Some cheer for individual taxpayers

Mayur Shah

The much awaited Revised Discussion Paper (RDP) on the draft Direct Taxes Code (DTC) which is meant to respond to the major concerns and comments received from various stakeholders on the draft DTC and the Discussion Paper (released on August 12, 2009) was released by the Government on June 15, 2010, for public debate and comments.

Manisha Paul, an IT professional, is wondering how the RDP would affect her salary income and correspondingly her tax liability. For those like Manisha, the following are some of the relevant changes brought in by the RDP to DTC.

The dilution of several provisions of the DTC should address many concerns of individuals and the salaried although the RDP leaves many questions unanswered, including relating to the tax rates and tax slabs.

Under the RDP, the Government has proposed the exempt-exempt-exempt (EEE) method of taxation for Government Provident Fund (GPF), Public Provident Fund (PPF), Recognised Provident Fund (RPF) and pension scheme administered by Pension Fund Regulatory and Development Authority.

Similarly, approved pure life insurance products and annuity schemes have also been proposed to be subject to the EEE method of taxation as opposed to the exempt-exempt-tax (EET) method proposed earlier.

Social security

It is pertinent to note that most countries that follow the EET method of taxation for retirement benefits have robust social security system in place. The RDP recognised that in the absence of a universal social security system in India, the proposed EET method of taxation of permitted savings would be harsh on the taxpayers as they would require some flexibility in making withdrawals in lump-sum without being subjected to tax.

Also, people may need lump-sum funds on retirement for various family obligations and, hence, continuation of the EEE regime is a welcome move. Further, the RDP acknowledges the fact that it is unlikely to have a social security system in place in the near future. Accordingly, the continuation of the EEE regime is a welcome step taken by the Government. It has also been proposed that the investments made, before commencement of the DTC, in instruments presently enjoying the EEE method of taxation would continue to be so eligible, for the full duration of the financial instrument. However, there seems to be an anomaly with regard to the tax treatment on the contributions/investments made to the financial instruments existing before the implementation of DTC, which we believe would be clarified once the DTC legislation is enacted.

However, what is not stated explicitly in the RDP is whether popular instruments such as equity-linked savings schemes and unit-linked savings schemes will continue with the EEE method of taxation when the DTC comes into force. Also, the RDP does not say either if the authorities propose to adopt the EET regime at a later date, once a solution is found to the administrative, logistical and technological challenges. Or would the EET regime be held in abeyance till universal social security system is in place, which, in any case, will take several years.

Retirement benefits

Further, the RDP also proposes that retirement benefits in the nature of gratuity, voluntary retirement scheme, commuted pension linked to gratuity and leave encashment receipts at the time of superannuation are proposed to be exempt for all employees, subject to specified monetary limits.

The tax exemption for retirement benefits is a welcome move and will mitigate undue hardship to employees as in the absence of adequate social security benefits, the social and economic norm is to use retirement benefit amounts for savings as well as for social expenditure.

The continuation of the exempt-exempt-exempt regime is a welcome step taken in the Revised Discussion Paper on the Direct Taxes Code.

(The author is Associate Director, Ernst & Young. )

Is base rate sustainable?

T.V. Gopalakrishnan

The Prime Lending Rate introduced early in 1990s and refined as Bench Mark Prime Lending rate (BPLR) in 2003 as a reference rate by the banking system has been replaced by the Base Rate effective from July 1.

What difference the base rate makes to borrower customers and the banking system and how this rate will help the Reserve Bank of India to transmit its monetary policy signals can be assessed or understood only after the rate stabilises.

Basically, the BPLR and the base rate should reflect the cost of funds, risk margin, and the rate of return to the bank but the difference lies in arriving at the cost of funds and the transparency in its computation and application. The computation of base rate is expected to be on a uniform basis and apparently leaves no scope for manipulation. It takes into account the cost of deposits, operating costs, negative carry on cost in the maintenance of statutory requirements that is, Cash Reserve Ratio and Statutory Liquidity Requirements, risk and profit margin.

BPLR and base rate

Compared to BPLR, which was basically computed on historical basis, the base rate has to be assessed more on a futuristic basis. The base rate will vary from bank to bank and should reflect on bank`s efficiency in bringing down the cost of funds and dynamism in the overall management of funds. Unlike in the case of BPLR, the banks cannot lend funds below the base rate except in certain permitted categories of lending under differential rate of interest schemes, advances against fixed deposits and agricultural advances having subvention from the Government and export credit. This is a major change and will be a challenge for banks to retain major corporate clients as borrowers as hitherto. This should also bring in some changes in the money market operations as some of the borrowers may switch over to short-term instruments such as commercial paper to raise funds at lower rates than the base rate.

