The Direct Taxes Code, unveiled by the finance minister last week, signals a paradigm shift in the direct tax regime for the Indian economy. It seeks to address some of the key facets of a progressive tax regime?simplicity, uniformity, clarity, stability, ease of compliance, and, more importantly, as the FM, himself, hopes, compatibility with the needs of a fast developing economy.

An attempt has been made to adopt the principles that have gained international acceptance and to adopt the best practices prevailing in the world. Having the draft code open for public comments, in itself, signals a pragmatic mindset shift and hopefully, sets the standard in which the code will be administered as well.

Some of the key changes proposed have been discussed in this article. Further, certain key deviations from/comparative reference of the current Income-tax Act, 1961, (the current Act) has also been provided at appropriate places.

Corporate taxation

The corporate tax regime in India, for years, is plagued on the one hand, with a higher base rate and on the other hand, with sector-specific tax incentives (exemptions/deductions). This complicated the effective tax computation as also resulted in protracted litigation.

The code seeks to rationalise corporate taxation in a big way. The corporate tax rate has been proposed at 25%. Consequently, the tax incentive provisions have been largely eliminated, as discussed in more detail below.

Business income computation

The code proposes to replace the current business profits with specified adjustments basis of computing income from business to an income expense model, as prevalent in certain developed and other Asean countries.

Under the new model, the income from business would be computed as gross earnings minus business expenditure. All receipts from business, including capital receipts, shall form part of gross earnings. Thus, for instance, profit from sale of business capital assets/slump sale of business undertakings, would now be taxable as business income (as against capital gains under the current Act). Also, remission of any loan, otherwise a capital receipt, would form part of gross earnings. Business expenditure is classified under three categories?Operating expenditure, permitted financial charges and capital allowance (a la depreciation & R&D allowance, under the current Act).

Business losses are sought to be allowed to be carried forward for an unlimited period.

Dividend distribution tax (DDT)

DDT at 15% is sought to be continued for dividends distributed by domestic companies, except to certain specified shareholders?MFs, VCFs, LIC and approved retirement benefit funds/trust. Further, the existing single-tier DDT exemption has been retained. This, taken together with the base tax rate of 25%, results in an effective corporate tax of 34.78% for Indian companies (assuming a full dividend distribution). A saving of nearly 880 bps!

Minimum alternate tax (MAT)

Again, the Code seeks to materially change the basis of computing MAT, which will now be computed with reference to the gross assets as against book profits under the current regime. The MAT rate is proposed at 2% of the value of gross assets for all companies, except for banking companies. The latter would be subject to MAT at 0.25% of the value of gross assets.

The value of gross assets will be the aggregate of the value of gross fixed assets and capital work in progress and the book value of all other assets as reduced by the accumulated depreciation on fixed assets and debit balance of profit and loss account. The provisions do not clarify whether the value of fixed assets etc for the purposes of the above would be taken as the book value or a valuation would have to be clarified every year. Further, MAT paid by a company would not be allowed as a credit against the tax liability of subsequent years, as under the current Act.

This proposed MAT regime would imply that even loss making companies would now be subject to tax, a hardship which certainly merits a re-look. Also, for equality sake, borrowed funds should be allowed to be reduced from the gross value of assets, for computing the MAT levy.

Individual taxation

Tax slabs: With a thrust on expanding the tax base and compliance, the new code proposes a very liberal re-jig of the individual tax slabs (see chart). Further, relaxation is proposed for women and senior citizen taxpayers. This move, if implemented, can positively discourage under-reporting, a concern that has, again, plagued the Indian tax regime for long.

RNOR concept gone

The concept of not ordinarily resident has been proposed to be done away with under the new code. Thus, upon crossing the 183-day mark in a financial year, person would be treated as a resident in India. However, resident individual would be eligible for exemption on income sourced outside India for two consecutive financial years (including the financial year in which the individual becomes a resident), if he was a non-resident for nine years immediately preceding the financial year in which he become a resident.

House property income

The code largely simplifies taxation of house property income. The taxable gross rent shall be the actual rent receivable upon letting out or a notional presumptive rent computed at 6% of the ratable value, whichever is higher. If no ratable value is fixed, the actual cost would be taken in lieu thereof.

While exemption for one self-occupied property (SOPs) continues for individuals, the deduction for repairs & maintenance is proposed to be reduced to 20% of the gross rent, from the current level of 30%. Besides, the current deduction for housing loan interest up to Rs 150,000 available for sops is sought to be done away with.

Savings taxation

The code proposes to introduce the Exempt-Exempt-Tax(EET) method of taxation for savings, including for employees provident fund. Thus, contributions and interest accumulation/accretions shall be exempt; however, all withdrawals shall be subject to tax in the year of withdrawal. The taxation of accumulated balances in approved provident funds until March 31, 2011 is, however, sought to be grandfathered and shall not be included in total income even upon withdrawal.

