Amendments, Clarifications, controversies & Litigation of issues related to Section- 40 (a) (ia) of the Income Tax Act, 1961

ANUMITA SARKAR

Controversies evolving out of each amendment to section 40 (a) (ia) seem to have come to an end, thereby giving some sigh of relief to the assessees & their Tax Representatives, till the time it receives it’s final verdict from the highest judicial authority i.e. Supreme Court of India

IDEOLOGIES OF TAXATION:

Law of Taxation and changes incorporated by CBDT (Central Board of Direct Taxes) every year has turned out to be more complex and controversial for each passing years. It is a charging statute and levy of tax is separate on each of the individuals and the levy is governed by the Income Tax Act, 1961. The strategy of Taxation can be broadly classified upon considerations like raising revenue/funds, put a check upon consumption and use of articles. The main source of earning of revenue is by way of application of TDS provisions which is laid down by the statute in Chapter-XVII “COLLECTION & RECOVERY OF TAX”.

 

 LEGISTATIVE HISTORY OF THE PROVISIONS OF SECTION – 40 (a) (ia):

Sec- 40 is placed in Chapter- IV D. – Profits and gains of business or profession consists of sec-28 to sec- 44DA, dealing with the “Amounts not deductible” while computing the income under this head. For ready reference, sec- 40 is produced herein, –

“Amounts not deductible

40. Notwithstanding anything to the contrary in sections 30 to 38, the following amounts shall not be deducted in computing the income chargeable under the head “Profits and gains of business or profession”, —

(a) in the case of any assessee—

(i) any interest (not being interest on a loan issued for public subscription before the 1st day of April, 1938), royalty, fees for technical services or other sum chargeable under this Act, which is payable,—

(A) outside India; or

(B) in India to a non-resident, not being a company or to a foreign company, on which tax is deductible at source under Chapter XVII-B and such tax has not been deducted or, after deduction, has not been paid during the previous year, or in the Page 3 of 26subsequent year before the expiry of the time prescribed under sub-section (1) of section 200 :

Provided that where in respect of any such sum, tax has been deducted in any subsequent year or, has been deducted in the previous year but paid in any subsequent year after the expiry of the time prescribed under sub-section (1) of section 200, such sum shall be allowed as a deduction in computing the income of the previous year in which such tax has been paid.

Explanation. —For the purposes of this sub-clause, —

(A) “royalty” shall have the same meaning as in Explanation 2 to clause (vi) of subsection (1) of section 9;

(B) “fees for technical services” shall have the same meaning as in Explanation 2 to clause (vii) of sub-section (1) of section 9;

The statute clearly states that Section 40 deals with certain amounts, which will not qualify for deduction in computing the income chargeable to tax. Subsequent insertion of New Sub-Clause (ia) to Section 40 (a) by Finance (No. 2) Act, 2004 w.e.f. 01.04.2005 i.e. from A.Y. 2005-06 was made with a sole objective i.e. to ensure effective compliance with the provisions of TDS (Tax deduction at source).

What the statute reads:

Sec- 40 (a) (ia) reads,-

(ia) any interest, commission or brokerage, rent, royalty, fees for professional services or fees for technical services payable to a resident, or amounts payable to a contractor or sub-contractor, being resident, for carrying out any work (including supply of labour for carrying out any work), on which tax is deductible at source under Chapter XVII-B and such tax has not been deducted or, after deduction, has not been paid on or before the due date specified in sub-section (1) of section 139,—

 

Provided that where in respect of any such sum, tax has been deducted in any subsequent year, or has been deducted during the previous year but paid after the due date specified in sub-section (1) of section 139, such sum shall be allowed as a deduction in computing the income of the previous year in which such tax has been paid.”

Finance (No.2) Act, 2004 states that sec- 40 (a)(ia) would cover, –

 any payment made to a resident for any interest covered by Sections 193 and 194A;

 commission or brokerage covered by Section 194H;

 fees for professional or technical services covered by Section 194J and;

 payments to contractors or sub contractors covered by Section 194C (specified expenditure)

on which tax has not been deducted, or having been deducted, has not been paid any time during the previous year or in the subsequent year or before expiry of the time limit prescribed u/s 200(1), shall not qualify for deduction in computation of income chargeable to tax under the head “Profits & gains of business or profession”.

 

It has also provided that, if tax is deducted in any subsequent year, or has been deducted in the previous year but paid in the subsequent year after the expiry of the time limit prescribed u/s. 200(1), then such sum will be allowed as deduction in computing the income of the previous year in which the tax has been paid.

As regards payments to a non resident or a foreign company, the existing Section 40(a)(i) (upto A. Y. 2004-05) provides for disallowances in respect of any interest, royalty, fees for technical services or other sums chargeable under the Act, which are payable outside India or in India to any non resident or to a foreign company, where either tax is not deducted at source or, having deducted the tax, payment is not made before the expiry of time prescribed u/s 200(1).

 

OBJECTIVE BEHIND INCORPORATION OF SUB- CLAUSE (ia) to SECTION- 40 (a) (ia)

To bring harmony in between the treatments of payments to a non-resident/ foreign company with that of payments to a resident, Section 40(a)(i) is amended retrospectively w.e.f. A. Y. 2005-06. It has been provided that if the tax is deducted and paid within the same previous year, even if the payment is beyond the time prescribed u/s 200(1), the deduction will be allowed in the previous year. Similarly, if tax is deducted in the previous year, and payment is made in the subsequent year before the expiry of time prescribed u/s 200(1), the deduction will be allowed in the previous year. But, if the tax is deducted in the previous year, but paid in the subsequent year beyond the time limit prescribed u/s 200(1), then the sum would be allowable in the subsequent year.

