For an economy on a growth trajectory, a developed and vibrant financial market is a sine qua non. The world is looking at India as the next big growth driver. India has most of the requisite attributes to be the agent for the next big global transformation and a financial market to support such a transition. Certain reforms in the sector, including a re-look at the existing regulations, are already on the anvil. With this, it may be prudent to look at certain tax issues that this sector is faced with, so as to create the jugalbandi required to create the perfect symphony between the financial sector and the other sectors. We touch upon some of these critical income-tax issues in this article.
With the financial sector attracting more and more foreign players who have access to developed financial markets and structured financial instruments, it is imperative that these complex instruments slowly find their way into the Indian market.
The Indian market has already seen rapid change with complex financing structures, securitisation, and derivative instruments catching the fancy of the players and the users of such instruments. The one thing that has not been seen though, is a corresponding march of the income-tax law.
But to just take an example, securitisation has posed some complex tax issues. Similarly, complex derivative instruments can pose challenges to a taxpayer who at the moment does not have any guidance on the tax treatment thereof. With financing structures becoming more complex, it has become imperative to simultaneously consider tax implications thereof.
To take a recent example, foreign institutional investors have recently been permitted to short-sell securities and then give delivery thereof at the settlement by borrowing securities consequent to a stock-lending scheme. This raises tax issues in the hands of the seller, such as: Would the gains from the sale be taxable as capital gains or as business income? And what would be the cost of acquisition of the shares borrowed? It also throws up some interesting tax questions vis--vis the lender of the shares as well as the intermediary.
Bad debt write-off
Banks as the largest players in the financial markets also have significant tax issues. One of the issues that banks have been facing is the allowability of a tax break on write off of bad debts.
The Income-Tax Act, 1961 was amended with effect from April 1, 1989, to provide for the allowability of a deduction for a bad debt in the year in which the debt was written off in the books of account of the lender.
The amendment was made to resolve a controversy over the year in which a debt actually became bad, because as the law stood earlier, the deduction was to be allowed in the year in which a debt went bad. One thought that with this amendment things would be simpler for claim of this deduction, but as it appears, post this amendment too the deduction for bad debts remains a point of contention, particularly between the banks as taxpayers and the I-T department.
Issues have arisen as to whether it is necessary to prove that a debt has become bad when it was written off. Is the write-off to be done only by way of a debit to the profit and loss (P&L) account, how does one tax a non-cash recovery of a debt that has been written off, are some of the fresh issues that have cropped up between banks and the tax office post the amendment.
For foreign banks, deductibility of inter-office interest and the related issue of whether tax is required to be withheld therefrom, is still a bugbear even after the decision of the Special Bench of the Income-tax Appellate Tribunal (ITAT) gave out its ruling in the ABN Amro Bank N.V. case.
The Special Bench has held that the payment of inter-office interest is a payment to self and hence not tax deductible in computing the profits of the Indian branches of foreign banks.
As a corollary, the payment being to self is not subject to tax withholding. Banks, on the other hand, are of the view that the interest paid should be deducted while computing the profits attributable to their Indian operations, based on a very logical principle of attribution of profits.
This issue also has witnessed a lot of litigation and it honestly is perplexing to fathom whose interest is served by prolonged litigation and uncertainty on the issue.
Another issue that has been the subject of recent litigation is the allowance of depreciation on assets given on a finance lease. But the Central Board of Direct Taxes (CBDT) had issued a circular in 2001 to the effect that irrespective of the accounting treatment given to lease transactions in the books of the lessor and the lessee, depreciation on leased assets would be available to the owner thereof, which, in law, ought to be the lessor.
The allowability of depreciation to the lessor in finance leases is however increasingly being questioned and one has seen ones fair share of cases where the lessor is not held to be the owner by the tax department. This promises to become another contentious issue for the financial services sector in the days to come.
Another issue affecting banks in particular is the treatment of notional loss on revaluation of forward or foreign exchange contracts. While the loss is required to be booked in accordance with the accounting standards, the tax authorities have been claiming that the loss is not permitted to be claimed for the purposes of computation of the tax liability. Though there are favourable decisions in this regard, owing to the lack of a universally accepted procedure, it has added to the quandary of the taxpayers.
One more significant issue where clarity is urgently needed is the quantum of disallowance of expenditure in relation to income not chargeable to tax. Unfortunately, the intent of prescription of rules to settle controversy in this regard has not yet translated into action. Nor is the fact that a certain portion of assets of banks, in particular, statutorily required to be invested in securities yielding tax exempt income looked at.
Another bugbear for the sector is the newly introduced fringe benefit tax (FBT) particularly on Employee Stock Options (ESOP). In spite of valuation rules being prescribed for levy of FBT on ESOP, some questions still remain unanswered.
Transfer pricing and withholding tax continue to be the financial services industrys bugbear. The lack of understanding of cross-border financial transactions by tax officers often results in unjustified adjustments being made to their income which potentially can result in significant tax payment issues (if not tax liability issues) for them.
Additionally, the complexity of the transactions often leads to questions about potential withholding tax requirements and liability, which neither the taxpayers nor the tax department appears to conclude successfully on. So the vice-like grip of the tax law will not only make taxpayers cough up significant amount of taxes, but can potentially throw the pricing mechanism of a product out of gear.
Many financial services are also subject to service tax and certain interpretation issues have the potential to result in long and significant litigation for the players in the financial services sector.
These and many other issues not discussed here, have resulted in considerable time and resources of the financial services sector being spent on tax compliance and litigation and have also hampered their ability to price their products competitively.
With financial sector reforms high on the Governments agenda currently, one cannot but help feel that the time is ripe to take a closer look at the tax issues that this sector faces and address some of them. Hopefully, in Budget 2008, the Finance Minister will try to resolve some of these tax issues.
Anish Thacker Sweta Kapadia (The authors are Mumbai-based chartered accountants)