The Modi Government has helmed significant reforms in India’s direct tax system. Some notable reforms include phasing out a complex system of tax incentives, reduction in Indian corporate tax rates to improve the country’s tax competitiveness, abolition of angel tax, simplifying capital gains tax regime, return to the classical system of dividend taxation and a strong impetus to the digital administration of taxes. In parallel, the Government has implemented bold steps for formalization of the Indian economy by increasing digital data sources and deploying technologies such as data analytics and artificial intelligence to widen the tax base. The proof is in the pudding as India’s direct tax collections continue to peak with a corresponding reduction in the costs of tax collections.
As India pushes its developmental goals, Indian businesses and foreign investors hope that the Government will continue with this streak and focus on a simple, certain and a globally competitive tax regime that promotes economic growth. In this article, we highlight some of the specific issues for businesses that should be considered in the direct tax proposals under the Union Budget 2025 and the new tax code.
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Expanding the scope of tax neutral corporate reorganizations: Currently, Indian tax rules are designed to render tax neutrality only to court approved amalgamations and demergers and include restrictions on transfer of tax losses. However, corporate reorganizations can take several other forms such as business transfers, share transfers, re-domiciliation, recapitalization and insolvency related reorganizations. Such transactions may still qualify as a reorganization so long as there is continuity of business enterprise and continuity of shareholder interest. As corporate India evolves, the Government should revisit the design of Indian tax rules for tax-exempt reorganizations (including issues around loss carryovers, method of accounting, successor liability, transfer of tax benefits). As a matter of policy, several countries do not consider it economically efficient to tax corporate reorganizations, because taxation could deter value enhancing reorganizations. Taxing the legal restructuring of the same business, should not result in realization of any gains or income warranting taxation.
Taxation of earn outs: The use of earn-outs as a pricing structure has become commonplace in India’s M&A space. While the commercial merit of earn outs is widely acknowledged, the lack of clarity under Indian tax rules on taxation of earn-outs creates issues in deal structuring. There is competing case law on the characterization and timing of taxation of earn outs, causing tax uncertainty. Clear tax rules that provide for taxation of earn out on the accrual of such amounts and provide criteria for capital gains treatment, will promote tax certainty in the M&A space.
Simplification of TDS and TCS regime: The function of TDS and TCS regime has evolved from just being a mechanism for advance collection of taxes to a mechanism for collection of data for enforcement of self-assessment tax. Over the past years, the Government has increased the scope of payments that are subject to TDS and TCS but has also correspondingly rationalized TDS rates to improve cash flow in the hands of businesses. Having multiple TDS rates for different categories of payments enhances compliance complexity and leads to disputes regarding characterization of payments. As we move towards simpler compliances in the new tax code, the next logical step in the rationalization of the TDS scheme would be to have two or three standard rates for TDS, that do not adversely impact cash flows in the hands of businesses.
International tax related proposals: Attribution of profits to permanent establishments has been a tricky issue given Indian policy’s leaning towards the formulary apportionment method against OECD’s authorized approach that relies on transfer pricing principles for profit attribution. This lack of clarity often hinders a foreign enterprise from being able to predict its tax outflow on setting up a PE in India. As we look to make India a global hub for contract manufacturing, global capability centres, et all, clear tax rules on profit attribution to PEs have become the need of the hour.
As Indian markets and businesses attract interest from foreign investors and Indian residents look to make portfolio investments overseas, clarity in the tax status and treatment of offshore collective investment vehicles (that may be fiscally transparent) should also be on the Government’s agenda to facilitate cross border capital flows.
Similarly, India’s commitment to Pillar 1 and Pillar 2 rules, and the interface of global minimum tax with tax incentives in India is also expected to take shape with Union Budget, 2025. Relatedly, the hope is that the Government will also consider deletion of the significant economic presence test from the Indian tax rules given its commitment to the Inclusive Framework.
Focus on alternate dispute resolution (ADR): India has been grappling with a heavy tax caseload resulting in significant expense of time and resources by the tax administration and the taxpayer. While we have ADR mechanisms such as advance rulings, MAP, APAs, and the intermittent Vivad se Vishwas scheme to settle pending tax disputes, the Government should now consider novel solutions such as arbitration, mediation and a permanent tax settlement scheme to tackle the caseload. CBDT should also consider proactively publishing papers and circulars from time to time setting out its position on ambiguous issues for clarity and consistency in interpretation.
With the Union Budget, 2025 on the anvil, the time is ripe for a new tax code with a business-friendly approach.
This article was originally published in Financial Express on 29 January 2025 Co-written by: Gouri Puri, Partner; Suyash Sinha, Principal Associate. Click here for original article
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Contributed by: Gouri Puri, Partner; Suyash Sinha, Principal Associate
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