Budget on the Anvil - Reforms for Capital Gains Tax Regime

This article has been co-authored by S. Krishnan (International Tax Consultant).

Taxation of capital gains is the most complex and confusing regime in India. The law has been amended multiple times creating a cacophony of rates and conditions. For instance, some specified categories of long-term capital assets get the benefit of cost inflation indexation whereby the base cost of the asset is increased by the ratio of inflation in the year of sale and purchase. Similarly, Securities Transaction Tax (STT) is payable only for some assets. If STT is not paid, the income tax rate increases.

An enormous amount of litigation has come by. This has also hurt capital raising leading to high cost of capital in India. Multiple amendments over the years without proper analysis has eroded the faith of investors, though in recent years grandfathering provisions have ensured some degree of stability.

The convoluted tax regime for Long Term Capital Gains (LTCG) of all capital assets is described below.

A. Defacto rules and exceptions for taxation of LTCG for Tax Residents in India.

1. Indexed cost of acquisition and indexed cost of improvement applies to all capital assets including capital indexed bonds issued by the Government and Sovereign Gold Bond issued by the Reserve Bank of India under the Sovereign Gold Bond Scheme, 2015. The intent of providing indexation benefit is to neutralize the impact of inflation, to the extent possible.

Exception:

Indexation benefit will not be applied in the computation of LTCG on transfer of

a. listed equity share in a company if STT has been paid on acquisition and transfer of such listed equity share (Sec 48 / Sec 112A);

b. a unit of equity mutual fund or a business trust if STT has been paid on transfer of such capital asset (Sec 48 / Sec 112A);

c. bond or debenture (Sec 48)

2. Income-tax rate on LTCG is 20% on all capital assets including securities denominated as a unit.

Exception:­­

Income-tax rate is 10% on

i. LTCG from the transfer of listed securities (other than a unit) and zero coupon bond, (no reference is made here to payment of STT) (Sec 112);

ii. LTCG exceeding Rs. 1 lakh, arising from the transfer of an equity share in a company or a unit of an equity oriented fund or a unit of a business trust, on which STT is payable. There is no income tax payable if the LTCG from these capital assets does not exceed Rs. 1 lakh (Sec 112A).

Transfers in both the above scenarios are not entitled to indexation benefit.

“Securities” include —

     (i) shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities of a like nature in or of any incorporated company or other body corporate;

     (ia) derivative;

     (ib) units or any other instrument issued by any collective investment scheme to the investors in such schemes;

     (ic) security receipt as defined in clause (zg) of section 2 of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002;

     (id) units or any other such instrument issued to the investors under any mutual fund scheme;

     (ii) Government securities;

     (iia) such other instruments as may be declared by the Central Government to be securities; and

     (iii) rights or interest in securities;

“Listed securities” means the securities which are listed on any recognised stock exchange in India;

3. Short Term Capital Gains (STCG) is charged to tax at normal rate of tax, which is determined on the basis of the total taxable income of the taxpayer.

Exception:­­

     Income-tax rate is 15% on STCG, arising from the transfer of an equity share in a company or a unit of an equity oriented fund or a unit of a business trust, on which STT is payable (Sec 111A).

4. Holding period for various capital assets:

“Short-term capital asset” means a capital asset held by an assessee for not more than 36 months immediately preceding the date of its transfer.

Exception:

a) in the case of a listed security (other than a unit) or a unit of an equity oriented fund or a zero coupon bond, the holding period is 12 months;

b) in the case of an unlisted share of a company or an immovable property, being land or building or both, the holding period is 24 months.

5. An individual or a HUF who is a tax resident in India, has the benefit of adjusting their capital gains (LTCG and STCG) against the basic exemption limit.

6. Under the present income-tax structure, income-tax is imposed on an individual’s total income at tax rates relevant to the slabs of income.

Surcharge is levied on the income-tax payable by the taxpayer. Surcharge is levied on income-tax at:

• 10% where total income exceeds Rs. 50 lakhs but does not exceed Rs. 1 crore.
• 15% where total income exceeds Rs. 1 crore but does not exceed Rs. 2 crores;
• 25% where specified income exceeds Rs. 2 crores but does not exceed Rs. 5 crores;
• 37% where specified income exceeds Rs. 5 crores.

Specified income – Total income excluding capital gains (both STCG and LTCG) arising from the transfer of an equity share in a company or a unit of an equity oriented fund or a unit of a business trust, on which STT is chargeable.

The Finance Minister had announced an enhanced surcharge of 25% and 37% under Finance (No.2) Act, 2019. It was later withdrawn on capital gains (both STCG and LTCG) arising from the transfer of an equity share in a company or a unit of an equity-oriented fund or a unit of a business trust on which STT is chargeable. The maximum surcharge chargeable on the capital gains from these securities is 15%.

Further, “Health and Education Cess” is levied at 4% on the aggregate of income-tax and surcharge.

The Marginal Tax Rate will be the aggregate of income-tax, surcharge and health and education cess payable at the highest rate, over the total taxable income. For instance, if the chargeable income tax rate is fixed at 15% and the highest surcharge on the base rate is 15%, then the marginal tax rate would be calculated as follows:

Taxable income – Rs. 100

Applicable income-tax rate – 15%

Income tax – 100 x 15% = Rs. 15.

Highest surcharge rate on income-tax – 15%

Income tax + surcharge = 15 + 15% on 15 = Rs. 17.25

Health and Education Cess – 4% on 17.25 = Re. 0.69

Marginal tax rate = 17.94/100 = 17.94% (@18%)

Existing Capital Gains Tax Structure for individual tax residents in India

The table below highlights the differences in the holding period, base income-tax rates and highest marginal tax rate for various types of capital assets, and the associated complexity for individual tax residents in India:

 Exemptions to avoid taxation of capital gains:

Taxpayers have the option of claiming exemption from paying LTCG tax on reinvesting the sale proceeds or LTCG in certain specified assets:

1. Section - 54 : LTCG arising on sale of a residential house in India is used to purchase or construct one residential house in India

Any LTCG, arising to an individual or an HUF, from the sale of a residential house (whether self-occupied or given on rent) shall be exempt from taxation to the extent the amount of LTCG is reinvested in the

1. purchase of one residential house in India within 1 year before or 2 years after the date of transfer of the original asset, or
2. construction of one residential house in India within a period of 3 years from the date of transfer of the original asset.

If the amount of the capital gain does not exceed Rs. 2 crores, the taxpayer may, at his option, purchase or construct two residential houses in India.

The amount of LTCG which is not used by the taxpayer for the purchase or construction of the new house before the date of furnishing of the Income Tax Return should be deposited by him under the Capital Gains Account Scheme, before the due date of furnishing the return.

If the purchased or constructed new residential house is transferred within 3 years from the date of its purchase or construction, for the computation of capital gains on the transfer of the new house, the cost of purchase or construction of the new house will be reduced by the amount of capital gains which was exempt on the transfer of the original asset.

2. Section - 54EC : Capital gain not to be charged on investment in certain bonds

LTCG arising from the transfer of land or building or both (original asset), shall be tax exempt if the taxpayer has within six months after the date of such transfer invested the whole of the LTCG in long term specified asset. If only a part of the LTCG arising from the transfer of the original asset is invested in the long-term specified asset, then the LTCG shall be tax exempt in the same proportion as the cost of acquisition of the long-term specified asset bears to the whole of the capital gain.

The investment made by the taxpayer in the long-term specified asset, from LTCG arising from transfer of one or more original assets, during the financial year in which the original asset or assets are transferred and in the subsequent financial year should not exceed fifty lakh rupees.

If the long term specified asset is transferred or converted into money at any time within five years from the date of its acquisition, the amount of capital gain which was exempt earlier, shall be deemed to be LTCG of the financial year in which the long term specified asset is transferred or converted into money.

“Long-term specified asset” for making any investment under this section on or after 1st April 2018, means any bond, redeemable after five years and issued on or after 1st April 2018 by the National Highways Authority of India or by the Rural Electrification Corporation Limited, or any other bond notified in the Official Gazette by the Central Government in this behalf.

3. Section - 54F : Capital gain on transfer of certain capital assets not to be charged in case of investment in a residential house.

LTCG arising to an individual or a HUF from the transfer of any long-term capital asset, not being a residential house (original asset) shall be tax exempt if the net consideration arising from the transfer is used fully to purchase within one year before or two years after the date on which the transfer took place, or has within three years after that date constructed, one residential house in India (new asset).

If the cost of the new asset is less than the net consideration in respect of the original asset, then the LTCG shall be tax exempt in the same proportion as the cost of the new asset bears to the net consideration.

The LTCG tax exemption will not apply if the taxpayer

(i) owns more than one residential house, other than the new asset, on the date of transfer of the original asset; or

(ii) purchases any residential house, other than the new asset, within a period of one year after the date of transfer of the original asset; or

(iii) constructs any residential house, other than the new asset, within a period of three years after the date of transfer of the original asset; and

the income from such residential house, other than the one residential house owned on the date of transfer of the original asset, is chargeable under the head “Income from house property”.

