India
Srinivasa Rao
Ernst & Young
India
Srinivasa Rao of Ernst & Young picks out some of the key provisions for multinational companies in the draft direct code, such as the redefinition of residence and the introduction of a general anti-avoidance rule
The tax legislation, which was introduced in 1961, has been subject to several amendments over the last few decades, raising concerns about its complex nature. Besides, there have been frequent policy changes due to a changing economy complexity in the market, increasing sophistication of commerce, development of information technology and attempts to minimise tax. The problem has been further compounded by a multitude of judgments, often conflicting, rendered by courts at different levels. This had resulted in an increase in the cost of tax administration and tax compliance. From a fiscal policy point of view, the need to broaden the tax base and improve the Tax-GDP ratio has often been expressed as one of the goals of the tax system. The strategy for broadening the tax base essentially comprises of minimising tax exemptions, addressing ambiguity in law and checking tax evasion.
With these objectives in mind the government recently released the draft Direct Tax Code Bill, 2009 (DTC) in an attempt to eliminate distortions in the tax structure, introduce moderate levels of taxation and expand the tax base.
Significant features of the code
The DTC, which will replace the existing Indian income-tax law, was released for public comments, along with a discussion paper, on August 12 2009 and is envisaged to come into force from April 1 2011. The DTC has broadly retained the existing scheme of the income-tax law, but under a modified structure, intended to lend simplicity, flexibility and stability to the taxation system and also to reduce the scope for ambiguity and litigation.
Corporate tax rates
The DTC pegs the corporate tax rate to 25%. This also removes the discrimination in the tax rate applicable to foreign companies and domestic Indian companies which are at 40% and 30%, respectively. However, foreign companies would be required to pay an additional branch profit tax (BPT) at the rate of 15% on their post-tax profits, resulting in an effective tax rate of 36.25%. The levy of BPT is comparable to a dividend distribution tax (DDT) payable by domestic Indian companies at the rate of 15% on the amount of dividends distributed. While DDT is payable at the time of distribution of dividends, BPT is not linked to remittance of profits to its head office.
Tax incentives and MAT
A significant deviation in the policy relating to tax incentives is being made by replacing the profit-based incentives with investment based incentives. Under this system, the taxpayer will be able to claim all revenue and capital expenditure (except on land, goodwill and financial instruments) as deductible expenditure during the period in which such expenditure was incurred. The new scheme of tax incentives is available to specified businesses, which include, for example, exploration and production of mineral oil and natural gas, and developing special economic zones (SEZs). The export oriented businesses in the manufacturing and information technology sector do not however find a place in the list of businesses entitled to tax incentives. The existing profit-linked incentives and area-based exemptions under the domestic tax laws are grandfathered.
Furthermore, while all companies would continue to be liable to pay tax as per the normal provisions or minimum alternate tax (MAT) provisions, whichever is higher, the base for levy of MAT has shifted from book profits to value of gross assets. Under the DTC, MAT would be levied at 2% of the value of gross assets (0.25% in the case of banks). The value of gross assets would be the aggregate of the gross block of assets less accumulated depreciation, capital work-in-progress and book value of other assets. No account would be taken of any loan or other liabilities, even if this is in connection with funding the acquisition of the assets. While the shift is sought to be justified on the grounds of encouraging optimal use of assets and thereby increasing efficiency, this measure, however, seems to run counter to the objective of encouraging capital investment for productive growth. Introducing investment-linked incentives and levying MAT on assets created by those very investments appears to be unfair and could prove quite burdensome for companies. This could possibly result in a kind of punitive tax on capital-intensive companies, as well as chronically sick companies making consistent losses. Furthermore, MAT would be the final tax and there would be no MAT credit available against the tax liability of the company in the subsequent years.
Residence and scope of taxable income
The code seeks to amend the definition of resident, stating that a company would be regarded as a resident even if partial control and management (C&M) of such company is situated in India. With this definition, a foreign company having even part of its C&M in India could end up being treated as a resident. This arguably is a more subjective rule compared to the rule in the tax law where a foreign company is treated as a resident in India only if during a tax year, the C&M of its affairs is situated 'wholly' in India. Judicial precedents have held that C&M is situated at the place where 'the head and brain and directing power' of the company's affairs is situated. It is generally the place where important business decisions substantially affecting the company are taken. This could adversely affect foreign companies having Indian resident individuals on boards or foreign companies undertaking management functions in India, if the place of its C&M is considered as being 'partly' situated in India. In the event such companies are regarded as residents because of partial C&M in India, then it could result in such companies being taxed on their worldwide income as well as being subject to DDT.
The existing system of taxation for residents and non-residents continues to apply under the DTC. While a resident in India is liable to be taxed on its worldwide income, a non-resident is liable to be taxed only on its incomes having a 'source' in India. The concept of source covers incomes accruing or arising, or incomes deemed to accrue or arise in India, or incomes received in India. Under the DTC, the deeming income provisions among others have been expanded to include (a) income from direct or indirect transfer of a capital asset situated in India; and (b) income from interest on debt used for earning any income from any source in India.