 

AMENDMENTS TO SEC- 40 (a) (ia):

First Amendment to the provisions of sub-clause (ia) of clause (a) of section 40 of the Income-tax Act was brought in by the Finance Act, 2008.

As per the provisions of sub-clause (ia) of clause (a) of section 40, any interest, commission, brokerage, fees for professional services, fees for technical service payable to a resident, or amounts payable to a contractor or sub-contractor, being resident, for carrying out any work, rent and royalty on which tax is deductible at source and such tax has not been deducted or, after deduction, has not been paid during the previous year, or in the subsequent year before the expiry of the time prescribed under sub-section (1) of section 200 shall not be allowed as deduction. However, the sum is allowed as a deduction in the year of actual payment of the TDS.

To mitigate any hardship caused by the above provisions of section 40 while maintaining TDS discipline, the Act has amended provisions of sub-clause (ia) of clause (a) of section 40.

This amendment allows an additional time (till due date of filing of return of income) for deposit of TDS pertaining to deductions made for the month of March so that disallowance under sub-clause (ia) of clause (a) of section 40 is not attracted in such cases.

Fore example, if the last date for filing the return of income in case of a taxpayer (deductor) is 30th September, he would get an additional time of six months (i.e. from April to September) for depositing the tax deducted at source on an expenditure incurred or payment made in the month of March so as to escape disallowance under sub-clause (ia) of clause (a) of section 40.

The amendment brought in by this Finance Act, 2008 has been made applicable with retrospective effect from 1st April 2005 and shall accordingly apply to assessment year 2005-06 and subsequent to the said assessment year.

Thereafter, another amendment to sec- 40 (a) (ia) was brought in by the Finance Act, 2010 which was made applicable with retrospective effect, but from the 1st April 2010 i.e. in relation to the A.Y. 2010-11 and subsequent years.

The provision so amended, reads as under –

“(ia) any interest, commission or brokerage, rent, royalty, fees for professional services or fees for technical services payable to a resident, or amounts payable to a contractor or sub-contractor, being resident, for carrying out any work (including supply of labour for carrying out any work), on which tax is deductible at source under Chapter XVII-B and such tax has not been deducted or; after deduction, has not been paid on or before the due date specified in sub-section (1) of section 139 Provided that where in respect of any such sum, tax has been deducted in any subsequent year, or has been deducted during the previous year but paid after the due date specified in sub-section (1) of section 139, such sum shall be allowed as a deduction in computing the income of the previous year in which such tax has been paid.”

To discourage the practice of delaying the deposit of tax after deduction, a significant change was incorporated vide this amendment of Finance Act, 2010 i.e. the rate of interest for non-payment of tax after deduction has been increased from the present one percent (1%) to one-half percent (1 ½ %) for every month or part of month as per provisions of section- 201 (1A) of the Act.

This amendment has been made applicable w.e.f. 1st July 2010.

DIFFERENCE IN CHANGES BROUGHT IN SEC- 40 (a) (ia) by FINANCE ACT, 2008 & FINANCE ACT, 2010

As per Finance Act, 2008, causing disallowance on the basis of the period of the previous year during which tax was deductible. These two categories of disallowances: –

 includes the cases in which tax was deductible and was so deducted during the last month of the previous year but there was failure to pay such tax on or before the due date specified in sub-section (1) of section 139;

 includes cases where it requires deposit of tax before the close of the previous year upto 31st March in case of deduction during the first eleven months i.e. a pre-condition for the grant of deduction in the year of incurring expenditure has been eased by extending such time up to the date u/s. 139 (1) of the Act.

The position with reference to first category of cases was left untouched by the Finance Act, 2010, however, in case of the second portion, the only change that has been made by Finance Act, 2010 is that, the assessee deducting tax either in the last month of the previous year or first eleven months of the previous year shall be entitled to deduction of the expenditure incurred during the year, if the tax so deducted at source is paid on or before the due date u/s 139(1).

 

UNRESOLVED ISSUE RESOLVED BY FINANCE ACT 2012

Recently, Finance Act, 2012 has made some significant amendment in section- 40 (a) (ia), which may have definitely given some sigh of relief to the Tax Practitioners.

The objective behind the amendment brought in by the Finance Act, 2012, is to rationalize the provisions relating to TDS.

The Issue towards Short-Deduction of Tax seems to have eased out the situation.

The amendment to section- 40 (a) (ia) reads that, disallowance of business expenses payable to resident payee due to non-deduction of TDS will not be made if the payer is not considered as an “assessee in default” under first provision  to section 201(1) of the Income Tax Act.

The first proviso to section 201(1) states that, if a payer who fails to deduct TDS from the amount paid to a resident or on the amount credited to the account of a resident shall not be deemed to be an “assessee in default”, if such resident: (conditions)

(a) has furnished his return of income under section 139;

(b) has taken into account such sum for computing income in such return of income;

(c) has paid tax due on the income declared by him in such return of income and;

(d) if the tax payer furnishes a certificate to this effect from an accountant in such form as may be prescribed.

In such a case, it shall be deemed that the payer has deducted and paid the tax on the date of furnishing of return of income by the resident payee.

To obtain the benefit of amendment to section 40(a)(ia), the payer should not be an “assessee in default” as mentioned in proposed first proviso to section 201(1) and all the above conditions need to be fulfilled in order to avoid disallowance of expenses.

The amendment is effective from assessment year 2013-14.

