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Direct Taxes Code Bill Introduced: Impacts on Multinationals Identified
On 30 August 2010, the Indian Government introduced a Bill enacting the Direct Taxes Code ("DTC"). The DTC is set to replace the current Income-tax Act, 1961 ("the Act") from 1 April 2012. The new DTC will provide clarity through a more stringent set of rules and as such should prove a welcome boost to investment into India.
Taxand warns however that multinationals will have to seriously scrutinise their tax planning and tax compliance procedures: if they don't closely align themselves with the new policies they could be penalised, particularly as regards the revised rules on residence of foreign companies and the introduction of General Anti Avoidance Rules (GAAR).
Mukesh Butani, Taxand Asia Leader said: "The Direct Tax Code of India is a necessary step in bringing Indian regulation in line with other leading global economies. It replaces flexibility and uncertainty with clarity and precision and will be attractive to companies already located in India or looking at investing in the Indian Subcontinent. Multinationals will however be forced to focus additional resources on tax planning and compliance with the Indian authorities under the new regime, although there should be a marginal reduction in overall compliance costs given the lowering of corporate tax rates."
Taxand India assesses the key issues set out in the revised DTC and its impact on multinational companies.
Rates of taxes
- The tax rate for domestic and foreign companies is proposed at 30 percent.
- In addition, foreign companies would be liable to pay a Branch Profits Tax in respect of their branches in India at the rate of 15 percent on post-tax profits of the branch.
- Minimum Alternate Tax ("MAT") is proposed at 20 percent on the book profits of companies. Credit for MAT paid in excess of the normal tax is allowed to be carried for up to 15 financial years immediately succeeding the financial year for which tax credit arises.
- Dividend Distribution Tax ("DDT") is proposed at 15 percent.
- Venture Capital Companies ("VCC") and Venture Capital Funds ("VCF") are not to be subjected to DDT. VCF Trusts have to be registered with the Securities Exchange Board of India ("SEBI") to avail the exemption.
- Income distributed by mutual funds and life insurance companies would be subject to tax at 5 percent.
Presumptive rate of profits
- The presumptive rate of profit for a non-resident engaged in the business of providing services or facilities in connection with the prospecting for, or extraction or production of, mineral oil or natural gas and supplying plant and machinery on hire for such activities, is proposed at 14 percent of gross receipts as against the present rate of 10 percent.
- The presumptive rate of profit for a non-resident engaged in the business of operation of ships and aircrafts is proposed at the rate of 10 percent as against the present rate of 7.5 percent of gross receipts.
Residence test for foreign companies
The residential status of foreign companies would be determined on the basis of 'Place of Effective Management' ("POEM") test, which is defined as:
- The place where the board of directors of the company or its executive directors make their decisions.
- In a case where the board of directors routinely approve the commercial and strategic decisions made by the executive directors or officers of the company, the place where such executive directors or officers perform their functions.
- Transfer of shares or interest in foreign companies would be taxed in India if the fair value of the Indian assets held by such foreign company is 50 percent or more of the total assets held by the foreign company in the preceding 12 month period. Such capital gains are to be computed with reference to the proportion of the fair value of the Indian assets to the total assets of the foreign company. This is a far reaching move, which could have implications for overseas acquisitions.
- Transfer of equity shares, which are subjected to Securities Transaction Tax (applicable only to securities traded on a stock exchange) would not be subjected to capital gains tax, in case of long term investments (more than one year). A deduction of 50 percent of profits would be available in respect of short term investments in such listed equity shares.
- Income earned by Foreign Institutional Investors ("FII") from transactions in securities would be treated as income from capital gains.
Incentives for Special Economic Zones ("SEZ")
- The revised DTC proposes to grandfather profits-based incentives available for SEZ units which become operational on or before 31 March 2014. Further, the investment linked incentives are proposed to be extended for SEZ units set up after 31 March 2014.
- The DTC proposes to grandfather profits based tax incentives for SEZ developers if the SEZ is notified on or before 31 March 2012, as against 31 March 2010 as per the original DTC. Further, the investment linked incentives are proposed to be extended for SEZ units set up after 31 March 2012.
