india taxation: India's Direct Taxes Code Bill, 2009 and nonresident taxation
Residence status
According to section 6(3) of the Income Tax Act, 1961 (ITA), a foreign company qualifies as a resident of India only if control and management of its affairs are wholly in India. Under section 4(3) of the DTCB, however, a foreign company would qualify as a resident of India if at any time during the year, the control and management of its affairs is wholly or partly in India. In other words, under the DTCB, a foreign company would be deemed to be a resident of India even if only part of its control and management is in India, with the result that the foreign company would be liable to tax in India on its worldwide income. The extended definition would have a significant impact on foreign companies doing business in India and they would need to ensure that no portion of control and management could be considered to be in India.
While the DTCB contains more than 300 definitions, no definition is provided for "control and management." It would therefore be necessary to rely on Indian case law that interprets the term. Based on Indian judicial precedent, control and management is said to be the place where the "head and seat and power" of a company's affairs is situated (e.g. the place where the directors' meetings are held).
As is made clear from the discussion below, this would lead to a significant increase in the tax liability of foreign companies. For example, assume a branch of a foreign company is set up in India and the CEO of the branch is responsible for making day-to-day decisions relating to the branch functions in India. Could this be deemed to constitute control and management in India? It may be possible to argue that, because key decisions relating to the branch are made outside India and only decisions relating to the day-to-day operations are made in India, the branch qualifies as a nonresident. However, if key decisions relating to the business of the branch are also made in India, the branch could be deemed to be resident because "part" of the control and management would be in India, with the result that the branch would be liable to tax in India on its worldwide income.
A broader issue that would arise is whether the foreign company would qualify as a resident of India as a result of control and management of the branch being in India. Could the head office be considered independent of the branch? While in certain respects, a branch and its head office are considered independent entities, there is judicial precedent that recognizes a branch and its head office as being one and the same. In the latter case, since the operations of the branch would be controlled and managed in India, would it be possible for the authorities to conclude that a portion of the control and management of the foreign company is also in India and consequently, the foreign company also qualifies as a resident of India.
Even if it were argued that only the branch should be deemed to be resident in India because only control and management of the branch is wholly or partly situated in India, there could be a risk to the foreign company of qualifying as a resident, thus exposing the foreign company's global income to tax in India under the Indian tax code. Further, if a director of a foreign company who is based in India makes decisions relating to the foreign company from India, can it be argued that part of the control and management of the foreign company is in India? If so, the foreign company would qualify as resident in India. With the introduction of the new definition in the DTCB, a foreign company would need to exercise extra care in appointing individuals to its board because of the potential deemed residence. This would similarly be a concern for an Indian company with a subsidiary outside India where some of the board members of the foreign subsidiary are based in India.
The DTCB also provides that the test of control and management will be made "at any time in the year." The situation could arise where the director of a foreign company has to visit India for business purposes, such as overseeing the operations of an Indian subsidiary, participating in a seminar or conference, etc. It should be possible to take a position that the mere presence of key personnel in India on these occasions should not result in any part of the control and management of the foreign company being in India. However, such executives should not participate in any decision-making activities on behalf of the foreign company while they are in India, nor should they attend any board meetings of the foreign company from India; otherwise, there is a risk that the foreign company could be considered a resident of India. The exposure to residence becomes more acute with modern technology, where board meetings are held via conference calls or video conferencing and the individual can participate in remote locations.
In cases where a foreign company qualifies as a resident of both its home country and India, the tiebreaker clause of an applicable tax treaty (under which the foreign company would be considered a tax resident of the country in which its place of effective management is located) may result in the foreign company being a tax resident of its home country. However, to the extent there is no tax treaty or if treaty benefits are unavailable, this issue could give rise to litigation. Given that it may be unfair to qualify a foreign company as a resident in India if only a portion of its control and management is in India, the proposal merits reconsideration.
Income deemed to accrue in India
Capital gains – Under section 5 of the ITA, an Indian resident is subject to tax on its worldwide income, while a nonresident is taxed only on India-source income, i.e. income accruing or arising in India or deemed to accrue or arise in India. Section 3 of the DTCB adopts the same concept, but expands the scope of income that would be deemed to accrue in India.
The effect of this expanded scope can be illustrated in the context of gains derived by a nonresident on the transfer of a capital asset situated in India. Under section 9(1)(i) of the ITA, only gains arising directly or indirectly from the transfer of a capital asset situated in India are taxable in India. In other words, gains arising on the transfer of a capital asset situated outside India are not taxable in India.
Assuming the only investment held by Cayman Islands Co is the shares of India Co, US Co's transfer of the shares of Cayman Islands Co to For Co is not taxable in India under the ITA because the shares of Cayman Islands Co are not situated in India. Accordingly, the shares of India Co can be indirectly transferred without triggering any taxable event in India.
