The draft Direct Tax Code Bill, 2009 (DTC or Code) was released for public comments by the Government of India (Government) on 12 August 2009. The stated objective of the DTC is to establish an economically efficient, effective and equitable direct tax system which will facilitate voluntary compliance and reduce the scope for disputes and minimize litigation.
Designing a tax system that seeks the best practical outcome for a country involves striking a complex balance among competing considerations. The variation in tax systems in the world emphasizes that each country must strike its own balance. However, there are common principles that apply to any tax system. The Code incorporates many aspects of international best practices. The discussion paper accompanying the Code clearly presents the objectives of the new system, the proposed provisions and the Government’s reasons for choosing those provisions. As such, it provides commentators a clear context in which to respond to the proposals.
The Code embraces what has become the international norm for income taxes i.e., low rates of tax being applied to a broad base. The proposed corporate tax rate of 25% appears well-calibrated, relative to the tax rates of India’s main trading partners and competitors for investment, without unnecessarily foregoing the revenue that India needs to meet its social and economic expenditure goals. There are, however, some provisions which depart from international best practices. The combination of these provisions could introduce economic distortions and could discourage Foreign Direct Investments (as well as outbound investments by Indian companies) which India needs to fulfill its growth potential.
This tax alert provides a summary of the recommendations that have been made to the Government on the key aspects of the DTC.
Relationship between the DTC and a tax treaty
The DTC provides that neither the tax treaty nor the DTC shall have a preferential status, by reason of it being a tax treaty or domestic tax law. In case of conflict between the provisions of a tax treaty and the DTC, the one that is later in point of time shal prevail. The current wording of the provisions could create
some uncertainty or concerns for taxpayers, as well as for India’s tax treaty partners, on the possibility of domestic tax law overriding all existing tax treaties once the DTC comes into force.
In order to avoid uncertainty and to properly reflect the intention of the Government of not unintentionally overriding tax treaties, the provision may be amended to indicate that the domestic tax law will not override a tax treaty, unless such intention of the legislature to override a tax treaty is specifically and categorically stated in the DTC provision that conflicts with a tax treaty. Such a provision, in addition to ensuring stability and certainty provided by tax treaties, may also assist in avoiding the potentially time- consuming process of revalidating the effective date of all tax treaties, through protocols, whenever there is a domestic tax law amendment.
General Anti-avoidance Rule (GAAR)
The DTC proposes to introduce a GAAR which is intended to serve as a deterrent against tax avoidance. While the GAAR is intended to prevent abusive tax avoidance arrangements, at the same time it should not interfere with legitimate commercial transactions. The objective should be to deter aggressive tax planning, without introducing uncertainty in the ordinary affairs of taxpayers. Consequently, the GAAR should distinguish between legitimate tax planning and abusive tax avoidance and establish a reasonable balance between the protection of the tax base and the need for certainty for taxpayers in planning their affairs. Modifying some aspects of the GAAR would help in better establishing this balance. The following proposals may be considered for modifying the GAAR:
1. The Code provides the definition or description of the target activity for invoking the GAAR, by defining the term ‘impermissible avoidance arrangement’. The definition should be redrafted to include all of the following: (a) There must be a tax benefit resulting from a transaction. (b) The transaction must be an avoidance transaction, in the sense that it cannot be said to have been reasonably undertaken primarily for a bona fide business or commercial purpose other than to obtain a tax benefit. (c) There must be abusive tax avoidance, in the sense that it cannot be reasonably concluded that allowing a tax benefit would be consistent with the object, spirit or purpose of the provision.
2. The inclusion of deferral of tax within the ambit of the definition of ‘tax benefit’ should be reconsidered. Countries that are concerned with tax abusive deferral structures have tried to deal with the problem by enacting specific anti-deferral rules or Controlled Foreign Corporation (CFC) rules, rather than through the GAAR.
3. The process through which the GAAR is invoked is as important to its success as is the legal drafting of the GAAR. The process of applying the GAAR should ensure that there is consistency in interpretation of the GAAR across the country and that taxpayers are not faced with spurious challenges. Further, the integrity of the GAAR should not be diluted by its application to inappropriate circumstances. If inappropriate GAAR challenges are made, it adds to the taxpayer’s uncertainty and increases conflict between the taxpayer and tax administrator. It is proposed that an independent high-powered central authority be constituted for reviewing and approving all cases proposed by a Commissioner for invoking the GAAR. This would help in maintaining the sanctity of the GAAR process. In addition, a process of obtaining advance rulings, specifically on applicability of the GAAR, should be considered.
