Tax relief: Here's what suits you best

February, 05th 2009

Now that you have calculated your tax liability for this year, you
will know exactly how much you have to save to minimise your tax
outgo. You have two choices. If you are short of liquid surplus
funds to invest, you can simply go ahead and pay this tax.

Outlook Money strongly recommends that you do not take a personal

loan or any other debt to pay off this tax liability. If you have
surplus funds and are ready to part with them for a medium- to long-
term period (about five years or more), you can choose option two
and invest them in the specified Section 80C instruments. The amount
you invest will be reduced, up to Rs 1 lakh, from your gross total
income.

Apart from long-term savings, the underlying objective of investing

in any of the Section 80C instruments is to save your taxes.

Tax is paid on the income left after the amount invested is deducted
from the gross total income. Taking an example, investment of the
maximum allowed amount of Rs 1 lakh in one or a mix of Section 80C
instruments reduces the taxable income by Rs 30,900 and Rs 33,900 if
the income tax rate is 30.9 per cent and 33.99 per cent,
respectively.

However, the days of merely looking at the tax benefits of tax-

saving investments are over. Now, you can, based on your risk
profile, choose to invest in products that save tax as well as earn
returns.

The Income Tax Act does not treat 80C instruments uniformly, and the
taxability of contributions, accumulations and withdrawals differs
from one instrument to another.

Investments in a public provident fund (PPF) scheme, for instance,

enjoy tax relief in the form of deductions, while the interest
escapes the taxman's axe. The money you get on maturity is not
taxable either.

This method of taxation is referred to as 'exempt-exempt-exempt'

(EEE) since all three stages -- contribution, accumulation and
withdrawal -- are exempt from tax.

On the other hand, contributions to and accumulations in certain

products are not taxable, but the amounts received, like periodical
pension in a pension plan, are taxable in the year of receipt. Such
financial products are governed by the 'exempt-exempt-tax' (EEE)
method of taxation.

The tax treatment is different for notified tax saving bank fixed
deposits (FD), National Savings Certificates (NSC) and Senior
Citizens Savings Scheme (SCSS). The investment made in these
instruments qualifies for exemption at the time of contribution, but
the interest earned is taxed on accrual basis, that is, on each-year
basis.

For example, if a notified tax saving bank FD gives a return of 8

per cent per annum, the effective post-tax return would be a mere
5.5 per cent, lower than the inflation rate, for someone paying 30.9
per cent tax. On the other hand, PPF gives a tax-free return of 8
per cent per annum. This return is the same for all tax brackets.

The return that should be examined while comparing tax saving

products is the one post-tax, not pre-tax. The returns of tax-free
products like and employees' (EPF) are not pruned by taxes. With the
tax scissors not clipping it, PPF's return stays at 8 per cent per
annum for all tax brackets.

We have shown the relative suitability of different 80C products on

the basis of their returns for the four tax rates

The relative performance of only one product, SCSS, is not uniform

across different tax rates. SCSS scores over in the 10.30 per cent
tax bracket as the post-tax return of SCSS is higher at 8.07 per
cent than 8 per cent. But beats SCSS on the return parameter for
other tax rates. However, that would again change if the senior
citizen's income is less than the minimum taxable amount of Rs 2.25
lakh a year.

Other than the post-tax return, your choice largely hinges on your
perception of the risk involved, your financial background and the
stage of life you are in. Many young individuals are reluctant to
invest in equity-related instruments at the initial stages of their
career.

At the other end of this spectrum are investors in their late

fifties or even retired people who have embraced the equity culture.
Equity had moved unilaterally in the last five years, but we saw a
reversal this year. cannot be relied on as an asset class to give
good positive returns in the short- to medium-term.

So, while retirees may have had nothing to complain about till
January 2008, the story is completely different for people who have
retired since.

The question then is: What comprises a portfolio that can stand the
test of time and deliver a decent return over a long term?

Too much exposure to equity may skew the risk-reward ratio. A bias
towards fixed income instruments, on the other hand, may adversely
impact the post-tax and post-inflation return. Risk and return have
a close relationship and are important pillars of wealth creation
over the long term.

Linking your 80C investments to your long-term financial goals is a

recognition of this fact. Liquidity is a crucial factor in all the
instruments and, hence, short- and long-term objectives should be
clear before you lock your funds in them.

Remember, there is a trade-off in the choice between a market-linked

product and an assured return instrument that is not linked to
market conditions. The liquidity, returns and safety of your funds
should be an integral part of your investment decision.
Hence, it is essential to have a portfolio with a prudent mix of
market and non-market products. A portfolio that has an unreasonable
bias towards any one of the two categories needs corrective action.

And, therefore, the final choice of instrument categories should,

ideally, be based on a combination of factors rather than solely
being driven by returns. One instrument by itself cannot help you
save tax and provide safe, assured and high return at the same time.

The endeavour should be to build a portfolio that can deliver a

decent return with little risk.

The product categories are stacked as per their post-tax return in

the adjacent table. Essentially, this gives you an idea which class
would be more suitable to you in terms of the actual return in your
hand.

