India's Proposed Direct Taxes Code

Paris, 06 juillet 2010 - Visualiser l'eAlerte

On June 15, 2010, the Indian Government issued a revised discussion paper on the draft Direct Taxes Code ("the Code").  The revised discussion paper outlines intended changes to the draft Code that was introduced by the Indian Government in August 2009, and it takes into account many of the constructive public comments received in response. The Government's intent is to make the new Code effective from April 1, 2011.

Asset Based Minimum Alternative Tax ("MAT")

The discussion paper proposes to retain the existing method of subjecting a company's "book profits" to MAT, rather than shifting the base for the levy of MAT, as originally proposed, from "book profits" to the "value of gross assets" of a company. The original proposal would have adversely impacted asset intensive companies as well as companies with long investment periods, by making them pay tax even in years when they had no profits.

Taxation of Capital Gains

The discussion paper proposes that all capital gains be taxed at ordinary income rates, while the original proposal would have eliminated the existing capital gains regime. The existing regime subjects capital gains to differing rates of tax based on the asset's holding period. In addition, it provides a long term capital gains tax exemption on listed securities and concessional tax rates on other long term capital assets.
The revised discussion paper provides the following mechanism for computing capital gains:

• Capital gains on listed equity shares or equity oriented fund units which are held for a period of more than one year from the end of the financial year (i.e. March 31): Capital gains on such assets will be computed after deducting a specified percentage of the gains, without indexation. Different percentages of deductions will be prescribed based on the tax brackets of taxpayers. As the proposal will result in the taxation of capital gains on the sale of listed securities (versus the existing exemption on long term gains on listed securities), the revised discussion paper contemplates a transition regime.
• Capital gains on other assets held for more than one year: With respect to all other assets, the base date for computing the acquisition cost (to be deducted from the sale price) will be the fair value of the asset on April 1, 2000, if the asset was acquired prior to that date.  Indexation benefits will be available on that acquisition cost.
• Capital gains on assets held for less than one year from the end of the financial year of acquisition (i.e. March 31): Capital gains on those assets will be computed without any specified deduction or indexation benefit as described above for long term assets.
• Characterization of Foreign Institutional Investors ("FII") income: With a view to end the ongoing debate surrounding the characterization of FII income trading in India, the revised discussion paper proposes that FII income derived from trading in India be classified as "capital gains" and not as "business income" and subject to tax in the manner noted above. Furthermore, there will be no withholding tax with respect to capital gains earned by FIIs as initially proposed in the Code. The Securities Transaction Tax which would have been abolished under last year's proposed Code will now continue, albeit in a revised manner which will be separately addressed.  

Special Economic Zones ("SEZ")

The revised discussion paper clarifies that tax holidays applicable to units located in SEZs would continue for the unexpired period of the tax holiday. This differs from the original proposal which would have abolished the existing "profit linked" year tax holiday regime and introduced a replacement "investment linked" tax holiday regime.

Residency Rules

The revised discussion paper introduces an "effective control and management" concept to test a foreign company's residency. "Effective control and management" is defined as:

• the place where a company's Board of Directors or its executive directors, as the case may be, make their decisions; or
• if the Board of Directors routinely approve commercial and strategic decisions made by executive directors, then the place where such executive directors perform their functions. As originally proposed, the Code would have deemed foreign companies to be tax residents in India, even if partial management and control was in India at any time during the year.

This provision might have subjected foreign companies to Indian tax on their global income, even when a single meeting of the Board of Directors was held in India.

Tax treaty provisions

The revised discussion paper continues to allow taxpayers to choose between the more favorable provisions available under Indian domestic law and treaties - without regard to whether a tax treaty has been entered into after the Code comes into effect. This choice is subject to the following situations (where domestic law will prevail):

• when General Anti-Avoidance Rules ("GAAR") are invoked;
• when Controlled Foreign Corporation provisions are invoked;
• when Branch Profits Tax is levied.

Tax Avoidance

The Code had proposed the introduction of sweeping GAAR, empowering tax officials to disregard transactions which they felt lacked commercial substance. Taxpayers were concerned that these provisions could be arbitrarily applied by tax authorities. In the revised discussion paper, the Government clarified that in order for a transaction to be covered by the GAAR provisions, the taxpayer must obtain a tax benefit and meet one of the following conditions:

• the transaction is not at arm's length;
• the transaction represents misuse or abuse of the provisions of the Code;
• the transaction lacks commercial substance; or
• the manner of the transaction is not normally employed for bona fide business purposes.

In addition, the Government has proposed the following safeguards in invoking GAAR:

• the Central Board of Direct Taxes will issue guidelines to provide for circumstances when GAAR may be invoked;
• GAAR provisions will be invoked only with respect to arrangements where tax avoidance exceeds a specified threshold; and
• the form of a Dispute Resolution Panel will be available in cases where GAAR is invoked.

The revised discussion paper also introduces Controlled Foreign Corporation Rules to enable the taxation in India of passive income earned by foreign companies controlled directly or indirectly by an Indian resident company.

Conclusion

The revised discussion paper has effectively addressed taxpayer concerns raised over the initial proposals.  However, some aspects of the proposals, including whether the transfer of indirect interests in an Indian company will be taxed, will only become clear when the revised version of the Code itself is made public. The revised discussion paper also notes that other issues will be considered while finalizing the Code. The new capital gains tax proposals, as well as the guidelines relating to GAAR (which are yet to be pronounced) could significantly impact investment into and structures relating to India.

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