Tuesday, September 29, 2009

Direct Taxes Code: Write up

The following is the write up on the Direct Taxes Code, and the session discussions:
I. Pranab Mukherjee said, upon entering his office, that his Ministry would release a draft bill for a completely new, simplified tax code within the first 45 days of his tenure. True to his word, the draft bill, called the Direct Taxes Code (DTC) has been released for public comment. While the promises of lower, stable rates of taxation have caused many to view the code positively; the DTC carries forward many of the shortcomings of the Income Tax Act, 1961 and brings in a fair share of problems on its own. The provisions of the new code and some of the policy considerations they throw up will be the central concern of this paper.

I will begin by discussing the objectives behind the new code and the reasons the need for it was felt. I will then look at the effect of the provisions of the code on non-profit organisations with a view to balancing anti-avoidance concerns with incentivizing public welfare.

The IT Act has become very complex and virtually unintelligible to the common (wo)man by virtue of a complicated structure, numerous amendments, frequent policy changes, and a multitude of judgments that gave varying interpretations to already undecipherable provisions. This complexity has not only increased the cost of compliance for the average tax payer, but also made it costly for the administration to collect tax. Lastly, the tax base has been eroded significantly due to an increasing number of exemptions and horizontal inequity.
These are some of the reasons that the need for a simplified new code was felt.

The OBJECTIVES of the new code are therefore
· Simplification
· level-playing field for domestic and foreign tax players
· equity and non-discrimination
· removal of ambiguity to encourage voluntary compliance
· stability in the tax regime
· increase tax to GDP ratio
· eliminating distortions in the tax structure,
· introducing moderate levels of taxation and
· expanding the tax base by
o minimizing exemptions that have been eroding it
o Reducing ambiguity that facilitates tax avoidance by making provisions clear and less liable to varying judicial interpretation
o checking tax evasion.

It is important to observe that while some of the provisions of the new code are very similar, even identical to those of the IT Act, Pranab Mukherjee says in the introduction to the discussion paper released by the Finance Ministry that the new code is not an attempt to amend the old code and therefore should be read in isolation, rather than by comparing provisions of the old with the new. If the new code is to be read in this way, will the interpretation, understanding and plugging of the holes in the IT Act be extendable to the provisions adopted here?

This is significant in the context of the above objectives of simplifying the tax law in India, making it less ambiguous by reducing scope for varying judicial interpretation etc.
Throughout my discussion on the provisions of the new code, I will argue that while the problems raised by their wording might have been plugged by judicial interpretation in the past, it is defeating the above objectives to the code to import the provisions verbatim in the new code. Rather, it would have served the objectives of the government better to incorporate judicial wisdom accumulated over the years into the new code by wording provisions better. In my opinion, clarifying some of these contentious issues in the bill itself in simple language would not have endangered the desired simplicity of the code. Instead, it would have furthered the goal of helping tax payers understand their liabilities and plan accordingly.

Currently, registered NGOs are under the income-tax net, but not liable to pay tax. The general rule is exemption from tax if the purpose is charitable. Thus it is that charitable public trusts and foundations have been a popular vehicle among corporate houses to bring in huge tax benefits. In fact, there are presently over 70,000 trusts and charitable institutions registered with the Income-Tax Department and get tax exemption on their activities.

The new code makes significant changes in this regime by making exemption the exception and taxation the rule. Under the code, non-profit organizations will be liable to pay tax at the rate of 15 per cent regardless of the nature of their work. The phrase “charitable purpose” in the IT Act has been replaced by the phrase “permitted welfare activities” which seeks to narrow the scope to-
o relief for the poor,
o advancement of education,
o provision of medical relief,
o preservation of environment,
o preservation of monuments or places or objects of artistic or historic interest
o any other object of general public utility.
But not
o any activity in the nature of trade, commerce or business, or
o any service in relation to any trade, commerce or business, for a fee or for any other consideration, irrespective of the nature of use, application or retention of the income from such activity.

An organization shall be treated as a non-profit organization if
· it is established for the benefit of the general public; it appears that the onus will now be on the organisation to demonstrate, by leading evidence, that the benefit has actually reached the general public. The amount of documentation to be maintained to demonstrate this may be, in certain cases, impractical. Thus it seems that rather than simplify matters, the code might be creating additional complications.
· it is not established for the benefit of any particular caste; the question that arises is whether a non-profit organization that works for manual scavengers, that tend to be dalits, would be excluded from the definition. It would seem that the judicial opinion on a similar provision in the old Act would apply here too, that such organization would not be excluded so long as it did not speak of itself as an organization dedicated to dalits. However, as I said earlier, I think it would serve the object of the code better to include that clarification in the code itself. Doing so would prevent unnecessary litigation and confusion thus increasing efficiency.
· it is not established for the benefit of any of its members- here again arises the contentious issue of what qualifies as the benefit of any of its members. Will the organization be excluded if it works towards fighting AIDS and the co-founder has AIDS?
· it does not intend to apply its surplus or other income or use its assets or incur expenditure, directly or indirectly, for the benefit of any interested person
· it is established for carrying on permitted welfare activities;
· it actually carries on the permitted welfare activities during the financial year;
· the actual beneficiaries of its activities are the general public;
· any expenditure by the organisation does not enure, directly or indirectly, for the benefit of any interested person;
· the funds or assets of the organisation are not used or applied or deemed to have been used or applied, directly or indirectly, for the benefit of interested person;
· the surplus, if any, accruing from its permitted activities does not enure, directly or indirectly, for the benefit of any interested person;
· the funds or the assets of the non-profit organisation are not invested or held, at any time during the financial year, in any of the forms or modes specified in section 91;
· it maintains such books of accounts and in the manner, as may be prescribed;
· it is registered as such under section 93; and
· it obtains a report of audit in prescribed form from an accountant before due date of filing of the return in respect of,- (A) the accounts of business, if any, carried on by it in accordance with the provisions of section 84; and (B) its accounts relating to the permitted welfare activities in a case where the gross receipts referred to in section 89 exceeds one lakh fifty thousand rupees;

