Inflation data based on monthly WPI series from new year

The Centre plans to release inflation figures based on a revised wholesale price index (WPI) series, with 2004-05 as the base year, from the start of the new calendar year.
“The test run of the new series is now under way, based on price data received from about 3,500 manufacturing units.
“The idea is to extend this universe to 5,000-plus firms, from where the entire backlog of weekly price information since April 2004 is to be sourced and which can, then, be used to generate the relevant product and group-wise indices,” a senior official involved with the exercise told Business Line.
He said the target is to construct the new WPI series and take it up with the National Statistical Commission by end-October. “After that, we need about two months to stabilise the flow of the new data, which can be received online by the Office of the Economic Advisor (OEA) and automatically processed through software developed by the National Informatics Centre. So, by end-December or early-January, the inflation numbers derived from the new series could be ready for launch,” the official added.
The existing WPI series, having 1993-94 as the base year, covers 435 commodities, which include 98 ‘primary articles’, 318 ‘manufactured products’ and 19 ‘fuel, power, light & lubricant’ items. The proposed 2004-05 base series will have 1,224 commodities. While the ‘primary articles’ and ‘fuel’ groups will have more or less the same number of items — 105 and 19, respectively — there would be as many as 1,100 ‘manufactured products’. Price quotations
Also, in each of these individual commodities, it is planned to obtain at least five price quotations. This is against the present WPI series, where of the total 435 items, there are 214 (with a combined weight of over 36 per cent) represented by three or less quotations and as many as 86 with single quotations.
“Covering 1,200-plus commodities and having a minimum of five quotations for each of them is ambitious. But, with 5,000-odd reporting firms who are required to submit data online to the OEA only once a month, it is not difficult,” the official pointed out.
Currently, the OEA releases weekly WPI inflation every Thursday. The Working Group for Revision of WPI Numbers, headed by the Planning Commission Member, Prof Abhijit Sen, has recommended changeover to a monthly index in line with standard practice in other countries. The idea has, however, not found complete favour with the Finance Ministry and the Reserve Bank of India.
“It is a trade-off you have to make between more frequent, less reliable data (as is now the case) and less frequent, more reliable data. Maybe once a proper system of flow and processing of data at the planned levels gets established, it is possible to release weekly indices as well,” the official added.

Asset liability management

Asset-Liability Management (ALM) can be termed as a risk management technique designed to earn an adequate return while maintaining a comfortable surplus of assets beyond liabilities. It takes into consideration interest rates, earning power, and degree of willingness to take on debt and hence is also known as Surplus Management. But in the last decade the meaning of ALM has evolved. It is now used in many different ways under different contexts. ALM, which was actually pioneered by financial institutions and banks, are now widely being used in industries too. The Society of Actuaries Task Force on ALM Principles, Canada, offers the following definition for ALM: "Asset Liability Management is the on-going process of formulating, implementing, monitoring, and revising strategies related to assets and liabilities in an attempt to achieve financial objectives for a given set of risk tolerances and constraints."

Basis of Asset-Liability Management Traditionally, banks and insurance companies used accrual system of accounting for all their assets and liabilities. They would take on liabilities - such as deposits, life insurance policies or annuities. They would then invest the proceeds from these liabilities in assets such as loans, bonds or real estate. All these assets and liabilities were held at book value. Doing so disguised possible risks arising from how the assets and liabilities were structured. Consider a bank that borrows 1 Crore (100 Lakhs) at 6 % for a year and lends the same money at 7 % to a highly rated borrower for 5 years. The net transaction appears profitable-the bank is earning a 100 basis point spread - but it entails considerable risk. At the end of a year, the bank will have to find new financing for the loan, which will have 4 more years before it matures. If interest rates have risen, the bank may have to pay a higher rate of interest on the new financing than the fixed 7 % it is earning on its loan. Suppose, at the end of a year, an applicable 4-year interest rate is 8 %. The bank is in serious trouble. It is going to earn 7 % on its loan but would have to pay 8 % on its financing. Accrual accounting does not recognize this problem. Based upon accrual accounting, the bank would earn Rs 100,000 in the first year although in the preceding years it is going to incur a loss. The problem in this example was caused by a mismatch between assets and liabilities. Prior to the 1970s, such mismatches tended not to be a significant problem. Interest rates in developed countries experienced only modest fluctuations, so losses due to asset-liability mismatches were small or trivial. Many firms intentionally mismatched their balance sheets and as yield curves were generally upward sloping, banks could earn a spread by borrowing short and lending long. Things started to change in the 1970s, which ushered in a period of volatile interest rates that continued till the early 1980s. US regulations which had capped the interest rates so that banks could pay depositors, was abandoned which led to a migration of dollar deposit overseas. Managers of many firms, who were accustomed to thinking in terms of accrual accounting, were slow to recognize this emerging risk. Some firms suffered staggering losses. Because the firms used accrual accounting, it resulted in more of crippled balance sheets than bankruptcies. Firms had no options but to accrue the losses over a subsequent period of 5 to 10 years. One example, which drew attention, was that of US mutual life insurance company "The Equitable." During the early 1980s, as the USD yield curve was inverted with short-term interest rates sky rocketing, the company sold a number of long-term Guaranteed Interest Contracts (GICs) guaranteeing rates of around 16% for periods up to 10 years. Equitable then invested the assets short-term to earn the high interest rates guaranteed on the contracts. But short-term interest rates soon came down. When the Equitable had to reinvest, it couldn't get even close to the interest rates it was paying on the GICs. The firm was crippled. Eventually, it had to demutualize and was acquired by the Axa Group. Increasingly banks and asset management companies started to focus on Asset-Liability Risk. The problem was not that the value of assets might fall or that the value of liabilities might rise. It was that capital might be depleted by narrowing of the difference between assets and liabilities and that the values of assets and liabilities might fail to move in tandem. Asset-liability risk is predominantly a leveraged form of risk. The capital of most financial institutions is small relative to the firm's assets or liabilities, and so small percentage changes in assets or liabilities can translate into large percentage changes in capital. Accrual accounting could disguise the problem by deferring losses into the future, but it could not solve the problem. Firms responded by forming asset-liability management (ALM) departments to assess these asset-liability risk.

