INTERNATIONAL TAXATION IN

INDIA - RECENT DEVELOPMENTS &

OUTLOOK (PART - II)
CMA Mrityunjay Acharjee
Associate Vice President, Tax and Chief Internal Auditor, Balmer Lawrie Ltd.

This part of the article is written in continuation with „Part 1‟ published in the Tax Bulletin dated 18.08.2018.

OUTLOOK FOR 2017-18

Introduction

Necessary steps have been taken in the recent past to gain confidence of the investors over Indian tax system
and implementation of tax laws. The tax issues are foremost in the mind of the investors, both
domestic/international, and confidence in the Indian economy will get dampened by adverse tax environment in
the country.

Over the past few years, the government has improved its engagement with taxpayers and have also provided
clarity on various controversial issues. The present economic and global environment offers huge opportunity to
the government and the budget for 2017 can be a platform for the government to announce and implement long
term systematic reforms that could also assure stability, certainty and predictability in the Indian regime.
There are various controversial issues which can be revisited and revised in order to provide taxpayer friendly
and effective policy implementation.

In the backdrop of developments of year 2016, both at India and outside India, economic activities in year 2017
will have many tax issues that would require adequate consideration. We have provided in the subsequent
paragraphs, a broad overview of tax issues and challenges for selected activities/transactions.

A. Cross Border M&A

Introduction

 Tax issues arise in cross border deals when two different jurisdictions seek to tax the same sum of
money or income or the same legal person thereby resulting in double-taxation. Many countries are
aware that double taxation acts as a disincentive for engaging in any cross border trade or activity.
Therefore, with the primary view to encourage mutual cooperation, trade and investment, the countries
enter into bilateral Double Taxation Avoidance Agreements (“DTAA”) to limit their taxing jurisdictions
voluntarily through self-restraint.

 The availability of such benefits and the ultimate tax liability often drives or breaks cross border
transactions. Particularly in the Indian context, where the tax administration is perceived to be aggressive
and the laws uncertain, any protection offered by a treaty jurisdiction is important. It is important for the
buyer in the context of whether there is any withholding obligation while making a remittance to the
seller.

Diagram Explaining Cross Border M&A

 The Diagram below depicts a Cross Border M&A where a Foreign company and domestic
company expands its operations by merger/acquisition

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Provisions for Cross-border Mergers

 The merger of two foreign companies involving the transfer of shares of an Indian company, is
normally tax exempt provided that the merger satisfies the criteria for an amalgamation and, at least 25%
of the shareholders of the merging company remain shareholders in the merged company, and such
transfer does not attract capital gains tax in the country in which the merging company is incorporated.
 The demerger involving the transfer of shares of an Indian company by a demerged foreign company
to the resulting foreign company is also tax exempt provided that,
o The shareholders holding not less than 3/4 of the shares in the demerged foreign company
remain shareholders in the resulting company and
o Such transfer does not attract capital gains in the country in which the demerged foreign
company is located. The merger of an Indian company with a foreign company is also tax
exempt, provided the resulting company is an Indian company.

Current/Likely Tax Issues

 India now levies a tax on the gains arising on the transfer of shares or an interest in a foreign company,
if the share or interest derives its value substantially from assets (tangible or intangible) located in
India. This tax on indirect transfers of Indian assets is one of the most important tax challenges that
investors will have to factor.

 Withholding Tax
The Finance Act, 2016 has introduced a tax at the rate of 10% on dividends in excess of INR 1 million
(approx. USD 15,000) declared by a domestic company and received by a resident individual, LLP or
partnership firm. This is in addition to the DDT paid by the distributing company. Such tax will affect
the ability of non-residents to claim foreign tax credit in its home jurisdictions on DDT paid by the
distributing company. The normal withholding tax rate on royalties and fees for technical services is
10%, and lower rates may apply if provided for in a tax treaty.