4. Section - 54GB : Capital gain on transfer of residential property not to be charged in certain cases

LTCG arising to a taxpayer from the transfer of a residential property (a house or a plot of land) owned by the taxpayer is tax exempt if the taxpayer, before the due date for furnishing of return of income under section 139 (1), utilises the entire net consideration for subscription in the equity shares of an “eligible start-up company” and the company has, within one year from the date of subscription in equity shares by the taxpayer, utilised this amount for purchase of a new asset.

If only a part of the net consideration is utilised for subscription in the equity shares of the eligible company, then the proportion of the exempt capital gain out of the total LTCG is the same proportion as the cost of the new asset bears to the net consideration. The provisions of this section shall not apply after 31st March 2022.

If the equity shares of the eligible company or the new asset acquired by the eligible company are sold or otherwise transferred within a period of 5 years from the date of their acquisition, the amount of capital gain exemption from the transfer of the residential property will be considered as the long-term capital gain of the taxpayer in the financial year in which such equity shares or such new asset is sold or otherwise transferred. This capital gain would be in addition to the taxation of capital gains on transfer of shares in the hands of the taxpayer or of the new asset for the eligible company, as the case may be. If a new asset being computer or computer software is sold or transferred by a technology driven start-up, the period of holding is 3 years instead of 5 years.

B. Taxation of Capital Gains for Non-residents Indians (NRIs).

1. “Non-resident Indian” means an individual, being a citizen of India or a person of Indian origin who is not a “resident”. A person shall be deemed to be of Indian origin if he, or either of his parents or any of his grand-parents, was born in undivided India.
2. A separate tax regime under Chapter XII comprising of sections 115C to 115-I is applicable to Non-resident Indians. They can choose to avail the benefit under this Chapter even after they become a tax resident in India. NRIs have the option to choose to be covered under the separate tax regime or the regular tax regime applicable to all assesses.
3. There is no separate tax regime for non-resident individuals who are not NRIs. They will be governed by the regular tax regime applicable to assessees in India unless something is carved out for them in a particular section of the Income-tax Act. For instance, there is a sub-section in Sec 112 for a non-resident (not being a company) or a foreign company which provides for taxation of LTCG from transfer of unlisted securities or shares of a company at the rate of 10% without neutralising the impact of foreign exchange fluctuations and without giving effect to indexation benefits.
4. Holding period for various capital assets:

In the case of a listed security (other than a unit) or a unit of an equity-oriented fund or a zero-coupon bond, the holding period is 12 months;

In the case of an unlisted share of a company or an immovable property, being land or building or both, the holding period is 24 months.

The holding period is 36 months for a unit of a debt oriented mutual fund, Gold mutual fund and Gold ETFs.

5. In the case of a non-resident assessee, capital gains arising from the transfer of shares in or debentures of an Indian company are computed by converting the cost of acquisition, expenditure incurred in connection with such transfer and the sale consideration into the same foreign currency as was initially utilized to purchase them. In summary, the capital gains are computed in foreign currency and reconverted into Indian currency. The intent behind this computation mechanism is to neutralize the impact of any foreign exchange fluctuations. The aforesaid manner of computation of capital gains will be applicable for every reinvestment thereafter in, and sale of shares in or debentures of an Indian company (Sec 48).
6. Indexation benefits do not apply to an NRI in the computation of LTCG

“Long-term capital gains” means income chargeable under the head “Capital gains” relating to a capital asset, being a foreign exchange asset which is not a short-term capital asset (Sec 115D).

“Foreign exchange asset” means any specified asset which the assessee has acquired or purchased with, or subscribed to in, convertible foreign exchange.

“Specified asset” means any of the following assets, namely :—

  (i) shares in an Indian company;

 (ii) debentures issued by an Indian company which is not a private company as defined in the Companies Act, 1956 (1 of 1956);

(iii) deposits with an Indian company which is not a private company as defined in the Companies Act, 1956 (1 of 1956);

(iv) any security of the Central Government;

(v) such other assets as the Central Government may specify in this behalf by notification in the Official Gazette.

Based on the above definition, indexation benefits can be availed by NRIs in the computation of LTCG on transfer of units of debt mutual funds, bonds, debentures issued by a private company and immovable property being land or building or both.

“Convertible foreign exchange” means foreign exchange which is for the time being treated by the RBI as convertible foreign exchange for the purposes of the FEMA Act, 1999 and any rules made thereunder.

       In addition, Indexation benefit will not be applied in the computation of LTCG on transfer of

a. a unit of equity mutual fund or a business trust if STT has been paid on transfer of such capital asset (Sec 48 / Sec 112A);

b. bond or debenture (Sec 48)

7. An NRI is liable to pay income tax at the rate of 10% on LTCG (as defined in Sec 115D, above).

In addition, a non-resident (not being a company) or a foreign company is liable to pay income tax at 10% on LTCG arising from the transfer of

1. unlisted securities or shares of a company not being a company in which the public are substantially interested, without neutralising the impact of foreign exchange fluctuations and without giving effect to indexation benefits (Sec 112),
2. listed securities (other than a unit). No reference to payment of STT is made here, or
3. zero coupon bond. No reference to payment of STT is made here (Sec 112).

Indexation benefit will not apply in all the above scenarios.

STCG on transfer of the above securities will be taxed at regular income-tax rates applicable to various individual tax payers and at 40% for foreign companies.

     “Securities” include —

     (i) shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities of a like nature in or of any incorporated company or other body corporate;

     (ia) derivative;

     (ib) units or any other instrument issued by any collective investment scheme to the investors in such schemes;

     (ic) security receipt as defined in clause (zg) of section 2 of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002;

     (id) units or any other such instrument issued to the investors under any mutual fund scheme;

     (ii) Government securities;

     (iia) such other instruments as may be declared by the Central Government to be securities; and

     (iii) rights or interest in securities;

     “Listed securities” means the securities which are listed on any recognised stock exchange in India;

8. A non-resident (not being a company) or a foreign company is liable to pay income tax at 10% on LTCG exceeding Rs. 1 lakh, arising from the transfer of

• an equity share in a company on which STT has been paid on acquisition and transfer of such equity share (Sec 112A);
• a unit of equity mutual fund or a business trust on which STT has been paid on transfer of such capital asset (Sec 112A);

Indexation benefit will not apply in both the above scenarios.

STCG on the above securities will be taxable at 15% (Sec 111A).

The enhanced surcharge of 25% and 37.5% shall not be levied on capital gains derived from the sale of the above securities. The highest surcharge rate will be 15%.

            TDS at the rate of 15% is applicable on STCG and 10% on LTCG.

9. A non-resident including NRI is liable to pay income tax at 10% (without indexation benefit and computed in Indian currency) on LTCG from the transfer of a unit of an unlisted debt oriented mutual fund.

STCG on transfer of a unit of a debt mutual fund will be taxed at regular income-tax rates applicable to various individual tax payers and at 40% for foreign companies.

The holding period for a unit of a debt oriented mutual fund is 36 months.

10. Surcharge and Health cess will be charged on all the above income tax rates. The maximum surcharge chargeable on the capital gains (both STCG and LTCG) arising from the transfer of an equity share in a company or a unit of an equity oriented fund or a unit of a business trust on which STT is chargeable is 15%.

11. NRIs do not have benefit of adjusting their capital gains against the basic exemption limit.

12. If the gross total income of an NRI consists only of investment income or LTCGs or both, no deduction under Chapter VI-A is allowed to the NRI. However, deduction under Chapter VI-A is allowed on all income other than investment income and LTCG (Sec 115D). “Investment income” means any income derived from a foreign exchange asset.”

13. Transfers made outside India by a non-resident to another non-resident, of a capital asset being bonds, Global Depository Receipts, rupee denominated bond of an Indian company, derivates or such other securities as notified by the Central Government, shall not be treated as transfer for calculating capital gains in India.

14. Any redemption made by a non-resident is subject to TDS at the highest tax rates. For any STCG on unlisted securities, the TDS will be at the highest tax slab rate, i.e. 30%. 

15. Any gains arising to a non-resident on account of appreciation of rupee against a foreign currency at the time of redemptio­n of rupee denominated bond of an Indian company held by him, shall be ignored for the purposes of computation of full value of consideration (Sec 48).

16. Capital gains exemption on reinvestment

If any LTCGs arise to an NRI from the transfer of a foreign exchange asset (referred to as the original asset), and if the whole or any part of the net consideration from such transfer is invested within 6 months from the date of such transfer in any specified asset or in any savings certificates referred to in sec 10(4B) (referred to as the new asset), the LTCG shall be dealt with as follows:

(a) if the cost of the new asset is not less than the net consideration in respect of the original asset, the whole of such LTCG shall be tax exempt;

(b) if the cost of the new asset is less than the net consideration in respect of the original asset, the LTCG shall be tax exempt in the same proportion as the cost of acquisition of the new asset bears to the net consideration received.

If the new asset is transferred or converted into money within 3 years from the date of its acquisition, the amount of tax exempt capital gain arising from the transfer of the original asset shall be deemed to be income chargeable under as LTCG of the previous year in which the new asset is transferred or converted into money.

