Is it the end of the Road for Wall Street Banks?-VRK100-28062010

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Is it the end of the Road for Wall Street Banks?


Rama Krishna Vadlamudi, BOMBAY       June 28, 2010



The US Government’s efforts to cage Wall Street Banks has finally taken some concrete shape after intense negotiations among US lawmakers. The US Congress has decided to overhaul the US financial system by imposing various restrictions on Banks in the areas of proprietary trading, bank capital and Swaps. The Wall Street reform has been hailed as one of the most sweeping financial reforms since the reforms undertaken in the wake of Great Depression of the 1930s in the US. The US Democrats, led by President Barack Obama, have been trying to do something to rein in negligent banks which have been blamed for the global financial meltdown of 2008.



The latest financial regulation reform bill is seen as an attempt by the US Government to control Wall Street financial firms, which have acted irresponsibly by playing with public money. The US banks have also been criticized for paying rich bonuses to their employees at the cost of taxpayers. The bill seeks to establish consumer financial protection. It tries to control financial firms from taking unwarranted risks that will threaten the economy. It wants to protect taxpayers’ money. After a long session of negotiations on June 24-25, 2010, the US legislators agreed for tougher restrictions on banks. This bill was approved by the US Senate. The reform bill will become law once it is approved by the House of Representatives and then signed into law by President Obama.



This article is organized into the following topics:

 The important provisions of the US financial regulation reform bill

 What will be the impact of these reforms?

 What is the criticism of the bill?

 What the other Governments across the Atlantic are doing?



What are the key provisions of the US Financial Regulation Reform bill?

 VOLCKER RULE: Named after the former chairman of the US Federal Reserve, Paul Volcker, the Rule tries to bar proprietary trading by banks for their own accounts; restrict banks’ investment in hedge funds and private equity funds; and limiting the liabilities that banks can hold. But, this Volcker Rule has been diluted. Now, the reform bill allows proprietary trading in certain areas, like, government debt, hedging purposes and small business investments. The new provision allows deposit-taking Wall Street banks to invest up to three per cent of their capital in hedge funds or private equity funds. Some analysts say these provisions may not be fully applicable for some banks for another seven years.

 The bill will set up a new Consumer Protection Agency, under the supervision of US Federal Reserve. The new agency will curb abusive practices by credit card companies and mortgage lenders. It may be recalled that reckless sub-prime lending in the US prior to 2008 had led to the near-collapse of banking system across the world in 2008. The new agency will be funded by fees that will be collected from banks.

 A new 10-member oversight council of financial regulators, headed by the Treasury Secretary, will be created to coordinate activities connected with regulatory oversight of financial markets & to monitory systemic risks

 Regulatory bodies will be given more powers to seize and conduct an orderly liquidation of large banks, like, Citibank. Large banks will be required to raise their capital. But, they will be given a time of five years to comply with this requirement.

 Most of the derivatives trading from now onwards will have to be done through third-party exchanges.

 Swaps: The size of the over-the-counter (OTC) derivatives market is USD 615 trillion. The bill allows banks to do trading in foreign exchange and interest rate swaps, which account for bulk of the OTC market. However, the bill requires banks to spin off dealing desks into affiliates for handling agricultural, energy and metal swaps, equity swaps and un-cleared credit default swaps. In future, most of the OTC derivatives trading will be done through more accountable and regulated channels such as clearing houses and exchanges.

 The reforms are expected to cost USD 19 billion. A new tax will be imposed on banks to recover the cost of implementing the reforms.

 Credit rating agencies will be subject to more scrutiny. They must disclose their methodologies.



What will be the impact of these reforms?



o Banks will make lesser profits due to curbs on proprietary trading, which allowed bank traders to take riskier bets with depositors’ money on bank’s accounts

o The decision to move most of the OTC derivatives trading to exchanges will improve transparency in swaps trading. This will allow authorities to regulate swaps in a better manner.

o The curbs on trading in credit default swaps will hit banks profits adversely

o Smaller banks will have a breather from the new rules. Banks, with less than USD 15 billion in assets, will be exempted from the rules.

o It remains to be seen whether the bill will be able to prevent the kind of bank excesses we have seen in the past and which led to the global financial meltdown of 2008



What is the criticism of the reform bill?



It is a watered down version of what was originally proposed. As democrats lack full majority in the US Congress, they have allowed some amendments in order to satisfy the viewpoints of republicans in the Congress. Of course, some democrats also opposed certain provisions.

Now, the reform bill allows proprietary trading in select areas, like, government debt, hedging purposes and small business investments. The new provision allows deposit-taking Wall Street banks to invest up to three per cent of their capital in hedge funds or private equity funds. Three per cent of capital for big banks, like, Goldman Sachs, is very big amount, some argue.

The regulation is too late as it comes after 20 months since the collapse of Lehman Brothers in September 2008.


Will the reform bill be able to cage unruly banks?


Even though some portion of swaps business will be taken out of banks into affiliates, banks will still be able to do in-house trading in foreign exchange and interest rate swaps, which form a major chunk of swaps market. Banks have to increase their capital; but they are given a time of five years to fulfill this rule. They will be able to invest in hedge funds and private equity; though with quantitative limits. The so-called Volcker Rule has been diluted. All these dilutions and compromises indicate that it may be business as usual for banks on Wall Street despite tall talk of sweeping reforms. Of course, a good beginning has been made to control unmanageable banks on the Wall Street.


