The revised discussion paper (RDP) on the direct taxes code (DTC) contains some provisions especially related to the proposed exempt-exempt-taxed (EET) method of taxation that would come as welcome relief to taxpayers. For those who are new to this entire concept of EET, it is a tax system where an investment in a tax-saving plan is deductible from income. So also is the interest earned. However, the maturity amount is taxable. This is in contrast to the current EEE system where investment, interest and the maturity amount is tax-free. A case in point is the Public Provident Fund (PPF). So it was no surprise that the impending tax on PPF and company provident fund (PF) balances was causing major apprehension and anxiety among taxpayers. Though DTC had provided for a grandfathering clause, it was deemed woefully inadequate.

As per the original provisions of the DTC, the withdrawal of any amount of accumulated balance in PPF/ PF as on March 31, 2011 was not to be subjected to tax. However, new contributions as well as accretions on or after the commencement of the DTC (April 1, 2011) would be subjected to the EET method of taxation. And as anyone who has a PPF account knows, as per the rules, the entire PPF balance cannot be withdrawn at one go except on maturity. So for most investors, only a part would have remained tax-free, all interest and accumulations post March 31, 2011 would have been taxable upon withdrawal or maturity.

Now, in what would be heartening news for all concerned, the RDP specifically states that PPF and PF would continue to remain tax-free even under the new DTC. Also, any investments made before the date of commencement of the DTC, in instruments which enjoy EEE method of taxation under the current law, would continue to be eligible for EEE method of tax treatment for the full duration of the financial instrument. Read the last mentioned provision again if you will - investments made before the commencement of DTC would continue the current tax treatment of EEE for the full duration. This has enormous implications for investors and this forms the main subject matter of this week's article.

For example, take bank fixed deposits (FDs) that offer the Section 80C deduction. Though the nominal return from a tax saving FD, per se, seems low, the real effective rate is much higher. In case of individuals who fall in the 30% tax bracket, the effective return is as high as 12.70% pa!

This is primarily because of the tax deduction. Remember that the initial investment saves you tax. And since a penny saved is a penny earned, the saving in tax payable works akin to having invested that much lesser in the first place. For example, let us assume that an individual deposits Rs 1 lakh in a fixed deposit under Section 80C and he is in the 30% tax bracket. What this means is that because of his investment, his tax outgo will be lower by Rs 30,000 (Rs 1 lakh x 30%). Or in other words, he will be receiving an interest of Rs 7,500 (7.5% of Rs 1 lakh) on an outlay of just Rs 70,000 (Rs 1 lakh - Rs 30000). This, as we shall see, jacks up the effective return.

It is assumed that a deposit of Rs 1 lakh is made on January 1, 2010 (see table). The deposit matures after five years i.e. on December 31, 2014. Interest is payable @7.5% on a half yearly basis. The depositor has opted for reinvestment of interest option and hence, interest is not paid out and accumulates. The second column specifies the interest earned every six months, the third column contains the post tax interest and the last column contains the cumulative deposit figure for each half year.

This is very similar to National Savings Certificate as far as the structure is concerned. In case of NSC VIII, the interest accumulates and is not paid to the investor every year. The interest that accumulates is treated as invested in NSC VIII. Hence, it qualifies for an exemption under Section 80C for the first five years. In the last year, the interest is handed over to the investor and does not qualify for a deduction and therefore, is taxable. Tax experts are of the view that if the investor opts for a reinvestment of interest option in case of fixed deposits, the accumulated interest should also be eligible for a tax deduction under Section 80C as it is in case of NSC VIII. However, since there is no clarification from the tax authorities on this issue, in the example, the interest is treated as fully taxable.

An initial investment of Rs 70,000 (as explained earlier), grows to Rs 1,29,578. Consequently, the effective return works out to be 12.70% pa. This is for the 30% tax slab. For the 10% and 20% tax slab, the return works out to be 14.25% pa. and 13.48% pa respectively! These numbers should make even those investors who reject fixed income investments for potentially higher returning equity-oriented products sit up and take notice. Because, this is like saving tax and getting paid for it.

At a time when there is a dearth of good fixed income avenues to invest in, the tax-saving fixed deposit with its high effective rate could prove to be extremely useful for the fixed income allocation in your portfolio. However, this window will be open only till the end of the current fiscal year - from April 2011 the DTC is slated to be operational and once that happens, EET would be applicable on any fresh investment in this instrument. However, as explained above, so long as the initial investment has been made before the advent of DTC, the maturity amount will continue to be tax-free even in the DTC regime. So do make hay when the sun shines.

Source: DNA Money