Personal Finance and Professional Management Fundamentals

March 8, 2007

Impact of Fringe Benefit Tax Imposed on Esops

The proposed law effective April 1, ’07 has shifted the focus from employee taxation to employer taxation on Esops. The benefit arising at the time of exercise of shares by the employees will be liable to FBT at an effective rate of 33.99%. Correspondingly, any benefit on account of Esops as perquisites is out of employee taxation.

Potential FBT impact is uncertain around the value of FBT to be taxed in the employer’s hands. Let us consider an example where employee A and employee B are granted Esops on the same date, but they exercise on different dates. The exercise price is Rs 10.

Employee A exercises his options in year 3 when market value (MV) on exercise date is Rs 30 and employee B in year 4 when MV is Rs 40. The value of taxable benefit for FBT purposes will be Rs 20 and Rs 30 respectively. Therefore, even a different date of exercise could impact the FBT liabilility. Companies find themselves in a quandary as to which other factors may influence their FBT liability. In case of a globally mobile work force, there will be issues around double taxation where foreign companies grant Esopsto their employees. Foreign companies may be liable to pay FBT on Esops in India and the employee may suffer personal taxes in the home country on the same benefit, leading to double taxation.

Confusion also surrounds the impact of the proposed law on Esop variants such as restricted stock units and stock appreciation rights and nothing has been clarified at present. Some clarifications from the government in this aspect are necessary. Taxation of Esops in the hands of the employer is something which does not find precedent in other countries. In fact, it is surprising to note that the government has sought to bring Esops within the FBT ambit, as clearly these are not in the nature of collective benefits but are employee specific.

In the US, tax treatment of Esops depends on whether the stock option plan is qualified or nonqualified. Options provided to employees under qualified plans are not subject to tax at the time the option is granted or at the time the employee exercises the option and buys the stock. Tax is only levied as capital gains tax when the employee sells the stock.

Options provided to employees under a non-qualified plan are taxed when it is granted, if the option has a readily ascertainable MV at that time. The exercise of a non-qualified stock option triggers a taxable event. An employee recognises ordinary income in the amount of the value of the stock purchased, less any amount paid for the stock or option. When the stock is sold, the difference between the sale price and the MV at the date of exercise, if any, is taxed as capital gain.

Esops may soon be history


ESOPS may soon be history. The proposed amendment in Budget ’07 may even eliminate the whole concept of Esops from the Indian scenario.

Why Esops will not be attractive now: First, the employer will be burdened with an effective post-tax cost of 45.54%, which is a huge cost for any company as it will hit its bottomline. Second, the employer is being made to pay tax on the benefit derived by the employee due to appreciation in the shares due to market forces and not because of any cost incurred by the employer. For example, say a new start-up company had granted options five years back at the face value of Rs 10 each.

The company is now listed and its shares are traded on the Indian stock exchange. The employee’s exercise period has commenced and he is entitled to exercise his options and covert them into shares. Say, now the fair market value is Rs 120. Due to the proposed amendment, the employer will have to pay FBT on Rs 110 ( Rs 120 less Rs 10). Third, the exclusion from the taxability as perquisites has been removed. Therefore, effectively, it means that the benefit still remains a perquisite.

Accordingly, it may still be taxed as a benefit in the hands of the employee, besides FBT, resulting in double taxation of the same benefit. Fourth, in most of the countries, the benefit arising under Esops is taxed in the hands of the employee. Therefore, if this benefit is taxed both in India and overseas, then the employees will not be able to claim credit for the same under the respective Double Taxation Avoidance Agreements between India and other countries.

Then, many foreign companies grant Esops to the employees of their subsidiary companies in India. As clarified by CBDT earlier, FBT is payable by the foreign company only if it has employees based in India.

Therefore, an issue arises whether there will be no FBT in case of Esops granted by foreign company if there is no employee based in India. Further, it remains to be seen whether FBT is payable by the foreign company or the Indian employer. There are many interpretation issues in the proposed provisions which may lead to unnecessary prolonged litigation. For example, it as not been clarified whether the provisions will apply to new Esops or the FBT will get triggered even in respect of the old Esops where grants have been made in the earlier years.

If the second one is the intent of the proposed legislation then it will be unfair to the employers as they have been caught unawares and are being made to pay tax for the contractual arrangements (Esops) entered into with employees based on the prevailing tax law in the earlier years, i.e. when there was no income tax either for the employee (personal tax) or for the employer (FBT) when the Esops were granted.

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Now, Parents May Be Able to Claim Tax Benefits on Higher Education Loans for Children

The Union Budget 2007-08 has brought some good news for students pursuing higher education and for their parents. If the proposals stated in the Budget do fructify, it will be possible for a taxpayer to claim deduction on account of interest on education loan taken for one’s children or spouse.

