Corporate Tax Cut: Bye, Bye Exemptions, Hello Lower Tax Rates - The Fineprint

The fineprint on India’s corporate tax rate cuts and what companies will do with the extra cash...

Wedding cakes created by luxury cake designer, Le Novelle Cake. (Photographer: Dimas Ardian/Bloomberg)
Wedding cakes created by luxury cake designer, Le Novelle Cake. (Photographer: Dimas Ardian/Bloomberg)

Rarely has tax news been the source of such cheer across business and markets. On Friday, Finance Minister Nirmala Sitharaman served up a wedding cake equivalent of tax confectionery. Like the traditional three-tiered cake, the minister offered corporate India a globally competitive 25 percent corporate tax rate, a 17 percent rate for new manufacturing units and accompanying the shift to a lower-tax-rate-no-exemptions policy is the promise of less litigation and more tax predictability.

“The underlying philosophy of the government is we are bringing you on a lower tax rate, don’t declare dividends, instead redeploy the profits for purposes of growth and prosperity, that’s the important message from these changes,” said Mukesh Butani, managing partner at BMR Legal Advisors.

The global average corporate tax rate is 23.79 percent and the OECD average is 23.38 percent, KPMG data shows. Averages for North America, Europe and Asia are 26.75 percent, 19.37 percent and 21.09 percent. India’s new tax rates sit comfortably with these.

“We are very much now in that benchmark range where we can feel that we are extremely competitive with most global economies with which India competes, as well as economies of the developed world where India exports, said Pranav Sayta, tax and regulatory partner at EY.

Old Vs New Tax Rates

Currently, India taxes companies at 30 percent plus surcharge and cess. That works out to an effective tax rate of 34.93 percent.

To avail of the new 25.17 percent rate (22 percent plus surcharge and cess) companies will have to give up tax incentives such as

  • Accelerated/Incremental depreciation (on new manufacturing units, units in the power industry)
  • Investment allowance (for a specified business like tea, coffee, rubber...)
  • R&D deduction (for pharmaceutical companies etc..)
  • Special Economic Zones – based exemptions (export-linked)
  • Area-based exemptions (setting up units is specific lesser developed areas)
  • Specified industry-based incentives (such as for low-cost housing, pipelines, etc..)

Companies now have the flexibility of choosing whether to live with the earlier higher rate so as to retain incentives/exemptions or give them up and shift to the lower rate. They can decide when to make the transition. But once they shift there’s no going back.

This will make each and every business evaluate the possibility and see where the arbitrage is, Butani said.

“The arbitrage could be different for different forms of businesses depending on whether they are claiming area benefits or special benefits by way of deductions. It could also be different for businesses depending on what is the ratio of profitability in a business on which they are achieving incentive versus the ratio of profitability on which they are paying regular tax. It will also depend on what is there on the drawing boards of various businesses, if there is a project in a backward area and it’s at an advanced stage, economically it is difficult to pull back. But if there are plans that have not fructified then people may opt for the new rate and not go to the backward area.”

Which Companies Benefit?

While directionally this is a good policy move, the scale of the impact may be limited, as many leading companies already enjoyed an effective tax rate, post exemptions and incentives, lower than 35 percent.

A Kotak Securities note points out that

  • the effective tax rate of the 50 companies in the Nifty50 index on an aggregate basis was 26 percent which will now come down to 25.17 percent.
  • there are only 20 Nifty50 companies which paid more than 30 percent effective tax rate.

Government data shows

  • The effective tax rate of the entire base of companies (3,90,644 companies or 46.41 percent) reporting profits was 29.49 percent for the financial year 2017-18.
  • The average effective tax rate of companies with turnover greater than Rs. 500 crore is 26.30 percent.

Sayta said exporters such as IT companies, companies investing heavily in research and development such as pharmaceutical companies, and those availing investment- or profit-linked incentives due to presence in backward areas are unlikely to benefit from the new, lower tax rate as the incentives linked to these activities may be tough to give up immediately.

Large consumer companies and financial institutions are likely to be paying the highest taxes and stand to benefit, Sayta pointed out.

State Bank of India
Effective: 46.4%
New: 25.6%

Effective: 34.5%
New: 25.6%

Hindustan Unilever
Effective: 30.7%
New: 25.6%

Bajaj Auto
Effective 30.3%
New: 25.6%

Maruti Suzuki
Effective: 28.3%
New: 25.6%

Effective: 30.4%
New: 25.6%

Asian Paints
Effective: 33.6%
New: 25.6%

Effective: 35.0%
New: 25.6%

Source: A few of the companies listed by Kotak Institutional Equities Research

The Manufacturing Boost

To set up a new manufacturing company and avail of the 17 percent rate (15 percent plus surcharge and cess) several conditions will have to be met to safeguard against shifting of profits and anti-abuse.

For instance, the new manufacturing company, which should be incorporated on or after Oct. 1, 2019, and commence production before March 31, 2023, should

  • not formed by splitting up or reconstruction of existing business
  • not use pre-used machinery or plant (imported pre-used machinery permitted)
  • not use any building previously used as hotel or convention centre
  • not engage in any business other than the business of manufacturing/production
  • not avail of certain specific exemptions

A company might set up a wholly-owned subsidiary for setting up of a new manufacturing unit and availing of this benefit, Sayta clarified.

