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India: Direct Tax Code 2009 review and analysis

The government has released a comprehensive discussion paper and draft of the new Direct Tax Code that seeks to revamp and simplify the Direct Tax Law and its administration in the country through several radical changes. The code, which the government plans to enact and implement FY2012 onwards with suitable changes if required, envisages meaningful reduction in the tax rates while simultaneously being revenue neutral for the government. It aims to achieve this by increasing the tax base and rationalising the myriad tax incentives prevalent under the current law. In our view, the overall changes proposed will be quite beneficial for a number of sectors and companies, albeit definitively withdrawing tax holidays being currently enjoyed by different sectors, something that has been contemplated and proposed often in the past and therefore should not come as a major negative surprise.

 

 

Reduction in effective tax rates for Individuals a positive
The Tax code proposes a significant increase in the tax slabs for personal income tax which, if implemented, will result in a meaningful increase in disposable income, especially benefiting FMCG and other domestic consumption stories. At the same time, the code proposes to do away with the distinction between long and short-term capital gains and abolish the Securities Transaction Tax (STT), effectively taxing all capital gains at the applicable marginal tax rate for the tax-payers’ total income. At present, the long-term capital gains tax is Nil on equity transactions on which STT is paid and 20% on all other assets, while the short-term capital gains tax rate is 10% on equity transactions on which STT is paid and 30% on other assets. In our view, the proposed increase in tax slabs is quite substantial in view of the country’s per capita income distribution, and should reduce the impact of the proposed increase in capital gains tax rates.

 

 

 

 

Tax incentives on Savings
The code also proposes to increase the tax deduction limit available on savings from Rs1lakh at present to Rs3lakh. However, the tax incentives on Interest paid on home loans is proposed to be withdrawn. On a further negative note, the code also proposes to tax the savings in various instruments including PPF, Insurance, etc. at the time of withdrawal, i.e. investments in tax savings instruments will only lead to a postponement of tax liability rather than an outright exemption as applicable at present. Moreover, retirement benefits such as gratuity will be tax-free only if deposited in specified retirement benefit schemes.

 

 

Reduction in Corporate Tax rate a positive; withdrawal of tax incentives on Exports, etc. not a surprise

Reduction in the Corporate Tax rate from 33% (including surcharge) to 25% will benefit companies across sectors but sectors, especially in FMCG and Banking where the effective tax rates are close to 33% for most companies. Moreover, business losses will be allowed to be carried forward indefinitely, unlike 8 years at present. The reduction in tax rates is intended to be compensated by a withdrawal of various tax incentives available to sectors such as exports, infrastructure, area-based tax holidays, etc. Moreover, the allowable Depreciation rate on plant and machinery is also proposed to be brought down to 15%.

 

Our analysis indicates that out of a total sample of 5,041 companies with a Market Cap of Rs48.4lakh crore, the latest effective tax rate was about 26%. However, this includes profits from businesses such as infrastructure, exports, etc. presently exempt from taxation under various provisions such as Section 10A, 10AA, 10B, 10BA, etc. While existing projects will not lose these benefits, over the next few years as these profit-based incentives on existing projects expire, broadly effective tax rates for the Corporate Sector as a whole are expected to normalise at similar levels as at present Sector, whole, present, making the proposed changes largely tax revenue neutral, albeit leading to a convergence in effective tax rates across sectors.

 

However, the code does provide for some investment-based incentives. In respect of revenue and capital expenditure on scientific research and development, deduction to the extent of 150% of the expenditure will be allowed to all companies. Under the new provisions, tax liability will accrue in various specified infrastructure sectors only after 100% of the capital expenditure is recovered, allowing these companies to postpone the tax liability. Sectors to be covered include:

- Generation, transmission and distribution of Power
- Specified infrastructure projects
- Hospitals
- Food processing, packaging, cold storage, agricultural warehouse
- Oil and Gas
- SEZ

 

MAT provisions a key negative
The tax code proposes a radical change in the MAT provisions. Under the new system, MAT will be paid at a specified percentage of Gross assets of a company (broadly equates to capital employed, although it is unclear whether Net or Gross Current Assets will be considered for computation). The specified percentage is 0.25% for banking companies and 2% for all other companies. Although intended to widen the tax base by reducing tax evasion, the new MAT proposals appear onerous on several counts:

- Companies suffering genuine losses or sub-normal RoCE due to initial gestation period or cyclical downturn would also have to pay MAT at 2% of gross assets.
- Moreover, MAT credit will not be available, making the provisions all the more onerous.

