Direct Tax Code: What does it mean to tax savers?

(Source: www.investmentyogi.com)

The Direct Tax Code (or DTC) has recently been proposed by the Government of India, to bring about a change in the whole taxation system of the country. The new tax code aims to make the system more efficient and easy for tax payers, with simplified rules and regulations. It is a step towards replacing the four decade old Income Tax Act of India.

The new DTC would impact both individuals as well as corporate with changes in taxation slabs, Public Provident Funds, insurance policies, home loans, mutual funds and shares.

Drafts of the DTC

The first draft: The Finance Minister floated the first draft of the DTC in August 2009 and kept it open for public comments. Here is a peek on a few of the proposals made in the first draft:

• Proposal to exempt tax if income is Rs 1.6 lakhs in a year. The tax slabs further would be 10 per cent from Rs 1.6 lakhs to Rs 10 lakhs, 20 per cent between Rs 10 lakhs and Rs 25 lakhs, and 30 per cent above Rs 25 lakhs
• Deduction levels for savings raised to Rs 3,00,000
• Wealth tax to be levied on wealth over Rs 50 crore
• Proposal of a uniform corporate tax rate of 25 per cent
• Securities transaction tax abolished

The revised draft of the DTC

Further to the 1,600 comments received, the second draft of the DTC was floated recently. It brought certain changes in retirement schemes, home loans and capital gains, to name a few.

DTC revised draft: What it offers investors

The second draft of the DTC is much simpler and offers investors a whole deal of exemptions, unlike the first draft. The revised draft was aimed towards promoting long term savings.

Capital gains tax

Equity: Investments in shares and equity based mutual funds would now be taxed using a new concept of 'Deduction' instead of the earlier Indexation method.

Certain deductions will be applied to long term capital gains of one year and above. This would be a percentage of the profits earned.  After the deductions are made, the balance amount would be added to the income and then taxed at applicable rates. Currently there is not much clarity on the percentage of deduction. Also, the holding period of shares, as of now, will be one year, from the end of the financial year, when the shares were bought.

For short term capital gains of less than one year, the entire amount will be included as a part of the income and taxed at applicable rates.

Debt, gold and real estate: Capital gains of less than a year, from gold, gold ETFs, debt and real estate investments would be added to the  taxable income, and normal slabs would apply. For all capital gains of more than a year old, gains will be added to the taxable income after adjusting for indexation benefit.

The base date for indexation values would however now be shifted to April 1, 2000 instead of the earlier April 1, 1981.

Life insurance policy, pension or annuity plans and provident funds

All pure life insurance policies, pension or annuity plans, PPF and EPF would come under 'EEE' and not 'EET' structure. This means that it would be completely tax free.

Understanding 'EEE' and 'EET'

EEE: Amount invested or contributed would be 'Exempt', the returns or the interest generated would be 'Exempt' and lastly the final maturity amount would also be 'Exempt' from tax.

EET: Amount invested or contributed would be 'Exempt', the returns or interest would be 'Exempt', but the final maturity amount would be 'Taxed'.

This proposal of EEE status for all retirement products would prove beneficial to pensioners and senior citizens. The first draft of the DTC included such schemes under 'EET' Status.

ULIP's and endowment plans

The DTC includes ULIPs and endowment plans under EET. The money received on maturity from such plans would now be taxed.

Tax on rental income: Tax would be applicable only on the actual rent received for the house. So, if there is no rental income earned, no tax is to be paid.

Earlier, it was proposed that tax was to be paid even if your house was not rented, by considering a notional rental amount.

Home loans: The interest on home loans would be exempt up to Rs 1.5 lakhs. However, the principal portion would now not be covered under section 80C. The first draft had proposed to remove all tax benefits on home loans, both on the principal and the interest. This has now been changed, bringing a relief for all home loan borrowers.

The crux of the DTC is to introduce moderate levels of taxation, expand the tax base and check tax evasion. There is however some areas which still require clarity.

The actual bill is still to be introduced in the parliament, and by this time we may probably see further amendments. It is expected to come into being by April 2011.

How to find the real value of property !!

Any investor (buyer or seller) can optimize his taxable profits from real estate transactions with proper tax management. What one needs to do is work out the cost of purchase, the sales consideration and consequently the taxable profits.

The first thing to work out is the difference in tax treatment for long-term and short-term capital gains (profits).

If the asset has been held for more than 36 months before sale, the profit is considered as long-term. Short-term profits are added to the individual's other income and taxed at appropriate rates. While computing long-term profits, indexation is allowed on the cost of acquisition.

Typically, capital gains are computed as under:

1. For net sale proceed deduct some costs from sale value. Sale value: Rs 50,00,000. Other charges: sale brokerage (Rs 1,00,000), incidental costs (say, lawyers' fees, Rs 10,000), transfer fees paid to society (Rs 10,000) and donation to society for transfer of flat (provided it can be shown that the society charges this donation as a matter of policy). Total: Rs 1,20,000. So, net sale would be Rs 48,80,000.

2. Deduct the following from the net sale proceed: cost of acquisition and improvement (for short-term profits) / indexed cost of acquisition and improvement (for long-term profits) = Rs 19,60,000 (assumed purchase price after indexation).

Add all the charges listed in the point above paid at the time of acquisition, for example brokerage paid then of, say, Rs 20,000. So, the capital gains would be Rs 30 lakh (48,80,000-19,80,000) 'Cost of improvement' would include major alterations carried out subsequent to the year of buying but not routine repairs and maintenance.

All the above deductions need proof so keep all bills or vouchers safely even if the purchase was made years back.

There is a perception that, in real estate transactions, some payment may be paid or received as unaccounted money and, hence, not recorded in the agreement. This reduces the real value and thus, the related stamp duty and income tax.

To curb this, many state governments have introduced the Ready Reckoner Index Value for calculating stamp duty. Under this, an RRIV is prescribed locality wise and is revised periodically.

The stamp duty is levied based on the RRIV, irrespective of the value mentioned in the sale agreement, which may be higher or lower than the RRIV.

At times, this can create tremendous hardships. In practice, the RRIV may not reflect the actual market rates in the locality or even of different locations in the locality. This became obvious in the recent past, when the RRIVs were not revised downwards though property prices were depressed.

In case the RRIV is higher, paying the additional stamp duty won't end the matter as the Income Tax Law (Section 50C) also adopts a similar concept. In other words, tax would have to be paid on sale profit based on the RRIV and not the actual profit. This means the seller pays tax on profits or income he hasn't earned.

Therefore, where the actual transaction value is below the RRIV, the parties should apply to the stamp act authorities for adjudication of the property's value giving full explanation.

In case you haven't got the value adjudicated and have paid the stamp duty as per the RRIV, the seller can still avoid Section 50C by requesting the tax officer to refer the matter to the valuation officer (VO).

When the VO visits, the reasons for the lesser consideration can be explained. If the fair market value (FMV) determined by the VO is lesser than the RRIV, the tax officer has to take the FMV as the correct figure. But, if the FMV is more, the RRIV stands.