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Top tax issues that bother corporates
September, 13th 2008

The new direct tax code that the Government is planning to introduce, to replace the current Income-tax Act, is expected to emphasise on transparency and taxpayer-friendliness. Similarly, making suitable amendments in the indirect tax provisions would be a welcome step towards getting more clarity and achieving simplification and transparency.

While such moves encourage not only tax compliance, but also convey the right messages to the tax paying community, there is a need, in the interregnum, to look at a few current issues that worry corporates, says Mr Uday Ved, Head of tax and regulatory services, KPMG India.

Talking of issues impacting foreign companies, he highlights the tax treatment of overseas M&A (merger and acquisition) transactions, cross-border sale of software, and PE (permanent establishment) and its profit attribution in India. And, in the realm of indirect taxes, Mr Ved mentions the cascading of taxes, frequent changes in tax laws, and the overlap between VAT and service tax as areas worthy of attention.

With India rapidly globalising, and the economy growing and showing positive results, a sound tax policy is a must-have, he insists, during the course of a recent email interaction with Business Line. For, tax is an important business cost to be considered while taking any business decision, particularly when competing with other global players.

Excerpts from the interview.

Is there a case for reducing corporate tax rates?

Corporate tax rates are continuing to fall worldwide. Globally, average rates have decreased from 26.8 per cent in 2007 to 25.9 per cent in 2008. On the other hand there has been an increasing importance of indirect taxes as a revenue-gathering strategy in many countries.

Other Asian countries corporate tax rates are significantly lower than Indias. For example, Hong Kongs rate is 16.5 per cent, Singapores rate is 18 per cent, and Malaysias rate is 26 per cent. China has also reduced the tax rate for the Foreign Investment Enterprises (FIE) from 30 per cent to 15 per cent or 24 per cent if the FIE is located in one of the specially designated zones.

These countries are also in the process of attracting global investment; and with their lower corporate tax rates they can provide stiff competition to India for attracting foreign direct investment (FDI).

How much should be the reduction?

Considering the current surge in the corporate tax collections, representations have been made to reduce the corporate tax rate from the existing effective rate of 33.99 per cent to 30 per cent. This is because the phasing out of tax exemptions should be logically accompanied by a corresponding reduction in the income-tax rate.

Looking at the current global trend and in view of the recommendations of the Kelkar Committee, that surcharges should only be temporary, a case can be made out for removal of the surcharge or, alternatively, a reduction in the corporate tax rates.

How has been the general experience of foreign companies in India with the tax regime here?

Companies are not opposed to paying taxes in India, as long as these taxes are fair and predictable, and consistent with bilateral tax treaty obligations and global norms. While today there are several multinational companies doing business in India, the tax treatment for such companies has been often varied and unpredictable.

Significantly, these companies, across a broad spectrum of industries, are saddled with ever-increasing number of tax audits and prolonged tax litigation in India on account of failure of our tax authorities to apply tax treaties or follow internationally-accepted standards in treaty interpretation and transfer pricing.

What are the key issues faced by foreign companies from a direct tax perspective?

Absence of clarity on tax treatment of overseas M&A transactions is a key issue. The concept of levy of tax on transfer of beneficial ownership in a cross-border transfer is not provided for in the current tax legislation.

However, the Indian tax authorities are taking a view that, in a cross-border transaction, gains arising out of transfer of shares of overseas entity attributable to the operation of the Indian entity should be subject to tax in India, in view of the business connection of the overseas entity with the Indian entity

To give comfort to the international investors, there is need for clarity in the domestic tax legislation that such overseas cross-border deals/share-transfers will not be subject to tax in India.

Youd mentioned cross-border sale of software as another area meriting focus

The consideration for sale of shrink-wrapped software is viewed by the Indian tax authorities as payment for right to use copyright embedded in a computer program and accordingly, taxed in India, and royalty income under the provisions of the domestic tax law and tax treaty.

Internationally, however, there is a common consensus that such a transaction is not in the nature of royalty and does not involve any commercial exploitation of software.

The position, that sale of shrink-wrapped software is not in the nature of royalty income but business income, has also been affirmed in various tax Tribunal decisions (Lotus, Samsung, Sonata, Motorola, Nokia etc).

Considering the importance of this issue for the software industry, it is important to get finality either through the CBDT (Central Board of Direct Taxes) issuing a clarificatory circular on characterisation and taxability of software, and/or a specific amendment in the Income-Tax Act, 1961, by excluding it as royalty under section 9 (1)(vi).

