16 June EY Tax Alert. Revised Discussion Paper on the Direct Taxes Code

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1 16 June 2010 EY Tax Alert Revised Discussion Paper on the Direct Taxes Code

2 Executive summary The Direct Taxes Code Bill, 2009 (DTC) was released by the Government of India (GOI) for public comments, along with a discussion paper, on 12 August Since then, a number of inputs on the proposals outlined in these documents have been received from a large number of organizations and individuals. These inputs have been examined and major issues on which various stakeholders have given their views have been identified. The GOI, on 15 June 2010, released a Revised Discussion Paper (RDP) that addresses 11 major issues. This Tax Alert summarizes the issues discussed in the RDP. The RDP has given due consideration to the concerns expressed as part of the public consultation process on most of the 11 major issues, including proposals such as levy of tax on gross assets, tax treaty override, residency rule for foreign companies, taxation of capital gains etc. Accordingly, the RDP proposes to withdraw the proposal on gross assets taxation, to significantly limit the circumstances when a tax treaty can be abrogated by domestic tax laws and to replace the narrow threshold of partial control and management with a much broader concept of place of effective management as a test for corporate residency. The RDP also provides that the profit-linked incentives of existing Special Economic Zone (SEZ) units would be grandfathered. However, the RDP also suggests that the GOI does not favor any further extension of profit-linked incentives. The RDP also proposes to provide for a notional deduction in computation of capital gains arising from sale of listed securities; but provides for taxing such gains along with ordinary income. Several comments were made on the need to dilute the proposal on General Anti-Avoidance Rule (GAAR), if not drop the proposal altogether. It was felt by the business community that the DTC proposal on GAAR did not adequately strike a balance between legitimate tax minimization and abusive tax avoidance. More specifically, there was a need to reconsider the definition of impermissible avoidance arrangement and shift the onus on the Tax Authority for invoking GAAR. The RDP proposes to continue with the proposal, with some fairly limited safeguards relating to the process for invoking GAAR. Other DTC provisions on which concerns were expressed, such as taxation of indirect transfers, expansion of source rule for interest, withholding tax provisions, computation of business profits, branch profit tax etc., are not addressed in the RDP. One would need to await the revised DTC to understand how the GOI seeks to address the concerns raised on these provisions of the DTC. In addition, a proposal for a Controlled Foreign Corporation (CFC) regime has been introduced in the RDP, which was not contained in the DTC. As this is a new proposal, the approach the GOI would adopt in drafting the legislation is not known. One would hope that the GOI would also consider the need to introduce a mechanism for allowing underlying foreign tax credits, along with the introduction of a CFC regime. The DTC had also proposed a reduction in corporate tax rate to 25% and an increase in taxable income slabs for personal taxation. The RDP hints that the GOI may need to consider a more calibrated approach to reduction in the tax rates, in light of the proposals contained in the RDP. The RDP invites responses to be posted/sent to the following address: directtaxescode-rev@nic.in before 30 June It is expected that the GOI would table the revised DTC in the next session of Parliament later this year, after taking into consideration public comments on the RDP. GOI intends to implement the DTC with effect from 1 April The release of the RDP indicates that the direct taxes reform process initiated by the GOI last year by releasing the DTC, is in progress. The business community would do well to assess the impact that some of these proposals could have on their current structures and business models and also engage proactively with the GOI to present their points of view. 2 EY Tax Alert

