From 2014-16, India Lost Rs.400,000,000,000 in Taxes. Here's How.
The Indian economy is a convolution of a diverse set of plans, policies and, rules and regulations. Known world over for the potential it holds as an emerging superpower, the dividend from a stable democratic polity, and a service sector powerhouse, the world’s 7th largest economy (3rd largest in PPP terms) has a rather notorious tryst with taxation. In the last decade, the country has conducted bumpy experiments with retroactive taxes on acquisitions, an attempted tax on Foreign Portfolio Investors, and a complex indirect tax system ironically aimed at simplifying the tax code. This article concerns the second item on that list – a proposed levy that was supposed to bring the government a bounty of INR 400,000,000,000 (US$ 5.7bn approximately).
Globally, direct tax laws incorporate a number of exemptions and incentives for taxpayers. These are geared towards incentivising research, capital investments, employment generation, or for remedying sectoral and regional imbalances and inequities. The principle behind these incentives is that the positive spillover from business activities in an economy are greater than the immediate benefit from increased tax revenue. Since companies are the primary vehicle for mobilizing investments at a scale large enough for the desired effects, they become the primary beneficiaries as well. However, over time, these deductions can cascade and reduce tax liabilities of massive corporations to almost zero. Often, this is also the result of careful planning and clever accounting by such companies. This violates the spirit but not the letter of the law, and is therefore known as ‘tax avoidance’, as distinct from ‘tax evasion’ – the latter being illegal while the former is legal. Consequently, to protect their tax base, countries have introduced specific provisions in their tax laws that cap the deductions and exemptions available to companies. This ends up with the companies paying a minimum tax, regardless of how many deductions they can claim — commonly referred to as an “Alternative Minimum Tax” (AMT). In India, this is known as the Minimum Alternate Tax (MAT).
Understanding the Minimum Alternate Tax
Minimum Alternate Tax (MAT) was first introduced in India by the Finance Act of 1987, vide Section 115J of the Income Tax Act (IT Act), to facilitate the taxation of ‘zero tax companies’ – a reference to companies availing exemptions to effectively avoid taxation altogether. Under the MAT regime, corporations under the tax’s ambit began calculating their annual taxes from the Corporate Tax Rate set each year, and could avail of exemptions on the same upto a cap. This cap is the minimum tax on ‘book profits’ (aka, net profits) that a company must pay if it falls under the ambit of the law. At present (Finance Act 2018), while the Corporate tax rate in India (for large companies) is 30%, MAT is set at 18.5%. Thus, every large firm must pay a minimum of 18.5% on any profits it makes – regardless of the number of deductions it may be eligible to avail.
There are certain circumstances where MAT paid may be higher than the actual taxable income of the company. This happens usually because ‘book profits’ and ‘taxable income’ are computed using different methodologies. Usually, ‘book profits’ are greater than the ‘taxable income for a particular year. For instance, a company may have completed a service for which it is yet to be paid at the time of tax filing, in such cases while the income will be a part of the book profits, since it is unrealized income, it will not form a part of taxable income until it is actually paid. In such cases, since MAT is calculated upon book profits, it will be higher than a company’s legal tax liability. Companies are allowed an interest free refund of this excess money paid through a “MAT credit” carry forward mechanism. This allows a company to carry forward the “excess” tax it pays, and offset it with its tax liability the next year. Companies can use the excess amount paid at any time over the next 15 years to offset against that year’s tax liability.
The entire structure was working properly – until, 2012. There is a category of foreign investors in India known as Foreign Institutional Investors (FIIs) and Foreign Portfolio Investors (FPI). These are hedge funds, High Net Worth Individuals, or any other person/group of persons who invest in the Indian stock markets. The two differ only slightly, in that FIIs are organized vehicles used to collectivize FPIs when entering a market. FIIs and FPIs manage money raised from individual investors in different countries and in return for the profits they make, they are paid fees or a share of the profit – much like any typical investment fund. For these profits, they maintain accounts, however, while profits are earned from Indian stock markets, they only become income for FIIs when they are paid in return for the work they have undertaken, by their clients. This usually happens outside India and thus FIIs/FPIs – while registered with SEBI, India’s stock market regulator – do not maintain books in India.