The memorandum to the Budget specifies that: “It is proposed to amend Section 80E so as to allow the deduction of interest on loan taken by an individual for higher education of his relative also. It is also proposed to define the term ‘relative’ for the purpose of Section 80E so as to mean spouse and children of the individual.”

This amendment holds important implications. Currently, only an individual who has taken loan for pursuing his/her higher education is eligible for tax benefits. The relief is not allowed to parents, but to the student himself/herself when he/she starts repaying the amount.

Now, it has been proposed that the tax benefits can be availed of even by ‘relatives’. With this, parents/spouse can take a loan for their children’s/spouse’s higher education and claim tax relief on repayment of interest. This amendment will apply in relation to the assessment year ’08-09 and subsequent years.

This will be a major advantage for parents of children pursuing higher studies. They will be able to lower their overall tax liability by claiming deduction on account of interest paid on the education loan. For students, this means that some part of the liability on account of the loan will have been paid off by the time they start their career. However, industry players are yet to read the fine print and decide how to put the revised education loan scheme into practice.

Says a senior manager with a public sector bank. “At present, the loans are disbursed in the student’s name. But with the possible amendment, we have to see if the bank can sanction a loan in the parent’s name so that they can seek tax relief.”

The amendment also raises a few questions. One will be able to say something definitively only once the details are disclosed by the tax authorities and by banks giving out education loans.

Here, we attempt to answer, with whatever information is currently available, a couple of basic questions that could crop up in a few cases.

Is it better to take an education loan than finance it from one’s own pocket? Bankers say that demand for education loans has picked up, as the cost of higher education has surged by 20-50% in the past few years. Now, with the proposed amendment, bankers see a further rise in the demand for education loans.

Industry players say that many institutes demand a huge portion of the fees as an upfront payment. This could drain the savings and disturb personal finances of parents. An education loan is more attractive now as even parents will be able to seek a tax relief on the same.

Should the parent take the loan? “In the current situation, the bank always disburses a study loan in the name of the student who has signed up for a course. A parent can only sign as a guarantor for the loan,” says a senior manager with Andhra Bank.

However, banking sources also say that soon, a time may come when the bank will sanction loans in the parents’ name. In such cases, there are two ways in which a study loan can be repaid.

One option is that the parents can service the interest component of the loan during the study period of the student. In this option, both the parents and the student stand to gain. Parents can seek tax relief to the extent of the interest outgo and the burden of repayment reduces considerably on the student.

The second option is to start repaying the loan once the student takes up a job. In this case, the student repays the loan.

However, these deductions are available up to a period of eight years. Please note that you cannot claim any tax deduction if your employer gives you an education loan. This also applies for family or friends. You have to borrow from a bank or financial institution or approved charitable institution to claim tax benefits.

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March 6, 2007

What are Composite Loans?

Loans where a lender gives you money not only for procurement of land, but also for construction of a house, are termed composite loan.

Huge apartment complexes, luxury villas and independent bungalows have mushroomed throughout the city. Projects are getting overbooked in localities with business and industrial activity. Affordable interest rates offered by most banks have fuelled heavy activity in the real estate sector. Manoj intends to purchase a piece of land at an affordable rate. He may choose to either sell the land once its value appreciates, or build his own house after a few years. Will he be eligible for a loan to purchase a plot?

There is good news for people like Manoj. Banks offer loans at competitive rates for purchasing a plot. You can either construct a house on it, or simply hold on to the land as an investment. Some lenders insist that you have to construct a house within a year or two of purchasing the land. So, not only do they offer you loan to buy a piece of land, but also provide you money for construction of a house. A plot can be purchased purely for investment purposes. It appreciates and yields manifold returns. Loans where a lender gives you money not only for procurement of land, but also for construction of a house, are referred to as composite loans. Manoj can get as much as 85% of the cost of the land from bankers. The minimum loan amount is Rs 3 lakh for most banks. The loan tenure varies from one to 20 years. Also, most banks lend only if the site falls under the municipality limits. Additional sops like free accident insurance cover packaged with the land loan are also on offer. Shop around and compare interest rates, just like you would for a home loan. A difference of a few percentage points could translate into savings of a few thousand rupees.

Resident Indians, as well as non-resident Indians (NRIs), in the age group 18-50 years, with independent and regular source of income, are eligible to apply for these loans. For those above 50 years, some lenders impose certain restrictions like shortening of maximum repayment period, or co-obligation of spouse/children. Documents required for applying for a land loan include filled application form with photograph, identity proof, residence address proof, latest salary slip, form 16, six months’ bank statement and processing fee, if applicable. While banks lend for purchasing a site, some insist that the borrower must undertake to commence the construction of house, after completing all formalities, within a maximum period of 12 months, with or without availing of more finance for this purpose. The site value should not be more than 50% of the total project cost. The maximum repayment holiday permitted, including the construction period, is 24 months.

