With the increase in outbound investments from India, the Government is concerned about the ability of such companies to park profits outside India in low or no tax jurisdictions. Until a dividend is declared by the overseas company, no tax liability arises in India.
The Indian tax law does not tax a shareholder of a company on the company's income until the income is distributed as dividend. Therefore, it has become common for Indian companies to form foreign subsidiaries in tax havens and shift "portable" income to those subsidiaries. Tax on this income is avoided until the subsidiary located in the tax haven country pays a dividend to the parent Indian company. This dividend could also be avoided indefinitely by loaning the earnings to the parent Indian company without actually declaring a dividend.
The Governments all over are not always happy that multinationals based in their countries are keeping large amounts of profits offshore. Therefore, in several countries, a new law has been introduced to eliminate the benefits of tax deferral, by taxing income in the parent country even when the income has not been actually repatriated or remitted to that country. These laws are generally referred to as Controlled Foreign Corporation (CFC) laws. The CFC rules have also been adopted by US, UK, Germany, etc to prevent avoidance or deferment of domestic tax collection by home companies on income earned from overseas businesses carried out through offshore subsidiaries or affiliates.
In India a Working Group on Non-resident Taxation was formulated in, January 2003. The Group termed the deferral of taxes as an unjustifiable loss of revenue and recommended the introduction of CFC regime in India. The intent is to prevent the avoidance or deferment of tax on income, by levying taxes in the hands of the parent company on the consolidated world income.
CFC legislation as prevailing in most countries, has a number of components. The rules generally have an ownership/control test, so that an entity will be treated as a Controlled Foreign Corporation only if a certain percentage of ownership/control is in the hands of the parent company or other residents of the parent country.
Once a CFC is identified, the rules set out the consequences of being treated as a CFC. Generally speaking, the consequence is to tax certain income of the CFC ‘currently’ in the hands of the parent company, as if the said income had been remitted to the parent company or was the income of the parent company, even though there is no actual remittance. In fact the income clearly remains in the legal ownership of the CFC abroad.
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The revised discussion paper on The Direct Taxes Code released on 15th June, 2010 also contains discussion on CFC as under:
“As an anti-avoidance measure, in line with internationally accepted practices, it is also proposed to introduce Controlled Foreign Corporation provisions so as to provide that passive income earned by a foreign company which is controlled directly or indirectly by a resident in India, and where such income is not distributed to shareholders resulting in deferral of taxes, shall be deemed to have been distributed. Consequently, it would be taxable in India in the hands of resident shareholders as dividend received from the foreign company.”
It is strongly felt that the Government should not take any hasty step in this direction. It is to be kept in mind that outbound investment from India is very small compared to inbound investment. In fact CFC Rules have generally been adopted by developed countries whose outbound investments far exceed the capital inflows. There is no comparison between India and such other developed countries.
The issue should be seriously addressed as to whether the economic conditions in India justify introduction of CFC Regime. Is India ready to afford restrictions on outbound investments? Should Indian tax regime deny the benefit of deferral of tax liability available to foreign arms of Indian companies, which makes them more competitive?
The author is a Sr. Partner in S.S. Kothari Mehta & Co.
E-mail: hp.agrawal@sskmin.com