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International Business Law and Taxation

This book is a part of the course by Jaipur National University, Jaipur.This book contains the course content for International Business Law and Taxation.

JNU, JaipurFirst Edition 2013

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Index

ContentI. ...................................................................... II

List of FiguresII. ........................................................ VII

List of TablesIII. ........................................................VIII

AbbreviationsIV. .........................................................IX

AssignmentV. ............................................................. 188

BibliographyVI. ......................................................... 192

Self Assessment AnswersVII. ................................... 195

Book at a Glance

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Contents

Chapter I ....................................................................................................................................................... 1International Business Theories ................................................................................................................. 1Aim ................................................................................................................................................................ 1Objectives ...................................................................................................................................................... 1Learning outcome .......................................................................................................................................... 11.1 Foundations of International Business ..................................................................................................... 21.2 International Trade Theories .................................................................................................................... 2 1.2.1 Theory of Mercantilism ........................................................................................................... 2 1.2.2 Theory of Absolute Cost Advantage ........................................................................................ 3 1.2.3 Theory of Comparative Cost Advantage.................................................................................. 3 1.2.4 Opportunity Cost Theory ......................................................................................................... 41.3 Efficiency in International Trade ............................................................................................................. 5 1.3.1 Heckseher-Ohlin Trade Model ................................................................................................. 9 1.3.2 The Leontief Paradox ............................................................................................................. 101.4 Foreign Direct Investment (FDI) Theories ............................................................................................ 10 1.4.1 Market Imperfections Approach .............................................................................................11 1.4.2 Product Life-Cycle Approach .................................................................................................11 1.4.3 Transaction Cost Approach .................................................................................................... 12 1.4.4 Different types of Investment for Internationalisation ........................................................... 12 1.4.5 Eclectic Paradigm .................................................................................................................. 131.5 Intra Industry Trade and Theories .......................................................................................................... 14 1.5.1 Economies of Scale ................................................................................................................ 16 1.5.2 Availability and Non Availability ........................................................................................... 17 1.5.3 Trade in Intermediate Goods .................................................................................................. 18Summary ..................................................................................................................................................... 20References .................................................................................................................................................. 20Recommended Reading ............................................................................................................................. 20Self Assessment ........................................................................................................................................... 21

Chapter II ................................................................................................................................................... 23International Regulatory Framework ...................................................................................................... 23Aim .............................................................................................................................................................. 23Objectives .................................................................................................................................................... 23Learning outcomes ....................................................................................................................................... 232.1 Introduction ............................................................................................................................................ 242.2 An Overview of Legal Framework ........................................................................................................ 24 2.2.1 Foreign Trade Act, 1992 ........................................................................................................ 24 2.2.2 Foreign Exchange Management Act, 1999 ............................................................................ 24 2.2.3 The Customs Act, 1962 .......................................................................................................... 25 2.2.4 Export (Quality Control and Inspection) Act, 1963 ............................................................... 252.3 Export-Import Policy ............................................................................................................................. 25 2.3.1 Registration Formalities and Export Licensing ..................................................................... 26 2.3.2 Procedure to Obtain Export Licence ...................................................................................... 272.4 General Provisions Regarding Exports And Imports ............................................................................. 282.5 Exports and Imports ............................................................................................................................... 29 2.5.1 Exports ................................................................................................................................... 29 2.5.2 Imports ................................................................................................................................... 312.6 Export-Import Documents ..................................................................................................................... 32 2.6.1 Rationale of Documents ......................................................................................................... 32 2.6.2 Kinds and Functions of Documents ....................................................................................... 34 2.6.3 Standardised Pre-Shipment Export Document ...................................................................... 41 2.6.4 Import Documents ................................................................................................................. 44

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Summary ..................................................................................................................................................... 45References ................................................................................................................................................... 45Recommended Reading ............................................................................................................................. 45Self Assessment ........................................................................................................................................... 46

Chapter III .................................................................................................................................................. 48International Financial Management ...................................................................................................... 48Aim .............................................................................................................................................................. 48Objective ...................................................................................................................................................... 48Learning outcome ........................................................................................................................................ 483.1 Introduction To International Financial Management ........................................................................... 49 3.1.1 International Finance ............................................................................................................. 49 3.1.2 International Flow of Funds ................................................................................................... 53 3.1.3 Goals for International Financial Management ..................................................................... 54 3.1.4 Nature of International Financial Management ..................................................................... 55 3.1.5 Comparison between Domestic and International Financial Management ........................... 563.2 International Financial Environment ..................................................................................................... 56 3.2.1 Gold Standard ........................................................................................................................ 57 3.2.2 The Bretton Woods System of Exchange Rate ...................................................................... 57 3.2.3 Theories of Exchange Rate Behaviour .................................................................................. 57 3.2.4 Global Capital Structure ........................................................................................................ 583.3 International Financial Markets ............................................................................................................. 59 3.3.1 National Markets as International Financial Centres ............................................................. 60 3.3.2 Euro Market ........................................................................................................................... 61 3.3.3 International Debt Instruments .............................................................................................. 63 3.3.4 Euro Issues in India ................................................................................................................ 703.4 Management of International Short Term Financing ............................................................................. 72 3.4.1 Short Term Markets ............................................................................................................... 72 3.4.2 Short Term Loans for Money Market .................................................................................... 73 3.4.3 Forfaiting ............................................................................................................................... 73 3.4.4 International Leasing ............................................................................................................. 73 3.4.5 Syndicated Loans ................................................................................................................... 74Summary ..................................................................................................................................................... 75References ................................................................................................................................................... 75Recommended Reading ............................................................................................................................. 75Self Assessment .......................................................................................................................................... 76

Chapter IV .................................................................................................................................................. 78Heads of Income ........................................................................................................................................ 78Aim .............................................................................................................................................................. 78Objectives .................................................................................................................................................... 78Learning outcome ........................................................................................................................................ 784.1 Introduction ............................................................................................................................................ 794.2 Salaries ................................................................................................................................................... 79 4.2.1 Heads of Income .................................................................................................................... 79 4.2.2 Meaning of Salary .................................................................................................................. 79 4.2.3 Incomes Forming Part of Salary ............................................................................................ 80 4.2.4 Basic Salary ........................................................................................................................... 80 4.2.5 Fees, Commission and Bonus ................................................................................................ 81 4.2.6 Taxable Value of Allowances ................................................................................................. 814.3 Income from House Property ................................................................................................................. 85 4.3.1 Conditions to be satisfied for income to be charged to tax Under the head ......................... 854.4 Profits and Gains of Business or Profession .......................................................................................... 88 4.4.1 Scheme of Business Deductions ............................................................................................ 89 4.4.2 Specific Deductions under the Act ......................................................................................... 89

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4.5 Capital Gains .......................................................................................................................................... 93 4.5.1 Short Term Capital Gains ....................................................................................................... 93 4.5.2 Long Term Capital Gain ........................................................................................................ 954.6 Income from Other Sources .................................................................................................................. 97 4.6.1 Incomes Not Specified In Section 56 .................................................................................... 97 4.6.2 Taxability of Select Incomes .................................................................................................. 98 4.6.3 Taxability of Dividend ........................................................................................................... 98Summary ................................................................................................................................................... 101References ................................................................................................................................................. 102Recommended Reading ........................................................................................................................... 102Self Assessment ......................................................................................................................................... 103

Chapter V .................................................................................................................................................. 105Computation of Taxable Income............................................................................................................. 105Aim ............................................................................................................................................................ 105Objectives .................................................................................................................................................. 105Learning outcome ...................................................................................................................................... 1055.1 Introduction .......................................................................................................................................... 1065.2 Statement of Taxable Income and Tax ................................................................................................. 1065.3 Computation of Taxable Income of HUF ............................................................................................ 109 5.3.1 Deduction from Gross Total Income .....................................................................................111 5.3.2 Calculating Tax Liability ......................................................................................................1115.4 Computation of Taxable Income of a Company ...................................................................................111 5.4.1 Compute Taxable Income of a Partnership Firm ..................................................................112Summary ....................................................................................................................................................113References ..................................................................................................................................................113Recommended Reading ............................................................................................................................113Self Assessment ..........................................................................................................................................114

Chapter VI .................................................................................................................................................116Tax Management .......................................................................................................................................116Aim .............................................................................................................................................................116Objectives ...................................................................................................................................................116Learning outcome .......................................................................................................................................1166.1 Introduction ...........................................................................................................................................117 6.1.1 What is an Income Tax Return? ............................................................................................117 6.1.2 Wealth Tax Return.................................................................................................................1176.2 Tax Returns ...........................................................................................................................................1186.3 Due Dates for Filing of Returns ............................................................................................................1186.4 Manner of Filing of Returns Manner of Furnishing Returns ............................................................... 121 6.4.1 Filing of Bulk Return by Employer [Section 139 (1A)] ...................................................... 121 6.4.2 Filing of Return of Income on Computer Readable Medium [Section 139(1B)] ................ 121 6.4.3 Filing of Return in Electronic Form .................................................................................... 121 6.4.4 Scheme of Filing Returns by Salaried Employees .............................................................. 1216.5 PAN Form ........................................................................................................................................... 122 6.5.1 Important Points to Remember while Filling the ‘Pan’ Form (form no. 49a) ..................... 1226.6 Filling up a Tax Challan ....................................................................................................................... 1236.7 Assessment of Return ........................................................................................................................... 123 6.7.1 Income ................................................................................................................................. 124 6.7.2 Person – One who earns Income .......................................................................................... 124 6.7.3 Types of Income ................................................................................................................... 124 6.7.4 Types of Assessment ............................................................................................................ 124 6.7.5 Normal Procedure of Taxation ............................................................................................. 125 6.7.6 Income Tax Return (ITR) ..................................................................................................... 125 6.7.7 Need for Checking by IT Department ................................................................................. 125

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6.7.8 Self Assessment - 1) Self Assessment u/s 140 A ................................................................ 126 6.7.9 Scrutiny Assessment - Regular/ Scrutiny Assessment u/s 143(3) ........................................ 127 6.7.10 Best Judgment Assessment - Best Judgement Assessment u/s 144: Conditions ............... 127 6.7.11 Reassessment - Assessment / Reassessment of Income Escaping Assessment u/s 147 ..... 1286.8 Advance Tax ......................................................................................................................................... 128 6.8.1 Who is Liable to Pay Advance Tax? .................................................................................... 129 6.8.2 Dues Dates and Instalments of Advance Tax ....................................................................... 130 6.8.3 Important Note for Salaried Tax-Payers .............................................................................. 130 6.8.4 How to Calculate Advance Tax? ......................................................................................... 130 6.8.5 Rates of Advance Tax .......................................................................................................... 130 6.8.6 How to Deposit Advance Tax? ........................................................................................... 1306.9 Interest ................................................................................................................................................. 131 6.9.1 Levy of Interest .................................................................................................................... 132 6.9.2 Assessment Scheme –Scope ................................................................................................ 132 6.9.3 Settlement Commission Scheme ......................................................................................... 1326.10 TDS .................................................................................................................................................... 134 6.10.1 Deduction of Tax at Source in Works Contract ................................................................. 134 6.10.2 What does the TNVAT Rules Say about the TDS? ............................................................ 136 6.10.3 Conclusion ......................................................................................................................... 136Summary ................................................................................................................................................... 138References ................................................................................................................................................. 138Recommended Reading ........................................................................................................................... 139Self Assessment ......................................................................................................................................... 140

Chapter VII .............................................................................................................................................. 142Wealth Tax, 1957 & Central Sales Tax ................................................................................................... 142Aim ............................................................................................................................................................ 142Objectives ................................................................................................................................................. 142Learning outcome ...................................................................................................................................... 1427.1 Introduction .......................................................................................................................................... 1437.2 Chargeability ........................................................................................................................................ 1437.3 Applicability of Wealth Tax ................................................................................................................. 143 7.3.1 Valuation Date ...................................................................................................................... 1447.4 Basic Concepts of Assets ..................................................................................................................... 145 7.4.1 Deemed Assets ..................................................................................................................... 147 7.4.2 Exempt Assets [Sec 5] ......................................................................................................... 1497.5 Debt Owed .......................................................................................................................................... 1507.6 Features of Central Sales Tax Act ........................................................................................................ 1527.7 Important Definitions .......................................................................................................................... 1527.8 Levy and Collection of Tax and Penalties ........................................................................................... 1547.9 Principles for Determining Place of Sale or Purchase ........................................................................ 155 7.9.1 In The Course of Inter State Trade ...................................................................................... 156 7.9.2 Sale or Purchase of Goods Outside a State ......................................................................... 156 7.9.3 Sale or Purchase of Goods in the Course of Import and Export – Section 5 ...................... 1567.10 Liability to Tax on Inter-State Sales ................................................................................................... 157 7.10.1 Rates of Tax ....................................................................................................................... 157 7.10.2 Determination of Turnover ................................................................................................ 157 7.10.3 Collection of Tax Section 9 A ........................................................................................... 1587.11 Registration of Dealers ....................................................................................................................... 158 7.11.1 Compulsory Registration Section 7 (1) ............................................................................. 158 7.11.2 Voluntary Registration Section 7 (2) ................................................................................. 158 7.11.3 Procedure for Registration ................................................................................................ 159 7.11.4 Amendment of Certificate of Registration ......................................................................... 1597.12 Cancellation of Certificate of Registration ....................................................................................... 160Summary ................................................................................................................................................... 161

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References ................................................................................................................................................. 161Recommended Reading ........................................................................................................................... 161Self Assessment ......................................................................................................................................... 162

Chapter VIII ............................................................................................................................................. 164Value Added Tax (VAT) & Central Excise Tax ...................................................................................... 164Aim ............................................................................................................................................................ 164Objectives .................................................................................................................................................. 164Learning outcome ...................................................................................................................................... 1648.1 Introduction .......................................................................................................................................... 1658.2 Features of VAT.................................................................................................................................... 1658.3 Advantages of VAT .............................................................................................................................. 1668.4 Disadvantages of VAT .......................................................................................................................... 1678.5 Set-off of Tax Credit under VAT .......................................................................................................... 1678.6 When Credit cannot be Availed? .......................................................................................................... 1698.7 Tax Relief under VAT ........................................................................................................................... 170 8.7.1 Distinction between ‘Zero Rated sale’ and ‘Exempt Sale’ .................................................. 170 8.7.2 Refund if VAT Credit of Input Tax Available cannot be Utilised for any Reason ............... 1708.8 Rates of Taxes under VAT .................................................................................................................... 1708.9 Concessions for Small Dealers ............................................................................................................ 171 8.9.1 Composition Scheme for Dealers with Turnover up to Rs 50 Lakhs ................................. 171 8.9.2 Dealers who make Inter-State Purchase .............................................................................. 1718.10 Variants of VAT .................................................................................................................................. 1728.11 Different Modes of Computation of VAT ........................................................................................... 173 8.11.1 Addition Method ................................................................................................................ 173 8.11.2 Tax Credit /Invoice Method .............................................................................................. 173 8.11.3 Subtraction Method ............................................................................................................ 173 8.11.4 Procedural Provisions Relating to VAT .............................................................................. 1738.12 Documentation Required to Avail Credit of Tax Paid on Inputs and Capital Goods ........................ 1748.13 Payment of VAT Tax and Filing of Returns ....................................................................................... 1748.14 Accounting Treatment of VAT ........................................................................................................... 1758.15 Tax ...................................................................................................................................................... 1768.16 Nature of Excise Duty ...................................................................................................................... 176 816.1 Taxable Event .................................................................................................................... 176 8.16.2 Rates of Excise Duty ........................................................................................................ 1778.17 Chargeability of Excise Duty ............................................................................................................ 1778.18 Definitions and Concepts .................................................................................................................. 177 8.18.1 Factory .............................................................................................................................. 177 8.18.2 Goods ................................................................................................................................ 177 8.18.3 Manufacture or Production ............................................................................................... 178 8.18.4 Manufacturer ..................................................................................................................... 1788.19 Classification of Goods ..................................................................................................................... 178 8.19.1 Scheme of Classification .................................................................................................. 178 8.19.2 Trade Parlance Theory ...................................................................................................... 1798.20 Valuation of Goods ............................................................................................................................ 1798.21 Registration of Goods ....................................................................................................................... 1808.22 Clearance of Goods ........................................................................................................................... 1818.23 Duty Payment Provisions .................................................................................................................. 1828.24 Excise Duty Set Off Provisions 254 .................................................................................................. 182Summary ................................................................................................................................................... 184References ................................................................................................................................................. 184Recommended Reading ........................................................................................................................... 185Self Assessment ........................................................................................................................................ 186

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List of Figures

Fig. 1.1 Efficiency under Autarky .................................................................................................................. 7Fig. 1.2 Efficiency under international trade ................................................................................................. 8Fig. 3.1 Transactions using a sight bill of exchange .................................................................................... 51Fig. 3.2 Transactions using letter of credit ................................................................................................... 52Fig. 3.3 Major global environmental factors ............................................................................................... 56Fig. 4.1 Incomes forming part of salary ....................................................................................................... 80Fig. 6.1 Types of income ............................................................................................................................ 124Fig. 6.2 Advance tax .................................................................................................................................. 129Fig. 7.1 Wealth tax chargeability ............................................................................................................... 143


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List of Tables

Table 1.1 Labour cost of production (in hours) ............................................................................................. 3Table 1.2 Labour cost of production (in hours) ............................................................................................. 4Table 1.3 Domestic exchange ratios .............................................................................................................. 6Table 1.4 The case of more than two commodities ........................................................................................ 6Table 1.5 Vernon product life cycle approach .............................................................................................. 12Table 3.1 Payment methods for international trade ..................................................................................... 53Table 3.2 Yield spread .................................................................................................................................. 67Table 3.3 Status of ECB approach ............................................................................................................... 71Table 4.1 Chargeability of various types of buildings and lands ................................................................. 88Table 4.2 Cost inflation index ...................................................................................................................... 95Table 5.1 Statement of taxable income ...................................................................................................... 106Table 5.2 Computation and assessment – individual ................................................................................. 107Table 5.3 Calculating taxable income ........................................................................................................ 107Table 5.4 Calculating tax liability .............................................................................................................. 108Table 5.5 Deduction from gross total income .............................................................................................111Table 6.1 Returns of income .......................................................................................................................118Table 6.2 Due dates for filing return ...........................................................................................................118Table 6.3 Due dates and the percentage of instalments of advance tax .....................................................119Table 6.4 Interest calculation for deferment of advance-tax ...................................................................... 120Table 6.5 Taxation process ......................................................................................................................... 125Table 6.6 Instalments and due dates of advance tax .................................................................................. 130Table 7.1 List of taxable and deductable under wealth tax ........................................................................ 144Table 7.2 Concepts of asset ........................................................................................................................ 146Table 7.3 Deemed assets ............................................................................................................................ 148Table 7.4 Assets exempt from wealth tax .................................................................................................. 150Table 7.5 Procedure for computation of net wealth ................................................................................... 150Table 7.6 Important definitions .................................................................................................................. 154

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Abbreviations

ACU - Asian Clearing UnionAPEDA - Agricultural and Processed Food products Export Development AuthorityBIE - Bill of ExchangeCHIPS - Clearing House Interbank Payments SystemCSC - Cold Storage CompanyCTD - Combined Transport DocumentDEPB - Duty Entitlement Pass BookDFRC - Duty Free Replenishment CertificateDGFT - Director General of Foreign TradeDP - Documents Against PaymentDTA - Double Taxation AvoidanceECB - External Commercial BorrowingEEC - European Economic CommunityEHTP - Electronic Hardware Technology ParkEOU - Export Oriented UnitsEPCG - Export Promotion Capital GoodsEPZ - Export Processing ZonesEXIM - Export and ImportFDI - Foreign Direct InvestmentFEDAI - Foreign Exchange Dealers Association of IndiaFEMA - Foreign Exchange Management ActFFI - Fast Forex InvestmentFIEO - Federation of Indian Export OrganisationFOB - Freight on BoardFRN - Floating Rate NoteGDR - Global Depository ReceiptGMAC - General Motors Acceptance CorporationGSP - Generalised System of PreferencesIEC - Importer-Exporter CodeIMF - International Monetary FundITC(HS) - Indian Trade Classification Harmonised SystemLDC - Least Developed CountryLIBID - London Inter Bank Bid RateLIBOR - London Inter Bank Offer RateMNC - Multinational CompanyMNE - Multinational EnterpriseMPEDA - Marine Products Export Development AuthorityMRS - Marginal Rate of SubstitutionMRT - Marginal Rate of TransformationPPC - Production Possibility CurveR& D - Research and DevelopmentRBI - Reserve Bank of IndiaRCMC - Registration-cum-Membership CertificateSOFTEX - Software Export DeclarationSTC - State Trading Corporation


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Chapter I

International Business Theories

Aim

The aim of this chapter is to:

introduce the international business theories•

explain the international trade theories•

highlight theeffeciency in international trade•

Objectives

The objectives of this chapter are to:

explicate the leontief paradox•

analyse the foreign direct investment theories•

elucidate the intra industry trade and theories•

Learning outcome

At the end of this chapter, you will be able to:

discuss trade in intermediate goods•

understand the eclictic paradigm•

enlist different types of investment for internationalisation•


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1.1 Foundations of International BusinessThe analytical framework of international business is build around the activities of MNEs enunciated by the process of internationalisation. The FDI, on the part of an MNE attempts to overcome the obstructions to trade in foreign countries.Thestrategiesrelatingtothefunctionalareas,suchasproduction,marketing,financeandpricepolicies,areadopted by the MNEs in such a manner that an amicable relationship between home and host nations is created.

Foreign direct investment can be distinguished from the other forms of international business, such as exporting, licensing, joint ventures and management contracts. Basically, it reacts to the restrictions in foreign trade, licensing, etc., and its growth at the global level has taken place. This is due to the imperfections in the world markets and protective trade policies pursued by different countries for the sake of protecting their economies. There are different ways in which the MNEs have provided challenges to the imperfections and restraints in the world markets from an important part of the conceptual methods underlying the expanding role of international business.

Before the emergence of the MNEs, foreign trade and international business were regarded as synonymous, and international trade doctrines based on labour cost differentials and free trade guided the international transactions among different trading partners. The multinationals undertook FDI abroad, and their innovative efforts in technological development and management techniques, in a way, refuted the traditional trade theories. Several FDI theories have been developed in support of international business for the improvement and welfare of world economies. The fast growth of international business has also been conducive to foster close international economic relations among different countries of the world.

Now, the world economy is not only interdependent but also inter-linked, and any kind of R & D taking place in any part of the world has its impact on the entire global economy. The multinationals are to keep a constant surveillanceonthefluctuatingforeignexchangeratesandinflationasthesehaveadirectbearingontheprofitabilityof international operations. The socio-cultural, political and economic environments of host countries also affect the investment decisions of foreign investors.

1.2 International Trade TheoriesInternational business began with international trade operations, facilitated by the laissez faire in the world economy. It improved the well-being of many nations, and the imposition of trade barriers reduced the gains from trade, giving rise to the search for alternate avenues to exporting. The latter resulted in the establishment of subsidiaries in foreign countries through FDI. In this context, it is pertinent to understand the determinants of and the effects of international trade and FDI on the trading partners, international operations of multinationals and the economies of the home and host countries. Several theories have been formulated, from time to time, which form the bases of international trade and FDI.

1.2.1 Theory of MercantilismDuring the sixteenth to the three-fourths of the eighteenth centuries, the world trade was being conducted according to the doctrine of mercantilism. It comprised many modern features like belief in nationalism and the welfare of the nation alone, planning and regulation of economic activities for achieving the national goals, curbing imports and promoting exports.

The mercantilists believed that the power of a nation lied in its wealth, which grew by acquiring gold from abroad. This was considered possible by increasing exports and impeding imports. Such reasoning gathered support on thegroundthatgoldcouldfinancemilitaryexpeditionsandwars,andtheexportswouldcreateemploymentintheeconomy. Mercantilists failed to realise that simultaneous export promotion and import regulation are not possible in all countries, and the mere possession of gold does not enhance the welfare of a people. Keeping the resources in the form of gold reduces the production of goods and services and, thereby, lowers welfare. The concentration in theproductionofgoodsfordomesticconsumptionbyusingresourcesinalessefficientmannerwouldalsomeanlower production and smaller gains from international trade.

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The theory of mercantilism was rejected by Adam Smith and Ricardo by stressing the importance of individuals, and pointing out that their welfare was the welfare of the nation. They believed in liberalism and enlightenment, and treated the wealth of the nation in terms of the “the sum of enjoyments” of the individuals in society. Any activity, which would increase the consumption of the people, was to be considered with favour. Their trade doctrines were based upon the principles of free trade and the specialisation in the production of those goods where resources were most suitable.

1.2.2 Theory of Absolute Cost AdvantageThe theory of absolute cost advantage was propounded by Adam Smith (1776), arguing that the countries gain from trading, if they specialise according to their production advantages. His doctrine may be understood with an example presented in the following table.

One Unit of Goods A One Unit of Goods BCountry I 10 20Country II 20 10

Table 1.1 Labour cost of production (in hours)(Source:http://www.egyankosh.ac.in/bitstream/123456789/35341/1/Unit-2.pdf)

The table shows that, in the absence of trade, both the goods are produced in both the countries, because of their demand in the domestic markets. The cost of production is determined by the amount of labour required in the production of the respective goods. The greater the amount of labour, the higher will be the cost of production, and the commodity will have a larger value in exchange. The pre-trade exchange ratio in country I would be 2A=1B and in country II IA=2B.

If trade takes place between these two countries then they will specialise in terms of absolute advantage and gain from trading with each other. Country I enjoys absolute cost advantage in the production of good A and country II in good B. One unit of good A may be produced in country I with 10 hours of labour, whereas it costs 20 hours of labour in country II. The production of the unit of good B costs 20 hours of labour in country I and 10 hours of labour in country II. After trade, the international exchange ratio would lie somewhere between the pre-trade exchange ratio of the two countries. If it is nearer to country I domestic exchange ratio then trade would be more beneficialtocountryIIandviceversa.

Assuming the international exchange ratio is established IA=IB, then both the trading partners would be able to save 10 hours of labour, which may be used either for the production of other goods and services or may be enjoyed by the workers as leisure, which improves their welfare in either way. The terms of trade between the trading partners would depend upon their economic strength and the bargaining power.

1.2.3 Theory of Comparative Cost AdvantageRicardo (1817), though adhering to the absolute cost advantage doctrine of Adam Smith, pointed out that cost advantagetoboththetradepartnerswasnotanecessaryconditionfortradetooccur.Itwouldstillbebeneficialto both the trading countries even if one country can produce all the goods with less labour cost than the other country. According to Ricardo, so long as the other country is not equally less productive in all lines of production, measurable in terms of opportunity cost of each commodity in the two countries, it will still be mutually gainful for them if they enter into trade.


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One Unit of Goods A One Unit of Goods BCountry I 80 90Country II 120 100

Table 1.2 Labour cost of production (in hours)

(Source:http://www.egyankosh.ac.in/bitstream/123456789/35341/1/Unit-2.pdf)

1.2.4 Opportunity Cost TheoryOne of the main drawbacks of the Ricardian comparative cost theory was that it was based on the labour theory of value which stated that the value or price of a commodity was equal to the amount of labour time going into the production of the commodity. Gottfried Haberler gave a new life to the comparative cost theory by restating the theory in terms of opportunity costs in 1933. The opportunity cost of anything is the value of the alternatives or other opportunities which have to be foregone in order to obtain that particular thing. For example, assume that a given amount of productive resources can produce either 10 units of cloth or 20 units of wine. Then the opportunity costof1unitofclothis2unitsofwine.Thus,theopportunitycostapproachdefinescostintermsofthevalueofthe alternatives of other opportunities which have to be foregone in order to achieve a particular thing.

According to the opportunity cost theory, the basis of international trade is the differences between nations in the opportunity costs of production of commodities. Accordingly, a nation with a lower opportunity cost for a commodity has a comparative advantage in that commodity and a comparative disadvantage in the other commodity. Suppose that the opportunity cost of one unit of X is 2 units of Y in country A and 1.5 unit of Y in country B. Then Country A must specialise in production of Y and import its requirements of X from B, and B should specialise in the production of X and import Y from A rather than producing it at home.

AssumptionsThe opportunity cost theory too is based on most of the common assumptions of the classical theories.

The important assumptions of this theory are as follows: Two-country, two-commodity model. •There are only two factors of production, viz., labour and capital. •Factors of production are perfectly mobile within a country but immobile between countries. Factors of production •arefixed.Thereisperfectcompetitionisfullinsupplyinbothfactorandproductmarkets.The price of each factor is equal to its marginal productivity in each employment. •The price of each commodity is equal to employment in each country.•There is no technical change.•International trade is free.•

Merits The opportunity cost approach is superior to the Ricardian theory in the following ways: It recognises the existence of many different kinds of productive factors (although for simplicity sake the theory considered only two factors) whereas Ricardo considered only labour. The opportunity cost theory tells us that even if we discard the labour theory of value as being invalid and rely on the opportunity cost theory, the comparative cost theory is still valid. The opportunity cost theory considers trade under constant, increasing and decreasing costs, whereas the comparative cost theory assumes constant cost of production. It recognises the It is based on the importance of factor substitution. It provides a simple general equilibrium model on a number of unrealistic approaches in production of international trade.

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CriticismsThe opportunity cost theory is subject to the following criticisms, Jacob Viner, in his Studies in the Theory of International Trade, argued that the opportunity cost approach is inferior to the classical real cost approach as tool ofwelfareevaluationinasmuchasitfailstomeasurerealcostsintermsofsacrifices,disutility’sorirksomeness.Viner also argued that the opportunity cost approach ignores the changes in factor supplies. However, V. C. Walsh points out that the changes in factor supplies can be measured in terms of opportunity cost by taking into account changes in commodity price ratio and marginal productivities of factors. Yet, another criticism of the opportunity cost approach by Viner is that it fails to take into account the preference for leisure vis-a-vis income. This criticism has also been refuted by Walsh by arguing that when the trading nations exchange at an international price ratio, there will normally be an increase in real income and part of this will be taken in the form of more leisure, so that the output of both commodities may decrease.

ConclusionTheopportunitycosttheoryofHaberlerisarefinementoftheRicardiantheory.Asfarasthebasisofinternationalspecialisation and trade are concerned, the logic behind the comparative cost approach and the opportunity cost approach are the same. Paul Samuelson, who has highly appreciated the comparative cost theory makes following observation about Haberler’s theory: “the opportunity cost approach is more fertile because it can be readily extended into a general equilibrium system. It is, therefore, not surprising that the opportunity cost approach has gained more and more popularity and it is used by even who, in principle, attack it.

1.3 Efficiency in International TradeAs shown in the above table, country I enjoys absolute cost advantage in the production of both the goods A and B as compared to their production in country II. But country I has comparative cost advantage in good A and country II in good B. We take the help of the concept of opportunity cost in order to know the relative comparative advantage in the production of the goods in the two countries me opportunity cost to produce one unit of good A is the amount ofgoodBwhichhastobesacrificedforproducingtheadditionalunitofgoodA.

In the example given in the table, the opportunity cost of one unit of A in country I is 0.89 unit of good B and in country II it is 1.2 unit of good B. On the other hand, the opportunity cost of one unit of good B in country I is 1.125 units of good A and 0.83 unit of good A, in country II. The opportunity cost of the two goods are different in both the countries and as long as this is the case, they will have comparative advantage in the production of either, good A or good B, and will gain from trade regardless of the fact that one of the trade partners may be possessing absolute cost advantage in both lines of production. Thus, country I has comparative advantage in good A as the opportunity cost of its production is lower in this country as compared to its opportunity cost in country II which has comparative advantage in the production of good B on the same reasoning.

The gains from trade in terms of Ricardo’s doctrine may be understood by distinguishing the terms of trade under `autarky’ (i.e., haying no trade with the outside world because of the closed economy) and in terms of trade with the outside world. The domestic exchange ratio is determined by internal cost of production. In the table, the exchange ratio before trade in country I should be 1A-0.898 and in country II 1A=l. 1B. If the international exchange ratio prevails between 0.89 and 1.2, the international trade would be gainful to both the countries. Assuming it settles at 1A=1B then country I gains 10 hours of labour and country II gains an equivalent of 20 hours of labour.

Both the absolute advantage and comparative advantage theories failed to realise that the welfare of society does not depend only on the gains from the international trade but depends upon the way the gains are distributed. The individual gains under the theories are not guaranteed unless the government adopts an appropriate redistribution policy. There have to be certain incentives for the producers also in order to keep them engaged in the exportable production. These theories have also been criticised on the ground that labour is not the only input determining the cost of production.


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Patterns of multilateral tradingTrade patterns in more than two countries involving two or more than two commodities.

Country I 1 unit of A = 0.89 unit of BCountry II 1 unit of A = 1.2 unit of BCountry III 1 unit of A = 1 unit of B

Table1.3 Domestic exchange ratios

(Source:http://www.egyankosh.ac.in/bitstream/123456789/35341/1/Unit-2.pdf)

The above table explains that given the domestic exchange ratios in different countries, the possibilities of multilateral trading among them would depend upon the existing international terms of trade. The limits within which the three countriesmaybebenefitedbytradeare0.89B<PA/PB<1.2B.Aftertrade,ifPA/PBsettlesasPA/PB>0.89Band>1B,thencountryIexportsgoodsAtoboththecountriesIIandIII;andimportsBfromthem.Allthethreetradepartnersbenefitbysuchtrade.

On the other hand, then PA/PB is greater than 1 unit of B but less than 1.2 units of B then both the countries I and III export good A to country II and import good B from these countries. In the case of PA/PB settling equal to 1 unit of B, trade will occur only between country I and country H. Country I will export good A to country H and import goodBfromcountryII.CountryIIIwouldnotbenefitfromitsentryintotheinternationaltrade.

Commodity Price in CountryI in Rupees

Price in CountryII in Dollars

Price in CountryIII in Franks

A 2 10 3B 5 8 5C 7 7 7D 9 5 10E 13 2 14

Table 1.4 The case of more than two commodities

In the table, prices per unit of different products are given in three countries in terms of their respective currencies. What commodities would or would not be dealt with among the trade partners would depend upon the prevailing exchange rates of their currencies in the market. If Re = $1- Fl, the price ratio in country II and country III remains the same.

Country I will export commodities A and B to country H and import commodities D and E from this country. In the case of country III, the exports of country I would consist of commodities A, D and E while commodities B and C would be non-tradable between them. Commodity C is non-tradable among all the trade partners.

Along with the change in the exchange ratio in the currencies of the trade partners, the prices of all the commodities in the trading countries are expressed in the same currency and then compared with the prices in the domestic economy. For instance, if Re 1 equals $2 and Re 1 is also equal to F2 then the prices of different goods in country II and III will be calculated in rupee terms and then compared with the price in country I for the purpose of exports and imports.

Efficiency in international tradeEfficiencymaybeachievedininternationaltradeandgainsmaximisedifacountrytradesinthosegoodswhereithas comparative advantages determined by the international price ratios. Given the competitive market system, a country under non-trade situation would be optimising its production and the welfare of its people when the marginal rate of substitution in consumption (MRS) equals the marginal rate of transformation (MRT) in production, and it

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is, in turn, equal to the relative price of the two goods, say A and B, PA/PB. The supply side of the economy of a country is illustrated by production possibility curve (PPC) and the preferences of the consumers are given by the communityindifferencecurve.Theefficiencyintheproductionsituationandtheoptimisationofthewelfareofacountryunderautarkytradepoliciesmaybeunderstoodfromthefigurebelow.

Y

B

B1

A1

I’0

I’1

I’2

I2I1I0

P

E

AX

P

O

Fig. 1.1 Efficiency under Autarky(Source: http://www.egyankosh.ac.in/bitstream/123456789/35341/1/Unit-2.pdf)

Inthefigureabove,theproductionlimitsofacountryareexplainedbytheABProductionPossibilityCurve.Thereare two goods A and B. Good A which may be assumed an agricultural commodity, is measured along the X axis and good B, a manufacturing commodity is measured along the Y axis. Given the resources and the techniques of production, the country may either produce OA amount of good A or OB amount of good B. Equilibrium in the domestic economy is achieved at point E where the price line PP in tangent to the production possibility curve and the community indifference curve I1I1 is also tangent to the price line at the same point.

MRS = MRT = PA/PB. On either side of E, the consumer will get on me lower indifference curve and lower welfare, which is not a preferred situation when the same resources can yield higher satisfaction. The country will not have resourceallocationinsidethePPC,becauseitwillendupwithlowproductionofgoods.Theefficiencyinbothproduction and consumption in a closed economy will be at point E.

The country will experience gains from trade, if the international terms of trade differ from the domestic terms of trade and the resources are reallocated towards the production of the commodity having remunerative price in the foreignmarket.Theefficiencyandthegainsfrominternationaltrademaybeillustratedinthefigure.


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Y

O XP

D

C

P

P2

I1 I2 I3

I’3

I’2

I’1

P2

P1

J

EK

K’

Fig. 1.2 Efficiency under international trade(Source: http://www.egyankosh.ac.in/bitstream/123456789/35341/1/Unit-2.pdf)

Theabovefigureexaminesthepossibilitiesoftradingandachievingefficientproductionandconsumptioninaneconomy which is opened to world trade. Before trade, the country produces and consumes at point E with welfare contour I1I’1. Under trade, the world price is given by P2P2 showing the exports of goods A which are being more profitableintheinternationalmarket.TheproductionisorientedtowardsgoodBwherethecountrynowenjoyscompetitive advantage and produces at J, which is the point of tangency between PPC and the world price line. At point J, the MRT = the international terms of trade, i.e., PTA/PTB. The consumption is at K where the highest I3I’3 is tangent to the international price line P2P2. Here, MRS = PTA/PTB.

The gains from trade are apparent by the movement of the country from indifference curve I1I’1 to I3I’3, which is a higher social welfare curve. The gains from trade arise because of two reasons:

the possibility of exchanging goods on favourable terms in the foreign exchange markets•the possibility of specialisation in exportable products. •

If a country is unable to change its production structure, the trade will still be gainful due to the higher prices abroad. For instance, the K’D amount of goods A may be imported by exporting only the ED amount of good B while production continues at E. This places the country at I2I’2, indifference curve, which is higher than I1I’1, and yields a higher amount of welfare EP1 is the world price line, and it is drawn parallel to P2P2 world price line, which means that trading is taking place at the international price line I2I’2 and the indifference curve is tangent to the EP1 world price line at K’. The movement from E to K’ is the gain from trade arising from the possibility of exchange.

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However, this would not be the optimal situation. The country would be maximising gains if it could produce more of good B by withdrawing resources from good A and produce at J and consumes at K. Both the community indifference curve and the PPC are tangent to the world price line P2P2, and MRT = MRS. The movement from K1 to K represents the gains arising from the possibility of specialisation in production. There is a balance in trade, i.e.,theexportsofthecountryareequaltoitsimports:PBxJC=PAxCK;Pstandsforthepriceofthetradablegoods.

1.3.1 Heckseher-Ohlin Trade ModelAdam Smith and Ricardo’s trade models considered labour as the only factor input and the differences in the labour productivity determining the trade. Eli Heckscher (1919) and Bertin Ohlin (1933) developed the international trade theory (H.O. Trade Model) with two factor inputs, labour and capital, pointing out that different countries have been bestowed with different factor endowments, and the differences in factor endowments cause trade between the trading partners.

The theory is based on the assumption that there are impediments to trade, and that there is perfect competition •in both the product and factor markets. Further, the theory is based on the comparative advantage in terms of the relative factor prices. A country specialising in the production of the goods which require its abundant factor can export them. Thus, if •a country is rich in capital, it will produce capital intensive products and export them in exchange for the labour intensive products. On the other hand, another country, rich in labour, will produce labour intensive goods and export them. It will import capital intensive goods.In the H.O. trade theory, the factor abundance has two meanings the factor abundance in terms of the factor •prices, and the, factor abundance in terms of the physical amount of the factors. Assume there are two countries: I and II, then the richness of the country in terms of factor prices means relatively low price of the factors of production.

CountryIisrichincapitalascomparedtocountryII,ifPic/Pig<P2c/P2c.Picisthepriceofcapitalin �country I and PiL is the price of labour in country I, and P2c is the price of capital in country II and P2L is the price of labour in country II.Theseconddefinitionofthefactorabundancecomparestheoverallphysicalamountoflabourandcapital. �CountryIiscapitalrich,iftheratioofcapitaltolabourinthiscountryislarger.C1/LI>C2/L2,whereC1and L1 are the total amount of capital and labour in country I, and C2 L2 are the total amount of capital and labour in country II, respectively. TheH.O.tradetheoryholdsgood,ifthefactorabundanceisdefinedintermsoffactorprices,becauseof �the incorporation of the demand factor in it.

In the overseas market, the price is given by the P2P2 international price line. Now, the countries move to the •points J and K tangent to the international price line, and country I is producing more of good A and country II more of good B. By exchanging goods of their specialisation under free trade, they reach to the I2I12 indifference curve at point E and enjoy gains from the international trade as E lies on the higher indifference curve.As in the case of the classical trade model, the H.O. trade theory also cannot guarantee the (desired) income •distribution among different classes in the country. In country I, the returns to capital are higher and, in country II, the returns to labour are higher because of the greater demand for producing respective goods for the world market.Thebasictrademodelsarebaseduponcertainassumptions,suchasnotransportationcostandfreeflowof•information to all the producers and consumers. They do not take into account the effect’s of trade on the world prices. These trade theories are static, and ignore the effects of technological progress on the growth of the worldeconomy.Thesearetherealissuesandneedtobeincorporatedinamodifiedversionoftheclassicalandneo-classical theories.Ifanationhasmonopolyincertainproducts,itmayinfluencetheworldprice.Itmayenhanceitsgainsby•“optimum tariffs’’, which seek to maximise the welfare of the country. Trade may complicate the growth process. It may affect the employment and may even reduce the welfare of the country. This may occur in the caseofimmerserisinggrowth(whenbenefitsfromthehigheroutputareneutralisedbytheunfavourabletermsof trade).


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The country ends up with lower real income after growth because the gains arising from higher output are wiped •outbythedeterioratingtermsoftrade.Itmay,however,bynotedthatthemodifiedversionofthebasictheorydoes not alter the conclusion that a country produces and exports the commodity in which it has comparative advantages,andusestheabundantfactorinitsproduction.Tradebenefitsthenation,butthedistributionofgainsmay be skewed. Adjustment to trade is not costless but the short-term cost to adjustment should be weighted against the long-term gains from trade.

1.3.2 The Leontief ParadoxThere was a setback to the proponents of the H.O. trade theory in the early 1950’s, when Leontief tested his hypothesis that capital rich countries export capital intensive goods and import labour intensive goods and vice versa with the help of the input-output data of the United State’s economy. His results refuted the H.O. contention. It was shocking news for the economists that the U.S. being a capital rich country should be exporting labour intensive goods and importing capital intensive goods. Several, explanations were looked into for resolving the Leontief paradox. The key factorsidentifiedinsupportoftheLeontiefparadoxwere:U.S.protectivetradepolicy,importofnaturalresourcesand the investment in human capital.

William P. Travis examined the Leontief theory in terms of the U.S. tariff policy. When Leontief tested his hypothesis, the U.S. was importing more of such items as crude oil, paper pulp, primary copper, lead, metallic ores and newsprint, which are capital intensive. Thus, according to Travis, the U.S. protective trade policy was responsible for Leontief’s findings.

The U.S. imports of natural resources like minerals and forest products and the exports of farm products further support the Leontief presentation. Investment in human capital raises the productivity of labour. That is why the exports of the U.S. consisted of labour intensive products and its imports were of capital intensive nature.

1.4 Foreign Direct Investment (FDI) TheoriesThe search for FDI theories is a recent phenomenon, despite the domination of world production and trade by the MNEs in the post Second World War period. It was in 1960, when Stephen, H. Hymer, in his doctoral dissertation. The International Operations of National Firms: A Study of Direct Investment (published in 1976) revealed that the orthodox theories of international trade and capital movements are unable to explain the involvement of MNEs in foreigncountries.Theirexistenceowedtothelocalfirmswieldingmarketpower,andwhoactedastheiragents.The approacheswhich explain the activities ofmultinational enterprisesmay broadly be classified into fourgroups.

Firstly,thereismarketimperfectionapproachwhosetheoreticalframeworkconsiderscertainspecific,advantages,•also known as ownership advantages, enjoyed by an enterprise. The FDI is controlled through these advantages andtheinternationalcompaniesalsoenterintocollusionwithotherfirmsforincreasingtheirprofits,Secondly,ProductLifeCyclemodelexaminesthevariousstagesofthefirm.Therearesequentialstagesinthe•life cycle of the products innovated by a particular company.Thirdly, the failure of the orthodox theories of international trade and capital movements based upon the •assumption of perfect competition and its prevalence in different segments of international market provide adequate explanation for the substitution of the FDI. It gave rise to the transaction cost theory of the FDI that thefirmsundertakeforeigninvestmentsforraisingtheirefficiencyandreducingthetransactioncosts.Fourthly, the eclectic paradigm encompassing other FDI theories which provide an analytical framework to the •analyst for carrying out empirical investigations most relevant to the problem at hand. The eclectic paradigm isnotatheoryinitselfbutsomesortofsynthesisoftheconflictingtheories.

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1.4.1 Market Imperfections ApproachThe rise of the MNEs continuously puzzled the minds of neoclassical economists as to how these enterprises could makeprofitsinforeigncountrieswhereproductioncostsaremorethanathome.Beinggenerallyunawareofthehostcountry’senvironment,itshouldberatherdifficulttotakeadvantagethere.Itmaybebetterfortheforeigncompany to pass on its advantages to the local entrepreneurs who, together with other local (inherent) advantages, could produce at a lower cost than the foreign investors.

The answer to this paradoxical situation is .available in the presence of the imperfect market in the foreign countries. Hymer presented a case for market imperfection approach. According to him, the orthodox theories of the international trade and capital movements were inadequate to explain the involvement of MNEs in international business. Their presence is due to market imperfections. The advocates of this approach thought that the prevailing market imperfections were ‘structural’ (imperfections of monopolistic nature), and arose from the innovation of superior technology, access to capital, control of distribution system, economies of scale, differentiated products (by the introduction of different advertising methods) and superior management. These factors enabled the foreign enterprises to more than offset the disadvantages from their operations in the foreign environment and the additional cost incurred there.

HymerwasbasicallyconcernedwiththemarketpoweroftheMNEs,whichrestrictedtheentryofotherfirms.Themarket power arises from collusion with others in the industry to avoid competition: which results in the larger profits.Thereisonewaycasuallinkbetweenthebehaviourofthefirmandtheimperfectmarketstructure.Themarketpowerisfirstdevelopedinthedomesticcountryand,aftertheprofitmarginbecomeslowerinthehomecountry,thefirminvestsabroadandcontrolstheforeignmarketsbyitspatentrights.

1.4.2 Product Life-Cycle ApproachThe product life-cycle approach is associated with the work of Raymond Vernon. Published in 1966, it deals with the evolution of the U.S. multinationals and foreign direct investment patterns. In Vernon’s model, three stages are followed in the introduction and establishment of new products in the domestic and foreign markets, with emphasis oninnovationandoligopolypowerasbeingthefirstbasisforexportandlaterfortheFDI.

Thefirststageinthesequentialdevelopmentoftheproductisthenewproductstagewhichemergesinthehome•country following innovations as a result of intense R&D activities by the company. The product is introduced intheoverseasmarketthroughexport,andtheinnovatingfirmearnsexcessiveprofitsbothfromdomesticsalesand exports abroad because of its monopoly position.The second stage is, characterised by the mature product stage, when the demand in the foreign countries expands •andthehostcountryfirmsbegintoproducecompetingproducts.Thehomecountryenterpriseisinducedtoinvest abroad for taking advantage of its technology and increasing demand for the product. As the company specificadvantagesofthefirmscontrollingthetechnologyaremuchhigherthanthelocalfirms,theproductionin the host country would be cheaper. It stimulates foreign investment in subsidiaries.In the third stage, the product becomes standardised, arid competition grows in, the world market. The MNEs •invest even in the LDCs, where the cost of production is lower. The host country, otherwise, has to import these products from abroad because its own production cost is more. The foreign investment may take the form of licensing arrangements also.

The initial analysis of the product life cycle approach gives a good account of the nature of the expansion of the U.S. companiesafterWorldWarH.ThetheorywasmodifiedbyVernonin1971and1977inthelightoftheoligopolythreatarisingfromglobalinnovativeactivities.Heidentifiedthefirststageastheemergingoligopoly,thesecondstage as the mature oligopoly and the third stage as the senescent oligopoly, referring to the state of production when the standardised product is entirely produced abroad. The home country, where the product was initially innovated, imports all of the goods that it needs. Vernon’s PCM model is summarised in the table.


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1.4.3 Transaction Cost Approach

Nature of stage product

Produce at Home or Abroad (1966)

Nature of Internal Business

Foreign Investment Modified (1977)

New product I Home Export Nil Emerging oligopoly (innovation based)

Maturing II Product Abroad Import FDI (By

Subsidiaries) Mature oligopoly

Standardised III Product Abroad Import (By licensing

agreements) Senescent oligopoly

Table 1.5 Vernon product life cycle approach

1.4.4 Different types of Investment for InternationalisationDifferent types of investment for internationalism are explained below.

Horizontal investmentsHorizontal investments take place for the internalisation of such assets of the company, which are intangible and cannotbepricedinthemarket.Someoftheintangibleassetsarethefirm’sspecificknowledge,goodwill,managementskills and marketing know-how. The basic problem is the protection of the investor’s right against the infringement of his patents (in the case of knowledge) and trade marks or brand names of the products creating goodwill for the producers.

If the patent system is such that the host country authorities provide full protection to the patents, then the more prevalent form of international business will be the licensing agreements. When the patent rights are not well-protectedandthetransferofknowledgemaynotbeeasilycodifiedintopatentsandthefearofimitationisaround,the horizontal investment will be the alternative undertaken by the investor himself for keeping his innovations secret and internalising the foreign market for his particular technology.

Vertical investmentTheverticalFDIforintegratingthevariousstagesinvolvedinthefinalproductionisthemostcommonformofinternalisation. It has been found both in backward and foward integrations. The MNEs based in the developing countries have undertaken direct investments for procuring and maintaining smooth supply of such raw materials as crude oil, iron ore and natural rubber needed for their downstream activities. The transaction cost theorists advocate that such backward integration is made when the transaction costs of buying new materials and intermediate products are high. The quality control also becomes possible in vertical integration.

Internalisation of foreign markets also takes place through forward integration in the form of distribution and marketing services. If the distribution and marketing services are left to the distributing agents, these may be problems with regard to their reliability. These may even be defaults in the timely supply of the produce, its demonstration, installation, after sales services, etc. All this bring a bad name to the company. Thus, an MNE invests abroad not only to lower the transaction cost but also to retain its goodwill.

Free standing companiesIn the period prior to World War I, many of the European multinationals were free standing companies. They were active in mobilising resources from the capital rich countries like the United Kingdom, and investing them in the capital poor countries. The foreign investment in Malaysia in the rubber plantations and tin manufacturing conforms to this type of investment pattern. Indeed, free standing Arms raise funds freely from the major capital exporting countries, and locate the plants abroad for reducing the transaction -cost. The lenders prefer to invest in equity capital rather than buying foreign bonds, because they can exercise a greater degree of control over the-management of standingfirms.

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Somewriters,suchasFieldhouse,donotincludethefreestandingfirmsinthetransactioncostapproach.Theirassertion is that the MNEs acquire competence from their R&D activities in the domestic market. These advantages areexploitedintheforeignmarketslateron.Thefreestandingfirmsdonotdevelopanyskill,andtheyjustoperateon a little more than a brass name plate somewhere in the city. The incapabilities and the lack of (Trade) Theories effortsonthepartofthefreestandingfirmstodevelopspecificadvantageshavebeenfoundtobethemainreasonsfor the failure of some British and U.S. companies.

Equity joint venturesEquity joint ventures are also explained by the transaction cost approach and preference for such alternatives as contracts,mergersandacquisitions.Undertheequityjointventures,themanagementandprofitsaresharedbytwoor more participants, while in contracts a single party holds the responsibility. The possibility of supplying the low qualityinputismuchunderthecontractmanagement,asthecontractsupplierdoesnotsharetheprofit.Inthecaseofequity joint ventures, the party supplying the inferior input is to bear the burden according to its equity stake. Thus, the equity joint venture arrangements are preferable, because they combine the interests of the interacting parties.

The equity joint ventures are in a better position to meet the high transaction cost conditions in contrast to the mergers and acquisitions, when there are complementary assets in the parent and host countries. If such assets are pooledinjoint,ventures,thecompanyspecificadvantagesandthecountryspecificadvantagesarecoordinatedmoreefficiently,leadingtosuccess.ThecaseofJapaneseMNEsisprominentinthisregard.Theypreferredtoenterintojoint ventures, when their experience of foreign markets was little because of the new businesses being different. Spot purchases and long term contractSpot purchases and long-term contracts for the supply of the raw materials and intermediate products are used as theefficientmodeoforganisationwhenthepredictabilityofenvironmentisquitesatisfactory.Itreducesthecostof enforcement, because of the ex-ante arrangement reached between the partners. But the drawback of contractual arrangement is that it operates under uncertainties, and its execution becomes complicated as the degree of uncertainties rises. The contracts are more operative and successful in the case of recurrent trades involving small number conditions and relatively predictable environment.

New forms of investment and counter tradeThese are the substitutes of FDI. The transaction cost theorists treat them as an attempt to have greater enforceability of the contracts, which is not possible in the simple type of contracts. Counter trade, which is a recent phenomenon, is not merely a barter trade. It also involves the reciprocity clause and inherent attributes of increasing the enforceability of the contracts. The counter trade constitutes more than 15 per pent of the world trade. It served very well when the FDI was not considered a viable or desirable option.

On the same lines, new forms of investment as contractual substitutes to the FDI, like turnkey contracts, franchising, product sharing and management contracts, have been supported by transaction cost approach as other ways of international business. They have been encouraged by the LDCs to obtain technology, management skills and access to the markets dominated by the MNEs. At the same time, it avoids the cost of environmental uncertainties.

1.4.5 Eclectic ParadigmThe eclectic paradigm was developed by John Dunning in 1979 as an attempt to synthesise the other FDI approaches basedonthecompanyspecificadvantages,internalisationadvantagesandcountryspecificadvantages.Asitisasynthesis of some of the foreign investment theories, it does not qualify to be a separate theory itself.

The main purpose of the eclectic paradigm is to provide an analytical framework to the analyst so that he could •choose the most suitable approach for the investigation that he intends to undertake. For example, the transaction cost approach may be most relevant for the investigations relating to the hierarchical coordination of the different stages of the production process. An MNE adopts both backward and forward integrations in this case.


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The eclectic paradigm assumes that the MNEs possess ownership advantages from their intangible assets in the •form of technology. This has enabled them to reduce the transaction cost through the internalisation process. Internalisation advantages arise because of the exploitation of technology and the locational and other advantages accruing in the host country.Although,theownershipadvantagesmaybetransferredtothehostcountrythoughthelicensingarrangements;•yetcertainadvantagesaresuchthatnon-transferablebenefitsfromthemwouldoccuronlyiftheyaremanagedwithin the MNEs themselves. Such advantages are organisational and entrepreneurial capabilities of the managers oftheinternationalfirms,theirexperienceofforeignmarkets,theirpoliticalcontactsandlong-termbusinessagreements with other enterprises. The control over technology and its coordination with the host country resources would promote R&D efforts, which can lead to the rapid growth of internationalisation of the world economy.The MNE’s follow different approaches for reaping the ownership advantages. Some adopt the competitive •approach for competing in the international markets, while others pursue the monopolistic approach. According to the competitive approach, the MNEs develop their competitiveness for a place in the foreign countries. In the case of monopolistic approach the ownership advantages arise from the monopolistic competition where thefirmsselldifferentiatedproducts.The eclectic paradigmprovidesmerely a comprehensive framework. It does not specifically highlight the•advantages of competitiveness in the foreign countries. It also does not take into account any single FDI theory on priority basis. It points out the circumstances which the investigator should take into account in deciding which FDI theory would suit his needs. The relevance of the eclectic paradigm lies in its application to the simultaneous, operation of the market imperfection approach and the transaction cost approach. The former theoryhelpsinidentifyingthebenefitsenjoyedbytheMNEsduetotheimperfectionsintheforeigncountries,and the latter is helpful in the reduction of the cost of transactions.

1.5 Intra Industry Trade and TheoriesOne important pattern of international trade left unexplained by the H-O theory is the intra-industry trade or the trade in the differentiated products, i.e., products which are similar but not identical (for example, different models of motor cars). A large proportion of such trade takes place between the industrialised countries. Historically, the pattern of international trade has undergone major changes. Until about the mid nineteenth century, an overwhelming proportion of international trade was constituted by inter-sectoral trade where primary commodities were exchanged formanufacturedgoods.Thistradewas,toasignificantextent,basedonabsoluteadvantagederivedfromnaturalresources or climatic conditions. During the period 1950-1970, inter-industry trade in manufactures, based on differences in factor endowments, labour productivity or technological leads and lags, constituted an increasing proportion of international trade.

Since 1970, intra-industry trade in manufactures, based on scale economies and product differentiation, has •constituted an increasing proportion of international trade. Intra-industry trade now accounts for a major share of the international trade. As indicated above, intra-industry trade refers to the trade between countries in the products of the same industry. For example, a country simultaneously exports and imports steel, exports and imports motor cars, etc. Intra-industry trade is highly prevalent in the case of trade between developed countries. Developing countries, however, have been increasingly participating in intra-industry trade. India, for example, has been exporting as well as importing motor cars, electronic products, electrical equipments, crude oil, petrochemicals, textiles and clothing, cardamom, sugar and so on. The North-North trade growth has been driven mostly by intra-industry trade. The intraEEC trade has grown •much faster than the average growth in the global trade. The trade growth between the members of the European Union has mostly been due to intra-industry trade rather than inter-industry trade. As Krugman and Obstfeld observe, “intra-industry trade tends to be prevalent between countries that are similar in their capital-labour ratios, skill levels and so on.

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Thus, intra-industry trade will be dominant between countries at a similar level of economic development. Gains •from this trade will be large when economies of scale are strong and products are highly differentiated. This is more characteristic of sophisticated manufactured goods than of raw materials or more traditional sectors (such as textiles or footwear). Trade without serious income distribution effects, then, is most likely to happen in manufactures trade between advanced industrial economies. Estimates of the indices of intra-industry trade for US industry in the early 1990s has shown that it is more than •90 per cent for inorganic chemicals, power generating machinery, electrical machinery and organic chemicals, morethan80percentformedicalandpharmaceuticalandofficemachineryandmorethan60percentfortelecommunication equipment and road vehicles. On the whole, “about one-fourth of world trade consists of intra-industrytrade,thatis,two-wayexchangeofgoodswithinstandardindustrialclassifications.Sincethemajor trading nations have become similar in technology and resources there are often no clear comparative advantage within an industry, and much of international trade therefore takes the form of two-way exchanges within industries - probably driven in large part by economies of scale - rather than inter-industry specialisation driven by comparative advantage.” Krugman and Obstfeld observe that “intra-industry trade produces extra gains from international trade, over and •abovethosefromcomparativeadvantage,becauseintra-industrytradeallowscountriestobenefitfromlargermarkets ... by engaging in intra-industry trade a country can simultaneously reduces the number of products it produces and increase the variety of goals available to consumers. By producing few varieties, a country can produceeachatlargescale,withhigherproductivityandlowercosts.Atthesametimeconsumersbenefitfromthe increased range of choice.”

