THE NEW DIRECT TAX CODE

What is good and what is bad for you?

The new direct tax code, which has brought in a lot of cheer in people with its lower slab rates, takes away from one hand most of what it gives from the other, especially for the common man. The salaried group falling in the lower tax brackets and those planning to buy a house are the worst affected as the new code proposes to remove almost all the exemptions for salaried people and disallows interest as a deduction for self occupied property. The proposed tax treatment of life insurance policies have made ULIPs highly unattractive and should especially force existing investors to surrender their current investments. Further, the proposed code has reduced the number of investment options that were available to save tax and have made small saving schemes such as PPF quite unattractive.

Almost after seven years since it was submitted, the Kelkar committee’s recommendation on tax reforms at last seems to have found a purpose with the new direct tax code that reflects the key recommendations of the committee. The code is still in the draft stage and is subject to change and is expected to be brought in with effect April 1, 2011.

The first thing, you would notice in the law is the higher income slabs and lower tax rates. The next thing you would notice is its simplicity. The law looks far more simple and easy to understand than the prevailing law. A detailed look into the law shows that the law is not just different in its structure but also in terms of its provisions with most of the exemptions available under the prevailing law finding no place in the new law (and probably that’s what make it simple). So, how does the proposed direct tax code affect your taxes and finance?

Common man betrayed?

The proposed code has removed almost all the exemptions (except transport allowance) including medical reimbursement and house rent allowance that were available for the salaried class. However, the proposed tax code has not increased the basic exemption limit and it is still expected to be at Rs.1,60,000 for a male (non senior citizen). The worst part is, it appears from the first look, that even the employer’s contribution towards provident fund would become taxable. Currently, only the contribution that is in excess of 12% is taxed. The actual sufferers are those who are within the ten per cent tax bracket as they loose on exemptions but save nothing to gain. However, if you belong to the higher income bracket, you have a lot to cheer as the income tax rates have been slashed for the higher income group.

The dream house has just gone a little more farther

The proposed tax treatment of income from house property is one more thing that would hit hard those owning a house or planning to own one.

Firstly, the minimum threshold that the government would consider as your rental income from a let out property is six per cent of its guideline value (or cost of acquisition if guideline value is not available). Considering that the rental yield on most of the properties in most places and especially the metro cities is far lesser than six percent, it is most likely the house owners would end up paying huge taxes on rents they never earned.

Secondly, the standard deduction for repairs and rents have been brought down to 20% of the rent compared to the prevailing rate of 30% which would once again increase the taxable income.

Lastly, the one that would hurt the most is the removal of deduction of interest on housing loan for properties that is occupied by the owner himself. Currently a deduction of upto Rs.1,50,000 can be claimed as a deduction towards interest on self occupied property. This interest can then be set off against salary income thus reducing the overall tax burden. However, under the proposed code, no such tax benefits will be available making your net post-tax interest cost far higher than its current level.

Trade in shares? You have a reason to smile

If you are a trader in shares or have a part time business income, then you probably have a reason or two to cheer. Firstly, the proposed code proposes to remove the security transaction tax that is being levied on a share trading transaction. Further, under the proposed code, you will be able set off the losses from your business against any other income. So, should you suffer losses from share trading, you can set it off even against your salary income and pay lower taxes which is not possible under the prevailing law.

Own a very old property? Probably you should smile

The new code allows the owner of an asset to use the fair market value as on April 1, 2000 as the cost of the asset for computing the capital gain on sale of assets. As such, if you have been owning an asset from a period prior to April 2000, you would be saving tax on all the appreciation on the value of asset till April 2000.

Mutual funds get an extra edge over direct equity investments

It is not just the expertise of the fund managers but also the tax treatment that will now make mutual fund a better option than investing directly in the equity market. Under the prevailing law, the long term capital gains on shares as well as income from mutual funds are exempted from tax. However, under the proposed code, gain on sale of shares will be taxed at the normal tax rate (no distinction between long term and short term capital gains) while the income from mutual funds would continue to be exempted from income tax.

Small savings scheme are no more attractive

Small savings scheme such as PPF and NSC are quite attractive under the prevailing law as investments in these schemes are eligible for deduction from total income and the returns are also not taxed (Interest from NSC is taxed but is considered as reinvestment u/s 80C). However, under the proposed code, these schemes do not enjoy these tax benefits and will be fully taxed. The impression that I get from the first looks is that your existing investment in such schemes will also get taxed.

