Tax-Free Bonds – Don’t miss the bus Again!!

Tax-free bonds first hit markets in 2012. Initial investors are currently sitting on a 20%+ capital gains in 3.5 years in addition to receiving tax-free interest thrice. These are one of the best instruments to earn fixed tax-free returns for a longer duration.

View last post on another good instrument in falling interest scenario ‘Protecting future investments against falling interest rates

Case FOR investing in tax-free bonds

  • Interest paid to investor is tax-free – that’s a big advantage, especially for individuals in higher tax brackets.
  • No market linked return – Interest is fixed throughout the tenure of the bonds thus providing a relief from market fluctuations
  • No lock-in period – though the bonds are subscribed for a fixed duration, these are normally listed on BSE and NSE, thus providing high liquidity
  • Capital Gains – High chances of capital gains as economy is currently in a falling interest rate regime. As interest rates fall, the bond value would increase thus providing an opportunity for capital gains. Latest issues of NTPC tax-free bonds (@ 7.63% for 20 years) that hit the market in September 2015 is already trading at Rs 1,050 (a 5% premium over the issue price). Even if a 1.6% inbuilt interest is covered, this translates into a premium of 3.4% over that – a decent gain in 2 months
  • Decent investment limit – Retail investor can apply upto Rs 10 lacs. Investment beyond that shall be classified under HNI category and lead to a tad lower interest rate (generally 0.25% lower than the rate offered under Retail category)

Case AGAINST investing in this issue

  • Annual interest payment – Power of compounding is lost as the interest is payable on annual basis, however, there are mechanisms to convert annual payments into power of compounding. These  mechanisms shall be dealt with separately.
  • There are instruments that have potential to earn a higher returns albeit with higher risk – Equity investment can generate much higher returns but the risk is incomparable, with tax-free bonds coming with near to zero risk, while the equity markets are highly volatile
  • Lower liquidity – Though the bonds are usually listed on NSE and BSE, the traded volume is not high enough to provide immediate liquidity without some hit on the returns due to call/bid spread

In case you missed the ride earlier, here’s another opportunity to get on the bus.

NHAI is the latest Government Undertaking to come up with Tax-free Bonds (@ 7.60% for 15 years). The offer opened on 17th Dec, 2015 and is open till 31st Dec, 2015, however, the issue is already oversubscribed in all the categories except retail. The issue is expected to close by 22nd or 23rd Dec once Retail category is subscribed as well.

Do not miss this golden opportunity!!

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Protecting future investments against falling interest rates

RBI recently reduced the repo rate twice, thereby, signalling an end to high interest rate regime. With softness in crude prices and inflation, the trend is expected to continue for some time now and experts are talking of some major rate cuts in coming quarters. These cuts in the repo rate shall be a boon to the people who have floating rate loans as the interest rates shall come down and shall impact the EMIs for such loans. However, this also means that the interest rates on fixed income instruments like bank fixed deposits, corporate deposits, bond yield etc would come down proportionately thereby negatively impacting the investors who plan to opt for these instruments in future. These also shall have impact on rates of savings account, PPF, EPF etc that are all market linked.

Before we look at a simple, yet powerful, mechanism of shielding our current as well as future earnings from the vagaries of falling interest rates, let’s have a quick look at how have the interest rates moved in past 15 years.

 Historical Interest Rates

Now, let us assume that ‘Amit’ has a cash of Rs. 10,000 that he wants to invest in a bank fixed deposit. He also expects to have a surplus of Rs. 10,000 per month for next 60 months. Suppose Amit wants to invest these in bank fixed deposit (FDs), he would face uncertainty in terms of interest rate that he can expect on his future FDs. To shield himself, Amit could decide on creating a recurring deposit (RD) for a long duration, say 5 years. This approach of starting a RD shall ensure that the current rate of interest offered by banks on a FD, is fixed for the RD created for the same duration. However, unlike FD, Amit can avail of same interest rate on his future investments, even when interest rates drop in future. Thus RD provides Amit a risk mitigation tool in terms of interest rate fluctuations.

