In the last few years, we have seen a spurt of cross-border transactions such as inbound as well as outbound acquisitions, corporate reorganisations in addition to greenfield inbound and outbound investments.
Accordingly, it may be interesting to note certain far reaching changes sought to be introduced in relation to the taxation aspects of such transactions under the recently released direct tax code (DTC). The code is expected to be effective from April 2011.
Domestic companies vs foreign companies
The tax rate for foreign companies is proposed to be reduced from the present 40% (excluding surcharge and cess) to 25%, which is same as proposed for domestic companies. This would be supplemented by branch profit tax of 15% on the taxable income minus income tax.
This seems to have been introduced to bring them on parity with domestic companies which are subject to dividend distribution tax. However, while domestic companies would have to pay dividend distribution tax only on dividend distributed, branch profit tax would have to be paid whether or not there is remittance of profits.
Tax treaties with other countries
Currently, the general principle is that provisions of the domestic tax law or tax treaty whichever is beneficial to taxpayer should prevail. Now, under the DTC, the provision which is later in time would prevail. This is a significant departure and could be disadvantageous to taxpayers.
For instance, the Indian tax treaties with many countries provide for taxation of royalties at the rate of 10% or 15%. However, the code seeks to tax royalties paid to non residents @ 20%. The way DTC is drafted, it could cause uncertainty over the fate of tax treaties signed under the current tax laws.
Controversy in cross-border transactions
As is well known, there is a controversy in relation to taxability in India of cross-border transactions between non-resident entities involving indirect transfer of capital assets situated in India. Now the scope of taxation is sought to be widened to also include income from indirect transfer of capital assets situated in India.
However, the DTC does not clarify what kind of specific cases are sought to be covered. It would be interesting to see as to whether this proposed change would have any bearing on the ongoing controversy under the current law.
Shift in tax residency principles
Another major shift is with regard to tax residency principles. At present, a foreign company is treated resident in India only if its control and management is wholly in India. Now, a foreign company shall be regarded as a tax resident in India even if it is partly controlled and managed in India.
Since what constitutes part control and management is not clarified, the test of residency would become all the more subjective. The consequence of a company being regarded as resident in India is that its worldwide income would be taxable in India. For instance, the worldwide income of foreign subsidiaries of Indian companies could come within the ambit of Indian tax.
Currently, certain exemptions (ensuring tax neutrality) are available in relation to merger /demergers and the view is that this benefit extends even to merger/demerger of a foreign company into an Indian company. The code seeks to introduce the concept of business reorganisation as one between residents. Technically, therefore it seems the exemptions may not be available to merger/demerger of foreign company into an Indian company.
Will uncertainty among taxpayers be resolved?
The code seeks to introduce a detailed general anti-avoidance rule to curb erosion of tax base on account of tax avoidance arrangements. Tax authorities have been empowered to declare an arrangement as an impermissible avoidance arrangement if it lacks commercial substance. The code further seeks to pass on the burden of proof on taxpayers. The sweeping powers given to tax authorities may cause considerable uncertainty for taxpayers.
This coupled with the shift of onus on to the tax payers has the potential of resulting in substantial controversy which seems to go against the avowed objective of reducing litigation. As is evident, there are a several areas which could lead to uncertainty and controversy and need further consideration. The good part is that the DTC is open for public debate and comments. One hopes that the uncertainties are resolved prior to finalisation and implementation of the code.