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Banking sector looks for rationalization of taxes with Budget 2010
February, 12th 2010

Amidst globalization, the banking system in India has attained vital importance and the relevance of financial sector in general and banking sector in particular to the India growth story is well accepted. As commercial banks are dominant institutions with linkages to other segments of the Indian financial system, the strength of this sector is necessary to provide an anchor to the economy, particularly in these turbulent times.

While the role of the Government and the Reserve Bank of India in responding swiftly to the changing dynamics of the sector through a series of monetary policy measures needs to be appreciated, the same cannot be said to be true when it comes to providing fiscal support via rationalisation of tax provisions.

As we approach yet another Union Budget, let's take a look at some of the expectations of the banking industry on the tax front, some of which have been long standing and continue to go unnoticed year after year.

One of the long pending demands has been to allow a deduction for provision made by banks towards bad and doubtful debts, in accordance with guidelines issued by the RBI. The provisioning norms prescribed by RBI are quite robust and are largely synchronised with the best practices followed by banking regulators globally.

Currently, the deduction for provision is limited to 7.5 percent of total income and 10 percent of rural advances for Indian banks (5 percent of total income for foreign banks), which distorts the taxable income of a banking unit.

Another significant area which has seen intense litigation is the disallowance of expenditure under Section 14A of the Income-tax Act in relation to earning exempt income. The current formula prescribed for computing the disallowance has been applied even in a scenario where there is no direct nexus between the earning of exempt income and the expenditure and has resulted in genuine hardship to banks. In the interest of justice, it is necessary that Mr. Mukherjee clarifies that only expenditure which has a direct nexus to earning exempt income should be disallowed.

Additionally, provision in the tax law which impacts Indian branches of foreign banks and needs to be re-looked at is the deduction for "head office expenses" incurred by the head office. The deduction is restricted to 5 percent of the adjusted total income of the Indian branch. What constitutes "head office expenditure" has been a subject matter of litigation between banks and the Revenue.

With India likely to be a strong growth market for existing foreign banks, there is also a need to change with times and revisit the limit for deduction, which was set in 1976 when the provision was introduced. Also, with robust transfer pricing provisions in place, the fear of misuse of the provision is misplaced. While the Direct Tax Code proposes to change the limit of deduction to 0.5 percent of sales, this may still limit the deduction for banks that have significant taxable income.

The role of Asset Reconstruction Companies (ARC) in relieving banks of the burden of Non Performing Assets (NPAs) would allow them to focus better 
on managing the core business, including new business opportunities cannot be overemphasised. Clarity in tax treatment of securitisation transactions is long overdue and would go a long way in evolution of an efficient set up for NPA resolution in the country.

Currently, investment in specified bank fixed deposits having a lock-in period of five years is allowed as deduction, while, computing the taxable income of individuals. In order to boost and incentivise individual savings with banks, this lock-in period should be reduced to three years to bring it at par with other tax saving instruments such as Equity Linked Savings Schemes offered by mutual funds.

Further, the amendment introduced to Section 36(1)(viii) of the Act in the Finance (No. 2) Act, 2009 to the term 'eligible business' in the context of financial corporations and banks to substitute the words "construction and purchase of houses in India for residential purposes" with "development of housing in India" may result in an unintended interpretation that deduction would be allowed only in the context of long-term finance provided to developers of residential houses only and not to individuals. To remove ambiguity, the definition may be amended to include "construction and purchase of houses in India for residential purposes including refinancing activities".

The aforesaid amendments would help achieve the objective of growth with equity in taxation for the banking sector as well as avoid wasteful litigation.

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