An aggregate deduction of Rs 300,000 is proposed for savings maintained with permitted intermediaries (approved retirement benefits trusts & life insurers) and children education. Investment in equity linked savings schemes of MFs, saving FDs with banks, housing loan repayment, etc, would no longer be eligible for the deduction.

The existing deductions in respect of interest on educations loans and medical premium/expenses is sought to be continued.

Capital gains tax

The code materially seeks to re-alter the provisions relating to capital gains taxation. First up, the code seeks to bifurcate capital assets as investment assets and business assets. Income arising upon transfer of an investment asset would only be taxable as capital gains.

Secondly, and more importantly, the code seeks to completely eliminate the distinction between short-term and long-term assets, by providing for taxation of gains arising on transfer of any investment asset at the applicable rates for the respective taxpayers.

Long-term assets, though, would continue to be eligible for indexation benefits. In another major change, the cost base for an asset acquired prior to April 1, 2000, can be taken, at the option of the taxpayer, as the fair market value as on that date. In cases where the cost is incapable of being determined, the cost shall be taken as nil. The amendment seeks to specifically overrule the decision of the Supreme Court in BC Srinivasa Shetty?s case.

The Securities Transaction Tax (STT)-based taxation of listed equity shares / equity linked MF units is proposed to be abolished. Consequently, capital gains on transfer of such assets would be taxable at the normal rate under the new regime, as against a full exemption for LTCG and a lower 15% rate for STCG, under the current regime. STT is sought to be abolished, in a move which should benefit day traders significantly. Further, the Code also proposes to do away with the special tax regime for FIIs / NRIs.

Business reorganisation

The code seeks to extend tax neutrality of business reorganisation by way of amalgamation, merger and demergers, as under the current Act. The code extend carry forward of losses upon any amalgamation (whether involving an industrial undertaking or not) of companies engaged in any sector (including services) subject to compliance with the prescribed condition for business continuity. The said business continuity conditions have been extended to cases of demerger as well, which was not the case under the current Act.

Further, the code also provides tax neutrality and carry forward of losses for business reorganization involving succession of sole-proprietary concerns and other unincorporated bodies (like partnership firms, etc) with a company, subject to fulfillment of prescribed conditions.

Non-resident taxation

The code also proposes some sweeping changes in taxation of non-residents, as broadly summarised below.

Foreign companies to be treated as Indian residents even if the place of control or management is partly situated in India. In such cases, the world-wide income can be taxed in India. This could impact tax residency of overseas subsidiaries of Indian companies, if the board/executive members take key managerial decisions in India.

Tax rate for foreign companies reduced to 25%. However, an additional branch profit tax of 15% on after tax income has been proposed. Incidentally, the code does not adequately clarify the computation of the branch profits for this purpose. It needs to be clarified that such tax should only apply to business profits (ie which is not royalty/fees for technical services (FTS)/ capital gains) remittance to the head office by an India Branch and not otherwise.

Royalty/FTS income subject to gross basis taxation at 20%. The net basis of taxation in respect of royalty/FTS earned by non-residents through permanent establishment is sought to be done away with.

FTS scope sought to be widened to include development and transfer of any design, drawing, plan and software or similar services. Also, royalty definition extended to cover consideration towards broadcasting rights including live coverage of any event.

Interest on funds borrowed for earning any source of income from India is, now, sought to be brought under the tax net.

Furnishing of tax residency certificate is sought to be made mandatory for claiming of relief under the applicable Tax Treaty.

In another significant move, income from even an indirect transfer of any capital asset in India is sought to be construed as income ?deemed to accrue? in India in the hands of a non-resident. Arguably, this should help clarify the existing provisions which does not specifically include indirect transfers.

Tax treaty applicability

Section 258 of the code provides that provisions of the Tax Treaty or the code, whichever is later in time, shall prevail. This is in sharp contrast with the corresponding Section 90 of the current Act, which clearly provides that the provision of the Treaty or the Act, whichever is more beneficial shall prevail. One, certainly expects, the FM to clarify the said position at the time of finalisation of the code.

Tax withholding at source

While there are no specific amendments as to tax withholding for residents, it may be particularly noted that the code do not provide for applying the Tax Treaty rate, where they are more beneficial to the foreign taxpayer. One will expect this anomaly to be removed as the Code is finalised.

Separately, the current Act provided for obtaining a nil or lower withholding tax certificate from the tax office where justified in the specified cases which warrants such nil or lower withholding. The code, however, restricts the scope of obtaining such certificates to case of nil withholding only. This could impact foreign companies having a permanent establishment in India where only the net income (and not the gross receipts) is subject to tax in India.

