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Govt drafts new, simpler direct tax code; experts cheer

Published on Wed, Aug 12, 2009 at 16:24 | Source : CNBC-TV18

Updated at Thu, Aug 13, 2009 at 12:17

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Q: If we were to take these rates as set in stone, which perhaps they are not, do you feel that considering the overall revenue situation and the overall growth of the economy, these are rates that will continue for a stable period of time or are we going to go back in the year 2012, 2013 to frequent tinkering of rates in accordance with the government's revenue requirements and the overall economic situation. Do you feel there will be long-term stability on this aspect?

Dalal: I think the discussion paper seems to stress a lot on stability. At the same time, it talks of flexibility. I think the intent is to have the law stable but still provide the flexibility to respond to a changing situation. But I think the basic intent is for it to be stable. But at this point it is very difficult to say what the situation will be and indeed one is not even sure whether this is case in stone because they have asked for comments. So, one will have to wait and see what emerges and what are the reactions in terms of the base of taxation and various other things. So, perhaps it would be premature to comment on a point like that.

Q: In terms of the quality of this code, how would you rank it vis-�-vis other codes across the world?

Dalal: The Income Tax Act 1961 was clearly due for a replacement because over 48 years it has probably undergone over 4,000-5,000 ammendments. There seems to be an attempt really to lay down a much clearer language. But what is important is that there has been a sort of change in the philosophy of income, the base of income. So, it is very difficult to comment at this point. All that I can say is that a very serious attempt seems to have been made to streamline the legislation. As I said, one will have to go into the fineprint to see whether that intent has been translated into reality or not.

Q: What are the specific provisions if at all to end exemptions and to widen the tax base considering that prima facie on the personal income tax side there will be lower revenues and on the corporate side, perhaps a gain of not more than Rs 8,000 crore, assuming the current policy structure?

Dalal: It is very difficult to know the details because this is a very voluminous code. But as you know, the income tax or the capital gains exemption on equity shares seems to have been done away with. That is obviously now included in the base for taxation.

The cost of the shares, the indexation will be taken from April 1, 2000. So, in that sense the cost base goes up and therefore the capital gains goes down. But the fact is that there will be capital gains whereas earlier there would not have been had it been sold through the stock exchange. So, that is one example.

The second example is I could not see any deduction for interest paid for acquisition of a house. So, for example today you get a deduction of Rs 1.5 lakh, if I remember rightly, as interest paid on borrowings for a house, there doesn't seem to be any deduction available if the house is self-occupied and the implication for that of course is that the base for taxation goes up.

Thirdly, the rollover benefit, which is if you sell one house and buy another house, which as well seems to have gone. So, there are a variety of examples. Clearly the base seems to have increased and the idea is to supposedly reduce the tax rate but increase the base. One will have to see how that arithmetic pans out.

Q: On anti-abuse and anti-avoidance, apart from the general rules that are spread over 3-4 pages it says that the general rules will be further supported by anti-avoidance rules to deal with the following circumstances.

A) Payment to associated persons in respect of expenditure.
B) International transactions not at arms length.

C) Transactions resulting in the transfer of income to non-residents.

D) Avoidance of tax in certain transactions in securities.

Prior to this, it said that there would now be provisions for the government to override a treaty despite the Vienna Convention, which sort of provides the overall architecture for this? Have you had a chance to go through this and can you explain in greater detail what the code is really up to on this front?

Dalal: Yes, I have had a chance to go through it atleast cursorily. You are right. There are two big items that have been legislated into this code. The first is regarding what is called the Treaty Override provision. Under the current income tax legislation, under section 90, the basic provision is that the treaty overrides the act to the extent that it is beneficial to the taxpayer.

Now it says that in the event that there is an abuse of a treaty then there is a treaty override, in the sense that the act will then override the treaty and that is a little disturbing because that tends to get very subjective. Given the fact that in India litigation tends to have a life of its own and these things tend to get a long time to resolve and tend to get very subjective, one is worried about something that appears as open-ended as that. So, that is one aspect.

The second is that while there has been a string of precedents even in the past of anti-avoidance interpretation so to speak and one of the earlier decisions on that point was the McDowell decision, which says that if a transaction does not have any commercial motive then that can be ignored or income can be recharacterised. But that was more a judicial precedent kind as opposed to something legislated. Therefore it was a little subjective.

