The Revised Discussion Paper on Direct Taxes Code (DTC), released by the government for public debate on June 15 has thrown up certain new propositions, including the concept of Controlled Foreign Corporations (CFC) and the modification of the concept of corporate residence in India.
The concept of CFC, which is not unique to India, has been proposed in the wake of criticism to an earlier proposal in the first draft of DTC, wherein it was sought that the definition of companies liable to tax in India be extended to companies whose control or management was wholly or partly in India. The discussion paper has now proposed to tax only such overseas companies in India whose ‘place of effective management’ is situated in India. Under the new proposal, companies whose board meetings and important commercial decisions are taken outside would not be considered taxable in India.
Separately, the discussion paper also provides for deemed distribution of passive income earned by a foreign company controlled directly or indirectly by a resident in India. This constitutes the core of the CFC regulations.
CFC: An overview
Conventionally, CFCs are corporate entities incorporated and conducting business in an overseas low-tax jurisdiction, independent of the residency of the controlling owners. Internationally, CFC regulations are targeted at offshore companies that tend to earn passive incomes in the form of royalty, interest, rent and dividend. Such income is sheltered by a low rate of tax and the income so generated is not distributed to the shareholders, leading to its deferral in the overseas high-tax jurisdictions. Several countries have formulated CFC regulations to prevent residents from reducing their tax liabilities by diverting profits to foreign companies they control and are situated in low-tax jurisdictions, thereby deferring tax on such profits. It may be useful to mention that generally CFC rules are of more significance in capital-exporting countries like the US, UK and Japan. Accordingly, most OECD member countries have such rules in some form.
CFC in India
As part of its proposal to curb tax avoidance, DTC aims to empower the revenue to tax “passive income” earned by a foreign company controlled directly or indirectly by a resident in India, and where such income is not distributed to shareholders resulting in deferral of taxes. Such passive income shall be deemed to have been distributed and, consequently, would be taxable in India in the hands of resident shareholders, as deemed dividend received from the foreign company. Presumably, such dividend would not be liable to tax on its actual distribution. The proposed introduction of the CFC regulation may have far-reaching implications for Indian multinationals that have offshore investments. While the definition of passive income remains unclear, It could also be argued that such rules have more relevance for the capital-exporting countries. India being a net importer of capital, a higher degree of circumspection is required in introducing such rules as may not have a material revenue collection impact, but may pose a great degree of compliance burden/complexity, not necessarily suited to the current growing financial/investment needs of India.
The way forward
It is recognised that most developed economies have CFC regulations. In concept, the CFC rules appear simple in operation. However, in practice, having regard to different financial/tax years in different jurisdictions and other ground-level challenges in the operation of CFC regulations add additional compliance burden for companies. In the Indian context, there is also a challenge of scaling up the sophistication/skill of the revenue to raise such challenges on a selective basis. Accordingly, it is recommended, in line with the practice in other countries, introduction of CFC rules in India should be accompanied by notified safe harbours, which exclude the operation of CFC rules for certain taxpayers, like listed companies or a company that distributes a certain percentage of its income every year. It is suggested that similar safe harbours be incorporated in the Indian legislation.
Shyamal Mukherjee
Executive Director & Joint Leader of Tax Practice, PricewaterhouseCoopers