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Draft Direct Tax Code Could be more friendly
August, 28th 2009

Policymakers, income-tax consultants, income-tax payers and the general public have been weighted down by the current Income Tax Act 1961, which has undergone innumerable and complex ad hoc changes. All economic agents have been calling out, for quite some time, for a total revamp of the income-tax laws.

It is to the credit of the of the present government that it has it has come out with an exhaustive draft Direct Tax Code (DTC) which, after open discussion, will be firmed up and implemented.

The draft DTC has evoked universal interest as it reflects the endeavour of the authorities to produce as complete a document as possible for meaningful discussion before implementation. In a sense, it reflects the best standards of participative discussion in the formulation of tax policies.

The new DTC refrains from minor tinkering of the existing Act. In fact, it would allow for the minimum of disputes and litigation and it goes a long way towards a system which is consistent with todays milieu. Criticism has been muted and any issues raised by commentators are by way of improving clarity or technical lacunae.

Higher exemption limits

The central theme of the reform is to raise substantially the basic exemption limits for all categories and, more importantly, alter the slabs at which the tax rates rise. What is significant is that a low tax rate of 10 per cent applies to what appear to be very high income levels.

For instance, senior citizens, who are at present subject to a 30 per cent tax rate at income levels as low as Rs 5 lakh per year, will, under the DTC, reach a 30 per cent tax bracket at a very high income level of Rs 25 lakh per year. This is made possible by removing all sorts of exemptions and deductions, which would make for a more equitable tax system.

A major reform that had got bogged down because of lack of clarity relates to the move from an Exempt (Investment), Exempt (Interest) and Exempt (Withdrawal), that is, an EEE system, to an EET system, under which all withdrawals would be subject to tax.

For quite some time the government appeared to be unable to grapple with the implementation issue but, on this occasion, it has come up with a system that could be workable with a few minor amendments. While the plethora of exemptions and deductions are drastically reduced, the endeavour is to move to a more equitable system by abolishing separate buckets under a number of deductions. There will be a global deduction of Rs 3 lakh.

Some glitches

A few glitches do need to be removed. Withdrawals by holders under the Public Provident Fund (PPF) Scheme will be exempt from tax up to March 31, 2011. It is not clear if the interest for the year ended March 31, 2011, payable in April-May 2011, will also be exempt from tax.

A more difficult issue is that while those employed in various organisations can cover the Rs 3 lakh deduction under various heads, such as PPF, Employees Provident Fund Organisation (EPFO) and other superannuation schemes, senior citizens have only to fall back on the PPF scheme. The New National Pension Scheme would obviously not be available to senior citizens.

The upshot is that the Rs 70,000 restriction on PPF would be a major disadvantage to senior citizens. One way out could be that the ceiling for annual investment in PPF could be raised from Rs 70,000 to Rs 3 lakh. A rider to this is that senior citizens could be allowed to remain in the PPF scheme without additional subscriptions and only that portion which is withdrawn should be subject to tax.

There is a need for clarity on the issue of withdrawals by the heirs of deceased holders in such schemes. There appears to be silence on this issue.

There is a need to build in a clause that, in the event of death of the holder, there would be no deduction of tax on the funds accruing to the heirs/nominees this could be analogous to the present National Savings Scheme 1987, which has an explicit clause that, on the demise of the holder, the heirs/nominees are not subject to tax.

There are some rumblings about tightening of the capital gains and wealth tax regimes. India is unique in that long-term capital gains arising from equity transactions in the stock market are totally exempt from income-tax, and financial assets are also exempt from wealth tax.

These two proposed measures are quite reasonable and the authorities should not be intimidated that these very mild measures would affect capital market sentiment.

With the handsome liberalisation of tax slabs there is no reason to defer these measures. The proposed wealth tax of 0.25 per cent for assets over Rs 50 crore is hardly a hardship and it is time these measures are implemented.

Regular review

To the credit of the draftsmen who have produced the DTC, one can readily say that they have addressed most issues. There is, however, one issue the exemption of dividends in the hands of the recipient from income-tax. It is ostensibly argued that taxing dividends in the hands of the recipient would amount to double taxation. This is a fallacy.

It is a basic principle of public finance that corporate tax and income-tax are paid by two different and distinct entities. The double taxation argument could be carried to its logical absurdity. An income-tax payer should not be subject to any tax on post income-tax expenditures, including on commodities subject to indirect tax.

Invariably, draftsmen responsible for setting out income-tax legislation are berated for convoluted regulations. The draftsmen of the DTC deserve kudos for their magnificent piece of work performed with due diligence.

One would hope that between now and the final implementation various uncertainties and glitches will be addressed. But once the Code is implemented the authorities should not go back to haphazard changes. There should be a five-yearly comprehensive review of the entire code.

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