What are the other Governments doing across the Atlantic?


As the global financial crisis has impacted almost all the major financial centres across the world, other Governments too have been raising their voices about bank regulation in their own countries and regions. Europe wants to levy a new tax on banks to create crisis funds. The European Union is proposing to impose restrictions on activities of hedge funds and private equity funds. These proposals are yet to attain a concrete shape as they have to be approved by the EU, which is an amalgam of 27 member countries.

However, the United Kingdom (the UK is not a part of the Euro Zone), under the new coalition Government, is making sweeping changes to its financial regulation. The changes are:

 The Financial Services Authority (FSA) will be scrapped and the Bank of England (BoE) will be entrusted with the task of financial regulation. At present, the FSA is the single regulator for banks, mutual funds and insurance companies.

 The UK Government will create a new Financial Policy Committee within the BoE. The Committee will be headed by Mervyn King, the governor of the Bank of England.

 Two new regulators will be created. The first is Prudential Regulation Authority, under BoE, which will regulate banks, insurers, investment banks and other financial institutions. The second is a Consumer Protection and Markets Authority.

 Under the new dispensation, the BoE will be given more powers. Till now, the BoE is entrusted with the task of conducting monetary policy and fixing interest rates for the economy; while banking regulation is taken care of by FSA. But under the new laws, the FSA will be dismantled and the Bank of England will have to take up additional duties in the form of regulating banks and other financial institutions. Monetary stability and financial stability will now be the responsibility of the BoE.

 The UK government will levy a new tax on banks and impose curbs on bank bonuses

 The new system will be completed by 2012


Once these changes have come into effect, experts say that it will be possible to break up the UK’s biggest banks. However, some banks are opposing such moves by regulators.

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Revised Direct Taxes Code 2010-A Critique on RDP-VRK100-21Jun2010

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On a cool Sunday evening, a Child walks on a beach with gay abandon. She starts to build a castle in the sand. She collects sand and arranges it into a big heap. She tries to mould it as per her imagination. After sometime, she completes the sand castle and she goes around the castle merrily – laughing, cheering and shouting.

This attracts some other people loitering on the beach. They come and start inspecting the castle. Some applaud it and some suggest little changes to the castle to make it more beautiful. First the child is confused about making the changes. At last, she obliges the onlookers’ advice and makes alterations with some tinkering to the minarets here and to the windows there.

Now, more onlookers start giving advice on making it look more wonderful. The child listens patiently to them and makes more alterations with her tender hands. Then a disaster strikes. The castle suddenly collapses due to too many alterations. Disappointed by it, the child walks home with a heavy heart.

Some of you may be wondering what this is all about! The above story sums up the predicament of the Government of India in bringing about several amendments to the Direct Taxes Code (DTC). It may be recalled that the Government had brought out a Revised Discussion Paper (RDP) on 15^th of June 2010 making certain changes to the draft DTC Bill which was released in August 2009. The Government has apparently messed up the whole issue of bringing a transparent DTC, which could have been understandable easily by ordinary persons; providing stability, equality and clarity; and without any distortions. This article provides a critical analysis of important issues in the DTC proposals.

The impact is explained with catchy photographs!

The article is organized on the following lines:

A critical analysis of the Capital Gains tax on shares

Why flip-flops are not good for the overall tax efficiency

Background to abolition of long-term capital gains in 2003/2004

Is 25 per cent Public Shareholding a joke?

Why it is a mixed bag for individuals and salaried class

A big climb down and dilution of reforms by the Government

The following important annexures are given at the end of this article: (A must-read for all investors, taxpayeers and market players)

Annexure I   : Difference between EEE and EET methods

Annexure II  : The Six Pack!

Annexure III : Types of tax exemptions that may be continued after DTC

Annexure IV : Types of tax exemptions that may be withdrawn after DTC

Abbreviations Used:

DDT-Dividend Distribution Tax	PFRDA-Pension Fund Regulatory and
DTC 2009-Direct Taxes Code  August 2009	Development Authority
EEE-Exempt, Exempt & Exempt	LTCG-Long-term capital gains
EET-Exempt, Exempt & Tax	PPF-Public Provident Fund
ELSS-Equity Linked Savings Scheme	RDP-Revised Discussion Paper of DTC
of the mutual funds	released by Govt on 15.6.2010
EPF-Employee Provident Fund	STCG-Short-term Capital Gains
GPF-Government Provident Fund	SCSS-Senior Citizen Savings Scheme
IT Act-Income Tax Act, 1961	STT-Securities Transaction Tax
LTC-Leave Travel Concession	MAT-Minimum Alternative Tax
NPS-New Pension System administered	ULIP-Unit Linked Insurance Plan of
by PFRDA	insurance companies
NSC-National Savings Certificate
PF-Provident Fund	VPF-Voluntary Provident Fund

Concept of DTC:

When it was conceived in August 2009, the proposed DTC is supposed to be a single code for all direct taxes, like, Income Tax, Corporation Tax, MAT, DDT, wealth tax, etc. Written in simple language and direct voice, the DTC is expected to be more transparent compared to the existing direct tax laws. It seeks to encourage simplification and aims for stable taxes and better tax compliance.

Some of the provisions, like the Minimum Alternative Tax (MAT) on gross assets, introduction of EET regime and removing several tax exemptions have not been received with enthusiasm by the affected people. After receiving several representations from various stakeholders, the Government on 15^th of June 2010 released a Revised Discussion Paper (RDP). This RDP has restored some tax exemptions for certain schemes bringing relief to several people. It has decided to continue with the existing system of taxing MAT on the basis of book profits.

