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All you wanted to know about Letter of Undertaking and Grandfathering
Why is this article relevant for IBPS / SBI Bank PO, RRB, and Other Bank Exam Aspirants?
Almost all exams including IBPS PO, IBPS RRB, SBI PO evaluate students on their knowledge of Banking General Knowledge and Current Affairs. This section is not only high scoring but also has high cut-offs. To ensure that you do well in this section, you need to ensure that you are regularly in touch with the latest news in the banking world and the economy.
What is LoU (Letter of Undertaking)?
Letter of Undertaking is a bank guarantee under which a bank allows its customer to raise money from another Indian bank’s foreign branch in the form of short-term credit. The loan is used to make payment to the customer’s offshore suppliers in foreign currency. The overseas bank usually lends to the importer based on the LoU issued by the importer’s bank.
So, let’s say a company called Ultron wants to import vibranium for a new shield. Ultron approaches a bank, let us assume, Bank of Simple, and asks it to arrange for a guarantee in the form of LoU for short-term loans from the foreign branches of Indian banks, to pay the supplier. Bank officials in Bank of Simple promptly send instructions from the local branch to other overseas banks offering LoUs. The messages are sent through SWIFT — an inter-bank messaging network for securely transmitting instructions for financial transactions.
Theoretically, such SWIFT instructions need to be recorded in a bank’s core banking system. But thanks to the connivance of bank officials, at times, the actual LoUs issued in the past escape scrutiny.
LoUs are important instruments that allow those in the import trade to transact their business. As an importer in India cannot simply buy dollars and send it abroad to make payments to his supplier, various instruments such as LoUs and Letters of Credit are required to carry out the transaction. LoUs, which are essentially a form of guarantee, have come to be a far cheaper and convenient way for importer to raise credit.
For instance, an exporter in India, essentially has two options to make the payment to his supplier. One, he borrows money from an Indian Bank in rupees, converts it dollars, and pays his supplier. But here, the interest rate on such loans would be at the higher domestic rate, say 12-13 per cent.
The other way would be through a bank guarantee offered by an Indian Bank. The bank would simply instruct the overseas bank through SWIFT to remit funds into the bank's overseas account, which is in turn used to pay the supplier. The bank earns a fee and the overseas bank offering the credit charges an interest at a spread over LIBOR.
What is Grandfathering in tax?
The stock market’s manic behaviour after the budget session has been (rightly or wrongly) blamed on the FM’s proposal to levy a 10 per cent long-term capital gains tax on stocks and equity funds. This was called as the Grandfathering clause.
Tax laws keep shifting and changing with every budget. A grandfathering clause in any new tax law allows people who made their decisions under the old law to continue to enjoy a concession, until the original time-frame for it runs out.
In the Union Budget 2018, there’s a grandfathering clause attached to the new section 112A on long-term capital gains. It seeks to shield investors who have bought listed shares or equity mutual funds before February 1 2018, from the impact of the 10 per cent tax. The section says that if a taxpayer has acquired listed shares or equity funds before February 1, all the long-term capital gains he has made on them will remain tax-free for all future years. In short, these past gains have been ‘grandfathered’ for the taxpayer. ‘Long-term’ here implies a holding period of one year.
The extent of gains (or losses) will be calculated based on two things: your cost of acquisition and the highest traded price for the stock (or closing Net Asset Value of the fund) as of January 31, 2018.
Why is it important?
Investors deciding where to put their money and businesses deciding on new projects, often base these decisions on existing tax structures. But if the Government changes its mind on tax at a later date, it could negate the basic premise for the decision.
Frequent changes to tax laws, can weaken public faith in the Government’s promises. This is indeed why there was such a furore over the retrospective tax amendments in the Vodafone case. Still, tax laws and rules do need to change with evolving circumstances.
Grandfathering provisions allow the Government to introduce changes to tax rules for the future, without reneging on its past promises.
In the case of the long-term capital gains tax on equity, the grandfathering clause is also a clever ruse to prevent investors from rushing to sell all their holdings before the effective date of April 1. With gains up to January 31 protected, only incremental profits will be taxed. Had there been no grandfathering, the recent correction may have turned out to be a full-blown meltdown.
The Math to explain Grandfathering:
Suppose you bought a fund at a NAV of Rs. 150 two years ago, it shot up to Rs. 200 by January 31, 2018 and you finally sell it at Rs. 250 on April 30, 2018 this year. Your taxable gains without the grandfathering would have been Rs. 100 per unit. That is Rs 250 - Rs 150 = Rs 100.
But with the grandfathering, you pay tax only on Rs. 50. That is Rs 250 - Rs 200 (the cut-off date of January 31st, 2018).
If the same fund sees its NAV tank to Rs. 90 on April 30, the clause ensures that you can book a capital loss of Rs. 60 per unit (Rs. 150 minus Rs. 90) and set it off against future profits. The only catch is that you will need records of prices and NAVs as of January 31 on all your equity holdings to avail of the tax break.
Also Read General Awareness Potpourri I