The Direct Taxes Code Bill, 2009, was released on 12 August.
The code has modified several established precepts of tax jurisprudence, especially in relation to cross-border taxation. While a significant reduction in deductions or exemptions is sought to be offset by a corresponding reduction in the rates of taxation, disparities remain, since the benefits are not equally offset across industries and sectors. Capital markets – particularly the interests of foreign investors and corporations – is one area that is affected by the code.
In line with recent legislative trends, the code is a skeleton intended to be fleshed out later by rules, regulations and notifications that confer substantial discretionary powers on the executive, rather than being the expression of guiding principles. (This is a reminder of the way that, during the recent electoral analysis and discussions in the Indian media, certain ministries were facetiously referred to as ATM (“any time money”) ministries, due to their ability to act as cash cows.)
A significant change in the code is the formulaic approach taken to calculate certain exemptions and deductions, as compared to the outdated, verbose and convoluted language used in the Income Tax Act, 1961, which in itself probably caused numerous past tax disputes. However, it is unclear whether a “one size fits all” formulaic approach will be successful or merely lead to triumph for the letter rather than the spirit of the law.
The code proposes to tax capital gains on all assets uniformly, replacing the present selective and differential rate taxation system. The removal of the securities transaction tax, which was the main differentiator between capital gains taxation on securities and other assets, is significant. Short-term and long-term capital assets are also treated on a par with each other.
Taxing capital gains at an assessee’s applicable slab rates may lead to declared undervaluation of most assets (especially where market value is a derived one and not based on trade), and a consequent boost to the parallel “cash payment” economy, which in turn could promote money laundering.
The most draconian overarching principle in the code is the one that overturns or negates a double tax avoidance agreement (DTAA) prevailing over local income tax law. The code states that the provision “later in point of time” will prevail. This is a “heads I win, tails you lose” situation, since the tax authorities can easily bring out a notification which is “later in point of time” and thereby override a DTAA as well as any judicial interpretation.
In view of this, the unkindest cut for foreign investors is the code’s provisions relating to cross-border capital gains, on which withholding tax (WHT) is attracted at a high rate. In such cases, it is unlikely that the residence jurisdiction of such a taxpayer would allow credit for this WHT if the local capital gains tax is at a lower rate (or worse still, if it is nil).
Other provisions in this vein are the anti-avoidance provisions and the lack of commercial substance provisions (giving effect to the substance over form rule). One can understand some stringency in these areas due to the India-Mauritius Tax treaty and its misuse in certain cases, but with these provisions, the pendulum seems to have swung to the other extreme. In addition, transfer pricing provisions now have far lower thresholds for deeming associated enterprises.
These provisions empower a commissioner of income tax to lift the corporate veil on the slightest whim, reallocating income, negating transactions and treating several entities as one for taxation purposes. In fact, the discussion paper equates tax avoidance with tax evasion. Thus the Supreme Court’s landmark decision in Azaadi Bachao Aandolan (which had conferred legality on treaty shopping as a legitimate tax planning method) has been overruled, and the “ghost” of the McDowell case (and therefore that of the UK case of Ramsay), which was supposed to be exorcised, is in fact being resurrected.
Another feature potentially affecting capital markets is the decision to treat mutual funds, employee benefit funds and trusts on a pass-through basis for taxation purposes (where the income is taxed in the hands of the ultimate recipient). However, in the absence of detailed provisions relating to the method of such pass-through, the impact on capital markets is difficult to ascertain.
The code endeavours to make all business reorganizations tax neutral. Whether this objective is successful will largely depend on how these provisions are interpreted by the tax authorities. However, cross-border mergers are not likely to be tax neutral. Another feature is that reverse mergers (of profit making entities into loss making entities) appear to be permitted if they comply with conditions that are set out.
Against its avowed objectives, the code is basically another round of the endless face-off between tax advisers and the tax man. The code seeks to arm the tax man with substantial discretionary powers, including the power to issuing directions to unwind, re-characterize and disregard transactions.
Freddy Daruwala is an of counsel and Prachi Loona is an associate at Juris Corp. Juris Corp is a full-service law firm based in Mumbai. The firm specializes in banking and finance, joint ventures, foreign investments into India, private equity, direct tax, bankruptcy and restructuring, cross-border M&A, insurance, energy and infrastructure, dispute resolution and international arbitration.
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