The Direct Taxes Code Bill, 2010International Taxation - GAAR

18th June, 2011 Hyderabad

The Institute of Chartered Accountants of India

Contents

• Back Ground

• Anti- avoidance provisions

• Controlled Foreign Company(CFC) Rules

• Transfer pricing

• Non-resident taxation

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Background

Background

• Indian Finance Minister presented the Direct Taxes Code Bill, 2010 to Parliament on 30 August 2010

• The revised proposed Code builds on a 2009 draft and a revised discussion paper released in June 2010

• The effective date of the new Direct Taxes Code would be 1 April 2012

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Anti-avoidance provisions

Anti-avoidance provisions

General Anti Avoidance Rules (GAAR) • Applicable to an ‘arrangement’

‒ A step in or a part or whole of any transaction operation scheme, agreement or understanding

‒ Whether enforceable or not and‒ Includes any of the above involving the alienation of property

• Could be declared as an ‘impermissible avoidance arrangement’ 1.Main purpose to obtain a “tax benefit” and2.a) creates rights, or obligations, which would normally not be created between persons

dealing at arm’s lengthb)results, directly or indirectly, in the misuse or abuse, of the provisions of this Codec) Lacks ‘commercial substance’ in whole part ord) Is entered into or carried out in such manner which would normally not be employed for ‘bona fide purposes’

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Anti-avoidance provisions

• Tax benefit in the relevant financial year or any other financial year would mean:‒ Reduction, avoidance or deferral of tax other amount payable under the code;‒ Reduction, avoidance or deferral of tax other amount that would be payable under the code but for a

tax treaty;‒ Increase in a refund of tax or other amount under the code;‒ Increase in a refund of tax or other amount under the code as a result of a tax treaty;‒ Reduction in the tax bases including increases in loss

• Commercial substance‒ Does not have significant effect on the business risks, net cash flows but results in a tax benefit‒ Legal substance differs significantly from the legal form of the individual steps‒ Includes or involves round trip financing; an accommodating or tax indifferent party; transaction has

an effect of offsetting or cancelling each other or‒ Conducted through one or more persons and disguises the nature , location, source, ownership or

control, of the fund

 • Bona fide purpose would not include

‒ Which creates rights or obligations which would not normally be created between persons dealing at arm’s length

‒ Results in the misuse or abuse of the provisions of the code.

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Anti-avoidance provisions

• In case conditions are complied with, it could result in consequences and the arrangement could be

 ‒ Disregarded, combining or re-characterising any of the step in transaction;

‒ Considering the transaction as not been entered into;

‒ Disregarding any accommodating party or treating the same as one party;

‒ Deeming persons who are associated as one person;

‒ Reallocating amongst the parties any accrual receipt of a capital or revenue nature; or any expenditure deduction, relief or rebate

‒ Re-characterising any equity into debt or any accrual of a capital or revenue nature, and any expenses, deduction, relief or rebate

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GAAR – Issues / Observations (1)

• Forum of Dispute Resolution Panel (DRP) would be available in cases where GAAR is invoked. Thus, no demand should be payable until objections are disposed off by the DRP. Further, order of DRP would be binding on the Revenue authorities

• Clear and unambiguous guidelines need to be prescribed in order to provide protection against arbitrary application of the Rules

• CBDT guidelines will be critical on the following issues:‒ Distinction between Tax Planning and Tax Avoidance‒ Applicability of Threshold limit‒ Interpretation of commercial substance

• In cases where GAAR provisions are invoked, could the taxpayer be entitled to the beneficial provisions of tax treaties, especially if the Limitation of Benefit clause in the tax treaty are satisfied?

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GAAR – Issues / Observations (2)

• Investments made into India through intermediary holding companies (such as Mauritius, Cyprus, etc.) could be subjected to detailed scrutiny in the GAAR regime.

• Adequate ―economic substance would have to be built into intermediary holding companies to prevent the applicability of GAAR.

• Whether GAAR provisions can be invoked against Court approved schemes?

• Can GAAR provisions be invoked against arrangements entered into prior to the implementation of DTC but resulting in a tax benefit under DTC?

• Can GAAR provisions be invoked for disallowing interest on an overseas debt by holding that the taxpayer has taken excessive debt?

