Saturday, March 1, 2008

Budget Impact

This year’s budget, termed by the media as a populist one, has received mixed reactions from the corporate sector. At the same time, it has not gone well with the stock markets, which fell following the budget announcements.

The entire set of budget materials is available here. Now, we look at some of the key implications of the budget on the corporate sector as well as financial markets:

Corporate Sector

1. Corporate tax rates have been left untouched, although there were some predictions of a possible reduction in rates. Further, there has been no change in the rate of surcharge either.

2. Dividend distribution tax has been streamlined to benefit holding company structures. Hitherto, dividend distribution tax (DDT) was payable by a company that distributes dividend to its shareholders. Where a holding company or parent receives the dividend income from the subsidiary, and then distributes dividend to its shareholders from its profits, it has to pay DDT, which would include as a component the amount distributed that represents the dividend income it received from the subsidiary (that has already been taxed in the hands of the subsidiary). This caused multiple levels of taxation on the same income.

However, the budget seeks to remove this anomaly by allowing the parent to set off the dividend received from a subsidiary so long as the subsidiary has paid DDT, and the parent company is not a subsidiary of another company. In other words, set-off is available only to the ultimate holding company, and not to the intermediates ones in a multiple holding company structure.

Although at first blush this appears to be a beneficial provision, it does have its set of limitations. For instance, in a multilayered holding structure (which is quite typical in infrastructure, real estate, and other companies), the DDT set-off is available only to the ultimate holding company and not intermediate holding companies. Hence, the same income is subject to multiple levels of taxation at intermediate levels, thereby not failing to fully eliminate the double taxation problem. While the proposal encourages holding company structures, it limits tax benefits to single holding companies and not multilayered structures (which would still be tax inefficient).

Further, set off is available only to a “holding company”, implying that such company should either hold shares in excess of 50% in the subsidiary (from which it receives dividends) or should control the board of the subsidiary. If the recipient of the dividend is not a holding company (e.g. if it holds 49% shares), then the set-off is not available. Hence, this benefit would not be available in cases of joint venture and other strategic arrangements where parties may not establish a holding-company relationship.

3. Short term capital gains on sale of shares is increased from 10% to 15%, in an apparent move to encourage investors to stay invested in the longer term.

Financial Markets

1. Market for Corporate Bonds has witnessed further measures for expansion in this Budget. Exchange-traded currency and interest rate futures will be launched. A transparent credit derivatives market with appropriate safeguards will be introduced. Additional measures include the option in domestic convertible bonds of separating the embedded equity option from the bond and possibility of separate trading of the two instruments, and development of a market-based system for classifying financial instruments based on their complexity and implicit risks.

These efforts would make the Indian financial markets more robust and liquid. At the same time, since derivatives trading is inherently risky, the nature of the safeguards that will be put in place assume great importance.

On this point, Ajay Shah has an article in the Business Standard.

2. Permanent Account Number will be the sole identification for all participants in the securities markets, subject to appropriate thresholds.

3. Pan Indian Market for Securities is to be created with cooperation from states. This is essential because stamp duty (for issuance of shares and for transfer of debentures) falls within the domain of the state legislatures in accordance with the Constitution. As states enact differing rates of stamp duty on such transactions, it causes significant difficulty in easily executing stock and bond transactions where investors are located across the nation. Uniformity in stamp duty rates on securities markets is a welcome step as it would dispense would ambiguities in costs of such financial transactions. Further, it would also benefit state governments by doing away with the need for companies to resort to “location shopping” by executing transactions in stamp-duty friendly states.

4. Securities Transaction Tax will be allowed as a deductible expenditure against business income rather than only as a rebate against tax liability (which benefit was restrictive in nature). Further, securities transaction tax (STT) on options have been streamlined to deal with two situations, i.e. where the option is exercised, and where it is not.

5. Commodities Transaction Tax will be introduced on transactions in commodity futures on the same lines as STT on options and futures.

6. Tax Deduction at Source (TDS) will not apply to listed corporate bonds issued in demat form—another measure to boost the bond market.

Other Aspects

Certain additional services have been brought under the service tax net. These include, services provided by stock/commodity exchanges and clearing houses, and customized software, to bring it on par with packaged software and other IT services.

The Budget has been disappointing to the corporate sector on a few counts:

(a) REITs did not receive any attention in the Budget. This leaves taxation of REITs in doubt. As we have discussed earlier on this blog (here and here), the market for REITs is unlikely to receive any impetus unless there is clarification on aspects of their taxation.

(b) Software Technology Parks (STPs) that are entitled to tax holidays until March 31, 2009 have failed to obtain an extension of the holiday to subsequent years. This is despite strong please from the IT industry. Although tax holidays under the SEZ policy are available for future periods, it is difficult for most small and medium IT sector players that were beneficiaries of the STP scheme, to establish SEZs for all their projects and hence the IT sector is likely to be at a disadvantage due to this.

Finally, the Finance Minister has indicated the need to manage foreign capital flows more actively. He stated that the “Government will, in consultation with the RBI, continue to monitor the situation closely and take such temporary measures as may be necessary to moderate the capital flows consistent with the objective of monetary and financial stability.” This implies that the Government will maintain a keen eye on aspects like foreign direct investments (FDI), foreign institutional investors (FIIs), external commercial borrowings (ECBs), foreign currency convertible bonds (FCCBs) and similar schemes, and announcements may be expected from time to time on policies governing these aspects depending on the foreign exchange position as monitored by the Government and the RBI.

Overall, the Budget has not witnessed significant benefits being conferred on the corporate sector or financial markets, though there have been some areas of stimulus for growth. That perhaps explains the mixed reaction from corporates and the markets.

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