CONSTITUIONAL VALIDITY OF THE SECTION- 40 (a)(ia) CHALLENGED BEFORE HIGH COURT

The challenge of the constitutionality of the said provision was raised before the Hon’ble Madras High Court in the case of Tube Investments of India v. Asstt. CIT [2009] 325 ITR 610, although the petition was rejected by the High Court. The petition is based on a very interesting ground wherein it was contended that, the effect of disallowance of the whole of expenditure under Section 40(a)(ia) for deduction of tax but when not paid as provided under the relevant rules, could be draconic and so harsh that it had to be held to be highly arbitrary and unreasonable and in violation of Article 14.

Looking at the practical aspect of the contention, it is pertinent to mention that, disallowance u/s. 40 (a)(ia) even if is made for the default committed in complying with the Tds provisions, the punishment is harsh in respect of the disallowing the entire expenditure that has actually being incurred during the previous year.

Hon’ble High Court of Madras has clarified by stating that,

“in the event of a reasonable doubt about the applicability of Chapter XVII-B, Section 40(a)(ia) cannot be invoked, would be stretching our jurisdiction beyond the permissible limit which cannot be done. In as much as we have reached a conclusion that the object sought to be achieved while enacting Section 40(a)(ia) was for augmenting the provision of TDS, with which object we do not find any impermissibility or lack of constitutionality and hence there is no scope for applying the doctrine of Reading Down to the said provision.”

Another issue that the petitioner had contended before Hon’ble High Court in this case was regarding the issue & controversy of “DOUBLE TAXATION”.

 

LANDMARK JUDGMENT BY HON’BLE SUPREME COURT IN HINDUSTAN COCA COLA BEVERAGE P. LTD. VS. COMMISSIONER OF INCOME TAX

The Apex Court held that, –

“the rigor of Section 40(a)(ia) is relaxed and thereby whatever tax liability created due to disallowance can be retrieved and thereby in the ultimate process, the collection of tax will be only that of the payee. It is a misnomer to call the process created under Section 40(a)(ia) as one resulting in Double Taxation.

Circular No.275/201/95- IT (B) dated 29.01.1997 issued by the CBDT, which specifically declares “no demand visualized under Section 201(1) of the Income Tax Act should be enforced after the tax deductor has satisfied the officer-in-charge of TDS, that taxes due have been paid by the deductee-assessee.

However, this will not alter the liability to charge interest under Section 201(1A) of the Act till the date of payment of taxes by the deductee-assessee or the liability for penalty under Section 271C of the Income Tax Act.” It was in the above stated legal position that decision came to be rendered by the Hon’ble Supreme Court.”

Hon’ble High Court strongly quoted in the case of Tube Investments of India v. Asstt. CIT that, the said decision has been rendered in the light of Sections 201(1) and 201(1A) could not have been made applied to a situation where Section 40(a)(ia) gets attracted, as both the provisions stands in different footing under different sets of circumstances.

 

CONTROVERSY & INTERPRETATION OF THE EXPRESSION ‘PAID’ & ‘PAYABLE’ IMLPLIED IN SECTION- 40 (a) (ia)

Section 40(a)(ia) creates a legal anomaly by virtue of which even the genuine and admissible expenses claimed by an assessee and when an assessee does not deduct TDS on such expenses the same are disallowed.

It was enacted for the purposes of augment of tax through the strict compliance of TDS provision in the light of furtherance to the said objective.

The issue that revolves around is in respect to the interpretation of the expression ‘paid’ & ‘payable’ implied in the section- 40 (a) (ia). The question is whether sec- 40 (a) (ia) would get attracted in the case when the amount is already being paid although the tax is not deducted or is not deposited after such deduction or not?

Several judicial Authorities have passed its decisions on this issue and ultimately Income Tax Appellate Tribunal Special Bench, Vishakhapatnam in the case M/s. Merilyn Shipping & Transports vs. ACIT has settled the issue by considering the majority view stating that, sec- 40 (a) (ia) of the Act is applicable only to such expenditures which are payable as on 31st March of every year and cannot be invoked to disallow the amounts which have already been paid during the previous year, without deducting tax at source.

 

AMENDMENT BY FINANCE ACT, 2010

WHETHER PROSPECTIVE OR RETROSPECTIVE ?

The amendment that has been brought by Finance Act, 2010 in the sec- 40 (a) (ia) states that, the due date of depositing the TDS for all the payments has been made as per Section 139(1) of the Act, i.e. before the due date for filing of the returns.

The question as to whether the Amendment by the Finance Act, 2010 shall be applicable with prospective or retrospective effect or not i.e. from 1.4.2005 came up for consideration before the Mumbai Special Bench Income Tax Appellate Tribunal in the case of Bharati Shipyard Ltd.

 

It was held that, the amendment made by the Finance Act, 2010 with a retrospective effect from assessment year 2010- 2011 cannot be held to be retrospective from assessment year 2005-2006.

The Special Bench held that the amendment brought in by the Finance Act, 2010 to section 40(a)(ia) w.e.f. 01.04.2010 is not remedial or curative in nature.

Finally, the matter came up before Hon’ble High Court Kolkata in the case of Commissioner of Income Tax vs. Virgin Creations, wherein it was held that, when a provision is inserted with an objective to make the provision workable, the same is required to be treated with retrospective operation.

Subsequently, Hon’ble ITAT Kolkata, Mumbai & Vizag Bench have taken similar views in several cases and thereby have provided a big sigh of relief to the assessee’s as well as to their Tax Representatives.

