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Anish Mehta, August, 2010 Contents Background Residency test CFC Provision Branch Profit Tax Transfer Pricing – Definition of Associated Enterprise Safe Harbour Advanced Pricing Agreement GAAR Definition of Income deemed to accrue or arise in India Treaty Override Income of FII Taxation of Royalty/FTS Capital Gains Direct Tax Code - International Taxation Page 2 2 Background - Asset based MAT - Residency test for companies - Treaty override FIRST DRAFT OF DTC - GAAR SEVERAL REPRESENTATIONS FILED CBDT HAS NOW RELEASED A INTRODUCED IN AUGUST - Capital gains BY INDUSTRY ASSOCIATIONS ON CONCEPTUAL DISCUSSION PAPER 2009 FOR PUBLIC - SEZs PROVISIONS OF THE CODE ADDRESSING 11 KEY PROPOSALS FEEDBACK - Income from House Property - EET v EEE - Individual taxation - Wealth-tax - Non Profit organization Page 3 Residency test Act • Resident only if controlled and managed ‘ WHOLLY’ in India DTC (1st Draft) • Resident only if controlled and managed ‘WHOLLY’ or ‘PARTLY’ in India Objective not defined World wide income taxable Sought to tax shell and conduit company Dividend subject to DDT Offshore operating companies having substantial activities/ operations overseas get adversely affected Issues raised The word “partly” sets a very wide threshold for regarding a foreign company as a resident in India Direct Tax Code - International Taxation Page 4 Residency Test – Revised Discussion Paper Residency definition to be brought in line with international practice Concept of Place of Effective Management (POEM) introduced: The place where Board of Directors (BOD)/Executive Director (ED) of the company make 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 of the company perform their functions. Most of the tax treaties recognize the concept of POEM for determination of tie breaker rule for avoidance of the double taxation Direct Tax Code - International Taxation Page 5 Residency Test - Indian Judicial Decision • : Ship Management activities Universal Cargo Carriers - (205 ITR 215-Cal) Meeting of board of directors Radha Rani Holding Pvt. Ltd. 16 SOT 495 (Del) Direct Tax Code - International Taxation Page 6 Residency test – Best Practices OECD Commentary – Key Management and Decision Klaus Vogel –Management directives are given General criteria for POEM under treaties: Head and Brain De facto control Director resides Key Management & Commercial decisions Direct Tax Code - International Taxation Page 5 Residency test – Impact/Issues Can a company have more than one POEM? Impact of following on POEM: Single board meeting in India Few directors based out of India Group CEO based out of India Situation where the facts reflect decision making at multiple places Direct Tax Code - International Taxation Page 5 Factors to support tax residency Chairman of the board is foreign resident and is given a casting vote Regular board meetings in foreign country All decisions carefully recorded to make it clear that decisions were effected at these meetings Day to Day aspect should be undertaken in Foreign country Company should have a foreign bank account Company should keep key legal records in foreign country However, the implications of the aforesaid will differ from country to country. Direct Tax Code - International Taxation Page 9 Residency test – Way Forward Existing Structure and composition of BOD/ED to be reviewd Documentation requirements for demonstrating POEM Robust TP Direct Tax Code - International Taxation Page 5 CFC Provisions Revised Discussion Paper Proposal to introduce CFC provisions as an anti-avoidance measure CFC provisions to apply to ‘passive income’ earned but not distributed by a foreign company which is ‘controlled directly or indirectly’ by a resident in India Such income to be considered as deemed distribution and shall be taxable in the hands of resident shareholders as dividends Objective /Features : limit artificial deferral of tax Direct Tax Code - International Taxation Page 11 Why CFC rules are needed ? Shift "portable" income to tax heaven subsidiary companies. US Income shifted included investment income (interest and dividends) Dividend Distributed 100 % and passive income (rents and royalties), as well as sales and services to income involving related parties. Mauritius Deferment of tax Dividend Parked in Mauritius & 100 % Avoiding of tax indefinitely not brought to The CFC are intended to cause current taxation to the shareholder India where income is of a sort that could be artificially shifted or was made available to the shareholder. Direct Tax Code - International Taxation Page 12 Concept of CFC CFC rules prevalent in over 25 countries In general, CFC is a foreign company that: is directly or indirectly controlled by resident taxpayer; and earns substantially passive