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Exempt Exempt Tax: Boon or bane?

July 03, 2009 20:31 IST

There has been considerable discussion during the past few years about the Government changing from the EEE to EET Tax regime related to tax saving financial products.

The acronyms have a simple expansion: Exempt -- Exempt -- Exempt and Exempt -- Exempt -- Tax.

With the upcoming Budget expected to give some direction on this issue, its time we understood what these terms mean and their impact on our pockets.

The tax incidence points

The terms explain the tax treatment of financial tools at different time periods. The different points at which can tax may be payable are:

  • At the time of the investment / transaction
  • During the tenure of the investment when cash flows occur
  • At the time of maturity /sale of the investment

Different financial tools will have different times during which tax may be payable.

Example

Let us see how transactions related to shares are taxed.

At the time of purchase of the shares, Securities Transaction Tax (STT) has to be paid. STT has to be paid by both the buyer and seller of the shares. It should be noted that the amount to be invested should have already suffered Income Tax in the hands of the investor.

When the company that we have invested in gives dividends, Dividend Distribution Tax (DDT) has to be paid. DDT is paid by the company directly and thus is a form of Tax Deducted at Source.

Finally when the share is sold, there will be Capital Gains Tax. Capital gains for shares can be Short Term (if the share is help for less than a year -- 365 days) taxed at 10%; or Long Term (greater an 1 year holding period) which is tax free.

Thus investment in shares is a case of TTE (Tax -- Tax -- Exempt).

Cases for EEE today

Almost all the tax saving financial instruments today fall in the EEE tax regime. The taxman is truly the best friend for the investors in these tools. These investments do not tax us, the investors, at the time of investment, during the tenure of the investment and also at the time of the maturity.

For example, the EPF (Employees Provident Fund) make an investment up to 12% of the Basic Salary tax free for the salaried class. The return in the form of the interest given is tax free too. Also the amount withdrawn on leaving the job or closing the account is also tax free.

The situation is the same with a number of other tax saving instruments -- Equity Linked Savings Scheme (ELSS) Mutual Funds, Life Insurance (subject to premium being not more than 20% of life cover)and 5 years Tax Saving Bank Deposit.

What happens with EET

EET tax regime is basically to exempt the tax at the time of investment and during the tenure of the investment but to tax the proceeds of the investment at the time of maturity / sale of the investment. This is a cause of worry.

We do get tax benefits at 2 places so why worry? The reason is that we are in reality never exempt from tax but only given more time to pay up the tax. Also, we pay for the growth on the investment too under EET. Thus EET is only a way to defer tax but is not tax free in spite of the 2 Es (exempts).

EET Example

Let us see an example to understand the situation better. Let us assume that we invest Rs 10,000 every year in a tax saving financial tools that gives a return of 10% over 10 years.

Also let us assume that the investor is a male in the 10% tax bracket (Income in the range of Rs 150,000 to Rs 300,000 category).

The value of the investment at the end of the 10 years will be around Rs 175,000. In the EEE regime this amount will come to us tax free! We would also have got the tax benefits on the Rs 10,000 invested every year -- Rs 1,000 per year. Joy!

In the EET regime, the Rs 175,000 will be taxed at 10%. Thus the investor will lose Rs 17,500 to tax after 10 years.  The effect is really that instead of paying tax every year at Rs 1,000 the investor has paid it all in one lump sum at the end of the 10th year.

The investor may comfort himself by saying, "Okay, but at least I do not pay tax every year. And I can make use of the money for the 10 years before giving it back to the government."

Guess what the value of the deferred tax of Rs 1,000 every year for 10 years and 10% return will be? Bingo. Rs 17,500 -- effectively negating the comforting thought!

No more tax savings?

Are there no more tax saving opportunities if EET is implemented? The answer here is 'It Depends' -- on a number of factors. In the EET regime the tax man has a number of options for administering the tax. The maturity amount instead of being added to income may be a charged at a fixed percentage of maturity as tax (as in capital gains tax).

There can be separate income head created for the investments to be taxed and different slabs even. But all these tax reducing measures goes against the principle of simplifying the taxation process.

Worldwide EET has been the favorite method of Governments to tax citizens. Indian may also follow suit soon. We cannot wish it away.

Proper planning -- Creating wealth

EET will remove almost all the tax-free investments from the market. EET will bring in awareness to make investments with a purpose of creating wealth not just to save tax.

In one way, EET is positive. Till date, inspite of the financial reforms happening for the past 15 years, Financial Planning in India = Tax Planning. This has been brought about because of the EEE regime.

Equating tax planning with financial planning has lead to financial disasters. Many people have even borrowed (at a higher interest) to invest in tax saving instruments. Housing loans have been taken without considering the potential income that the property could generate. Insurance Plans have been taken without life cover!! Many business people have shown lower income in their tax returns. The list goes on… The effects of all these are to save on tax but lose out on wealth.

The opportunity is being now created to get out of 'Saving Tax Mode' and get into 'Creating Wealth Mode'.

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