March 17, 2012

 

Recommendations of the Standing Committee on Finance

on the

Direct Taxes Code Bill, 2010

 

The Direct Taxes Code Bill, 2010 (“DTC”), introduced in Lok Sabha on August 30, 2010 was referred to the Standing Committee on Finance, chaired by Yashwant Sinha (“Committee”), on September 9, 2010 for examination and report thereon. Subsequently, a press release inviting suggestions of the public including experts on the DTC was issued on November 2, 2010. Taking the opportunity to provide comments and recommendations on the new code, the DTC Global Think Tank convened by Nishith Desai Associates analyses some of its key international dimensions. [Please click here for a summary of our recommendations presented to the Committee]. The Committee, after analyzing the views submitted to it by various stakeholders and the explanations given by the finance ministry in that regard, presented its report to the Parliament on March 9, 2012. The Committee has made specific comments on the various proposals of the DTC. The same have been discussed below:

1.       Change of threshold for determination of residence status of NRIs

Proposal: The relief granted to NRIs for stay up to 182 days in a year in the Income Tax Act, 1961 (“Act”) will be withdrawn and accordingly, NRIs, like other individuals, will lose their non-residential status if their stay in India exceeds 60 days in a year.

Issue

The proposed 60-day threshold may be a little too stringent and may act as a hurdle to building a long term mutually beneficial relationship between India and its diaspora.

Standing Committee’s Recommendation

The period of stay for NRIs to retain their non-resident status may be restored to the existing 182 days, subject to two conditions, namely:

(i)       indication by the NRI of the tax jurisdiction in which he is resident; and

(ii)     cases of fraud being severely dealt with so that nobody is allowed to become a global non-resident.

2.       Place of Effective Management (“POEM”)

Proposal: Body corporates incorporated by or under a foreign law will be treated as residents in India in respect of a particular financial year if its “place of effective management, at any time in the year, is in India”. The term “place of effective management” has been defined to mean—

(i)       the place where the board of directors of the company or its executive directors, as the case may be, make their decisions; or

(ii)     in a case where the board of directors routinely approve the commercial and strategic decisions made by the executive directors or officers of the company, the place where such executive directors or officers of the company perform their functions.

Issues

§         The POEM test will not address situations where a POEM could be said to exist simultaneously in multiple jurisdictions, for example, where directors from different countries conduct meetings by way of video-conferencing;

§         The expression, 'executive director' has neither been defined in the DTC nor under Indian corporate law. Questions will arise as to whether the definition will cover independent directors and nominee directors appointed by strategic or institutional investors;

§         The reference to 'officers' will lead to uncertainty as 'commercial or strategic' decisions may be taken at various levels in a modern corporation;

§         The definition strays away from international standards where the focus is on the place where the key management and commercial decisions, as a whole, are made;

§         The inconsistency between the DTC proposal and India's reservation to the OECD Commentary (i.e., the place where the main and substantial activity of the entity is carried on is also to be taken into account) is likely to give rise to some ambiguity while applying the POEM test in situations where it is necessary to interpret and apply the provisions of a tax treaty;

§         The DTC proposes to apply the POEM test at any time in the year. This may give rise to absurd consequences;

§         There are difficulties in applying the concept of POEM in the case of various offshore hybrid entities, which do not have ordinary or executive directors;

§         The application of the POEM test may also lead to potential situations of double taxation, especially in cases where the interpretation of POEM in India conflicts with the interpretation by tax authorities in other jurisdictions.

Clarification by the Ministry

Concerns in relation to the following would be considered:

§         the definition not being in consonance with internationally accepted standards;

§         the likelihood of there being more than one POEM.

Recommendations

§         The reference to executive directors or officer may be removed from the definition of POEM;

§         Residency should instead be determined on the basis of internationally accepted standards and judicially settled principles, where the focus is on the place, where the key management and commercial decisions, as a whole, are made or where the head and brain of the company is situated.

3.       Taxation of Offshore Share Transfers

Proposal: The tax powers extended to income from transfer of a share or interest in a foreign company by a non-resident, where at any time during twelve months preceding the transfer, the fair market value of the assets in India, owned directly or indirectly, by the company, represents at least 50% of the fair market value of all assets owned by the company. Such income would be taxed in proportion to the Indian assets directly or indirectly held by the foreign company.

