Sunday, March 11, 2007

Overview of direct tax provisions: The key issues

The Finance Bill 2007 was presented on February 28, 2007. While there are no major tax reform provisions in the Budget, the finance minister has proposed certain amendments relating to both direct and indirect tax. This article summarises some of the key amendments proposed in the Finance Bill 2007 relating to direct tax.
The personal and corporate tax rates have remained constant with two exceptions. One, an additional cess of 1% has been proposed across the board to all tax rates and the rate of dividend distribution tax (DDT) stands increased from 12.5% to 15%. Of specific importance is the increase in the DDT rate, as profit repatriation to shareholders through distribution of dividends becomes more expensive. In the case of multinational enterprises, the prevailing uncertainty on the creditability in the home country of the DDT paid in India is also an issue to contend with which continues to lead to double taxation.

The extension of the minimum alternate tax (MAT) regime to income streams, which in the normal course are exempt, appears to be a continuing trend. This year the budget has proposed to extend the MAT provisions to companies engaged in inter alia the IT and BPO sectors that are availing tax deduction under section 10A and 10B of the Income-Tax Act, 1961 (Act). The tax paid under MAT can be carried forward as a credit and offset against the normal corporate tax liability for a period of seven financial years. In light of the sunset provision contained in section 10A of the Act, which prescribes a date of March 31, 2009, on which the tax holiday scheme expires, the introduction of MAT for the IT and BPO sector is likely to represent at most a cash flow issue. The MAT impact may also be neutralised on account of foreign tax credits that are offset against MAT payable.

The taxation of employee stock options (ESOP) is also set to change with the Budget proposing a fringe benefit tax (FBT) levy on the difference between the fair market value on the date of exercise of the option and the price, if any, paid by the employee towards the exercise of the option. The Central Board of Direct Taxes (CBDT) is expected to prescribe valuation rules in this regard. The law which will take effect from assessment year 2008-09 (financial year 2007-08), will bring parity in the characterisation of ESOP income as capital gains for employees irrespective of whether the ESOP plan is compliant with the Central government guidelines or not.

Foreign and domestic venture capital funds are eligible for tax pass through status and are exempt from tax on income from investments in venture capital undertakings (VCU). The Budget has now restricted the scope of investments of foreign and domestic venture capital funds to specified industries such as IT, nanotechnology and biotechnology. A venture capital fund which has made a prior investment in a VCU may now be taxed on par with any other investor if the VCU does not undertake specified activities as contained in the Budget proposals. This provision could impact investor morale and could influence further inflows of venture capital on account of uncertainty in Indian tax laws.

The budget also seeks to plug a loophole in section 10AA of the Act as applicable to the tax holiday provisions for a special economic zone (SEZ) unit through introduction of anti-abuse formation conditions. The amendment is retrospective from February 10, 2006 and a SEZ unit will not be eligible for the tax holiday benefit if it has been formed by the splitting-up or reconstruction of an existing business or by the transfer of used plant and machinery to a new business. The amendment introduced is along the lines of the existing provisions as contained in section 10A and 10B of the Act. The amendment would lend clarity on the requirement to set up a new SEZ unit and would mitigate future litigation.

To conclude, the finance minister has announced the introduction of a new tax code later this year and a major tax reform through simplification of existing laws would be welcome.

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