Friday, November 27, 2009

Law Street - Economic Times (November 2009)

Dear Readers,

The provisions in the tax code seem to have disregarded the ground realities involved in running a non-profit organisation. Zenobia Aunty is very upset about it, but somewhat soothed as the Finance Minister has agreed to look into these provisions. Click here to read more.

As always, the column is also cut and pasted below

Booting charity?

• Capital expenditure, to qualify as a deduction, has to be from gross receipts
• Even partial business operations will subject entire income to higher tax
• Cash system of accounting could lead to a huge tax whammy

The government is on an austerity drive, not only is it frowned upon if a Minister travels by business class but the government had walked that “extra mile” and suggested that “India Inc refrain from doling out vulgar salaries to its top management.”

This is not the first time that such a reference has been made. True, when this columnist flies to her home-town Mumbai and the plane is about to land, she can see a sea of blue – this isn’t the Arabian sea, nor the cute blue-roofed settlements which one views in Jodhpur but blue plastic sheets housing the poor. These settlements are found amidst the splendor of the luxury residential towers, which seem to have sprung up everywhere. Yes, the divide between the rich and the poor continues unabated and if at all it is only increasing.

So what can the government do? It can help those who help others and try to bridge this gap. Unfortunately, the Tax Code tells us a different story. Yes, Zenobia Aunty is hopping mad! But her social worker friend soothes her by saying that Finance Minister Pranab Mukherjee, the good man that he is, has promised to take a re-look at these proposed provisions.

Before we take a look at the proposed provisions which had Zenobia Aunty tearing her hair, let us examine how the Tax Code proposes to tax non-profit organizations (NPOs).

The surplus generated from permitted welfare activities will be determined based on the cash system of accounting. In other words, the gross receipts as reduced by the outgoings will determine the taxable surplus. Of course, each term such as gross receipts, outgoings have all been defined. In addition, the amount of capital gains – computed in accordance with the provisions under the head ‘ Capital Gains’, arising on transfer of a financial investment asset held by an NPO will also be taxable.

The aggregate of both the taxable surplus income and capital gains will be taxed at 15 per cent. However, if one thought that at least NPOs will not be subject to the rigors of MAT based on gross assets, if MAT is applicable, they are wrong.

Does tax of NPOs sound simple and logical? The legal drafters of these provisions really need to volunteer at an NPO to understand the realities. More often than not, NPOs have to buy land or incur other capital expenditure upfront. Let us take an NGO involved in building and running vocational training centers for the differently-abled. It finds a suitable plot of land in the outskirts of Mumbai, takes a huge bank loan and begins to construct a training centre.

As a tax expert, whom Zenobia Aunty spoke to states: “The Tax Code effectively mandates that capital expenditure for the purpose of carrying on the permitted welfare activity should be incurred only out of gross receipts within that financial year.” Now, land required for charitable purposes cannot be acquired in fragmented pieces, based on the gross receipts during the year. Nor can construction be withheld merely because the gross receipts during that year are not adequate. Bank loans are taken, against land mortgage and these loans are repaid out of the gross receipts (largely donations received) in subsequent financial years.

Or take for instance, another example. A huge donation is received in March, towards the close of the financial year. The entire amount cannot be used by the NPO for its operations, even though it would be fully used in the next financial year. Now the entire amount, which would end up being a surplus, just because it could not be used as it was received at the ‘wrong time’ will end up being subject to tax.

Over a strong cup of coffee, which Zenobia Aunty needed to keep herself from fainting, the tax expert shared more horror stories which are embedded in the Tax Code. Gross receipts for a NPO include any rent received in respect of land/buildings owned by it. Fair enough. However, no deduction fro gross rent as prescribed in section 26 (such as 20% of the gross rent towards repairs and maintenance) which is available to other tax payers is available to an NPO. Now, isn’t this sheer discrimination?

What happens if an NPO partly carries on a business operation which is not incidental to the permitted welfare activities? In this case, the entire income of the NPO and not just that portion of the income derived from business operations is subject to the corporate tax rate of 30%. Why could the Tax Code not have distinguished between two different areas of operation, remains to Zenobia Aunty, a huge mystery? In fact, in most cases, even the profits of the business are ploughed back for welfare activities.

There are some likely procedural hassles also that may arise. It appears that once the Tax Code becomes effective a re-registration with the tax authorities may be required. We all know the hassles associate with several registration processes. Clearly, the provisions of the tax code covering both the tax implications and the procedural norms require a close relook and redrafting keeping in view the realities of how an NPO operates on a day to day basis.

Photograph of the statute taken at Lalbagh Garden, Bangalore.

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