The finance ministry plans to introduce Controlled Foreign Company (CFC) rules to check outbound investment in tax havens for avoiding or deferring tax. The rules will allow authorities to extend domestic laws for taxing profits of Indian subsidiaries abroad.

Now, profits made by foreign arms of Indian companies are taxed only when they are distributed through dividend to the parents.

Many Indian companies avoid or defer bringing back profits to India and instead, deploy the funds for overseas expansion. This results in delayed or non-payment of tax on profits made by foreign arms.

Introduction of CFC rules would require an amendment to the Income Tax Act. The government can either introduce the rules in the Finance Bill of 2011 or make the provisions in the second draft of the Direct Taxes Code, likely to be released for public discussion this month.

A committee under the director general of Income Tax (international taxation) was formed to give its recommendations on taxing income of CFCs to boost the governments revenues. The committee recently submitted its report to Central Board of Direct Taxes (CBDT) Chairman S S N Moorthy, a senior official in the finance ministry told Business Standard on condition of anonymity.

CFC rules have been adopted by many developed countries like the US, the UK, Japan and Germany, where outbound investments have exceeded capital inflows. The idea has been opposed by some quarters in India on the ground that the country is not prepared for such a regime. The argument is that capitals inflows are still higher than outflows.

The market has matured enough to have such rules. Outbound investments have showed a significant rise in the last few years. CFC rules will help us prepare for eventuality in case outward investments surpass inward capital flows. It is an enabling mechanism, said another finance ministry official.

S P Singh, senior director, Deloitte, said the rules would not affect outward investment by Indian companies, and instead, this would provide more clarity regarding taxation of foreign subsidiaries. The rules will not impact small investors. These are to check tax avoidance by large investors. Whenever outward investments go beyond a minimum threshold, such rules come into the picture, Singh said. He added profits of an overseas arm could be taxed in proportion to the parent companys investment into it.

In January 2003, a working committee on non-resident taxation under Vijay Kelkar had recommended introduction of CFC regime in India, terming deferral of taxes as an unjustifiable loss of revenue.

Normally, CFC rules do not apply when the foreign subsidiary is listed or distributes a particular percentage or profits every year. Also, when it is in a high-tax jurisdiction and not set up with the intent of evading taxes, or when its total income does not exceed a particular threshold, CFC rules do not apply.