Indian Direct Tax. Simplified. Aug 21, 2009

Indian Direct Tax. Simplified.

August 21, 2009

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Indian Direct Tax. Simplified.

Impact

As committed in the last week's Financial News Simplified, PersonalFN presents an analysis on the new Direct Tax Code, which was unveiled by the Finance Minister on August 13, 2009. The new code is likely to be effective from 2011 and will replace the existing Income Tax Act, 1961. The purpose of the new tax code is to simplify the tax laws as much as possible. The code proposes to:

Re-define the residency rule

The Residency rule is important to determine who is liable to pay income tax in India. At present, there are three categories - Resident, Resident but not Ordinarily Resident (RNOR) and Non Resident. Resident individuals are taxed on worldwide income whereas RNOR and Non Resident Indians are taxed only on Indian income.

The Direct Tax Code has proposed to do away with RNOR category and there will be only two categories - Resident and Non Resident. An individual shall fall in the Resident category if he has stayed in India in any financial year,

(a) for 182 days or more in that year or
(b) for 60 days or more in that year and 365 days or more within the 4 years immediately preceding that year.

This would increase the number of individuals paying tax on their income outside India as individuals belonging to RNOR category will now fall in Resident Category.

Change the nomenclature
At present, if a person earns any income during the year beginning on April 1, 2008 and ending on March 31, 2009, then 2008-2009 is called the "previous year" and the income is assessed to tax in 2009-2010 which is called the "assessment year".

An unified "financial year" term will replace "assessment year" and "previous year". Financial Year is a period of 12 months beginning April 1 and ending on March 31 next year.

This, in our view, will negate the confusion created by the use of two expressions. It will simplify the multiple definitions for "year" and the process of filing tax return.

Restructure the income-tax slabs
The tax slabs for individuals will change substantially as depicted in the table below:

Tax Rate	Existing	Proposed
Tax Slabs For Individuals
Nil	Upto 160,000	Upto 160,000
10%	160,001-300,000	160,001-1,000,000
20%	300,001-500,000	1,000,001-2,500,000
30%	Above 500,000	Above 2,500,000
Tax Slabs For Women
Nil	Upto 190,000	Upto 190,000
10%	190,001-300,000	190,001-1,000,000
20%	300,001-500,000	1,000,001-2,500,000
30%	Above 500,000	Above 2,500,000
Tax Slabs For Senior Citizens
Nil	Upto 240,000	Upto 240,000
10%	240,001-300,000	240,001-1,000,000
20%	300,001-500,000	1,000,001-2,500,000
30%	Above 500,000	Above 2,500,000

This we believe is the most vital reform proposed in the new Direct Tax Code. This will bring down the tax liability of an individual significantly resulting in more income in hand. Also, it will provide everyone an opportunity to save and invest more.

Tax the profits in lieu of salary and perks
The give and take policy always prevails. If the Direct Tax Code Bill proposes to enhance the income tax slabs, it also proposes to withdraw the tax deduction available on benefits like Leave Travel Allowance (LTA), Medical reimbursement and House Rent Allowance (HRA). Hence all these benefits will form a part of your salary and will be taxed as per the applicable income tax slab.

But there is some good news here as well. Food coupons, Employee Provident Fund (EPF), Transport Allowance, Gratuity etc will continue to enjoy deductions. It should be noted that Gratuity will be tax-exempt on change of jobs only if it is invested in a retirement fund.

Though this may increase the tax liability of the salaried individuals, but given that the increase in tax slabs are substantial, it could still lead to a lower tax liability under the new regime.

Consider the example depicted in the table below. An individual whose CTC is Rs 10 lacs p.a., has HRA, LTA and medical reimbursement of Rs 2.7 lacs. In the existing tax system, Rs 2.7 lacs would be exempted from tax and the taxable income would be Rs 6.45 lacs (Rs 10 lacs - Rs 2.7 lacs - Rs 0.85 lacs of Travelling Allowance, EPF and Gratuity), which will attract income tax of approximately Rs 97,500. Whereas, under the new tax code, Rs 9.15 lacs (Rs 10 lacs - Rs 0.85 lacs) will be the taxable income. This will attract income tax of Rs 75,500. The individual is still able to save Rs 22,000 per year.

		Existing	Proposed
Cost to Company (CTC)	1,000,000	Taxable Income	Taxable Income
Basic	445,000	445,000	445,000
Consolidated Allowance	200,000	200,000	200,000
Travelling Allowance	9,600
EPF	55,400
Gratuity	20,000
HRA	170,000		170,000
LTA	70,000		70,000
Medical Reimbursement	30,000		30,000
Tax (Rs)		97,500	75,500

Increase the Deduction Limit
The aggregate amount of deductions in savings schemes is proposed to be raised from Rs 1 lac (currently under Section 80C) to Rs 3 lacs.

Gross Income (Rs)	Existing Tax after Rs 1 lac Deduction (Rs)	Proposed Tax after Rs 3 lacs Deduction (Rs)	Savings (Rs)	Savings (%)
400,000	14,000	-	14,000	100
600,000	54,000	14,000	40,000	74
1,000,000	174,000	54,000	120,000	69
1,500,000	324,000	124,000	200,000	62
2,500,000	624,000	324,000	300,000	48
5,000,000	1,374,000	1,044,000	330,000	24

(Cess not taken into account while calculating the tax payable)

For example, an individual with an income of Rs 10 lacs will be able to save tax on Rs 3 lacs straight away by investing in prescribed saving instruments. The remaining income of Rs 7 lacs will attract tax of Rs 54,000 as compared to Rs 174,000 under the existing tax regime. This will result in savings of Rs 120,000 per year (an increase of 69%).