Under Section 195 of the ITA, any person making a payment of a sum to a non- resident that is
chargeable to tax under the ITA (read with relevant provisions of the applicable DTAA) would be
required to withhold tax on such sum at the appropriate rate. Such withholding is required to be made
either at the time of payment or at the time of credit of income to the account of the non-resident.
However, if the amount paid is not taxable in India, there is no requirement to withhold tax on
such payments. However, if the amount paid has an element of income that is taxable in India, then
even a non-resident who making such remittance is obligated to withhold as per the ITA.

 Credit for Taxes

The normal withholding tax rate on interest is 40%. However, more beneficial rates (ranging from 5% –
20%) of withholding are available to non-resident creditors depending on the nature of the security
involved, the status of the non-resident creditor, etc.

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  Treaty Benefits
India levies a tax on capital gains arising from the transfer of an asset located in India. In the case of
capital gains arising from the transfer of shares of an Indian company, the tax on such gains is typically
eliminated through the use of structures involving a Mauritian or Singaporean holding company, since under
the provisions of erstwhile DTAAs in place between India and the aforementioned countries, subject to
certain criteria being fulfilled (e.g., absence of a permanent establishment in India) only the country
of residence of the transferor is entitled to levy a tax on capital gains arising from the transfer of shares
of an Indian company, and importantly, these countries do not tax capital gains.

 LOB Article
In certain scenario, eligibility to claim relief under a DTAA may be conditional upon the satisfactions of
certain “substance” requirements. For example, the India- Mauritius/Singapore DTAA incorporates a
“Limitation on Benefits” clause, which requires a Mauritius/Singapore resident company to demonstrate the
following, before it can claim benefits under the DTAA. The primary purpose of its
incorporation in Mauritius/Singapore should not be to take advantage of the treaty benefits. It should not be
a shell/conduit company and it must have bona fide business activities. It will be deemed not to be a conduit
company if: Its total annual expenditure on operations in Singapore is at least $200,000 during 2 years prior to
share transfer, or it is listed on a stock exchange in Singapore.

B. Foreign Portfolio Investor (FPI)

Introduction

 In the year 2016, considerable developments have taken place on the Foreign Portfolio Investors
(“FPI”) front. There have been changes to the norms governing FPIs that have impacted the permitted
investments by them in India.
 The changes/amendments made in DTAAs & Indirect Transfer rules, the Foreign Portfolio Investors
are expected to face challenges, whereby making them liable to pay higher tax.

Diagram Explaining how Foreign Portfolio Investor (FPI) invest in India

 Foreign Portfolio Investors (FPI) makes investments in India by acquiring shares/assets of the
Indian company, Know-how, Technology & Management etc and earns by the way of Profit, Royalty &
Fees.

Current/Likely Tax Issues

 Clarification on Indirect Transfer of Shares:

A High Level Committee to be constituted which would be chaired by Revenue Secretary and will
consist of CBDT chairman and an expert from outside to oversee fresh cases where assessing officer applies
retrospective amendment in relation to indirect transfer of shares. However, the CBDT constituted a
working group on 15 June 2016, after it received queries about indirect transfer provisions raised by
offshore funds registered as FPIs. After considering the comments of the working group, CBDT issued
clarification through a set of 19 questions and answers depicting various scenarios under which offshore

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 funds may have invested in companies in India. For example, in case a fund is set up in an offshore
jurisdiction pools money from retail/institutional investors and invests in shares of Indian listed companies, if
the fund on request of its unit holders/shareholders, redeems their units/shares, then CBDT clarified
that it will be liable to pay taxes in India.

 Treaty Amendments:
Recently India has also amended the DTAA with Mauritius and Singapore. While this allows India to tax
capital gains on investments in the nature of shares, made by an FPI, this will not impact investments made by
them in debentures & derivatives in India.

However, further rationalization can be done by the government with respect to the taxation of derivatives;
FPIs should be given the option of categorizing their income from derivative transactions as business income,
if this is more beneficial to them. The short-term capital gain tax on derivatives should be made on a par with
that on equities.