Techniques for assessing Asset-Liability Risk Techniques for assessing asset-liability risk came to include Gap Analysis and Duration Analysis. These facilitated techniques of managing gaps and matching duration of assets and liabilities. Both approaches worked well if assets and liabilities comprised fixed cash flows. But cases of callable debts, home loans and mortgages which included options of prepayment and floating rates, posed problems that gap analysis could not address. Duration analysis could address these in theory, but implementing sufficiently sophisticated duration measures was problematic. Accordingly, banks and insurance companies started using Scenario Analysis. Under this technique assumptions were made on various conditions, for example: - • Several interest rate scenarios were specified for the next 5 or 10 years. These specified conditions like declining rates, rising rates, a gradual decrease in rates followed by a sudden rise, etc. Ten or twenty scenarios could be specified in all. • Assumptions were made about the performance of assets and liabilities under each scenario. They included prepayment rates on mortgages or surrender rates on insurance products. • Assumptions were also made about the firm's performance-the rates at which new business would be acquired for various products, demand for the product etc. • Market conditions and economic factors like inflation rates and industrial cycles were also included. The capital of most financial institutions is small relative to the firm's assets or liabilities, and so small percentage changes in assets or liabilities can translate into large percentage changes in capital. Accrual accounting could disguise the problem by deferring losses into the future, but it could not solve the problem. Firms responded by forming asset-liability management (ALM) departments to assess these asset-liability risk. Based upon these assumptions, the performance of the firm's balance sheet could be projected under each scenario. If projected performance was poor under specific scenarios, the ALM committee would adjust assets or liabilities to address the indicated exposure. Let us consider the procedure for sanctioning a commercial loan. The borrower, who approaches the bank, has to appraise the banks credit department on various parameters like industry prospects, operational efficiency, financial efficiency, management qualities and other things, which would influence the working of the company. On the basis of this appraisal, the banks would then prepare a credit-grading sheet after covering all the aspects of the company and the business in which the company is in. Then the borrower would then be charged a certain rate of interest, which would cover the risk of lending. But the main shortcoming of scenario analysis was that, it was highly dependent on the choice of scenarios. It also required that many assumptions were to be made about how specific assets or liabilities will perform under specific scenarios. Gradually the firms recognized a potential for different type of risks, which was overlooked in ALM analyses. Also the deregulation of the interest rates in US in mid 70 s compelled the banks to undertake active planning for the structure of the balance sheet. The uncertainty of interest rate movements gave rise to Interest Rate Risk thereby causing banks to look for processes to manage this risk. In the wake of interest rate risk came Liquidity Risk and Credit Risk, which became inherent components of risk for banks. The recognition of these risks brought Asset Liability Management to the centre-stage of financial intermediation. Today even Equity Risk, which until a few years ago was given only honorary mention in all but a few company ALM reports, is now an indispensable part of ALM for most companies. Some companies have gone even further to include Counterparty Credit Risk, Sovereign Risk, as well as Product Design and Pricing Risk as part of their overall ALM. Now a day's a company has different reasons for doing ALM. While some companies view ALM as a compliance and risk mitigation exercise, others have started using ALM as strategic framework to achieve the company's financial objectives. Some of the business reasons companies now state for implementing an effective ALM framework include gaining competitive advantage and increasing the value of the organization.

Asset-Liability Management Approach ALM in its most apparent sense is based on funds management. Funds management represents the core of sound bank planning and financial management. Although funding practices, techniques, and norms have been revised substantially in recent years, it is not a new concept. Funds management is the process of managing the spread between interest earned and interest paid while ensuring adequate liquidity. Therefore, funds management has following three components, which have been discussed briefly.