Existing Capital Gains Tax Structure for NRIs

The table below indicates the current capital gains tax impact in India on transfer of all capital assets of an NRI:

Need for reforms in taxation of capital gains taxation:

There is a dire need to reform the entire gamut of capital gains tax on securities and real assets in order to simplify the tax regime, ensure uniformity across asset classes, increase tax collection, improve compliance, reduce litigation and create an overall tax regime which fosters greater investment and therefore creates more jobs for the country. Reforms of taxation of capital gains would enable investors to invest in various assets after considering the risk and return rather than tax consequences.

Our recommendation for capital gains tax reform is provided below.

1.   The Government of India should introduce a separate LTCG tax regime for all financial securities whether listed or unlisted, such as

     (i) shares, scrips, stocks, bonds, debentures, debenture stock or other marketable securities of a like nature in or of any incorporated company or other body corporate;

     (ia) units or any other instrument issued by any collective investment scheme to the investors in such schemes;

     (ib) security receipt as defined in clause (zg) of section 2 of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002;

     (ic) units or any other such instrument issued to the investors under any mutual fund scheme;

     (ii) Government securities;

     (iia) such other instruments as may be declared by the Central Government to be securities; and

     (iii) rights or interest in securities;

2. The period of holding to qualify as a long-term capital asset should continue to be 12 months for all securities listed on a recognized stock exchange in India (listed securities) including a unit of the Unit Trust of India established under the Unit Trust of India Act, 1963 or a unit of an equity or debt-oriented fund or a zero-coupon bond.

3. The period of holding to qualify as a long-term capital asset should be 24 months for all securities not listed in a recognized stock exchange in India (unlisted securities).

Consequently, the period of holding for a unit of a debt oriented mutual fund will be reduced to 24 months from 36 months if they are considered under unlisted securities and 12 months if they are listed on a stock exchange in India.

4. The holding period to qualify as a long-term capital asset for real assets such as immovable property being land or building should continue to be 24 months.

5. Gold is an asset class which can be held in physical form or in digital form. Physical gold includes gold bars, coins, jewellery including ornaments made of gold, silver, platinum, etc., whereas Digital gold comprises of investments through gold mutual funds, gold ETF and Sovereign Gold Bonds.

The holding period to qualify as a long-term capital asset for investments in physical gold should be reduced to 24 months from 36 months.

Investments in digital gold should be treated as investments in a listed security in order to incentivize the shift to digital gold. Consequently, the holding period of investments in digital gold will be 12 months.

6. No indexation benefits should apply to all financial securities, whether listed or unlisted.

Shareholders of unlisted companies should be allowed to avail indexation benefits for FY 2017-18 for grandfathering tax exemption.

Indexation benefits should continue to apply to real assets such as land or building and to holdings in physical gold.

7. The LTCG tax rate should continue to be 10% for all listed securities or zero-coupon bond or a unit of an equity-oriented fund or a unit of a business trust or investments in digital gold.

The present LTCG tax exemption of Rs. 1 lakh should be extended to all listed securities in order to incentivise small savers.

The LTCG arising from transfer of equity shares, units of equity-oriented mutual funds, units of a business trust accruing as on 31st January 2018 should continue to be grandfathered for tax exemption, as under the present regulations.

The actual cost of acquisition or the fair market value of these securities as on 31st January 2018 should be considered as the cost of acquisition. However, to avoid an arbitrary loss situation, if the actual sale consideration is lower than the fair market value as on 31st January 2018, the cost of acquisition would be either the actual sale consideration or actual cost, whichever is higher.

8. The LTCG tax rate for all unlisted securities should be 11%, to make up for the loss in non-collection of STT and to equate both.

9. The LTCG tax rate should be 20% after considering indexation benefits or 15% with no indexation benefits for immovable property being land or building, and physical gold. Investments in digital gold will qualify as a listed security and hence the tax regime applicable to listed securities would apply.

All LTCG exemptions presently provided on reinvestment of LTCG/sale consideration should be withdrawn so that taxpayers determine their reinvestment based on risk and return and not on tax exemption of capital gains.

10. The STCG tax rate for all securities (listed or unlisted) including units of equity mutual funds, debt mutual funds and business trust, zero coupon bonds and digital gold should be 15%.

11. STCG from real capital assets such as land or building and physical gold should be added to the taxpayer’s taxable income which will be taxed at income-tax rates applicable to the taxpayer’s taxable income.

12. The surcharge payable on all capital gains (both LTCG and STCG) from transfer of securities (listed and unlisted), digital and physical gold, and real assets should be limited to 15%.

13. Need to abolish Buy-back tax

Companies that have a distributable surplus have an option to distribute the surplus through dividends or buy-back of shares.

When a company purchases its shares from its shareholders, it is buy back of shares. Buy-backs are implemented either through the tender route or open-market purchases. Under the tender route, the company buys back the shares directly from its shareholders on a proportionate basis. Under the open market purchases, the company generally purchases the shares through a stock exchange during a defined time period.

The Finance Act 1997 introduced Dividend Distribution Tax (DDT) at the rate of 10% to be paid by companies on payment of dividends and removed the taxation of dividends in the hands of shareholders. The computation process and the DDT rate were subsequently revised. When many unlisted companies resorted to buy-back of shares to avoid payment of DDT, the Finance Act, 2013 plugged the loophole by introducing buy-back tax as an anti-tax avoidance measure. Unlisted companies were required to pay buy-back tax at 20% (plus surcharge and health and education cess) on the ‘distributed income’, which is net consideration paid by the company on buy-back of its shares after reducing the amount received by it for issue of such shares. Consequently, unlisted companies had to either pay DDT on payment of dividends or buy-back tax on buy-back of shares. Shareholders were exempt from taxation on any income arising on account of dividends or buy-back of shares.

The buy-back tax was extended to listed companies from 5th July 2019. Listed and unlisted companies are now required to pay buy-back tax at 20% plus surcharge at 12% plus health and education cess at 4%, aggregating to 23.30% of the ‘distributed income’. Any income arising to a shareholder on account of buy-back of shares is exempt from tax.

DDT was abolished from 1st April 2020 and a withholding tax was introduced on the payment of dividends by companies. Consequently, shareholders are now required to pay income-tax on dividend income according to the income-tax rates applicable to them. This creates an anomaly. When companies pay dividends, there is no tax impact on them since DDT is withdrawn whereas when the same reserves are used to buy-back shares, companies are required to pay buy-back tax.

There is anonymity of selling shareholders in case of open market purchases. Shareholders sell shares in the open market and the company buys its shares in the open market. There is no linking between the two. Consequently, shareholders pay capital gains tax on sale of shares and companies pay buy-back tax on the same transaction, leading to double taxation.

We recommend that buy-back tax should be withdrawn, similar to the withdrawal of DDT. Shareholders tendering shares under the tender route should be made liable to pay capital gains tax. Consequently, shareholders will be liable to pay either income-tax on dividend income or capital gains tax on buy-back of shares.

Listed and unlisted companies now are not required to pay DDT on payment of dividends. Buy-back tax should not be imposed on them on buy-back of shares under any route. When companies buy-back shares through the stock exchanges under an open-market route, selling shareholders are anyway required to pay capital gains tax. So, there is no need for listed and unlisted companies to pay buy-back tax. This will simplify taxation.

Recommended reforms in capital gains taxation

The table below highlights the tax impact for various types of assets under the recommended method:

Transfer Pricing and Union Budget 2022-23 – The expectations continue galore

This article has been co-authored by Adarsh Rathi (Director- Transfer Pricing, Nangia Andersen India).

It’s Budget time again and we can already smell some amendments in the air. While we are yet to complete the compliance cycle for the previous year (FY 2020-21), we are already looking at Union Budget 2022-23 which will provide the road map for the next year.  Such is the state of the Government also, which has been juggling many things together. The current financial year (FY 2021-22) started with the second wave and is likely to end with the third wave of COVID-19 pandemic impact, so the Government has to deal with frequent partial lockdowns, trying to get the economy back on track, accelerating the vaccination drives and now booster doses, thrust on infrastructure development with PM GatiShakti plan, and not to forget the impact of world economic and political issues on the Indian economy.   

Although, the Indian government is making considerable efforts to counter the downturn in the economy, the Union Budget 2022-23 would be as vexed as the last budget, as the expectation galore from all corners. Not to be left behind, we have a bucket full of expectation from transfer pricing (TP) perspective as well. In this article, we would like to focus on the recommendations from TP perspective, to align to the global best practices, certain policy level initiatives which could be undertaken and some suggestions to ease out practical challenges faced by the taxpayers.

In the past year, everyone was eagerly waiting for the Supreme Court ruling on the issue of marketing intangible but that did not happen. Though in India there were not many changes on the TP front, on the global side we witnessed some world-wide initiatives by Organisation for Economic Co-operation and Development (OECD), under the Base Erosion and Profit Shifting (BEPS) Project action plan. In the last year, OECD introduced Pillar One and Pillar Two approaches, designed to provide foundation for future agreements across jurisdictions. While Pillar One aimed to update existing international tax framework with new “nexus” concept and new profit allocation rules; Pillar Two aimed to address remaining BEPS challenges by introducing new “global minimum tax rule”.

