Corporate tax planners could be forced back to the drawing board by the recently-tabled Companies Bill, 1997, which proposes that the pyramidal holding structure should be replaced by a two-tier structure, consisting of a holding company and a single layer of subsidiary companies.
Apart from reducing tax dodges, this provision will also make inter-corporate investments more transparent. Department of Company Affairs (DCA) officials said the decision was necessitated by the freeing of inter-corporate investments (the Companies Bill empowers a companys board of directors and shareholders to decide on such investments).
Therefore, a simple, transparent structure has become essential, to ensure that ordinary shareholders understand the implications of the companys investment decisions when they pass the requisite special resolution. This safeguard has become necessary since the government will no longer police the flow of funds within and outside corporate groups.
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The proposed new structure is expected to sound the death-knell for the widespread use of shell companies as tax shields. To understand how corporates dodge tax through shell companies, consider the following example:
Lets say company A2 (a first-layer subsidiary) has made a profit of Rs 50 crore. Meanwhile, company D4 (a fourth-layer subsidiary) is making losses. A2 invests its profits in buying D4 shares. This makes A2 a zero-tax company.
There is an additional benefit. The countrys tax law allows groups to offset capital gains by some of their companies against losses posted by other group companies. Thus, D4s losses can be used to offset capital gains by other companies.
Such benefits can be reaped even if both A2 and D4 are profit-making operations. Lets go back to A2s profits of Rs 50 crore. A2 would be required to pay Rs 15 crore (at a corporate tax rate of 30 per cent). Instead, A2 buys D4 shares. This makes A2 a zero-tax company.
Now, D4 has to pay capital gains tax on the Rs 50 crore that has been pumped into it by A2. But D4 will pay only Rs 10 crore (at a capital gains tax rate of 20 per cent). Thus, the group as a whole will save Rs 5 crore.
Department of Company Affairs (DCA) officials said rotation of funds and elaborate cross-holdings between different layers of subsidiaries will now no longer be possible. As a result, situations such as the imbroglio between financial institutions and the Modis will become a thing of the past. In 1989, the government appointed a arbitrator after the Modi family said it would return funds to banks and FIs then amounting to Rs 400 crore only after the familys property was divided, and liabilities individually allocated, between the various sub-groups.
As a result of the groups intricate cross-holding pattern, it took the government arbitrator eight years to unravel the maze. Meanwhile, the banks and FIs funds remained locked with the Modis.
Over the past eight years, considerable interest has accumulated, sending the entire groups liabilities rocketing to about Rs 1,000 crore.
The provision is likely to be lobbied against by the corporate sector, particularly telecom companies, which use cascading structures to get around the 49 per cent cap on foreign investment.
However, DCA sources said the widespread impact of the proposed legislation was factored in while taking the decision. There is no question of bungling. It was a conscious decision, taken knowing that companies across the board will be forced to restructure themselves. We are saying evolve alternate structures which are simple and transparent. How can this stunt the growth of the corporate sector? questioned the officials.
The officials added that the bill was moved only after seeking the consent of the concerned ministries. Assuming that these ministries missed the finer nuances, the provision had also been vetted by the law ministry.
As a nodal ministry, the law ministry had been involved with the decision to permit the cascading structure for private telecom operators and was aware of the various dimensions.
However, officials argued that the cascading structure permitted for the telecom sector is only a temporary arrangement. Ultimately, Parliament will have to take a view on whether we want foreign investment or not. And if we do, then we will have to take them directly, instead of working around the sectoral cap through such circuitous routes, said these officials.