insight
Direct Taxes Code:
Need for Greater Reflection
M Govinda Rao, R Kavita Rao
A new tax code that overhauls the
complexities that have emerged
in the Income Tax Act of 1961
has been long overdue. The draft
Direct Taxes Code put out by the
Finance Ministry for discussion
and comment does just that in
a number of areas. At the same
time questions must be posed
of the sweeping reduction
in rates and restructuring of
slabs in income tax, which are
likely to  rob the exchequer of a
significant amount of income.
Questions must also be asked of
the proposed taxation of
not-for-profit organisations.
M Govinda Rao (mgr@nipfp.org.in) and
R Kavita Rao (kavita@nipfp.oirg.in) are with
the National Institute of Public Finance
and Policy.
Economic & Political Weekly  EPW   september 12, 2009  vol xliv no 37
I
n the 2009-10 budget speech, Union
Finance Minister Pranab Mukherjee
promised to build “…a trust based
simple, neutral tax system with almost no
exemptions and low rates designed to pro-
mote voluntary compliance” and towards
that end, committed to unveil a Draft
Code of Direct Taxes for public discussion.
The purpose of the new code is to simplify
the enormous complexities in direct taxes
since the enactment of Income Tax Act,
1961. As stated by the finance minister, the
objective of the new code is, “…to improve
the efficiency and equity of our tax system
by eliminating distortions in the tax struc-
ture, introducing moderate levels of taxa-
tion and expanding the tax base”. In fact,
periodic redrafting of the code is n­ecessary
to update the tax system to conform to
emerging economic realities and clean up
the complexities it acquires over the years.
Income taxes – both individual and cor-
porate – have indeed become extremely
complex over the years. The plethora of
exemptions and tax preferences to fulfil a
variety of objectives has not only eroded
the base, it has also complicated the tax
system with unintended consequences on
resource allocation. The complexities in
the Income Tax Act have only made the
legal and accountants’ professions very
lucrative. The situation has led not only
to    high administrative and compliance
costs but also significant distortions in
resource allocation.
Not surprisingly, the taxpayers are very
enthused at the all-round reduction in the
rates, but not on giving up exemptions and
preferences. On the whole, the media and
businesses have welcomed the draft code
on the perception that a significant pro-
portion of the taxpayers – both persons
and businesses – will have to pay lower
taxes. In fact, virtually everyone is oblivi-
ous of the revenue implications, and take
it for granted that the expansion in the
base proposed in the code will compen-
sate for the revenue loss due to a change in
the structure. It was John Maynard Key-
nes who stated, “Soon or late, it is ideas
and not vested interests that are danger-
ous for good or evil”. But in India, the tax
system has been affected more by vested
interests than by ideas and eventually, we
should not end up with lower rates along
with continued exemptions and prefer-
ences! This article attempts to evaluate
the important changes proposed by the
new code.
1  Personal Income Tax
The attempts to broaden the base by doing
away with several exemptions and prefer-
ences in the new code are truly welcome
and they can help in reworking the strat-
egy towards achieving fiscal consolida-
tion. In general, removal of exemptions
and preferences is also important from the
point of view of avoiding unintended dis-
tortions in the economy, reducing the
compliance cost and ensuring greater hor-
izontal equity. The best practice approach
to tax reform advocates broadening the
base not only to achieve greater neutrality
and minimise the influence of vested
interests on the tax system but also to raise
revenues at lower tax rates. The latter is
important, for, the distortions caused by
the tax system is roughly equivalent to the
square of the tax rate, and the lower the
rate, the lower will be the distortions.
The new code seeks to broaden the base
of individual income tax in a number of
ways. The benefits provided by the
employer such as free or concessional hous-
ing, medical benefits in any form, value of
leave travel concessions and any encash-
ment of unavailed earned leave would be
included in the taxable income. Similarly,
limited deductions will be allowed in medi-
cal expenses, interest on loans taken for
higher education, rent paid and donations
to specified causes. This reduces the scope
of deductions to a considerable extent
when compared to the present regime.