The tax liability of a non-profit organisation shall be 15 per cent of the aggregate of-
(i) the amount of surplus generated from the permitted welfare activities; and
(ii) the amount of capital gains arising on transfer of an investment asset, being a financial asset;
The amount of surplus generated from the permitted welfare activities shall be the “gross receipts” as reduced by the “outgoings”.
The “gross receipts” shall be the aggregate of the following:-
(i) The amount of voluntary contributions (this would mean that donations would be taxable in the hands of the receiving organization though the donor would still enjoy exemption to some extent) received during the financial year;
(ii) Any rent received in respect of a property consisting of any buildings or lands appurtenant thereto;
(iii) The amount of any income derived from a business which is incidental to any of the permitted welfare activities; Profits of any business held under trust would not be eligible for concessional treatment even if such profits are to be mandatorily used for permitted welfare activities. This effectively overcomes the decision of the Supreme Court in the case of Thanti Trust, wherein it was held that exemption could not be denied to profits generated by a business of a charitable organisation which could not be utilised except for charitable activities. The only business that would now be permitted is which is incidental to the permitted welfare activities in a manner that the business itself is carried on in the course of actual carrying out of the permitted welfare activity.
(iv) Full value of the consideration received from the transfer of any investment asset, not being a financial asset;
(v) Full value of the consideration received from the transfer of any business capital asset of a business incidental to its permitted welfare activities;
(vi) The amount of any income received from any investment of its funds or assets; and
(vii) All other incomings, realizations, proceeds, donations or subscriptions received from any source.
The amount of outgoings shall be the aggregate of
(i) voluntary contributions received during the financial year by the nonprofit organisation made with a specific direction that they shall form part of the corpus of the non-profit organisation;
(ii) the amount actually paid during the financial year for any expenditure, excluding capital expenditure, on the permitted welfare activities; It is unclear what expenditure on permitted welfare activities would encompass. Would it include salaries paid to workers at the organization, expenses on media coverage, publicity etc that may not directly benefit the public but enable the organization to do so?
(iii) the amount actually paid during the financial year for any expenditure, excluding capital expenditure, on the permitted welfare activities;
(iv) the amount of capital expenditure actually paid during the financial year in relation to-
(a) any business capital asset of a business incidental to any of the permitted welfare activities; or
(b) any investment asset, not being a financial asset.
(v) any amount actually paid during the financial year to any other nonprofit organisation engaged in a similar permitted welfare activity;
(vi) any amount applied outside India during the financial year if the amount is applied for an activity which tends to promote international welfare in which India is interested and the non-profit organisation is notified by the Central Government in this behalf.

The income of any trust or institution recognised/registered under the religious endowment Acts of the Central Government or the State Governments shall be fully exempt from income-tax. However, donations to such trusts or institutions will not enjoy any deduction in the hands of the donor. I have not come across any rationale for this exemption so far.

The new regime shall not apply to any person who-
(a) holds any business under trust, notwithstanding a specific direction that the business shall form part of the corpus of such person or a specific direction that the income from the business shall be applied only for permitted welfare activities;
(b) carries on the permitted welfare activity involving the relief of the poor, advancement of education, provision of medical relief, preservation of environment or preservation of monuments or place or objects of artistic or historic interest and also carries on a business which is not incidental to the aforesaid permitted welfare activity
(c) ceases to be a non-profit organisation at any time during the financial year

In conclusion, it would appear that the provisions of the new code are perhaps unable to achieve the correct balance between incentivizing socially relevant work and preventing tax avoidance. What is definitely required are clarifications on some of the minute points raised. On a more fundamental level, it is even questionable as to why a non-profit organization that carries out welfare work the state is unable to ought to pay tax at all. An obvious concern is to avoid misuse, but is the appropriate response to impose a tax of 15 per cent or regulate the sector in other ways?
A. The Treatment of Savings Under the New Direct Tax Code

