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1 September 2010

TAX

DIRECT TAX CODE BILL 2010 – IMPACT ON POWER SECTOR

BACKGROUND

In an attempt to simplify the direct tax provisions, the Government released

the Direct Taxes Code Bill, 2009 (DTC Bill 2009) in August 2009 for public
comments. The provisions of the DTC Bill 2009, especially the one relating
to MAT on gross assets, would have been a big dampener for the power
industry as it is a capital intensive industry. Several representations were
made by various stakeholders as well as Industry forums on the proposals
made in the DTC to remove the inconsistency as well as unintended
hardship. The Government appreciated the sentiments and made a historical
move of issuing a Revised discussion paper in June 2010.

As a logical step post the Discussion Paper, the Government has now
presented the Direct Taxes Code Bill, 2010 (‘DTC’) before the Parliament.
The provisions of DTC are intended to come into effect from April 1, 2012
onwards. An analysis of the proposals in the DTC that are likely to impact
the Power sector is set out below.

KEY PROPOSALS AND THEIR IMPACT

Tax holiday to Power sector undertakings

Current situation:

Under the existing provisions of the Income-tax Act, 1961 (‘the Act’), profit
based deduction is available to undertaking set up for (‘Power sector
undertaking’) -

 generation or generation and distribution of power, if it begins to

generate power before March 31, 2011

 Reconstruction or revival of a power generating plant, if it begins to

generate or transmit or distribute power before March 31, 2011
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 DTC Proposals:

DTC has proposed to bring a paradigm shift in granting tax incentives to

undertakings engaged in business of generation, transmission or distribution of
power. The new scheme has proposed to substitute the profit-linked incentives
prevalent under the existing provisions of the Act with the expenditure /
investment based deductions. Further, it has provided for grandfathering of tax
holiday available to power units for the unexpired period.

Undertakings eligible for profit based deduction in Assessment Year 2012-13

 Undertakings eligible for profit linked incentives under the Act for the
assessment year beginning on April 1, 2012 would be grandfathered under
DTC

 While computing deduction, capital expenditure as well as expenditure

incurred prior to commencement of business shall not be allowed

 The conditions specified under section 80IA for availing Tax Holiday shall
continue to be applicable

Undertaking set up in the DTC regime

 profits shall be gross earning as reduced by business expenditure in

accordance with Schedule XIII of DTC

 capital expenditure and expenditure incurred prior to commencement of

business shall be allowable as business expenditure, except expenditure
incurred on acquisition of any land including long term lease, goodwill or
financial instrument.

Comments:

 Under the Act, undertaking which commences generation of power on or

before Mach 31, 2011 shall be eligible for profit linked incentives. The DTC
grandfathers those undertakings which are eligible to claim the exemption
under Act as on Assessment year 2012-13.

Accordingly, an issue arises as to whether an undertaking which commences

generaton of power during the period April 1, 2011 to March 31, 2012 will be
eligible for profit linked incentives and thus grandfathed under DTC. Though
the intention seems to provide the benefit to undertakings commencing
generation of power even beyond March 31, 2011, the same can be
implemented only on amendment in the Act. In view of this, this issue needs
to be suitably represented before the Ministry in the forthcoming budget.

 It has been provided that the profit linked deduction under DTC shall be
computed as per the provisions of the DTC, but no capital expenditure would
be allowed. Accordingly, there is an ambiguity as to whether depreciation on
the WDV carried forward from the Act would be allowable under DTC and
thus would need to be adequately addressed

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  The proposal to allow power companies to offset losses against profits of
other infrastructure projects or corporate income would be a welcome
measure

As such, continuation of these tax incentives to new power undertakings

under the DTC, though under a restrictive grandfathering clause, is still a
positive step. The grandfathering provisions would provide some relief to the
existing and new power undertakings.

Minimum Alternante Tax (MAT)

Current situation:

In light of the tax holiday available to the Power sector, MAT is a key provision
impacting the sector. Currently, MAT is applicable at the rate of 18% (effective
19.93% considering surcharge & cess) of the book-profits computed after
making specified adjustments to the net profit of the company. Further, the
companies are allowed to carry forward the MAT credit (which is the excess
of MAT tax paid over the tax computed in accordance with normal corporate
tax provisions) to future years.

DTC Proposals:

Under the Direct Tax Bill 2009, it was proposed that company shall pay tax on
its gross assets at the rate of 2 percent. (0.25% in case of banking
companies) if the tax liability is less than the tax on gross assets. The revised
draft of the DTC reintroduced profit based MAT .Under the DTC, the rate has
been increased from 18% to 20% of book profits.