Let us now look at some of the items in the TP bucket:

1. The interquartile range concept – 25th-75th percentile v. 35th-65th percentile

While India is keenly looking at OECD’s future initiatives and has adopted some its approaches in the past, however, to align ourselves with the global standard, we may have to look at some finer aspects as well. One such aspect is the inter-quartile range. Currently, under the range concept provided in Rule 10CA of the Income Tax Rules, 1962 (the Rules) for determination of arm’s length price (ALP), use of 35th to 65th percentile has been notified by the Central Board of Direct Taxes (CBDT), in case of 6 or more comparables. However, if the comparables are less than 6, then we fall back to the use of arithmetic mean (AM) along with the tolerance range. However, world over the range concept under interquartile range is between 25th - 75th percentile, in order to use the better representative of the sample population of the comparables considered. With the databases now being matured and over 20 years of TP regime in the Country, its time to adopt the range of 25th - 75th percentile.

2. Arithmetic mean (AM) & Tolerance Range band

AM is not used anywhere else in the world, as it is not the best measure of central tendency and shows distorted results which are easily influenced by extreme values or with more dispersed (volatile) data sets. Even if, AM is to be continued with for any reason, then it may be worthwhile to restore the +/-5% tolerance band than using the +/-3% or +/-1%, to allow some flexibility to the businesses.

3. Section 92E of the Act – Accountant Report (AR) in Form 3CEB for foreign entities

It is suggested that the CBDT should clear the ambiguity surrounding the issue around undertaking TP compliances by a to foreign company when there is no requirement to file any ITR.

4. Block TP audits

In line with the global best practices followed by many developed countries such as US, Germany, Australia, and many other European countries (as we witness in their specific jurisdictional TP case laws as well), it is suggested that block assessment of 3-5 years should be considered for TP, as the issues involved are mostly cyclical in nature and carrying out a separate assessment for each and every year results in unnecessary duplication/ investment of valuable resources of the taxpayer as well as the tax department. If under Advance Pricing Agreement (APA) regime, a resolution for 9 years can be reached then certainly block audits for TP can certainly be made possible. Though, this may conflict with the circular restricting the TP cases to risk-based assessment from value-based assessment, suitable amendments may be required there too.

5. One-time Settlement/ Amnesty scheme for past years

For the TP cases, say wherein a Mutual Agreement Procedure (MAP) application could not be filed in the past years since India’s position on acceptance of MAP cases in absence of Article 9(2) [correlative adjustment] in Double Tax Avoidance Agreements (DTAA) with countries such as Germany, South Korea, Singapore, etc. got clarified by CBDT in November 2017, a one-time settlement scheme could be announced for such Taxpayers. Though Vivad Se Vishwas (VsV) Scheme was implemented but since was a unilateral scheme and the merits were not considered, a settlement option having a consultative process would be a better option.

6. Litigation proceedings under Dispute Resolution Panel (DRP) and Commissioner Income Tax (Appeals) (CIT-A)

The CBDT could consider enhancing the powers of DRP and CIT-A to waive penalties and settle disputes with appropriate approvals from CBDT. If the amnesty under VsV Scheme was a success, then why not take a leaf from that book and write a new chapter in the powers of DRP and CIT(A). This would help save time and efforts of the judiciary machinery.

7. Promoting alternate dispute resolution mechanism under Safe Harbor Rules (SHR)

SHR has always been that abandoned child who has the potential to achieve much more if it is given proper direction and support. Looking at its SWOT analysis – Strengths: maximum reach with minimal efforts; Weakness: the rates in the provision are not closer to the ground reality, has limited applicability/ transactions in the ambit, the rates are announced post the end of the year and not being marketed well; Opportunities: it would be small price to pay in exchange for a predictable and definite solution, which would also curb litigation and can be afforded by those who cannot afford the extensive APA regimes. Threats: If litigation rises in applications under SHR, then these would be very vexed and protracted.

The CBDT may consider making the following changes to make SHR more attractive - consider having rationalized rates, increase applicability, announce the rates at the beginning of the year instead of announcing post the year end and make rules less cumbersome.

8. Multiple years’ vs Single year’s data

In order to even out the comparison between the data being considered for the tested party and the comparable companies, it is recommended to follow comparison of either latest three-year weighted average margins earned by the taxpayer with a similar three-year weighted average margin of comparables’ or single year’s data to be considered in case of both the taxpayer as well as the comparables. The catch-up at the time of audit creates unnecessary hurdles and renders the TP documentation inconsequential on the number crunching.  In the event, multiple year data is considered for Taxpayers, then implementation of block assessment period (as mentioned above) will also get aligned and easily implementable.

9. Due date of filing of AR in Form 3CEB

The due date of filing of the AR should be made along with the Income Tax Return (ITR) instead of the recent change of filing it one month prior to the ITR, so that the positions to be adopted in case of both the AR and ITR could be considered in tandem. Both the compliances are inter-related, especially for Foreign Entity (including Permanent Establishment) compliances.  

10. Section 94B of the Act - Limitation on interest deduction, during the pandemic period

Considering major economies are going through recession/ slowdown due to the pandemic, many entities including the ones with low capital base are facing the liquidity crunch. Given the downgraded credit rating of such entities, it becomes tough to borrow from the financial institutions, thus, the businesses to keep themselves afloat, would either avail funds through intragroup financing or through a guarantee provided by the Overseas Parent entity. To ensure no hardships due to the pandemic, it may be worthwhile to contemplate enhancing the applicability limit of Section 94B of the Act from existing INR 1 crore to provide adequate relief to the taxpayers in the admission of deductible interest expense on such intra-group loan availed and keep the loan backed by guarantee (both implicit and explicit) outside the purview of Section 94B of the Act.

11. Section 92CE of the Act - Secondary adjustment requires moderation

The secondary adjustment provisions were introduced vide Finance Act, 2017 implying adjustment in the books of account of the taxpayer and its associated enterprise (AE) to reflect the actual allocation of profits between the taxpayer and its AE in line with the ALP, determined as a result of the primary adjustment(s) exceeding INR 1 crores. Considering the current pandemic situation, the authorities should contemplate for upward revision of the said existing threshold of INR 1 crore provided in Section 92CE of the Act.

Further, even though CBDT issued notification dated 30 September 2019 clarifying the period for cash repatriation post APA and MAP conclusion, however, it is recommended that the secondary adjustment provisions should not be applicable in the first place on the dispute resolution programs, i.e., APA, MAP and Safe Harbour. If the settlement has already been provided by the Department, then there should be no further grievance or demands on their part at least. Even if the secondary adjustment is to be persisted with in such situations, then CDBT must look at increasing the threshold limit from INR 1 crore.  

12. Associated enterprise under Section 92A(2)(c) of the Act, needs revision

According to Section 92A(2)(c) of the Act, two enterprises shall be deemed to be AEs if, at any time during the previous year a loan advanced by one enterprise to the other enterprise constitutes not less than fifty-one percent of the book value of the total assets of the other enterprise.

Under the above provisions, an exception needs to be carved out for loans advanced by banks/ Non-Banking Financial Corporations (NBFCs) since such enterprises are into the business of lending funds and this creates undue issues/ challenges for small and medium enterprises not having sizable assets, particularly during COVID-19 times.

13. Revision of threshold limits and compliance for Master File (MF) to ease compliance burden

The threshold limit for MF should be enhanced to almost double from the existing threshold of Consolidated Group Revenue greater than INR 500 crores, to reduce the compliance burden on small and medium enterprises in India. In the last year, the threshold for Country-by-Country Report (CbCR) was revised upward, but the threshold for MF remained unchanged. 

Additionally, MF requirements should only be made applicable to constituent entities resident in India and should not be applicable for the non-resident or the foreign entities in order to reduce the unnecessary compliance burden on the non-resident entities. They would be undertaking such compliances in their respective jurisdictions, so the duplicative efforts should be avoided.

Concluding Thoughts

When the Union Budget for 2021-22 was being presented, the vaccine for Covid-19 was being rolled out in the Country. Now, when it is time for Union Budget 2022-23, the booster doses and vaccine for age group of 15-18 is being administered. Such has been the case of the economy which has to move from being stable to taking the booster dose and adopt the progressive path again. Thus, the budget must be well balanced and as we say in the financial markets’ terminology, the plan should be 50% equity and 50% debt to ensure both stability and progressive initiatives.  

Since being promulgated Vide Finance Act, 2001, as a binding statutory framework, the TP legislature in India has constantly evolved over the years keeping pace with the international best practices/ global developments. Considering the thrust is to make the Indian TP regime as aligned to the globally accepted and followed legislature, it would be prudent to adopt some of the suggested measures. It would be worthwhile to see which recommendation related to the TP wish list finds its way in the final prints, but as we have seen in the recent past, the flurry of notifications and amendments by CBDT do not wait for the forum called “The Union Budget”, to come out with the changes.

