Dear Professional members,
Sri A. Selvaraj, CCIT (Retd.) has consented to share his insight in Income Tax Laws under the head Salary Income and Tax deducted at source thereon for ‘Accounting for Investments’, which we gratefully acknowledge.
Sri A.Selvaraj, Chief Commissioner of Income Tax (Retd.) was the Chief Commissioner of Income tax at Mumbai, Indore and Chennai, till 2007. As Additional Director (Faculty), National Academy of Direct Taxes, Nagpur 1992 -1995 introduced several innovations in teaching tax law and he was the popular Course Director of the 46th Batch of Indian Revenue Service during 1993 -1994.
Mr. Selvaraj was a Member of the Expert Group for rewriting and simplifying the Income tax Act. As convener of the latter, forcefully canvassed for and succeeded in expressing tax law in simple and direct language.
He is considered a resourceful trainer in tax law, tax practices and tax investigations and in areas of general law and management, and is the visiting faculty of several institutions, both government and private.
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The buyer gets ‘protection’ on credit risk of the issuer. The seller acts as an insurer for the notional value of the CDS. The seller gets the premium and that is the maximum revenue that the seller of the protection gets.
The credit risk forms the subject matter of this insurance contract. ISDA enlists certain events as credit events, the occurrence of which triggers the termination of the contract.
The CDS contract has two parties the buyer of protection and the seller of protection. The contract is done over-the-counter (OTC).
The Issuer of the fixed income security on which protection is bought and sold is known as the Reference entity. The Reference entity could be a corporate entity or it could be a ‘Country’.
The specific security on which the protection is bought and sold is known as the ‘Reference Obligation’. The terms of the reference obligation are spelt out in the contract – for example, senior, senior-secured, senior-unsecured etc.
The ‘Protection buyer’ pays a fixed premium on a quarterly basis to the protection seller and the premium is all that has to be paid by the buyer of protection. The protection buyer is the insured.
Effectively the ‘Protection seller’ is the insurer. The protection seller lodges a percentage of the underlying with the protection buyer as collateral for the transaction. This partially ensures that the protection seller is in a position to fulfill his obligation when the credit event occurs.
The ISDA agreement specifies the standard credit events and the specific CDS contract will specify which credit events are covered in the particular contract.
Fixed income securities are issued by a company to raise debt financing. These are called corporate bonds and usually these bonds have a fixed coupon rate and a fixed maturity period usually 10 to 30 years. The coupon rates can also be variable and can be linked to any interest rate like LIBOR. An investor can subscribe to these bonds directly from the company at the time of initial issue or these can be bought from the secondary market. When an investor buys the bonds then the investor is subject to several kinds of risks as follows:
Interest rate risk
Fluctuations in the market interest rate will affect the market rate of the security. The interest rate and the market rate of fixed income security are inversely correlated. When the interest rate goes up, market rate of the fixed income security goes down and vice-versa.
Currency rate risk
Securities purchased in foreign currency are exposed to risk of fluctuations in foreign exchange rate. This will affect the effective yield of a security.
Issuer default risk
The issuer may default in the payment of interest and / or principal amount if the issuer faces liquidity crisis or files bankruptcy.
Issuer credit rating risk
The credit rating of the Issuer may undergo change and if it is downgraded the market rate of the security also will suffer to that extent.
An investor can take protection against each type of risk. There are hedging instruments available to cover the interest rate risk as well as currency risk. For the interest default or issuer bankruptcy risk the investor can buy protection and this form of protection is known as ‘Credit Default Swap’.
Credit card companies in the United States offered sub-prime credit cards usually with lower credit limits and charged high fees and interest rates sometimes as high as 30% or more. With slowdown in economic growth in the United States in 2002, the default rates for sub-prime credit card holders increased, compelling sub-prime credit card issuers to reduce or cease operations.
In 2007, many new vendors emerged making the market more competitive, forcing issuers to make the cards more attractive to consumers which resulted in the interest rates being available as low as 9.9% but even then in some cases it goes as high as 24%.
Following settlement date accounting, the asset as well as the liability is recognized on the settlement date. Here the asset gets recorded only at the value at which it is actually settled, the difference between the cost of acquisition actually payable for such investment and the value at which it is recorded in the books of accounts being taken as realized gains on the date of acquisition itself. If the asset is held for trading then it is taken to the profit and loss account directly, and if the asset is an ‘available-for-sale’ asset then it is taken directly to the equity as ‘other comprehensive income’.
Even if the asset happens to be in foreign currency, since the asset is recorded only the date of settlement, the revaluation entries in the functional currency is recorded only at the rate at which it actually gets settled and hence there is no necessity to record any FX translation entries in this case.
When an asset is purchased, in trade date accounting, the asset is recognized and brought into the books of account on the date of trade and a corresponding liability is established. The liability is knocked off when the settlement of the liability happens. When the asset purchased is in a foreign currency, it leads to a little more complication. The asset is recognized in the functional currency in which the reporting is made, on the basis of the foreign exchange rate that prevails as on the date of trade. The corresponding liability is also created equivalent to the asset purchased. However when the settlement is done after a few days, the foreign exchange rate is likely to be different from the rate at which the asset was converted. Hence when recording the settlement event in the functional currency, the liability would appear to be settled in the functional currency as either over paid or under paid. This is dealt with by passing appropriate FX translation entry known as ‘Consummated FX translation entry’.
This represents accounting for currency gains or losses that are seen on the continuing assets or liabilities of the investor. Example of this type includes the currency gains on the market value of the equity shares as recorded in the functional currency. This type of gain or loss is of temporary in nature and will be either reversed the next day or passed on an incremental basis, meaning that it is subject to change on a daily basis depending upon the FX rates prevailing at that day. This is called ‘Transient FX translation entries‘
This represents accounting for currency gains or losses that are realized or consummated. Example of this type includes the currency gains realized on the amounts payable to broker and the amount actually paid to the broker as recorded in the functional currency. The difference between the amount payable and the actual amount paid recorded in the functional currency represents the realized currency gains or losses. This is called ‘Consummated FX translation entries’.
What is a Credit Default Swap?
- A Credit Default Swap (CDS) is a form of protection against credit risk
- CDS is a bilateral contract where by the credit risk of a reference entity (the issuer) is transferred from the protection buyer to the protection seller
- The protection buyer pays a fixed premium to the protection seller in return for a contingent payment, which compensates the protection buyer from any loss incurred in case of a credit event
- A negative credit event (default by a third party) is usually pegged to an obligor’s performance on a reference obligation, like a bond or a loan
- The standard corporate credit events are bankruptcy, failure to pay, restructuring etc.
- CDS documentation is governed by the International Swaps and Derivatives Association (ISDA)
- ISDA Agreement provides standard definitions of credit default swaps terms, viz., reference obligation, credit event, reference entity and premium and so on
- CDS are traded over-the-counter (OTC). Standardization of CDS has made the credit default swap much more attractive to the customers in spite of being an OTC product