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Almost 10 months back, the Indian Finance Minister had released the much-awaited Direct Tax Bill Code, 2009 (Code) and Discussion Paper for public comments, fulfilling the promise he had made at the presentation of Budget for 2009-2010.

The philosophy behind the Code is to shift existing tax legislation with new 285 sections, 18 schedules, and 318 definitions by April 1, 2011 and to establish an economically efficient, effective and equitable direct tax system. The discussion paper accompanying the Code presented the objectives of the new system, the proposed provisions and the government’s reasons for choosing those provisions.

The Code incorporated many aspects of international best practices and embraced what has become the international norm for income taxes i.e., low rates of tax being applied to a broad base. There are, however, some provisions which depart from international best practices. The combination of these provisions could discourage Foreign Direct Investments (as well as outbound investments by Indian companies) which India needs to fulfill its growth potential. Among the controversial proposals made in the code, there were provisions related to taxation of foreign companies, which inter alia included the following:
* Residence rule for companies in India
* Relationship between the Code and the Double Taxation Avoidance Agreement (DTAA)

In addition, introduction of the General Anti-Avoidance Rule (GAAR) with wide and unrestricted scope has been the matter of considerable debate. Now, on the basis of the interactions with stakeholders, the government has released a Revised Discussion Paper (RDP) assimilating public consultation and concerns on the above stated proposals. The proposed changes on the above three key matters, along with its implications, have been discussed in the ensuing paragraphs:

Residence rule for companies in India
The Code provided that a company shall be resident in India, in any financial year, if it is incorporated in India (viz. an Indian company) or in case company is incorporated outside India (viz. foreign company), if at any time in the financial year, the control and management of its affairs is situated wholly or ‘partly’ in India. This is a notable distinction from the current provision, which provides for the residency of a foreign company in India only where the control and management of its affairs are wholly situated in India.

Given the current globalized landscape and overlapping situs of control and management, this shrunk the space for construing a foreign company as a resident in India, thereby risking double taxation because of ‘residence-residence’ conflict. A need was felt that the government should reconsider and realign this closed proposal with generally acceptable international tax principles of determining residency of a foreign company in India.

The RDP now proposes to withdraw this narrow proposal with a broader concept of place of effective management as a test for corporate residency. A foreign company is proposed to be treated as a resident in India, if its ‘place of effective management’ (POEM) is situated in India. The POEM has been defined to mean a place where the board of directors of the company makes decision or a place where the executive directors or officer of the company makes decisions, provided such decisions made are routinely approved by the board of directors of the company. The POEM is a well-recognized concept in international tax practices and is expected to put the debate on corporate residency in India at rest.

Besides, in the RDP, the government has indicated a proposal to introduce Controlled Foreign Corporation (CFC) regime, which is currently not a part of the Code. A CFC regime is an anti-avoidance measure aimed for taxation of passive income earned by an Indian-controlled foreign company. Under the CFC regime, the income earned by the foreign subsidiary even though not distributed resulting in deferral of taxes, would be deemed to have been distributed, resulting in taxation of the same in the hands of the Indian company holding shares of such companies. The RDP now places framing of CFC legislation for public consultation.

Relationship between the Code and the DTAA
The Code provided that neither the DTAA nor the Code shall have a preferential status, by reason of it being a DTAA or domestic tax law. In case of conflict between the provisions of a DTAA and the Code, the one that is later in point of time shall prevail. This resulted in the possibility of domestic tax law overriding all existing DTAAs once the Code comes into force thereby impacting the tax payers in the negative magnitude. Besides, concern was also raised on the validity of unilateral act of the Indian government by making amendment in the domestic tax law to override the bilateral agreement/treaty entered into by India with another country.

To clear the dense fog over the issue, a suitable amendment was recommended. The RDP now proposes to revert to the existing provisions of applying ‘the more beneficial provision’ out of the domestic tax law. However, it provides for specific three circumstances when a DTAA can be abrogated by the domestic tax law:
* Invocation of general anti-avoidance provision
* Applicability of CFC provision, and
* Levy of branch tax

Introduction of GAAR
In addition to certain Specific Anti-Avoidance Rules (SAAR) like transfer pricing, sale and lease back etc, the Code incorporated the GAAR provision which has the effect of invalidating an arrangement entered into by a taxpayer where the main objective is obtaining a tax benefit. To effectuate the GAAR, the tax authority is granted the power to adjust the assessment of the taxpayer so as to counteract the attendant tax advantage.

As per the discussion paper, the codification of GAAR is expected to combat tax avoidance arrangements. Since then GAAR was intensely debated for its advantages and disadvantages as it posed a danger of penalizing even genuine and bona fide commercial transaction, leaving a genuine tax payer at the prudence of the tax assessors.

It was suggested to strengthen GAAR and build in safeguards for the tax payers so that it achieves its intended objective of prevention of abusive tax avoidance arrangements without interfering with legitimate commercial transactions. It was recommended that GAAR should establish a workable distinction between legitimate tax planning and abusive tax avoidance.

Now the RDP has made an attempt to dilute the scope of GAAR by providing two deterrents. Firstly, by incorporating an additional condition which must be satisfied before invoking a GAAR. Besides obtaining tax benefit, a transaction has to satisfy one of the following conditions to be a tax avoidance arrangement:
* It is not at arm’s length
* It represents misuse or abuse of the Code
* It lacks commercial substance
* It is entered into or carried on in a manner not normally employed for bona fide business purposes

Secondly, by providing the following safeguards:
* Guidelines providing circumstances for invoking GAAR to be issued by CBDT
* A monetary threshold limit to be applicable
* Availability of Dispute Resolution Panel forum

The RDP seems promising and is a step in the right direction to set right certain aspects, which are absurd and raw in the Code.

The views expressed here are personal.

©Entrepreneur July 2010

Tags:
2009, Direct Tax Bill Code, tax, tax code