Issues

§         Exercise of source based taxation rights are justified only when the situs of asset, business or income earning activity is located in the source State, which implies the existence of a real territorial nexus and it is an established principle that the situs of shares is situated in the place where the company is incorporated and where its shareholder's register is maintained. So, transfer of offshore shares cannot be treated as transfer of assets in India. Such taxation would amount to extraterritorial operation of India's tax law to an extent that is unconstitutional and in conflict international law;

§         The corporate veil may be pierced only in exceptional circumstances. The proposal statutorily disregards centuries old common law jurisprudence on independent corporate personality and the principle that ownership of shares does not imply ownership of the company's assets;

§         The concept of 'indirect ownership of assets' is ambiguous and cannot be used as a basis for taxing offshore transactions;

§         The expression, 'interest in a foreign company' is difficult to understand in the context of modern corporate structures;

§         The manner of determining the fair market value of the assets and the timing for valuation has to be clarified;

§         The proposal does not exclude companies carrying on genuine business activities or listed companies which may have several shareholders;

§         The tax will be triggered even in case of small investors of the foreign company, which would cause undue hardship to such non-resident shareholders;

§         A taxpayer required to withhold tax, especially a small investor, will face difficulties in obtaining details regarding the cost of acquisition of the shares and in determining the fair market value of the assets owned directly or indirectly by the company;

§         The proposal also does not provide any exclusion for corporate reorganizations such mergers and demergers which should ordinarily not give rise to tax liability;

§         Foreign entities entering into such offshore transactions may face double taxation since they may not be able to claim tax credit in their respective countries on taxes paid in India under an unreasonable source taxation rule;

§         By placing the provision as an exception, a negative onus has been imposed on the taxpayer to show that the threshold has not been exceeded.

Clarification by the Ministry

Concerns in relation to the following would be considered:

§         transfer of small holdings;

§         date of valuation of assets.

Recommendations

§         Exemption should be provided to transfer of small share-holdings and transfer of listed shares outside India;

§         The computation of fair market value of assets to be made as on a particular date like the balance sheet date immediately preceding the date of transfer;

§         Exception may also be provided to intra group restructuring outside India.

4.       Taxation of Foreign Institutional Investors (“FII”)

Proposal: Indian securities held by a FII will be an investment asset for the purpose of capital gains and accordingly, transfer thereof will be capital gains irrespective of whether the securities were held as an investment asset or as a business asset.

Issues

§         The proposal ignores the dynamics of FII investment strategies and artificially re-characterizes income earned by an FII without considering key aspects such as volume of purchase and sale of securities in the year, frequency and repetitiveness of purchase and sale of securities over the year, ratio between purchase and sale and the period of holding, manner of maintaining books of accounts and the presence of a systematic trading activity with the object of earning profits rather than investment income;

§         The proposal is inequitable as it applies only to FIIs;

§         Due to the difference in tax treatment in India and the country of incorporation, FIIs may find difficulties in claiming tax credits in respect of taxes paid in India.

Clarification by the Ministry

Payment of brokerage by an FII to a stock broker in respect of transaction in securities will not be subject to TDS.

Recommendations

Indian securities held by FIIs should not be included in the definition of an investment asset.

5.       Taxation of Satellite Broadcasting

Proposal: Consideration paid for “the use or right to use of transmission by satellite, cable, optic fiber or similar technology” will amount to 'royalty' and accordingly such payments made to non-residents would be subject to withholding tax at 20%.

Issues

§         The provision is ambiguously worded. It is difficult to conceive a situation where 'transmission' is used, as opposed to a 'transmission facility';

§         The definition refers to the 'use of transmission by satellite or optic fiber' rather than the use of the satellite or optic fiber itself. It undermines the commercial reality that the transmission through such satellite or optic fiber is a service and does not involve any provision of the right to use any equipment or process;

§         The provision is not consistent with the understanding of the scope of 'royalty' accepted by judicial precedent and the OECD, which requires that characterization of income as royalty would require a degree of control over the equipment and the mere ability to transmit data through a satellite or optic fiber does not amount to such control.

Recommendation

The proposal is agreeable in view of the prevailing market situation.

6.       Branch Profits Tax (“BPT”)

Proposal: Foreign companies would be subject to BPT in addition to ordinary corporate tax. BPT would be payable at the rate of 15% of the income directly or indirectly attributable to the permanent establishment (“PE”) or immovable property situated in India, net of applicable corporate tax at 30% (thus raising the total corporate tax rate to 40.5%). The DTC provides that levy of BPT would override the provisions of tax treaties signed by India. PE is defined “as a fixed place of business through which the business of a non-resident is wholly or partly carried on” and as including a long illustrative list of circumstances. 

