BOMBAY MANAGEMENT ASSOCIATION
Liberalisations in Indian Legislation
C O N T E N T S
|Abbreviations used in the paper.||1|
|Introduction.||2 - 3|
|I.1||Present Law.||4 - 5|
|I.2||Liberalisation for outbound investments.||5|
|I.3||FERA liberalisation and International Tax Planning.||6 - 7|
|II.||MLPA.||8 - 9|
|III.||Recent Amendment in I.T. Act.|
|Tax on Dividends.||10|
|IV.||Draft I.T. Bill.|
|Provisions for NRI's.|
|IV.1||Capital Gains.||11 - 13|
|IV.2||Not Ordinarily Resident.||13|
|V.||Outbound Investments Comparison of Mauritius, Malta & Cyprus.|
|V.1||Present provisions of I.T. Act.||14 - 15|
|V.2||Underlying Credit.||15 - 16|
|V.3||Comparison amongst Mauritius, Malta and Cyprus.||17 - 23|
|V.3.1||Tax Systems and DTCs of the 3 countries.|
|VI.1||M.A. Rafik's Case.||24 - 25|
|VI.3||Bechtel's Case.||26 - 29|
|1.||FERA - Expenditure on Hospitality.||30 - 31|
|2.||References to the taxation laws & DTCs for the comparison amongst Mauritius, Malta & Cyprus.||32|
PAGE NO : 1
|BFA||-||Block of Financial Assets.|
|DTC||-||Double Tax Avoidance Conventions.|
|FEMA||-||Foreign Exchange Management Act (Proposed).|
|EEFC||-||Exchange Earner's Foreign Currency account.|
|FERA||-||Foreign Exchange Regulation Act.|
|I.T. Act||-||Income-tax Act.|
|Conventionally, outbound investments from India are referred to as joint ventures.|
|MLPA||-||Money Laundering Prevention Act.|
|RBI||-||Reserve Bank of India.|
|TH Co.||-||Tax Haven company.|
PAGE NO : 2
1. While Indian economy is being liberalised, the legislation has become outdated. Government of India is fully aware of the situation and is redrafting a whole set of laws or bringing in new laws.
Income-tax Act. A draft bill is published for public debate. A serious plan was made to present the bill at the earliest. However, because of the tumultuous political situation, the same is not yet presented before the Parliament.
Company Law. A draft bill is already presented before the parliament. The debate is on.
Money Laundering Prevention Act (MLPA). A committee has prepared a draft bill, it is considered by the Law Ministry and Finance Ministry. This bill was expected to be presented before Parliament in November/December, 1997.
Foreign Exchange Management Act (FEMA). The present law - Foreign Exchange Regulation Act (FERA) is already on the way out. The bill for FEMA was expected to be presented in the winter session.
Electronic Commerce. Government is already drafting the bill for commerce through the electronic media - internet and others.
In the next one year, there can be a considerable fresh air in the legal fields in India.
2. Let us see a sample -
Income-tax Act. We, Indians had been accustomed to high tax rates above 50% for a long time. Dr. Man Mohan Singh reduced the tax rates to 40% for individuals and 46% for companies. Mr. Chidambaram reduced these to 30% for individuals and 35% for corporates.
This has removed a big load off the shoulders of tax payers and a lot of tax planning has become redundant. What the Government could not do with incessant amendments in the basic law; it has been able to do by drastic rate reduction.
There are, today, industrialists and businessmen who would prefer to pay up full tax and avoid the hassles of tax planning through loop holes.
Under the new bill, capital gains are being so reduced and simplified that generally no one will pay more than 10% of sales price - and (depending upon facts) 20% of the capital gains.
Tax planning incentives are being removed deliberately and systematically.
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We have, today a drastic provision under the Income-tax Act. In case of sale of immovable properties, if the department suspects tax evasion, it can acquire the property at the declared price. So the seller loses the undisclosed portion of the price - if any. Now, the Government has realised that with such liberal tax rates, there is hardly any incentive for tax evasion. So why keep such drastic provisions on the statute books ?
It is proposed to delete the entire chapter dealing with acquisition provisions.
All these positive developments are unexpected, pleasant surprises for the Indian tax payers. Clearly, the Government wants to improve the Indian tax environment.
Similar positive trend is apparent in the other laws - like FERA.
3. We wanted to deal extensively with FEMA and MLPA in this paper. The bills for both these were as per earlier information - when the conference was being planned, to be presented in the Parliament in the month of August 1997. For several reasons the bills have not been presented/published till November, 1997. Hence per force the author had to reduce the emphasis on FEMA and MLPA. Both these subjects are discussed only briefly.
Hence the title of the paper is different from the title published earlier in the literature.
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Foreign Exchange Regulation Act (FERA) is proposed to be replaced by Foreign Exchange Management Act. For the benefit of foreign delegates the present law is briefly stated in paragraph 1.1. Subsequent two paragraphs deal with liberalisation and its impact on tax planning.
(i) Normal permissions under FERA are granted by either Reserve Bank of India (RBI);
Foreign Investment Promotion Board (FIPB); or
These three authorities are in the front & foreigners & NRIs see only them. All three are (at different degrees) highly professional & show the good face of India.