The Direct Tax Code make significant departures from the system that is in operation at present, the most significant changes being that of, firstly, an increment in the exemption amount from Rs. 1 lakh to Rs. 3 lakh, and, secondly, an alteration from the exempt-exempt-exempt system (or ‘EEE’) to the exempt-exempt-tax system (or ‘EET’). For the purposes of conceptual clarity, the two systems are explained hereinunder:

i) Exempt-exempt-exempt (EEE) – Under the EEE system the exemption is total, and there is no tax liability incurred on contributions, on interest accrued for the period of interest or on the amount withdrawn.
ii) Exempt-exempt-tax (EET) – Under the EET system imposes a tax liability on the investment at the time of withdrawal alone, tax not being payable at the time of contribution or on the interest that accrues on the contribution (the last ‘T’ naturally referring to ‘tax’)

The Direct Tax Code provides for the latter system of EET, and taxes the contributions made in certain schemes for the purpose of reduction; while under the Income Tax Act, the EEE system operated. The distinction between the systems is obvious, and a rational actor would most certainly prefer the EEE system to the EET. This, however, does not imply that the same rational actor would prefer the old Income Tax Act of 1961, on the simple reason that the increase in the exemption limit counter-opposes the damage done by taxing the scheme at the time of withdrawal. The following examples will make this argument clear:

Case 1: Tax Liability of a male A, with income of Rs. 10 lakhs

Under the Old Tax Scheme:

Income from Various Sources
Taxable Income (=Income - Deductions)
Tax Liability (= Rs. 54,000 + 30% on Rs. 4,00,000)

Under the Direct Tax Code:

Income from Various Sources
Taxable Income (=Income - Deductions)
Tax Liability (=10% on Rs. 5,40,000)

Case 2: Tax Liability of a male B, with income of Rs. 3 lakhs

Under the Old Tax Scheme:

Income from Various Sources
Taxable Income (=Income - Deductions)
Tax Liability (=10% on Rs. 40,000)

Under the Direct Tax Code:

Income from Various Sources
Taxable Income (=Income - Deductions)
Tax Liability

Case 3: Tax Liability of a male C, with income of Rs. 5 lakhs

Under the Old Tax Scheme:

Income from Various Sources
Taxable Income (=Income - Deductions)
Tax Liability (=14,000 + 20% on Rs. 2,60,000)

Under the Direct Tax Code:

Income from Various Sources
Taxable Income (=Income - Deductions)
Tax Liability

From the above, it is clear that the new direct tax code significantly reduces the tax payable at the time of assessment. However, it is important to remember that at the time of making withdrawal from the investment scheme that is available for deduction of taxable income, a tax liability is incurred. In this regard, the benefit still accrues to the tax payer since the interest on the investment remains tax free and only the capital amount is taxable. Furthermore, in light of the larger tax slabs under the new Code, this amount payable should be significantly lesser than the amount that is liable to be included in taxable income over above the Rs. 1 lakh exemption limit.

The preceding analysis will leave any investor jumping for joy. However, before booking the tickets for Hawaii, two important observations are in order. Firstly, there has been significant pruning of the schemes for which deductions are available, the most important ones being housing loans, unit-linked insurance policies, house rent allowances, contributions to fixed deposits and LIC premiums. This has potential repercussions on the middle-class, since these are the most popular schemes under which deductions are claimed. Secondly, the schemes are taxable at the time of redemption leaving the greatest impact on the retired, a class of people who do not have a steady source of income. However, this criticism can easily be countered by bettering tax planning for retirement, a task that will be made more simple, since there is tremendous incentive to save in the income earning years.

The trade-off is simple – the taxable amount has fallen, but the number of investment schemes for which deductions may be claimed have been significantly been reduced. The focus of the new Code, according to the Discussion Paper, is on long-term capital formation, with incentives being tremendous for the same. The greatest threat to the atmosphere of optimism that has been generated by the new Code is nothing but a change of heart by the government; and it remains to be seen whether it will see the proposals in the draft Code through.

B. The Impact of the Direct Tax Code on the Tax-GDP Ratio

The Discussion Paper claims that tax base has eroded through a steadily escalating range of exemptions. GDP growth in the years post-reform has been formidable, while the tax-GDP ratio remained low for the most of the years since. The new Code doesn’t seek to improve the situation further, and the government seems to be placing too great a reliance on the view that households and firms, if taxed lightly will increase their consumption expenditure and will invest more, and this in turn will fuel growth. The problems with this argument are simple. Firstly, it underestimates the role of public expenditure and capital formation. Secondly, it advantages GDP growth even at the cost of reducing the role of direct taxation in reducing the inequalities brought about by economic growth. Thirdly, it completely ignores the role of tax-financed public expenditure in alleviating poverty, and providing a social security net. Fourthly, the government’s assumption may be entirely wrong which result in an even greater detriment to the revenue collections, thereby off-setting the Tax-GDP Ratio even further.
C. Presumptions

The new Code makes a presumption that an arrangement is entered into for the tax benefit alone, unless it is rebutted by the taxpayer. The tax benefit is defined, amongst other things, to mean a reduction, avoidance or deferral of tax arising. The issue which such a presumption is that generally, tax statutes are to be interpreted in strictly and in a manner that provides benefit to the tax-payer, however, with this provision wide discretionary powers are vested in income tax commissioner. It is yet to be seen if this presumption will stand the test of judicial scrutiny.
A. What is tax avoidance?
People eliminate or reduce tax by following a transaction or many transactions that are legal. The various methods of Tax Avoidance are:
a) Legal entities
b) Country of residence
c) Double taxation

