Alignment of Corporation taxation Research Paper June 2013
In the international scenario, the corporate tax system is based on the following three regimes: 1) flat tax rate over all companies, 2) tax rate based on income generation and 3) tax rate based on sectors. While most developed countries implement the first two regimes, developing ones opt for the third regime, where the financial sector is charged a higher tax rate.
Bangladesh
charges 42.5% to banks, insurance companies and other financial institutions, while the corporate tax rate for other institutions is 27.5%. The reason for charging an even higher rate for BFIs and insurance companies is that it is a supplement regulation for this sector, as it deals with social capital and also to add to the government revenues.
Brazil has also always been known for its high tax burden. The reason for higher tax rates in Brazil is that the country lacks institutional stability in terms of educational, medical institutions, law enforcement agencies and other institutions. The government needs resources for such development and also to bring about social inclusion.
Inside this issue:
Alignment of Corporation taxation rates
Disparity in Tax Rate Refuted by the Financial Sector
Role of the Nepal Business Forum
Higher Tax Rate Rationalized through the Protection provided to the Sector
Reduction in Corporate Tax Rate will Widen Budget Deficit
Reform in the Taxation System
Alignment of Corporation taxation rates The Inland Revenue Department of Nepal charges taxes on business income, employment income, and investment income and windfall gains. All corporations conducting trade, profession or business in Nepal are liable to pay corporate taxes on the profits incurred. The corporate taxation system in Nepal differentiates between the rates charged to banks, financial institutions (BFIs), insurance companies and the rest of the corporations. While the former is charged at a rate of 30%, the latter is charged at 25%. Disagreeing with the differential taxation system the financial sector put forth this issue in the Financial, Monetary and Insurance Affairs Working Group of the Nepal Business Forum.
Inland Revenue Department
Disparity in Tax Rate Refuted by the Financial Sector In Nepal, BFIs and insurance companies are compulsorily listed on the stock exchange. A capital market listing automatically translates to stricter adherence, thereby ensuring transparency and accountability. Going by international practices in Thailand and Kenya, the tax system is altered in a way to incentivize companies to go for listing. However, this is not the case in Nepal. The non financial sector is already charged at a lower corporate tax rate, and so will not be motivated to be a part of the capital market as there are additional compliance issues. As a result, the capital market is heavily dominated by BFIs and insurance companies; approximately 86% of the listed companies at the Nepal Stock Exchange comprise of BFIs (76.8%) and insurance companies (9.2%). The whole corporate tax issue has become so intertwined that on one hand the capital market will continue to be highly dominated by BFIs and insurance companies, and on the other hand, the transparency and corporate governance of the non financial sector will remain questionable. In addition to the higher levels of transparency, accountability and assurance as compared to other sectors, BFIs are contributed a significant proportion of taxes and are included among the large tax payers in Nepal. Nonetheless, this sector deals with the social capital of the general public, which thereby entails a tighter regulation of the sector. Therefore, apart from being a major source of revenue to the government, the government justifies a higher tax rate as a control measure to keep a check of risky behavior which could reduce the possibility of future crises. However, BFIs and insurance companies have the perception that there is no rational justification behind the imposition of a higher tax rate by the government. They feel that the government is trying to collect additional taxes from this sector rather than trying to bring new sectors or segment within its tax parameters.
Role of the Nepal Business Forum The Nepal Business Forum through its Financial, Monetary and Insurance Affairs Working Group raised this issue as a differential treatment to the Banking and Insurance sector on the meetings held on 30 May, 2011 and 6 June, 2011. They raised the need to align the corporate tax rate amongst all sectors. As per the decision of the Working Group, the Nepal Rastra Bank (NRB) took the initiative and submitted certain recommendations to the Ministry of Finance (MoF) to reduce the corporate tax rate and bring it at par with the rates for the non financial sector. The advise was forwarded to the Ministry of Finance since fixation of corporate tax rates does not fall under the purview of NRB, and is yet to be implemented given the rationality behind the proposal.