 

 

 

 

SECTORAL IMPACT

 

 

Agriculture - Neutral

 

Measures
- Reduction in the Corporate Tax rate from 33% to 25%.
- Introduction of long term capital gain tax long-tax.
- Decrease in the depreciation rate for Plant & Machinery.
- As per current regulations, SEZ profits are 100% exempt for the first five years, then 50% for the next 5 years, and again 50% for the next five years, subject to re-investment.

Impact Analysis
- The industry is currently under a full tax regime; hence, a reduction in the tax rate would definitely increase profits of company. Positive for Jain Irrigation and Rallis.
- Negative for cash rich companies that have invested surplus cash in mutual funds and other financial instruments instruments. Negative for Rallis.
- Reduction in the tax shield: negative for all companies. However, the lower income tax rate might compensate for the same. Negative for Jain Irrigation and Rallis.
- However, in new tax code there is no mention about continuity of the above-mentioned SEZ regulations. If SEZ profits were to be taxed like regular profits, it would be substantially negative for Rallis, as it is setting up a new SEZ plant to cater to the export market, and plans to derive substantial revenue from it going forward.

 

 

Automobile - Positive 

 

Measures
- Significant changes in Personal Income Tax slabs.
- Cut in corporate tax rate to 25% (33% at present).
- The allowed rate of depreciation on Plant & Machinery has also been cut to 15%.
- Minimum Alternate Tax (MAT) will be 2% of the value of gross assets (15% of Book Profit at present).

 

Impact Analysis
- Change in tax slabs for personal income will boost consumption, owing to rising disposable income in the hand of consumers. Positive for most of the Auto majors. Specifically, this would boost the demand for consumer discretionary items like Two Wheelers and Passenger Vehicles. Positive for Maruti, M&M, Hero Honda, Bajaj Auto, TVS Motors and Tata Motors.
- A cut in the corporate tax rate to 25% will benefit high tax-paying companies like Hero Honda, Maruti and Bajaj Auto.
- The allowed rate of depreciation on Plant & Machinery has also been cut to 15%. Thus, companies going for higher investments, like Maruti, Tata Motors and M&M, that have been paying low tax will likely pay more on a higher PBT, and mitigate the positive effect of a lower tax rate.
- The rate of Minimum Alternate Tax (MAT) will be 2% of the value of gross assets. Marginally Negative for cyclical and highly capital intensive companies like Tata Motors and M&M M.
- There is a lack of clarity as regards the exemptions available to certain states like Uttaranchal, where most of the Auto companies are putting up incremental capacities or shifting their existing capacities. If these exemptions are withdrawn, it could be negative for the sector. More specifically, this would be negative for Hero Honda, Tata Motors, Bajaj Auto and M&M.

 

 

Banking - Positive 

 

Measures
- Reduction in Corporate Tax rate to 25%.
- MAT at 0.25% of Gross Assets.
- Increase in Tax incentive limit on savings from Rs1 to 3lakhs; taxation of such savings at the time of eventual withdrawal.
- Withdrawal of a key incentive for Home Loans, viz. tax exemption on the Interest paid up to Rs1.5lakh.
- Provision for NPAs allowable up to 1% of aggregate average Advances as against 7.5% of Total Income and 10% of Rural Advances at present.

 

Impact Analysis
- Positive, as majority of the companies in the Sector are paying taxes close to the maximum rate of 34%.
- Very few companies (mainly Mid-cap banks like DCB, UCO Bank, etc.) could be hit by the proposed MAT at 0.25% of gross assets.
- Increase in the limit is a positive for banks having large financial subsidiaries in life insurance and asset management such as ICICI Bank, SBI, etc. However, the prospect of eventual taxation at the time of withdrawal could weigh on investment decisions and reduce attractiveness of tax-saving instruments such as ULIPs, ELSS, etc.
- Negative for banks generally but especially for mortgage companies like HDFC and LIC Housing Finance generally, Finance.
- This should generally ensure allowability of NPA provisions for a majority of banks, except for few private banks like HDFC Bank, Kotak Mahindra Bank, etc. which have higher amount of provisioning due to larger proportion of retail loans in segments like Auto, Personal, etc. in their overall credit mix.

 

 

Capital Goods - Positive

 

Measures
- The Corporate tax rate is proposed to be reduced to 25% from 33% earlier.
- Significant changes in Personal Income Tax slabs.

