'Underlying tax credits are critical'

Q&A/ Shyamal Mukherjee

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With the Union Budget due in a little over a month, PricewaterhouseCoopers Pvt Limited's executive director Shyamal Mukherjee draws up a list of major tax irritants that the finance minister needs to act upon as far as direct taxes are concerned, and explains that some of them even act against Indian firms that want to invest abroad (in 2006, Indian firms spent nearly $10 billion to acquire firms abroad). Excerpts from his conversation with Sunil Jain:

What are underlying tax credits and how does this affect Indian firms trying to make overseas acquisitions?

Not allowing underlying tax credits makes it more expensive for Indian firms making overseas acquisitions. Here's how it works. If an Indian firm 'A' buys firm 'B' in the US, and 'B' makes a profit of $500, it will pay a tax of say $150 to the US government. It will give 'A' $350 in form of dividends. If 'A' brings this money to India, it will then pay $118 as income tax on this (33.66 per cent of $350).

If there was underlying tax credit available, 'A' would have got a credit of $150 against tax liability in India on such income. The existing law which does not allow such credits discourages Indian firms from repatriating dividends to India. They would prefer to keep the funds overseas.

Doesn't this get fixed if we have a double tax avoidance treaty?

More often than not, the problem remains even in a treaty situation. Most of the treaties that India has entered into restrict the tax credit to the withholding taxes deducted overseas on the dividend income.

The issue was not so important earlier because there were not many overseas acquisitions. But now that Indian firms are buying overseas firms aggressively, the need for underlying tax credits has become all the more important.

Apart from this, what is at the top of your direct tax list?

Dividend distribution tax (DDT). On the face of things, there is no problem as companies pay a DDT of 14.025 per cent, the dividend is tax free in the hands of the shareholder who may otherwise have had to pay a higher tax on this dividend, depending upon his/her tax slab.

But in a situation where there is a holding company structure (which is becoming increasingly common when you have SPVs for infrastructure projects for instance), the tax impact is multiple.

In such cases, the operating company (say, the company executing the power project) pays DDT, but when the parent distributes dividend on all of its profits (including the dividend received from the SPV), it pays DDT again on whole of the dividend "" in effect, that's double taxation.

Is there a problem with the tax structure for share buybacks/open offers?

Today, there is no capital gains tax on transfer of listed shares which have been held for more than one year since Securities Transaction Tax (STT) would have been paid on this. But in case of share buybacks or even open offers, the transaction doesn't go through the stock exchange and so no STT is payable.

Any shareholder offering his shares in a share buyback or open offer situation tends to lose significant amounts of money (since the STT is around 0.125 per cent versus an average rate of 10 per cent if long term capital gains tax is paid).

What about tax exemptions? Corporates are always looking to get them extended.

If you're referring to the software tax holiday benefits available under 10A/10B, there could be a case for such extension, given how much of India's software exports comes from smaller firms who may find it difficult to migrate to IT SEZs which are presently enjoying this benefit.

While the exemption can be debated, the larger point is that the government needs to come out with a policy statement on the various exemptions, including a white paper on the period by which they will be phased out. There's no point industry just relying on speculation which brings additional uncertainty.

What can be done to reduce the disputes the IT department is in? Cases take decades to decide.

The government needs to look at the repeated disputes taking place and come out with a solution. Take the dispute on whether software payments to foreign firms are royalty. If they do qualify as royalty, a withholding tax of 10 per cent can be levied. If however, this is treated like any other import, no tax then needs to be paid. In many cases the Tax Tribunal has now consistently held that such payments are not taxable as royalty. Why not then clarify this?

Payments to foreign companies for satellite connectivity is another area of dispute. The taxman considers it as royalty and so a 10 per cent withholding tax needs to be paid. This is in spite of the fact that the Supreme Court in a sales tax case has held that such contracts are essentially services contracts on which no right to use is granted to the service recipient.

But how can the government legislate? The tribunal may have decided in a particular case, but the Supreme Court can decide it the other way.

That's the point "" half the disputes relate to the taxman appealing against decisions of the tribunal/court that have gone against him. Take the example of software decisions rendered by the tax tribunal.

The tribunal has extensively gone into the merits of the case and decided in favour of the taxpayer not only in one but a number of cases. The tribunal has relied on many Indian and foreign court rulings, and their decisions are in consonance with international tax commentaries on the subject. Even after all this, it continues to be litigated.

What is the dispute over transfer pricing?

If firm 'A' imports a gearbox, say, from its parent company, then under the transfer pricing regulations, the firm has to substantiate that this is the arms length international price. The taxman generally accepts profit margins as the most appropriate basis for this.

Let's say there are three firms, A, B, and C, of which only 'A' has dealings with its international parent. Now, let's say 'A' has a profit margin of 5 per cent while 'B' has a 10 per cent margin and 'C' 14 per cent. So, the taxman can say that the profits of 'A' have been lowered by the parent charging more, and can simply say the profit should be 12 per cent (the average of profits of the other two firms) and charge tax on the difference without appreciating the economic realities of individual businesses.

There could be a number of reasons for profitability being different. The firms can have different business models, they can be in different expansion cycles (if 'A' is expanding, and has higher depreciation, it will have lower profits even if its transfer price is at an arm's length).

Transfer pricing is a contentious issue the world over, not just here. How does the US resolve this?

It is contentious. But there are ways to make it less so. In other countries, for instance, you don't look at the arithmetic mean profit rate since outliers (comparables) unduly influence this average, but accept the median and interquartile range. Instead of just looking at the profit numbers, more focus is on economics that affect the business. After all, transfer pricing is not an exact science.