Taxing controlled financial companies

LEGAL EYE

The credit goes to the USA, for conceiving the brilliant idea of parking investment assets and routing investments through off-shore companies incorporated in tax havens, till it is repatriated. Such tax deferral led to substantial loss of revenue to the US exchequer, and sometime in the 1960s the IRS woke up to this, and changed the tax laws to bring in the net the US holding entities for passive or notional income receipts. But the IRS faced an uphill task in trying to obtain information from these jurisdictions "" secrecy being sacrosanct, and only post 9/11 has the IRS been able to conduct an effective and successful witch-hunt. The US tax assessees are now required to disclose their offshore holdings.

An offshore entity is regarded as a controlled financial corporation (CFC) in the US, if more than 50 per cent is owned by US investors, and persons owning 5 per cent or more stock in CFCs are potentially liable to US tax. Following the US, the UK and the various EU and OCED nations have enacted special laws to make CFC tax compliant, imposing tax liability on the worldwide income of resident taxpayers. CFC rules apply to foreign companies controlled by residents, but some nations have extended it to foreign permanent establishments as well.

India has been considering introducing CFC regulations since 2000, when the Income Tax Authorities issued show-cause notices to some FIIs operating in India, on the grounds that these were shell companies which acted as conduits, resulting in a pull out of funds. The finance ministry was constrained to issue a circular clarifying that revenue officers had no power to go beyond the resident certificate issued by the Mauritian Authorities in this regard. Though quashed by the High Court, the circular's validity was upheld by the Supreme Court, in the Azadi Bacho Andolan (ABA) case with the immortalised lines "there are many principles in fiscal economy which, though at first blush might appear to be evil, are tolerated in a developing economy, in the interest of long terms development", and then gracefully left the issue of treaty shopping for the Executive's decision.

The Supreme Court in the ABA case was unable to pinpoint any contravention of Indo-Mauritian DTAA by reason of third state residents availing of its benefits, and no direction was given for incorporating any anti-abuse provision therein. But the perception of the reality has convinced the government to introduce a Direct Tax Code, incorporating parts of the Kelkar Committee Report, which express misgivings about conduit companies as well as certain financial instruments on treaty provisions being misused and manipulated for money laundering. Concern is also perceived on account of outbound M&AS as many are routed through low tax offshore vehicles to buy out companies of far large scales, with all profits presumably eluding the domestic tax net. Hence the intention to introduce the CFC regime to curb revenue losses from outbound and inbound investments.

But is that the global practice among developed nations? For one, most developed nations offer participation exemptions, i.e. exemptions to foreign investments based on minimum participation or holding levels in the entity located in their tax jurisdiction. The Dutch participation exemption is as popular a product as the country's tulips and cheese, with some value addition for the EU members. Participation exemption is extended to a foreign holding on certain conditions or combination of rules being satisfied, which could vary from minimum capitalisation level, long-term investment plan, sectoral considerations etc., and cover a range of gains from dividends, capital gains, interest thereon, deductions etc.

To given an example, if the laws of the country of residence of the investee, say Malta, permits remittance of dividend income, and the participation level dispenses with withholding tax, requiring tax payable according to the recipient's domestic laws being those of Mauritius, it would be a win-win situation all the way.

But India as on date does not offer partial exemptions, which go hand-in-hand with CFC regulations. And an overriding provision in the Income Tax Act may not be legally sustainable, unless replicated in DTTAs and could impact genuine investments to India adversely. It would also inevitably lead to double taxation, which goes against the intent and spirit of DTTAs.

As India still doesn't have capital account convertibility and the outbound investments are not comparable to those nations who have abolished exchange control, the best bet is to negotiate and incorporate anti-abuse provisions in all DTTAs as in the Indo-US treaty.

Kumkum Sen is a Partner at Rajinder Narain & Co.

kumkumsen@rnclegal.com