Tax-saving fund investors need not fear new code

Ordinarily, we would just now be getting into the time of the year when fund investors would be turning their attention to tax-saving funds. However, this year, there appears to be less enthusiasm for such funds and the fault seems to lie with the confusion caused by the draft of the Direct Tax Code. This is unfortunate and arises from a mistaken notion about what changes are impending and when. Fund investors should understand the issues involved and make the right decision.

During the past three months, fresh inflows into tax-saving funds are actually less than what they were last year, even though we were in the thick of a stock markets crash last year. Not just that, these inflows are just about half (Rs 434 crore; down from Rs 821 crore) compared to the year before that.

According to current tax laws, investments made into tax-saving mutual funds (and some other asset types) are
exempt from taxation under Section 80C. As with all tax-savings investments, these exemptions follow the so-called EEE principle. EEE stands for exempt-exempt-exempt and signifies that all three stages of the tax-saving investments — the initial investments, the returns earned and the eventual withdrawal are exempt from taxation.

The draft Direct Tax Code that the government has announced incorporates a change in this principle. According to the draft, when the new code comes into effect in 2011, tax-saving investments will be subject to the EET principle. The last T means that the eventual redemption of the tax-saving investment will be taxed. Under the EET principle, tax can only be deferred and not avoided.

Based on what I hear from investors and fund companies, it seems that people are under the impression that savings made into tax-saving funds this year will be taxed. The idea is understandable. Since these investments have a lock-in period of three years, they will only be redeemed after the new tax code comes into effect. The fear is that when money is withdrawn from these investments, it will be taxed.

This idea is misplaced. It is quite clear that the old and the new tax regime will be isolated from each other. The new tax laws will be so radically different in principle and practice from the old ones that it seems impossible for one part of a tax-saving transaction to be done under one system and another under the new. Nowhere in the new tax code does it say that the treatment of the old tax-exempt savings made under the existing law would change.

Moreover, the draft Direct Tax Code is just that yet — a draft. Based on what one hears, there will be changes in it before it is actually made into a law. Basically, the new law is vastly simpler to understand than the old one and complying with it would be a straightforward job. Meanwhile, investors have no ground to be apprehensive about tax-saving funds. These funds remain one of the best ways of saving on tax, and investors should certainly include them in their plans.