A. Liquidity Management Liquidity represents the ability to accommodate decreases in liabilities and to fund increases in assets. An organization has adequate liquidity when it can obtain sufficient funds, either by increasing liabilities or by converting assets, promptly and at a reasonable cost. Liquidity is essential in all organizations to compensate for expected and unexpected balance sheet fluctuations and to provide funds for growth. The price of liquidity is a function of market conditions and market perception of the risks, both interest rate and credit risks, reflected in the balance sheet and off-balance sheet activities in the case of a bank. If liquidity needs are not met through liquid asset holdings, a bank may be forced to restructure or acquire additional liabilities under adverse market conditions. Liquidity exposure can stem from both internally (institution-specific) and externally generated factors. Sound liquidity risk management should address both types of exposure. External liquidity risks can be geographic, systemic or instrument-specific. Internal liquidity risk relates largely to the perception of an institution in its various markets: local, regional, national or international. Determination of the adequacy of a bank's liquidity position depends upon an analysis of its: - • Historical funding requirements • Current liquidity position • Anticipated future funding needs • Sources of funds • Present and anticipated asset quality • Present and future earnings capacity • Present and planned capital position As all banks are affected by changes in the economic climate, the monitoring of economic and money market trends is key to liquidity planning. Sound financial management can minimize the negative effects of these trends while accentuating the positive ones. Management must also have an effective contingency plan that identifies minimum and maximum liquidity needs and weighs alternative courses of action designed to meet those needs. The cost of maintaining liquidity is another important prerogative. An institution that maintains a strong liquidity position may do so at the opportunity cost of generating higher earnings. The amount of liquid assets a bank should hold depends on the stability of its deposit structure and the potential for rapid expansion of its loan portfolio. If deposit accounts are composed primarily of small stable accounts, a relatively low allowance for liquidity is necessary. Additionally, management must consider the current ratings by regulatory and rating agencies when planning liquidity needs. Once liquidity needs have been determined, management must decide how to meet them through asset management, liability management, or a combination of both.

B. Asset Management Many banks (primarily the smaller ones) tend to have little influence over the size of their total assets. Liquid assets enable a bank to provide funds to satisfy increased demand for loans. But banks, which rely solely on asset management, concentrate on adjusting the price and availability of credit and the level of liquid assets. However, assets that are often assumed to be liquid are sometimes difficult to liquidate. For example, investment securities may be pledged against public deposits or repurchase agreements, or may be heavily depreciated because of interest rate changes. Furthermore, the holding of liquid assets for liquidity purposes is less attractive because of thin profit spreads.

When a sub-prime earthquake hits

Ever since the sub-prime crisis hit the US economy and began to impact its financial sector firms, the debate in the Indian software sector was whether the slowdown staring it in the face would be as bad as in 2001-02, when the technology and telecommunications bubbles burst and terrorist attacks hit New York.

Now, with the US financial sector going through an earthquake, the debate over whether things are 'as bad' has taken on a new, even fearsome, meaning. As much as 60 per cent of the revenue of India's software firms comes from the global financial sector, so the plight of the Indian IT sector can well be imagined.

Currently, the key vendors to the two casualties, Lehman Brothers and Merrill Lynch, are all claiming that they will not be seriously affected. But how serious is 'serious?'

Leading Indian IT firms, which had lately been acquiring consulting skills, will find their financial clients' appetite for contemplating 'transformational' change in their business models virtually gone. Indian firms have of course been trying over the last few years to de-risk their businesses by seeking growth in verticals like telecommunications, manufacturing and logistics, but it takes years to change a business mix and the present crisis has come too soon in the day.

The immediate challenge facing Indian firms will be the consolidation that will take place in the Western financial services industry as leading firms go belly up and are quickly taken over by the handful of firms which have not lost either their capital or the ability to raise fresh funds. The consolidation in the industry will affect not just its own staffing but also the vendors. With severe cuts in budgets all round, outsourcing spend is likely to be affected.

The saving grace is that nameplates can be replaced but legacy systems cannot, and the most important part of Indian IT's revenue still comes from the maintenance of such systems. Such jobs will continue to be outsourced, but vendors will have to face cuts in rates that will eat into not just top line but also margins.

Understandably, there is gloom all round, but innovative IT firms like Tejas Networks and Ittiam are either selling their own boxes or developing entire reference designs of gadgets like MP3 players and video phones, many of them made and sold under East Asian labels. Large Indian companies are needed who can take such products global under their own brand names.

How the global financial crisis affects India

The key question confronting the economy now is the backwash effect of the American (or global) financial crisis. Central banks in several countries, including India, have moved quickly to improve liquidity, and the finance minister has warned that there could be some impact on credit availability. That implies more expensive credit (even public sector banks are said to be raising money at 11.5 per cent, so that lending rates have to head for 16 per cent and higher -- which, when one thinks about it, is not unreasonable when inflation is running at 12 per cent).

