Several Indian companies are now venturing for outbound investments through M&As some of the recent acquisitions being the acquisition of Novelis by the Aditya Birla Group, Corus by Tata Steel and Tyco by VSNL.

Dividends, the most common medium of repatriating profits back from overseas operations to India, entails a tax in India. Developed tax regimes have mechanisms to avoid such impost. It is time for India to introduce a policy to mitigate such tax burden.

Dividends when repatriated back into India from overseas wholly-owned subsidiaries, or even JVs, attract corporate tax of 33.66% in the hands of the Indian holding company, or Indian JV investor.

Indian MNCs are pushed to look for tax-efficient jurisdictions to locate their holding firms typically in a low-tax jurisdiction where the incoming dividends and capital gains from overseas investments are tax exempt. As long as monies are parked at the overseas holding company level no corporate taxes are payable by the Indian investor company in India. Considering the role of outbound investments in the economic growth, it is important that the Centre introduces some remedial measures.

The Participation Exemption Regime: Several countries have adopted the regime to mitigate the tax impact on inflow of foreign dividends in the home country. Some of these countries are Netherlands, Luxembourg, Ireland, Spain, Cyprus and Austria.

Participation exemption is a regime under the domestic tax laws of a country, which provides for certain exemptions on all benefits received by a company from its qualified shareholdings. Primarily, tax benefits included under the regime are in respect of dividend, bonus shares and capital gains.

If an Indian firm were to invest into an operating firm through one of the preferred holding company jurisdictions mentioned above, then dividends and capital gains earned by the holding firm from the operating firm would be exempt from corporate tax in the holding firm jurisdiction. If the holding company and operating firm are EU members then no withholding taxes will be applicable at the operating company level as per the EU parent-subsidiary directive. The preferred holding company jurisdictions have a good treaty network, which provides for low withholding tax rates on dividend and capital gain flows.
 
The Netherlands has emerged as a popular jurisdiction for setting up of holding firms. Under the Dutch Participation Exemption rules, benefits derived from qualifying foreign subsidiaries are exempt. These benefits are dividends and capital gains from the disposal of the foreign shareholding.

The Dutch parliament has approved the bill for tax reforms 2007, which aims to make the Netherlands more attractive for foreign investor. As per revised regulation, the Dutch participation exemption applies when a Dutch parent, or Dutch permanent establishment of a foreign parent firm, along with its related companies, holds more than 5% of the nominal capital of the subsidiary and meets other conditions. These include that, in case the subsidiary firm has mainly passive investments, as determined on a consolidated basis, the subsidiary company should be subject to tax on profits that results in a charge at a rate of at least 10% to be determined on the basis of its profit calculated in accordance with Dutch principles.

Countries also take care to weave in suitable anti-avoidance measures. These include a minimum shareholding requirement in the investee firm, ensuring that the investments are not in the nature of passive investments and the fact that the subsidiary is subject to tax in the other country. Either all or variations of the above measures are adopted to prevent tax avoidance.

If India were to introduce a similar regime, it would gain higher visibility as an investment jurisdiction. While there are advantages in introducing the regime, a common drawback noticed is the misuse of the regime through set-up of mailbox firms. However, this drawback can be overcome by introducing suitable anti-avoidance benefits to ensure that source-based tax benefits are granted only to intended beneficiaries i.e., residents of the other contracting state and in respect of genuine investments.

GAURAV TANEJA
(Author is national tax director and partner, Ernst & Young India)