Decoding the direct tax code

Sweeping changes: People will pay less tax but evasion will be difficult

When archaic rules have to be replaced  with new ones, the changes must be dramatic and path breaking. This is what Union Finance Minister Pranab Mukherjee conveyed to all taxpayers when he introduced the draft Direct Tax Code (Tax Code) last week. The Tax Code, now open to  public debate, will be introduced as a Bill in Parliament’s winter session. If passed, it will become the new Income Tax Act, replacing the existing four decade old IT Act of 1961. The new IT Act will come into force from April 1, 2011.   

In the foreward to the Tax Code Mukherjee explains that the aim is to eliminate distortions in the tax structure, introduce moderate levels of taxation, expand the tax base, improve tax compliance, simplify the language and lower tax litigations. Initial analysis shows that most of these objectives are achievable by tweaking of some provisions.

Talking to Deccan Herald, KPMG Executive Director Personal Taxation, IT & ESOP Vikas Vasal said “The new proposals are in the right direction. They will simplify regulations and reduce unnecessary litigations significantly.”

Agreed Bangalore Chamber of Industry & Commerce (BCIC) President K R Girish. “The Code is a completely new law and not an amendment of the existing Income Tax Act. This is a commendable change as one has always experienced tinkering of  existing laws, ” observes Girish.  

Major gains for individuals

What do the major changes proposed in the Tax Code look like? Personal income tax, almost all salaried persons will agree, in our country is one of the highest in the world. More open and honest an employer is in terms of disclosing remunerations, worse it is for the employees because taxable income goes up. The present system thus rewards dishonesty and non-disclosure of income by way of lower tax.  The Tax Code will try to address these issues by significantly lowering income tax and by disallowing all tax-free perks. It proposed exemption of income tax on specified savings up to Rs 3 lakh a year as against the present deduction limit of Rs 1 lakh for all types of savings under 80C of the IT Act. The catch, however, is that a few long term investments like public provident fund, employer’s provident fund, insurance premium in pension (annuity) schemes, Post Office National Savings Scheme etc will be eligible for tax exemption.

But contributions to fixed deposits, interest and principal payment on housing loans, educational expenses of dependents, and a host of other forms of savings will not qualify as eligible for tax savings. The thrust, clearly, is to induce long term savings for future needs.

The Tax Code also raised income tax slabs significantly, lowering the tax burden on  individuals. The draft proposed exempting the general tax payer from paying tax for income up to Rs 1.60 lakh  a year.

According to the proposal,  a tax payer will pay at the rate of 10 per cent for income above Rs 1.60 lakh and up to Rs 10 lakh, at 20 per cent on income between Rs 10 lakh and Rs 25 lakh and at 30 per cent for income beyond Rs 25 lakh.

At present, while the basic exemption limit remains at Rs 1.60 lakh a year, the limit for tax slabs are much lower — one pays 10 per cent tax on income ranging between Rs 1.60 lakh and Rs 3 lakh, 20 per cent between Rs 3 lakh and Rs 5 lakh and 30 per cent beyond Rs 5 lakh.

Thus, for an individual with taxable income of Rs 10 lakh a year tax payment will drop from Rs 1.68 lakh to Rs 51,000, a net  annual saving of Rs 1.17 lakh. The exemption limit for women and senior citizens will continue to be Rs 1.90 lakh and Rs 2.40 lakh, respectively.   
      
Not without pains

If the finance minister is for giving major relief to tax payers, he will also make sure that there aren’t many avenues to avoid taxes. So, as a rider, the Tax Code proposes to add all perquisites enjoyed by a tax payer to income for the purpose of tax calculations. In other words, allowances like leave travel, furnishings, entertainment expenses, conveyance, medical etc, will be added to income.  

Similarly, the tax treatment for post-retirement benefits may prove to be a major dampener. Money saved in specified instruments  like PPF and PF for getting tax exemption will become taxable when they are  withdrawn later.

These investments, when accrued, were earlier exempted from  tax. The Tax Code says that under the Exempt Exempt Tax (EET) system all withdrawals will attract tax because the  amount withdrawn will be treated as part of the income for that year.

But in the Tax Code it is unclear if the employee’s contribution to PF and PPF will be taxed at the time of withdrawal. KPMG’s Vasal says that this is an anomaly that needs to be corrected. He believes that only the  employer’s contribution and interest accrued to the account will be taxed.

Though taxing financial gains available after retirement will pinch the retired people, Vasal is of the view that the proposal is equitable as income is liable to be taxed at least once.

However, as a relief to senior citizens, tax exemption limits for them should be raised to Rs 5 lakh per annum instead of Rs 2.40 lakh at present.  The Tax Code, however, specified that the tax exempt status currently available to withdrawals would continue to apply to amounts accumulated in post-retirement savings schemes like PPF, EPF, etc, up to March 31, 2011. Money that accrues from April 1, 2011 will be taxed on withdrawal.

Wealth tax benefits

The proposed Tax Code has sought to make  major changes in wealth tax calculations and rates.

The threshold limit for wealth tax will be raised to Rs 50 crore from the present Rs 30 lakh and the tax rate was reduced from 1 per cent to 0.25 per cent.

But, in a smart move, to expand the scope of taxation the Tax Code included financial assets like shares, corporate bonds, fixed deposits, etc in wealth tax. The valuation of these assets will be done at cost or at market price, whichever is lower. In case of capital gains tax too, the Tax Code proposed some sweeping changes. It has done away with the present system of short-term and long-term capital gain tax, and replaced it with a uniform structure  and gains will be taxed at the marginal tax rate as applicable to the tax payer. The implications of these changes are clear: The period of holding has no bearing on the tax payable and bigger investors will be taxed at higher rates than the smaller ones.

A mixed bag

For the corporate world, the proposed reduction in the tax rate to 25 per cent from the existing 30 per cent is certainly good news and will help lowering the tax burden of  India Inc in a big way. But at the same time the Tax Code proposes to do away with many exemptions that help lowering the tax. In a significant policy change, the Tax Code plans to discontinue all profit linked incentives for area-based investments like setting up plants in a backward area or in the north-east with investment-linked incentives in specific sectors like infrastructure, power, exploration and oil production etc.

Moreover, under the new proposal,  tax holiday will not be for a specific period, as is the case now, but will be equal to all capital and revenue expenditure barring land, goodwill and debts.

Once a  firm  recovers the permitted investments and  profits will be taxed. This change is aimed at incentivising capital formation in critical areas and remove incentives to shift profits from the taxable unit to the exempted unit.

On the mat

The Tax Code has also proposed changes in the calculation of minimum alternate tax (MAT) payable by corporates. MAT will now be levied at 2 per cent of the value of gross assets of a firm in case of all companies except for banks which will pay tax at 0.25 per cent. This shift in  MAT from book profits to gross assets is aimed at encouraging  optimal utilisation and increased efficiency of assets.

But Ernst & Young Partner- Tax & Regulatory Services, Sudhir Kapadia feels that this proposal seems to run counter to the objective of encouraging of capital investments for productive growth. Vasal of KPMG also of the view that changes in MAT rule will cause hardship to loss making companies as they will have to pay tax on assets.

Carrot and stick

If the Tax Code is generous in giving relief to tax payers, be sure, it will also make life miserable for those who evade tax through fraudulent means. As the Tax Code prescribes stiff penalties and prosecution for non-compliance with the tax laws, it proposes that every tax offense under the Code will be punishable by both imprisonment and fine. 

Apart from defaulters, the Tax Code proposes to punish tax consultants who help in tax evasion. It gives sweeping powers and blanket protection to Income Tax officials for initiating court proceedings on matters relating to tax offences.