Intra-industry trade theories The interest in the intra-industry trade was largely stimulated by the studies done in the 1960s on the impact of •theEEConthetradeflowbetweenthemembercountries.Thesestudieshaveshownthatthemajorchunkofthetrade is intra-industry trade. This encouraged economists to develop theoretical explanations for the growing intra-industry trade. There are indeed a variety of models, which seek to explain the reasons for intra-industry trade. Sodersten and Reed point out that these models, despite their variety, have the following common features: First, while it is possible to deduce that intra-industry trade will emerge, it is often impossible to predict which country will export which good(s). Second, diversity of preferences among consumers, possibly coupled with income differences, plays an important •role. Third, similarity of tastes between trading partners may playa major role. Fourth, economies of scale are a frequent element of intra-industry trade models, and may be an important source of gains from trade. Finally, in many of these models the move from autarchy to free trade will involve lower adjustment costs than would be the case with inter-industry trade. The explanations for the intra-industry trade vary from simple reasoning to intricate analysis. One of the simple explanations of the intra-industry trade is the transportation cost. For example, in the case of geographically very vast country like India, the cost of transporting goods from one end ofthecountrytotheotherextremeendwouldbeveryhighandcrossbordertradewillbebeneficialfortwoadjoining regions of neighbouring countries, other things remaining the same.Another simple explanation is the seasonal variations between different countries in the production of a •particular commodity. Factors such as transport cost, seasonal variations etc. cover a small proportion of the intra-industry trade. Another explanation for the intra-industry trade is that producers cater to ‘majority’ tastes withineachcountryleavingthe‘minority’tastestobesatisfiedbyimports.Suchminormarketsegmentswhichare overlooked or ignored by the major market players but have potential for other players are referred to as market niches in marketing management parlance. Such niches often provide an opportunity for entering the market by new or small players. For example, the large companies in the United States had ignored the market segments for small screen TVs, small cars, small horse-power tractors, etc. This provided a good opportunity for the Japanese companies, for whom these products had a large domestic market, to enter the US market. It may be noted that niche marketing has been a very successful international marketing strategy employed by Japanese companies.


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Over a period of time, sometimes consumer tastes and preferences, and demand patterns may change and •a ‘minor’ market segment may become a large segment. Thus, the oil price hike substantially increased the demandforthefuelefficientcompactcarsintheUSandtheJapanesecompaniesenormouslybenefitedfromit.Through shrewd marketing strategies a company could succeed, in many cases, in expanding a minor segment of the market into a large segment. Further, it has also been observed, particularly with regard to the Japanese companies, that after consolidating their position in a market segment, with the strength and reputation they have built up, they may gradually move to other segments and expand their total market share. Another reason for the failure of the basic H-O model to explain the intra-industry trade is, as Kindleberger •and Lindert observe, “to recognise the inadequacy of lumping factors of production into just capital, land and coupleoftypesoflabour.Infact,therearemanytypesandqualitiesofeach.Further,therearefactorsspecifictoeachsub-industryoreveneachfirm.Heterogeneity is especially evident in the higher reaches of management and other rate skills.”In short, the H-O •theory can be extended to the inter-industry trade if we recognise the existence within each industry of number segmentswithdistinctivecharacteristicsandenlargethedefinitionoffactorendowmentstoincludesuchfactorsastechnology,skillandmanagementalso.Disaggregatingthefactorsofproductionintofinergroupingscouldadd to the explanatory power of the H-O emphasis on factor proportions. Sectors of the economy are bound to lookmoredifferentintheirendowmentsoncefinerdistinctionsaremade.Intheextreme,endowmentsoffactorsofproductionthatarespecifictoeachsectorcanbeveryunequalacross•countries and very intensively used in their own sectors, thereby suggesting explanations for trade patterns. Search for the reasons for intra-industry trade led to the development of a number of models in the imperfect competitive environment, which are often referred to as new trade theories. These explanations of the intra-industry trade revolve around factors such as product differentiation, economics of scale, monopolistic competition or oligopolistic behaviour, strategies of multinational corporations, etc.

1.5.1 Economies of ScaleThe H-O model is based on the assumption of constant returns to scale. However, with increasing returns to scale (decreasingcosts),i.e.,wheneconomiesofscaleexistinproduction,mutuallybeneficialtradecantakeplaceevenwhen the two nations are identical in every respect.

Infig.3.2,PECrepresentstheproductionpossibilitycurvesofboththeCountriesAandB(boththenations•are assumed to have identical endowments and technology). The production possibility curve is convex to the origin implying economies of scale. In the absence of trade, both nations produce and consume at point E on indifference curve I. Since production is subject to increasing returns to scale, it is possible to reduce the cost of production if one •country specialises in the production of wheat and the other rice. For example, Country A may specialise completely in the production of wheat (i.e., move from E to P in production) and country B may move production from E to C, specialising completely in rice. By doing so both nations gain 10 units of wheat and 10 units of rice, as shown by the new equilibrium point N on the indifference curve II, although the production possibilities of both the nations remain the same.Evenifallcountriesareidenticalintheirproductionabilitiesandhaveidenticalproductionpossibilitycurves;•there could be a basis for trade as long as tastes differ. Theproductionpossibilitycurveshowninthefigurerepresentstheproductionpossibilitycurveforwheatand•rice of country A as well as of B because the production possibilities of both the countries are the same. In other words, both the countries can produce wheat or rice equally well. We assume that A is a wheat preferring country and B is a rice preferring country. In the absence trade, the preference for wheat and the resultant increase in the demand for wheat will increase the price of wheat in country A. Similarly, a higher price for rice will prevail in the rice preferring country B. International trade alters the •price structure and establishes a new equilibrium price ratio, fP. Producers in both the countries will shift their production so as to make their marginal costs equal to the same international price ratio. Since the production possibilities are the same for both the countries they will both produce at the same point E where the price line is tangent to the production possibility curve.

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The wheat preferring country will satisfy its greater demand for wheat by importing wheat. Its new consumption •point C at a higher indifference curve implies that trade enables it to attain a higher level of satisfaction with the same productive resources. Similarly trade enables the rice preferring country B to reach the point 0 on a higher indifference curve than the pre-trade situation. Thus, even if production capabilities remain same for two ormorecountrieswhentastesdiffer,mutuallybeneficialinternationaltradecouldtakeplace.There are two models which explain international trade based on technological change, viz., •

The Technological Gap Model �The Product Life Cycle Model �

In the case of both the models, the key element that causes the trade is the time involved acquiring the technology •by different nations. According to the Technological Gap Model propounded by Posner, a great deal of trade among the industrialised countries is based on the introduction of new products and new production processes. In other words, technological innovation forms the basis of trade. Theinnovatingfirmandnationgetamonopolythroughpatentsandcopyrightsorotherfactorswhichturns•other nations into importers of these products as long as the monopoly remains. However, as foreign producers acquire this technology they may become more competitive than the innovator •because of certain favourable factors (like low labour cost, for example). When this happens, the innovating country may turn into an importer of the very product it had introduced. Firms in the advanced countries, however, strive to stay ahead through frequent innovations which make the earlier products obsolete. The Product Cycle Model developed by Vernon represents a generalisation and extension of the technological •model.AccordingtothismodelaninnovativeproductisoftenfirstintroducedinanadvancedcountryliketheUSA (because of certain favourable factors like a large market, ease of organising production, etc.). The product is then exported to other developed countries.As the markets in these developed countries enlarge, production facilities are established there. These subsidiaries, •in addition to catering to the domestic markets, export to the developing countries and to the United States. Later, production facilities are established in the developing countries. They would then start exports to the United States - a TV receiving set is one such example. The international product life cycle model is described basically as a trickle-down model (Kenichi Ohmae •hastermeditaswaterfallmodelofworldtradeandinvestment-anewproductisfirstintroducedtothehigh-income-country markets and subsequently to the middle income and low-income countries. An alternative to the trickle-down approach shower approach, according to which the new product is simultaneously introduced in all the markets (high income, middle income and low income countries) of the world markets. This approach is relevant because of the emergence of the global village and fast obsolescence of the product.

1.5.2 Availability and Non AvailabilityThe availability approach to the theory of international trade seeks to explain the pattern of trade in terms of domestic availabilityandnon-availabilityofgoods.Availabilityinfluencestradethroughbothdemandandsupplyforces.In a nutshell, the availability approach states that a nation would tend to import those commodities which are not readily available domestically and export those whose domestic supply can be easily expanded beyond the quantity neededtosatisfythedomesticdemand.KravisarguesthatLeontief’sfindingsthattheUnitedStates’exportshavea higher labour content and a lower capital content than United States’ imports can be explained better and more simply by the availability factor. Goods that happen to have high capital content are being bought abroad because they are not available at home. Some are unavailable in absolute sense (for example, diamonds), others in the sense that an increase in output can be achieved only at much higher costs (that is the domestic supply is inelastic). When availability at home is due to lack of natural resources (relative to demand), the comparative advantage argument is perfectly adequate.


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According to Kravis, there are other facets of the availability explanation of commodity trade pattern that cannot be so readily subsumed under the ruberic ‘comparative advantage.’ One of these is the effect of technological change. Historical data for the United States suggest that exports have tended to increase most in those industries which have new or improved products that are available only in the United States or in a few other places, at the most. Product differentiation and government restrictions are some of the other factors tending to increase the proportion of international trade that represents purchases by the importing country of goods that are not available at home. According to Kravis, there are, thus, four bases of the availability factor, namely,

Natural resources•Technological progress•Product differentiation•Government policy•

Thefirstthreeofthefourbases-naturalresources,technologicalprogressandproductdifferentiation-probablytend, on the whole, to increase the volume of international trade.

The absence of free competition, a necessary condition for the unfettered operation of the law of comparative advantage, tends to limit trade to goods that cannot be produced by the importing country, argues Kravis. The most important restrictions on international competition are those imposed by the governments and by cartels. Those imports that are unavailable or available only at formidable costs are subject to the least government interference. Kravis thinks that the quantitative importance of the availability factor in international trade must be considerable. This appears to apply especially to half of world trade that consists of trade between the industrial areas, on the one hand, and primary producing areas, on the other. The availability approach has, undoubtedly, considerable merit in its explanation of the pattern of trade.

1.5.3 Trade in Intermediate Goods Intermediate goods constitute a substantial share of the international trade. Intermediate goods is fostered by the growingtrendsofglobalsourcing.Tradeinmostmanufacturedfinalgoodsembodyseveralintermediategoods(ormanufactured inputs). For example, hundreds of components/parts go in to the production of an automobile. These intermediate goods may be manufactured in-house or outsourced (i.e., obtained from independent intermediate goods producers.

For a long time, there had been a trend towards vertical integration (i.e., manufacturing more and more of the intermediates in-house). However, in the last few decades the trend has been just the opposite, i.e., de-integration (also known as hoI/owing of the corporation) or outsourcing even what were earlier manufactured in-house. Outsourcing hasbeenincreasinglyassumingglobaldimensionsbecauseglobalsourcingenablesfirmstoprocuretheintermediatesfrom the best source anywhere in the world (in terms of price, quality, features etc.).

Trade in intermediate goods has, therefore, been growing in importance and volume. It would this context be useful to understand the meaning of certain terms which are relevant in Gross Production and Net Production: Gross production or gross output is the total quantity of a good produced by a sector. A part of this output, may, however, gotoothersectorsasintermediategood.Netproductionisthatpartoftheoutputofthesector,whichgoesforfinalconsumption (i.e., gross production less that which goes to other sectors as intermediate good).

ValueAdded:Valueaddedisthedifferencebetweenthepriceatwhichafinalgoodissoldandthecostofthe•outsourcedintermediatesusedintheproductionofthefinalgood.Inputs and Factors of Production: The term input is sometimes used very broadly to include even the factors •of production (such as labour, land and capital). However, sometimes a distinction is made between inputs and factors of production so that inputs mean those goods used in the production of other goods. Value addition takesplacewhenafinalgoodismadeoutoftheseinputsusingthefactorsofproduction.

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Condition for Production of Intermediate and Finished Products: An intermediate good will be produced in a •country only if its cost of production is less than or equal to the international price. For example, an intermediate good,I,willbeproducedinthecountryonlyifthefollowingconditionissatisfied.Ic~IpWhereIcisthecostofproductionof the intermediategood in thecountryand internationalpriceof thatgood.Afinishedgoodembodyingintermediategoodwillthefollowingconditionissatisfied.Freetradetendstoincreasetradein intermediate goods in two ways. If the domestic cost of producing the intermediate good is more than its internationalprice, imported intermediategoodwillbeused in thefinishedgood for thedomesticmarket.Similarly,importedintermediategoodwillbeusedinthefinishedgoodforexports.Freetradeinintermediategoodstendstoincreasethetradeinfinishedgood.

Intheabsenceoffreetradeinintermediategood,acountrywillnotbeabletoexportthefinishedgoodifthecostoftheintermediategoodplusthevalueaddedishigherthantheinternationalpriceofthefinishedgood.However,whenthere is free trade in intermediate good, if the availability of the intermediate good at international price enables the countrytoproducethefinishedgoodatacost(costofintermediateplusvalueadded)lowerthantheinternationalprice;thecountrycanexportthatproduct.Indeed,itistheinternationalsourcingofintermediatesthatenablesmanyfirmstoachieveinternationalpricecompetitivenessfortheirfinishedproducts.

Non-price factors (such as quality, delivery etc.) also encourage international sourcing. Intermediates are relatively labourintensivethanthefinishedproducts.Thisprovidesacomparativeadvantageforthedevelopingcountries,where labour iscomparativelycheap, in theproductionof intermediategoods.Manydevelopedcountryfirms,therefore, outsource manufactured inputs from the developing countries.


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SummaryThe analytical framework of international business is build around-the activities of MNEs enunciated by the •process of internationalisation. The FDI on the part of an MNE attempts to overcome the obstructions to trade in foreign countries.The theory of mercantilism was rejected by Adam Smith and Ricardo by stressing the importance of individuals, •and pointing out that their welfare was the welfare of the nation. They believed in liberalism and enlightenment, and treated the wealth of the nation in terms of the “the sum of enjoyments” of the individuals in society.Ricardo (1817), though adhering to the absolute cost advantage doctrine of Adam Smith, pointed out that cost •advantagetoboththetradepartnerswasnotanecessaryconditionfortradetooccur.Itwouldstillbebeneficialto both the trading countries even if one country can produce all the goods with less labour cost than the other country.Efficiencymaybeachievedininternationaltradeandgainsmaximisedifacountrytradesinthosegoodswhere•it has comparative advantages determined by the international price ratios.Eli Heckscher (1919) and Bertin Ohlin (1933) developed the international trade theory (H.O. Trade Model) with •two factor inputs, labour and capital, pointing out that different countries have been bestowed with different factor endowments, and the differences in factor endowments cause trade between the trading partners.ThekeyfactorsidentifiedinsupportoftheLeontiefparadoxwere:U.S.protectivetradepolicy,importofnatural•resources and the investment in human capital.A Study of Direct Investment (published in 1976) revealed that the orthodox theories of international trade and •capital movements are unable to explain the involvement of MNEs in foreign countries.

References Cherunilam, Francis, 2010. • International Trade and Export Management, Himalaya Publishing House.Vaghefi,M.R.,Paulson,S.K.andTomlinson,W.H.,1991.• International business: theory and practice, Taylor and Francis.Unit 2: • International Business Theories[PDF](Updated15September2011)Availableat:<www.egyankosh.ac.in/bitstream/123456789/35341/1/Unit-2.pdf>.[Accessed15September2011].Ajami, Riad A. and Goddard, Jason G., 2006. • International business: Theory and Practice, 2nd ed., M.E. Sharpe Inc. lostmy1, 2011. • International trade: Absolute and comparative advantage[VideoOnline]Availableat:<http://www.youtube.com/watch?v=Vvfzaq72wd0>.[Accessed15September2011].Lseexternal, 2008. • Absolute, Comparative Advantage, Opportunity Cost[VideoOnline]Availableat:<http://www.youtube.com/watch?v=rUZX-Pv3JNg&feature=related>.[Accessed15September2011].

Recommended ReadingTayeb, Monir H., 1999. • International Business: Theories, Politics and Practices, Financial Times Management.Aswathappa, K., 2010. • International Business, 4th ed. Tata McGraw Hill. Rugman, Alan M., 1985. • International Business: Theory of the Multinational Enterprise, McGraw Hill Book company.

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Self Assessment______________________ was propounded by Adam Smith (1776), arguing that the countries gain from trading, 1. if they specialise according to their production advantages.

The theory of absolute cost advantagea. The theory of comparative cost advantageb. Theory of mercantilismc. Leontief Paradoxd.

___________________ was rejected by Adam Smith and Ricardo by stressing the importance of individuals, 2. and pointing out that their welfare was the welfare of the nation.

The theory of absolute cost advantagea. The theory of comparative cost advantageb. Theory of mercantilismc. Leontief Paradoxd.

Trade patterns in more than two countries involving two or more than two commodities are called _________3. ___________________________.

the theory of absolute cost advantagea. the theory of comparative cost advantageb. Theory of mercantilismc. Patterns of Multilateral Tradingd.

How many models explain the international trade based on technological change?4. Twoa. Threeb. Fourc. Fived.

The eclectic paradigm was developed by John Dunning in ________.5. 1979a. 1969b. 1989c. 1997d.

___________________modelexaminesthevariousstagesofthefirm.6. Product Life Cyclea. Horizontal investmentsb. Vertical Investmentsc. Periodic investmentsd.


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________ investments take place for the internalisation of such assets of the company, which are intangible 7. and cannot be priced in the market.

Horizontala. Verticalb. Foreignc. Capital d.

Match the following:8.

1. Free Standing Companies A. raise funds freely from the major capital exporting

countries, and locate the plants abroad for reducing the transaction cost

2. Equity Joint VenturesB. managementandprofitsaresharedbytwoormore

participants, while in contracts a single party holds the responsibility.

3. Spot Purchases and Long Term Contract

C. usedastheefficientmodeoforganisationwhenthepredictability of environment is quite satisfactory.

4. Eclectic Paradigm D. developed by John Dunning in 19791-D, 2-C, 4-A, 5-Ba. 1-A, 2-B, 3-C, 4-Db. 1-D, 2-C, 3-B, 4-Ac. 1-B, 2-A, 3-C, 4-Dd.

___________________ is the total quantity of a good produced by a sector.9. Gross thoroughputa. Gross inputb. Gross meanc. Gross outputd.

According to the ____________________ propounded by Posner, a great deal of trade among the industrialised 10. countries is based on the introduction of new products and new production processes.

Product Life Cycle Modela. The theory of absolute cost advantageb. Technological Gap Modelc. The theory of comparative cost advantaged.

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Chapter II

International Regulatory Framework

Aim


definelegalframeworkthatregulatesimportandexport•

introduce the export import policy•

explore the general provisions with regards to export and import•

Objectives


explain the documentation with relation to export and import•

elucidate the importability of goods by the EOU/EPZ/EHTP/STP unit•

explicate the types and functions of the documents•

Learning outcomes


enlist the interpretations, compliances and exemptions granted from the export import policy•

understand export import trade regulatory framework•

comprehend standardisation of import/export• documentation


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2.1 IntroductionIn a developing country like India, trade policy is one of the many economic instruments, which is used to suit the requirements of economic growth. The twin objectives of India’s trade policy have been to promote exports and to restrict the level of imports to the level of foreign exchange available to the government. The basic problem of n country like India happens to be non-availability or acute shortage of crucial inputs like industrial raw materials. capital goods and technology, The bottleneck can be removed only by imports. In the short run, import can be financedthroughforeignaid,borrowings,etc;butinthelongrun,importmustbefinancedbyadditionalexportearnings, The basic objective of the trade policy, therefore, revolves round the instruments and techniques of export promotion and import management.

2.2 An Overview of Legal FrameworkLegal framework of export import trade is explained below.

2.2.1 Foreign Trade Act, 1992Theforeigntradeofacountryconsistsofoutwardandinwardmovementofgoodsandservicesgivingrisetoinflowandout-flowofforeignexchange.WhiletheforeigntradeofIndiaisgovernedbytheForeignTrade(Developmentand Regulation) Act, 1992 and the Rules and Order issued there under, the payments for export and import trade transactions in terms of foreign exchange are regulated under the Foreign Exchange Management Act, 1999. The physical operation of the foreign trade transactions of export and import of other goods and services through various modes of transportation is conducted and regulated under the Customs act, 1962.

In order to project the image of the country as a producer and exporter of quality goods and services, a detailed programme of quality control and pre-shipment inspection is also in vogue under the Export (Quality Control and Inspection) Act, 1963. Besides the above four major Acts governing the foreign trade operation of the country, there are a number of other rules and regulations relating to export of commodities, modes of transportation, cargo insurance, international conventions, etc., which need to be strictly observed while conducting the export and import business.

2.2.2 Foreign Exchange Management Act, 1999‘The exchange control in India was introduced on September 3, 1939 as a war time measure in the early period of Second World War under the powers conferred by the Defence of India Rules. The emergency powers were subsequently replaced by the Foreign Exchange Regulations Act, 1947 which came into operation on March 25, 1947. This Act witnessed comprehensive revision in the wake of the changed needs of the economy during the post-independence period and was replaced by the Foreign Exchange Regulations Act, 1973 known as FERA.

The onset of the era of liberalisation of the external sector of the economy and the industrial licensing followed by Partial Convertibility of Rupee and full convertibility on current account necessitated the need for further extensive amendments in the FERA. which were brought about by the Foreign Exchange Regulations (Amendment) Act, 1993. FERA has been replaced by Foreign Exchange Management Act (FEMA), 1999.

FEMA has been brought to consolidate and amend the law relating to foreign exchange. The basic objective of this act is to facilitate external trade and payments and to promote the orderly development and maintenance of foreign exchange market in India. This act deals with various regulations of foreign exchange like holding and transactions of foreign exchange, export of goods and services, realisation and repatriation of foreign exchange, etc. The role of authorised person, the provisions of contravention and penalties and the procedures of adjudication and appeal, and the power of the directorate for enforcement are dealt at great length in this act.

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2.2.3 The Customs Act, 1962The consolidated and self-contained Customs Act, 1962 came into operation on December 13, 1962 repealing the earlier three Acts known as Sea Customs Act, 1878. Land Customs Act, 1924 and the Aircraft Act, 1934, each one of which was related to a particular mode of transportation. This comprehensive Act provides the legal framework, guidelines and procedures related to all situations emerging from the export and import trade transactions. The primary objectives of this Act are to

regulate the genuine export and import trade transactions in keeping with the national economic policies and •objectivescheck smuggling, •collect revenue•undertake functions on behalf of other agencies•gather trade statistics. •

Details about the rate and nature of customs duty leviable on any item, as decided by the Central government, are specifiedintheFirstandSecondScheduleoftheCustomsTariffAct,1975withregardtoimportsandexports,respectively.

2.2.4 Export (Quality Control and Inspection) Act, 1963The Export (Quality Control and Inspection) Act was enacted in the year 1963 with a view to strengthening the export trade through quality control and preshipment inspection, The Act empowers the Government not only to notify the commodities which may be subject to compulsory quality control and/or inspection prior to export but also specify the type of quality control or inspection. The Act prohibits the export of sub-standard goods as well as thegoods,whichdonotfulfiltherequirementsaslaiddownundertheAct.

For smooth operation of the Export (Quality Control and Inspection) Act, 1963, the Government of India established the Export Inspection Council (EIC) on January 1, 1964, and the Export Inspection Agencies (EIAs). While the EIC acts as an advisory body to the Government on matters related to quality control and inspection, the EIAs are the actualagencies,whichinspectthegoodsandissuetheexport-worthinesscertificates.

All out encouragement is given to the trade and industry for the purpose of upgrading the quality of products under the current Export-Import Policy so as to project the image of the country as a producer and exporter of world-class quality products. The various categories of export houses recognised under the Export-Import Policy are exempt from the requirements of this Act.

2.3 Export-Import PolicyThe Export-Import policy is detailed below.

ObjectivesGovernment control import of non-essential item through an import policy. At the same time, all-out efforts are madetopromoteexports.Thus,therearetwoaspectsoftradepolicy;theimportpolicy,whichisconcernedwithregulation and management of imports and the export policy, which is concerned with exports not only promotion but also regulation. The main objective of the Government policy is to promote exports to the maximum extent. Exports should be promoted in such a manner that the economy of the country is not affected by regulated exports of items specially needed within the country. The export control is, therefore, exercised in respect of a limited number of items whose supply position demands that their exports should be regulated in the larger interests of the country. In other words, the policy aims at:

promotingexportsandaugmentingforeignexchangeearnings;and•regulating exports wherever it is necessary for the purposes of either avoiding competition among the Indian •exporters or ensuring domestic availability of essential items of mass consumption at reasonable prices.


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Export-Import Policy (1992-1997)The government of India announced sweeping changes in the trade policy during the year 1991. As a result, the new Export-Import policy came into force from April 1, 1992. This was an important step towards the economic reforms of India. In order to bring stability and continuity, the policy was made for the duration of 5 years. In this policy, import was liberalised and export promotion measures were strengthened. The steps were also taken to boost the domestic industrial production. The major aspects of the export-import policy (1992-97) include:

introduction of the duty-free Export Promotion Capital Goods (EPCG) scheme, •strengthening of the Advance Licensing System, •waiving of the condition on export proceeds realisation, •rationalisation of schemes related to Export Oriented Units and units in the Export Processing Zones. •

The thrust area of this policy was to liberalise imports and boost exports.

Export-Import Policy (1997-2002)The need for further liberalisation of imports and promotion of exports was felt and the Government of India announcedthenewExport-ImportPolicy(1997-2002).Thispolicyhasfurthersimplifiedtheproceduresandreducedthe interface between exporters and the Director General of Foreign Trade (DGFT) by reducing the number of documents required for export by half. Import has been further liberalised and efforts have been made to promote exports.

The new EXIM Policy 1997-2002 aims at consolidating the gains made so far, restructuring the schemes to achieve further liberalisation and increased transparency in the changed trading environment. It focuses on the strengthening the domestic industrial growth and exports and enabling higher level of employment with due recognition of the key role played by the SSI sector.

It recognises the fact that there is no substitute for growth which creates jobs and generates income. Such trade activitiesalsohelpinstimulatingexpansionanddiversificationofproductioninthecountry.Thepolicyhasfocussedon the need to let exporters concentrate on the manufacturing and marketing of their products globally and operate in a hassle free environment. The effort has been made to simplify and streamline the procedure.

The principal objective of Export Import Policy 1997-2002 are:To accelerate the country’s transition to a globally oriented vibrant economy with a view to derive maximum •benefitsfromexpandingglobalmarketopportunities.To enhance the technological strength and efficiencyof Indian agriculture, industry and services, thereby•improving their competitive strength, while generating new employment opportunities. It encourages the attainment of internationally accepted standards of quality.To provide consumers with good quality products at reasonable prices.•The objectives will be achieved through the coordinated efforts of all the departments of the government in •general and the Ministry of Commerce and the Directorate General of Foreign Trade and its network of regional officesinparticular.Further,itwillbeachievedwithasharedvisionandcommitmentandinthebestspiritoffacilitation in the interest of export.

2.3.1 Registration Formalities and Export LicensingThe registration formalities and export licensing are explained below. Importer-Exporter Code NumberNoexportorimportshallbemadebyanypersonwithoutanImporter-ExporterCode(IEC)numberunlessspecificallyexempted.AnapplicationforgrantofIECnumbershallbemadebytheRegisteredHeadofficeoftheapplicanttothe Regional Import-Export Licensing Authority along with the following documents:

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Profileofexporter/importer•Bank receipt in duplicate DD for Rs. 1000 as fee•Certificatefromthebankeroftheapplicant•Two copies of the passport size photograph of the applicant duly attested by banker If there is any non resident •interestintheapplicantfirmandNRIinvestmentiswithfullrepatriationbenefits,providefullparticularsandenclose photocopy of RBI approval for such investment.Declarationonapplicant’sletterheadaboutapplicant’snon-associationwithacautionlistedfirm.•

The Licensing Authority shall issue an IEC no in the prescribed format. There is no expiry date on IEC No, hence, thisnumberonceallottedshallbevalidtillitisrevoked.IECNoistobefilledintheBillofentry(forimport),Shipping Bill (for export) or in any documents prescribed by the rules.

Registration cum Membership CertificateAnyperson,applyingfora licencetoimportorexportorforanyotherbenefitorconcessionunderthispolicyshallberequiredtofurnishRegistration-cum-MembershipCertificate(RCMC).RCMCmaybeobtainedfromanyone of the Export promotion Councils Commodity Boards (except Central Silk Board), FIEO, APEDA, MPEDA, Administrative authorities of EHTPI STP units. Export of the registered exporters having valid RCMC will only qualifyforthebenefitsprovidedintheEXIMpolicy.

Export LicensingAll goods may be exported without any restriction except to the extent such exports are regulated by the Negative List of exports. The Negative Lists consist of goods, the import or export of which is prohibited, restricted through licensing or otherwise or canalised. The Negative list of exports is divided into three parts which are as follows:

Part-1: Prohibited Items: These items can not be exported or imported. These items include: Wild life, exotic birds, •wildflora,beef,humanskeletons,tallow,fatandoilsofanyanimaloriginincludingfishoil,woodandwoodproductsintheformoflogs,timber,stumps,roots,barks,chips,powder,flakes,dust,pulpandcharcoal.Part-II: Restricted Items: Any goods, the export or import of which is restricted through licensing, may be •exported or imported only in accordance with a licence issued in this behalf.Part-III: Canalised Items: Any goods, the import/export of which is canalised, may be imported or exported by •thecanalisingagencyspecifiedintheNegativeLists.TheDirectorGeneralofForeignTrademay,however,grant a licence to any other person to import or export any canalised goods. Hence, barring a few items which are totally prohibited for exports, other items in the Negative lists can be exported under a licence or through a designatedagencyorunderspecifiedconditions.

Procedure to obtain export licenceAn application for grant of export licence may be made in the prescribed form to the Director General of Foreign Trade or its Regional Licensing Authority. The application shall be accompanied by the documents prescribed therein. There is no application fee on export licences/permits.

2.3.2 Procedure to Obtain Export LicenceAn application for grant of export licence may be made in the prescribed form to the Director General of Foreign Trade or its Regional Licensing Authority. The application shall be accompanied by the documents prescribed therein. There is no application fee on export licences/permits.

For restricted item an application is to be made in duplicate in the appropriate forms. There are two different export licence application forms:

Application for export of restricted items except special chemical and special materials, equipments and •technologies. This form is sent to the Director General of Foreign Trade, New Delhi.


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Application for grant of export license for export of special chemicals, etc. Applications are to be sent to the •DGFT. An interministerial group under the chairmanship of the DGFT shall consider applications for the export of these items.

For canalised items, applications are made to the DGFT in the prescribed form. For samples/exhibits exports exceeding ceiling limits, an application may be made to the DGFT. For gifts/spares/replacement goods in excess of ceilings, an application is to be made to the DGFT in the prescribed format.

2.4 General Provisions Regarding Exports And ImportsProvisions regarding exports and imports are explained below.

Exports and imports free unless regulated Exports and Imparts shall be free except to the extent they are regulated by the provisions of this policy or any other lawforthetimebeinginforce.TheitemwiseexportandimportpolicyshallbespecifiedinITC(HC)publishedby Director General of Foreign Trade (DGFT).

Compliance with lawEvery exporter or importer shall comply with the provisions of the Foreign Trade (Development and Regulation) Act, 1992 and the rules and orders made thereunder. They are also required to comply with the provisions of this policy, terms and conditions of any licence granted and provisions of any other law for the time being in force.

Interpretation of policyIf any question or doubt arises in respect of the interpretation of any provision of the EXIM policy, it shall be referred totheDirectorGeneralofForeignTradewhosedecisionshallbefinalandbinding.

Exemption from policy/procedureAny request for relaxation of the provisions of this policy or procedure on the ground of hardships or an adverse impact on trade, may be made to the Director General of Foreign Trade.

Trade with neighbouring countriesThe Director General of Foreign Trade may issue from time to time, such instructions or frame such schemes as may be required to promote trade and strengthen economic ties with neighbouring countries.

Trade with Russia under Debt Repayment AgreementIn the case of trade with Russia, under the debt repayment agreement, the Director General of Foreign Trade may issue from time to time such instructions.

Transit facilityTransit of goods through India from or to countries adjacent to India shall be regulated in accordance with the treaty between India and those countries.

Execution of Bank Guarantee /Legal UndertakingWhereveranydutyfreeimportisallowed,orwhereotherwisespecificallystated,theimportershallexecutealegalundertaking or bank guarantee with the customs authority before clearance of goods through the customs.

Free movement of export goodsConsignments of items allowed for exports shall not be withheld or delayed for any reason by any agency. In case of any doubt, the authorities concerned may ask for an undertaking from the exporter.

Import/Export of samplesImport and export of samples shall be by the provisions of EXIM Policy.

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Third party exportsA licence holder may export directly or through third parties.

Clearance of goods from customsThe goods already imported/shipped/arrived in advance but not cleared from customs may also be cleared against the license issued subsequently.

Green CardAll status holders and manufacturer exporter exporting more than 50% of their production subject to a minimum turnover of Rs. 1 crore in preceding year, shall be issued a green card by Directorate General of Foreign Trade. This card will also be issued to the service providers rendering services in free foreign exchange for more than 50% of their services turnover, subject to a minimum value of Rs. 35 lakhs in free foreign exchange in the preceding year. This card provides automatic licensing, automatic custom clearance and other facilities mentioned in the EXIM policy.

Electronic data interchangeIn an attempt to speed up transactions and to bring about transparency in various activities related to exports, electronic data interchange would be encouraged. Applications received electronically shall be cleared within 24 hours.

2.5 Exports and ImportsImports and Exports are explained below.

2.5.1 Exports

Free Exports: All goods may be exported without any restriction except to the extent such exports are regulated •by ITC (HS) or any other provision of this policy or any other law for the time being in force.Denomination of Export Contracts: All export contracts and invoices shall be denominated in freely convertible •currency and export proceeds shall be realised in freely convertible currency. Contracts for which payments are received through the Asian Clearing Union (ACU) shall be denominated in ACU dollar.RealisationofExportProceeds:Ifanexporterfailstorealisetheexportproceedswithinthetimespecifiedby•the Reserve Bank of India, he shall be liable to action in accordance with the provisions of the Act and the policy.Export of Gift: Goods including edible items of value not exceeding rupees one lakh in a licensing year may •be exported as a gift. Those items mentioned as restricted for exports in ITC(HS) shall not be exported as gift without a licence except edible items.Export of Spares: Warranty spares, whether indigenous or imported, of plant, equipment, machinery, automobiles •or any other goods may be exported up to 7.5% of the FOB value of the exports of such goods along with the main equipment or subsequently. This shall be done within the contracted warranty period of such goods.Exportofpassengerbaggage:Bonafidepersonalbaggagemaybeexportedeitheralongwiththepassengerorif•unaccompanied, within one year before or after the passenger’s departure from India. Those items mentioned as Restricted in ITC (HS) shall require a licence except in case of edible items.Export of imported goods: Goods imported in accordance with this policy, may be exported in the same or •substantially the same forms without a licence. This can be done provided that the item to be imported or exported is not mentioned as restricted for import or export in this ITC (FIS), except items imported under Special Import Licence.Export of replacement Goods: Goods or parts thereof on being exported and found defective/damaged or •otherwiseunfitforusemaybereplacedfreeofchargebytheexporter.Suchgoodsshallbeallowedclearanceby the customs authorities provided that the replacement goods are not mentioned as restricted items for exports in ITC (HS).


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Export of repaired goods: Goods or parts thereof on being exported and found defective, damaged or otherwise •unfitforusemaybeimportedforrepairandsubsequentre-export.Suchgoodsshallbeallowedclearancewithoutalicenceandinaccordancewithcustomsnotificationissuedinthisbehalf.Private bonded warehouse: Private bonded warehouse exclusively for exports may be set up Export-Import Trade •inDomesticTariffAreaasperthenormsandconditionsofthenotificationsissuedbyDepartmentofRevenue.Such warehouse shall be entitled to procure the goods from domestic manufacturers without payment of duty. Thesuppliesmadebythedomesticsupplier to thenotifiedwarehousesshallbetreatedasphysicalexportsprovided the payments for the same are made in free foreign exchange.

Deemed exportsDeemed exports refer to those transactions, where the goods supplied do not leave the country. The following categories of supply of goods by the main/sub-contractors shall be regarded as deemed exports under the policy, provided the goods are manufactured in India.

Deemedexportsshallbeeligibleforthefollowingbenefits.Advance licence for intermediate supply/deemed export•Deemed exports drawback•Refund of terminal excise duty•

Export of services Services include all the 161 tradable services covered under the General Agreement on Trade in services where payment for such services is received in free foreign Exchange. The service providers shall be eligible for the facility of EPCG scheme. They shall be eligible for the facility of EOU/EPZ/SEZ/STP scheme of the EXIM policy. Service providers shall also be eligible for recognition as Service Export House, International Service Export House, International Star Service Export House, International Super Star Service Export House, achieving the performance level as prescribed in the policy.

Export of servicesSupply of goods against advance licence DFRC under the duty exemption/remission scheme.•Supply of goods to units located in EOU/EPZ/SEZ/STP/EHTP.•Supply of capital goods to holders of licences under EPCG scheme.•Supplyofgoodstoprojectsfinancedbymultilateralorbilateralagencies/fundsasnotifiedbytheMinistryof•Finance.Supply of capital goods which are used for installation purposes till the stage of commercial production and •spares to the extent of 10% of the FOR value to fertiliser plants.Supply of goods to any project or purpose in respect of which the Ministry of•Financepermitstheimportofsuchgoodsatzerocustomsdutycoupledwiththeextensionofbenefitsunder•this chapter to domestic supplies.Supplyofgoodstothepowerandrefineriesandcoalhydrocarbons,rail,road,port,civilaviation,bridgesother•infrastructureprojectsprovidedminimumspecificinvestmentisRs.100croresormore.Supply of marine freight containers by 40% EOU (domestic freight containers manufacturers) provided the •said containers are exported out of India within 6 months or such further period as permitted by the customs, supply to projects funded by UN agencies.

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2.5.2 Imports

Actual user condition: Capital goods, raw materials, intermediates, components, consumables, spares, parts, •accessories, instruments and other goods, which are importable without any restriction, may be imported by any person. If such imports require a licence, the Actual user alone may import such goods unless exempted.Second hand goods: All second hand goods shall be restricted for imports and may be imported only in accordance •with the provisions of EXIM Policy.Import of gifts: Import of gifts shall be permitted where such goods are otherwise freely importable under this •policy.Importonexportbasis:Neworsecondhandjigs,fixtures,dies,moulds,patterns,presstoolsandlasts,construction•machinery, container packages meant for packing of goods for export and other equipments, may be imported for export without a licence on execution of legal undertaking/bank guarantee with the customs authority.Re-import of goads abroad: Capital goods, aircraft including their components, spare parts and accessories, •whether imported, or indigenous may be sent abroad for repairs, testing, quality improvement, or upgradation of technology and re-imported without a licence.Import of machinery and equipment used in project abroad: After completion of the projects abroad, project •contractors may import used construction equipment, machinery, related spares up to 20% of the CIF value of such machinery, tools and accessories without a licence.Sale on high seas: Sale of goods on high seas for import into India may be made subject to this policy or any •other law for the time being in force.Importunderleasefinancing:Permissionoflicensingauthorityisnotrequiredforimportofnewcapitalgoods•underleasefinancing.Export promotion capital goods scheme: New Capital goods including computer software systems may be •imported under the Export Promotion Capital Goods (EPCG) scheme. Under this provision on capital goods includingjigs,fixtures,dies,mouldsandsparesupto20%oftheCIFvalueofthecapitalgoodsmaybeimportedat 5% customs duty. This import is subject to an export obligation equivalent to 5 times CIF value of capital goodsonFOBbasisor4timestheCIFvalueofcapitalgoodsonNFEbasistobefulfilledoveraperiodof8years. This period is reckoned from the date of issuance of licence. Import of capital goods shall be subject to actual user condition till the export obligation is completed.Duty Exemption/Remission Scheme: The duty exemption scheme enables import of inputs required for export •production. The duty remission scheme enables post export replenishment/remission of duty on inputs used in the export product. Duty exemption scheme: Under duty exemption scheme, an advance licence is issued to allow import of inputs •which are physically incorporated in the export product. Advance licence is issued for duty free import of inputsasdefinedinthepolicysubjecttoactualusercondition.Suchlicencesareexemptedfrompaymentofbasic customs duty, surcharge, additional customs duty, anti-dumping duty and safeguard duty, if any. Advance licence can be issued for

physical exports �intermediate supplies �deemed exports �

Under the scheme of advance licence for intermediate supply, advance licence may be issued for intermediate supply to a manufacturer-exporter. This is done for the import of inputs required in the manufacture of goods to be supplied to the ultimate exporter/deemed exporter holding another advance licence.

Under the scheme of advance licence for deemed export, advance licence can be issued for deemed export to the main contractor. This is done for the import of inputs acquired in the manufacture of goods to be supplied to the categories mentioned in the policy.


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DutyRemissionScheme:This schemeconsistsofduty free replenishment certificate andduty entitlement•passbook scheme. DutyFreeReplenishmentCertificate(DFRC):Dutyfreereplenishmentcertificateisissuedtoamerchant-exporter•or manufacturer-exporter for the import of inputs used in the manufacture of goods without payment of basic customs duty, surcharge and special additional duty. Such inputs shall be subject to the payment of additional customs duty equal to the excise duty at the time of import.Duty Entitlement Passbook Scheme: For exporters not desirous of going through the licensing route, an optional •facility is given under duty entitlement passbook scheme. The objective of DEPB scheme is to neutralise the incidence of customs duty on the import content of the export product. The neutralisation shall be provided by way of grant of duty credit against the export product. Under this scheme, an exporter may apply for, credit as specifiedpercentageofFOBvalueofexports,madeinfreelyconvertiblecurrency.ThecreditshallbeavailableagainstsuchexportproductsandatsuchratesasmaybespecifiedbyDirectorGeneralofForeignTrade.TheDEPB shall be valid for a period of 12 months from the date of issue. The DEPB and/or the items imported against it are freely transferable. The exports under the DEPB scheme shall not be entitled for drawback. The holder of DEPB shall have the option to pay additional customs duty in cash as well.

Importability of goods by EOU/EPZ/EHTP/STP unitExport Oriented Units (EOU), units in Export Processing Zones (EPZs), Special Economic Zones (SEZs), Electronics Hardware Technology Parks (EHTPs) and Software Technology Parks (STPs) unit may import all types of goods withoutpaymentofduty.Thisincludescapitalgoodsasdefinedinthepolicy,requiredbyitformanufacture,services,trading or in connection therewith. These goods should not be prohibited items.

2.6 Export-Import DocumentsDocumentation for export-import are mentioned below.

2.6.1 Rationale of DocumentsExportdocumentationiscommonlyconsideredtobethemostcomplexanddifficultpartofoverseasmarketing.You may have come across such comments, which tend to discourage people from entering into export business. It is, therefore, necessary to emphasise that documentation is as much of an important activity as the conclusion of anexportorderanditsfulfilment.

If one is doing domestic business, one knows or can easily know the commercial practices, which bind the buyer and the seller. Similarly, the possibility of business both the buyer and the seller know/or can easily know laws governing contracts. However, when the buyer and the seller are operating in two countries, both the commercial practices and legal processes are different. Thus, for the protection of the respective interests of the buyer and the seller are protected, certain documentary formality by the country has its own laws governing imports and exports.

Consequently, the exporter has to comply with laws in his country through documenting formalities. At the same time, he has to send some documents to the importer, which will enable him to take possession of the goods after getting permission from the concerned government department (i.e., the customs authorities). There is yet another reason for documentation in export trade. Such documentation is linked with the claim of export incentives given by almost all countries world over.

Since most of these incentives are to be claimed after shipment) the exporter has to give documentary proof of the fact of shipment. Documentation formalities are necessary to enable the importer to get the contracted goods and the exporter to get sale value as well as to secure export incentives. In other words, export documents are needed to comply with commercial, legal and incentive requirements. .

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Commercial perspectiveTradebetweentwobusinessfirmslocatedindifferentcountriesbeginswiththeconclusionofanexportcontract.Under the contract, the duty of the exporter is to ship the corrected goods in the agreed form (for example, packing) and by agreed mode of transport as well as according to agreed time schedule. On the other hand, it is the duty of the importer to remit sale value to the exporter according to agreed terms of payment. In this process of physical movement of goods from the exporter to [the importer and remittance of sale value in the reverse order, neither the exporter nor the importer is personally and physically involved. Instead goods are handed over to a shipping company or an airline which issues a receipt for these goods.

Further, since goods in transit may be damaged or lost due to some accident, the exporter may be required to get an insurance policy. While these two documents will protect the interests of the importer, the exporter will ensure that these documents are not in the possession of the importer unless he has either paid for the goods or he has made a promise to make payment at a later date. For this purpose, physical possession of the good will be linked with the acceptance of a payment document by the importer.

In actual practice, a set of documents given proof of shipment and cargo insurance coverage along with a bill for payment is sent by the exporter to the importer through the banking channel. This set of documents symbolises ownership in goods. This will be handed over to the importer by the bank. in his country, which lie has received it from the bank in the exporting country only when he has honoured the bill. In other words, the importer will get delivery of the goods from the carrier on the basis of the transport document, which is obtained through the bank, after he has complied with the agreed terms of payment.

Legal perspectiveBesides commercial necessity, documentation for exports has a legal perspective. All over the world, laws regulating export-import trade as well as movement of foreign exchange has been enacted. In some countries, the regulations are few, which are enforced through simple procedural and documentation formalities. In other countries, the regulations are many and the enforcement procedures are complex.

Why should there be regulations in foreign trade? There is perhaps no country in the world where movement of goods and money is absolutely free. ‘The minimum regulations that one can think of are the one to record the movement of goods from and into a country. For this purpose, the exporter has to declare on a document the details of goods being exported by him. Other than this basic minimum requirement, the governments all over the world regulate movement of goods to protect political, economic, cultural and other interests and policies for implementing trade agreements with other countries.

Some countries do not have political relations with the others. As a result, goods originating from such a country •arenotallowedtobeimported.Thus,acountry,whichdoesnotpermitflowofgoodsfromcertaincountries,haslaiddowntherequirementofCertificateofOrigin,whichstatesthatthegoodsareofthecountry,whichis exporting them. For example, some of the countries in West Asia do not allow imports from countries or companies having any relation with Israel.Documents are needed for protecting the economic and social interests of the trading countries. For example, •under the Indian Export policy, the government has listed out products, which either cannot be exported or can be exported after obtaining permission from the designated agencies. Some of the products are subject to restrictions because of their short supply in the country. Consequently, these products can be exported only after obtaining a quota, for which a documentary proof is to be submitted to the customs, authority for shipment purposes. Similarly, there are a number of government regulations governing quality, standards, foreign exchange •flows,valuationofgoodsforcalculatingcustomsduties,etc.Compliancewiththeseregulationsnecessitatesdocumentation. Documentsarealsoneededforfulfillingrequirementsunderbilateralandmultilateraltradeagreements.For•example,anIndianexporterwillneedtoobtainGSP,CertificateofOriginforexportingcertainspecifiedproductsto those countries which operate the Generalised System of preferences. Under this System, the developed countryaccordpreferentialdutytreatmenttospecifiedgoodsoriginatingfromdevelopingcountries.TheGSPcertificatewillenabletheimportertopayconcessionalduty.


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Incentive perspectiveExport assistance and incentive measures have become an integral part of policy in larger number of countries. Since these incentives are to be given only to the export activity and documentary proof to this effect is required to be given by the claimant to the disbursing, authorities. Such a documentary proof should state that the claimant is eligible to receive the incentive, that the goods will be or have been exported according to the export contract and thattheclaimhasbeenfiledinthemannerspecifiedinthepolicy.

Inotherwords,bonafidesof theclaimhavetobeestablishedforreceivingincentivesandassistance.Youmayalsonotethatformakingaclaim,theexporterhastofileanapplicationonthespecifiedformthatsummarisestheshipment and other details. This application is to be accompanied by a number of supporting documents to enable the incentive disbursing authority to check the authenticity of details given in the application.

2.6.2 Kinds and Functions of DocumentsTypes and functions of documents for export-imports are explained below.

Commercial documentsCommercial documents, also known as shipping documents, enable the exporter and the importer to discharge their obligationsunderanexportcontract.Inspecificterms,thesedocumentsensurethattheexportermakesshipmentof the goods according to requirements of the contract and the importer makes payment for goods shipped in the manner as given in the contract. When goods are shipped by the exporter, he has a set of documents, which entitles him or its legal holder (example, agent, importer, bank) to the goods at the destination or in the event of damage or loss to compensation by insurance.

For a consignment under a c.i.f, contract, a set of commercial documents comprise:CertificateandBillofexchange•Commercial Invoice•Bill of Lading•Airway Bill•Post Parcel Receipt •Insurance Policy•

Certificate and bill of exchange: In addition to these documents, a particular shipment may necessitate additional commercialdocumentssuchaspackinglist,certificateofinspection,certificatesofqualityetc.Youmustalsonotethat for receiving payment from the importer, additional documents, satisfying the regulatory needs in the importing country, will have to be obtained by the exporter and sent to the importer. Let us discuss various commercial documents.

Commercial invoices:Thisisthefirstbasicandtheonlycompletedocumentamongallcommercialdocumentsfortheshipment.Besidesfulfillingtheobligationundertheexportcontract,theexporterneedsthisdocumentforanumber of other purposes including:

obtainingexportinspectioncertificate•getting excise clearance •getting customs clearance and •securing incentives•

Thus, this document is prepared at both the pre-shipment and post-shipment stages.Inthefirstplace,CommercialInvoiceisadocumentofcontentsthatdescribesdetailsofgoodssentbyexporter.•Itisthestatementofaccount,whichmustcontainidentificationmarksandnumbers,descriptionofgoodsandquantity of goods.

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Everyshipmenthasidentificationmarks,whichidentifythecargowithvariousdocuments.Theseareprivate•marks, which are made on the packages. These marks could be either in the form of symbols (say, a star, triangle, rectangle, etc.) or numerical. Similarly, every package under a shipment is numbered, usually written serially. The commercial invoice must specify the serial numbers given in a particular consignment.Commercial invoice must describe the goods shipped by the exporter. The description of goods must correspond •exactly with the description given in the contract or the letter of credit. It means that there’s not to be any difference (including spelling) between these descriptions, thus, if a contract describes the goods as “Ten Thousand Pairs of Blouses and Skirts”, the exporter should not describe them as “Ten Thousand Blouses and Ten Thousand Skirts”, though logically both the descriptions mean the same.Sometimes description of the goods includes the number of packages and the type of packing material. Thus, •ifthecontractspecifiesshipmenttobemadein“tennewgunnybags”,theexportershouldsendthecontractedgoods and describe them as needed. If the commercial invoice wrongly describes the shipment as “ten gunny bags” instead of “ten new gunny bags”, the bank may refuse to honour shipping documents and not pay for them.The quantity described on the commercial invoice should neither be less or more than the contracted quantity. •In other words, the exporter should not ship less than contracted quantity, unless the contract permits part shipment. However, if the goods are being shipped under a letter of credit, port shipment is permitted, unless it isspecificallyprohibited.Ontheotherhand,quantityshippedshouldnotbemorethanthecontractedquantity.This is so even if the exporter may not be charging for the additional quantity. Second function of the commercial invoice is that it is the seller’s bill given to the buyer.As a bill, it must contain the name and address of the buyer, unit price, amount and authorised signatures with •designation.Unlessrequiredbythebuyer,thetotalinvoicedvalueshouldbenetofanycommissionordiscount;in other words, it should be the realisable amount of goods as per the trade terms. Sometimes a contract requires a detailed breakup of the amount to be recorded on the invoice for enabling the customs authority in the importing country to calculate import duty. The name and address given in the commercial invoice should be the same as given in the export contract or the letter •ofcredit,asthecasemaybe.Underaletterofcredit,unlessotherwisespecified,thecommercialinvoicemustbemade out in the name of the applicant of the credit. As in the case of quantity to be recorded on the invoice, the amount should neither be less nor more than the stipulated amount in the contract or the letter of credit. The only exception is that if the contract or the letter of credit permits part-shipment, an individual invoice can be less than the total amount. The commercial invoice also sets forth the terms of sale (i.e. fob/cif/c&f) etc. mode and date of shipment and termsofpayment.Itcanalsoserveasapackinglistandacertificateoforigin.Apackinglistshowsdetailsofgoodscontainedineachpackofshipment.Whenthelawinanimportingcountrydoesnotspecificallyrequireaseparatecertificateoforiginissuedbyathirdparty,itcanbeself-certifiedbytheexporteronthecommercialinvoice. The format of Commercial invoke is devised by exporters themselves according to the requirements of their business. Look at Annexure 1 where the format of Commercial invoice has been given.

Bill of lading: Bill of lading is issued by the shipping company or its agents stating that goods are either being shipped or have been shipped. Essentially a transport document, it serves many purposes in international commerce. Bill of lading serves the following three distinct functions.

This document evidences the contract of affreightment (transport) between the shipping company and the •shipper (exporter or importer).It is a receipt given by the shipping company for cargo received by it.•Itisadocumentoftitle(Thisisthemostsignificantfunctionofthebilloflading).•


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The meaning of the term affreightment is “evidence of the contract of affreightment”. When goods are to be carried by any carrier (say, a ship), the contract of affreightment will apply carriage terms and conditions. In particular, this contract will mention the responsibility of the carrier (example, ship owner) in providing space, receiving, loading, carrying and unloading of the cargo. Thus, if there is any loss or damage to the cargo when it is in the custody of the carrier, the contract will provide for the circumstances in which the carrier can be held liable for the loss or damage. Further, in case the carrier is to be liable for loss or damage, the contract will provide to the amount of claim which carrier will be required to pay to the cargo owner. A bill of lading also contains printed terms and conditions of the contract of affreightment on it.

However,itisnotconsideredasacontractbyitself;insteaditisthemostimportantevidenceofthecontract.Lawcourts all over the world have held that in case of a dispute, the aggrieved party may produce any other evidence whichmaycontrovertaprintedclauseinthebilloflading.Anyotherevidencecouldbeaspecificagreementinwhich for example, the ship owner may have agreed to a higher amount of liability than the standard amount. Thus, in such cases, the ship owner does not have a defence that his maximum liability is as printed in the bill of lading.

Bill of lading is a receipt issued by the shipping company on its agents. Law requires that as a receipt, it must contain leadingidentificationmarks,numberofpackagesorquantityorweightoranyotherunitofaccount,andapparentorderandconditionofthegoods.Billofladingistheonlyevidencetofileaclaimagainsttheshippingcompanyinthe event of non-delivery, defective delivery or short-delivery of the cargo at the destination.

As a result, this document indicates that the contracted goods have been either given into the charge of the shipping companiesorshippedbytheexporterbythenamedshiponthedatespecifiedonthebilloflading.Ifshipmentisaccording to the contract terms, the exporter gets the right to demand the sale amount from the importer while the importer is entitled to get delivery of the goods at the destination.

As a receipt, the bill of lading can be of various types as discussed below: Received for Shipment B/L: It is issued by the shipping company when goods have been given into the custody •of the shipping company but have not yet been placed on board the ship.OnBoardShippedB/L:Itcertifiesthatthegoodshavebeenreceivedonboardtheship.•Clean B/L: It indicates a clean receipt. In other words, it implies that there was no defect in the apparent order •and condition of the goods at the time of receipt or shipment of goods by the shipping company, as the case may be. Claused or Dirty B/L: This bill bears a superimposed clause an annotation, which expressly declares a defective •condition of the goods. The clause may state “package number 20 broken” or “bale number 20 hook-damaged”. By superimposing such clauses on the B/L, the shipping company limits its responsibility at the time of delivery of goods at the destination. It is very important to note that only a clean BIL is acceptable for negotiation of documents with the bank.Combined B/L: It covers several modes of transport for performing the complete journey from the exporting •country to the importer’s warehouse. For example, part of the journey may be completed by ship while subsequent partsmaybeundertakenbyroad;railandair.ThroughB/L:Itcoversgoodsbeingtranshippedenroutebutwherethefirstcarrierhastheresponsibilityasthe•principal carrier for all stages of the journey. For example, goods may be shipped from Bombay to Dubai and transhipped from Dubai to a port in Latin America.Trans-shipmentB/L:IthassimilarcharacteristicastheThroughBILexceptthatinthiscasethefirstcarrieracts•only as an agent for effecting Trans-shipment of cargo.Charter Party B/L: It covers shipment on a chartered ship. The contract or the letter of credit will specify the •nature of bill of lading that the exporter has to procure for the importer. Generally, the importers insist on the “clean on-board shipped” bill of lading, with the prohibition of the trans-shipment of goods.

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Bill of lading is a document of title that will enable the lawful holder of any of the original BIL to take delivery of the goods at the stipulated port of destination, Thus, a claimant of title to goods is required to surrender an original B/L (also popularly known as negotiable copy of BIL) for claiming goods from the shipping company or its agents. A bill of lading is not a negotiable instrument, though it is transferable by endorsement and Policies delivery. What is the purpose of transferability of the bill of lading?

TransferabilityTransferability enables the banks to pay money to the exporter against surrender of shipping documents, including BIL, even before the goods reach the destination. Similarly, it enables the goods to be resold by the importer before goods reach the destination. For creating transferability, the bill of lading has to be made in such a way that the goods are consigned to the ‘order of a party. The party could be either the exporter himself, or a negotiating or paying bank or any other party as provided in the contract or letter of credit. For example, if BIL is prepared in the following way, it can be transferred through endorsement in the same manner as in a cheque. There are three main columnsinBIL.TheseareConsignor(Shipper);ConsigneeorOrderofandNotifyingparty.Notifyingpartyisthepartytowhomtheshippingcompanyistosend“noticeofarrival”.Transferabilitycanbecreatedbyfilling-upthesecolumns in the following manner:

Consignor: ABC Company, New Delhi•Consignee: (Or Order of) Bank of XYZ, New Delhi•Notifying Pam: KNM, London•

Bynotstriking-offthewords“OrOrderOf”andwritingthenameofthenegotiatingbank,thebankbecomesthefirstendorsee. Title to goods will be transferred from the negotiating bank to the paying bank to importer on endorsements by the negotiating and the paying banks in succession.

In contrast to the “Order BIL” is the consignee-named B/L. The consignee-named B/L is made out in the name of a specificparty.Hence,titletogoodscannotbetransferredtoathirdparty.Theexportershouldnotshipgoodsunderthis kind of BIL as goods can be released by the shipping company at the destination without the presentation of the ‘original’ B/L. Thus, if payment from the importer has not been secured, the exporter may lose hold over goods and may not get paid. However, if payment in advance has been received or if goods are being shipped under irrevocable letter of credit, the consignee named BL is a valid document.

According to international commercial practice, BL along with other shipping documents must be presented to the bank not later than twenty- one days of the date of shipment as given in BIL. Sometimes the buyers may also specify the last date or the number of days after shipment by which the documents must be submitted to the bank. Where this stipulation is not followed by the exporter, the documents are said to have become “stale” and B/L in such case will be known as Stale B/L. A Stale B/L, is one which is tendered to the paying bank at so late a date that it is impossible for it to be dispatched to the consignee in time to reach him before the goods themselves arrive at the destination port.

Airway bill: In air carriage, the transport document is known as the airway bill (AWB). This document constitutes prima facie evidence of the conclusion of the contract of affreightment, of receipt of goods and of conditions of carriage. This document, therefore, performs the triple functions as a forwarding note for the goods, receipt for the goods tendered and authority to obtain delivery of goods. By itself, AWB is not a document of title, nor is this document transferable. However, AWB can be made into a transferable document by which it can be transferred to a third party by’ endorsement like the BIL. But, by and large, the business and commercial practice does not treat the AWB as a document of title.


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Functions of airway billThe functions of AWB are similar to BIL in regard to its characteristics as an evidence of contract and as cargo receipt.

The AWB may be given as a receipt either for cargo given to the carrier pending shipment or for cargo loaded •on board the aircraft. It may either be a clean receipt or a claused receipt. As regards the document of title characteristics, AWB is not a document of title, but this feature can be incorporated •in it by making an Order AWB. General practices in the trade are to get the consignee-named AWB. •Consequently, goods are delivered to the consignee named in the AWE. The consignee will have to identify himself •as the party named in AWB and goods may be delivered to him without any hindrance. But if the interests of the exporter have not been protected, the consignee may get hold of the goods and may also not pay for them. Hence, exporters provide for a clause in the contract, which requires AWE to be made in the name of the paying •bank, which will ensure exchange of goods for payment, by the importer. On the other hand, the importer can protect him against the seller’s re-routing of the goods by obtaining the •consignor’s copy of the AWB (marked “Original 3 for Shipper”), which is sent to him through the balking channel by the exporter along with other shipping documents.

