No more double benefits?

The Direct Taxes Code, if implemented in its present format, could change the way of calculating double indexation.

As the Income Tax Act (ITA) enters its last lap, making way from April 1, next year for the new Direct Taxes Code (DTC), investors should be careful of overlapping investments. Such investments are those, where the ITA is applicable when making the investment, whereas it is the DTC that will apply at the time of maturity.

For example, take fixed maturity plans (FMPs) of mutual funds. A major selling point of such schemes is the benefit of double indexation – the scheme is so structured that the term overlaps two financial years. Under the DTC, this strategy of double indexation isn’t available.

First, let’s understand the concept of indexation. For calculating the gains/loss, we reduce the cost of acquisition from the sale value. The tax payable is either a flat 10 per cent on gains or at 20 per cent taking inflation into account. For the latter, the Central Board of Direct Taxes releases the index figures for each financial year. Such an index is known as the Cost Inflation Index (CII). The CII for FY 10-11 is 711.

In case of FMPs, double indexation is a neat trick, where you hold an investment for a little more than a year but get the benefit of the index multiple of two years. How is this done? Consider the table (DTC Effect) for the 370-day FMP.

The FMP is for 370 days, exactly five days more than one year. However, check out the date of investment and date of exit. The entry date is March 29, 2011, that is, financial year 2010-11. The date of sale is April 3, 2012, that is, financial year 2012-13. By holding the investment a little into the next financial year, an investor can use the facility of the CII for two years. The gains turn into long-term capital loss after indexation is considered. Consequently, the entire maturity value is rendered tax-free.
 

DTC EFFECT
	FMP - 370 Days (under ITA)	under ITA	under DTC
A	Investment date	March, 2011	March, 2011
B	Investment amount	Rs 1,00,000	Rs 1,00,000
C	Yield	8.50%	8.50%
D	Maturity date	2-Apr-12	2-Apr-12
E	Maturity amount	Rs 1,08,621	Rs 1,08,621
F	Inflation index for FY 10-11	711	711
G	Inflation index for FY 12-13 (at 7%)	814	760
H	Indexed Cost of Acquisition (B*G/F)	Rs 1,14,487	Rs 1,06,892
I	Long-term capital gain / loss (E - H)	Rs (5,866)	Rs 1,730
J	Tax payable @20.6%	-	Rs 356

However, in the above example, note the maturity date is April 3, 2012, that is, financial year 2012-13, when the DTC will be operational. So, though at the time of investing, it was the ITA that was applicable, at the time of maturity, the DTC will apply. This will change the tax impact. DTC also offers the indexation facility, but the taxpayer cannot consider inflation in the year the asset was purchased. Rather, it allows investor to consider indexation from the subsequent financial year onwards. In other words, in the denominator, instead of the CII pertaining to the year of purchase, the CII pertaining to the year after the year of purchase has to be taken.

This small but significant modification basically makes the entire double indexation concept redundant, as you can see in the table.

This dual applicability at the time of entry and exit will be applicable not only to mutual fund schemes but also to investments such as insurance plans, bonds and even to payments that earn tax deductions, such as home loan and tuition fees. Therefore, before committing their funds for the long term, investors should take care that the investments are tax-efficient and in conformity with DTC, rather than the current ITA.

The writer is Director,Wonderland Consultants