DTC

Kelkar Fiscal Report - Highlights

Recently, the Kelkar Committee published a roadmap for fiscal consolidation.  The report stresses the need and urgency to address India’s fiscal deficit.  A high fiscal deficit – the excess of government expenditure over receipts – can be problematic for many reasons.  The fiscal deficit is financed by government borrowing; increased borrowing can crowd out funds available for private investment. High government spending can also lead to a rise in price levels.  A full PRS summary of the report can be found here. Recent fiscal trends Last year (2011-12), the central government posted a fiscal deficit of 5.8% (of GDP), significantly higher than the targeted 4.6%.  This is in stark contrast to five years ago in 2007-08, when after embarking on a path of fiscal consolidation the government’s fiscal deficit had shrunk to a 30 year low of 2.5%. In 2008-09, a combination of the Sixth Pay Commission, farmers’ debt waiver and a crisis-driven stimulus led to the deficit rising to 6% and it has not returned to those levels since.  As of August this year, government accounts reveal a fiscal deficit of Rs 3,37,538 crore which is 65.7% of the targeted deficit with seven months to go in the fiscal year.   With growth slowing this year, the committee expects tax receipts to fall short of expectations significantly and expenditure to overshoot budget estimates, leaving the economy on the edge of a “fiscal precipice”.

Figure 1 (source: RBI)

 

  Committee recommendations - expenditure To tackle the deficit on the expenditure side, the committee wants to ease the subsidy burden.  Subsidy expenditure, as a percentage of GDP, has crept up in the last two years (see Figure 2) and the committee expects it to reach 2.6% of GDP in 2012-13.  In response, the committee calls for an immediate increase in the price of diesel, kerosene and LPG.  The committee also recommends phasing out the subsidy on diesel and LPG by 2014-15.   Initial reports suggest that the government may not support this phasing out of subsidies.

Figure 2 (source: RBI, Union Budget documents, PRS)

 

  For the fertiliser subsidy, the committee recommends implementing the Department of Fertilisers proposal of a 10% price increase on urea.  Last week , the government raised the price of urea by Rs 50 per tonne (a 0.9% increase). Finally, the committee explains the rising food subsidy expenditure as a mismatch between the issue price and the minimum support price and wants this to be addressed. Committee recommendations - receipts Rising subsidies have not been matched by a significant increase in receipts through taxation: gross tax revenue as a percentage of GDP has remained around 10% of GDP (see Figure 3). The committee seeks to improve collections in both direct and indirect taxes via better tax administration.  Over the last decade, income from direct taxes – the tax on income – has emerged as the biggest contributor to the Indian exchequer.  The committee feels that the pending Direct Tax Code Bill would result in significant losses and should be reviewed. To boost income from indirect taxes – the tax on goods and services – the committee wants the proposed Goods and Service Tax regime to be implemented as soon as possible.

Figure 3 (source: RBI)

 

  Increasing disinvestment, the process of selling government stake in public enterprises, is another proposal to boost receipts. India has failed to meet the disinvestment estimate set out in the Budget in the last two years (Figure 4).  The committee believes introducing new channels [1.  The committee suggests introducing a ‘call option model’. This is a mechanism allowing  the government to offer for sale multiple securities over a period of time till disinvestment targets are achieved.  Investors would have the option to purchase securities at the cost of a premium.  They also propose introducing ‘exchange traded funds’ which would comprise all listed securities of Central Public Sector Enterprises and would provide investors with the benefits of diversification, low cost access and flexibility.] for disinvestment would ensure that disinvestment receipts would meet this year’s target of Rs 30,000 crore.

Figure 4 (source: Union Budget documents, PRS)

 

  Taken together, these policy changes, the committee believe would significantly improve India’s fiscal health and boost growth.  Their final projections for 2012-13, in both a reform and no reform scenario, and the medium term (2013-14 and 2014-15) are presented in the table below: [table id=2 /]  


 

General Anti Avoidance Rule (GAAR)

The issue of the General Anti Avoidance Rule (GAAR) has dominated the news recently and there are fears that GAAR will discourage foreign investment in India.  However, tax avoidance can hinder public finance objectives and it is in this context GAAR was introduced in this year’s Budget.  Last week, the Finance Minister pushed back the implementation of GAAR by a year. What is GAAR? GAAR was first introduced in the Direct Taxes Code Bill 2010.  The original proposal gave the Commissioner of Income Tax the authority to declare any arrangement or transaction by a taxpayer as ‘impermissible’ if he believed the main purpose of the arrangement was to obtain a tax benefit.  The 2012-13 Finance Bill (Bill), that was passed by Parliament yesterday, defines ‘impermissible avoidance arrangements’ as an arrangement that satisfies one of four tests.  Under these tests, an agreement would be an ‘impermissible avoidance arrangement’ if it  (i) creates rights and obligations not normally created between parties dealing at arm’s length, (ii) results in misuse or abuse of provisions of tax laws, (iii) is carried out in a way not normally employed for bona fide purpose or (iv) lacks commercial substance.

