TAXATION, CANONS OF TAXATION,TAX IMPACT,TAX INCIDENCE,TAX SHIFTING,DIRECT TAX,INDIRECT TAX

 

Funds are required by the government to carry out their functions ie developmental as well as day to day functions. Taxation provides funds for carrying out such functions.

TAXATION:

• Taxation is a legal compulsory payment by the citizens to the government.
• There is no quid pro quo relationship between a taxpayer and the collecting authority.
• Taxpayer can neither claim any specific benefit against paid taxes nor it can ask its taxes back if desired services are not provided by the government.

CANONS OF TAXATION:

The most fundamental classification of taxes is based on who collects the taxes from the tax payer.

As Per Adam smith, Taxation should follow the following canon of taxation :

• Canon of ability :taxes should be paid as per the ability .
• Canon of certainty :rate of taxes should be clear with out any ambiguity .
• Canon of convenience :The tax collection method should be convenient so that people can pay taxes easily.
• Canon of economy: Government should impose only those taxes whose collection costs are very less and cheap as there are collection costs undertaken by the government.

Anecdotes related to Taxation: 

In Mahabharat:

Krishna started his campaign against kansa by not paying Income tax imposed by Kansa and krishna argued that kansa has abdicated his responsibility as a king so people should not pay the taxes.

In Ramayana:

• Shri Rama pointed out that it was necessary to collect tax from the subjects.
• But the tax should be taken by a king in the same way as the sun absorbed water from the earth.
• In reservoirs and rivers, where there was more water, it took more; from the land where there was less water, it took little. 
• In the same way it was   also the duty of the ruler to make it clear that the tax collected from the rich people of the state should be distributed equally for the works in the larger interest of the people.

TAX IMPACT:

• The term Tax impact is used to express the immediate result of imposition of  the tax.
• The impact of a tax is on the person on whom it is imposed first.
• Thus, the person who is liable to pay the tax to the government bears its impact.

TAX INCIDENCE:

Tax incidence is liability of the tax payment on the man’ who ultimately bears the

burden of the tax.

TAX IMPACT vs TAX INCDENCE:

• Tax Impact refers to the initial burden of the tax, while Tax incidence refers to the ultimate burden of the tax.
• Tax Impact is at the point of imposition while incidence occurs at the point of settlement.
• Tax impact of a tax falls upon the person from whom the tax is collected and the incidence rests on the person who pays it eventually.
• Tax Impact may be shifted but Tax Incidence cannot be shifted.

TAX SHIFTING:

• Tax Shifting is passing of the tax from the one who first pays it to the one who finally bears it.
• It is through this process of Tax Shifting that the impact of a tax is transformed to Tax incidence.
• Tax Incidence is the end of the shifting process.
• Direct tax are example where Tax impact and Tax incidence are borne by the same person

                                                        while

• In case of indirect taxes, Tax impact and Tax incidence are borne by different person through the process of Tax shifting.

TYPES OF TAXATION:

Taxation can be in the form of: Direct Tax and Indirect tax.

DIRECT TAX:

• Direct Tax is a tax that is paid directly by an individual or organization to the imposing entity .
• There is no Tax Shifting as tax impact and tax incidence is on the same person.
• A taxpayer pays direct tax to the government for different purposes.
• Tax payment cannot be shifted to another individual or entity.
• Direct taxes include income tax, Property tax, capital gains tax, Direct Dividend Tax, corporate tax etc.
• Income tax is the most popular direct tax.

IMPLICATIONS OF HIGHER DIRECT TAXATION:

• Direct tax collection accounted for 55% in FY 2022-23 which was 4 year high .
• A higher direct tax to indirect tax is considered as progressive in the sense that indirect taxation hurts the poor more intensely.

INDIRECT TAX: 

• Those taxes which are not directly levied on the Income of an Individual.
• This tax is indirectly levied on the Expenses incurred by the Individual.
• This tax is basically levied on the seller of goods but finally it is being paid by the end consumer.
• Examples: GST, custom duty

Global Minimum Tax,Base Erosion and Profit Shifting (BEPS),2 pillar approach in BEPS, INDIA AND BEPS, Digital Tax /GOOGLE TAX OR EQUALISATION TAX:

MNC's across the world are using multiple loopholes in the existing taxation laws of different countries  to evade taxes or paying of less taxes .Governments across the world are concerned about this trend and are aggressively trying to deal with this menace. Global Minimum Tax and Base erosion and profit shifting (BEPS) are such arrangements 

BACKGROUND OF BEPS:

• Large MNC’s have traditionally paid taxes in their home countries or in Tax Havens even though they did most of their business in foreign countries. 
• The countries of consumer base where these MNC’s carry out their business are at loss. 
• Corporate tax rates throughout the world are dropping over the last few decades as a result of competition between governments to promote private investments. 
• Global corporate tax rates have fallen from over 40% in the 1980s to under 25% in 2020 and even to the level of zero in tax havens ending up to “race to the bottom”.