(ii) The enforcement of FERA is done by the Enforcement Directorate.
FERA coupled with related laws is most draconian when it comes to enforcement. Fundamental rights are, in practice, shelved. People accused under FERA can be arrested without warrant. There are regular allegations of the accused being tortured and confessions being forced.
Simultaneously, the law is all encompassing. More than a decade back, Mr. V.P. Singh, who was then the Finance Minister, had stated that - "Assume that - I go to a restaurant in Delhi with my non-resident friend and we take tea. If I pay (in India, in Indian rupee, to the Indian restaurant) for the tea taken by my non-resident friend; I would violate FERA."
Once the law is violated, Enforcement Directorate assumes the powers of arrest without warrant, penalty & prosecution.
With all the liberalisation that is announced, the law, to a great extent remains the same. For example, if any Indian delegate in this conference takes out any non resident delegate to a restaurant; and pays for the tea consumed by the non-resident, he would still be violating FERA.
It may look surprising, but those who are interested, may see Annexure 1 to this paper for the full legal position. There has been a great deal of liberalisation but the underlying absurdity of the law remains. It is hoped, FEMA will remove these absurdities.
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(iii) Foreign exchange dealing
Before liberalisation all dealing in foreign exchange (fx) was completely controlled by RBI and the finance ministry. Dealings in fx could be done only by "authorised dealers" (banks) at the rates fixed by RBI & to the extent decided by RBI.
Now, officially the fx rate is to be decided by the market forces. Unofficially, the rupee is pegged to the U.S. Dollar. In a shallow market, RBI succeeds to a great extent in ensuring that the market rate remains around the rate preferred by RBI.
Even today, Indians cannot hold fx or deal in it. However, "exchange earners" are allowed to hold upto 50% of their earnings in fx with Indian banks in India.
There are some officers and ministers in the Government who want to liberalise the law. There are some officers & politicians who oppose the liberalisation. It is to be seen - who succeeds in this tug of war.
Pre-liberalisation, Indians could not invest abroad. They could not hold foreign exchange whether in India or outside India.
Now Indians are allowed to open offices abroad and to set up trading/manufacturing companies abroad. RBI gives requisite permissions more liberally. Exchange Earners are allowed to invest abroad even without RBI permission.
Earlier, Joint Ventures were permitted only by Commerce Ministry, Government of India. This power was then delegated to RBI, Bombay. Now, the power is delegated - in certain cases - to bankers all over the country.
And the investment permitted is also significant amount (compared to the past Indian practices) - upto $ 15 million.
The condition for this liberalisation is that the Indian company seeking to make foreign investment - must itself have earned the foreign exchange in its EEFC account. Complete details are given in RBI's circular A.D.(M.A. Series) No. 35 dated 28th August, 1997.
This liberalisation is bound to make foreign investment quite flexible. Exporters all over the country will be able to make foreign investments without any need to go Delhi or Bombay, for any permissions.
This should give considerable scope for tax planning for outbound investments from India. A new area for international tax planning is opening up. Paragraph five below may be interesting for this purpose.
PAGE NO : 6
FERA has so far prevented tax planning by several means. Once FERA is further liberalised, tax planning by Indians will be far more easy.
1. Before liberalisation, Indians could not freely set up companies abroad. The companies that were allowed were under very close scrutiny by RBI.
Under the latest liberalisation - RBI Circular A.D.(M.A. Series) No. 35 dated 28th August, 1997, setting up companies abroad is liberalised. A person earning foreign exchange can utilise 50% of his earnings and ask his banker for foreign remittance for investment abroad.
It is not clear whether he can make portfolio investment or open a consultancy services company.
Assuming that (i) either this is permitted under the above referred circular; (ii) or that it will be permitted under FEMA, Indians can do the activities described below.
2. An Indian trading world wide, can open a trading company in a tax haven. This company may, for example, buy Chinese toys and sell in U.S.A. No income will be taxed in India.
3. Similarly, a tax consultant can open a consultancy company in a tax haven. The business may be conducted while he is travelling abroad through the tele communication/internet. Bills will be raised by and the fees received by the TH company. It can always be so arranged that no income will be taxed in India. And this would be legal under I.T. Act.
4. Under the present FERA, a foreign company in which Indian residents are shareholders cannot invest in India. In the absence of FERA, the above referred TH companies can give loans to Indian operations & earn interest. This interest will be a deduction of expenses for the Indian operations saving 30% or 35% tax. The TH company's interest income may be liable to tax @ 10% or 20% depending upon the DTC.
5. There can be more such plannings depending upon each individual's requirements.
6. Draft Income-tax bill 1997 has made some attempt at trying to curb some tax avoidance. Clauses 72 & 73 of the bill make relevant provisions. However one can always plan his corporate structure effectively to avoid these provisions.
