With Indian and global economy showing concrete recovery signs, there are lot of expectations from the upcoming Budget 2010-11. This article talks about some of such areas in corporate taxation, where there is a need for reforms.

An effective corporate tax system reflects current economic realities of the country, and could be established by implementing suitable tax reforms.  Tax reforms in India has come a long way from narrow and complicated structure to adopting  the best practice of broadening the base, gradually reducing tax rates and  rate differentiation and keeping the system simple.  Inevitably tax policy in the country has responded to changing development strategy over the years.  Even today tax reforms in India are seen as a helping tool to bridge the fiscal deficit and for improving GDP.  Reportedly, the study published by Standard & Poor suggests that India can regain and sustain GDP growth rates of about 9% starting 2011 provided it hastens policy reforms in areas that include taxation and foreign investment regulations.

The Finance Minister proposed to make structural changes to the Indian tax regime by introducing draft Direct Tax Code (DTC) and proposed Goods and Service Tax (GST).  DTC, proposed to be effective from 1 April 2011, is aimed to attain simplification of the present direct tax regulations in India.  With the outlook of future corporate tax laws comprehensible, the Budget 2010 is likely to bring out some of the changes sought out in DTC and the India Inc is expecting new tax reforms that will be aimed at accelerating the pace of economic growth.

Below listed are some of the key suggestions for corporate tax reforms, which the Finance Minister may consider for Budget 2010:

Dividend Distribution tax ('DDT')

It is a known fact that taxes like DDT (presently @ around 17%) result in double taxation of the same income (profits are first taxed in hands of company, and then again taxed when distributed to shareholders).  Accordingly, DDT levy should be reduced, to say, 5%, if not abolished. This would provide a strong boost to the stock market, and should result in positive investor sentiments and boost investments.

DDT set off

The Government has introduced provisions to alleviate the cascading effect of DDT by providing for an offset of DDT paid by a lower-tier entity.  However, the provisions are fairly restricted in their scope.  For example, the benefit of set-off is available for distributions within a single-tier holding, the distribution between the companies should take place in the same fiscal year.  This is hypothetically illustrated below.

Notes: For the purpose of simplicity, we have not considered other incomes of A Limited and B Limited, transfer to general reserves, etc, and assumed that all income is distributed.

It can be observed that on the profits of Rs 100 mn earned by C Limited and ultimately distributed to the shareholders of A Limited, total group tax impact is Rs 51.80 mn (Income-tax Rs 34 mn and DDT Rs 17.80 mn).

As an immediate measure, the Government could consider extending the relief mechanism for eliminating the cascading impact.  This would enable effective circulation of cash within group companies having multi layered structure, and reduce cash outflow on account of DDT.

Taxation of Limited Liability Partnership (‘LLP’)

LLP Act was enacted in January 2009; however, the tax treatment for LLPs was a subject matter of debate and speculation for a long time.  Union Budget 2009 laid out the taxation policy for the LLP, by treating LLP at par with the general partnerships.

Under LLP Act, conversion of general partnerships, private companies and unlisted public companies to LLP is permitted.  Explanatory memorandum to Finance Bill (No 2), 2009 suggests non taxability of conversion from general partnership to LLP, however, express provisions for “tax neutrality” on conversion are not provided.  Still there are host of open issues, which need to be addressed, to illustrate, capital gains tax implication on conversion (including conversion from company to LLP, etc), carry-over of losses, continuity of tax incentives and deemed dividend trigger, etc.

A clarification in this regard followed by suitable amendments to the present income-tax law should provide a road of certainty in relation to the tax costs associated with carrying the business via the LLP mode.

Service/export sector – extending tax holidays

As a welcome move, in the Budget 2009, the tax holidays available IT / ITES / software sector had been extended till Financial Year 2010-11.  As the shadows of the global slowdown are still not cleared and, because of protectionist policies adopted overseas, this sector is still facing challenges.

As per a recent news report, selected 186 Chinese software companies are incentivized by the Chinese Government.  These companies will be taxed at preferential rate of 10%.  Also, reportedly, as a part of fiscal stimulus package, the corporate tax rate for qualified Chinese high and new technologies companies is slashed to 15%.  Given the competition and ‘cost effectiveness’ provided by China, India may lose foreign investments in IT / ITES / software sector.

Given the above, the Government may consider extending further support to this industry, including through tax policies and profit linked incentives, post introduction of DTC as well.

Withholding tax provisions related to payments to non residents

In a recent decision in the case of Samsung Electronics, the Karnataka High Court has decided that tax deduction is required in every case, unless spared by a certificate of NIL deduction obtained from the tax authorities.  This decision implies that all payments including purchase price payments, resulting in income in hands of non-resident would be subject to tax withholding and actual chargeability of income in the hands of non-resident is not relevant for determining withholding tax obligation in the hands of payer.  For non-withholding of taxes, an order from the tax authorities should need to be obtained.

Given the hardship and practical difficulties involved in obtaining an order prescribing rate of tax withholding from the tax authorities, clarity on the issue is warranted.

Introduction of provisions of the DTC

Recent news reports hint that the Government may move towards introduction of some of the measures announced in the DTC in Budget 2010-11.

However, a piecemeal introduction of these provisions could add to the misery and confusion among all stakeholders.