Post parcel receipt: Post parcel receipt (PPR) evidences merely the receipt of the goods exported through postal channels to the buyer. It does not evidence the title to goods. The parcel is consigned to the consignee named in the contract between exporter and importer. The consignee can identify himself with the postal authorities at the destination and obtain delivery of the goods.

Insurancepolicyorcertificate:CargoInsurancePolicy(alsocalledmarineinsurancepolicy)providesprotectiontocargo owners in the event of loss or damage to cargo in transit. This loss or damage is caused by accidents, which cannot be known in advance and against which no protection is possible. These may be caused by natural calamities as well as by man-made accidents. It is, therefore, necessary that the risk of loss or damage to the cargo be minimised by obtaining a suitable insurance cover from an insurance company.

There are different types of insurance policies for different categories of risks to be covered. We may emphasise that different types of risks to be covered will require different policies. Thus, the prevalent practice all over the world istofixinsuranceonfivetypesofpolicies.Theseare:

Institute Cargo Clauses A •Institute Cargo Clauses B •Institute Cargo•Clauses C •Institute Strikes Clauses •Institute War Clauses•

Among the three cargo clauses, Cargo clauses A provide the maximum cover, clauses B provide less cover while clauses C provide the least cover. When war and strikes clauses are attached to cargo clause’s A, the cargo owners are given protection against all kinds of risks admissible under the law.

It must be pointed out that insurance cover is given irrespective of the mode of transport used including sea, air, and road and rail carriers. Further, insurance cover can be secured for cargo going from the warehouse of the consignor, to the warehouse of the consignee. Generally, the export contract determines the party (exporter or importer) that will procure insurance cover. In the F.O.B. and C& F contracts, importer obtains insurance cover after the goods have been laid on board on carrier. On the other hand, in a CIF contract, it is the obligation of the exporter to insure goods.

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Sometimes,theexportcontractspecifiesthesubmissionof‘insurancecertificate’insteadofthepolicytobankfornegotiationofdocuments,Insurancecertificate,whichisonestagepriortoinsurancepolicy,comesintobeingwhena large and regular exporter obtains an open cover or concludes an open policy. Under these two arrangements, insurancecertificatesareissuedondeclaringshipmentsbytheexporterasandwhentheseareaffected.Insurancecertificatehasanadvantageasitcutsdowntimeingettingtheinsurancedocumentfromtheinsurancecompany.

Bill of Exchange: Bill of exchange or draft is “an instrument in writing containing an unconditional order, signed by the maker, directing a certain person to pay a certain sum of money only to or to the order of a person or to thebeareroftheinstrument.Further,thepersontowhomitisaddressedistopayeitherondemandoratfixedordeterminable future.

Bill of exchange (BIE) is an important commercial document, which bridges the time gap between shipment of goods and receipt of sale amount. This document is prepared by the exporter and given to the bank along with other shipping documents for securing the sale amount. In this sense, BIE is attached to other documents, which will be given to the make payment at a future date.

Simply stated, the maker of B/E is the exporter (drawer) and the person who is directed to pay is the importer (drawee), while the person who is entitled to receive payment is the exporter (payee) or anyone directed by him. The sum of money to be paid by the drawee is the amount billed in the commercial invoice and recorded in B/E.

B/E is to be honoured either on demand or on presentation to the drawee or at a determinable future. Where BIE is tobehonouredondemand,a‘Sightbill’isdrawnwhileinthesecondcase‘Usancebill’isdrawn.Inthefirstcase,the exporter does not give a credit facility to the importer. In the second case, he extends this facility for an agreed time period. Sight bill is drawn under DP (Documents against payment) terms of payment. For one shipment, two sets of shipping documents including B/L are mailed to the foreign correspondent (bank) through a bank in the exporting country for presentation to the drawee (importer). Each one bears a reference to the other. When anyone of the B/E is paid for by the drawee, the second BIE becomes null and void.

Combined Transport DocumentCombined Transport Document (CTD) is a document for multi-modal movement of goods in container. The movement is carried out by more than one mode, for example, rail and ship. The Foreign Exchange Dealers Association of India(FEDAI)hasbroughtoutbrochureNo.081and082tofacilitateexportofgoodsincontainersfromspecifiedinland centres in India. A CTD provides an alternative to establishing a series of separate and non-uniform contracts for each segment of the total transport process. It is acceptable for negotiation under L/C.

Legal regulatory documentsThese documents may be divided into two categories, i.e., documents needed in the exporting and the importing countries.LetusfirstdiscussregulatorydocumentsneededinIndia.

Legal documents for exports from IndiaRegulatoryexportdocumentsareoftwotypes.Documentsneededfordifferentkindofregistrationofthefirmanddocuments,whicharespecifictoashipment.

In thefirstcategoryare includedapplicationsandsupportingdocumentforobtaining(i) Importer-Exporter•CodeNumbervalidforthefirm’slife-time,and(ii)Registration-Cum-MembershipCertificate,(RCMC)fromtherelevantexportpromotioncouncil,Commodityboard,developmentauthorityetc.,validforaspecifiedtimeperiod. RCMC is strictly not a legal requirement for exporting from India, but is needed for claiming some of the important export incentives. The applications of the Importer-Exporter Code Number (IEC) is to be made in the prescribed form to the Regional Licensing Authority. RCMC is obtained from the concerned registering authority, which may either be an Export Promotion Council, or Commodity Board or a Development Authority. Application is to be made on the prescribed form available from the registering authority.


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In the second category are the documents, which an exporter or his agent has to prepare for shipment of goods. •These documents are:

Foreign Exchange Regulations requires that all exports other than exports to Nepal and Bhutan, shall be �declared on the following forms:GR Form: It is required to be tilled in duplicate for all exports in physical form other than by post. �PPForm:Itisrequiredtobefilledinduplicateforallexportstoallcountriesmadebypostparcel,except �when made on “value payable” or “cash on delivery” basis.VPICODForm:It is required tobefilled inonecopyforexports toallcountriesbypostparcelunder �arrangements to realise proceeds through postal channels on “value payable” or “cash on delivery” basis.SOFTEX Form: It is required to be prepared in triplicate for export of computer software in non- physical �form.

All these documents serve the purpose of monitoring the realisation of sale amount by the exporter in the stipulated manner For goods that are subject to the Export Trade Control policy of the Government of India, documents in the formofapplicationhavebeenspecified.

On the basis of that, the concerned authorities will grant documents either an export licence or an export permit will be granted by the concerned authorities. Licence or permission is generally given on the customs document known as shipping bill. For obtaining export licence from the licensing authorities the application is either the A-X Form orB-XFormwhichissubmittedalongwiththeShippingBillandotherdocuments,ifany.Inmanycases,specificpermission may have to be obtained from particular government ministries departments, in which case exporter has to apply on his letter head.

For a number of products under the Export (Quality Control and Inspection) Act, 1962 and various other regulations, itisobligatoryforanexportertoobtainInspectionCertificatefromthenotifiedagencies.Forobtainingthiscertificate,the exporter has to apply in a document called intimation for inspection along with supporting documents (commercial invoice,technicalspecifications,etc.)toanExportInspectionAgency.Thereafter,acertificateofinspectionwillbeissued, which along with other documents will be submitted to the customs authorities before permission to ship goods is given.

Under the Indian Customs Act, goods cannot be loaded on board the carriers unless permission from the customs authorities has been obtained. This permission is accorded on a document prescribed by the customs authorities. When goods are sent by sea or by air, this document is known as Shipping Bill. When goods are exported by land or by railitiscalledApplicationforExport.Postparcelconsignmentrequirescustomdeclarationformtobefilledin.

There are four types of shipping bills. These are:Free shipping bill: Usually printed on white paper, it is used for export of goods which neither attract any export •duty or cess nor are entitled to the duty drawback (an export incentive).Dutiable shipping bill: Printed on yellow paper, it is used in case of goods which are subject to export duty •excess.Drawback shipping bill: It is usually printed on green paper and is used for export of goods entitled to duty •drawback.Shipping sill for shipment ex-bond: It is printed on yellow paper for use in case of imported goods for re-export •which are kept in the customs bounded warehouses.

Application for export is used for seeking customs permission of export goods to the neighbouring countries like Bangladesh by road, river or rail. This is of Three Types, namely, for export of “Free”, “Dutiable” and “Drawback” cargos. Customs declaration form for goods sent by post parcel is a standard form for all types of cargo. However, forclaimingdutydrawback,theexporterhasalsotofileanotherdocumentknownas“FormD”.

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PortauthoritiesinIndiahavespecifieddocumentsforbringingthecargointotheshedforshipmentaswellasforpayment of port charges. This document is called port - trust copy of shipping bill in Bombay dock challan in Calcutta and Export application in Madras and Cochin. Like the shipping bill, this document is prepared by the clearing and forwarding agent of the exporter.

Legal documents in importing countriesSome of the well-known documents needed in the importing countries because of the legal necessity are discussed below. These documents are, however, obtained by the exporter to be sent to the importer.

Consularinvoice:usuallyissuedonthespecifiedform,itissignedandstampedbythelocalconsulateofthe•country to which goods are exported.Customerinvoice:itisalsomadeoutonaspecifiedformprescribedbythecustomsauthorityoftheimporting•country. The details given in the document will enable the customs authority of the importing country to levy and charge import duty.Legalised/visaedinvoices:theseinvoicesconstituteaswornaffidavitbytheexporteraboutthegenuinenessand•correctness of the sale. These could be sworn before the appropriate consulate or the chamber of commerce, as the case may be, which will put their stamp on them.Certifiedinvoice:thisistheself-certifiedinvoicebytheexporterabouttheoriginofthegoods.•Certificate of origin: this certificate is issuedby independent bodies like the chamber ofCommerce on a•prescribed form.GSPcertificateoforigin:goodswhichgetthebenefitofpreferentialimportdutytreatmentcountrieswhich•implementtheGeneralisedSystemofPreferencesshouldbeaccompaniedbytheGSPCertificateofOrigin.Thiscertificateisgivenontheformsprescribedbytheimportingcountries.Health/veterinary/sanitarycertificates:thesecertificatesareneededinacoupleofcountries,certifyingthatthe•goodsarefitforhumanconsumption.

Documents for claiming incentivesFor providing a number of facilities and incentives to the export goods, a number of documents are required to be made out by the exporter. Some of the important facilities and incentives and the corresponding documents are discussed as follows:

Priority allotment of wagons: the railways in India allot wagons to export consignments moving to ports for •shipmentonaprioritybasis.Forthispurpose,theexporterhastofileforwardingnote(arailwaydocument),Wagon registration fee receipt and shipping order, which is issued by the shipping company on reservation of space on the ship. Rebate in central excise: main documents are invoice and ar4/ar5 forms. •Duty drawback: For claiming this incentive, the main document is the customs attested drawback copy of •shipping bill. This is usually to be supported by drawback payment order (format prescribed by the customs authorities),acopyofthefinalcommercialinvoiceandacopyofbilloflading/airwaybill.

2.6.3 Standardised Pre-Shipment Export DocumentAlthough documents are essential in export operations, much of the documentation is overlapping in nature. Forms of documents prescribed by different agencies/bodies differ in size and layout even though much of the information is common. Consequently, these documents are required to be prepared individually and separately. This method of preparation of documents caused delays in processing of documents by the concerned agencies bodies besides resulting in errors and discrepancies.


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Considering the problems caused by the non-standardised documentation, a number of countries have been following a system of documentation known as the “Aligned Documentation System. This system is based on the “UNLayoutKey”andisinuseinanumberofcountrieswhereexportershavebeenbenefitedbecauseofeconomy,speed, accuracy and convenience in documentation work. By adopting the similar system, Government of India has developed Standardised Preshipment Export Documents. With the help of this systems, as many as 17 of the 25 documents can be prepared from only 2 Master Documents.

In this method, the information is created on a set of standardised form printed on paper of the same size. This is done in such a way that items of identical information occupy the same position on each of them.

Commercial documents: As you know that these documents are required for effecting physical transfer of goods and their title from the exporter to the importer and the realisation of export sale proceeds. These documents can be divided into

Principal export documents are:Commercial invoice•Packing list•Bill of lading/Combined transport document•Certificateofinspection/Qualitycontrol•Insurancecertificateofpolicy•Certificateoforigin•Bill of exchange•Shipment advice•

Auxiliary export documents are:Proforma/Invoice•Intimation for inspection•Shipping instructions•Insurance declaration•Shipping order•Mate receipt•Applicationforcertificateoforigin•Letters to the bank for collection/negotiation of documents•

Out of above mentioned 16 documents, 14 documents have been standardised. Two documents, shipping order and bill of exchange have not been standardised. The standardised system involves the use of standardised trade documents, which are also aligned in relation to one another. The documents are prepared on the same size of paper, which have the requisite information in a standard format. Commercial documents are to be prepared as under:

Standard size of paper•Paper: A4•Size: Length - 297 mm•Width - 210 mm•Margins: Top - 10 mm•Left - 20 mm•Right - 6 mm•Bottom - 7 mm•

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Inside Measurements•Length - 280 mm•Width - 184 mm•

Tolerance limitsSincethesedocumentsarealignedtooneanother,aMasterDocumentisfirstpreparedcontainingtheinformationcommon to all documents. Thereafter, individual documents are prepared from the master documents with the help of a suitable marking and reproduction technique.

Regulatory documents: As you know that different Government department or organisations like central excise, customs, RBI, Export Inspection Council etc., require these documents. Following documents are required at pre-shipment stage.

Central excise:Invoice•AR4lAR5 Forms•

Customs:Shipping bill/Bill of export•Port Authorities (Port Trust)•Export Application/Dock challan1Port Trust copy of Shipping Bill•Receipt for payment of port charges•

RBI:GRIPP Form •

Others:FreightpaymentCertificate•Insurance premium•

Out of these 9 preshipment regulatory documents only 3 documents have been standardised. These three documents are:

Shipping Bill/Bill of Export•GR Form•Export Application/Dock Challan/Port Trust copy of Shipping Bill•including receipt for payment of port charges.•

Regulatory documents are to be prepared as under:Standard size of paper•Paper: Full scape size•Length - 34.5 CMS•Width - 21.5 crns•Margins:•TOP - 1.5 cms•Left - 1.8 crns•Right - 0.5 cms•Bottom - 1.5 crns•


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Inside Measurements•Length - 31.5 crns•Width - 19.2 crns•Tolerance limits•

2.6.4 Import DocumentsOther important documents include:

Importer Exporter Code (IEC) Number: No person can import goods without obtaining an Importer-Exporter •Code(IEC)Numberunlesshehasbeenspecificallyexempted,TheIECNumberisobtainedfromtheRegionalLicensing Authority. Bill of Entry: It is a document on which clearance of imported goods is effected. All goods discharged from a •vessel, from foreign or coastal ports are cleared on Bill of Entry in the prescribed form. The Bill of Entry form has been standardised by the Central Board of Excise and Customs.

Four copies of bill of entry are submitted. Original and duplicate for customer departments, triplicate is owner’s copy and the fourth copy is for the purpose of foreign exchange to be submitted to bank. There are three types of Bill of Entry as discussed below:

Bill of entry for home consumption (white in colour): where an importer wants to get his goods cleared in one •lot, he has to present the Bill of entry for home consumption.Bill of entry for warehousing (into bond, yellow in colour): Where an importer wants to shift goods to a warehouse •and thereafter gets his goods cleared in small lots, he has to present ‘into bond’ bill of entry. Reason may be that he is unable to pay duty leviable on all goods at one instance or may be because of storage problem. Ex-Bond Bill of Entry (Green in Colour): When an importer wants to remove goods from the warehouse, he •has to present an Ex-bond bill of entry which is green in colour.

Bill of Entry is not required in the following cases:passengers baggage•favour parcels•mail box and post parcels•boxes, kennels of cargos containing live animals or birds•unserviceable stores, for instance, dunnage wood, empty bottles, drums etc. of reasonable value•ship’s stores in small quantities for personal use•cargo by sailing vessels from customs ports when landed at open bundles only•

For imports through the medium of post there is no bill of entry. Instead, a way bill is prepared by the foreign post officeforassessmentofduty.

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SummaryThe onset of the era of liberalisation of the external sector of the economy and the industrial licensing followed by •partial convertibility of rupee and full convertibility on current account necessitated the need for further extensive amendments in the FERA which were brought about by the Foreign Exchange Regulations (Amendment) Act, 1993. FERA has been replaced by Foreign Exchange Management Act (FEMA), 1999.The consolidated and self-contained Customs Act, 1962 came into operation on December 13, 1962 repealing •the earlier three Acts known as Sea Customs Act, 1878. Land Customs Act, 1924 and the Aircraft Act, 1934, each one of which was related to a particular mode of transportation.For smooth operation of the Export (Quality Control and Inspection) Act, 1963, the Government of India •established the Export Inspection Council (EIC) on January 1, 1964, and the Export Inspection Agencies (EIAs).The new EXIM Policy 1997-2002 aims at consolidating the gains made so far, restructuring the schemes to •achieve further liberalisation and increased transparency in the changed trading environment. It focuses on the strengthening the domestic industrial growth and exports and enabling higher level of employment with due recognition of the key role played by the SSI sector.Commercial documents, also known as shipping documents, enable the exporter and the importer to discharge •theirobligationsunderanexportcontract.Inspecificterms,thesedocumentsensurethattheexportermakesshipment of the goods according to requirements of the contract and the importer makes payment for goods shipped in the manner as given in the contract.Commercial Invoice is a document of contents that describes details of goods sent by exporter. It is the statement of •account,whichmustcontainidentificationmarksandnumbers,descriptionofgoodsandquantityofgoods.

ReferencesNewagepublishers.com. • Export Import Trade – Introduction to Regulatory Framework [PDF] Available at: <http://www.newagepublishers.com/samplechapter/001264.pdf>.[Accessed17October2011].Egyankosh.com. • Export-Import Framework [PDF]Available at: <http://www.egyankosh.ac.in/bitstream/123456789/8883/1/unit-1%28complate%29.pdf>.[Accessed17October2011].Cherunilam, Francis, 2010. • International Trade and Export Management, Himalaya Publishing House.Expert2go, 2009. • Import Export Training Course [Video Online] Available at: <http://www.youtube.com/watch?v=1MUAZ40QSc4&feature=related>.[Accessed17October2011].Informedtrades, 2010. • Understanding Currency Pricing - Forex Basics[VideoOnline]<http://www.youtube.com/watch?v=hCqzMwTaP48&feature=related>.[Accessed17October2011].Rama Gopal, C., 2007. • Export Import Procedures – Documentation and Logistics, New Age International.

Recommended ReadingSeyoum, B. 2008. • Export-Import Theory, Practices, and Procedures, 2nd ed., Taylor and Francis.Mattoo, A. and Stern, R. M., 2003. • India and the WTO, World Bank Publication.Deresky, 2006. • International Management: Managing Across Borders And Cultures, 5th ed., Pearson Education India.


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Self AssessmentUnder __________, the consignee can identify himself with the postal authorities at the destination and obtain 1. delivery of the goods.

Post parcel receipta. Airway billb. Bill of lading c. Commercial invoiced.

_____________ , also known as shipping documents, enable the exporter and the importer to discharge their 2. obligations under an export contract.

Commercial documentsa. Bill of ladingb. Airway billc. Commercial Invoiced.

Only ____ of the 16 principal export documents have been standardised.3. 10a. 11b. 13c. 14d.

________________ are among the group of units that may import all types of goods without payment of 4. duty.

Small scale industrya. Large scale industryb. Electronics Hardware Technology Parks (EHTPs)c. Softwarefirmsd.

_________________ is a receipt issued by the shipping company on its agents.5. Bill of ladinga. Bill of receiptb. Airway billc. Commercial invoiced.

________________ covers several modes of transport for performing the complete journey from the exporting 6. country to the importer’s warehouse.

Combined bill of ladinga. Charter party bill of ladingb. Clean bill of ladingc. Claused bill of ladingd.

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Match the following:7. On Board Shipped Bill of 1. Lading Goods have been received on board the ship.A.

Through Bill of Lading2. CoversgoodsbeingtranshippedenroutebutwherethefirstB. carrier has the responsibility as the principal carrier for all stages of the journey.

Trans-shipment B/L3. ThefirstcarrieractsonlyasanagentforeffectingTrans-ship-C. ment of cargo.

Received for Shipment Bill of 4. Lading

It is issued by the shipping company when goods have been D. given into the custody of the shipping company but have not yet been placed on board the ship.

1-D, 2-C, 4-A, 5-Ba. 1-A, 2-B, 3-C, 4-Db. 1-D, 2-C, 3-B, 4-Ac. 1-B, 2-A, 3-C, 4-Dd.

Which statement is true?8. A bill of lading is a document of title.a. An airway bill is a document of title.b. A post parcel receipt is a document of title.c. A commercial invoice is a document of title. d.

What does the acronym AWB stand for?9. Airway billa. Action withheld billb. Act wisely billc. After way billd.

____________________ enables the banks to pay money to the exporter against surrender of shipping documents, 10. including BIL, even before the goods reach the destination.

Transferabilitya. Migrationb. Motilityc. Distributiond.


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Chapter III

International Financial Management

Aim


explaininternationalfinance,currency,creditworthinessandmethodsofpayment•

elucidateinternationalfinancialmanagement•

comparedomesticandinternationalfinancialmanagement•

Objective


differentiate between the gold standard and the Bretton Woods exchange rate•

explain theories of exchange rate behaviour•

elucidate differences between domestic and international markets•

Learning outcome


identifymanagementofinternationalshorttermfinancing•

understand the process of short term loans for money market•

understan• d international debt instruments

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3.1 Introduction To International Financial ManagementInternational Financial Management has assumed an important role of the Indian economy, with FDI’s, FFI’s and FII’s playing a key role in the stock and capital markets. The recent estimate is that FIIs hold about 18% of market capitalisation of the listed companies, in the Stock Exchanges in India. Many Indian corporate are listed and traded on Foreign Stock Exchanges. Many foreign banks were permitted to operate in India and Indian banks have become more globalised in their operations. Indian exports are growing at a rate of 12%, as per annum as envisaged in the tenth plan. Nearly more than 50% of the manufacturing output in India is exported on an average. The total of exports and imports trade crossed U.S. $ 140 billion and its foreign exchange assets are also more than U.S. $ 130 billion. With such growing importance of global sector, the operations in International Finance are also growing faster than ever before.

World Trade estimated to grow in 2004 at a rate of 6% and that of the developing countries at 8%. The scope of expansion for International Financial Management has increased. India has a major role to play in the world trade andfinance.NetcapitalflowsintoEmergingMarketeconomiesonnon-officialbasiswereestimatedatU.S$113billion in 2004 and into India U.S $ 13 billion. India has emerged as a Creditor Country among the IMF of members. World Bank is reported to be planning to issue rupee bonds in India to raise rupee resources. Indian rupee has shown strength and resilience that it was in demand in International Finance Markets. Many big companies in India have become international market participants and are rated as domestic MNCs in addition to many MNCs of foreign origin in India.

Threemajordimensionssetinternationalfinanceapartfromdomesticfinance.Theyare:Foreign exchange and political risks.•Market imperfections.•Expanded opportunity set.•

Themajordimensionsofinternationalfinancelargelystemfromthefactthatsovereignnationshavetherightandpower to issue currencies, formulate their own economic policies, impose taxes, and regulate movements of people, goods, and capital across their borders.

3.1.1 International FinanceMost of us know that domestic business agreements are concerned with the basic issues like price, quantity and delivery date. But, international business agreements are concerned with other issues, in addition to the issues involved in domestic trade. These issues include:

Currency to be used in the international business transactions.•Creditworthiness of the importer. •Acceptable methods of payment. •Arrangingfinance.•

Currency to be usedSelecting currency to be used for settling the international business transactions is an important issue in international finance.Theexporterpreferstohavehishomecurrencyorhardcurrencywhiletheimporterpreferstopayinhishome currency. If the currency of the importing country is weak, the exporter prefers the payment in hard currencies like US dollars, UK pound, Japanese Yen and French Francs. The exports of most of the developing countries are invoiced in US dollar. Some companies prefer to settle their transactions in US dollar or other hard currencies. As such the hard currencies are the choice of the exporter for settling the transactions in international business. Hence, the importers and countries struggle to earn hard currencies in order to meet their import, bills. Next, the exporter is interested to know the importer’s creditworthiness.


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Creditworthiness of the importerTheexporternormallyfirstarrangesfortheshipmentofthegoodsandreceivesthemoneyatalaterstage.Therewould be an amount of risk involved in the payment of money by the importer. Hence, the exporter either should have a satisfactory business relations with the importer or the exporter may ask the importer to send his credit ratingdonebyaninternationallyreputedfirm.Export-ImportBankoftheUSA,Export-ImportBankofIndiaandsuchotherorganisationsprovidecreditratinginformationtotheexportersbycollectingafee.Theexportingfirmswhich do not demand for credit rating face serious problems. For example, one small US manufacturer exported fan blades worth of US $ 127,000 to a new customer in Africa and failed to get the payment even by handing over the account to a collection agency. After evaluating the creditworthiness of the importer, the exporter and importer should come to an understanding regarding the method of payment.

Methods of paymentBoth the exporter and importer should agree on a particular type of payment, after assessing the importer’s creditworthiness. The methods of payment include:

Payment in advanceMost of the exporters prefer the advance payment prior to shipment as it involves no risk. This method is most undesirable from the point of view of the importer due to the involvement of heavy risk in getting the delivery of the goods as per the order.

Open accountUnderopenaccounttheimporterfirstreceivesthegoodsandthenarrangesforthepayment.Hence,itisthesafestform of payment from the point of view of the importer. This form is undesirable and risky from the viewpoint of theexporter.Thismethodismoresuitablewhentheimporter’screditworthinessiscertifiedbyanauthorisedagencyor when the exporter has well-established long-term relation with the importer.

Documentary collectionInternationalfinancialinstitutionsandbankshavedevelopedanumberoffinancialinstrumentsduetotherisksandproblemsinvolvedinadvancepaymentandopenaccount.Oneoftheimportantfinancialinstrumentsisdocumentarycollection.

Under this method the commercial banks facilitate the payment process. The exporter draws up a document called abillofexchange,inwhichpaymentisdemandedfromtheimporterataspecifiedfuturedate.Therearetwotypesof bills of exchange, viz., (a) (b) (a) Sight Bill of Exchange Time Bill of Exchange Sight Bill of Exchange requires payment immediately after the transfer of title of the goods to the importer by the exporter. The importer’s bank after receiving the bill of lading and sight bill of exchange from the exporter’s bank, asks the importer to arrange for the payment. The bank gives the bill of lading to the importer after the payment is made by the importer. Figure below presents the transactions using a sight bill of exchange.

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1Exporter ships goods

EXPORTER IMPORTER(Title not transferred until step 6)

2Exporter submits

draft (bill of exchange),packing list, and

bill of lading

3Exporter'a bank

transfers documentsto importer's bank

4Importer's bank

notifiesimporterthatthe documents have been received

5Payment

7Payment

8Payment

6Importer's bank

releases bill of lading,transferring title ofgooods to importer

EXPORTER'S BANK IMPORTER'S BANK

Fig. 3.1 Transactions using a sight bill of exchange

Time Bill of Exchange requires the importer to arrange for the payment after some time (60 days or 90 days) receiving the possession of goods. The importer writes, “Accepted” on the bill of exchange offer after obtaining the bill of lading (i.e., after obtaining the title of goods). This document is called ‘Trade Acceptance.’ Trade acceptance is legally enforceable by the law of the most of the countries. This is a negotiable debt instrument. . The importer may not keep up his promise and fail to pay to the exporter, under the documentary collection. Thus there is the involvement of risk in this method of payment also. As such the banks developed another method of payment, i.e., Letters of Credit.

Letters of creditThis instrument is carried out to avoid the risk involved in other methods of payment. A letter of credit is an instrument issued by a bank wherein the bank promises the exporter to pay upon receiving the proof that the exporter completed allthenecessaryformalitiesspecifiedinthedocument.Thisguaranteestheexporterregardingpaymentandhence,the payment is free from risk. The importer bank does this work by collecting a fee from the importer and also after obtaining a security to this effect. Figure below presents the transactions using a letter of credit.


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1Salescontractspecifies

payment usingletter of credit

2Importer applies

to a local bank forletter of credit

9Amount due ispaid for (bank

may extend credit)10

Importer's banktransmits fundsdue to exporter

11Exporterreceivespayment

4Exporter's bankadviseorconfirms

letter of credit

5Exporter ships goods

6Exporter sends

documents to his bank

7Documents sent

for review

8Bank sends documents

to importer

3Importer's bank

informs exporter's bankwhen letter of credit

has been issued.

EXPORTEREXPORTER'S BANK

IMPORTERIMPORTER'S BANK

Fig. 3.2 Transactions using letter of credit

However, this instrument is costly for the importer. Hence, another instrument, i.e., credit card is being developed.

Credit cardsCredit cards are used for small international business transactions by the market intermediaries like retailers and also by the customers. Various credit cards include: American Express, Visa and Master Card. The next method of payment is counter-trade.

CountertradeCounter-trade is an arrangement to pay for import of goods and services with something other than cash. Thus, counter-trade is goods-for-goods deal. Types of counter-trade include: barter, counter purchase, compensation trade, and switch trading, offsets and clearing agreements.

Method Timing of Payment

Timing of Delivery of Goods

Risk(s) for Exporter

Risk(s) for

Importer

Availability of

Financing for

Exporter

Condition(s) Favouring Use

Payment in advance

Prior to delivery of goods

After payment, when goods arrive in importer’s country

None

Exporter may fail to deliver goods

n/a

Exporter has strong bargaining power;importerunknown to exporter

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Open account

According to credit terms offered by exporter

When goods arrive in importer’s country

Importer may fail to pay None

Yes, y factoring of exporter accounts and account receivable

Exporter has complete trust in importer, importer is part of the same corporate family

Documentary collection

At delivery if sight draft isused;atspecifiedlatertime if time draft is used

Upon payment if sight draft is used;uponacceptance if time draft is used

Importer may default or fail to accept draft

None

Yes, by discovering draft from its face value

Exporter trusts importer to pay asspecified;when risk if default is low

Letter of credit

After terms of letter of credit arefulfilled

According to terms of sales contract and letter of credit

Issuing bank maydefault;documentation is wrong

Exporter may honour terms of letter of credit but not terms of sales contract

Yes, by discounting letter from its face value

Exporter lacks knowledge of importer;hasgood credit with local bank

Credit card

According to normal credit card company procedures


None

Exporter fails to deliver goods

N/A Transaction size is small

Counter trade

When exporter sells countertrade goods


Exporter may not be able to sell counter traded goods

None No

Importer lacks convertible currency;importer or exporter wants access to foreign distribution network

Table 3.1 Payment methods for international trade

3.1.2 International Flow of FundsWe have seen that national economy of a country is composed of a number of sectors, including the foreign sector and the interdependence of these sectors either as suppliers of savings or of factors of production, or of other inputs intheproductiveprocessorasconsumersoftheiroutputleadstoeconomic,commercialandfinancialtransactionsas between these sectors. It is such transactions between the domestic sectors and foreign sector that gives rise to theinternationalfinancialsystem.

An extension of this principle of mutual interdependence to the case of national economy of one country depending uponthatofotherslendsfurthersupporttoourthesisthatemergenceofinternationalfinancialmarketsistheresultofsuchinterdependenceandintraflowoffunds.


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Thusnomodernnation/stateisself-sufficientnorisitclosedtoexternalforcesfromothernationsandstates.Thisdependence is the result of the expanding civilisation and modern socio-economic systems. It is now well recognised thatcountriesareinterdependentinvariousdegreesresultingineconomiccommercialandfinancialtransactionsamong them.

Such interdependence is anecessarybutnot a sufficient condition for theemergenceof internationalfinancialmarkets. But the conquering of the distance and time by revolution in Telecommunications, electronic media and informationTechnologyhasbrought theworld togetherand led toasufficientcondition foremergenceofInternational Financial Management, as an area of vital importance. The interdependence of nations can be ascribed to the following factors:

Differential factor endowments and natural endowments in different countries, leading to different production •functions. Different stages of growth economies of these countries, •Differences in demand functions habits, of industry, agriculture and other sectors in the different levels of •savings and investment. Differentials in technological advancement, R&D, and economies of scale tastes and consumer preferences, •leading to different demand functions.Differencesinstandardsoflivingandincomes,leadingtoflowoffundsthroughgrants,loans,etc.•

3.1.3 Goals for International Financial ManagementThe foregoing discussion implies understanding and managing foreign exchange and political risks and coping withmarket imperfectionshavebecome importantpartsof thefinancialmanager’s job. InternationalFinancialManagementisdesignedtoprovidetoday’sfinancialmanagerswithanunderstandingofthefundamentalconceptsand the tools necessary to be effective global managers. Throughout, the text emphasises how to deal with exchange risk and market imperfections, using the various instruments and tools that are available, while at the same time maximisingthebenefitsfromanexpandedglobalopportunityset.

Effectivefinancialmanagement,however,ismorethantheapplicationofthenewestbusinesstechniquesor•operatingmoreefficiently.Theremustbeanunderlyinggoal.Shareholderwealthmaximisationmeansthatthefirmmakesallbusinessdecisionsandinvestmentswithaneyetowardmakingtheownersofthefirm—theshareholders—betterofffinancially,ormorewealthy,thantheywerebefore.\Whereasshareholderwealthmaximisationisgenerallyacceptedastheultimategoaloffinancialmanagementin•“Anglo-Saxon” countries, such as Australia, Canada, the United Kingdom, and especially the United States, it is not as widely embraced a goal in other parts of the world. In countries like France and Germany, for example, shareholdersaregenerallyviewedasoneofthe“stakeholders”ofthefirm,othersbeingemployees,customers,suppliers, banks, and so forth. Europeanmanagers tend to consider thepromotionof thefirm’s stakeholders’overallwelfare as themost•important corporate goal. In Japan, on the other hand, many companies form a small number of interlocking business groups called keiretsu, such as Mitsubishi, Mitsui, and Sumitomo, which arose from consolidation of family-owned business empires. Japanese managers tend to regard the prosperity and growth of their keiretsu asthecriticalgoal;forinstance,theytendtostrivetomaximisemarketshare,ratherthanshareholderwealth.It is pointed out, however, that as capital markets are becoming more liberalised and internationally integrated •in recent years, even managers in France, Germany, Japan and other non-Anglo-Saxon countries are beginning to pay serious attention to shareholder wealth maximisation. In Germany, for example, companies are now allowedtorepurchasestocks,ifnecessary,forthebenefitofshareholders.In accepting an unprecedented $183 billion takeover offer by Vodafone AirTouch, a leading British wireless phone •company, Klaus Esser, CEO of Mannesmann of Germany cited shareholder interests: “The shareholders clearly think that this company, Mannesmann, a great company, would be better together with Vodafone AirTouch." Thefinaldecisionbelongstoshareholders.

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Obviously,thefirmcouldpursueothergoals.Thisdoesnotmean,however,thatthegoalofshareholderwealth•maximisationismerelyanalternative,orthatthefirmshouldenterintoadebateastoitsappropriatefundamentalgoal.Ifthefirmseekstomaximiseshareholderwealth,itwillmostlikelysimultaneouslybeaccomplishingother legitimate goals that are perceived as worthwhile. Shareholderwealthmaximisationisalong-rungoal.Afirmcannotstayinbusinesstomaximiseshareholder•wealth if it treats employees poorly, produces shoddy merchandise, wastes raw materials and natural resources, operatesinefficiently,orfailstosatisfycustomers.Onlyawell-managedbusinessfirmthatprofitablyproduceswhatisdemandedinanefficientmannercanexpecttostayinbusinessinthelongrunandtherebyprovideemployment opportunities.While managers are hired to run the company for the interests of shareholders, there is no guarantee that they •will actually do so. As shown by a series of recent corporate scandals at companies like Enron, WorldCom, and Global Crossing, managers may pursue their own private interests at the expense of shareholders when they are not closely monitored. Extensive corporate malfeasance and accounting manipulations at these companies eventually drove them •intofinancialdistressandbankruptcy,devastatingshareholdersandemployeesalike.Lamentably,someseniormanagers enriched themselves enormously in the process. Clearly, the boards of directors, the ultimate guardians of the interests of shareholders, failed to perform their •duties at these companies. In the wake of these corporate calamities that have undermined the credibility of the freemarketsystem,thesocietyhaspainfullylearnedtheimportanceofcorporategovernance,thatis,thefinancialand legal framework for regulating the relationship between a company’s management and its shareholders. Needlesstosay,thecorporategovernanceproblemisnotconfinedtotheUnitedStates.In fact, it can be a much more serious problem in many other parts of the world, especially emerging and •transition economies, such as Indonesia, Korea, China, and Russia, where legal protection of shareholders is weak or virtually nonexistent.Shareholdersaretheownersofthebusiness;itistheircapitalthatisatrisk.Itisonlyequitablethattheyreceive•afairreturnontheirinvestment.Privatecapitalmaynothavebeenforthcomingforthebusinessfirmifithadintended to accomplish any other objective. The massive privatisation that is currently taking place in developing and formerly socialist countries, which •will eventually enhance the standard of living of these countries’ citizens, depends on private investment. It is thus vitally important to strengthen corporate governance so that shareholders receive fair returns on their investments. In what follows, we are going to discuss in detail: the globalisation of the world economy, the growing role of MNCs in the world economy, and the organisation of the text.

3.1.4 Nature of International Financial ManagementInternationalfinancialmanagementreferstothefinancialfunctionofanoverseasbusiness.Specifically,thefinancefunction of an international business deals with:

Investmentdecisions–decisionsaboutwhatactivitiestofinance.•Financingdecisions-decisionsabouthowtofinancetheseactivities.•Money management decisions – decisions about how to manage the firm’s financial resources most •efficiently.

Thediscussionsinthischaptercentresonthethreebroaddecisionsofinternationalfinancialmanagement.Beforedescribingthethreevitaldecisions,itisusefultodrawcomparisonsbetweendomesticfinancialmanagementandinternationalfinancialmanagement.Similarly,abriefexplanationabouttheenvironmentofinternationalfinancialmanagement is also in order.


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3.1.5 Comparison between Domestic and International Financial ManagementTherearesimilaritiesbetweendomesticfinancialmanagementandfinancialmanagementofaninternationalbusiness.Objectivesoffinancialmanagement,thatis,profitmaximisationandwealthmaximisationarethesamewhetherthefirmservesonlythedomesticmarketordoesitsbusinessinoverseasmarkets.Themajordecisionsafinancemanager needs to make remain the same notwithstanding whether the business is domestic or international. The keydecisionsoffinancialmanagementare:investment,financing,andassetmanagement.Theinvestmentdecisionrefers tothedeterminationof thetotalamountofassetsneededtobeheldbyafirm.Determinationofsourcesoffundstoacquiretheassetsreferstothefinancingdecisions.Thethirdimportantdecisionofthefirmisassetmanagementdecision.Onceassetshavebeenacquiredandappropriatefinancingprovided,theseassetsmustsbemanagedefficiently.Thefinancialmanagerofadomesticbusinessoraninternationalbusinessisrequiredtomakeall the three decisions judiciously.

Therearedissimilarities,however,betweendomesticfinancialmanagementandinternationalfinancialmanagement.The motivation to invest funds in a foreign operation, for example, is to provide a return in excess of what is normally expected. There may be gaps in foreign markets where excess return can be earned.

International Financial Management requires an understanding of certain unique risks that are not normally a threat to domestic operations. These unique risks are related to foreign exchange risks and political risks. Foreign exchange risks can raise the cost of capital and lower the optimal debt ratios for international business.

International portfolio investors require a foreign exchange risk premium when valuing the equity and debt of MNC’s,especiallyifthosefirmshaveinvestedheavilyincountrieswithvolatilecurrencies.Contemporaryfinancialanalysis incorporates a political risk premium when foreign activities are being evaluated. Banks and investors require a higher rate of return on loans to, and bonds issued by foreign sovereign entities or corporations when they are residents in relatively unstable countries or even in emergent market countries.

3.2 International Financial EnvironmentAny corporate business unit faces global environment in various forms, particularly if it is an export industry, import dependent industry and import competing industry. Also, units in joint ventures, subsidiaries of foreign companies, and partly or wholly owned foreign companies face the global environment. The major global environmental factors are shown in this chart.

Economic and Financial Factors

Political and Government Policies

Socio-Cultural Factors

Demographic Factors

Natural Environment

Technological Factors

International Environment

Fig. 3.3 Major global environmental factors

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Internationalfinancialenvironmentinfluencesthesize,patternanddirectionofinternationalbusiness.Initially,theexchange rates were determined on the basis of the value of metal contained in the coins of the two countries. This system was referred to as the commodity specie standard. This system was followed by gold standard.

3.2.1 Gold StandardGold standard experienced a key day between 1870s and 1914, which was suspended during the Great War. However, itwasreadopted,butwasfinallyabandonedby1930s.GoldstandardwasinitiallyadoptedbyBritain.Later,Germany,Japan, the USA and other countries also adopted gold standard. The US Gold Standard Act of 1900 institutionalised thedollar-goldlink.CentralBankwasmaintainingofficialparitybetweenitscurrencyandgoldandassuchneededan adequate stock of gold reserves.

Policy makers viewed external balance not in terms of a current account target but as a situation in which central bank was neither gaining gold from abroad nor losing gold to foreigners at too rapid a rate. Bank notes were exchanged forgoldondemand.Thepriceofgoldwasofficiallysetatwhichitwasboughtandsold.Thegoldexchangestandardwas liberal as the currency was convertible into gold only through a currency being on gold specie standard. Rouble of Russia was convertible into British Pound and British Pound was convertible into gold. Gold standard allowed free flowofgoldamongcountriesandforautomaticadjustmentinexchangeratesandinbalanceofpayments.Deficitinthebalanceoftradeledtotheoutflowofgold.Thefixedsupplyofgoldledtothedemiseofgoldstandard.

3.2.2 The Bretton Woods System of Exchange RateThe collapse of gold standard led to the Conference in July 1944 and the establishment of International Monetary Fund in 1945 and evolution of a new system of exchange rates, which is known as the Bretton Woods System of ExchangeRates.BrettonWoodsSystemofexchangeratiorepresentedafixedparitysystemwithadjustablepegs.

Underthissystem,eachcountrywastofixtheparvalueofitscurrencyintermsofgoldorUSdollar.Monetaryauthoritieswereallowedtomakeadjustmentstotheextentof±1.0ofthefixedparvalue.Thoughthissystemcouldbring about stability in the exchange rate, it could not sustain for a long time conduct of the Bretton Woods Exchange Rate Regime since 1973 The committee appointed by the IMF suggested four options, in the wake of collapse of the Bretton Woods System of Exchange Rates. These suggestions were accepted by the IMF and incorporated into the text of the Second Amendment to the Articles of Agreement. These suggestions include:

FloatingRateSystem:Marketingforcesdeterminetheexchangerateofcurrenciesunderfloatingratesystem.•Pegging of Currency: Under this system, a developing country pegs its currency either to a strong currency or •toacurrencyofacountrywithwhichithasalargeshareoftrade.Peggingsystemprovidesforfixedexchangeratebetweenthetwocurrencies.However,theexchangeratesfloatwithrespecttotheothercurrencies.CrawlingPeg:Crawlingpegisahybridoffixedrateandfloatingrate.Theexchangerateofacurrencywith•whichitispeggedisstableintheshortrun,butitchangesgraduallyoveraperiodoftimeinordertoreflectthechangesinthemarket.Thissystemhastheadvantagesofstabilityandflexibility.Target-Zone:Arrangement:Underthissystemtheexchangeratesarefixedwithrespecttothecurrenciesofthe•countriesofaparticularzoneandtheexchangeratesfloatwithrespecttothecountriesoutsidethezone.Forexample, Eastern Caribbean Currency Union, Central African Economic and Monetary Community and Western African Economic and Monetary Union.

3.2.3 Theories of Exchange Rate BehaviourTheoriesofExchangeRatebehaviourareclassifiedasfollows:

Monetary approach •Behaviour: Balance of Payments Approach The theories •

Monetaryapproachofflexible-priceversionofexchangerate �Monetary approach of sticky-price version �

Portfolio balance approach•Balance of payments approach•


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ThistheoryisproposedbyAllenandKennen.Accordingtothistheory,in-flowofforeignexchangetakesplaceunder the following two situations : (ii) through export of goods and services when the price level in the domestic country is lower compared to that in foreign countries through foreign investment when the interest rates in the domesticcountryarehigherthanthatinforeigncountries.Theincreaseinin-flowofforeignexchangeandforeigncapital enhances the value of domestic currency against the foreign currencies. The opposite situations reduce the value of domestic currency against foreign currencies. According to this theory, the value of domestic currencies increasesconsequentuponincreaseinexportscapitalandvice-versacurrencyagainstforeignandin-flowofforeigncapital and vice versa.

Monetary approachFrenkelproposedthistheory.Accordingtothisapproach,theexchangeratebetweentwocurrenciesisfixedonthe basis of demand and supply of money in the two countries. Thus, the demand for and supply of money in two countries determines the exchange rate of the currencies of these two countries. Demand for money is positively related to prices and output and is negatively related to interest rate. Increase in supply of money results in rising of domestic prices which in turn reduce the value of domestic currency. Higher growth rate of money supply than that of real output results in decline of domestic prices and increase in the value of domestic currency and vice-versa.

Portfolio balance approachThistheoryemphasisesthattheexchangerateisdeterminedbasedonnotonlyinflowandoutflowofforeignexchange,butalsotheholdingoffinancialassetslikedomesticandforeignbonds.Accordingthisapproach,theexchangerate is determined on the basis of the interaction of real income, interest rates, risk, price level and wealth. The investormodifiestheportfoliobasedonthechangeinanyoftheseratesorvariables.Thisrebuildingofportfolioinfluencesthedemandforforeignassetsandtherebytheexchangerate.Demandforforeigncurrencyreducesthevalue of domestic currency and vice-versa. Further, the change in the exchange rate brings corresponding change intheportfolio.Thus,thechangesportfoliostructureinfluencestheexchangerateandthechangesexchangerateinfluencetheportfolio.Thenaturalinfluencescontinueuntilequilibriumisreachedbetweenthesefactors.

3.2.4 Global Capital StructureCapital is the basic resource for any kind of business either domestic or international.

Capital is of two kinds, viz., equity and debt. Capital provided by the owners is called equity capital. Capital •secured in the form of loans from banks and other institutions is called debt capital. Debt capital must be repaid with certain agreed rate of interest over certain agreed period. The company has no obligation to repay the equity capital or any return. However, the companies pay dividend to the equity shareholders, whenever, they have surplus or distributable •profits.However, equity shareholders enjoy higher returns,whenever the companies enjoy higher rate ofprofitability.Therefore,thecompaniespreferhighproportionofequitycapitalandlowproportionofdebtcapitalduringtheearlydaysofinceptionaswellasduringtheperiodsoflowprofitabilityastheyhavelesscommitmentof interest payment on debt capital. In contrast, the companies prefer high proportion of debt capital and low proportion of equity capital in order •toincreasetheprofitsharetotheequityshareholdersandmaximisetheequityshareholders’worth.Trade-offs.between equity and debt plays a vital role in maximising the equity shareholder’s worth and also reducing thecompany’scommitmentsofinterestpayment.Thesizeofthefirm,spreadofitsoperations,stageinfirm’slife cycle and the strategies it employs determine the proportion of equity capital and debt capital in the total capital. The companies should carefully determine the level of equity capital and debt capital as and when they expand, •diversifyandintegratetheoperationsandactivities.Theycanalso‘makeuseofaccumulatedprofitsandgeneratedreservesbasedonearlierperiodprofitstomeettheincreaseddemandforcapital.Internationalbusinessfirmsdeterminetheproportionbetweenequitycapitalanddebtcapitalbasedondebt-•equitystructureofpartnercompaniesordebt-equitystructureofthecompetitivefirmsinthehostcountry.Theforeign subsidiaries normally prefer higher proportion of debt capital as parent companies view equity capital in a foreign country would be at risk.

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However,financingtheforeignsubsidiarythroughdebtcapitalwouldbeatriskasitinvolvesdebtservicing•thoseresultsincashoutflowinfixedschedulestothelenders.Theparentcompanywouldfaceaproblemofstrictcontrolsofrepatriationinsomecountries,ifitfinancesthesubsidiariesbymeansofhighproportionofequitycapitalduringtheperiodsofheavyprofits.The option of high proportion of debt capital has certain limitations. Normally, the debt market is less developed •in most of the developing countries. The debt market in ‘ most of the small countries cannot afford to meet the debt capital requirements of the subsidiaries of MNCs in their countries. The third country debt market may not be interested in providing the debt capital in view of the risks involved •in it. Therefore, the parent company is forced to provide debt capital also either from its own sources or from its guaranteedsources.ThelargerMNCs,havetheirfinancialsubsidiariestomeettheirandtheirsubsidiariescapitalneeds of both equity capital and debt capital. However, the development of money market and capital markets in most of the countries reduces the hindrances for acquiring debt capital in host countries themselves.

Global cash flow managementWorking capitalmanagement dealswith short-termfinancing.Cashflows inmultiple directions in case of amultinationalcompany.MNC’shavetoplan,organiseandmonitorthecashinflowandcashoutflowinordertomaintainproperliquidity.Operatingcashflowsincludedirectandindirectcashflows.

Directcashflowsincludeinflowsandoutflows.Operatingcashflowsarenecessaryforday-to-daybusiness•activities in order to pay for acquiring raw material and other kinds of inputs (accounts payable) including remuneration for employees.Operating cash inflows include the revenue received from sales (accountsreceivable).Theindirectcashinflowsincludelicensefeeandroyaltiesreceivedandoutflowsincludelicensefeeandroyalties•paid.Inadditiontooperatingcashflows,therearefinancingcashinflows.Financingcashinflowsareessentialtoservice the existing funding sources, servicing debt, payment of dividends to the equity shareholders. Operating cashflowsofanMNCaremulti-directional.For example, a Japanese MNC receives cash from its accounts receivables of the USA and pays cash to its •accountspayableinSouthKoreaandfinancesitsIndiansubsidiary.TheIndiansubsidiaryinitsturnpayscashto its accounts payable in the UK and receives cash from its accounts receivables in Malaysia. MNCs sell either thefinishedproductorsemi-finishedproducttotheirsubsidiaries.Similarly,subsidiariesalsoselleitherfinishedorsemi-finishedproductstotheirparentcompanies.Theprice•at which these goods/services are sold either to MNC or subsidiaries is called ‘transfer price’. Normally the transferpriceisequaltoopenmarketpricing.But,itwouldbedifficulttocomparethetransferpricewithopenmarket price as open market price may not be available as MNCs and subsidiaries may transfer such products which are not traded in open market. The transfer price may favour either the parent company or subsidiary or both. But, such price affects the taxes in either of the countries or both the countries. Therefore, the governments may not agree with the transfer prices. In addition, the MNCs and subsidiary need •to pay license fee and royalties to either of them or to a third party. The license fee and royalties are calculated as a percentage of sales in the host country. Similarly, there are common overhead expenses and management expenses that are to be shared between the parent company and subsidiaries. The parent companies provide equity capital as well as debt capital to the subsidiaries. Then subsidiaries have •to pay interest to parent company regularly and dividend as and when they declare dividends. Parent companies provide additional equity capital and or debt capital to subsidiaries as and when the latter needs additional capital. Thus,thereisastrongneedforflowofcashfromparentcompanytosubsidiariesandviceversa.

3.3 International Financial MarketsInternationalfinancialmarketsandoperationscompriseexchangedeals,i.e.,buying/sellingcurrencies;bankingtransactions,i.e.,deposittakingandlending;andcapitalmarketoperations,i.e.,issuanceofsecurities.However,marketsegmentsareclassifiedaccordingtothenatureoffinancialoperations,theyare:


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Money markets or exchange markets: Exchange or exchange related transactions•Credit markets: Deposit taking and lending•Capital markets: Issuance of securities•Equity markets: Issuance of international equities. •

Commercialbanksareengagedinforeignexchangebusinessandtheyhandlefundflow(eitherinwardoroutward)emanating on account of trade between countries, payments for services rendered or servicing of capital market offerings. Such banks are called upon to accept deposits denominated in foreign currencies and deploy them for financingvariouscorporate,industrialortradeactivities.

The Euro markets are also closely tied to the foreign exchange markets. But the two markets are quite distinct in functions (almost all Euro banks deal with foreign currency). It has become traditional for borrowers to issue securities – bonds or Euro notes. For organising such business various merchant banking institutions have come to the fore. Such banks are referred to as Investment Banks, Merchant Banks or Securities Houses.

Whilethechoiceofraisingfinancethroughavarietyofinstrumentsislarge,comprisingofloans,Euronotesandbonds, all markets may not be accessible to all borrowers.

3.3.1 National Markets as International Financial CentresEachCountryhasitsmoneyandcapitalmarkets.Quitesimilartotheirdomesticcounterpart,internationalfinancialmarkets may be divided into money and capital markets.

Money markets deal with assets created or traded with relatively short maturity, say less than one year. Capital •marketsdealwithinstrumentswhosematurityexceedsoneyear(orwhichlackdefinitematurity).Animportantchannelthroughwhichmoneymarketflowsareinfluencedistheforeignexchangemarket.Inflows•from abroad into a small country can swamp the domestic money market with excess liquidity. During the 1970’s, for example, foreign demand for Swiss francs was very strong because of the weakness of the US dollar. The flowofmoneyintoSwissfrancspushedtheEuro-Swissfrancdepositmarketintonegativeinterestrates.Subsequently, the Swiss government imposed a 10% per quarter term commission tax. so that foreigners were •receiving minus 40% p.a. on Swiss franc deposits. Yet, because the Swiss franc appreciated by 50% during the year such an operation was still worthwhile. Ontheotherhand,ifacurrencyisseentobeunderpressure,fundswillflowoutofthatcurrencyintoothersthat•are perceived to be stronger. The authorities will often then raise interest rates to defend the currency. A classic example was the ERM (Exchange Rate Mechanism) crisis of 1992, when overnight (interbank lending rates in the call market) French franc rates hit 150% p.a. It was reported that overnight Irish pound (punt) reached 48.000% during the crisis. Euro-francs were being lent at 5,000% p.a. A related effect arises when the central bank intervenes to support, •(or alternatively to lower) the value of its currency. If the central bank intervenes in support of its currency, it buys the domestic currency and sells foreign exchange. Thus, the amount of domestic currency in circulation declines, which tends to push up interest rates. Conversely, •if it intervenes to lower the value of its currency, it supplies domestic currency to the market. Thus, the supply of domestic currency in the market rises, tending to lower interest rates. Again,onlinessimilartodomesticmarkets,intheinternationalfinancialmarketsalsowehaveprimaryand•secondary markets dealing with issue of new instruments and trading in existing instruments and negotiable debt instrument, respectively.Thegrowthofinternationalfinancialmarketshasfacilitatedcross-countryflowswhichcontributetoamore•efficient allocationof resources. Internationalfinancialmarkets candevelop anywhere, provided the localregulations permit the market and that the potential users are attracted to it. ThemostimportantinternationalfinancialcentresareLondon,TokyoandNewYork,alltheothermajorindustrial•countrieshaveimportantdomesticfinancialmarketsaswellbutonlysome,forinstance,GermanyandFrance,have gained prominence.

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ThemarketsofSwitzerland,Luxembourg,Singapore,HongKongandtheBahamasserveasfinancial“entrepots”.•Thesemarketsserveasfinancialintermediariesbetweennon-residentsuppliersoffundsandnon-residentusersof funds.A big difference between the Euro markets and domestic markets, for instruments in a particular currency, is that •all transactions done within the domestic market are directly subject to the rules and institutional arrangements ofthelocalfinancialsystem.For example, when Australian investors purchase securities in Tokyo, they do so according to the rules, market •practices and regulatory guidelines that governs such transactions in Japan. The same applies to those who place their funds in Japan (provided the transactions are not related Euro market).Also, a Korean borrower who approaches a Swiss Bank for a Swiss Franc loan borrows at rates and conditions •imposedbythefinancialinstitutionsofSwitzerlandandaredirectlyeffectedbytheSwissauthoritiespolicytoward lending to foreign residents. Euro markets are free from such regulations. Ithasbeenobservedthat,corporationsindifferentcountrieshavedifferentfinancialappetites.Companiesin•the UK put an average of 60% to 70% of their funding requirements from internal resources in UK. German companies get about 40% to 50% of their funds from external suppliers. InJapan,whentheirprofitabilityhasbeenlow,companieshavereliedheavilyonexternalfinance.Inthemid70’s•Japanese companies got almost 70% of their funding requirements from outside sources. This has now changed dramatically,andJapanesecompaniessource70%oftheirfinancingneedsfromtheinternalmarkets.InEuropeandtheUS, therehasbeennocomparable transformation.Internationalfinancehasconsistently•suppliedthemajorshareoffinancingrequirements.Thepercentageofexternalfinancefluctuatesmoreorlessinlinewiththebusinesscycle;whileprofitsarehigh,firmsareevenlessreliantonexternalfinance.

Risk difference between domestic and foreign financial marketsThere is a clear difference in the risks involved in domestic and foreign markets. Let us take an example. A US depositor in the Eurodollar market holds a claim in one jurisdiction (say, London) but receives payment in another (United States). He could be deprived of his funds at maturity by an action of either the British Government or the US Government.

However, in the case of a domestic depositor, only actions by the US authorities would matter. For a depositor residing in the UK the situation is quite similar. He may own a dollar denominated time deposit in (i) a US bank, directly (ii) a Euro bank operating in Luxembourg or (iii) a London based Euro bank. In all three cases, tile safety of his funds depends ultimately on the expectation that the United States will not restrict the disposition and transfer of foreign held dollar funds (i.e., that the US will continue to observe “non-resident convertibility”).

In comparison to the situation of our US investor, the UK investor will face a greater risk, to the extent that the US government may restrict non-resident convertibility more readily than it interrupts domestic bank transfers. Now from the point of view of the borrower of Eurodollars to the extent that the US government may place quantitative restrictions on US banks lending to foreigners (or some other class of borrowers), these borrowers may feel safer borrowing from unregulated Euro markets. Thus the fear of capital controls, could allow Eurodollar lending rates to rise above those in the domestic market.

3.3.2 Euro MarketThe major risks in Eurodollar transactions stem from the following:

the removal of non resident convertibility by the domestic authorities•the seizing of the assets and liabilities of the Euro banks by the authorities where the Euro banks operate•the possibility that central banks may not function as lenders of last resort in•


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Theprefix‘Euro’tendstocreateconfusionformanyasitdenotedacurrency.usedforfinancialtransactionsoutsidethecountryoforiginofthatcurrency,e.g.,USdollarweretermedasEurodollarswhentheyformedfinancialassetsand liabilities (denominated in dollars) but, traded outside the United States, Japanese yen traded out of Japan were termed as Euro yen, German marks traded out of Germany were termed as Euro marks, Swiss francs traded out of Switzerland were termed as Eurofranc.

Butafterlaunchingofthe‘Euro’astheofficialcurrencyofEuropeanMonetaryUnion(orwhatisalsoknownasEuroland),Eurocurrency(orEuros)denotestheofficialcurrencyoftheEuropeanUnionorEuroland.ThecurrencyusedforfinancialtransactionsoutsidethecountryoftheoriginofthatcurrencyisnownomorecalledEurocurrency.It is rather known as Eurodollar, Euroyen, Euromarks, Eurofrancs etc. depending on which particular currency is usedforfinancialtransactionoutsidethecountryoftheoriginofthatcurrency.TiletransactionsinEurodollar,Euroyen, Euro marks etc. are known as ‘Euro Markets’.

The main differences are that foreign currency markets signify transactions denominated in currency of the country of domicile Euro market centres if there is a shortage of any one currency in Euro market. Although the probability oftheseeventsoccurringarelow,theyareofsufficientimportancetowarrantcloseexaminationbyinternationaldepositors.

Whereas in Euro markets, transactions are denominated in the currency of the system country other than the country of the domicile. For example, when a bank located in the US makes a transaction with a foreigner in US dollar, it is a foreign currency transaction. As against this, when the same bank makes a transaction with a foreigner in a currency other than US dollar, it is Euro transaction. So when Reliance Industries of India takes a term loan, denominated in US dollar, from a New York bank, it is raising foreign currency loan.