7. This planning may be short term as further amendments to the Income-tax law may follow soon.
8. Some other quiet waters which may be disturbed in the medium term future may be as under.
Under the present law as well as under the draft bill :
PAGE NO : 7
9. There are no provisions for Anti - Thin Capitalisation.
10. Transfer pricing is largely a customs & FERA issue & not an income-tax issue.
11. External Commercial Borrowings are allowed fully tax free.
12. In the past, the concept of PE had little relevance. Foreigners were not allowed to do business in India. They had to open Indian subsidiaries for business in India. Now with liberalisation many more foreigners may be able to do business in India. Hence PE will become more & more relevant.
Tax Planning - Liberalisation of FERA will open up new areas of tax planning which, so far, neither the professionals nor the department have considered.
PAGE NO : 8
This bill has been approved by the Cabinet on 20th November, 1997. The actual bill is not available. As per the newspaper reports, following provisions are contained in the bill :
1. `Crime' has been defined to include - offenses under -
Indian Penal Code,
Prevention of Corruption Act,
Narcotics, Drugs and Psychotropic Substances Act, etc.
Offenses under FERA or Income-tax Act are apparently not covered. The purpose may be to concentrate on Drug traffickers and Mafia rather than tax & other minor offenses.
2. Any bank deposit of over Rs.2.5 million has to be enquired into by the banker. Bank officers will be entitled to; and it will be their duty to ask for the source of the money and its documentary evidence.
All transactions above Rs.2.5 million have to be reported to the MLPA authority. In case of any suspicious transaction, the bank must draw the attention of the authority.
3. The authority will have powers to enquire, interrogate and if the amounts are found to be gains of crime; to confiscate the amounts.
4. So far, there was no such law in India. All foreign investors transferred their funds into and out of India at their will. There have been repeated allegations that smugglers' and mafia funds have, through certain tax haven companies, found their way into portfolio investment markets. Bankers were not required to enquire about the `source' of the funds. Now it will be the duty of the bankers. Foreign investors will have to provide necessary evidence that the funds are "clean" funds.
5. More details will be available only when the MLPA bill is available.
6. In principle, as far as the objective of the law is concerned, it is a very wholesome law. We, in India do not want the drug/mafia money. All attempts must be made to make their business and investment activities difficult.
In the process, regular businessmen/investors will have to do some additional work. This may be accepted as a cost of `crime reduction'.
PAGE NO : 9
7. Under FERA, the common belief is that the real smugglers, mafia and politicians are not affected by the most drastic laws. But the common businessman is harrassed for his minor offenses. Let us hope, this experience will not be repeated under MLPA.
8. Tax Planning - MLPA cannot affect the tax planning which is being discussed in this conference. MLPA should affect the kind of people about whom we are not concerned.
PAGE NO : 10
The major amendment affecting NRIs & foreign investors is regarding taxation of dividends.
1. Indian Government has not accepted the concept that - taxing corporate income as well as dividend is `double tax'. No credit is given to the shareholder for the tax paid by the company. Till last year dividends were taxable in the hands of the shareholders; and companies were required to withhold tax from dividend and pay to the Government. Shareholders would pay their own tax or claim refund while filing their own returns.
2. Actual share holding pattern in India is unique. A very large number of Indians spread all over the country are prepared to take risks & invest in equity shares of public limited companies. There may be cases where individuals having annual income of less than U.S. $ 1,000 would have invested in several shares. They would file several dividend warrants with their tax returns and claim refunds of small amounts.
3. This had imposed a tremendous administrative burden on companies and the Government. Government tried with several measures to reduce the administrative load without much success. The latest method tried is S.115 O. Under this method :
(i) All Indian companies declaring dividends are liable to a tax @ 10% on the dividends declared.
(ii) All shareholders earning dividends from Indian companies are exempt from any tax on those dividends.
Shareholders are not allowed any adjustment for tax paid by the company U/s.115 O. - This is to avoid repetition of administrative procedures of refunds etc.
4. Thus a tax on shareholders' dividend earnings is replaced by a tax on company's declaration of dividend.
5. It is generally believed that this will be a very successful move cutting out laborious work and yet increasing Government's revenue.
But this system has thrown up new issues -
6. Foreign portfolio investment into Indian shares now gets tax free dividend. It is immaterial whether the share investment is direct or via an offshore finance centre like Mauritius.
7. It has become a doubtful issue whether the foreign shareholder will get setoff of the tax paid by Indian company under section 115 O against the tax payable in the country of residence. For substantial share holders, this becomes an important issue.
PAGE NO : 11
Government has published the draft Income-tax bill, 1997. This bill proposes substantial changes in the existing law. Two changes relevant to International taxation are discussed here :
Provisions for capital gains have generally been considerably simplified. For shares & debentures (securities) a novel and simple method is proposed.
1. A new concept of Block of Financial Assets (BFA) has been introduced. Following table explains the concept of BFA :
|Block of Financial Assets|
|Value at the beginning of the year||XXX|
|Add : Cost of acquisition of new assets during the year|
|Less : Sale proceeds of securities sold and cost of securities gifted|
2. Thus if the sale proceeds of securities exceeds the cost of opening block of securities plus additions during the year; then only capital gains tax will be payable. Otherwise, there will be no tax. However, the closing balance value of the securities will get reduced to that extent.
