Leaving the tax door open?

Finally, the newly enacted Company Law has replaced the more than half-a-century-old Companies Act. The new law has 470 sections, of which 98 are in force and the rest will be notified in phases.

The Ministry of Corporate Affairs has released the draft rules for 24 Chapters, inviting comments from the public and other stakeholders.

The new legislation promises an easy and efficient way of doing business in India, aids transparency and strives to make corporates socially responsible. Thus, it would be interesting to examine the impact of the new Act on the tax front. Some of the important issues would relate to tax deductibility of expenses, especially for Corporate Social Responsibility (CSR) initiatives, introduction of arm’s length concept for related-party transactions, and removal of the prohibition on tax-free payments.

Tax deductibility

CSR, a widely debated topic in the past few years, has finally been introduced as a specific provision in the new Act. Companies have to spend at least 2 per cent of the average annual profit accrued in three years on CSR initiatives. While this is a welcome move for a developing nation like India, the eligibility of such spending for tax deduction is unclear. In the absence of a specific provision, it is likely that some expenses may independently qualify for deduction under the Income-tax Act, such as payment for executing an eligible project, contribution to the Prime Minister’s Relief Fund and so on, while other payments may fail the “business purpose” test.

A clarification from the Central Board of Direct Taxes is needed.

The concept of arm’s length principle for related-party transactions is widely accepted in the taxation of cross-border or specified domestic transactions between associated enterprises under transfer pricing regulations.

Real-time approval

While the new Act introduces a similar concept, there is no clear guidance for determining how the arm’s length principle would be applied. Also, there is no reference to the transfer pricing rules under the Income-tax Act. Any valuation methodology prescribed under the new Act should be aligned with that prescribed under the Income-tax Act to avert undue hardship to corporates.

It is also interesting to note that while the Income-tax Act requires compliance with transfer pricing provisions after the financial year closure (when filing income-tax returns), the new Act requires the Board to review and approve the arm’s length principle for related-party transactions on a real-time basis (before the transaction is incurred). The new Act has a far-reaching impact on mergers and acquisitions. It allows the merger of an Indian company with foreign companies and participation in the global M&A activity.

While this is a progressive amendment, its success depends on how the rules shape up and whether it becomes tax-neutral, as there could be a loss of revenue to the exchequer.

Cross-border merger

Simultaneous changes in foreign exchange regulations are needed to operationalise external cross-border mergers.

The flexibility of paying shareholders through cash or depository receipts should be realigned to provide tax exemption to the company and the shareholders.

The new Act also states that there can be no second buyback for one year from the previous buyback, thereby making redundant the popular concept of multiple buybacks in quick succession. This amendment, coupled with the taxation of buyback transactions, would discourage companies from using this process to disburse excess cash.

Tax-free payments

The new Act allows Indian companies to pay its employees tax-free remuneration, aligned with judicial precedents that provide tax exemption on the “tax borne by the employer on non-monetary perquisites on behalf of the employees”.

Overall, while the new Act is a step in the right direction, a lot more clarity is needed as corporates pore over the fine print.

Similarly, the Finance Minister should consider and review changes in the existing income-tax legislation. The two laws should be aligned to avert controversies and hardship to corporates and investors.

Neeru Ahuja is Partner and Manpreeth Kaur is Manager, Deloitte Haskins & Sells