The annual reworking of tax laws, over the past decade and a half, has completely exhausted the nation’s taxpayers who have had to deal with a complex and fragmented tax code. Cynicism at the announcement of a new direct tax code was, therefore, not unexpected.
In the fine print of around 254 pages, however, sweeping and often radical changes to the tax framework are evident. This is a document that seeks to simplify the overall framework, incorporate international practices, remove profit-linked tax incentives and introduce progressive rates of taxation.
For individual taxpayers, the tax rates are certainly appealing, with the marginal rate of tax of 10% extending to income of up to Rs10 lakh; 20% up to Rs25 lakh; and the maximum rate of 30% thereafter. Considering India’s national gross domestic product per capita of Rs30,000, the slab rates are quite progressive and globally competitive. Investments and savings by individuals will be exempt up to Rs3 lakh a year and taxed only on redemption, thereby adopting the exempt-exempt-tax model that has been proposed by most task forces on tax reforms. The code also proposes the reintroduction of wealth tax, albeit at a reduced rate of 0.25% for net wealth in excess of Rs50 crore. This excludes ordinary citizens from the levy of wealth tax, but will capture the emerging class of multimillionaires and billionaires in India.
The finance minister has indicated 2011 as the possible time frame for the code to be legislated. This is welcome, given that the paradigm shift in the framework for corporate tax will take time to be fully absorbed, both by taxpayers and their advisers. The code proposes that profit-based tax incentives be replaced by an immediate deduction of the capital and revenue expenditure, but also suggests grandfathering for existing tax holidays. This will affect the infrastructure sector, including oil and gas, power, and roads, where companies have benefited from tax holidays over several years. The elimination of tax holidays will be balanced by a reduction in the corporate tax rate, which is now proposed to be 25%. This translates into a rate reduction of 5 percentage points. If one is to ignore the existence of surcharges and the cess, the corporate tax rate of 25% compares well with tax rates in other emerging markets.
The code proposes that MAT, or minimum alternate tax, which is currently levied on book profits, be based on the gross assets value at the rate of 2%. Therefore, asset-heavy companies which sought relief from the corresponding depreciation shelter will be adversely affected. Financial intermediaries such as mutual funds, provident funds and venture capital firms will be allowed pass-through status, which effectively means that there will be no direct tax costs created by such pooling vehicles.
The concept of dividend distribution tax has been upheld over the erstwhile dividend withholding tax. Over the years, there has been debate whether dividends are to be taxed at the shareholder level or at the dividend paying entity level. In the discussion paper accompanying the direct tax code, this debate has been captured with a conclusion for retaining dividend distribution tax as the preferred option. Therefore, while shareholders will enjoy dividend as tax-free income, the code proposes the elimination of the current exemption on capital gains on listed securities and the introduction of a new framework for taxing capital gains.
The code draws upon the tax avoidance measures in mature and sophisticated tax regimes. It has an entire chapter on special provisions to prevent evasion and provide for anti-avoidance rules. The scope and extent of what is sought to be considered as tax avoidance is wide and can be a cause of concern as it could place significant onus on taxpayers to defend the bona fides of a suspect transaction. But the provision on advance pricing agreements that has finally found its way in the proposed code should bring cheer to taxpayers.
The direct tax code does help provide a simple tax framework for individual taxpayers as the plethora of deductions and exemptions have been effectively replaced by a liberal tax rate framework. Corporate taxpayers now will have a sophisticated tax code that encompasses tax practices and concepts from developed economies. The tax code, which has been four years in the making, is well-meaning, comprehensive and refreshing, and with the opportunity for extensive public debate, it could become the much needed tax code for India in the 21st century.
Gokul Chaudhri is partner, BMR Advisors. Views expressed here are his own. Respond to firstname.lastname@example.org