In view of the above,it is evident that countries where MNC's carry out their operations are losing their revenues.To deal with this situations, efforts are undertaken at international level to root out this menace.

Global Minimum Tax: 

• The Global Minimum Tax is designed to tackle the problem of tax losses to the countries affected by profit shifting. 
• Various methods are adopted under the guise of Global Minimum Tax:
• Profit shifting by companies is reduced boosting the government revenue and reducing the wasteful use of resources for tax planning.
• Tax payments are increased from firms that shift profits to low-tax environments from the country of their origin.
• The focus is on reducing the international tax competition amongst the countries to reduce the taxation on MNC's so that countries are motivated to tax multinational profits at higher rates.

Base Erosion in BEPS:

• Company needs to pay tax for the incomes or profits they earn.
• MNCs used sophisticated tax planning practices to avoid tax payments by shifting their incomes to other countries, especially to tax havens (via shell companies) or deducting large interest payments, overhead expenses.
• These practices of shifting the companies to tax Havens erodes the tax base ie the income which is the basis of taxes to be paid, is said to be Base Erosion.

Profit Shifting in Base erosion and profit shifting (BEPS) :

• Tax is levied as a percentage on the income of the company.
• Once the company is shifted to another country or tax haven (s), the tax base is eroded, and  hence the incomes or profits of companies are also shifted to tax havens .
• Tax is not paid to the country of operation rather to the tax havens.

Base erosion and profit shifting (BEPS) : 

Base erosion and profit shifting (BEPS) can be understood from two perspectives:

1. One is common practices adopted by MNC’s that exploit gaps and mismatches in tax rules to avoid paying tax.
2. Other is strategies adopted by countries across the world to check the evasion of Taxes by MNC's.

In October 2021, a historic two-pillar international agreement Base erosion and profit shifting  2.0 was reached among 137 countries of the OECD/G20.

Base erosion and profit shifting (BEPS) has two pillars :

PILLAR 1 (MINIMUM TAX AND SUBJECT TO TAX RULES):

• Governments can fix local corporate tax rate to attract MNC's, but if companies pay lower rates in a particular country, their home governments could “top up” their taxes to the 15% minimum.
• This minimum taxation is to neutralize  the advantage of shifting profits and hence demotivate companies to shifting their offices to Tax Havens.

PILLAR 2 (REALLOCATION OF AN ADDITIONAL SHARE OF PROFIT TO THE MARKET JURISDICTIONS):

• Portion of MNEs’ profits (25% of the largest multinationals’ so-called excess profit) is allocated to the market or destination countries .
• Destination countries are based on where consumers or users are located, rather than solely on physical presence.
• By doing this, countries which are giving incomes to the MNC's will be benefited.

INDIA AND BEPS :

India is actively participating in the implementation of Base erosion and profit shifting (BEPS).In 2016, India adopted Equalisation levy .

Digital Tax /GOOGLE TAX OR EQUALISATION TAX: 

• Equalisation levy, introduced in 2016, is a unilateral amendment to the domestic tax provisions to implement  BEPS Action Plan 1. 
• Equalisation levy was introduced in India  to tax the digital Economy.
• Equalisation levy was levied at 6% of the total business transactions done for online and digital advertisements.
• Equalisation levy is applicable to B2B services and goods only and NOT on B2C {Business to Consumer} goods and services. 
•  The tax is applicable to only those companies which have no permanent physical establishment in India.  
• Its scope was widened in 2020 and it was  levied at 2% on the consideration amount paid to non-residents who own, operate or manage an e-commerce facility or platform. 

Once India implements the two-pillar tax package, it will have to withdraw the equalisation levy (EL), which earned the government a revenue of about Rs 5,000 crore in 2022-23,”

SPECIFIC ANTI AVOIDANCE RULE (SAAR),GENERAL ANTI AVOIDANCE RULE (GAAR),

 

To deal with the issues of Tax evasion by MNC's, various methodologies were adopted by Governments across the world .Various anti avoidance rules were implemented by  the Government of India to check the Tax avoidance. Specific Anti Avoidance Rule (SAAR), General Anti Avoidance Rule (GAAR), Arm Length Pricing, Advance Pricing Agreement and Safe Harbor were such prominent methodologies  to deal with Tax Avoidance.