income; and is subject to substantially lower taxation than in resident state Passive income arising in overseas jurisdiction is attributed to resident shareholders. Passive income – interest, rent, dividends, royalties and capital gains Direct Tax Code - International Taxation Page 13 Concept of CFC (cont..) Nature of control Generally > 50% ownership (e.g. US, UK); Voting power (USA) Generally only shareholders with a minimum holding are taxed (e.g. 10% in USA) Relief from double taxation Foreign underlying tax generally creditable Shareholder not to be taxed again upon actual distribution of dividend Direct Tax Code - International Taxation Page 14 CFC Regulations – US & UK Particulars US UK Background • First country to adopt CFC Rules in 1962 • Introduced in 1984 to prevent UK residents reducing their UK tax liability by diverting profits to foreign company in low tax jurisdiction Definition • CFC is one which US shareholders own more than 50%, • CFC is a non-UK company controlled by UK residents by vote or value & which operates in a ‘low tax’ jurisdiction • A non-resident company is regarded as to be controlled by UK residents if - UK residents hold more than 50% interest in the company or - UK residents holds more than 40% interest and other non-resident holds atleast 40% but not greater than 55% Key Elements • Only those shareholders that own (directly or • Subject to lower level of taxation, if tax paid in its indirectly) 10% or more of foreign corporation stock Resident country is < 75% of the UK tax are included in more than 50% ownership test Income subject to • Passive undistributed income of CFC taxable in the • Share of Profits (excluding capital gains) of CFC CFC Rules hands of resident shareholders taxable in UK • Amount included in income of a US Shareholder from a CFC is pro-rata share of CFC’s income for the year. Direct Tax Code - International Taxation Page 15 CFC Regulations – US & UK … Particulars US UK Exemptions from CFC Regulations do not apply if : CFC Regulations do not apply if CFC Rules • CFC is not established for avoidance of domestic tax • The dividend distributed to UK resident at least equal to 90% of its chargeable profits within 18 mths from • De - minimis test where total income of CFC does not the end of the accounting period exceed a certain amount • The chargeable profit is less than 50000 Pounds • CFC does have a business establishment in the territory where it is resident • It is proved that reduction in UK tax by diversion of profits from UK is not the main reason behind its existence • Public quotation: The public must hold shares carrying 35% of voting rights of CFC • CFC is resident in a territory listed in ‘Excluded country Regulation’ Tax Credit • Foreign taxes are ‘deemed paid’ on taxable • N/A distributions from foreign corporations Direct Tax Code - International Taxation Page 16 CFC provisions- International Perspective Country Provisions for CFC rule application USA • In totality >50% and Single shareholder >10% ownership UK • In totality >50% or if UK residents hold > 40% & a non-resident hold at least 40% but not more than 55% JAPAN • In totality >50% and Single shareholder >5% ownership FRANCE • In totality >50% and Single shareholder >5% ownership AUSTRALIA • 50% in totality or 40% if single shareholder. Concept of Listed/Unlisted Countries Direct Tax Code - International Taxation Page 17 CFC – Illustrative Issues US – US Operating Co. US Dividend declared 75000 Dividend 33.33% 33.33% 33.33% Distributed 25000 to Profit not 25000 25000 distributed to India Mauritius Singapore Mauritius Dubai Dividend Parked in Mauritius & not 100 % 100 % 100 % brought to India India India 50% Ownership Criteria Fulfilled 50% Ownership Criteria Fulfilled Direct Tax Code - International Taxation Page 18 CFC provisions – Impact/Issues Scope of CFC provisions to expressions impact outbound ‘passive income’ investment and ‘controlled structures directly or indirectly’ Scope of Conditions applicability of CFC triggering CFC provisions – provisions not whether applicable Need for robust tax to operating / provided in Revised credit regime including Discussion Paper holding / operating provisions for as well as holding underlying tax credit companies Direct Tax Code - International Taxation Page 19 Interplay of CFC & PEM concept Indian Co. Netherland Co. UK CO. Hit by CFC Only Passive proposal. Taxed in co.