Section 5(1)(d) of the DTCB, however, proposes to tax such transactions. According to the DTCB, capital gains arising directly or indirectly from the direct or indirect transfer of a capital asset situated in India would be taxable in India. Accordingly, in the above example, even where US Co transfers shares of Cayman Islands Co, the tax authorities are likely to take the position that, since the shares of India Co are sought to be transferred indirectly, the transfer could be taxable in the hands of US Co in India. This was the position taken by the Indian tax authorities in the Vodafone case (outcome still pending), in which the tax authorities argued that the transfer did not involve shares of the intermediate holding entity transferred but rather the shares of the Indian company because the value in the intermediate holding entity was derived from the shares of the Indian company.
While the proposed provision in the DTCB could help to tax cross-border transfers that are entered into with a motive to avoid/reduce tax, it also could result in undue hardship to nonresidents where shares of a company situated outside India that also holds shares of an Indian company are transferred for business reasons or as a result of an internal reorganization.
The proposed measure could bring within its scope genuine transfers where there is no motive to avoid/reduce tax in India.
It would therefore be helpful for the government to provide guidance as to the circumstances in which an indirect transfer of shares would be taxable in India.
Interest – Under ITA section 9(1)(v), interest paid by a nonresident to another nonresident is deemed to accrue or arise in India only if the nonresident payor carries on business in India, in contrast to the rules applicable to royalties and technical service fees paid by a nonresident to a resident under ITA section 9(1)(vi) and (vii), which are deemed to accrue or arise in India if the nonresident payor carries on business in India or if the payments are made for the purposes of earning or making any income from any source in India. Section 5(2)(d) of the DTCB proposes to amend the rules relating to interest, so that interest payable by one nonresident to another would be deemed to accrue in India if the interest is paid by the nonresident for the purposes of making or earning income from any source in India. This provision is likely to affect situations such as where a parent company makes a loan to its Indian subsidiary or where a foreign company (including a Foreign Institutional Investor or "FII") obtains a loan for purposes of investing in India to earn income in India. Under the ITA, interest payable by the parent company/FII is not deemed to accrue or arise in India as the parent company/FII does not carry on business in India. However, since the interest would be payable in connection with the making or earning of income from a source in India, under the provisions of the DTCB, the interest would be deemed to accrue in India.
Consequently, the nonresident parent company/FII would be liable to withhold tax in India on the interest and comply with the withholding tax obligations (subject to any treaty benefits that may be available to the nonresident recipient).
Royalties/Fees for technical services – The DTCB would amend the definition of a royalty to include the following payments:
- The use of, or the right to use, the transmission by satellite, cable, optic fibre or similar technology; and
- The live coverage of any event.
Similarly, the definition of technical services fees is proposed to be amended to include payments for the development and transfer of a design, drawing, plan or software, or any other service of a similar nature, which could qualify (under the ITA and based on judicial precedent) as a purchase of a product and therefore not in the nature of fees for technical services. Minimum Alternate Tax
Under the DTCB, Minimum Alternate Tax (MAT) would be payable at a rate of 0.25% of the gross assets on the close of the financial year in the case of banks, and 2% of gross assets on the close of the financial year of any other company (rather than the existing 15% levied on book profits). The MAT will be a final tax and no carryforward of MAT would be allowed to credit against MAT liability in subsequent years.
Under ITA section 115JB, a foreign company must pay MAT only if it is required to prepare its accounts in accordance with Parts I and II of Schedule VI of the Companies Act, 1956. In other words, it can be argued that a foreign company (or FII) that is not required to prepare such accounts is not liable to MAT. However, the DTCB provides that every person, whether or not required to prepare balance sheets, will be required to prepare a balance sheet and profit and loss account as if the above provisions are applicable. This is likely to have a significant impact on foreign companies, including FIIs, which could be liable to pay MAT in India based on the value of their gross assets. While this may not be the intent of the DTCB, it would be helpful if the provisions were amended appropriately.
Branch profits tax
Section 100 of the DTCB provides that every foreign company – not just foreign companies with a branch in India – would be liable to pay Branch Profits Tax (BPT), which currently is payable at a rate of 15% of the branch profits calculated as total income less income tax. The DTCB currently would require the payment of BPT even if a foreign company does not have a branch in India, as long as the foreign company is liable to pay income tax in India. For example, an FII that only invests on the stock exchange in India also would be liable to BPT as would a foreign company earning income from royalties or fees for technical services. This is likely to significantly increase the tax liability of nonresidents in India.
Rate of tax
Royalties and fees for technical services – Under section 115A of the ITA, royalty and technical service fees are subject to a 10% withholding tax. This rate is proposed to be doubled to 20% under the DTCB. At a time when most of India's tax treaties provide for a withholding tax rate of 10%, the proposed 20% rate is high, especially considering that the existing rate under the ITA itself is 10%. The reduction of the rate to 10% would go a long way in promoting foreign investment in India and making technical know-how available to Indian companies.
A welcome amendment, however, relates to the tax rate on royalties, fees for technical services and interest payable by a nonresident to another nonresident. Under the existing provision in the ITA, the concessionary rates of 10%/20% prescribed in section 115A are not available, with the result that such income is liable to tax at the rate of 40%. However, the DTCB generally does not make a distinction between such income being received by a nonresident from a resident or another nonresident. In either case, the income would be subject to the 20% rate. In such a case, the nonresident recipient may be entitled to claim treaty benefits, but in the absence of a treaty, the new rule would provide desired relief in most cases.
