A study conducted by the Tax Foundation, a tax policy non-profit organisation based in the US, on the CIT rates across 208 tax jurisdictions in 2018 revealed that India had the highest CIT, at 35%, amongst the large economies in the world.
By TV Mohandas Pai & S Krishnan
Finance minister Nirmala Sitharaman has slashed the corporate income tax (CIT) for domestic companies to 22% in order to promote growth and investment, and announced a new CIT of 15% for new domestic manufacturing companies, thereby providing a boost to the Make-in-India initiative. The new effective CIT would be 25.17% inclusive of a new lower surcharge of 10% and cess of 4%. With this announcement, the Narendra Modi government has fulfilled the promise made by the former finance minister in FY16 of a CIT of 25% with no exemptions/incentives and provided a fillip to manufacturing companies with a lower 15% CIT. It is for the first time that the government of India has used an ordinance to slash IT rates outside the conventional Budget.
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India’s CIT is now closer to the worldwide average statutory CIT of 23.03%. A study conducted by the Tax Foundation, a tax policy non-profit organisation based in the US, on the CIT rates across 208 tax jurisdictions in 2018 revealed that India had the highest CIT, at 35%, amongst the large economies in the world. The study further indicated that the average statutory CIT rate is 20.65% in Asia, 28.4% in BRICS, 21.86% among EU countries, 23.93% in OECD countries and 27.63% in the G7, which comprises of the seven wealthiest nations in the world. The US has a combined statutory rate of 25.84%. The majority of the 208 separate jurisdictions surveyed have corporate tax rates below 25%, and 103 have tax rates between 20% and 30%.
Before the CIT rate cut, the marginal CIT for FY20 was 35% for companies having a turnover above Rs 400 crore in FY18, and dividend distribution tax (DDT) of 20.56%. The accompanying table indicates that these companies had to earn pre-tax income of over 27% in FY20, by investing, running a business and creating jobs to enable investors in that company to earn a post-tax dividend of 12%. After the CIT reduction, it has to earn a pre-tax income of 23.5%, an absolute reduction of 3.5%. A sole proprietor of a business earning more than `5 crore in FY20 has to earn only around 21% to get the same return, disincentivising scale! In comparison, a company in the US with an effective CIT of 25.85% has to earn a pre-tax income of 20.22% in CY2019 to enable an investor to earn a post-tax dividend of 12%.
Before the CIT cut, India was collecting a total tax of about 55.64% on the Profit before Tax (PBT), whereas the US collected a total tax of 40.67%. The tax collected by India on PBT increased by 52% between FYs 2013-14 and 2019-20, forcing companies to generate a higher pre-tax income to enable an investor to earn the same post-tax dividend. The compulsion to generate a very high return imposes a high cost on the economy, reduces money for reinvestment, disincentivises investment and makes India a rent-seekers’ economy, always intent on avoiding taxes!
The high CIT had increased the cost of capital, thereby making Indian companies globally uncompetitive. Cost of capital is the hurdle rate below which no company would be able to run a sustainable business. The weighted average cost of capital (WACC) in India is around 12% considering 10-year G-Sec rate of 6.5% to 7%, and average risk premium on equity of 5%. The US WACC is 7%, in Europe it is 7.16%, and globally it is 7.9% (Prof Aswath Damodaran, Stern School of Business, NYU).
Indian companies are unable to compete globally when their cost of capital and CIT is significantly higher than the overseas competitors. When overseas companies with a lower cost of capital invest and operate in India, they dominate. In addition, Indian companies become a prime target for acquisition by global companies, which have a lower cost of capital. It is one of the major reasons why our entrepreneurs were selling out their companies, being unable to fight the battle of WACC.
Prime Minister Modi, during his 2019 Independence Day speech, recognised the role and contribution of wealth creators in India. He said, “Wealth creators should not be viewed with suspicion. They are the wealth of the nation. It is necessary that those who create wealth in the country should be equally respected and encouraged.” Wealth creators and entrepreneurs are the ones who take the risk, invest and create jobs. One big issue deterring the risk-takers was the high taxes on capital in India, which had gone up further in FY20 with the increase in surcharge for high net-worth individuals (HNI) who are major investors, as well as tax terrorism on an unprecedented scale.
Individuals having an income of more than Rs 1 crore are subject to IT surcharge between 15% to 37%, resulting in high tax rates of 35.88% to 42.74%. They pay IT at rates varying between 11.96% to 14.25%, on dividend income exceeding `10 lakh and long-term capital gains (LTCG) tax of 12% to 14.25% on gains exceeding Rs 1 lakh from listed companies. If the investment is in an unlisted company, the IT is 24% to 28.5%, after considering the indexation benefits. In a listed company, LTCG arises after 12 months, while it is 24 months for unlisted securities, so much for incentivising investment! The risk on unlisted securities is higher due to lack of liquidity and inadequate price discovery, but taxes are more. In India, the higher the risk, higher is the tax. Along with the CIT reduction, the finance minister has also provided some relief to high income earners by withdrawing the enhanced surcharge applicable on capital gains arising on sale of equity shares/units of an equity mutual fund that are liable to Securities Transaction Tax. But the enhanced surcharge on dividend income continues.
Imposition of DDT and the additional tax on individuals on dividend income beyond Rs 10 lakh resulted in multiple levels of dividend taxation. Distribution of dividends is another form of return of capital and tax rate on dividends is generally linked to the capital gains tax rate. A higher dividend tax relative to the capital gains tax could discourage companies from distributing earnings through dividends. A reduction in the effective DDT to 15% and withdrawal of taxation of dividends beyond Rs 10 lakh will increase the return to investors and incentivise them towards higher investments.
Reduced taxes will reduce the pressure on companies to generate higher returns, improve the risk-return trade-off for investors, and increase investment. Limiting the CIT effective tax rate at 25.17% is enabling Indian companies to provide a risk-adjusted return of 12% to the shareholders at a lower pre-tax income of 23.5% compared to 27% before the rate cut. It will also improve the liquidity for banks and financial institutions for lending and enable them to reduce lending rates. This should increase the capital efficiency of the economy and provide the much-needed growth impetus for the economy.
Pai is chairman, Aarin Capital Partners; Krishnan is a tax consultant