Removal of Housing Loan
Exemptions
An important area where a substantial
change is sought to be made to limit the
35
Insight
deductions is in respect of housing loans.
In the prevailing system, interest paid on a
housing loan is deductible from total
income irrespective of whether the house
is earning rental income or not. Further,
repayment of the principal could be uti-
lised as a part of the investments under
section 80C. However, in the new code,
deduction of loan repaid will no longer be
deductible, and deduction on interest paid
will be available only when the house earns
rental income and will be limited to the
extent of rent received. This is an impor-
tant change, for there is no evidence to
show that this incentive enhances the pur-
chasing power of the taxpayer to acquire
residential dwellings. In fact, anecdotal
evidence suggests that the expansion in the
benefits from this tax preference is accom-
panied by an increase in the price of dwell-
ings. In other words, the benefits of this tax
preference could be appropriated by the
developers rather than individuals.
Treatment of Savings
The code proposes to make a major depar-
ture in the treatment of savings from the
prevailing system of total exemption on
savings as well as the return from savings
to a system of Exempt-Exempt-Tax (EET). It
is proposed to increase the exemption from
the prevailing Rs 1 lakh to Rs 3 lakh in pre-
specified instruments. However, in the new
regime, the list of eligible instruments will
be pruned and while the savings as well as
the returns on such savings will not be
taxed, the tax will be levied when they are
withdrawn for purposes of consumption.
This treatment applies to current savings as
well as to any superannuation and savings
in pension funds. This brings the taxation
system closer to one based on taxation of
consumption rather than taxation of
incomes per se. While theoretically there is
much to commend this treatment of taxing
savings, its political acceptability remains
to be seen for, levying taxes on superannua-
tion benefits and pension funds may be
unpopular as it is perceived, inappropri-
ately so, to place hardship on senior citizens
who may not have any other regular source
of income.
Treatment of Capital Gains
A major rationalisation proposed in the
new code is in the treatment of capital
36
gains and this applies to both individuals provisions or whether such transactions
and companies. According to the new code, should be permitted a rollover. It may be
capital gains from all “investment assets” pointed out that in the absence of a rollo-
of an enterprise as well as all capital assets ver, it could alter the structure of financial
of an individual would be subject to tax markets. For instance, there could be more
upon realisation. The distinction between transactions in derivatives of the primary
long-term and short-term capital gains is assets held without actual sales in the
removed. For all assets, capital gains are to same. It is important to provide some clar-
be measured as the value realised, net of ity on this issue.
inflation adjusted costs. While all capital
gains will be subject to tax as a part of the Rates and Slabs
income, the securities transactions tax will The most important change proposed in
be abolished. Both taxing capital gains the code is in regard to the structure of
regardless of the length of holding the individual income taxation. The code has
assets and abolition of securities transac- proposed substantial changes in the vari-
tion tax are in the right direction. There is ous brackets. While the exemption limit
no reason for not considering capital gains has been kept unchanged, it is proposed to
as legitimate income and subjecting them levy the tax at 10% up to Rs 10 lakh, 20%
to tax. Further, any tax on transactions between Rs 10 lakh to Rs 25 lakh and
including the securities transaction tax above that at 30% as against the prevail-
adds to transaction costs and therefore is ing brackets of up to Rs 3 lakh, Rs 5 lakh
undesirable. and Rs 10 lakh. Thus, virtually every tax-
It is also important to note that rollover payer excluding those up to Rs 3 lakh
provisions for capital gains are limited to income will be paying less by a third or
only a few transactions – sale of agricul- more of the present tax liability and over
tural land to buy agricultural land, sale of 97% of the present taxpayers will be pay-
investment assets to finance the purchase ing the tax at just 10%.
of the first house by an individual, and By any reckoning this is a massive
sale of investment asset if the proceeds reduction in the tax rates involving sub-
from the same are invested into a capital stantial loss of revenue. Surely, high
gains savings scheme. There are evidently income earners would welcome this
some other transactions where rollover is change as they will have to pay less of the
considered integral to business practices – tax by a third or more. In fact, all the
fund management in a mutual fund for expansion in the base proposed in the
instance. If tax becomes due for each rea- code is not likely to offset the revenue loss.