Make in India’ Booster – Extending Deadline for 15% Corporate Tax Rate

This article has been co-authored by Chirag Chordia (Globeview Advisors LLP, India).

In September 2019, the finance minister announced a historic corporate income tax cut from 30% to 22% for domestic companies. In addition, with an intent to attract new manufacturing investment and boost the 'Make-in-India' initiative, the lowest ever 15% corporate tax rate was also announced from FY 2019-20 onwards.

The “Statement of Objects and Reasons” moved by the Finance Minister while explaining the rationale for the change mentions that:

“It was also noticed that many countries, the world over, had reduced corporate income-tax to attract investment and create employment opportunities, thus, necessitating the need of similar measures in the form of reduction of corporate income-tax payable by domestic companies in order to make Indian industry more competitive. Therefore, it was felt that a fiscal stimulus through reduction of corporate income tax rate of domestic companies may be provided so as to attract the investment, generate employment and boost the economy of the country”.

Any new domestic company incorporated on or after 1st October 2019 making fresh investment in manufacturing and commencing their production latest by 31st March 2023 now has an option to pay tax at 15% rate under section 115BAB. This benefit is available to companies that do not avail of any other exemptions/incentives. Additionally, such companies are exempt from Minimum Alternate Tax provisions. After including surcharge and cess, the effective tax rate continues to be 17.16% which is amongst the lowest corporate tax rates globally.

Soon after the announcement, the world was hit by global Covid-19. The pandemic, impacting human lives, has also hampered many businesses and economies. There was an unthinkable pause to the business operations due to lockdowns imposed worldwide. Many companies and economies are still facing periodic lockdowns resulting in supply chain disruptions on a global scale. To ensure recovery and emerge stronger, governments worldwide have come up with various reforms and incentives.

During the pandemic, the Indian government announced Production Linked Incentive Scheme.[1] across various sectors to create manufacturing champions and generate employment opportunities. India Brand Equity Foundation[2] notes that India’s manufacturing sector has the potential to reach US$ 1 trillion by 2025. India is on a path of becoming the hub for manufacturing as many global giants are setting up manufacturing plants in India. Index of Industrial Production, a key economic indicator, has also maintained significant growth from March 2021 onwards[3].

Against this backdrop and to support the entrepreneurs willing to invest in new manufacturing capacities, the business world expects some relaxation from the much-awaited Budget 2022. The economic, supply chain, and CAPEX cycle disruptions have delayed plans for setting up various manufacturing facilities. However, a recent GST report showing over INR 1 lakh crore collections for the last six months with 13% growth in collections for December 2021 compared to December 2020 indicates that economic recovery is setting a good pace in 2021. Building manufacturing capacities within the country would be even more crucial in the post-pandemic world. An extension in the original timeline under section 115BAB of commencing production of March 2023 by 1 to 2 years would allow existing affected Capex expansion plans to get ready and encourage new manufacturing investments. While one more Budget opportunity is available next year to consider this extension, an early announcement in the 2022 would help businesses plan.

The move of introducing a beneficial tax regime and various incentives are indeed appreciation worthy and would boost the growth of the manufacturing sector in India. The resultant employment and investment opportunities, too, would further contribute to uplifting the Indian economy. Timeline relaxation in this regard will undoubtedly play an essential role in further supporting the 'Make in India' initiative of the Indian government.

Indian Manufacturing Sector’s Tax Wishlist for Union Budget - 2022

This article has been co-authored by Padmaja Likhite (Associate Director, BSR & Company) & Hetal Desai (Assistant Manager, BSR & Company).

After almost two years of uncertainties due to the pandemic and with the ongoing third wave related economic impact, the Indian industry expects a fiscal booster dose specially in tax laws which would help carry forward the momentum of the reviving growth. Manufacturing sector, which has been one of the focus sectors in India and is yet to achieve full potential, could benefit from some specific fiscal stimulus. In this regard, we have attempted to present a wish list of the Manufacturing sector on key corporate tax matters: 

1. Revisiting incentives for newly set up manufacturing entities:

Under section 115BAB, newly incorporated manufacturing companies which commence operations before 31st March 2023 are eligible for 15% concessional income tax rate subject to fulfilment of specified conditions. There is need to rationalize said provisions by providing certain clarifications such as:  

• In light of delay in expansion/capex plans due to the pandemic, Government should extend the sunset date (31st March 2023) to start the operations by at least 2 more years.
• The benefit under said section should not be restricted to newly incorporated companies but should also be extended to companies expanding operations significantly by setting up new manufacturing divisions so as to be eligible to claim concessional tax rate on the eligible profits. This can be done subject to suitable anti abuse safeguards.
• Income derived from activities which are not incidental to manufacturing or production activity should be taxed at 22% tax rate on net basis as against on gross basis as per current provisions.
• Lastly, certain reasonable threshold should be prescribed for income derived by otherwise eligible companies, from non-incidental activities like trading, intra-group services etc. so that such companies should not get entirely disqualified from claiming the beneficial tax rate due to small side activity which is often a business reality.

2. Losses, Depreciation, and weighted deductions:

• Time limit for carry forward of business losses:

Businesses have taken a toll due to the ongoing pandemic and resultantly, small/mid-sized businesses are unlikely to have sufficient taxable profits in recent years. Thus, it would be a good to extend the maximum period for carry forward of tax losses from 8 years to 10 years specially for the losses that would lapse in years 2021 and 2022 due to the adverse business impact of recent years.

• Promoting green technology:

Manufacturing industry is considered as one of the significant sectors impacting environment and generating industrial waste. Thus, to promote sustainability and lower the carbon footprint, Govt. should offer more incentives in this area. In the past, depreciation rates under the IT Act for renewable energy assets/devices, pollution control devices, electric vehicles etc. were prescribed at 80/100% which were significantly reduced to 40% few years ago. Considering worldwide awareness and commitment to green initiatives, it would be more apt to consider enhancing depreciation rates on such assets. This will encourage the replacement of obsolete technology with green technology.

• Depreciation on Goodwill:  

Some corporates had to take shelter of mergers and acquisitions to survive and grow in the pandemic. However, in the previous budget, there was an amendment to treat Goodwill as non-depreciable asset. It would be reasonable if it is clarified that tax depreciation on Goodwill is allowable in certain cases, at least where the same arises from taxable transaction like slump sale.

• Weighted Deduction for Research and Development (R&D) expenses:

Weighted deduction of 150% was available for R&D expenses incurred by companies. During pandemic technological transformation of the production mechanisms, process has become new reality. Thus, government should re-consider allowing weighted deduction for R&D expenditure to stimulate R&D activities and investments in advanced technologies. Further, a concessional tax regime may be considered for profits generated from a new business started by commercializing new technology developed in recognized R&D center.

3. Revamping the Special Economic Zone (SEZ) regime:

In order to make SEZ more relevant in today’s world, certain amendments would be welcome such as:

• Sunset date for commencement of the SEZ Unit operations should be extended by a reasonable period to incentivize new units /significant expansions in export-oriented manufacturing businesses
• Provisions regarding the utilization of SEZ reinvestment reserve which are currently restricted to acquisition of plant and machinery should be relaxed to include investments in qualifying plant and machinery of other SEZ/non SEZ units. Further, the time limit for making the investment from the reinvestment reserve may also be extended by couple of years from the existing 3 years limit.

4. Other Considerations- Rationalization/Ease of doing business:

• Streamlining TDS/TCS Provisions

Last year, the Government introduced TDS provisions for goods which created confusion amongst the taxpayers as TCS provisions were already in place for sale of goods. Although CBDT has issued few clarifications, these provisions are overlapping to large extent and create unnecessary compliance burden. Hence scrapping the almost redundant TCS provisions or rationalization of said provisions would be welcome.

• Re-considering deemed dividend provisions

Inter-corporate loans/advances are effective mode of cash pooling in needy situations within group. Genuine transactions (with due safeguards/anti abuse rules) should be relaxed from the rigors of deemed dividend taxation provisions so as boost the liquidity within groups, especially in current times.

• Domestic laws to be amended for harmonization with Global Tax Approach

Government is expected to give clarity on the timelines as well as the mechanism to be adopted for the implementation of OECD Pillar 1 and Pillar 2 framework in India. It would be ideal to have clarity on timelines for withdrawal of equalization levy as well as scope of SEP rules to be clarified and no further unilateral steps should be taken until the global agreements in this regard are implemented in 2023.

• Rationalize advance ruling scheme

Earlier, taxpayers especially foreign companies used to approach the Authority for Advance Rulings or ‘AAR’ to obtain upfront clarity on taxation of proposed large /complex transactions. These decisions were binding on the tax authorities. In Budget 2021, ‘BAR’ replaced AAR. However, the formation and implementation of BAR has been delayed and moreover, decisions of the BAR have been made non-binding on the tax authorities. To provide certainty on the complex Indian taxation matters and reducing tax litigation, suitable amendments are needed to the advance ruling regime.

Union Budget 2022 - An Opportunity to Boost the Capacity Building

This article has been co-authored by Samudra Acharyya (Principal, Dhruva Advisors LLP).

