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Contract manufacturing to be taxed at source
August, 07th 2006
All contract manufacturing will be brought under the ambit of tax collection at source (TCS). The government proposes to amend the Income Tax Act to make it clear that outsourcing of any type of work, including manufacturing of goods as per the specifications given by the person responsible for paying the sum for outsourcing, will qualify for TCS. It will be collected at the rate of 2% of the payments value. The move may affect almost every company in the manufacturing sector, ranging from HLL, Ranbaxy, Maruti and even RIL. This is because most companies, in order to achieve economy in the cost of production, ask vendors to manufacture some segments of their products, according to standards set by them. According to a Federation of Indian Chambers of Commerce and Industry (Ficci) estimate, outsourcing comprises nearly a quarter of the entire manufacturing sectors output. When HLL, for example, buys soap manufactured according to its standard and specifications from Small Enterprise X worth Rs 10 lakh, it will add tax of 2%, to be passed on to the government as income-tax payment of Small Enterprise X. Small Enterprise X can later claim a refund or credit for this amount, when it files its tax returns. For the government, this will mean a spike in its advance tax collections. For the industry, it means an additional working capital load equivalent to the governments bumper harvest of taxes. If any of the sundry small enterprises contracting work from larger firms are not in the habit of paying income tax, TCS will mean a significant rise in their tax liability, and not just an increase in working capital needs. TCS is a method already employed by the government in sectors like liquor, timber and scrap. The bulk seller withholds tax from the buyer. Past attempts by the government to bring outsourced manufacturing within the ambit of TCS, governed by Section 194C of the Income Tax Act 1961 have been foiled by the Income Tax Appellate Tribunal and the New Delhi High Court. Manufacturers had successfully pressed their case that such deals were purchase and sales contracts and not works contracts. The governments point is that these products are made as per the specifications of the company, which owns the brand or is sourcing the products. Both, the company sourcing the product and the one buying it enter into a contract for a fixed number. And if the party, which supplies the products makes anything extra or not as per specification, it is legally bound by the contract to destroy the surplus/reject and cannot sell it in open market. Also the maximum retail price is often printed on the products as per the directions of the deductor companies, which proves that it is often an exclusive contract and not a simple buy and sell operation. Section 194C will, thus, be amended to explicitly include outsourcing into TCS ambit on payments to contractors and sub-contractors. Commenting on the move, Rahul Garg, executive director, PricewaterhouseCoopers said it will be a retrograde step. There will hardly be any addition to the revenue as it is a refundable tax, but it will hit the stretched working capital conditions, under which most companies operate, he said. There might be no net loss for the firms, but the governments advance tax kitty will certainly get a boost, said Mukesh Butani, partner, BMR & Associates. The proposed 2% tax might seem small, but only superficially. The value added in a manufacturing outsourcing contract might not exceed 10% of the value of the contract. In that case, the tax would be 20% of the value added, and a much higher proportion of the net profits liable to taxation.
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