Taxability of VRS compensation

Taxability of VRS compensation
Terminal benefits cannot be brought within the scope of “amount received” under Section 10(10C), which was introduced to make voluntary retirement attractive.
T. C. A. Ramanujam
Section 10(10C) of the Income-Tax Act, 1961 exempts payments received by a salaried employee from the employer under a Voluntary Retirement Scheme up to Rs 5 lakh. The law requires that the scheme should be framed in accordance with the guidelines prescribed in Rule 2 BA of the I-T Act. No relief is available if the scheme is not approved prior to the date of voluntary retirement. Subsequent approval will not entitle a retired employee to claim exemption. TO READ MORE CLICK ...BUSINESS LINE

No Form-16 needed in I-T return

No Form-16 needed in I-T return

19 Jul 2008, 0316 hrs IST,TNN ,ECONOMIC TIMES

NEW DELHI: While filing tax return this year, you need not attach Form-16 with the form. In a statement on Friday, Central Board of Direct Taxes (CBDT) said that annexures and certificates like Form-16, relating to tax deducted at source are not required for income tax returns filing. "No annexures, TDS/TCS certificates are required to be annexed to the returns of income." an official statement said. A senior CBDT official said that all informations regarding TDS are recorded in the PAN (permanent account number) data of a tax payer. He said the department collects data on TDS from various sources and keep it in the PAN data banks of tax payers. Therefore, he said, the tax payers should just provide the TDS informations in the specified column in the return form. If the figure provided in the return is not matched with the data collected in PAN, then the department would ask the tax payer to furnish the Form-16. The credit for TDS and tax collected at source (TCS) will be allowed on the basis of details furnished in the relevant schedules of the return forms. Assessing officer will not disallow claim in this regard (return against excess tax paid) only on the ground that the TDS/TCS certificates have not been filed along with the return of income, the statement said. Also, to enable tax-payers to file returns in the electronic mode, the new return forms have been made annexure-less, except ITR-7, which is the returns for trusts. The electronic return filed with electronic signature will be treated at par with a physical sign. In case of tax return filed without electronic signature, the department said, the tax payers will get an acknowledgement, which will have return receipt number. A tax official said the tax payer should send the acknowledgement to the department. He said only after receiving the acknowledgement form the tax payer, the assessing officer can assess return filed in the electronic form. The department also said a tax payer can make electronic payment of taxes from the account of any other person.

Tax can be paid online from another person’s a/c :

Publication:Economic Times Delhi;
Date:Jul 19, 2008;
Section:EFM;
Page Number:7
IN A NUTSHELL

Tax can be paid online from another person’s a/c :

CBDT • NEW DELHI: The government on Friday clarified it will allow a taxpayer to make electronic payment of taxes from the bank account of any other person as well. The idea is to facilitate electronic payment of taxes by different categories of taxpayers. However, the challan for making such payment must clearly indicate the Permanent Account Number (PAN) of the taxpayer on whose behalf the payment is to be made. It will not be necessary for the assessee to make payment of taxes from his own account in an authorised bank, the Central Board of Direct Taxes said.

Dell’s Indian subsidiary gets tax breather •

NEW DELHI: In a major relief to the Indian arm of the global IT major Dell International, the Authority for Advance Ruling on Friday said that the fees paid by it to an American company for using telecom bandwidth will not be taxed in India. The relief would be subjected to the existence of a permanent establishment of the overseas telecom company in India, the Authority clarified in a ruling.

TDS certificate not needed with tax return

Publication:Economic Times Delhi;
Date:Jul 19, 2008;
Section:EFM;
Page Number:7
IN A NUTSHELL
• NEW DELHI: The government on Friday said annexures and certificates relating to tax deducted at source like Form-16 are not required to be submitted along with income tax returns. “No annexures, TDS/TCS certificates are required to be annexed to the returns of income. Wherever, documents are attached with the return, the receiving official is required to detach and return to the tax payers all such annexures,” the Central Board of Direct Taxes said in a statement. It said that original documents and certificates may be produced by assessees as and when called for by the assessing officer.