· Legal entities are a method that people follow when they want to go for tax avoidance. Under this method, people legally defer paying personal taxes by creating a legal separate entity to which they donate their property. The legal separate entity that is set up is often a foundation, company, or trust. The properties are transferred to the trust or company, as a result of which the income that is earned belongs to this entity and not by the owner. Usually, people are taxed personally on earnings and property that they own and thus by transferring property to a legal separate entity, individuals can avoid personal taxation although certain taxes such as corporate taxes are still applicable.
· Country of residence is another method that people adopt when they go for avoidance of tax. Under this method, the company or person changes the tax residence to a place that is a tax haven in order to lower the amount of taxes that they pay.
· Double taxation means that many countries charge taxes on the income that has been earned inside that country without taking into consideration, the resident country of the firm or person. So that people do not have to pay double taxes, once in the country where the income has been earned and then again in the resident country, many countries have gone for bilateral treaties of double taxation with other countries. This helps tax-payers as they are able to avoid paying double taxes.

B. Why is tax avoidance bad?

a) First there is substantial loss of much needed public revenue, particularly in a welfare State like ours.
b) Next there is the serious disturbance caused to the economy of the country by the piling up of mountains of black money, directly causing inflation.
c) Then there is “the large hidden loss” to the community some of the best brains in the country being involved in the perpetual war waged between the tax-avoider and his expert team of advisers, lawyers and accountants on one side and the tax-gatherer and his perhaps not so skillful advisers on the other side.
d) Then again there is the “sense of injustice and inequality which tax avoidance arouses in the breasts of those who are unwilling or unable to profit by it”.
e) Last but not the least is the ethics (to be precise, the lack of it) of transferring the burden of tax liability to the shoulders of the guileless good citizens from those of the “artful dodgers”.
C. Anti –avoidance principles
1. Business Purpose Rule
A transaction must have a main or predominant business purpose other than tax avoidance.
2. Substance over Form Rule
It is basically lack of economic substance. Even if a person carries out a series of legal transactions, if on the whole the main aim is tax avoidance, the transactions will be taxed. Furthermore, sham transactions which hide the economic reality of a transaction that exists in form only are also taxable. The Code is concerned not merely with the genuineness of a transaction, but with the intended effect of it for fiscal purposes. No one can now get away with a tax avoidance project with the mere statement that there is nothing illegal about it.
3. Step transaction doctrine
Under the new code, a series of connected transactions will not be regarded as a single transaction but rather taxed as individual transactions.
D. Blurring the line between evasion and avoidance
In India, the law is settled that tax avoidance is legal and evasion is not. A taxpayer may create a device to arrange his commercial affairs to minimize his tax liability and its acceptance is based on operation of law. While revenue authorities are entitled to decipher the true meaning of a transaction, they cannot substitute its legal effect by a perceived “substance of the transaction” without related provisions under the tax legislation for Anti-avoidance rules. However the new code proposes to introduce General Anti-Avoidance Rule (GAAR), which would erase the thin line between tax avoidance and tax evasion.
· How is the new code different from the existing position?
The Supreme Court in 1967 held in the case of Commr. of Income-Tax v. A. Raman & Co [1968] 67 ITR 11(SC) that avoidance of tax liability by so arranging commercial affairs that charge of tax is distributed is not prohibited. A taxpayer may resort to a device to divert the income before it accrues or arises to him. Effectiveness of the device depends not upon considerations of morality, but on the operation of the Income-tax Act. Legislative injunction in taxing statutes may not, except on peril of penalty, be violated, but may lawfully be circumvented. This position was reiterated in the Mcdowell case in 1985. It was further held that tax planning may be legitimate provided it is within the framework of law. Colourable devices cannot be part of tax planning and it is wrong to encourage or entertain the belief that it is honourable to avoid the payment of tax by resorting to dubious methods.
However, under the new code, Section 112 empowers revenue authorities to declare any arrangement as “impermissible avoidance arrangement” if it results in certain tax benefits or it creates rights or obligations which would not normally be created between persons dealing at arm’s length or it results in abuse of the provisions of the code, lacks commercial substance or lacks bona fide business purpose. It allows revenue authorities to disregard, combine or re-characterize any step in any such arrangement, or re-characterize equity in to debt and vice versa.
Currently, a company is considered “resident” in India for tax purposes, if “control and management” of the affairs of such company is situated wholly in India. It is now sought to provide for a more stringent test for tax residency — a foreign company would be resident in India even where a fraction of the “control and management” of its affairs are situated in India, thus leading to worldwide income of such companies being taxed in India.
The Code further seeks to widen the tax net to bring within its purview income earned from transfers, directly or indirectly, of any capital assets situated in India. The intent, among other things, seems to tax overseas income from transfer of shares of companies abroad having downstream India holdings; this controversy has also recently been a subject matter of extensive litigation by the revenue authorities at the highest judicial levels.
· The concerns regarding GAAR and the wide powers of the Commissioner
Essentially, whereas the tax and business group is not opposed to GAAR, the widely worded proposals require deeper reflection. A liberal interpretation of the present silent law could perhaps have led to tax leakages; we ought to learn from experiences of other countries. International experience has suggested that taxpayer uncertainty is the most frequently cited argument against GAAR. Under the proposed code, a Commissioner rank officer can invoke GAAR under (what in his discretion is) “impermissible tax avoidance arrangement”. This principle is over and above commercial substance test and any action that directly or indirectly abuses the provisions of the code. Simply stated, besides wide administrative power, this would be amongst the strictest form of GAAR legislated by a country. The taxpayer is to establish that obtaining a tax benefit was not the main purpose of the arrangement. On invoking the GAAR, the CIT may determine the tax consequences by amending, disregarding or re-characterizing the arrangement. GAAR would also override the applicable treaties, and directions of CIT would be binding on the assessing officer.
· What do we mean by “tax benefits”?
The main purpose of an impermissible avoidance arrangement should be to obtain a tax benefit. Tax benefit has been defined to mean a reduction, avoidance or deferral of tax, an increase in refund of tax, reduction, avoidance or deferral of tax that would be payable under the DTC .
· How to address the concerns?
A specialised panel would lend independence and objectivity before exercising discretion and would help to avoid prolonged litigation. The GAAR panel should focus on taxpayers’ behaviour and contentious issues, recognizing the fact that the tax administration has to exercise its discretion in a judicious fashion. Though the maximum penalty has been scaled to 200 per cent (from 300 per cent), prosecuting tax evaders, particularly the five identified non-cognizable offences, would raise eyebrows. For instance, Section 234, 235, 236, 239 and 249 (including failures to furnish tax returns, false statements in verification, willfully attempting to evade tax) have been made non-cognizable offences. There could be genuine reasons for failure to furnish tax returns or delay in payment of withholding tax. It is interesting to note that the specified non-cognizable offences override the code of criminal procedure, which is presently the case.
While in general, introducing GAAR is a step in line with many of the mature economies, in India, it is apprehended that wide discretionary power provided to the tax officers may be used without a developed guiding principle. There is apprehension that GAAR could be used against even genuine transactions, thereby affecting the investment climate in the country. The introduction of GAAR must be coupled with suitable administrative and judicial reforms.
IV. The DTC seeks to essentially, reduce compliance cost, minimise tax avoidance and broaden the tax base. While these objectives are desirable and the need to raise collections is understandable, increase in the tax collection ideally has to be without increasing the burden on existing taxpayers; widening of the tax base has to be without alienating the existing taxpayer; and improvement in compliance has to be without harassment in enforcement. The implications of some of the provisions like exemptions, treaty override, residency and anti avoidance rules seem to have created unintended disadvantages to the Indian multi-national rendering them uncompetitive in the global market.

