Once known for its elephantine rate of growth, India’s economy is now racing ahead in the manner of a true Asian tiger. It has also witnessed an exponential increase in foreign investment since its first move towards liberalization in 1991. A key concern for most investors putting funds in India is structuring the investment in
a tax-efficient manner, to suit the needs of both the Indian firm receiving investment and the investor group as a whole. The tax considerations for foreign investors are peculiar to the different business models.
JAYACHANDRAN / MINT
In deciding on a structure for investing in India, several factors require consideration; the intended income streams from the Indian entity to the foreign investor and the tax treatment of such streams in India and in foreign jurisdictions are important. Also, selecting a jurisdiction through which to route investment into India would depend largely on such income streams.
Some of the income streams relevant to tax planning are: (a) interest, (b) royalties, (c) service or management fees, (d) dividends,?(e)?capital gains.
As there are no thin capitalization norms here, investment in Indian firms can be made through debt instruments such as debentures that are fully convertible into equity. These instruments must be structured carefully to be compliant with Indian foreign investment and exchange control laws.
Currently, there are stringent restrictions on incurring foreign currency debt and borrowing in foreign currency for expenditure within India, but fully convertible debentures are considered “capital” for purposes of foreign investment, and may generally be issued by eligible Indian companies under the automatic approval route. The coupon rate paid out on such securities would be “interest” for tax purposes, subject to a withholding tax of either 42.23% or 21.115% under the Income-tax Act, 1961 (ITA), depending on whether the debt is incurred in Indian rupees or in any foreign currency. This withholding tax may be relieved under applicable tax treaties. Caution must be exercised in fixing the coupon rate since, for foreign investment purposes, the instrument is quasi equity and not a debt instrument.
Royalties, service fees
Royalties may be paid by an Indian company to a foreign investor for the licensing of intellectual property. Likewise, an Indian company may incur expenditure on certain management or service fees to a foreign investor in consideration for services received, and claim a tax deduction for such expenses. These payments will need to be in accordance with Indian exchange control laws.
Under ITA, such payments would generally be subject to withholding tax at the effective rate of 10.5575% (currently, this rate being lower than the rate prescribed under many of India’s tax treaties, it would override treaty provisions as it is more beneficial to the assessee). Such arrangements will also have to be evaluated for service tax implications.
Dividends may be paid by an Indian company out of its profits after paying corporate tax in India at the effective rate of 33.99%. Indian companies are subject to dividend distribution tax at the effective rate of 16.995% on dividends distributed, and no tax is payable in India by the recipient of dividends (including a foreign shareholder).
Capital gains arising to a non-resident from the transfer of an Indian company’s shares or securities would be subject to tax in India under ITA. If the Indian company is unlisted, the income from transfer of its shares held for 12 months or less would be treated as short-term capital gains, and taxed at the effective rate of 42.23%. Long-term capital gains, earned by a foreign investor from a transfer of shares held for more than 12 months, are taxed at the effective rate of 21.115%. Capital gains tax is often relieved under applicable tax treaties.
Investments into India are often through special purpose vehicles located in tax-favourable jurisdictions. Based on the income streams discussed above, investors generally identify the jurisdictions through which they will make investments, so as to avail of tax treaty benefits. In terms of Section 90(2) of ITA, the provisions of the Act will apply to an assessee to whom a treaty applies only to the extent that it is more beneficial than the treaty. Some of the jurisdictions commonly used for investment into India are Mauritius, Cyprus and the Netherlands. Singapore and the United Arab Emirates also have favourable treaties with India, but are less popular.
Mauritius is the most commonly used jurisdiction. The primary benefit under India’s tax treaty with Mauritius is the relief from Indian capital gains tax. Also, the treaty provides for a credit of underlying taxes on dividends received from an Indian company against Mauritius corporate tax, generally bringing down the Mauritius tax on such dividends to nil. The India-Cyprus tax treaty also relieves capital gains tax and in addition, reduces the Indian withholding tax on interest paid to a resident of Cyprus to 10%. The India-Netherlands tax treaty provides relief from Indian capital gains tax in certain circumstances, including the transfer of shares within the group as part of a group reorganization.
There have recently been reports of attempts by the Indian government to renegotiate the India-Mauritius tax treaty. However, there may be significant political and economic considerations that both countries would need to take into account before such a renegotiation can take place. There are also reports about a potential renegotiation of the India-Cyprus treaty, although it is speculated that the Cyprus government is unwilling to renegotiate this treaty until India’s treaty with Mauritius is renegotiated.
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This column is contributed by AZB & Partners, Advocates & Solicitors