However, the Income Tax Department began issuing notices demanding MAT from these FIIs/FPIs on the capital gains accruing to them from the sale of shares, citing an August 2012 order by the Authority for Advance Rulings (AAR). The AAR is a quasi-judicial body set up under the Income Tax Act to provide authoritative, binding rulings on any question of law or fact that a foreign firm may anticipate before investing in India. It therefore functions like a pre-emptive court and allows foreign companies to get certainty on legal matters before they pledge any funds. In the case of Castleton Investment (In re [TS-607-AAR-2012]), the AAR had ruled that MAT is applicable on both domestic and foreign companies.
Since FIIs/FPIs are essentially foreign firms operating in India, the IT Dept. argued that they were also amenable to MAT’s jurisdiction. FIIs and FPIs opposed these notices in the AAR, arguing that since they did not maintain books in India, and payments for the services they offered – which were to their clients – were not made in India, they were not liable to pay Income Tax of any form in India.
As the government changed in India in 2014, the new dispensation under Prime Minister Modi was eager to resolve the issue. It therefore enacted an amendment that made MAT inapplicable on FIIs and FPIs beginning April 1, 2015. This date is key, since the tax was only prospectively overruled, meaning that the notices issued in 2012 would still be valid. A rough assessment of the total tax liability under the notices issued to various FIIs/FPIs came out to be INR 400,000,000,000 (US$ 5.7bn approximately, at 2019’s exchange rate). Meanwhile, the AAR ruled against the FIIs/FPIs, and declared that the notices issued by the IT Dept. for liabilities before 2015, were valid. The Indian Government was suddenly staring at a windfall tax gain of INR 40,000 crores. At the time, an elated Arun Jaitley (India’s Finance Minister) said,
“FIIs went to a tribunal, which is called the Authority for Advanced Rulings. The tribunal has decided against them. I can change the face of India’s irrigation with Rs.40,000 crore.”
The FIIs/FPIs individually appealed the AAR ruling in several High Courts in India. Each got varying orders (pending further consideration) based on their individual case’s circumstances. However, a final decision was pending when pressure on the Indian Government increased. During this time, a hoard of FIIs and FPIs began withdrawing their investments from India’s stock markets. India’s stock market became one of the worst performing in the world’s top 20 within a few weeks. It was evident that the FII withdrawal was a direct result of the ongoing MAT issue.
The first response of the Indian government was to dig its heels on the issue. The Finance Minister began rationalizing the entire scenario, explaining that his government was acting reasonably. He said,
“…we [Govt. of India] are reasonable, so for the future I have waived it [MAT on FIIs/FPIs]. But, the tax demand after winning the case [in AAR], if I waive off, we will be like a tax haven.”
However, within a few weeks as the stock markets refused to cool down. Mr. Jaitley issued the following statement during a debate on the Finance Bill 2015, in India’s Upper House of Parliament, the Rajya Sabha,
“I have received a large number of representations on the issue [liability of FIIs/FPIs with respect to 2012 MAT notices]. We have, therefore, decided to refer this matter as well as a few other tax issues which are legacy issues to a committee headed by Justice A.P. Shah, the current chairman of the Law Commission. The committee is requested to give its recommendations on the specific issue of MAT on FPIs expeditiously,"
A bizarre conflict marked Finance Minister Arun Jaitley’s attitude to taxation of profits earned by foreign institutional investors (FIIs) in India. He chose not to submit to their clamour that a set of tax demands relating to the last few financial years slapped on them be withdrawn. However, he first went ahead and removed the future liabilities starting April 1, 2015, and now had decided to skirt the judicial route by setting up a committee. It must be noted that while the committee was headed by a well-respected judge, it was not a judicial opinion since Justice Shah retired in 2010, and was not sitting to adjudicate the matter as a judge of any court. He had merely been invited by the government to provide his legal opinion – a perfectly legitimate exercise, however, one that should have been undertaken before the AAR ruling, not after the government had already won the case.
The Committee submitted its final report on applicability of MAT on FIIs/FPIs for the period prior to 01.04.2015 to the Government in August 2015. By this time, the appeals filed by FIIs/FPIs on the AAR ruling had reached the Supreme Court, but were still pending – in many cases because the government could potentially change its position in light of the Shah Committee Report. That is exactly what happened. In a 66 page report, the Committee unanimously recommended that section 115JB of the Income-tax Act may be amended to clarify the inapplicability of MAT provisions to FIIs/FPIs. Alternatively, the Committee suggested that a Circular may be issued clarifying the inapplicability of MAT provisions to FIIs/FPIs.
