As a first step towards simplifying and bringing about structural changes in direct taxes, the new Direct Taxes Code („Code?) Bill 2009 has been released for public debate. This is expected to be presented in the winter session 2009 of the Parliament. The Code, once enacted, is proposed to be effective from 1st of April 2011.
The Code attempts to simplify the language to enable better comprehension and remove ambiguity. It is claimed that the Code has been drafted considering the “principles that have gained international acceptance”.
This article summarises certain key provisions proposed in the Code which are relevant for outbound investments from India.
Residential status of a Foreign Company
Under the Code
Under the current tax regime, a foreign company is considered to be a resident in India, if the control and management of its affairs is wholly situated in India at any time during the financial year.
Under the Code, a foreign company would be treated as a resident in India if its place of control and management is wholly or partly situated in India at any time in the financial year.
Thus, if a foreign subsidiary of an Indian company is partly controlled and managed from India at any time in the financial year, it will be considered as a resident under the Code.
A direct consequence of foreign subsidiaries and joint ventures („JVs?) of India headquartered companies being regarded as resident of India could result in dual taxation of such companies both in India as well as in the host country, subject to availability of foreign tax credit, which will have to be separately ascertained.
Additionally, if it is held that the foreign subsidiaries and JVs of India headquartered companies are resident of India, transactions between the foreign company and the Indian parent may no longer need to comply with the Indian transfer pricing regulations (if applicable), as transactions between two residents are outside the scope of these regulations. However, any payment of expenditure to an associated person could still be disallowed by the tax authorities if it is found to be excessive or unreasonable.
The term „control and management? is not defined under the Code and reference could be made to the various judicial precedents in this regard.
The effect of this provision would have to be closely examined for all foreign subsidiaries and JVs of Indian headquartered companies.
Under the Treaty
Under the current tax regime, it is, inter alia, possible to apply the provision under the tax law or the relevant treaty, whichever is more beneficial, in relation to right of taxation of income or the rate of tax or both. Thus, in cases where a tax payer is regarded to be a resident of both the countries under the domestic law, it is possible to apply the „tie breaker rule? to determine the residential status of the foreign company for deciding the right of taxation of the two countries.
The Code seeks to provide that for determining the relationship between a provision of a treaty and the Code, neither the treaty nor the Code will have a preferential status and the latter provision will prevail.
Thus, any beneficial treatment under the provisions of the treaties entered into by India prior to the Code may not be available. However, this may not be the intention.
Capital gains
The taxation of capital gains regime has also undergone a substantial change.
- Income from transactions in all „investment assets? are to be taxed under the head “capital gains?. Investment in foreign subsidiaries could be categorised as „investment asset?, if not connected with business.
- Distinction between short-term investment assets and long-term investment assets is eliminated under the Code. Thus, even long term capital gains will be taxed at normal rate of 25%.
- Benefit of indexation will however, be available in computing capital gains on transfer of investment assets held for more than one year from the end of the financial year in which the asset is acquired.
- Base date for determining cost of acquisition for the purpose of computing capital gains has been shifted from 1 April 1981 to 1 April 2000 where investment asset has been acquired before 1 April 2000. This may benefit entities which have made investments prior to 1 April 2000 and where there has been a substantial increase in value.
- Thus, any gain on transfer of investment asset by an Indian parent in offshore companies will be liable to Indian capital gains tax at the normal rate of 25%. Likewise, gain on transfer of investment asset by foreign subsidiaries which are regarded as residents of India for tax purposes, will also be liable to capital gains tax in India.
Foreign tax credit (FTC)
- Under the Code, FTC will be available against the Indian income-tax payable by an entity against its income which has accrued outside India, of an amount determined in accordance with the relevant treaty.
- In the absence of a treaty,
? FTC on income accrued outside India will be determined at the Indian rate of tax or the rate of tax of the other country, whichever is lower.
? No FTC will be available in case the income is also deemed to accrue in India.
- The Central Government may prescribe the method, manner, etc of computing and claiming the FTC
Thus, in case of an offshore subsidiary which is regarded as a resident of India, FTC will be available only in relation to the income which accrues outside India. In the absence of a treaty, no FTC will be available in respect of income that is deemed to accrue in India. It is possible that an offshore subsidiary derives income from sources in more than one country. In such a case, it will be open to debate whether FTC would be restricted only to tax in respect of income sourced in that country or be available in respect of whole of the income taxed in that country. Potentially, these could lead to double taxation resulting in a higher tax cost.
General Anti Avoidance Rule (GAAR)
- The Commissioner will also be empowered to declare any arrangement as an „impermissible avoidance arrangement? and he could determine the tax consequences as if the arrangement had not been entered into. This includes disregarding, combining or re-characterising the arrangement, either in part or in whole (eg. treating equity as debt or vice versa). In the process, the Commissioner may also deny the benefit under the tax treaty.
- An impermissible avoidance arrangement is defined as a step in, or a part or whole of, an arrangement, whose main purpose is to obtain a tax benefit, and it, inter alia, lacks commercial substance, in whole or in part.
- The onus of proving that the arrangement is not for the main purpose of obtaining a tax benefit is on the tax payer.
All international business structures, cross-border transactions, arrangements between holding-subsidiary and related companies could potentially be challenged with regard to the business purpose unless there is adequate evidence.
Conclusion:-The philosophy behind the introduction of the Direct Tax Code is simple – make things easier for the tax-payer. The Code aims to incorporate international best practices as well as take in to account the dynamic but changed business environment of today. The Code seeks to reduce compliance cost, minimise tax avoidance and broaden tax base. While these objectives are desirable and the need to raise collections is understandable, increase in the tax collection ideally has to be without increasing the burden on existing taxpayers; widening of the tax base has to be without alienating the existing taxpayer; and improvement in compliance has to be without harassment in enforcement. The implications of some of the provisions like treaty override, residency, anti avoidance rules seem to have created unintended disadvantages to the Indian multi-national rendering them uncompetitive in the global market. Fiscal Regulations essentially seek to change behavior or give direction to it. They are made not only to control behavior but also give rights. Where regulations impose excessive burden, they can stifle enterprise, growth and productivity, which clearly cannot be the Government’s intent.
