Introduction:
The Government has released the Revised Discussion Paper on the Direct Taxes Code (“DTC”) on June 15. While retaining the basic philosophy and object of the DTC, the Revised Discussion Paper seeks to address 11 key issues that were raised by the stakeholders following the original draft released in August 2009. In some aspects the original proposals have been diluted whereas on other issues, the Government has held its ground.
The key proposals in the original draft DTC on-
Ø Gross Assets Taxation
Ø Treaty Override provisions
Ø Capital gains taxation
Ø Tax holiday for SEZ units
Ø EET scheme of taxation for tax savings instruments
Ø General Anti-Avoidance Rule provisions have been considerably relaxed.
Public comments have been invited on the revised paper till June 30. The detailed DTC is expected to be tabled before the Parliament in the monsoon session. The Government is committed to introduce the new DTC with effect from April, 2011.
MAT on book profits:
As per the RDP, Minimum Alternate Tax (‘MAT') would continue to be levied on the basis of book profits and not on the basis of the value of gross assets, as had been originally proposed. This is a huge relief for the loss making companies as well as companies in capital intensive sector including the manufacturing and infrastructure sectors. More importantly, it would remove the anomaly between the services sector and the manufacturing sector, as the services sector tends to use much lesser assets, as contrasted to the manufacturing and infrastructure sectors. Levy of MAT on book profits would also help loss making companies. This is highly welcome amendments as it proposes to roll back to the current MAT regime under the Act, i.e., impose MAT on the book profits. There is, however, no clarity on the rate at which MAT will be levied, eligibility of MAT credit, mechanism for computing book profits etc.
DTAA Position Clarified:
DTAA will now override DTC. In a major relief to foreign Companies in general and Foreign Institutional Investors (‘FIIs') in particular, the revised Discussion Paper clarifies that the assesses would be free to opt for either for the provisions of the Double Taxation Avoidance Agreement (‘DTAA') or the Indian Income tax Act, whichever is more beneficial. This is a major relief to the Foreign Companies given the fact that, in the original version, the DTC had stated that its provisions would override the provisions of the DTAA, which are generally more beneficial, including, in respect of the tax rates. Accordingly, the DTC is expected to restore the taxpayer’s option to be governed by more beneficial provisions of DTC or DTAA, except in the following Circumstances:
Ø Where the General Anti Avoidance Rule is invoked; or
Ø When the Controlled Foreign Corporation provision is invoked; or
Ø When branch profits tax is levied...
Taxation of FIIs:
In the context of income earned by Foreign Institutional Investors (”FIIs”) from the purchase and sale of securities, the Revised Discussion Paper proposes to deem such income to be capital gains. The paper seeks to prevent FIIs from treating such income as business profits and claim exemption under the Tax Treaty, which could be available in the absence of a Permanent Establishment (”PE”) in India. The paper is silent on classification of income from derivatives. It is also proposed to continue with the present scheme where the capital gains arising to FIIs are not subject to tax withholding and the FIIs are required to pay advance tax as applicable.
Clarity on Capital Gains brought in
Long term capital gains on listed shares and equity mutual funds would still get taxed. The revised discussion paper's proposal on treatment of long term capital gains on sale of listed shares and units held in equity oriented mutual funds however, falls short of expectations. Currently, as we know, the long term capital gains related to shares and investment in mutual funds are completely exempt from tax and this has been one of the significant reasons for the heightened activity in the stock markets. The original discussion paper had provided that gains and losses arising from the transfer of investment assets will be treated as capital gains or losses and that these gains or losses will be included in the total income of the financial year in which the investment asset is transferred. The original discussion paper had also provided that the capital gains will be subjected to tax at the rate of 30% in the case of nonresidents and in the case of residents at the applicable marginal rate and that, the current distinction between short-term investment asset and long-term investment asset on the basis of the length of holding of the asset will be eliminated. Of course, these proposals had created a lot of concerns and many had predicted that the stock markets would see much less activity, post the DTC, with the proposed elimination of the tax exemption for long term capital gains for listed shares. The revised paper states that the capital gains arising from transfer of an investment asset, being equity shares of a company listed on a recognized stock exchange or units of an equity oriented fund, which are held for more than one year, shall be computed after allowing a deduction at a specified percentage of capital gains without any indexation. The adjusted capital gain will be included in the total income of the taxpayer and will be taxed at the applicable rate. Hence graded basis of taxation in place of the cost indexation scheme for long term gains arising from sale of listed equity shares/ units of equity oriented funds is proposed. Capital gains or loss on the listed equity shares/ units of equity oriented funds will now be computed after allowing deduction at specified percentages, which are to be finalized in the context of the overall tax rates. As an example, if 50% deduction is provided, an investor in the tax bracket of 30% will pay tax on long term gains at the effective tax rate of 15%. The loss arising on transfer of such asset held for more than one year will be scaled down in a similar manner. This move to tax long term capital gains on listed shares and equity mutual funds might not enthuse the markets, for sure. The Government should try and retain the exemption that is available for long term capital gains available for listed shares and equity linked funds. The proposal to abolish Securities Transaction Tax (”STT”) has been withdrawn. Instead, STT will be calibrated based on the revised taxation regime for capital gains and flow of funds to the capital market. Also, the proposal to introduce the Capital Gains Saving Scheme has been withdrawn, considering the logistic challenges in administering the scheme.