In other words, there is a block of assets. It keeps changing with every transaction of sale or purchase. As long as there is some value for the block, no tax is payable. Only when the block value gets reduced to nil & there is a surplus; there will be a long term capital gains tax.
This provision throws open interesting opportunities.
3. A person may sell securities and make considerable capital gains. If he reinvests the sale proceeds in further securities, he will not have to pay any tax. Portfolio reshuffling has become tax free.
PAGE NO : 12
4. A person may earn capital gains & use up the funds for some purposes other than reinvestment. Before the end of the year, he must make sure that he buys further securities so that no tax is payable.
5. Once the capital gain is calculated as above, there will be a further relief under clause 34(2).
The amount of taxable capital gains will be reduced by 50%. This relief is to account for inflation or exchange rate fluctuation.
6. The reduced capital gains will carry normal income-tax. (Earlier, there was a concessional rate of 20%.)
7. Carry forward of capital losses has become automatic.
8. There are several NRI portfolio investors who have committed an amount for investments in India. They may reshuffle their portfolio and would like to have a right to repatriate. However, in practice, they have no intention of taking the funds out of India. These people need not worry about capital gains tax. Hence for them, the need to invest through Mauritius or Cyprus is now reduced.
9. The Turbulent Story of long term capital gains tax (LTCG tax) - for NRIs.
Chapter XIIA read with S.48 of the Income-tax Act.
9.1 For assessment year 1997-98 the tax position is as under -
(a) For computation of capital gains, a deduction on account of inflation or exchange rate fluctuation is available. S.48(2)
(b) On this reduced capital gains, the tax rate is 20%. S.115E
(c) In case of reinvestment of sale proceeds, there will be no capital gains tax - S.115F
9.2 For assessment year 1998-99 as per the law already amended, the position will be as under :
(a) S.48 adjustment on account of inflation will be available.
(b) Tax rate is reduced to 10%.
(c) Reinvestment relief is also available.
9.3 Under the draft Income-tax bill, the position will be -
(a) Inflation adjustment is omitted. Instead, capital gains will be reduced by 50%.
(b) No concessional tax rate will be available. Hence normal rate of 30% will apply.
(c) Reinvestment relief will be available under the `Block of Financial Assets' concept.
PAGE NO : 13
10. Following example explains the three different positions for capital gains.
|Cost of Asset||1,000|
|Cost as adjusted for FX Rate||2,000|
|Current market value/sale price||3,000|
|Capital Gains Computation|
|2. FX Rate adjusted cost||¦||2,000||¦||2,000||¦||1,000||¦|
|3. Sale Price||¦||3,000||¦||3,000||¦||3,000||¦|
|4. Capital Gains||¦||1,000||¦||1,000||¦||2,000||¦|
|5. 50% Relief||¦||--||¦||--||¦||1,000||¦|
|6. Tax Rate||¦||20%||¦||10%||¦||30%||¦|
|7. Tax Payable||¦||200||¦||100||¦||300||¦|
Clearly, there is no continuity in thinking while drafting the law.
I.T. Act - Section 6(6); Draft bill - clause 6(4). The concept of Not-Ordinarily Resident had been a mind bending exercise. The draft bill proposes to simplify the language.
Under the old law, if a person had been non-resident for two years, he could enjoy certain reliefs for next nine years.
The draft proposes to reduce this period for which the relief is available, to five years.
The concerned relief is, that an NOR is not liable to tax in India for his foreign income.
Because of the change in language, there is another effect. Earlier, a person could be non-resident in any two years out of preceding ten years and he would be an NOR. Thus, for example, he could be a non-resident in the 3rd and the 7th years. Under the draft bill, he has to be non-resident for two consecutive years.
PAGE NO : 14
Taxability of outbound investments from India are considered in some details.
i. Foreign investment is not allowed to individuals, partnership firms & other non-corporate bodies (under FERA). Only limited liability companies (private or public) can make foreign investments.
Let us consider tax liability of Indian companies. (And ignore, for this paper, non-corporate assesses.)
ii. When the Indian company gets dividend, technical knowhow fee & royalty incomes from its foreign subsidiaries, following tax treatment will be available in India.
Dividend Income - No tax relief. Normal tax 35%.
Royalties - 50% relief U/s.80 O. Net tax 17.5%.
Technical knowhow - No relief under the present law for fees A.Y. 1998-99. (Earlier, it got the relief like royalties.)
iii. Under the Draft Income-tax bill, it is proposed that -
Dividend Income - No tax Relief. Normal tax 35%.
Royalty - 40% relief u/c.64(2). Net tax 21%.
Technical knowhow fees - 40% relief u/c.64(2). Net tax 21%.
iv. Set off of the taxes paid in the "Source Country" will be available as applicable in the DTC.
PAGE NO : 15
v. No underlying credit (imputation) is available under the Indian Income-tax Act for dividend income.