Messy Capital Gains Tax!

However, in one area the Government has messed up a lot. That is capital gains. The RDP proposes to change the very definition of short-term capital gain (STCG) and long-term capital gain (LTCG). Long-term capital gain on listed equity shares and equity mutual funds are taxed at zero rate as of now. Now, the RDP proposes to introduce a system of including LTCG in one’s income and taxing LTCG at the tax rate applicable to the taxpayer, after adjusting the LTCG with a specified discount rate. The Government has said that the specified discount rate would be announced while introducing the DTC Bill in Parliament. This kind of flip-flop of LTCG relating to shares and mutual funds is detrimental to the long-term investments. Strangely, the Government seems to be encouraging

short-term gambling in equities rather than long-term investments.

Is 25 per cent Public Shareholding a joke?

The Government has recently come out with norms for making 25 per cent public shareholding compulsory in companies listed on stock exchanges. One fails to understand how the Government can increase the public shareholding to 25 per cent without encouraging long-term investments in shares and mutual funds.

When tax rates are changed frequently without any predictability, it changes the behaviour of investors and market players in a big way. Let us go back a little and see the amendments to LTCG relating to listed equity shares and equity mutual funds.

Taxes on STCG and LTCG before 2003:

Prior to 2003, STCG on shares was taxed at 30 per cent; and LTCG was taxed at 20 per cent with indexation benefits. There was no STT at that time.

UNION BUDGET 2003-04:

As per the Union Budget for 2003-04, long term capital gains (LTCG) on company equity shares (listed on any recognized stock exchange in India) was exempted from tax for shares acquired on or after March 1, 2003 but before March 1, 2004. This was made applicable from April 1, 2004 and was applicable for assessment year 2004-05 and for subsequent years. The intention of the then Government behind the tax exemption for LTCG on listed equity shares for a limited period was to “give incentive for investment in equity shares.”

The then finance minister, Yashwant Sinha, told the Parliament, during his budget speech in his own words:

“We need to improve the industrial sector and improve the equity markets”

“I am also committed to bringing the small investors back to the capital markets by restoring their confidence”

“In order to give a further fillip to the capital markets, it is proposed to exempt all long-term capital gains from tax for equity shares bought for a period of one year from March 1, 2003, and sold after a one year…”

UNION BUDGET 2004-05:

Now, you see P.Chidambaram’s, the then finance minister, spin on the rationale behind the abolition of LTCG while presenting the Budget 2004-05 to Parliament:

“Capital gains tax is another vexed issue… I’ve decided to make a beginning by revamping taxes on securities transactions…Our founding fathers wisely included entry 90 in the Union List in the seventh Schedule of the Constitution of India.

“Taking a cue from that entry, I propose to abolish the tax on long-term capital gains from securities transactions altogether. Instead, I propose to levy a small tax on transactions in securities on stock exchanges. The rate will be 0.15 per cent of the value of security. My calculation shows that the new tax regime will be a win-win situation for all concerned.”

This was done with a view to simplifying the tax structure on securities transactions, as per the Explanatory Memorandum to the Union Budget 2004-05. Accordingly, tax on LTCG was removed and tax on STCG was reduced to 10 per cent. And in the place of ‘nil tax’ on LTCG on securities transactions, a new tax called Securities Transaction Tax (STT) was introduced by P.Chidambaram.

Unfortunately, STT stays!:

When the tax on long-term capital gain was abolished by the then Finance Minister while presenting the Union Budget 2004-05, the FM introduced STT to fill the tax revenue gap caused by the abolition of LTCG. Unfortunately, the RDP says that STT will be revised suitably. Now, equity investors will have to pay both the STT and LTCG once DTC comes into force, which was not the case prior to the introduction of STT in 2004.

Current provisions:

As of now, STCG on shares is taxed at 15 per cent while LTCG is completely exempt from tax. And the RDP proposes to include STCG in one’s income and pay tax as per rate applicable to taxpayer; and LTCG will be given a specified discount rate and taxes as per taxpayer’s marginal tax rate. This is completely in contrast to what the previous finance ministers, Yashwant Sinha and P.Chidambaram had committed in Parliament while removing LTCG on shares.

Does it mean to say that as of now public participation in capital markets has improved compared to 2003/2004? Everyone in India knows that share of equities in India’s total savings is at a bare minimum of between 2 to 5 per cent.

To know more on the latest amendments given in RDP, just click:

http://ramakrishnavadlamudi.blogspot.in/2010/06/revised-direct-taxes-code-2010-impact.html

(In fact, the RDP does not use the words, short-term capital gain or long-term capital gain. For the sake of simplicity and better understanding, the words STCG and LTCG are used as they have been in existence for more than five decades.)

Sweet and Sour!

The Revised Discussion Paper is a kind of mixed bag for individuals and salaried class. The Government has now decided to provide tax exemption at the time of withdrawal (EEE method), even though for six types of investments only.

To know about the difference between EEE method, EET method and such eligible investments, see Annexures I to IV given at the end of this article.

Everything has a price. Take for example, the Indian public are very happy with the subsidy on petrol, diesel, LPG & kerosene. But, ultimately, the entire economy is paying the price for the subsidy as the subsidies are paid through the Union Budget! The cost of everything has to be paid by someone, i.e., the public.