For those looking to raise capital, the alternative of funding through fresh equity is not cheap either, since stock valuations have suffered in the wake of the FII pull-out. In short, capital has suddenly become more expensive than a few months ago and, in many cases, it may not be available at all.

The big risk is a possible repeat of what happened in 1996: Projects that are halfway to completion, or companies that are stuck with cash flow issues on businesses that are yet to reach break even, will run out of cash. If the big casualty then was steel projects (recall Mesco, Usha and all the others), one of the casualties this time could be real estate, where building projects are half-done all over the country and some developers who touted their 'land banks' find now that these may not be bankable.

The only way out of the mess is for builders to drop prices, which had reached unrealistic levels and assumed the characteristics of a property bubble, so as to bring buyers back into the market, but there is not enough evidence of that happening.

The question meanwhile is: Who else is frozen in the sudden glare of the headlights? The answer could be consumers, many of whom are already quite leveraged. More expensive money means that floating rate loans begin to bite even more; even those not caught in such a pincer will decide that purchases of durables and cars are not desperately urgent.

And it is not just the impact of those caught on the margin who must be considered. The drop in real estate and stock prices robs a much larger body of consumers of the wealth effect, which could affect spending on a broader front. In short, the second round effects of the financial crisis will be felt straightaway in the credit-driven activities and sectors, but will spread beyond that in a perhaps slow wave that could take a year or more to die down.

One danger meanwhile is of a dip in the employment market. There is already anecdotal evidence of this in the IT and financial sectors, and reports of quiet downsizing in many other fields as companies cut costs. More than the downsizing itself, which may not involve large numbers, what this implies is a significant drop in new hiring -- and that will change the complexion of the job market.

At the heart of the problem lie questions of liquidity and confidence. What the RBI needs to do, as events unfold, is to neutralise the outflow of FII money by unwinding the market stabilisation securities that it had used to sterilise the inflows when they happened. This will mean drawing down the dollar reserves, but that is the logical thing to do at such a time. If done sensibly, it would prevent a sudden tightening of liquidity, and also not allow the credit market to overshoot by taking interest rates up too high.

Meanwhile, there is an upside to be considered as well. The falling rupee (against the dollar, more than against other currencies) will mean that exporters who felt squeezed by the earlier rise of the currency can breathe easy again, though buyers overseas may now become more scarce. Overheated markets in general (stocks, real estate, employment-among others) will all have an element of sanity restored. And for importers, the oil price fall (and the general fall in commodity prices) will neutralise the impact of the dollar's decline against the rupee.

US meltdown: 5 lessons for investors

The stunning collapse of Lehman Brothers and the crisis engulfing Wall Street is having an impact across the world. There could be several more developments over the next few months that might make things more difficult.

For investors, this is an important period to learn from such developments. This will ensure that they are not in a tough situation in the future. Here are five such important lessons.

US crisis spooks global economy

Every investment has risk: Typically, during good times, investors tend to ignore the risk element in a paper and focus only on returns.

Investors in equities stand to lose their entire money, if the company goes down. The plunging shares prices of Lehman Brothers, Freddie Mac and Fannie Mae to one dollar proves that entire market capitalisations can simply get wiped out.

Even debt market products get badly hit on account of the write-down of the debt that they hold.  So, a portfolio needs to be as diversified as possible to insulate a person for such situations.

Everything is interlinked: From the price of a stock to an insurance policy, everything is linked. A fall in the price of a particular stock in Europe could mean the overseas mutual fund, where you have invested, is likely to see a fall in its net asset value. Even an insurance policy with a domestic company, which has a foreign partner, can be adversely impacted.

The latter implies you will lose your premiums as well as your cover. While such risks cannot be avoided, a portfolio that contains only domestic stocks or an insurance company may sound safe, but there is no guarantee that it will not be impacted adversely.

Diversify, the only mantra for retirement planning: The result of all the financial planning is gauged by the final corpus that you are able to create for retirement.

A sufficiently-big nest will ensure that there are adequate funds during the sunset years. Many people, even those who are in the financial sector, make the basic mistake of putting all their eggs in one basket.

Many a time, employees buy shares of their own companies thinking that being an insider they are privy to the most-sensitive information. This could lead to a great risk, if suddenly something were to go wrong.

The solution again is diversification. Having exposure to local equities, international equities, debt, commodities together would be a better idea to create a sound portfolio that will weather tough times. And even within each of these areas, spread the money across investment options.

Treat your career like an investment: Most people do not pay the right amount of attention to their career or working life. Just like an investment that needs constant monitoring and analysis, there is a need to monitor the career in the same manner. Most people are shocked when they lose their jobs.

The better way is to be prepared for the worst. That will help to insulate you from any career related problem.

Also, concentration on issues like upgrading skills through training, attending conferences and seminars and networking will help to improve your career. Yes, all these cost money. However, the returns over the years are much more.

Save during good times: Most importantly, when the earnings are high, save well. Good times are not for ever. Creating a meaningful portfolio or a simple savings corpus would be of great help during bad times. Proper investments will ensure that there are reserves that can be used during emergencies.

