Fenil's Library

A convoluted process to avoid deduction under the new code will increase paperwork for all parties

Sandeep Shanbhag

Most readers would be familiar with the concept of TDS or tax deducted at source.
TDS is tax deducted in advance — at the source of earning the income itself. At the end of the year, one aggregates one’s total income for the year and calculates the final tax thereon.

From such final tax, the amount of TDS is reduced and it is only the balance, if any, that is payable. Therefore, it is important that there is a nexus between the rates of final tax and TDS since the latter is a part of the former. Sadly, this doesn’t seem to be the case with respect to the new direct tax code (DTC) that seeks to replace the current Income-Tax Act, 1961.

For starters, the DTC has massive relaxations in the tax thresholds as they exist currently. Though the basic exemption limit is maintained at Rs 1.6 lakh, the 10% rate is applicable for incomes between Rs 1.60 lakh and Rs 10 lakh. The 20% rate is applicable for incomes between Rs 10 lakh and Rs 25 lakh. It is only for incomes above Rs 25 lakh that the highest tax rate of 30% is payable. Moreover, the equivalent of the Section 80C deduction the maximum ceiling for which is Rs 1 lakh has been tripled to Rs 3 lakh.

While the increased limits will give great relief to the average taxpayer, the problem is that the TDS rules do not seem to go hand in hand.

For example, the DTC has no provision for furnishing any declaration (as in current Form-15G for non-seniors and 15-H for seniors) for non-deduction of TDS. It will hurt all the investors earning income less than the tax threshold, particularly, senior citizens, widows, agriculturists and several others.

The only way of avoiding TDS is by making an application to the income-tax office (ITO). The rules regarding application and issue of such a certificate are as follows:

1 The DTC specifies that the deductee may make an application in the prescribed form and manner, to the assessing officer (AO), seeking a certificate for no deduction of income-tax from payments to be received by him. Similarly, the deductor may make an application, in the prescribed form and manner, to the AO seeking a certificate for no deduction of income-tax from payments to be made by him to a non-resident deductee.

2 The AO shall give to the deductee or the deductor, as the case may be, such certificate as may be appropriate, if he is satisfied that the total income of the deductee justifies no deduction of income-tax.

3 The deductor shall not deduct any tax until the certificate issued is cancelled by the AO or until the expiry of the validity of the certificate.
Obviously, the lawmakers are not in touch with the ground reality. Several questions needing clear-cut and realistic answers arise:

4 If all those who used to file Form-15G/H in ITA61 era make such applications and visit their ITOs in person, can the ITO handle this volume?

5 Even if one is successful in inducing the ITO to issue a certificate, will he give one which is valid for long? Improbable. This appears to be a yearly exercise.

6 Will he issue the certificate in good time to enable the assessee to send it to the persons responsible for applying TDS?

7 How can the individual send the original to two or more deductors?

8 Will a certificate of a notary be acceptable or will the ITO issue multiple certificates as requested by the applicant?

I have a suggestion for all those who are facing this peril. Distribute your investments in different avenues and ensure that the interest you earn is less than the prescribed limit for application of TDS.

Yes, this will increase paper work and your visits to the bank for crediting small amounts of cheques. This will also increase the cost of servicing your accounts.
The I-T Department is moving towards paperless regime to the extent possible. No annexures, not even TDS certificates, need be filed along with the returns.

The taxpayer is expected to hold these in his custody and present them to the ITO if called for. It is obvious that under the new regime, crores of additional TDS certificates will have to be issued by the deductors, increasing voluminous paperwork at their end. The department itself will be collecting money only to be refunded later, an activity which could have well been avoided. This will surely increase paperwork for the department by leaps and bounds. This is a national waste.

The only practical way out is to start filing your tax returns and begin praying for the refund due. Yes, this will create some liquidity problems for the assessee in addition to the fact that getting refund is associated with many hurdles.

The woes do not end here. The thresholds for application of TDS are contemptibly small amounts. The more common ones are of i) Rs 2,500 for interest on debentures, ii) Rs 10,000 for bank interest iii) Rs 5,000 for commission and brokerage vi) Rs 1.2 lakh for rent vii) Rs 1 lakh for acquisition of immovable property other than agricultural land and viii) Rs 5,000 for any other interest payable. The least they could have done was to increase these thresholds to a realistic level. Have you come across any immovable property being sold for under Rs 1 lakh? Why have such impotent provisions which will never come into the picture?

Schedule 3 lists the TDS rates for specific incomes. These are: — i) Salaries: rate applicable to the employee ii) Interest - 10% iii) Dividend which has not suffered DDT - 10% iv) Commission, brokerage, etc - 10% v) Rent - 1% for the use of machinery or plant or equipment and 10% for use of land or building and vi) Any other income - 10%.

This last item is a new residuary item. This is extremely frightful. It implies that any payment made for purchase of any goods or services or movable or immovable property, or for any item other than those listed above tax is required to be deducted at source and worse, there is no threshold. A strict reading of the above would suggest that TDS will also be applicable on day-to-day commerce and business income.