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Alignment of Corporation taxation rates
Higher Tax Rate Rationalized through the Protection provided to the Sector
To be finalized
The banking sector can be seen a safeguarded sector due to the entry barriers in place. The licensing policy for BFIs is strong and capital requirements are high, because of which only capacitated individuals can enter the industry. At present, licensing has also been completely halted for A, B and C class financial institutions. Foreign investments are also only allowed in the form of a joint venture. As a result, BFIs have emerged as one of the more lucrative industries despite a sluggish economic growth. The cumulated average
growth (CAGR) of profits of the banking sector for the past years stands at 22.8%. Therefore, in return for the safeguarding of the sector, a higher tax rate can be justified. Another reason for higher profitability of the banking sector can be attributed to the conservative lending rates it provides. In the absence of measures in place to control the fluctuation in interest rates, BFIs have been charging higher interest rates on the loans they extend. During the acute liquidity crisis in 2010, the av-
erage lending rates on overdraft loans went up to a rate as high as 18%. Such a practice helps the banking sector maintain their profits at a healthy level but in turn affects the profitability of other sectors. Since the growth of other sectors depends on the availability of cheap finance, when the contrary is taking place, the profitability of other sectors get impacted. Therefore, by this logic the additional 5% tax rate on the financial sector compensates for the low tax revenues from the non financial sector.
Reduction in Corporate Tax Rate will Widen Budget Deficit Tax parity can be brought about by either increasing the corporate tax rate for the non financial sector, or reducing the tax rate of the banking sector. However, increasing the tax rate of the non financial sector would face resistance non BFIs, their business forums and small corporations, therefore if a parity is brought about it will be through the reduction of the tax rate of the banking sector. On an average over the past five years, only 67% of the total government expenditure is met by internally generating revenue, both tax and non tax; foreign grants cover 13% on an average. For the remaining 20%, the government is dependent on foreign loans and internal borrowing. While the compounded annual growth rate (CAGR) for tax and non tax revenue stands at 23%, the CAGR for foreign grants stands at 31%. Over the past five years the percentage of tax and non tax revenue to expenditure has increased from 66% to 68%; while the percentage of foreign grants to expenditure has increased from 12% to 16%. This shows that the dependence on foreign grants is increasing over the years, in absolute terms and also in percentage terms.
A reduction in the corporate tax rates of the financial sector will have the following macro economic impacts on the economy.
Decrease in corporate tax revenue for the government: Going by past figures, the financial sector contributed significantly to the corporate tax revenues of the government. If the reduction in tax rate is taken into account, the corporate tax revenue for the government will reduce by NPR 2.7 billion every year on an average. (Amount in ‘000s)
Corporate Tax Collection in Two Scenarios Corporate Tax
FY 2012/13
Scenario 1: Corporate Tax @ 30% BFIs 8,036,505
FY 2013/14
FY 2014/15
FY 2015/16
FY 2016/17
8,691,028
9,472,412
10,418,296
11,578,560
Insurance Companies
3,624,882
4,738,107
6,193,211
8,095,187
10,581,272
Total
11,661,387
13,429,136
15,665,623
18,513,483
22,159,832
7,242,524
7,893,676
8,681,913
9,648,800
3,020,735
3,948,423
5,161,009
6,745,989
8,817,727
9,736,529
11,212,489
13,079,816
15,457,601
18,502,074
Scenario 2: Corporate Tax @ 25% BFIs 6,697,087 Insurance Companies Total
Research Paper
Increase in Dividend Tax: A reduction in corporate taxes will have a positive impact on the profitability of the financial sector which will lead to increased dividend distribution. The taxes applicable on dividends distributed will thereby add back to the revenues lost from the tax rate reduction. On an average, the incremental dividend tax per year amounts to NPR 26 million. A subsequent increase in profitability of the financial sector due to reduced tax rates can
Overall impact, deficit widened: While there would be a certain amount of taxes generated through the reduced rates, the overall impact on the budget would still be a negative one, as the increase in dividend tax would not match the decrease in corporate taxes. While in the first year, the budget deficit would increase by NPR 1.9 billion, by the fifth year, this deficit would have widened to NPR 3.6 billion. This is because the growth of tax and non tax revenue has been slower than the growth in expenditure of the government. Even without the decrease in corporate tax rate, the dependence
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Increased Dividend Distribution when corporate tax is reduced
Amount in ‘000s
Particulars
FY 2012/13
FY 2013/14
FY 2014/15
FY 2015/16
FY 2016/17
Increased Dividend Distribution
374,136
430,851
502,605
593,974
710,961
Dividend Tax
18,707
21,543
25,130
29,699
35,548
also lead to increased investment. Investment in other sectors might lead to generation of taxes from other sources. However, this is conditioned on the financial sector
making further productive investments; and even if this is done, there will be a gestation period, meaning the current needs of the government will not be addressed immediately.