Redeem your ULIPs before March 31, 2011

Yes, you heard it right. As per the prevailing law any sum received on a life insurance policy with annual premium that is less than 20% of the sum assured is exempted. However, under the proposed code the threshold has been brought down to 5% from 20%. Considering that most of the ULIPs that are currently in the market have premium that is atleast 10% of the sum assured, it is most likely that any amount you redeem from your ULIP plans will be fully taxed at normal slab rates. What’s worse is that, it is not just the gains that you made will be taxed but the entire redemption proceeds will be taxed if you redeem it after 2011.

Most of the ULIP plans that I know have a lower surrender charge if not nil charges for surrender of ULIP policies after payment of three full year premiums. Therefore, unless the surrender charges prove detrimental it would be a better option to redeem those policies and invest it elsewhere (i.e. mutual funds etc.)

Investment limit for deductions increased – but is it of any use?

The proposed direct tax code provides for a deduction on qualifying investments upto Rs.3,00,000 compared to the prevailing limit of Rs.1,00,000. However, the good news just stops there because it has reduced the number of investment options that we currently have. Under the proposed law, only the investments in approved pension fund, supperannuation fund, life insurance companies or the government’s new pension trust will be eligible for deduction. The small savings scheme such as PPF or NSC or ELSS schemes of the mutual funds are no more eligible for tax benefits.

In Short, redo your tax and financial planning

The proposed direct tax code has reduced the options that were available to save taxes. Probably, it means that there is too limited scope for tax planning. However, you still have a lot to plan about your existing investment and future finances. Unlike, EPF where the accumulated balance as on March 31, 2011 is exempted from tax, no such benefits are available for other investment the returns from which are currently exempted. This essentially requires you to plan your redemption of these investments to save taxes on their proceeds. Further, the amount you might be getting on such long term investments might no more match your initial expectations as you will have to pay taxes on it. This requires that you relook into your finances and plan for the extra savings that is required to meet your financial goals.

RELIANCE POWER BONUS ISSUE
Mega Effort that could end in Vain

February 25, 2008

Reliance Power or to be specific Mr. Anil Ambani is taking an unprecedented effort to compensate the investors who subscribed to its IPO. The intention behind the attempt look some what obvious. The group has a line up of IPOs planned and therefore wouldn't want loose the confidence that the investors have in the group.
Reliance Power today announced that it would issue bonus shares in the ratio of 3:5 to non promoter share holders. This bonus issue that is planned is certainly unprecedented. Atleast in the history I knew, there weren't any company that offered bonus shares only to a particular group of shareholders.
Before you go through the article, the first thing I would like to suggest to you is; Do not jump and buy the stock today based on the euphoria created by the news. There are still a lot of things yet to be clarified.

Now continuing further; This bonus issue is also unique in the way in which it would affect the shareholder wealth. Generally, when a bonus share is issued to all the shareholders the value per share would come down as the value of assets that each share is entitled to comes down. However, in this case, the value of a share wouldn't come down to that extent as only non-promoter shareholders are given the bonus shares. This would mean that the stake of such investors in the company would increase. This bonus issue is expected to increase the stake of non-promoter shareholders to 15% from 10%.

I am not a legal expert, but I think the company will have to take care of a lot of legal complexities in executing this transaction. Mr. Anil Ambani has taken enough care to ensure that he is the only party loosing out on the transaction by gifting a portion of his holding to Reliance Energy which would keep the Reliance Energy's stake at the same level. A report in Business Line today has also raised the question about the taxability of the stake gifted by Mr. Ambani to REL.

It is certainly understandable that the company is taking a huge effort to keep the investors happy. But will these solutions really meet its goals?
The main problem arises from the fact that a lot of shares has already changed hands from the original IPO investors. So, who are going to be the recipients of these bonus issue? The company is yet announce that. Whoever be the recipients, the company is going to leave a whole lot of investors unhappy.

First of all, if the bonus issue is awarded to shareholders who are currently holding the shares then the original IPO investors who have already sold the shares at a loss are going to be kept unhappy.