Various banks have announced their base rates and they range between 7.5 per cent and 8.5 per cent. How they have arrived at the base rates, however, have not been made transparent. The rates are also much higher than the one-year FD rates, call money rates, bank rate, repo rate, and the yield on Government bonds. They are also reflective of the generally high cost of the funds. The compulsion to maintain the Net Interest Margin at 3-3.5 per cent also seems to have influenced banks in fixing the base rate comparatively at a higher level.

Struggle to retain customers

Will the banks be able to realistically assess the base rate reflecting both the past and future trends and will the rate be able to transmit the Reserve Bank`s monetary policy signals effectively are the major doubts in the minds of knowledgeable public?

Although the base rate may come down in the long-run, immediately the large borrowers, particularly good borrowers, who had enjoyed funds at less than the BPLR will have to shell out more towards interest as they cannot borrow at less than the base rate. This may naturally lead them to resort to some other means to raise funds or banks will be compelled to compensate them to retain as their customers which is not desirable.

They may go in for Commercial papers or external commercial borrowings or raise deposits from the public directly at less than the base rate. In any case, this will have an adverse impact on banks` funds management and profitability. In such a situation, banks will be forced to entertain comparatively risky borrowers adding to their non-performing loans and consequent problems.

Good timing

Although, the concept of base rate is good to establish healthy credit market and improve banks` asset liability management down the years, it may in the immediate future upset the corporates` borrowing programmes and bring some visible changes in the money market operations. In case the base rate stabilises, it may also pave way to develop corporate bond market in a big way. Present surplus liquidity situation in the economy and continued persistence of higher level of inflation, however, supports a higher base rate and from that angle the timing of introduction of base rate seems well intended and justifiable.

(The author is a former Chief General Manager, RBI)

The risk perception

Ever had your friend exclaim at your investment choices with phrases such as ``That sounds like a very risky bet`` or ``That`s a very risky stock``? How about asking the friend to rank your investment risk on a scale of 1 to 10. The friend stares back blankly, implying either you have lost your marbles or they`re lost in translation. So what do you perceive as the risk in your investments?

Fundamental risks
Risk in its varying degrees of perception is the magnitude of fear at the thought of losing something. It could be the fear of losing your home, friend, mobile phone, or money. When it comes to investing, the idea of the risks intrinsic in the business, its operations and environment are also known as ``fundamental risks``.

To borrow the idea of investor Warren Buffett`s `fundamental` risk of investing in a business, there are five primary factors in appraising this risk: The first would be on how confident you are in your judgment of the long-term economics of the business you want to invest in. Take, for example, the much-maligned telecom sector, which has been in the news for deteriorating economics and expensive expansion.

Investing in this sector would entail having a perspective on how consumer behavior is likely to evolve over the next five years and whether consumers are likely to spend more on value-added services or more time on the phone. Add to this, the large number of players in several circles, which means little pricing power.

These are just a couple of factors in the economics of the business on which one needs an informed perspective. A rapidly changing business is often a risky one for an investor who is not watching it closely.

Human elementThe second and third factors deal with the ability of people to run their businesses effectively and their propensity to reward the shareholder and themselves in a proportionate and acceptable manner. Retail investors have traditionally had little say or sources on management. However, gauging how effectively the company communicates to its shareholders through interviews, press releases and annual reports can give you a cursive idea of the management behind a stock. A crooked manager or misinformed, yet ambitious, CEO is a major risk to an investor, considering how he can derail an otherwise good business. An instance of such behavior includes the Satyam episode that saw the slipshod Maytas merger attempt as a prologue to the expose of Ramalinga Raju`s number fudging.

The fourth factor is the effect of external factors such as inflation and taxes on a business. Companies in sectors such as alcohol or tobacco have the constant risk of taxes being hiked at various levels, considering how the products they produce are viewed as ``vices``.

Inflation ravages business with little pricing power or scope for passing on costs. Cyclical industries such as automobiles and consumer durables have often been squeezed by rising costs during periods of low consumer demand, as prices cannot be hiked.

Businesses which are easy scapegoats for government taxation or companies that can be squeezed by the economic cycle are inherent fundamental risks. Sugar companies are a classic example of a sector which gets pushed to extreme highs or lows depending on season, crop yield and a host of other factors. Scale is a savior in such a scenario as small mills become unviable and often go broke during the cyclical lows.

