Is taxation a democratic theft? There is a line of thought that it is so. Bad tax policies coupled with an aggressive stand adopted by the tax authorities may lend merit to this line of thinking. However, whether or not taxes are paid voluntarily, we do get something in return. A remark by US Supreme Court judge, justice Oliver Wendell Holmes, which is inscribed on the IRS headquarters in Washington, DC, aptly sums this up: “Taxation is the price we pay for civilization.”
But then, what constitutes a good tax regime? Perhaps one needs to go back to the four basic canons of taxation enunciated by noted economist Adam Smith and author of The Wealth of Nations (1776), viz., equity (taxes must be based upon the ability to pay); certainty (the timing and amount must be certain); convenience (means and timing of payment must be convenient to the taxpayer); and lastly, economy in collection (it should be easy to collect and administer).
As the years progressed, economists adopted varying interpretations of the above. Henry George, another classical economist, in his book Progress and Poverty (1879), while continuing to emphasize on “certainty” and “equity”, added that the tax must bear as lightly as possible upon production, minimizing the excess burden or deadweight loss. As regards “economy in collection”, he went on to say that the revenues must be easily and cheaply collected, and fall as directly as may be upon the ultimate payers—so as to take from the people as little as possible in addition to what it yields the government.
Modern economists have added on to these canons, in tune with the changing needs of the taxpayers. Today, as the world gets flatter, one important addition to tax canons is that a tax should also be compatible with international tax systems. As the date of presentation of the Union Finance Bill, 2008, draws near, it would be useful to evaluate to what extent our current tax policy adheres to the above canons of taxation.
Cross-border confusion: A file photo of the Convergys office in Gurgaon.The fringe benefit tax provisions assume that certain proportion of expenses incurred by a firm result in a collective benefit for the employees.
Burden of corporate tax rate: The basic corporate tax rate in India for domestic companies currently is 30%. In addition, companies also have to pay dividend distribution tax (DDT) at 15% and fringe benefit tax (FBT) at 30% on the value of the fringe benefit. The tax rates are further increased by surcharge and education cess. All taken together, the tax burden on companies is likely to exceed 40%.
Various global surveys conducted during 2007 by various professional bodies and organizations show the global average corporate tax rate standing at close to 27%, the average in Asia-Pacific slightly higher. OECD (Organisation for Economic Co-operation and Development) studies show that the average tax rate in OECD member countries is around 27.8%. A higher tax rate puts a company in a comparatively disadvantageous position. This suggests a case for rationalizing the current tax rate structure, to make it more equitable and ensure that the rate is comparable with that in other countries and it does not impair the productivity and global competitiveness of companies operating in India. As an example, in China, the corporate tax rate for domestic companies stands reduced to 25%, from January this year.
Lack of certainty: Adam Smith regarded certainty as the most fundamental canon. This is essential from the view point of the taxpayer and also the government. The ability of a taxpayer to resolve a tax dispute with the government in a timely and amicable manner is integral to the principle of certainty. In recent times many issues have arisen, particularly in the area of international taxation, which have resulted in an endless round of litigation. Varying interpretations by judicial authorities have only added to the uncertainty. These include issues such as circumstances when a foreign enterprise can be said to have created a taxable presence in India, determination of profits attributable to that business presence, appropriate classification of cross-border transactions for tax purpose, determination of the arm’s length nature transactions under transfer pricing rules, and so on.
Litigation risks prove detrimental to India’s competitive position in the global markets. Admittedly, taxation of international businesses is a complex subject, and India is not alone in facing these issues. However, it is important to recognize the need for certainty in the application of tax laws, and also to have a mechanism to resolve the issues expeditiously and fairly. This can be achieved by having detailed guidelines on interpretation and application of tax rules and mechanisms for speedier resolution of disputes, including provisions for a resolution mechanism outside the judicial process, a more robust system of advance rulings and advance pricing arrangements on transfer pricing issues. The change is necessary to meet the goals of producing a tax system which provides certainty and stability to international business operations.
Economy in tax collection, but at what cost? Taxes such as FBT and DDT may satisfy the requirement that a tax should be easy to collect and administer, but it stops at that. The FBT provisions assume that certain proportion of expenses incurred by a company result in a collective benefit for the employees; in particular it is difficult to understand the nature of collective benefit enjoyed by employees in the case of stock options which are granted to individual employees. Also, the fact that a company could be subject to FBT even if it incurs a net loss makes it difficult to reconcile this provision with the principle of equity and convenience.
Modern canon of taxation: One of the modern canons of taxation is that a tax must also be compatible with international tax regimes.
The dividend taxation system—whether for foreign or domestic dividends—also appears to create distortions in a cross-border situation. A foreign shareholder in a domestic company would normally be taxed on the dividends received in his country of residence, which may not recognize DDT paid by the Indian company as a creditable tax.
Further, the cascading impact of DDT in case of multiple-tier holding structures, without a mechanism to offset DDT paid by lower-tier companies, accentuates this distortion even in a domestic situation. In the case of dividends received from a foreign company by an Indian shareholder, the dividends are taxed in the hands of the shareholder, generally without relief for underlying taxes. Distribution of dividends to a shareholder represents distribution of after-tax profits of that company. If the dividends are taxed (without giving relief for the taxes paid on the underlying profits), it represents a form of economic double taxation. Such a system would impact location neutrality of investments, as dividends from domestic companies are tax-exempt in the hands of shareholders.
In recent years, various jurisdictions have considered a change in company-shareholder tax systems and a major reason for the change has been a shift of emphasis to consider alleviating potential double taxation. A relief from international double taxation could encourage Indian companies to repatriate their profits from global operations back to India for productive re-investment, which consequentially would fuel economic growth.
A good tax regime taking into consideration both the classical and modern canons of taxation can lend weight to the words of justice Holmes. Perhaps, the forthcoming Finance Bill can take a few steps towards achieving the same.
Gaurav Taneja is national tax director and partner, Ernst & Young.
This is the second of a two-part series on tax reforms. The first article was published on Friday.
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