Paying tax on the unrealised gains!

Many start ups offer ESOP - Employee Stock Option Plan. To know more details
about how it works, you can follow this link

https://blog.cleartax.in/getting-esops-salary-package-know-tax-treatment/

Quick summary:
The companies give stock options (right to purchase, no obligation on part of employees) at a said exercise price, which is lower than the fair market value at a future point in time. These options would be vested (become live) after serving for a predefined time.  After the vesting period, the employees may choose to exercise the option i.e. convert the options to shares by paying the exercise price to the company.

There are two kinds of taxes which are involved in here.
    1. Perquisite Tax
    2. Capital Gains Tax
   
When the employee exercises the option, the difference between the exercise price and the fair market value (FMV) of the company will be treated as income of the employee (perquisite) for that financial year and will be taxed in his income slab accordingly.  FMV of a listed company would be the market price as on the exercise date and for an unlisted company, it would be as per the valuation arrived at by the company.  Most of the start-ups belong to the later category.

Capital Gains Tax is to be paid when the employee chooses to sell the stocks. For a listed company (listed means listed in India), short term capital gains (selling within 1 year of purchase / exercise) attracts 15% tax on the gains and beyond one year, it attacts no tax, as the STT is paid. For an unlisted company (or listed companies abroad), short term capital gains will be as per the slab rate (within the 3 years time frame) and long term capital gains (beyond 3 years) attract tax @ 20% with indexation or @10% without indexation
   
Coming to the topic of the post:
Think of the perquisite tax.  On the date of exercise, if the stock trades at a value lower than the exercise price, the stock options which the employee holds has no value at all.  He can as well put them into dust bin.  Who would want to exercise at a price higher than the market price.  Instead one can directly buy from the market at a lower price, if one still has confidence in the company.

On the other hand, let us say, the options are given at Rs 100 exercise price and the stock is quoting at Rs 175.  If a person holds 1000 options, he can exercise and get stocks valued at Rs 175 for Rs 100 by paying Rs 100,000.  Now, the difference between Rs 175,000 and Rs 100,000 is taxed at the income slab (say 30%) - it works out to be Rs 22,500.  And this is what I am saying as a tax for unrealised gain.  In a listed company option, one can choose to immediately sell it in the market and at least be comfortable saying the tax is paid for the realised gain.

In an unlisted company, first of all one has no idea about the fair market value.  Though it is done by following certain standard procedures, the person holding options has not much of transparency into how it is arrived at.  And, he cannot choose to sell immediately, because there is no market that exists for shares of unlisted company.  Paying a tax on this unrealised gain and ending up holding an illiquid and non-transparent share does not make so much of sense. There are very few exit opportunities in the unlisted category.  Either hope for an IPO or for an acquisition or merger.

And consider this case where the fair market value is much higher when you exercised (paying a lot of perquisite tax) and further drops much lower even below the exercise price.  Money down the drain!  In this way, you would have footed the bills of the company which provided you the employment and the government, which gave you the freedom to enter into these transactions.

I do not need to name, but, many e-com companies currently fall into this bracket.

Ramanujan's Magic Square

Yesterday I got a whatsapp forward which I found interesting.  The forward is about Ramanujan square. This is the Ramanujan square.

It is a magic square. Magic square is a square with 3x3 or 4x4 or any such square matrix filled with distinct numbers, whose sum when counted in multiple ways (horizontal, vertical or diagonal) remains the same.

You can have a visit to the wikipedia page on this topic. There are 24 different combinations (of 4 squares) in multiple directions and as 2x2 blocks which all add up to the same number - 139.

The wikipedia page above depicts the different combination as below

Image Courtesy:
Antonsusi shared under Creative Commons license.

This uses six 4x4 squares to depict all the 24 combinations. I have tried the same using a different illustration, with 9 4x4 squares instead of 6.  These 9 squares are created attaching eight Ramanujan squares in all 8 directions (N, S, E, W, NE, NW, SE, SW) of the center 4x4 square.

The first row of the Ramanujan's magic square is his date of birth 22 Dec 1887 written in Indian Style - 22/12/1887!

The Power of Tax Deferment

In 2011 December, IDFC Infrastructure Bonds got issued - which provided for an additional Rs 20000 tax-saving investment option beyond the usual 80C limit.  The quoted interest rate was 9% p.a. So, someone who was in a 30% tax slab, saved Rs 6000 in FY 2011-12 by investing in this bond. This Rs 20k with 9% p.a compounding would yield Rs 30770 after five years.  The interest on the bond is taxable as per the individual investor's tax slab.  The interest over 5 years is Rs 10770. For a person who is in 30% tax slab, this means a tax liability of Rs 10770 * 30% = Rs 3231 in FY 2016-17. The net inflow in FY 2017 is Rs 30770 - 3230 = Rs 27540.  This is for a net effective investment of Rs 14000 (remember Rs 6000 saved on tax).  Works to a very good 14.5% p.a CAGR.

