest in it. You will be able to invest in this scheme up to Rs 50,000 and get a deduction of 50 per cent of the investment.

Courtesy: Investment-mantra.in 

So if you invest Rs 50,000 (maximum amount you can invest), you can claim a tax deduction of Rs 25,000 (50 per cent of Rs 50,000). The scheme is not for existing investors (Those who have a demat account are considered as existing investors as per RGESS but more about this later).

This will translate to a maximum benefit of Rs 5,000 (investors whose annual income is a maximum of Rs 10 lakh falls under the 20 per cent income-tax bracket).

Those whose annual income is Rs 10 lakh or more will not be able to invest in RGESS. Just like ELSS, your money will be locked in for three years.

The Rajiv Gandhi Equity Saving Scheme, announced in this year's budget, is eyeing 1.5 crore new investors for the equity market. But, investment under the scheme may be restricted to top 100 or 200 shares on the Bombay and National Stock Exchanges.

Among all the taxpayers, there are nearly 1.5 crore people, with income up to 10 lakh, who do not have a demat account. There would be enough attraction for these people to invest in the equity market.

Few facts about RGESS:

Who can invest?

New equity investors with annual income less than Rs 10 lakh.

Investment amount

Rs 50,000 (Maximum amount one can invest under the scheme).

Deduction available on

Rs 25,000 (50 per cent of Rs 50,000).

Maximum benefit

Rs 5,000 (Investors with annual income of 10 lakh fall under 20 per cent income tax slab).

Lock-in period

Three years (to get tax deduction in addition to 80 C).

Investments under the new scheme may initially be allowed only in the top 100 or 200 companies (on the basis of market capitalisation) listed on various stock exchanges.

RGESS vs ELSS

Benefits from RGESS are limited though, if compared with ELSS. ELSS is available for all investors and offers deduction up to Rs 1 lakh under section 80C. Also, your entire amount invested, subject to a maximum of Rs 1 lakh, gives you tax deduction benefits.

For FY12-13 though, both ELSS and RGESS will be at your disposal, provided the capital market regulator, the Securities and Exchange Board of India (Sebi), releases guidelines and allows these schemes to launch. Since the DTC has been postponed by a year, this year will be a sort of bonus for retail investors; both RGESS and ELSS will be available to invest.

Some key differences between ELSS and RGESS

The benefit of Rajiv Gandhi Equity Saving Scheme (RGESS) is limited to only a class of investors, that is, whose annual income is less than Rs 10 lakh. In case of ELSS, the benefit of this scheme is available to all the retail investors.

RGESS offers an income tax deduction of 50 per cent on the amount of investment. ELSS offers income tax deduction up to Rs 1 lakh under section 80C.

In RGESS, investors can invest directly in equities. In ELSS, investors invest through mutual funds.

RGESS requires direct participation of investors in stock market. ELSS requires indirect participation of investors in stock market.

Premature withdrawal

In RGESS, nothing is clear on this as of now. In ELSS, premature withdrawal is not allowed.

RGESS offer additional income tax deduction i.e. above existing limit of Rs 1 lakh. Investment under ELSS offers income tax deduction up to Rs lakh under section 80C.

RGESS may restrict investors to invest only in top 100/200 companies listed on BSE and NSE. There is no such restriction in ELSS.

Future roadmap for RGESS: Mutual funds or direct equities?

Budget 2012 is silent on how this scheme would operate. In his budget speech, the finance minister said this scheme would be available for investments made "directly in equities", but went on to add that "the scheme will have a lock-in period of three years".

In simple words, it is unclear that RGESS is available only if you buy equity shares directly or whether MFs will also be launch such "schemes".

The effort to increase retail participation in equity markets is a long-term positive.

The scheme will be lot more effective and successful if extended to equity funds as well. Small investors are better off accessing the equity markets through funds with a good track record rather than investing directly, which require expertise and resources.

The budget speech uses the words "direct equities", which means that investor will need to buy equity shares directly to be able to get this tax deduction benefit. ELSS is meant for indirect participation in the stock market, with no involvement of the asset holder.

RGESS, it seems, aims at encouraging direct participation in the stock market.

Is early exit from the scheme possible?

For an investor who wants to book profits and exit before completion of the three-year lock-in period, there may be a provision with a strict condition.

Under such a provision, the investor may be asked to return the benefit (deduction of Rs 25,000 for calculation of income tax) to the government.

Definition of 'first-time' investors

Although Budget 2012 remains silent on how it aims to identify "first-time investor" -- the group of investors that RGESS will target, once launched maybe those who do not yet have a depository (demat) account.

It is roughly estimated that there are around 15 million permanent account number (PAN) holders with income between Rs 2 lakh and Rs 10 lakh, that do not have a demat account at present.

These income tax payers would be the universe from which beneficiaries of the scheme would be drawn.

Probable drawbacks of the scheme

1. Scheme opens only to new investors (not existing investors).

2. Only a segment of retail investors can invest in RGESS scheme as those whose annual income is Rs 10 lakh or more are not allowed to invest in this scheme.

3. There is limit of Rs 50,000 on the amount of investment an investor can make in this scheme.

4. Investment will only be through direct equities, not mutual funds.

What next?

Till the complete details of the scheme is out, it will be unfair to rate it. For the time being, investors will be better off waiting for further clarification on the scheme by the government which is expected to be out this month.

Since RGESS is an investment scheme that warrants stock market investments, Sebi will regulate it and issue guidelines. In addition, clarity is needed on how the government will ensure that your equity investments are locked-in for three years and whether premature redemptions will be allowed under special circumstances or not.

ELSS schemes don't allow premature redemptions. For now, continue investing in ELSS if you're seeking tax deduction limits since ELSS will continue for one more year.

The new scheme, in nutshell, is being designed to encourage flow of savings in financial instruments and improve depth of the domestic capital market. We hope the scheme benefits the small investors and doesn't go the NPS way.

Clarity on more points as to why only new investors (and not existing investors) are allowed to avail the scheme and why restriction of income up to Rs 10 lakh is kept to avail the scheme.

Still we believe that the scheme will hopefully be a step in the right direction because it will give a fillip to equity investing. If the intent is to encourage first time investors to participate in equity markets, a better route would be to include well managed equity mutual funds with an established track record as part of the scheme rather than direct equities.