3 Minimum Alternate Tax (MAT) to be computed with reference to profits The objectives of the DTC were stated as broadening the tax base, minimizing exemptions and achieving horizontal and vertical equity. The proposal to introduce a new form of MAT on gross assets was stated to be a step towards expanding the tax base for companies to ensure a minimum guaranteed tax collection from all corporate taxpayers. As per the DTC, a company has to pay tax, either as per normal provisions of the DTC or as per MAT, whichever is higher. Further, MAT was proposed at 2% of the value of gross assets in a company (0.25% of the value of assets in case of banking companies). Furthermore, MAT was a final tax and there was no mechanism for credit of MAT against normal tax in subsequent years. The levy of MAT on the asset base raised strong apprehensions in corporate circles. Some of the concerns were in relation to the levy of MAT on loss-making companies, companies with long gestation period, companies under liquidation etc. The argument of incentive for efficiency was not reasonable in such cases. The levy of MAT on the asset base also contradicted the investment-linked incentives proposed in the DTC. In view of the above, the RDP proposes that the current approach of levying MAT, with reference to book profit, would continue. Change in the test of tax residence for a company incorporated outside India The tax residence of a company is usually based either on the place of its incorporation (legal seat) or the location of its management (real seat) or a combination of both. The DTC, similar to the provision contained in the Indian Tax Laws (ITL), provides that a company incorporated in India would always be treated as a resident of India. The DTC had proposed that a company incorporated outside India is to be treated as a resident in India if its place of control and management, at any time during a tax year, is situated, wholly or partly, in India. As against this, the ITL treats a company incorporated outside India as an Indian tax resident only if the place of control and management of its affairs is situated wholly in India during a tax year. The RDP acknowledges that inclusion of part control and management in India, as a test of residence, sets a very low threshold for regarding a non-indian company as a resident in India, whereas the existing residence test under the ITL of whole control and management in India is much wider. Also, widespread concerns were expressed that the narrow threshold of the DTC could result in uncertainty in taxation and impact foreign direct investments into India. Therefore, the RDP proposes that a company incorporated outside India would be treated as a resident in India if its place of effective management (POEM) is situated in India. POEM is a well-known concept used in tax treaties as a tie breaker rule to determine residence in case a company is determined to be a resident of both the countries under its domestic tax laws. It is generally understood as the place where key management and commercial decisions for the conduct of the entity s business as a whole are, in substance, made. As per the RDP, the POEM would mean: Or The place where the board of directors (BOD) or executive directors make their decisions In a case where the BOD routinely approves the commercial and strategic decisions made by the executive directors or officers of the company, the place where such executive directors or officers of the company perform their functions. A defined POEM rule should be welcomed as it helps to objectively determine the place of residence (the place where the BOD makes its decisions) for companies incorporated overseas. The second rule contains an anti-avoidance principle envisaged to apply in cases where the BOD routinely approves decisions made by other executive directors or officers. Thus, in case of an Indian parent with overseas subsidiaries, care may need to be taken to see that the BOD meetings of its subsidiaries are held in the respective jurisdictions for the nonresident to qualify as a non-resident of India. 3 EY Tax Alert

