Finance Bill 2015

Amendments – International Taxation

1. Introduction

Certain amendments were proposed in Finance Bill 2015 in the area of International Taxation.These proposals require some interesting discussion. Our economy is resilient to the economic downturn being faced globally. At this juncture it is very critical to restore Non-resident investor’s sentiment and confidence on India as an attractive investment destination. In this endeavour, rationalising some of the existing provisions in the Income Tax law seems to be very imperative.

In this direction Hon’ble Finance Minister brought clarity to taxation of indirect transfers under section 9(1)(i), reduced tax rate u/s. 115A and laid down the concept of “Place Of Effective Management” (POEM) for deciding residency of foreign companies. It is also a welcome proposal of increasing the basic threshold for application of domestic transfer pricing provisions from
Rs. 5 crores to Rs. 20 crores

We shall discuss these amendments which are effective from A.Y. 2016-17 in the following paragraphs of this article.

2. Sec. 6(1) – Residency of an individual

An Explanation has been inserted to clause (1) of sec. 6 to provide that in the case of individual being a citizen of India and who is a member of the crew of a foreign bound ship leaving India, the period or periods of stay in India shall, in respect of such voyage, be determined in the manner and subject to such conditions as may be prescribed.

Sec. 6 (3) – POEM for company

New sub-section 3 has been substituted which reads as under:

A company is said to be resident in India in any previous year, if, —

(i) It is an Indian company; or

(ii) Its place of effective management, at any time in that year, is in India.

An Indian company is always regarded as resident of India. As per the existing provisions, a non Indian company becomes resident of India only when during the year the control and management of its affairs is situated wholly in India. The proposal provides that a non- Indian company becomes a resident of India if its place of effective management, at any time in that year, is in India. Thereafter an Explanation is inserted to provide that POEM means a place where key management and commercial decisions that are necessary for the conduct of the business of an entity, as a whole are, in substance made.

Memorandum explaining the provisions observes that due to the requirement that whole of control and management to be situated in India, that too whole of the year, the company can easily avoid becoming a resident by simply holding a board meeting outside India. This facilitates creation of shell companies which are incorporated outside but controlled from India.

In view of the same it was proposed to introduce POEM which is an internationally well accepted concept. It is proposed in due course, a set of guiding principles to be followed in determination of the POEM, which is a fact dependent exercise, would be issued for the benefit of the tax-payers as well as tax administration.

2.1 The proposed amendment is intended to neutralise the decisions in the cases of Radharani Holdings (P) Ltd. v. Addl. CIT 110 TTJ 920 (Del), Sarswati Holdings corporation Inc. (2007) 16 SOT 535 (Del), Narottam & Pereira Ltd v. CIT [TS-10-HC-1953(Bom.)] The proposed amendment targets only few concerns of the revenue which are genuine but in the process results in unintended hardship whereby foreign companies with legitimate commercial operations outside India may end up being treated as resident of India on account of this rule by a stray incident of a board member of such company being present in India and participating in the board meeting through video conferencing. There could be many such practical situations where foreign companies with genuine activity outside India may end up becoming residents of India under this rule.

“At any time in that year” wording in the proposed amendment creates all the difficulty, as a foreign company may become resident by a stray incident ignoring its overall affairs throughout the year. In other words POEM is to be determined on the basis of evaluating the affairs of a company for the whole of the year and not for a part or fraction of the year.

“Effective management” has to be determined on the basis of looking at the whole year and not at stray incidents occurring during such year. This proposal is in conflict with OECD/UN approach for determination of POEM. OECD/UN commentaries give guidance as to how POEM is to be determined. POEM rule is applied as a tie breaker rule in determining residence of a non-individual i.e. a company etc.

2.3 OECD/UN Commentary gives some guidance in the form of the following criteria for determining POEM:

• Where the meetings of its board of directors or equivalent body are usually held

• Where the chief executive officer and other senior executives usually carry on their activities

• Where the senior day-to-day management of the person is carried on

• Where the person’s headquarters are located

• Which country’s laws govern the legal status of the person

• Where its accounting records are kept

2.4 It is very apparent that the proposed amendment which is supposed to be in line with the OECD/UN POEM principle in real is in conflict with the same. These apprehensions of the industry have been ventilated to the Government through various post budget meetings with Government officials in the Ministry of Finance. It was promised that CBDT would soon come out with guidelines and clarifications to address these concerns.

