MAT and Budget

Q.1) Why has the FM introduced MAT for IT companies? As such most companies

would exhaust their tax holidays under 10A and 10B in a couple of years?

Q.2) Why is the rate of MAT for 10A, 10B companies so high? Will this not act as a disincentive for software exports as 10A and 10B exclusively deal with export of articles things or computer software? This is considering the fact the IT industry has been the significant growth engine for the economy.

Ans : As u have stated correctly, the objective of MAT was to bring zero tax companies/companies which had declared losses as per their books of account also within the tax bracket if they had made book profits as computed under the IT act.

The increase in dividend distribution taxes and levy of MAT provisions on 10A and 10B companies are expected to garner Rs.3000 crore for the revenue. IT industry was all along being promoted as the sunrise sector of the economy. Now the industry has fully emerged out of its growth pangs and has become one of the largest wealth creating sectors of the economy. IT companies have enjoyed a zero tax regime for quite a long time and now the time has come for them to share a portion of their profits for the development of the economy. Therefore the FM must have clearly felt that a matured sector like IT cannot and does not require the cushion of tax benefits anymore. The reason for introducing MAT when the tax holiday is already set to expire in a couple of year’s time has to be examined from the following angles:

• There is a possibility that the FM might extend the tax holiday under Sec 10A and 10B for small cap and mid cap IT companies determined based on certain parameters like revenue and operational size. This is very much possible because a large number of small BPO’s and IT units are registered under STPI (Software Tech Park of India which enjoys 10A benefit alone). Therefore the FM might carry on the tax benefits for another 2-3 years while at the same time charging the IT companies for a lower rate of tax as per MAT provisions. Another point in favour of this view is that MAT credit provisions are available u/s 115JAA for these companies when they pay tax as per MAT/115JB. This credit will be offset in the subsequent 7 years once the tax holiday expires and the companies start paying taxes at normal rates, against such taxes on normal income. However at the rate of 11.33%, the margins of small and mid sized IT companies will definitely be affected in the short term and it will be a major negative for the sector if the FM now extends the tax holiday under 10A and 10B by more than 5 years because these companies will not be able to offset their MAT credit within the stipulated period of 7 years from the date of payment of tax under MAT. As far as large IT cos are concerned like TCS, Infosys and Wipro they already pay taxes at the average rate of 12-15% on both local and offshore activity which would be higher than MAT rate of 11.33%. But the concern of the sector as such is whether MAT credit would be allowed to be set off against the tax paid outside India on offshore activity/international operations which might fall under the purview of DTAA. No clarity has emerged on this issue. In effect if the same corporate taxation rates are maintained in the country, MAT provisions shudnt have an impact at all in the long run due to the credit availability for 7 yrs.
• There are a number of IT companies which have started setting up SEZ’s to avail benefits u/s section 10AA for a 15 year period and interestingly the act is silent on this section as 115JB does not include 10AA in its computation. Therefore it is deemed that these companies setting up SEZ’s will continue to enjoy the tax holiday for the moment. It will be interesting to notice what the FM decides next year as if these companies are allowed to enjoy tax benefits when other companies end up paying taxes, it creates an unfair advantage within the industry and we may end up witnessing a lot of cases/disputes under the Competition Act. Maybe that explains the flurry of companies setting up SEZ’s across the country and shifting their operations to these locations to escape the MAT onslaught.
• The cost of services of these IT companies affected by MAT will move up in the short run but with better and higher billing rates being secured by most players and with better employee utilizations, the margins will be easily managed. This in my opinion should not be a disincentive for software exports as it does not affect our export competitiveness in any way. Only the appreciation of rupee to below 40 levels is a concern now.

Q.3) why has the dividend distribution tax been increased from 12.5% to 15%? This will have a significant impact on dividend distributed to shareholders by companies.What sort of a negative impact could be created?

Dividend distribution tax increase from 12.5% to 15% is not a major negative as most investors in the stock market invest with the objective of capital appreciation and not for dividends. The opportunity to make short term gains are huge in the capital market with increase in the investment universe and therefore investors looking at dividend as a source of return has become a fairy tale of the old economy. But however as u have put it rightly the dividend being paid to shareholders will fall by a few basis points as companies will factor in the increase in the taxation rates in the dividend outgo as they would not want their accretions/accruals to be affected. But this whole concept of DDT by itself is a form of double taxation, as the profits from which the dividends are distributed are already taxed. DDT as such needs to be abolished in the long run as it pukes at the very concept of a reformist fiscal and vibrant tax structure (there’s no place for double taxation) . However if we carefully read into the FM’s mind… he has an idea behind this flip flop exercise. FM would like corporate India to use their distributable surplus to enhance and expand their operations through ploughing back of profits rather than declaration of liberal dividends. This increase in DDT rates in a way can be considered by prudent investors as blessing in disguise as it makes the corporate think tank ponder over better ways to utilize their idle funds.

Q.4) Why ESOP's have been brought under FBT? Why should companies pay tax on stock options which employees would take. Already their EPS could be diluted because of the stock options issued to employees.Is this applicable only when employees exercise the option or not?

FBT or Fringe Benefit Tax is a levy on all common benefits enjoyed by employees that cannot be apportioned or identified with them individually. ESOP has also been considered to be common benefit availed by all employees. The bone of contention of the FM that ESOP is a common benefit does not pass muster mainly because ESOP’s are not granted to all employees but to a select few decided on various parameters. It is one of the methods of securing the loyalty of the employee as well as retaining precious talent within the company. However since the government is firm on having ESOP’s brought within the purview of FBT (however illogical it may sound) to boost the Tax GDP ratio, we can straight away proceed to the crux of the matter as to how this taxation mechanism is going to work. Recent amendments have been made to ESOP-FBT provisions, though detailed guidelines on the mode of computation of FBT on ESOP’s are still awaited. Before this recent amendment, FBT was to be levied on ESOP based on the FMV as on date of exercise of option less Exercise price of the option. The problem under this mechanism was that the company would not know the date of exercise of the option by the employee and estimation of FBT liability, advance tax numbers, guidance estimates were proving to be difficult due to different dates of exercising of options by employees. The employer could not avail any deduction under the IT act for FBT paid and no tax would arise in the employee’s hands. The employee would only have capital gains liability on sale of shares vested under the option.

New amendment: The amendment in FBT provisions for ESOPs have tempered and assuaged the concerns of the IT sector to a large extent. As per the latest provisions:

• The FBT liability shall be computed based on the FMV as on date of vesting less

exercise price of the option. Every company would know the vesting date well in

advance and it becomes a lot simpler to compute various estimates. Also due to

the fact that the exercise price for any stock option is fixed at a discount to the

current market price, the company can fix the vesting date within a shorter

interval whereby there might not be a major run up in the share prices to reduce

its FBT liability

• The liability to pay FBT will arise only on the date of exercise of the option by the employee. So provisions will have to be created in the books of account. The recovery of the FBT paid can be made from the employee. In effect FBT on ESOP’s has become a tax deduction at source for the employee.
• Another important point to be considered here is the accounting and taxation of recovery of FBT from employees in the hands of the employer especially when FBT is not an allowable deduction.
• No clarity has emerged on FBT liability for employees based outside India who have been granted stock options.