Under the Indian income tax law, shares of listed Indian companies held by FPIs are deemed to be capital
assets irrespective of the holding period or the frequency of trading equity carried out by the concerned FPI.
As such, income from sale of shares results in capital gains and at present, FPIs enjoy the benefits of the
capital gains provisions under the Singapore Treaty. Since investments until March 31, 2017 have been
exempted from capital gains tax, there is no risk of an immediate outflow of funds. However, the amendment
impacts all prospective investments with effect from April 1, 2017.

As per the amended India – Mauritius treaty, FPIs (including P-note holders) who invest in securities
listed on the Indian stock exchange but exit before 12 months from the date of purchase will be impacted
since they will be required to pay short term capital gains tax in India @ 15%. During the transition
period (i.e. during 01.04.2017 to 31.03.2019), and subject to the satisfaction of the limitation of
benefits clause, this rate may be reduced to 7.5%. However, gains accruing to the investors who invest in listed
securities for more than 12 months will continue to remain exempt since long-term capital gains tax from
sale of listed securities is exempt in India, where the transaction is effected on Stock Exchange in India.

 General Anti-Avoidance Rules:

The Finance Minister announced in his budget speech that General Anti-Avoidance Rules (GAAR) will be
effective from April 1, 2017. The current Rules contain subjective tests around commercial substance,
main purpose, misuse / abuse, etc.. As per the Memorandum to the Finance Bill, 2015, investments made
up to March 31, 2017 would be protected from the applicability of GAAR provisions.

C. Outbound Investments

Introduction
 Outbound investments from India have undergone a considerable change not only in terms of magnitude
but also in terms of geographical spread and sectoral composition. Analysis of the trend in direct
investments over the last decade reveals that while investment flows, both inward and outward, were rather
muted during the early part of the decade, they gained momentum during the latter half.
 There has been a perceptible shift in Overseas Investment Destination (OID) in last decade or so. While
in the first half, overseas investments were directed to resource rich countries such as Australia, UAE,
and Sudan, in the latter half, OID was channelled into countries providing higher tax benefits such
as Mauritius, Singapore, British Virgin Islands, and the Netherlands.
 Indian firms invest in foreign shores primarily through Mergers and Acquisition (M&A) transactions.
With rising M&A activity, companies will get direct access to newer and more extensive markets, and better
technologies, which would enable them to increase their customer base and achieve a global reach.
 For countries like India, which have exchange control restrictions and tax their residents on worldwide
income, the relevance of an Offshore Holding Company (OHC) is very significant. An OHC gives an Indian
company sufficient amount of flexibility and speed in structuring and expanding its overseas operations by
setting up subsidiaries or joint ventures in other jurisdictions.

Diagram depicting Outbound Direct Investments

 The Diagram below depicts a typical Outbound Direct Investment where a domestic firm expands its
operations to a foreign country either via a Foreign Wholly Owned Subsidiary, merger/acquisition and/or
expansion of an existing foreign facility.

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Current/Likely Tax Issues

 Credit for Foreign Tax

From taxation point of view, direct investment from India completely distorts the dividend repatriation back
into India. In many cases, only 40 to 45 percent of the earnings of the foreign company are available to the
Indian parent. There is double taxation of the same income: once in the hands of the foreign company and
then in the hands of Indian company. In order to address such situation, many countries and tax treaties allow
tax credit for the corporate taxes paid on profits in the country of source against taxes payable on
dividends in the country of residence of the recipient company. Under these provisions, the recipient of
dividend could claim tax credit, for taxes paid in the other countries by the subsidiary companies on profits
from which such dividends are distributed. Such tax credit is known as "underlying tax credit". Underlying
tax credit is over and above tax credit for taxes withheld on dividend distributed by the subsidiary companies.
It reduces the final tax incidence by eliminating double taxation of the same income in the country of
source as well as residence. Since underlying tax credit is not available in India, except under some tax treaties
like India - Mauritius, the net result is higher incidence of tax.