3.0 Sections 9 & 9A – Indirect transfers and location of fund managers

Vodafone judgment delivered by the
Apex Court in early 2012 (341 ITR 1) in respect of indirect transfers was neutralised by the Government by bringing retrospective amendment to Section 9(1)(i) through Finance Act, 2012. This amendment was widely protested by the foreign investor community for its retrospective nature and lack of clarity to certain terms such as “substantially from the assets located in India “and as to the quantum of gains that is to be taxed in India. Consequently Parthasarathy Shome Committee was set up to go into these aspects and come out with its recommendations on several issues including indirect transfers. On the basis of these recommendations, an amendment is proposed to section 9(1)(i) to bring clarity relating to indirect transfers. Some of the important changes are to clarify as to what is meant by the term ‘Value substantially from the assets located in India’ and the quantum of gains to be taxed in India in such transfers.

3.1 The word ‘substantial’ is proposed to be meant as an absolute value exceeding
Rs. 10 crores and representing at least 50 per cent of the value of all the assets owned by the company or entity. In other words, the assets located in India should represent at least 50 per cent of the value of all assets of the company or entity as may be and such value should exceed the amount of
Rs. 10 crores.

In respect of quantum of gains to be taxed in India, it is clarified that only such part of the income as is reasonably attributable to assets located in India and determined in such manner as may be prescribed.

The specified date for valuation is the date on which the accounting period of the company or, as the case may be, the entity ends preceding the date of transfer of a share or an interest. If the book value of the assets of the company, or the entity on the date of transfer exceeds the books value of assets as on the date referred to above by 15 per cent, then the date of transfer is considered as the date of valuation.

Exception has been prescribed with respect to transfer of interest of stakeholders not exceeding 5 per cent of the total voting power or total share capital or total interest of such company or entity from application of these provisions.

The proposed amendment confirms the ratio laid down by Hon’ble Delhi High Court in the case of Copal Research Ltd. (2014) 49 taxmann.com 125 wherein it was held that the term ‘substantially from assets located in India’ means equal to or more than 50 per cent of the total assets of the entity.

CBDT vide Circular No. 4 of 2015 dated 26th March, 2015 clarified as under:

Declaration of dividend by such a foreign company outside India does not have the effect of transfer of any underlying assets located in India. It is therefore, clarified that the dividends declared and paid by a foreign company outside India in respect of shares which derive their value substantially from assets situated in India would not be deemed to be income accruing or arising in India by virtue of the provisions of Explanation 5 to section 9(1)(i) of the Act.

3.2 New section 9A was inserted in respect of Offshore Funds and the issue of business connection arising out of location of their Fund Managers in India. The existing tax treatment provides that such offshore fund would become resident in India if the fund manager is located in India. On account of this rule most of the fund managers of various offshore funds were located outside India.

In order to facilitate location of Fund Managers of offshore funds in India without triggering business connection of such funds in India, a new regime is proposed through sec. 9A. Certain conditions have been prescribed to be fulfilled by the offshore funds and the Fund Managers respectively in order to avoid business connection in India.

This is a welcome proposal to facilitate and streamline offshore funds business in India.

4. Section 115A and Section 195

Section 115A was introduced by Finance Act 1976 and the rate of taxation of royalty and FTS has been 10 per cent. An amendment was brought in through Finance Act, 2013 to increase the rate of taxation of royalty and FTS received by a foreign company from a resident taxpayer from 10 per cent to 25 per cent. Hon’ble Finance Minister clarified the purpose of increase of rate of taxation in his budget speech as under:

“Another case is the distribution of profits by a subsidiary to a foreign parent company in the form of royalty. Besides, the rate of tax on royalty in the Income-tax Act is lower than the rates provided in a number of Double Tax Avoidance Agreements. This is an anomaly that must be corrected. Hence, I propose to increase the rate of tax on payments by way of royalty and fees for technical services to non-residents from 10 per cent to 25 per cent. However, the applicable rate will be the rate of tax stipulated in the DTAA”.