SEZ Units – Position Clarified:
SEZ Units set up before the DTC would get tax holiday for the unexpired portion. It was widely expected that the Government would do a re-think on its earlier proposal to discontinue tax holiday for new SEZs set up, under the DTC. The reiteration of this stated position that SEZs set up after the coming into force of the DTC, is a major dampener for the very SEZ scheme, as this scheme would collapse without income tax holiday. It is also now very clear that there would be no tax holiday for STP Units beyond March 31, 2011. The revised paper does talk of tax holiday for SEZ Units, to be continued for the unexpired portion, under the Direct Tax Code. This would mean that the tax holiday under the DTC would be available for units which are set up prior to the coming into force of the DTC, which in all probability, should be April 1, 2011. The tax holiday under the SEZ scheme is too big an incentive, to be ignored, especially, by the medium to large IT exporters. Units in SEZs are entitled to get 100 per cent income tax exemption on export income for the first five years, 50% for the next five years. They also get exemption on 50 per cent of the ploughed back export profit for the next five years after the first 10 years. More importantly, unlike the STP Units, SEZ Units are also exempted from MAT. Viewed from any angle, the SEZ scheme is a far superior scheme, as compared to the STPI scheme and units currently operating as STP units would do well to act fast and ensure that they don't miss the tax holiday bus under the SEZ scheme. Following the release of draft DTC last year, scores of SEZ units and developers had raised concerns that the zones were attractive due to the tax sops and their withdrawal would drive away future investors. The Government has now assured that it would protect the tax holiday for SEZ Units, in respect of the unexpired portion, under the DTC. This is some good news for the STP Units, which should now immediately work towards moving into SEZs, prior to March 31, 2011. Of course, shifting of the existing business by the STP Units to the SEZs, would result in loss of the income tax holiday, as it would amount to re-structuring of an existing business. However, STP Units are entitled to plan their business operations in a legal manner, by ensuring that, a new ‘business' is set up in the SEZ, so as to ensure that, the tax holiday is available. It could mean that time is running out for the current STP Units, who would need to move to SEZs, in order to be able to get the tax holiday under the DTC. It is legally permissible for STP Units to start a unit in the SEZ, in a small scale and ramp up the same, in subsequent years. This announcement from the Government could see a mad rush by the existing STP Units and new Units, to move towards SEZs, resulting in a lot of sudden increase in business for SEZ Developers.
Ø Tax exemption on maturity for all existing approved provident and pension schemes- this is a highly welcome step which would go a long way in encouraging personal investments.
Ø The employer's contribution to provident fund and such schemes within prescribed limits shall not be considered as salary, as is the existing case.
Ø Amounts received as gratuity, from voluntary retirement schemes and pension at retirement would be exempt subject to specified limits.
Ø Perquisites in relation to medical facilities and medical reimbursements shall be valued as per the Act, with appropriate enhancement of monetary limits. It has also been clarified that the rent free accommodation perquisite will not be computed with reference to market value of the accommodation. The changes proposed in the Revised Discussion Paper are welcome as method of taxing employment income is likely to remain in line with the existing rules.
Changes suggested for taxing income from house property:
Rent on self owned house property will be the amount of rent received for the year and would not be taxed on a presumptive basis. This is brought on par with the current situation, a welcome proposal.
Wealth tax provisions –Changes:
Wealth tax will be levied broadly on the same lines as provided in the Wealth Tax Act, 1957. One does not understand the Government's continuing love for wealth tax when many of us have pointed out that it just does not make economic sense to levy tax on wealth. With no need to please the Communists any more, the Government would do well to abolish wealth tax altogether.
