In the draft direct tax code the Centre announced last week, one proposal that attracted significant attention is the new version of the minimum alternate tax (MAT). While the overarching theme of the direct tax code is to lower tax rates and do away with tax incentives, this tax falls short.

MAT is the minimum amount of tax that a profitable company has to pay, even if it is not liable to pay any other normal tax. There were instances in the past when, despite having sizeable earnings, companies did not pay any taxes by taking advantage of various tax incentives.

The government, noting this anomaly, had introduced MAT to counter the rapid increase of these zero-tax companies, which flourished on a cocktail of tax exemptions, deductions and high rates of depreciation.

MAT is currently at 15% of book profitsan accounting term that is equivalent to profit before tax, subject to some adjustments (as per tax provisions). If the draft code is passed, MAT will be levied at 0.25% of the value of a firms gross assets for banks, and 2% for other companies.

Gross assets refer to a firms fixed assets, the capital work in progress and the book value of other assets. According to the draft code, this will encourage optimal utilization of assets and increased efficiency.

The problem here is that MAT will be levied on all companies, whether they are earning profits or not. This adversely affects companies in its initial years of operations, when they are not in a position to make profits; it also affects sick companies, whose recovery process may receive a further setback.

Further, this proposal is likely to increase the tax cost for manufacturing and construction companies, which are capital-intensivenot so for services companies such as software and business process outsourcing (BPO). Thus, it has the potential to discourage capital spending by raising the cost of capital.

To worsen the situation, the draft code further proposes that MAT will be treated as a final tax and cannot be carried forward to claim tax credits in subsequent years. And existing MAT credit has also not been grandfathered in the proposed codethe old rule cant apply to existing situationsresulting in a loss of a companys entire unutilized MAT credit once the new code comes into force in 2011.

While asset-based minimum taxation of this sort exists in several other countries such as Argentina, Colombia, Mexico and Venezuela, India seems to have adopted this in the strictest form. For instance, no deduction is allowed for borrowings made by a company to finance the acquisition or construction of assets. This leads to unfair results.

In fact, with the increased removal of various tax exemptions and deductions, the original need for having a parallel MAT system has lost its relevance. True, there remains more of tax depreciation (whats recorded in tax returns) compared with book depreciation (whats recorded in financial statements). But taxing this differential through MAT only takes more money awayseemingly contradicting the governments basic aim to promote industrial growth by inducing the corporate sector to invest more.

The government itself has proposed in the draft code replacing profit-based incentives, wherever available, with investment-based incentives. Yet, there appears to be a dichotomy in the two approaches: It allows incentives for asset creation, on the one hand, and still levies tax on the same asset base, on the other.

The rationale of having an MAT actually needs to be revisited in the current economic scenario. Even the Vijay Kelkar committee report on direct tax reforms in 2002 recommended the abolition of MAT.

Indias corporations have come a long way since MAT was introduced. Perhaps the finance ministry will adopt a holistic perspective in the near future and revisit this new proposed MAT. Tax policies, ultimately, must favour growth and competition.