Comments:

DTC Bill 2009 had proposed to levy MAT on the basis of gross assets, which
would had been a dampener for capital based industry like power. However,
DTC has brought back MAT to Book Profits which is a positive step towards
development of the power industry.

Corporate tax provisions – Key provisions

Tax rates

Current Situation:

Currently, the domestic companies are subject to corporate tax of 30% (plus
surcharge and education cess) on their taxable income

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 DTC Proposals:

While the Direct Tax Code Bill, 2009 stipulated the corporate tax rate as 25%,
the Revised Discussion Paper had hinted that tax rates could be reviewed and
suitably calibrated considering the reduction in the tax base due to certain tax
benefits spelt out in the said paper.

The DTC now has retained the existing corporate tax rate of 30%.

Comments:

Maintaining the corporate tax rate at 30% is not a positive development, in as

much as other levies such as DDT of 15% and branch profit tax of 15% make
the effective tax rate quite high.

Test of Residency

Current Situation:

Under the provisions of the Act, a company is resident in India in any previous
year, if the control and management of its affairs is situated ‘wholly’ in India.

DTC Proposals:

Under DTC, it is proposed to shift the test of residence of a company from

‘control and management’ to ‘place of effective management’ in line with
international practice.

Accordingly, a company incorporated outside India will be resident in India, if its

‘place of effective management’ is situated in India.

Place of effective management of the company would mean:

 Place where the board of directors or its executive directors make their
decisions

 In cases where the board of directors routinely approve the commercial and
strategic decisions made by the executive directors or officers of the
company, the place where such executive directors or officers of the
company perform their functions.

Comments:

Although the concept of ‘place of effective management’ proposed under DTC

is in line with international practice, it is important that this provision is
administered in a fair and pragmatic manner. The new residency definition
could impact businesses where key decisions are taken by Indian management
/ executives and merely adopted by the board overseas.

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 Treaty Override

Current Situation:

Under the Act, the provisions of the tax treaties prevail over the domestic law
to the extent they are more beneficial to the taxpayer.

DTC Proposals:

The initial draft of the Direct Tax Code Bill, 2009 provided that in the case of
a conflict between the provisions of a treaty and the provisions of the Code,
the one that is later in point of time shall prevail. This led to apprehensions
whether the proposal would lead to treaty override and render the existing
treaties otiose. Post the Revised Discussion Paper, the DTC seeks to
restore the beneficial treatment between the Act and the Tax Treaty except
in specified cases-

 where GAAR is invoked or

 when CFC provisions are invoked or

 when Branch Profits Tax is levied

Comments:

The proposals seem to be in line with international practice.

Controlled Foreign Corporation (CFC) Provisions

Current Situation:

Under the Act, there are no CFC provisions.

DTC Proposals:

The introduction of the CFC provisions has come as a major surprise for
India Inc. The CFC provisions have been brought in as an anti-avoidance
measure. Under this, passive income earned by a foreign company
controlled directly or indirectly by a resident in India, and where such income
is not distributed to the shareholders, resulting in deferral of taxes shall be
deemed to have been distributed to the shareholders in India. The CFC
provisions are broadly summarized as under:

 The total income of a Resident taxpayer to include income attributable to

a CFC which means a foreign company:

– that is a resident of a territory with lower rate of taxation (i.e. where

taxes paid are less than 50 percent of taxes on such profits as
computed under the DTC)

– whose shares are not listed on any stock exchange recognised by

such Territory

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 – individually or collectively controlled by persons resident in India (through
capital, voting power, income, assets, dominant influence, decisive influence,
etc.)

– that is not engaged in active trade or business (i.e. it is not engaged in

commercial / industrial / financial undertakings through employees / personnel
or less than 50 percent of its income is of the nature of dividend, interest
income, income from house property, capital gains, royalty, sale of
goods/services to related parties, income from management, holding or
investment in securities/shareholdings, any other income under the head
income from residuary sources, etc.)

 has specified income of such company exceeds INR 2.5 million

 Tie breaker tests have been provided to determine the place of residence of a
controlled foreign company.

 Scope of passive income also covers supply of goods / services to associated

enterprises.

 Specific formula prescribed for computing income attributable to a CFC. Income

attributable to the CFC to be based on specified income. Specified income to be
based on the net profit as per the profit and loss account of the CFC, subject to
prescribed adjustments.

Comments:

CFC provisions are likely to bring additional complexity in the tax legislation and could
significantly impact Indian companies having outbound investment structures.
Specifically, CFC provisions could create cash flow problems for Indian companies
since they would be subject to tax without corresponding receipt of actual dividends.
This may necessitate a review of the existing overseas investment structure.