Hopefully the draftsmen of the code may not have realised the ramifications of some of the issues contained in the code. This article is dedicated to them with an earnest hope that corrective action would be taken.

They can avail HRA exemption and deduct interest on home loans

Harsh Roongta

“Can I get both, exemption of HRA as well as deduction in respect of home loan?” This is asked frequently by homeowners living outside the town where the house is.
That’s because these days, it’s common practice for people to relocate to other cities for work, with the intention of coming back to our home city at a future date. If we relocate, we live on rent in the new city, and continue to own the property back home.

Even if we live in the same city where we work, travelling distances can be quite daunting. Imagine a two hour commute to work everyday — say, someone living in Dhanu Road but having office at Colaba, to give an example from Mumbai. How many of us will be able to last this regimen?

Hence, some of us live in rented accommodation near the workplace, even while keeping a house in the same city.

So, what if we want to claim tax benefits on the home taken, as well as claim exemption for our rented house?

The answer is yes, we can.

Claiming deduction for interest payable on a home loan and claiming exemption for HRA in respect of rent is completely de-linked. There is no restriction with respect to claims for both.

Exemption of HRA is covered under Section 10 (13A). The only conditions for allowing the exemption of HRA are:

l Rent must actually be paid by the assessee (legal term for the person whose tax liability is being worked out) for the rented premises which he occupies, the rented premises must not be owned by him.

2 As long as the rented premises are not owned by the assessee, the exemption of HRA will be available up to the limits specified in the relevant rules. There is no mention here about any effect on the exemption because of ownership of any other property.

Let us now turn to the deduction of interest payable on a home loan. The interest is not a straight deduction allowed from the salary income. The deduction is actually allowed while calculating the income from house property, although the effect in the case of self-occupied property is the same as allowing it as direct deduction from salary income. The relevant sections are Section 22 to Section 27. The calculation of incomefrom house property is done using the following calculation:

1 Rental income (net of municipal taxes) = Annual value (A)
2 Less: 30% of A as a standard deduction (S)
3 Less: Interest payable on any loan taken for acquisition or construction of this property (I)

l Income from house property = A-S-I (H)
The point to remember is that income can also be negative, or in other words, include a calculation of loss.

In the case of self-occupied property, the annual value ‘A’ is taken as nil. Therefore, ‘S’ automatically becomes nil (as 30% of 0 is 0) and ‘I’ is restricted to a maximum of Rs 1.5 lakh. Therefore, in the case of self-occupied property, the result of calculation of income from house property or ‘H’ will always be a loss to the extent of the interest payable on the home loan or Rs 1.5 lakh.

Where the owned property is given on rent, the annual value will be calculated based on the rental and the final income (or loss) from house property will be calculated as given above. Please note that in such a case, there is no restriction on the maximum amount of deduction available in respect of ‘I’.

Where the owned property is lying vacant and is neither rented out nor self-occupied, the rental that could have been derived has to be taken as the rental income and the calculation has to be done as in point 3 above.

The calculation of such a notional value has several difficulties. So, if a similar property in the neighborhood has been given out on rent, it can serve as a good basis to calculate this figure.

There are also a large number of case laws which have gone into the method of calculation of notional value. You may need expert taxation advice to calculate this figure.

“Income from house property” is taxed if it is positive and allowed to be set off against income from other heads if it is a loss. There is nothing in the section that affects exemption of HRA. Also, there are no restrictions against deducting interest in case the assessee is staying in any other premises in the same city, or in another city.

The principal amount repaid on all loans taken from specified entities such as banks/ employer companies, to acquire/ construct residential house property is allowed as a deduction under Section 80C up to the overall limit of Rs 1 lakh. This is not affected by the exemption of HRA. Thus, homeowners staying elsewhere can enjoy a dual benefit.

Note: The proposed direct tax code, if implemented, will make this issue irrelevant as it neither allows exemption for HRA nor deduction of interest payable on a loan taken to acquire a self-occupied property.

Governments will keep the press running to finance at least some portion of the fiscal deficit, as rising interest rates are not politically expedient

Vivek Kaul. Mumbai

It was one of those mornings. It had rained all night. There were puddles of water everywhere. The red gulmohar tree was in all its glory. And I woke up to a smell of strong filter coffee and a bright smiling face.

“I am confused,” she said.

“What’s new about that?” I retorted. “You are confused all the time.”

“Arre, I am not confused about us. But about something else.”

“Oh. Something else! And what is that something else?”

“Inflation and deflation.”

“But what is there to be confused about? Inflation is a situation when prices are rising and deflation is a situation where prices are falling,” I explained.

“V, having lived with you all these months, I know that much.”

“Then?”

“What I am unable to comprehend is that almost every big economy in the world is resorting to currency printing in an unprecedented way, something the world has not seen before. Conventional economic theory, as you have explained to me time and again, suggests that more money chasing the same number of goods leads to an increase in prices, and thus inflation. With all the currency that is being printed, the world should have been in the midst of hyperinflation by now,” she said, explaining her predicament.