As against this, if Reliance takes loan denominated in Yen, from the same bank, it is a Euroloan. Eurocurrency market is the market in the currency of the Euroland. Likewise, Euro banks can be described as a commercial bank dealinginEuromarkets.Eurobanksarefinancialintermediariessimultaneouslyfordepositsandmakeloansinacurrency or currencies, other than that of the country in which they are located.

Over the years, Euro markets operations have centred in Asia, Europe and the United States. With the emergence of these centres, a continuous market mechanism has been established. Furthermore, the removal of exchange control and freer movement of capital, international markets have been integrated. Euro markets consist of banks (Euro banks) that offer wholesale deposits and Loans is in favourable jurisdiction (Euro markets) and in a variety of currencies, usually other than that of the country in which the banks are located.

Euro markets consist of banks (Euro banks) that offer wholesale deposits and loans in favourable jurisdiction (Euro markets) and in a variety of currencies, usually other than that of the country in which the banks are located. The domestic (national) disadvantages that are applicable to the operations of banks in their national markets are based almost exclusively on governmental rule and regulations (Euro banks being launch free of domestic monetary regulation.)The Euro markets thrived and grew because national money markets were hobbled with regulations such as interest rate controls, reserve requirements and deposit insurance costs. The major currencies ill the recent years have however gained enough nm-resident convertibility at a Euro market segment was able to rise.

Euro markets facilitate hedging possibilities for corporate borrowers e.g: American companies operating in the UK or Germany can borrow Eurodollars in the UK or Germany without being required to go in for Sterling or German mark borrowings (that imply currency risk exposure).

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An important feature of the Euro market that needs to be noted is that it is basically “deepest’ in the short-term market, where 3-6 months deposits are most popular (this does not mean that funds cannot be made available for long-termdeployment).DepositinstrumentsfocusontimedepositsandnegotiableCertificatesofDeposits(CDs).As a matter of fact, Eurobanks have always slow a willingness to accept deposits for various maturities-short , medium or long term. The banks take into consideration the borrowers requirements and have devised various instruments for preferred maturity. The Euro market is a wholesale market (generally restricted to transactions over US $ 1 million), with participants limitedtobanks,financialinstitutions,institutionalinvestors,majorcorporatesandhighnetworthindividuals.

ThebasicstructureinEuromarketoperationshasbeenmediumtolongtermlendingonvariable(floating)interestrates, with an option to re-set (roll-over), the interest rate periodically at 3 or 6 months.

3.3.3 International Debt InstrumentsBorrowers are the issuers of debt instruments in the form of Promissory Notes, Bonds and Commercial Papers. Therearevariousclassesofborrowershavingdiversifiedneedsforwhichfundsareneeded.Theneedsofborrowersdiffer in terms of amounts, the length or period for which borrowings are needed (maturities), and the currency in which borrowings are raised.

Forexample,borrowersmayneedshorttermorpermanentworkingcapitalrequirements;corporatesmayneedlongtermfundsforcapitalexpenditure;technologicalupgradation;plantexpansion;projectfinance;acquisitionofaircraftandships;financingmergersandacquisitionsandsoon.Governments(referredtoassovereignborrowers)raisedebtintheinternationalmarkettofinanceinfrastructure,purchaseofpetroleumproductsoreventoshoreupforeign exchange reserves.

Thedecisiontosourcedebtfinancebyanyborrowerwillbedependentonthecosts,borrowingtermsandcovenantsimposed by lenders. Project sizes are growing larger to access economies of scale and to withstand international competition. This, together with rising capital intensity necessitates accessing the international markets for both workingcapitalandprojectfinance.

Euro notesThe primary objective of the issuance of Euro notes is to structure a debt instrument with short term maturities, generally 3, 6 or 9 months, tenors (duration)and place it in the market.

However, the borrowing programme could be for medium or long term (say), 5-7 years or more. Banks that act as financialMarketsintermediariesagreetounderwritethepaper(instrument).Inreality,aborrowerisabletoborrowat short-term interest rates for short periods by issuing the “notes” to investors. At the same time the borrower avails ofthebenefitsandcomfortofhavingacommittedmediumtolongtermborrowingfacility(underwrittenbybanks).The funding portion is divided into two separate components.

Thefirstisalongtermcommittedstandbylendingfacilityprovidedbybanks.Thesecondisamechanismforthedistribution of short term debt instruments (the Euro note). The former component gives the borrower the long term assurance of availability of funds. The latter is the means by which cost-competitive funding can be achieved (since atanyspecifictime,shorttermfundingisusuallycheaperthanmediumlongtermfunding).Typically,aEuronoteissuance programme is referred to as a “Revolving Underwriting Facility” [RLTF] or “Note - Issuance Facility” PIF], where a group of banks (Syndicate) underwrites a commitment to the borrower.

A revolving credit facility permits the borrower to draw-down (or use) a credit facility and repay and again draw-down and repay, till the agreed upon expiration date of the credit facility. The credit facility could be made available for any duration. Until this time limit expires, the borrower is permitted to use the facility. Under the facility, the borrower can raise funds over periods of 3-10 years by ‘issuing notes in its own name, typically with tenors of 1-6 or 9 months.


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Under this arrangement, underwriting banks are committed either to purchase the Euro notes, which the borrower cannot sell or to provide standby credit (at the expiry of an agreed upon selling period say, 3-1 0 working days). The credit is provided by the banks at a predetermined spread relative to some reference rate such as LIBOR.

If the short term market fails to provide the liquidity to the issuer, the underwriting banks provide the liquidity for the agreed period of the facility Underwriters when required to do so fund their commitments only for the short term maturity of the notes. The issuer is free to repay at the end of each short period, e.g., 3-6 months, any amount itwishesto-dependingonitsrequirement.Theissuermayre-borrowatalaterdatebyfirstofferingtogenuineshort term investors, before the underwriters are obliged to pick up and provide liquidity again - pro rata to their underwriting commitments. Rarely do banks put the notes on their books and fund these assets. Doing so would be considered a failure of the issue. Instead, banks sell the notes to investors in search of short term paper. High quality borrowers can issue Euro notes even below LIBOR i.e., at around LIBID (which is about 118% below LIBOR).

Underwriting fees are paid on the full amount of the line of credit, regardless of the amount currently drawn. Fees may be 5 basis points & for top borrowers and above, may range up to 15 basis points for less creditworthy borrowers. [Basis Point (bp): one hundredth of one percent (0.0l%)].

The notes are generally denominated in amounts of US $ 100,000, $ 500,000 or more. The US dollar is the most common currency of denomination. Generally, placements of Euro notes is done through a tender panel (bidding banks are more often investment banks which have placement capacity). This is also called the Uncommitted Facility. The tender panel is merely an arrangement to panel members to promise to slow up at the auction but make no commitment to the system, purchase the notes. When they do want the notes (often because they think they can resell thematasmallprofit),theywillbidaninterestraterelativetoLIBORforExampleabankmaybuyEuronotesata spread of LIBOR, (say) (-) 15 bp, and resell it at LIBOR (-) 18 bp (a lower yield and a higher price). Those who bid the lowest rates get the paper.

It will be noticed from the tombstone’s advertisement announcing competition for the issue appearing for the Bigfoot in the newspaper that there is a division of banks into two groups:

Thefirstgroupconsistsofacommitmentbyagroupofbankstoprovidefundstotheborroweriftheborrower•findsitselfunabletoraisefundsThe second part is the tender panel members. •

Euro commercial paperAn alternate to bank borrowings for large corporations with strong credit ratings is to raise funds by issuing commercial paper (CP). Commercial Paper is a short term promissory note issued on an unsecured basis by commercial and financialinstitutions.Maturitiesrangebetweenamattersofafewdaysto360days,althoughonaweightedaveragebasis, the maturities seem to be well below 90 days. In the United States and Canada secondary markets in commercial paper have been established for more than 100 years.

The real expansion in commercial paper took place in the early 60’s when banks were strapped for liquidity. To expandtheiractivities,thebanksdevelopedtheCertificateofDeposit(CD)approach.However,theoverallcostofpurchasing funds (by the banks) continued to increase. Commercial borrowers were, therefore, encouraged to rely more on the commercial paper market (rather than on bank borrowings).

In these circumstances, commercial paper issued by the primary borrower (commercial institution) to the primary lender(theinvestor),sometimesthroughanintermediary(usuallyaninvestmentbank),wasbothmoreflexibleandcheaper. The most prominent markets for commercial paper are the United States, Canada, UK, Japan and Australia. Euro market prominence for US $ Euro commercial, paper markets are in Singapore and the UK.

Although typical issuers of commercial paper are those with high credit ratings, smaller and less well known companies with lower credit ratings have been able $0 issue paper in recent years (at competitive rates), by obtaining the support fromafirmwithhighcreditrating(calledcredit-supportedcommercialpaper)orbyprovidinganassetassecuritycollateralising) the issue is called asset backed commercial paper. An example of a “Credit Supported Commercial

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Paper”isanissuesupportedbyaletterofcredit(orguarantee).Thetermsoftheletterofcreditspecifiesthatthebank issuing the letter of credit will pay off the CP when it falls due, if the issuer (borrower) fails to pay. The credit enhancement of a low rated CP issuer can also be backed up by a “surety bond” from an insurance company.

In the United States, some prime automobile manufacturers have formed System subsidiary companies (called CaptiveFinanceCompanies), that issuecommercialpaper inEuromarkets tofinancecustomersof theparent.The threemajorUSautomobilemanufacturers, for example, have captivefinance companies:GeneralMotorsAcceptanceCorporation[GMAC];FordCredit;andChryslerFinancialGMACisthelatestissuerofcommercialpaper in the US.

Commercial Paper is marketed either directly by the issuer or through a dealer (investment bank). A large majority ofissuersmarkettheirCPdirectly.Theseissuersrequireacontinuoussourceoffundsandfinditcosteffectivetoestablish a sales force in the organisation to sell CP directly to investors. In the case of dealer-placed CP, the issuers usetheservicesofasecuritiesfirmoraninvestmentbank.CP’ssoldinthiswayarecalleddealerpaper.Competitivepressures have forced dramatic reductions in the fee charged by dealers.

Despite the fact that CP market is larger than markets for other money market instruments (short-term instruments), secondary trading activity is much smaller. The typical investor in CP’s is an entity that plans to hold it until maturity. Should an investor’s economic circumstances change, such that there is a need to sell the paper, it can be sold back to the dealer, or, in the case of directly placed paper, the issuer will re-purchase it.

CP’s are issued at a discount. In other words, if an investor buys a face value of US$ 1 million of CP, he pays less than the face value, though he receives back on maturity the full face value. The difference between the two represents ‘interest’. The return to an investor is made up by the difference between the purchase price and the redemption amount.

CPT’s are generally issued in denomination of US$ 500, 000 and US$ 1 million, the latter being more common. Smaller denominations of US$ 10,000 are also issued, but very rarely.

Calculating Yield On Commercial Paper: The simple discount formula is really a mirror image of the simple interest formula (with the difference that interest is added at the end of the life time and discount at the beginning). It goes withoutsayingthatasimplediscountproducesahighercost(orprofit)thansimpleinterestwiththesamenumericalvalue. The simple discount formula is the same as the simple interest with one exception that “D” [Discount] substitutes for “r” (rate).

Now, if an exporter in the US drew a 90 day bill on a UK importer for US$ 1million, and the bill was discounted at 10% p.a., the amount that the importer would receive would be the principal minus the discount, i.e.

Then the amount to be remitted to the exporter would be US$ 975,000. It is simple to see that as the discount is deducted at the time of selling the bill, the actual interest p.a. will be higher than the discount rate. In the case of our US exporter, interest rate equivalent of 10% p.a. discount will be


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Instead of stating a discount rate of 10% (which hides the true percent per annum cost) the buyer or seller could have negotiated a discount to yield rate of 10.26% p.a. this would be an easier price to compare with the true interest costs in the deposit and loan markets.

Commercial Paper is normally issued on a discount to yield basis. This really means that after applying the discount, the net amount earns (or costs) “x” % p.a.- which is equal to the discount to yield rate.

The main difference between discount to yield and simple discount pricing lies in the fact that a simple discount has to be converted to simple interest p.a., whereas discount to yield states the true cost (or gain).

The “Discount to Yield” or discounted amount equals:

To put it in numbers, a commercial paper of US$ 1 million discounted at a discount to yield rate of 10% would be sold/purchased for

To prove that the difference between $ 1 million and $ 975, 609.76 represents 10% p.a. should not present a problem any more, as

As no rates are mentioned on commercial paper at discounts (or discounts to yield), the nominal values of the instruments are plain to see. It is easier to market both in the primary and secondary markets.

Medium term notesSince the early 80’s Medium Term Notes [MTN’s] have emerged as a major source of funding for multinational corporations, supranationals (i.e. the World Bank, Asian Development Bank), and even governments. The market forMTN’s,wasestablishedasanalternativetoshorttermfinancingintheCommercialPapermarketandlongterm borrowings in the Bond market. Hence, the name ‘medium term’. The Euro - MTN market has grown at a phenomenal rate. In mid 90’s outstanding MTN’s in the domestic and international markets was estimated to have grown to over US$ 350 billion.

MediumTermNotesareinmanyrespectssimplyfixedratecorporatebondsbutforagenerallyshortermaturitythan Euro bonds or domestic bonds. As an investment vehicle, the MTN is often regarded by institutional investors as a temporary investment that can be designed to suit the particular investors choice. The reason is that MTN’s (unlike conventional bonds) are offered on a continuous basis in smaller amounts - as little as $2 - $5 million at a time - rather than a single large issue. For example, an investor, such as a Pension Funds (PF) might have $ 7 million to invest for 11 months in a good corporate name.

ThePFwillcallseveralMTNdealerstofindoutwhichcompaniesareborrowing.WhenthePFTreasurermakesthechoice,thenotewillbeissuedspecificallyfortheinvestorschoice.ThisspecialfeatureexplainswhyMTNfinancingisoftendescribedas“investordriven”.Ineffect,thedistributionprocessintheMTNmarketresemblesacommercial paper issuance programme – but without a “Revolving Underwriting or Guaranteed Facility”.

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UnderacomprehensiveMTNprogramme,anissuercanraisefundsbyissuing“fixedrate”or“floatingrate”or“deep-discount” paper in any of a number of currencies. Deep Discount Bonds carry very low interest, in most cases zero, and accordingly sold at prices representing “Deep Discount” from their principal amounts. Deep Discount Bonds tend to be more price volatile than full coupon bonds and thus offer greater potential for price appreciation if interest rates should fall. The MTN is a Commercial Paper - like instrument that has a maturities ranging from 9 months to 30 years. Generally, the Notes are unsecured but need not be. They pay interest on a 360 day basis unlike deposits that pay interest actual/360 tenure. Unlike corporate bonds, few are callable. The most distinguishing feature of a MTN from other debt instruments is that their issuance and even maturity is highly investor determined, not issuer determined.

Corporate Bonds are issued infrequently and often entail heavy issuance costs. Therefore, the borrower wants to do an issue in large amounts at a known cost and get it distributed as widely as possible. This means that there must beanunderwritingsyndicate.ThisisnotthecasewithMTN’s.MTN’sareissuedthroughdealers(a)atthetime;(b)intheamount;and(c)forthematuritythat‘theinvestorwants.

MTN’s have traditionally been sold on a “best effort basis” i.e. there is no guarantee by the dealer to market the notes. (This is in contrast to an underwriter in the conventional bond market who has guaranteed the subscription.) Through its agents, an issuer of MTN’s posts offering rates over a range of maturities. For instance, 9 months to I year, 1 year to 18 months, 18 months to 2 years, and annually thereafter. In the Euro markets, MTN rates are generally quotedonafloatingratebasisonanindexsuchastheLIBOR.Indomesticmarkets,many

issuers post rates as a yield spread over a Treasury Security of comparative maturity. The yield spread is illustrated as below.

:Medium Term Note Yield Spread of

MTN over Treasury Securities

Treasury Security

Maturity Range Yield % Maturity Yield %

2-3 years 4.35 35 2 years 4.03-4 years 5.05 55 3 years 4.504-5 years 5.60 60 4 years 5.00

Table 3.2 Yield spread

Let us now illustrate the MTN funding process. Assume, Hoechst A.G (a German pharmaceutical company) tells its Dealers that Hoechst will accept any money in the 1-5 year range at a certain spread relative to the bench-mark Treasury Yields. The Dealers would let their customers know from day to day who was offering MTN’s, at what rates andthepaperwouldbesoldonlyona“besteffortbasis”(i.e.,withoutacommitmenttothe‘issuerforaconfirmedsale), if and when an investor wanted it.

Now, consider a Swiss Bank Trust Department calls the Dealer and says: “we’ll buy ITS$ 20 million of 3% year HoechstMTNatover30”-thedealwouldbestruckthereandthen.Hoechst’sTreasurerwillbecontactedtoconfirmthe transaction. It will be quite evident that this process is much easier than waiting for the right Eurobond to be issued. It is also cheaper for Hoechst. Although, perhaps less predictable than a $ 250 million underwritten Eurobond. Hoechst will still gets its funding of its quarter billion, although, perhaps in dribs and drabs!!

The MTN market provides corporations with the ability to raise funds discreetly, because the issuer, agent and the investor are the only participants that have to know about the primary transaction. In contrast, the investment company obtains information about underwritten bond offerings from a variety of sources.


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Corporations often avoid the bond market in periods of heightened uncertainty about interest rate and the course of theeconomy(suchastheperiodafterthe1987stockmarketcrashorthesoutheastAsianfinancialcrisisof1997).Similarly, corporations in distressed industries (commercial banks in the second half of 19901s), can use the MTN markettoraisefundsquietlyratherthanrisknegativepublicityinthehighprofilebondmarket.Thus,duringperiodsoffinancialturmoil,thediscreetnatureoftheMTNmarketmakesitanattractivealternativetothebondmarket.

MaturitiesofMTN’sreflectthereflectthefinancingneedsofvariousclassesofborrowers(issuers).Financialfirms(banks)tendtoissueMTNwithmaturitiesmatchedtoloansmadetocustomers.Consequently, inthefinancialsector, maturities are concentrated in a range of 1-5 years and only a small proportion are longer than 10 years. Non financialfirms,incontrast,oftenuseMTN’stofinancelonglifefixedassets(plantandequipment).Resultantly,maturitiesissuedbynonfinancialcorporationscoverawiderrange.

Floating rate notesTheFloatingRateNote(FRN)asthenameimplies,isaninstrumentwhoseinterestratefloatswithprevailingmarketrates. Like Eurodollars deposits, it pays a 3 or 6-month interest rate set above or below LEBOR. Like international loans, the interest rate is re-set every 3 or 6 months, to a new level - based on the prevailing LIBOR level at the reset date. The term Floating Rate Note is taken to mean an intermediate to long term debt security whose interest rate is pegged to a short term rate or rate index and adjusted frequently.

Floating Rate Notes issued outside the country of the currency of denomination are issued in the form of Euro bonds. This feature makes them in some respects as much a capital-market instrument. The pricing framework really definesthecharacteroftheinstrument.FRN’sarepriced‘inpartlikemoneymarketinstruments(lessthan1yearmaturities)andinpartlikeconventionalfixedrate,bonds(over1year).ThebulkofFRNsareheldbybanksandfinancialinstitutions,whosecostoffundsvarieswithshort-termrates,becauseanFRNpaysaratethatistiedtochanges in short term interest rates. Financial institutions also bought FRN’s as medium-term substitutes for loans. Some banks, with a low cost of funds (but a shortage of prime borrower customers), were looking for a way to earn a spread with little risk or effort go for FRNs.

Euro bondsThe International Bond Market consists of the Euro bond market, the Foreign Bond market and those Domestic Bond market (such as the US, Japanese and French markets), in which global bond investors participate actively. The most international of these markets is the Euro bond market. The Euro bond market raises over US$ 200 billion perannuminnewcapitalforcorporations,financialinstitutionsandgovernments.

DomesticBondsareusuallyfixed-interest,fixed-maturityclaimswithrangingmaturitiesfrom1-30years.Theyareissued by domestic residents, in the domestic currency, and largely sold to domestic residents. Foreign Bonds are issued within the domestic market of the currency of denomination, but they are issued by non-resident borrowers. For example, a bond issued within the UK by a non resident issuer such as the Asian Development Bank is a Foreign Bond. Euro bonds are usually issued in the market for the borrower by a syndicate of banks from different countries andplacedincountriesotherthantheoneinwhosecurrencythebondisdenominated.IftheGermanfirmissuedabond in French francs in England, Switzerland, the issue is a Euro bond.

Companies might need medium and long term funds for expansion, new investments or for acquisition. Banks and financialinstitutionsneedlongertermmoneytofundtheirloanportfoliosortoincreasetheircapitalbaseasdefinedby the regulatory authorities. Euro bond is their popular choice.

The process of issuing a Euro bond begins with a discussion between the borrower and its bankers.

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Theissuerspecifiesthefollowing:desired currency of denomination•the amount•the target rate (an interest rate at which the issuer would be willing to borrow)•

If the bank obtains a mandate (formal authorisation), this bank becomes the lead manager of the Euro bond issue (there can be more than one lead manager) on the instructions of the issuer (or if the deal is large or complex), lead managers may invite other banks to be co-managers. Together, they form the management group, who negotiate the interest rate and other terms of the deal in such a way to be acceptable to the target investors. The lead managers and their lawyers also prepare the documentation and obtain necessary clearances.

The bond will normally be listed in Luxembourg or in a similar location where listing is cheap and there is no prospects of present or future withholding tax (the listing is a mere formality to satisfy those investors who are permitted to invest in listed securities. Few of the bonds will ever be traded on the Luxembourg exchange).

The key role of the management group is to form an underwriting group of a number of banks, investment banks and security houses (25, 50 or up to several hundreds), from different countries. The managers will undertake the task of sending out an invitation fax or telex to many banks inviting their participation in the deal. The underwriter (which include the management group), are selected on the basis of their ability to place the bonds in different sub-marketsoftheEurobonduniverse.Theunderwritersdemonstratetheirconfidenceintheirownabilitysystembycommitting themselves to purchase a share of the bond issue at a set price from the issuer.

When a bank underwrites a bond issue, it is in effect giving the issuer a put option (this is called a “put to seller”, when the option writer is obligated to buy the underlying bonds or shares, at an agreed upon price). If an XYZ June 40 were “put to seller” for instance, the Writer (underwriting bank), would have to buy 100 shares of XYZ at $ 40 a share from the put holder (issuer), even though the current market price of XYZ may be far less than $ 40 a share.

A third level of participation in the issue is the selling group of banks and dealers who actually sell the bonds to end investors. This selling group consists of the managers, the underwriters and other banks/dealers, who will try to sell the bonds but are not committed to purchasing them if they cannot sell.

A typical Euro bond issuance “Syndicate” consists of three overlapping parts: the managers•the underwriters •the selling group •

A manager’s commitment is a proportional responsibility: i.e., if one of the selling group fails to come up with its allotted amount (to sell and noncommittal), on the closing date, all managers are responsible for paying that amount to the issuer on a pro rata basis. (Each manager is responsible for the amount of its commitment).

Once the syndicate is in place, the bond can be announced - with its features and tentative terms. The preliminary version of the prospectus, called “the Red Herring” will have been prepared. Members of the selling group will now actively canvass the potential investors for [heir interest in the deal. The Red Herring will be perused by the “sales-people”, who are calling their clients to solicit interest in the bond. Although the precise terms of the bond remain provisional until the offering date, the bonds may actually begin trading before this date in a sort of “when issued market”, called the Grey market.


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The Grey market is a short term forward market, enabling investors to assure them of a certain investment at a known price for the bonds issued. It also allows members of an underwriting syndicate to verify their placement of bonds to be issued. This reduces [the inherent uncertainty in a bond issue and ultimately reducing the spread paid bytheissuer.Becausethefinalissueofthebondhasnotbeenset,Greymarketpricesareexpressedasadiscount(or very rarely as a premium), for instance a World Bank bond may quote a price of “less 318”, which means that itisbeingofferedtosellbondsat318percentagepointsbelowoffinalofferingprice.

Now,ifthefinalofferingpriceis101,theGreymarketdealerwilldeliverthemat100.Agreymarketcanonlyworkfor bonds whose issuers are well known and whose Non price features are established. After a few days or weeks of this preplacement, the selling group members will give a feedback to the Lead managers. Thereafter, the Lead managerswouldhavegainedsufficientconfidencetoreturntotheissuerwithacommitmenttothefinalterms.

The key feature will be tile coupon. If necessary (and market response warrants), the amount or even the maturity of the Euro bond will be adjusted to meet investor preferences. If the bond carries any sweeteners such as warrants or a convertibility feature, the terms may be altered. When the Lead Managers reach agreement with the issuer, the documentsarefinallysignedontheofferingday.Afinalversionoftheprospectusisprintedanddistributedandthebonds are publicly are offered. Members of the syndicate will try to sell the bonds at the offer price printed on the front of the prospectus (or a higher price, if they can).

Bonds are often placed at a price below the offer price. Selling Group members buy the securities at the issue price (minus the dealers discount selling commission), and may pass along a higher proportion of that discount to other dealers or even to institutional investors. In short, competition prevails. An important responsibility of the Lead Manager is stabilisation. This is achieved by intervening in the market to support the price of the new issue. The Lead Manager is permitted to undertake stabilisation in the primary market by direct participation and/or by readjusting the amount allotted to various members of the Selling Group. Two weeks after the signing, on the closing date, the securities are delivered to buyers in exchange for cash. The borrower receives the funds.

3.3.4 Euro Issues in IndiaIndiancompanieshavebeenraisingfundsfrominternationalfinancialmarketsbyissuingEurobonds,EuroconvertiblebondsandEuroequities.ThefirstGDRwereissuedbyRelianceindustriesinMay92withan,issuesizeofUS$150 million. The market at that time for Indian issues was so under developed that Reliance had to give discount up to 17% to GDRs to get the issue fully subscribed. Till March 1997198 Indian companies could raise US$5,180 million. Amounts raised by Indian corporates through GDRs and ADRs declined from US$ 645 million in 1997-98 to US$ 270 million in 1998-99.

Depressed capital market, industrial slackness at home and adverse emerging market sentiments affected GDR •prospectsunfavourablylastyear.However,therehasbeenaturnaroundinthefirsthalfofthecurrentfinancialyearwith large issues raised in the ADRIGDR market. The successful ADR issues include MIS Infosys Technologies ($ 75 million), MIS Satyam Infoway Ltd. ($ 86 million) and M/s ICICI ($ 3 15 million). To facilitate conversion of its GDRs into American Depository Shares (ADS), ICICI listed the ADS on the New York Stock Exchange with effect from 17 November, 1999 after complying with stringent listing requirements of the Securities and Exchange Commission (SEC) of the USA, including adherence of GAAP standards.Considering the enhanced opportunities of Indian software companies for expanding globally, operational norms •governingtheiroverseasinvestmentsandmodeoffinancingacquisitionofoverseassoftwarecompanieshavebeen liberalised. InDecember,1999anotificationwasissuedbytheMinistryofFinancepermittingIndiansoftwarecompanies,•whicharelistedinforeignexchangesandhavealreadyfloatedADR/GDRissues,toacquireforeignsoftwarecompanies and issue ADRs/GDRs without reference to the Government of India or the RBI up to the value limit of US$ 100 million, For acquisitions beyond US$ 100 million, proposals would require examination by a Special ‘Composite Committee in the RBI.With a view to further liberalise the operational guidelines for ADR/GDR issues. It has been decided to dispense •with the track record scrutiny process for ADR/GDR issues and the two stage approval by the Ministry of Finance. Indian companies would henceforth be free to access the ADR/GDR markets through an automatic route without

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thepriceapprovaloftheMinistryofFinancesubjecttothespecifiednormsandpost-issuereportingrequirement.As ADR/GDR are reckoned as part of FDI, such issues would need to conform to the existing FDI policy and permissible only in areas where FDI is permissible. Such ADR/GDR issues would, however, be governed by the mandatory approval requirements under the FDI policy.In India, External Commercial Borrowing (ECBs) are governed by guidelines on External Commercial Borrowing •Policy and Procedures issued from time to time. The 1996 guidelines were framed to increase the transparency in policy and simplifying the procedures to give Indian industry easier access to external funds to support investment and economic activity. Oneofhebasicobjectivesoftheseguidelineswastogivepriorityandprovidegreaterflexibilitytoinvestors•in critical infrastructure sector, to give priority to exporters in accessing ECB resources and to give additional flexibilitytotheseincurringlongtermdebts.TheGoIhasextendedECBfacilityforrupeeexpenditureforinfrastructure sector such as roads, (including bridges) ports, industrial parks, and urban infrastructure (water supply, sanitation, sewerage etc.) Previously this facility was given only to power, telecommunication and railways.Disbursements under ECB (including US$ 4230 million from RIBS), were US$ 7226 million in 1998-99, almost •at the same level as in 1997-98 (US$ 7371 million). Subdued demand for funds from borrowers due to slackness in domestic industry and higher premia for emerging market borrowers in the international market contributed to lower disbursements excluding RIBS. However, since repayments fell from US$3372 million in 1997-98 to US$2864 million in 1998-99, net overall •borrowings showed an improvement from US$3999 million in 1997-98 to US$4362 million in 1998-99.Thesluggishtrendindisbursementshascontinuedinthecurrentyear.Inthefirstquarterofthecurrentfinancial•year, disbursements were US$ 62 1 million against USS754 million during the corresponding period in the previous year. Repayments at US$ 63 1 million were only marginally higher by US$ 9 million. Therefore, there hasbeennetrepaymentinthefirstquarterof1999-2000ascomparedtonetborrowingofUS$132millioninthe corresponding period of the previous year. ECB guidelines in 1999-2000 were further liberalised and procedures streamlined to facilitate better access to •internationalfinancialmarkets,keepmaturitieslongcostslowandencourageinfrastructureandexportsectorfinancing.The third largest recipient of approvals was Ports and Roads with US$ 80 million. There has been no approval •inTelecom,CivilAviationandRailwayssofarinthecurrentfinancialyear.Itisexpectedthatasthedomesticindustrial recovery gathers pace and emerging market spreads narrow, ECB will be accessed more in the coming months.

Sector 1997-98 (US $ MILLION)

1998-99 (US $ MILLION)

1999-2000 (US $ MILLION)

Power 3014 3998 1699Telecom 1482 75 0Shipping 210 37 27Civil Aviation 373 0 0Petroleum and Natural Gas 230 40 218Railways 179 15 0Financial Institutions 795 150 50Ports, Roads, etc. 61 0 80Others (including exporters) 2358 885 62Total 8712 5200 2136

Table 3.3 Status of ECB approach


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3.4 Management of International Short Term FinancingManagementofInternationalhsorttermfinancingisexplainedbelow.

3.4.1 Short Term MarketsMainlycommercialbanksprovideshort-termfinance.Short-termmarketsaredividedintwocategories.

Currency loans from the domestic banks originating from the country of that currency Example: Mark loan from domestic Banks in Germany

Short-term laons from Euro-markets - loans in Euro-currency from offshore banks.Example: Dollar loan raised from the London market.

Whethertheyaredomesticbanksoroffshorebanks,theyarethesourceofallshort-termfinanceforMNCs.TheEuro-marketsarethesinglelongestsourceoffunds,specificallysincetheseventies,whenthecurrenciesdepositedfrom the Balance of payments surpluses of countries in the offshore Banks began to grow and they are outside the regulatory framework of any Monetary Authority. These are called offshore funds, as they are funds kept with foreign and multinational banks and are not controlled by domestic authorities.

The surpluses of ONGC, STC and G.E. shipping in dollars are credited to their SBI Account in London. But as current Account funds do not yield any return, the SBI, London is instructed to deposit these funds for short-term of 3 to 6 months or at the most upto 12 months, in a Euro-currency Account with Citi Bank in New York. These being short-term deposits, carry interest rates, which are different in different centres.

The Euro-currency market has thus supply coming from the short-term surpluses of dollars and other Convertible CurrencieslikeD.M.,Yen,U.K.£,etc.fromtheGovernments,companiesandexportingfirmsandevenindividuals.It is a wholesale market with funds being accepted and lent in large amounts. The demand comes from those who need funds for short-term shortfalls in income, import payments and working capital purposes. Sometimes even governments borrow for short-term and roll over the loans for medium-term.

Bulk loans are given for short-term as the deposits are also of short-term nature. The demand and supply factors in each of the currencies determine the interest rates. This market has two components:

Interbank •Dealings with the public. •

Apart from the customer transactions, there is a very active market among banks in these funds. The size of the inter bank market is much larger constituting about SO% of the total bank claims. In the inter bank market, active banks quote two way bids - offers. On the basis of these bid and offer rates the London Inter Bank Bid Rate (LIBID) and the London Inter Bank Offer Rate (LIB OR) have emerged as bench marks for lending and borrowing rates of banks and FIs. These rates change not only from currency to currency but from maturity to maturity.

The LIBID and LIBOR are averages of the leading six international banks dealing in Euro-Currency markets. These are quoted for various major trading Currencies for the major markets, viz., London, Frankfurt, New York etc. and the arbitrage operations bring about uniformity in these rates as between the centres. The margin between the Bid and offer rates which is generally of the order of l/S gives the trading margin for the bank. The year is taken as 360 days and the calculation of value dates of maturities of receipts and payments of deposits in the Euro-market is the same as in the case of Foreign Exchange market. A proper value date for a transaction has to be a working day both in the place where the transaction is done and home market of the currency concerned.

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3.4.2 Short Term Loans for Money MarketMajor short-term credits availed from the Global money markets are export credits and import credits. Export credit is provided by the buyer in foreign countries through the banks to promote exports particularly of capital goods from India or of any other country. Sometimes these credits emanate from the Government or Government sponsored agency like Exim Bank. Sometimes export credit is clubbed with insurance and bank guarantee, the fees for which are payable by the buyer. Export credits are again of two types, namely, supplier’s credit and buyer’s credit. Supplier’s credit is granted by the supplier or his bank to the buyer importer.

Deferred payments, come in this category and are accompanied by bills of exchange and promissory notes, carrying the bank guarantee. Buyer’s credit is granted by the buyer importer or his bank to the exporter for his short-term requirements. The Exim Bank makes available supplier and buyer’s credits and also extends lines of credit to foreign financialinstitutionstopromoteexportsofcapitalgoodsfromIndia.ImportersinIndiawouldliketoavailofshort-term credits from abroad because interest rates for most major currencies are well below the cost of rupee funds. But they will have to face foreign exchange exposure risk.

The overall cost of such short-term import credit comprises of: Nominal interest rate in foreign currency. •Forward premium, if the foreign exchange risk is to be covered in the forward market. Additional commission •to the Bank for usance letters of credit as sight credits as the former involves a time period of waiting. Stamp duty on usance bills, payable normally. •

Export credit is thus an important item of short-term credit from the international money market available to corporate.

3.4.3 ForfaitingForfaitingisacommercialsourceoffinance.Theclaimsoftheexporteronthebuyerarepurchasedbytheforfaitingbank without recourse to him. This is thus a credit sale converted into cash sale. Banks in London are very active in forfaiting business, both in the primary and secondary market. In India, forfaiting business is in initial stages and there is no secondary market in them. Forfaiting has grown in the world only in the recent past, and it is another sourceofexternalfinancetocorporateindevelopingcountries.Itsimportanceliesinconvertingthebookdebtsin foreign currencies in securitised debt, taken over by a bank or its subsidiary, without recourse. Forfaiting is the purchaseatafixedrateofmedium-termclaimsontheforeignbuyer.

Depending on the credit standing of the importer and the country risk, the importer’s bank guarantee is needed on the face of the promissory note or bill of exchange. The credit sales of the export are converted into cash and this isusedasworkingcapitalorproductionfinanceinthecycleofproductiveoperations.

3.4.4 International LeasingCrossboarderleasesarenowbecomingpopular.Theyareanimportantsourceofinternationalfinanceofshortandmedium-termnaturetofinanceships,aircraftandcapitalgoods.Theassetmaybeintheownershipofthesupplierbutitsuseiswiththebeneficiaryorlessee.Thisisanoffbalancesheetitemandonlyleaserentalspaidhalfyearlyor quarterly are debited to the current account.

TheLessormaybefromonecountry,thelesseefromanothercountrybutthefinancecanbeprovidedbyathird•country.Theadvantagesofleasefinancedependonthetaxbenefitsinthelessorandlesseecountries.Thelessoras the owner can provide for capital depreciation which gives a tax advantage.The lessor can write off the lease rentals as revenue expenses. The lessee is not normally given a purchase •option, as it might then become a Hire purchase deal rather than lease. The lease agreements provide for the lessee to renew the contract on a nominal rent to protect the lessee’s •interest in the residual value of leased asset. During the primary lease period, the entire value or at least 95% of the value of the asset along with the interest on the capital invested is recovered.


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The lessee will then have the use of asset after that period at a nominal rate. Many short-term facilities are availed •of from the international markets by the Government, RBI and Commercial and Co-operative Banks in India.Government borrows from other Governments, multinational and national and regional bodies for its investment •and for its balancing of Balance of payments of the country. Similarly, if it has surpluses, it invests in short-term instruments in foreign currencies which are convertible and •liquid. The RBI keeps its foreign exchange assets in Treasury bills of foreign Governments, Treasury bonds, deposits with foreign Central banks, B.I.S. (Bank for International Settlements) and securities of world bodies and of foreign Governments with convertible currencies. The RBI can borrow from IMF or the central banks of foreign countries or other multilateral agencies. The •domestic commercial and cooperative banks, who are authorised to deal in foreign exchange, called Authorised dealers, deal with the public for the exchange requirements of the latter and with the banks in the inter bank markets of domestic and foreign nature for covering operations and hedge and for genuine trade and commercial transactions. As per the recently liberalised guidelines of RBI, banks can borrow from abroad for temporary short-term •requirements up to some limits which are set by the Bank’s Top Managements. They can operate in currencies for import-export trade transactions, hedge in currencies covered in the domestic market and borrow from abroad from multinational banks and dealers in Euro-Currencies. Banks can also borrow from their branches abroad or correspondents abroad. Similarly they can invest in short-•term instruments abroad up to certain limits or keep deposits with foreign banks and correspondent banks.

3.4.5 Syndicated LoansMNCsrequirelargeloansforprojectfinanceandformedium-term.ManygovernmentsneededfundsformeetingCurrentAccountdeficits.Someusedthesefundsforworkingcapitalorformeetingthebudgetdeficit.Manyborrowersuse these funds for national development and investment plans. For such large size loans, no single bank will be in a position to lend or take risk of that order. Hence syndicated loans became popular. The lead bank invites other bank to participate in the loan. Fees payable for syndicated loans include a up-front management fee, commitment fee, agency fees, etc., in addition to other administration expenses. In this, many banks participate in the loan. Tax shared loans, as in the case of India reduce the cost of borrowing. The Double Taxation Avoidance (DTA) agreements between the borrowing and lending countries provide for waiver of withholding Tax, or tax deduction at source. The lender country will give the lender a tax credit, if a withholding tax of 10% is levied by the borrowing country. The tax shared loans lead to better after tax return to the lender country which the lender shares a part with the borrower by the lower interest rates. Most tax shared loans to India have been from Japan and western developed countries which have tightened their tax laws.

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SummaryThe Double Taxation Avoidance (DTA) agreements between the borrowing and lending countries, provide for •waiver of withholding Tax, or tax deduction at source. The lender country will give the lender a tax credit, if a withholding tax of 10% is levied by the borrowing country.Forfaitingisthepurchaseatafixedrateofmedium-termclaimsontheforeignbuyer.Dependingonthecredit•standing of the importer and the country risk, the importer’s bank guarantee is needed on the face of the promissory note or bill of exchange.The LIBID and LIBOR are averages of the leading six international banks dealing in Euro-Currency markets.•The Euro-markets are the single longest source of funds, particularly since the seventies, when the currencies •deposited from the Balance of payments surpluses of countries in the offshore Banks began to grow and they are outside the regulatory framework of any Monetary Authority. These are called offshore funds, as they are funds kept with foreign and multinational banks and are not controlled by domestic authorities.In India, External Commercial Borrowing (ECBs) are governed by guidelines on•External Commercial Borrowing Policy and Procedures issued from time to time.•DomesticBondsareusuallyfixed-interest,fixed-maturityclaimswithrangingmaturitiesfrom1-30years.They•are issued by domestic residents, in the domestic currency, and largely sold to domestic residents.

ReferencesInternational financial markets• [Online]Availableat:<http://www.egyankosh.ac.in/handle/123456789/132>[Accessed 14September 2011].Introduction to IFM• [Online]Availableat:<http://www.egyankosh.ac.in/handle/123456789/7437>[Accessed14 September 2011].Balance of payments - structure of the current account• [VideoOnline](Updated29May2008)Availableat:<http://www.youtube.com/watch?v=JKRBpJZ92QM&feature=related>[Accessed10September2011].Gasior, M. • Syndicated Bank Loans [VideoOnline](Updated22Dec2007)Availableat:<http://www.youtube.com/watch?v=Zx6eO65chLo>[Accessed10September2011].Avadhani, V. A., 2010. • International Financial Management, Global Media Mumbai.Agarwal, O. P• ., 2009 International Financial Management, Global Media Mumbai.

Recommended ReadingAswathappa, A., • International business,2010. Tata McGraw-Hill EducationApte., 2006. • International Financial Management,4th ed., Tata McGraw-Hill Education.Vyuptakesh, S., • International Financial Management, PHI Learning Pvt. Ltd.


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Self Assessment Under________________,theimporterfirstreceivesthegoodsandthenarrangesforthepayment.1.

closed accounta. open accountb. fixedaccountc. direct accountd.

In the _________________ method, the commercial banks facilitate the payment process. The exporter draws 2. upadocumentcalledabillofexchange,inwhichpaymentisdemandedfromtheimporterataspecifiedfuturedate.

Payment transfera. Documentary collectionb. Time Bill of exchangec. Letters of creditd.

_________________ requires the importer to arrange for the payment after some time (60 days or 90 days) 3. receiving the possession of goods.


___________________ is an instrument issued by a bank wherein the bank promises the exporter to pay upon 4. receivingtheproofthattheexportercompletedallthenecessaryformalitiesspecifiedinthedocument.


_________________ is an arrangement to pay for import of goods and services with something other than 5. cash.

Counter-tradea. Payment advanceb. Letter of creditc. Time Bill of exchanged.

Match the following6.

1. Keiretsu A. Many companies form a small number of interlocking business groups

2. Shareholders B. The ones whose capital is at risk.

3. Money management decisions C.Decisionsabouthowtomanagethefirm’sfinancialresourcesmostefficiently.

4. Bretton Woods System D. Fixed parity system with adjustable pegs1-A, 2-B, 3-C, 4-Da. 1-D, 2-C, 3-B, 4-Ab. 1-C, 2-B, 3-D, 4-Ac. 1-B, 2-D, 3-A, 4-Bd.

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Whichofthefollowingisahybridoffixedrateandfloatingrate?7. Counter tradea. Target zone arrangementb. Crawling pegc. Floating rate systemd.

_______________________ theory is proposed by Allen and Kennen.8. Balance of payment approacha. Monetary approachb. Portfolio balance approachc. Global capital structured.

___________________ are necessary for day-to-day business activities in order to pay for acquiring raw material 9. and other kinds of inputs (accounts payable) including remuneration for employees.

Operatingcashflowsa. Revenueb. Capital c. Dividendsd.

Themarkets of Switzerland, Luxembourg, Singapore,HongKong and theBahamas serve as financial10. _____________.

hubsa. nucleib. entrepotsc. routersd.


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Chapter IV

Heads of Income

Aim


classify income into various heads•

enumerate the income from other sources•

discuss capital gains•

Objectives


identify the calculation of depreciation•

discuss the concept of salary income•

enlist the types of commission an employee can get•

Learning outcome


understandtheprofitsandgainsofbusinessorprofession•

comprehend the computation of basic salary in grade system•

identify • the concept of allowances

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4.1 IntroductionUnderchapter4ofIncomeTaxAct,1961(Section14),incomeofapersoniscalculatedundervariousdefinedheadsofincome.ThetotalincomeisfirstassessedunderheadsofincomeandthenitischargedforIncomeTaxasunderrules of Income Tax Act.

InIncomeTax,anyincomeearnedbyapersonisbroadlycategorisedintofiveheadsofincome.Anyincomeearnedtobetaxedmustcomeunderanyofthefiveheadsofincome.Thefiveheadsofincomeare:

Incomeunderheadsalaries:Thisheadtaxestheincomeearnedbyanindividualassalaryfromanyfirmor•organisation.Income from house property: This head taxes rental income received by any person from way of renting of any •immoveable property.Profitsandgainsofbusinessorprofession:Thisheadofincomebroadlycoversincomeearnedbyapersonas•a result of some business or professional set-up by him.Capital gains: This head of income taxes the income earned on sale of any investment in form of gold, precious •ornaments, shares, etc or immoveable property.Income from other sources: This head of income covers any income which is not chargeable to tax under any •oftheaboveheadsofincome.Anyincomeincludinggamblingorprofit/lossonrunningofracehorses,camels,interest income, etc are chargeable to tax under this head of income.

4.2 SalariesThis includes allowances and taxability, perquisites and valuation of perquisites, provident funds and deduction from salaries.

4.2.1 Heads of IncomeIncomeofapersonisclassifiedinto5categories.Thus,incomebelongingtoaparticularcategoryistaxedunderaseparateheadofincomepertainingtothatcategory.Section14oftheAct,hasclassifiedfivedifferentheadsofincomeforthepurposeofcomputationoftotalincome.Thefiveheadsofincomeare:

Income under the head salaries (Section 15 – 17)•Income from house property (Section 22 – 27)•Profitsandgainsfrombusinessorprofession(Section28–44)•Capital gains (Section 45 – 55)•Income from other sources (Section 56 – 59)•

Itmaybenotedherethatanincomebelongingtoaspecificheadmustbecomputedunderthatheadonly.Ifanincomecannotbeplacedunderanyofthefirstfourheads,itwillbetaxedunderthehead“Incomefromothersources”.

Certain expenses incurred in earning incomes under each head are allowed to be deducted from its gross income accordingtotheprovisionsapplicabletothatspecifichead.Then,thenetincomeundervariousheadsisaggregatedtogether to compute gross total income of the person. After making certain deductions which are allowed from gross total income (relating to certain expenses incurred or payments made or certain incomes earned) we arrive at the figureoftotalincomefortaxationpurpose.

4.2.2 Meaning of SalarySalary, in simple words, means remuneration of a person, which he has received from his employer for rendering services to him. But receipts for all kinds of services rendered cannot be taxed as salary. The remuneration received by professionals like doctors, architects, lawyers etc. cannot be covered under salary since it is not received from their employers but from their clients. So, it is taxed under business or profession head. In order to understand what is included in salary, let us discuss few characteristics of salary.


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4.2.3 Incomes Forming Part of SalarySection17oftheActgivesaninclusivedefinitionofsalary.Broadly,itincludes:

Basic salary

Incomes Forming Part of Salary

Fees, Commission and bonus

Retirement benefits

Taxable value of

perquisites

Taxable value of

cash allowances

Fig. 4.1 Incomes forming part of salary

Although, all the components of salary income are included in salary, there are certain incomes in each of these categories, which are either fully exempt or exempt up to a certain limit. The aggregate of the above incomes, after the exemption(s) available, if any, is known as ‘Gross Salary’. From the ‘Gross Salary’, the following three deductionsareallowedunderSection16oftheActtoarriveatthefigureofNetSalary:

Standard deduction - Section 16 (i)•Deduction for entertainment allowance – Section 16 (ii)•Deduction on account of any sum paid towards tax on employment – Section 16(iii).•

4.2.4 Basic SalaryAllemployeesareentitledtoabasicsalarywhichisfixedaspertheirrespectivetermsofemploymenteitherasafixedamountoratagradedsystemofsalary.

Under this graded system, apart from the basic salary at which the employee will start, annual increments to be giventotheemployeeareprefixedinthegrade.

For example, if a person is employed on 1st May, 2004 in the grade of 12000 – 300 – 15000, this means that he will start at a basic salary of Rs.12000 from 1st May, 2004. He will get an annual increment of Rs.300 w.e.f. 1st May, 2005 and onwards every year on the same date till his basic salary reaches Rs.15, 000. No further increment is given thereafter till he is promoted and placed in other grade.

Advance Salary, if received in previous year for next year is taxable on receipt basis in the same previous year.

Illustration 4.1:X joins service in the grade of Rs.12000 – 300 – 13800 – 400 – 17800 on 1st June, 1999. Compute his basic salary for the previous year 2005-06.

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Solution:For the previous year 2005-06, basic salary of X will be calculated as follows:

1st June 1999 – 31st May 2000 12000 1st June 2003 – 31st May 2004 132001st June 2000 – 31st May 2001 12300 1st June 2004 – 31st May 2005 13500 1st June 2001 – 31st May 2002 12600 1st June 2005 – 31st May 2006 138001st June 2002 – 31st May 2003 12900

Basic Salary for April and May 2005 (Rs.13500 x 2) 27,000Basic Salary for June 2005 – March 2006 (Rs.13800 x 10) 1, 38,000Basic Salary for previous year 1, 65,000

4.2.5 Fees, Commission and BonusAny fees or commission paid or payable to an employee is fully taxable and is included in salary. Commission payablemaybeatafixedamountorafixedpercentageofturnovers.Inboththecases,itistaxableassalaryonlywhenitispaidorpayablebytheemployertotheemployee.Whencommissionisbasedonfixedpercentageofturnoverachievedbyemployee,itisincludedinbasicsalaryforthepurposeofgrantofretirementbenefitsandforcomputing certain exemptions that we will discuss later on.

4.2.6 Taxable Value of AllowancesAllowanceisafixedmonetaryamountpaidbytheemployertotheemployee(overandabovebasicsalary)formeeting certain expenses, whether personal or for the performance of his duties. These allowances are generally taxableandaretobeincludedingrosssalaryunlessspecificexemptionisprovidedinrespectofsuchallowance.For the purpose of tax treatment, allowances are divided into 3 categories:

Fully taxable cash allowances•Partially exempt cash allowances•Fully exempt cash allowances•

Fully taxable allowances: This category includes all the allowances, which are fully taxable. So, if an allowance is not partially exempt or fully exempt, it gets included in this category.

The main allowances under this category are enumerated below:

Dearness allowance and dearness payAs is clear by its name, this allowance is paid to compensate the employee against the rise in price level in the economy. Although it is a compensatory allowance against high prices, the whole of it is taxable. When a part of Dearness Allowance is converted into Dearness Pay, it becomes part of basic salary for the grant of retirement benefitsandisassumedtobegivenunderthetermsofemployment.

City compensatory allowanceThis allowance is paid to employees who are posted in big cities. The purpose is to compensate the high cost of living in cities like Delhi, Mumbai etc. However, it is fully taxable.

Tiffin / lunch allowanceIt is fully taxable. It is given for lunch to the employees.

Non practicing allowanceThis is normally given to those professionals (like medical doctors, chartered accountants, etc.) who are in government service and are banned from doing private practice. It is to compensate them for this ban. It is fully taxable.


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Warden or proctor allowanceThese allowances are given in educational institutions for working as a Warden of the hostel or as a Proctor in the institution. They are fully taxable.

Deputation allowanceWhen an employee is sent from his permanent place of service to some place or institute on deputation for a temporary period, he is given this allowance. It is fully taxable.

Overtime allowanceWhen an employee works for extra hours over and above his normal hours of duty, he is given overtime allowance as extra wages. It is fully taxable.

Fixed medical allowanceMedical allowance is fully taxable even if some expenditure has actually been incurred for medical treatment of employee or family.

Servant allowanceIt is fully taxable whether or not servants have been employed by the employee.

Other allowancesThere may be several other allowances like family allowance, project allowance, marriage allowance, education allowance, andholiday allowance etc.which are not coveredunder specifically exempt category, so are fullytaxable.

Partially exempt allowancesThis category includes allowances which are exempt up to certain limit. For certain allowances, exemption is dependent on amount of allowance spent for the purpose for which it was received and for other allowances, there isafixedlimitofexemption.

House rent allowance (H.R.A.)An allowance granted to a person by his employer to meet expenditure incurred on payment of rent in respect of residential accommodation occupied by him is exempt from tax to the extent of least of the following three amounts:

House rent allowance actually received by the assessee•Excess of rent paid by the assessee over 10% of salary due to him•An amount equal to 50% of salary due to assessee (If accommodation is situated in Mumbai, Kolkata, Delhi, •Chennai)

‘Or’ an amount equal to 40% of salary (if accommodation is situated in any other place). Salary for this purpose includesBasicSalary,DearnessAllowance (if it forms part of salary for the purpose of retirement benefits),Commissionbasedonfixedpercentageofturnoverachievedbytheemployee.

The exemption of HRA depends upon the following factors:Basic Salary •Rent paid•Place of residence •HRA received•

If an employee is living in his own house and receiving HRA, it will be fully taxable.

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Illustration 4.2:Mr. X is employed in A Ltd. getting basic pay of Rs.20, 000 per month and dearness allowance of Rs.7, 000 per month(halfofthedearnessallowanceformspartofsalaryforthepurposeofretirementbenefits).Theemployerhaspaid bonus @Rs.500 per month, Commission @1% on the sales turnover of Rs.20 lakhs, and house rent allowance of Rs.6,000 per month. X has paid rent of Rs.7, 000 per month and was posted at Agra.Compute his gross salary for the assessment year 2006-07

Solution:

Computation of Gross Salary Amount / Rs.

Basic Salary (Rs.20,000 x 12) 2,40,000Dearness Allowance (Rs.7,000 x 12) 84,000Bonus (Rs.500 x 12) 6,000Commission (1% of Rs.20,00,000) 20,000House Rent Allowance(Rs.6,000 x 12 – Amount exempt Rs.53,800) 18,200

Gross Salary: 3,68,200

Amount of HRA exempt is least of 3 amounts:1. 40% of Salary (Rs. 2, 40,000 + Rs.42, 000 + Rs.20, 000) = Rs. 3, 02,0002. Actual HRA received (Rs. 6, 000 x 12) = Rs. 72, 0003. Rent paid (Rs. 7, 000 x 12 – 10% of salary Rs. 30, 200) = Rs. 53,800Amount of HRA exempt is = Rs. 53, 800

Entertainment allowance: Thisallowanceisfirstincludedingrosssalaryunderallowancesandthendeductionisgiven to only central and state government employees under Section 16 (ii).

Specialallowancesformeetingofficialexpenditure:Certainallowancesaregiventotheemployeestomeetexpensesincurredexclusivelyinperformanceofofficialdutiesandhenceareexempttotheextentactuallyincurredforthepurpose for which it is given. These include travelling allowance, daily allowance, conveyance allowance, helper allowance, research allowance and uniform allowance.

Special allowances to meet personal expensesTherearecertainallowancesgiventotheemployeesforspecificpersonalpurposesandtheamountofexemptionisfixedi.e.notdependentonactualexpenditureincurredinthisregard.Theseallowancesinclude:

Children education allowanceThis allowance is exempt to the extent of Rs.100 per month per child for maximum of 2 children (grand children are not considered).

Children hostel allowanceAny allowance granted to an employee to meet the hostel expenditure on his child is exempt to the extent of Rs.300 per month per child for maximum of 2 children.

Transport allowanceThis allowance is generally given to government employees to compensate the cost incurred in commuting between place of residence and place of work. An amount uptoRs.800 per month paid is exempt. However, in case of blind and orthopedically handicapped persons, it is exempt up to Rs. 1600p.m.


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Out of station allowanceAn allowance granted to an employee working in a transport system to meet his personal expenses in performance of his duty in the course of running of such transport from one place to another is exempt up to 70% of such allowance or Rs.6000 per month, whichever is less.

Fully exempt allowancesForeign allowance•

This allowance is usually paid by the government to its employees being Indian citizen posted out of India �for rendering services abroad. It is fully exempt from tax.

Allowance to High Court and Supreme Court Judges of whatever nature are exempt from tax.•Allowances from UNO organisation to its employees are fully exempt from tax.•

Illustration 4.3: (based on different allowances received by employee)From the following particulars, compute gross salary of Mr X for the assessment year 2006-07. He is employed in textile industry in Mumbai at a monthly salary of Rs.4000. He is entitled to commission of 1% on sales achieved by him, which were Rs.10 lakhs for the year.

In addition, he received the following allowances from the employer during the previous year:Dearness Allowance Rs.2000 per month which is granted under terms of employment and counted for retirement •benefits.Bonus Rs.32000•House Rent Allowance Rs.1000 per month (Rent paid for house in Mumbai Rs.1200 per month)•Entertainment Allowance Rs.1000 per month•Children Education Allowance Rs.500 per month•Transport Allowance Rs.1000 per month•Medical Allowance Rs.500 per month•Servant Allowance Rs.200 per month•City Compensatory Allowance Rs.300 per month•Research Allowance Rs.500 per month (amount spent on research • Rs.3000)

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Solution:Computation of Income from Salary of Mr. X for the Assessment Year 2006-07

Amount/Rs.Basic Salary 48,000Dearness Allowance 24,000Commission 10,000Bonus 32,000House Rent Allowance 5,800(Rs.1000 x 12 – Amount exempt Rs.6200)* Entertainment Allowance 12,000Children Education Allowance 3,600(Rs.500 x 12 – Amount exempt Rs.100 x 2 x 12) Transport Allowance 2,400(Rs.1000 x 12 – Amount exempt Rs.800 x 12) Medical Allowance (fully taxable) 6,000Servant Allowance (fully taxable) 2,400City Compensatory Allowance (fully taxable) 3,600Research Allowance 3,000(Rs.500 x 12 – Amount exempt Rs.3000) Gross Salary: 152,800

* Amount of HRA exempt is least of 3 amounts50% of Salary (Basic Salary + DA granted under terms of employment +a. Commission based on percentage of turnover – Rs.48, 000 + Rs.24, 000 + Rs.10, 000 = Rs.82, 000) = b. Rs.41,000Actual HRA received: Rs.1000 x 12 = Rs.12, 000c. Rent paid (Rs.1200 x 12) – 10% of Salary (Rs.82, 000) Rs.14, 400 – Rs.8,200 = Rs.6,200d.

4.3 Income from House PropertySelf occupied property and let out property-deemed to be let out property-permissible deduction.

An assessee may be taxed on a notional income in the case of let out property if fair rent exceeds actual rent. Again, where an assessee owns more than one house property for self-occupation purposes, the annual value of only one such house shall be taken as nil and in respect of the other properties income shall be computed on a notional basis by deeming such properties as let out and by adopting fair rent as the gross annual value.

Thecomputationbecomeseasierifthestudentidentifiesthecategoryofthehousepropertyforwhichcomputationis sought to be made and then proceeds to apply the respective methodology. The Provisions relating to this head of income can be divided into three segments as follows:

4.3.1 Conditions to be satisfied for income to be charged to tax Under the head ‘income from house property’ [sec. 22]. As per Section 22The followingconditionsare tobesatisfied foran income tobechargedunder thehead“IncomefromHouseProperty” –

The property must consist of buildings or lands appurtenant thereto:The appurtenant lands in respect of a residential building may be in the form of approach roads to and from public streets, compounds, courtyards, gardens, cattle-shed, etc.


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(a) Vacant Plot: Vacant plot cannot be said to be a land appurtenant to a] building and thus, income from such vacant plot is not taxable u/s 22, but u/s 56 as income from other sources.

(b) Income from well within the outer walls of house: A well within the walls of a house cannot be said to be land appurtenant to house, as it is not necessary for enjoyment of the house. Thus, income from sale of water of well is not chargeable u/s 22, but u/s 56 as income from other sources –M. Ramalakshmi Reddy V. CIT [1998] 232 ITR 281 (Mad)

(c) Display of advertisement hoarding on roof of building: Rent on account of display of advertisement hoarding of various concerns on the roof of the building cannot be taxed as ‘Income from House Property’ but will be taxed as ‘Income from Other Sources’ because hoarding on roof of building cannot be treated as part of the building. – Mukherjee Estate Pvt. Ltd. v. CIT [2000] 244 ITR 1 (Cal.)

The assessee must be the owner of such house propertyFor the purpose of Section 22, ‘owner’ is a person who is entitled to receive income in his own right. Owner includes deemed owner u/s 27.