Barely few days to the annual Union Budget for the year, it’s the time of the year when corporate India eagerly awaits the Budget announcements as it keeps its fingers crossed on whether the numerous representations made to the Finance Ministry are accepted or not. 2021 has been a watershed year for the Indian capital markets as we saw the Indian start-ups listing in India.  Numerous successful listings are perhaps only an indication of things to come. At the same time, some not so successful listings offer their own lessons to entrepreneurs and investors alike.  Clearly, global investors have their eyes on India and the Indian capital markets and the listing activity is only expected to improve.  At the same time, we also saw Indian businesses list overseas.  The SPAC route has generated enough interest despite various regulatory complexities that remain.  The Make in India theme of the Government supported by tax incentives and production linked incentives has generated enough traction across sectors.

Against this backdrop, it is only prudent to expect the Budget to fuel the buoyancy of the capital markets, enable the Indian businesses raise more growth capital, undertake capital expenditures and create more capacity, and last but not the least, continue to foster the culture of innovation.

In order to support the start-up space in the third largest start-up economy in the world, taxation of ESOPs is an important area to review. While in 2020, a 4 year relaxation was provided to employees of eligible start-ups with certain restrictions on change in employment, it is important to consider the difficulty in paying taxes unless the shares allotted pursuant to exercise of the ESOPs are sold. Perhaps, without diluting the right to tax, an approach of establishing the income at the time of exercise but deferring the taxability to the year of sale may be a more equitable way to facilitate talent availability to these start-ups. Similar provisions exist in law today with respect to conversion of capital assets into stock in trade.

Another area that is worth reviewing is taxability of capital gains on sale of shares which are not listed in India but listed overseas. As the law stands today, there is a significant rate differential for taxing Indian residents for capital gains on shares listed in India and shares listed outside India. A level playing field, particularly to businesses which are essentially India centric, will go a long way in making available large pool of overseas capital at better valuations to these businesses, which will eventually only benefit the numerous stakeholders of these businesses in India. Towards this, relaxation in the rate of tax for capital gains on sale of shares of overseas listed companies which derive their value from India should be considered provided a substantial portion of the growth capital raised is brought into India. Another relaxation which is much awaited is the ability of businesses to list overseas, either by flipping the holding structures or by a direct listing. The draft of the new FEMA Regulations for overseas direct investments await notification in this regard. From a tax perspective, as businesses grow global and list overseas, the period of holding of shares of a foreign company received by shareholders in a demerger also needs to be brought at par with that of an Indian company in the same situation.

Again in the context of an India level listing, while the law today has grandfathering provisions for listed shares which allow the market price of January 2018 to be taken as cost, aspects around grandfathering provisions for shares sold under the offer for sale route in an initial public offer need to be clarified to settle any controversy that may arise in the future, considering the sheer activity on this front. Similarly, the benefit of period of holding provisions for listed shares involved in merger/ demerger activity need to be extended to the grandfathering provisions as well to prevent public shareholders from unnecessary duress and litigation. A clarity on this aspect will be quite welcome.

As the various PLI schemes evolve and India Inc. announces capacity augmentation and new capacity creation, the benefit of the 15% corporate income tax rate under section 115BAB should be extended beyond March 2023.  In a Covid hit economy, it is fair to expect that the Government recognises the hardships faced by corporates over the last two years on this front.

The last part of our expectations from the Budget would be on the resolution process under the insolvency law. Over the years, with a lot of foresight, the Government has relaxed a number of tax and regulatory issues for companies under insolvency to enable more companies and investors come forward to revive these businesses.  An important issue which needs to be relaxed is the applicability of deeming income provisions under section 56 for buyers of shares of such companies at distress values pursuant to the bidding under the insolvency and bankruptcy code.  Most of the times such acquisitions are agreed at prices lower than the book values or the prevailing market price, which leads to taxability under section 56. It will only help to provide immunity to the buyers against such deeming income provisions.  It is only a timing issue since tax will be collected when there is any future sale of shares by the buyers.

Apart from these, there are other areas which corporate India has been asking for some time now, such as greater flexibility to carry forward losses for all companies, making buybacks also taxable in the hands of the shareholders akin to dividends, it remains to be seen what the lawmakers are thinking about this. Clearly, an interesting budget to watch out for.

Views are personal.

Time to Address Tax on Anomaly in Valuation of Shares

This article has been co-authored by Yashvardhan S Gupta (Deputy Manager, Business Advisory of N A Shah Associates LLP).

Government has from time to time introduced the anti abuse provisions to protect the tax revenue leakage and prevent money laundering in the garb of tax planning methods. One such measure is that any receipt of equity shares or securities for a consideration less than fair value, the difference is taxable as other income (if difference cumulatively in a financial year exceeds Rs.50,000/- for such and other stipulated nature of transactions). On the other hand, on transfer of shares, this difference would also be taxable as capital gains in the hands of the transferor. Further, unlike Angel tax exemption, this provision is applicable to all including angel investors, AIFs and non-residents.

To determine the value of the unquoted equity shares, the rules prescribe a formula under rule 11UA of the Income Tax Rules which provides for a deduction of liabilities from the total fair value of assets to arrive at the net value for equity shareholders. It may be noted that all other securities (other than equity shares) are to be valued based on valuation report of a valuer.

Fundraising in the start-up ecosystem is at an all-time high and usually investors invest through a mix of instruments like equity including differential class of equity, convertible preference, and convertible debentures. In such a scenario, the value of equity shares needs to be seen firstly on a fully diluted basis as the convertible instruments are entitled to more than just face value of the instruments and secondly based on economic entitlement in case of differential class of shares.

However, by applying the net asset value method, the entire value of the company becomes attributable to all the class of equity share capital irrespective of the rights attached to such shares. This results in unnaturally inflating/deflating the value of the unquoted equity share which might not be intent of the law. Further, as convertible securities are to be valued independently, their values will be based on fully diluted basis. This anomaly results in incremental tax on receipt of equity shares specifically when convertible instruments are yet to be converted. This can be understood by way of a simple example:

The above tax could be detrimental to the much-needed growth capital of the country and could result in undue hardship and unwarranted litigation.

We believe the Government should provide necessary clarification by way of an amendment in this regard. The computation of the value of unquoted share should be on a “fully-diluted basis” and based on economic interest of the class of shares. These are widely accepted concepts and would actually reflect the true fair value of the instruments.

Views are personal.

Future of Indian Transfer Pricing

This article has been co-authored by Anuradha Rathod (Technical Director and Chartered Accountant, BSR & Co LLP).

An invariable topic of discussion at any finance team meeting in a multinational corporation (MNC) would be transfer pricing. Indian transfer pricing regulations have gradually evolved over the last two decades since their introduction in 2002. However, with the pace at which global trade and businesses are growing augmented by technology and digitalization, there is an urgent need to accelerate this evolution and adopt a more matured set of TP regulations and guidelines in India. 

Every year, as the Budget event draws closer, taxpayers and tax authorities alike, ponder where we are and where do we head from here. With the sinking in of guidelines issued by Organisation for Economic Cooperation and Development (OECD) under Base Erosion and Profit Shifting Plans (BEPS) 1.0 and release of BEPS 2.0 reports, it would be reasonable to infer that the future of transfer pricing is risk-based assessments based on plethora of information, that will now be available with tax authorities under mechanism of exchange of Country-by- Country reports and Master-files. This information will provide the tax authorities with complete blueprint and structure of MNCs businesses, insight into their operations and tax costs in various jurisdictions. Both, the taxpayers and tax authorities will have to understand the intricacies involved in determining what would be the adequate income to be booked in India vis-à-vis other jurisdictions, having regard to the principles of value creation. 

There is no denial to the fact that the Indian Government along with the tax authorities, has taken a variety of measures towards aligning Indian TP regulations to international best practices; like introduction and time-to-time revision of Safe Harbour rules, launch of the Advanced Pricing Agreement (APA) program and making the required amends to enable bilateral APAs, coming up with a dedicated plan to resolve long pending MAP disputes with US and measures to fast-track resolution of MAPs, signing Multilateral Instruments with various countries to open up exchange of information and dispute resolution with other jurisdictions etc. 

While the journey is on, the destination (taxpayer friendly regime) is still in the distance. Talking about risk-based assessments, it is very important to equip Indian taxpayers and tax authorities with clear guidelines and certainty on a few areas for the purpose of ease of doing business, meeting compliances, and bringing the litigation focus on areas that pose a bigger threat to the Government treasury. In this article we have presented some ideas and areas that need changes, from a transfer pricing perspective, which may be addressed as a part of this Budget or by way of notifications later: 

• Need for detailed guidelines on matters/issues like location Savings, Marketing Intangibles, Cost contribution arrangements, Intra-group services, benchmarking of loans and guarantees 

Indian Revenue authorities have been increasingly scrutinizing issues like compensation for location savings, marketing intangibles and their economic ownership and related returns, compensation for other intangibles where significant functions related to development, enhancement, maintenance, protection, and exploitation (DEMPE) of an IP are carried out in India, cost contribution arrangements, intra-group service charges, inbound and outbound loans and guarantees, etc.