“Do you understand the term velocity of money?”

“Oh. Physics in economics?”

“Yeah, physics in economics. Let us say a government prints $1 trillion and keeps it in its vaults. How much impact would this money printing have on inflation or price rise?”

“Zero impact,” she replied.

“Correct. Simply because all the printed money is in the vault and does not enter the economic system. Only when this money enters the economic system will it lead to a situation where in more money chases the same or even fewer goods, leading to a price rise. At the same time, it is important how fast does this money change hands, meaning how fast people receive and then go out and spend this money. The faster they spend this money, the more velocity money has and that, in turn, leads to a faster increase in prices and thus inflation.”

“Hmmm. So the question is why isn’t the money entering the system?” she asked.

“How does the printed money enter any economic system? I mean, no government prints money and then goes around dropping it down from a helicopter. Do they?”

“Stop being sarcastic. The money being printed enters any economic system through the banking system in any country.”

“Exactly. Now, take the case of United States of America. Commercial bank loans have gone down over a period of the last one, three, six and nine months. What does that tell you? As one economic commentator put it, ‘the bubble of trust has been broken’. Banks are no longer sure that what they lend will be repaid. So, it is better for them not to lend now, rather than be sorry later. Other than this, nearly 52 banks have closed down in the US and so have more than 300 home loan companies or mortgage finance institutions as they are called in the US. What does this do? The money remains in the vault, leading to a low velocity and thus, a situation where prices are not rising, but falling. In fact, the rate of inflation — or deflation, as we should call it, in the US right now is a negative 1.4%.”

“Is that the only reason for a low velocity of money?” she asked.

“In economics, there is never only one reason for anything. The other main reason for the low velocity of money is the fact that people are not spending it. In June, the U6 unemployment rate, which is the broadest measure the US has for measuring unemployment, reached an all-time high of 16.5%. This means one in six individuals has lost his or her job. In such an environment, people are obviously not going to go around spending the money they have. This again leads to a lower velocity and thus, no rise in prices despite the currency printing. Also, in an environment of such uncertainty, the rate of saving has shot up to around 5% of the gross domestic product from a near zero rate. People now realise they have huge debts to pay off and need to save money. Again, when people save, the velocity of money goes down, leading to a situation of constant prices or decrease in prices. The savings rate is only likely to increase in the days to come as people continue to save more. As they continue to save more, it implies they are highly unlikely to borrow money to spend as they had in the past. This in turn means velocity of money will continue to be low for sometime, and so inflation is not a threat for sometime at least,” I explained.

“But will the currency printing continue?”

“Yup, it will for some time. Governments, as I have told you, usually spend much more than what they earn. To make up the difference, they borrow. When they borrow, their outstanding debt goes up. As of end 2008, the US government debt stood at 41% of the GDP. This is expected to go up to anywhere between 71-80% of GDP over the next four years and around 100% of GDP over the next 8-10 years. This is a figure put out of the congressional budget office of the US. Now, it is highly likely the debt goes up at a much faster pace, given that tax revenues are slowing down big time. The US government’s tax revenues for April, which is the biggest revenue month, were down 34%. So the government will have to borrow much more than it is projected to borrow. And when that happens, the interest rates are likely go up, given that domestic as well as foreign investors may want a greater incentive to invest in debt issued by the US government. Rising interest rates is not a politically expedient scenario, given that US citizens have huge loans to pay off, as increasing interest rates will mean higher EMIs. So the easiest thing for the government to do is print currency to finance some portion of the fiscal deficit, instead of going out and borrowing the entire amount. And so the currency printing is likely to continue in the days to come.”

“Interesting. Anything else?”

“Some extensive research has been carried out on the topic of government spending and it clearly suggests that for every one dollar increase in government spending, private spending reduces by one dollar. In some periods, government spending does improve economic performance, but in other periods, it pulls it down. So net net, there is no impact on the GDP of the country, and at the same time, the government debt increases. This in turn leads to more currency printing to repay the debt. It also leads to increased taxes as the government tries to battle a slowdown in tax revenues as well as pay off its previous debt. One economic study even found that for every one dollar increase in taxes, private spending goes down by three dollars. Scary isn’t it?”

The example is hypothetical)

China’s markets are up because everyone’s banking on the greater fool theory

Vivek Kaul. Mumbai

“Wisdom always comes late,” I told her rather philosophically early on Sunday
morning.

“Are you still hallucinating?” she asked, making a reference to the late night drinking binge we had indulged in.

“And by the time it comes, the damage has already been done.”

“What comes?”

“Wisdom.”

“Oh. But why are we talking about wisdom early morning?”

“Simply because we refuse to learn from our mistakes.”

“Can you stop beating around the bush and tell me what is on your mind.”

“Yes Ma’m! Basically I had China on my mind.”

“China?”