 

PERSONAL OBSERVATION & REMARKS:

 

The judicial decisions are based on the finding of the correct facts and circumstances supported by law. The issue of whether Sec- 40 (a) (ia) would be applicable with retrospective effect i.e. from A.Y. 2005-06 (inception of the provision) or not, has indeed made me confused.

Although for the time being the issue has been resolved by Calcutta High Court in the case of Commissioner of Income Tax vs. Virgin Creations, however, after careful observation of the Judgment passed by Hon’ble High Court, it is necessary to state the finding & observation of Hon’ble HC, –

 

“It is argued by Mr. Nizamuddin that this court needs to take decision as to whether section 40(A) (ia) is having retrospective operation or not.

 

The learned Tribunal on fact found that the assessee had deducted tax at source from the paid charges between the period April 1, 2005 and April 28, 2006 and the same were paid by the assessee in July and August 2006, i.e. well before the due date of filing of the return of income for the year under consideration. This factual position was undisputed.

 

Moreover, the Supreme Court, as has been recorded by the learned Tribunal, in the case of Allied Motors Pvt. Ltd. and also in the case of Alom Extrusions Ltd., has already decided that the aforesaid provision has retrospective application. Again, in the case reported in 82 ITR 570, the Supreme Court held that the provision, which has inserted the remedy to make the provision workable, requires to be treated with retrospective operation so that reasonable deduction can be given to the section as well.

 

In view of the authoritative pronouncement of the Supreme Court, this court cannot decide otherwise.”

Now, it is pertinent to state briefly the issue, which was adjudicated & decided in the case of Allied Motors Pvt. Ltd. (P) Ltd. vs. Commissioner of Income Tax by Hon’ble Supreme Court of India.

 

This is as follows: –

“The following question has been referred to us under Section 256(1): –

“Whether on the facts and in the circumstances of the case, the sales-tax collected by the assessee

and paid after the end of the relevant previous year but within the time allowed under the relevant sales-tax law is to be Income-Tax Act, 1961 while computing the business income of the said previous year “?

In this case, the deduction that was claimed by the assessee was disallowed by the Income-tax Officer under Section 43B of the Income-tax Act, 1961 which was inserted in the statute with effect from 1.4.1984.

Again in the case of Commissioner of Income Tax vs. Alom Extrusions Limited, the controversy, which was adjudicated and decided by Hon’ble Supreme Court of India was that, –

“whether omission [deletion] of the second proviso to Section 43-B of the Income Tax Act, 1961, by the Finance Act, 2003, operated with effect from 1st April, 2004, or whether it operated retrospectively with effect from 1st April, 1988?”

 

After careful observation of the judgment passed by Hon’ble High Court of Kolkata in the case of Virgin Creations read with the afore-mentioned Supreme Court judgments, it shall not be out of place to mention that, section- 40 (a) (ia) has indeed not been adjudicated by the Hon’ble Apex Court. The judgment that was passed by Hon’ble High Court that states, “has already decided that the aforesaid provision has retrospective application” is erroneous and is apparent from record, which require some serious review.

Direct Tax Code

Direct Tax Code vis-à-vis Income Tax Act,1961

Direct Tax:

Direct tax is the tax which is charged directly on the tax payer.  In other words direct tax is that tax that is deducted from one’s salary.

In the general sense, a direct tax is one paid directly to the government by the persons on whom it is imposed which is  accompanied by a tax return filed by the taxpayer). Examples include some income taxes, some corporate taxes, and transfer taxes such as estate (inheritance) tax and gift tax. Some commentators have argued that “a direct tax is one that cannot be shifted by the taxpayer to someone else, whereas an indirect tax can be.
Direct Taxation in India:

Direct taxation in India is governed by Income Tax Act, 1961 and  taken care by the Central Board of Direct Taxes (“CBDT”); it is a division of Department of revenue under Ministry of Finance. CBDT is governed by the Revenue Act, 1963. CBDT is given the authority to create and control direct taxes in India. The most important function of CBDT is to manage direct tax law followed by Income Tax department.
Under Income tax Act, 1961(“Act, 1961”), taxes are charged on the basis of residential status and not on the basis of citizenship. The assesses are charged based upon the following factors

  • Resident
  • Resident but not ordinary resident.
  • Non-resident.

Capital gains tax, personal income tax, tax on corporate income and tax incentives all come under the purview of direct tax.

An income tax is a tax levied on the income of individuals or businesses (corporations or other legal entities. When the tax is levied on the income of companies, it is often called a corporate tax, corporate income tax, or profit tax.

Direct Tax Code:

TheDirect Tax Code (“DTC”) is said to replace the existing Act in India. It is expected to be enforced from 2012. During the budget 2010 presentation, the finance minister Mr. Pranab Mukherjee reiterated his commitment to bringing into fore the new DTC into force from 1st of April, 2011, but same could not be fulfilled and now it will be applicable from 1st April, 2012.[1]

The draft DTC along with a Discussion Paper was released in August, 2009 for public comments. Since then, a number of valuable inputs on the proposals outlined in these documents have been received from a large number of organizations and individuals. These inputs have been examined and the major issues on which various stakeholders have given their views have been identified. This Revised Discussion Paper addresses these major issues. There are a number of other issues which have been raised in the public feedback, which, though not part of this Discussion Paper, will be considered while finalising the Bill for introduction in Parliament.

“The key objective underlying the proposed enactment of the DTC is to mitigate the uncertainty and complexity created by the existing patchwork of direct tax legislations and annual finance acts,”. “At the same time, the DTC has not lost sight of the need for flexibility and ensures that amendments – of tax rates, for instance – can be accommodated within the schedules to the DTC. While the DTC has proposed to lower corporate tax rates simultaneously it incorporates new provisions which will result in broadening the tax base,”.

