EET Model of Savings and Taxation

[Dr. Sanjiv Agarwal]

Domestic savings are crucial to both, national economy as well as the persons who save, more so in times of recession. This has proved once again to be true, as India has by and large been insulated by the present economic slowdown, due to savings only, unlike many western countries.

Savings are generally made from taxable income, which has already been subjected to tax provisions. There are certain savings which, if made enjoy exemption from taxation. Not only this, the income or returns arising from such savings or investments are also exempt from tax and when such savings are redeemed on maturity, they are not subjected to any income tax. Thus, such amounts of savings are never taxed at any pint of time. Such a situation works on a model of exempt- exempt-exempt (EEE). An investment in provident fund or public provident fund or national savings certificate are typical examples of EEE model, at  present.

Investment in Future

Type	Investment	Returns	Withdrawals
PPF	Exempt	Exempt	Tax
NSC	Non Exempt	Tax	Tax
Term Deposit	Non exempt	Tax	Tax
Insurance	Exempt	Exempt	Tax
ULIPs	Exempt	Exempt	Tax
Pensions	Exempt	Exempt	Tax
Gold ETF	Non exempt	-­	Tax

This may not be so in future. Direct Tax Code envisages to shift to yet another model, exempt-exempt-tax (EET) from April 2011, as is the international practice for the purpose of taxation of savings. The first E indicates that original investment or contribution is exempt from tax. The second E indicates that returns or income or accumulation on the investment are also exempt from tax. The T indicates that all redemptions or maturity amount or withdrawals are subject to tax. Thus, effectively any amount will be taxed at least once, if not at the time of investment, then at the time of redemption.

EET is considered a fair and equitable way of taxation of savings as it encourages savings and at the same time, follows progressive approach for taxation. While withdrawals at the end do not actually represent the income of that year, it taxes the income of the year when investment was made at a deferred date (at the time of withdrawal). Under EET, what is supposed to be taxed at the time of withdrawal is both, original investment and accumulated income. So long as investments are made from taxable income, its fair but distortion shall creep in where such investments are made from non-taxable or exempt income. In effect what was not taxable at the time of investment also gets taxed at the time of withdrawal. Also, where investment is made out of income within basic exemption limit (Rs 3 lakh) in future, inequity will creep in when such investment is taxed on withdrawal. In such a case, EET model may lead to double taxation and create inequity and regression between two tax payers.

The following table provides  various tax models -

Model	Investment	Returns	Withdrawals	Example
EEE	Exempt	Exempt	Exempt	PPF, insurance
EET	Exempt	Exempt	Tax	New Pensions Scheme
ETT	Exempt	Tax	Tax	Tax saving bonds/DDB
TTT	Tax	Tax	Tax	N.A.
ETE	Exempt	Tax	Exempt	Capital gain bonds

The Code  has clarified on the taxation of accumulated balance of savings as on 31^st March, 2011 that such amount shall not be subject to tax. Only contributions on or after 1.4.2011 will be subject to EET method of taxation. So existing investors need not worry on the tax issue of present investments. Also, rollover of any amount from one scheme to other scheme will not be treated as withdrawal and hence not subject to tax.

The income from residuary sources will include the redemption or withdrawal of the principal amount from any investment that is eligible for deduction in computing the total income. However, with drawls or redemptions from provident funds and pure life insurance polices will not be included.

The code also introduces the concept of savings intermediary. Based on the aforesaid EET Principle, the code provides for deduction in respect of contributions (both by the employee and the employer) to any account maintained with any permitted savings intermediary, during the financial year. This account will be required to be maintained with any permitted savings intermediary in accordance with the scheme framed and prescribed by the Central Government in this behalf. The permitted savings intermediaries will be approved provident funds, approved superannuation funds, life insurance and the New Pension System Trust. The accretions to the deposits will remain untaxed till such time as they are allowed to accumulate in the account.

The permitted savings intermediaries would be required to be approved by the Pension Fund Regulatory and Development Authority (PFRDA). These intermediaries will, in turn, invest the amounts deposited with them in government securities, term deposits of banks, unit-liked insurance plans, annuity plans, bonds and securities of public sector companies, banks and financial institutions, bonds of the other companies enjoying prescribed investment grade rating, equity linked schemes of mutual funds, debt oriented mutual funds, equity and debt instruments. The choice of instruments will, in some schemes, be with the investor and in some others with the trustees of the schemes.

Thus, EET is going to be the most significant change for investments in approved provident funds, superannuating funds, public provident  funds,  life insurance and new pension scheme. This may also change investments and saving pattern in future as people may shift to short term investments or to market related investments.