The proposed TDS increase for professional fees from 5 per cent to 10 per cent in the recent Budget is a retrograde step, which may worsen the cash-flows of firms rendering professional services, especially those that are cash-strapped or in turnaround mode.

The TDS hike will affect different firms differently. For instance, for a professional services firm running a highly profitable service, with no tax planning to speak of, the impact would be only marginal. However, the TDS unfairly burdens even the profitable firm as compared to advance tax. Say, on April 30, the firm receives payment for work completed in early April.

The firm will receive only 90 per cent of the contract value as 10 per cent TDS is deducted upfront. If there were no TDS provisions, the firm would pay advance tax only in September (non-corporate).

A rate of 10 per cent for TDS means the tax component on the profits expected is Rs 10 on a contract of Rs 100. At a tax rate of 30 per cent, that translates into a net profit margin of 33.33 per cent. In how many businesses is the profitability so high that the tax applied on such profits works out to 10? Further, TDS is on the gross amount billed, inclusive of service tax and education cess. Hence, effectively, the firm's gross billing approximates to Rs 112.36 and the TDS becomes Rs 11.24.

The cash-flow implications for a marginally profitable enterprise or one that is currently running at a deficit can easily be imagined. To this extent, TDS provisions pose a serious threat to a firm's cash-flows.

Effect on Cash-flow

The timing difference between tax withheld from service payments and advance tax dues might not be a serious issue if the self-assessment and consequent advance tax that would have been paid match the recoveries by way of TDS. But when cumulatively TDS starts exceeding the advance tax components, the firm's cash-flow takes a beating. In most cases the only recourse is to await the income-tax refund.

Till the refund is obtained, the firm incurs interest cost on the incremental amount paid as TDS, which would be non-existent had there been no TDS provisions.

The shoe pinches hard for four categories: i) Unprofitable professional firms, ii) Professional firms that, though not loss-making now, are yet to come out of the red iii) moderately profitable firms receiving sizeable portion of the contract value as advance from customers, and iv) firms whose businesses exhibit intra-year volatility.

The TDS provisions would hit them as their real tax liability would be either zero or very low, in contrast to the amount of tax deducted. The cash-flow impact could translate into external borrowings which, in turn, lead to high interest expenses and reduced profits. Being firms with marginal profitability, they may not even enjoy significant credit limits from banks.

There are provisions in the tax laws that provide for an application to the tax authorities for deduction at lower rates or nil deduction for loss-making units, but in practice they do not work. The decision is `at the discretion of the Officer', effectively meaning that no Officer would stick his neck out to grant a reduced rate.

The process could also be time-consuming, defeating the spirit of granting a reduction. Besides, the logistics of securing such relief is also beyond the scope of most self-employed professionals managing a modest services operation.

The increase in TDS from 5 per cent to 10 per cent is thus uncalled for. When the Government has vested in itself the right to appropriate corporate profits through the medium of advance tax, there is no rationale in enhancing the TDS.

The conscious focus of the Government may be to target firms that do not disclose incomes and, therefore, do not pay tax. The TDS route may indirectly force these firms to pay tax. Chances are these firms may be ready to even forego the TDS amount rather than become income-tax assessees. But the tactics applied to such units can never warrant making a generalisation.

Why tinker with TDS?

Advance tax collections are at an all-time high and the Department is overshooting its target of Rs 2,10,000 crore in 2006-07. The Government's Ways and Means position is luxurious. Enjoying tax revenues much in advance of the year-end has already become an integral part of the taxation structure. Why tinker with TDS rates then? This is a step that may even impact entrepreneurship in the medium term.

If at all TDS rates have to be increased, the move must be accompanied by all or some of the following: i) encouraging banks to consider financing a part of the tax refund claimed as `receivables', ii) allowing non-deduction of tax on strength of self-declaration by firms to client companies that there is no expected tax liability at year-end, and iii) client companies to deduct tax at the effective rate, arrived at by dividing `actual' tax paid by the professional services firm in the last assessment year divided by its sales turnover, to be certified by a practising chartered accountant. Thus the rate need not be rigid at 10 per cent of the contract value.

Except in the case of owner-dominated firms or firms where most skills are contributed by the owner, where the firm's net profit to sales could be abnormally high, the proposed hike in TDS rates could slam the brakes on up and coming firms. The steps suggested above would considerably mitigate hardship to a major segment of professionals without in any way affecting the Government coffers.

Suresh S.
(The author is Director, DMS Financial Services Pvt Ltd., and visiting faculty at IIMs.)