One aim of the new tax code is to provide a system which takes into account the increase in cross-border mergers and acquisitions undertaken by Indian companies over the last few years. In addition, while lowering corporate tax rates, the DTC aims to remove the administrative burden on foreign companies and investors for whom the country is now a leading target for investment. By implementing the new code, the Government of India also intends to streamline and simplify legislation, as well as iron out many ambiguities in the current system[2].

The issues which this Revised Discussion Paper addresses are:

        i.            Residential status of foreign companies;

      ii.            Taxation of Companies;

    iii.            Minimum Alternate Tax;

    iv.            General anti avoidance Rules;

      v.            Double Taxation Avoidance Agreement;

    vi.            Branch Profit Tax;

  vii.            Royalties and Fees for Technical services;

  1. Controlled Foreign Companies;

    ix.            Wealth Tax.

Comparative Analysis of provisions :

1.     Residential status of foreign companies:

DTC discusses the test of residence of a person for tax purposes. The tax residence of companies (that is, where companies are established or carry on business) is usually based on either place of incorporation (legal seat), location of management (real seat) or a combination of the two. The DTC provides that a company incorporated in India will always be treated as resident in India. However, a company incorporated abroad (foreign company) can either be resident or non-resident in India. It has been proposed in the DTC that a foreign company will be treated as resident in India if, at any time in the financial year, the control and management of its affairs is situated „wholly or partly‟ in India (it need not be wholly situated in India, as at present).

Generally, the test of residence for foreign companies is the “place of effective management”or “place of central control and management”. At the same time, it is noted that the existing definition of residence of a company in the Act based on the control and management of its affairs being situated wholly in India is too high a threshold.  Place of effective management‟ is an internationally recognized concept for determination of residence of a company incorporated in a foreign jurisdiction.[3]

  • Act, 1961:

A company is said to be Resident in India only if, the company is controlled and managed wholly partly in India at any time during the said financial year[4].

  • DTC:

A company is said to be Resident in India if the place of effective management of company is in India. ‘Place of effective management of company’ means-

  • the place where the board of directors of the company or its executive directors, make their decisions; or
  • In a case where the board of directors perform their functions.”
  • Impact:

Such proposed change may create difficulties in implementation as their could be difference of opinion in regard to where is placed effective management

  1. Taxation of companies:

Under present legislation, the Domestic companies and Foreign companies are taxed at different rates, where there income exceeds 1 crore but DTC has proposed to make a uniformity in taxation of Domestic and Foreign companies at a same rate.

  • Act, 1961:

Under present law, Domestic companies are taxable @ 33.90% where income exceeds ` 1 crore and Foreign companies are taxable @ 42.33% where income exceeds ` 1 crore.

  • DTC

Under DTC, the proposal is to tax all companies including the foreign companies @ 30% and thus, to make a uniformity in taxation of companies.

  • Impact

Marginal relief for domestic companies.Welcome proposition for foreign companies- relief of about 13% on tax rates. However, profits of Indian branches of foreign companies will be subject to additional ‘Branch Profits Tax’ leviable @ 15%.

  1. Minimum Alternate tax:

The DTC has proposed a Minimum Alternate Tax (“MAT”) on companies calculated with reference to the “value of gross assets”. The economic rationale for the assets tax is that investors can expect ex-ante to earn a specified average rate of return on their assets, hence it provides an incentive for efficiency.Computation of MAT with reference to gross value of assets will require all companies to pay tax even if they are loss making companies or operating in a cyclical downturn[5]

  • Act, 1961:

Under present law, MAT rate is @ 19.93% (inclusive of surcharge and education cess) where income exceeds ` 1 crore. Tax credit for MAT paid is available for 10 years.

  • DTC:

Under DTC, MAT is proposed to be taxed @ 20% without any surcharge and education cess.Credit for MAT is proposed for 15 years.[6]

  • Impact:

After such proposed change MAT rate of tax increases slightly but Credit for MAT gets extended from 10 years to 15 years.

  1. General Anti Avoidance Rules (“GAAR”):

DTC deals with the provisions of the General Anti Avoidance Rule (GAAR). The harmful effects of tax avoidance on the tax base, on tax equity and on the compliance regime have been discussed at length. The need for general anti avoidance provisions instead of legislative amendments to deal with specific instance of tax avoidance has also been discussed. The GAAR provisions apply where a taxpayer has entered into an arrangement, the main purpose of which is to obtain a tax benefit and such arrangement is entered or carried on in a manner not normally employed for bona-fide business purposes or are not at arm‟s length or abuses the provisions of the DTC or lacks economic substance.

  • Act, 1961

There is no provision with respect to GAAR in the present law.

  • DTC

The following safeguards are also proposed for invoking GAAR provisions:-

  • The Central Board of Direct Taxes will issue guidelines to provide for the circumstances under which GAAR may be invoked.
  • GAAR provisions will be invoked only in respect of an arrangement where tax avoidance is beyond a specified threshold limit.
  • The forum of Dispute Resolution Panel (“DRP”) would be available where GAAR provisions are invoked.
  • Impact

Such proposed change can lead to harassment and hardship for taxpayers.

  1. 5.      DOUBLE TAXATION AVOIDANCE AGREEMENT (“DTAA”):

Under the current provisions of Act, 1961, the Domestic law and DTAA, the one which is more beneficial to taxpayer will apply But DTC provides that, DTAA will not have preferential status over the domestic law in the specified circumstances.