Benefits of RD

  • Interest rate is decided as per current prevailing rate and RD is best mechanism to make future investments interest-rate proof, when we are in falling interest rate regime
  • There is no TDS on RD as opposed to FD where a TDS is deducted at the rate of 10% (if PAN is submitted) and 20% otherwise
  • Proceeds of RD could be utilized for making a big purchase and this acts as an opposite to EMI. In EMI, an item is purchased and EMI is paid in subsequent months (and interest is paid) while in RD, saving is done on monthly basis (and interest earned) and purchase made from maturity proceeds
  • It can be created online just like a FD and has no specific formality

Things to consider while creating RD

  • It has been assumed that the interest rates are going to soften whereas in case interest rates start rising, this approach can be counterproductive albeit, an investor always has an option to liquidate RD with a minor penalty
  • Do not create a single RD rather go for multiple RDs so that in case of a need one can opt for foreclosing one/more RDs instead of the single one. For eg – if Amit wants to create RD for Rs 50,000 per month then he would be better off creating RDs of denomination Rs 5,000, Rs 10,000, Rs 15,000 and Rs 20,000
  • It is also advisable to create RDs for different durations – say maturing every 6 months to ensure liquidity is maintained
  • If an investor has variable surplus each month, don’t go overboard and rather create RD such that there is atleast 1 month advance contribution available

Through this simple mechanism one can be sure of having a fixed rate of interest on ones saving while reaping the benefits of lower interest rates on borrowed money. Over time, it might even happen that the interest being paid on a loan is lower than that earned on a fixed rate instrument.

Happy Fintelligent Investing!!

PS – [Updated on 26th Feb 2016] With effect from 1st June 2015 TDS is applicable on RDs as well.

How to best utilize a Windfall?

’Windfall gains’ – the word itself brings a spark in the eyes. This article is about options that one has for utilizing the windfall, and how to make the most out of it. It also highlights pitfalls to avoid while deciding on using the windfall.

What is ‘Windfall Gain’?

Windfall Gain is money received in a lump-sum like from winning a lottery/contest, gambling, insurance maturity pay-out, gain from speculation, business, bonus, arrears, inheritance, stock sale, provident fund withdrawal, gratuity etc.

Windfall gain can be expected (like arrears, PF withdrawal, bonus, insurance maturity pay-out etc.) or unexpected (like winning a lottery/contest, gambling, gain from speculation etc.)

Biggest mistakes

  • General tendency is to spend or invest the windfall immediately – in a jiffy. This is the biggest mistake and one is sure to repent if one doesn’t plan out the utilization.
  • There are certain windfalls that are tax-free like inheritance, insurance maturity, PF withdrawal, gratuity (to some extent) etc. however, there are quite a few that generate a tax liability like winning lottery, arrears, bonus, business etc. It is important to know the tax liability and consider the ‘Net’ windfall gains only. Not making provisions for taxes would haunt oneself towards end of financial year.

What to do?

