KPMG IN INDIA

KPMG Flash News

1 September 2010

TAX

DIRECT TAX CODE BILL 2010 – IMPACT ON IT / ITES SECTOR

BACKGROUND

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

the Direct Taxes Code Bill, 2009 in August 2009 for public comments. The
provisions of the DTC, especially those relating to Minimum Alternate Tax
(‘MAT’) on gross assets, withdrawal of tax holiday to SEZ units, etc. met with
vociferous protests from various stakeholders. Several representations were
made by NASSCOM and numerous industry groups, based on which, the
Government identified some major issues and released the Revised
Discussion Paper on DTC in June 2010. As a logical step post the Revised
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 Information Technology
(‘IT’) / Information Technology Enabled Services (‘ITES’) sectors is set out
below.

KEY PROPOSALS AND THEIR IMPACT

Tax holiday to SEZ units and SEZ developers

Current situation:

Under the existing provisions of the Income-tax Act, 1961 (‘the Act’), tax
holiday is available to IT/ITES units operating from Software Technology
Parks (‘STP’), Export Oriented Units (‘EOUs’) and Special Economic Zones
(‘SEZ’). While the tax holiday in respect of the STP and EOU units has a
sunset clause of 31 March 2011, SEZ units can avail tax exemption for a
period of 15 years (which may extend beyond 31 March 2011)

© 2010 KPMG, an Indian Partnership and a member firm of the KPMG network of independent
member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
1
 subject to fulfillment of certain conditions. Further, even SEZ developers are
eligible to claim tax exemption in respect of their profits for a period of 10
years.

DTC Proposals:

The DTC proposals seek to end the profit-linked incentive regime for SEZ
units operational after 31 March 2014 and SEZ developers notified after 31
March 2012. Further, it has provided for grandfathering of tax holiday
available to SEZ developers / SEZ units for the unexpired period.

Grandfathering of Tax Holiday for SEZ units

 Tax Holiday under section 10AA of the present Act would continue to be
availed by all existing SEZ units for the balance unexpired period out of
the prescribed 15 years. Such benefit would also be available to new
SEZ units which commence operations on or before March 31, 2014.

 For the purpose of computing profits eligible for the aforesaid Tax
Holiday, the methodology prescribed under Schedule 12 of the DTC
shall be applicable. However, capital expenditure as well as expenditure
incurred prior to commence of business shall not be allowed as a
deduction for such purposes.

 The conditions specified under section 10AA for availing Tax Holiday
shall continue to be applicable.

Grandfathering of Tax Holiday for SEZ Developers

 Tax Holiday under section 80-IAB of the present Act would continue to
be availed by all existing SEZ Developers for the balance unexpired
period out of the prescribed 10 years. Such benefit would also be
available in respect of new SEZs which are notified on or before March
31, 2012 under the SEZ Act.

 For the purpose of computing profits eligible for the aforesaid Tax
Holiday, the methodology prescribed under Schedule 12 of the DTC
shall be applicable. However, capital expenditure as well as expenditure
incurred prior to commence of business shall not be allowed as a
deduction for such purposes.

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

© 2010 KPMG, an Indian Partnership and a member firm of the KPMG network of independent
member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
2
 Comments:

The IT/ITES sector has been a key driver to India’s economic growth
trajectory. The tax incentives offered to companies operating in this sector
have provided them an edge in today’s fiercely competitive market.

As such, continuation of these tax incentives to new SEZ units under the
DTC, though under a restrictive grandfathering clause, is still a positive step.
The grandfathering provisions would provide some relief to the SEZ
developers, not just vis-à-vis the tax benefit availed by such developers, but
also vis-à-vis the business case for setting up a unit in SEZ, which is so
integrally linked to the tax benefit bestowed on the unit.

Minimum Alternate Tax (MAT)

Current situation:

In light of the tax holiday available to the IT/ITES 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. Presently,
MAT provisions are not applicable to SEZ units and SEZ developers.

DTC Proposals:

Under DTC, the concept and computation methodology of MAT have been
retained broadly. However, MAT rate has been increased to 20% of book
profits. Further, there is no exemption for SEZ developers and SEZ units
from MAT.

Comments:

This is a negative development for the IT/ITES sector. Absence of MAT

exemption under the DTC would mean that SEZ Developers and SEZ units
would need to pay a minimum tax of 20% on book profits. This provision
would lead to additional tax outflow for the SEZ units/ developers in this
sector. Further, DTC does not specifically provide for availing credit of MAT
paid under the Act (relevant for STP / EOU units).

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.

© 2010 KPMG, an Indian Partnership and a member firm of the KPMG network of independent
member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
3
 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.

© 2010 KPMG, an Indian Partnership and a member firm of the KPMG network of independent
member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
4
 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
© 2010 KPMG, an Indian Partnership and a member firm of the KPMG network of independent
member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
5
 – 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.