“Yeah, China. The stock market in Shanghai has gone up by a little over 90% since early November last year. Now what is surprising is that China, over the years, has evolved as an export-driven economy which is highly dependant on exports to the western markets. With western economies collapsing, Chinese exports have also collapsed. In the month of June, Chinese exports fell by 21.4% in comparison to the same period last year. This has had an impact on the earnings of companies. Profits of large scale industrial companies based out of 22 Chinese provinces fell by 21.2% for the first six months of 2009. But despite this, markets have been rallying. Why is that?”

“How would I know? You asked the question, you answer it!” she snorted.

“Well, the People’s Bank of China, which is the Chinese central bank, has been printing money big time. The Chinese money supply has gone up by around 28.5% from last year. This newly-printed money has found its way into the Chinese economy, with the government-controlled banks lending a record 7.4 trillion yuan ($1.2 trillion) of new loans in the first six months of 2009. Now, to give you a sense of proportion, these new loans are equal to almost one-fourth of the size of China’s economy and a little more than the size of the Indian economy. When such aggressive lending happening, a portion of these loans is being actively used to speculate both in the stock and the property markets, leading to both these markets going up so soon so fast, without any connect with the economic reality of the day,” I explained.

“And what is the economic reality of the day?”

“The economic reality of the day is that things are not good. As I explained, Chinese exports have fallen and so have company earnings, but the stock market is still going up. Or take the case of the Chinese property market. The average price per square metre in China is more or less the same as the price in the US. This, despite the fact that the per capita income in the US is seven times the per capita income in urban China. Property prices in the US have fallen dramatically in the last two years, but that still doesn’t justify similar prices. Basically, the Chinese economy has become a giant Ponzi scheme.”

“A Ponzi scheme? You love that phrase don’t you? To you everything looks like a Ponzi scheme!” she exclaimed.

“Actually, to tell you the truth, I did not figure this one out. Andy Xie, a former Morgan Stanley economist, who is now an independent economist based out of Shanghai, offered this insight around a week back. As I have told you earlier, the Ponzi scheme is named after Charles Ponzi, an Italian immigrant to the US. He launched an investment scheme in 1919, promising to double investors’ money first in 90 days, and later in 45 days. Investors got attracted to the huge returns the scheme promised. At its peak, the scheme had 40,000 investors who had invested around $15 million in the scheme. Ponzi had no business model in place to generate these huge returns. All he was doing was using the money brought in by the new investors to pay off the old investors. He ran his scheme till the money coming into the scheme was greater than the money leaving the scheme. One fine day, that stopped, and the scheme went bust.”

“But what has that got to do with the Chinese economy and stock market being a Ponzi scheme?” she asked.

“As I explained, the stock and property market going up has no link with economic reality. They are primarily going up because of all the money that is being lent and is finding its way into these markets. With all this new buying coming in, market prices are going through the roof. Such a market is akin to a Ponzi scheme. As a market starts giving good returns, more and more investors want to enter it. The money brought in by these new investors ensures that the price keeps going up and rewards the older investors, instead of any fundamentals, like in a Ponzi scheme. As Robert Shiller writes in his all-time classic Irrational Exuberance, ‘When prices go up a number of times, investors are rewarded by price movements in these markets, just as they are in Ponzi schemes.’ In addition, when the markets have been on their way up, investors tend to look at the recent past pattern and assume that the market will keep going up. They mistake probability for certainty.”

“Hmm. That makes some sense. But tell me something, what makes Chinese investors so convinced that the markets will keep going up?”

“Oh, that’s because of the Panda put.”

“Panda put?” she asked.

“Yeah Andy Xie, the economist, I talked about earlier, coined this term. It refers to the investor belief that the government won’t allow the markets to fall. The popular belief these days is that the Chinese government cannot allow the stock or the property market to collapse before October 1, 2009, the sixtieth anniversary of the foundation of People’s Republic of China. So, the bull run is on at least till then. The other major factor influencing this belief is the fact that taxes from property sales account for a major portion of the income earned by local governments in China. So, it is in their interest to sustain high property prices. With this belief in place, retail investors are getting into the market big time, hoping to get rich overnight, as they normally do towards the last stage of a bull run. Even informed investors are gambling on the hope that they will not be in the last wave of buyers. In modern parlance, this is known as the greater fool theory, wherein investors invest because they feel that some greater fool could be depended on to enter the market after they have, and this would give them handsome returns. This explains to a very large extent why Chinese foreign exchange reserves have gone up by $185.6 billion to $2.13 trillion in the first six months of 2009 — the foreign investors bringing dollars into China to invest in the stock market clearly seem to be hoping that they are not in the last wave of buyers. This is a mistake investors always make, when they become a part of a stock market or a property bubble. “

“Interesting as always… But till when will this last?”

“Oh that’ simple. It will last till banks keep lending and a portion of that money keeps getting diverted into the stock and property market for speculation.”

“And till when will that happen?”

“To get an answer to this question, you need to ask Zhou Xiaochuan.”

“And who’s he?”

“The governor of the Chinese central bank.”

“But what is the moral of the story?”