A sum of Rs 10,000 saved each month for 25 years growing at 15 per cent annually will give rise to a corpus of Rs 2.55 crore (Rs 25.5 million). All this money can be rather useful when the cash flow actually stops. 

10 tax-smart tips for salary earners

As in Alice's Wonderland, so too in the labyrinth-land of income tax, things are often not what they appear to be. 'Yes' may not always mean yes, and 'no' may not necessarily mean what we generally take it to mean.

So, it pays to be tax-smart; you can get to keep more of your hard-earned money for yourself rather than having to cough it up to the taxman . . .

1. Exemption on soft furnishing expenses Sec. 10(14) [of the Income Tax Act] offers exemption for expenses (and not allowances) incurred wholly, necessarily and exclusively in the performance of the duties. There are two distinct arguments to render soft-furnishing non-taxable.

The first one is to claim that the employee needs to entertain guests at his residence for official purpose. The second one is that the expense is incurred to protect the furniture belonging to the office at the residence of the employee from deterioration.

2. Notice period salary equivalent paid to employer is not tax deductible

Most employment conditions require an employee who desires to change his job, to give his employer a notice of his intentions and serve him for certain pre-fixed months.

In case an employee desires to leave the services immediately, or before the notice period, he should pay the employer an amount equivalent to the salary he would have earned during the notice period or shortfall thereof. Is this amount deductible from the salary income of the employee?

What the employee is paying to the employer cannot come under the head 'Salaries' since he is not the employer's employer. This amount represents application of his income and therefore, it is not deductible. He has merely applied this income to discharge a liability and therefore, it is not tax deductible.

This is the view generally accepted by all accountants and the income tax department.

3. Employment after retirement can be less taxing

These days many employees are re-employed by their ex-employers on retainership or contractual basis after their retirement. The fact that the person happens also to be the ex-employee is immaterial and inconsequential.

Such a person enjoys better concessions than a normal employee. He can claim deductions for expenses incurred for earning his consultancy fee. Moreover, the TDS applied by the principal would be only 10% of the fee paid.

4. How gardener and helper can be tax-free perks

Here, two points are of great interest: � Circular 122, dated 19.10.73, clarified that if the employer employs a gardener for a building belonging to the employer, it would not be treated as a perk. This principle continues to be applicable even now with the possibility of it being extrapolated to other servants. � This is more interesting. A helper engaged for the performance of the duties of an office or employment of profit; is not considered as a perk under Rule 2BB, read with Sec. 10(14). Many employees, particularly at the top level, and especially in view of communication handshakes available through e-mail, do not necessarily work only in the office. Some part of the work is done at residence. We will go to the extent of stating that the employee can directly engage the services of a helper and claim reimbursement from the employer without it being considered as a perk.

5. Tax nuances when a house / flat is given on lease to employer

Top management category employees usually get rent-free residential house as a perk. Sometimes, the flat belongs to the employee, taken on lease by the company from the employee and the employee is allowed to reside in it.

In other words, the landlord of the residential flat used by the employee is the employee himself and simultaneously he is also a tenant.

Under such a situation, the employee will have to pay tax on the lease rent received as income from house property and also as perk. Is this double taxation? Definitely not. The employee is enjoying double benefit and will have to pay tax on each benefit separately.

Is this flat self-occupied or let-out? Of course it is let-out. No one can pay rent to himself.

The Sec. 80C deduction is possible both on self-occupied and let out flats. The interest is deductible in full since the flat is let out. If the employee pays some rent to his employer, this rent cannot be deducted from the lease rent for tax purpose. This rent will be taken cognisance of while computing the perk value.

Before the revision in perk values, many of the employees used to give their flats or the flats of their wives on lease to the employers and benefit immensely. Now, after the large-scale amendments to perk values, the advantage has been watered down.

Nevertheless, normally the lessor takes an interest-free deposit from the lessee. This is a deposit and not a loan. Consequently, it does not have any perk value. We do not think the Department will question the size of the deposit in such cases.

6. Interest on deposit for a leased flat

The ITO cannot treat the difference between the market rate of interest and the actual interest paid by the landlord to his tenant on deposits placed by the tenant in custody of the landlord, as further rent received. [CIT v Satya Co. Ltd., (1994) 75Taxman193 (Cal.)].

7. LTA and Relatives

As per the Rules, you can claim the LTA benefit only twice during the block of 4 years. For this purpose

You should be on leave.

You should travel.

During such travel you may have your family with you. Family includes spouse, children as well as dependent parents, brothers and sisters. In respect of children born on or after 1.10.98, the exemption will be restricted only to two surviving children unless the birth after one child has resulted in multiple births.

The expense incurred by you is exempt up to the LTA received.

Obviously, if your wife and other family members travel, without you accompanying them, no LTA can be claimed.

LTA and working couple

Take the case of a working couple. Both the husband and wife can claim the exemption on LTA from their employers and claim benefit for 4 journeys in one block. There is no need for them to take the precaution of not travelling twice during the same year.

