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Background
India has taken the next step towards structural changes in direct taxes by releasing a draft of the proposed new Direct Tax Code (‘DTC’) for public debate.
The draft, along with a discussion paper, was made public by the Finance Minister, Mr Pranab Mukherjee yesterday. With this, the Finance Minister has fulfilled the promise he made in his Budget Speech on July 6 that the draft DTC would be put up for public debate within 45 days.
The proposed DTC would replace the existing Income-Tax law upon enactment. The principle aim of the DTC is to moderate tax rates, remove exemptions and simplify tax laws in line with international tax principles. Debate and discussions are expected on the DTC between now and the winter session of Parliament when the Government intends to introduce a Bill in the Parliament.
This News Alert briefly summarizes the key provisions under the DTC relevant to the financial services sector.
Direct Taxes Code – Financial Services Update
Financial Services
News Alert*
13 August, 2009
Investment vehicles like Mutual Funds, Venture Capital Funds, Domestic Investment Trusts
The DTC has done away with the complex and differential provisions relating to Investment Vehicles and largely treated these as pass-thru entities, irrespective of the sector in which they invest.
• Mutual Funds
− Taxation in hands of Mutual Fund:
• Treated as a pass-thru entity.
• Income earned by a Mutual Fund exempt from tax.
• No deduction of tax at source on payment of interest to Mutual Funds.
• No specific provisions relating to dividend distribution tax on distributions by a Mutual Fund.
• No dividend distribution tax payable by a Company on any income distributed to a Mutual Fund.
− Taxation in hands of Investors:
• The Discussion Paper explaining the DTC mentions that investors in pass- thru entities are liable to tax. However, as per the DTC, income earned by an investor in respect of the units of a Mutual Fund is exempt from tax.
• Capital gains to be taxed at normal rates applicable to investor. Distinction between long-term and short-term removed. Concessional rates on sale of equity oriented mutual funds no longer available.
• Securities transaction tax (‘STT’) is proposed to be abolished.
− Anti-avoidance provisions proposed to be introduced in case of transactions involving:
• Sale and buy-back in security.
• Buy and sale-back in security.
− A mutual fund is required to furnish a return of tax bases in relation to the dividend distributed by the mutual fund.
• Venture Capital Fund (‘VCF’) / Venture Capital Company (‘VCC’)
− A Mutual Fund has been defined, inter alia, to mean a VCF and a VCC. Provisions relating to Mutual Funds to also apply to VCF / VCC.
− VCF / VCC has been defined to mean a fund / company which -
• Has been granted a certificate of registration as a venture capital company / fund under the Securities and Exchange Board of India Act, 1992; and
• Fulfils all other conditions as may be prescribed in this behalf.
• Trust
− Trustee continues to be treated as a representative assessee.
− Taxability of the trustee shall be in the same manner and to the same extent as it would have been leviable upon persons represented by him.
− Any income accruing from a revocable transfer of asset to a trust would be taxable in the hands of the transferor if the transfer is revocable during the life time of the beneficiary of the trust.
− Differential and complex tax regime applicable for determinate and in-determinate trusts under the 1961 Act has not been provided for under the DTC.
− Also, current provision relating to business income being taxed at maximum marginal rate done away with.
Banks and other financial institutions
The DTC proposes to simplify provisions for financial institutions which have been classified as “Permitted Financial Institutions*”. Also, carry forward of losses is proposed to be extended to amalgamation / de-merger in the sector.
• Tax rates
− The corporate rate of tax for a company is proposed to be 25%.
− Minimum Alternative tax (MAT) for banking companies is proposed at 0.25% of the gross assets. For other companies, MAT is proposed at 2% of gross assets. MAT will be final tax and it will not be available as tax credit in subsequent years.
− Losses allowed to be carried forward indefinitely.
• Foreign banks
− Foreign bank branches liable to tax at the normal rates as above plus a branch profits tax @ 15%. For this purpose branch profits shall be total income reduced by income tax thereon.
− Head office expenditure in the case of foreign banks would be allowable to the extent of 0.5% of total turnover.
• Bad and doubtful debts
− Provision for bad and doubtful debts would be allowable to Permitted Financial Institutions to the extent of 1% of aggregate average advances if:
• The amount is accounted as per the prudential norms of the RBI; and
• The bad debts written off are debited to provision for bad and doubtful debt account in the books.
− Interest on bad and doubtful debts of Permitted Financial Institutions would be taxed based on credit or receipt, whichever is earlier. Bad and doubtful debts to be calculated as per the guidelines of the RBI/NHB.
