Sunday, July 31, 2011

Fake Profit/Loss

High networth individuals who 'buy' loss/profit from friendly brokers to either suppress taxable income or convert black money into white, will find it difficult to do so, from August 1. This follows the new rules on modification of client codes (the client’s trading account number), effective from Monday. Under the new SEBI rule, brokers will be penalized 2% of the turnover value of the non-institutional trades done in the wrong account, if the turnover value of such trades exceeds 5% of the total monthly turnover value. For errors up to 5% of the total turnover value, the penalty is 1%.

Till now, if a broker had executed a trade in the wrong client’s account, he could rectify that error at the end of the day by shifting the shares. But the regulator and the stock exchanges soon found out that a quite a few brokerages were shifting trades from one account to the other to help clients either evade tax or launder unaccounted money.

There are many brokerages who thrive by charging 5-6% commission by providing fake profits/losses to their clients. It is not a bad deal for tax evaders who can still save 25% after paying the commission. For brokerages, this is a far more lucrative business than plain vanilla broking service, which earns just 0.01-0.25% per trade.

From Monday, if brokers change client codes after the trade is executed, it will cost them serious money. More importantly, the new rule will distort the economics of profit/loss shopping.

Here is how the freedom to change client codes was being abused by brokers.

Broker X is a proprietary trader who makes money through day trading—buying and selling shares for small spreads sometimes as low as 5-10 paise. Everyday the broker will punch in a few hundred buy trades and equal number of sell trades on his trading terminal. Suppose two clients, A and B, approach him with opposite requirements. Client A needs to show a loss of Rs 50,000 so that he can offset that much against the profit he has made during the year. Client B wants to show a profit of Rs 50,000 so that he can show that much unaccounted money as income from trading.

X shifts some buy transactions and some sell transactions into an account created for client A in such a way that it shows a trading loss of Rs 50,000. He will charge between Rs 2500-3000 as commission for this ‘loss’. Client A will hand over a cheque of Rs 50,000 to the broker, who will deduct the commission and return the remaining amount in cash. Similarly another set of transactions showing a profit of Rs 50,000 will be shifted into an account for client B. The broker will give a cheque of Rs 50,000 to B, who will then return the amount in cash, plus the commission.

To generate a profit/loss of Rs 50,000 on very low spreads, the broker will have to do trades worth at least a few lakh of rupees, and that too in highly liquid stocks. (Losses/profits in illiquid stocks quickly arouse the I-T department’s suspicion) Assume the turnover value of such trades is Rs 10 lakh. From Monday, if the broker shifts these trades into another account, he will have to shell out Rs 10,000 as penalty. This money will have to be recovered from the client, for whom now the cost of evading tax will be 25-26% and the cost of paying tax, 30%. If the total turnover value runs into crores, or even just Rs 1 crore, the whole operation becomes unviable. A penalty of Rs 1 lakh to buy a profit/loss of Rs 50,000 does not make any sense.

The new rule could benefit many individual investors, who were otherwise being shortchanged by unscrupulous relationship managers. Many high networth individuals who subscribe to portfolio management services of broking firms, give the power of attorney to brokers to trade in their accounts and generate profits. The relationship manager, in connivance with the branch head, can shift some of profitable trades into another account, and under-declare the profits to their clients.

Some brokers are worried that the SEBI has given too much discretionary powers to the stock exchanges in implementing this rule, and that the penalty is too stiff.

Here is what the SEBI circular on the new client code modification rules says:

“If a Stock Exchange wishes to allow trading members to modify client codes of non-institutional trades, it shall lay down strict objective criteria, with the approval of its Governing Board, for identification of genuine errors in client codes which may be modified, and disclose the same to market in advance.”

And the penalty will really hurt. Consider this: On Rs 1 lakh of turnover, a broking firm will earn around Rs 15-20 as commission if it is a derivative (futures and option) trade, and between Rs 200-250 if it is a cash market trade. But if the same trade is entered in the wrong account, the broker will have to shell out Rs 1000 as penalty. That is the equivalent of commission earned on Rs 50 lakh of F&O trade or Rs 4-5 lakh of cash market trade.

“If a broker is not careful, even a couple of mistakes could wipe out a significant portion of his income at a time when trading volumes are shrinking by the day,” said a broker, suggesting that the penalty should be linked to the commission earned on that trade.

Most errors relating to client codes happen on the derivative contracts expiry day, when there is a huge surge in volumes.

But the quantum of penalty suggests that the regulator is convinced that the brokers are changing client codes for the wrong reasons, and is determined to make the entire practice of tax evasion/money laundering unviable.

And the punishment does not stop at the monetary fine. Stock exchanges have to ensure that modification of client codes is covered in the internal audit of trading. That means serial offenders will be closely watched, even if they come up with ways to beat the system.

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