In the original DTC, the Government had proposed to remove exemptions; while simultaneously reducing tax rates and increasing tax slabs. But due to public outcry, Government has now said it would restore certain tax exemptions. As the tax base comes down, the Government will not be in a position to reduce tax rates and increase tax slabs as proposed in the original DTC in August 2009. The net effect will be the same for public! (It may be recalled that it was proposed, in the draft DTC of August 2009, to increase the present exemption of Rs one lakh under Section 80C of the Income Tax Act to Rs three lakh and increase the tax slabs – up to Rs 10 lakh at 10 per cent; above Rs 10 lakh to Rs 25 lakh at 20 per cent; and above Rs 25 lakh at 30 per cent.)   

To know about the proposals of original draft DTC released in August 2009, just click: http://ramakrishnavadlamudi.blogspot.in/2009/12/direct-taxes-code-dtc-bill-2009-its.html

At this stage, it would be instructive to know the original objectives of the Government while drafting a Direct Taxes Code Bill in August 2009. They were:

1.    Providing stability: At present, the rates of taxes are stipulated in the Finance Act of the relevant year. Therefore, there is a certain degree of uncertainty and instability in the prevailing rates of taxes. Under the Code, all rates of taxes are proposed to be prescribed in the Direct Taxes Code itself thereby eliminating the need for an annual Finance Bill. The changes in the rates, if any, will be done through appropriate amendments to DTC brought before Parliament in the form of an Amendment Bill.

2.    All the direct taxes – income tax, corporation tax, dividend distribution tax, minimum alternative tax & wealth tax – were brought under a single code

3.    A very simple language was used in drafting the code so that an ordinary person also can understand the provisions of the law

4.    By reducing vagueness in the provisions, the Government aimed at reducing the scope for litigation between taxpayer and tax administration

It is very sad to read the contents of Revised Discussion Paper (RDP) released a week back. The Government has failed to provide clarity on many issues, like:

Ø     What will be tax rates and tax slabs

Ø     What is the specified discount rate for adjustment to LTCG on shares

Ø     No clarity what type of savings instruments would attract EET method

Ø     There is no reference as to whether principal paid toward instalments of loans taken for constructing a house property would be allowed tax deduction (The RDP has clarified that interest up to Rs 1.50 lakh would continue to be eligible for tax exemption).

Ø     The RDP has failed to indicate what the rate of MAT would be

The refrain now is that the legislature is the ultimate authority for deciding tax rates! It may be recalled that the original DTC 2009 had provided rates & slabs.

How to tweak your investments?

It appears that the RDP encourages tax evasion and avoidance and it does not bring any equity to the tax system. It fails to provide transparency and remove distortions in the present direct taxes regime.

There are various methods to protect our interests, in a legal manner, in relation to tax exemptions and liabilities. We need to show a little ingenuity and look for ways to protect our interests under the existing laws.

Let us hope that the Government would provide a reasonable transition period for investors and more clarity would exist when the real DTC Bill is presented in Parliament in the next few months.

Look at them with fresh pair of eyes!

Any direct taxes regime that is transparent, clear and simple to understand is very good for the economy as a whole. As taxpayers, we need to encourage any sincere attempts by the Government to clean up the existing messy laws. We shall be able to see the broader picture which will benefit the entire economy rather than a few individuals or smaller groups. Tax laws have to be amended keeping the ever changing economic and social environment in mind.

We need to look at the new Code with fresh eyes without any old baggage. Theoretically, the concept of EET, removal of all kinds of tax incentives/concessions, and clubbing all sums under taxable income, are sound and beneficial in the long-term. However, India is beset with its own set of peculiarities, lack of social security system, contradictions and problems as far as increasing tax base and administering taxes is concerned. We need to change our mindset – not only taxpayers, but also those in the tax administration and implementation.

To read other important document on Direct Taxes Code, just click:

http://ramakrishnavadlamudi.blogspot.in/2009/12/direct-taxes-code-impact-on-long-term.html

This explains why the Government seems to be encouraging PURE GAMBLING rather than providing incentives for long-term investments in equities.

To sum up:

The entire DTC exercise now looks very blurred!

Annexure I

WHAT IS THE DIFFERENCE BETWEEN EEE and EET METHOD?

The present system is called ‘EEE’ meaning investments enjoy benefits in three stages: 1). Exemption allowed at the time initial contribution, 2). Exemption through out the accumulation period, and 3). Exemption at the time of withdrawal. (EEE stands for Exempt, Exempt and Exempt).

It was proposed in the DTC 2009 that the EET method will apply for new contributions made after the commencement of the DTC. The DTC 2009 had proposed to shift to a new system called ‘EET’ whereby exemption would be allowed at the time of initial investment and accumulation period only; but the withdrawals will be included in the taxable income and taxed according to one’s tax slabs. (EET stands for Exempt, Exempt and Tax).

Annexure II

The Six Pack!

As the Revised Discussion Paper released on 15^th of June 2010, The Government will continue to provide EEE method of tax treatment to the following savings instruments:

Government Provident Fund

Recognised Provident Funds

Public Provident Fund Scheme

New Pension System (NPS) of the PFRDA #

Approved pure life insurance products *

Annuity schemes

   * There is a lot of confusion as the Government has not defined what an ‘approved pure life 

    insurance product’ is. Some experts believe that it refers to pure term insurance policies.