Foreign Company & NRI Taxation:
Ø Capital gains for foreign funds will not be subjected to TDS.
Ø A Company incorporated outside India would be treated as resident in India only if it’s effective management in within the country. This is a highly welcome clarification, considering the fact that in terms of the original discussion paper, a foreign company which had held its board meeting once in India, could have been required to pay tax on its global income. Government should work towards clarifying these unaddressed issues.
CFC Regime Introduced:
As an anti-avoidance measure, the Revised Discussion Paper proposes to introduce Controlled Foreign Corporation (“CFC”) provisions in the DTC. These provisions would aim to tax the passive income of a foreign company which is controlled directly or indirectly by an Indian resident, where such income is not distributed resulting in tax deferral. In such a scenario, the proposed provisions would deem that the dividend has been distributed and thus, would be taxable in the hands of the resident shareholder.
This is a surprise move as the original draft of the DTC did not contain CFC provisions. While most mature economies have CFC provisions in their tax framework, in order to effectively implement the same, CFC provisions will need to be accompanied by appropriate foreign tax credit mechanism.
General Anti Avoidance Rule:
The DTC had proposed to introduce General Anti Avoidance Rule (“GAAR”) to treat a transaction as tax avoidance transaction, if it is undertaken with the main purpose of obtaining a ‘tax benefit’ and is entered into or carried on in a manner not normally employed for bonafide business purposes or is not at arm’s length or abuses the provisions of the DTC or lacks economic substance. The revenue officers (Commissioner) were given powers to disregard or combine such transaction with any other step in the transaction or re-characterize the income, or the parties to the transaction could be disregarded as separate persons and treated as one person.
The provisions were drafted to permit lifting of corporate veil or apply substance over form test. The onus to prove that the transaction is not a tax avoidance transaction was cast on the tax payer.
Wide spread apprehensions were expressed against the sweeping nature of this provision. It was recommended that such provisions be either dropped or a robust mechanism should be provided to administer implementation of GAAR and ensure such provisions were not routinely invoked.
The Revised Discussion Paper proposes to retain GAAR as the Government perceives it to be an effective tool against tax avoidance. However, following safeguards have been proposed:
Ø The CBDT would issue guidelines on the circumstances in which GAAR may be invoked.
Ø A threshold limit (possibly a monetary limit) would be prescribed for invoking GAAR.
Ø The taxpayers, in whose cases GAAR is invoked, could approach Dispute
Resolution Panel (“DRP”). DRP is collegiums of three Commissioners, which was recently introduced for non-residents or those taxpayers in whose cases transfer pricing adjustments are proposed to resolve their tax dispute on a fast track basis. Now, the scope of DRP is proposed to be expanded to include cases where GAAR is invoked.
Specific rules for applicability of GAAR would make these anti-avoidance provisions easier to implement. However, the efficacy of the DRP is still to be tested and adjudication powers with a higher level authority may have been preferable to avoid harassment of the bonafide taxpayers. Further, while the Government is optimistic about curbing treaty shopping by invoking GAAR, the final outcome will be known only when the taxpayers challenge this position before the courts.
Taxation of Non-Profit Organizations:
The Revised Discussion Paper takes cognizance of practical difficulties in requiring Non-profit Organizations (“NPOs”) currently registered under the Act to re-register on commencement of DTC. Therefore, the revised paper proposes to withdraw mandatory re-registration provisions for existing NPOs and provides that such organizations would need to only submit additional information/ documents to facilitate administration under the new regime.
An important relaxation has been granted in the context of application and taxation of surplus accumulated by NPOs. Firstly, the Revised Discussion Paper proposes a basic exemption limit only beyond which surplus available with NPOs would be subject to tax. Secondly, NPOs may carry forward up to 15% of their surplus or 10% of their gross receipts, whichever is higher, for use within 3 years from the relevant financial year. NPOs that are unable to apply their funds due to circumstances beyond their control within the relevant financial year will now not be subject to tax.
The original draft of the DTC did not provide tax exemption for public religious trusts and religious-cum charitable trusts. The Revised Discussion Paper provides that tax exemption will now be available to these trusts, subject to the conditions laid down.
In summary, Proposals in the Revised Discussion Paper in line with tax reforms agenda of the Government. Many anomalies such as MAT, clarity on taxation of FII, etc are welcome moves.
Rationalization of such key proposals should pave the way for smooth implementation of new legislation.
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