lignment of the portfolio based on current In 2009-10, the revenue from personal
market assessment, there would be con- income tax is estimated at 2.2% of GDP
siderable outflow from the fund even if and the reduction in the tax rates is likely
the final investor is not liquidating the to reduce the revenue by at least half a per
investment. In other words, there is a cent of GDP at the present level and distri-
lock-in into early investments resulting from bution of incomes. At a time when it is
the tax structure proposed. It is important necessary to garner higher revenues to
to ask whether this is the intent of the return to the path of fiscal consolidation,
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september 12, 2009  vol xliv no 37  EPW   Economic & Political Weekly

such a massive giveaway may only make
fiscal adjustment process that much more
difficult. Such a liberal giveaway does not
serve the cause of vertical equity either.
For a country with per capita income of
Rs 25,500, levying the 10% tax up to Rs 10
lakh income is tantamount to throwing
the baby out with the bath water.
The proposal to bring back the wealth
tax into the tax system in the code is wel-
come from the viewpoint of equity as well
as revenue. However, levying the tax at
0.25% of the value of wealth when it
exceeds Rs 50 crore makes a mockery.
Such tokenism is unlikely to either garner
revenue nor will it improve equity and it
will not be surprising if the tax is given a
sound burial after trying it for a few years
It is not clear what is intended to be
achieved with such a tax.
2  Corporation Income Tax
The code proposes to make some signifi-
cant changes in the treatment of corporate
sector which are summarised in the
following:
(i) A reduction in the corporate tax rate
from 30% to 25%. Usually, the corporation
income tax rate is aligned to the highest
marginal rate of individual income tax.
This is because individual income tax
applies to individuals, Hindu Undivided
Families, association of persons including
small businesses and partnership firms.
Keeping the corporation tax rate lower
than the highest marginal rate of individ-
ual income tax can be desirable if that pro-
vides incentives to these smaller proprie-
tary and partnership firms to graduate into
becoming corporations. Any tax that helps
to formalise the non-formal sector is desir-
able. However, whether this will happen is
doubtful. There are various other taxes
and regulations that actually provide
incentives to the small firms to remain so.
(ii) In computing taxable profits of an
enterprise, assets of the enterprise are
segregated into business and investment
assets. Value realised from the sale of the
former would be included in the computa-
tion of profits of the enterprise. However,
in the case of the latter, there is a separate
regime for treatment of capital gains (dis-
cussed above). This segregation and dif-
ferential treatment has certain implica-
tions for enterprises   –   the investment
Economic & Political Weekly  EPW   september 12, 2009  vol xliv no 37
assets would not constitute an integral
part of the business planning of a firm.
Losses in the business activity of a firm
cannot be offset by sale of “investment
assets”. It is possible to view this as a
mechanism to ensure that “business
activity” of a firm is not diluted. Further,
there is a notional segregation of the assets
of the firm connected to the “business
activity” and the rest. Surely, this is a
potential area for litigation.
(iii) The above reduction in the tax rate is
combined with a reduction in the number
of exemptions available within the stat-
utes. While exemptions relating to the
development of infrastructure units
remain, most of the other exemptions of
the existing tax regime do not find place
in the new code. Specifically, exemptions
for investment in specified geographical
areas, those related to the information
techno­logy and business process outsourc-
ing sector, as well as those relating to
exports from the special export zones
(SEZs) are excluded from the code. The
code provides for grandfathering in these
provisions, meaning thereby that while
units currently availing incentives would
continue to do so, no new units established
after the enactment of this code will be
eligible for these concessions. Hopefully,
the sunset provisions in regard to some of
these incentives will not be renewed. The
rationalisation of the exemptions regime
would increase the liability of the corpo-
rate entities, to the extent some benefits
accrued in the present regime.