Deductibility of political donations

Contributions that are more than what is permissible under the Companies Act cannot be deducted under Section 80GGB of the I-T Act.

In the article ‘Bringing political donations to book’ (Business Line, June 28), the author has expressed the view that “the bottom line therefore is while a company would fall foul of the company law if it breaches the 5 per cent norm, it can get away under the income-tax law and the claim of entire contribution would be allowed in computing its taxable income.” There could be another view on this.Section 293A
Section 293 of the Companies Act, operative from May 24, 1985, permits donations to political parties with certain riders. The important ones are: TO READ MORE CLICK........

Reverse Mortgages

Reverse Mortgages:
According to the Budget 2007, the National Housing Bank
(NHB) will introduce a novel product for senior
citizens : a “Reverse Mortgage” under which a senior
citizen who is the owner of a house can avail a monthly
stream of income against the mortgage of his/her house
while remaining the owner and occupying the house
throughout his/her lifetime, without repaying pr servicing
the loan.
What is a reverse mortgage ?
A reverse mortgage enables older home owners (senior
citizens) to convert part of the equity in their homes into
tax-free income without having to sell the home, give up
title, or take on a new monthly mortgage payment.
The reverse mortgage is aptly named because the
payment stream is “reversed.” Instead of making
monthly payments to a lender, as with a regular
mortgage, a lender makes payments to you.
In India the actual process of reverse mortgage has not
yet started . But based on general practices followed
in other countries, some common questions asked by
consumers about reverse mortgages are being given
below :
What are common payment plan options?
You can choose to receive the money from a reverse
mortgage
• all at once as a lump sum,
• fixed monthly payments either for a set term or for
as long as you live in the home,
• as a line of credit,
• or a combination of these.
The most popular option is the line of credit, which allows
you to draw on the loan proceeds at any time.
Does unused balance in the Line of Credit Option
has a growth feature? Does that mean I'm earning
interest?
No, you're not earning interest like you do with a savings
account. The growth factor takes into consideration that
your home has appreciated in value over the past 12
months and that you are one year older.
How much money will I get?
No matter which reverse mortgage product you choose,
the amount of funds you are eligible to receive depends
on your age (or the age of the youngest spouse in the
case of couples), appraised home value, current interest
rates, and the lending limit in your area. In general, the
older you are and the more valuable your home (and the
less you owe on your home), the more money you can
get.
Does my home qualify?
Eligible property types include single-family homes, 2-4
unit properties; own constructed homes and flats in
housing societies.
How can I use the proceeds from a Reverse
Mortgage?
The proceeds from a reverse mortgage can be used for
anything, whether its to supplement retirement income
to cover daily living expenses, repair or modify your
home, pay for health care, pay off existing debts, buy a
new car or take a "dream" vacation, cover property taxes
etc.
Are there any special requirements to get a reverse
mortgage?
As long as you own a home, and Senior Citizen, and have
enough equity in your home, you can get a reverse
mortgage. There are no special incomes or medical
requirements.
What if I have an existing mortgage?
You may qualify for a reverse mortgage even if you still
owe money on an existing mortgage. However, the
reverse mortgage must be in a first lien position, so any
existing indebtedness must be paid off. You can pay off
the existing mortgage with a reverse mortgage, money
from your savings, or assistance from a family member or
friend.
For example, let's say you owe Rs.10,00,000/- on an
existing mortgage. Based on your age, home value, and
interest rates, you qualify for Rs.15,00,000/- under the
reverse mortgage program. Under this scenario, you will
be able to pay off ALL the existing mortgage and still have
Rs.5,00,000/- left over to use as you wish.
If, however, you only qualify for Rs.8,00,000/- then you
would need to come up with Rs.2,00,000 from your own
savings to get the reverse mortgage. Even then, all the
money from the reverse mortgage will have been used to
pay off the existing mortgage. On the other hand, you
won't have a monthly mortgage payment anymore.
If you find yourself in a deficit situation where you don't
have enough money to pay off the existing mortgage, you
may use funds from a grant or gift from a family member
or friend to cover the gap, but you cannot incur a new
debt obligation (i.e., loan).
When do I pay back my loan?
No monthly payments are due on a reverse mortgage
while it is outstanding. The loan is repaid when you cease
to occupy your home as a principal residence, whether
you (the last remaining spouse, in cases of couples) pass
away, sell the home, or permanently move out. The
amount owed can never exceed the value of your home.
Furthermore, if the home is sold and the sales proceeds
exceed the amount owed on the reverse mortgage, the
excess money goes to you or your legal heir.
Under what circumstances should I not consider a
Reverse Mortgage?
Because of the upfront costs associated with a reverse
mortgage, if you intend to leave your home within 2-3
years, there may be other less expensive options to
consider, such as home equity loans. Also, if you want to
leave your home to your children, then you should
consider other options, because in many cases, the home
is sold to pay back a reverse mortgage.

