13 August 2009 Key proposals on the draft Direct Taxes Code Bill, 2009 Executive Summary The Direct Taxes Code Bill, 2009 (DTC) was released for public comments along with a discussion paper on 12 August 2009. The DTC will come into force from 1 April 2011. This Tax Alert summarizes the key proposals of the DTC and the discussion paper. The DTC appears to broadly retain the scheme of the existing Income Tax Law (ITL), 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. The DTC proposes to consolidate direct taxes under a common tax code. It also proposes to substitute Minimum Alternate Tax (MAT) on companies (which is currently income-based) by a tax on gross assets. The other major changes include dispensing with the concept of assessment year, lowering of tax rates, substituting income-linked incentives with investment-linked incentives, treating business assets gains as part of business income, unlimited carry-forward of losses, introduction of far-reaching General Anti Avoidance Rules (GAAR) and rationalizationof provisions relating to penalties. Further, the DTC seeks to provide that, neither the DTC nor the tax treaty entered into between the Government of India (GOI) and the Government of a foreign country will have a preferential status and that a subsequent law can override prior law. The DTC also proposes to introduce an Advanced Pricing Agreement (APA) regime, to modify the test of residency for companies by treating a foreign company as a resident in India based on existence of partial control and management and to levy a Branch Profit Tax (BPT) on foreign companies.
Tax rates The DTC proposes to generally reduce the tax rates. The proposed rates are summarized in the following table: Scope of Total Income and computation provisions Scope of Total Income Status of the taxpayer Individual Tax rates as per the ITL Up to INR 160,000* INR 160,000 to 300,000 INR 300,000 to 500,000 Above INR 500,000 NIL 10% 20% Tax rates proposed by the DTC Up to INR 160,000* INR 160,000 to 1,000,000 INR 1,000,000 to INR 2,500,000 Above INR 2,500,000 * INR 190,000 for women taxpayers and INR 240,000 for senior citizens NIL 10% 20% The DTC seeks to continue with the present system of combination of residence-based taxation and source-based taxation. It also seeks to continue to apply residence-based taxation to residents i.e. global taxation and source-based taxation to non-residents. However, the DTC seeks to modify the test for determining the residence of a company by providing that the existence of partial control and management would result in residence in India. The principles relating to source of income are also proposed to be modified to cover even income arising from indirect transfer of capital asset situated in India, as deemed to accrue or arise in India and also to clarify that rendering of services in India is not essential for taxing service income. Domestic Company Foreign Company Branch Profit Tax Firm Wealth Tax Taxation of Companies Companies will be taxed at a flat rate of 25% as against the current tax rate of (excluding surcharge and cess). 40% Not Applicable 1% for net wealth in excess of INR 3 Million 25% 25% 15% 0.25% for net wealth in excess of INR 500 Million (No threshold for private discretionary trusts) Dividends distributed by domestic companies would continue to be subjected to Dividend Distribution Tax (DDT) at the rate of 15%. The dividends which are subjected to the levy of DDT will continue to be exempt from tax in the hands of the recipient. The DTC seeks to significantly alter the basis for levy of MAT on companies. Under the ITL, MAT is payable at the rate of 15% (excluding surcharge and cess) on the book profit of the company, subject to specified adjustments if the normal tax liability of the company is lower than MAT. The MAT liability will now be based on the gross assets of the company instead of the book profit. The MAT will be computed on the value of gross assets at 0.25% in the case of banking companies and at 2% in the case of all other companies. No tax credit will be allowed in respect of such MAT liability. The DTC seeks to replace the present dual concept of previous year and assessment year with the unified concept of financial year. Computation of Total Income The DTC seeks to classify incomes into 2 categories viz. special sources and ordinary sources. The special sources (specified in a separate Schedule) generally reflect items like Royalty, Fees for Technical Services (FTS), investment income etc. All other sources of income will be ordinary sources. Special sources would be subject to tax on the gross amount. The Total Income of the taxpayer for a financial year will be the aggregate of Total Income from ordinary sources and Total Income from special sources. Computation of income from employment The DTC proposes to introduce Exempt-Exempt-Taxation (EET) method of taxation of contributions made towards certain retirement benefits under which contributions and annual accumulations into the Fund are not taxed but withdrawal from the Fund is taxed. Computation of income from house property The deductions in respect of property taxes, standard deduction towards repairs and maintenance (reduced from of annual value allowed under the ITL to 20% of gross rent under the DTC) and interest expenditure will be allowed from the gross rent. However, no deduction for interest expenditure will be permitted in respect of selfoccupied property. 2
Computation of income from business An important change proposed by the DTC under this head of income is that every business will constitute a separate source of income, necessitating separate computation of income for each business. The present distinction between short-term investment asset and long-term investment asset, on the basis of length of holding of the asset, will be eliminated except that, for assets transferred after a year of holding, the indexation benefit will be available in the computation of capital gains. The framework proposed by the DTC for taxation of business income is as follows: Like business losses, capital losses will also be allowed to be carried forward for an indefinite period. All assets will be classified into business assets and investment assets. The business assets will be further classified into business trading assets and business capital assets. The income from transactions in all business assets will be taxed under the head income from business while the income from transactions in all investment assets will be taxed under the head capital gains. The profits from business will be computed by deducting