  1. Plan – Take time out to plan on spending vs investing the proceeds. Do not make any decision in haste.
  2. Temporary parking of fund – It is important to park the fund in some safe and liquid option. Idea is to reap returns on the fund while one plans out the spending and investing. Many a times the fund keep lying in Savings Bank account which fetches anywhere between 4% to 7% currently (depending on bank). Though 7% is a good return but it is taxable and if one falls in high tax bracket (say 30%) then the post-tax return comes down to around 4.9%. Instead it is better to park these funds in liquid funds that are currently churning out a return of around 7% post tax – the difference is huge.
  3. Make provisions for taxes – Find out the tax liability and the time by when tax need to be paid. TDS might have been deducted during the pay-out. Take that into consideration while making provisions for taxes.
  4. Spending vs. Investing – The most important aspect when planning is to determine the percentage of windfall that one should be spending vs investing. One can use the following guidelines to arrive at this
    • Repayment of high interest debt – Preference should be given to repaying high interest debt. The highest interest debt is the credit card dues followed closely by personal loans. Ensure that these are brought down to ‘0’ as soon as possible. These are the biggest drag on one’s finances with annual interest rates upto a whopping 50% (it is not possible to find an investment yielding return of this magnitude which is safe) and shall help one save a decent amount every month – so one can reap the benefits of the windfall monthly. Is there a better option than this? There could be other loans that one could prepay like vehicle, EMIs on household items etc. On the other hand, one can continue to service some loans like home loan or education loan – as these provide some tax benefits – bringing down the effective rate.
    • Invest in self – One might be waiting for completing a certificate, enrolling for a class that can give one a promotion or some technical course that shall help start one’s own venture. Fund any of these with the windfall. Investing in skill upgrade is the best investment as the benefits are reaped for all the time to come.
    • Goals – Find out whether one has been saving enough for the goals. Is there any goal that one is yet to start saving for? Windfall gives an individual a great opportunity to address any shortfall in the financial plan – in one shot.
    • Re-balance portfolio – Windfall can also be utilized to adjust the skew in asset allocation. Suppose one’s asset allocation is skewed too much in favor of debt than the proceeds can be invested in equity to re-balance the asset allocation.
    • Acquire asset to create additional revenue stream – Identify an asset that shall create additional revenue stream for future like acquire a property that shall generate rental income while also appreciating in value, tax-free bonds that shall generate annual income for years to come or the like.
    • Treat oneself – Only after one has considered all above aspects should one look at things that one always wanted to do – a vacation to an exotic location, a house renovation, a gadget or anything.

 

If one has a strong compulsion to splurge (after all we are humans ), think of the bad financial times – if one has been lucky to not have experienced a bad financial time, then think of some friend/relative who have had one.

By following the tips mentioned above, one is in for a pleasant time ahead and shall keep reaping benefits of one-time windfall for all the times to come.

Ways to Save Tax on ESOP sale in unlisted companies

By now you must be aware of the tax liability arising out of sale of ESOPs. If not, you might like to go through the previous blog “Tax treatment of profit from sale of ESOPS of unlisted shares and use the calculator.

I believe TDS is the best mechanism as that way we just see the post-tax amount. However, it is not easy to pay tax after receiving the whole amount in ones account. The good news is that there are legal ways to save tax – this article explores the same and deals with tax avoidance, and not tax evasion.

Option 1Pay Tax and have the right to use the money right away.

This is by far the simplest way if one wants to use the money right away. But this is not why we are here for 🙂

Option 2 – Offset the profits

If there are long term capital losses from other capital assets (except through stocks traded in recognized Stock exchange) the same can be offset by the profits earned.

The gain can also be offset against any short-term capital loss (including stocks traded on recognized stock exchange). Even if this loss has occurred in any of the past 8 years such loss can be used to offset the long term gains that have resulted from ESOP sale (provided the returns were filed in time, loss mentioned and not setoff yet against any other capital gain). This shall bring down the tax liability or may even nullify it.

Option 3 – Invest the profit in bonds under Section 54EC of Income Tax Act

The extent of profits invested in 54EC bonds issued by NHAI and REC is exempt from tax. Let’s take an example – Suppose Amit sells ESOPs in DreamCompany for INR 3,00,000 and earns a profit of INR 2,00,000 in this transaction. If Amit invests this amount of INR 2,00,000 in 54EC bonds then he shall not have to pay any tax. The exemption is capped by the amount invested in bonds and for remaining amount the tax liability remains as is. So if Amit invests INR 1,50,000 then his tax liability is reduced by this amount and remains INR 50,000. What’s the catch then?

i)                    54EC bonds have a lock-in period of 3 years – one cannot redeem, sell or obtain loan against these bonds.

ii)                   Rate of interest on these bonds is 6% paid annually and this interest is taxable; which translates to 4.15%, 4.76% and 5.39% post tax return for an individual in 30%, 20% and 10% tax bracket respectively.

iii)                 After 3 years the bonds are encashed and there is no tax on the amount received (which is same as that invested initially)

iv)                 The maximum amount of bonds that can brought is capped at INR 50,00,000 per Financial Year

There are certain rules that need to be adhered to while choosing this instrument for tax saving though

i)                    The bonds must be purchased within 6 months of sale of asset or last date of filing the tax return whichever is earlier.

ii)                   If the bonds are sold during 3 years of lock-in, the whole amount is considered LTCG for that year and taxed accordingly.