4. The onus to prove that a particular transaction is not in the nature of an ‘impermissible tax avoidance transaction’ currently lies with the taxpayer. This could result in the Commissioner seeking to invoke GAAR on mere suspicion in spite of the fact that there may not be evidence that the taxpayer has engaged in an ‘impermissible avoidance transaction’. The burden on the taxpayer in such circumstances is unmanageable. The GAAR should be modified to put the burden of proving the existence of an impermissible tax avoidance engagement on the Commissioner, prior to invoking the provisions of the GAAR in any transaction.
5. If the Commissioner imposes tax by applying any of the above, it should be mandatorily provided that relief by way of a corresponding adjustment is provided to a counter party.
Gross Assets Taxation (GAT) or Minimum Alternate Tax (MAT)
As per the DTC, a company would need to pay tax, either as per ‘normal provisions’ or MAT provisions, whichever is higher. The MAT provisions of the DTC shifts the basis for levy of MAT from ‘book profits’ to ‘gross assets’. The rate of tax is 2% of the value of ‘gross assets’ (0.25% in the case of banking companies). MAT is to be the final tax and no tax credit is available in respect of MAT in subsequent years.
The levy of MAT under the proposed provision raises some concerns, some of which are as follows: (a) The tax has no correlation to income and applies even to loss-making companies. (b) It is based on a presumption that a company is expected to earn a minimum return on its assets. (c) As it is levied on gross assets, it does not consider liabilities. (d) It poses a strong disincentive for investments in assets. (e) It has
a cascading effect, especially within investment companies. (f) It could create foreign tax credit (FTC) challenges in the residence country of the investor. (g) It could potentially be levied on foreign companies, even if they don’t have a fixed place presence in India.
The Government should reconsider the proposal to levy MAT based on gross assets. However, if the Government wishes to continue with such a tax, the following modifications could be considered:
Income deemed to accrue or arise in India
In the DTC, the provisions dealing with source of income rules have been widened to include the following:
The DTC proposals appear to extend the source of income rules, allowing India to tax income which may have even an indirect or remote nexus to its territory. While the proposals do raise questions on ability of a country to enforce taxation of such incomes, it also raises concerns of double taxation, as the source of income rule is incompatible with international practices/standards.
As the DTC provision, in its current form, could create a lot of uncertainty for taxpayers in understanding the circumstances under which their transactions could potentially create a tax liability, the Government should reconsider the introduction of such a provision in the Code. However, if the Government does consider the provision as necessary, an attempt should be made to properly define and prescribe the circumstances or circumscribe the limits on what would be regarded as an ‘indirect transfer’ of an Indian capital asset. In addition, exemptions should be provided for indirect transfer resulting from global mergers and acquisitions, intra-group transactions, transactions undertaken on stock exchanges etc.
The proposed expansion in source of income rule for interest income may not be warranted. It is therefore recommended that the existing rule contained in the current Income Tax Law (ITL) be continued. Further instead, the Government could reconsider appropriateness of a similar source of income rule which exists in the current ITL for royalty and fees for technical services.
Residence in India
The DTC provides that a company shall be resident in India, in any financial year, if it is an Indian company or its place of control and management, at any time in the financial year, is situated wholly or ‘partly’ in India. This would result in a fairly low threshold for regarding a foreign incorporated company as a resident in India and could increase the risk of double taxation arising because of ‘residence-residence’ conflict. This risk is greater in the current globalized environment, where control and management of a company can be peripatetic. This provision is also not in line with the generally accepted international tax principle that, for a country to exercise jurisdiction to tax under the residence principle on a corporate entity, there should be a fairly strong economic nexus with that country, demonstrated by way of incorporation and/or by way of existence of substantial management and control.
The Government should, therefore, consider continuing with the existing provision of the ITL (based on ‘whole’ control and management of affairs in India) for defining residence of a company. Alternatively, as against a broad test of partial control and management, the concept of ‘central control and management’ or ‘place of effective management’ can be considered.
Liability to deduct tax at source
The withholding tax proposals in the DTC are far reaching and raise significant concerns. Under the Code, any person (subject to certain exceptions) is under an obligation to withhold tax on ‘specified payment’ at the ‘specified rates’. With regard to payments to non-residents (NRs), withholding could apply on all payments, whether chargeable to tax or not. The specified withholding tax rate for all other income (other than royalty, fees for technical services, interest and capital gains) is 35% on the gross amount. Further, the DTC also does not permit application of tax treaty rates for the purpose of withholding tax.
The Government should consider the following proposals for redrafting the withholding tax provisions of the Code.
