Magazine Expert Advice A N Shanbhag May 2000

Say Goodbye to Small Returns - A.N.Shanbhag

Now that the various draconian changes proposed by the new Budget have become known, it is time to check your investment plans in the new light. As the proposals by Mr. Yashwant Sinha has started taking shape there are many questions and investor may ask. Can he take any action to obtain maximum benefits from his reading of the budget? The answer is - Yes, quite a lot.

Say Good Bye to PPF

PPF was wearing the crown of the champion until FA96 extended the benefit of Section 88 to infrastructure-related Bonds of FIs, such as ICICI and IDBI. Ever since the advent of the Bonds, I have been screaming in high decibels that PPF has been dethroned by the Bonds, but only a few listened. PPF interest is tax-free whereas the interest on Bonds is covered by Section 80L.

The rebate is at the rate of 20% of contributions up to Rs. 60,000 of the aggregate contributions to some specified avenues (which include PPF as well as the Bonds). Additional rebate on contributions up to Rs. 10,000 is available from the Bonds. In other words, one can earn full advantage by contributing Rs. 70,000 to the Bonds.

Why are the Bonds better than PPF? The advantage accrues from the lock-in period of only three years, least among all avenues under section 88. This helps you adopt a strategy - Buy Bonds worth Rs. 70,000 for three successive years. In the fourth year, sell the Bonds purchased in the first year, invest the capital gains under section 54EB to save tax on it and invest the capital amount in similar Bonds under section 88 for the fourth year. Repeat this process for subsequent years. You require only Rs. 2,10,000 for earning the full tax rebate during your entire life span. Excellent? No, more than excellent!! I am grateful to the authorities for reducing the interest rate on PPF from 12% to 11% w.e.f. January 15, 2000. I hope this will prompt those who have not yet contributed fully under section 88 to switch over to the Bonds. Those who have already fulfilled their quota should switch over to the Bonds from next year.

Partial Withdrawal from PPF

Cutting down the rate is the prerogative of the authorities, but I strongly feel that they should have maintained the 12% rate on the current balance and applied the new rate only to the fresh deposits. But in such a situations, all the investors should shift over to the tax-savings Bonds. No, not as a protest, but in recognition of the fact that Bonds have succeeded PPF long ago and now, they are the best.

If and only if the investor was savvy in the art and science of investment, and took on-line actions to shift to the greener pastures, the authorities would not have tinkered with the interest rate on bank deposits, leave alone PPF. But is there anything better than the Bonds?

Better than the Best?

Contributions to Equity-Linked Tax-Saving Schemes (ELSS) attract tax rebate under section 88 with a sub-ceiling of Rs. 10,000, within the overall ceiling of Rs. 60,000. The investor had written (ELSS) off from his portfolio because of the lacklustre condition of the equity market for a record period of over five years. It is high time they begin to have a good, close look at them once again. The market is witnessing a massive boom for the last one year and the good old happy days are back again.

Then again, from December 1998, the government has permitted MFs to have open-ended ELSS, subject to the condition that an MF will have only one such scheme. Earlier, the ELSS was required to be a close-ended product, with a term of 10 years and a lock-in period of three years. Yes, a lock-in of three years, the same as the Infrastructure-related Bonds! Have a look at the Table below charting the performance of some of such schemes which I fancy.

Yes, investment in ELSS is associated with market-related risk and those who have some appetite for this risk should unhesitatingly go in for them. ELSS today has emerged better than the Bonds.

Dividend Tax

The long-standing demand of all and sundry to abolish double taxation on dividends from equities was granted by FA97. It simultaneously slapped a dividend tax of 11% (10% plus surcharge) on dividends declared, distributed or paid by a domestic company. This was not fair. Evidently, the exchequer will collect more tax by applying this 'tax-free dividend' ruse than what it used to and also save the cost of collection and litigations. FA99 extended this so, called benefit to UTI/MFs. However, exemption from payment of this dividend tax has been granted upto March 31, 2002 to US-64 and all open-ended schemes of UTI/MFs having over 50% of their portfolio in equity. All close-ended schemes, equity-based or otherwise and open-ended debt-based schemes suffer the dividend tax. Taxing UTI/MFs is tantamount to triple taxing - Normal rate of 38.5% charged to the company tax of 11% on dividends paid to UTI/MFs 11% tax on the dividends paid by UTI/MFs.

FA2K has dropped a bombshell. This dividend tax has now been raised to 22%!

This amendment will come into effect from June 1, 2000. The investor can employ a nice strategy to bypass this draconian tax. Earn income through capital gains. Opt for growth and not dividend. After a holding period of one year, any withdrawal therefrom will attract the benefit of the concessional tax on long-term capital gains. But what does this mean?

Suppose you invest Rs. 1,00,000 and it grows to Rs. 1,12,000 (12%) at the end of one year. This is long-term growth and there is benefit of indexation plus the concessional flat tax rate of 22%, irrespective of the size of the fund.

Now, suppose you withdraw only Rs. 12,000 at the end of one year. The capital component of this Rs. 12,000, that is Rs. 10,714 (= 12000 x 100000 / 112000). The capital gain is Rs. 1,286. If this is short term capital gain the tax there on at the rate of 34.5% (the Budget has increased the surcharge from 10% to 15%) will be Rs. 443 if you are in the highest tax bracket. This works out at 3.70% on Rs. 12,000 withdrawn.

However, if this is long-term capital gain, the tax will be negligibly low. This year, the cost inflation index is 389 while it was 351. Assuming the index grows at the same rate in the future, the indexed cost would be Rs. 11,874 (=10714 x 389 /351). This results in capital gain of only Rs. 126. The tax thereon is flat at the rate of 22%, irrespective of the size of the gains. This works out at Rs. 28. In effect, you will be earning Rs. 12,000 and paying a tax of Rs. 28. Finally, even this small tax can be saved by investing Rs. 28 in an avenue under section 54EC. (The budget has withdrawn section 54EA and EB).

The growth option allows you to write your own dividend cheque. If necessary, you can write monthly cheques and convert the growth scheme into a tax-free 'Monthly Income Plan'!

To recap, if you desire to invest in US64 or any of the open-ended equity-based or Balanced schemes of UTI/MFs, opt for dividend. If you desire to invest in debt-based UTI/MF scheme, opt for growth.

Avoid, but do not evade the dividend tax.

Before Bidding Bye

The Budget has withdrawn the two sharpest edges which cut the tax on long-term capital gains most effectively Sectins 54EA/EB. These have been replaced with Bonds issued on or after April 1, 2000 of NABARD or NHAI with a lock-in of five years. These Bonds may have quite a blunt edge. Section 54EA as well as EB are in existence for capital gains earned before April 1, 2000. If you have units of UTI/MFs with a holding period of over a year, you may sell them merely to book long-term capital gains and save the tax thereon by investing in Section 54EA or EB, (within six months of sale) depending upon the proportion of the gains. You may use the same strategy in respect of shares, especially if you are in the demat mode.