In what is potentially seen as having far-reaching implications, the new direct tax code seeks to revamp the tax regime for non-residents doing business in India. The code’s thrust on clarity, certainty and an effective dispute resolution is quite salutary and should go a long way in boosting India’s image as a friendly investment destination.
However, there are many areas which would be of great concern to foreign investors, and this article seeks to highlight some of them.
Taxability of a foreign company is linked directly to its tax residence. A non-resident foreign company is taxed only in respect of income from Indian sources. On the other hand, if a foreign company is regarded as an Indian resident, it would be taxable on its worldwide income, as against merely on income from Indian sources.
Under the current regime, a foreign company is regarded as a resident only if the control and management of its affairs is situated wholly in India.
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The code proposes that even when the place of control and management of a foreign company is partly situated in India, the foreign company will be regarded as an Indian resident. The place of control and management has not been defined under the code.
What is not clear is the rationale for this change.
Illustration: Jayachandran / Mint
However, the way this is worded, it could hit even operating companies abroad. Further, partial control does not have any threshold. For example, is 40% holding partial control? Even if there is a low shareholding, will not the tax department seek to contend that there will be some management and control from India?
Further, although that does not seem to be the intent, what about India being the regional headquarters of a foreign multinational? Will those companies within, so to speak, an Indian oversight role, be deemed to be residents in India? Clearly, this seems to be very sweeping and needs a relook, especially considering the consequences of being an Indian resident, that is, global income taxation.
In case of expatriate individuals, the code proposes to eliminate the not ordinarily resident (NOR) status. Thus, an expatriate would be regarded as an ordinary resident if his stay in India exceeds 183 days in a financial year. However, the code does protect his overseas income from Indian taxation for a limited period of two years. This was earlier available for a period of at least three years under the resident but not ordinarily resident (RNOR) status.
There will be various issues arising out of this, including the interplay with the tie-breaker clause of residents under tax treaties and in any case, this seems to be too harsh since it will have the implication of exposing the global income of expatriates to Indian tax.
Also, the global mobility of Indian managers to international posting in most cases does not attract such treatment in those countries. Should not India look at this aspect?
Under the current regime, it is a settled law that the provisions of a relevant tax treaty or of domestic law, whichever is more beneficial to the non-resident taxpayer, shall apply. Section 258 of the code proposes that the provisions of the code or the tax treaty, whichever is later in law, shall prevail.
India has already signed treaties with most of its investment and trade partners such as the US, UK, Germany, France, Mauritius, Japan and Singapore, to name just a few. In relation to these treaties, the code would be regarded as subsequent legislation.
Again here, given the stated objective of adopting best international practices, it does not seem the intention that India seeks to override at least 75 tax treaties which it has entered into. In fact, the discussion paper itself clarifies that such steps should be restricted only to exceptional cases of abuse and not generally. Nonetheless, the code provisions would need appropriate clarification to reflect this intention.
Section 9 of the current Income-tax Act deems certain income as taxable in the hands of a non-resident. The scope of the said section is sought to be substantially widened by the code in many areas. Gains arising from an “indirect” transfer of an asset in India are proposed to be taxed. This seems to have been triggered by certain pending matters in litigation. It appears to be intended to strengthen the revenue department’s contention that an overseas transfer with underlying Indian assets should be exposed to Indian tax.
While this seems to be, on the face of it, an acceptable proposition, in reality it may not be so for various reasons, including the sanctity of a corporate entity existence, the fact that it is difficult to draw a line in terms of holding thresholds, as also the fact that similar treatment for Indian companies acquiring overseas companies through SPVs would then be subject to a similar treatment and the like.
The concept of business connection (the trigger to tax business profits in India) is sought to be widened to include independent agents. Interestingly, almost all international tax treaties, including ones which India has signed, exclude an independent agent from being a permanent establishment (equivalent of business connection in tax treaties).
This could cover a case of a non-resident, who sells goods in India through an agent acting in his ordinary course of business and who is neither legally nor economically dependent on the foreign principal (a typical case of an indenting agent or distributor selling goods in India on behalf of various principals, including the non-resident).
This can be a serious deterrent to global companies doing business in India and, indeed, could provoke retaliatory measures for Indian exporters internationally, who sell through independent agents in those countries.
