f o r    m a n a g i n g    t o m o r r o w
MARCH, 2007
 Cover Story
 Sector Analysis

The centre is looking at removing the distinction between FDI and FII investments. This will impact sectors like asset reconstruction, real estate and aviation, where separate ceilings apply to FDI and FII investment. However, allowing FDI through the FII route in the realty sector could result in prices shooting through the roof. The Asian financial crisis of the '90s is still fresh in mind, and a method should be devised to moderate possible volatility in key sectors.

S&P And After
For the first time in 14 years, international credit rating agency, Standard and Poor's (S&P), has raised India's credit rating to investment grade. S&P is the last of the three major international rating agencies to do so. Moody's Investors Service did it in January 2004 and Fitch Ratings in August 2006. The upgrade is likely to spur the flow of foreign investment into power, steel and other industries, which receive less than a tenth of the funds going China's way.
More Net Specials
A Conservative Budget
"The Budget has its share of positives-allocations towards agriculture, efforts to boost the rural economy, etc. A lot more could have been achieved if the Budget had incentivised industry to participate in the rural economy"

Over the last few years, the Finance Minister's performance in managing fiscal deficit has been exemplary and in the bright fiscal horizon the only small dark cloud is the rising inflation rate. Chidambaram presented the Union Budget 2007 against a backdrop of a booming economy with estimated GDP growth rate of 9.2 per cent in 2006-07 and foreign exchange reserves of approximately $180 billion. India's macroeconomic performance over the last few years had provided an opportune platform to the Finance Minister to introduce rationalisation and simplification in the tax structure and to support India Inc. in its growth. The industry expected simplification of the tax structure, reduction in tax rates and extension of tax incentives to support the growth of India as an economic super-power. However, unfortunately, the Finance Minister did not make the most of the available opportunity.

The Budget gives mixed signals with regard to the government's policy on infrastructure, technology and knowledge-based industries. The Finance Minister has extended the benefit of weighted deduction available for in-house scientific research for a further period of 5 years. He has also widened the scope of tax incentive available under Section 80IA (for infrastructure projects) to gas distribution networks and navigation channels in the sea. A new section has been introduced for providing tax holiday for five years for hotels to be set up for the Commonwealth Games.

However, instead of extending the tax incentives to the IT and IT enabled businesses the Finance Minister has actually hit them by extending the applicability of Minimum Alternate Tax (MAT) to software and other export-oriented units. The software and export-oriented units are the catalysts of growth in the economy and have the potential to make India one of the largest economies of the world. While MAT may be creditable over a period of time, the short-term cash flow impact of taxes would curb the growth efforts of smaller and medium-sized companies in this space.

The Finance Minister has introduced some reduction in tax rates for individuals and SMEs. However, with the extension of Fringe Benefit Tax (FBT) to cover stock options and increase in education cess by 1 per cent, the overall impact of such reduction is lost. The Finance Minister has introduced a two-stage taxation on stock option gains-first, a tax on employer by way of FBT and then a tax on the individual employee upon exercise of the options/sale of the shares. The proposed levy of FBT on the employer would discourage the employers from providing stock option benefit to the employees in view of the FBT levy.

Increasing dividend distribution tax (DDT) rate is another easy revenue increasing mechanism which the Finance Minister has resorted to. DDT started off at 10 per cent a few years back and has gradually crept up to 15 per cent. With surcharges and education cess, this rate actually works out to close to 17 per cent. With the increase in the DDT rate to approximately 17 per cent, the effective tax rate for an Indian branch of a foreign company (42.23 per cent) would work out lower than the effective tax rate for an Indian subsidiary of a foreign company (43.57 per cent), which may influence the inbound investment structures.

On the development front, the Budget has its share of positives-significant allocations towards agriculture, concrete efforts to boost the rural economy, allocation towards Rural Health Mission, etc. However, a lot more could have been achieved if the Budget had incentivised industry to participate in the rural economy and to improve the efficiency of the agricultural supply chain.

Gaurav Taneja is Partner (Human Capital), Global Tax Advisory Services, Ernst & Young