Some of the provisions of DTC, the introduction of which could have some unintentional implications on India Inc, are:

• Test of residency of a company in India

The proposed provisions for testing the residency of a company seeks to encompass a company as a resident in India whose “place of control and management” is situated “wholly or partly” in India at “any time in the year”. The present provision provides that a company would be resident in India, only if, the control and management is wholly situated in India.

Introduction of the new provision would enlarge the threshold for foreign incorporated company being regarded as a resident in India bringing the worldwide income of such company to tax in India, including an exposure to DDT. Hence, more clarity on what is intended by ‘part control and management’ is warranted. Also, some threshold on degree of such control and management should be specified to trigger such residency provisions.

• Treaty override

As per the proposed provisions, neither DTC nor treaty would have a preferential status, and the provisions which are later in point of time will prevail.  Under the current law of treaty applicability, an assessee could adopt a provision which is more beneficial between the domestic tax law and the relevant treaty.

While the real intent of the Government seems to be not to override the treaty, but to address treaty abuse in certain cases, a blanket provision may jeopardize the functioning of the treaty mechanism, leading to uncertainty in minds of foreign investors, thereby impacting foreign direct investments. Similarly, it cannot be ruled out that Indian companies having investments and operations overseas, could find some difficulty in claiming treaty benefits in overseas country, if India denies residents of overseas country the benefits of treaty.

• General Anti Avoidance Rules

DTC seeks to introduce a broad set of rules which have the effect of invalidating an arrangement that, inter alia, has been entered into by the tax payer with the main objective of obtaining a tax benefit.  The broad provisions and terms used in DTC can create ambiguity on the position which can be adopted by the tax authorities on a case to case basis.  DTC intends to confer a large number of discretions to the tax authorities to invoke these provisions which could cause undue hardship to a genuine tax payer.

Specific rules should be incorporated to define situations more precisely and specifically which could be treated as avoidance of tax, to avoid unintended application of these provisions.

• Indirect transfer of assets/global reorganisations

DTC proposes to tax the transfer, either directly or indirectly, of capital asset situated in India. These provisions seek to tax the transactions which sought to indirectly transfer the assets of an Indian company. However, this may impact the transactions of genuine global business reorganisation and cause administrative hurdles in enforcing these provisions.

• Minimum Alternate Tax (MAT)

MAT, as levied on the companies claiming tax incentives also, cannot be regarded as conducive tax collection vehicle.  The Government needs to consider abolition of MAT. DTC envisages for levy of DTC at 2% on gross assets of the company other than a banking company (computed as per the formula specified). MAT would be payable, even if a company is incurring losses, and this may cause undue hardship to the tax payers.  This mode of levy of MAT should be avoided for increased investment in infrastructure.

MAT in the present form also causes additional tax burden for the companies and if abolition is not possible, the rate should be reduced, say to 7.5% on book profits, as earlier.

Streamlining and refining the provisions so as to eradicate the absurd and unintended implications seems to be the need of the hour before a complete introduction and application of these provisions.

Rationalisation of corporate tax rates

Presently, effective corporate tax rate for Indian companies, including surcharge and cess, is almost 34%.  Companies are even required to pay dividend distribution tax (DDT) @ around 17%.  The effective direct tax burden could easily vary between 40% and 50%, depending on the facts in a particular case.

High corporate tax costs reduce the surplus cash flow with the company for generation of internal resources for expansion, modernization, technology upgradation and so on and reduce the profits available for distribution. Such high tax costs also add significantly to the total cost of doing business in India and can prove a major deterrent to doing business in India. The developing countries are increasingly recognising the benefits of rational tax rates.  Reportedly, the basic corporate tax rate in BRIC nations are as follows:

Country    Tax rates
Brazil        15%
Russia      20%
China        25%

Given the need for capital infusion, the Government should consider reducing the effective corporate tax rate, say to 25%.  Further, DTC also proposes the same tax rate of 25%. If we cannot have DTC rate to be introduced in the recent budget, at least we can expect the tax rate to be slashed to final effective rate of 30% (including surcharge, cess, etc).

Other tax reforms

In addition to the above referred specific provisions, there is a need to rationalize / clarify various other provisions, to illustrate,

• To exhibit India as a holding company jurisdiction and to encourage investment by Indian companies outside India, dividend from foreign companies should be exempted, if taxes have already been paid in overseas jurisdiction.

• In line with the global standards, restore the rate of depreciation in case of plant and machinery immediately, say to 25%.

• Extending the provisions of Dispute Resolution Panel to all assesses for speedy resolution of tax disputes at first appellate level.

• Clarify the treatment, granting refund or adjusting against advance tax, of the first installment of Fringe Benefit tax (FBT) paid by various assesses before announcement of its abolition.

Tax reform is a process and not an event. The key task for the Finance Minister would be to strike a balance between tax rationalization and fiscal deficit.  This could be achieved by expanding tax base, rationalising tax rates, improving tax administration and eliminating ambiguity in law.  A giant leap has been attempted in this direction by way of proposed DTC, but still a lot more can be done.  Looking forward to a positive ‘Budget 2010’!

(Views expressed are personal)

[The authors Paresh Parekh & Umang Shah are senior tax professionals with Ernst & Young]