Payments to residents
Payments to NRs
Branch Profits Tax (BPT)
A new concept of ‘tax on branch profits’ has been introduced under the DTC, wherein ‘every foreign company’ shall be liable to pay a BPT of 15% on its total income, as reduced by the corporate income tax. However, the term ‘branch’ is not defined, even though the terminology used is ‘BPT’. This could result in levy of BPT on all foreign companies, whether or not they have a branch/ PE presence in India.
The levy of BPT should be restricted to a foreign company that has a fixed place business presence in India, by virtue of a branch office or project office. The DTC should, therefore, provide for a definition of the term ‘branch office’. Further, the levy of BPT on branch offices of foreign companies should be only on remittance so as to achieve the objective of bringing parity between domestic and foreign companies. It would also be necessary to include suitable ‘grandfathering provisions’ to ensure that the levy of BPT is only on profits earned after 1 April 2011, as profits earned prior to 1 April 2011 would be subject to a higher corporate tax rate of 40% currently applicable to foreign companies.
Transfer pricing (TP)
Computation of Arm’s Length Price (ALP)
As per the DTC, where more than one price is determined by the most appropriate method, the ALP shall be taken to be the arithmetic mean (AM) of such prices. Further, a variation of up to 5% from the transaction price is permitted. As a statistical technique, the AM may not be a reliable measure, as it can be significantly influenced by extreme values. The extreme values distort the AM and provide a skewed result, when compared to other statistical methods.
Considering the fact that the AM provides skewed results under certain circumstances and taking guidance from international practices, the AM/ (+/-5%) range could be substituted with median/inter-quartile range. Use of median/ inter-quartile range would also help in improving the reliability of the analyses where the comparables are of lesser reliability. In addition, as a number of countries recognize median/inter-quartile range as a statistical measure, introduction of a similar provision in the Indian regulations would facilitate Competent Authority negotiations in the case of dispute resolution through Mutual Agreement Procedure (MAP).
Definition of Associated Enterprise (AE)
The DTC proposes to expand the definition of the term ‘AE’, in a number of instances, by lowering the threshold for constituting an AE (for e.g. 10% voting power, loan constituting 26% or more of the book value of total assets, guaranteeing 10% or more of the total borrowings). This could result in situations where an AE relationship may be created even without any significant participation in capital, control or management.
The existing definition which, by itself is quite broad, appears to have served the object and purpose well, with not many abusive instances of taxpayers structuring their relationships to avoid the AE relationship. Further, the fairly low threshold for AE may make the search for comparable uncontrolled enterprises even more challenging. Accordingly, the Government should consider continuing with the existing definition even under the DTC provisions. Further, it may be advisable to even relook at some of the existing aspects of the definition to assess if the same need to be modified or dropped.
Transfer Pricing Rules
The DTC contains provisions for computation of the ALP for an international transaction, whereby, the most appropriate method shall be applied for determination of the ALP. Further, it is stated that the most appropriate method shall be determined in the prescribed manner, having regard to the nature of the transaction, class of AEs, functions performed by such enterprises or such other relevant factors. The Government is, therefore, empowered to notify rules for this purpose.
The Government should give due consideration to international best practices and the Organization for Economic Co-operation and Development’s Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD TP Guidelines), including the September 2009 Discussion Draft of the OECD, while drafting the rules. Specifically, the Government could consider the following aspects while framing the rules:
? Provide flexibility to taxpayers in using a residuary or unspecified TP method.
? Enable taxpayers to use multiple year comparable data, where appropriate.
? An approach for aggregation of transactions for undertaking a TP analysis.
? An approach for selection of comparable data.
Advance Pricing Agreements (APAs)
As per the DTC, the Central Board of Direct Taxes (CBDT) is empowered to enter into an APA with a taxpayer, for determination of the ALP for an international transaction. The provision appears to permit the CBDT to enter into unilateral APAs only.
The provision should be modified to enable the process of bilateral or multi-lateral APAs as well. Having an enabling power in the law to permit such arrangements would provide flexibility to the Government in case the need for a bilateral or multi- lateral APA is felt, using the article on MAP of an applicable tax treaty.
Further, the provisions require the Government to frame an APA scheme so as to enable it to enter into APAs. The Government should consider international best practices, including practices contained in the OECD TP Guidelines, while framing the APA scheme.
Foreign Tax Credit Rules
The DTC contains the general principle for grant of FTC for taxes paid in a foreign country. The provision enables the Government to prescribe the method and manner for FTC, along with such other particulars as are necessary for double tax relief.
There are a number of policy, computation and procedural aspects that need to be considered while drafting the FTC legislation, some of which are outlined below:
? Per-country limitation – Whether FTC eligibility should be determined under a ‘country-by-country’ approach or a ‘worldwide aggregate’ approach.
