Indian direct tax proposals revised: The good and the not so good
The Indian Government has just released a revised version of the Discussion Paper explaining the provisions of the new Direct Taxes Code (“DTC”) proposed to be implemented from the year 2011. Once enacted, the DTC would replace the existing legal framework for income tax and wealth tax. The revised Discussion Paper seeks to address comments and criticisms leveled against the earlier draft of the DTC that was released in August 2009. While a conscious effort has been made towards resolving some of the ambiguities and controversial provisions impacting the global investing community, certain concerns continue to remain unanswered.
What’s good !
· No treaty override: The revised Discussion Paper has rejected the ‘later-in-time doctrine’ in favor of the current scenario where provisions of a tax treaty would apply to the extent they are more beneficial to the taxpayer. The fact that India’s existing tax treaties shall continue to be respected is truly a welcome move.
· Safeguards for application of GAAR: The controversial general anti-avoidance rules (“GAAR”) proposed in the first draft of the DTC are now subject to certain safeguards: (i.) The Central Board of Direct Taxes (“CBDT”) would specify the circumstances for application of GAAR; (ii.) GAAR provisions would not be invoked beyond a specified de minimis threshold; and (iii.) GAAR cases may be referred to the newly formed dispute resolution panel. The Government has also clarified its position that GAAR is not intended to apply to all tax mitigation structures and would only capture non-bonafide arrangements that are abusive or lack commercial substance.
· Tax residence of foreign companies: The Government has proposed to adopt the internationally recognized principle of ‘place of effective management’ for determining the tax residence of foreign companies. Accordingly, a foreign company would be considered an Indian resident if (i.) its board of directors or executive directors make their decisions in India; or (ii.) the executive directors perform their functions in India, in cases where the commercial and strategic decisions made by them are routinely approved by the foreign company’s board of directors. As a tax resident of India such companies would be taxable on their worldwide profits. The revised proposal provides more certainty than the earlier DTC provision which stated that mere ‘part control’ of a foreign company from India would trigger tax residence in India.
· Minimum Alternative Tax (“MAT”): It has been clarified that MAT would be linked to book profits and not gross assets as was earlier suggested. The tax rate for MAT is yet to be clarified. This proposal assuages concerns that an asset-based MAT would lead to double taxation and have negative ramifications on loss making companies and those with long gestation periods.
· Units in Special economic zones (“SEZ”): While the Government continues to maintain its position on phasing away area-based tax exemptions, incentives enjoyed by existing SEZ units would be grandfathered for the unexpired period.
What’s not so good !!!
· Taxing FII income: The Discussion Paper has sought to ‘resolve’ the current controversy regarding the tax treatment of FII income by deeming as capital gains, all income derived by FIIs from transacting on the stock market. Ordinarily, due to the volume and frequency of FII trades, income earned by such FIIs on the stock market should be treated as business profits taxable, only if the FII has a permanent establishment in India. The new proposal conflicts with the basic principles of income characterization. Further, FIIs paying tax in India on account of the new deeming fiction, may find difficulties in claiming tax credits in their country of residence. The proposal also creates an absurd situation where domestic market players such as stock brokers and financial institutions would not receive an identical tax treatment. However, it should be noted that, subject to the applicability of the GAAR provisions, FIIs investing from jurisdictions such as Singapore, Mauritius and Cyprus may continue to enjoy the treaty based exemption from capital gains tax. Additionally, capital gains income earned by FIIs would not be subject to tax deduction at source.
· GAAR not reasonable enough: GAAR creates a high degree of subjectivity in the application of tax laws and unless it is approached with extreme caution, it may lead to several unintended consequences. It is therefore not surprising that countries such as UK have expressly rejected GAAR. The revised Discussion Paper proposes that GAAR provisions would continue to be implemented by the Commissioner of Income Tax rather than a higher level body as is prevalent in countries such as Canada, which is necessary to ensure judicious application of mind to the facts and circumstances of each case. Further, GAAR provisions would continue to allow the tax authorities to override tax treaty provisions. The other problematic issue is the excessive delegation of ‘law making’ powers provided to the CBDT with respect to framing the guidelines for application of GAAR. The GAAR provisions in its current form would have an impact on several cross-border investment and M&A structures.