   # At present NPS is under EET method; after DTC it would be under EEE method

The above mentioned six instruments will continue to attract the current favourable tax treatment at all the three stages: 1. at the time of investment, 2. during the accumulation period, and 3. at the time of withdrawal. The investors can continue investments in the above six even after the DTC comes into force.

Annexure III

The following tax exemptions are likely to be continued even after DTC:

It is interpreted from the DTC Bill 2009 and RDP, that the Government in all likelihood will continue with the following exemptions and incentives:

A. DEDUCTIONS THAT WILL BE ALLOWED FOR SALARIED CLASS ON THEIR GROSS SALARY:

1. Professional tax paid

2. Transport allowance as per limits

3. Allowances incurred for official purposes

4. Compensation received under Voluntary Retirement Scheme

5. Gratuity received on retirement or upon death

6. Amount received on commutation of pension

B. DEDUCTIONS THAT MAY BE ALLOWED WHILE COMPUTING TOTAL INCOME:

As per the proposals of the draft DTC 2009 and the Revised Discussion Paper, the following deductions may be allowed for individuals/salaried class:

ü      Interest paid up to Rs 1.50 lakh per annum on housing loan for self-occupied property

ü      Tuition fee paid to a college/school in India for full-time education of two children of an individual/HUF is eligible for deduction

ü      An individual shall be allowed a deduction in respect of any amount actually paid by him in the financial year by way of interest on loan taken by him from any financial institution for the purpose of:

(a) pursuing his/her higher education; or

                  (b) higher education of his/her relatives.

ü      Health insurance premium of up to Rs 15,000 (Rs 20,000 for senior citizens) will be allowed as deduction for an individual/HUF. For health insurance on the health of his/her parents, an additional deduction of Rs 15,000 (Rs 20,000 if the parents are senior citizens) will be allowed .

ü      An individual will be allowed a deduction of up to Rs 40,000 (Rs 60,000 for senior citizens) for medical treatment of self or dependents

ü       An individual/HUF will be allowed a deduction of up to Rs 50,000 (Rs 1 lakh for severe disability) for medical treatment of a disabled dependant

ü      A person shall be allowed a deduction of up to 125% of donations made to laboratories and colleges engaged in scientific/statistical/social sciences research. A person shall be allowed a deduction of up to 100% of the donations made to PM National Relief Fund, CM Relief Fund, etc. And in other cases, 50% deduction is allowed for donations made to certain organisations.

ü      Dividends will not attract tax in the hands of the recipient if such dividend distributed by companies has suffered Dividend Distribution Tax (DDT) at the applicable rate. (The DTC 2009 has proposed to levy 15 per cent DDT.)

In the light of the overall tax exemptions, tax rates and tax slabs, the Government may change any of the above tax incentives/exemptions mentioned in part A and B above while presenting the DTC Bill 2009 in Parliament in the next few months.

As per Section 80C of IT Act, an individual or HUF is eligible to get tax exemption up to Rs one lakh per annum in certain notified savings instruments. The draft DTC Bill 2009 proposed to increase this limit to Rs three lakh per annum. However, the context has completely changed with the Government agreeing to continue with certain existing tax exemptions as per the Revised Discussion Paper. Now, one can safely assume that the Government will definitely not be in a position to provide a limit of Rs three lakh tax exemption.

Annexure IV

TAX DEDUCTIONS/INCENTIVES TO BE WITHDRAWN:

A careful reading of the provisions and the RDP and DTC 2009 indicate that the Government is most likely to withdraw the following existing tax exemptions being enjoyed by the taxpayers. One is forced to come to this conclusion because the Government has maintained a strange silence on these issues and these issues have not been mentioned either in the DTC 2009 or the RDP released on June 15, 2010. So, the important deductions that are most likely to be disallowed in future under proposed DTC could be:

o          Housing Loan instalments of up to Rs 1.00 lakh in a financial year and allowed as deduction under Section 80C of existing IT Act may not be allowed as deduction under the proposed DTC 2009

o          Contributions made to Equity Linked Savings Schemes of Mutual Funds

o          Notified Bank Time Deposits for a term of 5-years or more

o          Accrued Interest on NSCs

 

o          Contributions made under Unit Linked Insurance Policies

o          Under DTC, bonuses or sums received from life insurance policies may not be allowed for deduction in case: (1). Annual premium paid is more than five per cent of the sum assured; and (2). If the policy is surrendered before the maturity date (as per clause (a) of sub-section 3 of section 57 of DTC 2009

Note: 1. Capital Gains Savings Scheme will be scrapped..

          2. STT will continue along with LTCG on shares.

          3. Grandfathering Clause: In certain types of investments, only new contributions  

              on or after the commencement of the new Code will be subjected to EET

References:

1. Revised Discussion Paper released by Ministry of Finance, GOI

    dated June 15, 2010

2. Direct Taxes Code Bill and discussion paper released by Ministry of Finance,  

    GOI in August 2009

3. Newspapers

Photo courtesy: bing.com, bbc.com, AP and author.

Author’s Disclaimer: The author’s views are personal. The above article is written for information purpose only. Every care has been taken to provide authentic information as far as possible; however, the author is not responsible for any inadvertent discrepancies that may have crept in. Readers should consult their own certified tax consultants or experts to correctly interpret the provisions of tax laws or other matters.

