The effect of the ‘big bang’ corporate tax rate reform is limited to profitable, tax-paying enterprises, which, as per the 2019 Budget papers, are only 46.41% of all corporates.
By Siddarth M Pai
For those who brave the treacle-like Bangalore traffic, the board outside the tax office near Chinnaswamy cricket stadium offers a chuckle as it says “TDS isn’t Tedious” in a dark maroon font. While it can be argued that it isn’t tedious, thanks to simplifications since its introduction in 2004 (or due to Stockholm Syndrome, as one chartered accountant wryly put it), it has slowly become excessive on various sections of businesses, especially professionals and services companies.
The Tax Deducted at Source, or TDS, framework was introduced as a “pay as you earn” mechanism to help taxpayers clear their tax dues as they earn funds instead of having to grapple with a large payment in one shot. It helps reduce tax avoidance by ensuring that a paper-trail for income is created, and making reconciliations for the tax department easier, along with helping the government smoothen its fund flow instead of waiting for quarterly advance tax payments.
Captured in sections 192-196 of the Indian Income Tax Act, there exist over 20 provisions governing TDS and their respective rates. If one were to segregate the current TDS framework, it can be framed as passive income versus active income, with differential rates for both. Passive forms of income, such as interest on securities, dividend, rent, etc, have a high rate of 10% or more, with active incomes, such as commissions, payment to contractors, etc, having a relatively lower rate of 1%-5%. Salary income has the most progressive system—it is pegged to the normal slab rates, and thus varies proportionately with the income of the salaried taxpayer.
The primary exception to this seems to be payments to professionals, or services under section 194J. Fees for professional services (defined as legal, medical, engineering, accountancy, technical consultancy, and other items listed), technical services, royalty, and payments to directors (other than those as employees) have a rate of 10% if such payments are above `30,000 a year. It is here that the TDS framework becomes more pernicious than progressive.
The principle of income tax is that it is a tax on income, which is classified into five categories in India: Income from salary, income from house-property, profit and gains from business and profession, income from capital gains, and income from other sources. Of these, income is classified as revenue receipts for salaried class, renters, investors, and others, and as profits for businesses and professionals, i.e., income tax is on the gross-receipts for four out of five categories, but its on net receipts (profits) for those in any business or profession.
Yet, for professionals and those in the services field, TDS flips the principles of income tax and TDS on its head by applying a high withholding tax rate on income to a field where the income isn’t taxed, but the profits are. It is this practice of a high TDS rate on the income of professionals and services that leads to distortions in tax rates, high refunds, and a liquidity crunch for services.
If one were to take an example, a services business with a turnover of `10 lakh would have 10% of its revenue withheld as TDS, equal to `1 lakh. The tax rate on the business would be either 22% or 30% (for companies or firms/professionals, excluding surcharge & cess). Assuming that the TDS accounts for 100% of the tax liability, this implies a 45.45% net profit margin for companies, and a 33.33% net profit margin for firms/professionals! No business at scale has a net margin of over 33%, and a tax rate that assumes so is fatuous. This calculation is illustrated in the accompanying graphic.
The implication is clear: unless a business has a net profit margin above 33%, the current TDS rates are excessive and onerous.
It may be argued that services are a small portion of India’s tax receipts, but the 2019 receipts budget highlights that non-manufacturing companies, a majority of which are in services, contribute over 63% of India’s corporate tax revenue. Services also contributed to 56.19% of India’s GDP in the April-June 2019 quarter. They are also the largest drivers of exports, contributing $6.4 billion in September 2019, as per RBI data.
Startups are the biggest victims of this high TDS rate as a bulk of their revenue is in the form of technical services, subject to a 10% TDS. Their high-growth nature makes profits rare in the first few years of operations, and working capital support scarce. This high TDS rate further stresses their working capital flows, leading to the need to raise equity for working capital purposes, or slow down expansion due to liquidity constraints. The recent slowdown, and lack of credit growth have further exacerbated this for businesses in India.
Taking cognisance of this, the Indian Income Tax Act provides an avenue for obtaining a lower TDS rate under section 197. However, this requires one to provide the TAN (Tax Deduction & collection Number) of all customers, and the amount receivable during the year in advance to obtain the lower deduction certificate. This respite can only be obtained by businesses that have stagnated or require perpetual paperwork to derive any tangible benefit. The level of prescience required, combined with the paperwork, has effectively curbed this mechanism as a means of relief for startups and growing businesses. Bureaucracy is no balm for economic stress.
The money stuck as TDS will only be refunded once the business files its tax returns, which is usually done in September, after the financial year ends. Given the high refund amount, it is usually paid out 6-12 months after the taxes are filed, thus creating a 24-30 month period after which the TDS amounts come back to the business—further exacerbating the liquidity situation.
Excess TDS has become an institutionalised friction to growth and liquidity; this demands a remedy in the upcoming budget. In an economy starved of liquidity, reducing the TDS rate on services will help businesses create liquidity via retained earnings, thus allowing them the internally generated capital to expand when the rest of the businesses are contracting. All DPIIT startups should have a lower TDS rate of 2% for as long as they are a ‘startup’, and professionals should have a 5% TDS rate.
The effect of the ‘big bang’ corporate tax rate reform is limited to profitable, tax-paying enterprises, which, as per the 2019 Budget papers, are only 46.41% of all corporates. TDS reduction will build upon this and drive meaningful change by improving monthly cashflows for the largest driver of India’s GDP, which still awaits specific, meaningful reforms. TDS isn’t tedious—but a high limit makes it treacherous.
Founding partner, 3one4 Capital
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