The first part of this article “ Tax haven or terror hub ?” looked at the tax department’s case against FIIs (foreign institutional investors) to levy a tax on their capital gains under Minimum Alternate Tax (MAT), though their incomes may be exempt under the provisions of the Double Taxation Avoidance Agreement that India might have entered into with countries where they are incorporated.
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Two arguments could work in favour of the FII contention that the provisions of MAT should not be made applicable to them. One, that MAT should not be seen as an alternative structure of taxing incomes but rather one that works in harmony with the other provisions of income-tax law. While certain provisions of tax law had the effect of reducing the tax burden substantially if not altogether eliminating it, MAT was intended to mitigate somewhat the effect such provisions have on the state’s fiscal resources.
Viewed thus, MAT could be regarded as a mechanism to collect some tax in advance of when it becomes legitimately payable by the application of all other provisions of income-tax law. These provisions, which are in the nature exemptions, incentives and concessions, have the cumulative effect of reducing the tax liability on a given income. This is intended to promote certain social/public purposes that the framers of tax law saw as desirable and worthy of public support through the instrument of tax policy.
Easing the burden
Say a company wants to plough back more of its current profits into expansion or diversification of its businesses. The Government believes this is a good thing. One, such investment creates employment and, more important, generates higher taxes when operations go on stream and, later, greater profits. So it wants to extend concessions that will temporarily reduce the entity’s tax burden.
After all, the company could have taken the easier option of rewarding its shareholders with a larger dividend payout. To reward such self-denial, the tax law may favour the company with an accelerated charge of depreciation in the first year, when the new investment goes on stream. Consequently, profit available to the company after depreciation but before payment of tax is lower. Naturally the tax liability, too, is lower because the base (profit after depreciation but before tax) on which the tax liability is computed is lower.
In contrast, had the company not ploughed back its cash to make fresh investments it would have had no extra depreciation charge to protect its pre-tax profits and therefore would end up paying more taxes. Of course, the extra depreciation charge on the incremental also means that in later years the depreciation would be considerably lower as the machinery or plant already stands considerably diluted in value (for tax purposes).
Convergence of incomes
If the depreciation charge on pre-tax profits is lower, then the quantum of tax liability would be higher. In other words, the figure of income under tax calculations would first catch up with the figure of profits as per books (’Book Profits’) and eventually overtake profits under the income-tax method. So, there is eventually a convergence of incomes, irrespective whether one computes incomes under the normal accounting system or applies the tax provisions that understate incomes in earlier years but recognise a higher sum in the later years.
An example of how this works in actual practice is shown in the Table. As can be seen, there is a huge divergence between the ‘Book Profits’ and ‘Tax Profits’ in the first year, with the former showing a net profit of ₹693, while the figure under tax accounting results in a loss of ₹257. But in the very next year the tax profits overtake the figure under normal accounting.
Repeating the process for subsequent years, it is seen that in the seventh year, when there is no depreciation to be charged under both conventional and tax accounting methods, the cumulative profits under both are almost the same.
All that MAT has succeeded in achieving is to collect ₹157 by way of taxes in the first year when there are no taxable profits; this, however, got adjusted in the next year. In other words, the function of MAT provisions is to provide temporary fiscal relief to the exchequer, though it must operate in harmony with other provisions of tax law. That brings us to the law on FII investments and its tax objectives.
Interests of the economy
The legislature had in its infinite wisdom decided that the inflow of foreign capital is in the interests of the economy and that the process should be encouraged by granting tax exemption to incomes in the nature of capital gains accruing to foreign investors residing in countries with whom India has a tax treaty. That objective cannot then be frustrated by imposing MAT, which leaves little scope for congruence of incomes under conventional and tax accounting methods.
Why do we say the fundamental principle of ‘convergence’ of incomes between ‘income-tax profits’ and ‘book profits’ is broken when FIIs operating out of territories (such as, say, Mauritius) with whom India has a tax treaty are subject to MAT law on their investment profits in India?
If Mauritius chooses to tax capital gains at zero per cent and the bilateral tax agreement allows FIIs to pay taxes on capital gains at rates applicable in Mauritius, the tax profits will forever remain zero and there is no possibility of convergence between the two profit figures. So, FIIs can seek a quashing of tax proceedings on that ground.
The tax department’s case for subjecting FIIs to MAT rests on another ground too. They argue that MAT may be harsh on FIIs operating from DTAA jurisdictions. Even if a tax law provision practically nullifies the effect of such a DTAA, it must be accepted and the law should be applied as it stands, regardless. After all, it is an accepted principle of law that there is no equity to taxation! If the law says a tax has to be paid, it must be paid.
DTAA, the winner
The Chapter dealing with the law on MAT says that no matter what is said elsewhere in the I-T Act (which includes concessional treatment of FIIs’ capital gains under the DTAA), the provisions under MAT apply to all companies, including foreign entities. But the Chapter in Income-Tax law which deals with treatment of incomes of assessees operating from countries with whom India has an agreement granting tax relief (again, like Mauritius) the provisions of the I-T Act would apply only to the extent that they are more beneficial to the tax-payer.
In effect, the law is saying that no matter what is specified anywhere else in the I-T Act, it shall apply only to the extent it is more beneficial to a tax-payer from a country with whom India has such a tax agreement.
So, you have contradictory situation. One part of the law says MAT is applicable to foreign companies notwithstanding what has been spelt out elsewhere in the I-T Act. Yet, the very same Act says if India has a Double Taxation Convention — with Mauritius, for example — the provisions of the Act shall apply only to the extent they are more beneficial to the entity being taxed. Put differently, if provisions of the bilateral tax agreement on capital gains are more beneficial than the stipulations under MAT, the former shall prevail.
In a battle between two sections of the I-T Act, each of which says its stipulations override everything else in the Act, which one ought to prevail? At least in matters relating to tax agreements, the Parliament’s right to overturn treaty obligations is severely limited. So it is difficult to see how the Department hopes to persuade the judiciary to a point of view that the provisions of the law relating to MAT override what has been agreed on in a bilateral agreement with a foreign country. All told, it seems more like advantage FIIs rather than the taxman in this battle of legal wits.