“Wisdom always comes late. Once a government starts a Ponzi scheme, it is very difficult for it to stop it. As Satyajit Das, the internationally renowned derivative expert said in a recent interview, ‘The only lesson learned is that no Ponzi game can ever be allowed to stop.’”

(The example is hypothetical)

Tensing Rodrigues

Sebi’s circular SEBI/IMD/CIR No 4/ 168230/09 issued on June 30, 2009, mandates two distinct changes in the selling of MF schemes:

1) There shall be no entry load for all mutual fund schemes (Clause 4.a)
2) Distributors should disclose all the commissions (in the form of trail commission or any other mode) payable to them for the different competing schemes of various mutual funds from amongst which the scheme is being recommended to the investor. (Clause 4.d)

Let us first look at ‘entry load’. The Securities & Exchange Board of India (Mutual Funds) Regulations, 1996, amended as of date, do not define entry load, but the term is explicitly used in regulation 49 in a context which defines its meaning.

Regulation 49 sets limits on pricing of units, thus effectively regulating entry loads. It requires that “the sale price is not higher than 107% of the net asset value”, and further that “the difference between the repurchase price and the sale price of the unit shall not exceed 7% calculated on the sale price”.

The regulations do not specify for what this difference between sale price and NAV (that is the entry load) may be used. But it looks obvious that the logic of charging entry load is to not burden existing unitholders with the cost of selling new units/ selling to new unitholders/ creating new accounts.

It is fair that these transaction costs should not be transferred to the existing unitholders. Obviously, the commission paid to the MF agent by the AMC for selling fresh units/ acquiring new unitholders is to be paid from this load.

However, the regulations are more explicit on the use of the ongoing fees to be charged by the AMC.

Regulation 52 (4) lays down: “In addition to the fees mentioned in sub-regulation (2), the asset management company may charge the mutual fund with the following expenses:
…
(b) Recurring expenses including:

(i) Marketing and selling expenses including agents’ commission, if any;
(ii) Brokerage and transaction cost;
(iii) Registrar services for transfer of units sold or redeemed;
(iv) Fees and expenses of trustees;
(v) Audit fees;
(vi) Custodian fees;
(vii) Costs related to investor communication;
(viii) Costs of fund transfer from location to location;
(ix) Costs of providing account statements and dividend/ redemption cheques and warrants;
(x) Insurance premium paid by the fund;
(xi) Winding up costs for terminating a fund or a scheme;
(xii) Costs of statutory advertisements;
…
It is obvious that the same would apply to the entry load. This makes it amply clear that entry load is to meet the expenses of the AMC towards selling new units, selling to new unitholders and creating new accounts; agent commissions are only one of those expenses. The current circular reinforces the above interpretation of the purpose of entry load: “Mutual fund schemes were allowed to recover expenses connected with sales and distribution through entry load” (Clause 1).

Sebi is perfectly within its powers to legislate on the entry load by amending regulation 49, which it seems to be intending to do now. But where Sebi clearly oversteps its jurisdiction is in assuming a quid pro quo relationship between entry load and agent’s commission. The AMC is free to pay any commission to the agent for marketing its products. This is purely its business decision and outside Sebi’s jurisdiction, as long as the cost is not charged to the fund beyond permissible levels.

This is made amply clear by regulation 52(5): “Any expense other than those specified in sub-regulations (2) and (4) shall be borne by the asset management company or trustee or sponsors.”

The fundamental question we need to debate is: Why is a MF agent paid commission? There are two possible answers to this question — therefore two interpretations to a MF agent’s commission.

According to one interpretation, the commission is the agent’s fee for the advice he tenders to the investor. Here, the AMC collects it on the behalf of the agent and passes it on to him.

The Sebi circular seems to have assumed this interpretation when it says, “though the investor pays for the services rendered by the mutual fund distributors, distributors are remunerated by AMCs from loads deducted from the invested amounts.” (Clause 2).
The other interpretation of commission is as a fee the AMC pays to the agent for selling its products. Which of these is the right interpretation?

The interpretation that is implicit in Securities & Exchange Board of India (Mutual Funds) Regulations, 1996 is the latter.

Regulation 52(4)(b)(i), mentioned earlier, explicitly lists “Marketing and selling expenses including agents’ commission” as an expense the AMC can charge to the fund. The current circular reiterates this interpretation when it says: “Sebi (Mutual Funds) Regulations, 1996 also permit AMCs to charge the scheme for marketing and selling expenses including distributor’s commission.”

It is obvious from this that Sebi itself considers agent’s commission as marketing and selling expense. Therefore, by no stretch of imagination, can it be fee for advising the customer.

Therefore, the statement “though the investor pays for the services rendered by the mutual fund distributors, distributors are remunerated by AMCs from loads deducted from the invested amounts” in the circular, is inconsistent with the rest of the circular and contradicts the Mutual Fund Regulations, 1996.