Furthermore, the definition of royalty and fees for technical services (FTS) has been expanded to cover more transactions under the taxation net. The scope of FTS is sought to be widened to include development and transfer of any design, drawing, plan and software or similar services and the definition of royalty is also extended to cover consideration towards broadcasting rights, including live coverage of any event. The rate of tax applicable to non-residents for incomes in the nature of royalty and FTS is proposed to be increased from 10% to 20% on a gross basis, without providing for any deductions. The gross basis of taxation would apply even if the non-resident recipient carries on business in India through a permanent establishment. Also, the capital gains arising to non-residents including foreign institutional investors (FIIs) is proposed to be taxed at 30%, irrespective of the holding period of the underlying asset. The DTC seeks to abolish the distinction between a short-term and long-term capital asset and the concessional tax rate for FIIs. Furthermore, while the securities transaction tax (STT) on the sale of listed securities has been scrapped, the DTC has also removed the concessional rate of tax/tax exemption on short term/long term capital gains, respectively, arising from the sale of listed securities, which will now be taxed at 30%.
Transfer pricing
The transfer pricing provisions were introduced in India in 2001. The transfer pricing law being a relatively new one in India has been subject to a lot of controversy since its inception. To avoid litigation and provide certainty to taxpayers, the DTC has empowered the Central Board of Direct Taxes (CBDT), the apex authority for policy and administration of direct taxes in India, to enter into advance pricing agreements (APAs) with taxpayers. Under the DTC, the APA would be binding only on the taxpayer and the transaction for which the agreement has been entered into. Agreements would be valid for a specified period of no more than five years.
The DTC has also proposed changes to the manner in which transfer pricing audits would be conducted. The cases will be selected for scrutiny based on the internal risk management strategy to be framed by the CBDT and will not be disclosed to the public. Transfer pricing cases are subject to compulsory audit by specialist transfer pricing officers (TPOs), where the aggregate value of the inter-company transactions during a particular tax year is more than the specified limit of Rs50 million ($1.1 million). Furthermore, while undertaking transfer pricing audits, a TPO is authorised to use any information in his possession for determining the arm's-length price. This provision often raises concerning the ability of the TPO to use secret comparables or information the taxpayer does not have access to. The DTC proposes to introduce a safeguard against this by providing that such information cannot be used by the TPO, unless the taxpayer gets the opportunity to be heard.
Advance pricing agreements, along with the safe harbour rules (introduced in the Finance Act, 2009 and which find a place in the DTC) and a risk-based approach for the selection of cases for transfer pricing audits should certainly help to reduce transfer pricing controversies and disputes and also provide a basis which is fair and impartial to both the tax authorities and the taxpayers.
Domestic tax law and tax treaty and treaty override
A taxpayer can opt to be taxed under the provisions of the domestic tax laws or the applicable tax treaty, whichever is more favourable. The DTC seeks to redefine the relationship between the domestic tax laws and tax treaty law. It provides that neither a tax treaty nor the DTC shall have a preferential status by reason of it being a tax treaty or law and that the provision that came later shall prevail. The DTC proposal could potentially result in domestic tax law overriding a tax treaty, if a conflicting provision is enacted in the DTC after the entry into force of a tax treaty.
The ability of countries to change unilaterally, or override, their tax treaties through domestic legislation has frequently been identified as a serious threat to the bilateral tax treaty network. In most countries, tax treaties have a status superior to that of ordinary domestic laws. However, in some countries treaties can be changed unilaterally by subsequent domestic legislation. This result clearly violates international law as embodied by the Vienna Convention on the Law of Treaties (VCLT), which is recognised as customary international law even by countries that have not formally ratified it.
General anti-avoidance rule
The code seeks to introduce a general anti-avoidance rule (GAAR) empowering commissioners to declare an arrangement as an impermissible tax avoidance arrangement, if it has been entered into to obtain a tax benefit and which lacks 'commercial substance' or is not for a bona fide 'business purpose'. The onus would be on the taxpayer to establish that obtaining a tax benefit was not the main purpose of the arrangement. On invoking the GAAR, the commissioner may determine the tax consequences by amending, disregarding or re-characterising the arrangement. The GAAR would also override the provisions of the tax treaty and the directions of the commissioner would be binding on the tax officer.
The proposal to codify GAAR in the tax legislation represents a new government approach to combat tax avoidance. In framing a law that is sufficiently all-embracing to deter tax avoidance, there is always the danger of penalising those who have entered into bona fide transactions. The GAAR provisions are broadly worded and several terms used therein are capable of alternative interpretations. The terms such as 'commercial substance' and 'business purpose' are not defined in an exhaustive manner, which could result in arbitrary or subjective application of the provisions. The intention to apply GAAR by overriding India's tax treaties could have an impact on the stability and certainty provided to foreign investors under an applicable tax treaty.
Impact assessment
The approach of the government in releasing the draft DTC for public comments, before introducing it in the Parliament, is commendable. This has allowed stakeholders sufficient time to evaluate the impact of the DTC before it is brought into force and also to provide comments for the government's consideration. There are significant proposals in the DTC that have an effect on multinational enterprises. The business community should engage actively with the government in presenting their point of view. At the same time, it will be important to assess the impact some of these proposals could have on existing structures and business models.
Srinivasa Rao, partner & national director of tax & regulatory services at Ernst & Young India srinivasa.rao@in.ey.com