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Controlled Foreign Company - Accelerating Taxation On Undistributed Income

India
31 May 2011

Under the Direct Tax Code ("DTC"), which recently came into effect, the Government has set its sights on broadening the base from which it can collect taxes. The clearest indication of this can be seen in the proposals to bring in the regime of Controlled Foreign Company ("CFC") in the DTC. In doing so, India would join the league of a number of advanced economies like US, UK, Germany, France, Italy, Japan etc which have similar tax regulations with some commenting that India seems to be knocking on the doors of an "advanced economy" from a third world country. Taxand India analyses the CFC provisions and what it means for the taxpayer and the issues that this new far reaching legislation throws up.

The CFC regulations in summary, are a mechanism for accelerated taxation in India of undistributed profits, on a deemed basis, of overseas corporations qualifying as CFCs.

The proposals seek to cover a company which cumulatively meets the threshold of a 5 point test:

  • Control test
  • De minimus Test
  • Activity Test
  • Positive Activity Test
    AND
  • Negative Deemed Income Test

Once a foreign company qualifies as a CFC based on the above 5 point test, the tested Indian Resident needs to include in its taxable income, the portion of the specified income of the CFC, based on its own voting power of capital held in the CFC and pro-rated for the period during which it was so held in the CFC. Such attributed income is considered as "Income from Residuary sources". Deduction is however available in subsequent years where an actual distribution of dividends is made by the CFC out of the profits included earlier on a deemed basis under the CFC provisions.

Although modelled broadly on the basis of international CFC legislations followed in various other countries, the proposed regulations under the DTC are fraught with certain loosely defined terms and nuances, which could soon be the bone of contention between tax payers and taxing authorities. Furthermore, the new set of regulations also brings with it a degree of complexity, which could lead to difficulties in implementation and compliance.

Taxand's Take


The recent changes in the Budget earlier this year (providing for a limited period lower rate of 15% for dividends received from overseas companies in which an Indian company has a 26% stake) only reinforces the Government's commitment to bring in the CFC legislation. The fact that the threshold for this change was reduced to 26% from the 51% originally proposed also indicates the kind of control tests that may be adopted in the CFC legislation.

The Indian multinational taxpayer has therefore reasons to be apprehensive in relation to how the CFC regime is implemented. Although the regulations are similar to legislations in other jurisdictions, implementation by tax authorities is the key. It would augur well for India Inc if some of the sticky issues in the provisions are ironed out in the final regulations.

The regulations impact Indian taxpayers with investments in overseas companies and qualifying the 5 point test. It may well be the time for companies to evaluate the potential incremental tax costs owing to the CFC regulations which is here to stay along with any restructuring that could be done in the corporate structures to minimise the impact.

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Your Taxand contact for further queries is:
Mukesh Butani
T. +91 124 339 5010
E. mukesh.butani@bmrlegal.in

Taxand's Take Author