Exempt-Exempt-Taxable (EET) vs. Exempt-Exempt-Exempt (EEE) Regime for

Saving Schemes

Current Situation:

Under the Act, long-term saving schemes like Government Provident Fund (GPF),
Recognized Provident Fund (RPF), Public Provident Fund (PPF), Life Insurance etc.
are covered under the EEE method, wherein the contributions, accumulations /
accretions thereto and the withdrawals are exempt from tax.

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 DTC Proposals:

All long-term retiral savings schemes moved to EEE regime as against EET
proposed earlier. Deduction in respect of investment in approved funds such as
Provident Fund, Superannuation Fund or Pension fund reduced to INR 100,000
from INR 300,000. Receipts under a life insurance policy on death/maturity
would be exempt from tax.

Comments:

The continuation of EEE regime is a welcome step as it will provide a tax free
lumpsum amount to individuals to meet their post-retirement financial
requirements.

Withholding tax provisions – Others

Current Situation:

The withholding tax rate on royalty and fees for technical services payable to
non-residents is 10% (excluding surcharge and education cess).

DTC Proposals:

The withholding tax rate in respect of payment of royalties and FTS to non-
residents is proposed to be increased to 20%.

Comments:

The higher withholding tax rates would increase the overall cost of the Indian
companies in case of payments to tax residents of the country with whom India
does not have a Tax Treaty and grossing up of tax is required in case of tax is
borne Indian company.

Transfer Pricing

Current Situation:

Currently, there are no provisions under the Act in respect of Advance Pricing
Arrangement (‘APA’).

DTC Proposals:

It is proposed to introduce APA for upfront determination of pricing methodology

of an international transaction.

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member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity.
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 Comments:

Whilst the scheme specifying the procedure of APA has not yet been released, the
industry would expect that the same is in line with the international practice.

Leased Assets

Current Situation:

In the absence of any specific provision under the Act, there is a lack of clarity
surrounding the treatment of assets obtained on finance lease by Power sector
undertakings. In certain cases, companies are facing litigation from revenue
authorities on the question of whether they are eligible to claim depreciation on
such assets.

DTC Proposals:

Under DTC, the lessee would be treated as the owner of assets obtained on
finance lease and therefore, eligible to claim depreciation on the same.

Comments:

This is an important provision for the companies in Power sector and it will help to
end the long drawn litigation regarding ‘ownership’ of such assets & depreciation
eligibility with the Revenue authorities.

General Anti Avoidance Rule (‘GAAR’)

Current Situation:

Under the Act, there are limited specific anti-abuse provisions.

DTC Proposals

 The Code seeks to introduce GAAR which provides sweeping powers to the
Revenue authorities. The same is applicable to domestic as well as
international arrangements.

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  GAAR provisions empower the Commissioner of Income-tax (“CIT”) to
declare any arrangement as “impermissible avoidance arrangement”
provided the same has been entered into with the objective of obtaining
tax benefit and satisfies any one of the following conditions :

– It is not at arm’s length

– It represents misuse or abuse of the provisions of the DTC

– It lacks commercial substance

– It is carried out in a manner not normally employed for bona fide

business purposes

 An arrangement would be presumed to be for obtaining tax benefit

unless the tax payer demonstrates that obtaining tax benefit was not the
main objective of the arrangement.

 CIT to determine the tax consequences on invoking GAAR by

reallocating the income or disregarding/recharacterising the
arrangement.

 Meaning of ‘tax benefit’ widened to include any reduction in tax bases

including increase in loss.

 GAAR provisions to be applicable as per the guidelines to be framed by

the Central Government.

 GAAR shall override Tax Treaty provisions.

 Forum of DRP available in a scenario where GAAR is invoked.

Comments:

The guidelines to be issued by the Central Government would need careful

examination to assess the scope and impact of these provisions. It is an
open question whether GAAR can be invoked for transactions undertaken
prior to the enactment of DTC. A suitable clarification may be provided for
this purpose.

Concluding Remarks

Undoubtedly, the DTC has done more good to the power industry, for
instance, relief by way of grandfathering clause and removal of MAT based
on Gross assets, there are certain provisions where further clarity would be
required. for e.g. DTC has no specific provision for grandfathering of
unutilized MAT credit available under the Act.

In summary, the provisions of the DTC are expected to provide fillip to the
growth of the Indian infrastructure sector which is very crucial for the overall
growth of Indian economy.

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member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity.
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