(Holding Co.) Indian Co. hands No Passive & Active May be hit by CFC IS PEM of Income ( Operating provisions. Still no Netherland Co. in & Holding co.) clarity on it India Resident in India YES i.e. Taxed as a separate entity. Direct Tax Code - International Taxation Page 20 Branch Profit Tax • Proposed provisions Additional levy of Branch Profit Tax (BPT) @ 15% The same is to be levied on the total income for the financial year as reduced by the amount of income tax thereon • Foreign Companies liable to pay branch profit tax (PBT) on total Income reduced by corporate tax Particulars Amount Total Income for the FY 100 (Less) Corporate Tax (25) Taxable amount for BPT (A) 75 BPT @ 15% on (A) 11.25 • Effective tax rate for foreign companies is 36.25% Direct Tax Code - International Taxation Page 21 Branch Profit Tax … • Definition of Branch No definition and hence it should be defined to include branches and PE All LO to be excluded except if it is assessed as PE • Issues Tax on branch profits, even if undistributed BP tax is part of Second Schedule (C) and not referred in Section 2 (Liability to tax income-tax), hence issue arises about tax credit in foreign country • Way-forward To be in line with repatriation profit tax and not additional tax The term ‘branch’ is to be defined Direct Tax Code - International Taxation Page 22 Transfer Pricing - Definition of Associated Enterprises (AE) The threshold limits for determination of AE proposed to be reduced Modifications to AE definition General definition of AE i.e. direct or indirect participation in management, control or capital is omitted Changes in the threshold limits are tabulated below: Particulars Current Proposed Direct or Indirect shareholding/voting power 26% or more 10% or more Loan by one enterprise, as a % of book value of total assets 51% or more 26% or more of other enterprise Number of Directors or members of the governing board of More than 1/2 More than 1/3 one enterprise are appointed by other enterprise or by same person(s) in both the enterprise Raw materials and consumables threshold limit 90% or more of the 2/3rd or more of the supplies supplies Way forward Reduction to 10% is not correct as a shareholder having 10% cannot influence the decision in any manner Need to retain 26% as it has relevance even from a Companies Act perspective, viz, a person having 26% shareholding can block a special resolution Direct Tax Code - International Taxation Page 23 Safe Harbour Arm’s Length Price Determination of arm’s length price will be subject to safe harbour rules as may be framed by the Board. Safe harbor rules may not be applicable across all industries/transaction types Selection of transfer pricing cases for scrutiny is to be based on a risk management strategy as may be framed by the Board The strategy will not be disclosed to the taxpayer or any member of the public Safe Harbour Provides a measure of relief to taxpayers If the safe harbor provisions are set up at inordinately high levels or ranges, then taxpayers would continue to face litigation The global losses and financial crunch faced by the Group as such at present would also need consideration whilst exploring adherence with the safe harbor regulations Direct Tax Code - International Taxation Page 24 Advanced Pricing Agreement (APA) Key features Arm’s length price to be determined by the Board Board empowered to make further adjustments APA sought to be binding on the taxpayer and the Income-tax authorities APA is valid for maximum of 5 consecutive financial years APA shall not be binding in case of change in facts Subject to timely disposal, APAs are expected to considerably reduce uncertainty regarding arm's length pricing International approach (Multilateral APA/ Bilateral APA/ Unilateral APA Direct Tax Code - International Taxation Page 25 GAAR – Proposals The Direct Taxes Code Bill, 2009 (DTC) proposes to introduce GAAR in India to curtail tax avoidance GAAR to be invoked on satisfaction of prescribed conditions: an arrangement to obtain a tax benefit transactions not at arm’s length misuse or abuse of the provisions of DTC Lacking commercial substance defined to include situations where there is a: • Significant tax benefits without significant effect upon business risk or net cash flows • Legal substance or effect differs from legal form • It involves or includes: Round trip financing Any accommodating or tax indifferent party Direct Tax Code - International Taxation Page 26 GAAR … Powers given to revenue authorities to disregard, combine or re-characterise any part or whole of a transaction / arrangement GAAR further supported by specific anti-abuse rules (SAAR) in circumstances such as payment to associated persons in respect of expenditure, international transaction not at arm’s length, transactions resulting in transfer of income to non-residents and avoidance of tax in certain transactions GAAR to override the provisions of the tax treaties Onus is on the taxpayer to prove that a tax benefit was not the main purpose of the arrangement Issues raised GAAR provisions sweeping in nature and may be invoked by the tax authorities in routine manner. Also no distinction between tax