Interest on funds borrowed abroad by a non-resident for earning any source of income in India is sought to be brought under the tax net. This could raise the cost of borrowing funds overseas to invest in Indian assets, for PE/institutional players, particularly hedge funds. It could also have a bearing on leveraged buyouts of Indian companies by foreign players.
The code significantly revamps taxation of royalty/fees for technical services (FTS) earned by a non-resident. Firstly, the definition, per se, has been expanded. “Royalty” is specifically defined to include payments for broadcasting rights as also for live events.
Development and transfer of any design, drawing, plan or computer software has been included in the FTS definition. Indian courts had consistently held that such payments were not subject to tax in India [Davy Ashmore’s case (190 ITR 626)]. There is clearly a distinction between projects and payments for rights and it seems to be unfair to extend the definition to the former.
Secondly, the code provides that royalty/FTS income shall be regarded as income from special source and taxed on a gross basis. The base tax rate is enhanced to 20% (from the current 10%). Also, net basis taxation of royalty/FTS earned through a permanent establishment in India is proposed to be done away with.
The code proposes to reduce the base rate applicable to foreign companies from 40% (plus surcharge/cess) to 25% on income earned from ordinary sources (generally, business income, excluding special source income such as royalty/FTS/sportsmen, among others). Additionally, a 15% branch profit tax (BPT) is sought to be imposed on foreign companies. The provisions do not adequately clarify the computation of BPT, which is proposed to be levied on total income, net of tax.
As such, by definition, it seems to be intended to apply to an Indian presence and it should, therefore, be clarified that this does not apply to a virtual permanent establishment situation. Incidentally, including the 15% BPT, the effective rate works out to 36.25%; this is lower than the 42.23% currently.
The code proposes that the payments to non-residents shall be subject to tax as per the rates prescribed under the domestic law. Certainly, assuming a treaty applies and provides for a lower rate, the taxpayer is eligible to refund. However, this can amount to locking funds.
Separately, even the current practice of tax authorities issuing a lower withholding order in respect of business income of a non-resident taxable on net basis has not been specifically provided for in the code. One would wait for the detailed rules to look for clarity. In absence thereof, non-residents earning business income in India may be subject to a withholding of 35% on the gross receipts, which can result in undue hardship.
The ambit of transfer pricing regulations has been significantly expanded by lowering the associated enterprise benchmark (10% shareholding instead of 26%, among others).
A 10% holding threshold seems to be very aggressive. Also, in practice, the fact that there would be another shareholder with a large percentage in itself acts as a commercial safeguard.
The code introduces the advance pricing agreement (APA) framework, which should be a huge sigh of relief for non-residents.
An APA shall be valid for a maximum of five years. While this is a salutary move, in principle, the real test is in the implementation and one hopes that the expectations on this will be kept in mind, including in terms of the qualifications and quality of people manning APA.
Lastly, but most importantly, the code introduces general anti-avoidance regulations (Gaar) provisions. Without going into much detail, the basic purport thereof is to empower a tax commissioner to disregard an arrangement as impermissible if it has been entered into with the objective of obtaining tax benefit and lacks commercial substance.
The onus is on the taxpayer to prove otherwise. On invoking Gaar, the tax authorities can reassess the tax liability ignoring the disregarded transaction.
It almost seems as if the taxpayer is required to pay the maximum possible tax. One hopes that the draft will be amended, including discharge of onus by the tax department vis-à-vis tax avoidance motive of the taxpayer.
While the intent to check abuse is warranted, one hopes that the unfettered discretion is curtailed significantly, since it would otherwise lead to uncertainty and protracted litigation—both of which are rightly sought to be avoided by the code.
Undoubtedly, the code’s objective of simplifying the rules is welcome, but an equally important emphasis, as the finance minister himself identifies, is on being compatible with the needs of a fast developing economy and international practice.
Focus on the latter should help propel India’s image globally as a friendly tax jurisdiction, as more and more investors look at setting shop in India. It is also important to look at the reciprocity aspect, since we cannot be an island in this globalized economy. One hopes that some of the above thoughts are considered in the right perspective while converting this draft into final legislation.
Ketan Dalal is executive director and Vishal Shah is associate director, PricewaterhouseCoopers. Your comments and feedback are welcome at firstname.lastname@example.org