It was assumed that distribution of profits by subsidiaries to their foreign parents was being done in the form of royalty payments. However, all cases may not fall into the said category as there could be payments from resident payer to non-resident payee who are not related in any manner. All such genuine cases suffered from high rate of taxation of 25 per cent. Most of the service recipients in India are not able to bargain in a manner that non-resident payees will have to bear the tax burden. On account of this, most of the resident payers have to bear the tax burden and are thereby forced to gross up such taxes under sec. 195A of the Act. The effective tax rate in all grossing up cases is as high as 36.65 per cent.

4.1 Hon’ble Finance Minister restored the earlier rate of ten per cent taxation against royalty and FTS through the Finance Bill, 2015 and observed

“Today I see a lot of young entrepreneurs running business ventures or wanting to start new ones. They need latest technology. Therefore, to facilitate technology inflow to small businesses at low costs, I propose to reduce the rate of income tax on royalty and fees for technical services from 25% to 10%”.

The cost escalation in genuine cases has been appreciated as is evident from the above observations of the Hon’ble Minister. This rate aligns with some of the rates incorporated in DTAAs India entered into.

4.2 However, it is imperative to discuss the incompatibility between the provisions of sec.195A and provisions of sec.206AA in cases where a non resident payee does not have a PAN in India.

Section 206AA reads as under (relevant portion only):

“(1) Notwithstanding anything contained in any other provisions of this Act, any person entitled to receive any sum or income or amount, on which tax is deductible under Chapter XVII-B (hereafter referred to as deductee) shall furnish his Permanent Account Number to the person responsible for deducting such tax (hereafter referred to as deductor), failing which tax shall be deducted at the higher of the following rates, namely:—

(i) At the rate specified in the relevant provision of this Act; or

(ii) At the rate or rates in force; or

(iii) At the rate of twenty per cent……”

Section 195A reads as under:

“In a case other than that referred to in sub-section (1A) of section 192, where under an agreement or other arrangement, the tax chargeable on any income referred to in the foregoing provisions of this Chapter is to be borne by the person by whom the income is payable, then, for the purposes of deduction of tax under those provisions such income shall be increased to such amount as would, after deduction of tax thereon at the rates in force for the financial year in which such income is payable, be equal to the net amount payable under such agreement or arrangement.”

It is evident from the text of section 195A that it refers to foregoing provisions of Chapter XVII B and it also refers to the “rates in force” for the purpose of grossing up. Section 206AA is not a section preceding sec. 195A . Accordingly, it is only “rates in force” which are applied for withholding of taxes that are to be considered even for grossing up purpose under section 195A. An issue would arise when provisions of sec.206AA are to be applied to a payment made to a non resident by withholding taxes at higher rate of 20 per cent, whether grossing up is to be done at the same rate of 20 per cent or as per the “rates in force” referred in section 195A. It is clear through plain reading of definition of “rates in force” as per Sec. 2(37A)(iii) that rate prescribed in setion 206AA is not to be treated as “rate in force”.

4.3 In this context it is pertinent to consult the decision of the Hon’ble Bengaluru ITAT in the case of
Bosch Ltd v. ITO (International Taxation) (2013) 141 ITD 38 wherein it was held as under:

“…In the circumstances, the recipients are bound and are under an obligation to obtain the PAN and furnish the same to the assessee. For failure to do so, the assessee is liable to withhold tax at the higher of rates prescribed u/s. 206AA of the Income-tax Act, i.e., 20% and the CIT(A) has rightly held that the provision of section 206AA are applicable to the assessee….