In the committee’s opinion, therefore AAR ruling was “inconsistent”. Justice Shah spoke to the media after submitting the report (until then the contents of the report were yet to be made public). He said,
“We have examined the issues. There was some inconsistent judgement of AAR (Authority for Advance Ruling) and ITAT (Income Tax Appellate Tribunal). We have examined the legal issues, the working of FIIs (foreign institutional investors) and the report takes a holistic view on the matter,"
By September 2015, the Government accepted the recommendation of the Committee, and reversed its stance. It was no longer pressing ahead with a demand of Rs.40,000 crore that Finance Minister Jaitley had said could be used to “change the face of Indian irrigation”. The stance that was supposed to make India look like a “tax haven” had finally been taken. Since the Government gave up its demands, the appeals pending in courts abated, and an authoritative judicial determination of the issue never took place.
To be fair however, taxation has been a particularly litigious issue in India, and a sore spot for businesses – prompting governments to walk the extra mile to showcase their business friendly attitude to attract investment. For instance, tax provisions allow the adjustment of brought forward loss or depreciation whichever is less as per the books of accounts for arriving at the book profits chargeable to MAT. The Act does not specify a particular method for determining the brought forward amount. Moreover, the very fact of providing for a brought forward and set off of carry forward loss or deprecation; whichever is less, itself is inequitable. MAT, should be applicable, when there is actual profit after deducting both the carry forward loss and unabsorbed depreciation from the book profit, and not the lower of the two.
Otherwise, companies where depreciation element is low, say, finance companies, end up paying MAT despite heavy carry forward losses. Likewise, companies making nominal profit or loss before depreciation, but having a large stock of equipment (which depreciates in value) end up being liable MAT in the year during which there is net profit after depreciation, irrespective of the fact of heavy unabsorbed depreciation. Moreover, the main reason for the cycle of controversies is that the law is also silent about the applicability of MAT for foreign companies having just a liaison office or branch office in India. This remains true even after the 2015 amendment.
An amendment proposed by the Finance Bill 2018 sought to exempt foreign companies that are engaged in shipping, air transport, oil exploration, and turnkey construction projects from the ambit of the MAT. Brought in with retrospective effect from April 1, 2001, this amendment would help abate pending litigation, said tax experts. Any tax recovered from these companies would, however, have to be refunded. According to the Finance Bill 2018, this amendment will apply in relation to the assessment year 2001-02 as well as subsequent assessment years. In the Finance Bill 2018, a new explanation has been inserted in this section to keep away more foreign companies from the provisions of MAT.
Did the Government Buckle Under Pressure?
In the entire MAT controversy, the central theme that begs consideration is that of the amount of pressure businesses can exert on governments. To be clear, on this issue experts are also divided. Some have argued that there exists a legitimate reason to exclude FIIs/FPIs from liability since they generally do not have singular fixed place of business for a long term, but do carry on business from the source country on a continuous basis. Amit Singhania of Shradul Amarchand Mangaldas & Co said,
“The amendment proposed under MAT provisions to exempt foreign companies taxable under the presumptive taxation regime is encouraging.”
MAT was nothing but a solution to bridge the difference between book profits and taxable profits, this bridge is being narrowed through reduction in depreciation rates and phasing out of various exemptions. Reduction in tax depreciation for plant and machinery from a high of 25% to 15% by the Finance Act, 2005 has already significantly narrowed the disparity between book profits and taxable profits. The pros and cons of an alternative tax mechanism, such as MAT, has been matter of intense debate world over. Prudently most countries have not introduced MAT or its variations. From a reform standpoint, not only does MAT dampen growth initiatives by the corporate sector but it increases administrative costs for the tax payer and the revenue. There is a need for its complete withdrawal, without the introduction of another variant of MAT.
However, what happened in the case of MAT’s application on FIIs/FPIs, and whether it was right for the government to have changed stance under pressure, is a question that the public will have to answer.
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About the Author
Ananya Satish is a budding lawyer and is currently pursuing B.A. LLB from National Law University, Odisha. She is a passionate speaker and has participated in many Model United Nations Conferences and debate competitions in the school level and also has many citations in her name. Ananya also enjoys the law school tradition of mooting and has developed a keen interest and passion for the same. She is an avid reader and has a taste for classics and crime fiction. She is a trained bharatanatyam dancer and aspires to pursue legal journalism post law school.