The Hindu Business Line : A tax leg-up for bank deposits

Tax incentives for savings have always been controversial. Section 80C of the Income-Tax Act, 1961 provides for deduction in respect of over 26 saving instruments such as Life Insurance premium, contributions to Provident Funds and subscriptions to certain equity shares or debentures. Several committees have taken the view that there is no strong empirical evidence to support the hypothesis that tax incentives lead to increased financial savings at the macro level. The Kelkar Committee suggested elimination of `directed' savings in specific instruments. According to the committee, what may be "micro rational" for individuals has become "macro irrational" for the economy.

Bank FDs under Section 80C

The Finance Act, 2006 inserted a new Clause (xxi) to section 80C(2) of the I-T Act with effect from the Assessment year 2007-08.

Term deposit for a fixed period of not less than 5 years with a scheduled bank will now be eligible for deduction in the computation of income, subject to the overall ceiling of Rs 1 lakh under Section 80CCE. Section 80CCC is also amended so as to increase the limit of contribution to the pension plan to Rs1 lakh. Sectoral caps for various financial instruments stand removed.

The idea in bringing bank deposits within the ambit of Section 80C is to provide a level playing field among banks and other institutions such as insurance companies and mutual funds.

The 2005 Budget removed the exemption of Rs 12,000 for interest from bank deposits under Section 80L.

Instead of a separate exemption for bank interest, hereafter, the contribution to bank FDs will be eligible for straightforward deduction from gross total income.

It should be noted that interest income from bank deposits would be taxed at the appropriate rate.

Term versus time deposits

Deduction is available for a term deposit for five years in a scheduled bank. There is no statutory definition to indicate the meaning of "term deposits". The RBI's master circulars define it thus: "Term deposit means a deposit received by the bank for a fixed period and which is withdrawable only after the expiry of the said fixed period and shall also include deposits such as Recurring/Cumulative/Annuity/Reinvestment Deposits/Cash certificates and so on."

Since the income-tax law does not have a definition, the RBI's can be safely taken as correct. Section 194A Explanation 1 has a definition of the term "time deposits" to mean deposits repayable on the expiry of fixed period and excludes recurring deposits. This definition is given for the specific purpose of Tax Deducted at Source on interest income. This may not be applicable under Section 80C.

The RBI's definition includes a recurring deposit also among term deposits. Several issues need to be clarified: Investment in FDs of scheduled banks will qualify for deduction if it is for a period of not less than five years. What happens if the deposit is withdrawn before the end of the term? Under the NSC (VIII Issue) Rules, 1989 interest accrued at the end of each year up to the end of the fifth year shall be deemed to have been re-invested and aggregated with the amount of face value of the certificate. Will this rule apply to cumulative and reinvestment deposits of banks?

The exemption is available for deposits made in banks on or after April 1, 2006. Is it open to depositors to foreclose the deposits made in the earlier years and opt for fresh deposits to avail themselves of the exemption? Can the depositors take loan on the Security of FD?

The Central Board of Direct Taxes will have to clarify these issues when Rules are framed under Section 80C. It would have been better if the Section itself had clarified these matters.

A welcome change

The new exemption conferred on investments in bank FDs should be welcome. If the rate of interest on bank FDs is 6 per cent per annum and the taxpayer is in the 30 per cent tax bracket, the tax-adjusted effective return will be 8.56 per cent. It will be 7.5 per cent if the marginal rate of tax is 20 per cent.

Mutual funds garnered assets of over Rs 2,30,000 crore up to March 31, 2005. According to recent surveys, the middle-class has a penchant for investing in bank FDs. The latest tax incentives will make them even more attractive and provide a rival platform for mutual funds. The amendment applies only to deposits in scheduled banks. Deposits in co-operative banks have been excluded from this benefit.

The various financial instruments available for tax saving have different periods of maturity and lock-in periods ranging from three to15 years. It has rightly been pointed out that the risk profile is different for each instrument and ad hocism characterises the approach of the Government in this matter.

There is no level playing field among the various financial instruments. The rate of return also varies.

And, finally, the Damocle's Sword of EET (exempt exemp tax) hangs over the tax incentives for bank FDs. Will the whole amount be taxed at a later date on maturity if the EET regime comes into operation next year? Depositors will have to be on guard.

(The author is a former Chief Commissioner of Income-Tax.)

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