for large companies may now have to forego a part of their revenues upfront
as tax deducted at source (TDS) under new rules being considered by the
government to widen the tax net and make revenue collections more efficient.
The government is proposing changes to tax laws that will mandate
companies outsourcing manufacturing work to smaller producers to deduct a 2%
tax on the order value while making payments, a finance ministry official
said.
This TDS will be adjusted against actual tax dues at the time these
firms pay advance taxes or file annual tax returns. The move would, at the
very least, raise working capital requirements and, therefore, costs for the
actual producers, who in turn would pass on the burden to the outsourcers,
and eventually to the final consumers in the form of higher prices.
"A significant share of manufacturing in sectors like auto, fast-moving
consumer goods (FMCG) and pharma is outsourced. Implications of such a move
will be huge on the cash flow of these companies as most operate on thin
margins," said Amitabh Singh, partner at accounting firm Ernst & Young.
Manufacturers in sectors such as FMCG, consumer electronics,
automobiles, pharmaceuticals and readymade garments outsource the actual
manufacturing to smaller entities. Large companies such as Hindustan
Unilever (HUL) and Procter & Gamble (P&G) are extensive users of the
outsourcing model, which allows them to lower costs and focus on marketing,
distribution and brand building. Small and mediumsized firms that undertake
work for large companies account for a quarter of the country's
manufacturing output, according to industry estimates. Move to have wide
impact
WHILE the 2% tax deduction might seem nominal, the actual effect would
be anything but small, given that small producers typically work on margins
of 4-5%. The government's proposed move is aimed at bringing contract
manufacturing deals under the scrutiny of the income-tax department and
thereby widening the tax net. A large number of outsourcing agreements
escape the tax net as they are currently treated as buyer-seller agreements.
The income-tax department now wants to treat these deals as 'work
contracts', which will make them liable for TDS. Presently, if a company
outsources manufacturing of a complete product, it is not covered by TDS,
whereas tax would be cut at source if it outsources only a part of the
manufacturing. This ambiguity in the law has led to confusion and largescale
litigation, and allowed many companies to escape TDS and even taxation
altogether, the tax department suspects. For example, at present, if a shirt
manufacturer buys shirts from another contract maker and puts only its brand
name, the company does not need deduct tax on the payment it makes. But, now
the finance ministry wants to cover such transactions too, as most of such
buyer-seller agreements are actually work contracts wherein one large
manufacturer gives specifications of the product to a smaller manufacturer.
In some cases, the smaller contract manufacturer is also bound to
destroy the product if it manufactures more than the specified number of
items or does not follow prescribed specifications.
In sectors such as automobiles, vehicle manufacturers and component
makers have a very active exchange of ideas on design and specifications of
parts, distinguishing them clearly from pure buyer-seller deals.
Upfront tax deductions on payments to contractors and sub-contractors
are covered by Section 194C of the Income-Tax Act of 1961. According to this
provision, the entity outsourcing a works contract is required "to deduct 2%
of the amount paid to in lieu of the contract". The proposed rule changes
seek to clear the air to cover even such contract manufacturing deals and
give ready revenue to the government.
"The controversy on contract manufacturing covered under 194C has been
raging for sometime. Probably, the income-tax department now wants to settle
the issue as also garner more resources though TDS," said Mr Singh at E &Y.
The change was suggested by an expert group set by the CBDT and is now
under active consideration. A finance ministry official said the I-T
department was examining whether the change would require an amendment to
the income-tax Act or could be clarified through a circular.
While any change in the I-T Act will have to await the next Budget, a
circular can be issued any time. A final call on the issue is expected to be
taken shortly, said the finance ministry official, who did not wish to be
named. Mr Singh, however said that in such a non-beneficial move, an
amendment to the I-T Act would be more suitable as it would settle the law.
Expansion of TDS, which is considered a neat and efficient way of
collecting taxes and establishing an audit trail is high on the CBDT's
agenda. In fact, the board, recently established a dedicated directorate to
monitor TDS.
However, the proposal is expected to leave contract manufacturers
unhappy. Although the TDS will ultimately be adjusted against final tax
payments, the working capital requirement of these firms could go up as they
will receive less payment upfront. Besides, small companies not currently in
the tax net could see their paper work increase if they have to claim
refunds.