The draft Direct Tax Code (DTC) released by the Finance Ministry in August 2009 posed certain challenges for taxation of non-residents. In order to clarify the concerns and issues raised by taxpayers, the Central Board of Direct Taxes (CBDT) released a revised discussion paper on 15 June.
Treaty override and GAAR
The discussion paper clarifies that non-residents would not be able to enforce treaty provisions where General Anti Avoidance Rules (GAAR) are invoked by the tax department. When GAAR is not invoked it is proposed that either the provisions of the DTC or the tax treaty, whichever is more beneficial to the taxpayer, will be applicable.
The DTC provisions would also prevail when branch profits are to be taxed or when the tax officer invokes the Controlled Foreign Corporation (CFC) provisions.
Using the GAAR provisions to negate treaty protections enjoyed by a non-resident may often be in respect of a country with which India has a favourable tax treaty. This is so because, the tax authorities could presume that the offshore company is incorporated primarily to take the benefit of favourable treaty provisions. Though it is proposed that guidelines would be laid down for invoking GAAR, to what extent such guidelines would come to the rescue of non-residents can be determined only once the guidelines are drafted and released.
Profits as capital gains
Profits of foreign institutional investors (FIIs) would now be taxable as capital gains rather than business profits. This may fasten tax liability on FIIs.
Such profits will include those from the sale of shares by FIIs, which will be deemed to be capital gains. This could be detrimental to FIIs. It will also be contrary to the views taken by the judiciary on various occasions, as different courts have held that profits on the sale of shares are business profits and not capital gains of FIIs. In reaching this decision, the courts considered that FIIs frequently trade in shares and so the income they earned in the process was business income.
In this regard CBDT had issued instructions to the tax officers, which were based on different tests laid down by various courts to determine whether income on the sale of shares is business income or capital gains. If the tests laid down in the CBDT instructions are applied to the way FIIs normally buy and sell shares, it is more likely that the profit on the sale of the shares will be characterized as business income.
How the FII’s income is characterized is very important. If it is deemed to be business income, it will not be taxable in India as the FII may not have a permanent establishment in India.
However, if the income is characterized as capital gains, the profits on the sale of shares would be taxable as per the provisions of the treaty that is applicable to the FII.
Residence and CFC Rules
The revised discussion paper states that a company will be a resident in India if the “place of effective management” is situated in India. However, the paper does not categorically define the term “place of effective management” and this may raise concerns as to how it will be determined.
Where the passive income is earned by a foreign company, which is controlled directly or indirectly by a resident in India, the discussion paper proposes that CFC regulations would apply. As such this income would be taxed in India, irrespective of its remittance to India.
Introducing CFC regulations could be more of a challenge for Indian companies than it would be to foreign companies. The discussion paper also does not outline the extent of direct or indirect control by the Indian resident.
It appears from these proposals that the legislature has attempted to tax non-residents in India. However, the guidelines for invoking GAAR are yet to be framed.
When that happens, non-residents will be able to better understand the circumstances in which the tax department will invoke GAAR and so it will be possible for them to arrange their activities in order to mitigate tax exposure in India.
While the revised discussion paper shows the intent of the government to address concerns, many of them have not been fully addressed. The simplification of tax laws is yet to be achieved and only the implementation of the DTC will reveal its actual impact on various stakeholders including non-residents.
Pranay Bhatia is a partner at Economic Laws Practice where Vidushi Maheshwari is an associate. Economic Laws Practice is a full-service law firm headquartered in Mumbai and has offices in New Delhi, Pune and Ahmedabad.
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