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Revised Discussion Paper Released on the Direct Taxes Code
In August 2009, the Government of India had released a discussion draft of the new Direct Tax Code ("DTC") that is proposed to replace the current Income-tax Act, 1961 ("the Act") from April 1, 2011. The draft contained several proposals that were considered contrary to generally accepted principles of taxation. After considering the several representations made, the Government of India had indicated that it would re-look at some of the key proposals. On 15 June 2010 the Government released a Discussion Paper articulating its position on several key issues. Taxand India assesses the key issues set out in the Revised Discussion Paper and impact on multinationals.
Double Taxation Avoidance Agreements vis-?-vis Domestic law
The original draft of the DTC had proposed a shift from the option currently available to non-resident taxpayers to be governed by the Domestic Law or the Tax Treaties, whichever is more beneficial. The DTC provided that the provisions of the Tax Treaties or the DTC, whichever is later in time will prevail. The Revised Discussion Paper recognises the limitation of such a sweeping change and proposes to revert to the current position with some exceptions. Accordingly, the DTC is expected to restore the taxpayer's option to be governed by the more beneficial provisions of DTC or Tax Treaties, except in the following circumstances:
- where the General Anti Avoidance Rule is invoked
- when the Controlled Foreign Corporation provision is invoked
- when branch profits tax is levied
Tax holiday for SEZ units
The original draft of the DTC proposed a shift from profit linked incentives to investment linked incentives. While the DTC proposed to protect the tax holiday available to already existing developers of notified Special Economic Zones ("SEZs") for the unexpired period, there was little clarity on the tax holiday for units already operating in the SEZs. The Revised Discussion Paper now states that the tax holiday would be available for such units as well for the unexpired period. However, it does not clarify if such tax holiday would be investment linked considering the policy shift or if it would continue to be profit linked for the unexpired period. The cut off date to determine units already in existence is also not clear.
Minimum Alternate Tax - Gross assets vis-?-vis book profit
The DTC proposed to levy Gross Assets Tax ("GAT"), instead of the current Minimum Alternate Tax ("MAT") with the book profit as the basis of tax. GAT was proposed at the rate of 2 percent of the value of gross assets (0.25 percent in case of banking companies). No credit for GAT was allowable in subsequent years. The proposed Revised Discussion Paper considers the lacunae in the proposal and proposes to roll back to the current MAT regime, i.e. impose MAT on the book profits. However, the proposed rate of tax is not specified.
Taxation of capital gains
Originally, the DTC proposed to tax capital gains earned by non-residents at 30 percent, treating it as income from special sources. The Revised Discussion Paper proposes to consider all capital gains, including those arising to a non-resident, as income from ordinary sources, which would be taxed at the normal rates.
Presently under the Act, long term capital gains arising on the transfer of listed equity shares or units of equity oriented funds is exempt from tax whereas short term capital gains are taxed at 15 percent. The DTC proposed to remove the distinction between long term and short term capital assets, while retaining the benefit of cost indexation in computing capital gains in the case of investment assets held for more than one year from the end of the financial year in which they were acquired. The base date for computing the cost indexation was proposed to be shifted from 1 April 1981 to 1 April 2000.
The Revised Discussion Paper proposes a graded basis of taxation in place of the cost indexation scheme for long term gains arising from sale of listed equity shares/ units of equity oriented funds. Capital gains or loss on the listed equity shares/ units of equity oriented funds will now be computed after allowing deduction at specified percentages, which are to be finalised in the context of the overall tax rates. Long term gains arising from other assets will be taxed at ordinary rates after cost indexation. Short term gains will be taxed at the ordinary rates without any specified deduction.
The original proposal to abolish Securities Transaction Tax ("STT") has been withdrawn. Instead, STT will be calibrated based on the revised taxation regime for capital gains and flow of funds to the capital market.
In the context of income earned by Foreign Institutional Investors ("FIIs") from the purchase and sale of securities, the Revised Discussion Paper proposes to deem such income to be capital gains. The paper seeks to prevent FIIs from treating such income as business profits and claim exemption under the Tax Treaty, which could be available in the absence of a Permanent Establishment ("PE") in India. The paper is silent on classification of income from derivatives. It also proposes to continue with the present scheme where the capital gains arising to FIIs are not subject to withholding tax and the FIIs are required to pay advance tax as applicable.
Concept of Residence in the case of a company incorporated outside India
The original draft DTC had proposed that a company incorporated outside India will be treated as resident in India, if at any time during the financial year, the control and management of its affairs is situated 'wholly or partly' in India'. The Revised Discussion paper now seeks to determine the residence status of a foreign company by applying the 'place of effective management' test, which is defined as:
- The place where the board of directors of the company or its executive directors make their decision
- In a case where the board of directors routinely approve the commercial and strategic decisions made by the executive directors or officers of the company, the place where such executive directors or officers perform their functions
CFC regime introduced
As an anti-avoidance measure, the Revised Discussion Paper proposes to introduce Controlled Foreign Corporation ("CFC") provisions in the DTC to tax the passive income of foreign companies which are controlled directly or indirectly by an Indian resident. Under the proposal, income which is not distributed resulting in tax deferral is deemed to be dividends in the hands of the resident shareholders and accordingly brought to tax.
General Anti-Avoidance Rule
The DTC had proposed to introduce General Anti Avoidance Rules ("GAAR") to treat a transaction as a tax avoidance transaction, if it is undertaken with the main purpose of obtaining a 'tax benefit' and is entered into or carried on in a manner not normally employed for bona fide business purposes or is not at arm's length or abuses the provisions of the DTC or lacks economic substance. The provisions were drafted to permit lifting of corporate veil or apply substance over form test.
The Revised Discussion Paper proposes to retain GAAR as the Government perceives it to be an effective tool against tax avoidance. However, following safeguards have been proposed:
- The Central Board of Direct Taxes ("CBDT") would issue guidelines on the circumstances in which GAAR may be invoked.
- A threshold limit (possibly a monetary limit) would be prescribed for invoking GAAR.
- The taxpayers, in whose cases GAAR is invoked, could approach the Dispute Resolution Panel ("DRP"). DRP is a collegium of three Commissioners, which was recently introduced for non-residents or those taxpayers in whose cases transfer pricing adjustments are proposed, to resolve their tax dispute on a fast track basis. Now, the scope of DRP is proposed to be expanded to include cases where GAAR is invoked.
The efforts of the Government to retain the spirit of the original draft DTC while at the same time rationalising some of the proposals is encouraging. While the continuation of GAAR causes concerns about the implementation of such rules, it is also encouraging that the Government has allowed a fast track mechanism of DRP to settle any executive action. GAAR could be used even against any investment structures not backed by adequate commercial substance. The proposed amendment to charge gains arising to FII as capital gains could negate the argument that such gains are to be treated as business profits and that they cannot be taxed in India in the absence of a PE. It would be interesting to assess the impact proposed in the final version of the DTC bill once it is placed before the Parliament in the next few months.
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