Tax Reforms To Push MFs Higher
What will be the impact of the corporate tax rate cut on mutual funds? Our study shows that they will indeed stand to benefit. However, now it is in the hands of companies to use this benefit provided by the finance ministry. Meanwhile, for mutual fund investors a ‘wait and watch’ stance is advisable.
July 6, 2019 turned out to be an historic day for India in terms of its economy. This is when Finance Minister Nirmala Sitharaman presented the Union Budget with a vision for the next 10 years. Unfortunately, in just a short span of time, the Indian economy has started showing signs of moderation and hit a rough patch. The stock market has begun to bear the brunt of an economic slowdown thanks in some measure to the tax imposed on the super-rich. In order to infuse some correction, the finance minister has henceforth made many provisions through a series of Friday announcements. This includes rolling back of the enhanced surcharge on foreign portfolio investors that was present in the original budget.
This has been done to encourage investments in the Indian capital market. The government has, since then, also withdrawn the angel tax provisions for start-ups and even for investors. To provide liquidity in the financial system of up to Rs 5 lakh crore, capital infusion of Rs 70,000 crore was done into the public sector undertaking banks. Provisions have also been announced to make loans for homes and automobiles cheaper as well as for consumer goods. Now, to improve the sagging economic growth, the government has also relaxed its stringent fiscal deficit targets. This was done by introducing a deep cut on corporate tax rate. When this news was made public on September 20, 2019, the equity markets turned buoyant.
In fact, immediately after the announcement the Sensex surged by around 5 per cent that day. On the other hand, on the same day those who have invested in debt turned fearful as the 10-year sovereign bond yield moved up byaround 25-30 basis points, which led to a drop in the bond prices by around 2.23 per cent. Therefore, the bond funds invested for the long term posted a decline in their NAV. In the coming paragraphs, we will see how the changes that have been made will impact the earnings of various sectors and on mutual funds’ NAV. We have also carried out a study to gauge which funds would be most benefited with this decision of corporate rate tax cut.
Making Corporates Happy
On September 20, 2019, Finance Minister Nirmala Sitharaman made her boldest move by announcing a slash in the corporate tax rate. This was done with the intention to boost sentiments of India Inc. and make the country a more attractive investment destination for foreigners. Having said that, for existing companies the corporate tax rate has been curtailed to 25.17 per cent (including surcharge and cess) from the present 35 per cent (including surcharge and cess) and for new manufacturing companies – those incorporated after October 1, 2019 and starting their operations before March 31, 2023 – the tax rate has been cut down from 25 per cent to 15 per cent (excluding surcharge and cess).
This reduction of tax rate by almost 10 per cent is the biggest reduction in corporate tax rate in the past 28 years and it would be interesting to see how corporates use this benefit i.e. whether they use it to reduce their debt which will in turn improve their balance-sheet and would also help them to improve their earnings or they use it to invest to expand the capacity which would also help them boost their earnings going ahead. Another way they can use this tax cut is to reduce their product prices, as has been done by Maruti Suzuki Limited, which in turn is likely to increase demand for their products. The decision will be based on sector and company dynamics. For example, the automotive sector, which is already seeing a fall in demand and low capacity utilisation, may have to go for price deduction to stimulate demand.
Impact of Tax Rate Cut on Sectors
The oil and gas sector would be one of the major beneficiaries of lowering of the tax rates. Here the lower tax rate means higher cashflows. Apart from the oil and gas sector there are various other sectors that would be benefited from this decision. Sectors like aviation, automobiles, capital goods, FMCG (fast moving consumer goods), paints, agro chemicals, metals, cement, infrastructure, financials and consumer durables are also the likely beneficiaries of this decision. Wherein some will use this benefit to reduce their working capital cost or increase the capex or reduce the debt, some sectors like paints may pass on this benefit to their customers.
In fact, the automobile makers have started to pass on this benefit to customers to revive sluggish demand. On the contrary there may be some companies who are posting losses, such as telecom and logistics, that won’t be able to benefit from this decision.There is one more angle to this: If there are Deferred Tax Assets (DTA) in the books of the company, it will impact those companies in different ways going ahead in the next two years. FY20 will see downside in earnings due to the reversal of DTA, whereas earnings will rise from FY21.
Impact of Tax Rate Cut on MFs
Mutual funds being a product deriving value from investment in shares and bonds may feel an indirect impact of corporate tax rate cut. However, whether the impact is positive or negative, it depends on which side of the court you are playing from. If you are on the equity side then you may have reasons to cheer as the tax rate cut may contribute to a company’s growth which will ultimately lead to increase in their earnings and finally get reflected in the share price.
On the contrary, if you are on the debt side then the tax rate cut will lead to an increase in the fiscal deficit projections and in turn rising yields, which have negatively impacted on longterm bond funds, gilt funds and funds holding long duration papers. However, government is taking measures such as divestment to contain the deficit. So, maybe there is a possibility that yields may fall after sometime. To cut a long story short, the decision of slashing the corporate tax rate may have an impact on mutual funds, whether equity or debt.