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Revised Direct Taxes Code 2010-Impact on Salaried Class & Individuals-VRK100-20062010

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The Government of India had come out with a Revised Discussion Paper on June 15, 2010, with regard to the implementation of the Direct Taxes Code Bill 2009 which is supposed to replace the Income Tax Act and other acts. The Revised Discussion Paper (hereinafter referred to as RDP) has taken into consideration various concerns of taxpayers and other players and proposed to make some changes to the proposed Direct Taxes Code Bill 2009. It may be recalled that the Government in August 2009 brought out the DTC Bill and a discussion paper with a view to making direct taxes (income tax, dividend distribution tax and wealth tax) simpler and equitable.

Even though the RDP has touched upon a total of eleven issues, the present article will confine itself to the impact of these provisions on individuals and salaried class.

Abbreviations Used:

DTC 2009-Direct Taxes Code  August 2009	PFRDA-Pension Fund Regulatory and
EEE-Exempt, Exempt & Exempt	Development Authority
EET-Exempt, Exempt & Tax	PPF-Public Provident Fund
ELSS-Equity Linked Savings Scheme	RDP-Revised Discussion Paper of DTC
of the mutual funds	released by Govt on 15.6.2010
EPF-Employee Provident Fund
GPF-Government Provident Fund	SCSS-Senior Citizen Savings Scheme
NPS-New Pension System administered	ULIP-Unit Linked Insurance Plan of
by PFRDA	insurance companies
NSC-National Savings Certificate
PF-Provident Fund	VPF-Voluntary Provident Fund

What are the new proposals in the RDP?

The proposals of the Revised Discussion Paper are explained in relation to the existing tax provisions so that readers can appreciate how their tax liability is going to be changed in future if and when the DTC comes into force.

1. Tax treatment of savings – EEE regime versus EET regime:

TABLE 1

Existing Tax Provisions		Revised Discussion Paper
Many investments are under the purview		In future, the EEE method is applicable
of EEE method now. These investments		only to the following:
include GPF, EPF, PPF, most of the
insurance policies (except annuities),		GPF
recognised PFs, NSC, ULIPs, ELSS,		Recognised PFs
deposits in SCSS, 5-year bank term		PPF
deposits, 5-year post office fixed		NPS
deposits, etc		Approved pure life insurance products*
		Annuity schemes
As of now, NPS is subject to EET.

   Note: To know about what EET method and EEE method are, please see Annexure I

   * There is a lot of confusion as the Government has not defined what an ‘approved pure life  

    insurance product’ is. Some experts believe that it refers to pure term insurance policies.

EEE Method: In India, we do not have any social security meaning that Government does not provide any income to the needy persons after their retirement or old age. This lack of social security puts a heavy burden in old age. Keeping this in mind, the Government now says that they want to continue with the EEE method for certain schemes as mentioned in Table 1 above. When the DTC comes into force, investments pertaining to only these schemes will continue to enjoy tax benefits at the time of investment, during accumulation period and at the time of withdrawal. As of now, NPS administered by PFRDA is under the EET method, and as per RDP it will be brought under EEE method of tax treatment.

EET Method: After reading the intent and purpose of the Government as given out in RDP and DTC Bill 2009, it can be interpreted that the following schemes will not be subject to tax at the time of investment and accumulation period only; but, investors will have to pay tax at the time of withdrawal: NSC, ULIPs, ELSS, SCSS, 5-year bank term deposits and 5-year post office term deposits. All these schemes will be subject to EET method once DTC comes into effect. 

A Consolation: Investments made, before the date of commencement of the DTC, in instruments which enjoy EEE method of taxation under the current law, would continue to be eligible for EEE method of tax treatment for the full duration of the financial instrument (this is called grandfathering clause).

2. Taxation of Retirement Benefits and Perquisites:

TABLE 2

Existing Tax Provisions		Revised Discussion Paper
An employer’s contribution to PF,		The status quo will be maintained
superannuation fund and NPS		and these will continue to be exempt
are not subject to tax. Retirement benefits		from tax even after DTC comes into
received by an employee are out of the		effect.
tax purview subject to monetary limits.

As per RDP, the Government has clarified that the following will be exempt from tax, subject to specified limits, for all employees:

ü     amount of gratuity received,

ü     amount received under a voluntary retirement scheme,

ü     amount received on commutation of pension linked to gratuity received

ü     amount received from encashment of leave at the time of superannuation      

     

(In the original DTC 2009, it was proposed to include them under salary and a Retirement Benefits Account – RBA – was proposed to be created to enjoy tax benefits. Now, the idea of creation of the RBA was scrapped as per the RDP.)

Valuation of Perquisites: It was proposed in the original DTC 2009, that the perquisites provided by the employer to the employee relating to lease housing accommodation, leave travel concession, encashment of unavailed earned leave, medical reimbursement and cost of medical treatment will be included in the salary of the employee and taxed accordingly.

As per the RDP, the Government has now clarified that the method of valuation of perquisites will be appropriately provided in the rules. It is proposed that perquisites in relation to medical facilities/reimbursement provided by an employer to its employees shall be valued as per the existing law with appropriate enhancement of monetary limits. It is clarified that the DTC does not propose to compute perquisite value of rent free accommodation based on market value. The revised RDP has provided partial relief to the salaried class as far as taxation of retirement benefits and perquisites is concerned.

In real life, it so happens that what is not stated explicitly is more important than what is stated. Investors will probably be shocked to know that many existing exemptions will be withdrawn once the DTC comes into force. For such exemptions to be withdrawn, please see Annexure II given at the end of this article.

