In an attempt to simplify the direct tax provisions, the Government released the Direct Taxes Code Bill, 2009 in August 2009 for public comments. The provisions of the DTC, especially those relating to Minimum Alternate Tax çMAT’) on gross assets, withdrawal of tax holiday to SEZ units, etc. met with vociferous protests from various stakeholders. Several representations were made by NASSCOM and numerous industry groups, based on which, the Government identified some major issues and released the Revised Discussion Paper on DTC in June 2010. As a logical step post the Revised Discussion Paper, the Government has now presented the Direct Taxes Code Bill, 2010 (‘DTC’) before the Parliament. The provisions of DTC are intended to come into effect from April 1, 2012 onwards. An analysis of the proposals in the DTC that are likely to impact the Information Technology çIT’) / Information Technology Enabled Services (‘ITES’) sectors is set out below.
KEY PROPOSALS AND THEIR IMPACT
Tax holiday to SEZ units and SEZ developers
Current situation: Under the existing provisions of the Income-tax Act, 1961 (‘the Act’), tax holiday is available to IT/ITES units operating from Software Technology Parks (‘STP’), Export Oriented Units (‘EOUs’) and Special Economic Zones çSEZ’). While the tax holiday in respect of the STP and EOU units has a sunset clause of 31 March 2011, SEZ units can avail tax exemption for a period of 15 years (which may extend beyond 31 March 2011) subject to fulfillment of certain conditions. Further, even SEZ developers are eligible to claim tax exemption in respect of their profits for a period of 10 years.
DTC Proposals: The DTC proposals seek to end the profit-linked incentive regime for SEZ units operational after 31 March 2014 and SEZ developers notified after 31 March 2012. Further, it has provided for grandfathering of tax holiday available to SEZ developers / SEZ units for the unexpired period.
Grandfathering of Tax Holiday for SEZ units
- Tax Holiday under section 1 0AA of the present Act would continue to be availed by all existing SEZ units for the balance unexpired period out of the prescribed 15 years. Such benefit would also be available to new SEZ units which commence operations on or before March 31, 2014.
- For the purpose of computing profits eligible for the aforesaid Tax Holiday, the methodology prescribed under Schedule 12 of the DTC shall be applicable. However, capital expenditure as well as expenditure incurred prior to commence of business shall not be allowed as a deduction for such purposes.
- The conditions specified under section 10AA for availing Tax Holiday shall continue to be applicable.
Grandfathering of Tax Holiday for SEZ Developers
- Tax Holiday under section 80-IAB of the present Act would continue to be availed by all existing SEZ Developers for the balance unexpired period out of the prescribed 10 years. Such benefit would also be available in respect of new SEZs which are notified on or before March 31, 2012 under the SEZ Act.
- For the purpose of computing profits eligible for the aforesaid Tax Holiday, the methodology prescribed under Schedule 12 of the DTC shall be applicable. However, capital expenditure as well as expenditure incurred prior to commence of business shall not be allowed as a deduction for such purposes.
- The conditions specified under section 80-IAB for availing Tax Holiday shall continue to be applicable.
Comments: The IT/ITES sector has been a key driver to India’s economic growth trajectory. The tax incentives offered to companies operating in this sector have provided them an edge in today’s fiercely competitive market.
As such, continuation of these tax incentives to new SEZ units under the DTC, though under a restrictive grandfathering clause, is still a positive step. The grandfathering provisions would provide some relief to the SEZ developers, not just vis-à-vis the tax benefit availed by such developers, but also vis-à-vis the business case for setting up a unit in SEZ, which is so integrally linked to the tax benefit bestowed on the unit.
Minimum Alternate Tax (MAT)
Current situation:In light of the tax holiday available to the IT/ITES sector, MAT is a key provision impacting the sector. Currently, MAT is applicable at the rate of 18% (effective 19.93% considering surcharge & cess) of the book-profits computed after making specified adjustments to the net profit of the company. Further, the companies are allowed to carry forward the MAT credit (which is the excess of MAT tax paid over the tax computed in accordance with normal corporate tax provisions) to future years. Presently, MAT provisions are not applicable to SEZ units and SEZ developers.
DTC Proposals: Under DTC, the concept and computation methodology of MAT have been retained broadly. However, MAT rate has been increased to 20% of book profits. Further, there is no exemption for SEZ developers and SEZ units from MAT.
Comments: This is a negative development for the IT/ITES sector. Absence of MAT exemption under the DTC would mean that SEZ Developers and SEZ units would need to pay a minimum tax of 20% on book profits. This provision would lead to additional tax outflow for the SEZ units/ developers in this sector. Further, DTC does not specifically provide for availing credit of MAT paid under the Act (relevant for STP / EOU units).
