India is witnessing a spate of outbound investments (about $11 billion during 2006-07), which are often made under a global tax-efficient structure.
At times, this involves the incorporation of holding company structures and formation of entities in various tax-efficient jurisdictions. While there have been murmurs of Controlled Foreign Corporation (CFC) regulations in the Indian context, it seems that the government is seriously considering enactment of CFC regulations. A common feature of CFC regulations is their complexity, which often makes it unattractive from an implementation perspective, though it may have a sound appeal from an economic viewpoint.
JAYACHANDRAN / MINT
The genesis of a CFC regulation lies in the fact that the government of a country can generally levy taxes on global income of only those companies that are incorporated in the country, or a company that is a resident of that country under the domestic tax laws. The right of the government to levy tax on income of foreign companies is generally restricted to income derived from sources within its jurisdiction.
Conceptually, the purpose of enacting CFC regulations could be to shore up tax revenue collections, curb transfer of profits to low-tax foreign jurisdictions; and support existing anti-avoidance legislations.
For instance, a company called HoldCo Ltd, incorporated in Country A, would be liable to tax on its global income under the domestic tax laws of such country. However, a subsidiary of HoldCo, for instance, ‘SubCo’, incorporated in Country B and carrying on business abroad would not be taxable in Country A. Country A can only tax the dividend declared by SubCo to HoldCo, or the capital gains earned by HoldCo by way of divesting the shares of SubCo.
If profits are accumulated in SubCo, but it does not declare dividend to HoldCo, nor does HoldCo sell the shares of SubCo, Country A would not get tax revenues. If SubCo is based in a tax haven, it may avoid paying substantial taxes in that country. From an economic perspective, it means that while HoldCo, as a group, may be earning substantial profits abroad, it does not pay taxes in Country A since the profits are accumulated at SubCo level.
It is to address such scenario that many countries, such as the US and the UK, have enacted CFC regulations. Usually, the CFC rigours apply to passive incomes; that is, CFC regulations usually do not apply to those CFCs engaged in genuine business activities. To put it simply, if Country A had enacted CFC regulations, then (especially if SubCo is a holding company only) whether or not SubCo declares dividend to HoldCo, the proportion to the profits earned by SubCo vis-à-vis the shareholding of HoldCo in SubCo would have been taxed in Country A.
The Indian scenario
Several Indian companies are looking at holding company structures for outbound investments, either greenfield or acquisitions. If CFC regulations are introduced in India, it would result in tax on passive income and could impact outbound investments negatively.
In the recent past, several export income earning companies, especially in the information technology and pharmaceutical sectors, which have made acquisitions outside India, have devised holding company structures for operational and tax reasons. These companies would ordinarily be eligible to tax benefits under Section 10A or the Special Economic Zone (SEZ) Act. If CFC regulations are introduced in India, an issue which could arise would be whether such passive income accruing from the business acquired abroad would be eligible to the benefit of Section 10A/SEZ Act.
The Non-Resident Working Group report issued by the government in January 2003 had also suggested the introduction of CFC regulations in India.
However, given the significant change in the scenario, and the traction on outbound investments currently, the introduction of CFC regulations seems still somewhat premature.
US regulations define CFCs to be any “foreign corporation” where more than 50% of the total combined voting power of all classes of stock entitled to vote or total value of stock of such corporation is owned, directly or indirectly, by “US shareholders”. Under the UK regulations, a CFC is a non-UK company controlled by UK residents operating in a low-tax jurisdiction.
One of the concepts under a CFC regulation is regarding the categories of income earned by the CFC which would be taxed in the hands of the principal shareholder in the home country. Usually, passive incomes are included and, indeed, there are also “motive” exemptions, that is, inapplicability for non-tax-avoidance situations.
There is also a ‘high tax’ exemption existing under US CFC regulations, whereby if the CFC has paid tax in the foreign country at a rate greater than 90% of the existing US tax rate, then such income is not included in the gross income of the CFC’s shareholders. The UK CFC regulations provide various tests for a corporation to be exempt from CFC rules, for example, the chargeable profits of the CFC must be less than £50,000.
From an Indian perspective, it is desirable that CFC regulations are not enacted for at least the next few years, until the Indian companies have spread their global wings comprehensively.
However, one hopes that if CFC regulations are enacted, they should begin with very limited applicability;this would then perhaps not be a leash on the outbound mergers and acquisitions scene.
Girish Mistry is executive director, tax & regulatory services, PricewaterhouseCoopers. Ketan Dalal will return with the next column. Respond to the column at email@example.com