In an expedition to enlarge the scope of taxation of Residents, the revised discussion paper on the Direct Tax Code has yet again instituted a platform for debate with the introduction of taxation for Controlled Foreign Corporations( hereinafter CFC ). On an ongoing debate the legal fraternity has been divided amongst those who opine that India does not still require such a change as they believe in the existence of two different and distinct legal entities; those incorporated within and those incorporated outside the country. On the flipside others propagate that the Revenue is suffering losses as the recent trend shows an increase in outward investment, thereby making it necessary to introduce such laws for taxation. In my opinion there is a necessity to examine the proposal as laid down under the DTC, secondly to put forward the shortcomings of the proposal and finally to determine whether India has adhered to the principles recognised by most developed jurisdictions for taxation of the CFC’s.
In the Indian context, Controlled Foreign Corporations are understood as Companies which have been incorporated abroad, in countries with low tax jurisdictions, controlled directly or indirectly by Residents in an attempt to accumulate income without having to pay tax in India. It can therefore be concluded that such a structure is an added method for legally avoiding the payment of taxes in India.
The present proposal can be seen as yet another attempt by the Revenue to overcome the recognition given to the principle of Tax Avoidance in Azadi. It has sought to tax the Resident controlling such a Foreign Corporation on the passive income earned by the same. Furthermore in order to check the deferral of taxes from dividend earned by the CFC’s which are not distributed in India to the shareholders, the DTC(Chapter 8) proposes to tax such dividends as deemed dividend from the Foreign Corporation. The effective test laid down under the DTC is the ‘place of effective management’ of the corporation which is an internationally recognised principle for determining the residence of the Corporation. The DTC defines the term ‘place’ as being the country in which the ‘ key management’ and ‘commercial decisions’ are made for the ‘entity as a whole’. Therefore in substance it widens the ambit of residence of a Foreign Company if it is managed wholly or partially in India unlike the present law which limits a Foreign Corporation liable to tax only if the management and control are wholly in India (s.9 Income Tax Act, 1961). Further the DTC lays down a two-fold test for determining the Place of effective management under Schedule 10 of the code-
(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.”
In order to understand the true nature of the applicability of laws governing CFC’s, it is necessary to analyse the limitations of the provisions relating to its induction within the tax structure. Pursuant to the above definition of place of effective management, there should essentially be a bracket which categorises the term ‘ routinely’( clause ii) in such a manner that no further room for interpretation is left. This would check a series of litigation which may arise subsequently. Furthermore the code should specify the ambit of passive income such that there is no ambiguity to the jurisdiction in which such an income arises. There should also exist provisions which specifically limit the applicability to only passive income and does not affect active income. Another issue which arises is in the definition of a Controlled Foreign Income. The DTC should encompass within the meaning of a CFC, structured requisites for determining what would constitute a CFC. By doing so it would thus prevent persons from interpreting the term to their advantage and avoiding tax. Since the concept of CFC’s is not yet developed in India and since this is the first composite legislation governing the same, it lays a higher burden on the drafters to fully analyse the benefits and the limitations, thereby structuring the legislation by according well defined definitions, explanations, exceptions and its effect on the DTA Agreements which India shares with several foreign jurisdictions.
Over the years the developed countries have extensively advanced several principles relating to the taxation of CFC’s as a result of which there has come to exist a set of uniform global principles which have been adopted. A glance at some of the provisions under foreign jurisdictions and the proposal under the DTC makes it evident that India needs to make its law more comprehensive. Illustrating further, most jurisdictions have adopted the principle of determining ‘control’ under the control/ ownership test where a definite percentage is specified which determines if such a corporation could be subject as a Controlled Foreign Corporation. Secondly most of these jurisdictions follow the 50% Shareholder test according to which a Corporation is taxed as a CFC only if 50% of its shareholders are residents of India or have voting power comprising 50%. Such a threshold ensures that there are no two ways in interpreting the provision. Most countries which have adopted this regime do not impose these provisions on Corporations which have their residence in countries with a high tax rate. Therefore it can be inferred that as long as there is bona fide intention for not evading tax, the Corporation will not be taxed. Further, certain exemptions are also granted in favour of these corporations such as the application of the De minimis rule which is prevalent in the UK and the U.S. whereby an exemption is granted only when no part of the gross income of the corporation exceeds a specific limit under the governing laws. In the case of the United States the limit is specified as 1 million dollars.
It is pertinent to take into account that the Indian law still needs to develop a lot further before it has a fully functional system to tax CFC’s. First and foremost the Government should take into consideration the necessity for such legislation. The justification given by the Government for instituting such a provision is that there is a trend for outbound investments which is causing the Revenue to incur losses as it is not being able to tax these entities. However it is vital to understand that a fundamental difference exists between being an economy which has advanced to making outbound investments on a large scale and an economy which is progressively increasing its outbound investments. India today largely depends on inward flow of funds; therefore such legislation would be highly premature. Some considerations are needed to be taken by the Government which largely consists in determining the functioning of the Indian market. Rather than inducting a premature legislation the Government should study the market pattern for a few years such that it is in a position to frame proper laws applicable to the Indian markets than making regular amendments to such provisions. This would be highly ineffective and would lead to a series of unnecessary litigations. A consequent effect of such law would prevent Corporations having Holding Companies in India which would largely affect Mergers and Acquisitions made by Indian Residents.
Concluding, the Government needs to prioritise the needs of the Indian market which would enable the advancement of the Indian economy. Arguendo, the Government should not enact a legislation justifying it as precautionary if there exists no proper framework for its governance. This would entail hardship on a number of Companies which are trying to develop and expand. Therefore a thorough understanding is necessary not only at the domestic level but also the impact on an International platform. Only then can a proper legislation can be brought into effect.
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