Now also it is subjective but a lot of provisions have been laid down. For example, there is the substance versus form provision and some of things that you said earlier. So, there is a whole host of general anti-avoidance provisions and that in one sense can plug abuse but in another sense can open up a whole host of litigation because these kinds of things will obviously get subjective and they are subjective.

Q: On total income, it says total income from ordinary sources will be aggregated with total income from special sources to arrive at the total income. The loss under the head capital gains shall be ring-fenced and such losses shall not be allowed to be setoff against income under other heads. Similarly, loss from speculative businesses will also be ring-fenced. The losses will be allowed to be indefinitely carried forward for setoff against profits in the subsequent financial year. How would you react to this? What does this really mean?

Dalal: You were reading on something like speculation loss and capital loss being ring-fenced and that is the position broadly even today. Of course I don't know whether there is any significant change in the fineprint. But from what you are saying that is the same.

However, as you rightly pointed out, the indefinite part of it to my mind is a significant change because there are very capital intensive businesses which can incur a loss for 4-5 years and then the limitation of eight years today does act as a constraint. To that extent, the ability to carry forward loss indefinitely is certainly a benefit. But one has to see whether there are any conditionalities or caveats attached to it. But on the face of it, it certainly seems a good provision.

Q: You've perhaps had a chance to go over the fineprint at this point, would you say that what the government is actually hoping to do, which means actually keep pace with the changes in the financial sector not just in India but globally as well, they have been able to achieve that with the changes proposed?

Sabnavis: I think one of the key messages that came in from the Finance Minister is that the new code is definitely a step forward to reduce litigation. The first thing that struck me is basically he is going to change the fundamentals of taxation for foreign companies wherein the way foreign companies will now be taxed is even if they are partly managed from India they would be taxed as residents or they would be treated as residents in India.

Clearly, this changes some of the fundamental ways in which both foreign companies probably manage some of their businesses and probably the more you are looking at a regional or a global role, you've got to be very clear that the moment a foreign company is deemed to be partly managed from India, we are going to be taxed in India like any other resident.

Q: So, this is not going to go down very well with MNCs, don't you think?

Sabnavis: Yes, absolutely, because this clearly opens a huge litigation area. The question really is that on the one hand you are saying that we want to reduce litigation and we want to simplify it. So, this clearly is not going to go down well.

The other bit is also wherein there are tax treaties that have been entered with various countries and one particular ammendment the way I see it has been thought about is if there are changes that have been introduced in the code then those changes prevail. So, where does that leave the foreign taxpayer who comes in from a jurisdiction which has a double tax treaty?

Q: Have you actually picked up anything in terms of ending exemptions and plugging other loopholes as far as the new code is concerned?

Sabnavis: No, I have not looked at the complete fineprint. But clearly one fundamental thing as I have mentioned earlier is the fact that there is one particular ammendment that has been brought about stating that if there is a change, or if when you compare the treaty and the Income Tax law, whichever is later, those provisions will prevail. Given the fact that the tax code is being introduced in August 2009 and all our treaties with most countries are prior to 2009, what happens to those? That is a big question as far as MNCs or for that matter even Indian companies operating overseas are concerned.

As far as exemptions go, I did glance through some of the provisions but honestly it is too early for me to provide any insight on that.

Q: What is your initial reaction on the broad philosophy with which this document has been prepared? Will it actually bring down the cost of compliance and will it make compliance easier and as the Finance Minister was pointing out, will this mean that legal disputes in a sense and question marks will be reduced as well?

Butani: It is a very general question whether the cost of compliances will come down or not, we need to wait and see but if I may just illustrate one change which is applying the maximum marginal rate of tax of 30% on individuals about Rs 25 lakhs of income, this is clearly going to result in greater level of compliance because the incentive for individuals to evade taxes has completely been done away with. That will increase the overall tax to GDP ratio and certainly increase the overall tax collection and the cost of compliance will go down. The other measure is what they call it as a computer based risk management procedure that they will follow to pick up tax returns for scrutiny. So there are several path breaking changes - most of them are unprecedented. It is reformative and if you take a medium to long-term view I have no doubt in my mind that cost of compliances will go down.

Q: Let us talk about the not so positive surprises because we have been speaking with tax experts and the sense that we seem to be getting is that the business of foreign companies even if partly managed in India will now be treated as residents. Now this is likely to throw up a whole host of litigation as well as create more controversy?