1. Treaty Override
A startling new introduction in the Bill has been to introduce the concept of what is known as `Treaty Override’ [Section 258(8)(b)] in international tax parlance, seeking to neutralise the provisions of the treaties entered into by India with various countries, by providing that provisions of Treaty or Code, whichever is later in time, shall prevail. A corresponding provision in the Code, however, provides for the continuance of applicability of existing tax treaties entered into by India, once the Code comes into force. The aforesaid provisions certainly give rise to some confusion and dichotomy of views as regards ‘Treaty Override’.
In this context, it would be pertinent to note that treaties are solemn obligations that should not be disregarded except in extraordinary circumstances, and, as is often done, the country overriding the tax treaties should consult with its treaty partners.

As per current Indian domestic tax laws, where the central government has entered into an agreement with the government of any country outside India for granting relief from tax or, as the case may be, for the avoidance of double taxation, a taxpayer entitled to the treaty’s benefits may apply the provisions of the domestic tax law to the extent they are more beneficial to that taxpayer. This means that a non-resident taxpayer having a source of income in India has an option to be governed by either the provisions of the domestic Indian tax laws or the tax treaty, whichever are more beneficial to the taxpayer.

It is true that the Constitutions of some countries, for example the USA, permit treaty overriding through domestic law, as under such Constitutions, treaties are ranked equal to the domestic law, with the result that they are subject to the rule “lex posterior derogat legi priori”, i.e., later law overrides the prior law. Again, there are countries like France, whose Constitutions clearly give treaties a superior position as compared to the domestic law, by virtue of which treaty overriding through amendment of domestic law is not permissible. Though the Indian Constitution does not fall under either of the two extreme categories, yet, there is support and comfort available from at least the Directive Principles of State Policy of the Constitution, in the form of Article 51, which inter-alia requires the State to foster respect for international law and treaty obligations. The issue of whether treaty benefits can be unilaterally overridden by a State through domestic laws is also a vexed one.

Tax Treaties & International Law
Tax treaties are governed by the Vienna Convention. Though India is not a signatory to the Vienna Convention yet the principles of the Convention can nonetheless be applied to any Indian tax treaty, a proposition which finds support from the International Fiscal Association. Article 18 of the Convention provides that a State, which is party to a treaty, is obliged to refrain from acts which would defeat the object and purpose of the treaty. Article 26 of the Convention lays down the principles of pacta sunt servanda, i.e., “Every treaty in force is binding upon the parties to it and must be performed by them in good faith”.

