ELSS - A good tax planning instrument

ELSS - A good tax planning instrument

June, 2001

Many believe that two months into the new financial year is perhaps too early to worry about tax planning. This belief can be harmful, particularly for those planning to invest in Equity Linked Saving (ELS) Schemes of Mutual Funds. ELS schemes offer tax rebate under Section 88 for an investment upto a maximum of Rs 10,000. These schemes typically invest atleast 80 per cent of their corpus in equities and carry a three-year lock-in period. The unitholder is free to redeem his holdings once this lock-in expires at a price based on the Net Asset Value (NAV).

Timing can be advantageous. Since ELS Schemes invest primarily in the equity markets, timing can be a distinct advantage for any investor. At a time when equity markets are down, exposure can be made to these schemes to lower holding cost. Thus, an investor can put in money in these schemes even at the beginning of the financial year if, in his opinion, the equity markets at that moment present a good investment opportunity.

For instance, many analysts feel that the current downtrend in the equity markets presents a good opportunity for those intending to use ELSS for tax saving purposes. The first advantage of ELSS is that these carry a lock in of just three years compared to a much higher lock in other options like PPF, NSC and Life Insurance Policies among others. Moreover, in ELS Schemes the lock in period commences from the very day the money is invested on. So, for money invested on 10 April 2001, the lock in period will come to an end on April 9, 2004. The lock-in is, therefore, independent of financial year squabbles.

The situation turns even more advantageous when the concerned ELS schemes decides to distribute a dividend or bonus during the lock in period. Dividends distributed and the units credited in the event of a bonus declaration are not covered by the lock in clause. Thus, an investor can, in these schemes, get back a portion of his money invested even during the operation of the lock in period.

There is however a catch to this. Claiming dividends in these schemes is extremely beneficial presently as all dividend distributions from open-end equity funds are not charged with any distribution tax. This advantage will be mitigated once dividends from these funds are taxed. As per the existing provisions the 'no distribution tax' status of such funds will continue only till the end of this financial year.

The third advantage is that this investment comes with greater transparency. Mutual Funds are, by law, required to disclose their portfolio to their unitholders. It is therefore easy for the investor to monitor how his investment is doing. Another advantage is that these schemes carry an upside potential as they invest in equities. Most other tax saving alternatives carry a fixed rate of return. Also, like other tax saving instruments this route too offers the flexibility of investing regularly in small amounts. This can be done through systematic investment plans of these mutual fund schemes.

However there are drawbacks too. One of the most important drawbacks of ELS Schemes is that there is no assurance of even any base level of returns. This is because these funds invest in the equity markets which, as we all know, can fluctuate wildly. However, the long-term investment horizon of this fund does help in lowering the risk on this front.

But a smart investor can choose well keeping in mind the following parameters. Scrutinise Past Performance: While past performance is no assurance that a scheme will do well in the future, it is a good indicator of its future potential. Choose the correct option: Many ELS Schemes offer a choice between dividend and growth options. Choosing the dividend option will make an investor eligible to receive dividends from the scheme which, if declared during the lock in period, serve to reduce the total capital locked in. However, once dividends from these funds are made taxable, one will need to re-examine the relative benefits of the dividend-growth options of the fund. Potential to declare dividends & bonus: For investors not very eager to put in their money for a three year period it makes sense to choose a scheme that can potentially declare a dividend or a bonus. Schemes with their NAV much above par value are good candidates for such distributions.