As the Modi Government prepares to present its last complete budget before the 2019 general elections, we reflect on the current fiscal year and evaluate the key target areas for the financial and tax reform proposals of 'Budget 2018'.
This year has witnessed sweeping legislative reform – introduction of the Insolvency and Bankruptcy Code, 2016 (IBC) to facilitate the corporate insolvency resolution process, passing of the Real Estate (Regulation and Development) Act, 2016 to regulate the real estate sector, and introduction of GST as single national tax which streamlines the indirect tax regime in India. Within the realm of direct taxes, the year witnessed the introduction of the General Anti-Avoidance Rules, thin capitalisation norms, secondary adjustments in India's extant transfer pricing regime, the issuance of the final guidelines on 'POEM' (i.e. place of effective management) as a test of corporate residency, the widening of fair valuation basis taxation and implementation of country by country reporting for transfer pricing.
Against the backdrop of this legislative overhaul, and the commitment of the present Government to establish an investor and business friendly regime, set out below is a quick round - up on the key expectations from 'Budget 2018'.
Reduction in Corporate Tax Rate
The Finance Minister had promised in his first budget to reduce the corporate tax rate from 30% to 25% and remove all tax sops in a phased manner. Thus far, the reduced tax rate of 25% has been extended to certain companies engaged in the manufacturing sector and those below the prescribed turnover limits only. In the changed world investment scenarios and the need for huge capital investments in India, there is a strong case to reduce the corporate tax rate to 25% with investment linked tax sops and reduce the accounting profits based minimum alternate tax (MAT) rate to less than half of the corporate tax rate in line with the practices in competing jurisdictions. One may not overlook the recently proposed corporate tax reduction from 35% to 20% in the United States.
Clarity in respect of Indirect Transfer Tax Provisions
Offshore transfer of shares or interest in a foreign company deriving 'substantial value' from Indian assets on 'specified date' triggers Indian tax. In order to assess whether the substantial value test under India's indirect transfer tax provisions is met, it is presently unclear whether the standalone or consolidated accounts / financial statements of the target foreign company are to be considered. Clarity in this regard is critical for global deals with Indian leg.
In this context, in view of the manner in which 'specified date' is defined for valuation purposes, even if the target foreign entity does not own any Indian assets on the date of transfer but held such assets on the last day of its accounting period immediately preceding the transaction date, the indirect transfer tax provisions may trigger. This needs to be addressed to avoid taxation when the target has already disposed of its Indian assets and paid the due taxes (subject to any relief that may be available).
Further, while law exempts a foreign merging/ demerging entity from the indirect transfer tax, there is no shareholder level exemption (unlike domestic tax neutral restructuring). This aspect needs to be addressed.
Replace DDT with a Withholding Tax
Currently, dividend distribution tax (DDT) is payable by an Indian company on the dividends distributed to its shareholders, in addition to corporate tax payable by the distributing company on its income. This can result in double taxation as foreign investors are often unable to claim credit of the DDT paid in India in their home jurisdiction. Thus, they bear the incidence of DDT plus tax on dividend income in their home jurisdiction, thereby reducing their return on capital employed. This can make India unattractive as an investment destination. Replacing DDT with a Dividend Withholding Tax (DWT) would enable the recipient shareholders to claim credit for taxes paid in India.
Clarity on Thin Capitalisation Norms
The language of the thin capitalisation provisions creates doubt as to whether interest paid to third party lenders would also be capped under the rules or only the interest paid to associated enterprises (or loans guaranteed by them). To address this, and in line with the intention of such measures, clarity should be provided that interest on third party loans should not be impacted by the interest cap limits. Further, these norms are attracted even where the debt is issued by an independent third-party lender, but an associated enterprise provides an "implicit or explicit guarantee" to such lender. The term "implicit or explicit guarantee" is rather vague, and could possibly cover within its sweep even simple comfort letters issued by an overseas parent in relation to a loan taken by an Indian subsidiary. Greater clarity could thus be expected on the meaning of the said term. Further, while an exemption from the applicability of thin capitalisation norms has been provided to Indian companies engaged in the business of banking and insurance, a similar exemption ought to be provided to non-banking financial companies and infrastructure companies with businesses with long gestation periods.