Therefore, any unilateral act on the part of India to override existing tax treaties through the insertion of provisions in domestic tax laws would be in conflict with Articles 18 and 26 of the Vienna Convention.

Article 27 of the Convention provides that a party may not invoke the provisions of its internal law as justification for its failure to perform a treaty. Article 27 of the Convention is without prejudice to Article 46, which provides that a State may not invoke the fact that its consent to be bound by a treaty has been expressed in violation of a provision of its internal law regarding competence to conclude treaties as invalidating its consent unless that violation was manifest and concerned a rule of its internal law of fundamental importance. The said Article further provides that a violation is manifest if it would be objectively evidenced to any State conducting itself in the matter in accordance with the normal practice and in good faith. Revenue laws are not considered as laws of fundamental importance. These are required as fiscal measurements to support the economy of the country. Therefore, any unilateral act on the part of the Parliament to override existing treaty benefits in the manner referred to above through amendment of domestic tax laws, would again contravene both Articles 27 and 46 of the Vienna Convention.

Relevance of Tax Treaties
Double taxation treaties are essentially agreements between two countries that seek to eliminate the double taxation of income or gains arising in one country and paid to residents/companies of the other country. The idea is to ensure that the same income is not taxed twice. In many instance, however, these agreements are misused to evade taxes. This is called ‘treaty shopping’, where usually residents of a third country take advantage of a tax treaty between two countries. For example, many companies in other countries route their investments into India through Mauritius or Cyprus to take advantage of the tax treaty that these countries have with India. Both, India-Mauritius and India-Cyprus tax treaties provide that capital gains arising in India from the sale of securities can only be taxed in Mauritius and Cyprus. This means no capital gains tax on investments in securities routed through Mauritius and Cyprus, as they do not levy tax on capital gains.

To first briefly touch upon the historical importance of Mauritius in the context of total foreign direct investments in India, Mauritius tops the list with a 44% ($35.18 Billion out of $81 Billion) during the period lasting April 2000 to April 2009 (in contrast, Singapore stands at 9% and the U.S. at 7%). With a difference of 35 percentage points between the top two spots and Mauritius not being an investing country in its own right, it is anybody’s guess that Mauritius has been used as a holding company jurisdiction for making investments in India with actual investors being tax residents of countries outside Mauritius. The reasons for using Mauritius are simple: India has a tax treaty with Mauritius providing that gains on any transfer of shares in an Indian company by the Mauritius holding company shall not be taxable in India but in Mauritius as per the domestic tax laws in Mauritius. Domestic tax laws in Mauritius do not tax capital gains. Therefore, any transaction on account of the transfer of shares in an Indian company by a Mauritius holding company is a tax free transaction both in India and Mauritius.

The Indo-Mauritius tax treaty was unsuccessfully challenged in the famous case of Union of India v. Azadi Bachao Andolan and Anr. (2003)[1]. The following principles were expounded by the Indian Supreme Court in its decision:
An important principle that needs to be kept in mind in the interpretation of the provisions of the international treaty, including one for double taxation relief, is that treaties are negotiated and entered into at a political level and have several considerations as their basis.
The main function of a treaty should be seen in the context of aiding commercial relations between treaty partners and as being essentially a bargain between two treaty countries as to the division of tax revenues between them in respect of income “falling to be taxed” in both jurisdictions.
In a fiscal economy, certain evils like treaty shopping are tolerated in the interest of long term development.

Perhaps it was intended at the time the Indo-Mauritius treaty was entered into. Whether it should continue and, if so, for how long, is a matter that should best be left to the discretion of the executive as it is dependent upon several economic and political considerations.

Under the draft Direct Taxes Code Bill, 2009, however, power has been given to the central government to enter into an agreement with the government of any country to provide relief from double taxation and also for the purpose of exchanging information for the prevention of evasion or avoidance of income tax. Further, the draft Code provides that neither a double taxation avoidance treaty nor the Code shall have preferential status by reason of its being a treaty or law and 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 time will prevail. This is a significant departure. India already has entered into tax treaties with about 75 countries. Given that the draft Code would come into force on 1 April 2011 if enacted, it would be later in time with respect to all 75 tax treaties and may override them (including Mauritius).

Of specific interest to current or would-be beneficiaries under the Indo-Mauritius treaty, the draft Code provides that any income from the transfer, directly or indirectly, of a capital asset situated in India will be deemed to accrue in India and thus will be taxable in India in the hands of a non-resident. Therefore, any transfer of an Indian company’s shares by a Mauritius holding company may become liable to tax in India under the new Direct Taxes Code (once enacted) without relief from the treaty.

The consequences of this provision are likely to hamper foreign investments as well as souring relationships with these countries since these tax treaties will be overridden without any negotiation or consultation with these respective countries.