4 Residence rule extension through CFC regime The GOI, for the first time in the RDP, indicated a proposal to introduce a CFC regime. A CFC regime is an anti-avoidance measure aimed to provide for taxation of passive income earned by a foreign company that is directly or indirectly controlled by a resident in India. This income is not distributed to its shareholders, resulting in deferral of taxes. Under the proposed CFC regime, this income is deemed to have been distributed and, therefore, taxed in the hands of the resident shareholders as dividend received from the foreign company. As the CFC proposal was not part of the DTC, at this stage, the approach which the GOI would take in drafting the CFC legislation is not known. Public consultation on the proposal, before finalizing, would be welcome. Relationship between tax treaty and domestic tax law The present ITL enables a taxpayer to choose between a tax treaty and the ITL, whichever is more beneficial to it. The DTC sought to redefine this relationship by providing that neither a tax treaty provision nor a DTC provision shall have a preferential status by reason of it being a tax treaty or domestic tax law and that the provision that is later in point of time shall prevail. The DTC proposal potentially resulted in domestic tax law overriding a tax treaty, if a conflicting provision is enacted in the domestic tax law. Such an outcome was against the principles of good faith incorporated in Article 26 of the Vienna Convention on the Law of Treaties. The RDP proposes to revert to the provisions of the existing ITL to provide that, between the domestic tax law and the tax treaty, the one which is more beneficial to the taxpayer shall apply. However, certain safeguards are proposed to be introduced by the RDP to provide that this rule would not apply in the following circumstances: When GAAR is invoked. When CFC provisions are invoked. When Branch Profits Tax (BPT) is levied. It may be recalled that while, generally, BPT is levied on remittance of profits by a branch to its head office, the DTC proposed levy of BPT as an additional tax on all foreign companies, irrespective of remittance of profits. The limited circumstances in which domestic tax law would override a tax treaty, as described in the RDP, are welcome, as the treaty override provision of the DTC had lead to serious concerns on the certainty and stability a tax treaty offered to foreign investors. SEZ units eligible for tax holiday only for unexpired period The existing profit-linked incentives in the ITL are proposed to be replaced by investmentlinked incentives, as per the DTC provisions. However, though the DTC provisions provide for grandfathering of tax incentives to SEZ developers, they were silent on SEZ units, which created apprehension amongst SEZ units. The RDP reiterates that profit-linked deductions are distortionary in nature as they create an incentive to inflate profits, as well as to transfer profits from a taxable entity to a non-taxable one. Therefore, the period of such profit-linked deductions would not be extended. However, provisions for protecting deduction for the unexpired period to existing SEZ units are proposed to be incorporated. The grandfathering provisions for the taxpayers operating in SEZ units would now ensure that such units are not adversely impacted. The RDP also makes a clear statement that the GOI does not favor any further extension of profit- linked incentives. Wealth tax levy extended to all taxpayers, but aligned to present levy The DTC proposed levy of wealth tax on the net wealth only of individuals, Hindu Undivided Family (HUF) and private discretionary trusts. Furthermore, net wealth was defined as assets chargeable to wealth tax as reduced by the debt 4 EY Tax Alert

5 owed in respect of such assets. Assets chargeable to wealth tax were defined in the DTC to include all assets, including financial assets and deemed assets, but excluding certain exempted assets. The net wealth of an individual or HUF in excess of INR 500m was to be charged to wealth tax at the rate of 0.25%. The RDP proposes levy of wealth tax broadly on the same lines as in the present regime, but extends it to all people (other than non-profit organizations), since it is an anti-abuse measure that ensures reporting of significant assets held by a taxpayer. Therefore, specified unproductive assets would be subject to wealth tax and the threshold limit and rate of tax would be suitably corrected in the context of overall tax rates. GAAR continues to stay but with some suggested safeguards The DTC proposes to introduce GAAR as a deterrent and a tool against tax avoidance. GAAR is a broad set of provisions that have the effect of invalidating an arrangement that has been entered into by a taxpayer with the main objective of obtaining tax benefit. The Tax Authority, in such cases, is granted the power to adjust the assessment of the taxpayer so as to counteract the attendant tax advantage. GAAR was strongly objected to on account of its sweeping nature and granting of vast powers to the Tax Authority to invoke GAAR arbitrarily. There were also no legislative and administrative safeguards for genuine taxpayers against the abusive use of GAAR by the Tax Authority. The RDP clarifies that the proposed GAAR provisions do not envisage that every arrangement for tax mitigation would be liable to be classified as an impermissible avoidance arrangement, but only where, besides obtaining tax benefit, it also satisfies one of the following conditions: It is not at arm s length. It represents misuse or abuse of the DTC. It lacks commercial substance. It is entered into or carried on in a manner not normally employed for bona fide business purposes. In addition, the RDP proposes the following safeguards for invoking GAAR: Issue of guidelines by the Indian administrative authority to provide for the circumstances under which GAAR may be invoked. To be invoked only where tax avoidance is beyond a specified threshold. Availability of Dispute Resolution Panel forum. Taxation of capital gains The proposal of abolition of Securities Transaction Tax (STT) by the DTC has been withdrawn. STT would now be payable on specified transactions, which would be determined, based on the taxation regime of capital gains and flow of funds to the capital market. Under the proposed DTC, any gains arising from investment assets were liable to be taxed as capital gains at the rate of 30% in case of nonresidents and at the applicable marginal rates in case of residents. In the RDP, the capital gains would be taxable at normal rates applicable to the taxpayer, including non-residents. Listed equity shares or units of equity-oriented funds, held for more than a year, would be taxed after allowing a certain prescribed percentage of capital gains as notional deduction. Losses, too would be scaled down. The main object of the computation of adjusted capital gains is to benefit the lower and middle income group taxpayers, as the effective tax rate would be lesser in case of taxpayers falling under the lower tax rate. The specified rate of deduction has not been notified but a rate of 50-70% of capital gains has been indicated. A transition regime is proposed in case of capital gains on listed securities, which are exempt under the ITL and would be taxable under the DTC. Indexation benefit would be allowed for other capital assets and unrealized gains up to the tax year would not be taxed. Rollover exemption benefit introduced by the DTC, through Capital Gains Savings Scheme proposal has been withdrawn. 5 EY Tax Alert

