Redo the Income Tax Act not just to simplify but rationalize taxation

The committee set up by the government and led by Chief Commissioner of Income Tax V.K. Gupta to review India’s Income Tax Act is expected to submit its report soon. Its remit, as it appears, is to simplify and rationalize the Act without altering its core. 

While its language needs to be simplified, this opportunity for more substantive changes must not be lost—for, once a new law is enacted, further changes are likely to face resistance no matter how badly they are required. 

The Income Tax Act of 1961 has undergone thousands of amendments over the past six decades. The world has changed substantially since it was framed and it needs to be updated in keeping with today’s economic scenario as well as a new corporate landscape. 

For one, the advent of digital commerce and blurry international boundaries for trade and services have become a major challenge for taxation. For another, corporate growth is being encouraged as part of the country’s policy mix.

Also read: Income tax reform: Go beyond simplifying India’s unwieldy code

The principle of light taxation being good for business is now better accepted, as evident in the corporate tax rate being cut to 25% five years ago. This is a far cry from the 1970s, when India had a 97% marginal rate of tax, which did little but incentivize evasion.

Tax compliance has improved in line with corporate governance, the quality of which is reflected in higher capital-market valuations. Indian listed companies contribute heavily to tax collections today. 

While there may still be errant taxpayers in India that try to dodge their liability, it is likely that their proportion of the whole has shrunk considerably over the years and the value of tax evaded has fallen to a level that does far less damage than earlier. 

It would therefore be prudent of the review panel to avoid recommending measures to enhance tax collections that could turn out to be so harsh that they impact the ease of doing business.

There are, however, several areas of taxation that badly need a review. Here are some:

Provisions related to mergers and acquisitions (M&As): In any dynamic economy, M&As, including corporate exercises of internal restructuring, are critical for the efficiency of economic activity. Many of the law’s current provisions, however, are not in tune with this contemporary reality. Let’s look at some examples:

The provision of setting off losses on mergers remains mainly available only to manufacturing companies, but this is a relic of a bygone era, when it was assumed that other types of companies—such as NBFCs or service companies—could not have losses arising from M&A activity.

Also read: India’s six-decade-old tax laws are in for a revamp. Govt wants real-world solutions.

In the case of listed companies held by an unlisted company, the law’s insistence on their ‘minimum adjusted net worth’ being the base transfer price could be a disaster for genuine transactions if the holding firm’s value is at a discount.

A ‘deemed gift’ provision that was supposed to tackle suspicious credits disguised as gifts was expanded to unjustified areas, including to non-tax-neutral mergers and demergers. This has been contentious.

Also, the definition of a ‘demerger’ is extremely restrictive and needs to be changed.

The tax deductibility of interest on money borrowed for an acquisition is restricted to 20% of dividends, but in most strategic acquisitions, the dividend yield may be only 2-3%, while interest may be 10-12%. This cap is unfair and illogical.

Dispute resolution: At a fundamental level, preventing disputes is crucial. An Income Tax law that is well drafted, with a practical ground-level understanding, can be effective in this endeavour. 

Tax circulars on technical matters  should not only reflect the perspective of tax authorities. The broad principle should be ‘prevention is better than cure.’

There should be alternative dispute-resolving mechanisms. We need an advance-ruling body that could determine cases within a maximum of three months. 

An earlier advance-ruling system, which was only for non-residents and cross-border payments, worked well for a few years, but then collapsed for a variety of reasons. The key point here is the need of a framework to close disputes within a defined time frame.

Taxation of salaried individuals: A standard deduction of ₹50,000 is simply too low. For somebody drawing, say, ₹3 crore, this seems pointless. Many of those with such salaries do actually incur expenses that should be allowed as a tax deduction. Perhaps the quantum of this deduction should be a proportion of one’s salary.

Also read: Income tax reforms: Will the review deliver on promises?

Taxation of employee stock ownership plans (ESOPs) need a relook. Representations have been made that taxation triggered at the stage of stock options being exercised is inappropriate, given that this involves no monetization. Employer-allotted shares should be taxed at the time of their sale. 

Tax deducted at source (TDS): The deductor is actually doing the government’s work, so complex provisions that place an onerous burden (with penal consequences) on tax deductors are unfair; TDS provisions need to be changed, not just in terms of their compliance burden, but also applicable rates.

To conclude, there are several substantive issues of taxation that need to be addressed and it is crucial that India’s amended legislation aligns with our ease-of-doing-business goals. Simplifying language will not be enough. We need taxation rationalized.