TAX NEWS - 2010

New tax code of India good for non-resident companies

While the proposed Direct Tax Code (DTC) promises not to be very friendly with individual overseas Indians, a revised version unveiled last week provides some succour for non-resident companies in terms of taxation.

The DTC, introduced by India's Finance Minister Pranab Mukherjee late last year, is to replace the 49-year-old Income Tax Act on April 1, 2011.

A revised The much awaited discussion paper of the DTC) was released last week for a second round of public consultations.

The paper seeks to address major concerns raised in the first round and promises a consideration of left out issues with the suggestions on the fresh proposals in the Bill to be introduced in Parliament.  Consultations on the modified proposals last only until June 30, 2010.

The revised proposals in relation to non-resident taxation seek to restore confidence that was terribly shaken at the time of first round. Among other issues, the discussion paper has clarified that a foreign firm would be treated as a resident only if its 'effective place of management' is in India.

The norms are in contrast to the earlier version of the DTC which sought to bring foreign firms into the domestic tax net if their control and management was 'partly' in India at 'any time' during a financial year.

The new draft DTC provides that gains (losses) arising from the transfer of investment assets will be treated as capital gains (losses).  These gains (losses) will be included in the total income of the financial year in which the investment asset is transferred.

The capital gains will be subjected to tax at the rate of 30% in the case of non-residents and in the case of residents at the applicable marginal rate.

If the result of the aggregation of gains and losses over the tax year year is a loss, then the total amount of capital gains will be treated as 'nil' and the loss will be treated as unabsorbed current capital loss at the end of the financial year.

The current distinction between short-term investment assets and long-term investment assets on the basis of the length of holding of the asset will be eliminated.

However, in the case of a capital asset which is transferred anytime after one year from the end of the financial year in which it is acquired, the cost of acquisition and cost of improvement will be indexed to reduce the inflationary gains.

The test of Indian tax residence for a foreign company in the DTC provided that even a part of control and management in India is sufficient to expose the foreign company to a tax residence in India.

The new draft makes a case for applying the test of 'place of effective management'. Accordingly, a company incorporated outside India will be treated as a tax resident of India and taxed in India if its 'place of effective management' is situated in India.

The test is well recognised as a tie-breaker rule for determining tax residence under most of the tax treaties concluded by India with other countries.

Currently, short-term capital gains arising on transfer of listed equity shares or units of equity oriented funds are being taxed at 15% and long term capital gain arising on transfer of such assets is exempt from tax.

The rate of 30 per cent for taxation of capital gains in the hands of non-residents is very high as in the case of listed equity shares they are currently being taxed at nil rate if held for more than one year.

The hitherto fully exempt long-term capital gains on equity and equity mutual funds were slated to be taxed at a flat rate of 30 per cent. In fact, under the new regime, there would be no distinction between long-term and short-term gains as is practiced currently. All capital gain income of an NRI would be aggregated and taxed at a flat rate of 30 per cent.

For resident Indians, the shelter of slab rates would be available i.e. income between Rs 160,000 and Rs 1 m was to be taxed at 10 per cent, between Rs 1 m and Rs 2.5 m was to be taxed at 20 per cent and only income beyond Rs 2.5 m was to be taxed at 30per cent. In other words, Indian residents would pay 30 per cent tax on capital gains only if such gains were above Rs 2.5 m. This tiered system of tax was not available to NRIs under the DTC.

Under the existing Income Tax Act, on the basis of physical presence, an individual taxpayer is classified into Non Resident (NR) and Resident and Resident is further divided into Resident and Ordinarily Resident (ROR) and Not Ordinarily Resident (NOR).

The RORs are subject to tax in India on their worldwide income but the NORs/ NRs are taxable in India only on their India sourced income. One of the biggest change that the Code has proposed, which will impact the NRIs is the removal of the NOR category of residential status.

So now an individual would either be a Resident or a Non Resident based on the rules, which are similar to the existing provisions of the Income Tax Act.

In case of a returning Indian who has been out of India for a long period of time, he may become liable to tax on his worldwide income (if he retains sources of income overseas) from 3rd or 4th year of coming to India.

This provision will need to be considered for cross border movements of NRIs who typically come back to India on say short term assignments so that appropriate planning of the assignment duration can be done in case of any proposed secondment to India.