There are some concerns that have been raised alongside marking down the corporate tax rate. The government has estimated that with its decision about the corporate tax rate cut, there is going to be a loss of Rs. 1.45 trillion which translates to about USD 20.45 billion – about 0.7 per cent of the GDP (Gross Domestic Product). Will this improve the overall economy as it will only have impact on the financials of corporates? The real problem that is faced by India is that there is no demand. Higher expenses as well other things come later. Therefore, a cut in GST (Goods and Service Tax) would have served for that purpose of lack in demand as the slashing of GST rates would bring down the prices and in turn prove to be an effective way to stimulate consumer demand.
On the other hand, some economists believe that there should have been rate cuts on individual taxes as this would have resulted in consumers having more cash at their disposal and in turn the consumer demand would have automatically got a boost. Nonetheless, it will definitely have a positive impact on earnings of the corporates. Earnings estimates had continued to come down over the past quarter prior to the tax cut. Some of the prominent domestic as well as international broking houses had revised down the FY20 Nifty EPS forecast by 8-11 per cent last quarter until mid-September and by 13-17 per cent since January. The latest corporate tax cuts, they believe, will lift FY20 Nifty earnings by about 8 per cent.
In order to understand the impact of the corporate tax rate cuts on equity mutual funds we carried out a study wherein we estimated the probable gain that a fund might get with this decision. Keeping other things constant, here we have estimated the post-tax income of the companies based on the recent tax rate cuts. What we have done is that we divided the tax expense by the PBT (profit before tax) to understand the current tax rate. Then we came up with the actual benefit by deducting the existing rate with the new one. Based on the same, we have estimated the returns that the stock may generate.
We have thereafter combined this with the weights of each stock in each mutual fund portfolio to show us which mutual funds have the potential to provide more returns. After the announcement the market surged sharply and therefore we have factored that as well. Here, we have deducted the percentage gains (September 19, 2019 to September 30, 2019) from the actual benefit due to slashing of corporate tax rates. All the data has been sourced from Ace Equity (Accord Fintech).
As seen from the above, pharmaceutical funds are the ones mostly benefited from the corporate tax rate cut. In these funds, Tata India Pharmaceutical and Healthcare Fund is expected to give higher returns. The stock that is contributing to this big gain is Sun Pharmaceutical Industries. Even the PSU Banks have shown the highest expected returns of a whopping 14 per cent. This may come in the next two years as for PSUs the impact of DTA reversal is highest as in some cases reversal is greater than 100 per cent.
In the above table we can see that Nippon India Large-Cap Fund has topped the charts in the large-cap category followed by Tata Large-Cap Fund and HDFC Top 100 Fund with expected returns of 2.24 per cent, 2.13 per cent and 2.10 per cent respectively. State Bank of India is the topmost stock that contributed to the Nippon India Large-Cap Fund’s expected gains.
Mid-cap category funds have gained around a per cent higher than large-cap funds. Here, Edelweiss Mid-Cap fund gained the highest with expected gain of 3.31 per cent followed by ICICI Prudential Mid-Cap Fund and Taurus Discovery Mid-Cap Fund with expected gains of 3.25 per cent and 3.18 percent respectively. Info Edge (India) Ltd. is the stock that contributed the most towards the gains of Edelweiss Mid-Cap Fund.
Small-cap category funds too have gained around a per cent higher than large-cap funds. In the small-cap category, HSBC Small-Cap fund is on the top followed by HDFC Small-Cap Fund and Invesco India Small-Cap fund with expected benefit of 3.04 per cent, 2.97 per cent and 2.91 per cent respectively. The stock that majorly contributed to the gains of HSBC Small-Cap Fund is Orient Electric Ltd.
In the multi-cap funds category, Nippon India Multi-Cap Fund has gained the most followed by HSBC Multi-Cap Fund and HDFC Equity Fund with expected returns of 2.77 per cent, 2.31 per cent and 2.10 per cent respectively. Here, The Indian Hotels Company Ltd. has contributed majorly towards the gain of Nippon India multi cap fund.
Even aggressive hybrid funds would be benefited from the slashing of corporate tax rates. In this category, UTI Hybrid Equity Fund tops the charts followed by IDBI Hybrid Equity Fund and Nippon India Equity Hybrid Fund with expected gains of 2.74 per cent, 2.50 per cent and 2.30 per cent respectively. Lupin Ltd. has majorly contributed to the gains of UTI Hybrid Fund. The same stock has also contributed to the gains of many of the pharmaceutical funds as well.
As can be understood from our study, mutual funds are indeed going to benefit from the slashing of corporate tax rates. Though it is to be noted that the data used here is historical and so there is a probability that the stockholdings of the funds may change going forward that may impact their future returns.
Undoubtedly, this has been a bold step from the government which will indeed benefit the corporates and also help attract foreign investments. However, these measures are in no way in line with the reviving of the economic slowdown. The reason is that main culprit for the economic slowdown is lack of consumer demand and unemployment.
In a nutshell, with the decision of slashing the corporate tax rates, many companies would be positively benefited and as mutual funds also invest in them, indirectly they would also be the beneficiaries. However, now it is in the hands of companies to use this benefit provided by the finance ministry. For mutual fund investors a ‘wait and watch’ stance is advisable.
Don’t just rush into buying them. Rather it would be better to stick with your financial plan. Strictly adhere to your investment strategy and do periodic reviews and rebalancing. Before making any investment or financial decision do consult your financial planner.