As per the Bill, arrangements which lack commercial substance could involve round trip financing, an accommodating party and elements that have the effect of offsetting or cancelling each other.  A transaction that disguises the value, location, source, ownership or control of funds would also be deemed to lack commercial substance. The Bill as introduced also presumed that obtaining a tax benefit was the main purpose of an arrangement unless the taxpayer could prove otherwise. Why? GAAR was introduced to address tax avoidance and ensure that those in different tax brackets are taxed the correct amount.  In many instances of tax avoidance, arrangements may take place with the sole intention of gaining a tax advantage while complying with the law.  This is when the doctrine of ‘substance over form’ may apply.  ‘Substance over form’ is where real intention of parties and the purpose of an arrangement is taken into account rather than just the nomenclature of the arrangement.  Many countries, like Canada and South Africa, have codified the doctrine of ‘substance over form’ through a GAAR – type ruling. Issues with GAARcommon criticism of GAAR is that it provides discretion and authority to the tax administration which can be misused.  The Standing Committee responded to GAAR in their report on the Direct Taxes Code Bill in March, 2012. They suggested that the provisions should ensure that taxpayers entering genuinely valid arrangements are not harassed.  They recommended that the onus should be on tax authorities, not the taxpayer, to prove tax avoidance.  In addition, the committee suggested an independent body to act as the approving panel to ensure impartiality.  They also recommended that the assessing officer be designated in the code to reduce harassment and unwarranted litigation. GAAR Amendments On May 8, 2012 the Finance Minister amended the GAAR provisions following the Standing Committee’s recommendations.  The main change was to delay the implementation of GAAR by a year to “provide more time to both taxpayers and the tax administration to address all related issues”.  GAAR will now apply on income earned in 2013-14 and thereafter.  In addition, the Finance Minister removed the burden upon the taxpayer to prove that the main purpose of an alleged impermissible arrangement was not to obtain tax benefit.  These amendments were approved with the passing of the Bill. In his speech, the Finance Minister stated that a Committee had also been formed under the Chairmanship of the Director General of Income Tax.  The Committee will suggest rules, guidelines and safeguards for implementation of GAAR.  The Committee is expected to submit its recommendations by May 31, 2012 after holding discussions with various stakeholders in the debate.

Draft Policies on Telecom, Electronics and Information Technology: Some Issues

The Ministry of Communications and Information Technology released three draft policies on telecommunications, information technology and electronics.  The Ministry has invited comments on the draft policies, which may be sent to epolicy2011@mit.gov.in. These policies have the common goal of increasing revenues and increasing global market share.  However, the policies may be incompatible with the Direct Taxes Code Bill, 2010 (DTC) and India’s international obligations under the General Agreement on Tariff and Trade (GATT).  Below we discuss these policies within the scope of the GATT and the DTC. The draft National Information Technology Policy, 2011 aims to formulate a fiscal structure to attract investment in the IT industry in tier II and III cities.  It also seeks to prepare SMEs for a competitive environment by providing fiscal benefits.  Similarly, the draft National Electronics Policy provides for fiscal incentives in manufacturing on account of infrastructure gaps relating to power, transportation etc. and to mitigate the relatively high cost of finance.  The draft policy also provides preferential market access for domestically manufactured or designed electronic products including mobile devices and SIM cards.  The draft National Telecom Policy seeks to provide fiscal incentives required by indigenous manufacturers of telecom products and R&D institutions. The theme of the DTC was to remove distortions arising from incentives.  The detailed note annexed to the Bill states that “tax incentives are inefficient, distorting, iniquitous, impose greater compliance burden on the tax payer and on the administration, result in loss of revenue, create special interest groups, add to the complexity of the tax laws, and encourage tax avoidance and rent seeking behaviour.”  It further notes that the Parliamentary Standing Committee on finance had recommended removal of exemptions other than in exceptional cases.  As per the Department of Revenue, tax holidays should only be given in businesses with extremely high risks, lumpy investments and lengthy gestation periods.  The DTC also removes location-based incentives as these “lead to diversion of resources to areas where there is no comparative advantage”.  These also lead to tax evasion and avoidance, and huge administrative costs.  The proposals to provide fiscal incentives in all three draft policies contradict the direction of the direct tax reforms. Article 3 of GATT provides that foreign products should be accorded the same treatment accorded to similar domestic products in respect of all laws, regulations and requirements affecting their internal sale, offering for sale, purchase, transportation, distribution and use.  The provisions in the draft electronics policy to secure preferential market access to products manufactured in India may contravene this Article. In granting such fiscal and trade incentives, the policies may be contrary to the approach adopted in the DTC and India’s obligations under the GATT.  These draft policies will have to be reconciled with tax reforms and trade obligations.