Butani: It doesn't surprise me because the issue is very simple over here. They have kind of given now a narrow interpretation for management in control of foreign company clearly with an intent that India should not lose out on its tax base. So it is certainly gives legislative tooth under the new tax code for the tax administration to tax the profits of the foreign company but it is no different than what is happening today. The tax authorities are really extending themselves given what the current legislation is in taxing those profits. So I think the intent is very clear and the foreign companies will now have to be more careful from the point of view of the test of control and management such that their profits are not taxed in India.

Q: Let's talk about the other features with regards to the Dividend Distribution Tax and Minimum Alternate Tax (MAT). MAT we understand now will be calculated with respect to gross assets - 0.25% of the value of gross assets as well as the Dividend Distribution Tax at a flat rate of about 15%. Take us through what you made of both these proposals?

Butani: The MAT currently is levied on book profits. This recommendation that it should be levied on a base of gross assets is a recommendation that was there given by Dr. Shom in 2000 and this is also aligned with global practices. What I am confused with and not very pleased about is the rate of tax. So the 0.25% MAT rate of tax that you mentioned applies to banking companies. For the other companies that is 2% and this 2% rate of tax in my view is very high by global standards. If you look at countries that levy MAT as a percentage of the value of gross assets, the rate is anywhere between 0.50-0.75%. I think 2% is a very high rate. So if you look at a company that is capital intensive, it's making investments, its building assets - I think 2% is a very regressive rate of tax.

Q: The difference between the long-term and the short-term capital gains has been done away with? What kind of ramifications is that likely to have? Was this on expected lines?

Butani: I have not been able to understand the rationale for doing it away because the changes in the capital gains tax provisions are again path-breaking. So, you have to read the change on long and short-term capital gains with this whole distinction about capital assets for business purposes and investment assets. You have to read these two changes together.

I have not been able to absorb what is the outcome of these changes. But there is no doubt that the distinction between long-term and short-term capital gains seems to be aimed at providing for a fixed rate of capital gains tax on transactions whether they are long-term or short-term in nature. You also have to read this provision with elimination of the Securities Transaction Tax, which was levied in 2005 in lieu of exemption for long-term capital gains and a reduced rate of tax for short-term capital gains.

Q: I wonder if you have been able to see one particular clause and this relates to tax holidays for certain business. The code says that it proposes to substitute profit linked incentives by a new scheme where a person would be allowed to recover all capital and revenue expenditure. It would be for the period of the tax holiday and then it goes on to list several sectors on which it will be levied, for instance, business of exploration and production of mineral oil or natural gas and so on. This is perhaps one part of the exemption. What does this really entail? And if you could broadly take us through the overall exemptions that are being taken away for the corporate sector and perhaps for the individual taxpayer as well?

Butani: Let's look at the tax incentive provisions today. First of all, all of these changes are grandfathered. So, currently if you have a special economic zone or you are operating a power plant or any of those specified businesses, hospitals, so on and so forth, those will not be impacted.

What it essentially says is that after the new code comes into effect, all the profit-linked incentives will now be turned into amortisation of capital and revenue expenditure. So, if you start any of those specified businesses after the new tax code comes into play, then you will get the benefit of not paying any taxes only until the time you have written off all your revenue and capital expenditure.

These changes signal two things to me. Number one is elimination of profit-based incentives. So, this whole concept that you set up a new business and 10 years you don't pay any profits is gone away. It also aligns with the overall government policy that we are not going to give away any tax holidays.

However, in order to make sure that there is suitable incentivisation for businesses that make significant capital investments in high risk and where the payback period is very long they will say that you will not pay any tax till the time you have written off your capital and revenue expenditure.

As a matter of fact, the first signal for this was already there in the 2009 budget when they brought about the ammendment in a manner in which you compute tax holiday for cross-country natural gas pipeline projects.

Q: One of the other issues that seems to be causing a little bit of consternation at this point is the fact that the code actually proposes a treaty override provision. What do you make of it?

Butani: Again, currently, as the law stands today and if you look at the jurisprudence it simply says that treaty overrides domestic law under all circumstances. The change that has been brought about in the anti-avoidance rules provision says that ordinarily the treaty will override the domestic law. But in case you have ammended the domestic law subsequently then that law will prevail over the treaty. So, the universal rule of treaty overriding the domestic law under all circumstances will not hold good any longer. There are countries that have implemented these changes. I am not very sure and I am circumspect whether India should have embarked on this predominantly because we are a capital importing country and we will continue to be capital importing for many years.

Attachments : Direct Taxes Code Bill 2009.pdf

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