Issues

§         Branch profits should not be taxed to the extent they are not repatriated to the foreign enterprise;

§         The DTC refers to BPT as a tax in addition to income-tax. Thus, in the absence of a clarification that BPT is in the nature of income tax, foreign companies may not be able to claim credit in their home jurisdictions for the taxes paid in India;

§         The PE definition does not clarify whether the illustrative PE list is subject to the fundamental requirement that the non-resident should have a fixed base in India, implying a degree of continuity justifying source based taxation;

§         The definition of PE is wider than the PE scope in any tax treaty signed by India. The expansive scope of specific parts of the definition (as described below) violates the principle of territorial nexus laid down under the Indian Constitution and recognized under international law:

o        A PE may be constituted if services are provided through employees of the nonresident even if such services are not provided from India. Under the UN Model Convention, such a PE may be constituted only if the services are carried out within the contracting State. The OECD Commentary cites various justifications for not including a services PE in the model treaty;

o        No time threshold has been prescribed in respect of provision of services through employees or for construction, installation and supervisory activities;

o        Substantial equipment in India used by, for, or under a contract with the non-resident can give rise to a PE in India. The definition does not suggest that the equipment should be under the control of the non-resident. Further, there is also no clarity on the meaning of 'substantial equipment'. It is necessary for the scope of the threshold to be narrowed down based on thresholds like degree of continuity in operation, use or lease exceeding a certain period, etc.;

o        The concept of 'securing orders' expands the scope of agency PE to situations where an entity does not act in a representative capacity (in the contractual sense) but merely provides some sort of marketing or facilitation services to the non-resident;

§         There is no specific exclusion with respect to activities which are preparatory or auxiliary in nature;

§         Treaty override conflicts with the constitutional mandate to respect treaty commitments as well as international law principles. Further, it would lead to anomalous results on account of the following:

o        wider PE definition,

o        indirect Profit Attribution,

o        attribution of other income,

o        double Taxation;

§         Taxation of income attributable to a PE of non-resident at a higher rate (40.5%) than a similarly placed company in India (30%) is in conflict with the principle of non-discrimination which is recognized under India's tax treaties. The argument that BPT allows for parity in treatment of a subsidiary and a branch requires reconsideration in the light of the other tax and non-tax benefits of a subsidiary which are not available in the case of a branch.

Clarification by the Ministry

§         BPT will be levied on income as computed after allowing deductions available in the DTC;

§         BPT will be an additional income tax and therefore in the nature of income-tax;

§         BPT of the PEs of a non-resident would get clubbed in determining BPT of the non-resident;

§         Mere existence of a subsidiary will not fasten any tax liability on a non-resident assessee unless he carries on a business using the premises or personnel of the subsidiary.

Recommendations

§         It may be suitably clarified that the concept of a branch and PE for direct tax purposes would remain aligned with bilateral tax treaties/agreements so that foreign entities would not be put to dis-advantage in availing tax credit as applicable under their domestic laws;

§         Ambiguities obscuring the fulfillment of the objective of bringing in equity between domestic and foreign companies are to be removed;

§         Ambiguities in the definition of PE such as the meaning of ‘substantial equipment’ should be amply clarified;

§         Consequences of the mere existence of a subsidiary in the country constituting PE should be clarified;

§         Suitable thresholds, wherever required, may be incorporated to bring greater clarity to the definition.

7.       Controlled Foreign Corporation (“CFC”)

Proposal: Passive income of foreign companies controlled directly or indirectly by Indian shareholders is sought to be brought to tax. When profits of such foreign companies are not distributed to the Indian shareholders, they will be deemed to be dividends in the hands Indian shareholders and be accordingly taxed.

A CFC is defined as a foreign company which satisfies the following criteria:

§         The 'specified income' of the foreign company is in excess of INR 2.5 million;

§         The company is a resident of a country where the amount of tax paid by the CFC on its profits under the laws of that country is less than 50% of the tax payable in India as a domestic company;

§         The shares of the foreign company are not traded on any stock exchange in the country where it is a tax resident;

§         The company is not engaged in any active trade or business;

§         One or more persons resident in India individually or collectively exercise control over the company individually or collectively, by way of:

(i)       possessing or being entitled to acquire directly or indirectly shares carrying 50% or more of the voting power / capital of the company,

(ii)     being entitled to secure that 50% or more of the income or the assets of the company shall be applied directly or indirectly for their benefit,

(iii)    exercising dominant influence on the company due to special contractual relationship,

(iv)    having, directly or indirectly, sufficient votes to exert a decisive influence in a shareholder meeting of the company.