SPECIFIC ANTI AVOIDANCE RULE (SAAR):

• Anti avoidance rules are basically divided into two categories—General and specific.
• Specific Anti Avoidance Rule (SAAR) was operational before General Anti Avoidance Rule  (GAAR).
• General Anti Avoidance Rule (GAAR) refers to legislation dealing with “general” rules, while Specific Anti Avoidance Rule (SAAR) refers to legislation dealing “specific” avoidance. 
• The prevailing law deals with instances of specific tax abuse and the general tax avoidance is addressed by judicial doctrine.
• Specific Anti Avoidance Rule (SAAR ) provides for a set of rules which target specific ‘known’ arrangements of tax avoidance. 
• They specifically lay down the conditions where they may be invoked.

GENERAL ANTI AVOIDANCE RULE (GAAR):

• General Anti Avoidance Rule (GAAR) is an umbrella tool for checking aggressive tax planning especially those business transactions which are entered into with the objective of avoiding tax. 
• The General Anti Avoidance Rule  (GAAR) itself is an unconventional type of tax legislation; bringing tax avoidance under the scrutiny of tax officials.
•  It has been introduced in India due to VODAFONE case ruling by the Supreme Court. 
• General Anti Avoidance Rule  (GAAR) has been implemented from 1^st of April 2017 on the recommendation of Shome committee.

ISSUES WITH GENERAL ANTI AVOIDANCE RULE (GAAR):

• The concern is about the arbitrary usage of the powers that the officers might have under General Anti Avoidance Rule  (GAAR) 
• The line of difference between an objectionable and a permissible avoidance is very thin.
•  There is also another fear that tax officers can harass people using this law.

DOUBLE TAXATION AVOIDANCE AGREEMENT (DTAA),TREATY SHOPPING,HYBRID MISMATCH

There are number of tools used by MNC's to evade taxes. Few of them are discussed as below :

DOUBLE TAXATION AVOIDANCE AGREEMENT (DTAA):

• Double Taxation Avoidance Agreements (DTAA) is a treaty signed between two countries, which ensure that the taxpayer is not being taxed twice (in country of job and of residence) for the same income (earned in country of job).
• Double Taxation Avoidance Agreements (DTAA) applies in cases where a tax-payer resides in one country and earns income in another.
• Double Taxation Avoidance Agreements (DTAA) is intended to make a country an attractive investment destination by providing relief on dual taxation.
• Double Taxation Avoidance Agreements (DTAA) can provide reliefs in various arrangements like:

1. Exemption of income earned abroad from tax in the resident country
2. Provisioning of amount to the extent of taxes that have already been paid abroad.

TREATY SHOPPING:

“Treaty shopping” generally refers to a situation where resident of source country (A), earning  income from another country (B), is able to benefit from a tax treaty ie DTAA between the source country (A) and yet another country (C).  

Jurisdiction A --imposes a 25% withholding tax, 

Jurisdiction C --imposes a 5% withholding tax .

Jurisdiction A    0% treaty with Jurisdiction C.

Impact of Tax deduction on any company X belonging to country A :

01.Company X located in jurisdiction A ---Direct Investments in Jurisdiction B

Tax implications on Company X:25% withholding tax is imposed on incomes earned from Jurisdiction B.

02.If company X located in jurisdiction A ---Indirect Investments in Jurisdiction B via Jurisdiction CTax implications on Company X :

Effectively ,5 % withholding tax is imposed on incomes earned from Jurisdiction B. 

So, withholding tax payment is reduced by 20% , compared to paying them directly. 

In the above example, it is clear that Tax Treaty reduces the tax implication.

HYBRID MISMATCH :

• Hybrids mismatch arrangements (HMA) are arrangements which exploit differences in the tax treatment of various financial instruments
• Hybrids mismatch arrangements (HMA) may significantly reduce overall tax for taxpayers and therefore decrease tax revenues of countries.

Example :

• An Indian Company is having its subsidiary in US. Indian company gives a loan to its US subsidiary.  
• Interest taxed @ 15% in USA; and 30% in India. 
• Net tax cost will be 30%.

but Instead of loan,

• Indian company invests in Preference shares in its US subsidiary, redeemable at premium. 
• In USA, premium on redeemable preference shares is treated as interest and US will levy tax @ 15% on interest.
• In India, inflation adjusted capital gain on redemption of preference shares may be almost 0.
• So effective Tax  implication will be 15%.

So Tax implication is reduced from 30 % to 15 % by merely change in the nature of instrument.