ITAT DECISION

Issue: Taxability of Interest Income u/s 56
DCIT, circle, Bulandshahr v. Allied construction {105 ITD
1 (Delhi-SB)}
The firm received interest on FDR placed with the bank.
The FDR was placed out of surplus business fund of the
firm. Further, the FDR was pledged with the bank for
availing loan for the business purpose. Hence, the firm
offered interest income as business income. Dept did not
accept the contention of the assessee and taxed it as
income from other sources. The tribunal also endorsed
the view of Department in as much as the source of
interest income was FDR with bank which is different
from business receipt. It was further decided that taking
FDR and pledging them for business loan are two
different transactions. Hence, Interest income on FDR
was considered as income from other sources.
Issue: Re-opening Proceedings
S.K. Jain v. Deputy commissioner of gift Tax Spl. Range,
Bhilai{105ITD205(Nag)}
In this case, the department collected some information
at the back of the assessee and used it for reopening of
gift tax assessment proceedings. The Tribunal decided
that department has right to re-open the case even if the
information is collected through illegal means by them. It
was decided that truth of affair and not manner of getting
material is to be taken note of in case of reopening the
cases.
Issue: Capital receipt.
JCIT, Spl Range-1 v. Kwality Café & Restaurant (P) Ltd
{105 ITD 169 (Chd)}
In this case, the company sold its right to use trade mark
and manufacturing facilities. The company offered capital
gain on surrender of trade mark as long term capital gain
and certain portion of consideration as capital receipt not
liable for taxation . It took the view that it lost income
earning apparatus. The Department taxed it as a revenue
receipts. However, the Tribunal accepted assessee's
contention and held that loosing a source of income in the
case of a person, who is not in a business of buying and
selling of business, would amount to transfer of a capital
assets and compensation received therefore clearly falls
within the ambit of a capital receipt.
Issue: Deduction u/s80HHC
Brook Crompton Greaves Ltd., v. ITO Ward 1,
Ahmednagar {105 ITD 146(Pune)}
The Tribunal decided that unabsorbed depreciation / loss
of earlier years need to be reduced from the income of
current year to determine the business income for
computation of deduction u/s 80HHC.
It was also decided that CIT (A) has power to enhance the
income on the issue which was not the subject matter of
appeal before him if the A.O. has overlooked any aspect
relating to the assessment. Therefore, one needs to be
careful before filing appeal to CIT (A) since it will open
entire case even the issue is not agitated before CIT (A).
Issue: Deduction u/s 35D
LIC Housing Finance Ltd., v.DCIT Spl. Range 36, Mumbai
{105 ITD 86(Mum)}
It was decided that if company wants to claim deduction
for preliminary expenses after it commence business; it
can be claimed only by industrial undertaking and that
too, after fulfilling condition of extension of undertaking
or setting up of new undertaking. Therefore, one has to
be careful while claiming deduction u/s35D i.e. public
issue expenses, expenses for increase of authorized
capital.
Issue: Allowability of Expenses u/s37 (1) & MAT
u/s 115JA
IBM Ltd., v. CIT (Appeals)-I {105 ITD 1(Bang)}
In this case it was decided that liability to pay warrant is
not contingent liability. It arises no sooner sales are
effected and therefore, it is to be allowed in the year of
sale of products.
As regards purchase of application software, it was
decided that purchase of application software in the
course of business, which merely enabled to carry on
business operation efficiently and smoothly even though
it gives enduring benefit, would be considered as revenue
expenditure.
The tribunal held that in case provision for doubtful debts
are made in the books, the deduction thereto would be
available in the computation of book profit for the
provision of MAT in view of the fact that such provisions
are not made for meeting and liability, it simply reduce
the assets. Hence, such provisions are deductible for
computation of book profits under the provisions of MAT.
Issue: Un-explained cash credit u/s 68.
Davinder Singh v. ACIT Circle-III, Ferozepur {104 ITD
325 (ASR)}
In this case, it was decided that if any credit found unexplained
by the assessee, the same would be hit by the
provisions of section 68 of the Act. It is not necessary that
only cash receipt on credit side ought to be considered. It
was held that it covers all credits loan, trade credits and
also other receipts be that of cash or kind. Therefore, one
need to be careful while showing creditors which are not
verifiable, the same may be subjected to tax u/s 68 of the
Act.
Issue: Statement recorded u/s 132(4).
Ms. Aishwarya K. Rai v. DCIT, Central circle2, Mumbai
{104 ITD 166(MUM) (TM) }
In this case, if any person makes any disclosure on the
day of search u/s132 (4) of the Act and thereafter during
the post search operation, he makes statement u/s131
denying the confession made earlier , the disclose will not
have any evidentiary value in the assessment . The A.O.
must have conclusive evidence , other than the mere
disclosure , that assessee has undisclosed income. This
judgment will come to rescue in those case where
department merely extract disclosure and makes
addition solely on the basis thereof.