© 2010 KPMG, an Indian Partnership and a member firm of the KPMG network of independent
member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
6
 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 and would benefit the people driven IT/ITES space.

Withholding tax provisions

Bandwidth and Software payments

Significant components of cost for companies in the IT/ITES space include

bandwidth charges and standardized software costs paid to overseas
service providers / vendors.

Current Situation:

Based on various judicial precedents, the payments are not subjected to tax
withholding on the basis that payment for bandwidth to overseas service
providers is not ‘royalty’ and payments towards shrink-wrap software are
akin to payments for purchase of goods and not ‘royalty’ or ‘Fees for
technical services’.

DTC Proposal:

Under DTC, the definition of ‘royalty’ has been amended to specifically

include consideration for use or right to use of transmission by satellite,
cable, optic fiber or similar technology. Also, the definition of the term ‘Fees
for technical services’ is redefined to include “development and transfer of a
design, drawing, plan or software or similar services”.

Comments:

These amendments cast a doubt whether the definition of royalty would

cover charges for bandwidth which is merely a ‘facility’ availed by the
IT/ITES companies and whether the term fees for technical services would
also cover payments for standardized software which are essentially akin to
© 2010 KPMG, an Indian Partnership and a member firm of the KPMG network of independent
member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
7
 payments for purchase of goods.

Typically, tax burden is passed on to the Indian service recipients and results
in the increase in the overall cost of operations.

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.

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.

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
IT/ITES entities. In certain cases, companies are facing litigation from
revenue authorities on the question of whether they are eligible to claim
© 2010 KPMG, an Indian Partnership and a member firm of the KPMG network of independent
member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
8
 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 IT/ ITES space 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.

 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.

© 2010 KPMG, an Indian Partnership and a member firm of the KPMG network of independent
member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
9
  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

It is interesting to note the path of the Direct Tax Code from the 2009 Bill to
the 2010 one. The promises of a lower corporate tax rate have not
crystallised. However, relief has been given to SEZ developers & SEZ units
by way of grandfathering clause, the benefit of which has been partly
nullified by the proposed levy of MAT at a high rate of 20%. Introduction of
GAAR and CFC signals a tough tax regime for the corporate sector. All in all,
DTC seems to be a mixed bag of goodies.

© 2010 KPMG, an Indian Partnership and a member firm of the KPMG network of independent
member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity.
All rights reserved.
10
 in.kpmg.com

Bangalore Mumbai
Maruthi Infotech Centre, 11-12/1 Lodha Excelus, Apollo mills
Inner Ring Road compound,
Koramangala, Bangalore 560071 NM Joshi Marg, Mahalaxmi,
Phone: + 91 80 3980 6000 Mumbai 400 011
Fax: +91 80 3980 6999 India
Phone: +91 22 39896000
Chennai Fax: + 91 22 39836000
KPMG House
No.10, Mahatma Gandhi Road, Pune
Nungambakkam High Road, 703, 7th Floor Godrej Castlemaine,
Chennai 600034 Next to Ruby Hall Clinic,
Phone: +91 44 39145000 Bund Garden Road, Pune 411001
Fax: +91 44 39145999 Phone: +91 20 30585764/65
Fax: +91 20 3058 5775
Chandigarh
SCO 22-23 Kochi
1st Floor, Sector 8 C 4/F, Palal Towers, M. G. Road,
Madhya Marg Ravipuram, Kochi 682016
Chandigarh 160019 Phone: +91 (484) 305 9000
Tel: 0172 3935778 Fax: +91 (484) 305 9001
Fax: 0172 3935780

Delhi
DLF Cyber City, Building no. 10,
Block B, Phase II
Gurgaon, Haryana 122 002
Phone: +91 124 307 4000
Fax: +91 124 254 9195

Hyderabad
KPMG, 8-2-618/2
Reliance Humsafar, 4th Floor
Road No.11, Banjara Hills
Hyderabad - 500 034
Phone: +91 40 30465000
Fax: + 91 40 30465299

Kolkata
KPMG Infinity Benchmark
Plot No. G-1, 10th floor Block - EP &
GP,
Sector – V, Salt Lake City
Kolkata - 700091
Phone: +91 33 4403 4000

The information contained herein is of a general nature and is not intended to address the circumstances of © 2010 KPMG, an Indian Partnership and a member firm
any particular individual or entity. Although we endeavour to provide accurate and timely information, there of the KPMG network of independent member firms
© 2010that
can be no guarantee KPMG, an Indian Partnership
such information is accurate asand a member
of the date it is firm of the
received KPMG
or that it willnetwork
continueof
to independent member
affiliated firmsInternational
with KPMG affiliated with
Cooperative (“KPMG
be accurate inKPMG International
the future. Cooperative
No one should (“KPMG
act on such International”),
information a Swiss professional
without appropriate entity. All rights
advicereserved.
International”), a Swiss entity. All rights reserved.
after a thorough examination of the particular situation. 1