If the bonus shares are issued to the IPO investors, then the effective price per share subscribed in IPO would come down to Rs.269. This would mean that the investors who have subsequently bought the shares at above Rs.300 or Rs.350 in the secondary market are going to be made unhappy.

The third option is to issue shares only to those shareholders who subscribed in the IPO and who are still retaining the shares. Undoubtedly this would keep all the other investors unhappy.
Luckily I haven't invested in the shares and therefore am able to look at the developments as an independent spectator. Once again, I haven't been in a situtation in which Mr. Ambani and his team are and I might not be as competent as them. However, I guess there had been a similar instance in the recent past but in a different field though and the company can take a similar step.

Well, curious about what that instance was? Don't get surprise but the man involved in that instance was none other than the South Indian Super Start Mr. Rajnikanth. No!!! Am not talking about what he did for BABA. I am talking about what he has promised for the distributors of Sivaji. As you might know, the news that came up was that while the movie was a mega hit the distributors eventually lost money as they had bought the movie at a huge premium. The solution?? A promise to give the distribution rights for his next movie 'Robot'.

Well, you might think I am getting a little silly. However, I do not see any other proper analogy to pick up and neither a better solution. What I suggest has the best move to the group would be to promise the IPO investors a higher preference for allotment of the other IPOs in pipe line.
This move might not be free from legal complexities and neither might provide the amount of immediate financial benefits that the proposed bonus issue could provide. However, if the subsequent IPOs are priced competitively and higher preference is given, then it would definitely benefit the people who actually need to be compensated. It will not leave any investor group unhappy (Ofcourse, investors planning to invest in the other IPOs of the group but who haven't subscribed to the Reliance Power IPO might be a little unhappy).

In any case and whatever be the methodology the group attempts; if the company emerges successful in making all its non-promoter shareholders (IPO investors and current investors) happy then it is definitely going to be a great and commendable effort and would definitely make Mr. Ambani the object of blind faith for the investors.

THE CATS AND THE MONKEY STORY

.

Few days ago, some of my friends were arguing that stock is a zero sum game stating that you might make money on an occassion but you will also loose money on another occassion and as such people don't make money from the market. Recently, I also came across a topic in one of the orkut communites. The originator of the topic claimed that the retail players in the stock market basically end up with a loss. Few people admitted that their stock market endeavour was a failure while few said that they made good money in the market. I started my enquiry into the subject to ascertain why a lot of retail investors end up with a loss.

.

Let me analyse it from the Indian context. Well, we all know that the market has performed really well in the last few years. However, let us take a realistic view of the market returns. Let us consider the ten year period between April 1,1996 and March 31, 2007. The performance of the nifty during the decade is shown below

.

I don't know if there was some other time period that was as exciting as the last decade. As you can see in the chart, the first few years of the decade witnessed a relatively flat market. However, middle of the decade witnessed two major stock market bubbles. One was the Ketan Parekh scam and the other one being the dot com bust. The latter part of the decade saw sharp upturns followed by some correction at the fag end of the decade. I am fairly convinced that this decade fairly represents the general movements of a stock market and hence it is suitable to be used as a proxy for calculation of long term metrics.

.

The decade started of at 968.30 and ended at 3821.55 resulting in a Compounded Annual Growth Rate (CAGR) of roughly around 15%. This CAGR of 15% is basically the geometric mean of the return on the Nifty. I don't have details about the dividend yield of the index during the period but I am sure that it can't be too significant. Taking cue from this past data and assuming an optimistic dividend yield of roughly 1%, the total return that could be expected from the market is around 16%.

.

I don't have adequate data in hand. However, in general, organised fund houses tend to outperform the market and which means that the return that is available to a retail investor is even below this 16% mark.

.

Let me now, introduce to you the biggest villain of the Indian stock market - 'Transaction Costs'. Well, transaction costs are highly inevitable in the world of business. There is always a gap between the seller and the buyer and you need a middleman and a vehicle to fill up this gap. The more underdeveloped the market is the higher is the transaction cost. In the Indian scenario, the transaction cost comprises basically of Brokerage, Security transaction tax and Other taxes such as service tax etc. You will soon realise why I called 'Transaction cost' a villain.

.