Further, the General Anti-Avoidance Rules (“GAAR”) in Sections 112 and 114 are likely to put more and more foreign transactions under the scanner because even if new tax treaties are entered into or old treaties renegotiated after the Code comes into force, anti-avoidance and abuse provisions will come into play unless it is demonstrated to the satisfaction of the Indian revenue authorities that the holding arrangement is not an impermissible avoidance arrangement. According to the GAAR, an arrangement declared an impermissible avoidance arrangement shall be presumed to have been entered into for the main purpose of obtaining a tax benefit. The onus has been put on the taxpayer to prove that a tax benefit was not the main purpose of the arrangement. The general anti-abuse rule will override the provisions of the tax treaties.

The GAAR will have, associated with it, high administrative costs. Even if a treaty that comes into force after the enactment of the DTC and has to be notified, the Advance Ruling Mechanism wherein the taxpayer will process his documentation to prove that the transaction is not for tax-avoidance, the time period for such negotiation which could be anywhere between 2 to 3 months may just be too much of a waiting period for deals which are required to be done instantly and hence may prove to further take away from India’s image of being a lucrative country for investment.

According to the researcher, there doesn’t seem to be a justification of a double-safeguard in the form of GAAR for the treaties which are likely to be signed in the future, not only because it will deter any investment due to these barriers, since most of these treaties have provisions such as “limitation of benefits” or “beneficial ownership” neatly defined (Singapore).

B. Status of Foreign Companies
It is indeed heartening to note that the tax rates applicable to non-resident corporates are sought to be brought at par with the domestic companies, to be taxed at the rate of 25% from the current 34 per cent and 42.23 per cent (including surcharge and education cess), thus reducing the paper-work associated with it. However, correspondingly, the concept of the branch profit tax is proposed to be introduced (which appears to be somewhat akin to the permanent establishment tax levied on profits of business carried on by foreign companies in the United States), whereby an additional tax of 15% on branch profits is sought to be levied.

The Code further seeks to widen the tax net to bring within its purview income earned from transfers, directly or indirectly, of any capital assets situated in India. The intent, among other things, seems to tax overseas income from transfer of shares of companies abroad having downstream Indian holdings (Vodafone International Holdings B.V v. UOI, 2009 (4) Bom CR 258).

Under the current tax regime, a foreign company is considered to be a resident in India, if the control and management of its affairs is wholly situated in India at any time during the financial year.

Under the DTC, a foreign company would be treated as a resident in India if its place of control and management is wholly or partly situated in India at any time in the financial year.[2] Thus, if a foreign subsidiary of an Indian company is partly controlled and managed from India at any time in the financial year, it will be considered as a resident under the Code. The catch here lies in the interpretation of partly since the terms have not been defined in the DTC and this could lead to a flurry of litigation. The partly could even be 1%.

A direct consequence of foreign subsidiaries and joint ventures (JVs) of India headquartered companies being regarded as resident of India could result in dual taxation of such companies both in India as well as in the host country, subject to availability of foreign tax credit, which will have to be separately ascertained. Thus further complicates the situation for companies which derives income from sources in more than one country. In such a case, it will be open to debate whether the amount would be restricted only to tax in respect of income sourced in that country or be available in respect of whole of the income taxed in that country. Potentially, these could lead to double taxation resulting in a higher tax cost.

Deviating from the existing provisions of the Income Tax Act, the new code has proposed to tax interest payments by non-residents where the debt has been used to earn income from any source in India. This is likely to have a serious impact on cross-border leveraged buy-outs. Thus, if a reverse of Tata-Corus deal was to happen in India, this provision would possibly impose a huge burden on the company buying-out shares of an Indian company if these leverages are to the tune of billions of dollars like in the Tata-Corus deal.

Consider an example where a US company makes a bond issue in that country to mobilise funds to invest in shares of an Indian company. Since these investments would result in the earning income (say, dividends or capital gains) from an Indian source, interest payments on bonds can now be taxable in India under the code.

Large infrastructure projects in fields of oil and gas, ports, roads, etc which typically involve foreign entity in form of an engineering, procurement & construction (EPC) contractor. Normally, the key responsibility of this contractor is to provide advance technology not available in India, for which they are remunerated by way of royalties or fees for technical services (FTS).

Normally, the arrangement between the Indian project owner and the non-resident EPC contractor stipulates that taxes on income of the contractor are to be borne by the Indian party i.e. grossing up of taxation needs to be done.

The code proposes to increase the tax rates on royalties/FTS earned by foreign entities from 10% to 20%. Consequently, the said change would imply a considerable increase in costs for Indian project owners. In such cases, the onus/ burden of proof is on the Indian party to prove the genuineness of EPC structure, especially split contracts. The code retains the presumptive taxation regime for certain non-residents providing certain services to turn-key power projects, oil & gas exploration, etc. However, the provisions as drafted in current form leave a major ambiguity as regards determination of income, which needs to be sorted out.[3]

Further more, the definitions of FTC (Fees for Technical Services)[4] now include ‘development and transfer of design, drawing, plan and software or similar services’ and Royalty[5] now include ‘right to use of transmission by satellite, cable, optic fibre, ship or aircraft and live coverage of any event’. Hence, he increase from 10% to 20% is not only just in amount but also in terms of what is being taxed.