A. Inter Corporate Dividend Tax when no Under-lying Credit is available.
|1. Foreign Company Income||1,000.00|
|2. Foreign Corporate Tax @ 35% (assumed)||350.00|
|3. Surplus available.||650.00|
|4. Dividend declared||650.00|
|5. Shareholder's tax @ 5%||32.50|
|6. Net surplus at `source' country||617.50|
|7. Within India, the Indian Company will be taxable on||650.00|
|8. Indian tax @ 35%||227.50|
|9. Less : Tax paid in source country||32.50|
|10. Net tax payable in India||195.00|
|11. Net amount available (617.50-195)||422.50|
|12. Total taxes paid (350+32.50+195)||577.50|
B. With Underlying Credit.
|1. Foreign Company Income||1,000.00|
|2. Foreign Corporate Tax @ 35%||350.00|
|3. Surplus available.||650.00|
|4. Dividend declared||650.00|
|5. Shareholder's tax @ 5%||32.50|
|6. Net surplus at `source' country||617.50|
PAGE NO : 16
|7. Within India, the Indian Company will be taxable on||1,000|
|8. Indian tax @ 35%||350.00|
|9. Less : Tax paid in source country||32.50|
|Maximum credit available||350.00|
|10. Net tax payable in India||NIL|
|11. Net amount available (617.50-195)||617.50|
|12. Total taxes paid (350+32.50+195)||382.50|
1. As seen in above examples since India does not offer underlying tax credit, the Indian companies earning foreign dividends suffer.
2. Indian Government view for not providing `underlying tax credit' in case of foreign dividends can be as under :
3. India has accepted the principle for DTCs - of sharing taxes as per the U.N. model. Thus, tax on dividend is shared by both countries - the country of source & the country of residence. Once underlying tax credit is given, entire tax will be payable in the source country and no tax may be available to the country of residence.
4. The counterview can be -
At present, as per official records, foreign inbound investment is far more than Indian outbound investments. By adopting `underlying credit' principle on `mutual' basis in DTCs, Indian Government may be able to attract more investments whereas its losses will be comparatively less.
5. Indo-Mauritian DTC permits underlying tax credit to the Indian companies - Article 23(2)(b) - in case of dividends received from Mauritian companies. However, the plan of foreign investment through Mauritius suffers from a problem :
6. A new offshore company in Mauritius would be liable to tax only @ 15% tax rate. Hence claiming credit higher than 15% is not possible. (For clarification, see next example.)
PAGE NO : 17
In this paper, let us compare and contrast outbound investments from - India. This comparison highlights a few concepts of DTC. It also shows which finance centre may be better depending upon the facts of the case.
V.3.1 For understanding the full impact of taxation, one must consider -
(a) The tax system of the `source' country,
(b) The tax system of the `offshore finance centre',
(c) The DTC between the two,
(d) The tax system of the `residence' country, and
(e) The DTC between the finance centre & the `residence' country.
Understanding all these five legal systems can give a comprehensive picture. In the following example, we may consider Indian tax system, the finance centre tax system and two way DTCs. Third country's tax system is `assumed' on a very simple terms.
Three offshore centers with which India has DTCs are considered - Mauritius, Malta and Cyprus.
In this example we may consider an Indian corporation investing in Russia.
V.3.2 Before approaching the example, we may briefly look at the present tax laws in all these three offshore centers and Indian DTCs with them.
Note: I am aware of the fact that for an Indian chartered accountant to comment on tax system or DTC of any other country is liable to errors. This example may be considered only for having a "macro view" for specific issues, one must consult experts form the relevant countries.
V.3.3 Malta has a complex system of taxation. Basic rate of tax for offshore companies is 35%. However, they are entitled to set off of taxes paid abroad, imputation credit, and some other credits. Ultimately whatever net tax is paid by the company is refunded to its shareholders in 14 days. The shareholder is exempt from any tax on dividend declared by Maltese companies. (This exemption is important in considering article 24(3)(b) of the DTC - elimination of double tax.)
PAGE NO : 18
The Indo-Maltese DTC provides that
Dividend - may be taxed in both the countries of source and residence.
Interest also may be taxed in both the countries.
Capital Gains on portfolio investment in shares may be taxed in the country of source.
The `double tax elimination' provision in article 24 provides for `tax sparing' provisions. Thus an Indian shareholder earning dividends from a Maltese company can claim credit for the tax which Maltese Government has exempted. Hence a relatively high tax rate of 35% in Malta is more helpful.
V.3.4 Cyprus has a very simple tax system.
Normal tax rate for the residents is 20% or 25%.
However, offshore companies are given a concession. Hence they pay a flat rate of 4.25% tax.
The DTC with India provides that :
Dividend may be taxed in both the countries.
Interest also may be taxed in both the countries.
Capital Gains may be taxed only in the country of residence.
Cyprus DTC with Russia follows the `exemption' method of `Double Tax Avoidance'. Thus for example, dividend is taxable in the country of residence and exempted in the country of source.
V.3.5 Mauritius has a tax system which is still evolving.
(i) Under the 1974 Income-tax Act, offshore companies had an option to decide tax rates from 0% to 35%.
(ii) Under the 1995 Act, new offshore companies are liable to a fixed rate of tax @ 15%.
(iii) This system is still inadequate - as we will see in the example and hence needs improvements. Probably, MOBA may be working on further improvements.