Typically, large players like mutual funds or high networth individuals are subject to a very low level of brokerages. However, a typical retail investor in the Indian market pays not less than 0.35% (per leg) as brokerage for a transaction. Then you have a security transaction tax of 0.125% (per leg) besides a service tax on the brokerage fee. All this roughly converts to something around 0.5% of the value of a transaction. So, in case, if you are going to buy and sell a stock then you would eventually be shedding out roughly 1% of the entire transaction cycle. So, your return further gets eroded by 1% per transaction.

.

Perhaps people wouldn't mind too much about incurring a flat 1% since the potential returns from the market far exceeds that of any other investment avenue. However, this is where a normal retail player committs blunder. Quite a lot of the retail players (atleast those who I know and including me) try to outsmart the rest of the crowd. In an endeavour to outsmart the market they keep switching stocks and every time one switches stocks he incurs the 1% transaction cost. Roughly 15 switches a year or roughly 5 switches every 4 months, by an investor erodes his share of the return from the market. If you are wondering whether people switch stocks so frequently, then perhaps you would be even more surprised to know that quite a lot of retail guys switch stocks even more frequently.

.

Day trading is again another game where you probably have several loosers for every single winner. A typical day trader incurs atleast 0.2% (both the legs put together) of his trade value every day. So, in total a day trader incurs more than 50% (assuming 250 session per year) of his average investment as brokerage. This 50% is perhaps the total return of three guys. So, if he is going to make money beyond this 50% then definitely for every such winner there will be atleast four loosers.

.

Besides you also have a crowd that tries to make money by using instruments such as the futures and options. While these derivative instruments represent one another exciting stock market instrument, it should be understood that they derive their value only based on the actual stocks that are traded. Hence the sum of the returns for the stock market and the equity derivatives market of all the players put together cannot exceed the total return of the stock market. However, derivative instrument also incur transaction cost.

.

This is no different from the typical cat and monkey story that we read in our childhood - but perhaps a little modern. While the cats - the investors, fight between themselves to grab the bigger pie, the monkeys - the brokers (and the Government too), are calmly eating the cakes.

.

Well, perhaps my intention was not to negatively portray the brokers. They play a very vital role in bringing the buyer and the seller together. But investors, out of their greed to outsmart their counterparts basically end up loosing all their profits to the brokers.

.

I think perhaps, you would've realised by now as to why most of the retail investors end up loosing their money even in a market that is rewarding well. No doubt, there are people who make huge money despite switching stocks continuously. However for you to be that successful, you definitely need to be damn smart and have enough financial resources to drive the prices or the lady luck should be sitting on your lap. Again, as I mentioned above, for every such winner you are going to have several loosers.

.

Before, I conclude, let me clarify one more thing. I am not saying that stock market doesn't reward. Neither I am saying that one shouldn't try to outsmart the market. But timing and continuous switching of stock is the not the best way to do that. If you want to outperform the market, then put your effort to see what others cannot see and identify that long term bet which will take you to the road of richness.

PURCHASE PRICE AND THE SELLING DECISION

.

Are you an investor in stock? Did the loss or profit that was made on a stock influence your decision to sell or hold that stock? If yes, then you will definitely need to go through the rest of this page.

.

Those who succeed in the stock market say that shares are a great investment. On the other hand those who fail quite often mention that share market is more of gambling. Shares are definitely one of the best investment avenues. However investing in stock requires understanding of business fundementals and common sense. I have a strong conviction that understanding of business is not too important if you are sure that your money is going to be with a strong management team. However, there is no substitute for common sense and unless someone has that, it is indeed difficult to make money in the market.

.

One of the most commonest mistake that people do is to take their selling decision based on their purcahse price. Let us take two categories of investors who decide their selling decision based on the purchase price. The first case are investors who want to hold on to their stock because the stock price has gone below the purchase price. The second case are those who want to sell their stock because they have suffered considerable loss on the stock already.

.

Among those two, who do you think are the most rationale group? If you answered that it is the first group then you are wrong. But if you think that second group is more rationale then again you are wrong. Neither of them are rationale investors. The loss that one has suffered on a stock is a past event and your selling or holding decision cannot undo such losses. In short, those are sunk costs and your subsequent actions will have no impact on them.

.

Once you purchase a stock, the purchase price should cease to be a factor driving your sell or hold decision. What should drive your decision is the return that you could expect on stock at its prevailing market price.

.

