Indian MNCs should rejig business models to avoid DTC sting.
The government of India stands committed to exploring every avenue to bring back Indian money stashed in tax havens.
The paradigm shift in the way the Direct Taxes Code (DTC) proposes to tax Indian businesses with global operations — commonly referred to as Indian MNCs — is a case in point.
Under no stretch of imagination can the DTC be termed as old wine in a new bottle — at least when it comes to taxing overseas companies ultimately owned or controlled as well as managed by Indians.
New ground has been broken with the proposed introduction of concepts such as controlled foreign company (CFC) and place of effective management, which are in line with global standards.
Read this in the backdrop of revised tax treaty with Switzerland that contains provisions for exchange of information related to bank account details in accordance with the Organisation for Economic Cooperation & Development standards and notification of the areas identified as ‘specified territories’, enabling the government to enter into a double taxation avoidance agreement (DTAA). It is only a matter of time before the taxman embraces global practices.
Jurisdictions that follow residence-based taxation are active in carving their share of tax revenue by means of these regulations.
The US regulations covered under ‘subpart F’ income of the IRS Code rendered ineffectual through checkthe-box approach, is being re-examined under US President Barack Obama’s comprehensive healthcare reform legislations.
The outcome is that the regulatory authorities are rewriting antiabuse provisions by placing greater importance on economic substance.
Broadly, a CFC is an overseas unlisted company not engaged in any active trade or business that is controlled by one or more Indian residents.
India tax will be triggered if such CFC is a resident of a territory in which the amount of tax paid in respect of profits is less than 50% of the corresponding Indian tax payable if the CFC were an Indian domestic company.
A formula is provided to compute the CFC income attributable to Indian resident, taking into account the percentage of value of capital or voting share or interest held in the CFC, whichever is higher, and the number of days during which the company remained a CFC in an accounting year ending within a financial year.
A foreign company will also be considered tax resident in India if its place of effective management is in the country.
Further, under the general anti-avoidance rules, authorities can disregard, combine or recharacterise any part or whole of transaction if it is considered ‘impermissible avoidance arrangement’ and domestic law will override DTAAs.
Some of the typical overseas structures that are likely to be challenged include:
Trading or bill-to/ship-to companies that predominantly deal with related parties,
Investment or intermediate holding companies with no or low substance used mainly as ‘blockers’ for treaty benefits.
Even if the overseas companies have resident directors, the fact that they may be indemnified by the Indian parent could be a cause of concern,
Multi-layered or complicated structures not backed by adequate business reasons (‘motive’) directly or indirectly controlled by Indians,
Companies listed on overseas stock exchanges, especially if the listing is on a stock exchange not recognised by the territory in which the holding company is a tax resident,
Funds that have Indian residents as either general or limited partners even though they are members of a limited liability corporation (LLC) registered in the US,
Holding companies for intellectual properties that earn royalty income without the underlying research and development activities,
Cross-border M&A using special purpose acquisition companies (SPAC) and ‘debt pushdown’ structures, and
Companies set up through the liberalised scheme of the Reserve Bank of India to acquire house property abroad.
The implications of these provisions are that profits of the overseas entity would be taxed in India at 30% in the year in which it is earned even if the same is not repatriated to India — as a CFC under ‘income from residuary sources’ or if place of effective management is deemed to be in India, then as resident under the relevant heads of income.
The DTC currently provides only broad contours of the new regime. It is expected that procedural aspects, especially with regard to loss offsetting, credit for foreign taxes paid, etc, would evolve through detailed rules.
With the DTC expected to become a law effective April 1, 2012, it provides a short window of just 18 months for taxpayers to relook at their business models, restructure them and be better prepared.
Indian MNCs should, therefore, immediately undertake a comprehensive review of their group organisational structure and align with business operations to ensure that tax deferral benefits continue to accrue.
Adequate economic substance should be placed in jurisdictions yielding passive incomes.
This may be through a central business model: a coordinated, tailored approach to achieve and maintain lowest sustainable structural tax rate.
Indian MNCs could explore alternative structures to optimise the group’s effective tax rate.
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