mitigation and tax avoidance Direct Tax Code - International Taxation Page 27 GAAR- Revised Discussion Paper GAAR not to be invoked for every arrangement involving tax mitigation GAAR to be invoked only in case any One of the basic conditions is satisfied CBDT to issue guidelines providing circumstances under which GAAR may be invoked Threshold limit of tax avoidance to be provided for invoking GAAR Dispute Resolution Panel (DRP) route to be available for resolving GAAR related disputes Direct Tax Code - International Taxation Page 28 GAAR … Impermissible Avoidance Arrangement Circumstances Rights / Obligations not at Lacks commercial arm’s-length substance A step in, or a part or whole of an arrangement whose main purpose is to obtain a tax benefit Misuse / Is not for bonafide Abuse of DTC purposes GAAR Invoked by CIT • Treat the arrangement as void / any manner as the CIT deems appropriate • Disregard accommodating parties, etc • Re-allocate income, expenses, relief, etc Empowered to • Disregard / combine / re-characterize any step in /whole / part of the arrangement • Treat connected persons / accommodating and other party as one and the same • Deeming connected persons as same • Re-characterize, Equity -Debt, Income, expenses, relief, etc Direct Tax Code - International Taxation Page 29 GAAR – Impact/Issues Whether specific LOB provision Impact of GAAR would prevent on India Mauritius application of Tax Treaty GAAR? Impact on existing structures / arrangements - no savings clause for protecting existing structures / arrangements Direct Tax Code - International Taxation Page 30 Definition of Income Deemed to accrue or arise in India Existing Provision Income deemed to accrue or arise in India directly or indirectly Includes Income arising from a transfer of a Capital Asset situated in India Proposed Provisions Income deemed to accrue or arise in India directly or indirectly Through or from transfer directly or indirectly of Capital Asset situated in India Intention of the proposed legislation Tax the transfer of shares of the overseas holding company which is intended to be transferred Shares of the Indian company But the intention seems to have far-reaching implications Taxing the genuine transfer or genuine corporate reorganization Direct Tax Code - International Taxation Page 31 Definition of Income Deemed to accrue or arise in India … Implications Indirect transfer of a Capital Asset situated in India has a wider meaning It may tax the transactions which have taken place outside India between two nonresidents. It may tax the transactions relating to Global reorganization though the transactions may not have any impact in India. Way-forward Existing provisions to be maintained. Definition of the term indirectly to ensure that genuine transfers are not brought to tax Strengthen Limitation of Benefits clause (LOB) in the respective treaties to overcome treaty shopping Direct Tax Code - International Taxation Page 32 Treaty Override Act • Act or treaty, whichever is more beneficial, shall apply DTC (1st Draft) • Resident only if controlled and managed ‘WHOLLY’ or ‘PARTLY’ in India Issues Raised General treaty override is against the spirit of Vienna convention as it renders existing DTAA redundant. It could effect the inflow of FDI as it would result in higher rates of taxation on royalty, fees for technical services and interest income Direct Tax Code - International Taxation Page 33 Treaty Override- Revised Discussion Paper Act or treaty, whichever is more beneficial, shall apply Limited Treaty Override - Tax Treaty not to have preferential status where the GAAR is invoked; or when CFC provisions are invoked; or when Branch Profits Tax is levied Limited Treaty Override in line with international practice Direct Tax Code - International Taxation Page 34 Thank You DISCLAIMER With respect to information available herein, BDO Consulting Pvt. Ltd. does not make any warranty, express or implied, including the warranty of merchantability and fitness for a particular purpose, or assume any liability or responsibility for the accuracy, completeness and usefulness of such information. BDO Consulting Pvt. Ltd. shall not be liable for any claim or losses of any nature, arising indirectly or directly from use of the data or material or otherwise howsoever arising. Before implementing any of the views the expert guidance is recommended. Direct Tax Code - International Taxation Page 35 Indirect transfer of capital asset If Foreign Co has other assets , Parent Co Foreign Co 2 would proportionate value of Transfer of “capital asset” situated in In Shares in Foreign co 1 to India be taxed ? Foreign co 2 Foreign Co 1 Overseas Indian Indian Co Direct Tax Code - International Taxation Page 36
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