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.

Trivia 2

Trivia question - Does the stock price on the market directly reflect the performance of the company such as increase in the bottom line is because of increase in the stock price? This is with reference to the equity market.

The reason for asking this question is because I was going through an abstract of the press interview of the CFO where it was asked that though the performance of the company was good, the stock was not doing that well. The CFO replied that sharp movements in the stock price had nothing to do with the performance of the company.Rather he was not clear on the reasons for the volatile movements in the stock market.

Also he mentioned that the stock price could be affected because of the recent rights issue for raising funds within the company which could have had an impact.This has resulted in the share capital to be expanded.

If the answer is no, does it mean that the investors are not really making an informed decision on buying or selling stocks such as scrutinizing the balance sheets or income statements or making an analysis of the stock price movements? this should mean that they just speculate on the price of a particular stock to go up or go down and not really bothered about the company's bottom line.

can you let me know your views when you are free?

Ø Well the stock price of any company represents a combination of various factors. What we find as the valuation of a stock on the bourses factors in macro economic, industry/sectoral and company specific events and news flows.

Ø A mix of fundamental and technical analysis is used in arriving at the right valuation for a stock. These are the two main approaches in analyzing the movement of share prices –the fundamental and technical approach. Both the approaches have the objective of buying the share at a lower price and selling it at a higher price.

Ø A fundamental analyst would be concerned with the fundamental factors affecting the industry and the company forming part of that industry like geo political factors, sectoral outlook, past financial performance of the company, earnings outlook for the future, evaluation of the operational metrics like management quality and governance issues,capacity utilization, Production efficiency, inventory management, supply chain management etc… Based on all the above factors the fundamental analyst will arrive at a fair valuation for the company. If the current market price at which the scrip is being traded is lower than the fair value/intrinsic value, the analyst would recommend a buy on the stock and vice versa a sell if the intrinsic value is lower than the current traded value or market price of the stock.

Ø A technical analyst on the other hand is concerned with the direction of the share price movement (trend analysis). He studies the price- volume data of the underlying scrip and takes his directional call on investing in that stock. His approach would be based on the analysis of supply demand situation for particular scrip. If the demand for a scrip is greater than the supply, obviously the prices would move up. A normal investor will enter into the scrip only after the price has risen substantially as price movements in the market can happen within a matter of seconds. Whereas a technical analyst would have spotted this movement in the scrip atleast a couple of weeks earlier than the normal investor and he would have entered the scrip at a much lower price. Even a fundamentally strong stock which has been giving consistent results and has been showing a strong growth pattern will not merit a high at higher price levels. Similarly a company with poor fundamentals and moderate market presence will be a strong buy at lower price levels. But a share analyst or a broker will combine both the methods of fundamental as well as technical analysis to his investing/trading approach. Both these approaches to investing compliment each other quite well. A technical analyst would look at the basic fundamentals before investing and a fundamental analyst would bear in mind the technical position of the market at the time of investing. Usually short term traders trade purely based on news flows and technical analysis. A combination of fundamental and technical analysis usually serves its purpose only for medium to long term investors who have an investing timeframe of not less than 6 months. Technical analysis is a vast complicated subject which encompasses a number of statistical theories and methods for clinical analysis of the stock markets. It identifies trend reversals, enables forecasting of stock prices, identifies overbought-oversold stocks and provides a general indication of the direction of the market for a given time frame.