The researcher believes that all these provisions have been framed with an intention of increasing the instances of taxation while reducing the tax-rates for foreign companies thus trying to incentivise voluntary compliance to taxation. The move also seems to try and bring as many foreign transactions under the net or conversely encourage foreign establishments to operate fully in India and be taxed at 25% alone rather than as foreign companies with additional transactional taxes and breach-profit taxes. The reason for this could be that

Thus while the tax base has definitely been broadened, there seem to be many conditional provisions attached with them. While lowering of tax rates might be an incentive for these multi-national companies, whether increasing the incidents of taxation will actually let that happen will only be seen once the Bill is approved.

C. Other provisions affecting Corporations

A. Minimum Alternate Tax (“MAT”)
Minimum Alternate Tax is a tax that is levied on companies that have no tax liability as per the provisions of the Income Tax Act, although they make a profit, on account of the numerous deductions, depreciations and set-offs that are allowed. Thus, seemingly wealthy and prosperous companies are able to escape the tax net and the government loses thousands of crores of revenue in the process. In an attempt to cash in on this phenomenon of zero tax paying profitable companies, Minimum Alternate Tax was introduced back in 1984. Thus, essentially, MAT is used to calculate presumptive income so as to overcome the problems
of tax incentives and tax evasion.

According to the DTC, the basis for computation of MAT for companies has been shifted from book profits to gross assets. As a result, any company having gross assets as defined will be required to pay tax even if there is book loss. Such tax will be final without any carry forward.

While companies have been exempted from wealth tax, the 2% MAT on gross assets may be significantly higher than 25% on book profits, as it is in the Income Tax Act, 1961.[6] No provision for availing MAT credit for subsequent years is provided and the MAT exemption for SEZ developers and units is sought to be discontinued.

According to the Finance Ministry, the economic rationale for the assets tax is that investors can expect ex-ante to earn a specified average rate of return on their assets. The shift in the MAT base from book profits to gross assets will encourage optimal utilization of the assets and thereby increase efficiency.[7]

While for most functional companies this may not be an unfair assumption, for start-ups and companies that are yet to establish a business presence, it could be an additional cost to surmount.

The new 2% on gross assets could be significantly higher than 25% on book profits and will negatively affect capital-intensive companies with long gestation periods and may be required to pay MAT even in the initial years of low or virtually no profits and without deducting from their liabilities.

The other issue which in the opinion of the researcher, will arise, is that there is going to be huge cascading effect of the tax because in corporate structures, you will have organizations which holds shares in downstream company which inturn for various regulatory or other reasons have a third generation company. So each level of these companies are going to pay 2% of tax possibly without having profits especially if there are newer businesses including all the leverage which they would take on.

B. Investment Based Incentives
Another significant change in policy with respect to corporations which has been brought about is the rationalising of tax exemptions. Traditionally, the exemptions provided were ‘profit-based’ tax incentives in form of tax holidays for a certain number of years. Since profit is the basis for exemption, there is no incentive for investment and upgradation during the period of tax holiday. Such profit-linked incentives also lead to significant loss of revenue and encourage rent-seeking behaviour. The code proposes to replace the same by ‘investment-based’ incentive, which implies a tax exemption for the period until the whole of investment made by an entity is recovered.[8]
The new incentive augurs well for projects which are in high growth phase -- for example, the cross-country gas pipeline, which currently needs sustained investment for a number of years.

A significant omission from the businesses eligible for investment-based incentive is a unit in special economic zones (SEZs). The list includes only developer of SEZ, though SEZ operations are NOT included. Sixth Schedule of the DTC lists all incomes that are exempt. It, however, does not include profits of newly established units in SEZs (currently exempt under Section 10AA; profits derived from operations in SEZ facility is exempt 100% for the first five years of operations and 50% for the next five years and 50% again for the next five years, subject to reinvestment).
Considering sunset clause for Section 10A/B, the IT sector has started migrating incremental business to SEZ facilities. However, if the exemption stands withdrawn, the future profitability may be subject to normal tax rates.[9]
The rationale behind this omission is hard to understand, especially when development of SEZs is a primary focus area for the government.
Thus, the DTC has seen a shift in policy which may or may not benefit large infrastructural investments. However, the process of graduating from the current Income Tax Act to the DTC will have to supported with really good justifications since the corporations which avail of the tax exemptions as per the 1961 Act will be left in a limbo with the change in the basis for computation of these taxes.

[1] MANU/SC/1219/2003.
[2] Section 198, DTC.
[3] See generally http://www.dnaindia.com/money/comment_will-direct-tax-code-prove-to-be-a-roadblock-for-infrastructure_1288374 (Accessed on September 23, 2009).
[4] Section 105, DTC.
[5] Section 240, DTC.
[6] 1(b) Second Schedule on Tax on Gross Assets, DTC.
[7] Ministry of Finance, Discussion Paper on the Direct Taxes Code, August 12, 2009, p. A-13, sourced from ://finmin.nic.in/DTCode/Discussion%20Paper.pdf.
[8] Supra note 7, at A-36.
[9] See generally http://www.reliancemutual.com/CMT/Upload/ArticleAttachments/draft%20Direct%20Taxes%20Code%20Bill.pdf (Accessed on September 23, 2009).
---Aqseer, Bhishaan, Archit, Leeneshwari

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