Friday, April 25, 2003

Impact of the 2003/2004 Budget on Companies’ Profitability

Now that the new tax package has been announced, it is time for companies to examine its impact on their operations. The question is, “What are the additional costs of operations and how attractive are the investment options?” The measures that will affect most companies are:
· 4% cess on imports;
· 20% GCT on telephone charges;
· Assets tax increase and
· Removal of tax credit on bonus shares

Cess and Telephone Tax
The Minister of Finance in his presentation stated that, “From the perspective of the importer who systematically files returns, this cess would have minimal impact, only so far as it affects his cash flow.” What companies will need to examine are the various effects that this will have on their operations, as the cost of money differs between companies. Whatever the extent of the impact, it is certain to be negative.

The Minister is correct in saying that the measures will affect cash flow. The effect on cash flow and, ultimately, operations could be devastating. The table below shows a typical company, with revenue of $100 per month, a cost of sale of 50% and other costs of 40%. It further assumes that this company invests approximately $200 every quarter in capital goods, imports 80% of cost of sales and has telephone expenses of 2%. The imposition of the 4% cess and additional 5% GCT on telephone charges will reduce this company’s net cash flow position by more than half.

This may be seen as a timing difference as the tax can be recouped in the tax returns at the end of the year and the GCT is reclaimable the following month, but the implications are much greater. Effectively, the company’s cost of capital has increased and a comparison must be made against other investment options. If the company is unable to claim the tax until the following year (for whatever reason) then the additional cost of capital will be approximately 5%. The recent press conference by the Minister suggests that companies will be able to claim this against quarterly filings, which is good, but what of the companies who are carrying forward a tax loss. They will be left with the additional cost of capital and ironically they are the ones who will need the cash flow most.

In our present environment, it would be better to take the additional cash and invest it in bank deposits making 30% before tax. In a rational economic environment, the company would reduce (or eliminate) the quarterly investments in capital goods and place that additional cash in relatively risk-free cash deposits, based on current rates. The implication for the economy is that we may have reducing long-term investments, as companies may only keep cash for working capital purposes. Furthermore, when it comes to retooling, the rational investment decision may be not to reinvest.

The new tax measures, therefore, is not simply a matter of cash flow but becomes a matter of capital and investment decision. What has effectively happened is that the Government will receive a loan to be financed by the private sector, which will be paid back at the time of the tax returns being filed. If we follow the 70:30 ratios, this means that the government will have to raise funds to replace the 70% of tax collections at the time of the returns being made.
The argument put forward by the Minister is that “…of the real economy only 70 per cent of activities are included in the tax net. All are agreed that we must seek to bring this additional 30 per cent into the tax net.” No one will disagree with the intention, but the method seems to create more problems than it will solve. Why stifle the 70% to get at the 30%? What may happen is that the 30% will be brought in at a cost greater than the additional collections, as many companies will not be able to afford an additional 5% on their cost of capital and there will be reduced capital investments.

In addition, new entrants to the market may be even further restricted. It might have been a better solution to increase General Consumption Tax (GCT) and eliminate income tax, as we would achieve the purpose of capturing more of the informal economy and equating the tax burden for the existing taxpayers, as was suggested at the ICAJ forum on April 9th.

These measures are also going to increase the tax burden on the current PAYE taxpayers. Companies may have to increase prices to deal with the increased cost of capital and increased GCT, which will negatively impact consumers. We will, therefore, see a direct impact on inflation from the tax measures announced. The combined factors of reduced investment and increased inflation may in turn have the undesired effect of reducing consumption and economic activity, thereby reducing future tax collections.
It is evident from the reaction of private sector leaders that the confidence needed to drive the economy forward is being eroded. What has been presented are stop-gap measures that cannot be maintained, if we want long-term solutions to the economy. It is similar to a company seeking short-term working capital funding, until revenue inflows become stronger.

The only problem is that we have a “Bridge Financing Budget” without the prospect of the increased revenue flows being outlined. In addition to the above consequences, the following will also have to be considered:

· How are companies that are already making losses or who have tax losses carrying forward, to be compensated? Will this cess increase the tax loss or is a cheque to be reimbursed to companies on a timely basis? It is necessary that this be clarified so that companies can make projections to determine what their options are
· The administration of this cess will no doubt cause the income tax to become an even more inefficient tax. What is the return on the tax dollar from implementing such measures? Will the cost of administering the tax be more or less than the additional revenue collected? What of the increased operational cost to companies of administering this tax?

Tax Credit on Bonus Shares
The removal of the tax credit on bonus shares may also have the effect of reducing investment in capital. Companies may now find it more prudent, in light of lower returns, to pay out profits by way of dividends instead of reinvesting in capital through bonus issues. What this means is that the company who wants to expand may be faced with more expensive funding.

There is no doubt that the new tax measures will have a negative impact on the cash flow, and effectively a company’s cost of capital. This may mean reduced capital investments and profitability. In the long run, this will result in lower economic activity and tax revenues. Companies will have to go back to the drawing board and take another look at their investment options, as the option of business activity is now even less attractive compared to holding cash deposits.


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