It is two days since Mr. Pranab Mukherjee presented what many are calling the boldest budget from the ruling NDA coalition in recent years. And while the budget would have been dissected and laid bare thread by thread at the time of this writing, the most amusing aspect is noting the reactions that come from of various quarters to the proposed changes.
I specifically noted with much amusement the various reactions that came from the IT and ITES sector head honchos. Being part of the IT fraternity myself, while the budget made no specific gains for the IT/ITES sectors, there was the very visible tax whammy that the sector was hit with.
In a nutshell, with respect to the IT and ITES sector, the 2011-12 Union Budget proposed:
Tax exemption to export-oriented units under the Software Technology Parks of India (STPI) scheme ceases in 2010-11. This effectively removes the following benefits:
Minimum Alternate Tax (MAT) was increased to 18.5% from 18%. MAT was introduced in the direct tax system to make sure that companies having large profits and declaring substantial dividends to shareholders but who were not contributing to the Govt by way of corporate tax, by taking advantage of the various incentives and exemptions provided in the Income-tax Act, pay a fixed percentage of book profit as minimum alternate tax. MAT now is applicable to units operating in Special Economic Zones (SEZ), which enjoyed a 100% tax exemption, among other benefits.
Dividends from foreign subsidiaries on Indian companies would be taxed at the lower rate of 15% instead of the normal tax rate. This would facilitate flow of this revenue into the country.
So to appreciate the full impact of these recommendations, let us examine the typical case of an IT company that has three units, one in an STPI, one in a SEZ and one in a foreign country. Let’s say each of these units makes Rs. 100 in profit. The normal corporate tax rate is roughly 34% including surcharge and cess.
Net Loss / Gain
34% x (10% of 100) = 34% of 10 = Rs. 3.40
|34% of 100 = Rs. 34.00
||Added Tax of Rs. 30.60
0% of 100 = Rs. 0.00
|MAT of 18.5%
18.5% of 100 = Rs.18.50
|Added Tax of Rs. 18.50
||Normal tax rate
34% of 100 = Rs 34.00
|15% tax rate
15% of 100 = Rs. 15.00
|Lowered Tax of Rs. 19.00
|Total Tax on Rs. 300.00
||Additional tax of Rs. 30.10
* MAT provision explained below
So effectively, while companies paid an effective tax rate of 17.33% before, they will now pay an effective tax rate of 22.50%, roughly 5.17% more tax. Naturally, this will vary based on the proportions of profit revenue from the various types of units.
IT Industry pundits and players have obvious reason to be disappointed. The removal of STPI tax exemption was coming, as it was a time bound incentive scheme which was supposed to end in 2009-10 and was extended for one more year. While further extension was on the wish list, it was unrealistic to expect it.
The MAT inclusion for SEZ units was the unexpected blow. While large, established firms like TCS, Infosys and Wipro would only see a rise in their tax burden, the implications run deeper for smaller firms.
MAT is the minimum tax payable if the tax computed normally is less than 18% of the book profit. Take the case of the STPI unit before budget. Let’s say that out of an income of Rs. 100, the book profit is the complete Rs. 100. (A lot of consulting companies have this kind of business model, whereby the profit margin is 100% or more)
Normal computation of tax would make the tax liability only Rs. 3.40, which is less than 18% of Rs. 100. Thus the MAT provision would kick in and the company would have to pay a minimum tax of 18% i.e. Rs. 18.00.
Book profit refers to profit which is booked, but not realised. For example, a computer maintenance services company gets a contract for annual computer maintenance a year. This company would show the contract amount as its revenue for this financial year, while it will provide the services and get actually paid for in the next financial year. While the company has not received the money, its income for computation of tax has increased by this amount.
Now though MAT was a way of earning tax revenue by the Govt. from high profit making companies who were enjoying incentives, MAT was just unfair additional taxation. So, to make it look fair, a provision was made whereby the difference between actual tax and minimum tax could be carried forward for a period of upto 10 years and used to offset the tax liability when the normal tax exceeds the minimum tax.
So the differential amount in our STPI unit example (18.00 – 3.40 = 14.60), could be carried forward as tax credit and be used in a year when the normal tax (90% exempt, 10% taxed) exceeds the minimum tax (18%).
If in the next year, our STPI unit has a income of Rs. 100 again, but makes a profit of only Rs. 10. (Either low sales or too many expenses). The normal tax would again be 34% of (10% of 100) = Rs. 3.40 while the minimum tax would be 18% of Rs. 10 = Rs. 1.80.
Now in this case, the real tax is higher than minimum tax and the company is liable to pay the higher amount. But due to the tax credit of Rs. 14.60, it can reduce its tax liability from Rs. 3.40 to Rs. 1.80 by using some of that credit.
Due to the years of tax exemptions, larger and older companies have accumulated large reserves of tax credit under this provision, These tax credit reserves can be used now to offset the added tax burden. However smaller and newer companies do not have the benefit of such tax credit reserves and hence will be strongly affected by the pure tax burden. Such newer companies also have main units in SEZ areas and virtually no foreign units. As a result, the budget provisions only add their woes.
Long term solution
The Indian IT Industry is predominantly a Services oriented industry. It is true that there are few products in the market, but given the size of our economy as well as the number of potential innovators, the numbers are few and far between. While services are undoubtedly the strength of the Indian IT Industry, it is fast becoming evident that the traditional business model is not sustainable. Factors that contribute to this are:
Shrinking profit margins: Gone are the days of Y2K where India was a dormant pool of readily available talent. As services business models have matured, so has the commoditization of services grown. Rather than the service offering being a niche area of expertise, it has transformed into a downward spiralling price game.
Increased competition from other low cost outsourcing destinations: The solitary position of India as a natural English speaking outsourcing destination is a story in the past. The emergence of Brazil, Russia and China as major competitors for the outsourcing pie has put a direct threat on the viability of the services model.
Economic downturn in traditional markets: The focus of the IT Industry continues to be US and UK markets. Both these markets are currently saturated with an influx of service providers and customers in these markets are spoiled for choice. Moreover, both these traditional markets are becoming increasingly hostile to the concept of outsourcing, mainly driven by local political pressure.
If the industry’s blind adherence to this kind of static business model continues, increased taxation and eliminating incentives, which will slowly become a norm towards good fiscal policy making, will eventually cause the Indian IT Industry to lose its competitive edge.
The answer lies in making a shift from the supply driven model of outsourcing services to the demand driven model of IT products and branded services. Products and branded services predominantly enjoy the luxury of naming their price, as against a commoditized service, whose price is solely based on what the buyer is willing to pay. Moreover, products are also easy to quantify in terms of value, as against services, whose value is increasingly subjective and largely perceptive.
When a company sells products, the revenue and subsequently profit, is booked immediately. As a result, the book profit and realized profit is more or less the same. This eliminates the need for additional taxation elements like MAT. Moreover, the taxation is simplified as corporate tax will be calculated on the income revenue only.
[Disclaimer: The views expressed in this article are solely the opinion of the author and are not under the influence of any external parties thereof]