• Business Reorganisation
− Accumulated losses of the predecessor in business re-organization (including amalgamation, merger and de-merger) deemed to be loss of the successor if the successor satisfies the test of continuity of business.
• Other relevant provisions
− Income accruing from a debt instrument, transferred during the year, shall not be less that the amount of broken-period income from the instrument.
− Anti-avoidance provisions are proposed to be introduced in case of transactions involving:
• Sale and buy-back in security.
• Buy and sale-back in security.
− Permissible deductions include permitted finance charges like proportionate amount of discount / premium payable on bond or debenture, to be computed in the prescribed manner.
− Amount of incidental financial charges for issue of debentures, bonds or share capital would not be allowed as deduction.
− In case of a finance lease, the lessee would be eligible to claim capital allowance.
* Permitted Financial Institution defined to mean-
− A banking company or a scheduled bank
− A non-banking financial company
− A public financial institution
− Sate financial corporations
− Sate industrial investment corporation or
− A housing-finance development company
Insurance
While the DTC has proposed to bring in clarity on taxability of life insurance business, there are still certain grey areas, which need to be addressed.
• Life Insurance business
− Profits proposed to be profits disclosed in Shareholders’ Account (Non- Technical Account) in accordance with the Insurance Act, 1938:
• Increased by items which are included within the scope of ‘gross earnings’
not considered as income in the annual accounts; and
• Decreased by the negative profits (as computed under the DTC) for any financial year immediately preceding the relevant financial year.
If the profit arrived at as above is negative, the same to be treated as Nil.
− Life insurance companies treated as “pass-thru entity”. Discussion Paper clarifies that life insurance companies would not be liable to pay tax on income received by them for or on behalf of their investors. The investors will be liable on any income which accrues to them from investment with pass-thru entities.
− Further, contributions by the insured will be liable to EET method of taxation.
As a result, life insurance companies will not be required to pay any tax on the actuarial surplus in the policyholders’ account.
− Dividend distribution tax is not applicable on dividends by a company to a life insurance company.
• Other Insurance business
− Similar to existing provisions, profits of other insurance business to be profits disclosed in the annual accounts furnished under the Insurance Act, 1938:
• Increased by items which are included within the scope of ‘gross earnings’
not considered as income in the annual accounts;
• Increased by amount of expenditure not generally allowable as a deduction if such expenditure has been reduced in the profits in annual accounts; and
• Decreased by the negative profits (as computed under the DTC) for any financial year immediately preceding the relevant financial year.
If the profit arrived at as above is negative, the same to be treated as Nil.
− The profits above are presumed to be computed after giving effect to allowances (including depreciation), deductions, etc. prescribed under the DTC.
− Successor in a business re-organization shall be allowed a deduction in respect of the negative profits of the specified period, determined for the predecessor.
• Product related taxation
− Life insurance policy
• Sums received under a life insurance policy on maturity or death exempt if premium for any of the years does not exceed 5% of the capital sum assured.
• In other cases, sums received under the policy including bonus taxable.
• Deduction available for sums paid to any permitted savings intermediary (includes a life insurer) upto an aggregate of INR 300,000.
− Pension / Annuity
• No specific provision for sums received under pension / annuity policy.
• Exemption currently available to approved pension funds [viz. 10(23AAB) funds] proposed to be continued.
• The amount (from account maintained with a permitted savings intermediary) used for purchasing an annuity plan or rolling over the amount from one account (with permitted savings intermediary) to another account (with same or other permitted savings intermediary) proposed to be non taxable.
• No specific exemption for commuted portion of pension received from Approved pension fund.
− Provisions pertaining to Keyman Insurance Policy, Family pension and Health Insurance Policy continue to be similar to existing provisions.
Foreign Institutional Investors (‘FIIs’)
No separate tax regime has been proposed for FIIs under the DTC. FIIs would accordingly be governed by the normal provisions applicable to other non-residents
• Tax Rates
− If securities are held as investment asset (termed as special source)
• Capital gains to be taxed at uniform rate of 30% irrespective of period of holding. Concessional rates on sale of equity shares on stock exchange and on equity oriented mutual funds no longer available. Though distinction based on holding period is eliminated, capital gains arising from the transfer of investment asset after one year from the end of the financial year in which the asset was acquired would be eligible for indexation benefit
• Interest income to be taxable @ 20%
− If securities are held as business trading asset (termed as ordinary source)
• Tax @ 25% for corporates
• Tax @ 30% for others
− STT is proposed to be abolished
− Dividend income continues to remain exempt in the hands of investor
• Withholding tax
− Exemption in respect of deduction of tax at source on capital gains proposed to be removed
− All incomes (other than interest on Government Securities) to be subject to deduction of tax at source at the taxable rates
• Set-off and carry forward of losses
− Loss from special source can be set-off only against gain from the particular special source
− Loss from ordinary source can be set-off against gains from the ordinary sources.
