Double indexation not available under New Direct Tax Code

As the Indian Income Tax Act (ITA) enters its last lap, making way w.e.f. 1.4.2011 for the new Direct Tax Code (DTC), investors should be careful of overlapping investments.

Overlapping investments are those where the ITA is applicable while making the investment, whereas it is the provisions of the DTC that will apply at the time of maturity.

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For example, take fixed maturity plans (FMPs) or close-ended schemes of mutual funds i.e. where the term of the scheme is fixed. A major selling point of such schemes now-a-days is the benefit of double indexation. The scheme is structured in such a manner that the term overlaps two financial years thereby affording the investor the tax advantageous double indexation benefit on long-term gains.

In cases where the scheme overlaps three financial years, even triple indexation is being offered. But did you know that under the DTC, this strategy of double indexation cannot be implemented?

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In other words, any investment made today keeping in mind the doubsle indexation benefit under the ITA will necessarily mature at a time when the DTC will be in force. And under DTC, double indexation is not available. Let's understand how and why.

Double indexation

Before discussing double indexation, it is necessary to understand the concept of indexation itself. For calculating capital gains, we reduce the cost from the sale value.

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For calculating long-term capital gain, such cost can be enhanced by the inflation multiple. For this purpose, CBDT releases the Cost Inflation Index (CII) during each financial year. The base year is 1981-82 for which the index is 100. The CII for FY 09-10 is 632. Let's examine a simple example to illustrate the use of the CII.

Therefore, instead of paying tax on Rs. 3,00,000 just on account of the indexation benefit, you get the option of paying tax on Rs. 2,56,455.

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Now, how do we use this principle in the case of FMPs? Like mentioned last time, FMPs are nothing but non-equity funds. Long-term capital gains on non-equity funds are taxed at the lower of 10% without cost indexation or 20% with cost indexation (as detailed above).

As mentioned earlier, double indexation is a neat trick where you hold an investment for a little more than one year but get the benefit of the index multiple of two years. How is this done? Consider the table for the 370-day FMP.

The FMP is for 370 days, exactly 5 days more than one year. However, check out the date of investment and date of exit. The entry date is March, 29, 2010, i..e FY 09-10. The date of sale is April 3, 2011, i.e. FY 11-12. By holding the investment a little into the next financial year, an investor can use the facility of the CII for two years. The rest of the table is self-explanatory.

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The CII usage boosts the cost beyond the sale price due to which the investor suffers a notional capital loss. Consequently, the entire maturity value is rendered tax-free.

The net annualised return remains at 7% without any tax incidence whatsoever. What's more, the long-term capital loss, which is notional and not actual can be set-off against any other taxable long-term gains of the investor thereby further reducing the overall tax liability.

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Change as per the DTC

In the above example, note that the maturity date is the April 3, 2011 i.e. FY 11-12 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. And this will change the tax impact.

Now though the DTC too offers the indexation facility, there is a significant departure from the ITA. Under the ITA, as can be seen above, the ratio of the Cost Inflation Index (CII) of the year of sale to the CII of the year of purchase is to be taken for cost inflation purposes.

However, under the DTC, it is the ratio of the CII of the year of sale to the CII for the financial year immediately following the financial year in which the asset was acquired that has to be adopted! 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. Let us see how the DTC will change the tax impact in the above example.

Note how under the DTC, a notional capital loss of Rs 5,243 turns into an actual capital gain of Rs 1,129. This is because the benefit of an extra year's inflation index is lost. In other words, under the DTC, double indexation turns into single indexation whereas cases of triple indexation will get converted to double indexation. At all times, the extra year's indexation benefit will remain unavailable.

Note that though for sake of understanding, we have linked the CIIs with the current levels where the base year is FY 81-82, DTC will take the base year as FY 2000-2001 when the CII will be 100.

To conclude

We are fast approaching the transitionary phase where one Act gets discontinued paving the way for a brand new law. This dual law applicability at the time of entry and exit will be applicable not only to mutual fund schemes but also to a host of other investments such as insurance plans, bonds and even to payments that earn tax deductions such as home loan installments and tuition fees.

Of course it must be mentioned that as yet the DTC is only in a draft stage and when it becomes operational, some of the currently existing provisions therein (including the above discussed ones) may or may not be applicable in their entirety.

However, as investors, we must be careful and make any investment with full knowledge of the facts.

Therefore before committing their funds for the long-term, investors should take care that the investments are tax efficient and in conformity with the proposed provisions of the DTC rather than the current ITA.

The authors may be contacted at wonderlandconsultants@yahoo.com