Option 4 – Invest the sale proceeds in a residential property under section 54F of Income Tax Act

This option is available only if the individual has no more than one residential property in his/her name i.e. if someone already have 2 or more residential properties in his/her name, he/she cannot avail this option. Another catch here is that whole proceeds from sale need to be invested in order to claim 100% tax rebate. So in our example earlier, Amit needs to buy residential property worth INR 3,00,000 or more in order to save 100% tax. If Amit decides to buy a property worth less than INR 3,00,000 then the rebate available is calculated as below.

Tax rebate = (Profit_from_sale * Cost_of_new_property) / Sale_proceeds

So if Amit decides to buy a property worth INR 1,20,000, he shall be eligible for

Tax rebate = (2,00,000 * 1,20,000)/3,00,000  = INR 80,000

Following are the rules governing this act

i)                    The new property must be brought within 1 year before the date of transfer of original asset to 2 years after the date of transfer. In case the property is being constructed the time limit is upto 3 years after the date of transfer.

ii)                   The new property cannot be sold within 3 years of purchase. In case it is sold the entire amount becomes taxable in that year.

iii)                 The individual cannot buy another residential property with 2 years of transfer of original asset (ESOPs in this case) or construct one within 3 years of transfer of original asset.

The drawback of article 54F is that to avail complete rebate, full amount needs to be invested thereby leaving no cash for immediate use.

The above transaction needs to be completed by the time return is filed. An instant question that comes in that case is – How is it possible to complete the transaction by the time of filing the return when the time limit available is 2 years and 3 years respectively for purchasing or constructing a new house? Well for the same a facility of Capital Gain Accounts Scheme (CGAS) is available. If the individual is not able to buy a house by the date of filing the tax return, the amount must be parked in a CGAS account. This account can be opened with specified nationalize banks and are for the sole purpose of parking funds till appropriate property is finalized. However, the full amount shall become taxable when the time is over and the property is not bought.

So what are you thinking? Go ahead and choose the option that best suits you. In case you have any queries, feel free to comment or send those to fintelligenceindia@gmail.com

Stay tuned for the next blog

How to best utilize a windfall?

Disclaimer – This article is for information purposes and should not be treated as legal advice.

References

http://taxmantra.com/faq-on-capital-gains-tax-and-capital-gains-exemption.html/
http://taxmantra.com/capital-gains-arising-longterm-capital-asset-house-property-exempted-54f.html/
http://law.incometaxindia.gov.in/Directtaxlaws/act2005/sec_054.htm
Link

Congratulations!! You are here so it’s most likely that you either cashed out your options/shares or are holding some and expecting those to be bought out soon. In any case, my heartiest congratulations to you!!

This article deals with the tax treatment on profits arising out of sale of either ESOPS or shares held in a privately held company – a company not traded on recognized stock exchange.

Let us consider an example and look at various scenarios to understand tax treatment on various types of proceeds – Let us assume that Amit works in the Indian subsidiary of a company called DreamCompany (a US based multinational) and has been granted options as per the table below. It is assumed that the vesting schedule is monthly proportionate basis in 4 years (i.e. every month 1/48 of the granted options vest).

Number of Options Options grant date Exercise Price Number of Options exercised Option exercise date Exchange rate Fair Market Value (FMV) as of exercise date
Scenario 1 1000 1st April 2005 USD 0.20 1000 15th June 2009 47.50 USD 1.04 = INR 49.40
Scenario 2 1000 1st April 2007 USD 0.55 1000 30th July, 2013 58.29 USD 2.85 = INR 166.13
Scenario 3 1000 1st April 2011 USD 1.85 1000 N/A N/A N/A

Let’s also assume that on 1st Dec 2013 the DreamCompany gets acquired by another company which agrees to pay USD 3.85 for each share and option of DreamCompany. Let us visit Amit’s tax liability in the above scenario. Let’s also assume that by the time Amit get’s the amount credited to his account (say 10th Dec, 2013), the exchange rate between USD and INR is 60.83.