Rationalising Fair Value basis Taxation on Transfer of Shares
Since the scope of fair value basis taxation under the (Indian) Income-tax Act, 1961 (IT Act) was widened by the Finance Act 2017, and valuation norms to determine "fair market value" (FMV) were revised, there is a pressing need to rationalise these provisions to exclude certain transactions such as those which are specifically exempt from capital gains tax (like transfer of capital assets inter se parent-subsidiary). Further, there is lack of clarity on the manner of computation of FMV of shares of a foreign company (which falls within the purview of the provision) as valuation rules seem more suited to shares of an Indian company.
Further, in case of cross-holding structures, i.e. where company A holds certain unquoted shares of company B, and company B also holds unquoted equity shares of company A the valuation exercise leads to an unending loop, rendering the valuation exercise impossible. Special provisions are required to address this situation.
Harmonizing Income-tax Provisions for Companies under Insolvency
To bolster the revival of non-performing assets and accord success to the path breaking IBC, suitable amendments ought to be made to provide exemptions in relation to (i) tax on any write back of notional income pursuant to a resolution plan approved under the IBC; (ii) inability to carry forward and set off of tax losses on account of a change in control which generally applies; and (iii) book profits based MAT. There is also a need for certainty in relation to contingent liabilities relating to pending income-tax litigation, in order to encourage investor interest in distressed companies.
Alignment with provisions of Ind-AS
While the Government has pragmatically attempted to address diverse issues arising due to Ind AS (IFRS converged Indian accounting standards) under MAT provisions, the fundamental condition of a tax neutral demerger of recording the assets at 'book value' is not possible in case of a demerger involving unrelated entities, which needs to be recorded at 'fair value'. The change in income-tax implications due to change in accounting method is clearly an unintended consequence, and needs to be addressed.
Revising Monetary Thresholds for tax neutral conversion of Company to LLP
Currently, conversion of a company into a limited liability partnership (LLP) triggers an income-tax levy if the company's turnover exceeded INR 6 million or the value of its assets exceeds 50 million in any of the 3 years preceding such conversion. These limits are far too low, even for present – day MSMEs and it is unclear what objective it achieves. Budget 2018 should revise the limits for such conversion.
Exemption for Start-ups and SEZ Units from MAT
To make tax sops currently available under the IT Act to start-ups and export oriented units set up in Special Economic Zones (SEZ) more meaningful, concessions from the levy of MAT ought to be provided to such entities.
Taxation of Income from Cryptocurrencies
Even though the Ministry of Finance has disregarded cryptocurrencies as valid legal tender in India, it is impossible to ignore the overwhelming popularity that cryptocurrencies have assumed across the globe. While the income-tax authorities have issued notices to several high net worth individuals who have transacted in bitcoin, expectation is rife amongst professional circles that Budget 2018 will address the issue of the manner of taxability of cryptocurrencies, mainly its characterisation as business income (or speculative income/ capital gains).
Comment
In keeping with the consultative approach of the present Government in bringing about legal reform, the Finance Minister has already held several rounds of pre – Budget consultation meetings with industry – wide stakeholders.
A significant and urgent need is to reform the tax administration to make it less adversarial and more pragmatic. Courts have time and again passed strictures against overzealous and aggressive stances taken by tax officers on the ground. But lasting change requires administrative reforms. Target based tax collections have done more harm than good and must be replaced with an alternative mechanism. While a task force has already been formed to draft a new direct tax legislation, one sincerely hopes that the Government addresses some of the above concerns in this Budget. As a Government that would most certainly leave an indelible mark in the history of financial and tax reforms in the country, it would not be a stretch to expect Budget 2018 to have more hits than misses.
- Direct Tax Team
This article was first published in CFO magazine.
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