Therefore, Sebi’s claim that the circular is issued under regulation 77 “to remove any difficulties in the application or interpretation” of the regulations is untenable; regulation 77 does not give Sebi power to repeal or amend any part of the regulations through circulars.

Let us now turn to the second part of Sebi’s circular: “The distributors should disclose all the commissions”.

Sebi seems to continue its confusion over the interpretation of commission by clubbing together “distribution” and “advising”.

When you go to buy a toilet soap or a cellphone, the dealer does not disclose to you the commission that the manufacturer or the distributor pays him. And there is no reason why he should.

The customer has to evaluate and compare the value of the product in terms of service that it can render to him, with the price quoted by the dealer; and if the value-price equation seems favourable, buy the product. If he wishes, he can bargain to improve the equation. But he has no business to seek information on the commission the manufacturer or distributor pays to the dealer.

It is often argued that this model is not appropriate to the MF agent-investor relationship; a better model would be that of doctor-patient relationship. The reason being that a financial product is complex and beyond the understanding of a common investor, just like a sickness and the therapy for it.

The argument does not hold good. In case of a doctor, a clear distinction is made between “distribution” and “advising”. A doctor does only advising, or at least is bound by law to do only that; he does not do distribution. The distribution is done by a chemist.

Imagine a situation where an investor goes to a MF agent. The agent recommends funds A, B and C and he discloses that he earns 3.25%, 2.75% and 2.25% commission respectively, on the funds.

How is the investor to judge whether the recommendations are motivated by the suitability of funds or by the commission for the agent?

One way would be to ask the agent to disclose his commission on all the funds he sells. The customer may then find that there are funds which pay the agent only 0.25% or 0.50%. Should the customer buy these funds from the agent rather than the ones recommended by him? The assumption of investor ignorance leads to a contradiction.
The only way out of this situation is to assume that the investor is at least somewhat knowledgeable, can understand the financial products at least to some extent, and can know what is and what is not in his interest.

If that is the case, why does he need to know the agent’s commission to take his investment decision?

The point is, an agent’s commission is redundant information in investment decision making process. Even worse, given insufficient knowledge on the part of the investor, it is positively detrimental to decision making.

Devendra Nevgi. Mumbai

Many a times, retail investors consider a host of factors before investing into the individual stocks or markets in general. Some of the major ones are the historical financials, company prospects, group to which the company belongs, past dividend record, the P/E ratio and so on.

A very important factor, “liquidity” is, in often ignored. Many investors might be surprised to know that the epicentre of the recent global financial crisis was liquidity: Initially the excess of it, followed by the scarcity of it.

What is liquidity? Why is it so vital to the economy and markets in general?

Liquidity often has different interpretations in different contexts. There are three
concepts in relation to liquidity:

* Monetary liquidity, which refers to the general monetary and credit conditions in the economy.

* Markets liquidity, determined by how easily financial assets (such as stocks) can be bought or sold without significantly impacting their price.

* Balance-sheet liquidity or funding liquidity, which is the ability of a corporate or bank to raise money at very short notice, either via availing credit or selling short-term assets that it holds on its balance sheet.

From an investment perspective, we will focus only on the monetary and markets liquidity.

Monetary liquidity includes the price of money (interest rates) as well as quantity and availability of money in the system, to the borrowers. The RBI, by its policies, influences the price and quantity of money available in the economy. This kind of liquidity is reflected in the monetary aggregates such as money supply (M3) and banks lending figures. Both of these figures are available on the RBI’s website.

A thumb rule to determine how much monetary liquidity is good for an economy is that money supply should grow at more or less the same rate as the real GDP growth rate plus the inflation (nominal GDP). If money supply is higher, it might lead to higher inflation and rise in asset values (such as stocks, commodities, real estate etc) in the country. If it is lower, it might choke growth and be deflationary.

Appropriate liquidity levels are necessary for sustained economic growth. In recent times, many central banks have been pumping money into the system to re-inflate their economies. Such liquidity often “spills over” to other countries, and creates demand for the assets in those countries. Many a times, such liquidity disappears at a very short notice too.

Market liquidity refers to the ability of the market (such as a stock market) or the financial system to absorb large buy or sell orders without significantly impacting the price levels. The speed at which a transaction can be executed without much movement (impact cost) in prices, the difference between buying and selling quotes at same time (breadth or bid/ ask spreads), how fast the prices return (resilience) to their fundamental levels after a large order is executed are all indicators of market liquidity.

Higher the market liquidity, better for the markets and vice versa, since it facilitates accurate price discovery of traded asset classes such as stocks.
Monetary liquidity and market liquidity are often inter-linked and have reasonable positive influence on asset prices, such as stocks or real estate, through the “risk appetite” and “confidence” channels.

Global monetary liquidity (FII inflows) has been an important driver of the Indian stock markets in recent years, both on the way up and on the way down. This is evident in the last few months, where Nifty levels have almost moved in tandem with the higher liquidity, thus creating higher volumes.

