2000 points jump in SENSEX and 570 points jump in NIFTY!
When was the last time you saw these magical numbers?
That’s because Nirmala Sitharaman, our FM, did something extraordinary. The tax rate cut will have a great long run impact on Domestic Companies as this is not a one time benefit.
India always had higher rate of tax on companies which was way more than the average rate of taxes worldwide, especially its Asian counterparts.
Firstly, let us understand few basics before we can go ahead with the technical details.
1] What is Corporate Tax?
Simply put, it is the taxes which corporates (companies) pay on their profits. It is basically a fixed percentage. Thus, higher the corporate profits, higher will be the corporate tax.
2] What is Effective Tax Rate (ETR)?
Effective Tax Rate is the net tax percentage which the company is paying in the form of Income Tax.
Effective Tax Rate = Total Tax ÷ Earnings Before Taxes
Let us analyse the importance of this concept.
Say, a domestic company need to pay 30% tax on their profits as per the Income Tax Act. Suppose ABC ltd, a domestic company, is having earnings (profits) of Rs.100 lakh. Also, the company is availing few deductions and exemptions amounting to Rs.20 lakh. Now, the company has to pay 30% tax on only Rs.80 lakh which comes to Rs.24 lakh.
So, we have Effective Tax Rate as 24% (24/100).
Hence, even though the Actual Tax Rate is 30%, the company is paying only 24% of its earnings/profits as tax. Thus, ETR can be on lower side if the company is availing tax benefits.
The major amendments made by Finance Minister, Nirmala Sitharaman:
- The corporate tax rate for all companies will be slashed to 22 percent from 30 percent, if the companies do not avail exemptions.
- New manufacturing companies will have to pay only 15% tax from previous high of 25%.
Before the amendment, the rate of tax for all domestic companies was 30%. However, adding all the surcharge and cess, the rate would shoot up to 34.94%
Now, after the announcement by our FM, the rate for domestic companies will come down to 22% and the surcharge and cess will make the rate go up to 25.17%.
So, we have the rate slashed from 34.94% to 25.17%. But, the condition is that the company must forgo all the exemptions provided to it under the Income Tax Act,1961.
Now, let me put an analysis of the Effective Tax Rates for different sectors. Here, what one must keep in mind is that for different sectors there are different sections in Income Tax Act, 1961 which speak on exemptions and tax benefits. Hence, there will be difference in the Effective Rate of Tax.
Let us analyse the companies with lesser ETR.
(Data Compiled from Moneycontrol)
For these sectors, there will be no great impact. As they will be better off if they avail tax benefits instead of going with the new rate of 22% which will effectively come to 25.17%.
The real beneficiaries are the companies who were ending up paying a larger amount of their profits as tax and where the ETR is more than 25.17%. Here is the analysis,
(Data Compiled from Moneycontrol)
So, for investors too, it will be prudent if they put more of their money in these companies. Here are the reasons:
- These companies will get directly benefited with lesser tax rates. Thus, they will have more funds in hands. These companies may think of passing on the benefits to their customers. Look at the automobile sector for instance! The lack of demand will now change as the auto makers may slash their prices and there will be increase in the consumption.
- The companies may think of spending the extra funds in the form of advertising to increase their sales.
- There will be less slashing of employees as a measure to reduce cost.
- Improved ‘Earnings after taxes’ would mean more Earnings Per Share. EPS. More EPS, would clearly reflect in the market price of the share. (Read this to know more).
The picture of the economy was gloomy with decline in the private sector investment. However, now with the lower rate of 15% (from 25%) on new manufacturing companies, the private investment will certainly move up.
Greed is a dangerous emotion in stock market. Hence, instead of putting money in anything that is going up, one must analyse and allocate funds smartly in those stocks which are having goods fundamentals and which will be benefited greatly with the above move.
Here’s a list for reference issued by Kotak Securities,
The only negative which pops up is the revenue loss to the government. The Fiscal deficit will increase due to the revenue loss.
For someone who is not aware of the term Fiscal Deficit, it is nothing but the difference between Government’s revenue and Government Expenditure. As India’s difference is negative, we call it as ‘Deficit’, which implies our ‘Expenditure’ is more than our ‘Revenue’.
Thus, Fiscal Deficit= Public Expenditure – Public Revenue
Needless to say, lowering the tax on companies will increase the Fiscal Deficit as the Public Revenue will fall.
Government will probably try to fill this gap with Divestment of Public Sector Units (PSUs). With the rally in the stock market, the divestment of PSUs will give more revenue to the government. Also, the increase in demand and investment would likely revive the economy and we may probably see better revenue collections in the time to come
Swapnil Kabra (स्वप्निल काबरा), Chartered Accountant