Thus, it can be seen that the income shall be increased to such amount as would after deduction of tax thereto at the rate in force for the financial year in which such income is payable, be equal to the net amount payable under such agreement or arrangement. A literal reading of section implies that the income should be increased at the rates in force for the financial years and not the rates at which the tax is to be withheld by the assessee. The Hon’ble Apex Court in the case of GE India Technology Center (P.) Ltd. v. CIT [2010] 327 ITR 456/193 Taxman 234/7 taxmann.com 18 has held that the meaning and effect has to be given to the expression used in the section and while interpreting a section, one has to give weightage to every word used in that section. In view of the same, we are of the opinion that the grossing up of the amount is to be done at the rates in force for the financial year in which such income is payable and not at 20% as specified u/s. 206AA of the Act.”

This creates an incompatible situation whereby you withhold taxes as per Sec.206AA at 20 per cent where the non-resident payee does not have PAN but the grossing up has to be done as per the rates of DTAA or section. 115A whichever are beneficial, say at 10 per cent for example, for the purpose of section 195A. It is to be noted that this approach of adopting two different rates one for withholding of taxes and one for grossing up where the payer has to bear the tax creates an inconsistent outcome of not achieving the purport of Sec.195A. In other words, the resultant amount to be paid to a non resident payee would not be equal to the net amount payable under an agreement or arrangement entered into between the payer and the payee. Simple example is illustrated for easy understanding as under:

Royalty payable : 2,00,000
Rates in force : 10 per cent
Grossed up royalty : 2,22,222
WHT @ 20 per cent : 44,444
Per Sec.206AA
Net amount payable : 1,77,778

This will end up payer not meeting the agreement of paying Rs. 2,00,000 net of taxes to the payee. Therefore, in order to effectively pay
Rs. 2,00,000 net of taxes to the payee as royalty the payer should either adopt the same rate of 20 per cent or 10 per cent both for withholding as well as for grossing up purposes. Otherwise, it would not work.

4.4 There has been a basic issue whether provisions of section 206AA override the provisions of DTAA. Many scholars opined that Sec. 206AA cannot override the provisions of DTAA. Contrary view is that section 206AA is procedural in nature whereby a non-resident has to suffer higher withholding taxes in the absence of PAN who is entitled to be governed by beneficial rates of tax as per DTAA in the assessment and claim refund of excess taxes withheld. However, in order to file a tax return non-resident has to obtain PAN.

In this context it is pertinent to consult the recent ruling of Hon’ble ITAT Pune Bench in the case of
DDIT v Serum Institute of India Ltd. ITA Nos. 1601 to 1604/PN/2014 wherein it was held that Sec. 206AA of the Act does not override provisions of section 90(2) of the Act. In other words, section 206AA cannot override the provisions of DTAA. The operative portion of the judgment reads as under:

“Thus, where section 90(2) of the Act provides that DTAAs override domestic law in cases where the provisions of DTAAs are more beneficial to the assessee and the same also overrides the charging sections 4 and 5 of the Act which, in turn, override the DTAAs provisions especially section 206AA of the Act which is the controversy before us. Therefore, in our view, where the tax has been deducted on the strength of the beneficial provisions of section DTAAs, the provisions of section 206AA of the Act cannot be invoked by the Assessing Officer to insist on the tax deduction @ 20%, having regard to the overriding nature of the provisions of section 90(2) of the Act. The CIT(A), in our view, correctly inferred that section 206AA of the Act does not override the provisions of section 90(2) of the Act and that in the impugned cases of payments made to non-residents, assessee correctly applied the rate of tax prescribed under the DTAAs and not as per section 206AA of the Act because the provisions of the DTAAs was more beneficial. Thus, we hereby affirm the ultimate conclusion of the CIT(A) in deleting the tax demand relatable to difference between 20% and the actual tax rate on which tax was deducted by the assessee in terms of the relevant DTAAs. As a consequence, Revenue fails in its appeals.”

4.5 In view of the above controversy it is desirable that a suitable amendment is to be proposed that in cases of grossing up under section 195A, provisions of section 206AA are not to be applied. In the light of recent Hon’ble ITAT Pune bench decision as explained above, it is also desirable to clarify that provisions of section 206AA do not override the provisions of section 90(2).