For investors, market liquidity remains a crucial input for buying stocks. Historical average volumes per day and the bid/ ask spreads are indicators of the same. Stocks with higher volumes and lower bid/ ask spreads should be preferred, as the influence of speculators and the impact of large orders on the stock is relatively lower.
Liquid stocks don’t rally on a large buy order, nor crash after that buy order is fulfilled, or if a large sell order is placed. Illiquid stocks are a speculator’s paradise and investor’s nightmare, and should be avoided by risk-averse investors, since they are susceptible to price manipulation.

Lower market liquidity increases the risks in stocks and distorts its factual realisable value.

Monetary liquidity can be easily tracked on the web on the RBI website and through periodical reports. And in general, the higher the liquidity, the better for risky assets, and vice versa. But there is a caveat — a sustained excess monetary liquidity can lead to asset price bubbles, wherein asset prices substantially deviate from their intrinsic values. And it does cause lot of pain when such bubbles ultimately burst.

To conclude

Investors should also take into account the market liquidity before buying into an individual stock.

This will prevent a situation of their being saddled with illiquid stocks in falling markets, which they can never sell at the right price. Illiquidity weakens the fair price discovery process.

Life insurance is a necessity, not an investment. But it is required only if the demise of the breadwinner will put immense financial pressure on family members

Sandeep Shanbhag

I am often asked whether life insurance products are good investments. The following is my detailed answer.

Life insurance is a necessity and not an investment. There is no substitute for life cover, none whatsoever. It is the only means of providing security to your near and dear ones against your untimely death or to yourself against your old age.

The yield on investment per se, to that extent is of lesser importance. The ‘cover’ or ‘protection’ overrides all other considerations. However, note that it is a necessity, if and only if, the demise of the breadwinner of the family will put immense financial pressure on the family members left behind.

However, if that is not the case, you must reconsider your options. Every product has an associated cost and so does insurance. Do not buy a product you do not need. Excessive insurance injures financial health. It is very important to carry out a cost-benefit exercise before buying a policy.

Never ever buy an insurance product with the sole purpose of saving tax. That would be like meeting a short-term liability with a long-term obligation. The tax payable is your short-term obligation that you have to fulfil for that particular year.

However, insurance products are of a long-term nature and you may find that though you may have saved the tax for that particular year, you will be paying for it by way of future premiums for many years to come. In any case, with the introduction of the new direct tax code, permanent tax saving will not be any more possible, but more on that next week.

Coming back to our topic, look atinsurance like a life saving pill that is to be administered only when you need it. Otherwise, the side-effects of the pill may be worse than the imaginary disease.

Term insurance

Perhaps one of the best, least-promoted products of the insurance industry is term insurance. It is the most economical and efficient way to insure yourself. Those who find that they need life cover should compare and contrast the term insurance products offered by various insurers and opt for the one that most satisfies their needs.

Term insurance covers the policyholder for a desired number of years against death, accident, disability etc — the same as other policies. In contrast, it does not have any maturity, paid-up, surrender or loan values. On occurrence of the contingency, the beneficiary gets the sum assured but on survival, the insured gets nothing.
In the case of any other policy, with or without bonus, whole life or endowment, actually the return on assurance component is also nil. However, it gets mixed up with the return on the investment component which could be (depending upon the policy) lower than other comparable investment products. Take care of this.

Basically, all insurance policies have term insurance as their base with optional add-ons, allowing the proponent to formulate his own policy, consistent with his personal needs. Each rider has its own premium.

You can choose one or more riders (or none) as add-ons and should undertake a comparative analysis of such riders in the stable of all the insurers for choosing the one that has the best cost-benefit ratio. Some examples of riders are personal accidental death benefit, terminal illness, major surgical assistance, hike in sum assurance, spouse insurance, renew/ convert benefit, etc.

Tax benefits of life insurance

As some cynic said, “There are only two certain things in life. One is death, the other is income-tax.”

In India, death may be certain but income-tax, with its vagaries of rules, is certainly not certain. So let’s briefly examine the tax benefits associated with insurance. For starters, any sum received under a life insurance policy, including the sum allocated by way of bonus is totally exempt from tax under Section 10(10D).

There are 3 exceptions:

Keyman insurance.

Policies covered by Section 80DD.

If the premium paid, in any of the years during the term of the policy, exceeds 20% of the actual sum assured, the maturity value received by the policyholder will be fully taxable. However, any sum received under such policy on the death of a person shall continue to be exempt.

Also, a deduction under Section 80C up to Rs 1 lakh is available on premiums paid on policies in the name of self, spouse or children, major or minor, even married daughters but not parents, whether dependent or not.

Where a taxpayer discontinues an insurance policy before premiums for two years have been paid, the deduction allowed during earlier years shall be withdrawn and shall be deemed to be the income of the year in which the policy is discontinued.

In sum

Without the foundation of insurance, the grandest of the financial planning edifice is only a castle in the air. However, never lose sight of the fact that over-insurance and excessive protection is bad for financial health.

