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Kelkar Plan: Depreciation is not evasion

Ashok V Desai

People's income represents the accretion to their purchasing power - and hence their power to enjoy themselves - in the year.

It seems fair that those who can enjoy themselves more should sacrifice more to keep the government running; that is the case for progression. But people may earn money, which they cannot use to enjoy themselves - for instance, they may have to buy materials, or employ people, or go and see their clients.

The expenses incurred to earn the income should obviously be deducted before the income is taxed. Hence in the case of producers or value adders, taxable income is the difference between revenue and essential expenses, or profit.

Should that profit be taxed in the hands of businesses or in those of their owners? Ideally in the latter's hands. But if it is not distributed to them, they will have to pay tax on income they did not receive, and may run short of cash. Hence it has to be taxed in the hands of businesses.

If expenses are not taxed, a business will have an incentive to maximise expenses, and its owners to pass off expenses on things that they enjoy as expenses of the business.

So once a tax on businesses is introduced that is separate from the tax on individuals, revenue authorities have to keep making judgments on (a) whether an entity is a person or a business, and (b) if it is a business, whether it is trying to pass off a personal expense as a business expense.

It was (a) that exercised my colleague TCA Srinivasa-Raghavan no end some weeks ago: he felt that people like him were passing themselves off as businesses, and that the revenue authorities were allowing them expenses on the basis of a standard ratio that was too high - and thereby giving all persons an incentive to pass themselves off as businesses.

I think the answer to this is that even persons that are not businesses should be allowed to charge expenses that are essential to earning their livelihood. The number of individual taxpayers is so high that checking their expenses would require the employment of a huge tax collector base.

Hence it is necessary to adopt a rule of thumb. This is the rationale of the standard deduction for employed people, which the Kelkar Task Force on Direct Taxes has erroneously recommended the abolition of.

But the standard deduction should not be a constant amount; it should be proportional to income. That the CBDT should allow a similar, informal standard expense ratio for small businesses seems to me to be a just approximation.

The other problem, that expenses should be passed on to businesses, is bound to arise if the tax rate on the beneficiary is higher than on the business. If the personal tax rate exceeds the business tax rate, the owner of a business will save tax by passing off his own expenses as the businesses.

This is why the business tax rate should be the same as the peak personal tax rate - as the TFDT has recommended.

But equalising the two tax rates will still not remove the incentive for a business to spend as much as possible and not make any taxable profits at all. Tax authorities have to monitor and police such tendencies.

It is actually done by means of extremely detailed rules about allowable expenses, and is mired by intricate lawsuits and court decisions. The income tax officer also exercises considerable discretion. This is why jobs on the corporation tax side are prized by income tax officers.

It is this jungle of rules, judgments and discretion that the TFDT should have looked at. It had neither the time nor the expertise to do so. So it has followed Kelkar's mega-principle and looked for exemptions to abolish; for the rest it has advanced certain proposals pressed upon it by the tax authorities.

It says that "the erosion in the tax base is evidenced by the divergence between the statutory corporate tax rate and the effective tax rate… the effective tax rate of a sample of 2585 companies in 2000-01 was 21.9 per cent as against the statutory rate of 39.55 per cent. This is in spite of the provisions of Minimum Alternate Tax which is, in itself, a sore point with trade and industry."

Being an official report, it never cites sources; but the presence of Ajay Shah in the ministry makes it pretty certain that the figures came from the CMIE database. But then, Ajay Shah should in fairness have told the TFDT precisely how the difference between 21.9 and 39.55 per cent arose.

It arises almost entirely because of the fact that expenditure on fixed assets - buildings, plant, machinery etc - is lumpy and the accounting practice is to charge that expenditure, not against the profits in the year in which it was incurred, but in a series of years on a declining balance or a straight-line basis.

Tax authorities accept this practice. But the speed at which the assets are depreciated affects the time pattern of the revenue: the faster they are depreciated, the more unstable the revenue.

So the tax authorities lay down very, very slow allowable rates of depreciation. But even with these allowable rates, in years of low capital expenditure, such as recent years have been, the actual tax rate will be lower than the maximum.

This is the cause of the difference between 12.9 and 39.55 per cent, not some jiggerypokery by companies.

But for a business, depreciation is just a form of reserve, or accumulated profit; if it is making big profits it may want to write off its fixed assets faster. It can thereby retain more profits, reinvest them, build up its assets faster, and get an edge against competition.

This is a perfectly legitimate practice. Professional audit regulators lay down good practice in this regard; companies may follow it, or be more conservative.

The TFDT wants to ban such discretion: it wants to impose the depreciation rates laid down in the Companies Act, and wants to put a ban on companies charging any other rate. This is completely wrong-headed; a company must have the right to dispose of its gross profits in any way it likes.

If that confuses the tax authorities, it is only because of their laziness or incompetence. In these days of computers, it is most easy to convert the basis on which accounts are maintained; all that the tax authorities are entitled to do is to insist that companies keep two sets of accounts, their own and one for the tax authorities, and explain the difference between the two.

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