  • Act, 1961:

The current provisions of the Income-tax Act provide that between the domestic law and relevant DTAA, the one which is more beneficial to the taxpayer will apply. However, this is subject to specific exceptions e.g., the taxation of a foreign company at a rate higher than that of a domestic company is not considered as a less favourable charge in respect of the foreign company.

  • DTC:

It is proposed to provide that between the domestic law and relevant DTAA, the one which is more beneficial to the taxpayer shall apply. However, DTAA will not have preferential status over the domestic law in the following circumstances:-

  • when the General Anti Avoidance Rule is invoked, or
  • when Controlled Foreign Corporation provisions are invoked or
  • when Branch Profits Tax is levied. [7]
  • Impact:

This limited treaty override is in accordance with the internationally accepted principles. Since anti-avoidance rules are part of the domestic legislation and they are not addressed in tax treaties, such limited treaty override will not be in conflict with the DTAAs. Further this will not deprive any taxpayer of any intended tax benefit available under the DTAAs.

  1. Branch profit tax:

Under DTC additional levy of Branch Profit Tax (“BPT”) @ 15% is proposed. The same is to be levied on the total income for the financial year as reduced by the amount of income tax thereonForeign Companies liable to pay branch profit tax on total Income reduced by corporate tax.

  • Act, 1961

There is no provision with respect to BPT in the present law.

  • DTC

Under DTC, it is proposed to levy Additional branch profit tax @ 15% on all foreign companies having any form of PE in India.

  • Impact

This can have dampening effect on foreign trade transactions and volumes.

  1. Royalties and Fees for Technical services:

The ambit of fees for technical services (“FTS”) widened to include development & transfer of design, drawing , plan & software or similar services. The ambit of Royalty widened to include the consideration for use/right to use of transmission by satellite, cable, optic fibre, ship or aircraft and live coverage of any event

  • Act, 1961

Currently, royalty and FTS are taxable @ 10% on gross income for foreign companies[8]

  • DTC

Under DTC, Royalty and FTS proposed to be taxed @ 20% on gross income for foreign companies

  • Impact

Rate of tax on these income is proposed to be doubled. Can adversely affect import of technology in the country.

  1. Controlled foreign companies (“CFC”):

It is proposed to introduce Controlled Foreign Corporation provisions so as to provide that passive income earned by a foreign company which is controlled directly or indirectly by a resident in India, and where such income is not distributed to shareholders resulting in deferral of taxes, shall be deemed to have been distributed. Consequently, it would be taxable in India in the hands of resident shareholders as dividend received from the foreign company[9].

  • Act, 1961:

There are no rules concerning CFCs in the current legislation.

  • DTC:

CFC provisions have been introduced to tax passive income earned by a foreign company (controlled directly or indirectly by a resident in India).

Under proposed CFC rules, even income of such foreign companies not distributed to shareholders would be deemed to be distributed and consequently taxable in India in the hands of resident shareholders as dividend received from the foreign company.

  • Impact:

The proposal can affect outbound investments. There is no provision for getting credit for taxes paid abroad. This can result in double taxation.

  1. Wealth tax:

DTC deals with the levy of wealth tax. Under the DTC, wealth-tax will be payable by an individual, HUF and private discretionary trusts. It will be levied on net wealth on the valuation date i.e. the last day of the financial year. Net wealth is defined as assets chargeable to wealth-tax as reduced by the debt owed in respect of such assets. Assets chargeable to wealth-tax shall mean all assets, including financial assets and deemed assets, as reduced by exempted assets. Exempted assets include stock in trade, a single residential house or a plot of land etc. The net wealth of an individual or HUF in excess of Rupees fifty crore shall be chargeable to wealth-tax at the rate of 0.25 per cent. [10]

  • Act, 1961:

Wealth tax Act, 1957 is applicable but there is no wealth tax is levied on companies.

  • DTC:

Wealth tax is proposed on wealth exceeding ` 1 crore. Tax generally on non-productive assets. However value of equity in preference shares held by a resident in controlled foreign company will be liable to tax.

  • Impact:

Companies hitherto non-taxable will be taxable. Favourable aspect is that limit of ` 30 lakh gets extended to 100 lakh.

CONCLUSION:

Thus, it can be said that the key objective underlying the proposed enactment of the DTC is to mitigate the uncertainty and complexity created by the existing patchwork of direct tax legislations and annual finance acts,”.
One aim of the new tax code is to provide a system which takes into account the increase in cross-border mergers and acquisitions undertaken by Indian companies over the last few years. In addition, while lowering corporate tax rates, the DTC aims to remove the administrative burden on foreign companies and investors for whom the country is now a leading target for investment. By implementing the new code, the Government of India also intends to streamline and simplify legislation, as well as iron out many ambiguities in the current system.
However, the professional community is divided over the logic and scope of some of the Code’s provisions and some experts are anxious about the impact such legislation will have on business and investment activity. The need to maintain a balance between reaping tax rewards under the new legislation and maintaining the interest of businesses and investors is of utmost importance. There is some anxiety as to whether the DTC achieves this balance, especially given the Government of India’s reputation for enforcing tax legislation. “Since there is a direct correlation between taxation and economic growth, tax policies need to be directed so they achieve objectives such as increasing growth, savings and investments, consumption, and so on,”. “Although the goals of the DTC are laudable, some of the provisions raise concerns stemming largely from an unsatisfactory experience with the manner of enforcement of tax provisions at the field level.”