In determining the dimensions of the
tax incentives in sectors or activities where
the incentives remain, the code limits the
extent of incentive that the unit can avail
to the amount of capital investment. In
other words, the incentive regime is
designed to help the units to recover their
capital costs. Given the considerable
apprehensions regarding extensive tax
planning in response to the tax prefer-
ences resulting in evasion and avoidance,
it is useful to limit the benefits proposed in
the act. Since a bulk of the incentives now
available extend to infrastructure sectors,
this seems reasonable an interesting
mechanism to quantify the benefits that
the units can derive from the schemes.
(iv) Another major change is in the form
of the Minimum Alternate Tax (MAT)
insight
– in the present regime, the tax is on book
profits. Further, it was formulated in the
nature of an advance tax from the poten-
tial taxes payable on corporate income –
hence MAT paid was creditable against the
taxes payable in subsequent years. The
new code proposes to change the regime
to a tax based on the value of assets and,
further, it is proposed as a sunk cost rather
than as an advance tax. This change is
likely to have a profound impact on the
tax liabilities of corporate firms in India.
The proposed tax is at the rate of 2%1 of
the value of assets, where the value of
assets includes all existing operational
assets as well as assets under construction.
The rationale provided for this change
is that a tax on assets allows for better and
more efficient utilisation of the capital
invested, since there are gains from the
improved efficiency at least until such
time as the companies are paying MAT in
the place of a regular income tax. For a 2%
tax on value of assets to be at least equiva-
lent to a 25% tax on profits, there is an
underlying assumption that the profits in
the enterprise are at least 8% of the value
of assets. While for most functional com-
panies this may not be an unfair assump-
tion, for start-ups and companies that are
yet to establish a business presence, it
could be an additional cost to surmount.
Further, the cost of a business is altered by
introducing this additional levy into the
picture – the overall tax liability for any
firm increases, implying thereby that the
post-tax profits would be adversely
affected, even if we assume that the pre-
tax profits remain unaltered.
It should be mentioned here that the
reasons for introducing a MAT in the first
place was to reduce the scope for compa-
nies to undertake tax planning and become
no or low profit companies with very little
liability for corporate tax, while, at the
same time, declaring reasonable book prof-
its. The difference between the profits for
income tax purposes and book profits
arises on account of two major reasons –
owing to accelerated depreciation provi-
sions within the income tax act and as a
result of tax incentives that might be avail-
able in law. It is not clear why these dif­
ferences should be retained and at the
same time an attempt to correct for the
imbedded impact is attempted through an
37
Insight
additional levy such as the MAT. It should
be kept in mind that the impact of these
provisions is different across companies.
Companies which derive benefits from
accelerated depreciation and exemptions
can broadly be classified into two catego-
ries – those that are expanding their busi-
nesses and those that are in the nature of
start-up firms working with the first or
first few units. Since the former would
have some reasonable tax liability from
the older units, they can use this to offset
the gains from the concessions available
from the new units. In the case of the
l­atter, however, such possibilities do not
exist and hence the tax imposes additional
costs on these units. In other words, these
provisions seem to be driving a wedge
between the already existing prosperous
firms and the new entrants. With a bind-
ing cost, this wedge would be driven in
deeper than before.
3 Treatment of Non-Profit
Organisations
The most contentious issue is the proposal
to withdraw exemptions to charitable insti-
tutions. Presently, not for profit organisa-
tions (NPO) enjoy exemption on their dona-
tions as well as any surplus they create
under Sections 80-G or 35(1)(3) of the
Income Tax Act. Many recent committees
on tax reform have suggested changes in
the treatment of NPOs to avoid the misuse
of the exemptions by them. Indeed these
institutions provide various public services
and serve a variety of public purposes
which the government is unable to.
Although the intent is to prevent the mis-
use of the exemptions, the proposal extends
the scope of the tax even to genuine insti-
tutions involved in anti-poverty interven-
tions, social organisations, education and
healthcare activities and those engaged in
serious academic and policy research.