There are no specific guiding principles currently in the Indian TP regulations to determine arm’s length compensation for the above transactions (except for receipt low value intra group services, introduced under the revised safe harbour rules). As regards marketing intangibles there are some judicial rulings where the Tribunals and Courts have laid down certain important principles of arm’s length price (ALP) determination, but these rulings do not provide clear guidance on what methodologies/approaches can be adopted by the taxpayers for determining arm’s length price. Moreover, there are also several contradicting judgments on these matters and from a taxpayer’s perspective, litigation cannot be ruled out unless these principles or guidance are introduced in the regulations.

Both the taxpayers and tax authorities need to be equipped with clear guidelines on the above-mentioned issues to understand and manage such issues coming up in bilateral APAs and MAP applications, and secure tax Revenue for the country. 

• Acceptable arm’s length range to be broadened to 25%-75% - interquartile range (IQR) 

The Government of India has prescribed rules for the application of range which states that the arm’s length range would be margins in the data set (i.e., set of comparable companies) lying between the 35th and 65th percentile. However, the range used in India i.e., between 35th to 65th percentile is a narrower range and a deviation from global norms, which state that if a range includes a sizeable number of observations, interquartile range may help enhance reliability of the analysis. Also, since the interquartile range represents about 50% observations (i.e., 25% of observations on either side of the median), it tends to eliminate the outliers.

As stated above, since 35th to 65th percentile range is a narrow range which is normally not followed globally and in several cases, the arithmetic mean does not even fall within this range, measures can be taken to broaden it to the interquartile range i.e., the data points lying between 25th to 75th percentile. Interquartile range is also a prescribed range internationally and followed by OECD and by many countries, including USA, United Kingdom, Germany, China, Singapore, Australia, etc. Broadening of the range to interquartile range between the 25th to the 75th percentile will help in widening the arm’s length range, thereby reducing litigation, quicker resolutions in bilateral APAs and MAP applications, as the country tries to align its regulations with globally accepted norms and practices.

To prevent misuse of a broader range by the taxpayers and address the predicament of Revenue Authorities in accepting a broad range, the regulations can prescribe certain preconditions for application of interquartile range. 

• Rationalization of the Safe Harbour Rules 

The Central Board of Direct Taxes (CBDT) extended the application of erstwhile Safe Harbour rates (applicable during the FY 2016-17 to FY 2018-19) to FY 2019-20 and thereafter to FY 2020-21, for determining arm’s length rates for certain specified international transactions. Further amendment in the Safe Harbour provisions was made through the Finance Act, 2020 to cover profit attribution to permanent establishment (PE), however, the CBDT is yet to specify the methodology for attribution of profits to the PEs. There is mixed judicial precedence on this issue and clear guidelines is a must to avoid litigation. 

The Safe Harbour Rules were last revised in 2017, when the Safe Harbour ratios were rationalized. upper turnover threshold of INR 200 crore was introduced for all contract service providers like IT, ITeS, KPO, R&D for IT and generic pharmaceutical drugs. Safe Harbour for receipt of low value adding intra group services and rates on loans advanced in foreign currency were introduced. Although most of these reforms were positive and much needed, they have neither been widely accepted and adopted by the taxpayers, nor have they helped in reducing litigation. It is therefore important for the tax administration to acknowledge the ground realities, understand the issues that need to be addressed, to find favour with taxpayers which will de-clog the tax administrations’ time from unwanted litigation. In this regard, the following measures can be undertaken to further rationalize the Safe Harbour Rules: 

• The definitions of various eligible international transactions under the Safe Harbour Rules like KPO services vis-a-vis ITeS, Software development services vis-à-vis contract R&D services relating to software development, leave a lot of room for subjective interpretations and there is lack of clarity on categorization or classification of these services. Clear and more objective criterions may be introduced for classification of services. For e.g., the artificial barrier between contract IT services simpliciter and contract IT R&D services should be removed to have one uniform rate for all contract IT services.
• The prescribed Safe Harbour rates for outbound loans are otherwise fair, yet the obligation of having the credit rating of the overseas borrower being approved by CRISIL, is perhaps an additional cost burden for taxpayers who wish to opt for the Safe Harbour Rules. Thus, the requirement of CRISIL approved credit rating can be removed for the purpose of easing out the compliance requirement and reducing the cost burden for the overseas borrower. 
• Further, a taxpayer in India, opting for Safe Harbour rules is required to undergo scrutiny assessment as per the prescribed rules. This may act as a deterrent for a large MNC having multiple and huge volume of transactions to opt for Safe Harbour Rules, as it may not be practically and economically feasible to adopt a two-way street i.e., opt for Safe Harbour regime for the eligible transactions and follow a normal route for transaction not covered / eligible under Safe Harbour. Therefore, to overcome this limitation, the scope and purpose of the Safe Harbour rates can be widened to use the Safe Harbour rates, as reference rates while preparing transfer pricing documentation and during assessment proceedings and to be duly accepted by Department.
• Considering that the Safe Harbour Rules were last revisited in 2017 and are applicable only till financial year 2020-21 (AY 2021-22), the extension of Safe Harbour Rules for further period of say 2-3 years with the revisions as discussed above and with rationalized rates, will also be an encouraging step for more taxpayers to opt for this route. 

• Requirement of recording an entry in the books of accounts for Secondary Adjustment 

The taxpayer in India, fulfilling certain conditions as laid down in section 92CE(1) of the Income Tax Act, is required to make an adjustment in its own books of accounts as well as in the books of the relevant AE(s), to reflect the actual allocation of profits between the taxpayer and its AE with the transfer price determined based on the Primary Adjustment. Now in a scenario where funds are received by the taxpayer from its AE on account of the primary adjustment, the same would necessarily be accounted for in books of accounts. However, in a case where the taxpayer does not bring the funds into India and in absence of an agreement between the taxpayer and its AE, neither the AE nor the taxpayer itself may be required to make an entry in their respective books of accounts as internationally accounting norms do not allow any notional entry in books of accounts. Further, the AE of the taxpayer would be governed by their local statute and accounting norms and requiring the AE to make accounting entries consistent with Indian requirements may be beyond the control of the taxpayer and the jurisdiction of the Indian tax authorities. Therefore, to address these practical difficulties in implementing the mandate of making entry in the books of accounts for Secondary adjustment should be done away with, to make the process compliance friendly for the taxpayer.

At the risk of stating the obvious, once the statute prescribes the action to be taken by a taxpayer as far as the secondary adjustments are concerned, the taxpayer would be duty-bound to implement the same in compliance with the local accounting regulations and mandating the same under the Income Tax Act, may not be required. 

• Limitation of interest deduction 

As per the section 94B of the Income Tax Act, where an Indian company, or a permanent establishment of a foreign company in India borrows any sum from its non-resident AE and incurs any expenditure by way of interest, exceeding INR One Crore, then any interest amount which exceeds 30% of the EBIDTA of the taxpayer shall qualify as ‘excess interest’ and shall not be deductible in computing the taxable income. India being a developing country with a need for foreign investments to fund various initiatives, in the development of India’s infrastructure, the imposition of the restrictions on disallowance of the ‘excess interest’ on overseas loans is creating uncertainty for foreign as well as Indian parties at a policy level on overseas borrowings.

Therefore, to resolve the afore mentioned limitation, the restriction imposed on the interest deduction on overseas borrowings, for certain priority sectors like infrastructure, manufacturing etc., can be deferred for 5-10 years to give India an opportunity to achieve its anticipated growth through required foreign funds. Also, in the future, In lieu of a fixed 30% EBITDA restriction, a Group Ratio in lines with the BEPS Action Plan 4 could be considered in order to apply the interest deduction restriction. The Group Ratio refers to the Group’s overall third-party interest as a proportion of the Group’s EBITDA and that ratio is applied to the individual company’s EBITDA to determine the interest restriction. This would consider the actual third-party debt and leverage at global level vis-à-vis third parties as against the current requirement of determining the threshold at taxpayer’s level in India. 

• Increased threshold for TP documentation: 

The threshold for preparation and maintenance of mandatory TP documentation in India is currently INR 10 million that was set in FY 2001-2002 when Indian TP regulations were first introduced. With the increase in global trade and business due to digitalization, even small entrepreneurs in India can do businesses overseas. With this, there is a need to increase the threshold for maintaining mandatory documentation to allow ease of compliance to smaller taxpayers and encourage them to be compliant. Moreover, it is equally important to also align the information requirements and threshold for maintenance of TP documentation with the local file guidelines as prescribed in BEPS Action 13 as also enshrined in other developed economies. 

• Dispensation on reporting of Dividends under section 92E of the Income-tax Act 

Section 92E of the Act requires every person who has entered into any international transaction to obtain and furnish an accountant’s report in Form 3CEB. Clarity is required on whether a payment / receipt of dividend qualifies as an international transaction that is to be reported and benchmarked. 

Since payment of dividend does not impact the profit and losses or assets and liabilities and is only an appropriation of after-tax profits –there are no means of avoiding taxes on such dividend payouts. 