On PEs too, there are differences?

True. The Indian tax authorities have been aggressively alleging that the Indian subsidiaries are economically dependent on the foreign parent company and therefore constitute a PE of the parent company.

In claiming that the parent company has a PE in India, the Indian tax authorities ignore that the rule only applies if the transaction between the foreign company and the agent are not on arms length terms.

The decision of the Supreme Court in the case of Morgan Stanley has given clarity that once an agent is compensated on an arms length basis (in compliance with the transfer pricing regulations), there is no further tax liability on the foreign parent.

The recent decision of the Bombay High Court in the case of SET Satellite (Singapore) Pte. Ltd. also supports a similar view.

The Indian tax authorities have also been aggressive when asserting PE, based on their own interpretation of the rules relating to place of business in India, provision of services in India, etc., rather than relying on internationally-accepted rules.

Transfer pricing also continues to be a fertile area for differences between the taxpayer and the Department

Given the increasing global integration of Indian businesses, transfer pricing is inevitably one of the most important and complex tax aspects to be addressed by modern businesses. Transfer pricing regulations require all international transactions amongst group entities to be priced on an arms length basis, leading to the often-debated and vexed question of what the best manner of determining the arms length price is.

Some of the key issues common to several taxpayers include -- use of multiple year data, correlative adjustments, financial adjustment to the comparable data, availability and use of contemporaneous data, use of simpler entity as tested party, use of loss-making companies for benchmarking, high margins assessed for captive units, etc. Internationally, too, a majority of tax litigation is due to transfer pricing related aspects.

In India, we find the litigation on transfer pricing increasing, so corporates need to manage these risks. Introduction of advance pricing agreements (APAs) and safe harbour provisions, further development of practice around mutual agreement procedures (MAPs) are key steps required to take the Indian transfer pricing regime to the next level.

What is your suggestion for reducing delay in the resolution of tax disputes?

At present, the dispute resolution mechanism in India moves slowly. Assessment proceedings continue for more than two years from the date of filing of the tax return.

Thereafter, the two appellate levels take approximately two to seven years to dispose off an appeal. If the dispute still continues, on a question of law, the matter gets referred to the High Court and the Supreme Court which takes very long. This is worrying corporates as it takes lot of management time and effort.

There is a need to speed up the litigation procedure. There should be a limitation period on disposal of appeals too. Two years ago, the National Tax Tribunal (NTT) was set up to speed up the dispute mechanism. The NTT has, unfortunately, yet not been functional.

Your assessment of the indirect taxes scenario.

The indirect tax laws are constantly evolving and the last decade witnessed a significant change in the Indian indirect tax regime. Key among the changes have been the substantial expansion of service tax, which now covers a plethora of services, the introduction of State Value Added Tax (VAT), cross credit at federal level between Service tax and Central Excise, and now the impending hope of a Goods and Service Tax (GST) regime by April 2010.

Given the current structure, the key issues being faced by businesses are the cascading of taxes, frequent changes in tax laws, and the overlap between VAT and service tax as areas.

Cascading of taxes: Federal level taxes are not allowed as a credit against State taxes and vice versa. While input VAT is allowed as a set-off against output VAT, Central Sales Tax (CST) paid on inter-state procurement becomes a cost. As a result, the final prices of most consumer products contain a significant proportion of imbedded taxes.

Frequent changes in tax laws: Indirect tax laws have been ever evolving in India and businesses have always felt uncertainty in their business including the future implications of such taxes.

For example, the ambit of service tax has been increasing over the years through amendments in Finance Act. Further, the Government has from time to time given various exemptions/ concessions which relate to specific services. This has resulted in significant litigation and dispute over the applicability of service tax on various services and other related issues.

While GST is proposed to be introduced by April 1, 2010, the basic framework itself has not been finally decided as yet. Businesses often struggle to plan their strategies in view of these frequent changes in laws and the uncertainty surrounding the tax policy.

Overlap between VAT and service tax: The current structure has also led to long-drawn disputes as to whether the transaction should be considered as sale of goods or provision of services.

The recent introduction of service tax on software-related services is a case in point, where the Government has seemingly imposed service tax on standard software which has been considered as goods and subjected to VAT. Similar issues have arisen in the context of telecom services as well, in the past.

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