Moreover, they can take the same family members or different ones as long as they stick to the definition of the members for this purpose.

8. Tax-free perks of ex-employees

Aditya Cement Staff Club v Union of India & Others is an interesting case which states that where an employee has resigned and is allowed to occupy company quarters free of rent or at concessional rent, it is not to be taken as perk value, unless it is a contractual obligation to that effect according to the terms of employment.

In order that any benefit, amenity or payment may be termed as perquisite, it must be in pursuance of a right conferred on or option given to the employee to receive such benefit or advantage from his employer.

Unless such advantage or benefit flows from the status of the person working as an employee it cannot be termed as perquisite. The employee must have a vested right to claim advantage or benefit whether in cash or in kind, in order to fall within the purview of perquisite as part of salaries taxable under the ITA.

9. Provident Fund not encashed

Interest on Registered Provident Fund (RPF) of an employee is tax-free. Does it still remain tax-free after the employee retires and does not claim his Provident Fund for say 2 to 3 years?

If one goes strictly according to the drafted provisions, it appears that this interest is tax-free since the amount becomes payable only when the ex-employee asks for it. However, we are told that many ITOs take the stand that the balance in Co-PF gets the colour and character of company fixed deposits when the employee retires. This stand is challengeable.

10. When PF becomes taxable

If an employee leaves the service before completion of 5 years, Rule 10 of Part A of Schedule IV, requires the trustees of a Recognised PF to deduct tax when the accumulated balance due to an employee is paid. This payment is to be treated as income chargeable under the head 'Salaries.'

Rule 9 puts a different responsibility on the Assessing Officer. He shall calculate the total of the various sums of tax which would have been payable by the employee in the respect of the total income for each of the related years to arrive at the amount by which such total exceeds the total of taxes paid by the employee for such years.

This excess amount is payable by the employee in addition to tax on the income during the year in which the accumulated balance of PF becomes payable.

According to Rule 8 of Part A of the Fourth Schedule, this requirement of 5 years shall not be applicable where the service has been terminated by reason of the employee's ill-health, or by the contraction or discontinuance of the employer's business or other causes beyond the control of the employee.

All the same, it is not clear if the employer's contribution becomes taxable if the employee has to retire on attaining superannuation age after a continuous service of less than 5 years. It is our considered opinion that since the retirement is beyond the control of the employee, the amount does not become taxable.

It is erroneous to feel that the employee's contribution to PF is not taxed during the year of contribution. It is fully taxed in any case. All he gets is the deduction which stands withdrawn if the employee withdraws the PF before 5 years. To tax the contribution once again in the year of withdrawal is tantamount to double taxation.

In the case of unrecognised provident fund, there is a triple taxation if the employee withdraws within 5 years. Not only he is not allowed any deduction on his own contribution but also the employer's contribution is taxed during the year of contribution and also during the year of withdrawal.

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[Excerpt from the book, Taxpayer to Taxsaver by A. N. Shanbhag and Sandeep Shanbhag, published by Vision Books.]

Don't worry about the economic slowdown

The first-quarter (April-June) GDP numbers, released by the Central Statistical Organisation on August 29, are along the expected lines, even though they show a significant drop to 7.9 per cent, from the 9.2 per cent achieved in the first quarter last year, and constitute the lowest growth rate since 2004. Forecasters have been converging in the 7.5-8 per cent range when it comes to growth for the full year, and the first-quarter numbers are consistent with that. In fact, the range may need to be scaled down a bit, because it now implies that growth rates will not be very different in the next three quarters whereas, in reality, the likelihood of a further slowdown is quite high.

Most official Indian forecasts (by the finance ministry, Reserve Bank and the Economic Advisory Council to the Prime Minister) as well as some private sector projections have only recently dropped to less than 8 per cent; by way of contrast, the international forecasters have caught on faster to the extent of the slowdown. Still, some comfort can be obtained from the fact that the growth rate will remain in the 7.5 per cent range, give or take a bit. This reinforces the belief that the underlying trend is strong enough to limit the damage caused by the downturn, a factor critical to sustaining investment levels in the economy.

From the sectoral perspective, agriculture grew by 3 per cent, on trend. However, the somewhat deficient rainfall during July in several parts of the country could adversely affect second-and third-quarter numbers for this sector. Manufacturing grew by 5.6 per cent, down from 10.9 per cent last year, a drop that was clearly visible in the monthly Index of Industrial Production numbers.

The construction sector, however, has been a surprise. Growth accelerated from 7.7 per cent last year to 11.4 per cent this year. Given that this is viewed as an interest-sensitive activity, the interest rate dynamics of the past couple of quarters would have been expected to slow this sector down considerably. The fact that it didn't is probably attributable to the steady increase in investment in infrastructure, as opportunities for the private sector increase.

