THE much-hyped, much-discussed and much-awaited Direct Taxes Code Bill, 2010 (DTC) has finally been placed before the lower house of the Parliament. Professional analysts have already analyzed this 405 pages document containing the Bill with 319 sections and 22 Schedules and the accompanying Notes on clauses and given their verdict. The euphoria generated by the original DTC Bill in its pristine form that promised the moon by way of a very low taxation regime has now been replaced by a sense of distinct disappointment. The reason for the disappointment is obviously the realization in the minds of the North Block Mandarins that the Government cannot be profligate with its expenditure and lax with its revenue at the same time. The original Bill had proposed an almost flat tax of 10% for more than 90% of the tax-paying population, earning income above Rs 1,60,000 per year. Instead, the Government now proposes to increase the basic exemption limit to Rs 2,00,000 but is much more conservative with the slab, the 10% rate being applicable only up to Rs 5, 00,000 as compared to Rs 10,00,000 as proposed in the original version. The highest marginal rate of 30% now kicks in for income above Rs 10,00,000 with the 20% rate being applicable for income between 5,00,000-10,00,000. The Secretary Revenue in his press conference has very rightly pointed out that the threshold limit in India as proposed in the Bill is now 5 times the average per capita GDP and that even in the diluted form, the revenue sacrifice for the various proposals would be to the tune of Rs 53,172 Crores. There is some speculation that this may be the reason for deferring the applicability of the proposed legislation by one year so that the shortfall can be made up by the new GST, which cannot be implemented in 2011 because of the opposition from a significant number of the States.

The corporate tax rate has been maintained at the current level of 30%. As of now, there is no proposal for any surcharge and cess. Therefore, actually there will be a reduction of 3.3% in corporate tax. It is not clear whether there will be a separate education cess or whether the same will be subsumed in the overall tax rate. The Revenue Secretary in his conference was again very categorical that the overall corporate tax rate will not exceed 30%.

Now that the Bill has been introduced, even though it will be in force only from April 2012, there is no point in discussing whether the rationalization measures could have been achieved through a Finance Bill rather than having a new code with its concomitant uncertainty in defining new terms and concepts.

In so far as non-resident taxation is concerned, we have discussed most of the proposals of the draft code and the revised discussion draft in this column. The most welcome change from the present regime is, of course, the rate of taxation for foreign companies. For the first time since independence, foreign companies will be taxed at par with the domestic companies at 30%. Such differential rate was introduced in Independent India’s first budget for 1948-49 on the ground that in absence of information about the particulars of shareholders and the dividends distributed to them by the foreign companies, the super tax on the dividends paid by such companies in respect of their Indian business which India was entitled to, could not be recovered. Much water has flown down the Ganges since then. Having a differential rate has spawned quite a number of unnecessary litigations, particularly involving branches of foreign banks operating in India who had been taking recourse to the non-discrimination article that India has signed with most of its treaty partners. Foreign companies operating through branches will, of course, pay branch profit tax at the rate of 15% as proposed in the original DTC. This will introduce a new element of discrimination and will fall foul of the non-discrimination clause at least till such time that the treaties already entered into by India are not modified to include a specific stipulation that charging branch profit tax will not be considered discriminatory by the Contracting States. Even the Code does not make any mention in this regard although, interestingly, the explanation that charging foreign companies at a higher rate does not amount to discrimination, continues in the new code!

A new schedule XX has been added for the new CFC provisions which were not there in the original DTC but was proposed in the revised version. We will examine the CFC provisions in some details in the coming days. Then there is the provision of GAAR, which does find a place in the Bill despite some hectic lobbying. This is also another topic requiring serious analysis. The provision of the so-called treaty override however has been dropped and the old provision of section 90(2) of the current Income Tax Act (ITA) to the effect that the taxpayer has the option to choose between the treaty or the domestic law whichever is more beneficial has been brought back. The domestic law will however prevail in the case of application of GAAR, levy of Branch Profit Tax and the application of CFC rules. The concept of the place of effective management will now determine corporate residence. Place of effective management has been defined as follows:

“place of effective management means— (i) the place where the board of directors of the company or its executive directors, as the case may be, make their decisions; or
(ii) in a case where the board of directors routinely approve 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”

Transfer pricing provisions have been tightened to some extent and may again form a separate topic for our discussion. There is also the provision for Advance Pricing Arrangement (APA), which the MNCS have been demanding ever since the Transfer Pricing legislation was introduced in India. However, the actual modalities of the APA programme are still not known.