Controlled Foreign Company (CFC) rules

CFC – Background (1)

• CFC means a corporation being set up in a foreign low tax or no tax jurisdiction, under direct or indirect control of a local resident tax payer

• As large amounts of profits are kept offshore, governments in various countries have introduced legislation aimed at eliminating the benefits of deferral, by currently taxing income in the parent country even when the income has not been repatriated or remitted to that country

• These laws are generally referred to as CFC laws

• CFC regimes are used in many countries as a means to prevent erosion of the domestic tax base and

• To discourage residents from shifting income to jurisdictions that do not impose tax or impose tax at low rates

• While the rules applicable to CFCs and the attributes of a CFC differ from country to country, the hallmark of CFC regimes in general is that they eliminate the deferral of income earned by a CFC and tax residents currently on their proportionate share of a CFC’s income

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CFC – Background (2)

• CFC regimes are in existence both in developed countries and in developing countries like Australia, China, France, Germany, Indonesia, Italy, Japan, Mexico, New Zealand, Norway, South Africa, Spain, United Kingdom and United States

• Countries like Belgium, Cyprus, Singapore, Malaysia, Switzerland, Mauritius, Hong Kong, etc. do not have CFC regimes

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CFC - Provisions

• Income attributable to CFC is chargeable to tax in India in the hands of the resident tax payer as “Income from Residuary Sources” based on a specified formula

• Income attributable is based on the “Specified Income” of the CFC whose methodology for computation has been specified

• Deduction is available of the amount received as dividend from a CFC in a subsequent year to the extent the same has been offered to tax as CFC income in any preceding previous year

• CFC has been defined as a Foreign Company which fulfils certain specified conditions

• Accounting period comprises of 12 months ending on 31 March except in certain circumstances

• For the purpose of Wealth Tax, specified assets includes any equity or preference shares held by a resident in a CFC

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CFC – Mechanics of taxation of CFC income in India (1)

• Applies from 1 April 2012

• Income attributable to a CFC is taxable in the hands of resident taxpayers who exercise control

• Taxed in the financial year in which the CFC earns the income

• Such income is taxed as “Income from Residuary Sources” based on a specified formula

• Formula based on Net Profits of the CFC as adjusted for certain items

• Formula allows for time apportionment based ownership of CFC

• Attributable income to CFC shall be included in the total income of the resident taxpayer for the financial year in which the accounting period of the CFC ends

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CFC – Mechanics of taxation of CFC income in India (2)

• Accounting period shall be the 12 months period ending on 31 March except in certain circumstances

• The amount received from a CFC as dividend in a subsequent year will be reduced from the total income to the extent it has been taxed as CFC income in any preceding previous year

• Resident taxpayer will have to furnish details of investments and interest in entities outside India in the prescribed form and manner

• For the purpose of wealth tax, specified assets includes any equity or preference shares held by a resident in a CFC

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CFC – Key Terms (1)

A CFC is a foreign company which meets the following conditions

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* Low rate jurisdiction means where the taxes paid by the foreign company in any accounting period is less than 50% of the corresponding tax payable on those profits computed under the DTC 2010

• It being liable to tax on account of its place of management or place of incorporation situated in that territory

• In a jurisdiction with a lower rate of taxation*

– Where the taxes paid by it in on the profits of a company that accrue in any accounting period is less that 50% of the corresponding tax payable on those profits computed under the DTC 2010, as if such company was a domestic company

CFC – Key Terms (2)

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$ Control means – • One or more persons resident must either individually or collectively be• In possession of / entitled to acquire, directly / indirectly, ≥ 50% voting power/ capital of

CFC• Entitled to secure ≥ 50% of income / asset, shall be applied directly / indirectly, for their

benefit• Able to exercise dominant influence by virtue of special contractual relationship• Able to exert decisive influence in shareholder meeting of the company

CFC – Key Terms (3)

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$ Active trade or business means that – • It actively participates in industrial, commercial or financial undertakings through employees or other

personnel in the economic life of the territory of which the foreign company is tax resident; and• Less than 50% of the income foreign company during the accounting period is of a specified nature

– see below

# Specified income would include :• Income from house property• Capital gains• Dividend, Interest, Royalty, Annuity payment• Sale or licensing of Intangible rights on Industrial, literary or artistic property• Sale of goods or services including financial services to specified companies / enterprise• Income from holding / managing / investment in financial assets (i.e. shares, securities, etc.)• Any other income falling under the head “Income from Residuary sources”

Existing provision Proposals in the DTC 2010

Dividend declared by Sing Co. is taxable in the hands of India Co. in Year 4

Dividend income, if qualifies as specified income than it shall be attributable to CFC and accordingly, may be taxable in the hands of India Co. in Year 1 (instead of Year 4)

India Co.

