Budget to dent HDFC, IDFC earnings

Tax exemption on profits from long-term funding halved to 20% from 40%.

The Budget's proposal to halve tax exemption on profits from long-term financing of housing, industrial, infrastructure and agricultural development is expected hit Housing Development Finance Corporation (HDFC) and Infrastructure Development Finance Company (IDFC) the most. The impact on banks is, however, not likely to be so significant.

JP Morgan has estimated 3-4 per cent impact on HDFC's profits and a 7 per cent earnings impact on IDFC.

The tax exemption is provided on transfer of part of the profits earned from long-term financing to special reserves. The finance ministry has proposed that the tax exemption would be available up to 20 per cent of the profit from such lending in 2007-08, down from 40 per cent now.

The ministry has described the reduction in tax exemption on profits from long-term funding as rationalisation of the provision. The exemption is applicable to financial companies engaged in providing long-term finance for industrial, agricultural or infrastructure development and companies formed for providing long-term finance for construction or purchase of houses.

This special tax exemption is allowed under Section 36(i)(viii) of the Income Tax Act and the aggregate benefit is capped at twice the amount of paid-up share capital, plus general reserves.

The finance ministry said since the overall ceiling has not been changed, the proposed reduction in the level of deduction to 20 per cent will have the effect of elongating the time period during which the deduction can be claimed. Hence, long-term lenders would not be adversely affected in the long term.

The special tax exemption exists since 1922. The objective underlying this provision has been to enable financial corporations to build up their internal resources at an accelerated pace and become independent of subventions from government for financing their activities.

The ministry said since the introduction of this special deduction and subsequent widening of its scope, high tax incidence on companies has come down substantially.

The benefit of this deduction was also intended to enable corporations to augment their initial low equity base on account of limited accessibility to capital market. In the wake of liberalisation, from the beginning of the nineties, there has been considerable expansion and deepening of the capital market.