business expenditure from gross earnings of the business. The gross earnings will ordinarily include all accruals and receipts derived from or connected with business assets, whether trading or capital. Business expenditure will be classified into 3 mutually exclusive categories (i) Operating expenditure (ii) Permitted financial charges (iii) Capital allowances. The benefit of weighted deduction at 150% for any expenditure (both revenue and capital) incurred on inhouse scientific research and development by a company is proposed to be extended to (i) cost of building (ii) all industries (not restricted to manufacturing). As a disincentive for asset stripping and loss manipulation, the DTC proposes that loss on sale of business capital assets will be treated as an intangible asset on which depreciation will be allowed at the rates applicable to the relevant block of assets, which will effectively result in allowance of such loss on amortized basis. The Securities Transaction Tax (STT) will be abolished and, consequently, exemption presently enjoyed on long-term capital gains derived from transfer from equity shares and units of equity-oriented mutual funds, will no longer be available. The base date for determining cost of acquisition under the ITL i.e. 1 April 1981 will be shifted to 1 April 2000. As a result, appreciation in value of the asset till 1 April 2000 will not be liable to tax. The DTC proposes to make a general provision to deem the cost of acquisition and cost of improvement of assets as Nil, where cost is not determinable for any reason. The benefit of rollover i.e. exemption of capital gains for reinvestment of the sale consideration or capital gains in specified modes, will be restricted to limited circumstances. Tax Incentives The DTC seeks to replace profit-based tax holiday incentives with investment-based incentives. The taxpayer will be allowed to recover all capital and revenue expenditure (except land, goodwill and financial instrument). The period consumed in recovering all capital and revenue expenditure will be the period of tax holiday. Current profit-linked incentives and area-based exemptions in the ITL will be grandfathered. Business reorganization The DTC recognizes that business reorganizations should ordinarily be tax neutral. Computation of Capital Gains The income from transactions in all investment assets i.e. other than business assets, will be taxed under the head capital gains. Similar provisions in the ITL for ensuring tax neutrality of business reorganizations, in the form of amalgamation, demerger, corporatization of firms/ proprietary concerns, to continue in the DTC. The successor entity will be entitled to the benefit of accumulated losses of the predecessors, upon fulfillment of certain conditions. 3
Anti-Abuse provisions Transfer Pricing The Central Government will be empowered to formulate a scheme for introducing APA with taxpayers, in relation to International Transactions (ITS). Under the DTC, a taxpayer will need to report specified ITS directly to the Transfer Pricing Officer (TPO) as against the current practice of reporting to the Assessing Officer (AO). The TPO will determine Arm s Length Price based on which the AO will assess the income of the taxpayer. Penalties The DTC proposes to elaborate, define and explain circumstances in which penalties can be levied. The basic condition for levy of penalty would be willful underreporting of the tax base. Primarily, failure to file tax return by the due date and assessment of the tax base at an amount higher than the amount disclosed in the tax return i.e. variances, shall be presumed to be willful under-reporting of the tax base. Tax on net wealth GAAR The DTC also proposes to widen the scope of the definition of associated enterprises by fixing the threshold at 10% holding as against 26% under the ITL. The DTC proposes to introduce GAAR to serve as a deterrent against tax evasion and avoidance and to dissuade taxpayers from violating tax equity, by use of legal constructions or transactions. The DTC seeks to provide for levy of wealth tax on high net worth entities viz. individuals, Hindu Undivided Families and private discretionary trusts. Companies are proposed to be excluded from the scope of taxable entities. The DTC proposes to reintroduce the regime of wealth tax provisions as prevalent prior to changes brought in the year 1992, by providing for levy of wealth tax on all assets, including financial assets, except for certain specified assets. Commissioner of Income Tax (CIT) will be empowered to invoke GAAR and to declare an arrangement as an impermissible avoidance arrangement if it is entered into for obtaining a tax benefit like round-tripping, transaction through an intermediary, self-canceling transactions etc. As against the present threshold limit of INR 3 million, the DTC seeks to increase the threshold to INR 500 million. Further, the rate of wealth tax would be reduced from the current rate of 1% to 0.25% on the net wealth exceeding the threshold. The onus will be on the taxpayer to prove that obtaining a tax benefit was not the main purpose of the avoidance arrangement. The CIT can determine the tax consequences for an impermissible avoidance arrangement i.e. the CIT may disregard the arrangement, any party involved, any accommodating parties involved or reallocate/recharacterize the income or transaction or disregard the entire arrangement as if it had not been entered into. The CIT may also disregard the provisions of the tax treaty. Relief from Double Taxation Similar to the ITL, the Central Government will be empowered to enter into a tax treaty for relief from double taxation and for exchange of information. Comments The DTC marks a new era in the Indian tax scenario after more than 50 years of operation of the current ITL. The approach of the GOI to release a draft of the DTC for public comments, before introducing it in the Parliament, is commendable. This allows the stakeholders sufficient time to evaluate the impact of the new law before it is brought into force and also to provide its comments for the consideration of the GOI. Business community would need to watch the developments and actively engage with the GOI for presenting its points of view. At the same time, it would be important to assess the impact that some of the proposals could have on current structures and business models. Neither the DTC nor the tax treaty will have a preferential status and in case of a conflict between the two, the latter in point of time shall prevail. 4
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