Sing Co.

Aus Co.

DividendYear 2

DividendYear 4

IncomeYear 1(DTC)

• India Co. incorporates Sing Co. for making investments into Aus Co.

• Dividends received from Aus Co. is tax exempt in Singapore

• No withholding tax on dividends paid by Singapore

IncomeYear 1(DTC)

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CFC – Illustration

CFC – Transfer Pricing

• Activities of overseas “associated enterprise”(AE) business to be included• Specified transactions within AEs are covered:

‒ Sale of goods; and‒ Supply of services incl. financial services

• Income arising from above transactions be (less) than 50%• Rule to apply even if economic substance is present or arm’s length test is met• Likely activities to fall under the ambit include:

‒ Holding/investment companies, ‒ Centralized regional entrepreneurs, ‒ Contract manufacturers and limited risk distributers;‒ IP companies, ‒ Coordination centres, etc.

• Absence of grand-fathering clause may lead to double taxation

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CFC – Issues (1)

• Definition of CFC is wide and could include target tax havens or low tax countries

• Definition of a territory with a lower rate of taxation – Income compatibility, Tax paid v/s Payable ?

• Does not distinguish between third parties and related parties except for sale of good and supply of service - income from “sale of goods” is also covered

• Royalties and income from sale or licensing of rights to third parties treated as passive income – often this could be an active trade

• Presumably applies to multiple layers – what happens if a dividend is paid between two CFCs

• No DTAA relief or no credit for taxes paid by CFC in foreign jurisdiction

• Computation of income of the foreign company as a domestic company could be a problem

• Impact on tax provisioning in consolidated accounts

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CFC – Issues (2)

• Since DTC is applicable from the 1 April 2012, CFC’s whose accounting period ends before 31 March 2013, could be subject to tax under DTC – Whether DTC is retrospective in nature to that extent

• Applicability of the provisions where CFC accounts are for more than twelve months

• Determination of dominant influence or decisive influence

• Determination of fair market value of the shares of a CFC liable for wealth tax

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Transfer Pricing

Transfer pricing

• Introduction of Advanced Pricing Agreement Mechanism‒ Board with the approval of the Central Government may enter into an agreement with any

taxpayer for determining the arm’s length price of an international transaction‒ Board is empowered to determine the arm’s length price under any method whether

prescribed or otherwise, as it may be necessary‒ Validity of the APA is limited to 5 consecutive financial years‒ APA in relation to the international transactions for which it is being sought is binding on

the taxpayer and the Income-tax authorities

• Definition of Associated Enterprise(s) widened to include:‒ If the enterprises are located in any specific or distinct location as may be prescribed; and‒ Where services are provided by one enterprise to another and the amount payable and

other conditions relating thereto are influenced by the other enterprise (under the Act, only goods or articles manufactured by an enterprise was covered)

• Changes in Transfer Pricing Assessment Procedure‒ Accountant’s report to be filed with the Transfer Pricing Officer (TPO) instead of the

Assessing Officer (AO)

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Transfer pricing

• Penalty Provisions‒ Non-filing of Accountant’s Report is INR 50,000 to INR 200,000 instead of

INR100,000‒ Non-maintenance of documentation is INR 50,000 to INR 200,000 as against

2%‒ Underreporting of tax base is 100 % to 200% of the amount of tax payable on

the adjustment as against 100% to 300%‒ Non-furnishing of documentation is INR 5,000 to INR 100,000 as against 2% of

the value of the international transaction

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Non resident taxation

• Income deemed to accrue in India, if it accrues, directly or indirectly, through or from transfer of a capital asset situated in India

– Does not include income from transfer outside India, of any share or interest in a foreign company

• Exception for non-inclusion ~ the fair market value of assets in India, owned, directly or indirectly, by the company, represent at least 50% of the fair market value of the assets owned by the company at any time in 12 months preceding the transfer

• Computation mechanism ~ A * B / C

A ~ Income from transfer as if the transfer was effected in India

B ~ Fair market value of assets in India, owned directly or indirectly by the company

C ~ Fair market value of all assets owned by the company

Non Resident Taxation - Transfer of shares outside India ~ Law

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Attempt to tax Vodafone-like transactions

• No specific inclusion of indirect transfer of shares (similar to ITA)

