India Tax: Revised Discussion Paper on Direct Taxes Code issued
The DTC and the original Discussion Paper, unveiled on 12 August 2021 to replace the current Income Taxes Act (ITA) that dates from 1961, propose to bring about significant structural changes to direct taxation in India. The DTC would consolidate and amend the law relating to all direct taxes and would create a system that facilitates voluntary compliance, with the ultimate goals of improving the efficiency and equity of the Indian tax system by eliminating distortions in the tax structure, introducing moderate levels of taxation and expanding the tax base.
The revised Discussion Paper addresses a host of concerns raised by stakeholders about the DTC; however, this alert only highlights key provisions that would affect companies, and primarily companies engaging in cross-border transactions.
Changes proposed under revised Discussion Paper
Residence: Under the DTC, a foreign company would be deemed to be resident in India if the management and control of its affairs are situated "wholly or partly" in India at any time during the financial year.
Because the inclusion of the word "partly" sets a very low threshold for regarding a foreign company as resident in India, the revised Discussion Paper now proposes that the "place of effective management" be used as the test for determining whether a company incorporated outside India is resident in India. "Place of effective management" for these purposes would be defined to mean:
- The place where the board of directors of the company or its executive directors, as the case may be, make their decisions; or
- If the board of directors routinely approves the commercial and strategic decisions made by the executive directors or officers of the company, the place where such executive directors or officers of the company perform their functions.
Capital gains: The DTC provides that gains (losses) arising from the transfer of investment assets will be treated as capital gains (losses), included in the total income of the financial year in which the investment asset is transferred. Capital gains derived by a nonresident will be subject to a 30% tax and gains derived by a resident will be taxed at the applicable marginal rate. The DTC also would abolish the distinction between long- and short-term capital gains, as well as the Securities Transaction Tax (a tax levied on stock exchange transactions).
Stakeholders contended that the proposed changes would significantly increase tax liability and potentially affect the capital markets, and that the 30% withholding tax on capital gains of nonresidents was very high (as compared to the current 0% rate when shares are held for more than one year).
Under the revised Discussion Paper, capital gains would be considered income from ordinary sources for all taxpayers and taxed at the rate applicable to the taxpayer. A specific deduction would be granted for capital gains on listed equity shares and units of an equity-oriented fund that are held for more than one year, with the adjusted capital gains included in the total income of the taxpayer and taxed at the applicable rate. Further, the Securities Transaction Tax would not be eliminated.
While several representations were made for restoring the current exemption from long-term capital gains on the sale of listed securities, etc., no exemption is provided in the revised Discussion Paper. However, the proposed specified deduction may provide some relief, as it would reduce the effective rate of tax on such capital gains. The sale of unlisted shares held long term, which would have been liable to tax at the rate of 20% under the existing Income Tax Act, would now be taxed at a higher rate, as applicable to income from ordinary source.
Controlled foreign corporations (CFCs): A provision introducing the taxation of CFC income is proposed for the first time. Under these provisions, passive income earned by a foreign company controlled directly or indirectly by a resident in India, if such income is not distributed to shareholders, will be deemed to have been distributed and be taxable in India in the hands of resident shareholders as dividends received from the foreign company.
General anti-avoidance rule (GAAR): The DTC would introduce a GAAR to deal with specific instances where a taxpayer enters into an arrangement, the main purpose of which is to obtain a tax benefit and the arrangement is entered into or carried on in a manner not normally employed for bona fide business purposes, is not at arm's length, abuses the provisions of the DTC or lacks economic substance.
Stakeholders raised several issues relating to the proposed GAAR:
- The GAAR was sweeping in nature and could be invoked by the tax authorities in a routine and potentially arbitrary manner;
- Legislative and administrative safeguards and appropriate thresholds should be provided for invoking GAAR; and
- The proposed GAAR does not distinguish between tax mitigation and tax avoidance, with the result that any arrangement to obtain a tax benefit could be deemed to be an impermissible avoidance arrangement.
While the government has decided to retain the proposed GAAR in its existing form, it has clarified that not every arrangement that would mitigate tax liability would be classified as an impermissible avoidance agreement and it has proposed that the Central Board of Direct Taxes issue guidelines to provide for the circumstances and thresholds under which GAAR could be invoked. Further, the Dispute Resolution Panel would be made available when the GAAR is invoked against a taxpayer.
Relief from double taxation: The draft DTC contains a provision that the "later in time" doctrine would apply in the event of a conflict between the provisions of a tax treaty and the provisions of the DTC.
Stakeholders raised several arguments against this provision, including:
- A general treaty override would render India's tax treaties redundant and would violate the spirit and intent of the Vienna Conventions;
- The proposal would result in higher rates of taxation on interest, royalties and fees for technical services, in particular, which are currently taxed in the source country at concessional rates under relevant tax treaty provisions; and
- The proposal could negatively affect the inflow of foreign direct investment.
The revised Discussion Paper indicates that the DTC would be amended to provide for a limited tax treaty override, i.e. it would apply only when the GAAR or CFC provisions are invoked or when the branch profits tax is levied. Further, taxpayers could continue to elect to apply the provisions under a tax treaty if they are more beneficial than the Indian tax law provisions.
Minimum alternate tax (MAT): The draft DTC proposed significant changes to the imposition and tax base of the MAT. MAT would be imposed at a rate of 2% of gross assets (0.25% for banks) and the base for computing the MAT would be shifted from book profits to the "value of gross assets" (i.e. the aggregate of the value of the gross block of fixed assets, capital works in progress and the book value of all other assets on the last day of the relevant financial year, as reduced by accumulated depreciation on the value of the gross block of fixed assets and the debit balance of the profit and loss account, if included in the book value of other assets). The MAT would be a final tax, thus eliminating the carryforward of MAT credits.
After receiving comments about the negative effects of the proposed changes to the MAT (i.e. the measures would result in significant hardships to loss-making companies and companies operating in a cyclical downturn, create inequalities where a business wished to set up a new infrastructure company or expand a business as compared to the old business), the revised Discussion Paper has proposed that MAT be computed with reference to book profits.
Special Economic Zone units: The draft DTC did not provide any relief for units set up in Special Economic Zones (SEZs). Stakeholders pointed out that, while profit-linked deductions for developers of SEZs were protected, no relief was granted to units set up in SEZs.
The revised Discussion Paper re-affirms the view that profit-linked deductions would not be extended. However, specific provisions for protecting deductions available to units in SEZs for the unexpired period would be incorporated in the DTC.
The revised Discussion Paper does not address all issues that have been raised about the proposed DTC and there may be more changes once the text of the DTC is amended to incorporate the changes in the revised Discussion Paper and when the final DTC bill makes its way to Parliament. The changes proposed in the revised Discussion Paper will provide relief to taxpayers on certain major issues, such as MAT and the tax treaty override. However, taxpayers will need to carefully monitor the CFC and GAAR legislation once the DTC bill is made public and investor reaction with respect to the transition of capital gains provisions from "nil" taxation to a taxpaying position also bears watching.