Ø Now most players in the share market will tell u that the market discounts everything and every bit of news flow, financial information, brand image of the company, insider news, investor expectation, and speculative interest is factored in into the stock prices. Therefore from the market participants’ point of view, the market is always considered to be supreme and all positive and negative views of any company are already taken into account in the traded price or current market price of the stock. I would largely agree with them because speculation in the share market does exist but cannot sustain itself on a longer timeframe. Speculation used to be a major concern in the 80’s and early 90;s before the advent of SEBI when it was possible to get the market rigged through a cartel formation …As u may be knowing Harshad Mehta and Ketan Parekh are standing examples…Now with the information dissemination systems and regulatory mechanisms getting robust, speculation has been largely curtailed and restricted to High Net Worth Individuals(HNI) and hedge funds and such activities are largely seen in illiquid stocks or penny stocks where investor interest is pretty low. It has become increasingly difficult to speculate in Nifty 50, BSE -500, CNX – 500/Midcap related stocks due to continued efforts and the hawkish stance of the market watchman (SEBI)...to give u an example. the very existence of circuit filters came in to being to prevent the price of any particular scrip from rising or falling by more than 20% on any particular day. Investor interest and protection has become a paramount objective of SEBI these days.

Now coming to the case with California Software, my observation is as follows:

Revenues on stand alone inc by 24%,, interest by 250% and employee cost by 45%..PAT margins 18 to 12%, Op margins from 21 to 17

• The CFO is partly right in his observation that the rights issue has affected the share price. From what I have observed the rights issue of this company has been completed in May 06 and the issue price was at Rs.66 (which was a discount to the market price of Rs.82 as on May 06) .Ever since then the share price has shown a decrease to a low of Rs.54 this May and has rebounded to Rs.68 levels as on date. Every rights issue will be seen with a slightly negative bias as the equity base of the company will increase and as a result the EPS is bound to come down. The dilution of the earnings per share will lead to a temporary negative sentiment on that particular scrip. However this may not be the case all the time. For eg ADitya Birla Nuvo came out with a rights issue at around Rs.750 when the share price was trading at 1250 and its still trading at Rs.1300 levels. The share price did not fall after the rights issue. There is a difference in investor perception towards each counter. Aditya birla nuvo is a conglomerate with a presence in various industry verticals like textiles, cement, aluminium & copper, mining, retail etc and each of its verticals have been showing consistent growth with expanding margins. Therefore investors associate a higher premium for such counters due to the earnings growth story. They believe that even on an expanded equity base the company will be able to deliver their return expectations. Therefore the counters where the share prices fall in the long term, post rights issue are the ones where the investors believe that their returns will be diluted due to rise in the equity base.
• Even if we take the case of California software, one can observe that the EPS on a stand alone base has fallen from 13.49 for FY 06 to 7.58 for FY 07. Even assuming that rights issue had not taken place, the EPS would have still been 12, which is a drop below the previous year. Though the company has shown robust growth in the last few years, the following reasons can be attributed for the company’s non performance in the stock market over the last one year:

1.) The negative impact of the rights issue leading to a diluted equity base

2.) The turnover on a stand alone basis has increased by 24% whereas the employee cost has risen by 45% and interest cost has risen by a whopping 250% compared to FY06. Higher interest cost indicates that the balance sheet is highly geared and a high debt equity ratio is always a negative for the stock prices. As a result both the operating margins and PAT margins have been hit drastically with the OPM falling from 21% in FY 06 to 17% in FY 07 and the Pat margins dropping almost by more than 30% from 18% to 12%. Though the company has reported strong growth in its consolidated financials, the stand alone organic growth for the current year has not been impressive from the market’s point of view. Falling margins are a major negative which gets factored in to the stock prices also.

3.) The company has acquired a few companies, launched new products in the last one year and has also entered into Joint venture agreements with various companies abroad. Though these events show promise in the long run as the company is making efforts to expand across its major verticals, the clarity on the funding pattern for these acquisitions, multilayered financial transactions has not yet emerged and the effect of the new launches as to whether they will be revenue accretive and their ability to penetrate into new markets will have to be seen in the long run.

4.) Other factors that are holding the stock down are the general concerns in the IT industry about recession in the US economy and rupee appreciation which will affect the realizations of all exporters and the competitiveness of Indian exports in the global markets.