It is also quite striking that the two largest service sectors, "trade, transport, hotels and communications" and "financial and business services", although growing at slower rates than last year, still displayed great strength. The former grew by 11.2 per cent, compared with 13.1 per cent last year, while the latter grew by 9.3 per cent, compared with 12.3 per cent last year.

Looking at the numbers from the demand side, the investment/ GDP ratio came in at 32.3 per cent, slightly higher than the first quarter of last year but down sharply from the 38.5 per cent believed to have been reached at the peak last year. This suggests that investment activity, while responding to the business cycle, is still quite buoyant, an inference consistent with that emerging from the construction numbers. In fact, growth can probably be sustained at about 7.5 per cent even if the investment/ GDP ratio drops further, to 30 per cent.

As far as policymakers are concerned, these numbers provide some reassurance that, while the recent monetary tightening has affected growth, the impact has not been enough to raise questions about the anti-inflation stance. If the extent of the downturn is going to be limited to 7.5 per cent growth, or marginally less, and even if such a slowdown were to persist for some time, the monetary authority can continue to focus on reining in inflation. The bottom line is that, while there are undoubtedly problems emerging on the macroeconomic front, notably the widening fiscal gap, the economy has so far displayed remarkable resilience in the face of a succession of shocks.

14 tax tricks and traps when buying property

With incomes rising, property and home purchases have grown exponentially in recent years. Being large-ticket investments, it's important to be savvy about the tax breaks and pitfalls that lie en-route.

1. Cancellation of contract by buyer

The courts have held that any advance, earnest money, part payment or any other sum paid by a prospective buyer to a prospective seller for the purchase of capital asset is not an income. The character of such a payment cannot change simply because the seller decides to confiscate it for non-performance by the buyer.

Since no transfer of any capital asset has actually taken place, there is no capital gain for the seller. Though it is a pecuniary loss for the buyer, he would not be able to claim it as a capital loss under Section 45 of the Income Tax Act as the prospective buyer neither ever owned nor relinquished the capital asset in question.

This means that the entire forfeited amount escapes the tax net, but only in the present dimension. When the property is eventually sold, Section 51 stipulates that in computing cost of acquisition, any advance or other money received and forfeited by the assessee is to be deducted from the cost or the written down or fair market value, for which the asset was acquired.

2. Buying a house in spouse's name using your money

Purchasing a house in the name of your wife by applying your own funds means that you are using her as a name-lender and this amounts to a 'benami' transaction, which is illegal. The house squarely belongs to you and you will have to treat it as such.

The transaction can be made legal by gifting the money to the wife to enable her purchase the property in her name. Another alternative is to gift your house to her, but this will attract stamp duty and registration charges. It is also necessary for you to follow the procedure for gifting. There is no sense in taking either of the actions in most of the situations.

The utility, if any, is lost because of the clubbing provision, which requires the property income to be added to your income for income tax and its value to be added to your wealth for wealth tax.

If you take a housing loan in your name, you would not be able to claim any tax benefits associated with the loan, because the house belongs to your wife.

In short, do not buy a house property (or any other asset) in the name of your spouse. The tax concessions on housing loan can be availed only by the person who owns the house.

3. Loan taken prior to acquisition of house

Both the deductions u/s 24 and 80C are allowed only when the income from house property becomes chargeable to tax. In other words, the construction should be complete, the flat should be ready for occupation and the municipal annual value should be known. The interest for the years prior to the year in which the property was completed, shall be deducted in equal installments for the year during which it was completed and each of the 4 immediately succeeding years.

Unfortunately, there is no corresponding provision for deduction u/s 80C for capital repayment.

Thus, protracted delays by a builder end up unfairly punishing the assessee. Beware.

4. Taking a loan to repay an earlier loan may be beneficial

If you find that it is quite beneficial to borrow funds for the express purpose of repaying the old loan, go ahead. Loan taken from a permissible source to extinguish loan from another permissible source, qualifies for deduction (Circular 28 dated 20.8.69).

The following is the relevant part of the Circular:

"If the second borrowing has really been used merely to repay the original loan and this fact is proved to the satisfaction of the Income Tax Officer, the interest paid on the second loan would also be allowed as a deduction u/s 24(1vi)."

This gives rise to two issues:

• The interest on the second loan continues to get the benefit of the deduction u/s 24. Unfortunately the deduction u/s 80C is not available. Illogical? But that's how it is.
• Suppose, the first loan is taken before 1.4.99 and the second after that date. Does the ceiling on interest deduction go up from Rs. 30,000 to Rs. 1,50,000? Logically, since the 2nd loan maintains the continuity and does not change the colour and character of the 1st loan, the deduction should stay put at Rs. 30,000. Some of the housing finance companies push their products claiming that the 2nd loan gives the borrower the right to claim higher deductions.

5. Second loan for a second flat

Suppose an assessee has taken a flat through housing loan and is claiming deduction on interest and also on repayment of loan. Subsequently, he takes a second flat and also takes a loan for its purchase. This second house will be treated as let out or deemed let out. The entire interest payable without any ceiling is deductible against the income from it. Even if he does not let it out, the annual value of the flat will be treated as income for income-tax purpose.