– Unlike circular issued by China in December 2009 specifically stating that sale of an offshore intermediary holding company owning a Chinese resident enterprise may be taxed in certain cases

– Presumption that covered under indirect transfer of a capital asset situated in India

– Apparently to safeguard Revenue’s interest in the Vodafone case

• 'Interest in a foreign company' covered ~ however not defined

• Presumption that ownership of shares leads to indirect ownership of assets ~ can be challenged

• Determination of 'fair market value' of assets to be prescribed ~ interesting to see what method will be prescribed

• Internal group restructuring may be hit by the provisions

• No threshold limit in respect of shareholding % for triggering provisions

Non Resident Taxation - Transfer of shares outside India ~ Issues

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Branch Profits Tax

• Every foreign company liable to pay branch profits tax [BPT]

– Levy of BPT in addition to income-tax

• BPT payable @15% of branch profits

• Branch profits ~ Income attributable, directly or indirectly, to PE or immovable property in India less income-tax on such income

– BPT not payable if no PE or immovable property in India

– No BPT if special source income like royalty & fees for technical services not attributable to PE in India

• BPT liability to be discharged by way of pre-paid taxes

• BPT payable regardless of treaty provisions ~ treaty override

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No concept of BPT under ITA

Branch Profits Tax - Issues / observations

• Only foreign companies liable to pay BPT

– BPT not payable by other non-residents like firms, AOPs, etc.

• BPT not payable if no PE in India

– If business connection but no PE, BPT should not be payable

– Definition of PE as per DTC or as per relevant treaty?

• Very significant issue as definition of PE under DTC is very wide

• TDS provisions not applicable in relation to BPT ~ BPT liability to be discharged suo moto by foreign companies

– Issues ~ BPT to be paid by way of advance tax or self-assessment tax, non-payment of advance tax to attract interest liability?

• Interplay between income-tax and BPT unclear

– Can additional income-tax (TDS / advance tax) be adjusted against BPT or does it need to be paid separately

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Branch Profits Tax - Presumptive taxation

Whether BPT shall be applicable to companies opting for presumptive taxation?

• Foreign companies involved in turnkey power projects, oil & gas service providers, airlines, shipping companies, etc.

• No specific exemption from levy of BPT in case of presumptive taxation

• BPT applicable only if foreign companies have a PE in India

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Branch Profits Tax - Credit for BPT in home country

• Income-tax payable at the rates specified in the First Schedule; BPT specified in the Second Schedule

• BPT is a tax, but is not income-tax

• Taxes covered under treaties typically include only income-tax

• Provision under treaties to cover identical or substantially similar taxes imposed in addition to or in place of existing taxes

• Whether BPT could qualify as a substantially similar tax in addition to income-tax

• Foreign companies having PEs in India to analyze issue in detail in accordance with legislation & precedents in home country

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Foreign Tax Credit – DTC Provisions (1)

• All residents eligible to claim foreign tax credit (FTC)

• FTC in respect of income tax paid by deduction or otherwise, in any foreign country or other specified territory

• Against the Indian income-tax payable by him in respect of his income of the financial year, which is being taxed twice

• Where double tax avoidance agreement (DTAA) exists, amount of FTC in accordance with the DTAA

• Where no DTAA exists, amount of FTC should be the lower of the Indian rate of tax or the rate of tax of the other country

• The amount of credit of foreign tax shall not exceed the Indian income-tax payable in respect of income which is taxed outside India or the Indian income-tax payable on total income of the assessee

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Foreign Tax Credit – DTC Provisions (2)

• Operating expenditure allowed as a deduction does not include any taxes paid in a foreign country which is eligible for FTC

• FTC to be claimed in the same manner as tax deducted at source for the purpose of:– Ascertaining advance tax / self assessment tax liability– Interest computation– Processing of returns by Assessing Officer – for determining tax payable or

refundable

• The DTC provisions are more specific in this regard empowering the Central Government to prescribe the method for computing the amount of credit, manner of claiming credit and such other particulars as may be considered necessary

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Foreign Tax Credit – Issues

• DTC empowers the Central Government to prescribe the method for computing the amount of credit, manner of claiming credit and such other particulars as may be considered necessary

• No FTC Rules prescribed as yet

• No FTC mechanism prescribed in respect of taxes paid in the following specific scenarios:– Taxes paid by CFC in the foreign country– Taxes paid in a transaction wherein foreign taxes are paid but the DTAA

benefits are denied by virtue of disregarding the transaction under GAAR provisions

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THANK YOU