5.) Though the operational metrics for Calsoft look strong backed by a quality management team, the lack of impressive growth in the stand alone financials during the last one year, fall in dividend rates from 10% to 7.5% on an expanded equity base, falling margins, lack of clarity on international operations and a highly geared balance sheet are concerns that have been factored into the stock prices with a negative bias. The company needs to improve its financials in the long run through certain restructuring efforts on the cost front, as whatever may be the explanation any management might give on the operations and growth plans of an entity, investor’s needs hardcore numbers in the form of a bulging topline, bottom line and returns from holding the scrip.

6.) Frequent investor conferences and meet ups to create awareness and bring out clarity on the domestic and international operations of the company will improve liquidity in the counter. The counter has witnessed very low trading volumes in the last one year explaining the dormancy in its market price.

7.) California Software at the current market price of Rs.68 discounts FY 07 consolidated earnings of Rs.10.29 by around 6.8 times. The share price should move up to 90-100 in the next 6 months supported by reasonable improvement in margins as well as buttressed by the fact that the average trading PE for companies of similar size is in the range of 9 to 10 times trailing FY 07 earnings.

Therefore in my view, based on the above factors the share prices do have an axiomatic relationship with a company’s performance in the medium to longer term time frame.

Delisting Guidelines : Investors watch out

A guide on investor approach to profit taking from delisting companies:

The Q2 (2^nd Quarter from July to Sept) is going to be termed as the season of “delisting” or “divesting” to the say the least. Not many among the investing community are aware that SEBI had way back in Aug. 2005 issued a dictum ordering listed companies (excluding Public Sector Units) to raise their non promoter shareholding to 25% i.e.: in other words where the promoter holding exceeds 75% for private sector companies, the promoter shareholding has to be brought down to within 75% levels and the time limit specified in the order was 2 years. Now we are almost nearing the expiry of two years by Aug.2007, therefore a lot of frenzied activity should be witnessed on the bourses over the next two months whereby companies falling within the ambit of the SEBI order will figure out ways and means to comply with the provisions contained therein.

There are only two options that such companies can explore namely:

Ø Delisting of securities from the bourses through the reverse book building mechanism

Ø Dilution of stake by offloading a portion of the stake through a follow on public issue or private placement with a PE investor

Lets examine the first option: Delisting of securities from the bourses

The SEBI guidelines for delisting of securities issued in 2003 provide for a minimum delisting price computed on the basis of an average of the 26-week high prices prior to the date of delisting. The company can also explore the reverse book building mechanism (used in buyback of shares) for price discovery and usually such price discovered is always at a steep premium to the prevailing market price. Even if the investor analyses the last 26-week highs of all these companies, he/ she will find that most of them have touched their lifetime highs in the last 6 months only and therefore the exit price will be quite close to their highs to make it attractive for investors to exit the counter.

The second option before the promoter is: Dilution of Promoter’s stake

Where the promoters/parent company want to continue the listing of the company and opt for diluting the stake, they will definitely want to get a better valuation for the shares they are disposing and in case of fundamentally strong companies with a good track record, PE investors and FII’s shall only be too willing to acquire a stake in these entities even if stakeholding comes at a high premium. Especially companies having 90% or more of promoter stake have to offload 15% to non-promoters and this if done to a single investor will also trigger an open offer at a high price to acquire additional shares in the company as per SEBI Guidelines.

A lot of these companies which are prospective delisting candidates have already been witness to hectic buying activity over the last 2 weeks indicating investor interest in the delisting process and the profit potential that’s waiting to be tapped therein. A number of fundamentally strong delisting candidates are trading at 20-30% below their all time highs and can be accumulated over the next one month on broad market declines.

A list of the probable delisting/stake sale counters where prominent activity may be witnessed in the coming days is being complied and will be forwarded shortly. These stocks should be accumulated with a short-term view as the movements in these counters are expected to be news driven and investors should book profits once the upside is noticed in these counters within the next couple of months. The base case assumption here is that SEBI shall not postpone the due date for compliance beyond Aug 2007. Investors in the mean time can visit NSE/BSE websites or other corporate databases to scout for companies that have a promoter shareholding of 75% and above.