Transfer pricing

In a salutary move, Advance Pricing Agreement (APA) mechanism is proposed to be introduced by the code. APA is an agreement between the taxpayer and the tax authorities for an upfront determination of the arm?s length price for an international transaction. The APAs shall be valid for five years.

Further, the scope of transfer pricing provisions are sought to be enlarged by reducing the benchmark for determining associated enterprises relationship, for instance, shareholding of 10% against the existing 26%, appointment of 1/3rd of the board of directors instead of 50%.

The code also significantly rationalises the penalty provisions by reducing the penalty for failure to maintain documentation/accountant?s report to a maximum of Rs 200,000 instead of 2% of the transaction value.

General Anti-Avoidance Rules (GAAR)

The Code seeks to introduce GAAR empowering Commissioners to declare an arrangement as impermissible if the same has been entered into with the objective of obtaining tax benefit and which lacks commercial substance. The tax payer has 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.

GAAR would override the applicable Tax Treaty and the directions of the commissioner would be binding on the assessing officer. The arrangements covered by GAAR include round trip financing, lifting of corporate veil, etc. It is respectfully submitted that the discretion provided for under the new rules should be adequately ring-fenced to obviate litigation.

Not for profit organisations

The code proposes a 15% tax on income of a not for profit organisation from permitted social welfare activities (the concept which replaces charitable or religious purposes under the current Act). The permitted social welfare activities covers activities involving relief for poor, education advancement, medical relief, general public utility objects, etc. The Organisation would have to register itself with the tax authorities for this purpose.

Wealth tax

Wealth tax has been proposed to be abolished for corporate taxpayers. Wealth tax would, however, be leviable on individual, HUFs and private discretionary trusts (ie where the shares of the members are indeterminate).

The threshold limit for levy of wealth tax is proposed to be enhanced to Rs 500 mn and the rate reduced to 0.25% (as against 1% currently). In a major shift, all assets (including items like shares and securities) are now subject to wealth tax, except for a small negative list. This change could materially impact promoter family trusts, which hold shares in group companies.

Industry specific exemptions/deductions

The current Act provides for various “profit based tax incentives” for specific industries such as Infrastructure sector (roads, ports, airports, etc), power sector, SEZ developers, exploration and processing of mineral oil and natural gas, export oriented units, etc. The code seeks to discontinue the profit-based tax incentives and provides for an expenditure-based incentive scheme in relation to some of these sectors. This is akin to the Investment-based allowance, essentially allowing deduction of capital expenditure on day one instead of a depreciation allowance yearly.

Infrastructure/Backward area incentives

The discussion paper released with the Code specifically provides that area-based incentives granted under the current Act would be grandfathered. To provide for the above, Sec 282(2)(n) of the code provides that taxpayers would continue to be eligible for tax deduction for the remaining period under the following sections of the current Act.

* Section 80-IA (infrastructure development, power, telecom, etc)

* Section 80-IAB (SEZ developers)

* Section 80-IB (Oil & gas, housing, hospital, hotel, etc)

* Section 80-IC (unit in backward areas)

* Section 80-ID (hotel & conventions centers in heritage sites, etc)

* Section 80-IE (unit in north-eastern states)

* Section 80-JJA (incentives for industries employing new workmen)

To clarify, while entities currently enjoying tax incentives under the above section would continue to benefit for the unexpired even under the new code, new units set-up after April 1, 2010, would not be so eligible.

Export sector

Separately, the code does not have similar grandfathering provisions for entities in export (primarily IT/ITeS) sector set-up in EOUs, STPs and SEZs. Given the downward trend in Indian exports, the industry would certainly look up to the government for transition of the existing tax incentives for the unexpired period. The FM had specifically acceded to the demand of this sector, even in the recent Budget.

Venture capital funds

The much-awaited demand for treatment of specific investment vehicles as pass-through entities has been met. Particularly, venture capital funds (VCF)/venture capital companies (VCC), investing in any sector, would now be treated at par with Mutual Funds and eligible for the pass through status.

This would mean that the income earned by a VCF / VCC would be exempt from tax under the new code. Further, while the discussion paper provides that the investors would be taxable, the code per se specifically exempts any income received from a mutual fund (which is defined to include a VCF/VCC). Capital gains, however, in the hands of the investor would continue to be taxable. This should pave way for easier fund raising by venture capitalists.

Conclusion

As the finance minister himself stated, tax reform is a process and not an event. The next few months will see continued attention on this new development as one attempts to further analyse the new provisions. It is expected that the DTC would be debated amongst stake-holders and representations would be invited by the finance minister which hopefully would lead to emergence of a simplified and stable tax regime.

?Also assisted by Smit Sheth, manager, PricewaterhouseCoopers