[2]http://www.financierworldwide.com/article.php?id=7632

[3]Revised discussion paper on DTC June 2010,  Central Board of Direct Taxes, Department of Revenue (Ministry of Finance)

 

[4]Section 6 of Income Tax Act, 1961

[5]Revised discussion paper on DTC June 2010,  Central Board of Direct Taxes, Department of Revenue (Ministry of Finance)

 

[6]Section 115 JB of Income tax act, 1961

[7]Revised discussion paper on DTC June 2010,  Central Board of Direct Taxes, Department of Revenue (Ministry of Finance)

 

[8]Section 115 A Income Tax Act, 1961

[9]Revised discussion paper on DTC June 2010,  Central Board of Direct Taxes, Department of Revenue (Ministry of Finance)

 

[10]Revised discussion paper on DTC June 2010,  Central Board of Direct Taxes, Department of Revenue (Ministry of Finance)

 

Demerger – An Analysis

DemergerDefinition and Meaning of Demerger:

Demerger is a form of corporate restructuring. One of the prime reasons why large corporate houses go in for demerger is to increase the role of specialisation in the particular segment. In case of large conglomerates, demerging entities often are the departments which are growing at an impressive rate and have substantial potential.

Demerger is the converse of a merger or acquisition. It describes a form of restructure in which shareholders or unit holders in the parent company gain direct ownership of the demerged entity or the subsidiary entity. Underlying ownership of the shares of the company/ trusts that formed part of the group does not change. The company or entity that ceases to own the entity is called the demerging entity. If the parent entity holds a majority stake in the demerged entity, the resulting company is referred to as the subsidiary.

Sections 391 to 394 of the Companies Act, 1956 deal, inter-alia with the reconstruction and amalgamation of companies or what is commonly referred to as “mergers”. The procedures contemplate an application by the company to the concerned High Court by way of a scheme of compromise or arrangement with its creditors or members or any class of its members. Such a Scheme is a viable option for the amalgamation of two or more Indian companies. Moreover, sections 391 to 394 of the Act envisage a “single window clearance” by providing a composite code for facilitating mergers and amalgamations which obviates the need for making multiple applications under the Act and ensures that the interested entities are not put through unnecessary and cumbersome procedures involving protracted consequences for implementing such schemes

Sec 390 – Interpretation of sections 391 and 393 (Companies Act, 1956).

[In sections 391 and 393,

(b) the expression “arrangement” includes a reorganisation of the share capital of the company by the consolidation of shares of different classes, or by the division of shares into shares of different classes or, by both those methods] ; and

Sub Section 19AA of Section 2 of Income Tax Act, 1961:

[(19AA) “demerger”, in relation to companies, means the transfer, pursuant to a scheme of arrangement under sections 391 to 394 of the Companies Act, 1956 (1 of 1956), by a demerged company of its one or more undertakings to any resulting company in such a manner that—

(i) all the property of the undertaking, being transferred by the demerged company, immediately before the demerger, becomes the property of the resulting company by virtue of the demerger;

(ii) all the liabilities relatable to the undertaking, being transferred by the demerged company, immediately before the demerger, become the liabilities of the resulting company by virtue of the demerger;

(iii) the property and the liabilities of the undertaking or undertakings being transferred by the demerged company are transferred at values appearing in its books of account immediately before the demerger;

(iv) the resulting company issues, in consideration of the demerger, its shares to the shareholders of the demerged company on a proportionate basis;

(v) the shareholders holding not less than three-fourths in value of the shares in the demerged company (other than shares already held therein immediately before the demerger, or by a nominee for, the resulting company or, its subsidiary) become share-holders of the resulting company or companies by virtue of the demerger,

otherwise than as a result of the acquisition of the property or assets of the demerged company or any undertaking thereof by the resulting company;

(vi) the transfer of the undertaking is on a going concern basis;

(vii) the demerger is in accordance with the conditions, if any, notified under sub-section (5) of section 72A by the Central Government in this behalf.

Explanation 1.—For the purposes of this clause, “undertaking” shall include any part of an undertaking, or a unit or division of an undertaking or a business activity taken as a whole, but does not include individual assets or liabilities or any combination thereof not constituting a business activity.

Explanation 2.—For the purposes of this clause, the liabilities referred to in sub-clause (ii), shall include—

(a) the liabilities which arise out of the activities or operations of the undertaking;

(b) the specific loans or borrowings (including debentures) raised, incurred and utilised solely for the activities or operations of the undertaking; and

(c) in cases, other than those referred to in clause (a) or clause (b), so much of the amounts of general or multipurpose borrowings, if any, of the demerged company as stand in the same proportion which the value of the assets transferred in a demerger bears to the total value of the assets of such demerged company immediately before the demerger.

Explanation 3.—For determining the value of the property referred to in sub-clause (iii), any change in the value of assets consequent to their revaluation shall be ignored.

Explanation 4.—For the purposes of this clause, the splitting up or the reconstruction of any authority or a body constituted or established under a Central, State or Provincial Act, or a local authority or a public sector company, into separate authorities or bodies or local authorities or companies, as the case may be, shall be deemed to be a demerger if such split up or reconstruction fulfils 81[such conditions as may be notified in the Official Gazette82, by the Central Government];

(19AAA) “demerged company” means the company whose undertaking is transferred, pursuant to a demerger, to a resulting company;]

Demerger of a company takes place when:

1. De-merger is essentially a scheme of arrangement under Section 391 to 394 of the Companies

Act, 1956 requiring approval by;

i. majority of shareholders holding shares representing three-fourths value in meeting convened for the purpose, and;

ii. sanction of High Court.

2. De-merger involves ‘transfer’ of one or more ‘undertakings’.

3. The transfer of ‘undertakings’ is by the demerged company, which is otherwise known as transferor company. The company to which the undertaking is transferred is known as resulting company which is otherwise known as ‘transferee company’.

