Tax incentives are conventionally considered a fiscal tool to spur economic or industrial growth in priority sectors and areas. Over the years, various tax incentives have been granted and withdrawn, depending on the need to provide impetus to a particular economic activity or industry.
Taxpayer’s due: A file photo of people gathered to file their annual returns at the special counters opened by the income-tax department at Pragati Maidan in New Delhi. Arvind Yadav / Hindustan Times
In 2006, the Union government invited comments from stakeholders for withdrawal or continuance of various exemptions and deductions on a long list of 162 items (tax incentives) provided under the income-tax laws. The incentive provisions are so scattered in various part of the Income-tax Act that it could be mindboggling for a layman to locate a particular incentive. The incentives could be classified based on various parameters:
Nature of income (for ex-gratuity, voluntary retirement scheme compensation);
Nature of taxpayer (for ex-Coffee/Rubber Board);
Nature of source of income (for ex-tax holiday on income from infrastructure sector or certain export income);
Nature of location of source of income (for ex-income of undertakings set up in the North-East);
Based on savings—in case of individuals or Hindu undivided families.
The incentives can also be classified based on the manner of computation in three categories: (i) exemptions for specified income; (ii) deduction from gross total income (GTI); (iii) deduction from the respective head of income such as salary, house property, income from profits and gains of business or profession.
What has gone wrong?
Initially, the logic of providing an incentive by way of exemption or deduction was well conceived. A receipt, which by its nature was not to be treated as taxable, was placed in the category of exemptions (for example, agricultural income and death-cum-retirement gratuity), whereas if any incentive was to be allowed in respect of an income, which otherwise was taxable in nature, it was allowed as deduction.
With the passage of time, this difference has got diluted and it has been rather a drafting convenience whether to put an item in the category of exemption or deduction. Even whether a deduction is to be allowed from a respective head or from GTI has not been given due thought.
The tax incentive sections in their current form are full of loopholes and ambiguities that limit the benefit originally envisaged. In fact, most of the tax litigations centre around the allowance of tax incentives.
In our earlier article on, “simplification of tax code” (23 June), we have discussed how the classification has different ramifications, inasmuch as exemption and deduction from respective source of income give more benefit vis-à-vis the ones that allow deduction from gross total income.
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Since the government is in the process of drafting a new simplified direct tax code, an attempt can at least be made to reclassify tax incentives in the right category, so that similar incentives to industries are covered under the same classification and the benefit can be provided to the full extent. Also, an effort can be made to simplify the provisions for calculation of quantum of benefit to put an end to the prevailing ambiguities and litigation.
Exemption sections can be converted into deduction sections providing 100% deduction. This will not only synchronize the exemption and deduction sections but could also bring information (regarding exempt income) on record.
All tax holidays that are allowed from GTI can be allowed from the respective heads of income.
At present, there is a lot of litigation on determining the quantum of deduction in respect of an undertaking being in tax holiday when there are losses in some other heads of income. Since the Act envisages computation of income from each source separately, it is appropriate that any incentive in respect of income or expenses relating to that source should be allowed in determining the net income or loss from that source or head. This will help in reducing the litigation not only on quantum of incentive but will simplify and rationalize the complicated procedure of intra/inter-head set-off of losses.
Only those incentives that have no link with the nature of income of the taxpayer, such as incentives for savings (life insurance, provident fund, medical treatment, etc.) should be allowed from the aggregated income, i.e., GTI.
Continuity of tax holidays in respect of eligible units (such as infrastructure undertakings) is another area of litigation in a situation where such units are transferred form one taxpayer to another by way of outright sale, or in a scheme of merger or demerger.
The situation as on date in this regard is really chaotic. For some incentives, it is explicitly clarified that the tax holiday continues while for some it doesn’t. In some other cases, the law is silent, and ambiguity prevails. Clarity is clearly warranted in such cases and given that tax holidays are industry-specific and not taxpayer-specific, the benefit should continue to be available to the transferee.
There is one more category of incentives that is available by way of rebate—capital gains, which are subject to concessional tax rates. The issue with this kind of incentive is that the identity of such income (subjected to concessional rate) continues even after aggregation of all income (in GTI) and thus, when there are losses from some other sources, disputes arise about the priority of set-off of income entitled to different rates of taxation.
The concessional rate can be withdrawn and instead corresponding concession should be allowed by way of deduction from income so that for all purposes, the net income (eligible for concessional rate) is not treated differently.
To instill confidence in taxpayers and signal the government’s commitment to a stable tax incentive regime, it is necessary to have parity in the tax incentives vis-à-vis the policy. The legislators need to consider that the beneficial provisions will not be effective unless these implementation issues are resolved and suitable amendments are made in the tax provisions so that the benefit can be availed in its full spirit.
Ganesh Raj is tax partner, policy advisory group, Ernst and Young. This is the third of a four-part series on key issues which need to be addressed by the proposed overhaul of the direct tax code.
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