6 In relation to Foreign Institutional Investors (FIIs), the RDP has proposed the following to eliminate litigation and simplify the tax system: Income from purchase and sale of securities to be taxed only as capital gains. No withholding tax would be levied on capital gains earned by FIIs. FIIs would need to discharge their tax obligation by way of advance tax. Exempt Exempt Exempt (EEE) method of taxation to continue in certain cases The DTC had proposed an Exempt Exempt Tax (EET) method of taxation i.e., any withdrawals from permitted savings intermediaries such as approved provident funds, approved superannuation funds, life insurance and New Pension System Trust, would be taxable on withdrawal. The RDP proposes to continue with the EEE method of taxation for Government Provident Fund, Public Provident Fund and Recognised Provident Fund and the pension scheme administered by the Pension Fund Regulatory and Development Authority. Approved pure life insurance products and annuity schemes would also be subject to EEE method of taxation. Furthermore, it has been clarified that investments made, before the date of commencement of the DTC, in instruments which enjoy EEE method of taxation under the ITL, would continue to be eligible for EEE method of taxation for the full duration of the financial instruments. Income from employment, perquisites and retirement benefits The DTC proposed to tax the amounts received by way of gratuity, pension, encashment of leave and under voluntary retirement scheme in the year they become due or are paid to the employee. A deduction, subject to certain conditions, was, however, provided if they are deposited in a Retirement Benefits Account (RBA), in accordance with the scheme framed and prescribed by the GOI. The proposal of depositing the retirement benefits into an RBA, to avail exemption, has been withdrawn. Furthermore, amounts received by way of gratuity, pension, encashment of leave and under voluntary retirement scheme are proposed to be exempt up to specified limits for all categories of employees. Under the DTC, all perquisites, allowances i.e., house rent allowance, medical allowance etc., except transport allowance, were proposed to be taxable. The RDP has proposed to retain the valuation norms for perquisites as per existing rules in the ITL, with an appropriate increase in the monetary limits. The proposal of the DTC to provide for valuation of free accommodation, based on market value, has been done away with by the RDP. Income from house property The income from house property under the DTC was to be computed in relation to gross rent, with certain specified deductions. However, no deduction was allowable for taxes or interest in case of a self-occupied property. The RDP has proposed to revise the computation mechanism of income from house property as follows: In case of let-out house property, gross rent would be the amount of rent received or receivable and no presumptive rate would be applicable. The deductions remain the same as proposed in the DTC. In case of house property which is not let out, gross rent would be taken as nil and no deductions would be allowable from the gross rent. However, in case of any one house property which is not let out, deduction on account of interest on capital borrowed for acquisition or construction would be allowed, subject to a limit of INR 150,000, as currently available in the ITL. 6 EY Tax Alert

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