By Pranay Bhatia & Balaji Balasubramanian, Economic Laws Practise Introduction of CFC rules would be a step towards prevention of potential tax avoidance or deferment.
Recent news reports indicate that Indias tax legislators propose to introduce Controlled Foreign Company (CFC) regime under Indian income-tax law. Such CFC rules have been so far adopted by countries such as US, UK, Germany, etc to prevent erosion of domestic tax collections due to avoidance or deferment by home companies on income earned from overseas businesses carried out through offshore subsidiaries or affiliates.
What is CFC?
CFC is a terminology specific to income-tax, which refers to an overseas corporate subsidiary or affiliate that is controlled by the parent. Control is typically defined to mean holding of prescribed percentage in the share capital or exercising control over the composition or the decision-making ability of the Board of Directors.
As per extant Indian income-tax laws, income of CFCs are not taxed in the hands of the Indian parent company until such income is brought back to India. Thus, at the option of the Indian parent, Indian income-tax on income of CFCs could be deferred or avoided. Typically an Indian company would defer bringing the foreign income back to India to facilitate its global expansion as the Indian taxes would reduce its ability to deploy capital.
In this context the Working Group on Non-resident Taxation (in January 2003) termed the deferral of taxes as an unjustifiable loss of revenue and recommended the introduction of CFC regime in India. The intent is to prevent the avoidance or deferment of tax on income, by levying taxes in the hands of the parent on the consolidated income.
Historically CFC regime has been introduced as part of a countrys tax structure when forex controls are done away with. Indian corporates on the other hand dont have the advantage of full capital account convertibility. Accordingly, one may argue that its a little early for introduction of CFC rules in India. However, given the recent initiatives of the G-20 nations against the use of tax havens and the quantum of outbound investments witnessed in the past, it may not be surprising that India has sought to introduce CFC regime as part of its tax system at this juncture.
What does it legally mean?
The CFC would be treated as a pass through for tax purposes and proportionate share of the income of the Indian parent in the CFC would be taxable in India. Consequent to such fiscal consolidation, the tax paid, if any, in the overseas jurisdiction would be allowed as credit against Indian tax payable or claimed as an expense.
How & when could it be introduced?
Introduction of CFC rules to the Indian tax regime would require a structural change to the income-tax law. The FM in his budget speech had indicated that we would see significant structural changes in the new Direct Tax Code which is expected to be tabled shortly.
Exceptions to the CFC rules
Typically, CFC rules provide for exceptions from application of the rules to cases such as:
* Where the CFC distributes a particular percentage each year
* Where the CFC is not set up for the purpose of evasion of domestic taxes but for genuine business activities (Motive test)
* Where the CFC is set-up in a high-tax jurisdiction (such as India, US, UK, Germany, etc)
* CFCs that are listed
* Where the total income of the CFCs does not exceed a particular threshold
The implications of CFC introduction could adversely impact the tax cost of existing outbound structures.
Global scenario & CFC issues
CFC rules are prevalent in many mature jurisdictions such as US, UK, Japan etc, they are complex and fraught with issues. For eg, in the UK, tax credits are not available in respect of taxes paid on account of overseas CFC regulations. In the US, losses of CFCs are not eligible for set-off against the profits of the parent.
Introduction of CFC regulations in India, could give rise to many challenges/ issues such as:
* Claim of credit for taxes paid in the CFC jurisdiction;
* Identification of taxable dividend receipt from the income already taxed;
* Taxation of capital gains on disposal of shares in CFC, where undistributed income has already been taxed.
* Set-off of losses of CFC against the profits of the parent.
The aforesaid issues could give rise to protracted litigations causing hardship to both, tax payer and the authorities.
It also needs to be seen whether only CFC regime would be introduced or the tax legislators would make an attempt to enable Indian companies file consolidated return enabling Indian group to mitigate tax by providing shelter of the losses of the group companies.
Introduction of CFC rules would be a step towards prevention of potential tax avoidance or deferment. While, it would increase tax collection, certain sections of the tax payers may feel that undue tax costs and compliance requirements have been thrust upon them. Applicability of these rules to cross border LBOs may cause concerns to the International lender and the promoter.
We need to watch out if along with the CFC rules, related anti-avoidance/ relief measures such as thin capitalization and group fiscal consolidation rules are also introduced. Given the innovative nature of Indian entrepreneurs, it remains to be seen if the governments intention of curbing the existence of dividend-trap or money-box companies would achieve its slated purpose.
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