Law Street in The Economic Times (Aug 2009) - Tax Code

Dear Readers,

We sorely needed a new simple tax code. After all, the current one dates back to 1961, and it is now riddled with amendments that happen each year, without fail, via the Finance Bills. Some amendments are even introduced with retrospective effect. To this extent the Tax Code is a breath of fresh air, alas, it appears to be regressive in nature on several fronts. Progressive measures like participation exemption have not been introduced. Please click here for the online edition of The Economic Times, or scrawl below.

Source of the photograph

Best regards,
Lubna


Storm in the tax cup

• Anti-avoidance provisions are included, similar to the mechanism in well developed tax regimes, but could impact genuine transactions;
• Developed tax regimes also have measures in place such as participation exemption provisions, which are missing
• A balanced code, aiding Indian companies to go global, would have been beneficial

David and Shawn who jointly ran an IT company in Sweden were chatting on myriad topics on a beach in Goa, including where they should travel next. Eventually, they also took a few decisions regarding the immediate plans for their IT Company. Suddenly, a tax guy loomed large on the scene. “Your company is partially controlled and managed from India. You have just taken an important decision. Hence you pay taxes here,” he bellowed. He then disappeared in a cloud of smoke. Zenobia Aunty woke up in a cold sweat.

But the fact of the matter is that while the Tax Code seeks to continue with the present system of combination of residence- based taxation and source-based taxation and seeks to continue to apply residence based taxation to residents (taxing their world wide income) and source-based taxation to non-residents, there are a few major changes.

For instance, it provides that that, for a company, the existence of partial control and management would result in residence in India. The principles relating to source of income are also proposed to be modified to cover even income arising from indirect transfer of capital asset situated in India, as deemed to accrue or arise in India.

Zenobia Aunty’s dream (sorry, nightmare) may have been a tad exaggerated but the fears are real. Whether or not a company is partially controlled and managed from India will be dependent on the fact and assessments could only get tougher. This may mean maintenance of the relevant records to prove that there was no control and management from India. It could well result in a host of litigation.

Much has been written already about MAT and one needs to agree that the proposed provisions of a gross asset-based taxation seem flawed. More so, since the Tax Code seeks to replace profit-based tax holiday incentives with investment-based incentives. Is this a classical example of the left hand not knowing what the right hand does?

Under the investment based incentives, the taxpayer will be allowed to recover all capital and revenue expenditure (except land, goodwill and financial instrument). The period consumed in recovering all capital and revenue expenditure will be the period of tax holiday. The only silver lining is that, the Tax Code also provides for grandfathering provisions in connection with current profit-linked incentives and area-based exemptions under the existing Income-tax Act. If you recall when the provisions relating to taxation of a VCF had been amended and only investments in certain sectors were treated as eligible for pass through provisions, there was no grandfathering clause. At least, this mistake has not been repeated.

Zenobia Aunty feels that the Tax Code is not progressive enough. True anti-avoidance provisions have been introduced, as is the case in well developed tax regimes.

However, these developed regimes also have measures in place such as participation exemption provisions or parent subsidiary directives. Subject to conditions, foreign dividends from qualified overseas entities, including wholly-owned subsidiaries are not subject to tax in the home country. Countries such as UK and Japan have sought to exempt foreign source dividend which is repatriated back, subject to fulfillment of conditions.

As the newsletter of the organization this columnist is currently employed with states: The proposal to codify General Anti Avoidance Rules (GAAR) in the tax legislation represents a new approach of the Government for dealing with tax avoidance. While policy makers world-wide have extensively debated the advantages and disadvantages of GAAR, the most common argument against a statutory GAAR is that it promotes uncertainty for tax payers. In framing legislation that is sufficiently all embracing to deter tax avoidance, there is always the danger of penalizing those who have genuine reasons for entering into a bona fide transaction. Further, by recognizing deferral of tax as a tax advantage and by empowering the tax authority to re-characterize debt into equity, the GAAR contains elements of “thin-capitalization” principles and “anti-deferral” principles. The intention to apply GAAR by overriding India’s tax treaties could also impact the stability provided to foreign investors by an applicable treaty.

Zenobia Aunty feels that: A balanced Tax Code, which would have aided Indian companies to go global would have been beneficial. The Tax Code, could have introduced progressive mechanisms such as participation exemption, underlying tax credit or even exempted foreign dividends. It has introduced an Advance Pricing Mechanism, but nothing else. Zenobia Aunty recalls her nightmare and quips: “It is more of an attempt to treat global companies as local.”

Neighbour Gopal, the software techie grins. Pointing to this columnist he chuckles, “You will have a new Tax Act and a new Companies Act. Happy studying!” Yes, it is back to school, but unfortunately life does not promise to be carefree, rather a tad more taxing.