Price
The fifth factor is possibly the simplest - the price you pay. Paying a sensible price can help the investor avoid a great deal of pain associated with moody equity markets. Several retail and professional investors got suckered into buying newly-fangled, esoterically-named, mutual fund schemes or over-priced IPOs during the market peak of late 2008 only to lose their shirts over the next year.

Overpaying is possibly the most common risk the investor overlooks. As Buffett says, the above factors are difficult to `precisely quantify` but ``investors in an inexact but useful way `see` the risks inherent in certain investments without reference to complex equations or price histories.``

The perception of various factors which are deemed `risky` does not always lend itself to a convenient number. But acknowledging that they exist and attempting to base the price you pay after roughly factoring in those risks goes a long way in determining your investment outcome.

When should investors `chase` higher returns?

At a recent social gathering of investment professionals, a portfolio manager wanted to know why this column encourages people to seek investment solutions instead of trying to achieve returns higher than a market index (Nifty, for instance). This question is a telling sign of how portfolios are typically constructed - without clear investment objectives. As a follow-up to that debate, we ask the following question: When should investors `chase` higher returns?

This article discusses how individuals` construct layered sub-portfolios to meet their financial goals. It then explains the circumstances when individuals can `chase` higher returns within such sub-portfolios.

Tiered portfolio

Individuals do not construct portfolios based on the correlations between various assets so as to reduce overall risk and optimize returns. They instead construct portfolios, hoping to achieve their financial goals.

Financial goals are typically three kinds. First, the lifestyle desires which include pre-retirement and post-retirement needs. Second, the intergenerational wealth transfer - how much assets should be given to the children. And third, the philanthropic needs - how much should be donated to charitable causes.

These multiple goals create complexity in the portfolio construction process; for the risk attitude towards each of these goals is different. The risk tolerance to lifestyle goals, for instance, is low compared with that of philanthropic goals. This means that the assets required to meet these three objectives differ substantially.

It is, hence, imperative that an individual has three sub-portfolios to meet these goals. Academic literature on portfolio construction suggests that such sub-portfolios may not be optimal. The reason is not far to seek.

Assets in each sub-portfolio may react adversely with those in other sub-portfolios to increase overall risk. Decline in government bond exposure in the lifestyle portfolio may, for instance, drag down returns in wealth transfer portfolio, if the correlation structure was not considered while building these sub-portfolios.

The positive side to having such sub-portfolios is that it acknowledges investor preferences and matches their financial desires with appropriate investment solutions.

Wealth mapping
Of the three sub-portfolios, lifestyle needs require the most conservative portfolio. The reason is because individuals need to sustain their basic standard of living and aspire for improvement in their quality of life. Investing is risky assets may expose the portfolio to high downside risk, jeopardizing basic living standards.

A conservative portfolio requires exposure to income-generating assets with low tolerance to downside risk. A major proportion of this portfolio would, hence, constitute fixed-income securities such as bonds and bank fixed-deposits, maturity-matched to the individual`s investment horizon.

The wealth transfer and philanthropic sub-portfolios will have some exposure to equity but not for `chasing returns`. These portfolios are instead custom-tailored to meet the desired financial goals.

So, can individuals `chase` returns at all? This is where one has to consider the importance of minimum desired portfolio level. Consider the wealth transfer portfolio. This portfolio is set up to generate wealth that can be tax-efficiently transferred to the next generation. Suppose an individual desires to leave Rs 100 million to her children but is determined that the intergenerational wealth transfer should not be less than Rs 60 million.

The wealth transfer sub-portfolio should be tightly structured to reduce shortfall risk on Rs 60 million. Beyond this threshold, the sub-portfolio can be structured to `chase` returns through exposure to alpha-generating strategies including market timing and security selection. The same principle applies to the philanthropic sub-portfolio and the aspiration component of the lifestyle portfolio.

Conclusion

Chasing returns is clearly not an objective. Portfolios ought to be constructed to meet financial goals. Differing risk attitudes towards each goal prompts construction of several sub-portfolios. Investors can consider `chasing returns` within these sub-portfolios, but only after the asset exposure is custom-tailored to meet the minimum desired investment objectives.

Investors are often misled into believing that chasing higher returns is by itself an investment objective. This article shows why multiple financial goals create complexity and leads to construction of several sub-portfolios. It then explains when investors can `chase returns` within such sub-portfolios.

US Congress approves financial overhaul

The US Congress on Thursday approved the most sweeping overhaul of the financial sector since the 1930s, hoping to end Wall Street`s riskiest practices and handing a major victory to President Barack Obama.