Existing provisions relating to amalgamations of companies were rationalised and new ones relating to demerger of companies, or sale/transfer of business as a going concern through slump sales were introduced.

In demergers, tax benefits and concessions available to any undertaking are made available to the undertaking on its transfer to the resulting company. The condition regarding continuity of the same business for the allowability of loss to an assessee under Section 72 of the Income-Tax Act, 1961 was dispensed with. The accumulated losses and unabsorbed depreciation in a demerger is allowed to be carried forward by the resulting company if these are directly relatable to the undertaking proposed to be transferred. Where it is not possible to relate these to the undertaking, such losses and depreciation will be apportioned between the demerged company and the resulting company in proportion of the assets coming to the share of each as a result of demerger. Tax benefit to such business reorganisation is limited to transfer of specific assets, which would amount to sale of assets and not business reorganisation.

Demerger And Spin Off/Out:

Another term commonly associated with demerger is that of a ‘spin out’ or ‘spin off’.

Spin out refers to the process when a division of a company or organization becomes an independent business. The “spin-out” company takes assets, intellectual property, technology, and/or existing products from the parent organization. Shareholders of the parent company receive equivalent shares in the new company in order to compensate for the loss of equity in the original stocks; thus, as the moment of spin-off, the ownership of the original and spun-off companies are identical.

A demerger can take place through a spin out by distributed or transferring the shares in a subsidiary holding the business to company shareholders carrying out the demerger.The demerger can also occur by transferring the relevant business to a new company or business to which then that company’s shareholders are issued shares of.

Demerger also take place through the process of ‘decartelisation’, i.e the transition of a national economy from monopoly control by groups of large businesses, known as cartels, to a free market economy.

Demerged Company and Resulting Company – Meaning of

According to Sub-section (19AAA) of Section 2 of the Income-tax Act, 1961, “de-merged company” means the company whose undertaking is transferred, pursuant to a de-merger, to a resulting company.

According to Sub-section (41A) of Section 2 of the Income-tax Act, 1961 “resulting company” means one or more companies (including a wholly owned subsidiary thereof) to which the undertaking of the de-merged company is transferred in a demerger and, the resulting company in consideration of such transfer of undertaking, issues shares to the shareholders of the de-merged company and includes any authority or body or local authority or public sector company or a company established, constituted or formed as a result of demerger.

The definition of ‘resulting company’ has clearly brought out three important requirements while establishing its relationship with de-merging company. They are:

1. Consideration for transfer of undertaking would be by issue of shares only by resulting company. [Price Consideration]

2. Such consideration would be paid only to the shareholders of de-merged company.

3. Resulting company can also be a subsidiary company of a de-merged company.

Conclusion

It is now a just and proper statement to state that, demergers are a fairly common term involved with corporate restructuring nowadays. They provide an opportunity to create individual profit centres and investors in the company also benefit from the process as there is fresh valuation of the demerged entity which in turn often results in an increase in the share price. Demerger is often done with an eye to segregate, categorise and more importantly specialise a particular segment of a corporate entity.

However due to the creation of an altogether new business entity, the same requires prudence and astute decision making on the part of the investor.

The following are some of the important points and key notes that the investors must make and

take heed of in case of Demerger of a corporate restructuring:

Extent of separation

First, the activities separated at the time of demerger is a critical factor. It is important to remember that the overall size of the business entity and the extent of the profits that it makes is one important factor that determines the pricing of the newly-listed shares. Also, the future potential will determine the price impact after the demerger.

Identifying benefits

The key role for the investor is to identify an entity where the strong or profitable business remains. And then, look for the company which has a future potential.

Trading price

Demerger can lead to some immediate gains for the investors where the price of the separate entities shoots up. Too high a rise and one should immediately opt for the sell option. It is not uncommon to find valuations touch dizzying heights after a demerger and the benefits have to be booked.

Investor interest

There is often a high interest on a particular scrip, immediately after the demerger leading to a shooting up of the scrip. Following a thumb rule where the price of the scrip vis-a-vis actual valuation gives a fair idea about the extent of overvaluation or undervaluation taking place.

Limitations/Hindrances in the Current Legal Provisions Relating to Demerger:

Questionable re-structuring exercises are undertaken with a view to strip parent companies of

vital assets and defeat revenue. In the process, the parent company’s business is reduced to the minimum and no significant assets are left from which the I-T Department can recover its dues.

The parent company becomes a shell company though styling itself as a holding company.

When the amendments were made, the Central Government was able to prescribe guidelines or

conditions so as to ensure that the demergers were made for genuine business purposes. Section

281 of the I-T Act declares certain transfers to be void. But this applies where such transfers are

made during the pendency of any proceeding under the Act. It also does not apply to assets not

forming part of the stock-in trade of the business. It was not anticipated that the provisions would be abused not merely to take advantage of tax concessions but also to defeat legitimate tax revenues.

Asset-stripping is a favourite mechanism always used by errant taxpayers to defeat the Revenue. Such abuses have, however, not become widespread. Proper amendments should be made to the law to safeguard revenue.

The definition of demerger in Section 2 (19AA) requires fresh look. The property and liabilities of the undertaking being transferred by the demerged company, as per the definition, will be transferred at book value. Even a unit or a division or a business activity of an undertaking can be transferred. No doubt, all the property of the undertaking, including liabilities relatable to the undertaking being transferred by the demerged company, shall become the property and liabilities of the resulting company. But it is necessary to specifically lay down that demergers should not result in defeating the Revenue by way of transfer of assets.