The choice of the instrument would further hinge on your risk

appetite. The table details three risk profiles: low, medium and
high. Under each investor risk category, the products are stacked as
per their return and risk profile.

Taxpayers in the low risk category can, for instance, continue their
EPF account and then consider any of the products shown. Being
averse to risk, it would be better for them to avoid products that
invest in equity, such as equity-linked savings schemes (ELSS) and
unit-linked insurance plans (Ulips).

Endowment plans would be the best way to take life cover for them.
However, taxpayers in the medium-risk category may benefit if they
replace life insurance endowment plans with Ulips or ELSS.

Having both an endowment plan and a Ulip would amount to duplication

of benefits as both serve the basic objective of providing
protection. Investors in the high-risk category should give priority
to equity-linked products such as ELSS or Ulips over fixed income
products.

Once you have identified products that suit your risk profile, do
also consider their holding period. funds diverted towards tax-
saving instruments need to be locked in for at least three years, in
many cases more. Some products have a lock-in mandate and they
should never get money that you feel you are likely to require in
this period.

A good mix of medium- and long-term products should be present in

your portfolio to help you not just save tax but also fulfil your
financial objectives.

Wealth can be created over the long tem only from a decent real rate
of return, that is, after taking inflation into account.

Finally, having made your investments and claimed the tax breaks,
don't forget to keep the records and documents of your investments
and tax deduction certificates, since you will have to produce them
if called upon to do so by the taxman.
Subject: Investing and Theory of Inversion

66", muttered the grocer to himself as he reached out to his cash counter at
one of
the corner grocery stores and pulled out few notes and coins totaling Rs 66.
He
settled the transaction by promptly handing over the money to the customer who
had
bought goods worth Rs 34 but had paid Rs 100 for lack of change.
While the grocer moved onto other activity with nonchalant ease, we were
impressed
by how quickly he managed to mentally calculate the difference between 100 and
34.
After watching him settle few more of such transactions, it finally dawned
that
rather than subtraction, he relied upon a quicker and a less error prone
technique
of starting with the base amount and then continuing adding to it until he
reached
the amount that the customer actually paid him. Like in the case of the
customer who
gave him Rs 100, he started with 34 and kept on adding until he reached 100.
'66',
the number struck to us at lightening speed and we had just discovered a
technique
that is sure to save us few hours over the course of our lifetimes.

Little did the grocer realize that he was relying upon a mental exercise that
the
famous mathematician Carl Jacobi had made immortal with his words, "Invert,
always
invert". Jacobi had reasoned that it is probably in the nature of things that
a lot
of problems in the world can be solved by thinking backwards. This phrase has
been
made more famous in recent times by Charles Munger, the lesser known but an
equally
erudite partner of Warren Buffett and who is believed to have had one of the
greatest influences on him.

Let us try and find answers to few simple questions like 'What does it take to
be
successful?' or 'What should I eat to remain healthy?' While the answers to
these
questions can definitely be worked out, exactly opposite queries to the above
set of
questions will most likely lead to new insights and make our job that much
more
easier. Thus, if we now try answering questions like 'What qualities makes a
man
unsuccessful and how should I avoid them?' or 'What food will make me fat and
unhealthy?' These questions are exactly opposite in nature to the ones posted
above
and rely upon the theory of inversion. To test the efficacy of the method,
additional sets of questions, one proper and one inverted should be framed and
indeed analysed. After going through the results, we don't think that there
would be
doubt in anyone's mind that this technique is indeed a very important tool to
solve
many of the life's problems.

Now, how do we use this theory of inversion in the field of investing? We

believe
that inversion works just as fine in investing as any other field and if
properly
adhered to, is likely to result into much better investment results. Say for
example, after an investor has carefully analysed all the reasons for
investing in a
stock, he should resort to inversion and ask himself, "What are the reasons
that
will make me not invest in the stock?" More often than not he is likely to
stumble
upon something he had not known previously and hence, would help him take a
more
informed decision.

Another way in which the technique can be used effectively is by questioning

the
price that a stock commands in the market place. Normally, while analyzing the
investment worthiness of a stock, an investor makes some assumptions about
future
cash flows and discount rates and then arrives at a fair value. This fair
value is
in turn compared with the stock price and depending upon the premium or
discount,
one chooses to invest or not to invest in the stock. How about inverting the
analysis and starting with the market price and then questioning ' What kind
of
future cash flows does the current market price imply?' The results that such
kind
of analysis throws will be no less than startling.

Let us consider a company ABB, which as per our database is currently the most
expensive stock on the Nifty with a trailing twelve-month price to earnings
ratio of
50 times. Now if you are the one looking to invest in 5 baggers with an
investment
horizon of five years then is the stock a right bet for you? Let us assume
that in
five years time, the stock will come down to a more realistic and the broader
market
like P/E of 20 times. Thus, for the stock to become a five bagger in five
years, it
will have to grow its earnings at a CAGR of around 66% (explanation given
below), a
feat that is really difficult if not impossible to achieve for most of the
well-established companies like ABB.

This wonderful insight was made possible because of inversion. We started with
the
price and the P/E ratio and then went on to check whether it is really
possible for
the stock to become a five bagger, realising that the probability of such an
event
happening is indeed low. Hence, the next time you come across a good stock to
consider for investment, do not forget to pass it under the screen of the
inversion
theory and as mentioned before, the results might surprise you.