3. Taxation of Income from House Property:

The DTC 2009 had proposed that income from house property would be calculated as gross rent less specified deductions. The gross rent would be higher of the following:

          (i).  the amount of contractual rent for the financial year

          (ii). the presumptive rent calculated at 6% pa of ratable value    

                   fixed by the  local authority

The DTC 2009 had proposed to withdraw tax exemption of Rs 1.50 lakh for interest on borrowed capital relating to self-occupied property.

The above proposals have received criticism from various quarters. Taking these views and criticism into consideration, the Government has now proposed the following modifications as per the RDP:

ü     In case of let out house property, gross rent will be the amount of rent received or receivable for the financial year

ü     Gross rent will not be computed at a presumptive rate of six per cent of the rateable value or cost of construction/acquisition

ü     In case of any one self-occupied property, an individual or HUF will be eligible for deduction on account of interest on capital borrowed for acquisition or construction of such house property subject to a ceiling of  Rs. 1.50 lakh from the gross total income

The above modifications have been widely welcomed by the public.

As far as Rs 1.50 lakh deduction from the gross total income is concerned, the Government says it would retain the existing tax provisions. However, the Government has stated that the overall limit of deduction for savings will be revised accordingly. Which means, the Government is likely to revise the tax rates and tax slabs that were proposed in the original DTC 2009.

4. Taxation of Capital Gains:

As per the RDP, income under the head Capital Gains will be considered as income from ordinary sources in case of all taxpayers. It will be taxed at the rate applicable to that taxpayer.

(A). Long-term capital gain for listed equity shares and equity mutual funds

TABLE 3

Existing Tax Provisions		Revised Discussion Paper
If a listed equity share or equity MF is held		If a listed equity share/equity mutual fund
for more than one year, any gain from sale		is held for more than one year from the
of such asset will be treated as long-term		end of the financial year in which it is
capital gain or LTCG.		acquired, the gain from sale of it
		will be considered as LTCG.
As of now, LTCG attracts zero tax rate.		A specified deduction will be allowed
		without any indexation benefit. Such
		adjusted LTCG will be included in one’s
		income and taxed at the applicable rate. *

* The Revised Discussion Paper (RDP) does not mention any specified deduction rate, but gives some illustrations based on 50, 60 & 70% specified deduction. The Government states that the specified deduction will be decided later keeping in view the overall tax rates. This is a BIG NEGATIVE for investors who have accumulated substantial long-term capital gain over a period of several years. The Government’s flip-flop is causing severe heartburn to long-term investors. 

One important feature of RDP is the definition of long-term capital gain itself. The distinction is stated in Table 3 above. The Revised Discussion Paper states that a long-term capital gain is gain from sale of a listed equity share or equity mutual fund that is held for more than one year from the end of the financial year in which such listed equity share or equity mutual fund is acquired. For example, if you buy a share on April 1, 2011 and sell it on or before March 31, 2013; any gain from such share will be considered as STCG. Suppose, if you sell it on or after April 1, 2013, any gain from such sale will be considered as LTCG. Effectively, the holding period for LTCG consideration can be between 366 days and 729 days. The Government has created unnecessary confusion among public with such revised definitions.

STT stays: When the tax on long-term capital gain was abolished by the then Finance Minister while presenting the Union Budget 2004-05, he introduced Securities Transaction Tax (STT) to fill the tax revenue gap caused by the abolition of LTCG. Unfortunately, the RDP says that STT will be revised suitably. Now, equity investors will have to pay both the STT and LTCG once DTC comes into force, which was not the case prior to the introduction of STT in 2004. In toto, the Government has messed up the provisions relating to capital gains tax.

As there will be a shift from nil rate of tax on listed equity shares and units of equity oriented funds held for more than one year, an appropriate transition regime will be provided, if required, claims the Government as per the RDP.

(B). Long-term capital gain for assets other than listed equity shares and equity mutual funds @

TABLE 4:

Existing Tax Provisions		Revised Discussion Paper
Long-term capital gain for assets like		If such asset like house property, land,
house property, land, gold, etc (other		gold, etc (other than listed equity share or
than listed equity shares or equity MFs)		equity MFs) is held for more than one
is gain that arises from sale/transfer of		year from the end of the financial year
such asset after holding it for more than		in which it is acquired, gain arising from
three years from the date of purchase.		sale of such asset will considered as
		LTCG.
Such LTCG at present is being taxed		The LTCG will be adjusted with indexation
at 20% after providing indexation		benefits; and such adjusted LTCG will be
benefits based on cost of inflation index.		included in one’s income and taxed at the
		applicable rate. $

    @ Such assets include house property, land, gold, etc.

$ The base date for determining the cost of acquisition will now be shifted from 1.4.1981 to 1.4.2000. As a result, all unrealized capital gains on such assets between 1.4.1981 and 31.3.2000 will not be liable to tax. The capital gains will be computed after allowing indexation on this raised base.

The existing Capital Gains Account Scheme will be discontinued as per the RDP.

One important feature of RDP is the definition of long-term capital gain itself. The distinction is stated in Table 4 above. The Revised Discussion Paper states that a long-term capital gain is gain arising from sale of an asset like house property, land, gold, etc (other than listed equity share or equity mutual fund) that is held for more than one year from the end of the financial year in which such asset is acquired. The Government has created unnecessary confusion among public with such revised definitions.