ISSUES WITH TRANSEFR PRICING, CLASSIC CASE OF VODAFONE-HUTCH TRANSFER PRICING ISSUE

ISSUES WITH TRANSEFR PRICING (VODAFONE-HUTCH) :

By manipulating the income tax laws, MNC’s avoid payment of taxes. There is loss of revenues to the countries because of manipulation of the laws. Vodafone-Idea transaction is the most popular case of Transfer pricing in India. To deal with isuues with transfer Pricing ,The countries have come up with the ideas of Armed length Price (ALP), General Anti Avoidance rule (GAAR)  Advanced Price Agreement (APA), and Base erosion Profit Sharing (BEPS). Here is the brief of the case with the timeline :

February 2007:

Vodafone International Holding (Netherlands company) acquired a 100% stake in CGP Investments (Holding) Ltd (CGP), at the cost of $ 11 billion from Hutchison Telecommunications International Limited (HongKong).

• CGP Investments (Holding) Ltd (CGP) is in Cayman Islands company
• CGP holds 67% shares in an Indian company Hutchison Essar Limited ("HEL").
• Hutchison Essar Limited (HEL) has its operations in India.
• With this acquisition of CGP, Vodafone acquired control of CGP and its subsidiaries, including Hutchison Essar Limited (HEL). 

September 2007:

Indian tax authorities questioned the Vodafone Company on following grounds:

1. Why the capital gains tax had not been withheld from the HTIL purchase transaction.
2. Transaction triggers the transfer of indirect assets in India as the company Hutchison Essar Limited (HEL) has its operations in India.
3. Transaction involved purchase of assets of an Indian Company, so there is liability to be taxed in India to an amount of 12000 crores.

Response of Vodafone:

Vodafone appealed to the Bombay High regarding the jurisdiction of the tax authorities in this case.

September 2010:

Bombay High -Court dismissed the Vodafone arguments and ordered Vodafone to pay the Capital Gains tax to the authorities.

Vodafone Response:

The order of Bombay High -Court was subsequently challenged in the Supreme Court of India by Vodafone.

20 January 2012:

The Supreme Court delivered its verdict on the case on 20 January 2012 with the key highlights:

• Indian authorities do not have jurisdiction on an overseas transaction as visible in this case as the tax is levied on the basis of the source and the source is the location where the sale takes and not where the product is derived or purchased from.
• Tax policy should be stable and certain as it is crucial for taxpayers (including foreign investors) to make rational economic choices in the most efficient manner.
• The demand of nearly 12,000 crore in the form  of capital gains tax, would amount to imposing capital punishment for capital investment since it lacks authority of law and therefore stands squashed.

Budget 2012 ---RESPONSE OF GOVERNMENT OF INDIA :

• In Budget 2012, the government of India proposed an Amendment to the Finance Act and changed the Supreme Court’s decision.
• As per the Finance Act, Income Tax Department can retrospectively tax such deals applicable to residents or non-residents, having business connection in India,
• Accordingly, The buyer (Vodafone in this case) will have to deduct tax at source and pay it to the government even if the deal is executed on a foreign soil.
• Finance bill 2012, also redefined the concept of indirect transfer.

As per the new definition, any asset company or entity registered or incorporated outside India shall be deemed to be situated in India, if the share or interest derives, directly or indirectly, its value substantially from the assets located in India.

• With the passage of the Finance Bill, 2012 by Parliament, the British telecom giant Vodafone might have to pay Rs 20,300 crore as tax, interest and penalty on its acquisition of Hutchison stake in Hutchison Essar in 2007. 

Response to Finance Bill 2012:

• Provisions in the finance bill 2012 were criticised by investors globally.
• This impacted the market sentiment and the flow of foreign funds to India.

Reaction of the Government:

• Because of international criticism and negative impact due to the provisions, GOI  tried to resolve the matter with Vodafone, but the Finance Ministry failed to settle the issue and in 2014, the Vodafone Group initiated arbitration against India at the Permanent Court of Arbitration at the Hague,
• When NDA government came to power in 2014, it said it would not create any fresh tax liabilities for companies using the retrospective taxation route.
• But the government did not take back route on provision in Finance Act and those provision wrt vodafone taxation remained.

Response of Vodafone :

Vodafone approached ICJ against the decision of the Indian Government and ICJ constituted Permanent Court of Arbitration (PCA).

Dec 2020:

In Dec 2020, Vodafone won arbitration against India over the retrospective tax demand of Rs 20,000 crore . The International Court of Justice (ICJ) ruled that:

1. The conduct of Indian Income-Tax department was in breach of fair and equitable treatment .
2. The imposition of tax liability on Vodafone violated the investment treaty agreement between India and the Netherlands.