Issues

§         There is a possibility of the CFC definitions extending to non-low tax jurisdictions, especially in cases where the foreign country provides specific profit or investment linked tax incentives because of which a subsidiary operating in such country may be subject to taxes that are far lesser than Indian taxes. Further, the DTC only takes into account taxes paid under the laws of the company's country of residence and does not consider taxes paid by the company under the laws of a third country;

§         While the definition of a CFC excludes foreign companies listed in their country of tax residence, a company resident in one jurisdiction but listed in another jurisdiction may still be treated as a CFC;

§         The use of the words 'traded' as opposed to 'listed' may give rise to uncertainty, especially if the word, 'traded' implies frequent purchase and sale of shares which may be too onerous for the Indian resident company to establish;

§         The CFC provisions require that an Indian resident 'exercises control' over the foreign company. There is no indication that the list of criteria specified for determining control is exhaustive. Further:

o        There is no minimum threshold in respect of individuals who would comprise the collective 50% threshold;

o        There is no clarity on whether capital includes loan creditors;

o        Terminology such as 'decisive influence' and 'dominant influence' makes it very difficult to understand the scope of the control threshold (for example, whether it will cover veto rights);

o        It is difficult to understand the manner in which such influence may be 'collectively' exercised by Indian residents and whether there is a requirement of any form of common purpose or design among such persons;

o        The concept of 'indirect' entitlement to shares may give rise to interpretational issues;

o        Questions may also be raised with respect to whether the threshold of control covers contractual rights such as put or call options providing the Indian resident the right to acquire shares of a foreign company;

§         It is difficult to understand the scope of the active business test considering the immense subjectivity associated with participation “in the economic life of the territory” of the foreign company. Further:

o        Use of income as the threshold could give rise to difficulties for companies incurring losses and for companies with long gestation periods;

o        It is unfair to cover income from supply of goods and services to related entities;

o        Absence of an exclusion from the definition of passive income of income ordinarily considered as passive income but earned from active business activities (eg: income earned by entities undertaking the business of banking, insurance, etc.) or earned from regional headquarters would lead to absurd consequences;

§         Set off of losses of the CFC against its profits should be permitted;

§         Non-availability of comprehensive foreign tax credit covering the following would create an unreasonable burden on Indian corporate groups and reduce their competitiveness on account of double taxation:

o        income tax paid by the CFC both in the country of its residence and in other countries which exercise a right to tax its income,

o        any special relief (including tax sparing credits) available under an applicable tax treaty,

o        federal, state and other taxes imposed on the profits of the CFC,

o        differences in financial / accounting years;

§         India enforces stringent exchange control restrictions on outbound investments and capital account convertibility. One of the important justifications for introduction of CFCs by developed countries is the elimination of exchange controls and free capital mobility significantly 26 eroding the domestic tax base. Introduction of CFC without liberalization of exchange control restrictions on outbound investments and capital account convertibility would lead to imposition of extremely onerous obligations.

Clarification by the Ministry

In determining whether the threshold 50% Indian tax has been paid in the country of the CFC, foreign tax credit in respect of the actual tax paid in a third country will be included.

Recommendations

§         A mechanism for granting tax credit should be allowed for the foreign income tax paid by CFCs;

§         The control tests widely defined by way of terms such as ‘directly or indirectly’, ‘dominant influence’ and ‘decisive influence’ require to be more precisely defined;

§         It may be clarified that the attributable income to the persons resident in India, who are exercising control over the CFC, should be only such amount of current profits of a CFC, which are capable of being distributed as per the applicable laws of the foreign country;

§         Since the triggering points for invoking CFC regulations are so many, cumulative or combined trigger of two or three points / criteria should be stipulated instead of merely a single-point trigger

8.                   General Anti-Avoidance Rules (“GAAR”)

Proposal: GAAR provisions empower the tax authorities to declare any transaction as impermissible and determine the tax consequences thereof, if the transaction has been entered into with the main object of obtaining a tax benefit and either:

(i) involves non-arm’s length dealings;

(ii) results, directly or indirectly, in the misuse or abuse, of the provisions of the DTC;

(c) lacks commercial substance, in whole or in part; or

(d) is entered into for non-bona fide purposes

The onus of proving that the main purpose of a particular transaction was not to obtain a tax benefit, is on the tax payer. The GAAR confers wide discretionary powers on the Commissioner of Income Tax (“CIT”) including the power to invoke GAAR. The DTC provides for a Dispute Resolution Panel (“DRP”), comprising of three Commissioner level officers, which can be approached by the tax payer against the decision of the CIT.

