The tax stimulus

It is becoming increasingly clear that tax policy will pay a pivotal role in resuscitating the global economy, as we see governments across the world unveil streams of tax reforms to revive economic sentiment, stoke capital investments and aid job creation. Budget 2009 was presented against this backdrop.

The government acceded to the request of the export sector, and tax holiday benefits under Sections 10A and 10B of the Income Tax Act, 1961, which were set to expire on March 31, 2010, have been extended by a year. The Budget also seeks to amend and broaden the tax base on which units located in a Special Economic Zone (SEZ) are entitled to claim income tax holiday benefits. The much-awaited amendment to Section 10AA(7) of the Income Tax Act logically provides that profits of a SEZ unit are to be computed with respect to the proportion of its export as well as total turnover. This amendment would put STP and SEZ units at par with respect to the computation of exempt profits.

The Budget also seeks to spur research & development (R&D) activity in India. Section 35(2AB) of the Income Tax Act provides a weighted deduction of 150 per cent for expenditure incurred on in-house R&D in select manufacturing activities such as computers, telecom equipment, drugs, etc. The Budget proposes to extend this benefit to other sectors.

The Budget seeks to abolish the muchdespised Fringe Benefits Tax (FBT) regime. This meets a long-standing demand of industry, which perceived FBT as imposing a huge cost of tax compliance and collection, without proportionate results in terms of actual tax revenues. Taxation of ESOPs and specific employee benefits will now revert to the classical perquisites system.

The Budget proposes to increase the Minimum Alternate Tax (MAT)—introduced to ensure there is no total tax avoidance by firms— rate from 10 per cent to 15 per cent. While the MAT credit period has been extended to 10 years, the increase in the rate will impact the cash flows of the IT/ITES and infrastructure sectors.

The Budget has provided that LLPs would be taxed at par with partnership firms. This would mean that the LLPs will be taxed at an “entity” level and not be accorded a “pass-through” status. This may provide for tax planning opportunities such as mitigation of dividend distribution tax, and reduction of maximum marginal tax rate, while according benefits of limited liability.

Transfer Pricing—price at which merchandise is sold between related firms—has been a subject of much litigation since its inception in 2001-2002. The Budget seeks to amend provisions on the manner in which the arm’s length range— price charged by unrelated firms—needs to be determined. The Budget also proposes the introduction of “safe harbour” rules—that allow automatic acceptance of transfer pricing—to be introduced by the Central Board of Direct Taxes. In addition, the Budget provides for the creation of a Dispute Resolution Panel (DRP), which will review orders proposed to be passed by Assessing Officers. DRP’s directions will be binding on the Assessing Officers. These amendments are very welcome and likely to reduce the enormous volume of transfer pricing litigation and provide tax certainty to multinationals.

In summary, despite the burgeoning fiscal deficit, the decision of the government to keep most income tax rates stable reflects a pragmatic approach towards providing impetus to growth, and deferring fiscal consolidation to “better times”, consistent with the approach of most other countries. The commitment to introduce the new Direct Tax Code for public comments in the next 45 days also signifies the government’s vision to keep tax laws simple and, at an overall level, promote tax certainty and improve the quality of tax compliances.

—The author is Tax Partner & National Tax Director, Ernst & Young, India