Registered ownership is not necessary: Where a house property is handed over by contractor/builder to a •purchaser, the purchaser is to be treated as ‘owner’ of that property for purpose of Section 22 even though no registered documents as required by Transfer of Property Act, 1882 or the Registration Act, 1908 are executed. The requirement of registration of the sale deed in the context of Section 22 is not warranted. [CIT v. Podar Cement (P) Ltd. [1997] 226 ITR 625 (SC)]Dispute in title of property: In case there is dispute in relation to ownership of the property, the income thereafter •shall be assessed in the hands of the person who is in respect of such income.The property should not be used by the owner thereof for the purpose of any business or profession carried on •byhim,theprofitofwhicharechargeabletotax:Ifthepropertyisusedbytheownerthereofforany business orprofessioncarriedonbyhim;andtheprofitsofsuchbusinessare chargeable to tax, then income from such property shall not be chargeable to tax under this head.

The following points are relevant to explain this point:Use for business must be by owner: For example, if a company gives its house property to its subsidiary for •business of such subsidiary, then income from such property shall be taxable under this head, as use for business purposes is not by owner of house i.e. the company, but by its subsidiary.Letting out for business purposes is use for business purposes: For example, when a house property owned by an •assessee is occupied for residence by its employees/directors, etc., whether on payment of rent or otherwise, to enablethemtodischargetheirfunctionsefficientlyandlettingoutofthepropertyissubservientandincidentalto the main business of the assessee, such an occupation amounts to use of the property by the assessee itself for the purpose of its business, even though no business is actually carried on in such premises. Income from such property is not assessable as ‘Income from House Property’, but as income from business or profession. – CIT v. Modi Industries Ltd. [1994] 210 ITR 1 (Delhi) (FB).Partner’sPropertyinwhichfirmcarriesonbusinessistobetreatedasusebythepartnerforhisbusiness:When•apartnergiveshispropertyforusebythepartnershipfirmforthepurposeofcarryingonbusinessofthefirm,then it will be treated as use by the partner for the purpose of his business and therefore, the income from such propertyshallnotbechargedtotaxunderthishead.–[CITv.RasiklalBalabhai[1979]ITR303(Guj);CITv.Mustafa Khan [2005] 276 ITR 601 (All.)]PropertyofHUFletouttofirminwhichHUFispartnerthroughtheKarta:Inthiscase,thepropertywillnot•beassessableunderthishead,asthepropertyisusedbytheowner(HUF)forits(firm’s)business–CITv.ShriChampa Lal Jeevraj [1995] 215 ITR 289 (Mad.).

However,incasepremisesownedbyHUFisusedbyfirminwhichitsmember/Kartaispartnerinindividualcapacity,thenthebonafideannualvalueofsuchpropertywouldbeassessableunderSection22inthehandsofHUF–CITv. Shiv Mohan Lal [1993] 202 ITR 60 (All.)

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Other points relating to charge of income under this head:Property held as stock-in-trade: Even if the property is held by the assessee as a stock in trade, or is engaged •in the business of letting out of property on rent, or the assessee is a company incorporated for the purpose of owninghouseproperty,theincomefallsunderthehead‘IncomefromHouseProperty’becauseitisthespecifichead for charge income from house property.Sublet receipt: Income from sub-letting of property is not assessable as income from house property as the person •sub-letting the property is not the owner thereof. Subletting receipt is taxable as income from other sources. However,ifsub-lettingiscarriedonasabusinessactivity,theincomethereafterwillbechargeableasProfitsand Gains of Business or Profession.Intention of the parties is also relevant: If the letting out of the property is for earning rental income thereafter , •then the income from such property will be chargeable under Section 22, even if some additional facilities are also provided and the monthly rent is inclusive of charges for such facilities and the property, both. However, if letting out of the property is for the purposes of the business of the assessee, the income from such property will not be taxable under this head – Shambhu Investment P. Ltd. v CIT [2003] 263 ITR 143 (SC).Building constructed on leasehold land: The income from property being building or land appurtenant thereto •is assessable under this head. In case of building constructed on a leasehold land, though the assessee is not the owner of the land but he is the owner of the superstructure that is. the building. Thus, the income arising from building is assessable under the head ‘Income from House Property’.Principle of mutuality: The assessee members club provided recreational and refreshment facilities exclusively •toitsmembersandtheirguests.Itsfacilitiesarenotavailabletonon-members.Theclubisrunonnoprofitnolossbasis.Membersarenotentitledtoanyshareintheprofits.Theassessee’sbusinessisgovernedbythedoctrine of mutuality and does not come within the scope of business. In the case of such a mutual concern. It is not only the surplus from the activities, but even the annual value of the clubhouse that shall be excluded from the purview of the levy of income tax. Therefore, the annual value of the building is not chargeable to tax-Chelmsford club versus CIT (SC).Exempted buildings: The following buildings are exempted subject to satisfaction of the conditions prescribed •under the relevant sections:

farmhousesoutsidethespecifiedarea-section10(1); �buildingsownedbyaneducationalorcharitableinstitution–section10(203C)orsection11; �buildingsownedbyatradeunion-section10(24); �buildingsownedbyapoliticalpartyin-section13A; �buildingsownedbyalocalauthority-section10(20);and �buildingsownedbyApprovedscientificresearchinstitution-section10(21) �

Treatment of Composite Rent, which is received for letting of property as well as other services and/or assets: •Treatment of Composite rent is given as under :

Composite rent on account of rent for the property and service charges for various facilities provided along �with the house: Composite rent is to be split up and the sum that is attributable to the use of the property is to be assessed in the form of annual value under Section 22. While the income received fro services is chargeable under Section 28 or Section 56.Composite rent on account of rent for the property and hire charges of machinery, plant or furniture belonging �to the owner: If the letting of property is separable from letting of other assets, then rent for house property is taxable u/s 22 and rent for other assets is taxable u/s 28 or 56, as the case may be. If letting is inseparable, then the entire income is taxable u/s 28 or 56, as the case may be.


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Chargeability of various types of buildings and lands appurtenant thereto

Sr. No. Types of Buildings and Lands Chargeability

1.

Tiled house with mud walls or cement •walls;RCCbuildings,Palaces;•Apartments/Individualflats;•Bungalows, Row House, Beach House •andPentHouse;Auditoriums;•Godowns,Warehouses;•Offices,Commercialshops,theatres;•Farmhouses;College/libraryBuildings•

The buildings referred here should be of permanent nature. Temporary structure shall not be considered as buildings for the purpose of income from house property. For example, Circus, Tents, exhibition structures, etc.

2.

Buildings does not include -Incompleteunits;•Buildings, which are in a dilapidated •condition

The building is left incomplete as the construction •is not completed due to litigation or any other reason;Building, which is not capable for self-occupation •or letting out for residential or commercial purposes. E.g. Substantial structure of the building is destroyed due to earthquake.

3. Lawns, Gardens, parking places, etc. attached to the buildings. Chargeable as land appurtenant to the buildings.

4. Buildings situated in foreign country.

The income from such property shall be computed similar to the properties situated in India.

However, students may note that the taxability of such buildings is based on the residential status of the assessee. In case the Double Taxation Avoidance Agreement provides for tax relief in respect of such income, then Sec. 90 would apply and subject to the terms of such agreement, the income from house property in foreign country will be subjected to tax.

Table 4.1 Chargeability of various types of buildings and lands

4.4 Profits and Gains of Business or ProfessionIncomeundertheheads“Profitsandgainsofbusinessorprofession”and“Incomefromothersources”shallbecomputed in accordance with method of accounting regularly employed by the assessee.

Therearetwomainmethodsofaccounting—mercantilesystemandcashsystem.•Inthecaseofmercantilesystem,netprofitorlossiscalculatedaftertakingintoconsiderationallincomeand•expenditure of a particular accounting year irrespective of the fact whether income is not received or expenditure is not actually paid during the accounting period. Therefore, if books of account are kept by an assessee on the basis of mercantile system, income of a business or profession, accrued during the previous year, is taxable whether it is received during the previous year or in a year preceding or following the previous year. Similarly, expenditure of business or profession, relating to the previous year, is deductible even if it is not paid during the previous year.

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In the case of cash system of accounting, on the other hand, a record is kept of actual receipts and actual payments •of a particular year. If books of account are kept by an assessee on the basis of cash system of accounting, income collected during the previous year is taxable whether it relates to the previous year or a year preceding or following the previous year. Similarly, expenditure actually paid during the previous year is deductible irrespective of the fact whether it relates to the previous year or some other year(s).

4.4.1 Scheme of Business DeductionsSection28definesvariousincomewhicharechargeabletotaxunderthehead“Profitsandgainsofbusinessorprofession”.Section29permitsdeductionsandallowanceslaiddownbysections30to43Dwhilecomputingprofitsor gains of a business or profession.

4.4.2 Specific Deductions under the ActSections 30 to 37 cover expenses, which are expressly allowed as deduction while computing business income, sections 40, 40A and 43B cover expenses which are not deductible. The following expenses are expressly allowed asdeductionsagainstprofitsandgainsofbusinessorprofession:

Rent, rates, taxes, repairs and insurance for buildingUnder section 30, the following deductions are allowed in respect of rent, rates, taxes, repairs and insurance for premises used for the purpose of business or profession:

the rent of premises, the amount of repairs (not being capital expenditure), if he has undertaken to bear the a. costofrepairs(thisisapplicableiftheassesseehasoccupiedthepropertyasatenant);the amount of current repairs (not being capital expenditure) (if the assessee has occupied the premises b. otherwisethanasatenant);anysumonaccountoflandrevenue,localratesormunicipaltaxes;andc. amount of any premium in respect of insurance against risk of damage or destruction of the premisesd.

Application of section 43B - Land revenue, local rates or municipal taxes is deductible subject to the conditions as specifiedbysection43B.

Repairs and insurance of machinery, plant and furnitureThe expenditure incurred on current repairs (not being capital expenditure) and insurance in respect of plant, machinery and furniture used for business purposes is allowable as deduction under section 31.

DepreciationDepreciation shall be determined according to the provisions of section 32.

Conditions For Claiming Depreciation - In order to avail depreciation, one should satisfy the following •conditions:

Condition 1 Asset must be owned by the assessee.Condition 2 It must be used for the purpose of business or profession.Condition 3 It should be used during the relevant previous year.Condition 4 Depreciation is available on tangible as well as intangible assets.

Asset should be owned by the assessee - The asset should be owned by the assessee or the assessee should be •the co-owner of the asset.Asset must be used for the purpose of business or profession•

The asset, in respect of which depreciation is claimed, must have been used for the purpose of business or �profession.

User of the asset in the previous year - The asset, in respect of which depreciation is claimed, must have been •used for the purpose of business.


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Normal depreciation (i.e., full year’s depreciation) is available if an asset is put to use at least for sometime during the previous year. However, depreciation allowance is limited to 50 per cent of normal depreciation, if the following twoconditionsaresatisfied—

whereanassetisacquiredduringthepreviousyear;anda. it is put to use for the purpose of business or profession for less than 180 days during that year.b.

Depreciation is available on tangible as well as intangible Assets - Under the Income-tax Act, one can claim depreciationinrespectofthefollowingassets—

Tangible assetsIntangible assets acquired after March 31, 1998

Building, machinery, plant or furniture Know-how, patents, copyrights, trade marks, licenses, franchises or any other business or commercial rights of similarnature.

Building - “Building” means the superstructure only and does not include site.

Plant-“Plant”includesships,vehicle,books(includingtechnicalknow-howreport),scientificapparatusandsurgicalequipments used for the purpose of business or profession. It does not include tea bushes or livestock or buildings orfurnitureandfittings.

Consequenceswhenaboveconditionsaresatisfied-Iftheaboveconditionsaresatisfied,depreciationisavailable.•Depreciation is available whether or not the assessee has claimed the deduction for depreciation in computing his total income.

To understand method of computation of depreciation, one must know the meaning of the following terms:Block of assets �Written down value �Actual cost �Block of assets [Sec. 2(11)] - The term “block of assets” means a group of assets falling within a class of �assetscomprising—tangibleassets,beingbuildings,machinery,plantorfurniture;a. intangible assets, being know-how, patents, copyrights, trade marks, licenses, franchises or any other b. business or commercial rights of similar nature, in respect of which the same percentage of depreciation is prescribed.

A taxpayer may have 19 different blocks of assets.Written down value [sec. 43(6)] - Written down value for the assessment year 2006-07 will be determined �as under:

Step 1 Find out the depreciated value of the block on the April 1, 2005.

Step 2 To this value, add “actual cost” of the asset (falling in the block) acquired during the previous year 2005-06.

Step 3 Fromtheresultantfigure,deductmoneyreceived/receivable(togetherwithscrapvalue) in respect of that asset (falling within the block of assets) which is sold,discarded, demolished or destroyed during the previous year 2005-06.

Other points - The following points should be noted:The resulting amount is the written down value of the block of assets on March 31, 2006 relevant for the 1. assessment year 2006-07.The amount of reduction under Step 3 cannot exceed the value of assets computed under Step 1 and Step 2.2. One may determine written down value for other assessment years on similar basis.3.

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Insomecases,computationofwrittendownvalueisbaseduponnotionalfigures[seeproblem91-P6].4. Under Step 3, only actual money (received or receivable in cash or by cheque or draft) is deductible. In other words, 5. anyotherthingsorbenefit(whichcanbeconvertedintermsofmoney)cannotbedeductedunderStep3.

Specific disallowanceThe following expenses given by sections 40, 40A and 43B are expressly disallowed by the Act while computing incomechargeableunderthehead“Profitsandgainsofbusinessorprofession”.

Amount not deductible under section 40(A)In the case of any assessee, the following expenses are expressly disallowed under section 40(a):Interest, Royalty, Fees for Technical Services Payable To ANon-Resident [Sec. 40(A) (I)] - Disallowance under section 40(a) (i) is attracted if the following conditions are satisfied:

Condition one The amount paid is interest (not being interest on any loan issued for public subscription before April 1, 1938), royalty, fees for technical services or other sum.

Condition two The aforesaid amount is chargeable to tax under the Act in the hands of therecipient.

Condition three

Theaforesaidamountispaid/payableasfollows—Situation Place of payment To whom it is paid / payable

Situation 1 Outside India To a resident or non-resident

Situation 2 In India To a non-resident or foreign company

Condition four Inrespectoftheaforesaid,taxisdeductiblebuttaxhasnotbeendeducted;ortaxhasbeen deducted but after deduction it has not been paid to the Government in the previous year [or in a subsequent year before the expiry of time given under section 200(1)]

Consequencesiftheaboveconditionsaresatisfied-Iftheaboveconditionsaresatisfied,theaforesaidexpenditureis not deductible.

Consequences if tax is deducted subsequently - If tax is deducted/paid subsequently then deduction is available in some cases.

Compliance of tds provisions in case of a resident [sec. 40(a)(ia)] - Section 40(a) (ia) is applicable from the assessment year 2005-06 if the following conditions are satisfied—

It covers interest, commission or brokerage, fees for technical services, fees for professional services and 1. payment to contractors/ sub-contractors.In the above cases recipient is resident in India.2. Inrespectoftheaforesaid—3.

taxisdeductiblebuttaxhasnotbeendeducted;ora. tax has been deducted but after deduction it has not been paid to the Government in the previous year [or b. in a subsequent year before the expiry of time given under section 200(1)].


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Consequencesiftheaboveconditionsaresatisfied-Iftheaboveconditionsaresatisfied,theaforesaidexpenditureis not deductible with effect from assessment year 2005-06.

Consequences if tax is deducted subsequently - If tax is deducted/paid subsequently, then deduction are available insomecases.Thesameisexplainedinthetablegivenbelow—

Different situations Deductible in which yearIf in respect of expenses mentioned above, (a) tax has been deducted under the relevant sections, and (b) paid to the Government in the same year and before the expiry of time limit given under section 200(1)

Deductible in the year in which the liability to pay interest, commission, brokerage, and so on., is incurred

If in respect of expenses mentioned above , (a) tax has been deducted under the relevant sections, and (b) paid totheGovernmentinthesamefinancialyearbutaftertheexpiry of time limit given under section 200(1)

Deductible in the year in which the liability to pay interest, commission, and so on. is incurred

If in respect of expenses mentioned above, (a) tax has been deducted under the relevant sections, and (b) paid to the Government in the subsequent year but before the expiry of time limit given in section 200(1)

Deductible in the year in which the liability to pay interest, commission, brokerage, and so on., is incurred

If in respect of expenses mentioned above, (a) tax has been deducted under the relevant sections, and (b) paid to the Government in the subsequent year but before the expiry of time limit given in section 200(1)

Deductible in the year in which tax has been paid

If in respect of expenses mentioned above, (a) tax has not been deducted, or (b) tax has been deducted but not paid to the Government

Not deductible

Provident fund payment without tax deduction at source [Sec. 40(A) (Iv)] – Anypaymenttoaprovidentfund(orotherfundestablishedforthebenefitofemployeesoftheassessee)isnotdeductible if the assessee has not made effective arrangements to secure that tax shall be deducted at source from any payments made from the fund which are chargeable to tax under the head “Salaries”.

Tax on perquisite paid by the employer [sec. 40(a) (v)] -•

Theprovisionsofsection40(a)(v)aregivenbelow—The employer provides non-monetary perquisites to employees.1. Tax on non-monetary perquisites is paid by the employer.2. The tax so paid by the employer is not taxable in the hands of employees by virtue of section 10(10CC).3. While calculating income of the employer, the tax paid by the employer on non-monetary perquisites is not 4. deductible under section 40(a) (v).

Amount not deductible in respect of certain unpaid liabilitiesSection 43B is applicable only if the taxpayer maintains books of account on the basis of mercantile system of accounting.Theprovisionsofsection43Baregivenbelow—General Rule - Certain Expenses Are Deductible on Payment Basis - The following expenses (which are otherwise deductibleundertheotherprovisionsoftheIncome-taxAct)aredeductibleonpaymentbasis—

any sum payable by way of tax, duty, cess or fee (by whatever name called under any law for the time being a. inforce);any sum payable by an employer by way of contribution to provident fund or superannuation fund or any b. otherfundforthewelfareofemployees;anysumpayableasbonusorcommissiontoemployeesforservicerendered;c.

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anysumpayableasinterestonanyloanorborrowingfromapublicfinancialinstitution(thatis.,ICICI,IFCI,d. IDBI,LICandUTI)orastatefinancialcorporationorastateindustrialinvestmentcorporation;interestonanyloanoradvancetakenfromascheduledbankincludingacooperativebank;ande. any sum payable by an employer in lieu of leave at the credit of his employee.f.

The above expenses are deductible in the year in which payment is actually made.Exception - When Deductible on Accrual Basis - The exception is applicable if the following two conditions are satisfied—

Condition one: Payment in respect of the aforesaid expenses is actually made on or before the due date of submission of return of income1.

Condition two: The evidence of such payment is submitted along with the return of income.

Iftheabovetwoconditionsaresatisfiedandiftheassesseemaintainsbooksofaccountonmercantilebasis,thenthe expenditure is deductible on “accrual” basis in the year in which the liability is incurred.

Provisions for maintenance of books of account/compulsory audit - not applicable• - The following privileges are available to a taxpayer who declares his income from the aforesaid business at the rate of 5 per cent of gross receipts(oratahigherrate)—

Privilege 1 He is not required to maintain books of account according to the provisions of section 44AA in respect of the aforesaid business.

Privilege 2 He is not required to get his books of account audited under section 44AB in respect of the aforesaid business.

It may be noted that the aforesaid privileges are available only in respect of the aforesaid business. Even such an assessee has to comply with the requirements of both sections 44AA and 44AB in respect of his business, which are not covered by this scheme.

Provisions illustrated - A person has gross receipts of Rs. 30 lakh from the business of retail trade and Rs. 35 lakh from wholesale trading in paper.

Although his total gross receipts are Rs. 65 lakh, he will not be required to have his accounts audited, since his gross receipts after excluding those from the business of retail trade are still less than Rs. 40 lakh, the limit provided in section 44AB

4.5 Capital GainsAny Income derived from a Capital asset movable or immovable is taxable under the head Capital Gains under Income Tax Act 1961. The Capital Gains have been divided in two parts under Income Tax Act 1961. One is short term capital gain and other is long term capital gain.

4.5.1 Short Term Capital GainsIf any taxpayer has sold a Capital asset within 36 months and Shares or securities within 12 months of its purchase then the gain arising out of its sales after deducting there from the expenses of sale(Commission etc) and the cost of acquisition and improvement is treated as short term capital gain and is included in the income of the taxpayer. The deduction u/s 80C to 80U can be taken from the income from short term capital gain apart from the short term capital gain u/s111A

Taxability of short term capital gains: Section 111A of the Income tax Act provides that those equity shares or •equity oriented funds which have been sold in a stock exchange and securities transaction tax is chargeable on such transaction of sale then the short term capital gain arising from such transaction will be chargeable to tax @10% upto assessment year 2008-09 and 15% from assessment year 2009-10 onwards.


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The short term capital gains other than that u/s 111A shall be added to the income of the assessee and no such benefitisavailableonshorttermcapitalgainsarisinginothercasesandtheywillbetaxednormallyatslabratesapplicable to the assessee.

If an assessee does the business of selling and purchasing shares he cannot take advantage of section 111A or section 10(38). In this case income will be treated as business income.

Capital gains in case of depreciable assets : According to section 50 of Income tax act if an assessee has sold a •capital asset forming part of block of assets (building, machinery etc) on which the depreciation has been allowed under Income Tax Act, the income arising from such capital asset is treated as short term capital gain. Where some assets are left in block of assets: If a part of such capital asset forming part of a block of asset has •been sold and after deducting the net consideration received from sale of such asset from the written down value of the block of such asset the written down value comes to NIL then the gain arising shall be treated as short term capital gain and in such case where written down value has become NIL no depreciation shall be available on such block of asset even if some assets are physically left in the block of assets.When no assets are left in block of assets: If the whole of the capital assets forming part of a block of assets •have been sold during a year and the assessee has suffered a loss after deducting the net sale consideration from the written down value of the block of assets then such loss shall be treated as short term capital loss and no depreciation shall be allowed from such block of assets.

It was decided by Chandigarh tribunal in (2004) 3 S.O.T. 521/ 83 T.T.J. 1057 if the whole of capital assets in a block have been sold in a year and some gain arises after the sale such gain shall not be treated as short term capital gain if some new asset has been purchased within the same year in the same block of assets and the total value of new and old capital assets in the same block is more than the sale consideration of the assets sold, since the block of asset does not cease to exist in such case as is required u/s 50(2). This can be explained with an example as below:

Written down value of Machinery as on 01-04-2008 500000 machinery sold on 01-05-2008 600000. New Machinery purchased on 01-06-2008 250000 now in above cases the difference between the w.d.v and sale value, that is., Rs. 100000 can not be treated as short term capital gain in the year 2008-09 since new machinery has been purchased in the same block of asset afterwards in the same year and the total of new and old machinery is more than the sale value of the machineries sold as a result the block of asset continue to exist.

Short term capital gain where land and building are sold together:Some times it happens that in a block of assets namely land and building, the whole of land and building is sold together. In such cases the capital gain on land and building should be calculated separately.

The Supreme Court has held in (1967) 65ITR 377 that depreciation is available on the value of building and not on the value of plot. Considering the above decision of Supreme Court, the Rajasthan High court in (1993)201 ITR 442 has held that Plot and building are different assets. If the assessee has purchased plot more than 3 years back and constructed building on it less than 3 years back then the gain arising on sale of plot shall belong term capital gainandthebenefitofindexationshallbegivenonitwhereasthegainarisingonsaleofbuildingshallbeshorttermcapital gain and will be added to the income of the assessee. Therefore, both should be calculated separately.

Where the plot has been purchased more than three years back and the building has been constructed on it less than 3 years back, it is advisable that in the sale deed the sale value of plot and building should be shown separately for more clarity and if the consolidated sale value of the Plot and building has been written in the sale deed then the valuation of plot and building should be done separately from a registered valuer.

Capital asset transferred by the partner to the partnership firm:As per section 45(3) of the Income Tax Act 1961ifanypartnerinafirmtransfershisassettothefirmthenthecapital gain on such asset as arising to the partner shall be calculated by presuming the sale value of such asset as isshowninthebooksofaccountsofthefirmandnotthemarketvalueoftheasset.Whethersuchgainistreatedaslong term or short term will be decided as below:

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Ifthedepreciationhasbeenclaimedontheassettransferredtothefirmtheninviewofa. section 50(2) the gain arising there from will be treated as short term capital gain. If the partner has been the owner of the asset for more than 36 months and no depreciation has been claimed b. on it then the gain arising from such asset shall be treated as long term capital gain.

Capital gain in case of dissolution of a firmAspersection45(4)oftheIncomeTaxActwhereanypartnershipfirmorAOPorBOIisdissolvedandthecapitalassetsofthesuchfirmorAOPorBOIaretransferredbywayofdistributionofassetstothepartnersatthetimeofDissolution in such case the gain arising from such transfer to the partners will be treated as capital gain and the firmwillbeliableforpayingtaxonitintheyearofdistributionoftheassets.

For the purpose of section 48 the fair market value of the asset on the date of such transfer shall be deemed to be the full value of the consideration received or accruing as a result of the transfer.

4.5.2 Long Term Capital GainA capital asset held for more than 36 months and 12 months in case of shares or securities is a long term capital asset and the gain arising there from is a long term capital gain. Long term capital gains are arrived at after deducting from the net sale consideration of the long term capital asset the indexed cost of acquisition and the indexed cost of improvement of the asset.

TheCentral govt notifies cost inflation index for everyyear.The indexed cost of acquisition is calculatedbymultiplying the actual cost of acquisition with C.I.I of the year in which the capital asset is sold and divided by C.I.I of the year of purchase of capital asset. Similarly the indexed cost of improvement can be calculated by using the C.I.I of the year in which the capital asset is improved. Where the capital asset was acquired before the year 1981 then the cost of acquisition shall be the fair market value or the actual cost of its acquisition which ever is higher. The Fair market value of a capital asset can be known by the valuation of the registered valuer.

The cost inflation index table as notified is here below:

Cost Inflation Index Notified by the GOVTFinancial Year (CII) Financial Year (CII)

1981-82 100 1995-96 2811982-83 109 1996-97 3051983-84 116 1997-98 3311984-85 125 1998-99 3511985-86 133 1999-2000 3891986-87 140 2000-2001 4061987-88 150 2001-2002 4261988-89 161 2002-2003 4471989-90 172 2003-2004 4631990-91 182 2004-2005 4801991-92 199 2005-2006 4971992-93 223 2006-2007 5191993-94 244 2007-2008 5511994-95 259 2008-2009 5822009-10 632

Table 4.2 Cost inflation index


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Ifacapitalassethasbeensubjectedtodepreciationthennoindexationbenefitisallowedonsaleofsuchcapitalasset in view of section 50(2) as discussed above.

Capital gain from plot and building should be separately calculatedAs discussed above plot and building are separate assets and the capital gain on above should be calculated separately. If the plot is purchased more than 3 years back and building has been constructed within 3 years the capital gain on plot will be considered as long term and the capital gain on building will be treated as short term capital gain.

Taxation of Long term capital gainsThelongtermcapitalgainsaretaxed@20%afterthebenefitofindexationasdiscussedabove.Nodeductionisallowed from the long term capital gains from section 80C to 80U. But in case of individual and HUF where the income is below the basic exempted limit the shortage in basic exemption limit is adjusted against the long term capital gains.

Section 112(1) provides that any capital gain arising from a long term capital asset being the listed securities which are sold outside the stock exchange the long term capital gain shall be calculated on such securities as below:a) Tax arrived at @ 20% on such long term capital gain after indexation u/s 48 orb) Tax arrived at @ 10 % on such long term capital gain without indexation, whichever is less.

The long term capital gain on equity shares or units of equity oriented mutual fund which are sold in the stock exchange and on which securities transaction tax is paid, is exempt u/s 10(38).

Section 50C: Section 50C has been introduced with effect from 01-04-2003 and is a very important section while calculating capital gain on land and building. Section 50C provides that where the consideration received or accruing as a result of the transfer by an assessee of a capital asset, being land or building or both, is less than the value adopted or assessed or assessable by stamp valuation authority for the purpose of payment of stamp duty in respect of such transfer, the value so adopted or assessed or assessable shall, for the purposes of section 48, be deemed to be the full value of the consideration received or accruing as a result of such transfer.

It means that the capital gain will be calculated by considering the sale value of the capital asset as equal to the value adopted or assessed by the stamp valuation authority for that capital asset if the actual sale value is less than the value assessed by stamp valuation authority.

If the assessee claims that the value adopted by the stamp valuation authority exceeds the fair market value then theassessingofficermayrefertothevaluationofficerforvaluationofthefairmarketvalueoftheasset.Ifthefairmarket value declared by the valuer is more than the value adopted or assessed or assessable by the stamp valuation authority, the value so adopted assessed or assessable by the stamp valuation authority will be taken as full value of consideration of the capital asset.

CBDTvideitscircularNo8/2002dt27-08-2002hasdeclaredthatifthevaluationofficerhasdeclaredthefairmarketvalue of the capital asset less than the value adopted, assessed or assessable by the stamp valuation authority then the capital gain shall be calculated on the value so declared by the valuer.

After the adding of word assessable u/s 50C in 2009 now it has become clear that even those immovable properties inwhichnosaledeedisenteredintoandwhichhavebeensoldonafullandfinalagreementwillbewithintheambit of section 50C.

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4.6 Income from Other Sources Income of every kind which are to be taxed, and which are not included in the income heads of salary, house property, capital gains, profession and business shall be charged under the head income from other sources.

Income chargeable under this head shall be computed as per the method of accounting followed by assesses. There are two methods of accounting namely cash basis and mercantile basis. In the cash basis of accounting the income is recognised only on its actual receipt and expenses are recognised only on its actual payment. However, in mercantile basis of accounting the income is recognised even before its actual receipt and expense is recognised even before its actual payment.

Illustration 4.4 ABC Ltd. has sold goods worth Rs. 5 lakh in cash and Rs. 12 lakh on credit and purchased goods worth Rs. 2 lakh incashandRs.6lakhoncredit.Determinetheprofitoncashbasisandmercantilebasisofaccounting.

Solution:Profit on cash basis:SaleswillbeRs.5lakhandpurchasewillbeRs.2lakh.Thus,profitwillbesalesminuspurchase,i.e.,Rs.3lakh.

Profit on mercantile basis:SaleswillbeRs.17lakh(bothcashandcredit)andpurchasewillbeRs.8lakh(bothcashandcredit).Thus,profitwill be sales minus purchase, i.e., Rs. 9 lakh.

FollowingincomesarespecificallymentionedintheI.T.ActU/s56,whichareincludedintheincomefromothersources:

Dividend•Interest on securities if not chargeable under the head business or profession.•Wining from lotteries, crossword puzzles, races including horse races, card games and any other sort of games •or gambling or betting of any form.Income from machine, plant or furniture let on hire.•Income from machinery, plant, or furniture along with building and letting thereof is inseparable.•Any sum received under a key-man insurance policy including bonus if not taxable as salary or business •income.

Dividend is the shareof profit,which is distributedby the company to its shareholders; this is an income forshareholders. Interest on securities means interest on debentures, bonds, and so on. which is an income of the person receiving this interest. Letting machine, plant, furniture generates the rental income. We will study the taxation of thefirstthreeincomes,andsoondividend,interestandwinningbrieflyintheparagraphsgivenbelow.

4.6.1 Incomes Not Specified In Section 56Following incomes are not mentioned in the Income Tax Act but are to be charged to tax. Therefore, these incomes are also included in the head of income from other sources.

Income from subletting•Interest on bank deposits and loans and securities•Agricultural income from a place outside India•Rent of plot of land•Mining rent and royalty•Casual income under a will, contract, trust deed•Salary payable to a member of parliament•Income from undisclosed sources•


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Gratuity paid to a director who is not an employee of a company•Any casual income exceeding Rs. 5,000•

4.6.2 Taxability of Select IncomesNow, we will discuss in brief the taxability of dividend, winning from lotteries, interest on securities and family pension.

4.6.3 Taxability of DividendTaxability of Dividends [Sec 56(2)(i)]Dividends is taxable, irrespective of the fact, whether it is paid in cash or in kind or it is paid out of taxable income ortaxfreeincomewhetheritispaidoutofrevenueprofitsorcapitalgains.Dividendincludesdeemeddividendmentioned u/s 2(22).

Normally, dividend is taxable on the basis of its declaration while deemed dividend and interim dividend is taxable on the basis of payment.

Acompanyattheendoftheyearaftercalculatingitsprofitrecommendsthedistributionofsomepartofitsprofittoitsshareholders.Theprofitdistributedamongshareholdersiscalleddividend.

Generally,dividendisgivenattheendoffinancialyear.Butsomehighprofitcompanyalsogivesthedividendinbetweenoftheyearwithoutcalculatingitsyear-endprofits.Thisdividendiscalledinterimdividend.

Dividends from Indian Company are exempt from tax since 1.6.97. But dividend from any other company is taxable. Similarly any deemed dividends U/S 2(22) are also taxable.

Deduction of expenses on collection and interest on loan, taken for investment in shares, is available against dividend income.

Ifthedividendismorethanthespecifiedlimitundersection194(whichisatpresentRs.2,500inayear)thenthedividendactuallyreceivedwillbeafterdeductingaspecifiedpercentageoftaxofTDS(TaxDeductedatSource).In these cases, some tax is deducted and the balance amount of Dividend is paid to the shareholder. The balance amount paid to shareholder is called net dividend or dividend received and the total dividend is called the gross dividend. Thus,

Gross Dividend = Dividend received + TDSTDS = Gross Dividend * TDS RateGross Dividend = Dividend received* 100 / (100- TDS)TDS rate u/s 194 is 20% plus surcharge plus 2% Education cess. The surcharge varies from case to case.

Illustration 4.5 Mr. X received a dividend of Rs. 7000 from a non-domestic company during the previous year. He spends Rs. 100 towards collection charges. Calculated the Gross Dividend and income form other sources.

Solution: In this case let us assume for the sake of simplicity that the surcharge is nil. Thus, TDS will be 20% plus 2% education cess, which comes to 20.4%.Gross Dividend = Dividend received *100/ (100-TDS rate)Gross Dividend = 7000 *100/ (100-20.4)Gross Dividend = Rs. 8,794Dividend chargeable as income from other source = Gross dividend minus Collection charges = Rs. 8,794 – Rs. 100 = Rs. 8,694.

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Taxability of winningTaxability of wining from lotteries, cross word puzzles, horse races and card games etc. is similar to the taxability of dividend with some changes like the rate of TDS is 30 % plus surcharge plus 2% Education cess, and the exemption amount is Rs. 5,000 (however it is 2,500 in case of horse races) and no deduction on account of any expense in relation to the winning is allowed. That is the entire winning amount is taxable.

Gross amount = Rs. 5,000 + (net income received on wining – 5,000)*100(100-TDS)Rs. 5,000 will be Rs. 2,500 in the case of wining from horse races.Rs. 5,000 is an exemption, which is available because it is a casual receipt.Winning on lotteries races, crossword puzzles are all casual income.

Illustration 4.6 Mr. X receives Rs. 7000 from a lottery prize won by him during the previous year. He spends Rs. 100 towards collection charges and the purchase of ticket. Calculated the gross winning and income form other sources.

Solution: In this case let us assume for the sake of simplicity that the surcharge is nil. Thus, TDS will be 30% plus 2% education cess, which comes to 30.6%.Gross winning = Rs. 5,000 + (net income received on wining – 5,000)*100 (100-TDS rate)Gross winning = Rs. 5,000 + (7,000– 5,000)*100 (100- 30.6)Gross winning = Rs. 7,881Winning chargeable as income from other source or Gross Winning =Rs. 7,881.Note: The collection charges are not deductible in case of winning.

Taxability of interest on securitiesTaxability of interest on securities is also similar to the taxability of dividend with some changes like the rate of TDS is 10 % plus surcharge plus 2% education cess

(20% plus surcharge plus 2% education cess in case of unlisted securities) and the exemption amount is Rs. 5,000 and deductions on interest income are collection charges interest on loan and any other revenue expense incurred fully for the purpose of interest is allowed.

Gross interest = Net received * 100 / (100 – TDS rate)

In case of tax-free govt. Securities, grossing up is not required as there is no deduction or TDS. However, grossing up is required in case of following securities.

Tax-free non govt. Securities•Less tax non govt. Securities•Less tax govt. Securities•

Rate of TDSGovt.Securities-10%pluseducationcess;listedsecurities–10%pluseducationcess;unlistednon-govt.Securities- 20% plus education cess.

Illustration 4.7Mr. X received a dividend of Rs. 7000 from a listed security during the previous year. He spends Rs. 100 towards collection charges.


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Calculate the Gross Dividend and income form other sources.Solution: In this case let us assume for the sake of simplicity that the surcharge is nil. Thus, TDS will be 10% plus 2% education cess, which comes to 10.2%.Gross Interest = Interest received *100/ (100-TDS rate)Gross Interest = 7000 *100/ (100-10.2)Gross Interest = Rs. 7795Interest chargeable as income from other source = Gross Interest minus Collection charges = Rs. 7,795 – Rs. 100 = Rs. 7,695.

Taxability of family pensionTaxable as income from other sources, a standard deduction of 1/3rd of pension or Rs. 15,000 whichever is less is allowed.

All those incomes which are not exempt and are to be taxed and are at the same time not covered in any of the four heads of income namely salary, house property, capital gains and business and profession is included in the head of income from other sources. The income included here is taxable on cash or mercantile basis whichever method assesseefollows.Therearecertainincomes,whicharespecificallymentionedinsection56oftheincometaxacttobeincludedintheheadofincomefromothersources,buttherearevariousotherincomes,whicharenotspecifiedin section 56 of the income tax act but are still included in the income from other sources. If the tax is deducted at source then it is clubbed back in the income and then the whole of the income is included in the income from other source, in other words, if tax is deducted at source ad the balance income is received then the tax so deducted is added back in the income so received and then the whole of income is included in the income from other sources.

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SummaryThefiveheadsofincomeareIncomeunderHeadSalaries,IncomefromHouseProperty,ProfitsandGainsof•Business or Profession, Capital Gains and Income from other Sources.Salary, in simple words, means remuneration of a person, which he has received from his employer for rendering •services to him.There are incomes in certain categories, which are either fully exempt or exempt up to a certain limit, the •aggregate of which, after the exemption(s) available, if any, is known as ‘Gross Salary’.Commissionpayablemaybeatafixedamountorafixedpercentageofturnovers.•Allowanceisafixedmonetaryamountpaidbytheemployertotheemployee(overandabovebasicsalary)for•meeting certain expenses, whether personal or for the performance of his duties.Foreign allowance is usually paid by the government to its employees being Indian citizen posted out of India •for rendering services abroad. It is fully exempt from tax.As per Sec 22, the property should not be used by the owner thereof for the purpose of any business or profession •carriedonbyhim,theprofitofwhicharechargeabletotax.Aspertheconditionstobesatisfiedforincometobechargedtotaxunderthehead‘incomefromhouseproperty’•[sec. 22], the assessee must be the owner of the concerned house property.Depreciation is available on tangible as well as intangible assets.•The term “block of assets” means a group of assets falling within a class of certain tangible or intangible •assets.Any Income derived from a Capital asset movable or immovable is taxable under the head Capital Gains •under Income Tax Act 1961.Short term capital gain where land and building are sold together• should be calculated separately. A Capital Asset held for more than 36 months and 12 months in case of shares or securities is a long term capital •asset and the gain arising there from is a long term capital gain.The indexed cost of acquisition is calculated by multiplying the actual cost of acquisition with C.I.I of the year •in which the capital asset is sold and divided by C.I.I of the year of purchase of capital asset.Section 50C has been introduced with effect from 01-04-2003 and is a very important section while calculating •capital gain on land and building.There are two methods of accounting namely cash basis and mercantile basis.• In the cash basis of accounting the income is recognised only on its actual receipt and expenses are recognised •only on its actual payment.In mercantile basis of accounting the income is recognised even before its actual receipt and expense is recognised •even before its actual payment.Dividends is taxable, irrespective of the fact, whether it is paid in cash or in kind or it is paid out of taxable •incomeortaxfreeincomewhetheritispaidoutofrevenueprofitsorcapitalgains.Taxability of winning from lotteries, cross word puzzles, horse races and card games etc. is similar to the •taxability of dividend with some changes.The capital gains have been divided in two parts under Income Tax Act 1961. One is short term capital gain •and other is long term capital gain.If any taxpayer has sold a capital asset within 36 months and Shares or securities within 12 months of its purchase •then the gain arising out of its sales after deducting there from the expenses of sale(Commission etc) and the cost of acquisition and improvement is treated as short term capital gain.Capital gain from plot and building should be separately calculated.•Dividendistheshareofprofit,whichisdistributedbythecompanytoitsshareholders;thisisanincomefor•shareholders


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ReferencesRao, V. G., • The Corporation Income Tax in India. Concept Publishing Company.Bajaj, A., • Capital Gains Under Income Tax Act 1961[Online]Availableat:<http://www.taxmanagementindia.com/visitor/detail_article.asp?articleid=1120>[Accessed26december2011]Income Tax Liability• [Online]Availableat:<http://dateyvs.com/incom_primer.htm>[Accessed26December2011]Dividend and Tax Information• [Online]Availableat:<http://www.experianplc.com/investor-centre/dividend-and-tax-information.aspx>[Accessed26December2011].Corporate Education, 2010. • Capital Gains Under the Indian Income Tax Act - Part II CA, CS and ICWA [Video Online]Availableat:<http://www.youtube.com/watch?v=2Vrj2dovNro>[Accessedon28December2011].Taxsumcom, 2011. • Which income is exempt from house property.avi[VideoOnline]Availableat:<http://www.youtube.com/watch?v=rHwAgzh-JM8>[Accessed28December2011].

Recommended ReadingShuklendra, A., • Law of Income Tax, Modern Law House, 2000.Manupatra Information Solutions Pvt. Ltd. • The Income Tax Act, 1961, 12th ed., India.Lal, B. B., Vashishth, N., • Income Tax and Central Sales Tax- Law and Practice, 29th ed.

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Self Assessment__________istheshareofprofit,whichisdistributedbythecompanytoitsshareholders;thisisanincome1. for shareholders.

Capital Asseta. Capital Gainb. Depreciationc. Dividendsd.

The _____________ value of a capital asset can be known by the valuation of the registered valuer. 2. fair Marketa. depreciationb. dividendc. salaryd.

________, in simple words, means remuneration of a person, which he has received from his employer for 3. rendering services to him.

Depreciationa. Taxationb. Salaryc. Dividendd.

What is “Gross Salary”?4. An income for shareholdersa. The aggregate incomes in certain categories, which are either fully exempt or exempt upto a certain limitb. Actual salaryc. Basic salaryd.

_________payablemaybeatafixedamountorafixedpercentageofturnovers.5. Commissiona. Salaryb. Gross salaryc. Dividendd.

There are two methods of __________, namely cash basis and mercantile basis.6. taxationa. dividendsb. accountingc. allowancesd.

______________isafixedmonetaryamountpaidbytheemployertotheemployee(overandabovebasic7. salary) for meeting certain expenses, whether personal or for the performance of his duties

Taxationa. Accountingb. Allowancesc. Gross salaryd.


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Which of the following statements is true? 8. The Capital Gains have been divided in two parts under Income Tax Act 1961,namely, the short term and a. long term capital gain.Capital gain from Plot and building should not be calculated separately, but together.b. In the mercantile basis of accounting the income is recognised only on its actual receipt and expenses are c. recognised only on its actual payment.In cash basis of accounting the income is recognised even before its actual receipt and expense is recognised d. even before its actual payment.

Which of the following statements is false? 9. Depreciation is available only on tangible assets.a. Foreign allowance is fully exempt from tax.b. The term “block of assets” means a group of assets falling within a class of certain tangible or intangible c. assets.Dividends is taxable, irrespective of the fact, whether it is paid in cash or in kind or it is paid out of taxable d. incomeortaxfreeincomewhetheritispaidoutofrevenueprofitsorcapitalgains.

__________ has been introduced with effect from 01-04-2003 and is a very important section while calculating 10. capital gain on land and building.

Section 10Aa. Section 4Bb. Section 50Cc. Section 20Bd.

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Chapter V

Computation of Taxable Income

Aim


comprehend the computation of taxable income•

identify the meaning of gross total income•

compute taxable income of individuals•

Objectives


comprehend the clubbing of income •

compute taxable income of HUF(Hindu Undivided Families)•

identify the ways to calculate tax liability•

Learning outcome


understand the calculation of taxable income•

understand the deductions from gross total income•

comput• eataxableincomeofapartnershipfirm


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5.1 IntroductionIncome tax is levied under Entry No. 82 of List I of Seventh Schedule to Constitution (Union List), which reads, ‘Tax on income other than agricultural income’. Entry No. 46 of List II of Seventh Schedule to Constitution (State List) reads, ‘Taxes on agricultural income.

Income Tax Act, 1961 imposes tax on income other than agricultural income. Tax on agricultural income can be imposed only by State Governments.

Section 4 of Income Tax Act, which is the charging section, states that where any Central Act enacts that income tax shall be charged for any assessment year at any rate or rates, income tax at that rate or those rates shall be charged for that year in accordance with, and subject to the provisions (including provisions for the levy of additional income tax) of this Act (i.e. Income Tax Act) in respect of the total income of the previous year of every person.

IncometaxRatesfixedunderFinanceActeveryyear-The‘CentralAct’asreferredtoinsection4ofIncomeTaxActis the ‘Finance Act’ enacted every year. Income Tax is payable by every assessee at the rates prescribed by Finance Act every year. The Finance Bill is presented at the time of presenting budget, usually on last day of February every year. The relation between Finance Act and budget is so close that often people associate budget only with taxation. Really, taxation is only one of the aspects of the budget.

Who is assessee?Assessee means a person by whom any tax or any other sum of money is payable under Income tax Act. It includes deemed assessee [section 2(7) of Income Tax Act].

Person - ‘Person’ includes * Individual * HUF * Company * Partnership Firm * Association of Persons (AOP) or bodyofindividualswhetherincorporatedornot*LocalAuthoritylikeMunicipalityetc.*ArtificialJudicialpersonnot falling in any of the aforesaid categories, for example, a Hindu deity [section 2(31) of Income Tax Act].

5.2 Statement of Taxable Income and TaxFollowing is the statement of calculating the taxable income and tax.

Particulars Amount

Income from salaryAdd: Income from house propertyAdd:ProfitandgainfrombusinessadprofessionAdd: Capital gainsAdd: Income from other sourcesGross Total IncomeLess: DeductionsTaxable Income

Tax on Taxable IncomeAdd: SurchargeTax and surchargeAdd: Education cessTotal taxLess: Advance taxLess: T.D.STax Payable at the time of submission of Income

Table 5.1 Statement of taxable income

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Computation and assessment – individualWhile computing taxable income of an individual, the following points should be considered.

Nature of Income Tax treatment

Income earned by the taxpayer

Except the following, all other incomes shall be included:Income exempt under section 10 to 13Aa. Incomes to be included in income of others by virtue b. of sections 60 to 64.

ShareofprofitfromaHUF It is exempt under section 10(2)Shareofprofitfromafirmassessedasfirm. It is exempt under section 10(2A)Salaryandinterestfromtheaforesaidfirm. These are taxable business income.

Shareofprofitfromanassociationofpersons/bodyof individuals.

If the association/body use taxable at the maximum marginalrate,thenshareofprofitisnottaxableinthehandof recipient.

Income earned by others and included in the income of the taxpayer by virtue of sections 60 to 64.

Such income shall be included in the income of the taxpayer.

Table 5.2 Computation and assessment – individual

Calculating taxable incomeTaxable income shall be computed as follows:Step 1-incomeunderthedifferentheadsofincome-Firstfindoutincomeunderthefiveheadsofincome.Step 2 - adjustment of losses of the current year and earlier years-Losses should be set off according to the provisions of sections 70 to80. The income after adjustment of losses is gross total income.Step 3 - deduction from gross total income- from the gross total income, the following deductions are available.

Section Nature of Deduction80C Payment of insurance premium, contribution to provident fund, etc.80CCC Contribution to certain pension fund80CCD Contribution to pension scheme of central government80D Payment of medical insurance premium80DD Maintenance including medical treatment of a dependent being a person with disability80DDB Medical treatment expenditure80E Repayment of loan taken for higher studies80G Donations to charitable institutions and funds80GG Rent paid80GGA Donationsforscientificresearchorruraldevelopment80GGC Contributions given to political parties80-IA Profitsandgainsbyanundertakingorenterpriseengagedininfrastructuredevelopment,etc.

80-IAB Profitsandgainsbyanundertakingorenterpriseengagedindevelopmentofspecialeconomiczone

80-IB Profits and gains from certain industrial undertakings other than infrastructure developmentundertakings

80-IC Profitsandgainsofcertainundertakingsincertainspecialcategoryofstates.80-JJA Profitsfromthebusinessofcollectingandprocessingofbio-degradablewaste80QQB Royalty income of authors80RRB Royalty on patents80U Income of a person with disability

Table 5.3 Calculating taxable income


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Step 4 - Rounding off-The balance should be rounded off to the nearest Rs. 10. It is known as net income or total income or taxable income.

Calculating tax liabilityFinal tax liability shall be determined as under.

Particulars AmountTax on net incomeLess:Tax rebates under section 88EBalanceAdd: SurchargeTax and surchargeAdd: Education cess (2% of tax and surcharge)Total taxLess: Tax rebate or relief under sections 86,89,90,90A and 91Add: Interest payable under sections 234A,234B and 234CLess: Prepaid taxTax deducted at source on his own income and on income of others included in his taxable incomeTax collected at sourceAdvance taxTax payable at the time of submission of return of income

Table 5.4 Calculating tax liability

Special provisions relating to non-residents [sec.115C to 115-I] These provisions are given below.

Who can claim the benefit of special provisions?Thebenefitofspecialprovisionscanbeclaimedbynon-residentIndians.Thefollowingare“non-residentIndians”for this purpose.

Citizen of India who is a non-resident, or•A person of Indian origin who is a non-resident.•

A person shall be deemed to be of Indian origin if he, or either of his parents or any of his grandparents, were born in undivided India.

Incomes which are qualified for special treatmentThe provisions under sections 115C to 115-I are applicable only in respect of the following incomes derived by a non-resident Indian:

Investment income derived from a “foreign exchange assets.”•Long term capital gains on sale or transfer of “foreign exchange assets.”•

Foreign exchange asset: Itmeans those specified assetswhich the assesse has acquiredor purchasedwith, orsubscribed to inconvertible foreign exchange.

Thefollowingarespecifiedassetsforthispurpose:SharesinanIndiancompany(publicorprivate);•DebenturesissuedbyanIndiancompanywhichisnotaprivatecompany;•Deposits with an Indian company which is not a private company ± it may be even deposit with SBI or any •otherbankingcompany;

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Anysecurityofthecentralgovernment;and•SuchotherassetsastheCentralGovernmentmayspecifyinthisbehalfbynotificationintheofficialGazette.•

Calculate investment incomeIn computing the investment income of a non-resident Indian, no deduction in respect of any expenditure or allowance shall be allowed under any provisions of the act. Moreover, No deductions under sections 80C to80U shall be allowed in respect of investment income of non-resident Indians.

Calculate long-term capital gainLong-term capital gain on sale or transfer of foreign exchange assets shall be calculated subject to the following points:

Thebenefitofindexationisnotavailableinrespectofsaleortransferofforeignexchangeassets.•No deduction is permissible in respect of long-term capital gain under sections 80C to 80U.•By investing sale consideration in another asset, the non-resident Indian can claim exemption under section •115F.Tax on investment income and long-term capital gain•

Non-resident Indian are chargeable to tax on investment income and long-term capital gain at the rate of 20% and 10%respectively.

Return of income not to be filled in certain casesIn cases where a non-resident Indian has income only from a foreign exchange asset or income by way of long-term capital gains arising on transfer of foreign exchange asset, or both, and tax deductible at source from such income hasbeendeducted,heisnotrequiredtofilethereturnofincomeundersection139(1).Theincomefromforeignexchange assets and long-term capital gains arising on transfer of such assets would be treated as a separate block andchargedtotaxataflatrateasexplainedabove.

If the non-resident Indian has other income in India, such other income is treated as an altogether separate block and charged to tax in accordance with other provisions of the act.

Benefitavailableevenaftertheassesseebecomesresident•A non-resident Indian, in any previous year, becomes assessable as resident in India in any subsequent �year.Hemayfurnishtotheassessingofficeradeclarationinwritingtotheeffectthatthespecialprovisionsshall �continue to apply to him in relation to the investment income derived from any foreign exchange asset.The foreign exchange assets for this purpose are debentures and deposit with an Indian public limited �company and Central Government securities.If he does so, the special provisions shall continue to apply to him in relation to such income for that �assessment year until the transfer or conversion into money of such assets.

5.3 Computation of Taxable Income of HUFUnder the Income tax Act, a Hindu Undivided Family is treated as a separate entity for the purpose of assessment. ThetermHinduUndividedFamily´hasnotbeendefinedundertheIncomeTaxAct. Theexpressionis,however,definedundertheHinduLaw,asafamilywhichconsistsofallpersonslineallydescendedfrom a common ancestor and includes their wives and unmarried daughters. The relation of a Hindu Undivided Family does not arise from a contract but arises from status.

What are the basic conditions for assessment of Hindu Undivided Family?Income of a joint Hindu Family may be assessed as a Hindu Undivided Family if the following two conditions are satisfied.


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There is a coparcener ship. In this connection, it is worthwhile to mention that once a joint family income is •assessed as Hindu Undivided Family, it continues to be assessed as such in subsequent assessment years till partition is claimed by its coparceners.There is a joint family property which is consists of ancestral property, property acquired with the aid of ancestral •propertyandpropertytransferredbyitsmembers.Ancestralproperty,inthisconnection,maybedefinedastheproperty which a man inherits from any of his three immediate male ancestors, i.e., his father, grandfather and great-grandfather. Therefore, property inherited from any other relation is not treated as ancestral property.

What is the basis of computation of taxable income of HUF?First ascertain income under different heads of income, ignoring incomes exempted under sections 10 to 13A. While computing income one should keep in mind the following additional points:

IffundsofaHinduundividedfamilyareinvestedinacompanyorfirm,feesorremunerationreceivedbythe•memberasadirectororapartnerinthecompanyorfirmmaybetreatedasincomeofthefamily,ifthefeesorremuneration is earned essentially as a result of investment of fund.If any remuneration is paid by the Hindu undivided family to the Karta for services rendered by him in conducting •familys business, the remuneration is deductible if remuneration is

Paidunderavalidandbonafideagreement; �Intheinterestof,andexpedientfor,thebusinessoffamily;and �Genuine and not excessive = Jugal Kishore Baldeo Sahai v.CIT [1967] 63 ITR 238 (SC).3. �

The following incomes are not taxed as income of Hindu undivided family: If a member has converted (or transferred without adequate consideration) after December 31, 1969, his self-acquired property into joint family property, income from such property is not taxable in the hands of the family.

Income from impartial estate is taxable in the hands of the holder of the estate and not in the hands of Hindu •undivided family. Though the impartibly estate belongs to the family, income arising there from belongs to the holder of the estate who is the senior most male member of the family.Income from impartial estate is taxable in the hands of the holder of the estate and not in the hands of Hindu •undivided family. Though the impartibly estate belongs to the family, income arising there from belongs to the holder of the estate who is the senior most male member of the family. Income from impartial estate is taxable in the hands of the holder of the estate.Personal income of the member cannot be treated as income of Hindu undivided family.•As • stridhan (gold and other jewellery items gifted by the girl’s parents) is an absolute property of a woman, income thereafter is not taxable as income of Hindu undivided family.Under the • Dayabhaga school of law, no son has any right in the ancestral property during the lifetime of his father. If, therefore, the father does not have any brother as a coparcener, income arising from ancestral property is taxable as his individual income.

Clubbing and adjustment of lossesIn this regard the following points should be noted.

Under sections 60 to 63, income belonging to some other person, may be taxable as income of a Hindu undivided •family. For instance, if a Hindu undivided family transfers income without transferring the asset, such income is taxable under section 60 in the hands of the family. Likewise, if an asset is transferred under revocable transfer´ by the family, its income is taxable in the hands of the family.Losses of the current year as well as preceding years will be setoff under sections 70 to 80.•

Aftertheaforesaidadjustments,thetotalofthefiveheadsofincomeisgrosstotalincome.

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5.3.1 Deduction from Gross Total Income

Section Nature of Deduction80C Paymentoflifeinsurancepremium,contributiontoprovidentfirm,etc.80D Payment in respect of medical insurance premium.

80DD Maintenance including medical treatment of a dependent being a person with disability.

80DDB Expenditure in respect of medical treatment, etc.80G Donations to charitable institutions and funds80GGA Donations to charitable institutions and funds80GGC Contributions given to political parties

80-IA Profitsandgainsfromindustrialundertakingsorenterpriseengagedininfrastructuredevelopment, etc.

80-IAB Profitsandgainsbyanundertakingorenterpriseengagedindevelopmentofspecialeconomic zone.

80-IB Profits and gains from certain industrial undertakings other than infrastructure development undertakings

80-IC Profitsandgainsofcertainundertakingsincertainspecialcategoryofstates.80-JJA Profitsfromthebusinessofcollectingandprocessingofbio-degradablewaste.

Table 5.5 Deduction from gross total income

5.3.2 Calculating Tax LiabilityFirst determine net income and tax payable thereon at the prescribed rates. If the Hindu undivided family has agricultural income, then give due consideration to the rules so as to arrive at tax on non- agricultural income. From the amount of tax so determined, deduct the rebate under section 88E.

To the balance add surcharge and add education cess and then, deduct rebate under sections 86, 90,90A and 91.From the balancing amount, prepaid tax (like advance tax, tax deducted or collected at source, etc.) shall be deducted to findouttheamountoftaxpayable.

5.4 Computation of Taxable Income of a CompanyTaxable income of a company can be computed in the following steps.

Ascertain the ‘total income’ of the company by aggregating incomes falling under following four heads:•Income from house property, whether residential or commercial, let-out or self-occupied. However, house �property used for purpose of company’s business does not fall under this head.Profitsandgainsofbusinessorprofession. �Capital gains. �Income from other sources including interest on securities, winnings from lotteries, races, puzzles, etc. �Also, income of other persons may be included in the income of the company. But, income under the head �‘Salary’ is not included under company.


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To the total income so obtained, ‘current and brought forward losses’ should be adjusted for set off in subsequent •assessment years to arrive at the gross total Income. Thus the total income so computed is the ‘gross total income’. The ‘set off ‘ means, adjustment of certain losses against the incomes under other sources/heads (Section 79). This section applies to all losses including losses under the head ‘Capital Gains’.Unabsorbed depreciation may becarried-forwardforset-offindefinitely.Butcarrybackoflossesordepreciationisnotpermitted.However,businesslossescanbecarriedforwardforeightconsecutivefinancialyearsandcanbesetoffagainsttheprofitsof subsequent years.From the gross total income, prescribed ‘deductions’ under Chapter VI A are made to get the ‘net income’.•

Generally, all expenses incurred for business purposes are deductible from taxable income, given that the expenses must be wholly and exclusively incurred for business purposes and also that the expenses must be incurred/paid during the previous year and supported by relevant papers and records. But expenses of personal or of capital nature are not deductible.

Capital expenditure is deductible only through depreciation or as the basis of property in determining capital gains/losses. Deductions shall also be allowed in respect of depreciation, as per Section 32 of Income Tax Act, of tangible assets such as machinery, buildings, etc., and non-tangible assets such as know-how, patents, etc., which are owned by assessee and used for the purpose of business/profession. Depreciation is deducted from the written-down value of the block of assets mentioned under Section 43 of the Act. However, where an asset is acquired by assessee during the previous year and is put to use for business/profession purpose for a period of less than 180 days, the deduction in respect of such assets shall be restricted to 50% of the normal value prescribed for all block of assets. But no deduction shall be allowed in respect of any expenditure incurred in relation to income which does not form part of total income.

Tax liability is computed on the ‘net income’ that is chargeable to tax. It is done either on accrual basis or on receipt basis (whichever is earlier). However, if an income is taxed on accrual basis, it shall not be taxed on receipt basis.From the tax so computed, tax rebates or tax credit are deducted.

