Greater capacity, lower taxable income!

The Income-tax Act, 1961 (the I-T Act) turns the concept of economies of scale on its head when it attributes progressively lesser income for ships with greater capacity. For, economies of scale consist in exactly the opposite — greater profits with increase in capacity due to fixed costs remaining constant up to a capacity level. This concept is found all the more vindicated when a business has a very high operating leverage i.e. its fixed expenses considerably outweigh the variable expenses.

One thought shipping industry is one such but the presumptive tax scheme called tonnage tax in vogue since 2005 attributes lesser profits for additional capacities. To elaborate, a ship having a capacity of 1,000 tonne is deemed to have earned Rs 46 per every hundred tonne, with capacity exceeding 1,000 tonne but up to 10,000 tonnes Rs 460 plus Rs 35 for each 100 tonne in excess of 1,000 tonne, Rs 28 for each 100 tonne when the capacity crosses the 10,000 tonne mark but not the 25,000 mark and Rs 19 per 100 tonne for tonnages in excess of 25,000 tonne. To be sure, the tonnage tax scheme is not mandatory but optional, but one cannot choose the scheme partially for a few ships while choosing the regular scheme for other ships.

Harsh on small cos

Curiously the above scale of tonnage income prescribed by section 115VG of the extant law is sought to be carried forward as it is by the Direct Taxes Code 2. The lawmakers appear to have latched on to another hoary economic law - law of diminishing marginal returns, a theory that has considerable validity with reference to extraction and mining industries. But to extend it to ships seems to defy logic unless the lawmakers have fatalistically assumed that big vessels often go half empty. The scheme is certainly a disincentive for smaller vessels. If an Indian shipping company has got ten vessels with 1000 tonne each, it would be deemed to have earned Rs 4,600 per day from these ten vessels whereas if the entire capacity was built into a single vessel, the deemed profit per day would be Rs 3,610. And if it had gone for a still larger vessel, the deemed profit would have been still less.

Reward for giant capacities

If the thinking underpinning the above scale of shipping profits per day is indeed encouragement to bigger vessels and simplification of the taxation scheme, the experiment can be extended perhaps to all industries secularly both in the manufacturing and services sector wherever possible.

Firstly, it would give a huge leg-up to consolidation, often the most important objective of an M&A exercise. Giant capacities, apart from engendering the fear of an incipient monopoly, do result in cost reduction and more efficient utilisation of resources. Secondly, tax compliance and administration would cease to be adversarial once the true capacity of a factory is certified. Thirdly, if the presumptive profits are fixed leaving something on the table for the industry and it would most certainly gravitate towards the scheme.

In fact this is what Israel does by scientifically fixing the deemed profit for each industry thereby doing away with laborious assessment and the resultant bitterness inevitable in any adversarial proceeding. But it would be a tall order to a government which is finding it extremely difficult to market its original presumptive tax scheme – 8 per cent of turnover so long as it does not exceed Rs 60 lakh per annum (it was 5 per cent of turnover up to Rs 40 lakh till a few years ago). Of course, such a scheme applied on a wider front would call for a paradigm shift in policymaking. In such a milieu, the minimum tax on book profits would be out of place.

Progressive rates

If the government were to be guided by the credo greater the income, lesser the tax there would be a lot of adherents to it from the upper strata of the society and it may even prove to be the ultimate answer to the vexed problem of black money, but would certainly not go down well with political parties wooing the common folks. Indeed such an approach would invite instant opprobrium and castigation on the grounds of being elitist and pro-rich.

(The author is a Delhi-based chartered accountant.)

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