As per existing provisions of the Income Tax Act, 1961 (“ITA”), income of an Indian company is subject to
tax at the rate of 30% in addition to 3% cess, subject to 12% surcharge if income exceed 1 crore.. Therefore
dividends received by an Indian company from an overseas company will be subject to tax in India at the rate
of 30% in addition to 3% cess, subject to 12% surcharge if income exceed 1 crore. ITA does not provide for
underlying tax credits, however, an Indian company could claim such underlying tax credit if the double
taxation avoidance agreement (“DTAA”) that India has entered into with the country of residence of
the company paying such dividends provides for the same. Indian company can claim tax credit in India for
the taxes that have been withheld by the foreign company on such distribution. Long- term capital gains
realized by an Indian company from sale of shares of a foreign company will be subject to tax in India at the
rate of 21%, whereas short-term capital gains would be subject to tax at normal corporate tax rates of 30% in
addition to 3% cess, subject to 12% surcharge if income exceed 1 crore. As such, there is no golden rule for a
preferred structure for outbound investments as it depends on the country in which the investment is
sought. However, countries like Mauritius, U.K., and Netherlands etc. are close contenders for location of
OHC out of India for holding investments worldwide.

 Place of Effective Management

The parties most impacted by the amended PoEM rule shall be Indian individuals and companies which have
set up foreign JV‟s and or WOS and routinely take decisions for such entities from India, also affected will
be groups where the executives of the Indian entity are also on the board of the foreign subsidiary. These
companies shall soon see that their legitimate foreign companies are now deemed to be Indian
residents and are subject to taxation in India, this imposes a huge cost in the form of taxes (incomes of
foreign companies are taxable at 40% in India) on such companies and the group as a whole.

The consequence of this provision, unless amended or clarified, is going to be a large uptick in tax disputes,
where the department will invariably look at a foreign entity owned by Indians and tax it at the maximum
marginal rates. That there is no established jurisprudence on this matter in India also means that litigation on
this matter will only increase. Start-ups and established Indian players have few options by way of recourse,
one option would be to decouple ownership and management/Control and ensure that such management is
situated only outside of India and no overlaps exist. This is easier said than done and will certainly be a
challenge for all businesses looking to go global.

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D. Payment to Foreign Collaborator

Introduction

 The globalisation of economic reforms throughout the world has led to an increasing degree of
inter-dependence between countries in the field of technology, manpower, finance, etc. The Indian economy
too has been and is continuing to be liberalised by successive Governments through the mode of reducing
custom duties and of other levies, relaxing foreign exchange regulations and by encouraging boost in exports.
 The survival and growth of the industrial sector depends to a great extent upon technological
advancement. This is possible through collaborations with developed countries to import their expertise and
aid. While drafting foreign collaboration agreements both parties have to necessarily take into consideration
the tax laws in the respective countries.
 This is necessary so as to ensure, on the one hand, that the statutory requirements under the various tax
laws in India and the other country are met, as also, on the other hand, to minimise the burden of tax which
falls on the income, profits and gains arising from the collaboration.

E. Sensitivity Analysis

The Table below summarizes the sensitivity analysis on the identified economic activity having regard to the
relevant provisions of Income tax law

Parameters Provision Impact of Provision Impact of Transparency

of GAAR BEPS of Treaty POEM and Exchange of
Information
Cross Border High High Moderate High High
M&A
Foreign Portfolio High Moderate High Low Low
Investors
Outbound Moderate High High High High
Investments
Payment to Low Moderate High High Moderate
Foreign collaborator by way of
Dividend, Royalty and Fees for
technical service
Financing by High High High Low High
way of Debt
Provision on High High Low High High
Indirect Transfer

Conclusion

The government has announced number of initiatives that will change the future of the investment, tax and regulatory
landscape in India. The opening up of the commodities market to institutional investors and permitting of FPI
investments in unlisted debt securities as well as securitized debt instruments are being actively considered.

We can expect from the government further steps in this direction of providing the adequate direction and certainty in
tax policy/regulation &it‟s implementation. Budget 2017 would offer one opportunity to government in this regard. In
the post BEPS environment, MNEs would welcome unambiguous, transparent & clear tax rules and policy from the
government. Such positive steps by the government will further support its ambitious and inclusive growth oriented
schemes like Make in India, Digital India, etc.

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