Sec 88 investments may be taxed at the end of term

MUMBAI/NEW DELHI: A change in the taxation structure on savings instruments could well benefit investors in the short and medium term, but could hurt in the long run.

Along with the proposed restructuring of income-tax slabs, the government is looking at having two parallel methods of tax treatment on savings instruments.

This means all contributions, accumulations and withdrawals in a savings plan like the public provident fund, the government provident fund, other provident funds and insurance policies up to a particular cut-off year, could be tax-exempt at all stages. Alongside, after the end of the cut-off year, say, for instance after the end of this fiscal, all withdrawals would be taxed.

Currently, investors are not taxed at all three stages — contributions to a long-term savings plan, the interest earned on the scheme or accumulations, and finally on withdrawals.

According to officials, this option of a change in tax treatment could be exercised if the government is unable to fully eliminate the tax rebates under Section 88 of the Income Tax Act for a range of savings instruments, which include the popular PPF, the government provident fund, other provident funds and insurance policies.

In one of the options being considered, investors may continue to enjoy tax benefits on fresh contributions made in these instruments in the initial years. The benefit could be in the form of a deduction which could even be more than the 15% rebate currently available under Section 88. Since a deduction from taxable income would be allowed, the benefit could go up to 30% as this would be the tax rate on income in the highest tax slab from which the investment is reduced.

The blow would come later as investors may have to pay tax at the time of withdrawals. In technical parlance, this method of taxation is termed as ‘Exempt Exempt Tax (EET)’. The ostensible aim is to remove the distortions related to investments made only for securing tax benefits. This would prevent premature withdrawals.

Currently, investors enjoy a tax rebate under Section 88 for investing in these savings instruments. A 20% rebate is available under Section 88 for those with a gross total income up to Rs 1.5 lakh. for those with a gross total income of between Rs 1.5 lakh and Rs 5 lakh, the rebate is 15%. They would not have to pay tax at the withdrawal stage also since contributions, accumulation and withdrawal are exempt.

The aim is to freeze accounts of investors on the contributions made up to a specified period. Two accounts would be operational — the first account (or the existing account of, say, PPF) where the final receipts up to a particular cut-off year, say, the end of this fiscal, are tax-free. There would be a second account with a different tax treatment, where the maturity amount received on all these long-term savings schemes would be taxed on withdrawal.

Senior officials said that such a proposal was considered during the ’04-05 budget too. “It was deferred then because there was not much clarity about reforms in the pension sector,� said a senior official.

Under the new pension scheme, tax would be levied at the time of withdrawal. With greater clarity now on pension reforms, the government may set the ball rolling for a two-tier system. This would automatically mean phasing out the tax rebate under Section 88.

Officials admitted that there were administrative complexities in running two accounts. “Post offices, the EPFO, pension fund managers and LIC need to have systems in place to run two parallel accounts for each investor,� said an official.