Corporate tax provisions – Key provisions
Tax rates
Current Situation: Currently, the domestic companies are subject to corporate tax of 30% (plus surcharge and education cess) on their taxable income.
DTC Proposals: While the Direct Tax Code Bill, 2009 stipulated the corporate tax rate as 25%, the Revised Discussion Paper had hinted that tax rates could be reviewed and suitably calibrated considering the reduction in the tax base due to certain tax benefits spelt out in the said paper.
The DTC now has retained the existing corporate tax rate of 30%.
Comments: Maintaining the corporate tax rate at 30% is not a positive development, in as much as other levies such as DDT of 15% and branch profit tax of 15% make the effective tax rate quite high.
Test of Residency
Current Situation: Under the provisions of the Act, a company is resident in India in any previous year, if the control and management of its affairs is situated ‘wholly’ in India.
DTC Proposals: Under DTC, it is proposed to shift the test of residence of a company from ‘control and management’ to ‘place of effective management’ in line with international practice.
Accordingly, a company incorporated outside India will be resident in India, if its place of effective management’ is situated in India.
Place of effective management of the company would mean:
- Place where the board of directors or its executive directors make their decisions
- In cases 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 of the company perform their functions.
Comments: Although the concept of ‘place of effective management’ proposed under DTC is in line with international practice, it is important that this provision is administered in a fair and pragmatic manner. The new residency definition could impact businesses where key decisions are taken by Indian management / executives and merely adopted by the board overseas.
Treaty Override
Current Situation: Under the Act, the provisions of the tax treaties prevail over the domestic law to the extent they are more beneficial to the taxpayer.
DTC Proposals: The initial draft of the Direct Tax Code Bill, 2009 provided that in the case of a conflict between the provisions of a treaty and the provisions of the Code, the one that is later in point of time shall prevail. This led to apprehensions whether the proposal would lead to treaty override and render the existing treaties otiose. Post the Revised Discussion Paper, the DTC seeks to restore the beneficial treatment between the Act and the Tax Treaty except in specified cases-
- where GAAR is invoked or
- when CFC provisions are invoked or
- when Branch Profits Tax is levied
Comments: The proposals seem to be in line with international practice.
Controlled Foreign Corporation (CFC) Provisions
Current Situation: Under the Act, there are no CFC provisions.
DTC Proposals: The introduction of the CFC provisions has come as a major surprise for India Inc. The CFC provisions have been brought in as an anti-avoidance measure. Under this, passive income earned by a foreign company controlled directly or indirectly by a resident in India, and where such income is not distributed to the shareholders, resulting in deferral of taxes shall be deemed to have been distributed to the shareholders in India. The CFC provisions are broadly summarized as under:
- The total income of a Resident taxpayer to include income attributable to a CFC which means a foreign company:
§ that is a resident of a territory with lower rate of taxation (i.e. where taxes paid are less than 50 percent of taxes on such profits as computed under the DTC)
§ whose shares are not listed on any stock exchange recognised by such Territory
§ individually or collectively controlled by persons resident in India (through capital, voting power, income, assets, dominant influence, decisive influence, etc.)
§ that is not engaged in active trade or business (i.e. it is not engaged in commercial / industrial / financial undertakings through employees / personnel or less than 50 percent of its income is of the nature of dividend, interest income, income from house property, capital gains, royalty, sale of goods/services to related parties, income from management, holding or investment in securities/shareholdings, any other income under the head income from residuary sources, etc.)
§ has specified income of such company exceeds INR 2.5 million
- Tie breaker tests have been provided to determine the place of residence of a controlled foreign company.
- Scope of passive income also covers supply of goods / services to associated enterprises.
- Specific formula prescribed for computing income attributable to a CFC. Income attributable to the CFC to be based on specified income. Specified income to be based on the net profit as per the profit and loss account of the CFC, subject to prescribed adjustments.
Comments: CFC provisions are likely to bring additional complexity in the tax legislation and could significantly impact Indian companies having outbound investment structures. Specifically, CFC provisions could create cash flow problems for Indian companies since they would be subject to tax without corresponding receipt of actual dividends. This may necessitate a review of the existing overseas investment structure.
Exempt-Exempt-Taxable (EET) vs. Exempt-Exempt-Exempt (EEE) Regime for Saving Schemes
Current Situation: Under the Act, long-term saving schemes like Government Provident Fund (GPF), Recognized Provident Fund (RPF), Public Provident Fund (PPF), Life Insurance etc. are covered under the EEE method, wherein the contributions, accumulations / accretions thereto and the withdrawals are exempt from tax.
DTC Proposals :All long-term retiral savings schemes moved to EEE regime as against EET proposed earlier. Deduction in respect of investment in approved funds such as Provident Fund, Superannuation Fund or Pension fund reduced to INR 100,000 from INR 300,000. Receipts under a life insurance policy on death/maturity would be exempt from tax.