Tax Treaty vis-?-vis domestic law
The revised DTC provides for application of domestic law or Double Taxation Avoidance Agreement ("Tax Treaty") whichever is more beneficial to the taxpayer. However, in circumstances wherein General Anti Avoidance Rule ("GAAR") is invoked or Controlled Foreign Corporations ("CFC") rule is applied or branch profit tax is levied, the provisions of the domestic law would prevail over Tax Treaty. The revised DTC has also widened the scope to cover within the ambit of Tax Treaty, wealth-tax in addition to the income tax.
General Anti-Avoidance Rules
The original DTC Bill introduced GAAR to serve as an effective deterrent and compliance tool against tax avoidance. GAAR could be invoked on any impermissible avoidance arrangement, if it lacks commercial substances or creates rights and obligations, which would normally not be created between persons dealing at arms length with each other or results in an abuse of the Code. A transaction would be regarded as lacking commercial substance if it results in the significant tax benefit without having a significant impact on the business risks, or net cash flows of the parties to an arrangement. A transaction could also be deemed to lack commercial substance if the form of the transaction significantly differs, in whole or in part, from its legal substance or involves round tripping. In case a transaction is regarded as an avoidance transaction, such transaction could be disregarded, combined with any other step in the transaction or re-characterised, or the parties to the transaction could be disregarded as separate persons and treated as one person. The rules are drafted in a manner to permit application of principles relating to lifting corporate veil, substance over form test, economic substance test, controlled foreign holding companies rules and thin capitalisation rules, without providing any threshold. The onus to prove that the transaction is not an avoidance transaction is on the tax payer.
The revised DTC proposes that the Central Board of Direct Taxes ("CBDT") would issue guidelines on the circumstances in which GAAR could be invoked and that the taxpayers, in whose case GAAR is invoked, could approach Dispute Resolution Panel ("DRP") against an order made in pursuance of the Commissioner's directions under GAAR.
Controlled Foreign Corporation ("CFC") Rules
The revised DTC proposes to introduce CFC rules, wherein any undistributed income earned by a foreign company which is controlled directly or indirectly by a resident in India would be deemed to have been distributed and consequently, would be taxable in India in the hands of resident shareholders as dividend received from the foreign company. Under the rules, a resident is required to furnish prescribed details of investment and interest in any entity outside India.
Under the provisions, a CFC would be a foreign company which satisfies the following conditions:
- It is a tax resident of a territory with tax rate of less than 50 percent of the tax payable under the revised DTC.
- Its shares are not traded on a stock exchange of such territory.
- One or more Indian residents exercise control over it - Control is determined based on satisfaction of prescribed thresholds, i.e. 50 percent or more of the voting power or capital or ability to get income / assets, or dominant influence, or votes to influence a shareholder meeting.
- It is not engaged in active trade or business - Active trade or business test is determined based on active participation in industrial, commercial or financial undertakings or that less than 50 percent of its income is either passive income (like dividend, interest, royalty, etc) or is under the head residuary sources.
- Its income (computed as prescribed) exceeds INR 2,500,000.
Advance Pricing Agreements ("APA")
One of the most significant proposals relates to introduction of APAs. A taxpayer can approach the Revenue authorities and upfront agree on an arm's length price for its international transactions. Such an agreement would be binding on tax payers and the Revenue authorities. APAs can be entered into for a maximum period of 5 years. There is no proposal for renewal or roll forward of APAs. Details regarding the composition and functioning of a body to administer APAs have not been provided in the Code.
The timely introduction of the revised Code for Parliamentary debate and approval is encouraging and re-emphasises the Government's commitment to usher in new tax reforms. The approach of the Government took allowing public discussion is appreciable. The changes carried out in the revised DTC after taking into account the concerns expressed to several provisions in the original DTC Bill is also good to see. Deferral of the proposed legislation by one full year will snooth the hurried rush for transition, as the extended time would hopefully allow taxpayers to plan their affairs and enable trade and industry to gear up to the new law.
In the interim, there is no gainsaying that the revised Bill is well intentioned to simplify archaic IT Act with adequate flavour of international best practices. It would be reasonable to pat the working group and the Finance Minister in particular for not springing any surprises with which the industry at large would not have been amused. Before a verdict can be passed, however, the right thing to do shall be to analyse the revised Code considering this is the future of the Direct tax law.
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