There is much ado about the merits of investment-based tax incentives, particularly after such a move was proposed by the Direct Taxes Code Bill in 2009. In the Indian scenario, profit-based incentives were primarily meant for export earnings. Until March 2011, profit-based incentives prevailed for software technology parks and export-oriented units that earned revenue from export of articles or computer software. The expiry of tax incentives on profit earned by software export units has marked the beginning of the end of profit-based export incentives. Profit-based deductions remain only for specified infrastructure projects, Special Economic Zones, units within an SEZ, and some other categories to spur investment in areas such as the North Eastern States.

Whether DTC comes into effect or not, incentives for capital formation and infrastructure spending survive. The reason why tax incentives are still in use is to attract investment in general and foreign direct investment in particular.

According to the Organisation for Economic Cooperation and Development, the advantages of tax incentives are as follows:

It is easier for Government agencies to provide, rather than correct, core deficiencies such as labour supply or establishment of supporting infrastructure;

Does not require actual expenditure of funds or cash subsidies;

Politically easier compared to other incentives and subsidies;

Action-based versus plan-based.

It is, however, left to individual countries to determine what kind of incentives works better for them. A primary reason for the dilution of profit-based tax deductions, particularly export-based, in India is the WTO requirement that countries with a certain amount of per capita income should dilute or eliminate export-based incentives. India’s rising per capita income and its WTO obligation are believed to be the prime driver for the proposed introduction of investment-based deductions to replace the profit-based one.

Services sector demurs

So, why the resentment towards investment-based deductions? The obvious rationale in the Indian context is the role of the services sector and its larger share of contribution to the GDP growth. The service industry is generally not capital-intensive, and the low gestation period ensures quicker realisation of profits. This reduces the sheen of investment-based deductions. On the other hand, capital-intensive industries such as infrastructure development suffer from long gestation periods that escalate costs and extend the revenue-earning cycle. Nevertheless, going forward, investment-based incentives are likely to become the reality.

Regulator’s take

From the regulator’s perspective, the preference in the Indian landscape is a no-brainer. Profit-based incentives can be manipulated by dressing profits. This increases the administrative burden to verify the profit eligible for incentives. On the other hand, investment-based deductions follow real capital investment, which is relatively easier to verify and administer. Historically, however, there have been several examples of investment-based deductions in the Act. The most obvious have been deductions relating to research-and-development capital expenses, telecom licences and the like. Many of us would perhaps recall the investment allowance/ deposit scheme under which a certain percentage of capital expenditure was allowed deduction from taxable profits between April 1976 and March 1990.

The proposed DTC reveals the Government’s thinking on the use of investment-based deductions. The primary shift is that such deductions are not time-bound. In other words, it works on a ‘claim as you spend’ basis. So, as long as capital expenditure (subject to restrictions) is incurred, it is deductible from the revenue or income over and above other regular operating expenses. DTC proposed to cover SEZs and specified infrastructure projects under this form of deduction. To perhaps reiterate, the reason why this scheme was not as well-received as expected was twofold.

First, for SEZs, which are skewed towards labour-intensive service industry, the deductions would have effectively reduced the time frame for claiming tax incentives due to the relatively lower capital expenditure and low gestation periods.

Second, land and land-related cost was a conspicuous exclusion in the proposed scheme. In the Indian context, that seems unreasonable given the proportion of land cost in the overall project cost.

DTC or no DTC, investment-based deductions could become a reality. In an attempt to boost capital formation, attract FDI and provide a stable fiscal incentive regime that regulators are comfortable with, this may be the appropriate garnish to a larger infrastructure focus.

Vikram Bapat is Executive Director, PwC India

Related Topics
comment COMMENT NOW