− Losses permitted to be carried forward for an indefinite period
• Tax Treaty eligibility
− No clause specifically permitting Treaty to override the DTC. Provisions of the Treaty or the DTC, whichever is later in time to prevail.
− Furnishing of tax residency certificate mandatory for claiming relief under the applicable tax treaty.
• Ant-abuse provisions
− The DTC seeks to introduce Anti-abuse provisions empowering the Commissioner of Income-tax (CIT) to declare an arrangement as impermissible if the same has been entered into with the objective of obtaining tax benefit and lacks commercial substance.
− Onus on tax payer to establish that tax benefit was not the main purpose.
− On invoking the Anti-abuse provisions, the CIT may determine the tax consequences by modifying, nullifying or re-characterizing the arrangement.
− Anti-abuse provisions to override the applicable tax treaties.
• Other provisions
− Interest paid by FIIs on offshore leverage for investment in India could become taxable in India in the hands of the lender, subject to availability of Treaty benefits.
− The income accruing from a debt instrument, transferred by a person at any time during the financial year, shall not be less than the amount of broken-period income from the instrument.
Other amendments
The DTC has proposed certain other amendments such as change in the criteria for determining residential status of foreign companies, introduction of general anti-abuse provisions, taxation of indirect transfer of capital assets, etc. that impact cross border transactions across the financial services’ spectrum.
• Residential status of foreign companies
− Foreign company considered as resident in India even if control and management is situated partly in India at anytime during the financial year.
− This could impact fund structures having entities based overseas and especially, entities based in non-treaty countries.
• Indirect transfer of capital asset situated in India
− Income from “indirect” transfer of a capital asset situated in India treated as accruing or arising in India.
− This could impact offshore funds / companies contemplating exits at offshore level.
• Anti-abuse provisions
− Detailed anti-abuse provisions empowering the Tax Authorities to declare any transaction as impermissible if the same has been entered with main objective of obtaining tax benefit and lacks commercial substance.
− The anti-abuse provisions cover several aspects like round tripping of funds, thin capitalisation, piercing the corporate veil, etc.
− Onus on tax payer to establish that tax benefit was not the main purpose.
− Even where whole arrangement may not seek to obtain tax benefit, if main objective of a step or a part of the arrangement is to obtain tax benefit, the
arrangement shall be deemed to be entered for purposes of obtaining tax benefit.
− On invoking the anti-abuse provisions, the CIT may determine the tax consequences by modifying, nullifying or re-characterizing the arrangement.
− Anti-abuse provisions to override the applicable tax treaties.
− This will significantly enhance powers of Tax Authorities to scrutinize transactions that they believe involve any element of abuse. The amendment could lead to increased litigation.
• Tax Treaty eligibility
− No clause specifically permitting Treaty to override the DTC. Provisions of the Treaty or the DTC, whichever is later in time to prevail. This may introduce a significant element of uncertainty in the context of taxation of non-residents who enjoy protection under a Tax Treaty.
− Furnishing of tax residency certificate mandatory for claiming relief under the applicable tax treaty.
• Offshore borrowings
− Interest paid by Offshore Investors on offshore leverage for investment in India could become taxable in India in the hands of the lender, subject to availability of Treaty benefits.
• Services rendered from outside India
− There has been a debate on taxability in India of services rendered by a non- resident outside India. As per the DTC, fees for services utilized for earning income from source in India is taxable in India irrespective of the payment being made outside India or the services being rendered outside India.
− This will impact foreign service providers (especially based in non-treaty countries) who render services to offshore funds who, in turn, invest in India.
Concluding remarks
Simplification of tax laws, reduced litigation and flexibility are the stated objectives of the DTC.
As the Finance Minister himself stated, tax reform is a process and not an event. The next few months will see continued attention on this new development as one attempts to further analyze the new provisions. It is expected that the DTC would be debated amongst stake-holders and representations would be invited by the Finance Minister which hopefully would lead to emergence of a simplified and stable tax regime.
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