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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 statement that is prepared as per the Company Act. Assume that after deducting this expense, the profit before tax comes to Rs 1000 crore as shown in the hypothetical income statement below.

The Income Tax Act, however, may not allow the entire amount of "provision for doubtful debts" to be recognized as expense for the calculation of tax. Why would that be? The logic, I believe, is this item is only a “provision” for the debt that the company believes may not be repaid by its debtor.

In other words, there may still be a probability that the loan could be repaid (fully or in part), though at a later date, as the bank continues to follow up with recovery from the debtor.

Think of it this way: What happens if the entire provision expense of Rs 100 crore is allowed to be deducted for tax purposes? It would result in lower profits and therefore lower tax revenues for the tax authorities in the current year, isn’t it?

This, even though the debts have not yet turned bad. The bank has only made provisions because it thinks the debts will turn bad in future.

Assume that the provision expense that is allowed for tax purposes, as per the Income Tax Act, comes out to be only Rs 30 crore rather than Rs 100 crore (this is our assumption). This would imply that the company would still have to pay income tax on the remaining Rs 70 crores of income. At 30% tax rate, the tax would come out to be Rs 21 crore.

See the table below to understand this better:

Notice that the provision for doubtful debts is lower in the income statement for tax purposes (again, we are assuming this for our example). This would lead to higher pretax profit and therefore a higher tax expense of Rs 321 crore compared to Rs 300 crore earlier.

In the two tables above, notice the difference in taxes reported for financial purposes and for tax purposes. The tax expense reported for tax purposes is Rs 321 crore (or 30% of pretax income of Rs 1070 crore). The tax expense reported for financial purposes is Rs 300 crore (or 30% of Rs 1000 crore).

This difference of Rs 21 crore is reported as a ‘deferred tax asset’ under the asset section of the balance sheet. How does our hypothetical balance sheet look? Let's assume that our hypothetical balance sheet has property, plant and equipment of Rs 100 crore (under assets), and loans worth Rs 100 crore (under liabilities and equity).

This rather simplistic balance sheet, after adding deferred tax asset worth Rs 21 crore as discussed above, looks like this:

Deferred tax is an asset because we are paying excess tax in the current year than what is reported in the income statement. The addition of deferred tax in the income statement in turn flows into equity (addition) under ‘liabilities and equity’ side of the balance sheet in the form of retained earnings.

Now look at the right side of the balance sheet. There is also equity (which is retained earnings) of Rs 21 crore. Where did this come from?

It flowed from the income statement! The deferred tax of Rs 21 crore is reduced from tax expense, thereby increasing the profits as shown below. Why is it reduced? Because it is the portion of the tax expense that is paid during the current year (as per the income statement for tax purposes).

This impact of an increase of profit by Rs 21 crore in turn shows up as retained earnings under the equity section of the balance sheet as shown above.

This makes the balance sheet tally. The asset side increases by Rs 21 crore (deferred tax asset) and the liabilities and equities side increases by Rs 21 crore (as profits are reinvested into the business).

Remember that deferred tax assets are reversible

Later on, when the debts actually turn bad, the deferred tax asset of Rs 21 crore is removed (or reversed) from the asset side of the balance sheet and the amount is deducted the income statement as well (by adding it to the tax expense).

Thus, the asset side reduces by Rs 21 crore, and the ‘liabilities and equities’ side also reduces by Rs 21 crore (higher tax expense leads to lower profits, which leads to lower retained earnings and therefore lower equity).

For tax purposes, this bad debt of Rs 21 crore, which was not allowed to be deducted earlier, is now allowed (since the debt has actually turned bad). This leads to lower profits and thus lower taxes.

To summarize, any addition to the deferred tax asset under the asset side of the balance sheet is added to profits (by reducing tax expense), and any reduction in deferred tax asset is reduced from the profits (by increasing tax expense).

Now… many banks had created large deferred tax asset balances on the asset side of their balance sheet in the previous years. They did this by increasing provisions for doubtful debts.

But since such large provisions were not allowed for tax purposes, it led to higher profits and therefore higher taxes for banks in the previous years.

Now, when the corporate tax rates were reduced from 30 per cent to 22 per cent, the banks realized that they would not be able to remove a portion (30-22 = 8 %) of the deferred tax asset in the future, when debts do turn bad.

Thus, they removed it in the September quarter. In our example, the bank would have to reduce the deferred tax asset balance by 8% of Rs 21 crore or Rs 1.68 crore.

This, as mentioned previously, would also be recorded as an addition to the tax expense in that period, thus reducing the profits and retained earnings and equity by Rs 1.68 crore.

This explains why several companies reported (one-time) tax losses despite a reduction in corporate tax rates. Going forward, however, these companies may benefit from the reduced tax rates as there would be no further impact of deferred tax assets.

What does this mean for investors?

When considering the company's performance, many anaylsts remove the effect of the one-time tax increase (on account of the deferred tax adjustment) from their net profit calculations.

This is understandable, since deferred tax expenses do not impact the actual cash flow. They are non-cash transactions! Removing the effect of deferred tax expense from the income statement improves comparability -- it is easier to compare the financials with previous years or with peers in the industry -- and gives a better picture of the financial position of the company.

If, after excluding the impact of the one-time deferred tax expense, the profits and cash flows show a reasonable increase year on year, then it is a good sign.

Questions or doubts? Comment below!

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