The Senate`s 60-39 vote in favour of the broad reforms sends the landmark legislation to Obama`s desk for signature. The lower House of Representatives passed the bill last month.

Obama made the reforms a top priority in the wake of the 2008 financial crisis. He is expected to sign the bill into law next week, marking an end to more than a year of heated debate over how to reform the nation`s financial sector.

The reforms aim to prevent financial firms from engaging in the kind of excessive risk-taking that led to a near-collapse of Wall Street in 2008 and ushered in the wider global recession. Obama has championed the bill as essential to prevent a future crisis.

European leaders in particular had demanded that the US clamp down on shady bank practices and are in the process of considering their own round of major regulatory reforms.

Obama said the overhaul would bring `greater economic security to families and businesses across the country` and `prevent the kind of shadowy deals that led to this crisis`.

`Wall Street reform will bring greater security to folks on Main Street,` Obama said in brief remarks from the White House.

The law gives the government broader oversight over hedge funds and derivatives markets and new powers to wind down failing financial firms. It creates a council of regulators to monitor systemic risks and a new consumer protection agency to prevent firms from offering misleading financial products.

While the jobs and wealth lost during the financial crisis could never be returned, `we can see to it that we never, ever again have to go through what this nation has been through`, said Senator Christopher Dodd, a key architect of the legislation.

Republicans have largely opposed the bill as over-regulation, and Obama`s fellow Democrats needed 60 votes in the 100-member Senate to close debate and overcome a `filibuster` delaying tactic meant to kill the legislation.

Senator Richard Shelby, the Republican`s key financial expert in the upper chamber, said the bill would harm the economy, and he accused the Obama administration of trying to `exploit the crisis in order to expand government further`.

Just three moderate Republicans, all from Democratic-leaning northeastern states, joined 57 Democrats in voting for the bill. One Democrat, Russ Feingold, opposed the reforms.

Wall Street, worried about profits, was lukewarm to the reforms and lobbied for looser rules. But the industry recognized that public anger over the costs and consequences of the financial crisis meant some form of expanded oversight was inevitable.

The legislation marked `a new day for the industry`, said Steve Bartlett, head of the Financial Services Roundtable, the top lobbying association for Wall Street. `We are committed to being a part of the solution and earning back the trust of the American public.`

Passage of the financial reform bill marks the second major domestic victory this year for Obama after health-care reform. But his public approval ratings have remained below 50% amid anger over the still-sluggish economy and a skyrocketing budget deficit.

The US public has been broadly supportive of the Wall Street overhaul, though a survey by Bloomberg News found that nearly four out of five Americans have little or no confidence that the reforms will prevent a future financial crisis. Democrats hope to convince voters otherwise ahead of November congressional elections.

`I think this bill will stand the test of time, creating a new set of rules of the road for not just America`s financial sector but also the world`s financial sector for decades to come,` said Democratic Senator Mark Warner.

NPS: The cheaper and tax friendly alternative

Keeping aside the fact whether the New Pension System (NPS) has reached the masses as intended, we shall discuss and examine its various facets and how it is an important and beneficial savings and retirement tool.

Why you also need NPS?

With the setting up of the PFRDA and the new pension system, the long-awaited pension reforms have now become a reality. For the most part, the Indian pension scenario has been dominated by employer sponsored plans with contribution from the employee to a certain extent. The conventional retirement options like the employee provident fund (EPF) and the employee pension scheme (EPS) give fixed or defined benefits which may not be adequate to meet post employment expenses. NPS primarily aims to bring into the pension fold a huge population which is part of the unorganized/non-government sector.

NPS Structure

The unique option that the NPS gives to subscribers is a selection of fund managers with whom they wish to entrust their funds` management.

Pension fund managers currently offering services under the NPS:

> ICICI Prudential Pension Funds Management Company
> IDFC Pension Fund Management Company
> Kotak Mahindra Pension Fund
> Reliance Capital Pension Fund
> SBI Pension Funds Private
> UTI Retirement Solutions

Subscription Types:
To apply for the voluntary pension scheme, there are two types of accounts:
Non-withdraw-able account: The tier 1 account is the basic NPS account which is non-withdraw-able till retirement or in the case of death of the subscriber.
Withdraw-able account: A tier 2 account is available to only those who are existing subscribers of the tier 1 account. The unique selling point (USP) of the tier 2 account is that money contributed into this account can be freely withdrawn as and when the subscriber wishes except for a minimum balance that needs to be maintained at the end of each financial year.