Explanation - Assume that ABB's current EPS is Re 1. So, at 50 times P/E, the
company's current stock price will be Rs 50. If the stock were to become a
five
bagger in five years, the price has to touch Rs 250. Now, assuming that after
5
years, the stock's P/E were to come down to a more realistic and the broader
market
like P/E of 20 times, the EPS thus calculated will be Rs 12.5 (Rs 250 divided
by
20). Compared to the current assumed EPS of Re 1, for the same to grow to Rs
12.5 in
five years times would require it to grow by 66% CAGR. 66", muttered the
grocer to
himself as he reached out to his cash counter at one of the corner grocery
stores
and pulled out few notes and coins totaling Rs 66. He settled the transaction
by
promptly handing over the money to the customer who had bought goods worth Rs
34 but
had paid Rs 100 for lack of change.

While the grocer moved onto other activity with nonchalant ease, we were
impressed
by how quickly he managed to mentally calculate the difference between 100 and
34.
After watching him settle few more of such transactions, it finally dawned
that
rather than subtraction, he relied upon a quicker and a less error prone
technique
of starting with the base amount and then continuing adding to it until he
reached
the amount that the customer actually paid him. Like in the case of the
customer who
gave him Rs 100, he started with 34 and kept on adding until he reached 100.
'66',
the number struck to us at lightening speed and we had just discovered a
technique
that is sure to save us few hours over the course of our lifetimes.

Little did the grocer realize that he was relying upon a mental exercise that
the
famous mathematician Carl Jacobi had made immortal with his words, "Invert,
always
invert". Jacobi had reasoned that it is probably in the nature of things that
a lot
of problems in the world can be solved by thinking backwards. This phrase has
been
made more famous in recent times by Charles Munger, the lesser known but an
equally
erudite partner of Warren Buffett and who is believed to have had one of the
greatest influences on him.

Let us try and find answers to few simple questions like 'What does it take to
be
successful?' or 'What should I eat to remain healthy?' While the answers to
these
questions can definitely be worked out, exactly opposite queries to the above
set of
questions will most likely lead to new insights and make our job that much
more
easier. Thus, if we now try answering questions like 'What qualities makes a
man
unsuccessful and how should I avoid them?' or 'What food will make me fat and
unhealthy?' These questions are exactly opposite in nature to the ones posted
above
and rely upon the theory of inversion. To test the efficacy of the method,
additional sets of questions, one proper and one inverted should be framed and
indeed analysed. After going through the results, we don't think that there
would be
doubt in anyone's mind that this technique is indeed a very important tool to
solve
many of the life's problems.

Now, how do we use this theory of inversion in the field of investing? We

believe
that inversion works just as fine in investing as any other field and if
properly
adhered to, is likely to result into much better investment results. Say for
example, after an investor has carefully analysed all the reasons for
investing in a
stock, he should resort to inversion and ask himself, "What are the reasons
that
will make me not invest in the stock?" More often than not he is likely to
stumble
upon something he had not known previously and hence, would help him take a
more
informed decision.

Another way in which the technique can be used effectively is by questioning

the
price that a stock commands in the market place. Normally, while analyzing the
investment worthiness of a stock, an investor makes some assumptions about
future
cash flows and discount rates and then arrives at a fair value. This fair
value is
in turn compared with the stock price and depending upon the premium or
discount,
one chooses to invest or not to invest in the stock. How about inverting the
analysis and starting with the market price and then questioning ' What kind
of
future cash flows does the current market price imply?' The results that such
kind
of analysis throws will be no less than startling.
Let us consider a company ABB, which as per our database is currently the most
expensive stock on the Nifty with a trailing twelve-month price to earnings
ratio of
50 times. Now if you are the one looking to invest in 5 baggers with an
investment
horizon of five years then is the stock a right bet for you? Let us assume
that in
five years time, the stock will come down to a more realistic and the broader
market
like P/E of 20 times. Thus, for the stock to become a five bagger in five
years, it
will have to grow its earnings at a CAGR of around 66% (explanation given
below), a
feat that is really difficult if not impossible to achieve for most of the
well-established companies like ABB.

This wonderful insight was made possible because of inversion. We started with
the
price and the P/E ratio and then went on to check whether it is really
possible for
the stock to become a five bagger, realising that the probability of such an
event
happening is indeed low. Hence, the next time you come across a good stock to
consider for investment, do not forget to pass it under the screen of the
inversion
theory and as mentioned before, the results might surprise you.

Explanation - Assume that ABB's current EPS is Re 1. So, at 50 times P/E, the
company's current stock price will be Rs 50. If the stock were to become a
five
bagger in five years, the price has to touch Rs 250. Now, assuming that after
5
years, the stock's P/E were to come down to a more realistic and the broader
market
like P/E of 20 times, the EPS thus calculated will be Rs 12.5 (Rs 250 divided
by
20). Compared to the current assumed EPS of Re 1, for the same to grow to Rs
12.5 in
five years times would require it to grow by 66% CAGR.