Life insurance is a haven of security, shielding the family against hardships in the event of the demise of the breadwinner. To give an analogy, if your child is ill and requires medicine, you should buy it regardless of its cost. Life insurance is an absolute parallel case in all respects except one. When you do not buy the drug, the suffering of the child is visible. When you do not buy the life cover, you are not there to see the suffering. In either case, the effect is the same.

But the drug should be administered if and only if the child is ill. If taken otherwise, its side-effects could cause untold harm. When your dependents are already well provided for, excess-covering your life has the same effect. You do not fathom the loss but it exists.

Khyati Dharamsi. Mumbai

People still using banks to transact cash might have found that banks have been charging higher than earlier on cash transactions at bank branches.

So, if you are looking to transfer funds to your father in your native place, handing over cash to the lady sitting at the bank counter and waiting for the transfer to happen might not be all that cheap. Bankers have made it clear that they want to eliminate cash in the system and hence charges for those making cash transactions are bound to go higher.

Of course, one can always use a cheque book, on which the charges might be lower or none at all. However, remember there are cheque-collection charges levied on outstation cheques.

Also, If you are not dealing in a large amount, or are based out of the National Capital Region, your money would reach your father’s account only after three days later, excluding public and weekly holidays.

The cheque truncation system, whereby an image of the cheque would just be sent to the bank from which money is to be deducted and cheques would be cleared within a day, will go live soon. Till then, there are other electronic options that banks offer. After perseverance from the Reserve Bank of India (RBI), banks have even lowered the charges that ran quite high during the initial days and deterred customers from using the facility.

Apart from phone and Internet banking, which are becoming popular, there are three other ways of transferring money at lower costs either to a bank account within your own city or outside, which help you save charges:

Electronic Clearing Service (ECS): If you wish to avoid issuing multiple cheques for transferring funds to your father at regular intervals like every month or year, you can use the ECS facility. There are no charges on this facility once a mandate is submitted, but incase there is not enough balance, there will be heavy charges.

This can also be used for other regular payments such as life insurance premium or mutual fund contributions. This saves you the trouble of remembering each month by what date a particular cheque is to be submitted. Some firms also penalise you for not using ECS for some services. For instance, ICICI Prudential Life Insurance’s Hospital Care policy charges 5% extra if monthly premium is not paid by the ECS route. In ECS, you can state the number of payments in advance and even discontinue the facility when you want. Similarly, an ECS application can be given for receiving funds, such as dividends.

Real-time Gross Settlement (RTGS): Here, the money is transferred on a real-time basis. The amount would be deposited to your father’s account as and when your bank processes and transfers the request. This has to be done between 9 am and 3 pm on regular days and 9 am and 12 pm on Saturdays.

Individual banks may have other deadlines so as to process the application before the RBI deadline. RTGS applications are settled on an individual basis and are the fastest way to transfer money. Banks will not wait for all applications to come in and then processed with transactions. If any transfer request does not materialise due to any complication, the bank is required to return the money to the customer within two hours. However, there is a minimum requirement of Rs 1 lakh for using RTGS facility. To transfer funds lower than Rs 1 lakh, one can use the National Electronic Funds Transfer (NEFT).

National Electronic Funds Transfer (NEFT): Under this facility, the amount is transferred within three hours of transacting. This happens as the funds are transferred electronically six times a day — at 9.30 am, 10.30 am, 12 noon, 1 pm, 3 pm and 4 pm and up to the first three batches on Saturdays. So, if you submit a request to transfer funds to your father via NEFT at 11 pm, the electronic message to transfer your money would be sent during the 12 pm cycle. RBI then segregates the requests bank-wise and tells each bank to either withdraw or deposit cash according to the request and the money will be transferred to your father’s account with the respective bank.

Things to remember

To transfer fund through either RTGS or NEFT you will need a few accurate details. These include the account number and bank name of the person sending the money, the account number, bank name, branch name, account type (savings/ current etc) of the person receiving the money.

While transferring money, you would also need something called as the IFS code, which is a number to identify a bank branch. If you know the bank name, branch and the city name, the bank official can help you with the IFS code. The system can also automatically update details when you provide other details.

The newly-issued cheque books of some banks contain the 11-digit IFS code on cheque leaves.

The above facilities are available at around 50,000 branches of around 98 banks, which have major banks and most of their branches in its ambit. A list of these banks and branches is available on the RBI’s website

http://www.rbi.org.in/Scripts/bs_viewcontent.aspx?Id=112 and

www.rbi.org.in/Scripts/Bs_viewRTGS.aspx.

In case your bank doesn’t offer the NEFT facility, you can transfer up to Rs 50,000 using a bank which offers the same.

The RBI website and some bank websites also provide application forms for NEFT and RTGS to be submitted at your bank branch. The application can also be submitted electronically by netbanking customers of some banks such as State Bank of India, Axis Bank, HDFC Bank, etc.

There is no acknowledgement given to the person who will receive funds (in this example, your father). The only way to check whether the funds have been transferred is to see the passbook or the account statement. In case your father hasn’t received the funds, you can contact the bank branch or the RBI general manager.