PAGE NO : 19
DTC between India and Mauritius provides that
(i) Dividends may be taxed in both the countries,
(ii) Capital gains may be taxed in the country of residence,
(iii) Interest may be taxed in the country of source.
The DTC provides for `imputation' credit for - which there is no provision either in the Indian Income-tax Act or in most other DTCs. However, it is now well established in India that the Income-tax Act or DTC whichever is more beneficial to the assesses shall prevail.
Pages 20 - 22 coming soon.
PAGE NO : 23
1. Russian tax system of corporate tax and dividend tax is assumed. The actual tax rate & system may be different.
2. Since a "macro" view is attempted in this example, micro details and controversies are not discussed.
3. Since the DTC between Russia and Cyprus follow the `exemption' method, dividend is exempted from tax in the country of source. No tax in Russia.
Cyprus has exempted dividend incomes hence there is no tax in Cyprus also. Thus this dividend income goes tax free.
4. Malta has no DTC with Russia. However, it unilaterally provides for underlying tax credit/imputation.
Mauritius Foreign Tax Credit Rules under the Mauritian Income - Tax Act provide for underlying credit.
5. Credit for tax withheld in Russia, on Russian dividends will be available in the offshore centre.
6. Indo-Mauritian treaty provides for underlying tax credit. Mauritian Income-tax Act provides for 15% tax. Because of offsetting with the Russian tax, there is no tax payment in Mauritius. But the Indian shareholder gets the credit of Mauritian tax.
This is where a `low' tax rate of 15% hurts. If the Mauritius Income-tax rate were 35%; then,
(i) Still there would be no real tax payment in Mauritius;
(ii) Indian shareholder would get the Full 35% tax credit.
7. Indo-Maltese DTC provides for tax sparing. On the dividend declared by the Maltese company, a tax credit of 35% is available in India.
All the three finance centers offer different benefits. Depending upon the requirements of different investors, a specific finance centre may be selected.
In the given example, Malta offers the best tax treatment.
Ironically, that is the country not represented in this conference.
PAGE NO : 24
India has, now the provision of Advance Rulings. Two important decisions are discussed below very briefly.
Reported in Volume 79 Taxman Page 75, Year 1995.
1. Facts : Mr. Rafik, a chartered accountant, Indian citizen, was working in UAE - Dubai for last seventeen years. he was staying in Dubai with his family. He had incomes in India but major work was in Dubai. There is no income-tax on individuals in Dubai.
2. The query was whether he could get the benefits of Indo-UAE Treaty.
3. The AAR has stated following land mark ratios in the ruling :
3.1 Even though there is no tax liability for individuals in Dubai, the Indo-UAE treaty benefits will be available to residents of Dubai. The applicability of the treaty is immediate.
The purpose in signing the treaty - to attract UAE investments to India has to be given due weightage.
It is not necessary that the person concerned should actually be liable to tax at present.
3.2 For considering whether a person is resident of Dubai or India, the following facts are helpful -
The person is practically staying in Dubai for the major part of the year.
His main income-earning activity is in Dubai.
He is staying in Dubai with family.
His children are studying in Dubai.
3.3 Once the treaty applies, the treaty benefits are available to all the incomes arising in the relevant assessment year.
It even applies to income arising out of or relating to the following assets -
(i) Assets acquired before the treaty came into effect;
(ii) Assets acquired before the assesses became non-resident of India;
(iii) Assets acquired out of non-repatriable funds.
PAGE NO : 25
All these three issues clarify several doubts. And there is ample legal support for these issues.
4. I personally add support for the first issue - "liability to tax" from Klaus Vogel's book - (not cited in the AAR ruling).
Following commentary is useful - Klaus Vogel, Page 229 -
"any interpretation of that provision (article 4-1) within its context must take account of the provision's function as a condition for applying distributive rules. Application of the distributive rules is NOT conditional on the person concerned actually being taxed (as a resident). All it requires is that the person concerned has that personal attachment to at least one of the contracting states - the `State of Residence' - which might result in him becoming subject to full tax liability.
5. A person can be considered as "Liable to tax" even if he has income below the taxable limit - if he otherwise fulfills the condition of personal attachment with the country. Thus, a person may, today, have income of only, say Rs.35,000 per year. Still, if he is physically present in India during the previous year for 182 days or more, he is "liable to tax". He will not have any tax payable. As & when his income crosses the then exemption limit, he will have to pay tax.
6. The ruling has also stated the following ratio -
Because Mr. M.A. Rafik had source of income in India, he was liable to tax in India. Hence, he was an Indian resident as far as the treaty was concerned.
Under the tie-breaking rules, Mr. Rafik would be treated as resident of U.A.E.
7. With the highest respect for the authority and with all humility, I submit to disagree from this ratio of the ruling.
To bring out the full legal support for my submission would need a full paper and hence, I am avoiding the same in this paper.
8. Very briefly the argument runs as under -
As stated in OECD commentary under article 4, The DTCs do not provide for the criteria for defining residential status. They only refer to the domestic legislation.
Residential status even for the purposes of treaty, has to be determined as provided in the domestic legislation and not by any other means.