5.4.1 Compute Taxable Income of a Partnership FirmStepsforcomputationoftaxableincomeofafirm

Findoutthefirmsincomeunderthedifferentheadsofincome,ignoringtheprescribedexemptions.Theheads•of income are:

Income from house property �Profitsandgainsofbusinessorprofession �Capital gains �Income from other sources including interest on securities, winnings from lotteries, races, puzzles, etc., �(‘Salary’ income head is not included).

The payment of remuneration and interest to partners is deductible if conditions of section 184 and section •40(b)oftheIncomeTaxActaresatisfied.Anysalary,bonus,commissionorremunerationwhichisduetoorreceivedbypartnersisallowedasadeductionfromincomeofthepartnershipfirmandthesameistaxableinthe hands of partners.Makeadjustmentsonaccountofbroughtforwardlosses/disallowancesofinterests,salary,etc.,paidbyfirmto•its partners. The total income so obtained is the “gross total income”.From the “gross total income”, make the prescribed deductions and the balancing amount is the “net income” •ofthefirm.

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SummaryIncome Tax Act, 1961 imposes tax on income other than agricultural income.•Tax on agricultural income can be imposed only by State Governments.•The ‘Central Act’ as referred to in section 4 of Income Tax Act is the ‘Finance Act’ enacted every year.•Thefinancebillispresentedatthetimeofpresentingbudget,usuallyonlastdayofFebruaryeveryyear.•Assessee means a person by whom any tax or any other sum of money is payable under Income tax Act. It •includes deemed assessee [section 2(7) of Income Tax Act].‘Person’ includes * Individual * HUF * Company * Partnership Firm * Association of Persons (AOP) or body •of individuals whether incorporated or not * Local Authority like Municipality, etc. *A‘Person’includesartificialJudicialpersonnotfallinginanyoftheaforesaidcategoriesforexample,aHindu•deity [section 2(31) of Income Tax Act].The income after adjustment of losses is gross total income.•A person shall be deemed to be of Indian origin if he, or either of his parents or any of his grandparents, were •born in undivided India.Foreignexchangeassetmeansthosespecifiedassetswhichtheassesseehasacquiredorpurchasedwith,or•subscribed to inconvertible foreign exchange.If the non-resident Indian has other income in India, such other income is treated as an altogether separate block •and charged to tax in accordance with other provisions of the act.If the Hindu undivided family has agricultural income, then give due consideration to the rules so as to arrive •at tax on non- agricultural income.Tax liability is computed on the ‘net income’ that is chargeable to tax.•Makeadjustmentsonaccountofbroughtforwardlosses/disallowancesofinterests,salary,etc.,paidbyfirmto•its partners. The total income so obtained is the “gross total income”.From the “gross total income”, make the prescribed deductions and the balancing amount is the “net income” •ofthefirm.

ReferencesSaxena, N. T• ax Assignment on Computation of taxable income of individual, HUF and firms.Business Knowledge Resource [Online]. • Compute Taxable Income of a Firm.Availableat:<http://business.gov.in/taxation/partnership_computetaxable.php>[Accessed26December2011]LLP. • Tax on LLP. [Online]Available at: <http://www.llponline.in/tax_llp.php> [Accessed 26December2011].Babu, G. R., 1963. • Financial Services in India. D. K. Agencies.Income Tax Liability • [Online]Availableat:<http://dateyvs.com/incom_primer.htm>.[Accessed26December2011Corporate Income Tax• .[VideoOnline]Availableat:<http://www.youtube.com/watch?v=XB4wdTxw6zc>[Accessed26 December 2011]Calculate Corporate Tax Using Excel[VideoOnline]Availableat:<http://www.youtube.com/watch?v=Jaek-SLQAoo>[Accessed26December2011].

Recommended ReadingBhargava, U. K., 1977. • Taxation. The University of Michigan.Brudno, W., 1960. • Taxation in India. Little Brown.Lal, B. B., 2008. • Income Tax and Central Sales Tax, 29th ed., Pearson Education India.


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Self AssessmentThe Finance Bill is presented at the time of presenting Budget, usually on last day of ___________ every 1. year.

Februarya. March b. Januaryc. Decemberd.

The balance rounded off to the nearest Rs. 10 is known as ___________ income.2. salarieda. balanceb. grossc. taxabled.

______________assetarethosespecifiedassetswhichtheassessehasacquiredorpurchasedwith,orsubscribed3. to inconvertible foreign exchange.

Subscribeda. Purchasedb. Foreign exchangec. Inconvertibled.

Tax liability is computed on the _____________that is chargeable to tax.4. net incomea. gross salaryb. balance incomec. income taxd.

The income after adjustment of losses is _____________.5. gross total incomea. salaryb. net incomec. non-taxable incomed.

_______________ is a person by whom any tax or any other sum of money is payable under Income tax Act.6. Accessora. Assesseeb. Taxerc. Payerd.

Income Tax Act, 1961 imposes tax on income other than____________ income.7. educationala. governmentb. agriculturalc. businessd.

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The ___________ as referred to in section 4 of Income Tax Act is the ‘Finance Act’ enacted every year.8. Central Acta. National Actb. State Actc. Regional Actd.

Which of the following statements is false?9. Tax on agricultural income can be imposed only by State Governments.a. ‘Person’includesartificialJudicialpersonnotfallinginanyoftheaforesaidcategoriese.g.aHindudeityb. [section 2(31) of Income Tax Act].A person shall be deemed to be of Indian origin if he, or either of his parents or any of his grandparents, c. were born in undivided India.If the non-resident Indian has other income in India, even such other income is non-taxable in accordance d. with other provisions of the act.

Which of the following statements is false?10. In computing the investment income of a non-resident Indian, no deduction in respect of any expenditure a. or allowance shall be allowed under any provisions of the act.A non-resident Indian, in any previous year, becomes assessable as resident in India in any subsequent b. year. c. stridhan (gold and other jewellery items gifted by the girl’s parents) is an absolute property of a woman, income there from is taxable as income of Hindu undivided family.From the “gross total income”, make the prescribed deductions and the balancing amount is the “net income” d. ofthefirm.


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Chapter VI

Tax Management

Aim


comprehend tax management•

discusstheprovisionforfilingofreturn•

define“advancetax”•

Objectives


enumerate various types of assessments of Return•

enlist the simple problems on interest•

specify different types of returns•

Learning outcome


knowtheexactproceduretofilereturns•

identify the pre-requisites of TDS•

understand “in• terest” in detail

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6.1 IntroductionThefilingofincometaxreturnandwealthtaxreturnisalegalresponsibilityofeverypersonwhohadearnedorpossess more than a maximum of amount which is exempted to income tax/ wealth tax under the provision of Income TaxAct,1961/WealthTaxAct1957duringthepreviousfinancialYear.Thereturnshouldbeprovidedonorbeforethe due date(s) and only in the form which is approved by the government.

Selfcomplianceofthetaxpayersisveryimportantasperthegovernmentpolicy.Theassessingofficeracceptsthereturns u/s 143(1) of the Income Tax Act or u/s 16(1) of Wealth Tax Act, generally, based on the documents or the returns submitted by the assesses. But in some cases, where income tax department doubt for fraud in giving the real income statement and thus paying the income tax, legal action can be taken against the assessee. It is, therefore, advised to the taxpayers to give complete and correct details in the Income Tax/ Wealth Tax returns.

6.1.1 What is an Income Tax Return?Anincometaxreturnisadocumentwhichgivestheassessingofficeorthetaxcollectortheinformationabouttheincomeofthetaxpayerfromallsourcesinthepreviousfinancialyearandthusthetaxpayer’staxliability.

It is compulsory for every company to furnish return of income. Every person, other than a company, whose total income from all sources of income exceeds the maximum amount which is not chargeable to income tax in any previousyearendingon31stMarchis liabletofile theIncome-taxReturn.Themaximumlimitof incomenotchargeable to tax under the provisions of the Income Tax Act, 1961 is Rs. 1,10,000 (except in case of resident women below 65 years of age and resident senior citizens above 65 years of age) for assessment year 2008-09.

6.1.2 Wealth Tax ReturnToknowaboutWealthTaxReturn,itisimportanttoknowaboutWealthTaxfirst.Wealthtaxisactuallyasocialistictax.Thistaxdoesnotdependupontheearnedincomeofapersoninthepreviousfinancialyearbutispayablebecause of the wealth or the property, a person possessed.

The net wealth, a person has on the valuation date, is the base on which the wealth tax is paid. As per Section 2(q), valuation date of properties and wealth is 3rdMarcheveryyearwhichistheendingoftherespectivefinancialyear.It is compulsory to be paid by every individual, company and Hindu undivided family, who r wealthier than the limitfixedbythegovernment.

A Wealth Tax Return is the document which provides information about the assets and wealth, which the taxpayer possess and thus, the taxpayer’s tax liability.The tax rate is 1% on the amount exceeding Rs. 30lakhs as net wealth from AY 2010-11 (the limit was Rs. 15lakhs till 31st March 2009). No surcharge or education cess is to be paid as the part of wealth tax.

Exceptions Wealth tax is exempted in respect of net wealth of any company which is registered under section 25 of the Companies Act,1956.Co-operativesocieties,socialclubs,politicalpartiesandaMutualfundspecifiedundersection10(23D) of the Income-tax Act (sec-45) are also exempted of wealth tax.


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6.2 Tax ReturnsThrough Latest Amendments, the Central Board of Direct Taxes (CBDT) has prescribed new return of income forms for the assessment years 2008-09 onwards, as shown in the table below:

ITR-1 Individuals having salary, pension, family pension or interest income.ITR-2 Individuals and Hindu undivided family (HUFs) not having income from business or profession.

ITR-3 IndividualsandHUFswhoisapartnerinpartnershipfirmbutdoesnotcarryonaproprietarybusinessor profession.

ITR-4 Individuals and HUFs carrying on a proprietory business or profession.ITR-5 Partnershipfirms,AssociationofPersons(AoP)andBodyofIndividuals(BoI).ITR-6 Companies other than companies claiming exemption under section 11.

ITR-7 Personsincludingcompanieswhicharecharitableorreligioustrust,politicalparty,scientificesearchassociation,newsagency,hospital,tradeunion,university,collegeorotherinstitutionspecifiedinsub-section (4A), (4B), (4C) and (4D) of section 139 of the Act.

ITR-8 Personsnotliabletofilereturnofincomebutareliabletofilereturnoffringebenefits

ITR-V WherethedataofthereturnofincomeorFringebenefitsinFormsITR-1,ITR-2,ITR-3,ITR-4ITR-5, ITR-6 &ITR-8 is transmitted electronically without digital signature.

Table 6.1 Returns of income

Theabove formsarenot required tobefiled induplicate.Butwhere the return form isfiled inpaper format,acknowledgementslipattachedshouldbedulyfilled in.Wherea returnof incomeor returnof fringebenefits,relates to the assessment year commencing on the 1st day of April, 2007 or any earlier assessment year, it shall be furnished in the appropriate form as applicable in that assessment year.

All these Forms (except Form ITR-7) have been designed as annexure-less so as to make them amenable for electronicfiling.Thus,exceptformITR-7,whichisinrespectofcharitable/religioustrusts,politicalpartiesandothernon-profitorganisations,alltheformscanbeelectronicallyfiled.

6.3 Due Dates for Filing of ReturnsTheDuedatesforfilingIncomeTaxreturnsare:

I Company as the assessee 31st October of the assessment yearII Person as the assessee

Where accounts of the assessee are to be audited•aworkingpartner of afirmwhose accounts are•required to be audied under the Income Tax Act or any other law

31st October of the assessment year

Wherethereturnhastobefiledundertheone-by-sixcriteria Discontinued w.e.f. A. Y. 2006-2007

Any other assessee 31st July of the assessment year

Table 6.2 Due dates for filing return

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AccordingtotheVideFinanceAct,2008,theduedateforfilingofreturnforthefollowingcategoriesofassesseeshasbeenspecifiedas30thSeptemberoftheassessmentyearinsteadof31stOctoberoftheassessmentyear(w.e.f.1-4-2008):

a company•a person (other than a company) whose accounts are to be audited•aworkingpartnerofafirmwhoseaccountsaretobeaudited•

Submission of return after due dateIf a return is submitted after the due date, the following consequences will be applicable:

The assessee will be liable for penal interest under section 234 A.•A penalty of Rs 5,000 may be imposed under section 271 F if belated return is submitted after the end of the •assessment year.If the return of loss is submitted after the due date, a few losses cannot be carried forward.•If the return is submitted belated, deductions allowable under certain sections will not be available.•

Interest u/s. 234-a for late or non-furnishing of income tax return

For defaults in furnishing Return of income

Simpleinterest@1%foreverymonthorPartthereoffromtheduedateoffilingoftheReturntothedateoffurnishingofthereturn&incasereturnisnotfiled,itis upto the date of completion of assessment u/s 144. The interest is calculated on the amount of the tax on the total assessed income as determined under sub-section (1) of section 143 or on regular assessment u/s 143(3) as reduced by the Advance Tax, if any, paid and any tax deducted or collected at source.

Penalty for not filing return of incomePenaltyofRs.5000isimposablefornon-filingofreturnwithintheassessmentyear.Interestisalsochargeablefornon-filingorlatefiling,asshownabove.

Tax paid during the financial year on the basis of pay earnedTaxtobepaidduringthefinancialyearisonthebasisofpayastheassesseeearns.Suchpaymentshavetobemadein instalments and are known as ‘Advance-Tax’ payments. However the liability for payment of advance tax arises only where the amount of such tax payable by the assessee during that year is Rs. 5,000 or more. The due dates and the percentage of instalments of Advance Tax for assessees other than companies are as below:-

Due date of instalments Amount payable1st on or before 15th September. Amount not less than 30% of such advance tax.

2nd on or before 15th December. Amount not less than 60% of such advance tax after deducting amount paid in earlier instalment.

3rd on or before 15th March. Entire balance amount of such advance tax.

Table 6.3 Due dates and the percentage of instalments of advance tax for assessees other than companies

Incaseofcompanies,thereare4instalmentsofadvancetaxpayableonorbefore15thJune(15%);15thSept.(45%);15thDec.(75%);&balanceamountofAdvanceTaxpayableby15thMarch.Also,anyamountpaidbywayof Advance Tax on or before the 31st March of that year, is treated as Advance Tax Paid during that Financial Year. Thepercentagesof45%and75%specifiedwithreferencetodatesof15thSept.and15thDec.includetheamountof advance tax paid earlier during the year.


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If the tax payer fails to pay 90% tax plus applicable interest then how is interest for short payment of such advance-tax calculated? What will be the interest u/s. 234-b for short payment of advance tax?

Interest u/s. 234-b for short payment of advance tax

Shortfall in payment of Advance tax of more than 10%

Simple interest @ 1% for month or part thereof is chargeable w.e.f. 1st April of the Assessment Year to the date of determination of income u/s. 143(1) or regular assessment u/s 143(3) on the assessed tax. ‘‘Assessed tax’’ means the tax on the total income determined under sub section (1) of section No. 143 or on regular assessment u/s 143(3), as reduced by the amount of tax deducted or collected at source.

Calculating interest for deferment of advance-tax

(A) Interest u/s. 234-c for deferment of advance tax (Non Corporate assessees)

If no advance tax is paid or the advance tax paid in 1st instalment on or before 15th September is less than 30% of the tax payable on the returned income as reduced by taxes deducted at source.

Simple interest @ 1% p.m. is chargeable on the amount of shortfall for a period of 3 months.

If no advance tax is paid or if the advance tax paid in 2nd instalment on or before 15th December is less than 60% inclusive of 1st instalment of the tax payable on the returned income as reduced by taxes deducted at source.

Simple interest @ 1% p.m. is chargeable on the amount of shortfall for a period of 3 months.

If the advance tax paid on the current income on or before the 15th day of March is less than the tax due on the returned income.

Simple interest @ 1% is chargeable on the amount of shortfall from the tax due on the returned income.

(B) Interest u/s 234c for the corporate assessees

If advance tax paid on or before June 15th is less than 12%

Simple interest @ 1% p.m. is chargeable on the amount of shortfall for a period of three months.

If advance tax paid on or before Sept. 15th is less than 36%


If advance tax paid on or before Dec., 15th is less than 75%


If advance tax paid on or before March 15th is less than tax due on returned income (100%).

Simple interest @ 1% is chargeable on the amount of shortfall from the tax due on the returned income.

Table 6.4 Interest calculation for deferment of advance-tax

However, no interest is liveable if the short fall in payment of advance-tax is on account of under estimation or failure to estimate the amount of capital gains or any income from winnings from lotteries, crossword puzzles, races, and other games including an entertainment program on television or electronic mode, in which people compete to win prizes etc., and the assessee has paid the tax on such income as part of the remaining instalments of advance tax which are due or if no instalment is due, by 31st March, of the Financial Year.

Due dates for filing of wealth tax returnsTheduedatesforfilingWealthTaxreturnsbydifferentassesseesarethesameasthatgivenaboveforfilingIncomeTax returns.

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Consequences of not filing or late filing of wealth tax returnsWhere the assessee had defaulted in timely furnishing of his return of wealth, then penal interest @ 1% for every monthorpartofamonthofdelayischargeableforNon/Latefilingofreturn.

6.4 Manner of Filing of Returns Manner of Furnishing ReturnsRule12(3)providesthatthereturnofincomeorreturnoffringebenefitsreferredtoinrule12(1)maybefurnishedin any of the following manners namely:

furnishing the return in a paper form•furnishing the return electronically under digital signature•transmittingthedatainthereturnelectronicallyandthereaftersubmittingtheverificationofthereturninForm•ITR-Vfurnishing a bar-coded return in a paper form.•

Provided that:AfirmrequiredtofurnishthereturninFormITR-5andtowhomprovisionsofsection44ABareapplicable•oracompanyrequiredtofurnishthereturninFormITR-6shallfurnishthereturninthemannerspecifiedinclauses (ii) or (iii) above.ApersonrequiredtofurnishthereturninFormITR-7shallfurnishthereturninthemannerspecifiedinclause•(i).

6.4.1 Filing of Bulk Return by Employer [Section 139 (1A)]Undersection139(1A)theBoardhasspecifiedaschemeforBulkfilingofreturnsbyemployer,whereintheeligibleemployee at his option may furnish a return together with documents to his employer and such employer shall furnish returns received by him on or before the due date on computer readable media using the authorized Bulk Return Preparation Software (BRPS).

6.4.2 Filing of Return of Income on Computer Readable Medium [Section 139(1B)]Any person may, at his option, on or before the due date, furnish a return of income under section 139(1) in accordancewiththeschemespecifiedbytheBoard.Underthisscheme,returnhastobesubmittedinacomputerreadablemedia(includingonafloppy,diskette,magneticcartridgetape,CD-ROMoranyothercomputerreadablemedia) and such return shall be deemed to be a return furnished u/s 139(1).

This is an optional scheme and under this scheme, an eligible taxpayer can furnish his return to one of the intermediaries authorized for this purpose, who will transcribe the data from paper return to the Income-tax department. The intermediary will then submit the paper return to the department. The intermediary will also provide the facility of preparing the returns of income of taxpayers at their request on the basis of the documents provided by such taxpayers.

6.4.3 Filing of Return in Electronic FormSection 139 D provides that the Board may make rules providing for:

Theclassorclassesofpersonswhoshallberequiredtofurnishthereturninelectronicform;•Theformandthemannerinwhichthereturninelectronicformmaybefurnished;•Thedocuments,statements,receipts,certificatesorauditedreportswhichmaynotbefurnishedalongwiththe•returninelectronicformbutshallbeproducedbeforetheAssessingOfficerondemand;The computer resource or the electronic record to which the return in electronic form may be transmitted.•

6.4.4 Scheme of Filing Returns by Salaried Employees (getting Form No. 16AA) through EmployerThe scheme is optional and provides an additional mode of furnishing returns of income by persons deriving income from salaries.


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An eligible employee (having gross salary up to Rs 1,50,000) may at his option furnish his return through he employer under the Scheme, as follows:

On receipt of TDS in Form 16AA from the employer, he shall verify the information given and furnish the same •after signing and verifying to the employer before the due date.OnreceiptofthedulysignedandverifiedForm16AA,theemployershallfurnishthereturnofi9ncometothe•income tax department and receive an acknowledgement.The employer shall ensure that the return is furnished before the due date and distribute the acknowledgement •to the respective eligible employees and the date on which the employer furnished the return shall be treated as thedateoffilingofreturnbytheeligibleemployee.”

6.5 PAN FormThe following persons should apply for allotment of PAN in Form 49A:

Every person whose assessable income exceeds the maximum amount which is not chargeable to tax or any person •carrying out business or profession whose total sales/turnover is likely to exceed Rs 5,00,000 in a year.A person who is required to furnish return under sub-section (4A) of section 139.•Anemployerwhoisrequiredtofurnishreturnoffringebenefitstax.•TheCentralGovernmenthaspowertospecifybynotificationanyclassorclassesofpersonsbywhomtax•is payable under the Income-tax Act or any tax or duty is payable under any other law for the time being in force.

6.5.1 Important Points to Remember while Filling the ‘Pan’ Form (form no. 49a)ThePANformshouldbefilledinbytheassesseewithduecareandcaution.Thereshouldbenocorrectionsoroverwritinganditshouldbeproperlysignedandverifiedbythepersonswhoisauthorizedtodoso,undertheprovisionsofITAct.Thefollowingimportantpointsmaybetakencareofwhilefillinguptheform:

Name and addressThenameandaddressmustbewritteninblocklettersandwhilefillingupthesame,onecagemaybeleftblankaftereachword.Noinitialsareallowedtobeusedwhilefillinginthesame.Fullnamehastobegiven.

StatusCorrectcodenumberoftheassessee’sstatus/residentialstatusmaybefilledin.

Date of birthDateofbirthisveryimportantandshouldbefilledcorrectly.

Father’s nameFather’s name has to be given even in case of married ladies.

Sources of incomeA person should have at least one source of income to apply for PAN. So the relevant box should be checked in the form.

Incaseofcompanies,thefollowingadditionaldetailshavetobefilledintheformThe ROC registration number of the company.•The date of incorporation of the company.•The date of commencement of business by the company.•In which business activity the company is engaged in.•

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VerificationTheverificationmustbesignedbytheauthorizedperson,andotherparticularsviz.Name,AssessmentYear,Capacity,PlaceandDateshouldbecorrectlyfilledtherein.Pleasenotethatanypersonmakingafalsestatementisliable-tobe prosecuted under Section 277 of the Income-Tax Act.

Verify and sign the ‘pan’ formIndividual:TheindividualfillinghisPANformhastosignit.Incasetheindividualismentallyincapable,then•the PAN form may be signed by his Guardian or by any other person competent to sign on his behalf.

In case the individual is absent from India or because of any other reason, he is not able to sign and verify his PAN form, then any person duly empowered by him through valid Power of Attorney may sign on his behalf. In such case,acertifiedcopyofPowerofAttorneymustaccompanythePANform.

Hindu Undivided Family: By the Karta or where he is absent from India or he is mentally incapacitated from •attending to his affairs, by any other adult member of such family.Company: In this case by the following:•

Resident: The Managing Director or, where there is no Managing Director or he is not able to sign and �verify the PAN form due to any unavoidable reason, by any director thereof.Non-Resident:ThePANformmaybesignedandverifiedbyapersonholdingavalidPowerofAttorney �from the Non-Resident, which should be attached to the PAN form.Woundup/takenoverbytheGovt.:ThePANformshouldbesignedandverifiedbytheLiquidatororthe �PrincipalOfficerasthecasemaybe.Firm: Managing Partner, or, where there is no Managing Partner or due to some unavoidable reasons, he is �not able to sign and verify the PAN form, by any partner thereof, not being a minor.LocalAuthority:BythePrincipalOfficer �AssociationofPersons:ByanymemberoftheAssociationorthePrincipalOfficerthereof. �

6.6 Filling up a Tax ChallanAllthecolumnsinthechallansformshouldinvariablybefilledinsuchasPANNo.,assessmentyear,AssessingOfficer,andhiscode,statusandfulladdressoftheassesseeincapitalletters.Therelevantcolumnsoftax,interestetc.shouldalsobefilledinproperly.

‘‘ONLINE TAX ACCOUNTING SYSTEM (OLTAS)’’The Department and the RBI with the participation of 31 commercial banks have introduced the OLTAS, for simplifyingthepaymentoftaxesfrom1stJune2004.Thenewsimplifiedsinglecopychallanforthispurposeisavailablewith Income-taxoffices.Thecounterfoilwillbe returned to the taxpayerafterstamping the ‘ChallanIdentificationNumber(CIN)’.TheCINistobequotedinthereturn.

ForpaymentofAdvance-taxorselfassessmenttax,taxpayerswillfillinchallanformITNS280specifyingthetypeof payment i.e. Advance-tax or Self assessment tax.

FordepositingTDSortaxcollectionatsourcetax-payerswillfillthechallanform‘‘ITNS281’’.

6.7 Assessment of ReturnAssessment u/s 143(1), scrutiny assessment u/s 143(3) and best judgment assessment u/s 144.

Every taxation system requires assessment. So does the Income Tax Laws of India. Assessment simply means determination of Tax. This tax is determined as per Taxation laws existing in that particular Assessment Year.


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6.7.1 IncomeWhat constitutes income is a very dynamic concept – as that is determined through mix of legislation, court judgement, custom, business practice etc. Many times, there are retrospective amendments in law that leads to change in amount of income for particular assessment year (AY), and consequently change in tax liability.

Here we may remember that the process of Assessment comes when income has already been earned or accrued. Consequentlyfirsttheincomeyearcomesandtheyearnexttoincomeyearistheassessmentyear.ForexampletheAssessment Year 2009-10 would relate to income year 2008-09. Here in common parlance, the income year might becalled‘financialyear’.However,theIncomeTaxActofIndiapreferstocallit‘PreviousYear’.

6.7.2 Person – One who earns IncomeThe ‘Person’ who is under assessment is called the Assessee. The Person/Assessee can be an Individual/ HUF/ Firm/ LLP/Cooperative/Company/AOP/BOI/ArtificialJuridicalPerson.

6.7.3 Types of IncomeTax is assessed (that is. determined) under the following heads of income:

Salary

Types of Income

House Property

Other sources

Business/ Profession

Capital Gain

Fig. 6.1 Types of income

Now it is understood that these heads of income would be applicable depending on type of Assessee. For example a Company or Firm etc cannot earn salary. – Only an individual can earn it.

6.7.4 Types of AssessmentHere we focus on the various procedures of assessment. Under Income Tax Act 1961, there are the following types of assessment:

Sec 140 A – Self Assessment•Sec 143 (3) – Regular / Scrutiny Assessment•Sec 144 – Best Judgment Assessment •Sec 147 – Assessment / Reassessment of Income Escaping Assessment.•

Here we shall not deal with search and seizure situations.

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6.7.5 Normal Procedure of TaxationThe usual process of Taxation is:

The assessee earns income

He deposits tax-based on self calculation

or as determined by his Tax Consultant

TheassesseefilesIncome Tax Return(ITR)

Table 6.5 Taxation process

6.7.6 Income Tax Return (ITR)Here, it may be noted, that just paying tax is not enough. The ultimate thing is the ITR. This ITR can be called a self declaration of information containing various sources of income earned and tax paid. The Government requires ITR because, in absence of that, it would not be able to understand as to what amounts and from what sources the assessee has earned in the year, and what taxes has to been paid by the assessee.

Here,withoutgoingintodetails,itmightbeadded,thattheITRundernormalcourseshouldbefiledu/s139(1).ThissectiondescribesthenormaltimelimitoffilingtheITR–whichisfornon-auditcasesisJuly31oftheAssessmentyear, and for audit cases- September 30 of the Assessment year.Generally, a person who has income above the minimum exemption limit (without giving effect of any sections of ITAct)isobligatedunderlawtofileITR.Howeverassesseee.g.acompanyhastofileITRcompulsorilywhetheritearnsprofitornot.

Also, a person, who has income below the minimum exemption limit, though not required by law, is not barred from filingITR.OftenpeoplehavingincomebelowtheminimumexemptionlimitalsofileITR–andthemotivationforfilingitvaries–itcanbethatsomeonewantsaCreditCardoraloanfromsomeBankorNBFC,orhastoproducethe ITR for getting some contract. Many of those who return such income are genuine cases. However, there are others who would try to manipulate law for their ends. For example, some people who are in receipt of black money – Legally one should return only that much income which s/he earns. However our Income Tax laws are so complicated – that people would take advantage of it in different ways and sometimes in a wrong way.

6.7.7 Need for Checking by IT DepartmentOftenpeoplemaythinkthatITDepartmentwouldnotbeconcernedifanypersonfilesITRshowingincomeofRs.85,000 – when the exemption limit is Rs. 150,000. But I have seen that even Assesses returning such low level of income as Rs. 83,000 come under net of scrutiny assessment!

Then there are also mal-practice in case of many assesses who earn high income. The usual tendency is to show less income so as to pay less tax. This is quite prevalent among Company assesses and Trusts.


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Often, such malpractice of returning less income is deliberate. But sometimes, it can even be due to ignorance of law or miss-application of law. Given this situation – where the culture of honesty is not there in society – whether deliberate or by design or by ignorance of law – the IT Department has come out with its own ways and procedures of assessment. Every year it comes out with a list of assesses – which is a certain percentage of assesses – of which it does detailed scrutiny. The list is generated by computer [Computer Assisted Scrutiny System (CASS)] based on certainpre-definedcriteria,asdeterminedbytheITDepartmentfromtimetotime.

Examples of such criteriaAll returns where deduction claimed under Chapter VI A of the Income tax Act is Rs. 25lakhs or above in stations •other than the cities on computer network.AllcaseswheretotalvalueofInternationalTransactions(asdefinedu/s92BoftheIncometaxAct)exceed•Rs.15crores) etc.

Usuallyeveryyear,theITDepartmentcomesoutwithnumberofsuchcriteria–whichitconsidersfitcasesfordetailed scrutiny. Here it may also be added that u/s 2(7) Assessee means a person by whom income tax or any other sum of money is payable under this

Act, and includes Every person in respect of whom any proceeding under this Act has been taken for the assessment of his income •or of the income of any other person in respect of which he is assessable, or of the loss sustained by him or by suchotherperson,oroftheamountofrefundduetohimortosuchotherperson;EverypersonwhoisdeemedtobeanassesseeunderanyprovisionofthisAct;•EverypersonwhoisdeemedtobeanassesseeindefaultunderanyprovisionofthisAct;•

Consequently the department can issue assessment notice to any person – including non-asessees and non residents – if in opinion of department such person is liable to tax. The other thing is that the above-mentioned types of assessments are assessment under different conditions or (legal) situations or stages. It would be even more appropriate to call them different procedures of assessment. Because ultimately – and simply stated – assessment is determination of tax. One cannot determine different tax for same income at different times (till one is following the same law for the particular AY). It is basically the kind of information that the IT Department has with itself that it undertakes to assess the tax liability under the different provisions.

6.7.8 Self Assessment - 1) Self Assessment u/s 140 A ThissimplymeansthatthepersoniscalculatinghisowntaxliabilityandthereafterfilingITRafterpaymentofself-calculated tax. Since assessee himself calculates the tax and income returned – it is called self-assessment. However, the system of self-assessment is only to make the work of IT Department easier – it is not the end of assessment. ItissimplypayingtaxandfilingofReturnbytheassessee.TheITDepartmentonlygivesanacknowledgement/intimationu/s143(1).TheassesseecanfileITRasSelfassessmentunderthedifferentsectionsof139(Returnwithin due date / Belated Return / Return of Loss etc) or in response to notice u/s 142(1) or 148 or 153A. The Self AssessmentalsocoverscasewhereonehasfiledITReturn–andsomeRefundisdue.ThenwhentheITDepartmentprocesses the Return and sends the Refund Cheque (Income Tax Refund Order) – it is sent under cover of ‘Intimation u/s 143(1)’.

There is no assessment order by the department under Self Assessment simply because the assessment is not being donebythedepartment.Inmyopiniontheself-assessmentshouldonlybeconsideredanexerciseinfilingofITR–andjust–thefirststepintheprocessofassessment(s)thatareundertakenbythedepartment.IftheDepartmentdoes not take up the case for any further assessment – then there is nothing else to do. Since the assessment is not being done by the IT Department, for legal purpose the acknowledgment / intimation by IT Department is not considered as ‘Assessment’.

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6.7.9 Scrutiny Assessment - Regular/ Scrutiny Assessment u/s 143(3)For this notice is issued u/s 143(2). The salient features are:This notice can be issued only when the assessee has furnished Return of Income u/s 139(1) or 142(1). The notice u/s143(2)hastobeservedontheassesseewithinsixmonthsofexpiryoffinancialyearinwhichthereturnwasfurnished.

Only 3% to 5% cases are taken for scrutiny assessment.

TheAssessingOfficer(AO)isnotrequiredtopossessany‘reasontobelieve’.InthisassessmentAOischargedwith the duty to ensure that the assessee:

has not understated income•has not computed excessive loss•has not under paid taxes•

Also, the AO may require documents / proof from the assessee – on which the AO would make his assessment and calculate the tax liability. Sometimes, AO may also wish to physically verify the Creditor etc.

Also while the scrutiny assessment is in process, the assessee can also put forth claims that he had not done in the ITR – and these have to be considered by the AO.

Consequently, in his assessment u/s 143(3) the AO can even reduce income below the returned income or assess loss higher than the returned loss. The assessment u/s 143(3) is completed with an assessment order in writing – which should contain the tax computed under the signature of AO.

Under this AO can also do protective assessment – that is assess the same income in hands of more than one person till it becomes clear in whose hand the income should be assessed. Protective assessment is undertaken so that there is no loss to Revenue. If assessment u/s 143(3) is done on basis of invalid return – the assessment order continues to operate – till it is invalidated by the court. On remand (i.e. if the cases goes to IT AT on some points, and IT AT sendsitbacktoAOforreconsiderationorcorrectiononquestionoffactorlaw)onlythespecificpointcanbedealtby the AO. On remand, the AO cannot bring in new sources of income or open new issues. Assessment made under thissectionwouldbefinalandthedepartmentcannotopenthecaseagain–unlesstherearevalidreasons(‘reasonsto believe’). These are dealt in reassessment proceedings.

6.7.10 Best Judgment Assessment - Best Judgement Assessment u/s 144: Conditions

Assessee fails to furnish ITR u/s 139(1) and has not furnished it u/s 139(4)•fails to comply with all terms of notice u/s 142(1)•fails to comply with direction issued u/s 142 (2A)•fails to comply with terms of notice u/s 143(2)•

Then the AO to the best of his judgment can determine the income and tax payable by assessee based on records possessed by AO.

Prior to proceeding on assessment u/s 144, the AO should give a show cause notice to the assessee. However if the AO has already issued notice u/s 142(1)(i) and the assessee has not complied with its terms, then AO can go ahead with assessment and no show cause notice is required.

U/s 144 AO cannot assess income below returned income and cannot assess loss higher than the returned loss. Even incasethereisnoreturnfortheyear,theAOhastobasehiscalculationoncertainlogical/rational/scientificandreasonable ways viz. based on ratios, growth rate of industry / sector. The assessment order should therefore be a speaking order.


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Assessmentu/s144canalsoberesortedtoifAOisnotsatisfiedwiththecorrectness/completenessofBooksofAccounts. Also the AO can reject Books of accounts u/s 145 if assessment proceedings are in process u/s 143(3)/ 144 / 147 / 153A – and in such case, the AO shall assess the income and tax to the best of judgement (ie. as per the requirements / procedure of sec 144) and complete assessment proceedings under the particular section under which the proceedings are going on.

6.7.11 Reassessment - Assessment / Reassessment of Income Escaping Assessment u/s 147T o undertake assessment u/s 147, notice has to be issued u/s 148. Before issuing notice u/s 148 the AO shall ‘record his reasons’ for issuing the notice. The notice has to be issued separately for each AY for which proceedings are to betakenupu/s147.TheassesseehastofileReturninresponsetonoticeu/s148–evenifhehasfiledthereturnpreviously within due date. Also, the AO is duty bound to provide the assessee the reasons recorded by him – if theassesseerequestsforitafterfilingReturnofIncomeinresponsetothenotice.Ifonrequestthereasonsarenotsupplied – then the AO cannot precede u/s 147.

If there has been no previous assessment u/s 143(3) or 144, then proceedings u/s 147 is called assessment, else it is called reassessment. Also assessment / re-assessment u/s 147 cannot be undertaken for any AY, if assessment proceedings are already underway under any other section of IT Act.

In this, the most important thing is that the AO should have ‘reasons to believe’ that income chargeable to tax has escaped assessment. In proceeding under this section, the AO can also consider any other income under any head of income that comes to his detection subsequent to issue of notice u/s 148. However, u/s 147 can only relate to issues of underassessment – and unlike assessment u/s 143(3), the AO cannot reduce income or increase losses. This assessmentcanbeundertakenwhethertheAssesseehasfiledreturnornot–orwhetheranyassessmenthasbeenundertakenpreviouslyornot.Thisisbecause;thesection147speaksbothofassessmentandalsoreassessment.

Reasons to believe include:pdfcrowd.comT

Here has been retrospective change of law – either by legislation or due to court order (usually Supreme Court) •–andtheAOfindsthattheassesseeneedstobere-assessedinlightofthenewlaw/rulethatistobeappliedretrospectively.Evidence that has come to notice of AO. This evidence can be from any source – including any other assessment •proceedings or information received from revenue intelligence etc.Mistake apparent from records the interesting thing is that it is only necessary that there is prima facie some •materialonbasisofwhichthecasecanbereopened.Thesufficiencyorevencorrectnessofmaterialisnottobe considered at the stage of opening / reopening of case/s 147. However reasons to believe does not include – rumours, gossips, suspicion or change of personal opinion of AO.

Now, the assessment u/s 147 and 143(3) (and also 144) is sort of linked. After all, any assessment can be done only on scrutiny of records. Now as previously mentioned – to take up assessment u/s 143(3) – notice u/s 143(2) has to beservedontheassesseewithinsixmonthsofexpiryoffinancialyearinwhichthereturnwasfurnished.

6.8 Advance TaxPayment of Advance Tax on estimated Income during the current year is required to pay for all assesses. As example, In the Financial Year 2010-11 (Assessment Year 2011-12) advance tax is payable in instalments during the period 01.04.2010 to 31.03.2011 itself. The total amount of Advance Tax will be adjusted during the Assessment Year 2011-12 at the time of assessment.

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e-PaymentIncome Tax Department

Tax Applicable*

(0020)INCOME-TAX ON COMPANIES (CORPORATE TAX) (0020)INCOME-TAX (OTHER THAN COMPANIES)

Challan No./ ITNS

280

Permanent Account No* Assessment Year* Assessment Year

Full Name*

Flat/ Door/ Block No. Name of premises/Building/ Village

Road/ Street/ Lane Area/ Locality

City/ District* State* State

Pin Code*

Email ID

Mobile No.

Type Of Payment*

(100) ADVANCE TAX (102) SURTAX

(300) SELF ASSESSMENT TAX (106) TAX ON DISTIBUTED PROFITS

(400) TAX ON REGULAR ASSESSMENT (107) TAX ON DISTIBUTED INCOME

Bank Name* Bank

Type the characters you see in the picture below. These characters are case sensitive

Fig. 6.2 Advance tax(Source: http://4.bp.blogspot.com/_-AHtLecEd0M/TQBXTrA0CaI/AAAAAAAAAWk/255WQy7VjJo/s1600/

Untitled.gif)

6.8.1 Who is Liable to Pay Advance Tax?Advance Tax is required to pay under section 208 of Income Tax Act 1961 for all those assesses including Salaried and Pensioners whose advance tax on estimated income comes (after deducted TDS/TCS if any) to Rs. 10,000/- or more in a Financial Year e.g. F.Y. 2010-11.

Thus,ifIncomeTaxpayable(afterdeductingalldeductions,rebatesandTDS)islessthan10000inafinancialyear 2010-11, there is no need to deposit any Advance Tax and the same tax will be deposited at the time of self assessmentbeforefilingofincometaxreturn.

In case an order u/s 210(3) is received by the person to pay an amount by way of Advance Tax in Form No. 28, shoulddepositsuchamountintheinstalmentsasspecifiedintheorder.ThistypeoforderscanbeissueduptothelastdayofFebruaryofthefinancialyear.

Ifthatpersonestimateshisincomeatahigheramountthanthatspecifiedintheordersu/s210(3),thenheshouldpay advance tax in accordance with such higher estimate.

However, under sections 210(4) & (5) of Income Tax Act 1961, if he estimates him income at a lower amount, then he should send an estimate of such lower income in Form28-A, before the next instalment falls due and deposit the remaining instalments of advance tax accordingly.


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6.8.2 Dues Dates and Instalments of Advance Tax

Installment number and Due Date

For Other than Companies(Individuals, HUF, Partnership

Firms and others)

For Companies(Limited or Private Companies)

15th June Nil 15% of Advance Tax15th Sept. 30% of Advance tax 30% of Advance Tax15th Dec. 30% of Advance tax 30% of Advance Tax15th March 30% of Advance tax 25% of Advance Tax

31st MarchTax on Capital gains or casual incomes arising after 15th March, if any

Tax on Capital gains or casual incomes arising after 15th March, if any

Notes: -Any amount deposited by 31st March, is treated as advance tax for that Financial Year.If the last day of payment of any instalments of advance tax is a day on which the receiving bank is closed, the assessee can make the payment of the next immediately following working day, and in such cases, the mandatory interest liveable u/s 234B and 234C would not be charged vide CBDT’s circular No. 676 dated 14.01.1994.

Table 6.6 Instalments and due dates of advance tax

6.8.3 Important Note for Salaried Tax-PayersAdvance Tax is different from Tax Deducted at Source (TDS). In case of salaried people, normally tax is deducted at source from their salaries, by the employer. Their income for the year is estimated, tax calculated thereon and 1/12th of such estimated tax is deducted from their monthly salary bill. Salaried persons are normally not required to pay advance tax. However, in case the tax liability estimated for the year is more than the TDS, then such employees shall be liable to pay advance tax as indicated above. 6.8.4 How to Calculate Advance Tax? Advance Tax is payable (in instalments, as above) on total income (estimated for the Financial Year) including capital gains and casual incomes such as winning from lotteries races, etc and after adjusting expenses or losses.

Therefore, income for the current year should be estimated as precisely and correctly as possible. •If any capital gain or casual income arises subsequent to payment of an instalment, the remaining instalments of •advance tax should be accordingly revised. If any such income arises after 15the March, tax should be deposited on such incomes latest by 31st March of the Financial Year. Remember, non/short payment and deferment of Advance Tax attracts penal interest.•

6.8.5 Rates of Advance TaxRates of Advance Tax are declared in the Finance Act every year. The rates of advance tax shown in above are as per Finance Act 2010. 6.8.6 How to Deposit Advance Tax? Advance Tax can be deposited through Challan No. 280 in the Government Treasury (RBI) or any of the authorised branchesofnationalisedbanks.PrintedchallanformsareavailablewiththeIncomeTaxOfficefreeofcost.Whilefilingchallanthefollowingfieldsarerequiredtobefiled.

Assessee’s Name•Complete Address of Assessee.•Permanent Account Number •Assessment Year •

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AssessingOfficer’sWardorCircle•Amount of Advance Tax, Surcharge and Cess (if any).•

Online deposit of Advance Tax is best payment method. When we deposit or pay online Advance Tax, there is no need to collect Physical Challan No. 280 or no need to stand in big rows to deposit advance tax in banks or treasury etc. for online Tax payment.

6.9 Interest The Supreme Court Constitutional bench order in Brij Lal & Others v. CIT dated 21st October 2010 case is a must read for all those who deal with the subject of taxation. In fact the decision format is one of a kind that must be read all through and practiced by the appellate authorities in every discipline as well as by the Judges of the Court. The decision is one that goes on to write the law regarding the powers of the Settlement Commission in the imposition of interest u/s 234A, 234B and 234C of the Income tax Act, 1961. In a nutshell the Apex Court went on to hold that Chapter XIX-A which refers to procedure of settlement, is in fact an alternative system of expeditious assessment under the Act in a smaller way. The judgement unfolds like a defogger enabling a clear view of outside. In fact as onegoreadingthefirstfewpagesoftheanalysistheunderstandingstartgettingclearer. The following three questions are framed in this regard:

Whether sections 234A, 234B and 234 of the Income Tax Act, 1961 (for short “the Act”) are at all i. applicable to proceedings of the Settlement Commission under Chapter XIX-A of the Act?Whether the Settlement Commission can reopen its concluded proceedings by having recourse to ii. section 154 of the Act so as to levy interest under sections 234A, 234B and 234C of the Act, though it was not so done in the original proceedings?Whether in the absence of period of limitation prescribed for making the order of the Settlement, iii. the relevant date for determining the quantum of interest could be the date of the said order?

Inthefirstsectionwhichis26pagesbeinghalfofthetotalwritingisdevotedtothefollowingaspects:

Section I- Relevant machinery sections of the ActTherelevantdefinitionsoftheIncometaxAct,1961ontotalincomeandregularassessmentunderSections.21. (40)and2(45);The text of the relevant provisions of the Income Tax Act, 1961 under chapter XIV dealing with the procedure 2. ofassessment/selfassessment/rectification/insections140A,143and154;The text of the relevant provisions of the Income Tax Act, 1961 under chapter X VII dealing with the procedure 3. of collection and recovery of tax under sections 207 (liability for payment of advance tax), 209 (computation of advance tax), 210 (manner of payment of advance tax) , 215 (interest payable), 234A (Interest for defaults in furnishing return of income), 234B (Interest for defaults in payment of advance tax) , 234C(Interest for defermentofadvancetax);The text of the relevant provisions of the Income Tax Act, 1961 under chapter XIX-A dealing with the procedure 4. ofsettlementofcasesundersections245A(definitions),245C(Applicationforsettlementofcasesalongwithreproduction of the text of Form of application in Form 34B), 245D (Procedure on receipt of an application under), 245E (Power of Settlement Commission to reopen completed proceedings), 245F (Powers and procedure of Settlement Commission), 245I(Order of settlement to be conclusive).

Section 1 of the judgement is devoted to the analysis of the provisions of the Act dealing with the following relevant subjects:


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6.9.1 Levy of InterestS. 215 v. Ss. 234A, B & CThe SC went on to hold that the levy of interest under the erstwhile section 215 is part of the process of assessment. Moreparticularlyiftheincometaxliabilityonthefirstdayoftheassessmentyearislargerthantheamountofadvance tax standing to the credit of the assessee then interest will have to be paid under section 215 on 75% of thedeficitamountoftaxfromthefirstdayoftheassessmentyeartothedateofcomputationoftotalincomevideassessment order. At the same time the amended provisions of section 140A(1) by the Direct Tax Laws Amendment Act, 1987 w.e.f. 1.4.1989 vide Finance Act of 1999, the assessee is required to calculate the tax payable on the basis of the return to be furnished under section 139 or under section 142 or under section 148 after taking into account the amount of taxpaidundertheAct;tocalculatealsointerestpayableundersection234Aorundersection234B/234Cforanydefaultordelayinpaymentofadvancetax;topaysuchtaxwithinterestbeforetheassesseefurnisheshisreturn. 6.9.2 Assessment Scheme –ScopeIn perhaps a very bold statement the Constitutional bench held that the word ‘assessment’ must not be used in a narrower sense and rather must be used to cover the whole procedure to ascertain the liability and the machinery for enforcement. The older version in Section 143 (1A) (a) prior to 1.6.1999 as the Constitutional bench read which provided that where the total income as a result of any adjustments made exceeded the total income declared in the return by any amount then it was open to the A.O. to levy additional income tax of an amount equal to 20% of the tax payable on the amount of difference between the total income determined under section 143(1) and total income declared in the return and for this purpose the A.O. had to serve a notice under section 156. Thus levy of additional tax formed part of assessment scheme.

On the other hand the Constitutional bench revealed from their reading of Chapter XVII dealing with collection and recovery of tax that the assessee is suo motu required to calculate his liability of payment of advance tax and pay accordingly a per the scheme mentioned therein. The Constitutional bench further noted that interest for defaults in payment of advance tax falls under section 234B, apart from sections 234A and 234C, in section F of the very Chapter XVII hence according to the Constitutional bench levy of interest is incidental to the liability and computation of advance tax. Hence one cannot ignore the same in framing an assessment under the Act. From their further reading of sections 234A (4) and 234B (4) it found that these in-turn refer to the increase or reduction of interest subsequent to the Order of the Commission under section 245D(4) increasing or reducing the amount of tax payable and so also interest under sections 234B(4)/ 234A(4).

6.9.3 Settlement Commission SchemeFrom their reading of the provisions of section 245C the Constitutional bench found that section 245C incorporates within it the provisions of Chapters XVIIB, XVIIC and section 140A of the Act even when the word ‘regular assessment’ is not found anywhere within the section. Further from their detailed reading of the provisions/ sub-sections in sections 245C and 245D the Constitutional bench came to the conclusion that one has to keep in mind above provisions of the Act and the concepts of self-assessment, assessment, regular assessment and computation of total income which have been engrafted in Chapter XIX-A. The vital question No. 1: Whether Sections 234A, 234B and 234C are applicable to Chapter XIX-A proceedingsAnswering in ‘YES’ the Constitutional bench pronounced that though Chapter XIXA is a self-contained Code, the procedure to be followed by the Settlement Commission under sections 245C and 245D in the matter of computation ofundisclosedincome;inthematterofcomputationofadditionalincometaxpayableonsuchincomewithinterestthereon;thefilingofsettlementapplicationindicatingtheamountofincomereturnedinthereturnofincomeandtheadditional income tax payable on the undisclosed income to be aggregated as total income shows that Chapter XIX-A indicates aggregation of incomes so as to constitute total income which indicates that the special procedure under Chapter XIX-A has inbuilt mechanism of computing total income which is nothing but assessment (computation of total income). The following observations are relevant (Para 11):

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“To elaborate, under section 245C (1B), if the applicant has furnished a return in respect of his total income, tax shall be calculated on the aggregate of total income returned and the income disclosed in the settlement application as if such aggregate were total income. Under the Act, tax is payable on the total income as computed in accordance with the provisions of the Act. Thus, section 143(3) provision is sought to be incorporated in section 245C. When Parliament uses the words “as if such aggregate would constitute total income”, it presupposes that under the special procedure the aggregation of the returned income plus income disclosed would result in computation of total income which is the basis for the levy of tax on the undisclosed income which is nothing but “assessment”. Similarly, section 245C (1C) provides for deductions from the total income computed in terms of section 245C (1B). Thus, the special procedure under sections 245C and 245D in Chapter XIX-A shows that a special type of computation of total income is engrafted in the said provisions which is nothing but assessment which takes place at section 245D (1)stage.However,inthatcomputation,onefindsthatprovisionsdealingwitharegularassessment,self-assessmentand levy and computation of interest for default in payment of advance tax, etc. are engrafted. [See sections 245C (1B), 245C (1C), 245D (6), 245F (3) in addition to sections 215 (3), 234A (4) and 234B (4)].” (Unquote)

In a nutshell the Constitutional bench held that under section 245C (1) read with section 245C (1B) (ii) and section 245C(1C) (b), the additional amount of income tax payable is to be calculated on the aggregate of total income returned and the income disclosed in the settlement application as if such aggregate is the total income. Simply speaking therefore the scheme of the said sections is regarded as one based on computation of total income and in that sense it is held that such application for settlement is akin to a return of income. Hence sections 234A, B and C are held applicable.

The vital question No. 2: Terminal point for the levy of interest –whether interest is payable under Chapter XIX-A up to the date of the order under section 245D(1) or up to the date of the order under section 245D(4)?The Constitutional bench opined that once the Settlement Commission accepts the Voluntary Disclosure vide the application for settlement, section 234B (2) steps in and the assessee once liable to pay advance tax would be duty bound to pay interest if he commits default in payment to the extent of the undisclosed income as he offers to pay additional income tax himself. The following observations are worth noting (Para 12) :“Under sections 245C (1B) and (1C) the additional amount of income tax payable on the undisclosed income shall be on the total income as calculated under section 245C (1B). On computation of total income under sections 245C (1B) and (1C), interest follows such computation. It is important to note that interest follows computation of total income. Once such computation takes place under section 245C (1B) then section 234B (2) applies. The said sub-section deals with the situation where before determination of total income under section 143 (1) or 143 (3) tax is paid under section 140A or otherwise interest shall be calculated in accordance with section 234B (1) up to the date on which tax is so paid. In that sense an application under section 245C (1) is a return. Section 245C (1) deals with computation of total income.” (Unquote) In that sense the Constitutional bench thus held that interest under section 234B in such a case would be payable up to the stage of section 245D (1) that is admission of the case. Furthermore, the Constitutional bench held that scheme of 245C is similar to the scheme of section 140A and further from their reference to the provisions of section 140 A (1B) the Constitutional bench found that even under section 140A (1B) interest payable under section 234B has to becomputedonanamountequaltotheassessedtaxasdefinedintheExplanationtomeantaxonthetotalincomeas declared in the return. Moving further the Constitutional bench held that in the absence of any provision either under Chapter XIX-A or under section 140A no interest is chargeable beyond the date of application for settlement after the same is admitted by the Commission under Section 245D (1).

It is here that the Constitutional bench found that there is a difference between assessment in law [regular assessment or assessment under section 143(1)] and assessment by settlement under Chapter XIX-A. As per the Constitutional bench the order under section 245D (4) is not an order of regular assessment much less an order under section 143 (1) or 143 (3) or 144. The following distinguishing features marked difference in the two kinds of assessment:


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“Undersections139to158,theprocessofassessmentinvolvesthefilingofthereturnundersection139orundersection142;inquirybytheA.O.undersections142and143andmakingoftheorderofassessmentbytheA.O.under section 143 (3) or under section 144 and issuing of notice of demand under section 156 on the basis of the assessment order. The making of the order of assessment is an integral part of the process of assessment. No such steps are required to be followed in the case of proceedings under Chapter XIX-A. The said Chapter contemplates the taxability determined with respect to undisclosed income only by the process of settlement/ arbitration. Thus, the nature of the orders under sections 143(1), 143(3) and 144 is different from the orders of the Settlement Commission under section 245D (4).” (Unquote)

After their perusal of the scheme of settlement the Constitutional bench held that there are two distinct stages under Chapter XIXA and that the Legislature has not contemplated the levy of interest between order under section 245D (1) stage and section 245D (4) stage. Thus, interest under section 234B will be chargeable till the order of the Settlement Commission under section 245D (1), i.e., admission of the case. Thus there is a twist as noted by the Supreme Court and perhaps a food for thought for the legislature. The Constitutional bench further made note of the provisions of section 245D (6A) which fastens the liability to pay interest when the tax payable in pursuance of an order under section245D(4)isnotpaidwithinthespecifiedtimebeingsimilartotheprovisionsofsection220.

Vital Question NO.3- Whether the Settlement Commission can re-open its concluded proceedings by having recourse to Section 154 of the Act so as to levy interest under section 234B, if it was not done in the original proceedings?The Constitutional bench held that Settlement Commission cannot reopen its concluded proceedings by invoking section 154 of the Act as in their view it contemplates assessment by settlement and not by way of regular assessment or assessment under section 143 (1) or under section 143 (3) or under section 144 of the Act. Citing reasons given in section 245I the Constitutional bench held that the Scheme of Chapter XIX-A does not contemplate invocation of section154otherwisetherewouldbenofinalitytotheassessmentbysettlementwhichisdifferentfromassessmentunder Chapter XIV where there is an appeal, revision, etc. Above all the Constitutional bench inferred that settlement of liability and not determination of liability is the object of Chapter XIX-A. Here one would like to note that section 245D (4) contain the words ‘in accordance with the provisions of the Act’ and that would in sum and substance contain answer to all the questions that are put up before the Constitutional bench. However, one had omitted reference to such words in the section which could have made the task relatively easy. To that extent perhaps the interest should be chargeable even beyond the cut off date in the order under section 245D (1).Howeveronefindssilverlininginthedecision.Thedecisionisfullproofwelljudgedandlandmark.Perhapsone of a kind that must be lauded by one and all.

6.10 TDSTDS from salary, lottery, horse racing, interest on securitiesTax Deduction at Source or TDS under the Tamil Nadu Value Added Tax Act, 2006 & Value Added Rules 2007 In Tamilnadu, Tamilnadu Value Added Tax, 2006 received the accent of the Governor of Tamilnadu on the 14th of December, 2006 and was enacted in the Legislature as Act No. 36 of 2006. This act repealed TNGST Act, 1959 and TNAST Act, 1970. ThebareProvisionsrelatingtoTaxdeductionatSourceiscontainedinSection13whichisreproducedbelow;Section 13.(1) Notwithstanding anything contained in this Act, every person responsible for paying any sum to any dealer for execution of works contract shall, at the time of payment of such sum, deduct an amount calculated, at the following rate, namely:-

6.10.1 Deduction of Tax at Source in Works ContractCivilworkscontract–twopercentofthetotalamountpayabletosuchdealer;i. Civilmaintenanceworkscontract–twopercentofthetotalamountpayabletosuchdealer;ii. All other works contracts –four per cent of the total amount payable to such dealers:iii.

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Provided that no deduction under sub-section (1) shall be made where –No transfer of property in goods (whether as goods or in some other form) is involved in the execution of a. workscontract;orTransfer of property in goods (whether as goods or in some other form) is involved in the execution of works b. contractinthecourseofinter-Statetradeorcommerceorinthecourseofimport;orThedealerproducesacertificateinsuchformasmaybeprescribedfromtheassessingauthorityconcernedc. that he has no liability to pay or has paid the tax under section 5:

Provided further that no such deduction shall be made under this section, where the amount or the aggregate of the amount paid or credited or likely to be paid or credited, during the year, by such person to the dealer for execution of the works contract including civil works contract does not or is not likely to, exceed rupees one lakh.

Explanation. – For the purpose of this section –The term ‘person’ shall include –a.

TheCentraloraStateGovernment;i. Alocalauthority;ii. AcorporationorbodyestablishedbyorunderaCentralorStateAct;iii. A company incorporated under the Companies Act, 1956 including a Central or State Government iv. undertaking;Asocietyincludingaco-operativesociety;v. Aneducationalinstitution;orvi. Atrust;vii.

The term “civil works contract” shall have the same meaning as in the Explanation to section 6.a. Any person making such deduction shall deposit the sum so deducted to such authority, in such manner and b. within such time, as may be prescribed.Anyperson,whomakesthedeductionanddeposit,shallwithinfifteendaysofsuchdeposit,issuetothesaidc. dealeracertificateintheprescribedformforeachdeductionseparately,andsendacopyofthecertificateofdeduction to the assessing authority, having jurisdiction over the said dealer together with such documents, as may be prescribed.On furnishing a certificate of deduction referred to in sub-section (3), the amount deposited d. under sub-section (2), shall be adjusted by the assessing authority towards tax liability of the dealer under section 5 or section 6 as the case may be, and shall constitute a good and sufficient discharge of the liability of the person making deduction to the extent of the amount deposited: Provided that the burden of proving that the tax on such works contract has already been deposited and of establishing the exact quantum of tax so deposited shall be on the dealer claiming the deduction.Any person who contravenes the provisions of sub-section (1) or sub-section (2), shall pay, ine. addition to the amount required to be deducted and deposited, interest at one and a quarter per cent per month of such amount for the entire period of default.Where the dealer proves to the satisfaction of the assessing authority that he is not liable to pay tax under f. section 5, the assessing authority shall refund the amount deposited under sub-section (2), after adjusting the arrears of tax, if any, due from the dealer, in such manner as may be prescribed.The tax or interest under this section shall become due without any notice of demand on the date of accrual g. for the payment by the person as provided under sub-sections (1) and (2).If any person contravenes the provisions of sub-section (1) or sub-section (2), the whole amount of tax h. payable shall be recovered from such person and all provisions of this Act for the recovery of tax including those relating to levy of penalty and interest shall apply, as if the person is an assessee for the purpose of this Act.


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6.10.2 What does the TNVAT Rules Say about the TDS?Rule No. 9 governs the TDS provisions found in Section 13 of the TNVAT Act. The following is the reproduction of rule 9 of TNVAT Rules.