Let me illustrate it with this example. Suppose, you bought a stock for Rs.300 three years earlier and the stock now trades only at around Rs.150. At the same point in time you see another stock that has been doing so well and has got a potential to earn 20% return based on its prevailing price. Investors might generally get tempted to switch stock at this point in time. However, just imagine that if on the other hand the stock that is trading at Rs.150 is undervalued and can has the potential to yield a 30% return. If you decide to sell the stock at Rs.150 and switch to the other stock you would end up loosing 1/3rd of your total returns in addition to the transaction charges.

.

On the other hand if the stock that you hold is not a good bet and has a dull future, then holding on to it for the reason that you suffered losses would only mean that your loss is going to increase further.

.

However, the principle of 'Stop loss' (squaring of the position to protect against further loss) is not always a bad one. Especially if you are a trader or an investor with a very short terms perspective. Stock prices move in a very random fashion in the short run and therefore traders or short term investors necessarily need to inculcate the habit of stop loss.

.

To conclude, a short term investor or a trader definitely needs to follow the principle of 'Stop loss' as a regular discipline. However, a long term investor should never decide on a sell vs hold decision based on the loss that has already been suffered since such losses are a sunk cost and cannot be recovered.

INVESTING IN REAL ESTATE

.

The real estate market in India is booming like never before. Such a phenomenon is suppose to attract too much of attention and the real estate sector is no exception to it. In fact, I would say that it has got a little too much of attention that today every single individual has got his own opinions on it.

In an endeavour to enable the investing community to smartly invest their money I am bringing you this piece of writing on real estate - the market, the players, the forces, the fundamentals and valuation. In all the subsequent lines I address the topic only from an individual's perspective rather than from the perspective of a commercial player.

Let us first start off understanding the unique features of real estate compared to other investment avenues.

UNIQUE FEATURES

• Real estates are real assets that have physical existence.
• They have real value as compared to other real assets like gold or art which only have a perceived value.
• They have alternate uses. For eg. a piece of land can be used for agriculture, industry or for domestic residential purpose
• They are immovable.

THE PLAYERS

I would classify the players in the market into three.

• Firstly, the property developers.
• Secondly, the citizens who want to buy their dream houses and
• Finally, those who see it as an investment option.

The market also has got several organised and indegenous middlemen. However, the rest of this post will adress the issue only from the point of view of an individual who sees real estate as an investment option.

.

THE FORCES

.

Real estate is also subject to the market forces i.e. the demand and supply factors. Population growth is a very obvious factor which will increase the demand for real estate on a overall basis. However, I believe that increase in industrialisation is the most important factor that would influence the demand for real estate in a particular geographical area. Increasing industrialisation provides more employment opportunities and increases the concentration of people around a particular geographical location. Further, it also increases the standard of living thus prompting people to expect more space around them. Industries themselves would also need real estate spaces to carry their operations.

.

The supply side of the real estates is theoretically limited. However, practically, multi storied building and apartments expands the scope for realty space and reduces the limitations to a good extent.

The real estate market certainly has a relatively elastic demand at this juncture notwithstanding the fact that shelter is one of the basic necessities. Hence it is impossible for any one to be an absolute price maker. On the other hand, the lower amount of liquidity enables all the players to influence the prices upto a certain degree away from the equilibrium price.

.

THE FUNDAMENTALS IN INDIAN CONTEXT

.

Any investment, derives its value based on the return that it generates. So, the fundamental factor that needs to be analysed first is the return or more precisely the rent that a real estate would generate. The tenth five year plan in India estimated a shortage of 22.4 million dwelling units. I believe that the severity of such a shortage in the urban area would be much higher compared to other parts of the nation. I further believe that India is still an under industrialised nation and see a huge potential for further industrialisation which would fuel the demand further. On the other hand the population density in the major cities in the nation is already at an alarming level (see table 1) and could be a major constraint, in the short term, to increase the supply. Therefore, as far as, the major cities like Bombay, Delhi, Chennai, Pune, Banglore etc. are concerned, I believe that the rentals might see an uprecedented growth levels in the short term. However, I believe that in the long run, the industrialisation would get widespread in terms of the level of concentration which could reduce the pressure on rentals in such locations. On the other hand, I believe that the rentals in the 'not so hot' regions of the nation would be fairly stable now. However as the industrialisation gets widespread the rentals in such regions will also see the same phenomenon that the major cities are witnessing today.