 

Impact Analysis
- Since all the Capital Goods companies under our coverage universe fall in the full tax bracket, any reduction in the their bottom line corporate tax rate would positively boost bottom-line.
- The proposed increase in the personal tax slabs, prima facie, seems to place higher disposable income in the hands of individuals, thereby triggering increased consumption and spending in the economy. This would ultimately provide a fillip to industrial capex and, consequently, the Capital Goods industry would also benefit, in the form of increased inflows long run order inflows, albeit in the run.

Positive for ABB, Areva T&D, BHEL and Crompton Greaves.

 

 

Cement - Positive

 

Measures
- Corporate tax rate reduced to 25% from 33% earlier.

 

Impact Analysis
- As companies under our coverage come under the full tax bracket, the reduction in corporate tax rate will bring down the overall tax liability of these companies and will provide a push-up to the bottom line.

 

Positive for ACC, Grasim Industries, Ultratech Cement, Ambuja Cements, India Cements, Madras Cements, JK Lakshmi Cement.

 

 

FMCG - Positive

 

Measures
- Significant changes in Personal Income Tax slabs. No tax payable up to an income of Rs1.6lakh, 10% tax up to Rs10lakh and 20% up to Rs25lakh.
- Basis for computing Minimum Alternate Tax (MAT) changed from "Book Profits" to "Gross Assets"; Gross Assets to include: Value of Gross Fixed Assets + Capital work-in-progress + Book Value of all other assets - Accumulated Depreciation - Debit Balance in P&L A/c; MAT to be charged at 2% of Gross Assets and will be the final tax and will not be available as tax credit in subsequent years.
- Corporate Tax rate proposed to be reduced to 25%.

 

Impact Analysis
- Changes in the Personal Income Tax slabs are likely to drive higher consumption owing to rising disposable income levels. This is a key positive for FMCG companies.
- The rate of MAT will be 2% of the value of Gross Assets. This proposed measure could have a Marginal impact on companies paying tax at lower rates - Godrej Consumer, Dabur, Marico, HUL and Colgate. However, since most of these companies manage a low Gross Asset base (Debt free and high Dividend payouts), we expect this provision is likely to have a Positive impact impact.
- A cut in Corporate Tax rate to 25% will benefit most FMCG companies which generally pay full tax rate. Key beneficiaries include GSK Consumer, ITC and Nestle.

 

 

Hotel - Positive

 

Measures
- Tax rate of companies (both domestic and foreign) to be reduced to 25% from 33% earlier.
- Significant changes in Personal Income Tax slabs

Impact Analysis
- Since the industry falls in the full tax bracket (33% tax), the proposal of reducing the tax rate would be positive, consequently providing a boost to the bottom-line bottom line.
- The tax slabs for individuals are proposed to be revised significantly, thereby leading to increased disposable income in hands of individuals, and triggering additional spending. As per the proposed provisions, no tax is payable up to an income of Rs1.6lakh, 10% tax up to Rs10lakh , 20% up to Rs25lakh, and 30% tax on income beyond Rs25lakh.

 

 

Infrastructure - Neutral

 

Measures
- Basis for computing MAT changed from "Book Profits" to "Gross Assets"; Gross Assets to include: Value of Gross Fixed Assets + Capital Work-in-progress + Book Value of all other assets - Accumulated Depreciation - Debit balance in P&L A.c; to be charged at of Gross Assets and will be the final tax and will not be available as Tax credit in subsequent years.
- An investment-linked tax incentive has been proposed, which allows for tax exemption only for the period until the investment is recovered.
- Corporate Tax rate proposed to be reduced to 25%.

Impact Analysis
- Negative for companies having presence in BOT space and claiming MAT credit such as Nagarjuna Construction credit, Construction, Madhucon Projects, etc, since they will not be able to claim further credit. However, it would be mildly negative as the BOT Segment does not contribute significantly to our Target Prices.
- This, in effect, implies that once all capital expenditure (exceptions: land, goodwill and financial instruments) is recovered, the entity will be subject to the normal (full) tax rates.
- Proposed reduction in the Corporate Tax rate is likely to be a Positive for all Construction companies as they pay tax at a marginal rate, on a Standalone basis, and constitutes lion's share of our SOTP Target Prices.

 

 

Logistics - Neutral

 

Measures
- Under the new code, MAT rate will be 2% of the value of gross assets for all other companies.
- Corporate tax rate proposed to be reduced to 25% from current level of 33%

Impact Analysis
- Marginally Negative for companies such as Allcargo, Gateway Distriparks (GDL) and Concor as they claim MAT for income generated from container rail and CFS/ICD profits However in case of GDL it is entitled for MAT only till profits. GDL, FY2011 for JNPT and Chennai CFS. So effectively they would have to pay 34% tax rate from FY2012 which would now reduced to 25% under new tax code. On other hand, new MAT law on gross block will negatively impact GDL's rail segment (which is likely to break even at PAT level in FY2011) as they are in high capex mode.