Difference in Overall Tax Collection in Two Scenarios ParticuFY FY FY lars 2012/13 2013/14 2014/15 Scenario 1: Corporate Tax @ 30% Corpo11,661,387 13,429,136 15,665,623 rate Tax Scenario 2: Corporate Tax @ 25% Dividend 18,707 21,543 Tax Corpo9,736,529 11,212,489 rate tax Reduction in Revenue
(1,924,858)
(2,216,647)
on foreign grants and loans has been increasing over the past few years. A slash in the corporate tax rates will further bloat up the dependency of the government foreign grants and
25,130
(Amount in ‘000s) FY FY 2015/16 2016/17 18,513,483
22,159,832
29,699
35,548
15,457,601
18,502,074
(3,055,882)
(3,657,757)
13,079,816 (2,585,807)
loans which is not an ideal scenario. Therefore, unless the government locates alternate sources of revenue, the reduction in tax rates will be less likely.
Reform in the Taxation System Considering the given scenario, and impact on the government brought about by a tax parity, the following approach can be taken for the future. Given the current taxation system, that puts listed companies at a disadvantage by charging higher corporate tax rates, there is need for a complete overhaul of the taxation system. Only a decrease in the tax
rates for the financial sector cannot be justified based on the needs of the government. With the status quo situation, financial institutions can avail additional services on account of being charged her tax rate. For example, a bail-out fund can be created with the revenues from the additional tax increment. Similarly, deposit insurance for development
banks and finance companies can also be initiated. In time, the maximum amount of deposit insured can be increased. Nonetheless, if the financial sector is insistent on reducing their corporate tax rates, they must conduct an in depth analysis on how they would utilize the increased profits to increase investments. Recommendations backed by such a
study will help show the government how such an alteration will lead to development in other sectors, impact on the government revenue and other alternative sources, through which the reduced revenue can be compensated, will help make their claims stronger and will be taken as a case in point for private sector led development.
Breakdown on Government Revenue Impact on Various Ratios as a Result of Corporate Tax Rate Reduction Particulars
Amount in NPR billions
Particulars
FY 2006-07
FY 2007-08
FY 200910 259.69
FY 2010-11
CAGR
161.35
FY 200809 219.66
Total Expenditure
133.6
295.36
21.9%
22.8%
Past Five Year Average 55.62%
Future Five Year Average without Tax Change 57.93%
Future Five Year Average with Tax Change 57.93%
Foreign Grant to Expenditure
13.34%
20.45%
20.45%
Tax & Non Tax Revenue
87.78
107.62
143.47
179.85
199.82
Deficit to Expenditure
-19.72%
-9.78%
-10.19%
In % of total expenditure
65.7%
66.7%
65.3%
69.3%
67.7%
Revenue to GDP
11.56%
14.71%
14.71%
Budget Deficit to GDP
-4.07%
-2.44%
-2.55%
Total Foreign Grant
15.76
20.33
26.36
38.43
45.78
In % of total expenditure
11.8%
12.6%
12.0%
14.8%
15.5%
Total Revenue
103.54
127.95
169.83
218.28
245.60
24.1%
Deficit (in Amount)
30.06
33.40
49.83
41.41
49.76
13.4%
In Percentage
22.5%
20.7%
22.7%
15.9%
16.8%
Tax Revenue to Expenditure
This research note was commissioned by the Nepal Business Forum and undertaken by beed Pvt Management (beed), as part of a series of papers to provide independent analysis and background information on selected issues raised by the working groups of the Nepal Business Forum. The views expressed are those of beed, and do not necessarily represent the views of the Nepal Business Forum.
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