Comments: The continuation of EEE regime is a welcome step as it will provide a tax free lumpsum amount to individuals to meet their post-retirement financial requirements and would benefit the people driven IT/ITES space.
Withholding tax provisions Bandwidth and Software payments
Significant components of cost for companies in the IT/ITES space include bandwidth charges and standardized software costs paid to overseas service providers / vendors.
Current Situation: Based on various judicial precedents, the payments are not subjected to tax withholding on the basis that payment for bandwidth to overseas service providers is not ‘royalty’ and payments towards shrink-wrap software are akin to payments for purchase of goods and not ‘royalty’ or ‘Fees for technical services’.
DTC Proposal: Under DTC, the definition of ‘royalty’ has been amended to specifically include consideration for use or right to use of transmission by satellite, cable, optic fiber or similar technology. Also, the definition of the term ‘Fees for technical services’ is redefined to include “development and transfer of a design, drawing, plan or software or similar services”.
Comments: These amendments cast a doubt whether the definition of royalty would cover charges for bandwidth which is merely a ‘facility’ availed by the IT/ITES companies and whether the term fees for technical services would also cover payments for standardized software which are essentially akin to payments for purchase of goods.
Typically, tax burden is passed on to the Indian service recipients and results in the increase in the overall cost of operations.
Withholding tax provisions – Others
Current Situation: The withholding tax rate on royalty and fees for technical services payable to non-residents is 10% (excluding surcharge and education cess).
DTC Proposals: The withholding tax rate in respect of payment of royalties and FTS to nonresidents is proposed to be increased to 20%.
Comments: The higher withholding tax rates would increase the overall cost of the Indian companies in case of payments to tax residents of the country with whom India does not have a Tax Treaty.
Transfer Pricing
Current Situation: Currently, there are no provisions under the Act in respect of Advance Pricing Arrangement (‘APA’).
DTC Proposals: It is proposed to introduce APA for upfront determination of pricing methodology of an international transaction.
Comments: Whilst the scheme specifying the procedure of APA has not yet been released, the industry would expect that the same is in line with the international practice.
Leased Assets
Current Situation: In the absence of any specific provision under the Act, there is a lack of clarity surrounding the treatment of assets obtained on finance lease by IT/ITES entities. In certain cases, companies are facing litigation from revenue authorities on the question of whether they are eligible to claim depreciation on such assets.
DTC Proposals: Under DTC, the lessee would be treated as the owner of assets obtained on finance lease and therefore, eligible to claim depreciation on the same.
Comments: This is an important provision for the companies in IT/ ITES space and it will help to end the long drawn litigation regarding ‘ownership’ of such assets & depreciation eligibility with the Revenue authorities.
General Anti Avoidance Rule (‘GAAR’)
Current Situation: Under the Act, there are limited specific anti-abuse provisions.
DTC Proposals
- The Code seeks to introduce GAAR which provides sweeping powers to the Revenue authorities. The same is applicable to domestic as well as international arrangements.
- GAAR provisions empower the Commissioner of Income-tax (“CIT”) to declare any arrangement as “impermissible avoidance arrangement” provided the same has been entered into with the objective of obtaining tax benefit and satisfies any one of the following conditions :
§ It is not at arm’s length
§ It represents misuse or abuse of the provisions of the DTC
§ It lacks commercial substance
§ It is carried out in a manner not normally employed for bona fide business purposes
- An arrangement would be presumed to be for obtaining tax benefit unless the tax payer demonstrates that obtaining tax benefit was not the main objective of the arrangement.
- CIT to determine the tax consequences on invoking GAAR by reallocating the income or disregarding/recharacterising the arrangement.
- Meaning of ‘tax benefit’ widened to include any reduction in tax bases including increase in loss.
- GAAR provisions to be applicable as per the guidelines to be framed by the Central Government.
- GAAR shall override Tax Treaty provisions.
- Forum of DRP available in a scenario where GAAR is invoked.
Comments: The guidelines to be issued by the Central Government would need careful examination to assess the scope and impact of these provisions. It is an open question whether GAAR can be invoked for transactions undertaken prior to the enactment of DTC. A suitable clarification may be provided for this purpose.
Concluding Remarks
It is interesting to note the path of the Direct Tax Code from the 2009 Bill to the 2010 one. The promises of a lower corporate tax rate have not crystallised. However, relief has been given to SEZ developers & SEZ units by way of grandfathering clause, the benefit of which has been partly nullified by the proposed levy of MAT at a high rate of 20%. Introduction of GAAR and CFC signals a tough tax regime for the corporate sector. All in all, DTC seems to be a mixed bag of goodies.
