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Budget: looking for supportive tax laws

The financial sector is one of the fastest growing segment and with globalisation, many complex financial products slowly find their way in the Indian market. While the Indian economy is in its growth trajectory, this sector and its divergent products play a key role in resource mobilisation in a cost-effective manner. The forthcoming Union Budget is expected to give a tax system supportive of extensive and effective use of financial products and services, which is vital to growth.

The market has already seen rapid change with complex financing structures, securitisation and derivative instruments. “The one thing that has not been seen though, is a corresponding march of the income-tax law,” argues Naresh Makhijani, Executive Director, KPMG, a global professional services firm, which provides tax and regulatory services. For example, securitisation has posed some complex tax issues. Similarly, complex derivative instruments can pose challenges to a taxpayer who at the moment does not have any guidance on the tax treatment thereof. “With financing structures becoming more and more complex, it has become imperative to simultaneously consider tax implications thereof.” The unresolved tax issues — connected with the Centre as well as the State governments — are the major hurdles for the development of a secondary market for debt instruments, which is vital for resource mobilisation.

To take a recent example, foreign institutional investors (FIIs) have been permitted to short-sell securities and then give delivery thereof at the settlement by borrowing securities consequent to a stock-lending scheme. This raises tax issues in the hands of the seller such as would the gains from the sale be taxable as capital gains or as business income, and what would be the cost of acquisition of the shares borrowed. It also throws up some interesting tax questions vis-a-vis the lender of the shares as well as the intermediary. The outgoing Securities and Exchange Board of India (SEBI) Chairman, M. Damodaran, also expressed his displeasure in his last press conference as head of the capital market regulator that the delay in taking a decision by the Central Board of Direct Taxes (CBDT) on taxes concerned with short-selling and securities lending and borrowing, failed the early implementation of short-selling by FIIs. The SEBI was expecting to implement this product on stock exchanges by the beginning of February.

Banks, as the largest players in the financial markets, also have significant tax issues. One of the issues that banks have been facing is the allowability of a tax break on write-off of bad debts. The Income-tax Act, 1961, was amended with effect from April 1, 1989, to provide for the allowability of a deduction for a bad debt in the year in which the debt was written off in the books of account of the lender. The amendment was made to resolve a controversy of what was the year in which a debt actually became bad, because as the law stood earlier, deduction was to be allowed in the year in which a debt went bad. “One thought that with the amendment, things would be simpler for claiming this deduction but it appears that post this amendment too, deduction for bad debts remains a point of contention between the banks as taxpayers and the income-tax department,” says Mr. Makhijani.

Another issue that has been the subject of recent litigation is the allowance of depreciation on assets given on a finance lease. But the Central Board of Direct Taxes had issued a circular in 2001 to the effect that irrespective of the accounting treatment given to lease transactions in the books of the lessor and the lessee, depreciation on leased assets would be available to the owner thereof, which, in law, ought to be the lessor. The allowability of depreciation to the lessor, in finance leases is however, increasingly being questioned and one has seen one’s fair share of cases where, the lessor is not held to be the owner by the tax department. According to Mr. Makhijani, this promises to become another contentious issue for the financial services sector in the days to come.

One more concern for the sector is the newly introduced Fringe Benefit Tax (FBT) particularly on Employee Stock Options (ESOP). In spite of valuation rules being prescribed for levy of FBT on ESOP, some questions still remain unanswered.

Transfer pricing and withholding tax continue to be the financial services industry’s bugbears. The lack of understanding of cross-border financial transactions by tax officers often results into unjustified adjustments being made to their income which potentially can result in significant tax payment issues (if not tax liability issues) for them. Additionally, the complexity of the transactions often leads to questions about potential withholding tax requirements and liability, which neither the taxpayers nor the tax department appear to conclude successfully on. “So, the vice-like grip of the tax law can not only make taxpayers cough up significant amount of taxes, but can potentially throw the pricing mechanism of a product out of gear, which is very concerning for the payers in the financial services sector.”

Many financial services are also subject to service tax now and even as far as service tax is concerned, certain interpretation issues have the potential to result in long and significant litigation for the players in the financial services sector.

These and many other issues not discussed here, according Mr. Makhijani, have resulted in considerable time and resources of the financial services sector being spent on tax compliance and litigation and have also hampered their ability to price their products competitively.

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