TDS CERTIFICATE

TDS CERTIFICATE FORMS
The CBDT has issued Notification No 83/2007, Dated
26-3-2007 prescribing the new forms of TDS
certificates. These forms are:
• Form 16 TDS certificate for Salaries
• Form 16A TDS certificate for other than salaries
• Form 27D Certificate for tax collection at source
The new forms have come into effect with immediate
effect. This article will elaborate on the changes as
compared to old formats and other practical issues.
Time limit of issuance of TDS certificate
Periodicity and Due Date
Monthly Certificate
Form No 16A is to be issued for all the TDS deductions
made during a month. Such monthly certificates are to
be issued on or before the end of next month. For
deductions in February 2007, TDS certificate must be
issued on or before 31st March 2007.
Yearly Certificate
Form No 16
TDS certificate for salaries is always issued once a year
and the due date is 30th April of the assessment year.
Form No 16A
• The yearly certificate can be issued only if the
deductee so requests.
• Such yearly certificate which can be issued on or
before 30th April of the current assessment year.
• If there are provisional entries at the end of the year,
the certificate for the same can be issued on or before
7th of June, since, the last date of payment of
provisional entry is 31st May.
Based on above, it is clear that the following must be
issued in the new TDS forms
• Form 16 for FY 2006-2007
• Form 16A / 27D for February and March 2007
• Form 16A / 27D consolidated for FY 2006-2007
Changes in the forms
Form 16
1. 'PAN No. of the Deductor' instead of PAN/GIR No.
earlier
2. 'TAN No. of the Deductor' instead of TAN earlier

