Why government should withdraw tax exemptions allowed to companies

By 2019-20, the corporate tax rates are to be lowered to 25 per cent from the current 30 per cent. The easing of the headline tax rate on incomes of companies will be accompanied with a gradual withdrawal of tax exemptions and incentives by companies. The government expects the move to be revenue neutral for itself, that is, lower tax rates will not translate into a fall in revenues for the government.

However, the same cannot be said for companies. Some companies will see their tax liability on profits earned decline, while many others may actually see their tax liability rise.

Here's why. Although companies are required to pay income tax at the rate is 30 per cent on their profits together with education cess of three per cent and other surcharges, taking the tax liability to 32.45 per cent - 33.99 per cent depending on the size of their profit, effectively, India Inc paid tax at the rate of 23.22 per cent on an average in 2013-14. When tax paid on dividends distributed was added, the effective tax rate averaged 25.47 per cent. Tax liability of companies fall with a rise in exemptions and incentives availed. As a result, some companies pay as little as five per cent tax of their net profit while others pay as much as 40 per cent as tax.

The intent to lower tax rates and withdraw most exemptions is a welcome move for more than one reason. It will clean up the tax structure, making tax laws easier to interpret, and thus bring down disputes between companies and tax administration on liability of an entity. At 25 per cent tax rate, Indian rates would also be seen as competitive with those of China, South Korea, Malaysia and Thailand for investors looking to do business in India.

More importantly, it will bring about greater equity in the sharing of tax burden among various classes of companies. It will also ensure that the smaller companies are not over-taxed while the larger ones pay at lower rates by availing every exemption they can. To understand how inequitable the system is, one only needs to look at data shared by the government in budget documents.

The tax department extracts data from tax returns of companies to estimate revenues lost due to various exemptions and incentives. Budget 2015-16 document on revenue impact of tax incentives is based on returns filed by 5.65 lakh companies till November 30, 2014 for financial year 2013-14. Some key observations:

One, small companies pay more taxes than very large companies: The effective tax rate for companies with pre-tax profit of less than one crore rupees was 26.89 per cent. In comparison, the effective tax rate for companies with profit in excess of Rs 500 crore was 20.68 per cent. What is seen from the data is that as pre-tax profit rises, effective tax rate declines. Effective tax rate is total taxes paid, including cess and surcharge but excluding dividend distribution tax, as ratio of pre-tax profits and expressed as a percentage.

Incidentally, India is a land of small companies and therefore the number of companies with pre-tax profit of less than one crore rupees is huge - two point seven nine lakh - according to returns filed till end November. That's about half of the companies that filed their tax returns. In contrast, just about 263 companies reported pre-tax profit greater than Rs 500 crore.

Thus, the change in tax regime could hurt these large companies as their effective tax rate will rise while the smaller ones may get some relief. Yet, the government will not lose because large companies account for 60 per cent of the pre-tax profit generated by the corporate sector. It may also be noted that over 2.5 lakh companies, 40.5 per cent of the sample, reported losses in their income tax returns for 2013-14. Many of these may report pre-tax profit when most of the deductions for exemptions and incentive are disallowed and thereafter become taxpaying entities.

Two, service sector companies pay higher tax than manufacturing companies: The effective tax rate for manufacturing sector companies was 21.96 per cent in 2013-14, way lower than 24.37 per cent for service sector companies. About a fourth of all companies filing tax returns are in the manufacturing sector and many of them are much larger corporations than their counterparts in the service sector. According to the tax department data, manufacturing companies together account for about 45 per cent of tax payable.

But then all manufacturing sector companies do not pay tax at that rate. The effective tax rate varies across industries and within an industry, depending on which company avails the allowed exemptions and incentives. For instance, within the manufacturing sector, the effective tax rate for cement companies was five point eight four per cent and for paper manufacturers, it was 13.8 per cent. In contrast, the effective tax rate for rubber companies was 43.69 per cent and for electronics including computer hardware makers, 31.28 per cent.

In the services sector too such variations were visible. Effective tax rate for courier agencies was 36.71 per cent compared to 21.71 per cent for transporters. In the financial services industry, effective rate for leasing companies was a measly one point eight four per cent compared to 21.2 per cent for financial institutions. In the entertainment industry, it ranged between nine point two three per cent for film distribution and 54.41 per cent film laboratories.

Allowing tax exemptions and incentives has proven expensive for the government: The net loss of revenue for the government due to these deduction was estimated at Rs 57,793 crore in 2013-14 and at Rs 62,399 crore for 2014-15. Deductions for depreciation above the normally permissible level, better known as accelerated depreciation in tax terminology, was a major cause for loss of revenue for the government. Depreciation allowance is a way for setting aside money to replace assets such as machinery. Accelerated depreciation was allowed to encourage companies to invest more to create capacity.

Other major sources of revenue loss include deductions allowed to power generation, transmission and distribution companies and petroleum and natural gas companies. Deductions for scientific research and for setting up industry is special areas such as Uttarakhand too costs the government its revenues.

Withdrawing these exemptions, even with advance notice, is not going to be easy for finance minister Arun Jaitley. Once a roadmap for withdrawal of exemptions and lowering of corporate tax rate is made public, there is bound to be lobbying by various interest groups to get the exemptions extended. Hopefully, the government will resist these pressures and stick to its resolve to clean up tax laws and thus enhance ease of doing business in India.