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Retrograde norms mar Direct Taxes Code Bill
January, 18th 2011

Business reorganisation is critical to growth process, whether for acquiring technology through joint ventures or for acquiring critical size through mergers or for converting partnership firms into companies so as to raise capital for growth.

The Direct Taxes Code Bill, 2010 has many retrograde provisions, even as compared to the existing law. The bill classifies assets into: a) investment asset; b) business trading asset; and c) business capital asset. Earlier, the transfer of any capital asset , including a business unit, to a 100% subsidiary company was tax-free ; now only gains on investment asset transfer will be tax-free . Thus, transfer of business undertaking to a 100% subsidiary will attract tax as business income.

Remission of loan , advance or credit will be business income as against only trade liability at present. Revival of weak companies by any loan write off or interest waiver will suffer.

The new law provides that in a demerger , equity shares only must be issued as against full flexibility today. Why take away this flexibility? Let the business contingencies decide the plan. The valuation will always be checked by regulatory authorities. Issue of preference shares convertible (CCP) to equity will not satisfy this condition.

Issue of CCP to be converted as per Sebi formulae of average stock exchange prices leads to fair price discovery.
New trends internationally accepted have not been recognised by the bill. Instead of merging into one company, the contemporary practice is that companies create a holding and subsidiary company structure by issuing their shares to the shareholders of the target company. There is thus a pooling of interest of the shareholders of the acquirer and the target company as in a merger. Migration of registered offices of companies from abroad to India and their tax consequences will incentivise foreign companies to be domiciled here.

In merger or demerger which are now currently tax-exempt , it appears [as per section 45 (e)] that only capital gains on investment assets will be tax-free (and not business assets). This law was in existence from 1961 is being overturned. Both groups of shareholders owning two companies are pooling their interests in one company; there is no sale to the third party and for encouraging business growth, it was not subject to the taxation. Mercifully , the tax exemption for the shareholder of a company has been continued.

Further, the DTC Bill provides any arrangement entered into by a person may be declared as an Impermissible Avoidance Arrangement (IAA). The latter is defined as a step in, or a part or whole of, an arrangement, whose main purpose is to obtain a tax benefit.... If the ITO holds that there is an IAA, then he gets immense powers: (a) to disregard the transaction or any step therein; b) to reduce thetaxbenefit;c)toreallocatetheincome and expenditure among various parties to the arrangement, etc; and d) or exercise any of the other wide powers which have been given. This is virtually overturning any other exemption provisions of the bill. And the test is at the subjective discretion of the ITO. Will this not hit business reorganisations? It is better to have a system of approval by ITO (as under section 72A currently).

The provisions for assessing foreign companies on the basis of effective place of management, the General Anti Avoidance Rules, the thin capitalisation rules, and the rules for full examination of schemes which transfer asset or income to non-residents are welcome. These should be tempered by well laid-out internal circulars that lay down transparent rules. Approval of higher authority with a reasoned order should be made necessary to ensure judicious use.

The provisions for taxing undistributed income of controlled foreign companies (CFC) controlled by Indian entities should be reconsidered.

The bill also has many draconian provisions which lead to uncertainty regarding taxation. The bill authorises the disallowance of any expenditure to any associated person if it is not at a fair market value (without any margin of error), or is not for the legitimate needs of the business, or the purchaser does not derive adequate benefit . To satisfy these tests will be purely the ITOs judgmental opinion. Fair market value justification will require businesses to maintain a host of data and documentation (Sec 115).

Finance minister Pranab Mukherjee had stated in his Budget speech: How of foreign investment is extremely sensitive to a prolonged uncertainty in tax related matters ? Does the DTC Bill 2010 pass this test?

(The author is managing partner, S S Kothari Mehta & Co)

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