RuleNo9.Taxdeductionatsource.—Any person who makes a deduction under section 13, shall deposit the sum so deducted to the assessing authority 1. having jurisdiction over the person or to any other authority authorized by the Deputy Commissioner to receive such payment, on or before the 20th day of the succeeding month in which the deduction was made with a statement in Form R.Thecertificatethatadealerhasnoliabilitytopayorhaspaidthetaxundersection5,referredtoinclause(b)2. ofthefirstprovisotosub-section(1)ofsection13shallbeinFormS.Thecertificateofdeductionoftaxreferredtoinsub-section(3)ofsection13shallbeinFormT.3. The notice in writing, indicating the amount payable under the Act, referred to in sub-section (5) of section 45 4. shall be in Form U.

6.10.3 ConclusionAs provided in Section 13 of TNVAT Act and Rule 9 of TNVAT Rules, it could be concluded that tax should be deducted on TOTAL PAYMENT, if it exceeds or is likely to exceed Rs. ONE LAKH per annum, at the rates prescribed in section 13 and should be handled as directed in rule 9.

Mismatching issues and the difficulties faced by the dealersLet me take up a hypothetical issue to pinpoint the issue and the hypothetical situation is as follows:

An employer contractor, say a state or central Government Department (here in after called as Govt. dept.), who is not a registered dealer under the VAT act, who extended a contract (here in after called as works contract), to an employee contractor to execute the CIVIL contract works, who is a registered dealer under the act (herein after called as dealer), for a consideration of Rs.100 lakhs. Additional details are:

Date of order/ assignment : 301. th Sep 2010Date of acceptance of the contract and execution of agreement: 102. th October 2010Date of commencement of execution of work/ Contract: 153. th October 2010Date of completion of works execution 284. th Nov 2010Date of Tax Invoice issued by the dealer: 295. th Nov 2010Date of payment by the Govt. dept. to the dealer: 106. th Dec 2010

In the given hypothetical case, considering the nature of work and its quantum of payment to the contractor, the percentage of WCT TDS is 2% and the quantum of TDS amount is Rs.2 lakhs.

In the given hypothetical case, considering the provisions of Rule 9 (1) due date for depositing the tax deduction by the govt. department is “20th Jan 2010” with statement in Form R, with the assessing authority of the dealer.

Andconsidering the provisions ofSec13, the govt. dept., can take15days time to issuedTDScertificate in Form–T,tothedealer.Ifso,inthegivencasethedealerwillgettheWCT-TDScertificateonlyon5th or 6th of Feb 2011 only and hence at the earliest the dealer can adjust the WCT-TDS made by the Govt. department only against thetaxliabilityforthemonthofJan2011,inthereturnfiledon20th Feb 2011.

On the other hand, the dealer who has raised the tax invoice on 29th Nov 2010 has to settle the tax liability with the VAT authorities not later than 20th Dec 2010 and the amount involved in the given case Rs.2 lakhs. Considering the mismatching issues, highlighted herein above, the contractor working capital is blocked to the extent of Rs.2 lakhs till he adjust the credit of Rs.2 lakhs as against the actual tax dues, tax dues of any other projects or get the refund, whichever is later.

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In the absence of clear cut provisions to remove these anomalies the dealers will always try to resolve the issue without cutting their working capital and/or with little cost as additional burden. one of the best example to obtain form S by the dealer from his assessing authority by making the advance payment of the said 2 lakhs to him and stay away from the burden of working capital blocking with the VAT authorities.


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SummaryAnincometaxreturnisadocument,whichgivestheassessingofficeorthetaxcollectortheinformationabout•theincomeoftaxpayerfromallsourcesinthepreviousfinancialyearandthusthetaxpayer’staxliability.Wealth tax is actually a socialistic tax.•Wealthtaxdoesnotdependupontheearnedincomeofapersoninthepreviousfinancialyearbutispayable•because of the wealth or the property, a person possessed.The net wealth, a person has on the valuation date, is the base on which the wealth tax is paid.•A Wealth Tax Return is the document, which provides information about the assets and wealth, the taxpayer •possess and thus, the taxpayer’s tax liability.‘‘Assessed tax’’ means the tax on the total income determined under sub section (1) of section No. 143 or on •regular assessment u/s 143(3), as reduced by the amount of tax deducted or collected at source.Assessment simply means determination of Tax.•ForpaymentofAdvance-taxorselfassessmenttax,taxpayerswillfillinchallanformITNS280specifyingthe•type of payment i.e. Advance-tax or Self assessment tax.The ‘Person’ who is under assessment is called the Assessee.•As per the Income Tax Act 1961, there are four types of assessment, namely, the Self Assessment (Sec 140 A) •,Regular / Scrutiny Assessment (Sec 143 (3)),Best Judgment Assessment (Sec 144),Assessment / Reassessment of Income Escaping Assessment (Sec 147). ITR can be called a self declaration of information containing various sources of income earned and tax paid.•A person, who has income below the minimum exemption limit, though not required by law, is not barred from •filingITR.(u/s140A)meansthatthepersoniscalculatinghisowntaxliabilityandthereafterfilingITRafterpayment•of self-calculated tax.Thesystemofself-assessmentissimplypayingtaxandfilingofReturnbytheassessee.•If there has been no previous assessment u/s 143(3) or 144, then proceedings u/s 147 is called assessment, else •it is called reassessment.Payment of Advance Tax on estimated Income during the current year is required to pay for all assesses.•Advance Tax is required to pay under section 208 of Income Tax Act 1961 for all those assesses including •Salaried and Pensioners whose advance tax on estimated income comes (after deducted TDS/TCS if any) to Rs. 10,000/- or more in a Financial Year.Any amount deposited by 31• st March, is treated as advance tax for that Financial Year.Advance Tax is payable (in instalments, as above) on total income (estimated for the Financial Year) including •capital gains and casual incomes such as winning from lotteries races, etc and after adjusting expenses or losses.

ReferencesSmiter,S., • Payment of Advance Tax (How to Calculate Advance Tax) [Online] Available at http://www.caclubindia.com/forum/how-to-calculate-advance-tax--116138.asp [Accessed 26 December 2011].Nathani, G., • Assessment By Settlement – Charge of Interest u/s 234A, B & C [Online]Availableat:<http://www.taxmann.com/TaxmannFlashes/Articles/flashart11-11-10_5.htm>.[Accessed26December2011]Apte, P. G., • International Financial Management. 5th ed. The MCGraw Hill Comapanies.Kelkar, V., Chelliah, R., Parthasarathy, 2002. • Reports on India’s Tax Reforms. Academic Foundation.Money control, 2009. • Changing face of Indian taxation: Mark Weinberger[VideoOnline]Availableat:<http://www.youtube.com/watch?v=6aFq-M0ZO0c&feature=relmfu>[Accessed28December2011].Elagaan, 2011. • How to pay Income Tax / TDS (tax deducted at source)[VideoOnline]Availableat:<http://www.youtube.com/watch?v=0ZT1yjCxHTI>[Accessed28December2011].

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Recommended ReadingTax Management Inc. • Tax Management Portfolios. Tax Management Inc., 2006.Tax Management Inc. • Tax management transfer pricing report, Volume 10. Tax Management Inc., 2001.Poirson, H. • The tax system in India: Could reform spur growth? International Monetary Fund, April.


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Self Assessment___________ is actually a socialistic tax.1.

Water taxa. Agricultural taxb. Wealth taxc. Assessed taxd.

A Wealth Tax Return is the document which provides information about the assets and wealth, the taxpayer 2. possess and thus, the taxpayer’s _________.

Incomea. Tax-liabilityb. Occupationc. Statusd.

A/An ____________ is not required to possess any ‘reason to believe’.3. assessingofficera. individualb. constitutional benchc. HUFd.

The ‘Person’ who is under assessment is called the _____________.4. assessora. individualb. personnalc. assesseed.

__________can be called a self declaration of information containing various sources of income earned and 5. tax paid.

ITRa. CINb. TDSc. ITNSd.

Thesystemof________________issimplypayingtaxandfilingofreturnbytheassessee.6. self-assessmenta. regular / scrutiny assessmentb. best judgment assessment c. reassessment of income d.

______________ can be issued only when the assessee has furnished Return of Income u/s 139(1) or 142(1).7. Self-assessmenta. Regular / Scrutiny assessmentb. Best Judgment assessment c. Reassessment of Income d.

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If there has been no previous assessment u/s 143(3) or 144, then proceedings u/s 147 is called assessment, else 8. it is called _________________

self-assessmenta. regular / Scrutiny assessmentb. best judgment assessment c. reassessment of Incomed.

Which of the statements is false?9. A person, who has income below the minimum exemption limit, though not required by law, is barred from a. filingITR.Assessment simply means determination of Tax.b. Payment of Advance Tax on estimated Income during the current year is required to pay for all assesses.c. Advance Tax is different from Tax Deducted at Source (TDS).d.

Which of the statements is false?10. Any amount deposited by 31a. st March, is treated as advance tax for that Financial Year.Rates of Advance Tax are declared in the Finance Act every year.b. Under Income Tax Act 1961 , Advance Tax is required to be paid by all those assesses including Salaried and c. Pensioners whose advance tax on estimated income comes (after deducted TDS/TCS if any) to Rs. 10,0000/- or more in a Financial Year.The net wealth, a person have on the valuation date, is the primary base on which the wealth tax is paid.d.


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Chapter VII

Wealth Tax, 1957 & Central Sales Tax

Aim


introduce wealth tax act•

explain wealth tax chargeability•

discuss applicability of wealth tax•

Objectives


definedeemedassets•

elucidate debt owed•

explain basic concepts of assets•

Learning outcome


understand the procedure for computation of net wealth•

recognise taxable and deductable under wealth tax•

identify • assets exempted from wealth tax

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7.1 IntroductionThe wealth tax Act came into force on April 1, 1957 and it extends to whole of India including the State of Jammu and Kashmir [sec. 1]. Wealth tax is a direct tax, which is charged on the net wealth of the assessee. It is a direct tax under the wealth tax act, 1957.

Wealth tax is applicable for individual, HUF, and Company. Wealth tax is charged every assessment year on the net wealth of the assessee on the valuation date. Valuation date is 31 March of the previous year. Rate of Tax - 1% on the net wealth exceeding Rs. 15 lakh. Net Wealth = Excess of assets over debts. Wealth tax is not applicable for:

Section 25 company•Co-operative society•Social club•Political party•Mutual funds•

7.2 ChargeabilityThe Wealth tax is charged for every assessment year in respect of the net wealth of the corresponding valuation date of every individual, Hindu Undivided Family, and company, @1% of the amount by which net wealth exceeds Rs.15 lakh. By virtue of section 45, no wealth tax is chargeable in respect of net wealth of the following persons:

any company registered under section 25 of Companies Act 1956 •any co-operative society •any social club •any political party •amutualfundspecifiedundersection10(23D)oftheIncomeTaxAct•

Chargeability

IndividualHUF /

Companies

Nationality Residential Status

Location of assets as on the valuation date

Residentail Status

Location of assets as on the valuation date

Fig. 7.1 Wealth tax chargeability

7.3 Applicability of Wealth TaxThe details of applicability of wealth tax are given below.

Individual: The following persons are treated as ‘individual’ U/s 3 of the wealth tax:

Legal hires of an individual•Holder of an impartible estate•


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Hindu deities (it means formal a god/goddess )•Trustees of a trust who are liable U/s 21A•Trade unions•

HUF �Company �AOP chargeable U/s 21AA: �

Situation Wealth tax assessment

Shares of members of an AOP are determinate or known.

Interest of members in the assets of the AOP shall be valued as per Rule 16 and 17 of Schedule III.

Shares of members of an AOP are indeterminate or unknown

Wealth tax is levied on the AOP. It is liable to tax at the rate leviable upon and recoverable from an individual who is any Indian citizen and resident.

7.3.1 Valuation DateSec.2 (q): It refers to the 31st March and immediately preceeding the assessment year. This provision does not apply to:

Company registered U/s 25 of the companies Act, 1956•Co operative society and•Any social club•Any political party •Any mutual fund U/s 10(23D)•

Citizenship/Residential Status of the assessee in India

Assets Located Debts incurred on assets

In India Outside India In India Outside India

Individual who is an Indian National and HUF

Residential and ordinarily resident•Resident but not ordinari ly •residentNon-resident•

Taxable

Taxable

Taxable

Taxable

Not Taxable

Not Taxable

Deductable

Deductable

Deductable

Deductable

Not Deductable

Not Deductable

Individual who is a Foreign National Taxable Not taxable Deductable Not DeductableResidential company•Non-resident company•

Taxable Taxable Deductable Deductable

Taxable Not taxable Deductable Not Deductable

Table 7.1 List of taxable and deductable under wealth tax

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7.4 Basic Concepts of AssetsThe term assets include the followings:

Building Sec.2 (ea) (i)

Any building or land appurtenant thereto u/s2 (ea) (i) is treated as an asset and it includes: Commercial building •Residential building •Any guest house •A farmhouse situated within 25 kilometres from the local limits of a local authority, •

However following buildings are not treated as assets A house meant for residential purposes is allotted by a company to an employee or an •officerorawholetimedirector,havingagrossannualsalaryoflessthanRs.5lakhsAny house for residential or commercial purposes, which forms part of stock in-trade •Any house occupied by assessee for the purposes of his own business or profession •Any residential property that has been let out for a minimum period of 300days in the •previous year

Motor Cars Sec.2 (ea) (ii)

Any motorcar is an asset except the following Motor cars used by the assessee in the business of running them on hire •Motor cars held as stock- in- trade•

Jewellery, Bullion, Utensils Of Gold, Silver etc. Sec. 2(ea) (iii)

Jewellery, bullion furniture, utensils or any other article made wholly or partly of gold, silver, platinum, or any other precious metal of any alloy containing one or more of such precious metals are treated as an asset

For this purpose, the term jewellery includes Ornaments made of gold, silver, platinum or any other precious metal of any alloy •containing one or more of such precious metals, whether or not containing any precious or semi precious stone, whether or not set in any furniture, utensils, or other articles or worked or sewn into any wearing apparel. Precious or semi precious stones, whether or not set in any furniture, utensils or other •articles or worked or sewn into any wearing apparel.

However, the term jewellery shall not include the Gold Deposit Bonds issued under Gold DepositScheme,1999notifiedbytheCentralGovernmentHowever,ifanyoftheabovestated assets are held by the assessee as stock-in trade, then it is not treated as an asset

Yachts, Boats and Aircrafts Sec 2(ea) (iv)

Yachts, boats and aircrafts are treated as “assets” excluding yachts boats and aircrafts used by assessee for commercial purposes.


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Urban Land Sec 2(ea) (v)

Urban land is treated as an “asset” and urban land means land situated in any area which is comprised within the jurisdiction of local authority and which has a •populationofnotlessthantenthousandaccordingtothelastprecedingfiguresofcensusofwhichtherelevantfigureshavebeenpublishedbeforethevaluationdate;oris any area within such distance, not being more than 8 kilometre from the local limits •of the local authority as the central government may, having regard to the extent, and scopeforurbanisationofthatareaandotherrelevantconsiderations,specifiedinthisbehalfbynotificationintheofficialgazette.

However land is not treated as “asset” in the following cases: Land on which construction of a building is not permissible under any law for the time •beinginforceintheareainwhichsuchlandissituated;Land occupied by any building which has been constructed with approval of the •appropriateauthority;Any unused land held by the assessee for industrial purposes for a period of two years •from the date of acquisition by him Land held by an assessee as stock-in-trade for a period of 10 years from the date of its •acquisition by him

Cash-in-hand Sec 2(ea) (vi)

Following is treated as an “assets”: In case of any individual and HUF, cash in hand on the last moment of the valuation •date in excess of 50,000 shall be treated as “asset” In case of any other person any amount not recorded in the books of accounts shall be •treated as “asset

Table 7.2 Concepts of asset

Illustration 1Discuss whether the following are assets:

A residential house property given on rent by X for a period of 320 days. •A commercial house property used by Mr. Y for his business purposes. •Mr. A was having cash of Rs. 1, 20,000 on 31st March 2006, out of which he deposited Rs. 40,000 in bank on •the same day. Aircrafts owned by Sahara Airlines •AmountheldbyMr.Zinfixeddepositsinban•

SolutionSince the residential house or property has been given for rent on more than 300 days in previous year, hence •it is not be treated as an asset under section [2 (ea) (i)]. Since commercial house or property is being used by assessee for his own business purposes hence it is not be •treated as an asset. Since on the last moment of valuation date i.e. 31st March’2006, Mr. A is having cash of Rs 80,000 and out of •which Rs. 50,000 is not an asset under section [ 2 (ea) (vi)], thus remaining Rs 30,000 is taken as an assetUnder section 2 (ea) (iv) aircrafts used by assessee for commercial purposes is not an asset. •AmountheldbyMr.Zinfixeddepositisnotanassetundersection2(ea)•

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7.4.1 Deemed AssetsDeemed assets represent those assets, which belong to some other person but for the purpose of calculation of wealth tax, these are included in the wealth of the assessee (transferor), it is because at time an individual may transfer his assets without adequate consideration to persons in whom he may be interested. Thus, to prevent avoidance of wealth tax in this manner, wealth tax Act provides that assets transferred by an individual after 31-03-1956 (in case of Dadra Nagar Havely, Goa, Daman and Diu and Pondicherry on after 01-04-1963) shall be included in the net wealthofthetransferor,providedfollowingconditionsaresatisfied.

The individual must be the owner of these assets. •The assets must be transferred without adequate consideration in money or money is worth. In case of inadequate •consideration, difference between adequate consideration and inadequate consideration shall be included in the net wealth of the transferor. The asset must be held by the transferor on the valuation date whether in the same form or in converted form.•

If assets have been lost, destroyed, transferred by the transferee to a third party and it is not held by transferee on the valuation date, then the value of the assets shall not be included in the net wealth of the transferor, further the form of asset has been changed by transfer then value of substituted asset is included in the wealth of transferor if it is taxable U/s 2 (ea).

If the asset transferred by an individual to the spouse without adequate consideration was not an asset U/s 2 (ea) but on the valuation date, it has been substituted by an asset taxable U/s 2 (ea) then value of such asset shall be included in the net wealth of transferor.

Deemed Assets U/s 4 (i) are as follows.

Assets transferred to spouse Sec. 4(1) (a) (ii)

If the assessee has transferred an asset to his/her spouse without adequate consideration or in connection with in an agreement to live apart, then value of such asset in included in the wealth of assessee provided their relationship exists both on the date of transfer and on the date of valuation.

Assets held by minor child Sec. 4 (1) (a) (ii)

The value of assets held by minor child including step child and adopted child, excluding a married daughter, a handicapped child, illegitimate child and grand child of an individual is included in the wealth of a parent. If marriage of parents subsists, then in the wealth of that parent whose net wealth is more. If marriage of parents does not subsist, then in the wealth of that parent who maintains the minor child in the previous year.

However there are certain exceptions to it. Assets acquired by the minor child out of his income arising on account of his •manual work or activities involving application of his specialised knowledge and experience shall not be included in the net wealth of a parent. Assets held by a disabled minor child shall not be included in the wealth of the •parent.

In these cases, net wealth of the child shall be determined separately and assessed in his hands.

Assets transferred to a person or to AOP’s, Sec. 4 (1) (a) (iii)

If an individual transfers his assets to another person or AOP’s without adequate consideration,directlyorindirectly,fortheimmediateordeferredbenefitoftheindividualor his spouse then these assets are included in the wealth of the individual provided their relationship exists on valuation date.


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Revocable transfer of asset Sec. 4(1) (a) (iv

Revocable transfer means a transfer which can be revoked at any time by the transferor. Thus, if an individual has transferred any assets to another person or AOP under revocable transfer then value of such assets is included in the wealth of the individual.

Assets transferred to son’s wife Sec. 4(1) (a) (v)

If an individual transferred an asset to his son’s wife directly or indirectly after 31-05-1973 without adequate consideration then the value of such assets is included in the net wealth of the individual.

Assets transferred to a person/AOP for the benefitofson’swifeSec. 4(1) (a) (vi)

If an assessee has transferred his asset to another person or AOP directly or indirectly after31-05-1993withoutadequateconsiderationfortheimmediateordeferredbenefitofhis son’s wife then value of such assets shall be included in wealth of the individual.

Interest in a Firm or AOP Sec. 4(1) (b)

IftheassesseeisapartnerinafirmoramemberofanAOP(notbeingacooperativehousingsociety),thenvalueofhisinterestintheassetsoffirmorassociationshallbeincludedinhisnetwealth.WhereaKartaofH.U.F.isapartnerinafirm,hisinterestinthefirm’sassetsisincludibleinthenetwealthoftheH.U.F.

Converted Property Sec. 4(1A)

If an individual who is a member of an HUF converts his individual property after 31-12-1969 into Joint family property either by throwing it into the common stock or by making gifts of separate property or through act of impressing such separate property with the character of property belonging to family without adequate consideration, such properly is called converted property. In this case value of the converted property or any part of it held by the family on valuation date is included in the net wealth of the individual. However in case the converted property becomes the subject matter of partition among the members, then the part of the property received by the individual and his spouse is includible in his net wealth.

Transfer by means of book entry [Sec.4 (5A)]

Where a person makes a gift of money to another person by means of entries in the books ofaccountmaintainedbythedonororanindividualorHUForfirmorAOPorbodyofindividuals with which the done has business or other relationship. Then value of such giftisincludibleinthenetwealthofdonorunlessthedonorsatisfiestheAssessingofficerthat the money was actually delivered to the done at the time of making the entries.

Impartible Estate Sec. 4(6)

Impartible estate of an H.U.F. is that estate which by special law or custom descend to one member of the family though it is a Joint property belonging equality to all, Value of mpartible estate is included in the net wealth of such holder, so far wealth tax purposes. He is the deemed owner of the impartible estate.

House from a Co-operative Housing society etc. Sec. 4(7)

If the assessee is a member of a co-operative Housing Society, company or AOP’s and he is allotted a building a part thereof or leased under a house building scheme of the society, company or association, as the case may be then he is the deemed owner of that building part thereof and hence value of such building shall be included in his net wealth

Building in part performance of a contract Sec. 4(8) (a)

If a person is allowed to take or retain possession of any building in part performance of a contract of the nature referred u/s 53 A of Transfer of Property Act, 1882 then he is the deemed owner of that building or part thereof and hence value of such building shall be included in his net wealth.

Building on lease Sec. 4(8) (b)

If an assessee acquires any right by way of lease with respect to a building by virtue of any transaction to a building by virtue of any transaction referred to in clause (f) of Sec. 269 U A. shall be the deemed owner of the building or part thereof and its value shall be included in his net wealth, however it excludes any right by way of a lease from month to month of for a period not exceeding 1 year.

Table 7.3 Deemed assets

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Illustration IIExplain the taxability of the following in the net wealth computation of Mr. A

Gifts of jewellery made to wife Rs 60,000, Market value on valuation date is Rs 2, 00,000. a. He gifted cash Rs. 2, 00,000 to his son’s wife without consideration, which she deposited in bank. b. Urban land transferred by him to his minor handicapped childc. AminorsonofMr.Areceivesincomebyactinginfilms.Outofthisincome,hepurchasedaCarandad. residentialhouse;valueoftheseonvaluationdateisRs50Lacs.He transferred a house valued at Rs 20 Lacs to his married daughter but he has reserved the right to live in e. that house for whole life.

SolutionSince the gift has been made without adequate consideration, hence the value of jewellery on valuation date a. will be included in wealth of Mr. X. Although the gift has been made without any adequate consideration but as on valuation date it is in form b. offixeddeposits,whichisnotanassetundersection2(ea),henceitisnotanasset.Assets held by minor handicapped child are not taxable in the hands of parents, hence the value of urban c. land is not to be included in wealth of Mr. X, but it is chargeable in hands of the child. The assets acquired by the minor child out of his income arising on account of any manual work done by d. him or activity involving application of his specialised knowledge or skill is not included in the wealth tax of parents, hence the assets valued at Rs 50 Lacs will be included in the wealth of the child. Mr. A transferred his house to his married daughter. Hence he does not remain the owner of the house on e. the valuation date, but he has reserved the right to live in that house for whole life, hence it is a revocable transfer u/s 4 (1) (a) (iv) thus value of the house will be included in wealth of Mr. A.

7.4.2 Exempt Assets [Sec 5]The following assets are exempted from wealth tax.

Property held under trust Sec. 5(i)

Any property held under trust or other legal obligations by the assessee for any public purpose of a charitable or religious nature in India is exempted.

Interest in the coparcener property Sec. 5(ii)

If the assessee is a member of H.U.F., he is not liable to pay tax on his share in the joint property, so as long as the property remains joint and he continues as the member of that family.

One building in the occupation of former Ruler Sec. 5(iii

Any one building which is in the occupation of a Ruler and which has been declared ashisofficialresidencebytheCentralGovt.istotallyexemptfromtax.Howevertheexemption available only to the Ruler during his life time.

Jewellery in possession of a former Rule Sec. 5(iv)

Jewellery in possession of a former Ruler not being his personal property which has been recognised by the Central Govt. as his heirloom, before commencement of Wealth Tax Act or by the board after that shall be exempt. However this exemption is subject tofulfilmentofcertainconditionslikekeepingofjewelleryinIndia,initsoriginalshape, allowing authorised person to examine the jewellery as and when necessary.


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Assets of Indian repatriate Sec. 5 (v)

Indian repatriate means a person of Indian origin or a citizen of India who was residing in a foreign country and on leaving such country assessee has returned to India with the intention of permanently residing therein. In this case his following assets shall be exempt for 7 successive assessment years, commencing with the assessment year following the date of his return to India.

Money brought by him in India. •Assets brought by him in India. •Any balance in Non-Resident External Accounts in India on the date of his •return Assets acquired by him out of money in his Non-resident External Account or •by sending money from foreign country within 1 year immediately preceding the date of his return to India. Any assets acquired by him out of money brought in by him in India or out of •the balance in NRE account after his arrival in India.

House [Sec 5 (vi)] One house or part of a house or a plot of land belonging to an individual or HUF is exempt provided size of plot is not bigger than 500 square meters.

Table 7.4 Assets exempt from wealth tax

7.5 Debt Owed Debt owed represents an obligation to pay an amount either in present or in future. In the computation of net wealth, from the total of all assets value of debts owed by an assessee is deductible provided following conditions aresatisfied.

Debt is owed by assessee on valuation date.•Debt should have been incurred in relation to acquisition or creation of nay asset, which is taxable for wealth •tax in the hands of assessee.

Computation of net wealth and wealth tax Procedure for computation of net wealth is as follows.

Computation of net wealth of the assessee. RupeesAssets owned by assessee on valuation date including deemed assets and excluding exempt assets. X

Less deductible debts owed by assessee on the valuation date. (Y)Net Wealth X-Y

Table 7.5 Procedure for computation of net wealth

Procedure for computation of wealth taxWealth tax is chargeable @1% of the amount by which net wealth exceeds 15 lac rupees, hence if net wealth is •up to Rs. 15 lac, there will not be any wealth tax. If net wealth exceeds Rs.15 lac, wealth tax is calculated as: •Wealth Tax = 1% [Net Wealth – Rs 15 Lac]•

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IllustrationMr. Gupta has the following assets and liabilities on the valuation date:

S.N. Details Rs.

1 Residential House 40,00,000

2 Cars for personal use 10,00,000

3 Jewellery 16,00,000

4 Aircrafts and boats for personal use 1,30,00,000

5 Farm house 15 Kms away from local limits of Mumbai 12,00,000

6 Cash in hand 2,20,000

7 Shops given on rent 12,00,000

8 Loan taken to purchase aircrafts 50,00,000

9 Loan taken to purchase residential house 22,00,00

Compute net wealth and wealth tax?

Solution

S.N. Details Rs.

1 Residential House (exempt u/s 5 (vi) ) -

2 Cars for personal use 10,00,000

3 Jewellery 16,00,000

4 Aircrafts and boats for personal use 1,30,00,000

5 Farm house 15 kms away from local limits of Mumbai 12,00,000

6 Cash in hand ( In excess of Rs. 50,000 is an asset) 1,70,000

7 Shops given on rent ( Commercial establishment not an asset u/s 2 (ea) ) -

8 Less - Loan taken to purchase aircrafts (50,00,000)

9 Loan taken to purchase residential house ( Not deductible since residential house is exempt) -

Net Wealth 1,19,70,00

Wealth tax = 1% of [net wealth – Rs. 15 lakhs] = 1% (1, 04, 70,000) = Rs. 1, 04,700


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7.6 Features of Central Sales Tax ActFollowing are the important features of CST Act:

It extends to the whole of India. •Everydealerwhomakesaninter-statesalemustbearegistereddealerandacertificateofregistrationhastobe•displayed at all places of his business. There is no exemption limit of turnover for the levy of central sales tax. •Underthisact,thegoodshavebeenclassifiedas:•

Declared goods or goods of special importance in inter-state trade or commerce and �Other goods �

The rates of tax on declared goods are lower as compared to the rate of tax on goods in the second category. The tax is levied under this act by the Central Government but, it is collected by the state government from •where the goods were sold. The tax thus collected is given to the same state government which collected the tax. In case of union Territories the tax collected is deposited in the consolidated fund of India.The rules regarding submission of returns, payment of tax, appeals etc. are not given in the act. For this purpose, •the rules followed by a state in respect of its own sales tax law shall be followed for purpose of this act also.Even though the central sales tax has been framed by the central government but, the state governments are •allowedtoframesuchrules,subjecttosuchnotificationandalterationasitdeemfit.

7.7 Important Definitions Followingaretheimportantdefinitionsunderthecentralsalestax:

Appropriate State [Section 2 (A)]

It means – In relation to a dealer who has one or more place of business situated in the same state, that •state, and In relation to a dealer who has more than one place of business situated in different states, •every such state with respect to the place or places of business situated within its territory

Business [Section 2 (Aa)]

Any trade, commerce or manufacture or any adventure or concern in the nature of trade, •commerce or manufacture, whether or not it is carried on with a motive to make gain or profitandwhetherornotanyprofitorgainaccruesfromit,andAny transaction in connection with or incidental or ancillary to such trade, commerce, •manufacture, adventure or concern.

Accordingtotheabovedefinition–Itisnotnecessarytohaveprofitmotivetocallanactivityabusiness.•Regularity of business is not essential.•Business may be legal or illegal.•

Any transaction incidental or ancillary to business will also be treated as business. For example, if a registered dealer sells outdated machines, he will be liable to pay central sales tax on it

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Dealer [Section 2(B)]

Any person who carries on (whether regularly or otherwise) the business of buying, selling, supplying or distributing goods, directly or indirectly, for cash or for deferred payment, or for commission, remuneration or other valuable consideration It includes -

A local authority, a body corporate, a company, any cooperative society, other society, club, •firm,Hinduundividedfamily,associationofpersonswhichcarriesonsuchbusiness.A factor, broker, commission agent who carries on business of buying, selling, supplying •or distributing goods belonging to any principal An auctioneer who carrier on the business of selling or auctioning goods belonging to any •principal. Government. •

However, in case of sale, supply or distribution of old obsolete or waste products, government is not liable to pay tax under this Act. This exception does not apply to government companies, public sector undertakings, and private enterprises. Under this Act services are not considered. Therefore, if a person is rendering professional service of any type say teacher, doctor etc. shall not be treated as dealer.

Registered dealer [Section 2 (f)] This means a dealer who is registered under Section 7 of the Act

Declared Goods [Section 2(C)]

It includes those goods which are considered to be of special importance in interstate trade or commerce under section 14.Some of these goods is –

Cereals •Coal•Cotton •Crude Oil •Jute •Oilseeds•Pulses •Sugar •

Goods [section 2(d)] This includes all material articles or commodities and all kind of movable property excluding newspapers, actionable claims, stocks, shares, and securities. If newspapers are sold as scrap then, it will be charged to central sales tax if it is an inter-state sale.

Place of Business [Section 2 (DD)]

Central sales tax is collected by that state Government where the dealer has place of business. This includes –

the place of business of agent if, business is carried on through such agent•place where dealer stores his goods like warehouse, godown•place where a dealer keeps his books of account•


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Sale [Section 2 (G)]

It means transfer of property in goods by one person to another for cash or for deferred payment or for any valuable consideration. However, a mortgage, hypothecation of, or a charge, or pledge on goods is not included.

Essential elements of sale: Goods should be transferred •General property in good should be transferred •Price must be paid •There must be a seller and a buyer •There must be a valid consent of both buyer and seller•

Sale Price [Section 2 (H)]

It means amount payable to a dealer as consideration for the sale of any goods which includes the following -

Central sales tax•Excise duty•Cost of packing material•Packing Charges•Bonus given for effecting additional sales •Insurance charges, if goods are insured by seller•Freight charges if, not shown separately •Any sum charged for anything done by the dealer in respect of goods at the time of or before •delivery thereof

Sale price does not includes the following - Freight or transport charges for delivery of goods, if charged separately •Cost of installations, if charged separately •Cash discounts for making timely payments. •Trade discount •Insurance charges of goods insured on behalf of the buyer •Goods rejected •Goods returned within 6 months of the date of sale•

Sales Tax Law [ Section 2 (I) ]

It means any law for the time being in force in any state, or part thereof, which provides for the levy of taxes on the sale or purchase of goods generally. Now VAT Legislation of a state shall alsobeincludedwithintheambitofthedefinitionof“StateTaxLaw”.

Turnover [Section 2 (J)]

It is the aggregate of the sale prices received and receivable by the dealer in respect of sales of any goods in the course of inter-state trade or commerce made during a prescribed period. Prescribedperiodistheperiodinwhichsalestaxreturnisfiled.

Year [Section 2(K)

It means the year applicable in relation to a dealer under the general sales tax law of the appropriate state,andif,thereisnosuchyearapplicable,itisthefinancialyear.

Table 7.6 Important definitions

7.8 Levy and Collection of Tax and PenaltiesLevyandcollectionoftaxandpenalties.—(1)ThetaxpayablebyanydealerunderthisActonsalesofgoodseffectedby him in the course of inter-State trade or commerce, whether such sales fall within clause (a) or clause (b) of section 3, shall be levied by the Government of India and the tax so levied shall be collected by that Government in accordance with the provision of sub-section (2), in the State from which the movement of the goods commenced:

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[2]Provided that, in the case of a sale of goods during their movement from one State to another, being a sale subsequenttothefirstsaleinrespectofthesamegoodsandbeingalsoasalewhichdoesnotfallwithinsub-section(2)ofsection6,thetaxshallbeleviedandcollected— (a) Where such subsequent sale has been effected by a registered dealer, in the State from which the registered dealer obtained or, as the case may be, could have obtained, the form prescribed for the purposes of 3[sub-section (4) of section8]inconnectionwiththepurchaseofsuchgoods;and (b) Where such subsequent sale has been effected by an unregistered dealer in the State from which such subsequent sale has been effected. (2) Subject to the other provisions of this Act and the rules made there under, the authorities for the time being empowered to assess, re-assess, collect and enforce payment of any tax under general sales tax law of the appropriate State shall, on behalf of the Government of India, assess re-assess, collect and enforce payment of tax, including any 4[interest or penalty] payable by a dealer under this Act as if the tax or 4[interest or penalty] payable by such adealerunderthisActisataxor4[interestorpenalty]payableunderthegeneralsalestaxlawoftheState;andforthispurposetheymayexercisealloranyofthepowerstheyhaveunderthegeneralsalestaxlawoftheState;andthe provisions of such law, including provisions relating to returns, provisional assessment, advance payment of tax, registration of the transferee of any business, imposition of the tax liability of a person carrying on business on the transfereeof,orsuccessorto,suchbusiness,transferofliabilityofanyfirmorHinduundividedfamilytopaytaxintheeventofthedissolutionofsuchfirmorpartitionofsuchfamily,recoveryoftaxfromthirdparties,appeals,reviews, revisions, references, 5[refunds, rebates, penalties,] 6[charging or payment of interest,] compounding of offencesandtreatmentofdocumentsfurnishedbyadealerasconfidential,shallapplyaccordingly: Provided that if in any State or part thereof there is no general sales tax law in force, the Central Government may, berulesmadeinthisbehalfmakenecessaryprovisionforalloranyofthematterspecifiedinthissub-section. 7[(2A) All the 8[provisions relating to offences, interest and penalties] (including provisions relating to penalties in lieu of prosecution for an offence or in addition to the penalties or punishment for an offence but excluding the provisions relating to matters provided for in section 10 and 10A) of the general sales tax law of each State shall, withnecessarymodifications,applyinrelationtotheassessment,re-assessment,collectionandtheenforcementof payment of any tax required to be collected under this Act in such State or in relation to any process connected with such assessment, re-assessment, collection or enforcement of payment as if the tax under this Act were a tax under such sales tax law]. 9[(2B) If the tax payable by any dealer under this Act is not paid in time, the dealer shall be liable to pay interest for delayed payment of such tax and all the provisions for delayed payment of such tax and all the provisions relating to due date for payment of tax, rate of interest for delayed payment of tax, of the general sales tax law of each State, shall apply in relation to due date for payment of tax, rate of interest for delayed payment of tax, and assessment and collection of interest for delayed payment of tax under this Act in such States as if the tax and the interest payable under this Act were a tax and an interest under such sales tax law.] (3)Theproceedsinanyfinancialyearofanytax,10[includinganyinterestorpenalty]leviedandcollectedunderthis Act in any State (other than a Union Territory) on behalf of the Government of India shall be assigned to the Stateandshallberetainedbyit;andtheproceedsattributabletoUnionterritoriesshallformpartoftheConsolidatedFund of India.]

7.9 Principles for Determining Place of Sale or Purchase It is necessary to determine when a sale or purchase of goods takes place in the course of inter-state trade in order to impose central sales-tax.


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7.9.1 In The Course of Inter State Trade According to section 3, a sale or purchase of goods shall be deemed to take place in the course of inter state trade or commerce if the sale or purchase:

Occasionsthemovementofgoodsfromonestatetoanother;or•Is effected by a transfer of documents of title to goods during their movement from one state to another. •

Occasions movement of goods section 3 (a) This means there is a completed sale in pursuance of contract of sale or purchase where by goods move from one statetoanother.Asalecanbetreatedasaninter-statesaleif,allthefollowingconditionsaresatisfied.

Transaction is a completed sale.•The contract of sale contains a condition for the movement of goods from one state to another. •There should be physical movement of good from one state to another •The sale concludes in the state where the goods are sent and that state is different from the state from where •the goods actually moved. It is not necessary that sale precedes the inter- state movement of goods, sale can be entered before or after the •movement of goods. It is immaterial in which state the ownership of goods passes from seller to buyer.•

Sale by transfer of documents Section 3 (b) If sale or purchase of goods is affected by transfer of documents of title to the goods during their movement from one state to another then, such sale or purchase shall be deemed to take place in the course of inter- state trade. A Document of title to goods, bears internal evidence of ownership of goods by holder of document. Some of the examplesareLorryReceipt(LR)incaseoftransportbyroad;Railwayreceipt(RR)incaseoftransportbyrail,billof Lading (BL)in case of transport by sea, Airway bill (AWB) in case of transport by air.

7.9.2 Sale or Purchase of Goods Outside a State As per section 4 (1) when a sale or purchase is inside a state as per section 4 (2) such sale or purchase shall be deemed to have taken place outside all other States.

Sale inside a state as per section 4 (2) means – Incaseof specificgoodsorascertained, ifgoodsarewithin the stateat the timeof thecontractof sale is•made. In case of unascertained or future goods, if goods are within the state, at the time of their appropriation to the •contract.

7.9.3 Sale or Purchase of Goods in the Course of Import and Export – Section 5 State Government cannot impose any tax on sale or purchase of goods in course of import and export. In order to make our exports competitive no central sales tax are imposed, and tax is also not imposed on imported goods because they are already subjected to custom duties.

Export of Goods out of India – Section 5 (1) A sale or purchase of goods shall be deemed to take place in the course of export of goods outside India if, such sale or purchase -

either occasions such export, or is effected by transfer of documents of title to the goods after the goods have crossed the customs frontier of India

As per section 5 (3), last sale or purchase of any goods preceding the sale or purchase occasioning the export of thesegoodsshallalsobedeemedtobeinthecourseofsuchexport,iffollowingconditionsaresatisfied–

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The last sale or purchase has been made after the purchaser of such goods has obtained the order of export or •agreement for export was entered into by him. Such last sale or purchase has been made for the purpose of complying with such order of export or agreement •of export. Form ‘H’ has been submitted by the dealer to the prescribed authority. The form should be signed by the exporter •to whom the goods are sold.

Deemed Exports Section 5 (5)IfanydesignatedIndiancarrierpurchasesAviationTurbineFuelforthepurposeofitsInternationalflightsuchpurchase shall be deemed to take place in the course of the export of goods out of territory of India.

Import of goods into India Section 5 (2) A sale or purchase of goods shall be deemed to take place in the course of the import of the goods into India if, such sale or purchase:

either occasions such import, or •is effected by transfer of documents of title of goods before the goods have crossed the customs frontiers of •India

7.10 Liability to Tax on Inter-State SalesAs per Section 9 (1) central Sales tax shall be levied by the central government but shall be collected and retained by the state government where the movement of goods have commenced.

7.10.1 Rates of TaxTherateofcentralsalestaxis4%orlocalstateratewhichever,isloweronthefirstpointofinter-statesaleif,thegoodsaresoldtothegovernmentortoaregistereddealer,andonthefulfilmentofspecifiedcondition,subsequentsales during the movement of same goods will be exempted from tax. But, if any of the dealers in these subsequent sales is or an unregistered dealer then the last registered dealer will collect tax @ 10% from an unregistered dealer to whom goods have been sold.

7.10.2 Determination of TurnoverAs per section 8 (A), to determine turnover following amounts will be deducted

Central sales tax •Sale price of goods returned within six months •Other items as the central government may notify•

Central sales tax If tax forms a part of aggregate sales price then amount of tax collected by a registered dealer shall be deducted from his gross turnover. Tax is calculated by the following formula.

If the turnover of a dealer is taxable at different rates, then above formula shall be applied separately in respect of each part of the turnover liable to a different rate of tax.

Returned goods shall be deducted If goods are returned by the buyer within 6 months, its sales price will be deducted from aggregate sale price after submitting necessary evidence. Sale price of rejected goods will be deducted even after six months.


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Transaction exempted from sales tax Subsequentsalebytransferofdocuments;•Saleofgoodswhicharegenerallyexemptorchargeableunderthelocalsalestaxprovisionsatlowerrate;•Exemptionbyvirtueofanotification;•Saleincourseofimportorexport;•Saletoaregistereddealertomanufactureorprocessingofgoodsinaspecialeconomiczone;•SaletoanyofficialofforeigndiplomaticmissioninIndiaorUNbody.•

7.10.3 Collection of Tax Section 9 A The central sales tax can be collected from the buyers only by the registered dealers on the inter-state sale affected by them. According to rules prescribed under this Act. Dealers who are not liable to pay tax under general sales tax lawtheperiodoffilingthereturninafinancialyearis:

Quarter ending on 30 June •Quarter ending on 30 September •Quarter ending on 31 December •Quarter ending on 31 March•

7.11 Registration of DealersAccording to Section 7, registration of dealer can be done in any of the two ways-

Compulsory registration •Voluntary registration•

7.11.1 Compulsory Registration Section 7 (1) Every dealer who is liable to pay central sales tax should make an application for registration under the Act to appropriate authority in his state. If a dealer does not get himself registered, he would be subject to penalty under section10whichisimprisonmentwhichmayextendtosixmonthsorfineorbothandincaseofcontinuingoffence,afineofRs.50perdaytillthedefaultcontinues.

7.11.2 Voluntary Registration Section 7 (2) Under following circumstances any dealer can voluntarily apply for registration even though he is not liable to pay tax under central sales tax act.

If he is registered under sales tax law of state but, is not liable to pay tax under central sales tax act.•If there is no sales tax act in a state or any part of it, any dealer having a place of business in that state or part •there of.If he deals in a tax-free goods in a state.•

The dealer can apply for registration at any time and, if he does not apply for registration no penalty will be imposed upon him.

Advantages of registration A registered dealer has to pay actual sales Tax @ 4% only on goods purchased by him for manufacture or resale •and, he buys the same against Form C. otherwise, he will be charged @ 10%. Subsequent sales in the course of movement of goods by transfer of documents of title to goods will be exempted •from central sales-tax if, registered dealer effecting sales is able to produce Form E-I or E-II.

FormE-I:ThisformisfilledbythedealerwhoaffectsthefirstsaleundertheInter-Statetradeorcommerce.FormE-II:Thisformisfilledbythedealerwhoaffectsthesubsequentsaleunderinter–statetradeorcommerce.

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7.11.3 Procedure for Registration

The dealer must make an application to the concerned authority in the appropriate state, in Form A within 30 •days of the day when he becomes liable to pay tax. The form contains the following details.

Name of the manager of business �Name and addresses of proprietor or partner of the business. �Date of establishment of business. �Dateonwhichfirstinter-statesalewasmade. �Name of the principal place and other places of business in the appropriate state. �Particulars of any license held by the dealer. �

Single place of business – If a dealer has single place of business in the appropriate State and he is registered •in that state, he shall apply to the sales tax authority of that state only for obtaining registration under central sales tax act More than one place of business in the same state – If a dealer has more than one place of business in the •samestate,heshallselectoneoftheseplacesastheprincipalplaceofbusinessand,getonlyonecertificateofregistration. More than one place of business in different states. If a dealer has more than one place of Business in different •states,hewillgetaseparatecertificateofregistrationwithrespecttoeachstate.FeesforRegistrationisRupeestwentyfivetobepaidincashorcourtfeestamp.•The application has to be signed by, in case of – •

Sole proprietorship , the proprietor �Partnershipfirm,anyonethepartner �HUF, the karta �Company, the director �Government,authorisedofficer �

Grant of Certificate of Registration sec 7 (3) Iftheapplicationisinorderandassessingofficerisfullysatisfiedwiththefactscontainedtherein,hewillregisterthedealerunderthisactandissueacertificateofRegistrationinFormB.Ifadealerhasmorethanoneplaceofbusinessthenadditionalcopiesofcertificatewillbeissued.

7.11.4 Amendment of Certificate of RegistrationCertificateofregistrationmaybeamended–

At the request of dealer. •By authorities themselves after giving one notice to the dealer. •

The amendment will be made If dealer has changed the name, place or nature of his business or •If dealer has changed the class or classes of goods. •For any other reasons•


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7.12 Cancellation of Certificate of Registration It may be cancelled either.

At the request of the dealer. •By authority granting registration. •

Cancellation at the request of dealer Dealershallsubmitanapplicationalongwithhiscertificateandcopiesthereoftotheregisteringauthoritywithinsixmonthsbeforetheendoftherelevantyear.Thecertificatewillbecancelledifdealerisnotliabletopayanytaxunder CST Act.

Cancellation by the authority Certificateofregistrationwillbecancelledunderfollowingsituation.

The dealer has discontinued the business. •The dealer dies. •Dealer fails to furnish security or additional security. •Dealer has failed to pay tax or penalty under CST Act. •Voluntarily registered dealer has ceased to be liable to pay tax under state tax law of that state. •Foranyothersufficientreasons.•

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SummaryDeemed assets represent those assets, which belong to some other person but for the purpose of calculation of •wealth tax, these are included in the wealth of the assessee (transferor).Wealth tax is a direct tax, which is charged on the net wealth of the assessee.•Wealth Tax is applicable for individual, HUF, and Company.•Debt owed represents an obligation to pay an amount either in present or in future.•Net Wealth = Excess of assets over debts.•The wealth tax is charged for every assessment year in respect of the net wealth of the corresponding valuation •date of every individual, Hindu Undivided Family, and company, @1% of the amount by which net wealth exceeds Rs.15 lakh.Only state legislature enacted state sales tax laws in their respective state for levy of sales tax on sale or purchase •of goods other than newspapers. It is necessary to determine when a sale or purchase of goods takes place in the course of inter-state trade in •order to impose central sales-tax.State government cannot impose any tax on sale or purchase of goods in course of import and export.•If tax forms a part of aggregate sales price then amount of tax collected by a registered dealer shall be deducted •from his gross turnover.If goods are returned by the buyer within 6 months, its sales price will be deducted from aggregate sale price •after submitting necessary evidence.The central sales tax can be collected from the buyers only by the registered dealers on the inter-state sale •affected by them.

References2011.• The Central Sales Tax, 1956.New Delhi: Universal Law Publishing Co. Pvt. Ltd.Lal, B. B. and Vashisht, N., 2008.• Income Tax and Central Sales Tax Law and Practice.29th ed., New Delhi: Dorling Kindersley(India) Pvt Ltd.Pebreja, R., • Lesson – 22 Central Sales Tax [Online]Availableat:<http://www.du.ac.in/fileadmin/DU/Academics/course_material/TM_22.pdf>[Accessed29December2011]The Central Sales Tax Act• , 1956 [Online]Available at: <www.portal.ap.gov.in/Acts%20%20Policies/CSTAct’1956.doc>[Accessed 29 December 2011].ETnow, 2011. • Sales tax of 24% on ATF hurting airline industry: Vijay Mallya to ET NOW. [Video Online] Availableat:<http://www.youtube.com/watch?v=yw7iy7hgy9g>[Accessed29December2011].Money control, 2009. • Sales Tax Dept freezes bank accounts of Indage Vintners [Video Online] Available at: <http://www.youtube.com/watch?v=PGhiOJ5ZHuE>[Accessed29December2011].

Recommended ReadingPathak, A., 2008. • Legal Aspects of Business.3rd ed., New Delhi: Tata-Mcgraw Hill Publishing Company Limited.Prasad, K., 2001.• Development of India’s Financial System. New Delhi: Sarup & Sons.Sharma, R. S., 1988. • Administration of Sales Tax. New Delhi: Atlantic Publishers & Distributers.


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Self AssessmentAccording to the ________of the constitution of India, no tax of any nature can be levied or collected by the 1. central or State Governments except by the authority of law.

article 265a. article 365b. article 256c. article 320d.

Imposition of central sales tax became effective from _______.2. 01.07.1957a. 01.07.1958b. 01.01.1957c. 10.07.1957d.

Which of these is not included in Declared Goods [Section 2(C)]?3. Cereals a. Cotton b. Crude Oil c. Vegetables d.

Which of these is not included in Dealer [Section 2(B)]?4. A local authoritya. A brokerb. An auctioneerc. A transactiond.

Which of these do not include the essential elements of sale?5. Goods should be transferred a. General property in good should be transferred b. Price must be paid c. There must be an auctioneer and a broker d.

If tax forms a part of aggregate sales price then amount of tax collected by a _____________shall be deducted 6. from his gross turnover.

dealera. registered dealerb. business agentc. buyerd.

_______ refers to any transaction in connection with or incidental or ancillary to such trade, commerce, 7. manufacture, adventure or concern.

Businessa. Saleb. Turnoverc. Deald.

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Which of the following statements is false?8. According to the article 265 of the constitution of India, no tax of any nature can be levied or collected by a. the central or State Governments except by the authority of law.Imposition of central sales tax became effective from 01.07.1957.b. Central sales tax Act 1956 was enacted by the Parliament and received the assent of the president on c. 1.07.1957.Registered dealer means a dealer who is registered under Section 7 of the Act.d.

Which of the following statements is false?9. Prescribedperiodistheperiodinwhichsalestaxreturnisfiled.a. Element of sale is the aggregate of the sale prices received and receivable by the dealer in respect of sales b. of any goods in the course of inter-state trade or commerce made during a prescribed period.Sale price does not include trade discount.c. Sales price means amount payable to a dealer as consideration for the sale of any goods.d.

Match the following.10.

1. Essential elements of sale A. Section 2(B)

2. Place of Business B. Price must be paid

3. Declared Goods C. Section 2(C)

4. Dealer D. Section 2 (DD)1-D, 2-A, 3-C, 4-Ba. 1-A, 2-D, 3-C, 4-Bb. 1-B, 2-D, 3-C, 4-Ac. 1-C, 2-D, 3-B, 4-Cd.


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Chapter VIII

Value Added Tax (VAT) & Central Excise Tax

Aim


introduce value added tax•

highlight the features of VAT•

describe the advantages and disadvantages of VAT•

Objectives


elucidate set-off of tax credit under VAT•

explain tax relief under VAT•

explicate rates of taxes under VAT•

Learning outcome


understand variants of VAT•

comprehend different modes of computation of VAT•

discuss• the accounting treatment of VAT

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8.1 IntroductionVAT(ValueAddedTax)isataxonfinalconsumptionofgoodsandservices.VATworksontheprinciplethatwhenrawmaterial passes through various manufacturing stages and manufactured product passes through various distribution stages, tax should be levied on the ‘Value Added’ at each stage and not on the gross sales price. This ensures that same commodity does not get taxed again and again and there is no cascading effect. In simple terms, ‘value added’ means difference between selling price and purchase price. VAT avoids cascading effect of a tax. Basically, VAT is multi-point tax, with provision for granting set off (credit) of the tax paid at the earlier stage. Thus, tax burden is passedonwhengoodsaresold.Thisprocesscontinuestillgoodsarefinallyconsumed.

Hence, VAT is termed as ‘consumption based’ tax. It is tax on consumption of goods and services. VAT works on the principle of ‘tax credit system’.

VATwasinitiatedfirstinFranceinmid-1950,theninEuropeancountriesin1960’sandsubsequentlyintroducedin about 130 countries, including several federal countries. In Asia, it has been introduced by a large number of countries from China to Sri Lanka.

Even in India, there has been a VAT system introduced by the Government of India for about last ten years in respect of Central excise duties. Value added tax is an indirect tax charged on sale of goods. Before the implementation of ValueAddedTax,Salestaxwaschargedonsales.Salestaxwasleviedatfirstpointofsale,andtheresellersdidnot contribute to the Government. Government was losing huge revenue due to this system. Finally Government introduced VAT on 1st April 2005, with the motto of uniformity in tax structure and to reduce the evasion of tax.

8.2 Features of VATFeatures of Value Added Tax are detailed below.

ItisasimplifiedSalestaxsystem• VAT is same as Sales tax but it is being levied in a different manner.

VAT works on the principle that when raw material passes through various manufacturing stages and manufactured •product passes through various distribution stages, tax should be levied on the ‘Value Added’ at each stage and not on the gross sales price.Itisaconsumptiontaxbecauseitisborneultimatelybythefinalconsumerandnotbycompanies.Itischarged•as a percentage of prices, which means that the actual tax burden is visible at each stage in the production and distribution chain.This ensures that same commodity does not get taxed again and again and there is no cascading effect. In simple •terms, ‘value added’ means difference between selling price and purchase price. VAT avoids cascading effect of a tax.It is collected fractionally, via a system of deductions whereby taxable persons can deduct from their VAT •liability the amount of tax they have paid to other taxable persons on purchases for their business activities. This mechanism ensures that the tax is neutral regardless of how many transactions are involved.Basically, VAT is multi-point tax, with provision for granting set off (credit) of the tax paid at the earlier stage. •Thus,taxburdenispassedonwhengoodsaresold.Thisprocesscontinuestillgoodsarefinallyconsumed.Hence, VAT is termed as ‘consumption based’ tax. VAT works on the principle of ‘tax credit system’.Vat system is not same in all States•

The VAT system as introduced is result of deliberations of committee of representatives from 29 States. Each State hasitsownviewsandpeculiarities.Hence,havinguniformnationwideVATisverydifficultandsomecompromises/adjustments are inevitable.


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Vat law is not uniform in all StatesEach State has made changes as per their needs. Though basic concepts are same in VAT Acts of all States, provisions in respect of credit allowable, credit of tax on Capital goods, credit when goods are sold inter-state are not uniform. Evendefinitionsoftermslikebusiness’,‘sale’,‘saleprice’,‘goods’,‘dealer’,‘turnover’,‘inputtax’,etc.,arenotuniform. Schedules indicating tax rates on various articles are also not uniform, though broadly, the schedules are expected to be same.

8.3 Advantages of VATAdvantages of VAT are explained below"

CoverageIt offers all the economic advantage of a tax that includes the entire retail price within its scope. Direct payment of taxisspreadoutoveralargenumberoffirmsinsteadofbeingconcentratedonparticulargroupssuchaswholesalersand retailers. If retailers do evade tax, tax will be lost only on their margins. One particular advantage is that of the widening of the tax base by bringing all transactions into tax net.

Revenue securityVAT represents an important tool against tax evasion and is superior to a business tax or a sales tax from the point of view of revenue security. If payment of tax is successfully avoided, at any particular stage of production and distribute on cycle nothing will be lost if the tax is picked up at a later stage. And even if it is not picked up subsequently, the Government would have at least collected the VAT paid at stage previous to that at which the tax is avoided.

On the other hand if evasion takes place under sales tax, the Government looses all the taxes due on the product. Asignificantadvantageofthevalueaddedtaxinanycountryisthecrossauditfeature.Taxchargedbyonefirmisreportedasadeductionbythefirmsbuyingfromit.

SelectivityVATmaybeselectivelyappliedtospecificgoodsorbusinessentities.Inaddition,VATdoesnotburdencapitalgoodsbecause the consumption type VAT provides a full credit for the tax included in purchase of capital goods. The credit does not subsidize the purchase of capital goods it simply eliminates the tax that has been imposed on them.

Co-ordination of VAT with direct taxesMost tax payers cheat on their sales, not to evade VAT but to evade personal and corporate income tax. Thus operations of an effective VAT, in implementation greatly help income tax administration and revenue collection.

Other important advantages of VAT are:Uniform rates of VAT will boost trade activities and will create a favourable atmosphere for the expansion and •economy.VATHelpsamassingtaxrevenuestofinancethefundnecessaryforsocio-economicgrowthoftheeconomy.•It has the in-built capacity to raise more tax revenues without altering the existing tax structure and is yet able to expand the tax-base.SinceVATismostlybasedon100%self-assessment,itwillreducethetaxpayers’hazardstovisittaxoffices•frequently and lead to better tax compliance.It became easier to give tax concessions to goods used by common man or goods used for manufacture of capital •goods or exported goods.Since there is no tax on tax, price escalation is avoided and will make prices more competitive with the foreign •counterparts. This matter is very important in present era of globalisation and economic liberalisation.The VAT will therefore help common people, traders, industrialists, and also the Government. It is indeed a •movetowardsbetterefficiency,healthycompetitionandfairnessinthetaxationsystem.

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8.4 Disadvantages of VATIt will be a virtual crime not to look for the other side of the coin of the Indian VAT System. Main disadvantages thathavebeenidentifiedinconnectionwithVATareasfollows:

VAT is regressiveIt is claimed that tax is regressive that is. its burden falls disproportionately on the poor as they are likely to spend more of their income than a relatively richer person.

VAT is inflationaryVATistoodifficulttooperatefromthepositionofboththeadministrationandbusiness.Somebusinessmenseizealmost any opportunity to raise prices and the introduction of VAT certainly offers such an opportunity. However, temporary price controls are a result of the careful setting of the rates of VAT.

VAT favours the capital intensive firmItisarguedthatVAThasadirectimpactonthetaxofthelabour-intensivefirmscomparedtothecapital-intensivefirms.Since theratioofvalueaddedtosellingprice isgreaterfor theformer, this isarealproblemfor labourintensive economies and industries.

Powers given to sales tax inspectorsIn order to give effect to the various provisions of the VAT legislation more powers have been given to sales tax inspectors. This may cause harassment to the assesses of VAT. This may even lead to return of “Inspector Raj” which will play havoc and might lead to corruption in the system.

Central sales taxCentral Sales tax is a major issue connected with the implementation of Value Added Tax in our country. There is aneedtophaseoutCSTandmovetocompletelydestination-basedtaxsystem.Itisaverydifficulttaskasitisanimportant source of revenue for government.

8.5 Set-off of Tax Credit under VATManufacturer will be entitled to credit of tax paid on inputs used by him in manufacture. A trader (dealer) will be entitled to get credit of tax on goods which he has purchased for re-sale [para 2.3 of White Paper on State-Level VAT].

Essentials for set-off of tax creditThere are certain requirements which have to be completed for claiming Set-off.

Set-off to be allowed only to a registered dealer.On purchase for manufacturing /Trading/ Works contract/Lease, set-off can be claimed by registered dealers.

A registered dealer can avail set off on purchases of the following:Raw materials, parts, components, spares.•Fuel•Trading goods•Packing material•Capital asset•

A valid TAX INVOICE is must to claim set-off.A registered dealer, selling any goods, must issue to the purchaser a TAX INVOICE containing following particulars, and retain a copy there of for three years from the end of the year in which sale is booked.