The Finance Act, 2020 has reintroduced the classical system of taxing dividend income in the hands of the shareholders by abolishing the Dividend Distribution Tax (‘DDT’) regime. With abolition of the DDT regime, dividend income is now taxed in the hands of shareholders. In the erstwhile regime Dividend was exempt in the hands of the shareholder – hence the obligation to report such income did not arise. In the current scenario, the dividend would be paid by the dividend declarant only after deducting the withholding taxes. 

Historically, dividend transaction was not reported by the payer and the receiver in the Form No. 3CEB owing to DDT regime and exemption under section 10(34) of the Act. Post the abolition of DDT regime, there should be a clarification that the payer and the recipient would not require to report the declaration or receipt of dividends in Form No. 3CEB.The said clarification would immensely help non-resident entities who may have single transaction of receipt of dividend income and also the Indian entity paying dividend mainly because payment of Dividend is always a voluntary act of payer and there is no scope of negotiating the quantum of dividend. It cannot be termed as a transaction between 2 parties as only one party voluntarily decides and pays dividend without any contract or obligation from the other party. Further, it is not capable of being benchmarked hence the question of determination of arm’s length price does not arise. 

Conclusion

As can be seen from above, despite a plethora of ongoing reforms in the India Transfer Pricing regulations, there are still several areas which ought to be addressed by the Revenue authorities to achieve the objective of ease of doing business and compliance by taxpayers and enabling efficient administration by the tax authorities for protecting the Government Treasury. It is equally important to address these aspects at the earliest, since the technology has enabled Government to analyze the large flow of information on a real-time basis and focus on redundant data will unnecessarily block governments and taxpayer’s resources with no fruitful use.

• The income of individual
• Consumption
• Reduced demand
• Less indirect tax collection (being regressive in nature)
• Burden on the government finance

According to reports by Oxfam, the number of Indian billionaires grew during 20-21 from 102 to 142, almost many listed companies reported unprecedented profits, thanks to lower tax regime and pent-up demands. On the contrary to this, the said reports claimed that 84% of Indian household saw an income decline amid the pandemic. It is a hard truth that the pandemic has brought us here at the juncture of inequality. Unequal access to incomes and opportunities does more than create unjust, unhealthy, and unhappy societies.[2]

According to this reports, top 100 wealthy Indian families have 98% of the wealth generated by all Indian households. Wealth of the richest 98 same as bottom 552 million. This suggests the rising inequalities. Every pandemic follows this suit I.e., rising inequality. The reason being the wealthy can whether the shock better and with the readily available capital they can bounce back easily. The same pandemic which makes rich richer, makes poor poorer because they do not have enough corpus to cope up with the life living.

The origin country of covid, China has already put in the various measures to tackle the case of rising inequality. Such measures include non-profit organization for education, increased pay for the low skill workers at the cost of the profit of the company, mandating banks to maintain profit in a single digit to foster the credit culture. China being an autocratic country, can take such measures as they don’t need to pass laws and regulations which makes it decision making process easy and early.

However, India cannot follow this blindly as we are a democratic country and cannot rule the decision-making process of the companies and individual. However, the country can pay heed to the taxation regime based on what United States is about to apply I.e., taxing the top richest in the country.

The report of Oxfam claims that 4 per cent tax on the wealth of 98 billionaires can fund the mid-day meal programme for 17 years. A 1 per cent wealth tax would be enough to take care of the total expenditure for school education and literacy or fund the government health insurance scheme Ayushman Bharat for more than seven years.

Tax rate of 28.8% is still lower than the highest tax rate of 43.4% in the country.

Let us look at the source wise income distribution:

So, around 2.66% of the taxpayers are having long term capital gain income which is taxed at generous rate of 10%, with indexation benefit. Higher tax rate on the super-rich will even have less percentage if we consider the income earners with income exceeding Rs. 100 Crore. The discussion which we have considered here will be mostly affect the very minority portion of Indian household. Majority income earners are from salary and business income which has higher average rate of taxation.

Let us look at the data declared by the Income Tax department for AY 18-19, with reference to long term capital gain income[3]:

If you break the data in detail to analyze as to what is the range of income offered in this income head and what is the tax collected, we get another surprise!

Out of the long-term capital gain income of Rs. 142,033 crores, about 38% of such income comes from high net worth individual i.e., who earns more than 100 Crore a year.  This scenario is not different when we consider the short-term capital gain income. Remarkably, this data is of the AY 2018-19 i.e., pre pandemic scenario.

So, various reports doing the rounds about raising inequality believes to be true, then this scenario would have been even worse off in post pandemic scenario. Also, with GST collection soaring all time high, which is a regressive tax i.e., burden fall on to the consumer rather than the producer, there is no doubt that rich become richer and poor become poorer.

Many countries have higher capital gains tax rate for individual. Report of PwC shows the applicable capital gain tax rate as follows[4]:

Union Budget 2022 - A Start-up Booster?

This article has been co-authored by Gurwinder Singh (Chartered Accountant).

With one of the world’s third-largest and most happening ecosystem, start-ups in India have become the poster boy of the country’s entrepreneurship dexterity. India is now home to over 84[1] unicorns, out of which over 44 were born in 2021 and three in the first month of 2022. With the push from post-pandemic digitisation, India has approximately 73[2] soonicorns which are expected to become unicorns in 2022. With two–three start-ups being founded every day,[3] this growth story is expected to continue. As a testament to the importance of start-ups and the nation’s resolve to nurture this ecosystem, PM Narendra Modi said that start-ups are the ‘backbone’ of a new India and declared 16 January as the ‘National Start-up Day’.

With an audacious goal to become a USD 5 trillion economy by 2025, the Government of India has been working to enable ease of doing business and incentivising investments in the start-up ecosystem. Initial public offering (IPO) could be one such source of investment. In the recent past, many Indian start-ups have realised their dream of going public and made blockbuster debuts on Indian stock exchanges. However, the Indian start-up community still passionately harbours the dream of listing on overseas stock exchanges like their foreign counterparts to have access to international markets for better valuations, easy availability of funds and increased stability. Though the Companies Act, 2013, was amended last year to allow direct listing of Indian corporates on overseas stock exchanges, operationalisation of the same is yet awaited and requires amendment to several laws, including foreign exchange regulations and taxation laws. The start-up community is keenly expecting an announcement in this regard.

Attracting overseas investments is crucial but motivating domestic investments is indispensable. While an overseas investor in a private company pays a capital gains tax of around 10% (for investment held for more than two years), a resident investor has to cough up nearly 20% tax on the same transaction. Moreover, even though various relaxations and safeguards have been introduced in relation to the angel tax issue and its abuse, if specified thresholds and conditions are not met, the risk of the taxman knocking on the doors of a start-up receiving such investment still remains. The start-up and the Indian business community at large will be eagerly following this budget eyeing equal treatment for Indian investors vis-à-vis their overseas counterparts.

Start-ups, by definition, are required to bring in innovation, disrupt markets, and change consumer behaviours and traditional business models. In most cases, start-ups end up burning a lot of cash in the initial years and have a long gestation period (over ten years in some cases) before turning profitable. It is the earning potential built over the initial years which contributes to subsequent profitability and success of start-ups. Despite these unique business factors, start-ups are allowed to carry forward business losses for only eight years (same as any other traditional business). In many cases, the bulk of such losses lapse and start-ups are unable to set-off such losses (incurred in building the earning potential) against the profits realised subsequently. Increase in the time period allowed for such carry-forward losses and mechanisms for setting off such losses with capital gains earned by investors may increase the value and attractiveness of investing in start-ups. On a connected note, though the restrictions on carrying forward of losses in case of an exit by existing investors were lifted in 2019, the benefit of the same is still not available in cases where the existing shareholders are required to exit the start-up.

For a comparatively smaller subset of start-ups which are profitable, a baseline tax rate of 22% is applicable unless such a start-up is engaged in manufacturing where a baseline tax of 15% is applicable. As a bulk of start-ups are engaged in technology, e-commerce and the services sector, this incremental benefit is not available to them. The industry is clamouring for an equal treatment of the service industry vis-à-vis the manufacturing industry.

Stock-based compensation (commonly known as Employee Stock Option Plans [ESOPs]) is another tool which has helped start-ups in their growth and ability to attract and retain talent. ESOPs not only help start-ups by deferring immediate cash flows and incentivising employees, but also aid employees in creating wealth and partaking in the start-up growth story. The start-up community’s demand of deferral of taxation of ESOPs for employees to increase their attractiveness and linking the same to actual realisation of gains for the employees was accepted by the Government. However, this relaxation was limited only for five years or till cessation of employment or actual sale of an ESOP, whichever is earlier. The industry is advocating for the complete removal of taxation of notional value of ESOPs and is asking for taxation only at the time of actual realisation of the gains (as there is no loss to the exchequer per se).

Other than this, the start-up community is also looking forward to simplification of various compliances under GST laws, withholding taxes, etc., to ease the compliance burden. All eyes are now on the Finance Minister to see how PM Modi’s vision and moral stimulus get translated fiscally.

The views expressed in this article are personal.