The Hindu Business Line : What to look for in the Finance Bill

It is that time of the year when middleclass anxiously look forward to some tax relief. Direct taxes have touched 50 per cent of the tax revenues of the Central Government for the first time. India’s tax system can take pride in the fact that it is on a par with developed countries in the matter of spreading the tax burden on that section of the public which can afford to pay.

Indirect taxes can be shifted and the impact and incidence vary. This is not so, at least in theory, in the matter of income taxation. The progressive principle is built into the direct tax code to ensure that those with greater ability to pay share a higher burden.

Dividend Taxation

The above principle is seen to have been violated in the matter of taxation of dividends. For a long time, dividends were being taxed in the hands of the shareholders. The profits of the company are already taxed. To avoid this double taxation of the same profits, once in the hands of the company and again in the hand of the shareholders, dividends were exempted from taxation in the hands of the shareholders. Instead, a flat distribution tax of 12.5 per cent was levied on company profits paid out as dividends. Actually, it did not end the argument about double taxation. Companies receiving dividends from their investment in other companies can still complain about double taxation.

That apart, the promoter shareholders with huge investments in the companies were getting away paying no tax in their individual tax assessments on dividend running into crores of rupees. They are treated on a par with small shareholders receiving Rs 10,000 as dividends.

Is there equity in this system? These promoter-shareholders can manipulate their salary, allowances, sitting fees and other perquisites in the light of the heavy dividend payout so as to avoid paying the maximum marginal rate of 33 per cent tax on salary and other perquisites. There is no way by which the income-tax department can stop this manipulation. Is it possible to so organise the dividend distribution tax as to ensure a higher rate of tax on profits distributed to promotional shareholders?

A better idea may be to bring back the old Section 80L and limit the exemption for dividend income up to Rs 1 lakh and tax the excess. This may satisfy considerations of equity.

The FII tax regime

A problem requiring solution in the ensuing Finance Bill concerns the taxation of the income earned by foreign institutional investors (FIIs) from their stock market operations in India. The Authority for Advance Ruling (AAR) has handed over several judgments in this regard. It had pointed out in the Fidelity case that the Fidelity trust was registered with SEBI and that the frequency of purchase and sale was enormous.

The transaction in shares gave rise to business income and not dividend income. This meant that under the relevant Double Taxation Avoidance Agreement (DTAA), such income will be exempt depending on the availability or otherwise of Permanent Establishment (PE) in India.

In the Morgan Stanley case, the derivative contracts were examined and the view was expressed that derivative contracts gave rise to business income. Recently, a Bench of the Income Tax Appellate Tribunal (ITAT) expressed the same view about stock market operations from Mumbai entering into derivative contracts. Such contracts are new to India. Several aspects of derivative trading require clarification.

The Board issued Circular No. 4 of 2007 dated June 15, 2007, to resolve the issue of the nature of the income from the stock market earned by the FII. The matter has been left in doubt. Is the FII an investor or a trader? The answer is not easy to suggest.

Our scheduler system of taxation creates complication in fixing the total income. And when the law was amended to clarify that the DTAA provision will prevail over the sections in the income-tax law if those provisions are beneficial to the taxpayer, the problems were shifted from the interpretation of the income-tax law to an interpretation of the DTAA law.

Complexity of the Finance Bill

Every Finance Bill is loaded with a large number of amendments to the income-tax law. Between 1998 and 2007, the annual Finance Bills contained a total of 1,285 clauses, of which, 853 related to direct taxes. There are more amendments to the income-tax law than for the law relating to indirect taxes. Successive governments have not been able to resist the temptation of tinkering with tax law through frequent amendments to the Finance Bills.

The Finance Minister has announced that a new direct tax code will be in place within the next two years. Will it be too much to expect that Finance Bill, 2008 should contain minimum amendments to the income-tax law? After all, the new direct tax code can be expected to take care of the directions the tax policy should take henceforth.

(The author is a former Chief Commissioner of Income-Tax)