 

 

Metals - Positive

 

Measures
- Corporate tax rate reduced to 25% from 33% earlier.

 

Impact Analysis
- As companies under our coverage come under the full tax bracket, the reduction in corporate tax rate will bring down the overall tax liability of these companies and will provide push-up to the bottom line.
- Positive for Tata Steel, SAIL, JSW Steel, Nalco, Hindalco, Hindustan Zinc, Sesa Goa. Neutral for Sterlite Industries, as the company has an effective tax rate of around 27%.

 

 

Media - Positive

 

Measures
- Significant changes in Personal Income Tax slabs. No tax payable up to an income of Rs1.6lakh, 10% tax up to Rs10lakh and 20% up to Rs25lakh.
- Basis for computing Minimum Alternate Tax (MAT) changed from "Book Profits" to "Gross Assets"; Gross Assets to include: Value of Gross Fixed Assets + Capital work-in-progress + Book Value of all other assets - Accumulated Depreciation - Debit Balance in P&L A/c; MAT to be charged at 2% of Gross Assets and will be the final tax and will not be available as tax credit in subsequent years.
- Corporate Tax rate proposed to be reduced to 25%.

 

Impact Analysis
- Changes in Personal Income Tax slabs are likely to drive higher consumption owing to rising disposable income levels. Key positive for Media companies as it is likely to drive higher Advertising.
- A cut in Corporate Tax rate to 25% will benefit most Media companies, which generally pay full tax rate.

 

 

Oil & Gas - Neutral

 

Measures
- The Draft has recommended moving away form the Profit linked tax exemption to Investment linked tax exemption for activities in E&P and refining. Under this, an entity would be allowed to recover all capex (except land, goodwill and financial instruments) Post recovery of the capex the entity would pay the Income Tax on the Profits instruments). capex, thereafter. Hence, the time taken in recovering entire capital and revenue expenditure will be the period of tax holiday.
- Basis for computing MAT changed from "Book Profits" to "Gross Assets"; Gross Assets to include: Value of Gross Fixed Assets + Capital Work-in-progress + Book Value of all other assets - Accumulated Depreciation - Debit balance in P&L A/c; MAT to be charged at 2.0% of Gross Assets and will be the final tax and will not be available as tax credit in subsequent years.
- Corporate Tax rate proposed to be reduced to 25% for domestic and to 36.75% for Foreign Companies

Impact Analysis
- Shifting to Investment-linked Tax incentive from Profit-linked Tax incentive would be negative for upstream companies, such as, RIL, ONGC and Cairn India. Currently, there exists a 7-year tax holiday on crude production from the NELP blocks and certain pre-NELP blocks, while there exists ambiguity regards Taxability of the Gas Profits from the NELP blocks. Upstream companies tend to recover the capex involved within the 3-4 years depending on realisations, capex and ramp-up in production. Thus, under the current scenario of 7-year tax holiday, the upstream companies earn Tax-free Income for the remaining period However given that the proposal impacts the fiscal Tax period. However, stability clause under the PSC, implementation of the recommendation appears difficult.
- Shifting of MAT computation coupled with absence of MAT credit is likely to adversely impact RIL as it will have to pay higher tax based on Gross Assets as the business is capital intensive.
- Proposed reduction in the Corporate Tax rate is likely to be a Positive for companies that are expected to pay tax rates in excess of 25% by FY2012, such as ONGC, OMCs, IGL, Gujarat Gas and Petronet LNG.

 

 

Power - Neutral

 

Measures
- Basis for computing MAT changed from "Book Profits" to "Gross Assets"; MAT to be charged at 2% of Gross Assets and will be the final tax and will not be available as tax credit in subsequent years.
- Gross Assets to include: Value of Gross Fixed Assets + Capital Work-in-progress + Book Value of all other assets - Accumulated Depreciation - Debit balance in P&L A/c
- Corporate Tax rate proposed to be reduced to 25%.
- Reduction in rates of Depreciation on Plant & Machinery to 15%.

