When antiquated rules have to be replaced with new ones, the changes must be dramatic and path-breaking, the finance minister had stated while releasing the draft Direct Tax Code, 2009 (Code) for public comments. No doubt, several proposals of the Code are path-breaking and some are aimed at bringing dramatic change in the way we look at a particular issue.

However, a combined reading of the discussion paper and the Code gives the impression that in several areas, what was intended has not been effectively translated into the language of the Code. This article discusses some key proposals related to the financial services sector which may have far-reaching implications.

Banks/NBFCs

The Code recommends changing the base for levying minimum alternate tax (MAT) from profit to gross assets at 0.25%. This may adversely affect banks which are loss-making or have less than 1% return on gross assets. Further, non-banking finance companies (NBFCs) are liable to pay MAT at 2%, which assumes 8% return on gross assets. This may actually put some of the NBFCs out of business. Banks and NBFCs should have been treated at par with respect to the MAT rate.

Mutual funds (including venture capital funds)

The Code seeks to change fundamentally the way MFs are taxed. The discussion paper clarifies that MFs shall be treated as 'pass through' entities and all income would be taxed in the hands of investors. However, a plain reading of the Code sections suggests that investors in MFs would not be liable to pay tax. There is no specific section in this regard like Section 115U of the Income-Tax Act, 1961; and as per the Sixth Schedule of the Code, any income received in respect of units of a MF is exempt from tax.

Also, the discussion paper clarifies that income accruing to MFs shall be taxed in the hands of the investors (currently, the tax is levied when the income is distributed to investors). This could create tremendous and uncontrollable administrative burden on MFs, since they trade daily and therefore would need to intimate investors on a very frequent basis about the gains/loss attributable to them.

It is only fair that income from MFs is taxed only on distribution on net basis and not on accrual basis. Else, they might be required to pay tax for the gain they have not even received.

Further, no dividend distribution tax (DDT) is payable on distribution of dividend to MFs, as the same is proposed to be taxed in the hands of the investor. The rate of tax in such cases could go up to 30% instead of 15% if the DDT was paid in the fist instance.

Further, the requirement of tax-withholding in such cases would only increase the administrative burden and hassle of the investors in claiming credit of the tax withheld.
Foreign institutional investors (FIIs)

The Code has proposed to do away with the separate regime for taxation of FIIs and brought them on par with any other non-residents for tax purposes. The tax rate would increase from 0% in case of long-term capital gains (LTCG) and 15% in case of short-term capital gains (STCG) to 30% for all capital gains. It is also unclear whether FIIs will be liable to MAT.

Many FIIs currently claim exemptions or lower tax rates by choosing to avail Double Taxation Avoidance Agreements (Treaty) benefit. The Code proposes to take away this right of selecting to be governed by the Treaty over the tax provisions and provides that the Code or Treaty, whichever is later in time, shall prevail.

This may not go down favourably with FIIs unless treaty commitments are honoured. The requirement to withhold tax on capital gains may also not be feasible to implement as FIIs trade only on stock markets, where buyers and sellers are not identified.

Insurance companies

The Code proposes a 'pass through' status for life insurance companies and specifies a specific method for calculation of profits of other insurance businesses. The discussion paper clarifies that investors shall be liable to pay tax on income accruing to the life insurance companies.

Here again, no DDT is required to be paid on distribution of dividend but withholding of tax is required. Also, MAT may spell the death knell for insurance companies and needs to be reviewed.

The author is executive director - tax & regulatory services (financial services,) PricewaterhouseCoopers. Views are personal.