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DTC to strengthen Indias tax demands on cross-border M&As
August, 31st 2010

Provisions of the proposed direct taxes code will strengthen Indias tax demands on cross-border acquisitions involving Indian companies. Section (5) of the code stipulates that tax is payable in India whenever a foreign companys shares are transferred, if at least 50% of its assets are situated in India.

This provision enhances the extra-territorial jurisdiction of Indian income-tax laws. The current laws do not have look-through provisions of this nature, says Dinesh Kanabar, deputy CEO and chairman, tax, at consulting firm KPMG.

It is not clear if the proposal will have any bearing on the ongoing Vodafone case, as DTC is yet to become law. The Bombay High Court is expected to give its ruling in a few weeks on the case, in which Vodafone has challenged Indian tax regimes jurisdiction over a transaction that took place outside India, through a company based in Cayman Islands.

The rules governing cross-border transactions in the new code can effectively check tax avoidance by Indian firms by setting up shell companies in tax havens across the world. With the modification under clause 124(5), any transaction with an entity situated in tax havens or any low-tax jurisdictions will be brought under the transfer pricing rules. This is irrespective of whether the entity in tax haven is controlled by the Indian company or not.

These changes are in line with the practises prevailing in most countries which have put in place transfer pricing regulations. Under the existing laws, if the taxpayer can prove that he has no connection with the entity in the tax haven through which he has carried out the transaction, he is outside the jurisdiction of Indias transfer pricing rules.

Most countries which have incorporated transfer pricing rules in their tax laws have similar provisions for checking tax avoidance, says Samir Gandhi, partner, Deloitte India.

Another feature of the code is the provision for taxing undistributed dividend of foreign corporations that are controlled or owned by Indian companies.

Controlled foreign corporations (CFC) laws, as they are known internationally, enable the authorities to tax the income of a resident of India, derived from a foreign corporation.

This is irrespective of whether the profit/dividend of the foreign entity is transferred to India or not.

Most countries have adopted CFC laws for pre-empting the probable loss of revenue arising from the transfer of profit of foreign corporations to offshore havens or low-tax jurisdictions.

CFC laws have been in force in the US since the 1960s. They require corporations to pay tax in the US on the profit of its foreign corporations, irrespective of whether the foreign corporations have distributed dividends or not, says Bala Rajaraman, tax partner at Deloitte India, adding that the US government is proposing to strengthen its CFC laws.

Under the sections 113 and 291 of the proposed code, if the Indian resident holds no less than 50% of the shares of a foreign company, it could be categorised as a CFC. This is similar to the laws prevailing in the US where 50% of voting rights or 50% of the value of shares constitutes a CFC.

This provision will be applicable if the tax rate in the other jurisdiction is less than 60% of tax rate in India. Indian tax authorities have been asking the government for enacting such a law for some time, in the context of the increasing number of cross-border acquisitions by Indian companies.

Another prominent feature of the DTC is the unification in the tax rate for domestic as well as foreign companies. It will be 30% for both. Foreign companies at present pay 40% tax. The rationale for higher rate of tax on foreign companies was based on the fact that the latter do not pay dividend distribution tax.

However, the gain is nullified by the introduction of branch profit tax on foreign companies by which the foreign companies will have to pay additional tax. The effective rate for a domestic corporation after considering the dividend distribution tax will be 39.13%. The effective rate for a foreign company after branch profits tax will be 40.5%.

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