If the borrower fails to keep up the undertaking to commence construction within 12 months or sells the site, the loan is treated as misused and attracts interest at commercial rates; then the loan has to be repaid at once. Many other financial institutions do not bother whether you buy the land purely for investment purposes or desire to construct a house on it. Before you finalise the loan agreement, get a clear picture whether your bank has any such clause attached to it or not. To start his construction project, Manoj can either top up his existing loan or avail of a new construction loan. A composite loan scheme meets your requirement of both purchase of site and construction. Permitted margin money has to be maintained in both the stages of land purchase and construction. The portion of the margin towards construction has to brought in before the first disbursement towards construction.

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March 3, 2007

Make The Most Of Personal Loan

Personal loans are often taken for financing short-term needs or unforeseen expense. It is popular among borrowers as you need not state any reason to the bank. To top it all, you need not offer a collateral or have guarantors. All you have to do is submit a salary slip, proof of personal identity, residence proof and sign on a form. And the money is yours.

WHAT MORE CAN YOU ASK FOR?

But there is more to the story. Personal loans, though easy, come at a high interest rate. So it is pertinent for you to know if you are the right candidate and have the right reason to go in for such a loan.

ARE YOU THE RIGHT CANDIDATE?

Renters: If you do not own a home, a personal loan may be the only option available for you. You also have the option of credit cards, but the annual interest rate works out to 35.4%, against a personal loan, which charges interest rate in the range of 18-25%.

Home equity utilised: If you have already used a lot of your home equity and still need a small loan, a personal loan can be a good choice.

Small loan amount: If you need a few thousand rupees, which you can pay off in a year, then a personal loan is a better option compared to using home equity or credit cards.

However, there is a catch here. Most banks do not let you repay the loan before 180 days. So, even if you end up getting some extra money to repay your debt, you are still stuck with the loan and the high interest rate.

WHEN TO TAKE A PERSONAL LOAN?

For buying a consumer durable: You can opt for a personal loan to buy the latest LCD television or that cool music system. You may think of going in for a consumer durable loan, but the interest rate on personal loan is much lower than that on consumer durable loans.

A consumer durable loan comes at an interest rate in the range of 25-30%. In addition, the flexibility of duration and availability of various schemes make personal loans an attractive option.

Go for personal loan than your credit card: Opting for a personal loan may be a better choice than borrowing on your credit card if you want to keep your credit limit available for impulse purchases or an actual emergency requiring instant purchasing power. Often, borrowing money on your credit card carries a higher rate of interest than a personal loan.

To repay your credit card debt:
Assume you have revolving credit on your credit card at the rate of 2.95% per month. This amounts to 35.4% per annum.

Every time you swipe your card to make a purchase, your card is subject to this rate of interest. Eventually, you have to pay off your debt at an exorbitant rate. Instead, opt for a personal loan and clear all your credit card outstandings. That will weigh less on your wallet.

To service multiple loans: You could be servicing a consumer durable loan, revolving credit on your card and probably have even taken an overdraft on your bank deposit. Instead of servicing the debt at different rates of interest with different repayment tenures, you can consolidate it into one single source.

It will help you manage your finances better. But you have to check if the interest outgo will be much higher than servicing multiple loans. To determine this, calculate how much money you will need to repay all your loans. Check with the bank and ask them how much the equated monthly instalments (EMIs) will be on such a loan, along with the repayment tenure. If the EMI will be much higher than all your existing loans taken together, then avoid a personal loan, despite the convenience.

WHAT YOU NEED TO KNOW?

Qualifying criteria are usually stricter as there is no collateral. Most banks have eligibility criteria such as age limit, minimum educational qualification, number of years in the current company/residence and minimum net/gross annual income. Most banks maintain an approved list of companies. You will automatically get a loan if you are an employee of one of those companies. It also helps you to negotiate a better rate.

Personal loans are generally offered up to Rs 10 lakh, starting from Rs 20,000. Look out for closure charges, service charges and any other ‘hidden’ charges. Personal loans are expensive with higher interest charges than most other loans, except consumer durable loans.

You also need to verify if the interest component is being calculated on a monthly, weekly or a daily reducing balance method or on a lower period. Higher the frequency, lower is the interest rate charged.

FINANCING MADE EASY

Personal loan is popular as you need not state any reason to the bank

Opting for a personal loan may be a better choice than borrowing on your credit card, which comes at a higher interest rate than a personal loan

Instead of paying off your debt at an exorbitant rate, opt for a personal loan and clear all your credit card outstandings. It will weigh less on your wallet

Personal loans are generally offered up to Rs 10 lakh, starting from Rs 20,000. Look out for closure charges, service charges and any other ‘hidden’ charges

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