The word tax Invoice in bold letter at the top or prominent place.•Name, address and registration number of selling dealer.•


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Name and address of the purchasing dealer.•Serial number and date•Description, quantity and price of the goods sold.•The amount of tax charged, to be shown separately.•Signed by the selling dealer or a person authorised by him.•

Maintenance of accountEvery registered dealer shall keep and maintain true and correct account of daily transaction showing goods produced, manufactured, bought and sold, value thereon together with invoice and bills. Along with all these details all VAT dealers are required to keep following records.

VAT accountThis can be maintained manually or computerised. VAT account should contain details of Input and Output tax, Debit note and credit note issued/ received during the period.

Purchase recordsProper accounting of all purchases in a chronological order stating therein the date on which the goods so purchased, the name and registration number of the selling dealer, tax invoice number and date, the amount of purchase price and amount of tax paid separately should be maintained.

Sales registerSales register should contain tax invoice number, name and address thereof, total sale value, exempted sales- such as consignment sales/ sock transfer, etc. All copies of invoice should be retained in serial number.

Debit notes and credit notes registerCopiesofthedebitnoteandcreditnoteissued/receivedaretoberecordedinabookandshouldbefiledseparatelyunder different rates of tax in the same manner as that of purchase/sales register. The end result of debit/ credit note accounts are to be taken into account while adjusting monthly tax payable.

Period of retention of accountsAll books and records shown above shall be retained by a dealer until the expiration of 5 years after the end of the year to which it relates or for such other period as may be prescribed.

Set-off of input tax credit Credit will be available of tax paid on inputs purchased within the State. Credit will not be available of certain goods purchased like petroleum products, liquor, petrol, diesel, motor spirit (position of furnace oil is not clear in white paper, but many States do not give credit). No credit is available in case of Inter-State purchases.

Set-off of tax paid on capital goods Credit will be available of tax paid on capital goods purchased within the State. Credit will be available only in respectofcapitalgoodsusedinmanufactureorprocessing.Thecreditwillbespreadoverthreefinancialyearsandnotinfirstyearitself.Therewillbeanegativelistofcapitalgoods[para2.4ofWhitePaperonState-LevelVAT].

States has deviated from these provisions. In West Bengal and Kerala, it is available in 36 monthly instalments. In Karnataka, it is available in 12 monthly instalments, but value of capital goods should be minimum Rs 10 lakhs. Capital goods of value less than Rs 10 lakhs will be ‘inputs’ and immediate credit will be available. In Maharashtra, entire credit is available immediately.

Instant credit Credit will be available as soon as inputs are purchased. It is not necessary to wait till these are utilised or sold [para 2.3 of White Paper on State-Level VAT].

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No credit of CST paid - Credit of Central Sales Tax (CST) paid on inputs and capital goods purchased from other States will not be available [para 2.6 of White Paper on State-Level VAT]. This appears to be discriminatory and violative of Articles 303 and 304(a) of Constitution.

Set-off of tax on opening stock as on 1st April 2005 Input tax as already paid on goods lying in stock as on the day when Vat was introduced (which are purchased within one year prior to that date) was available to dealer. For example, if Vat was introduced on 1-4-2005, credit of tax paid on stock lying as on 31-3-2005 was allowed if the goods were purchased on or after 1-4-2004.

Detailed stock statements were required to be submitted to sales tax authorities. This credit will be available over aperiodofsixmonthsafteranintervalof3monthsneedforverification[para2.7ofWhitePaperonState-LevelVAT].

States have deviated from these provisions.

Very few sales tax forms Most of present sales tax forms will disappear, [para 2.14 of White Paper on State-Level VAT] However, forms relating to EOU/SEZ may continue. Forms under CST Act will continue.

One to one correlation not required VAT does not require one to one i.e. Bill to Bill correlation between input and output. Credit is available as soon asinputs/capitalgoodsarepurchased.ThecreditcanbeutilisedforpaymentofVATonanyfinalproduct.Itisnotnecessary to wait till the input is actually consumed/sold.

8.6 When Credit cannot be Availed?Credit of tax paid on inputs will be denied in following situations:

No credit if final product is exempted.Creditoftaxpaidoninputsisavailableonlyiftaxispaidonfinalproducts.Thus,whenfinalproductisexemptfrom tax, credit will not be availed. If availed, it will have to be reversed on pro-rata basis.

Restricted credit if output goods are transferred to another State –IfthefinalproductsaretransferredtoanotherStateasstocktransferorbranchtransfer,inputcreditavailedwillhaveto be reversed on pro-rata basis, which is in excess of 3%. In other words, in case of goods sent on stock transfer/branch transfer out of State, 3% tax on inputs will become payable e.g. if tax paid on inputs is 12.5%, credit of 9.5% is available. If tax paid on inputs is 3%, no credit is available (This is termed as ‘retention’). Thus, the VAT as introduced is State Vat and not a national Vat (In case of some States, even if CST is reduced to 3%, retention has been kept @ 4% only).

No input credit in certain cases In following cases, the dealer is not entitled to input credit

Inputsusedinexemptedfinalproducts•Final product not sold but given as free sample•Inputs lost/damaged/stolen before use. If credit was availed, it will have to be reversed.•

No credit on certain purchases Generally, in following cases, credit is not available

Purchase of automobiles (except in case of purchase of automobiles by automobile dealers for resale) •fuel•

There are variations between provisions of different States.


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8.7 Tax Relief under VATThere are two methods mentioned for lowering the tax burden.

ExemptionsIt is a partial relief provided to the trader, for instance, in case of exemptions, traders need not charge any VAT on the goods sold. But the trader cannot claim set-off or credit for the input tax paid by him on purchases.

Zero ratingIt is complete relief provided to the trader, there is no tax charged on Sales and trader can avail Input tax credit for purchases made.

8.7.1 Distinction between ‘Zero Rated sale’ and ‘Exempt Sale’Certainsalesare‘zerorated’,thatis,taxisnotpayableonfinalproductincertainspecifiedcircumstances.Insuchcases, credit will be available on the inputs, that is., credit will not have to be reversed.

Distinction between ‘zero rated sale’ and ‘exempt sale’ is that in case of ‘zero rated sale’, credit is available on tax paid on inputs, while in case of exempt goods, credit of tax paid on inputs is not available.

As per para 2.5 of White Paper on State-Level VAT, export sales are zero rated, that is., though sales tax is not payable on export sales, credit will be available of tax paid on inputs.

In respect of sale to EOU/SEZ, there will be either exemption of input tax or tax paid will be refunded to them within three months. If supplies to EOU/SEZ are exempt from sales tax, then the question will arise whether these are ‘zero rated’ or ‘exempt goods’.

In case of stock transfer to another State, CST is not payable, but input credit will have to be reversed to the extent of 3%. Thus, stock transfer of goods to another State is ‘exempt’ and not ‘zero rated’.

It is not clear what will be the policy after CST is reduced to 2% or when CST is reduced to zero. As per basic concept of Vat, inter-state transactions should be ‘zero rated’ and not ‘exempt’.

8.7.2 Refund if VAT Credit of Input Tax Available cannot be Utilised for any ReasonEntireinputtaxwillberefundablewithinthreemonths,whenfinalproductisexported.InrespectofsaletoEOU/SEZ, there will be either exemption of input tax or tax paid will be refunded within three months [para 2.5 of White Paper on State-Level VAT]. If tax credit exceeds tax payable on sales, the excess credit will be carried to end of nextfinancialyear.

Excess unadjusted credit at end of second year will be eligible for refund [para 2.4 of White Paper on State Level VAT].Suchexcesscreditcanarisewhenpurchasesofinputsaremadelocally,butfinalproductismainlyexportedor stock transferred to another State.

8.8 Rates of Taxes under VATIdeally, VAT should have only one rate. Though this is not possible, it is certain that there should be minimum varieties of rates. Broadly, following VAT rates are proposed [para 2.18 and 2.19 of White Paper on State-Level VAT].

0% on natural and un-processed produces in unorganised sector, goods having social implications and items •whicharelegallybarredfromtaxation(forexample,newspapers,nationalflag).Thiswillcontain46commodities,out of which 10 will be chosen by individual States which are of local or social importance. Other commodities willbecommonforallStates.CertainspecifiedlifesavingmedicineshasbeenexemptedfromVATtax.NoVATonAdditionalExciseDutyitems(textile,sugarandtobacco)infirstyear.Positionwillbereviewed•later. Vat has been imposed by State Governments @ 12.5% on tobacco products w.e.f. 1-4-2007.1%floorrateforgoldandsilverornaments,preciousandsemi-preciousstones.•

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4% for goods of basic necessities (including medicines and drugs), all industrial and agricultural inputs, declared •goods and capital goods. This will consist of about 270 commodities.12.5% RNR (Revenue Neutral Rate) on other goods.•Aviation turbine fuel (ATF) and petroleum products (petrol, diesel and motor spirit) will be out of VAT regime. •Liquor,cigarettes,lotterytickets,willalsobetaxedatahigherrate.ThesewillhaveuniformfloorratesforallStates (generally 20%). Tax paid on these will not be eligible for input tax credit.

Broadly, VAT rates of all States follow this pattern, but still there are many variations.For example, in some States, Vat rate on gold and silver ornaments has been reduced to 0.25%, as traders were facing competition from neighbouring States. Kerala State has imposed tax @ 20% on some luxury goods, though tax on such goods should be @ 12.5% as per the white paper.

In some States, hand tools are taxed at 4%, while in some States, these are taxed at 12.5%.

Policy about turnover tax, surcharge, additional tax etc. imposed by State Governments - States were levying turnover tax, surcharge etc. on sales tax. Those taxes on sale will go. However, Octroi and Entry tax (which is in lieu of octroi) will continue. Other type of Entry Tax will either be discontinued or will be made Vatable [para 2.16 of White Paper on State-Level VAT].

8.9 Concessions for Small DealersVATtaxwillbepayableonlybythosedealerswhoseturnoverexceedsRsfivelakhsperannum.ThedealerswhoseturnoverislessthanRsfivelakhscanregisteronoptionalbasis.Dealershavingturnoverexceeding5lakhsshouldregister within 30 days from date of liability to get registered [para 2.9 of White Paper on State-Level VAT]. In case ofKarnataka,thelimitisonlyRstwolakhs.MostofStateshavekeptthelimitasRsfivelakhs.

8.9.1 Composition Scheme for Dealers with Turnover up to Rs 50 Lakhs Small dealers having gross turnover exceeding Rs 5 lakhs but less than Rs 50 lakhs have option of composition scheme. They will have to pay a small percentage of gross turnover. They will not be entitled to any input tax credit [para 2.9 of White Paper on State-Level VAT]. The percentage has not been announced in white paper, but earlier, it was announced as 1%. This rate has been prescribed in West Bengal VAT Act, AP VAT Act, Delhi VAT Act, Kerala VAT Act and Karnataka VAT Act.

In case of Karnataka, composition scheme is available only to a dealer whose turnover in a period of four consecutive quarters does not exceed Rs 15 lakhs.

In Maharashtra, tax payable under composition scheme is 8% of difference between value of turnover of sales less value of turnover of purchases including tax (other than excluded goods) (in short, it is 8% of gross margin of trader). Second hand car dealer is required to pay sales tax @ 4%. In case of works contract, tax can be paid @ 8% of total contract value after deducting amount payable towards subcontracts to the sub-contractors.

8.9.2 Dealers who make Inter-State PurchaseState purchases are not eligible for the composition scheme. This provision applies to VAT law of almost all States. The scheme is optional. They can opt to pay normal VAT tax and avail credit of input tax. Composition scheme is a practical scheme considering ground realities, though it dilutes the basic concept of vat that tax is payable at consumption stage. Of course, such schemes are provided in almost all Vat regimes prevailing in Europe and elsewhere,consideringpracticaldifficultiesinassessingandcollectingtaxfromsmalltraders.


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8.10 Variants of VATVATcouldbeleviedwiththreespecificvariants:

Gross product variant•Income variant•Consumption variants•

These variants could be further distinguished their methods of calculation:Additional method•Subtraction method •

Direct Subtraction method �Intermediate Subtraction method �Indirect subtraction method �

Gross product variantThe gross product variant allows deductions for taxes on all purchases of raw materials and components, but no deduction is allowed for taxes on capital inputs. That is, taxes on capital goods such as plant and machinery are not deductible from the tax base in the year of purchase and tax on the depreciated part of the plant and machinery is not deductible in the subsequent years. Capital goods carry a heavier tax burden as they are taxed twice. Modernisation and upgrading of plant and machinery is delayed due to this double tax treatment.

Income variantThe income variant of VAT on the other hand allows for deductions on purchases of raw materials and components as well as on depreciation on capital goods. This method provides incentives to classify purchases as current expenditure toclaimset-off.Howeverinpractice,therearemanydifficultiesconnectedwiththespecificationofanymethodofmeasuringdepreciation,whichbasicallydependsonthelifeofanassetaswellasontherateofinflation.

Consumption variantConsumption variant of VAT allows for deduction on all business purchases including capital assets.

Thus, gross investment is deductible in calculating value added. It neither distinguishes between capital and current expendituresnorspecifiesthelifeofassetsordepreciationallowancesfordifferentassets.Thisformisneutralbetween the methods of production, there will be no effect on tax liability due to the method of production (that is., substituting capita] for labour or vice versa). The tax is also neutral between the decision to save or consume. Among the three variants of VAT, the consumption variant is widely used. Several countries of Europe and other continents have adopted this variant. In our Country generally income variant is adopted. The reasons for preference of Consumption variant are:

It does not affect decisions regarding investment because the tax on capital goods is also set-off against the VAT •liability. Hence, the system is tax neutral in respect of techniques of production.The consumption variant is convenient from the point of administrative expediency as it simplifies tax•administration by obviating the need to distinguish between purchases of intermediate and capital goods on the one hand and consumption goods on the other hand.

In practice therefore, most countries use the consumption variant. Also, most VAT countries include many services in the tax base. Since the business gets set-off for the tax on services, it does not cause any cascading effect.

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8.11 Different Modes of Computation of VATThere are several methods to calculate the ‘value added’ to the goods for levy of tax. The three commonly used methods are:

Addition method•Tax Credit method / Invoice method•Subtraction method (Direct, Intermediate and Indirect)•

8.11.1 Addition MethodThismethodaggregatesallthefactorpaymentsincludingprofitstoarriveatthetotalvalueadditiononwhichtherate is applied to calculate the tax.

A drawback of this method is that it does not facilitate matching of invoices for detecting evasion.

8.11.2 Tax Credit /Invoice Method This is the most common and popular method for computing the tax liability under ‘VAT’ system. Under this method, tax is imposed at each stage of sales on the entire sale value and the tax paid at the earlier stage is allowed as set-off.

In other words, out of tax so calculated, tax paid at the earlier stage, that is, at the stage of purchases is set-off, and at every stage the differential tax is being paid. The most important aspect of this method is that at each stage, tax is to be charged separately in the invoice. This method is very popular in western countries.

In India, under Central Excise Law this method is followed. This method is also called the ‘TAX CREDIT METHOD’ or ‘VOUCHER METHOD’.

8.11.3 Subtraction MethodWhile the above-stated invoice or tax-credit method is the most common method of VAT, another method to determine the liability of a taxable person is the cost subtraction method, which is also a simple method. Under this method, the tax is charged only on the value added at each stage of the sale of goods. Since, the total value of goods sold is not taken into account, the question of grant of claim for set-off or tax credit does not arise.

This method is normally applied where the tax is not charged separately. Under this method for imposing tax, ‘value added’ is simply taken as the difference between sales and purchases.

8.11.4 Procedural Provisions Relating to VATA system of audit checks will have to be established to keep check on bogus invoices. One essential requirement is togiveTIN(TaxIdentificationNumber)toallregistereddealers,sothatacheckismaintainedthat:

The tax as shown in the invoice has really been paid •There is no double credit on basis of same invoice. •

TIN will have to be indicated on each invoice issued. It will be an 11 digit numerical code. First two digits will indicate State Code [para 2.10 of White Paper on State-Level VAT].Thus, State level computer network with check based on TIN will be established. Otherwise, misuse will be uncontrolled.


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8.12 Documentation Required to Avail Credit of Tax Paid on Inputs and Capital Goods Tax credit will be given on basis of document, which will be a ‘Tax Invoice’, cash memo or bill. Such invoice can be issued only by a registered dealer, who is liable to pay sales tax. The invoice should be serially numbered and duly signed, containing prescribed details. The tax payable should be shown separately in the Invoice. The dealer should keep counterfoil/duplicate of such invoice duly signed and dated [para 2.8 of White Paper on State-Level VAT]. In case of manufacturer, Invoice issued under Central Excise Rules should serve purpose of VAT also, if the invoice contains required particulars. Dealers availing composition scheme shall not show any tax in their invoice. They are not entitled to any credit of tax paid on their purchases.

Debit note and credit note If sale price is increased / reduced subsequent to sale, the transaction will be recorded through proper debit/credit note. The buyer will adjust the input credit available to him accordingly.

Records and accountsEach State has prescribed records to be maintained. Broadly, following records will be required.

Records of purchases of Inputs.•Record of debit notes and credit notes.•Quantity record of inputs.•Record of credit notes received from supplier.•Record of capital goods.•Sale register and tax charged on sales.•

Record of tax credit available Monthly/quarterly totals of the following should be taken

Input credit available •Credit available on capital goods •Credit notes from suppliers.•

Carry forward/refund of tax credit If input tax credit cannot be utilised in a particular month/ year, the credit can be carried forward and used in subsequent months/year. Refund of such excess credit is permitted only if goods were exported out of India. If credit is not utilised in two years, refund will be granted.

Preservation of records Sinceassessmentcanbeopenedforprescribedperiod(usuallyfivetorightyears),itisnecessarytopreserveallrelevantrecordsforprescribedperiodfromcloseofthefinancialyear.Therecordscanbeauditedbydepartmentalaudit party.

8.13 Payment of VAT Tax and Filing of ReturnsEverydealerisrequiredtofilereturnsonmonthly/quarterlybasis.Iftherecordsarekeptproperly,filingthereturnwill be very easy and mistakes will be minimum.

Net tax payable Net tax payable will have to be calculated as follows –(a) Output tax XXX plus (b) Reversal of Credit (On exempted goods, stock transfers, free samples, lost inputs) XXX Less –(c) Input tax credit available (XX)

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Net Tax PayableThis net amount is required to be paid through prescribed challan on or before due date.

8.14 Accounting Treatment of VATICAI has issued Guidance Note on Accounting for State level VAT on 15-4-2005. The guidance note is based on principles of VAT as contained in White paper released on 17-1-2005. However, there are variations in respect of each State. Hence, accounting policies will have to be adapted to suit provisions of VAT law of the particular State. Following broad principles should be kept in mind:-

As per AS-2, cost of purchase for purpose of inventory valuation should not include tax, if credit of tax paid •is available.For purpose of income tax, inventory valuation should be inclusive of taxes, even if its credit is available, as •per section 145A of Income Tax Act.Purchase account should be debited with net amount. VAT credit receivable on purchases should go to ‘VAT •Credit receivable (Input) Account.Account of each rate that is. 0%, 1%, 4%, 12.5% etc. is required to be kept separately.•Incaseofcapitalgoods,asperAS-10,costoffixedassetsshouldincludeonlynon-refundabledutiesortaxes.•If entire credit of tax on capital goods is not available immediately, the credit that is available immediately should •be debited to VAT Credit Receivable (Capital Goods) Account and credit which is not available immediately should be taken to ‘VAT Credit Deferred Account’.In case of sales, the sales account should be credited only with net amount (i.e., exclusive of VAT). Tax payable •should be credited to separate account ‘VAT Payable Account’ [This is ‘exclusion method’. Interestingly, in caseofexcisedutypaidonfinalproduct,‘inclusivemethod’ispermitted,i.e.,saleaccountiscreditedinclusiveofexcisedutyonfinalproduct].If any VAT is payable at the end of period (after adjusting VAT credit available), the balance is to be shown as •‘current liability’.

Illustration 1Compute the invoice value to be charged and amount of tax payable under VAT by a dealer who had purchased goodsforRs.1,20,0000andafteraddingforexpensesofRs.10,000andofprofitRs.5,000hadsoldoutthesame.The rate of VAT on purchases and sales is 12.5% compute the VAT payable.

Solution:Invoice value to be charged

Purchase price of goods 1,20,000Add: Expenses 10,000Add:Profitmargin 15,000Amount to be billed 1,45,000Add: VAT @ 12.5% 18,125Total invoice value 1,63,125

VAT to be paid VAT charged in the invoice 18,125Less: VAT credit on input 12.5% of Rs. 1,20,000 (15,000)Balance VAT payable 3,125


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8.15 TaxTax is of two types such as: Direct Tax and Indirect Tax. Direct Tax is the tax, which is paid directly by people to the government, while indirect tax is the tax, which is paid indirectly by people to the government. Income Tax is paid directly to the government therefore it is a direct tax while excise duty is paid by people to the manufacturer who pays it to the government, therefore it is an indirect tax.

The Constitution of India (COI) has given power to levy tax to central and state government under seventh schedule. The taxation in India is either charged by the state governments or by the central government. In the basic scheme of taxation in India, it is conceived that central government will levy and collect tax revenue from Income Tax (except on Agricultural Income), Excise (except on alcoholic drinks) and Customs while state government will get tax revenue from sales tax, excise on liquor and tax on Agricultural Income and the municipalities will get tax revenue from octroi and house property tax.

Central Excise Law is a combined study of: CentralExciseAct(CEA),1944;•CentralExciseTariffAct(CETA),1985;•CentralExciseRules,2002;and•CENVAT Credit Rules, 2004•

8.16 Nature of Excise Duty As per section 3 of Central Excise Act (CEA) excise duty is levied if:

There is a good•Goods must be moveable•Goods are marketable•Goods are mentioned in the central excise tariff act (CETA)•Gods are manufactured in India•

If production or manufacture is in special economic zone then no excise duty is levied. Therefore, we can say that excise duty is not levied on:

Services such as doctors treating the patients, accountants preparing the accounts, in these cases service tax •are levied. Immovable goods such as roads, bridges and buildings. •Non-Marketable goods, that is., goods for which no market exists, for instance, melted iron ore at 1600 degree •Celsius. Goods that are not mentioned in CETA•Goods manufactured or produced out of India.•

Excise duty is levied on production or manufacture and not on sale. At the time of sale, another tax called Value Added Tax (VAT) or Sales Tax is applicable.

816.1 Taxable Event Taxable event means the stage when tax is levied/ applied. Manufacture or production in India is the stage of levying tax. However, the government, at the time, when the goods are removed from the factory, i.e., goods are taken out from factory, collects tax. Since, excise duty is levied at the time of removal of goods. Thus, it becomes taxable at the time of their removal and therefore, the date of its actual production is not relevant. The date of removal is relevant and the rate of excise duty applicable on the date of removal shall be actual rate of excise duty to be paid.

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8.16.2 Rates of Excise Duty The basic rate of excise duty is 16% while in some cases there is a special duty if 8% which makes the excise duty inthosecasesat24%.Thereisatpresentacessforeducationcallededucationcess,whichis2%oftheexciseduty;therefore, the effective excise duty comes out as 16.32% or 24.48%.

8.17 Chargeability of Excise Duty Excise duty is levied on production of goods but the liability of excise duty arises only on removal of goods from the place of storage, i.e., factory or warehouse. Excise duty is levied even if the duty was paid on the raw material used in production. Excise duty is levied on government undertakings also, for example, Railways is liable to duty on the goods manufactured by it.

Excisedutyisanexpensewhilecalculatingtheprofitsinaccounting.Excisedutyisleviedifgoodsaremarketable.Actual sale is not relevant. Therefore, goods, which are given for free replacement during warranty period, are also liable for excise duty.

8.18 Definitions and Concepts Central Excise Law is levied on manufacturer or production of goods. The liability of paying the central excise isonthemanufacturer.Soletusexaminetheconceptanddefinitionsofgoods,manufactureandmanufacturerindetail.

8.18.1 Factory According to section 2(e) Factory means any premises where any part of the excisable goods other than salt are manufactured or any manufacturing process is carried out.

8.18.2 Goods GoodshavenotbeendefinedinCentralExciseAct.AsperArticle366(12)ofConstitutionofIndia,Goodsincludesallmaterialcommoditiesandarticles.SaleofGoodsActdefinesthat“Goods”meanseverykindofmovablepropertyotherthanactionableclaimsandmoney;andincludesstocksandshares,growingcrops,grassandthingsattachedto or forming part of the land which are agreed to be severed before sale or under the contract of sale. Goods must be:

Movable•Marketable •

Moveable means goods, which can be shifted from one place to another place, for example, motor car, mobile phone, computer, etc. The goods attached to earth are immovable goods, such as, dams, roads, and buildings,etc.

Moveable goods are manufactured or produced but immoveable goods are constructed.

Marketable means goods which are capable of being sold, for example, Molten iron ore at 1300 degree to 1400 degreeCelsiusisnotmarketable,thereforenotagood.Similarly,flourproducedinownfactoryforuseasrawmaterial in own.

Sales tax or VAT is applicable on actual sales. Excise duty is applicable on production of goods. Actual sale is not relevant.

Goods produced for free distribution, as sample, gifts, or replacement during warranty period is also liable of excise duty.

Excisablegoodsarethosegoods,whicharementionedintheitemsoftariffinCETA.Sec2(d)defines“ExcisableGoodsasgoodsspecifiedinthescheduleofCETA1985asbeingsubjecttoadutyofexciseandincludessalt.”


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8.18.3 Manufacture or Production According to Section 2(f) of Central Excise Act “manufacture” includes any process: -

Incidental or ancillary to the completion of manufactured product or •WhichisspecifiedinrelationtoanygoodsintheSectionorChapternotesoftheScheduletotheCentralExcise•Tariff Act, 1985 as amounting to manufacture, or Which,inrelationtogoodsspecifiedinthirdscheduletotheCEA,involvespackingorrepackingofsuchgoods•in a unit container or labeling or re-labeling of containers or declaration or alteration of retail sale price or any other treatment to render the product marketable to consumer

Clause (ii) and (iii) are called deemedmanufacture.Thus, definition of ‘manufacture’ is inclusive and notexhaustive.

ThewordManufactureasspecifiedinvariousCourtdecisionsshallbecalledonlywhenanewandidentifiablegoodsemergehavingadifferentname,character,oruse;forexample,manufacturehastakenplacewhentableismade from wood or of pulp is converted into base paper, or sugar is made from sugarcane.

Deemed manufacture: Deemed manufacture is of two types:CETAspecifiessomeprocessesas‘amountingtomanufacture’.Ifanyoftheseprocessesarecarriedout,goodswillbe said to be manufactured, even if as per Court decisions, the process may not amount to ‘manufacture’ [Section 2(f) (ii)].

InrespectofgoodsspecifiedinthirdscheduleofCentralExciseAct,repacking,re-labeling,puttingoraltering•retail sale price etc. will be ‘manufacture’. The goods included in Third Schedule of Central Excise Act are same as those on which excise duty is payable u/s 4A on basis of MRP printed on the package. [Section 2(f) (iii)].

Production:ProductionhasalsonotbeendefinedinCEAbutproductionisusedtocoveritemslikecoffee,tea,tobacco, etc. which is called to have been manufactured nut produced.

Assembly: Assembly of various parts and components amount to manufacture provided it result in movable goods which have distinctive identity, use, character, name, etc., for example, assembly of computer is manufacture.

Assemblyofairconditionerinacarisnotmanufactureasnonewidentifiableproductemerges.

8.18.4 Manufacturer Manufacturer is a person who actually manufactures or produces the excisable goods. A person who gets the production of other and sell it after putting its own brand then he will not be called manufacturer, for example, if Khaitan company gets the fans made from some person and sell it after putting their brand name, the Khaitan company will not be manufacturer. The person actually making the fans will be called manufacturer.

8.19 Classification of Goods Theexcisedutyischargeableatdifferentgoodsatdifferentrates.Therefore,goodsareclassifiedfordeterminationofduty.TheclassificationofgoodsadoptedincentralexciseTariffActandCustomActiscommon.Theclassificationuses8-digitnomenclature.CETAconsistsof twoschedules; thefirstschedulegivesbasicexciseduty(that is.,CENVAT duty) and second schedule gives export duties.

8.19.1 Scheme of Classification CETA and Customs Act both have sections and chapters. Remember you have read above that the scheme of class is common for both CETA and Customs Act. Each section has various chapters. A section relate t a class of goods for example, Section – I is ‘Animal Products’, Section – XI is ‘Textile Products’, Section – XVII is ‘Vehicles, Aircraft, Vessels and Other Transport Equipments’. A chapter contains goods of one class for example, Section – XI of Textile Products has Chapter 50 relating to Silk, Chapter 51 relating to Wool and Chapter 52 relating to Cotton.

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Each Chapter is further divided into headings and headings are divided into sub-headings, for example, Chapter 50 of silk has 5 headings:

50.01 Silk and Cocoons •50.02 Raw Silk •50.03 Silk Waste •50.04 Silk Yarn •

The heading 50.04 ‘Silk Yarn’ has sub-headings 5004.11 Silk Yarns with 85% or more silk and sub-heading 5004.19 relates to Silk Yarns with less than 85% silk.

Inthisclassificationschemeletuselaborateon5004.19,inthisthereareupto6digits.Thefirsttwodigits‘50’ischapternumber;nexttwodigits‘04’isheadingnumberandnexttwodigitsafterdecimal‘19’issubheadingnumber.The2moredigits(tomakethese6digitsto8digits)areadditionaldigittofacilitateandprovideflexibilityin international trade.

8.19.2 Trade Parlance Theory Trade Parlance Theory emerged out of case of Grenfell vs. IRC (1876), where justice Pollok concluded that nay word in statue should be interpreted (understood in its popular sense, in which people understand it.

Some examples: A mirror is not a glass wear, as glass loses its character after it is converted into mirror. •Windscreen of motor vehicle (front glass of car) is not a glass it is understood as automobile part. •Plasticpenhasaseparateidentity.Itcannotbeclassifiedasarticleofplasticlikepipes,plasticsheetsetc.•Carbon paper is not a paper because paper is used for writing, •Printing, drawing, etc. •

Aproductisalsoclassifiedonthebasisofitsenduse,ifclassificationisrelatedtothefunctionofthegoods.

8.20 Valuation of Goods Excise duty is payable on the basis of:

Specificdutybasedonmeasurementlikeweight,volume,lengthetc.•Percentage of tariff value•Maximum retail price•Compounded levy scheme•Percentage of Assessable Value (Ad-valour duty) •

Specificexciseduty:Specifiedexcisedutyisthedutyonunitslikeweight,length,volume,andsoon.

Excisedutyontariffvalue:Tariffvalueisthevaluefixedbygovernmentfromtimetotime.Governmentcanfixdifferenttariffvaluefordifferentclasses.Tariffvalueisfixedforpanmasala,readymadegarments.

Excise duty on MRP: Government can specify the goods on which excise duty will be based on MRP. MRP shall bethemaximumpriceatwhichexcisablegoodsshallbesoldtothefinalconsumers.Itincludestaxes,freightandtransport charges, commission to dealers, etc.

Excise duty on MRP is applicable on products on which quoting of MRP is necessary under the Weights and Measurements Act, for example, chocolates, biscuits, wafers, ice creams, camera, refrigerators, fans, footwear, toothpaste, etc.


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Compounded Levy Scheme: In case of small manufacturer, government allow small manufacturer to pay excise dutyonthebasisofspecifiedfactorslikesizeofequipmentemployed,atthespecifiedrates.

Excise Duty on Assessable Value: Assessable value is the value of transaction, that is., the value at which transaction takes place, in other words it is the price actually paid or payable for the goods on sales. It is also called transaction value. It includes freight and transportation charges, commissions to dealer, and so on.

Excise duty is paid on transaction value or assessable value if: Goods are sold at the time and place of removal•Buyer and assessee (Manufacturer/seller) are not related•Price is the only consideration for sale,that is., money or some valuable item is received on sale•

Assessable value excludes amount of excise duty, sales tax or other tax actually paid. Following items are included:

Primary packing or main packing or necessary packing •Royalty charges•Commission to sales agent•

Following items are excluded: Secondary packing•Returnable primary packing like cold drinks bottles, LPG cylinders•Discount given at the time of sales•

Assessable year =

IllustrationIf the sales price of a good is Rs. 10, which includes the cost of bottle of Rs. 2 and the excise duty of 16% plus 2% education cess. What will be the assessable value?

Solution:Assessable value = Price Less Deduction – Allowable deductions/ (1+ rate of duty) Assessable Value = (10 – 2) / (1+0.1632) = Rs.9.54

8.21 Registration of Goods According to section 6 of Central Excise Act, every manufacturer or producer, who produces excisable goods, must get two types of registration:

Registration for manufacturer. •Registration for warehouse, where goods are stored.•

Rules of registrationFollowing are the rules of registration:

Separate registration is required for each premise.•Registration is not transferable. •Registrationcertificateshallbegivenwithin7daysofapplicationforregistration.•If manufacturer cease to produce, i.e., stops the production permanently then he should apply for •de-registration. Registration can be revoked or suspended by AC/DC if any condition of the Act or Rules is breached. •

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Procedure for registration Following are the steps for registration under central excise act.

Application for registration is given in prescribed format to the Assistant Commissioner or Deputy Commissioner •in duplicate. Application should be accompanied be a self-attested copy of Permanent Account number (PAN) allotted by •income tax department. Incaseofcompanyandpartnershipfirmsnameofcompanyorpartnershipshouldbementionedasnameof•business and not the name of owner who sign the application. Onreceiptofapplicationofregistrationtheexcisedepartmentallotstheregistrationcertificatewithin7days.•TheregistrationcertificatementionstheExciseControlCode(ECC),theECCisa15digitnumberwhichhas•first10digitsofPAN,nexttwodigitsareeither‘XM’formanufactureror‘XD’fordealerandthelastthreedigits are number like 001,002 etc.

Theregistrationcertificateincludes:Name of assessee •Constitution of the business •Types of business (Manufacturer, Dealer or warehouse or depot)•Export Oriented Unit (EOU)•Address of the business •The Excise Control Code (ECC)•

8.22 Clearance of Goods Clearancemeans takinggoodsoutof factory.Thus,finishedgoods canbe storednot removed in theplaceofmanufacture (factory) without payment of duty. There is no time limit for removal of goods from place of manufacture, that is., factory.The records have to be maintained by manufacturer indicating particulars regarding:

Description of goods manufactured or produced •Opening balance of goods manufactured or produced•Quantity produced or manufactured•Stock of goods•Quantity of goods removed•Assessable value•Amount of duty payable•Amount of duty actually paid. •

The record should be preserved for 5 years. If the records are not maintained then penalty up to duty payable can be imposedandgoodscanbeconfiscated.Ifgoodsarestoredatanyotherplaceotherthanfactory,thengoodscanbecleared from factory without payment of duty, if commissioner permits.Goods can be cleared out of factory without payment of duty for carrying out tests and omission per unit.


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8.23 Duty Payment Provisions Goods cleared from factory are cleared under an invoice. Duty is payable on monthly basis by 5th of the next month in which duty payment becomes due, i.e., the month in which goods are cleared from the factory. Duty is paid through current account called PLA and /or Central Value Added Tax Credit, i.e., CENVAT Credit. Goods can be cleared out of factory without payment of duty for carrying out tests and omission per unit. Small Scale Industry (SSI) is required to pay the duty by 15th of the next month. However, the duty for the month of March is paid by 31st March itself not on 5th of next month, i.e., 5th of April because government accounts closes on 31st March.

If the due date is Sunday or holiday, the duty can be paid on next working day. If duty is not paid then assessee is liable to pay the interest also on outstanding amount. If duty and interest is not paid for 30 days after due date, then the facility to pay duty on monthly basis will be withdrawn till the time interest and duty is paid or 2 months, whichever later. Thus, the facility of monthly payment of excise duty is withdrawn at least for 2 months. During this period duty will be paid on removal basis.

Duty is paid by assessee through current account known as PLA (Personal Ledger Account). The PLA is credited whendutyispaid,thatis.,depositedinthebankbyfillingachallancalledTR-6onmonthlybasis.OnlyexcisedutypaidcomesinPLAtheitemslikefine,penalty,interestdoesnotappearinPLA.

A PLA contains: Serial number and date •Details of TR-6 challan number •Balance duty etc. •

The PLA is maintained in triplicate using both sided carbon.

Excise return: Excise return is submitted to the excise department with the two copies of PLA and TR-6 challan. The excise return is prepared in form ER-1 and ER-3.

CENVAT: CENVAT has its origin from the system of VAT, which is very common in European countries. VAT meansValueaddedTax;itisasystemoftaxationinwhichtaxispaidonlyonthevalueaddition.Valueadditionisthe difference between the sale price and the purchase price. Thus, if a person buys a good for Rs. 40 and sells it for Rs. 100 after doing some works on it. Then he has added value of Rs. 60 on these goods. If the rate of taxation is 10% then the tax will be Rs. 6, i.e., 10% of Rs. 60.

ThissystemofVATwasintroducedinCentralExciseActin1986anditwasnamedasMODVAT(ModifiedVAT)later in 200 the name was changed to CENVAT. The system of VAT was brought in Service Tax in 2002 and now it is brought even in Sales Tax Law too.

8.24 Excise Duty Set Off Provisions 254TaxofRs.6canalsobecalculatedusingtheconceptofsetoffoftax.TaxonsaleofRs.100isRs.10;taxonpurchase of Rs. 40 is Rs. 4. Thus, if a manufacturer pay tax on the total value of goods manufactured by him of Rs. 100, i.e., Rs. 10 he can claim back Rs. 4 as his tax liability on value addition of Rs. 60 is only Rs. 6. This claiming back of tax is called tax credit or set off of duty scheme.

CENVAT System: CENVAT is applicable on central excise duty. In Central Excise, the manufacturer has to pay tax on the value of goods manufactured but taking the VAT system he can claim the tax credit, i.e., CENVAT credit of the tax paid on:

Input goods used in manufacture•Input services used in manufacture. •

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It should be noted that no CENVAT credit is available if: Final production is exempt from excise duty. •The document showing proof of payment of duty on input is not available. •

It is worth to note that duty paid on input cannot be enchased / refunded it can only be adjusted against duty on finishedgoods.

Input output relation: There need not be an input –output relation for claiming CENVAT credit, for example, duty paid on automobile components used in automobile manufacturer can be adjusted against duty on textile production.

CENVAT credit on capital goods: Any duty paid on machinery and plant, spare parts of machine, tools, dies etc. used in manufacture can also be adjusted against duty payable on production. However, up to 50% credit is available in currentyearandbalanceinsubsequentfinancialyear.

Motorcar is not a capital asset and for the purpose of CENVAT Credit for all manufacture. However it may be taken as capital good for service tax in case of service provider uses motor car for service providing purpose for example, Courier, tour operator, rent-a-cab, cargo, outdoor caterer, pandal and shamiana operator, and goods transport agency.


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SummaryVAT works on the principle that when raw material passes through various manufacturing stages and manufactured •product passes through various distribution stages, tax should be levied on the ‘Value Added’ at each stage and not on the gross sales price.Credit will be available of tax paid on inputs purchased within the State. Credit will not be available of certain •goods purchased like petroleum products, liquor, petrol, diesel, motor spirit (position of furnace oil is not clear in white paper, but many States do not give credit). No credit is available in case of Inter-State purchases.There are two methods mentioned for lowering the tax burden, exemptions and zero rating.•Ideally, VAT should have only one rate. Though this is not possible, it is certain that there should be minimum •varieties of rates.VAT tax will be payable only by those dealers whose turnover exceeds Rs 5 lakhs per annum.•The income variant of VAT allows for deductions on purchases of raw materials and components as well as on •depreciation on capital goods.Everydealerisrequiredtofilereturnsonmonthly/quarterlybasis.Iftherecordsarekeptproperly,filingthe•return will be very easy and mistakes will be minimum.Tax is of two types such as Direct Tax and Indirect Tax.•Direct Tax is the tax, which is paid directly by people to the government, while indirect tax is the tax, which is •paid indirectly by people to the government.Income Tax is paid directly to the government therefore it is a direct tax while excise duty is paid by people to •the manufacturer who pays it to the government, therefore it is an indirect tax. Constitution of India (COI) has given power to levy tax to central and state government under seventh •schedule.Excise duty is levied on production or manufacture and not on sale.•Taxable event means the stage when tax is levied/ applied.•Excise duty is levied on production of goods but the liability of excise duty arises only on removal of goods •from the place of storage, i.e., factory or warehouse.Excise duty is levied even if the duty was paid on the raw material used in production.•Central Excise Law is levied on manufacturer or production of goods.•Moveable means goods, which can be shifted from one place to another place, for example, motor car, mobile •phone, computer etc.Moveable Goods are manufactured or produced but immoveable goods are constructed.•Manufacturer is a person who actually manufactures or produces the excisable goods.•The excise duty is chargeable at different goods at different rates.•Assessable value is the value of transaction.•

ReferencesBhushan, K., 2006. • Working with VAT. New Delhi: Dorling Kindersley (India) Pvt. Ltd.Bakshi, P. M., 2011.• The Constitution of India. 10th ed., New Delhi: Universal Law Publishing Co. Pvt. Ltd.Kunwar, R., • Value Added Tax [Online]Available at: <http://www.ranjeetkunwar.com/downloads/VAT.pdf>[Accessed30December2011].Liability of Central Excise Duty• [Online]Availableat:<http://dateyvs.com/cenex02.htm>[Accessed30December2011].Mercatus Center, 2010. • At what cost? Basic Economics of a Value Added Tax. [Video Online] Available at: <http://www.youtube.com/watch?v=7aywtAJgHsY>[Accessed28December2011].Mckenzie, R., 2007. • Excise Taxes[VideoOnline]Availableat:<http://www.youtube.com/watch?v=pJypeUeZ5fM>[Accessed 30 December 2011].

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Recommended ReadingMandal, R. M., 2009. • Value Added Tax in North-East India. New Delhi: Mittal Publications.Bird, R. M. and Gendron, P., 2007. • The VAT in developing and Transitional Countries. Cambridge University Press.Singh, S.R., Shrivastava, M.P. and Gupta, S.K., 2008.• Economics of Value Added Tax(VAT).New Delhi: A P H Publishing Corporation.


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Self Assessment ____________isataxonfinalconsumptionofgoodsandservices.1.

Sales taxa. Value added taxb. Excise taxc. Wealth taxd.

Whichofthefollowingisasimplifiedsalestaxsystem?2. Wealth taxa. Excise taxb. Income taxc. Value added taxd.


1. VAT A. Set-off to be allowed only to a Registered Dealer2. Advantages of VAT B.Favoursthecapitalintensivefirm3. Disadvantages of VAT C. Revenue security4. Essentials for Set-off of Tax Credit D. Multi-point tax

1-A, 2-B, 3-C, 4-Da. 1-D, 2-C, 3-B, 4-Ab. 1-B, 2-D, 3-A, 4-Cc. 1-C, 2-A, 3-D, 4-Bd.

Which of the following allows deductions for taxes on all purchases of raw materials and components, but no 4. deduction is allowed for taxes on capital inputs?

Gross product varianta. Income variantb. Consumption variantsc. Subtraction methodd.

Capital goods carry a heavier tax burden as they are taxed ______.5. twicea. thriceb. onesc. highd.


1. VAT account A. Contain Tax Invoice number, name and address thereof, Total sale value, etc.

2. Debit notes and credit notes register B. Can be maintained manually or computerised3. Sales register C. Expiration of 5 years4. Period of retention of accounts D. Into account while adjusting monthly tax payable

1-A, 2-B, 3-C, 4-Da. 1-D, 2-C, 3-B, 4-Ab. 1-B, 2-D, 3-A, 4-Cc. 1-C, 2-A, 3-D, 4-Bd.

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___________ will be payable only by those dealers whose turnover exceeds Rs 5 lakhs per annum.7. VAT taxa. Income taxb. Sales taxc. Wealth taxd.

Which of the following statement is false?8. Exemption is complete relief provided to the trader, there is no tax charged on Sales and trader can avail a. Input tax credit for purchases made.Zero rating is complete relief provided to the trader, there is no tax charged on Sales and trader can avail b. Input tax credit for purchases made.Variant is complete relief provided to the trader, there is no tax charged on Sales and trader can avail Input c. tax credit for purchases made.Income variant is complete relief provided to the trader, there is no tax charged on Sales and trader can avail d. Input tax credit for purchases made.

___________ allows for deductions on purchases of raw materials and components as well as on depreciation 9. on capital goods.

Gross product varianta. Income variantb. Consumption variantsc. Subtraction methodd.

Whichofthefollowingmethodaggregatesallthefactorpaymentsincludingprofitstoarriveatthetotalvalue10. addition on which the rate is applied to calculate the tax?

Addition methoda. Subtraction methodb. Tax credit methodc. Invoice methodd.


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Assignment I

Rajesh, a director at young Pvt Ltd., Mumbai carrying on transport business has submitted the following particulars of his income for the assessment year 2011-12. Compute his taxable income and tax payable:

a) Directors Remuneration and Perquisites:Remuneration @ Rs.11, 000 per month – Rs.132000.•Freeuseofcarofenginecapacityof1.5lr.ProvidedbythecompanyforbothOfficialandpersonaluse.•The company has provided rent free accommodation (unfurnished) to Rajesh at Mumbai It is ascertained that •forthispurposethecompanyhasobtainedaflatonleasefromPremLtd.Forwhichthecompanypaysarentof Rs.40000 per annum this is also the fair rental value.Medical expenses met by the company on ordinary treatment of Rajesh & Members of Family Rs.4500•

b) Rajesh was occupying a bungalow on rent at New Delhi since November, 1986. He agreed to transfer his tenancy right in the said bungalow in favour of Bala Ltd. For a sum of Rs.200000 payable as follows:Rs.50000 in cash.•A Flat valuated at Rs.150000 (at cost) in the new building to be put up by Bala Ltd. to be allotted free of cost. •The cash payment was made on 5thApril,2010andtheflatwasallottedtohimon5th October, 2010 which was kept for his own allotted to him on 5th October, 2010 which was kept for his own residence from that date

Solution:Computation of Total Income of Rajesh for the A.Y2011-12

Particulars Working Amount Amount AmountSalariesRemuneration Rs.11000 *12 132000Perquisites :Free use of car Rs.1800*12 21600Rent free accommodation 15% of remuneration 19800Medical facility Exempt up to Rs.15000 Nil 41400 173400Capital GainsTransfer of Tenancy rightSale consideration 200000Less: Expenses on transfer Nil

200000Less: Indexed Cost of acquisition / improvement Nil

Long term capital gain 200000

Less: Exemption u/s 54F Rs.(150000* 200000/200000) 150000 50000

Total Income 223400

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Computation of Tax Liability

Particulars Other income LTCG TotalIncome Rs.173400 Rs50000 Rs. 201800Tax Rs.1340 Rs.10000 Rs.11340

Total tax Rs.11340

Add: Education cess & SHEC @ 3% Rs.340

Tax liability (Rounded off u/s 288B) Rs.11680


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Assignment II

Following details are furnished by Ritik, an Indian citizen, for year ending 31st March, 2011:

Particulars AmountSalary (net of tax and Ritik’s contribution to Provident Fund) 48000Ritik’s contribution to Provident Fund 4950Employer’s contribution towards Provident Fund 4950Interest credited to Provident Fund (@ 3.75% per annum) 14000Leave travel allowance received 3600House rent allowance (rent paid on house in Hyderabad, Rs.4500) 4500Dividends from ACC Ltd., an Indian Company 2500Dividend collection charges 200Tax deduction at source on Salary 1500Contribution to Public Provident Fund 4000Contribution National Laboratory approved u/s 35 5000Amount received on maturity of a Keyman Insurance Policy. 6000

Ritik acquired 2000 Listed shares of Xltd for Rs.5 Lakhs during 1985/86. Company allotted him equal value of bonus shares during 1991-92. Second bonus issue was made during March, 2010, when he received 1 bonus share for every 2 shares held by him. The entire shares held in the company have been sold by him during November, 2010 @ Rs.1100 per share.

(Source:CAclubindia,2011.[Online]Availableat:<http://www.caclubindia.com/forum/files_download.asp?msg_id=690576>[Accessed1January2012].)

QuestionDetermine the total income and tax liability of Ritik for the A.Y. 2011 -12.

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Assignment III

J.C.Professionals,apartnershipfirm,givesthefollowingparticularsrelatingtotheservicesprovidedtovarious•clients by them for the half-year ended on 30.09.10:

Total bills raised for Rs. 8, 75, 000 out of which bill for Rs. 75, 000 was raised on an approved International �Organisation and Payments of bills for Rs. 1, 00, 000 were not received till 30.09.10.Amount of Rs. 50, 000 was received as an advance from XYZ Ltd. on 25.09.10 to whom the services were �to be provided in October, 2010.

You are required to work out the:Taxable value of services.•Amount of services tax payable.•

Compute the invoice value to be charged and amount of tax payable under VAT by a dealer who had purchased •goodsforRs.1,20,000andafteraddingforexpensesofRs.10,000andofprofitsRs.15,000hadsoldoutthesame. The rate of VAT on purchases and sales is 15.5%.

(Source: Murarka, A, K., Service Tax and Value Added Tax [PDF].Available at: <https://s3.amazonaws.com/caclubindia/files/share_files/177055_39208_vat__service_tax__past_exam_solved_problems.pdf> [Accessed 1January 2012].


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Bibliography

References 2009.ImportExportTrainingCourse[VideoOnline]Availableat:<http://www.youtube.com/watch?v=1MUA•Z40QSc4&feature=related>.[Accessed17October2011].2010.UnderstandingCurrencyPricing-ForexBasics[VideoOnline]<http://www.youtube.com/watch?v=hC•qzMwTaP48&feature=related>.[Accessed17October2011].2011.HowtopayIncomeTax/TDS(taxdeductedatsource)[VideoOnline]Availableat:<http://www.youtube.•com/watch?v=0ZT1yjCxHTI>[Accessed28December2011].2011. Sales tax of 24% on ATF hurting airline industry: Vijay Mallya to ET NOW. [Video Online] Available at: •<http://www.youtube.com/watch?v=yw7iy7hgy9g>[Accessed29December2011].2011. The Central Sales Tax, 1956.New Delhi: Universal Law Publishing Co. Pvt. Ltd.•2011.Whichincomeisexemptfromhouseproperty.avi[VideoOnline]Availableat:<http://www.youtube.com/•watch?v=rHwAgzh-JM8>[Accessed28December2011].Agarwal, O. P., 2009 International Financial Management, Global Media Mumbai.•Ajami, Riad A. and Jason G., 2006. International business: Theory and Practice, 2nd ed., M.E. Sharpe Inc. •Apte, P. G., International Financial Management. 5th ed. The MCGraw Hill Comapanies.•Avadhani, V. A., 2010. International Financial Management, Global Media Mumbai.•Babu, G. R., 1963. Financial Services in India. D. K. Agencies.•Bajaj,A.,CapitalGainsUnderIncomeTaxAct1961[Online]Availableat:<http://www.taxmanagementindia.•com/visitor/detail_article.asp?articleid=1120>[Accessed26december2011]Bakshi, P. M., 2011.The Constitution of India. 10th ed., New Delhi: Universal Law Publishing Co. Pvt. Ltd.•Balance of payments - structure of the current account [Video Online] (Updated 29 May2008) Available at: •<http://www.youtube.com/watch?v=JKRBpJZ92QM&feature=related>[Accessed10September2011].Bhushan, K., 2006. Working with VAT. New Delhi: Dorling Kindersley (India) Pvt. Ltd.•BusinessKnowledgeResource[Online].ComputeTaxableIncomeofaFirm.Availableat:<http://business.•gov.in/taxation/partnership_computetaxable.php>[Accessed26December2011]CalculateCorporateTaxUsingExcel[VideoOnline]Availableat:<http://www.youtube.com/watch?v=Jaek-•SLQAoo>[Accessed26December2011].Cherunilam, Francis, 2010. International Trade and Export Management, Himalaya Publishing House.•Cherunilam, Francis, 2010. International Trade and Export Management, Himalaya Publishing House.•Corporate Education, 2010. Capital Gains Under the Indian Income Tax Act - Part II CA, CS and ICWA [Video •Online]Availableat:<http://www.youtube.com/watch?v=2Vrj2dovNro>[Accessedon28December2011].CorporateIncomeTax.[VideoOnline]Availableat:<http://www.youtube.com/watch?v=XB4wdTxw6zc>[Accessed•26 December 2011]DividendandTaxInformation[Online]Availableat:<http://www.experianplc.com/investor-centre/dividend-•and-tax-information.aspx>[Accessed26December2011].Egyankosh.com. Export-Import Framework [PDF]Available at: <http://www.egyankosh.ac.in/•bitstream/123456789/8883/1/unit-1%28complate%29.pdf>.[Accessed17October2011].Gasior,M.SyndicatedBankLoans[VideoOnline](Updated22Dec2007)Availableat:<http://www.youtube.•com/watch?v=Zx6eO65chLo>[Accessed10September2011].IncomeTaxLiability[Online]Availableat:<http://dateyvs.com/incom_primer.htm>[Accessed26December•2011]IncomeTaxLiability[Online]Availableat:<http://dateyvs.com/incom_primer.htm>.[Accessed26December•2011

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Internationalfinancialmarkets[Online]Availableat:<http://www.egyankosh.ac.in/handle/123456789/132>•[Accessed 14September 2011].IntroductiontoIFM[Online]Availableat:<http://www.egyankosh.ac.in/handle/123456789/7437>[Accessed•14 September 2011].Kelkar, V., Chelliah, R., Parthasarathy, 2002. Reports on India’s Tax Reforms. Academic Foundation.•Kunwar, R.,ValueAddedTax [Online]Available at: <http://www.ranjeetkunwar.com/downloads/VAT.•pdf>[Accessed30December2011].Lal, B. B. and Vashisht, N., 2008. Income Tax and Central Sales Tax Law and Practice.29th ed., New Delhi: •Dorling Kindersley (India) Pvt Ltd.LiabilityofCentralExciseDuty[Online]Availableat:<http://dateyvs.com/cenex02.htm>[Accessed30December•2011].LLP.Tax onLLP. [Online]Available at: <http://www.llponline.in/tax_llp.php> [Accessed 26December•2011].lostmy1,2011.Internationaltrade:Absoluteandcomparativeadvantage[VideoOnline]Availableat:<http://•www.youtube.com/watch?v=Vvfzaq72wd0>.[Accessed15September2011].Lseexternal,2008.Absolute,ComparativeAdvantage,OpportunityCost[VideoOnline]Availableat:<http://•www.youtube.com/watch?v=rUZX-Pv3JNg&feature=related>.[Accessed15September2011].Mckenzie,R.,2007.ExciseTaxes[VideoOnline]Availableat:<http://www.youtube.com/watch?v=pJypeUeZ5fM>•[Accessed 30 December 2011].Mercatus Center, 2010. At what cost? Basic Economics of a Value Added Tax. [Video Online] Available at: •<http://www.youtube.com/watch?v=7aywtAJgHsY>[Accessed28December2011].Moneycontrol,2009.ChangingfaceofIndiantaxation:MarkWeinberger[VideoOnline]Availableat:<http://•www.youtube.com/watch?v=6aFq-M0ZO0c&feature=relmfu>[Accessed28December2011].Money control, 2009. Sales Tax Dept freezes bank accounts of Indage Vintners [Video Online] Available at: •<http://www.youtube.com/watch?v=PGhiOJ5ZHuE>[Accessed29December2011].Nathani,G.,AssessmentBySettlement–ChargeofInterestu/s234A,B&C[Online]Availableat:<http://•www.taxmann.com/TaxmannFlashes/Articles/flashart11-11-10_5.htm>.[Accessed26December2011]Newagepublishers.com. Export Import Trade – Introduction to Regulatory Framework [PDF] Available at: •<http://www.newagepublishers.com/samplechapter/001264.pdf>.[Accessed17October2011].Pebreja,R.,Lesson–22CentralSalesTax[Online]Availableat:<http://www.du.ac.in/fileadmin/DU/Academics/•course_material/TM_22.pdf>[Accessed29December2011]Rama Gopal, C., 2007. Export Import Procedures – Documentation and Logistics, New Age International.•Rao, V. G., The Corporation Income Tax in India. Concept Publishing Company.•Saxena,N.TaxAssignmentonComputationoftaxableincomeofindividual,HUFandfirms.•Smiter,S., Payment of Advance Tax (How to Calculate Advance Tax) [Online] Available at http://www.•caclubindia.com/forum/how-to-calculate-advance-tax--116138.asp [Accessed 26 December 2011].TheCentral SalesTaxAct, 1956 [Online]Available at: <www.portal.ap.gov.in/Acts%20%20Policies/•CSTAct’1956.doc>[Accessed29December2011].Unit2:InternationalBusinessTheories[PDF]Availableat:<www.egyankosh.ac.in/bitstream/123456789/35341/1/•Unit-2.pdf>[Accessed15September2011].Vaghefi,M.R.,Paulson,S.K.andTomlinson,W.H.,1991.Internationalbusiness:theoryandpractice,Taylor•and Francis.


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Recommended ReadingApte, 2006. International Financial Management, 4th ed., Tata McGraw-Hill Education.•Aswathappa, A., 2010. International business, Tata McGraw-Hill Education•Aswathappa, K., 2010. International Business, 4th ed. Tata McGraw Hill. •Bhargava, U. K., 1977. Taxation. The University of Michigan.•Bird, R. M. and Gendron, P., 2007. The VAT in developing and Transitional Countries. Cambridge University •Press.Brudno, W., 1960. Taxation in India. Little Brown.•Deresky, 2006. International Management: Managing Across Borders And Cultures, 5th ed., Pearson Education •India.Lal, B. B., 2008. Income Tax and Central Sales Tax, 29th ed., Pearson Education India. •Lal, B. B. and Vashishth, N., Income Tax and Central Sales Tax- Law and Practice, 29th ed.•Mandal, R. M., 2009. Value Added Tax in North-East India. New Delhi: Mittal Publications.•Manupatra Information Solutions Pvt. Ltd. The Income Tax Act, 1961, 12th ed., India.•Mattoo, A. and Stern, R. M., 2003. India and the WTO, World Bank Publication.•Pathak, A., 2008. Legal Aspects of Business.3rd ed., New Delhi: Tata-Mcgraw Hill Publishing Company •Limited.Poirson, H. The tax system in India: Could reform spur growth? International Monetary Fund, April.•Prasad, K., 2001.Development of India’s Financial System. New Delhi: Sarup & Sons.•Rugman, A. M., 1985. International Business: Theory of the Multinational Enterprise, McGraw Hill Book •company. Seyoum, B. 2008. Export-Import Theory, Practices, and Procedures, 2nd ed., Taylor and Francis.•Sharma, R. S., 1988. Administration of Sales Tax. New Delhi: Atlantic Publishers & Distributers.•Shuklendra, A., Law of Income Tax, Modern Law House, 2000.•Singh, S.R., Shrivastava, M. P. and Gupta, S.K., 2008.Economics of Value Added Tax(VAT).New Delhi: A P •H Publishing Corporation.Tax Management Inc. Tax Management Portfolios. Tax Management Inc., 2006.•Tax Management Inc. Tax management transfer pricing report, Volume 10. Tax Management Inc., 2001.•Tayeb, Monir H., 1999. International Business: Theories, Politics and Practices, Financial Times •Management.Vyuptakesh, S., International Financial Management, PHI Learning Pvt. Ltd. •

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Self Assessment Answers

Chapter I 1. ac2. d3. a4. a5. a6. a7. b8. d9. c10.

Chapter IIa1. a2. d3. c4. d5. a6. b7. a8. a9. a10.

Chapter IIIb1. b2. c3. d4. a5. a6. c7. a8. a9. c10.

Chapter IVd1. a2. c3. b4. a5. c6. c7. b8. a9. c10.


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Chapter Va1. d2. c3. a4. a5. b6. c7. a8. d9. c10.

Chapter VIc1. b2. a3. d4. a5. a6. b7. d8. a9. c10.

Chapter VIIa1. a2. d3. d4. d5. b6. a7. c8. b9. c10.

Chapter VIIIb1. d2. b3. a4. a5. c6. a7. b8. b9. a10.