Capital gains – Under the ITA, capital gains derived from the transfer of listed securities and other securities on which Securities Transaction Tax (STT) is paid are taxable at concessionary rates depending on how long the asset has been held, i.e. whether the gains are long- or short-term. No tax is payable on long-term capital gains, but short-term capital gains are taxed at a rate of 15%. The new framework proposes to eliminate the distinction between short- and long-term (capital) investment assets. Accordingly, capital gains on the sale of such assets would be taxable at the normal rates. In the case of nonresidents, capital gains would be taxable at a flat rate of 30%.
The DTCB does not provide concessionary treatment of capital gains for FIIs, which would be taxed like any other nonresident if the FII's investment is regarded as an "'investment asset." The proposed amendment under the head "capital gains" would have an adverse impact on the taxability of FIIs in India because they would be liable to tax at 30% as compared to the concessionary rates ranging from 0% to 30% as may be applicable under current rules.
The possibility of FIIs taking a position that gains arising on the sale of shares are from a business trading asset and therefore not taxable in India in the absence of a permanent establishment (PE), as held by the Authority for Advance Rulings (AAR) in Fidelity Advisors Series VIII, may need to be explored after taking into consideration the related compliance obligations. The AAR held that the gain arising on the sale of portfolio investments was in the nature of business profits and, in the absence of a PE in India, was not taxable in India. In addition, the subsequent ruling of the AAR in Fidelity Northstar Fund and Others may also have to be considered; the AAR, after considering the entire scheme relating to FIIs, held that the transaction of an FII relating to the purchase and sale of shares/securities was only in the nature of capital assets to earn capital gains.
Indexation benefit – Under section 13 of the DTCB, capital gains income earned by a nonresident would qualify as income from a special source. The computation of such income is contained in the Ninth Schedule; under Rule 2 of the Ninth Schedule, income from a special source is to be computed on a gross basis. Thus, the gross amount of capital gains could become chargeable to tax without even considering the deduction for costs. This does not seem to be the intent of the DTCB and should be modified.
Subject to the above, as a matter of relief, the DTCB does provide that the indexed cost of acquisition and the indexed cost of improvement may be taken into account if the assets are held for more than one year from the end of the financial year in which the asset is acquired. This benefit would be extended to nonresidents that currently are excluded from the relief. In addition, the base for substitution of cost by fair market value would be shifted from 1 April 1981 to 1 April 2000. This is a welcome change as it would provide an increased cost to a taxpayer – no capital gains tax would be payable on the appreciation of assets.
Securities Transaction Tax
STT, which currently is applicable on the purchase/sale of securities through stock exchange, would be abolished.
General anti-avoidance rules and tax treaties
Section 112 of the DTCB proposes to introduce certain general anti-avoidance rules (GAAR) whereby the Commissioner of Income Tax would be empowered to declare an arrangement as impermissible if it is entered into with the purpose of obtaining tax benefits and if it lacks commercial substance or satisfies certain other conditions. In such a case, the taxpayer would have to demonstrate that obtaining tax benefits was not the main purpose of the arrangement.
A significant portion of foreign direct investment in India is currently routed through Mauritius. Under the India-Mauritius treaty, the transfer of shares of an Indian company by a resident of Mauritius is not taxable in India and there are no antiabuse or limitation of benefits provisions in the treaty. In other words, if a person qualifies as a resident of Mauritius, it will be able to claim the benefits of the treaty. This position was confirmed by the Indian Supreme Court in Union Of India And Another v. Azadi Bachao Andolan And Another (And Other Appeals), in which the court ruled that a tax residence certificate from Mauritius is sufficient to claim treaty benefits and the principles of piercing the corporate veil cannot apply.
It will be necessary to determine whether the proposed GAAR would override the provisions of all of India's 80 tax treaties.
If so, the proposed GAAR would curtail the benefits of the Mauritius treaty if it can be shown that the investment was routed through Mauritius only for the purposes of claiming treaty benefits.
Under section 90 of the ITA, a taxpayer can opt to claim the benefits under the ITA or a tax treaty, whichever is more beneficial. However, section 258(8) of the DTCB provides that neither the treaty nor the DTCB would have preferential status by reason of its being a treaty or law, and in the case of a conflict, the provision that is later in time would prevail.
With the DTCB proposed to be effective from 1 April 2011, the question arises whether treaty benefits could still be claimed or whether the provisions of the DTCB would override the provisions of India's existing treaties, since the DTCB is later in time.
It may be important to note here that the provisions relating to GAAR may apply even in the absence of the later-in-time rule. Another question that arises is whether the GAAR would be applicable only to transactions entered into on or after 1 April 2011 or whether it also would apply to transactions that are executed before 1 April 2011.
The reaction of the international community to the proposed amendments will need to be closely watched. The provisions clearly will give rise to apprehension in the minds of foreign investors.
TAX NEWS - October 2009
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