The Government of India had released the draft Direct Tax Code (‘DTC’) along with a Discussion Paper in August 2009 for public comments. Various stakeholders have provided their feedback and the Government subsequently released a Revised Discussion Paper in June 2010 addressing some of the key concerns on the DTC. The DTC would replace the existing direct tax legislation constituted by the Income Tax Act, 1961 and the Wealth Tax Act, 1957 with effect from April 1, 2011. It aims to simplify the language with an intention to remove uncertainty in interpretation of the tax law and mitigate undue litigation.
While most of the provisions in the DTC meet these objectives, there are certain provisions relating to Minimum Alternate Tax (‘MAT’), General Anti-Avoidance Rules (‘GAAR’) and Determination of Residential Status of Foreign Corporate, which could have adverse and undesirable consequences. This term paper provides an overview of the key proposals in the DTC and their impact on both domestic and international businesses in India. Introduction The compatibility and conduciveness of a taxation system plays an important lubricating role in the overall growth and direction of an economy.
Tax laws are often seen not as a mere framework for the government to collect revenues, but as an effective tool to direct and propel the economy to higher levels, more so in a developing economy like Indian economy. The government of India proposed several changes in the tax system from time to time. The new Direct Tax Code (DTC) seeks to bring about a paradigm shift in the direct tax system. The objective of the new code is to improve the efficiency and equity of Indian tax system. The proposed DTC has several features in its favour. First, in naming it, the direct tax code and not the Income tax (IT) Act.
Second, there has been a conscious effort to do away with exemptions – so that effective rates of taxation reflect the charges on incomes that are transparently defined. This is a major shift away from area – based exemptions from choosing winners and losers in industry and indeed in removing distortions that have crept in the way of development initiatives. What the code seems to be saying is that while particular classes of individuals – such as women and senior citizens – deserve differential treatment, there is no room for distortion on the basis of geographical region or industry segment. This is again a sign of a maturing economy that believes in market forces rather than on state – sponsored growth initiatives.
Discussion CORPORATE TAXATION Tax Rates Under the existing provisions, the tax rate applicable to domestic companies is 30 per cent (plus surcharge and education cess). Additionally, domestic companies are required to pay a tax of 15 per cent in respect of dividend distributed to the shareholders. On the other hand, foreign companies are subject to a 40 per cent tax (plus surcharge and education cess), with no obligation to pay tax on remittance of such profits to their head office verseas.
The DTC has proposed to bring harmony in the tax structures applicable to Indian and foreign companies by introducing a unified rate of tax at 25 per cent in respect of both entities. However, Distribution tax at 15 per cent would continue in respect of domestic companies and a new levy, namely Branch Profit Tax (‘BPT’) is proposed on branch profits earned by foreign companies. This proposal would bring parity in tax rates and also reduce the effective tax liability in respect of both domestic as well as foreign companies.
Minimum Alternate Tax Presently, companies are required to pay Minimum Alternate tax (‘MAT’) at 18 per cent (plus surcharge and education cess) of its ‘book profits’ (adjusted net profit). Credit of MAT can be availed during ten subsequent financial years. The DTC had initially proposed a radical shift in the manner of computing MAT liability, by considering the value of ‘gross assets’ against ‘book profits’ and reducing tax rate to 2 per cent1 from existing 18 per cent. However, the Revised Discussion Paper has retained the existing scheme of computing MAT i. e. with reference to ‘book profits’.
The manner of computing ‘book profits’, provisions relating to MAT credit and rate of MAT has not been specified. Business Income Under the existing scheme of taxation, computation of business income is based on ‘business profits’, which is then adjusted to arrive at the ‘taxable income’. The DTC has proposed a complete revamp of the existing ‘business profits’ model to an ‘income expense model’, which is prevalent in certain developed and ASEAN countries. Under the proposed ‘income expense model’, capital receipts from business shall also be taxable as normal business profits.
For instance, profits from sale of business capital assets, presently considered as Capital Gains, would be taxable as business profits. Furthermore, income from each business would be computed separately. The Discussion Paper has indicated that the proposed change in the method of computing business income would mitigate disputes arising from taxability of receipts and deduction for expenses, which are a subject matter of frequent disputes between tax-payers and authorities. Further, the computation of income for each business separately would require a more etailed exercise by taxpayers. Loss on Depreciable Assets Under the existing regulations, loss arising due to transfer of depreciable assets results into ‘short-term capital loss’ to the business. However, the DTC has proposed that loss arising on transfer of business capital assets, be treated as intangible asset, which is eligible for depreciation at applicable rates. In effect, only a fraction of such loss would be set off against business income each year in the form of depreciation.
Wealth tax is payable in cases where the net wealth (net value of specific assets) of the company is higher than the threshold exemption limit, presently at Rs 3 mn. The rate of tax is 1 per cent. The DTC has proposed to abolish wealth tax on companies. CAPITAL GAINS TAX Long Term vs Short Term Capital Gains Under the existing provisions, capital gains are bifurcated as long term or short term, wherein long term gains are eligible for concessional rate of tax. The DTC had initially proposed to eliminate the differential tax treatment for long term and short term capital gains.
However, the Revised Discussion Paper has again provided for differential treatment of capital gains arising from transfer of assets held for more than one year and less than one year. In respect of transfer of listed equity shares or units of equity oriented funds, the DTC has done away with the process of indexation of costs and instead provided that a percentage would be deducted from the amount of capital gains to arrive at the taxable gain. Income of Foreign Institutional Investors (‘FIIs’) would be taxed as capital gains and not business income.
This has been done to ensure that FII’s are subject to Indian tax even when they do not establish a PE in India. INTERNATIONAL TAXATION Residential Status of Foreign Companies Under the existing scheme of law, a foreign company is considered to be a resident of India if the whole of its management and control is situated in India. Test of residency is critical to determine the scope of income chargeable to tax. A resident company is taxable in India on its worldwide income.
The DTC had proposed a drastic change to this provision by providing that foreign companies would be treated as residents in India if control and management is even partly situated in India. This had raised significant issues for overseas subsidiaries of Indian companies or for foreign companies who may have some part of their control and management situated in India. The Revised Discussion Paper has proposed to adopt ‘Place of Effective Management’ as the criteria for determination of residential status of a foreign company.
It refers to the place where board of directors of the company or its executive directors makes their decisions. In case where board of directors routinely approve the commercial and strategic decisions taken by the executive directors or officers of the company, the place where such executive directors or officers perform their functions. The proposed criteria for determining the ‘Effective Place of Management’ is rather ambiguous and leave a lot to interpretation. Specific issues viz. eaning of expression ‘strategic and commercial decisions’ and what constitutes a ‘routine’ approval would likely invite litigation. Royalty and Fee for Technical Services (FTS) Royalty and FTS earned by non-residents are presently taxed at 10 per cent (plus surcharge and education cess) on gross amount. Should these payments relate to a Permanent Establishment (‘PE’) of the foreign company in India, these are taxable on net income basis at an effective rate of 40 per cent (plus surcharge and education cess).
The DTC has proposed to enhance the tax rate from 10 per cent to 20 per cent tax on gross amount of royalty and FTS income earned by non-residents in India, even when a PE of such foreign company is in existence. The increase in tax rates would adversely impact non-residents earning royalty / FTS from India. This would also lead to increase in cost of importing technology and services into India should the impact of additional tax cost is shifted to the Indian customer. Further, removal of net income basis of taxation may increase the tax cost for non-residents having a PE in India.