Why did many companies report a higher tax expense despite a reduction in the corporate tax rate?
In the quarter ended September 2019, Axis Bank reported a net loss of Rs 112 crore despite the fact that its operating profit (or profit before depreciation, interest expenses, and tax expenses) grew by 45 per cent to Rs 5952 crore compared to the same quarter previous year.
If operating profit was so high, why did the bank report a loss? It is because it reported a large tax expense. Take a look at Axis Bank's income statement pertaining to the September quarter of 2019 below:
The tax expense reported is Rs 2545.27 crore, which is significantly higher than Rs 708.1 crore reported during the June quarter of 2019 or Rs 377.01 crore reported during September quarter of the previous year (2018).
Given that the government reduced the corporate tax rate from 30 per cent to 22 per cent last year, reporting a higher tax expense sounds absurd, doesn't it?
Ideally, a reduction in corporate tax rate should lead to lower, not higher tax effective tax. What explains this anomaly?
Just like Axis Bank, several others reported higher tax expense (and therefore lower profit after tax and some even loss) despite generating good profit before taxes. IDFC Bank reported a loss of Rs 680 crore even as the profit before tax was Rs 100 crore. Yes Bank reported a loss of Rs 600.08 crore in the September quarter, a large part owing to the higher tax expense. GE Power reported a loss of Rs 22.32 crore owing to higher taxes.
Enter deferred tax assets.
The reason why the tax expenses of these companies increased in the September quarter despite the reduction in effective corporate tax rates by the government has to do with something called ‘the reversal of deferred tax assets’.
Scroll down to Note 5 of the income statement of Axis Bank and you'd notice this:
If this looks difficult to comprehend, don't worry. We will discuss what it means in simple terms below.
As an investor, when you study the quarterly or annual financial reports including the income statement, the balance sheet, and the cash flow statement, you must strive to understand each line item clearly. If a line item such as ‘deferred tax assets’ is abnormally high leading to lower profits, then it only makes sense that you must know what this means and why this is so.
What are deferred taxes?
Typically, a company has to deal with two separate income statements: One for financial purposes and another for tax purposes. The former is what you see in the company's annual or quarterly reports. They are prepared in accordance with the Companies Act. The latter (the one for taxation purposes) is prepared in accordance with the Income Tax Act.
The main difference between the two relates to what expenses are allowed under each of them as deduction from income in the current period. Remember, higher expenses lead to lower income and therefore lower taxes. Similarly, lower expenses lead to higher taxes in the current period.
For instance, the Income Tax Act limits the amount of bad debt expense (also called “provision for doubtful debts”) that can be recognised for tax computation purposes in a given year. This lower "provision for doubtful debts" expense leads to higher profits and therefore higher taxes during that year. Under the Companies Act, however, companies can report higher provision expenses, leading to lower profits and lower taxes in a given year.
The difference between the two amounts is a deferred tax asset. It is "deferred" because the difference is only temporary. The amount of deferred tax asset would be reversed in the future when the debt actually turns bad and is recognized as an expense in the income statement prepared for tax purposes.
Confused? Perhaps an example would help!
Consider a bank that reports a provision for doubtful debts of Rs 100 crore in its income statem