In the given case, since Mr. Rafik was not in India during the relevant year for 182 days or more, he was not a resident of India. - Whether for the purposes of Indian I.T. Act or for the treaty.
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1. Summarised Facts.
Reliance Group of Industries (RG) had decided to setup a Petroleum refinery at Jam Nagar, India. Bechtel group's French company (BEFRA) expected to get the award of the contracts for design, installation, procurement and several other services which would be covered under the definitions of "Royalty" and "Technical knowhow fees".
BEFRA would carry out about 85% of the work outside India. It would establish two offices in India which would carry out about 15% of the work.
2. Summarised decision
The AAR decided that -
2.1. The consideration receivable by BEFRA would be covered under the definitions - `Royalties & Fees for Technical Services'. (Article 13 of Indo-French Convention.) (IFC)
2.2. BEFRA's Indian offices would constitute permanent establishments (PE) within India.
2.3. Since BEFRA would be doing business in India through PE, its income will not be taxed under article 13 but under article 7 pertaining to business profits.
2.4. Article 13 provides for a flat rate of 20%. Since article 7 will be applicable, this rate of 20% will not apply to BEFRA's income.
2.5. Under article 7, BEFRA's income pertaining to the PEs (15%) would be taxable in India and the balance 85% income would not be taxable in India -
I.T. Act S.9(1)(i) explanation (1)
DTC - Art.7 & protocol clause 3
2.6. Article 7(3)(a) of the IFC provides for - deduction of expenses ..... in accordance with the provisions of and subject to the limitations of the taxation laws of that Contracting State."
AAR ruled that in view of the above express provisions, BEFRA's PE income will get deduction of expenses to the extent permitted under the Indian I.T. Act.
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3. Position under Indian I.T. Act is as under :
3.1 S.9(1)(vi) & (vii) define royalties & technical knowhow & make provisions when these will be deemed to accrue or arise in India.
3.2 S.44 D(b) provides that no expenses will be deductible in the computation of a foreign company's income by way of royalty or fees for technical services.
S.115 A(3) also repeats the provision that no deduction of expenses will be allowed.
3.3 S.115 A(1)(b) provides that -
a foreign company's income by way of royalty or fees for technical services will be taxed @ 30%.
(Note - both rates have been reduced after the ruling has been delivered to 20% (u/s.115 A) and 48% normal flat rate for foreign companies. (Finance Act 1997.)
4. Considering the above situation, the authority ruled that BEFRA's PE income in India would be taxable on `gross basis' - without allowing any expenses @ 30 %.
5.1 It is worthwhile to note that the specific restriction that - expenses would be allowed as per domestic law - is contained only in the treaties signed by India. This provision is not contained in OECD/UN/US model conventions.
5.2 The reason why the model conventions do not contain such a provision is that -
It is the normal principle that the income will be computed as per the domestic law prevalent in the country in which it is to be taxed.
Klaus Vogel - Pages 458 & 459 - Para III
According to Klaus Vogel, this clause is only "clarificatory". Since income has to be computed as per domestic law, as a corollary, expenses will be permitted as per the domestic law.
5.3 It appears that -
In the constantly changing Indian Income-tax Act, there was a phase when the law provided for numerous artificial disallowances in computing business income.
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The Indian treaty negotiators, in their desire to ensure that these disallowances shall also apply to all non-residents & foreign companies, inserted this clause.
5.4 Similar clause is not provided in Indian treaties for the following incomes even though, they may be taxable in India -
Income from Immovable properties, capital gains, salaries, etc. There is no need to make such a provision. If the income is taxable in India, it has to be computed as per the Indian law.
5.5 Receipts like Royalty, dividend, interest etc. are not comprehensively taxed in the country of source. Final comprehensive tax will be in the country of residence.
However, the country of source is also given powers to collect tax not exceeding the prescribed rates over gross receipts. This is the "distributive" rule under the U.N. model.
Despite pressures by developed countries, the developing countries have not accepted tax on "net income" basis. Where the tax is at a flat rate on "gross" basis, naturally there is no question of allowing any expenses.
5.6 Thus there are two clear divisions of types of incomes :
(a) Where the net profit has to be computed, like in business income; the computation will be as per the domestic law. Allowance or disallowance of expenses & incentives will be as per the domestic law.
(b) Where a flat rate on gross receipts is applied, no expenses will be allowed.
5.7 Taxing under article 7 as business income and then not allowing expenses is contrary to generally accepted international taxation; and quite likely, unintended.
5.8 Incidentally, in this case, the damage was limited. DTA provided for 20% rate while Indian I.T. Act provides for 30%. And this is to be applied only on 15% of BEFRA's income.
In some other cases, the damage can be much more. Such an anomalous situation has arisen because of the specific provisions in the Indian I.T. Act.
6. To remove possibilities of such damages, it is necessary that within the Indian I.T. Act, the Non-Residents' taxation should be reorganised.
6.1 Almost all provisions for NR taxation should be brought into one chapter, or a continuous series of two or three chapters.
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6.2 Those receipts which are to be taxed on gross basis, should be grouped together & their lower rates specified.