Impact Analysis
- Discontinuance of the provision to carry forward MAT is a negative for companies availing MAT such as CESC and GIPCL. However, since the companies have a pass through clause (as the Returns are regulated), we believe that it will not impact the financials of these companies.
- Reduction in the Corporate Tax rate to 25% from 33% is a positive for the companies not covered under MAT and which fall under higher tax bracket like Lanco Infratech on a Standalone basis.
- Reduction in rates of Depreciation on Plant & Machinery to 15% will negatively impact companies availing high rates of Depreciation.

 

Neutral for the sector as the tax benefits would be somewhat mitigated by the decrease in depreciation expense claimed.

 

 

Pharmaceutical - Negative

 

Measures
- Basis for computing MAT changed from "Book Profits" to "Gross Assets"; Gross Assets to include: Value of Gross Fixed Assets + Capital Work-in-progress + Book Value of all other assets - Accumulated Depreciation - Debit balance in P&L A/c; MAT to be charged at 2% of Gross Assets and will be the final tax and will not be available as tax credit in subsequent years.
- Corporate Tax rate proposed to be reduced to 25%.
- Export-based incentive under Section 10 to be eliminated.

 

Impact Analysis
- The stated provision will be a negative for most Pharma companies under our coverage as Tax expense in the Income statement is likely to increase on non-availability of MAT credit. We believe Sun Pharma, Piramal Healthcare and Indoco Remedies would be primarily affected.
- Reduction in Corporate Tax rate will be beneficial for companies such as Dr Reddy's Labs.
- Negative for most Pharma companies under our coverage.

 

 

Retail - Positive

 

Measures
- Tax rate of companies to be reduced to 25% from 33% earlier.
- Significant scale-up in the tax slabs for individuals.

 

Impact Analysis
- Since the industry falls in the full tax bracket (33% tax), the proposal of reducing the tax rate would be positive, conseq entl pro iding a boost to the bottom line consequently providing bottom-line.
- The tax slabs for individuals are proposed to be revised significantly, thereby leading to increased disposable income in hands of individuals, and triggering additional spending. As per the proposed provisions, no tax is payable up to an income of Rs1.6lakh, 10% tax up to Rs10lakh , 20% up to Rs25lakh, and 30% tax on income beyond Rs25lakh.

We believe that the proposed provisions will be positive for Pantaloon Retail Ltd, Shoppers Stop Ltd, Titan Industries Ltd and Vishal Retail Ltd.

 

 

Software - Neutral

 

Measures
- Basis for computing MAT changed from "book profits" to "gross assets"; gross assets to include: Value of Gross Fixed Assets + Capital work-in-progress + Book value of all other assets - Accumulated depreciation - Debit balance in P&L A/c; MAT to be charged at 2% of gross assets and will be the final tax; will not be available as tax credit in subsequent years.
- Corporate tax rate proposed to be reduced to 25%.

 

Impact Analysis
- Negative for companies with a low tax rate and claiming MAT credit, such as 3i Infotech, since they will not be able to claim further credits.
- There is a lack of clarity as regards the exemptions available to SEZs (currently under Section 10AA), which is where IT companies are shifting most of their incremental business owing to the sunset clause for the STPI scheme (Section 10A/B).
- If the exemptions under the SEZ scheme are withdrawn, there is no rationale for shifting to an SEZ, and this is likely to lead to IT companies coming under the purview of a full tax regime, which is a Negative for companies like Cranes Software, 3i Infotech and Tech Mahindra.
- However we do not expect this to significantly impact the top tier IT companies under our coverage universe as we However, top-universe, have already factored in effective tax rates in excess of around 20-24% in FY2012E, thus leading to the impact being Neutral for TCS, Infosys, Wipro and HCL Technologies.
- The proposed reduction in the Corporate Tax rate is likely to be a Positive for companies that are expected to pay tax rates in excess of 25% by FY2012E, such as Infotech Enterprises, Bartronics India, Sasken Communication Technologies Educomp Solutions and Everonn Systems Technologies, Systems.

 

 

Telecom - Negative

 

Measures
- Basis for computing MAT changed from "book profits" to "gross assets"; gross assets to include: Value of Gross Fixed Assets + Capital work-in-progress + Book value of all other assets - Accumulated depreciation - Debit balance in P&L A/c; MAT to be charged at 2% of gross assets and will be the final tax; will not be available as tax credit in subsequent years.
- Corporate tax rate proposed to be reduced to 25%.

Impact Analysis
- Negative for companies with a low tax rate and claiming MAT Reliance credit, such as Bharti Airtel, Communications, Idea Cellular and Tulip Telecom.
- The proposed reduction in the Corporate Tax rate is a Positive for the sector.