The freshly unveiled direct taxes code (DTC) is an idea which was overdue and whose time has perhaps never been more appropriate. There seem to be three key objectives behind the introduction of the DTC: simplification of language, resulting in lesser litigation; a law which promotes inclusive growth and yet retains the incentives for businesses to make profits; and allow businesses to function in the free market economy but with proper regulations. This article attempts to analyse some of the key provisions of the DTC in the light of the above objectives.
Taking a leaf out of the Chinese tax code, the DTC pegs the corporate tax rate to 25% which is clearly a very attractive rate compared to prevailing rate elsewhere. This, of course, comes with the removal of profit-linked incentives. We now have investment-linked incentives in specific sectors (infrastructure, power, exploration and production of mineral oil, etc) to incentivise capital formation and to remove the incentive to shift profits from taxable units to exempt units.
We also now have capital assets deployed in the businesses (e.g., plant and machinery) to be treated as business assets and any profits arising on sale of these assets to be treated as normal business income and not as capital gains.
In practical terms, a company will now be subject to the same uniform rate of 25% tax on gains from transfer of such business capital assets as against the current rate of 20% for long-term capital gains on transfer of all capital assets.
The downside in these provisions is the fact that a loss arising on such a business transfer will not be allowed to be written off in one year but will be amortised like depreciation over a period of time. This provision seems to be inconsistent with the treatment of gains as business income in the year when the gains arise.
However, there is a significant dampener to this feel-good story in the form of the new basis of levy of minimum alternate tax (MAT). The MAT will now be levied at 2% of the value of gross assets in the case of all companies except in the case of banking companies (tax at 0.25% for banking companies). This shift in the MAT base from book profits to gross assets is sought to be justified on the grounds of encouraging optimal utilisation of the assets and thereby increased efficiency.
This measure, however, seems to run counter to the objective of encouraging capital investment for productive growth. For e.g., in the case of an infrastructure company where the pay back on the investments is longer, on the one hand we have the investment-linked capital allowance reducing taxable profits significantly, on the other hand is the imposition of MAT calculated at the same base of capital investments.
To make matters worse, there is no provision for reducing liabilities incurred for acquisition of assets, i.e., MAT is to be calculated on value of gross assets without corresponding reduction in borrowings incurred. This could result in a kind of punitive tax on capital-intensive companies including public sector companies as well as chronically sick companies making consistent losses.
A very significant shift is sought to be made in the area of capital gains taxation. Since 1991, capital gains on sale of shares and securities has always been accorded preferential tax treatment to encourage investment in equity market. The DTC now proposes to remove the distinction between short-term and long-term capital gains on all classes of assets, thereby taxing any gains on transfer of capital assets at normal rates of tax.
Thus individuals in the higher tax bracket of 30% would be more adversely affected than companies, as companies would pay taxes at a uniform tax rate of 25% on similar gains. This also means that the abolition of the Securities Transaction Tax (STT) will be more than made up by a levy of normal tax on all stock market transactions, be they short term or long term.
Further, gains on transfer of immovable property which at present is at 20% if property is held for more than three years will now be taxed at the normal rate of 30% for individuals in the higher tax bracket and 25% for companies.
Some very significant changes are proposed in the international tax area. A time-tested principle of characterising a foreign company as a resident Indian company on the basis of the foreign company being wholly controlled and managed from India is sought to be substituted by a more stringent and arguably a more subjective rule, i.e., a foreign company partly controlled and managed from India will also be regarded as an Indian resident company.
In its present form, it would appear that overseas subsidiaries of Indian companies would be subjected to taxation in India on their worldwide income solely on the basis of them being partly controlled and managed from India. This seems to be an unintended onerous outcome which needs to be corrected.
An elaborate provision spelling out the general anti-avoidance rule is proposed. While it has features of comprehensiveness, it seems ripe for several different interpretations in respect of features like commercial substance, round trip financing, accommodating party, etc. It is further provided that the general anti-abuse rule will override the provisions of any tax treaty.
Thus, for example, the current controversy on the use of Mauritius DTAT will get further ammunition as the Revenue will now seem to invoke the general anti-abuse rule in specific cases to override the provisions of the Mauritius treaty. If the intent behind the code was to eliminate litigation and simplify provisions of law, this particular provision certainly does not stand anywhere close to achieving that objective.
In continuation of the introduction of the Alternate Dispute Mechanism in Budget 2009, the DTC seems to now extend this benefit to all taxpayers and not restrict it to foreign companies which is a welcome move and will help the entire tax community. Also, there is a proposal to introduce advance pricing mechanism on transfer pricing which has been a long standing request by multinational corporations.
All in all, the idea of the DTC is great, many of the provisions are well intentioned and most importantly time has come to embrace, adapt and run with the DTC as early as possible.