Draft DTC drops move for MAT on gross assets, cheers India Inc

The government on Tuesday dropped its controversial plan to levy minimum alternate tax (MAT) on value of gross assets instead of book profits, giving a big relief to corporates, especially infrastructure players and those in capital-intensive businesses. This climb-down in revised Direct Taxes Code (DTC) draft would, however, provide it with the ammunition to raise MAT rate further ? from 18% at present to about 25%, the rate prescribed for other tax-paying companies in the draft.

The rationale for MAT on gross assets was that it would spur efficiency and ensure productivity of assets, but in the revised draft, the government admitted that ?there may be practical difficulties and unintended consequences,? if the shift was to be implemented.

In a move that could hit inflows into India?s capital markets, the revised draft closed the window for foreign institutional investors to claim ?business income? from market transactions, and said that such income would invariably be ?capital gains?and taxed accordingly. Any negative fallout of this measure on FIIs has, however, been moderated by the near removal of the ?treaty override? provision ? supremacy of double taxation avoidance treaties on domestic law ? which would have curtailed their freedom to benefit from tax havens.

Corporate tax rate for domestic companies is currently over 33%, with the effective rate being 21-22% in most cases thanks to various incentives. A 25% rate would come with the removal of most incentives, barring a few like ?profit-linked incentives? for SEZ developers and units already operating in these zones, a facility the new code does not favour.

The revised draft also abandons the plan to tax all withdrawals from savings instruments and insurance products at the personal marginal rate, accepting the widespread opinion that in the absence of a universal social security system in the country, such an impost would be unfair. So, all ?approved? savings instruments ? provident funds, superannuation funds and the new pension system, insurance products and annuity schemes ? would continue under the exempt-exempt-exempt (EEE) regime, which means that they would not be taxed at any of the three stages ? contribution, accretion and withdrawal. Dropping the move to tax savings at the time of consumption is good for low-income people, but it could ultimately undermine the government?s ability to lower tax rates and hence, not necessarily a good news for the rich.

To the chagrin of taxpayers, the revised draft does not do away with the distinction, proposed in the original draft, between short-term and long-term capital gains. Neither does it intend to end the differential treatment between equity shares/equity-oriented mutual funds and other assets.

While the code illustrates how at different specific rates of deduction the effective tax rate on capital gains on assets held for more than one year would be benign, since the rates are not prescribed, the concern is still very much there. The original proposal was to tax all capital gains at 30%. Of course, for assets held for less than a year, the gain will be computed without any deduction or indexation and would be charged to tax at the personal marginal rate.

The happiness of corporate India over the decision to drop the plan to impose MAT on gross assets was however tempered by some proposals and lack of clarifications on key issues in the revised draft. One irritant is the proposal to introduce Controlled Foreign Corporation (CFC) provision which would practically lead to a situation that most foreign subsidiaries of Indian companies are taxed in India. ? The CFC rules would result in current taxation of passive income of foreign subsidies and could be a problem for Indian MNCs,” Sudhir Kapadia of Ernst and Young said.

Significantly, the revised code proposes to introduce the concept of ?place of effective management? in regard to taxation of foreign companies, which basically raises the threshold for taxing such companies, and therefore, is a relief to businesses. ?A matter of concern is that modifications proposed in the the general anti-avoidance rule don’t exactly dilute their sweeping nature. The tax authorities’ guidance notes in this regard should be based on specific examples based on their real experience with regard to tax-avoiding transactions, rather than being too general and therefore a potential harassment to taxpayers,? said Rahul Garg, executive director at PWC.

Importantly, there would still be ?limited treaty override? which means that DTAAs won’t have preferential status over domestic law when anti-avoidance rules and CFC provisions are invoked and when book profits are levied.

The virtual removal of tax incentives for new SEZ units (units that won’t be operational at the time of implementation of the code, which is now slated for April 1 2011) is also flayed by experts. With 150 notified SEZs and 600 SEZs with formal approvals, the denial of tax incentives for new SEZ units could adversely impact demand for SEZs and discourage investments.