All the conditions which will dis-entitle a business from claiming the benefit of the lower tax rate are the usual safeguards which are prevalent in the law even today, Butani explained. So if a company wants to set up a new SEZ unit the same set of conditions will apply. Including, the fact that there is no deliberate attempt that has been made to transfer price the profit to an exempt or less taxable entity, so these are all usual, he added.

These are all usual anti-abuse provisions just to make sure that only genuine incremental investment in the manufacturing sector is entitled to the lower rate of tax and not that you are currently manufacturing and you choose to now shut this manufacturing or relocate the plant into a newly incorporated company which avails of the tax benefit.
Mukesh Butani, Managing Partner, BMR Legal Advisors

Watch | Mukesh Butani, Pranav Sayta, MS Unnikrishnan, Vivek Karve and Jatin Dalal in conversation with Menaka Doshi.


From Bottomlines To The Economy

Expectedly, these tax rate cuts have gone down well with Indian businesses. Especially as they come at a time of a shift in global supply chains due to the U.S.-China trade war.

“Post the trade war initiation between America and China and the current visit of the Indian Prime Minister to America, where he is expected to announce a lot more of benefits—inviting people to set up their manufacturing in India instead of China, is a major move, said MS Unnikrishnan, managing director and chief executive officer of Thermax Ltd.

But will Friday’s move help revive the sagging domestic economy and slowing consumption? The lower tax rates will boost profit, the question is what companies will do with the spare cash?

Debt reduction
Will result in healthier balance sheets and investment preparedness for when the cycle turns.

Business Expansion
Will result in boosting private investment and help job creation.

Return to shareholders
Will boost stock prices, improve investor sentiment, attract more domestic and foreign capital to equity markets and make it easier for companies to raise capital.

Return to employees
Will mean higher wages and could catalyse higher consumption.

Return to consumers
Will result in lower prices of goods and services and catalyse consumption.

For many business the prospects of new investments are low due to excess capacity. To be clear, there has been improvement during the last year - Reserve Bank of India data on manufacturing companies shows capacity utilisation inching up from 73.8 percent in the first quarter of FY19 to 76.1 percent as of March-end 2019. But year-on-year that rise has been marginal - from 75.2 percent in Q4 FY18.

At this point, additional capacity being put in just for the heck of it, (companies) will not do it because capacity utilisation is between 60-65 percent.
MS Unnikrishnan, MD and CEO, Thermax Ltd.

But, he sees an uptick in investments in the future as these tax cuts will support smaller businesses that were finding it difficult to generate capital. When that happens, that will mean new orders for businesses like his, Unnikrishnan added.

“Maybe demand is a little lower in the country today but this could give a big boost to ‘Make In India’ and you could be servicing orders on manufacturing for the U.S. or Europe. Just the way IT services did 20 years back when we started our journey,” said Jatin Dalal, chief executive officer at Wipro Ltd.

Information technology companies such as his already enjoy an effective tax rate of close to 22 percent due to export and SEZ exemptions. But the new tax rate could provide continuity when these run out.

We will have to evaluate but this makes us more competitive, keeps investments in the country. As we speak, we are putting additional money in infrastructure between now and next 24 months.
Jatin Dalal, CFO, Wipro

The least this has done is given a boost to the sentiment, said Vivek Karve, chief financial officer at Marico Ltd. “Over the long term there will be capital investment that will happen in the country. Immediately, whether it will spur consumption, I am not very sure.”

Marico’s effective tax rate is already below 22 percent, so it doesn’t stand to gain much. But other consumer companies may pass on the benefit via lower product prices, he said.

Given the low rate of growth that the consumer sector has been facing—the best option would be to pass it on to the consumers and give an uplift to the overall consumer demand.
Vivek Karve, CFO, Marico
Tax Cuts Are Terrific, But Should Have Gone Directly To People

What About The Fisc?

As for the collateral impact of this tax revenue give away, totaling Rs 1.45 lakh crore, on the fiscal deficit, resulting in higher government borrowing and the crowding out of private fund-raising - Unnikrishnan shrugged it off. Why should India be the most disciplined country, he asked.

In fact, he noted, last week Thailand cut the tax rate of startups that shift business from China, to 10 percent. Vietnam does the same. “So, the new regime that we are currently talking about for foreign companies to set it up over here, India has not become the most attractive location. That is something we should be recognising. If you are unable to catch those, it cannot be only on the math or the tax structure. A lot more of other benefits should also be offered to them.”

The focus will now be on alternate sources of revenue, such as asset sales, Butani said while adding that in the longer-term lower tax rates will boost buoyancy.

“The third aspect is where we are in the midst of the 15th Finance Commission, which has been given an extension, and the one important aspect that needs to be figured out is the devolution of revenues. This Rs 1,45,000 crore in the short to medium-term is going to impact the states’ share of the revenue. And states are obviously going to exercise more pressure on the Centre to increase their share, which means that the Centre’s fiscal deficit in the short term will become an ever-increasing problem.”

Growth Gain Versus Fiscal Pain: The Economic Impact Of Corporate Tax Rate Cuts