6.3 A clear provision should be made that -
Where any income is to be taxed comprehensively within India - whether by operation of article 7 of DTC or otherwise, then all expenses as per S.28 to 44C would apply. S.44D or 115 A(3) will be inoperative. In other words, expenses allowable or disallowable to any Indian resident would also be applicable to the Non-residents.
6.4 Pending comprehensive reorganisation, this can be provided by amending S.44D & 115 A(3).
7. It may be examined whether -
Such a discriminatory treatment of BEFRA would be covered by the article 26 for "Non-Discrimination".
8. It may also be examined whether -
The French revenue authorities could take following stand while assessing BEFRA'S income -
As per DTA, BEFRA should be taxed on "Net" basis.
Any undue taxes paid to the Indian Government will not be allowed by the French Government while eliminating double tax under article 25.
Indian Income-Tax has envolved over a period of time.
One can see two distinct parts of the law.
1. The part dealing with taxation, assessment etc. of the income earned in India.
Till the year 1991 there was an aggressive trend by the Government to plug loopholes and make strict assessments.
1991 to 1997 the trend has been towards simplification and reduction in cases.
There is always something happening in this part of law.
2. The second part is taxation of non-residents' incomes from India.
Here, generally, a "hands off" approach is there. The only time law is changed, it is for the benefit of the tax payer (generally). (See S.90(2)).
Time has now come to have a comprehensive look at this part of the law.
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1. Consider an example where an Indian delegate to this conference - Mr. I, takes out a foreign delegate Mr. F for a cup of Tea. Mr. I pays Rs.10 to the restaurant owner Mr. R for two cups of tea. Mr.F has come to India purely to attend this conference. He is not invited to India by Mr. I and has no other business with Mr. I.
2. Section 9(1)(a) of FERA reads as under :
"..... no person ... resident in India (Mr.I & Mr.R) shall ....
(a) make any payment to or for the credit of any non-resident (Mr.F);
(b) receive, otherwise than through a bank, any payment on behalf of a non-resident. "
3. Notes -
3.1 The language of the law is simplified to make it understandable for a foreigner who may not be conversant with the language of FERA.
3.2 Clause (a) is interpreted as under -
If Mr.I pays Rs.5 to Mr.R on behalf of Mr.F, Mr.I is violating FERA.
3.3 If Mr.R receives from Mr.I, cash payment for tea given to Mr.F; Mr.R is violating FERA - clause (b).
3.4 Under FERA, there is no provision in law for a minimum amount for which no legal action may be taken. (In practice, of course, no action may be taken for such small amounts.)
4. Now consider the notification issued to liberalise this drastic provision of law.
Notification No.F.E.R.A. 91/92-RB dated 13th September, 1991.
"Expenditure on Hospitality to Non-resident visitors -
... the RBI is pleased -
(a) to permit any person resident (Mr.I), to make payment to another resident (Mr.R), in Indian rupees for boarding, lodging and services related thereto of a non-resident (Mr.F) who is on a visit to India in connection with business, activity or any other work of the host;
(b) to permit a resident (Mr.R) to receive from another resident (Mr.I) any payment towards boarding etc. expenses of a non-resident (Mr.F) on visit to India."
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5.1 This general permission gives relief from the provisions of S.9(1). However the permission in clause (a) above is dependent upon fulfillment of a condition. Mr.F must have come to India in connection with some business of Mr.I. Since in our example, both the delegates have no business connection, this condition is not fulfilled. Hence the permission is not applicable. Hence S.9(1)(a) applies and the payment of Rs.5 by Mr.I to Mr.R remains a violation of FERA.
5.2 There is no such condition in clause (b). So Mr.R does not commit any violation of FERA by accepting Rs.5 from Mr.I.
5.3 It is clear that this interpretation of law is not the intention of the Government or the RBI. The moot issues are -
(i) Why have an absurd law which can make illegal, innocent and small - routine transactions ?
(ii) Why give permissions in such cases which are attached with unnecessary conditions ?
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Authority for several calculations in the examples.
|Mauritius||Foreign Tax Credit Regulations|
|1.||Imputation Credit - Russian Income.||Regulations 5 & 7 of FTC.|
|2.||Tax Credit on dividend.||Regulations 3, 4 & 6 of FTC.|
|3.||Grossing up.||Regulation 5 of FTC.|
|4.||Tax rate.||Cl.16, Part-II, First Sch. of I.T. Act.|
|5.||Underlying Credit in India.||Article 23(2)(b) of DTA.|
|1.||DTC - Exemption Method.||Article 7 of DTA.|
|2.||Tax Rate, Cyprus I.T. Act.||Section 28A|
|4.||Tax Sparing.||Article 25(4) of India & Cyprus DTA|
|Malta||Maltese I.T. Act|
|1.||Unilateral credit for foreign tax.||Sections 80 & 81.|
|2.||Unilateral Underlying Credit.||Section 82|
|3.||Grossing up.||Section 85|
|4.||Tax rate.||Section 56(6)(a).|
|5.||Tax sparing||Indo Maltese DTC. Section (3)(b)|