Net tax outgo of Rs 3230 after 5 years is far better compared to a tax outgo of Rs 6000 currently!

There is an option to extend this for another 5 years. Assume this gets extended. Amount accumulated at the end of 10th year is Rs 47347, the interest Rs 27347 would attract tax @ 30% (based on the slab) which means effective net inflow will be Rs 20000 + Rs 27347 * 0.7 = Rs 39143, this on a net investment of Rs 14000 gives a CAGR of 10.83% p.a.  Definitely not impressive compared to the 5 year CAGR.  Figure out how!

Had it been taxed as long term capital gains (as the debt mutual funds are taxed), it would have been a different scenario.  We need to take into out the increase in cost inflation index from the investment year to the current year.  In 2012, it was 758, in 2016-17 it is 1125.   Indexed Cost would be 1125 / 758 * 20000 = Rs 29683.  The net gain of Rs 30770 - Rs 29683 = Rs 1087 will be taxed at 20%, which is just Rs 217!   Net post tax gain of Rs 10553, working out to be 8.84% CAGR  (assuming no tax benefit of Rs 6000 in the tax saving year)

If the investment had been kept for 10 years, 2006-2007 index was 519. Indexed cost is 1125 / 519 * 20000 = Rs 43352.  Total amount accumulated at the end of 10th year is Rs 47347, the difference is Rs 3995 which is taxed at 20% (Rs 800) Net post tax gain of Rs 26547, works out to be 8.81% CAGR.

Tax Treatment on Stock Split and Bonus Shares

Recently, I happened to look at a stock which was bought long back and forgotten.  For a moment I thought that the price has doubled since then, so possibly I can exit the position.  Since the stock was bought before one year, even if I sell, it would be considered as long term capital gains on equity and would not be taxed at all.

I was wrong.

I remember I bought 50 shares, but now I had 100 shares, when I looked at the corporate actions, I realised that the company has recently issued a 1:1 bonus.  So, if you had 1 share, now you will have 2 shares - accordingly the stock price would also have halved.  The total value of my position is still at a gain, but because of the bonus shares - not all will be treated as LTCG (Long Term Capital Gain)

Here it goes
2011 - Bought 50 Shares - Price 40  => Rs 2000
2016 - Have  100 Shares - Price 40  => Rs 4000

So, the original 50 shares - LTCG is Rs 0 - Then it was at 40, now it is again at 40
the additional 50 shares - Gain is Rs 2000 - Since it was allotted as a bonus - effective cost is zero - the entire value is gain and since it is recently allotted, this gain of Rs 2000 will be treated as short term capital gain (STCG) if sold within one year of allotment and taxed accordingly (@15%)

The way the Indian taxation works with stock split is different.  A 2-for-1 stock split will make the investor hold 200 shares of face value Rs 5 if he originally had 100 shares of face value Rs 10.  Note that the face value is not changed in the issue of bonus shares, but gets altered in the stock split.

Since these are the same shares whose face value have changed and because of which the number of shares got increased, the additional shares credited is considered to be bought as on the original date of purchase.  So, in the case illustrated above, if the company had issued a 2-for-1 split instead of 1:1 bonus, I would still be holding the same number of shares (but of half the face value - which is immaterial), all of my shares would still be qualified for LTCG if I sell it today.

Books 2016

2016 was a good year for my book reading habit.  Mostly I was able to use my long commute for the same.  I generally do not like long commutes, but it so happened that that was the case.  I have been spending around 2.5 hours a day up and down in commute alone.  I do not like the commute - especially in the Bangalore traffic, but the habit of book reading is the savior.  Book reading has become an almost essential part of my life, now.

These are the books which I completed in 2016
1. The Art of Thinking Clearly by Rolf Dobelli
2. Richdad's Cashflow Quadrant - Robert Kiyosaki
3. Nudge: Improving decisions about health wealth and happiness by Richard Thaler et al
4. Intelligent Investor - Ben Graham
5. Scarcity: Why Having Too Little Means So Much - Sendhil Mullainathan et al
6. Influence: The Psychology of Persuasion - Robert Cialdini
7. Fooled By Randomness - NN Taleb
8. The Goal 2 - Eliyahu Goldrat
9. The Little Book That Builds Wealth by Pat Dorsey
10. Extraordinary Popular Delusions and the Madness of Crowds by Charles McKay
11. Man's Search For Meaning - Viktor Frankl
12. One Small Step Can Change Your Life: The Kaizen Way - Dr. Robert Maurer
13. Beating the Street - Peter Lynch
14. As a Man Thinketh - James Allen
15. The Richest Man in Babylon - George Calson
16. Think and Grow Rich - Napolean Hill
17. The Way to Wealth - Benjamin Franklin
18. The Checklist Manifesto - Dr Atul Gawande

I realised that I like fiction much less compared to essays, biographies and conceptual books.