Issues / Concerns

§         The definitions of 'impermissible avoidance arrangement' and 'commercial substance' are not exhaustive and left open ended;

§         The expressions 'round trip financing' and 'misuse or abuse of the provisions of the Code’ will lead to uncertainties;

§         The definition of 'bona fide purpose' renders the provision otiose;

§         Applicability of the concept of 'commercial substance' and 'business activity’ to the non-profit sector

§         The imposition of the burden of proof on the taxpayer to show that the arrangement entered into by him has not been entered into with the main purpose of obtaining a tax benefit imposes a very onerous obligation on the taxpayer;

§         There is lack of clarity on the applicability of GAAR to structures put in place prior to coming into effect of GAAR;

§         No threshold for invoking GAAR has been prescribed;

§         No limitation period for invocation of GAAR proceedings has been prescribed;

§         No time limit for disposal of cases by the DRP has been prescribed;

§         Non-statutory guidance is contemplated for a wide range of aspects that are not merely procedural in nature;

§         There is no exclusion with respect to invocation of GAAR on court approved arrangements like mergers;

§         There is no prohibition against invocation of GAAR during or to initiate re-assessment proceedings;

§         There is no provision for providing corresponding relief to the other party to the transaction / arrangement;

§         There is no provision for availability of binding advance ruling determination of the impact of GAAR provisions on proposed transactions.

Recommendations

§         There should be greater clarity and preciseness to the scope of the provisions. The conditions dealing with ‘misuse or abuse of DTC provisions’ and the ‘manner applied for the arrangements not for bona fide business purpose’ and ‘lacks commercial substance’, being very widely worded and being subjective, need to be more specifically defined to avoid undue discretion to tax authorities;

§         The onus should rest on the tax authority invoking GAAR and this should not be shifted to the taxpayer;

§         The provisions to deter tax avoidance should not be end up penalizing tax-payers who have genuine reasons for entering into a bonafide transaction;

§         The Assessing Officer should record his reasons, in writing, before passing the order invoking GAAR.

§         It will be fair and just if the review is done by a more independent DRP headed by a Chief Commissioner of Income Tax and two other Members who will be independent technical persons. The DRP should give ample opportunity to the assessee to present his case.

§         It would be fair to apply GAAR provisions prospectively so that it is not made applicable to existing arrangements / transactions. Alternatively, suitable grandfathering provisions may be made to protect the interest of the tax-payers who have entered into structures / arrangements under the existing law.

§         A threshold limit for specific amount of tax may be prescribed for application of GAAR, which may be reviewed with experience.

§         Tax-payers may also be permitted to obtain an Advance Ruling to determine whether any kind of transaction would fall within GAAR.

§         It needs to be clarified that GAAR would be invoked only with respect to that part of the arrangement which is proved as ‘impermissible’.

§         Uncertainties with regard to applicability of tax treaty provisions should be removed so that India’s credibility as a reliable treaty partner is not affected.

Concluding Remarks

The Committee has also made certain critical observations of a general nature on the DTC initiative and the same are reproduced below:

v       “The Direct Taxes Code does not provide a classification provision under different heads as to what kinds of income are classified to fall under a particular head to be computed in accordance with the provisions contained thereunder.”

v      “The Committee find that there are around 200 clauses in the Code which expressly leave scope for rule-making. The Committee are of the view that such extensive rule-making powers would compromise the supreme authority of Parliament.”

v      “With a view to enforcing accountability of the Department, the unreasonable tax demands raised and adjudicated, if finally quashed at higher levels, should be adversely reflected in the career dossier of the concerned officials.

v       “Uncertainties with regard to applicability of tax treaty provisions should be removed so that India’s credibility as a reliable treaty partner is not affected.”

v      “The Direct Taxes Code has missed an opportunity to incorporate certain new features in the proposed tax regime of the Country which would make it make more tax payer friendly vis-à-vis the existing tax system.”

The above observations make it amply clear that the DTC, while a laud-worthy initiative in some respects, represents in many ways a missed opportunity and a move towards a tax friendly as opposed to a tax payer friendly regime.

 

 

 

 

- T.P. Janani & Abhay Sharma

You can direct your queries or comments to the authors

 

 

 

 

 

 

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