In his budget speech, Finance Minister Pranab Mukherjee said that the new Direct Taxes Code (DTC) would become effective from 1 April 2012. The revised version of the much-awaited legislation, which is being examined by a parliamentary committee, is nowhere close to the pathbreaking reform it was meant to be.
Insurance: Stiff conditions
The DTC is a game changer for insurance. Most Indians buy life insurance policies only to save tax. Under DTC, a policy should give a life cover of at least 20 times the annual premium to be eligible for tax deduction. If this condition is not met, you will not get any tax deduction on the premium and even the income from the policy will be taxable. Right now, the income received from insurance policies is tax-free.
The tax deduction limit for life insurance itself will get reduced from the present Rs 1 lakh a year to only Rs 50,000 a year. Besides, this annual limit of Rs 50,000 would include the amount paid for tuition fees of children as well as medical insurance for self and parents. So, an insurance policy with a very large premium of say, Rs 80,000-Rs 1 lakh will fetch a maximum tax deduction of Rs 50,000.
The DTC will also nudge policyholders to take a long-term view of their investments. Premature withdrawals from Ulips will be taxed, so think twice before you buy an insurance policy. Don't believe the agent when he tells you that surrender charges have been capped and you can withdraw after five years without paying a penny.
Though the revised draft had indicated that the tax exemption enjoyed by existing policies will continue till the term of the plan, this is a grey area and clarity will come when the DTC is passed.
Real estate: Mixed bag
The repayment of the principal of your home loan will not be eligible for tax deduction under the DTC. The people who are paying large home loan EMIs and claim benefits under Sec 80C may have to find the money for other tax-saving investments after the DTC comes into effect. But this setback is minor when compared with the gain from the removal of tax on notional rent.
Right now, people who own more than one house have to pay tax on notional rental income even if the second house is lying vacant. Paying tax on your earnings is bad enough, but having to pay tax on the income you haven't received is worse. The DTC will end this anomaly and make investments in second homes more tax-efficient. Another landlord friendly move is that advance rent received from a tenant will be taxed in the year to which it relates, not when it was received. In some cities, landlords take up to 6-12 months rent in advance, which pushes up their tax liability. The DTC has fixed this too.
Similarly, by retaining the tax benefits on the interest paid on a home loan the DTC has helped cushion some of the impact of rising interest rates. The tax benefits reduce the effective cost of the home loan, thus making it affordable for borrowers.
Debt: New rules for indexation
With earlier plans to tax withdrawals from the PPF junked, investors should continue investing in this tax-free haven. Of course they should take their overall asset allocation into account while gorging on debt. Suppose you have Rs 4 lakh to invest in a year and want to put 25% in debt. Invest Rs 70,000 in PPF and the remaining in fixed deposits. You can also consider debt funds but the change in the taxability of long-term and short-term gains will rob them of the tax efficiency they have enjoyed so far.
One significant change that will impact investments in debt funds is the new rule for calculating the indexation of capital gains. Indexation takes into account the inflation during the holding period and allows the investor to adjust his buying price. If you invested in a debt fund in March 2008 and redeem it in April 2011, your investment gets indexation benefits for four financial years-from 2007-8 to 2010-11.
The DTC has changed this and the asset will have to be held for more than 1 year from the end of the financial year in which it was bought to avail of the indexation benefit. This is a significant change and will impact the way investors in FMPs and debt funds use this benefit.
Pension funds: Major change
Under the DTC, most of the current tax saving investment will not be eligible for deduction. Instead, the focus has shifted to long-term options, with pension plans leading the way. An annuity is an investment that gives out a regular income to the investor. Pension plans require an investor to put at least 65% of the corpus received on maturity in an annuity, which then gives him a monthly pension.
Though details are still awaited, the DTC has proposed to make annuity income exempt from taxation, which makes them a good tax-saving investment. The New Pension Scheme is a low-cost pension fund but you must assess the track records of the six funds that are managing the scheme before entrusting your money to one of them.
Equities: Minor changes
Investors can continue investing in stocks and equity mutual funds because the exemption on long-term capital gains will continue. The most important advice for equity investors, however, has nothing to do with the DTC. In fact, it has nothing to do with tax at all.