? Per-category limitation – Whether foreign taxes should be ‘pooled’ or whether they should be separately computed for each category/item of income.
? Carry-forward of excess FTC – In case a taxpayer has ‘excess’ FTC in a particular year, the FTC provisions would need to address whether the excess FTC would be allowed to be carried over to be utilized in the subsequent years.
? Allocation of expenses – FTC rules would need to address issues relating to allocation of expenses between foreign source and domestic source.
? MAT and FTC – Whether FTC can be used to set-off tax under the MAT provisions.
? Proof/evidence of foreign tax payments to be considered for FTC.
? Difference in tax years/financial years in the country of residence and country of source.
? Difference in year of foreign tax payment and inclusion of income in India.
? Foreign exchange fluctuation differences.
Some of the above aspects would have a substantive effect on the manner in which amount eligible for FTC is determined, thereby having an effect on revenue base as well as on effective tax rates of Indian companies. The Government should, therefore, consider introducing some of the aspects identified above in the DTC, while those aspects that are largely procedural/compliance-related could be prescribed by way of rules. Such an approach to FTC legislation would provide certainty and stability with regard to the Government’s policy of the Government relating to double tax relief.
Taxation of foreign source dividends
While the DTC contains provisions for FTC, they seem to limit credit only to income tax directly paid by the Indian resident and, therefore, they may not enable credit being claimed for underlying foreign taxes paid by the foreign subsidiary or group companies. As a result, foreign dividends may suffer taxation again, in the absence of specific provisions in this regard. The goal of a double tax relief system is to avoid double taxation of foreign income in a manner which balances the taxpayers’ needs to avoid double taxation with the objective of preserving the national tax base. Also, a provision for tax relief against double taxation of foreign source dividends would encourage Indian companies to repatriate their profits from global operations to India for productive reinvestment which, consequential y, would fuel economic growth.
While there are a number of mechanisms that exist in the international context for relieving economic double taxation of dividends, the Government could consider the following alternatives:
? Participation exemption – An exemption from tax in the residence state is provided on the benefits (generally, dividends and capital gains) derived by ‘qualifying participants’ on the basis of a prescribed percentage of shareholding.
? Underlying tax credit – Another method for eliminating double taxation of dividends is by way of granting an underlying tax credit. A similar recommendation was also made in January 2003 in the ‘Report of the Working Group on Non- Resident Taxation’. The Report stated that if an underlying tax credit mechanism is adopted, it would give an incentive for the flow of funds to the parent Indian company, which would make them more competitive, generate investments and be a source of more taxes in India.
Computation of Business Income
Dividend Distribution Tax (DDT)
The DTC provides for levy of DDT on a domestic company. The provisions are broadly comparable to similar provisions contained in the current ITL. The DTC provisions, like those contained in the current ITL, provides for avoiding a cascading effect of DDT when distributed by a subsidiary to its holding company, by offsetting the dividend received against the dividend payable. However, the circumstance under which such offset is available is fairly restricted. It is requested that the Government considers providing a much broader set of situations where the cascading effect can be avoided.
The existing profit-linked incentives under the ITL are proposed to be replaced by investment-linked incentives. While most of the existing profit-linked incentives, area- based exemptions are ‘grandfathered’, the tax incentives relating to units of Special Economic Zones (SEZs) are not grandfathered. By not including grandfathering provisions for SEZ units, taxpayers operating in SEZ units will be adversely affected. Accordingly, it is requested that the Government introduces suitable ‘grandfathering’ provisions to ensure that the units operating in SEZs are not adversely impacted.
Taxation of Capital Gains
The Code proposes to remove the distinction between long-term and short-term capital gains. In addition, it proposes to levy a 30% tax on capital gains arising to an NR. The Government should review these proposals and consider the need to continue with the provisions as contained in current ITL with regard to taxation of capital gains of NRs.
Deduction for Head Office expenditure
The DTC places a limitation on the quantum of head office expenses that can be claimed by an NR while computing the taxable income of the Indian business. While a similar provision is also contained in the current ITL (although with a different mechanism for determining the limitation), the need to have such a limitation is called to question. As allocation of expenses by a head office to its branch in India would be subject to TP provisions/tax treaty rules, the purpose originally envisaged while providing for a cap may no longer be valid.
A number of provisions relating to taxation of employment income and income from letting of house property contained in the DTC may also need to be reviewed and either dropped or modified.
Some of the provisions dealing with the procedural aspects of taxation, as contained in the DTC, such as the powers given to the CBDT to make rules, powers for re-opening of assessments, revision of orders prejudicial to revenue etc., should be reconsidered.