There are a few other significant changes that have not as yet received much attention. One such is the modification of the scope of total income to clarify that any income accruing to a resident outside India shall be included in total income whether or not such income has been charged to tax outside India. Courts in India have been wrongly taking the view that if a resident has overseas income in a foreign country and if the right of taxation in respect of such income has been given to that country by the applicable tax treaty stating that the income concerned may be taxed there, India loses the right of taxing its residents in respect of that income. Even the Supreme Court endorsed such a view in the case of Kulandagan Chettiar. Hopefully, with this clarification, such situations will not recur.

The provision of deemed accrual of income of non-residents corresponding to section 9 of the existing ITA has also been strengthened and the controversy regarding territorial nexus should finally be put to rest.

One provision, which has caught attention of the media though, is the new section 5(4)(g). It has been commented that the change has been effected to bring to tax the Vodafone type arrangements. However, the proposed change may have larger ramifications.

Mr Harish Salve, the counsel for Vodafone in the just concluded arguments in that case before the Bombay High Court is understood to have been harping on the fact that in the absence of a look through provision, it is not possible for the tax authorities to try to tax the gains arising out of the transfer of underlying assets which in the Vodafone case was the controlling interest in an Indian firm. We may recall that in that case, the tax Department treated Vodafone as an assessee in default for not deducting tax from the payments to Hutchison Essar from whom it had purchased the controlling interest. Vodafone had taken the plea that the income was not liable to Indian taxation in as much as the transfer was of shares outside India of a Cayman Island Company. The facts may be somewhat more complex but it is interesting to note what the Code proposes in this regard in section 5(4)(g):

“The income deemed to accrue in India under sub-section (1) shall, in the case of a non-resident, not include the following, namely:
…..

(g) income from transfer, outside India, of any share or interest in a foreign company unless at any time in twelve months preceding the transfer, the fair market value of the assets in India, owned, directly or indirectly, by the company, represent at least fifty per cent. of the fair market value of all assets owned by the company; …” (emphasis supplied)

And subsequently, in section 5(6), a formula is given for the calculation of the income deemed to accrue in such cases as follows:

“(6) Where the income of a non-resident, in respect of transfer, outside India, of any share or interest in a foreign company, is deemed to accrue in India under clause (d) of sub- section (1), it shall be computed in accordance with the following formula —

AxB/C
Where A = Income from the transfer computed in accordance with provisions of this Code as if the transfer was effected in India;
B = fair market value of the assets in India, owned, directly or indirectly, by the company;
C = fair market value of all assets owned by the company.”

In simple terms, assuming that Indian assets represent 60% of the total assets of the non-resident company, only 60% of the income arising out of the transfer of the shares of such non-resident company outside India may be taxed in India.

There are a few problems with this approach. First, of course, the concept of fair market value is inherently complex and the mechanism of the determination is problematic. The Code defines fair market value as follows: "fair market value in relation to an asset, means the price determined in such manner as may be prescribed" [314(91)]. So, as of now, there is no clarity about the matter. Secondly, there is one situation, which is quite common in the treaty context and that is the transfer of immovable property through transfer of shares. Right of taxation of gains arising from transfer of immovable property generally rests with the country where the property is situated. Recognising the fact this rule can be very easily violated, the UN model introduced Article 13(4) which states that gains from the alienation of shares of the capital stock of a company, or of an interest in a partnership, trust or estate, the property of which consists directly or indirectly principally of immovable property situated in a Contracting State may be taxed in that State. This is one of the rare examples where OECD subsequently chose to follow the UN model and now the same provision is found in most modern treaties including many of the treaties signed by India. Since prima-facie, there is no separate provision for such type of situation in the proposed new Code, clause (g) will also cover such transfers and then the provisions of the code being more beneficial will apply and in terms of the provision of section 5(6), only a percentage of the income can be taxed even where the treaty might have granted the exclusive right of taxation to India. This is not a very happy situation as the domestic law needs to be stronger particularly when one takes into account the provision which says that the non-resident can choose between domestic laws or the Code which is more beneficial.

This then is a bird’s eye view of the provisions relating to non-resident taxation as has been introduced in the Bill. We will continue with our comments and analysis in days to come.