Started, but not yet completed
1. The Man Who Knew Infinity - Biography of Srinivass Ramanujan, Mathematician
2. Black Swan by NN Taleb
3. The Summons by John Grisham
-- In the first 2 instances, switched books in between - it is still on my to-read list. I did not like "The Summons" - so stopped reading.
4. The Little Book of Valuation by Aswath Damodaran (still in my list) - this is not a casual read, so waiting till I get a working time with this book.

I would like to do better in reading, this year.

The Goal 2

The Goal 2 is a sequel to the book The Goal by Eliayu M. Goldratt.  Goal talks about Theory Of Constraints.  Goal 2 talks about a concept called "Thinking Process".  The protagonist Alex Rogo is now EVP in UniCo managing three newly acquired businesses.  A printing company, cosmetics company and a pressure-steam company.  The book starts with the board of UniCo deciding to sell off Alex's 3 business and wanting him to turn around the struggling companies to fetch a better sale price.

Over the course, all the 3 divisions make a turn around after analysing the current situation and identifying what the market wants.  The printing company positions itself to give a better price per usable unit thereby cutting costs and reducing unwanted orders from the customers, creating value. The cosmetics company makes a turnaround by acquiring good shelf presence in return of reduced ticket sizes and frequent deliveries to the customers (shops) thereby reducing the financial burden of customers.  The pressure-steam, instead of selling the unit and spare parts, starts selling the pressure steam itself, thereby converting the capex of customer to opex.

The author introduces a negotiation technique involving visual articulation of common objectives and conflicting premises, which would help breaking the conflict.  The Thinking Process involves the construction of Current Reality Tree, Transition Tree and Future Reality Tree.

The Current Reality Tree is the wholesome flowchart of UDEs (UnDesired Effects - shortcomings) for a given objective, as of now.  This connects all the UDEs from one to another.  The premise is that all the UDEs are the experienced pain points which arise from majorly one or two main causes - the idea is to find such a cause.

The Future Reality Tree is built from the current reality tree, with an end objective in mind and creating possible paths for the same.  The paths will have negative branches for which a resolution is sought after. For example increasing sales is a path; reducing price (and thereby creating price war) is a negative branch which needs to be addressed.

The book emphasizes on the point that the product is not simply the physical product.  The product is the wholesome unit including the physical product, packaging, service, delivery along with the financial terms which the customer would value. It proposes to create a competitive advantage, especially sustainable competitive advantage, kind of a moat, which the competitors would find difficult to catch up.

Advocates one of the known but often overlooked idea.  The price of the product is not the cost plus markup, it depends on what the value that the product brings to the customer.  Or is equivalent to the value of the pain that the product or service offers to remove.

Towards the closing chapters, there is a significant talk on what makes a good strategy - an organisation needs to uphold the values of 3 key people - shareholders, employees and the customers.  Any idea which propagates to benefit one group at the expense of other is not a long term sustainable one.

Enjoyable read - this is one of the 2 novels that I read in 2016.

Happy New Year 2017

Wish you a very happy new year 2017!

Sometime back, I wanted to refresh my blog writing.  So, started it small in November and now in the last 2 months, I have written around 20 posts - most related to personal finance topics and products. Looks like it is a significant one considering my hibernation in the last two years.  The post I did before Nov 2016 was in Jan 2015 and that too a new year post, after a hiatus.

Seems I did well - but actually not.  I decided to do a post every day when I started.  But had to put off for many days.  Just procrastination and nothing else.  I got the inspiration from a Tamil movie "Pichaikaran" where the protagonist sticks to an arduous routine for 48 days. I thought why not I practice something for 48 days.  It did not work - though, I think I did better than nothing at all previously.  On a side note, the movie got an instant celebrity status after PM's announcement of demonetisation on Nov 8, 2016.

Similarly another activity which I wanted to renew was walking. I have been practising walking since late 2008 - but on and off.  The inspiration was my economics professor Dr. Tripati Rao, who is practising for around 20 years now!  The new year 2009 was coming, but I did not want to wait for it, I started sometime in December itself.  In the last one and half years, my long bus commute has been prefixed and suffixed by the walks.  But, I wanted to do it as an activity alone, not combined with the bus commute.  So, restarted it in the last few months. It is one of the most enjoyable activity.  I strongly recommend.  I used to use Sportstracker in the early days, now using Google Fit - I find people say it is not accurate - but works for me than having nothing.  At least I know that I am progressing.

I think I am too addicted to metrics - see I count the number of steps, count the number of blog posts that I did.  In the modern day where every minute of living generate data and metrics, it is something which we cannot avoid.  The editor (notepad++) which I am typing in keeps track of the word count, line and columns!

I plan to continue these enjoyable activities in the new year as well.

Give the 48-day challenge, an attempt! On any of the activities you like doing, you feel good doing but unable to do!

All the best to each of your individual aspirations!