As is evident from the table above, the increase in tax slabs combined with the increase in the deduction limit will substantially boost the savings of individuals.

However, it should be noted that investments in equity-link savings scheme (popularly known as tax-saving mutual funds) and 5-year fixed deposit will not be exempt anymore.

Introduce the Exempt-Exempt-Tax (EET) structure
Investments in small savings like provident fund, life insurance etc will be brought at par with National Pension Scheme (NPS) i.e. they will be EET (Exempt-Exempt-Tax). This means the withdrawal amount will be taxed from April 1, 2011. The withdrawal amount will be clubbed with the individual's income and taxed as per the new slab mentioned above.

Grandfathering Clause: Withdrawal of any amount invested in retirement and superannuation schemes as on March 31, 2011 will not be taxed.

Relief on rollover: The rollover of money withdrawn from one account of the permitted saving to another will not be treated as withdrawal.

Small saving scheme such as Public Provident Fund (which offers an assured return of 8% p.a.) currently enjoys Exempt-Exempt-Exempt (EEE) status. Like this there are other schemes as well which are used by many individuals to achieve their long-term financial goals like retirement, children's marriage and education. Individuals investing in them will have to set aside more funds every year to build the targeted corpus. For example, an individual who wants a retirement fund of Rs 20 lacs after 15 years will now have to set aside Rs 1.66 lacs per year instead of Rs 1.38 lacs assuming he has to pay a tax of 20% on the withdrawal amount.

Scrap the benefits on home loans
This could come as a blow to many existing and prospective home buyers. The new Direct Tax Code proposes to scrap the tax benefit currently available on home loans.

The tax benefit on home loans is used to bring down the tax liability of an individual (who has bought a home on loan) to a great extent (i.e. upto Rs 1.5 lacs on home loan interest and Rs 1 lac on repayment of home loan). But the scrapping of the same would increase the tax liability of individuals.

If this happens as has been proposed, we recommend that individuals should consider making higher down payment and taking lesser loan.

Enhance the exemption limit for Wealth Tax
The limit for wealth tax will be increased substantially from Rs 30 lacs to Rs 5000 lacs (or Rs 50 cr). The rate of taxation will be reduced from 1% to 0.25%. The scope of wealth has been expanded to include more instruments like shares, mutual fund units and fixed deposit investments and house property including self-occupied house.

Inspite of these inclusions, very few individuals will have a net wealth of more than Rs 50 cr. Furthermore, many individuals who are currently paying wealth tax will move out from this ambit.

Simplify the Capital Gains taxation
Distinction Scrapped: The distinction between short-term and long-term capital gains tax will be scrapped. This means capital gains will be taxed irrespective of the investment horizon.

Indexation benefit: One year cap remains in order to avail indexation benefits. The same will be applied to houses sold after one year. The indexation base has also been proposed to be shifted from April 1, 1981 to April 1, 2000.

Rate of Capital Gains: The capital gains will be taxed as per the tax slab applicable to the individual.

Some exceptions: Capital gains will not apply to transfer of assets on partition of Hindu undivided family, gifts, transfer under an irrevocable trust, of any investment asset, other than sweat equity share

Here the crux is that investors will no more enjoy zero tax benefit on equities held for over one year.

Abolish the Securities Transaction Tax (STT)
Since the time STT was introduced, it has been an eyesore for many traders and investors investing in the stock markets. There has been a long standing demand to abolish the same, which in all probability may happen on April 1, 2011.

This would result in bringing down the transaction cost for investors and traders. Besides bringing smiles on the faces of traders, in our view it will also help in increasing retail participation in the stock markets.

MFs reduce the lock-in period

Impact

Following SEBI's order to cease entry loads on mutual fund investments, fund houses faced a massive drop in income levels. This triggered many fund houses to increase the period of holding, before which one has to pay exit load, from 6-12 months to 3 years. SEBI has asked mutual fund houses to reduce the lock-in period from 3 years to 1 year.

The increase in lock-in period was unfair to those investors who had invested in a poor performing fund and had no choice but to pay exit load to move out.

IRDA extends deadline for submitting PAN

Impact

The Insurance Regulatory and Development Authority (IRDA) has extended the deadline from August 1, 2009 to September 1, 2009 for collecting the Permanent Account Number (PAN) from customers purchasing insurance policies with annualized premiums of over Rs 1 lac. Furthermore, NRIs and people with only agricultural income are exempted from submitting the PAN as they have no assessed income under the IT Act, 1961.

This decision would relieve insured individuals who had applied for PAN card but are yet to receive it.

Surrender charges on Ulips banned

Impact

The IRDA has declared that there shall be no surrender charges on unit-linked insurance plans (Ulips) after 5 years, thereby leaving more money in the investors' hands. Investors will gain from this as policies withdrawn after the compulsory lock-in period (which is 3-years) are charged a percentage of the fund value.

However, to the delight of insurance companies, mortality and morbidity charges will be excluded from the overall cap on Ulips. IRDA had earlier stated that the overall charges including mortality and morbidity charges on Ulips will be capped at 3% i.e. the difference between the gross and the net yield to investors should not exceed 3% incase of insurance contracts less than and equal to 10 years and 2.25% for contracts more than 10 years.

Mortality (probability of death) and morbidity (probability of disability) charges increase with the age of the policyholders. This will increase the cost to the policyholders as they will now have to pay 3% plus these charges depending on their age.

They have also revised the fund management charges at 1.35% irrespective of the policy tenure. Earlier there were two caps for fund management charges, one below and one above 10 years.