· New controlled foreign corporation (“CFC”) rules: The Government would introduce for the first time, a regime for taxing undistributed passive income earned by foreign companies directly or indirectly controlled by Indian residents. Such income would be taxed as dividends in the hands of the resident shareholders. While this is in line with the practice adopted in several developed capital exporting countries which primarily rely on residence based taxation, doubts may be raised whether India is ready for such a step. The proposal can have a significant impact on outbound structures adopted by Indian companies for overseas expansion and globalization. It could also affect carried interest structures used by India based fund managers.
· Taxation of capital gains: The Government has not heeded to suggestions in favor of retaining the current tax exemption for long term capital gains (where shares are held for more than a year) derived from sale of shares on the stock exchange. As an alternative, it has proposed that investors may avail of a specified deduction in respect of such long term capital gains. Transactions on the stock exchange would also be subject to a securities transaction tax at a rate yet to be decided. Such double taxation of investment income may not augur well for the stock market. On the bright side, investors earning long term capital gains from off-market share transactions should be entitled to indexation benefits leading to an increased basis for computing capital gains. However, investors earning short term capital gains (where shares are held for less than a year), would neither receive a deduction nor be entitled to any sort of indexation benefits.
The revised Discussion Paper has failed to address a crucial issue regarding the extraterritorial reach of the DTC. The earlier draft sought to tax offshore transactions that led to an ‘indirect transfer’ of capital assets in India. It also extended the tax net to offshore interest payments by non-residents on foreign borrowings which are used to finance investments in India.
Equally problematic is the DTC proposal (now incorporated into the present income tax law pursuant to the Finance Act, 2010) to tax offshore technical and professional services rendered from outside India despite the absence of sufficient nexus with the territory of India.
In addition to the controversies discussed above and several others, it was seen that the initial draft of the DTC was fraught with numerous ambiguities and legislative drafting errors. For this reason, we were of the view that it was not fit to be presented before Parliament.
True, by releasing the revised Discussion Paper the Government has taken a positive step in recognizing taxpayer concerns and even addressing some of them.
It must, however, be understood that the task of developing a model tax system based on international best practices is far from simple. Proposals such as introduction of CFC rules and alteration of the concept of tax residence require a holistic analysis of India’s macroeconomic objectives, capital inflows and outflows, and its current positioning in global investment and trade. The proposals should take into account canons of efficient taxation including equity, certainty and the rule against double taxation. Guidance may be taken from well-established constitutional and international law principles such as non-arbitrariness, territorial nexus and respect for international commitments.
In terms of best practices, it would be appropriate for the Discussion Paper to match the depth and quality of the 12th Report of the Law Commission of India (1958) which recommended sweeping changes to the Income Tax Act of 1922 and paved the way for the enactment of the present Income Tax Act of 1961. Reference may also be made to the reports of the Joint Committee on Taxationexplaining the US Presidents’ budget proposals, which are in the form of in-depth theses bringing out the rationale behind each proposal, the theories backing them, references to scholarly writings, empirical data and also the projected quantitative impact of each proposal. Evidently, the DTC Discussion Paper has failed to meet such standards.
Only with thorough analysis and deliberation of such high order would it be possible to evolve an efficient and sustainable tax policy. It would therefore be advisable to refer the DTC to an independent commission comprising of experts in the field of law, economics, accountancy and legislative drafting.
Comments on the revised version of the Discussion Paper are invited till June 30, 2010. The Government intends to present a final draft of the DTC before Parliament during the monsoon session beginning in July. It is, however, doubtful whether this is possible considering the widespread and fundamental changes to be made to the earlier draft of the DTC.
Transitioning towards a new tax regime involves a number of implementation and administrative challenges, requiring sufficient time for both taxpayers and tax authorities to gear up for the change. Rushing the bill through Parliament is definitely NOT a step in the right direction.