Scenario 1 – When Amit exercised his vested options on 15th June, 2009, he would have paid the company a sum of INR 9,500 (Number_of_options * exercise_price * exchange_rate = 1000 * 0.20 * 47.50). He would have also paid the taxes on the difference between this amount and the Fair Market Value of the stocks = INR 49,400 (Number_of_options * FMV * exchange_rate = 1000 * 1.04 * 47.50). Tax would have been paid on INR 39,900 (FMV – exercise_price = 49,400 – 9,500). The acquisition price of the 1000 stocks in DreamCompany for Amit in this case becomes the FMV on 15th June, 2009 i.e. INR 49,400. The sale proceeds that Amit is entitled to is INR 2,34,195 (Number_of_shares * acquisition_price * exchange_rate = 1000 * 3.85 * 60.83). As the date of acquisition (15th June, 2009) is older than 12 months from the date of sale (10th Dec, 2013), this shall be considered a Long Term Capital Gain (LTCG).

LTCG Tax on such transaction is 20% of the LTCG which is arrived at by deducting ‘indexed cost of acquisition’ from the sale proceeds.

To calculate Indexed cost of acquisition, cost inflation index (CII) for Financial Year of Purchase (FY 2009-10 in this case) and CII for FY of sale (FY 2013-14) needs to be determined and used in formula (CII_of_sale_year / CII_of_purchase_year) * purchase_price. For our example this works out to be

Indexed cost of purchase = (929/632) * 49400 = INR 72615

Thus the profit for Amit on this transaction is INR 1,61,580 (sale proceeds – acquisition cost = INR 2,34,195 – INR 72,615)

And LTCG Tax = 20% of INR 1,61,580 = INR 32,316

With Cess of 3% this comes out to INR 33,286

Note – a surcharge of 10% on income tax is levied and thereafter 3% cess levied on whole amount if income exceeds 1 Cr

Scenario 2 – When Amit exercised his vested options on 30th July 2013, he would have paid the company a sum of INR 32,059.50 (Number_of_options * exercise_price * exchange_rate = 1000 * 0.55 * 58.29). He would have paid the taxes on the difference between this amount and the Fair Market Value of the stocks = INR 1,66,126.50 (Number_of_options * FMV * exchange_rate = 1000 * 2.85 * 58.29). Tax would have been paid on INR 1,34,067 (FMV – exercise_price = 1,66,126.50 – 32,059.50). The acquisition price of the 1000 stocks in DreamCompany for Amit in this case becomes the FMV on 30th July, 2013 i.e. INR 1,66,126.50. The sale proceeds that Amit is entitled to is INR 2,34,195 (Number_of_shares * acquisition_price * exchange_rate = 1000 * 3.85 * 60.83). As the period of holding has been less than 12 months (July 2013 to December 2013) this is considered as Short Term Capital Gain and added to the total income of the individual for that FY and is thus taxed at the rate of 10%, 20% or 30% as the case may be.

Scenario 3 –  Amit holds options that are still vesting. Out of 1000 allotted on 1st April 2011, 667 options would have vested. Depending on the type of acquisition company might or might not buy out the options. In case options are bought by the company the income arising is considered as Short Term Capital Gain and added to the total income of the individual. Here as there has been no investment from individual’s end, individual is entitled to the difference of the acquisition price and exercise price. So in our example, Amit made a profit of INR 81,147 (Number_of_vested_options * (acquisition_price – exercise_price) * exchange_rate = 667 * (3.85 – 1.85) * 60.83)

ESOPs Capital Gains Calculator

Upcoming blogs in this series –

–          Ways to Save Tax on ESOP sale in unlisted companies

–          How to best utilize the windfall?

DisclaimerThis article is for information purposes and should not be treated as legal advice.

References

http://cadiary.org/cost-inflation-index-capital-gain/ – CII table

Practical approach to Income Tax by Girish Ahuja and Ravi Gupta

http://www.moneycontrol.com/news/tax/confused-about-taxesincomeshares-heres-help_973559.html