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DTC: Basics and approach remain same

For savers and investors who were living in dread of new Direct Taxes Code completely transforming their tax-planning approach, the new law must come as a relief, writes Dhirendra Kumar.

india Updated: Aug 31, 2010 21:25 IST
Dhirendra Kumar

For savers and investors who were living in dread of new Direct Taxes Code completely transforming their tax-planning approach, the new law must come as a relief. There are two main reasons for this. One, generally, the basic structure and the approach to taxation is very much the same. And two, specifically, long-term capital gains on equity and equity-backed mutual funds remain untaxed.

The retention of the zero-tax rate on long-term equity gains is probably the fundamental difference between the DTC as it was proposed originally and the shape it has finally taken. However, on a relative basis, long-term capital gains are now more attractive by a smaller margin than earlier.

Since short-term gains are now taxed at half the rate of the income tax slab the investor is in, they can be no more than 15 per cent and potentially as low as 5 per cent. The basic bias of the tax laws for shorter-term gains remains intact.

For mutual fund investors, there are two big changes. One, equity linked saving schemes (ELSS) will be history after the act comes into force. What used to be the Section 80 C deductions are now applicable to much smaller range of investments. This is unfortunate — ELSS were important in being tax-saving investment which brings the benefits of equity returns.

ELSS also have another benefit. For many retail investors, they tend to be gateway products in which the investor gets the first taste of equity investing and of mutual funds. The tax-savings attract people to these funds and the three year lock-in generally ensures that investors get good returns. This experience converts many of these investors to investing in equity mutual funds.

Under the DTC, 80 C-type benefits are limited only to term insurance, PF, PPF and the New Pension System. Of these, only the NPS offers some equity exposure but only up to 50 per cent and with a lock-in to retirement age.

The other change is the imposition of tax on dividends distributed by mutual funds.

In theory, this has been imposed on ULIPs as well but that's just a characteristically fake attempt to show that the government is treating mutual funds and ULIPs similarly. In reality, ULIPs don't actually pay dividends so this measure hits only mutual fund investors.

Worse, this tax will be a disproportionately harder hit on older investors who rely on mutual funds to provide regular income. I would expect it to be a disproportionately harder hit on asset management companies like UTI, which has historically been stronger among this class of investors.

For investors who understand the mechanics of fund dividend, it would be a better strategy now to derive regular income from redemptions rather than dividends. As long as they avoid short-term capital gains tax by not redeeming within one year of investing, they'll find it better to simply redeem a regular income. Fund companies already offer a facility for this called Systematic Withdrawal Plan (SWP).

The new tax code has added art to the list of assets which qualify as investments. These will now be available for a reduction of capital gains tax by becoming eligible for indexation of acquisition cost. Given the impossibility of nailing down an unambiguous valuation of art, I expect this to become a handy loophole for creating capital losses and gains by the art-owning classes.

One can also look forward to a recurrence of the plague of dubious art funds that were floated 2006 and 2007.