The code dispenses away with the term
“Charitable Purpose” and replaces it with
“permitted welfare activities” which
include relief of the poor, advancement of
education, provision of medical relief,
preservation of environment, preserva-
tion of monuments or places and objects
of artistic or historic value and any other
object of general public utility. It is pro-
posed that the surplus earned by these
organisations be taxed at the rate of 15%.
38
The surplus would be computed to include
surplus from the welfare activity and the
capital gains from transfer of any finan-
cial investment asset. Here, any donations
to the corpus of the institution are not to
be included in the computation of surplus.
All expenditure, current and capital
incurred in order to provide the welfare
activity can be deducted from the gross
receipts from the activity. It may be men-
tioned that the gross receipts would
include all receipts from the transfer of
any business asset of any investment asset
of a non-financial nature. In order to
ensure that tax planning does not drive
the establishment of a non-profit organi-
sation (which can then transform into a
body corporate, for instance) it is pro-
posed that whenever a non-profit organi-
sation changes form such that it no longer
remains non-profit, tax at the rate of 30%
would be payable on its net worth.
Working under the assumption that the
rationale for providing tax preferences to
the non-profit sector remains unchanged,
and given the fact that the surplus in any
NPO does not accrue to any individual,
there is a continuing need to support such
institutions. Closer and more effective reg-
ulation and a more precise definition of
what constitutes welfare activities might
help to minimise the perceived misuse. The
former is critical since, part of the rationale
for introducing a tax on these institutions
is to provide a regulatory and monitoring
mechanism within the income tax system,
in the absence of such a mechanism out-
side the tax network. It should, however,
be recognised that with the introduction
of the tax, even if the rate is a lower 15%,
limits the scope for these activities. It is,
therefore, important to explore the alter-
native mechanisms to limit misuse rather
than the proposed taxing their surpluses
even if it is at a lower rate.
Clearly, the code seems to have under-
estimated the good work done by many
NPOs. While it is possible that provision
for exemption has been misused, it would
be improper to deny the benefit to g­enuine
charitable institutions, research organi­
sations and other NPOs which do con­
siderable philanthropic work, further
the     cause of education, health and
research. In fact, providing incentive to
them to generate surpluses will enable
september 12, 2009  vol xliv no 37  EPW   Economic & Political Weekly
them to build c­orpuses which in the
longer run will reduce their dependence
on the government.
Concluding Remarks
The proposal to expand the tax base by
doing away with various exemptions and
preferences in the new code is welcome.
However, its actual implementation will
require the finance minister to resist the
pressure from special interest groups who,
while welcoming the reduction in rates,
would like the exemptions to continue. In
particular, the proposal to expand the tax
base by rationalising savings incentives,
deductions for housing and partial allow-
ance for education and medical expenses
should help to expand the tax base and
simplify the tax system. The distinction
between short-term and long-term capital
gains, abolition of securities transaction
tax and tax on the income from gains after
indexation at regular rates too is welcome.
However, the proposed changes in the
tax brackets will rob the exchequer of the
benefits of a larger tax base and is likely to
result in significant revenue loss to the
exchequer. If, indeed, the special interest
groups prevail in keeping the exemptions
and preferences unchanged while the tax
rate is reduced, there will be a huge loss of
revenue. The important question is
whether the country can afford this at the
time when the need of the hour is to return
to the path of fiscal consolidation. The
proposed wealth tax is likely to be a mere
token and it is not likely either to generate
any significant revenue or improve equity
in the tax system. It makes no sense to
have an exemption limit as high as Rs 50
crore and levy the tax at 0.25% on the
wealth above that. The code does not
r­ecognise the good work many of the NPOs
have done over the years in providing
various services which the government
cannot and in its attempt to prevent
m­isuse ends up reducing a conceptual
argument for not taxing these organisa-
tions into a tax preference.
Note
1 The rate for firms in the banking sector is
dif­ferent at 0.25% of the value of assets. Since
the usual relationship between the assets of a
bank and the returns from the same are signi­
ficantly different from the returns on assets in
the rest of the economy, this seems like a fair
differentiation.