3. 'PAN No. of the Employee' instead of PAN/GIR No.
earlier
4. “TDS Circle where annual return u/s 206 is to be filed”
is removed completely.
5. New column - Acknowledgement Nos. of all quarterly
statements of TDS under sub-section (3) of section
200 as provided by TIN Facilitation Centre or NSDL
web-site
6. New line added after “Details of Tax Deducted and
Deposited”
(The Employer is to provide transaction-wise details
of tax deducted and deposited)
Form 16A
1. Heading 'For interest on securities --------- is
changed
2. 'PAN No. of the Deductor' instead of PAN/GIR No. of
the deductor earlier
3. 'PAN No. of the Payee' instead of PAN/GIR No. of the
payee earlier
4. TDS Circle where annual return u/s 206 is to be
delivered is removed completely.
5. New column - Acknowledgement Nos. of all quarterly
statements of TDS under sub-section (3) of section
200 as provided by TIN Facilitation Centre or NSDL
web-site
6. New line added after the “Details of Payment, Tax
deduction and deposited”
(The Deductor is to provide transaction-wise details
of tax deducted and deposited)
Form 27D
1. Heading 'For Collection of tax --------- is changed.
2. 'Name and address of the buyer or licensee or lessee
or a person who is awarded the contract' instead of
Name & address of the buyer earlier
3. 'Tax deduction and tax collection account no. of the
collector instead of Tax collection account no. of the
collector earlier
4. 'PAN No. of the Collector' instead of PAN/GIR No. of
the Collector earlier
5. PAN No. of the Buyer or Licensee or Lessee or a person
who is awarded the contract' instead of PAN/GIR No.
of the Buyer earlier.
6. Nature of goods referred to in the table in section
206C (1) or nature of contract or licence or lease
referred to in the Table in section 206C (1C)' instead
of Nature of goods referred to in the table in section
206C (1) earlier.
7. Circle where return u/s 206C (5A) is to be delivered is
removed completely.
8. New Heading - Acknowledgement Number of all
quarterly statements of TCS under sub-section (3) of
section 206C as provided by TIN Facilitation Centre or
NSDL web-site
9. New line added after the "Details of Payment, Tax
collected and deposited".
(The Collector is to provide transaction-wise details of
tax collected and deposited)

Analysis
Minor Changes
As is evident , the column TDS circle where Annual
Return is filed as TDS circle is removed , as this
identifiable on the basis of TAN.
Redundant expressions like GIR number of the deductor
or collector have also been dropped.

Major Changes
Quarter Wise Acknowledgement No.
The most significant change in the forms is about giving
details of Quarter Wise Acknowledgement numbers. The
format of the same is as follows:
Quarter Acknowledgement No.
1
2
3
4
Quarter Acknowledgement No.
• The details are to be given for all quarterly
statements.
• The details are as provided by TIN Facilitation Centre
or NSDL web-site. If the returns are filed at TIN
Facilitation Centre, a printed Acknowledgement is
provided. However, when the electronic returns are
filed online using digital signature, the number is
available at the filing web site.
• The most important question is about giving details
for all quarterly statements. For this we need to check
the due dates of filing quarterly statements. Please
refer to the table given below.
• Co-relating the due date of filing eTDS statements and
due of Monthly / Yearly TDS certificates, it is clear
that:
o For Monthly certificates for April and May, no
details of eTDS Acknowledgement Number can be
provided. Similarly for July and Aug, details of Q1
Acknowledgement Number can be provided.
o For Yearly certificates only details of Q1, Q2 and
Q3 eTDS Acknowledgement Number can be
provided.
• So unless the due dates of certificates and eTDS
statements is synchronized, details of all quarterly
Acknowledgement Number cannot be provided.
Payment-wise transaction-wise details
• The new forms specifically requires the deductor,
collector and employer to furnish payment-wise,
transaction-wise details of the tax deducted or
collected and paid to the credit of the Central
Government.
• Earlier, many deductors used to give one
consolidated figure of TDS deducted, mentioning
only the name of bank branch where amount was
deposited. Similarly , the TDS certificates issued by
institutions on interest on bonds etc. generally does
not give the details transaction wise. Such
certificates are printed on the back of interest
warrant. This change will make all such TDS
certificates invalid.
• The idea behind this is to facilitate matching of the
entries in the electronic returns with those in the TDS
certificates.
• Similarly employers will now have to provide details
regarding deposit of taxes each month, after deducting
from the salaries of employees.
• The changes in the tax forms are expected to provide
complete details to taxmen about the gross income of
employees and improve flow of income taxes on schedule
to the State Exchequer.