Asset Allocation Class Options:
> Asset Class E - Most aggressive option where the cap for equity investment is 50% of the investment corpus.
>  Asset Class C - Medium risk option
> Asset Class G - Low risk option

Investment Options
Auto Choice - Lifecycle fund: Your contributions are pooled into a lifecycle fund and then invested as per pre-defined asset allocations that change over the life cycle of the subscriber. For example, up to 35 years, 50% goes into the aggressive class E with 30% and 20% in asset class C and G respectively. As retirement nears at age 55, only 10% is invested in class E and C but 80% is transferred in less risky class E.
Active Choice: You can choose not only which fund manager to use but also what asset allocation to go with. Once subscribed, there is also a switch window available every year in May.

NPS - The Cheaper Option
Shown below is a projection of how an investment of Rs 1 lakh per annum (p.a.) would behave over a period of 30 years. This is considering that all three options give similar returns at the rate of 10% p.a. For the sake of this projection we have considered funds that would match the asset allocation pattern followed by the aggressive portfolio under NPS.

	NPS	Insurance Pension Plans (ULIP Based)	Mutual Fund Pension Plan
Investment amount per year	100000	100000	100000
Charges per year (Initial period)*	925	13200	1250
Charges per year (5 years to 10 years)*	388	6000	1250
Charges per year (11 years to 15 years)*	455	3000	1250
Charges per year (16 years+)*	455	0	1250
Fund Management	0.0009%	1.25%	1.25%
Age limit for annuity	60	Flexible	58
Assume CAGR	10%	10%	10%
Maturity proceeds after 30 years	1.8 Crore	1.3 Crore	1.39 Crore
Lump sum (Maximum)	60%	33%	0 - 100%
Pension Corpus (Minimum)	40%	67%	0 - 100%

*Premium allocation charge and policy administration charges are calculated at the end of the year. Typically, these charges are computed on premium at the beginning of the year/month.

NPS being the option with the lowest costs eats into the investments the least and hence delivers the highest returns.
Chart 1: Increase in retirement corpus over 30 years

 

Important Note: The projection shown above takes an investment of Rs 1 lakh every year because this is where the charges under ULIPs based pension policies and MF pension plans are at the lowest.

Chart 1 shows how the progression of the invested amount happens over 30 years. An important fact to remember is that as of today, NPS is taxed under the EET regime. This however may change or could be amended to bring all other retirement instruments at parity when the Direct Tax Code is introduced.

Tax Advantage
Investment vehicles are taxed in two ways currently; one is the EET (Exempt-Exempt-Tax) and the other being the EEE (Exempt-Exempt-Exempt) framework.

Under the EET method, the first E in EET means that the contributions towards certain savings products are deductible from taxable income, the second E represents that the accumulation from the investment are exempt, and also, all withdrawals at any time are exempt from tax in case of the third E.

The draft of the much awaited Direct Tax Code, which is expected to bring about a consolidation of the current tax laws and also effect some changes in the tax laws, has recently been made public.

With the drafts of the Direct Tax Code, there seems to be a decided push for making the NPS product more attractive to investors. The major change that the DTC will bring about in the retirement products scenario is that ULIPs will now also be taxed under the EET (Exempt-Exempt-Tax) Regime. This means that unlike in the current scenario, withdrawals from ULIPs will not be tax exempted.

It has long been seen in the Indian investments market that the behavior of the retail investors is largely guided by tax concerns. There is always a rush to invest in order to save on tax. ULIPs had an advantage over the NPS and mutual funds because it was taxed as EEE. This means that the withdrawal and is tax free too. Surely this is a major plus, but with the provisions in the new Direct Tax Code, the NPS will also be taxed in the EEE framework. This will invert the tax situation among retirement products with investment benefits.

NPS will be the only product to be taxed under EEE out of the three (Mutual Funds, ULIPs and NPS). As a result, its major handicap will now be removed. The government has designed the NPS to benefit the investor to the maximum and the new taxation vis-a-vis the NPS will only add to the attractiveness of NPS.

Conclusion:
NPS remains a very good product for its purpose and by aligning the distributors` interests with the PFMs would greatly help the NPS increase its strike rate. Re-iterating that NPS is a post-retirement safety tool, it is a very effective tool that covers capital protection and also provides growth. With its lowest charges, it also is the cheapest way to get an exposure to the market. For the thousands and lakhs of employees in the unorganized sector who have negligible or no post-retirement social security benefits, NPS is a boon.

!!!Don't be serious, be sincere.......!