One more point. Even if two loans are taken for the same flat, total benefit can be claimed on both the loans as long as both the loans are for acquisition or construction.

6. Joint loans

In case of joint holding, both the holders will be able to claim 100 per cent of the concessions separately, if and only if, their individual share in the property and also in the loan is defined and ascertainable.

Unfortunately, housing loans are not normally granted to those who go in for flat in joint names. In the case of default, it is easy to deal with property entirely belonging to the defaulter. Joint ownership is riddled with legal hassles. When one defaults and the other does not, it is impossible to evict both of them. Two separate loans are also riddled with the same problem.

7. Tax breaks on self-occupied and let-out properties

The entire interest on loans taken is admissible when the property is not self-occupied whereas the deduction for self-occupied property is restricted to Rs. 30,000 or Rs. 1,50,000.

8. Interest on housing loans deductible on accrual basis

Sec. 24(b) allows deduction of interest payable on borrowed capital. The deduction is allowed even if the interest is not paid and even if the borrower is in default. Illogical, but that's how it is!

9. Loan taken after acquisition of a property

Loan taken after taking possession of the house is obviously not taken for purchasing the house. Hence it will not attract any tax benefits associated with housing loans.

10. Land and superstructure can be valued separately for capital gains

The definition of a capital asset includes property of any kind and land held by the assessee is a capital asset and a building held by the assessee is also a capital asset. Suppose the land is held for more than 3 years and the superstructure is of recent origin.

It is not possible to say that by construction of the building, the land, which was a long-term capital asset, has ceased to be a long-term capital asset, and it continues to remain as an identifiable capital asset even after construction. The courts have held that the land and the superstructure can then be assessed separately as 'long term capital asset' and as 'short term capital asset', respectively, for the purpose of capital gain.

One important aspect: Suppose the superstructure belongs to one person and land to another. When the house is sold, the exemption on capital gains can be claimed only u/s 54F and not u/s 54. Sec. 54 is applicable only to houses and neither the land nor the superstructure separately can be regarded as a house.

Therefore, for the purpose of claiming the benefit of housing loan, it would be difficult to claim any deduction on interest payable or capital repayment, where the land belongs to wife and the superstructure belongs to husband.

This difficulty can be bypassed by the wife giving the land to the husband on lease or by selling it to him.

11. Administrative charges and processing fees

The repayment of loan is eligible for deduction u/s 80C and interest payable thereon is deductible u/s 24. Some housing finance companies build up their initial charges into the EMI in which case, the tax benefits are available. If the company makes you pay a lump sum towards the administrative and processing charges, no tax benefit is possible as these are neither a repayment nor interest.

12. Difference between purchase and construction

Sec. 54 gives exemption from tax on long-term capital gains arising out of sale (or transfer) of a residential house, self-occupied or not, provided the assessee has purchased within 1 year before or 2 years after the date of sale or has constructed a residential house within 3 years after that date.

Note that the exemption is available on purchase of new property made within 1 year before the sale of the old house. But in the case of construction, the exemption is not available if the construction is completed even 1 day before the sale of the old house. Illogical!

13. Dates of registration and acquisition

Normally, the title to an immovable asset does not pass till conveyance deed is executed and registered. However, in a landmark judgement, the courts held that "taking into consideration the letter as well as the spirit of Sec. 54 and the word 'towards' used before the word 'purchase' in Sec. 54, it is clear that the said word is not used in the sense of legal transfer and, therefore, the holding of a legal title within a period of one year is not a condition precedent for attracting Sec. 54."

Thus, even if the documents are not registered but the following conditions of Section 53A of the Transfer of Property Act are satisfied, ownership in the property is held to have been "transferred" -

• (a) there should be a contract in writing;
• (b) the transferee has paid consideration or is willing to perform his part of the contract; and
• (c) the transferee should have taken possession of the property.

When these conditions are satisfied, the transaction will constitute "transfer" for the purpose of capital gains.

14. Loss from house property

The treatment for loss from house property has a drawback. Suppose the normal income is Rs. 1,62,000 and the loss from the property is Rs 20,000. The total net income works out at Rs 142,000. This being less than Rs 150,000, the minimum tax threshold, no tax is payable.

In effect, only Rs 12,000 of the loss is useful for reaching the threshold. The rest of the loss of Rs 8,000 is wasted as it is not allowed to be carried forward!! This is so, because Rs 8,000 does not remain a loss but becomes a gap between the tax threshold and the income.

On the other hand, if the total income were Rs 15,000, then the assessee would be allowed to carry forward the loss of Rs 5,000. If the total income were nil, the entire loss of Rs 20,000 could be carried forward to next year. Such carried forward loss can be adjusted only against income from house property.

(Excerpt from Taxpayer to Taxsaver (FY 2008-09) by A. N. Shanbhag and Sandeep Shanbhag, published by Vision Books.)