Due Dates of Quarterly e-TDS / e-TCS Statements

Qtr No :- Q1
Quarter:- April to June
Due Dates for Form NO.24Q/26Q :- 15th July
Due Dates for Form No.27Q :- 14th July
Due Dates for Form No. 27EQ :- 15th July

Qtr No :- Q2
Quarter:- July to September
Due Dates for Form NO.24Q/26Q : 15th Oct
Due Dates for Form No.27Q:-14th Oct
Due Dates for Form No. 27EQ:-15th Oct

Qtr No:- Q3
Quarter: Oct to Dec
Due Dates for Form NO.24Q/26Q: 15th Jan
Due Dates for Form No.27Q:-14th Jan
Due Dates for Form No. 27EQ:-15th Jan

Qtr No:-Q4
Quarter :-Jan to March
Due Dates for Form NO.24Q/26Q: -15th June
Due Dates for Form No.27Q: -14th April/14th June *
Due Dates for Form No. 27EQ:- 30th Apr

*If there are TDS deduction provisional entries as on the last date of the accounting year, then due date of return is 14th June. If there are no such entries, then it is 14th April

KING BHOJA

KING BHOJA

King Bhoja was taking a leisurely evening stroll by a river. He was enjoying looking at the trees and the flowers. He spotted a man carrying a huge bundle of sticks on his head. The woodcutter was apparently carrying more than he could easily manage and was perspiring profusely. But he looked happy. The King felt an urge to talk to him. The king stopped the man and said, ?Hey, who are you?? The man replied cheerfully, ?I?m King Bhoja?. The King was taken aback. He asked, ?Who?? The man repeated, ?King Bhoja!? The King was now quite intrigued. He said, ?Well, if you are King Bhoja, would you tell me your income?? The woodcutter replied, ?Why not? I earn six paise per day!?The King thought about the huge sum of money that was there in his coffers. How could a man who earned six paise a day think himself to be a king? How could he look so happy? The King thought of the numerous worries and problems that besieged him. He wanted to know more. So he asked the old man, ?If you earn just six paise per day, what are your expenses? Are you really King Bhoja??The old man said, ?Well, if you really want to know, let me explain. I earn six paise every day. I give one paisa each to my capitalist, my minister and my borrower. I deposit one paisa in my savings account and use one paisa to serve my guests. The remaining one paisa, I keep for myself.? By now the King was totally hooked. What planning! What vision! By a man of such humble means! But how was he doing this? It was like a puzzle and the King wanted to solve it. He said, ?Please explain, I don?t understand.?The wood cutter said, ?Alright. My parents are my capitalists, because they invested in my upbringing. They expect me to look after them in their old age. They invested and lent with a plan to earn interest and get the principal back too. Isn?t that what all parents expect from their children??The King was quick to ask, ?What about your borrower?? The old man smiled, ?My children of course! They are young. It is my obligation to support them. But when they are older and are able to earn, they shall repay me, just as I am repaying my parents. They too shall discharge their Pitri-rin!?The King was quite at a loss for words, ?Who is your minister?? asked the King. ?My wife of course,? replied the man. ?She runs my house; she is in charge of everything on the home front. I depend on her for physical as well as emotional support. She is my best friend and advisor.??Where is your savings account?? he asked sheepishly. The old man said, ?A person who does not save for his future is a fool. Life is full of unforeseen contingencies. Each day I set aside one paisa into my treasure.?The king said, ?Go on, please.? The wood cutter said, ?I set aside the fifth paisa to serve my guests. As a householder, it is my duty to keep an open house for guests. Who knows when a guest may drop by? I have to keep aside something for that eventuality.?The man continued smiling, ?The sixth paisa my friend I keep for myself; to look after my daily needs.?The King was immensely impressed as the wise old man put all the pieces of the jigsaw puzzle into place.Surely, happiness and contentment do not stem from wealth, position or worldly comforts. Attitude and disposition towards your current situation are important. If one can learn to live within his means and organize one self accordingly, a lot is achieved. This is the power of positive thinking and right attitude. The old wood cutter was a king because his attitude was such!

BY SANJAY TANDON

INFLATION

Continued from yestarday..............