Source: Wikipedia

.

According to Wikipedia the population density of India is at around 312 persons per k.m. While this is quite high compared to several other countries, I believe that this figure is much nominal considering the fact that most part of India is habitable. With a population growth estimated at just around 1.50% per annum I believe that population growth wouldn't be such a huge factor affecting the real estate prices atleast in the medium term.

.

The next fundamental factor that needs to be analysed is the required rate of return. The required rate of return on a particular investment depends on the returns that are available in alternate avenues adjusted for the specific risk charteristic of the investment. So, in order to determine the required rate of return on real estate, the starting point perhaps from an individual's point of view must be the return that is available on a bank deposit. I would be stretching myself a little too much if I try to project the interest rate over the next 15-20 years. So, I am proceeding based on today's scenario. Today, a fixed deposit for a decent duration would provide a pre-tax return of 9%. However, the interest rate is driven by an inflation that is above 6%. I believe that economy would turn more stable and the normalised inflation rate would be at somewhere around 4% to 4.5%. Thus the normalised return that could be expected out of a bank deposit would be around 7%. Considering the fact that rental incomes are subject to the risk of default and under realisation due to vacancy, I expect a slightly higher premium over the bank deposit rate. In my opinion a return of close to 9.5% on a pre-tax basis would really be a decent return to be expected out of a real estate investment.

.

The input cost wouldn't affect the valuation of the super structure since the asset is valued based on its return generating capacity. However an increase in costs of inputs like cements, steels and sand, in an ideal scenario, would push the land price downward. This is because the value of the the entire asset as a whole on cetris peribus basis, has to remain same. Therfore an increase in the cost of construction will bring down the land price to compensate for the escalation.

.

VALUATION

.

The rentals and the fundamentals are too different for different geographical locations. Rentals also vary too much within a particular city. Therefore, I am not going to ascertain the fair value in a particular location. Instead, in this section I shall explain on how should one try to find out the fair value of a residential property and I will be illustrating it with an example of an hypothetical city that is growing as well as the cities like Pune, Banglore or Chennai.

.

Before proceeding to discuss further, it is necessary that I introduce the concept of present value. Today the bank interest rate is around 9%. Rs.100 invested in a bank deposit would increase the value of your wealth to Rs.109 one year down the line. Looking at it from another point of view, Rs.109 to be received one year down the line is worth Rs.100 today.

.

Essentially the value of the real estate should be the present value of the rental income that will be realised in the future. Rental income and interest income are subject to differential tax system. Hence, the analysis of valuation would be more accurate if it is on a post-tax basis. Therefore both the income as well as the opportunity cost of capital should be adjusted for tax. As mentioned above, an individual should realise atleast a pre-tax return of 9.5%. Assuming that he is subject to a 30% tax, the post tax return should be at around 6.65%. Similarly the rental income is also subject to tax. However, as per the current tax structure, in India, only 70% of the rental income is taxed and as such the effective tax rate will be at around 21%. Table 2 provides a sample valuation sheet for a hypothetical city mentioned above.

The assumptions in the table about annual growth rate, taxes etc. are purely for illustration purpose and shouldn't be considered as my estimate or opinion about how much future rentals could go up in any part of the nation. Considering such assumption the value of the property in the hypothetical city is only worth 79 times the annual pre-tax rentals that the property could fetch today.

.

VALUATION OF VACANT LAND

.

A prudent reader might be wondering now as to how could these principles be employed to value a real estate property like a vacant land that does not earn any rentals. In an ideal situation the market would never reward an asset that is kept idle. Therefore the valuation of such a land should be based upon how much rental could it fetch if a proper super structure is constructed on it. The cost of constructing the super structure should be reduced from the present value thus computed to arrive at the value of the vacant land.

.

The above principles are easier said than used. Most importantly, it is very difficult to identify the future rentals of a property as real estate has got alternate uses and the returns that could be generated varies based on the purpose to which it is put. It is neither correct to assume that all the investor would use it for the purpose the produces maximum return. For instance, a commercial property might yield more returns than a domestic property but there cannot be too many commercial properties. It is also really difficult to predict the growth rate of rentals. A different growth rate than what is projected could affect the valuations both favourably (if actual growth rate is higher) as well as adversly (if the actual growth rate is lower).