(C). Short-term capital gain for assets including listed equity shares, equity mutual funds, house property, land, gold, etc:

TABLE 5:

Existing Tax Provisions		Revised Discussion Paper
For shares and equity MFs:		As per RDP, the tax treatment of all assets,
Short-term capital gain is the gain that		(whether shares, mutual funds, immovable
arises from sale of a listed equity share or		property, gold or others) will be the same.
an equity MF after holding it for less than
1 year. Such STCG is taxed at 15%.		Short-term capital gain is the gain from sale
		of an asset holding it for less than 1 year
For assets other than listed equity		from the end of the financial year in
share or equity mutual fund:		which the asset is acquired.
STCG is gain from sale of house,
land, gold, etc, after holding it for less		Short-term capital gain will be taxed at
than three years. Such STCG is included		the rate applicable to taxpayer. No
in one’s income and taxed at the rate		specified deduction or indexation will be
applicable to the taxpayer.		allowed while calculating STCG.

One notable feature of the RDP is that it treats all assets as same as far as treatment of short-term capital gains is concerned. As mentioned in Table 5 above, under existing tax provisions, the tax treatment of short-term capital gains for listed equity shares or equity mutual funds; and other assets like, immovable property or gold is different.

Another important feature of RDP is the definition of short-term capital gain itself. The distinction is stated in Table 5 above. The Revised Discussion Paper states that a short-term capital gain is for assets that are held for less than one year from the end of the financial year in which the asset is acquired.

(In fact, the RDP does not use the words, short-term capital gain or long-term capital gain. For the sake of simplicity and better understanding, the words STCG and LTCG are used in this article as they have been in existence for than five decades.)

Other issues covered in the Revised Discussion Paper:

v    Minimum Alternative Tax (MAT) will be based on book profits as is the current practice. However, the Government has not given any MAT rates.

v    Non-profit organizations can carry forward unused grants for three years

v    Wealth tax will be paid by all taxpayers except non-profit organizations

v    Existing units in Special Economic Zone (SEZ) will enjoy profit-linked deductions just like the developers of these zones for a limited period when the new Code comes into force

Annexure I

WHAT IS THE DIFFERENCE BETWEEN EEE and EET METHOD?

As of now, individuals enjoy several tax benefits – of course, subject to certain quantitative limits – on their investments in a variety of savings instruments; namely, EPF, VPF, PPF, GPF, NSC, insurance policies, ULIPs, ELSS, bank fixed deposits, post office deposits, housing loan instalments, interest paid on housing loan, etc. The present system is called ‘EEE’ meaning investments enjoy benefits in three stages: 1). Exemption allowed at the time initial contribution, 2). Exemption through out the accumulation period, and 3). Exemption at the time of withdrawal. (EEE stands for Exempt, Exempt and Exempt).

It was proposed in the DTC 2009 that the EET method will apply for new contributions made after the commencement of the DTC. The DTC 2009 had proposed to shift to a new system called ‘EET’ whereby exemption would be allowed at the time of initial investment and accumulation period only; but the withdrawals will be included in the taxable income and taxed according to one’s tax slabs. (EET stands for Exempt, Exempt and Tax).

Simply put, under the proposed EET regime, tax savers will be postponing their tax liability for future or till the date of retirement. Is retirement the best time to pay our taxes by avoiding payment of taxes during our earning years?

Logically, EET system is sound in principle and good for the economy. However, in India, we lack a social security system and as such, some concessions are required for the needy persons.

Annexure II

TAX DEDUCTIONS/INCENTIVES TO BE WITHDRAWN:

A careful reading of the provisions and the RDP and DTC 2009 indicate that the Government is most likely to withdraw the following existing tax exemptions being enjoyed by the taxpayers. One is forced to come to this conclusion because the Government has maintained a strange silence on these issues and these issues have not been mentioned either in the DTC 2009 or the RDP released on June 15, 2010. So, the important deductions that are most likely to be disallowed in future under proposed DTC could be:

o         Housing Loan instalments of up to Rs 1.00 lakh in a financial year and allowed as deduction under Section 80C of existing IT Act may not be allowed as deduction under the proposed DTC 2009

o         Contributions made to Equity Linked Savings Schemes of Mutual Funds

o         Notified Bank Time Deposits for a term of 5-years or more

o         Accrued Interest on NSCs

 

o         Contributions made under Unit Linked Insurance Policies

o         Under DTC, bonuses or sums received from life insurance policies may not be allowed for deduction in case: (1). Annual premium paid is more than five per cent of the sum assured; and (2). If the policy is surrendered before the maturity date (as per clause (a) of sub-section 3 of section 57 of DTC 2009)

References:

1. Revised Discussion Paper released by Ministry of Finance, GOI

    dated June 15, 2010

2. Direct Taxes Code Bill and discussion paper released by Ministry of Finance,  

    GOI in August 2009

3. Newspapers

Author’s Disclaimer: The author’s views are personal. The above article is written for information purpose only. Every care has been taken to provide authentic information as far as possible; however, the author is not responsible for any inadvertent discrepancies that may have crept in. Readers should consult their own certified tax consultants or experts to correctly interpret the provisions of tax laws or other matters.

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Revised Direct Taxes Code 2010-

Criticism of the Revised Discussion Paper

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Direct Taxes Code-DTC-Its impact on Salaried Class

and Individuals

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Direct Taxes Code 2009-DTC-Its impact on individuals, etc

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Direct Taxes Code 2009-DTC-Its impact on Long-term

Capital gains and short-term capital gains of shares/MFs

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