Capital requirements.......
All banks are required to hold a certain percentage of their assets as capital, a rate which may be established by the central bank or the banking supervisor. For international banks, including the 55 member central banks of the Bank for International Settlements, the threshold is 8% (see the Basel Capital Accords) of risk-adjusted assets, whereby certain assets (such as government bonds) are considered to have lower risk and are either partially or fully excluded from total assets for the purposes of calculating capital adequacy. Partly due to concerns about asset inflation and repurchase agreements, capital requirements may be considered more effective than deposit/reserve requirements in preventing indefinite lending: when at the threshold, a bank cannot extend another loan without acquiring further capital on its balance sheet.
Reserve requirements
Another significant power that central banks hold is the ability to establish reserve requirements for other banks. By requiring that a percentage of liabilities be held as cash or deposited with the central bank (or other agency), limits are set on the money supply.
In practice, many banks are required to hold a percentage of their deposits as reserves. Such legal reserve requirements were introduced in the nineteenth century to reduce the risk of banks overextending themselves and suffering from bank runs, as this could lead to knock-on effects on other banks. See also money multiplier, Ponzi scheme. As the early 20th century gold standard and late 20th century dollar hegemony evolved, and as banks proliferated and engaged in more complex transactions and were able to profit from dealings globally on a moment's notice, these practices became mandatory, if only to ensure that there was some limit on the ballooning of money supply. Such limits have become harder to enforce. The People's Bank of China retains (and uses) more powers over reserves because the yuan that it manages is a non-convertible currency.
Even if reserves were not a legal requirement, prudence would ensure that banks would hold a certain percentage of their assets in the form of cash reserves. It is common to think of commercial banks as passive receivers of deposits from their customers and, for many purposes, this is still an accurate view.
This passive view of bank activity is misleading when it comes to considering what determines the nation's money supply and credit. Loan activity by banks plays a fundamental role in determining the money supply. The money deposited by commercial banks at the central bank is the real money in the banking system; other versions of what is commonly thought of as money are merely promises to pay real money. These promises to pay are circulatory multiples of real money. For general purposes, people perceive money as the amount shown in financial transactions or amount shown in their bank accounts. But bank accounts record both credit and debits that cancel each other. Only the remaining central-bank money after aggregate settlement - final money - can take only one of two forms:
physical cash, which is rarely used in wholesale financial markets,
central-bank money.
The currency component of the money supply is far smaller than the deposit component. Currency and bank reserves together make up the monetary base, called M1 and M2.
Exchange requirements
To influence the money supply, some central banks may require that some or all foreign exchange receipts (generally from exports) be exchanged for the local currency. The rate that is used to purchase local currency may be market-based or arbitrarily set by the bank. This tool is generally used in countries with non-convertible currencies or partially-convertible currencies. The recipient of the local currency may be allowed to freely dispose of the funds, required to hold the funds with the central bank for some period of time, or allowed to use the funds subject to certain restrictions. In other cases, the ability to hold or use the foreign exchange may be otherwise limited.
In this method, money supply is increased by the central bank when the central bank purchases the foreign currency by issuing (selling) the local currency. The central bank may subsequently reduce the money supply by various means, including selling bonds or foreign exchange interventions.
Margin requirements and other tools
In some countries, central banks may have other tools that work indirectly to limit lending practices and otherwise restrict or regulate capital markets. For example, a central bank may regulate margin lending, whereby individuals or companies may borrow against pledged securities. The margin requirement establishes a minimum ratio of the value of the securities to the amount borrowed.
Central banks often have requirements for the quality of assets that may be held by financial institutions; these requirements may act as a limit on the amount of risk and leverage created by the financial system. These requirements may be direct, such as requiring certain assets to bear certain minimum credit ratings, or indirect, by the central bank lending to counterparties only when security of a certain quality is pledged as collateral.
Examples of use
The People's Bank of China has been forced into particularly aggressive and differentiating tactics by the extreme complexity and rapid expansion of the economy it manages. It imposed some absolute restrictions on lending to specific industries in 2003, and continues to require 1% more (7%) reserves from urban banks (typically focusing on export) than rural ones. This is not by any means an unusual situation. The US historically had very wide ranges of reserve requirements between its dozen branches. Domestic development is thought to be optimized mostly by reserve requirements rather than by capital adequacy methods, since they can be more finely tuned and regionally varied

TO BE CONTINUED TOMORROW.................