4.6 Section 195(6) and section 271-I: It is proposed to substitute sub-section (6) of section 195 with new text. The existing sub-section (6) requires a payer referred to in sub-section (1) to furnish the information relating to payment made to a Non-Resident of any sum in Form 15CA. The proposed new sub-section (6) provides for furnishing of information whether or not such remittances are chargeable to tax, in such form and manner, as may be prescribed.

New section 271-I has been inserted to provide for a penalty of
Rs. 1 Lakh if the person required to furnish information under section 195 fails to furnish such information or furnishes inaccurate information. It is to be noted that there was no provision for such penalty under the existing sub section.

These two amendments are effective from 1st June, 2015.

5. Domestic Transfer Pricing – Specified Domestic Transactions – Section 92BA

Hon’ble Supreme Court made an observation in the case of
CIT v. GlaxoSmithKline Asia (P.) Ltd. 2010 195 Taxman 35(SC) that even in respect of transactions with related parties in the domestic field which an assessee enters into, it is desirable that such transactions be benchmarked in a scientific manner as per Transfer Pricing Regulations (TPR) which was hitherto applicable only to International Transactions with Associated Enterprises. In response to such observation, the Govt. readily brought in an amendment with effect from A.Y. 2013-14 that “Specified Domestic Transactions” (SDT) are covered by TPR. Accordingly, section 92BA has been inserted in the statute book making it applicable to those assessees having SDTs of value more than
Rs. 5 crores.

In view of this amendment, every assessee irrespective of it’s status, is under an obligation to comply with this requirement of maintaining documentation and obtaining a certificate in Form 3CEB from an Accountant if the SDT value is more than
Rs. 5 crores. This has created compliance burden even on smallassessees.

5.1 In order to address the issue of compliance cost in case of small businesses on account of low threshold of
Rs. 5 crores, it is proposed to amend Sec.92BA by increasing the threshold of SDTs to
Rs. 20 crores. In other words, only when the value of the aggregate of Specified Transactions entered into by the assessee in the previous year exceeds a sum of
Rs. 20 crores, the same are to be treated as SDT. This is a welcome proposal.

5.2 Circular 6-P dated 6th July, 1968 issued by CBDT at the time when section 40A(2) was introduced clarified that provisions of this section would apply only in case where there is a tax leakage and would not apply to revenue neutral transactions. Said circular is not withdrawn and is available for the benefit of the assessee even as of now. Unlike international transfer pricing wherein Associated Enterprises are located in two different tax jurisdictions, Domestic Transfer Pricing is concerned with related party transactions wherein both parties are residents of India. In view of the same, there would not be any tax leakage as both parties are residents of India unless, the transactions are between loss making and profit making entities or between tax holiday and non–tax holiday units of the same assessee. If an adjustment is made in the hands of an assessee who incurred expenditure on a related party, on the premise that the expenditure is excessive, there must be a corresponding adjustment in the hands of such related party by reducing his income to avoid double taxation.

5.3 As of now, no such provision of corresponding adjustment is available on account of which it would result in economic double taxation. Circular 6-P dated 6th July 1968 which is still in force clearly covers such situations and provides for avoidance of double taxation. It is desirable to provide such corresponding adjustment through an explicit amendment to the existing section 92BA.

5.4 Another vexed issue is in respect of Director’s Remuneration which is to be benchmarked so as to demonstrate that such payment is at Arm’s Length. Remuneration to a director is based on his/her experience, technical qualifications and other professional parameters. There cannot be any thumb rule or a benchmark for the same. However, Company Law has got inbuilt provisions to ensure that proper approvals and sanctions are granted by the Board of Directors and by the members at the General Meeting. Such procedure by itself establishes the Arm’s Length Principle in respect of payments to directors. It is found practically difficult to apply any method for benchmarking payments of remuneration to the directors. In view of the same, it is desirable that the item “Director’s Remuneration” be excluded from the definition of SDT under the provisions of section 92BA.

6. Conclusion

It is evident that amendments proposed under respective provisions concerning International Taxation deserve some more modifications as discussed above. Professional bodies should canvas through Post Budget Memorandum in respect of modifications discussed. I am thankful to AIFTP for giving me an opportunity of writing this article.

CA. PVSS Prasad