Small and medium-sized firms that undertake the bulk of actual manufacturing for large companies may now have to forgo a part of their revenues upfront as tax deducted at source 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 tax deducted at source (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 thus costs for actual producers, who in turn would pass on the burden to the outsourcers and, eventually, to final consumers in the form of higher prices.
A significant share of manufacturing in sectors like auto, FMCG, 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 ready-made garments outsource the actual manufacturing to smaller entities.
Large companies such as Hindustan Unilever and Procter & Gamble are extensive users of the outsourcing model, which allows them to lower costs and focus on marketing, distribution and brand building. Small and medium-sized firms that undertake work for large companies account for a quarter of the countrys manufacturing output, according to industry estimates.
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% to 5%. The governments 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 to pay TDS. Currently, 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 large-scale litigation, and allowed many companies to escape from paying TDS and even paying taxes, the 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 to deduct tax on the payment it makes. But, now the finance ministry wants to cover such transactions too, as most of such buyer and 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, 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 Ernst & Youngs Mr Singh.
The change was suggested by an expert group set by the Central Board of Direct Taxes (CBDT). 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 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 considered as a neat and efficient way of collecting taxes and establishing an audit trail is high on CBDTs 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.