New Delhi: The government is looking to reorder the skewed nature of the present direct tax structure wherein smaller businesses, including beauty parlours and legal professionals, end up paying tax at a rate three times that paid by back-office and software companies.

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The government signalled its intent in the budget presented in July and reiterated its commitment in the Union Budget presented on 26 February when it fixed a date for the introduction of the direct tax code (DTC), which will, among other things, set right this anomaly and bring about greater convergence of rates between sectors.

Costlier makeover: A beauty parlour in Ahmedabad. The government is looking to rejig the direct tax structure wherein smaller businesses such as beauty parlours have higher effective tax rates than software firms. Ramesh Dave / Mint

Essentially, this means the tax exemptions availed by firms will soon be scrapped, resulting in a higher effective rate of tax payout for companies using these provisions.

“Moderate rates require all sectors to contribute," Sunil Mitra, revenue secretary, said at a post-Budget meeting organized by industry lobby Associated Chambers of Commerce and Industry of India on Wednesday.

Currently, most tax exemptions that end up benefiting large firms are profit-linked incentives. These will be replaced by investment-linked incentives, which will bring a bigger proportion of these companies’ profits into the tax net.

Major corporate tax incentives have been estimated to lead to a revenue “forgone" (governmentspeak that means notional loss) of Rs79,554 crore in 2010-11, or about 26% of the Rs3.01 trillion estimated to flow in as corporate tax in 2010-11. About 70% of the revenue forgone on account of tax incentives is linked to profits.

“Not too many exemptions left, with those of software technology parks and export-oriented units being phased out," said Ketan Dalal, executive director at audit and consulting firm PricewaterhouseCoopers, and also a columnist at Mint, commenting on the likely scenario in the wake of DTC. “Effective tax rate will go up from 1 April 2011."

The Union government’s annual Budget documents put out statements on effective tax rates for companies of different sizes and also the tax shelters, which account for the largest extent of revenue forgone.

The big boys of the corporate world pay the least amount of tax as they enjoy the maximum benefit from the various tax exemptions.

Data in the Budget documents shows that while the effective tax rate in fiscal 2009 for 179 companies with profit before tax (PBT) of Rs500 crore and above is 22.05%, the effective tax rate for companies with a PBT of up to Rs1 crore was higher at 25.52%.

Across sectors, the contrast is starker. For instance, software and pharmaceutical companies have an effective tax rate of 11.8% and 17.2%, respectively. At the other end of the spectrum, beauty parlours and broadcasters have effective tax rates of 35.5% and 34%, respectively.

According to a senior finance ministry official, who did not want to be identified, once DTC is rolled out, effective tax rates will begin to converge across companies of all sizes and sectors.

A key feature of the draft DTC, which was followed in finance minister Pranab Mukherjee’s last two budgets, is a move away from profit-linked incentives towards investment-linked incentives.

“Such benefits (profit-linked) are inefficient, inequitable, impose higher compliance and administrative burden, result in revenue loss, increase litigations and lead to competitive demand for similar tax benefits," said the July 2009 Union Budget documents.

The variance in effective tax rates between different sectors is expected to narrow with the transition to DTC.

A DTC environment does not rule out a situation where companies with large profits and a balance sheet tilted towards fixed investments pay tax at an effective tax rate lower than that at which its peer group as well as smaller companies pay tax, the finance ministry official added.

What DTC would do is reduce the extent of disparity by eliminating distortionary tax shelters, this person added.