by Shashwat Sharma & Mansi Seth, Nishith Desai Associates
The Indian tax landscape changed significantly for multinationals in 2017 with the adoption of new laws incorporating the OECD/G20 base erosion profit shifting (BEPS) plan agenda and the government’s issuance of a series of circulars on controversial topics such as the general anti-avoidance rule (GAAR) and Indian tax residence.
The Indian courts also made their mark in 2017, particularly in the area of when a foreign firm has a permanent establishment (PE) in India.
GAAR implementation
One of the most significant developments in 2017 was the coming into force of the GAAR from April 1, 2017.
These provisions, originally introduced in the Income Tax Act, 1961 (ITA) by the Finance Act, 2012, confer unprecedented broad powers to the tax authorities to deny tax benefits, including tax benefits applicable under tax treaties, if the tax benefits arise from arrangements that are ‘impermissible avoidance arrangements.’
India’s Central Board of Direct Taxes (CBDT) on January 27, 2017, released a circular clarifying the GAAR after considering the submissions of a working group which took into account public comments.
Through the GAAR circular, the CBDT expressed its view that GAAR provisions may still be invoked in cases which there exist special anti-avoidance rules (SAARs) or where arrangements are covered under India’s double taxation avoidance agreement with a limitation on benefits (LOB) clause.
The CBDT said special anti-avoidance rules and LOB provisions are inadequate to address all situations of tax abuse.
Further, the CBDT declined requests to clarify that GAAR provisions should not apply in case of long standing structures.
Also, in a disappointing move, the CBDT has stopped short of fully exempting court-sanctioned mergers/ demergers from the ambit of GAAR by adding a caveat that only where the tax implications of such an arrangement have been “explicitly and adequately” considered by the courts will GAAR not be applicable. Use of such ambiguous language does not dispel the uncertainty faced by taxpayers.
Corresponding adjustments in the hands of other participants in an arrangement/transaction with a taxpayer which is declared as an impermissible avoidance arrangement have also been denied by the CBDT.
However, the GAAR circular did include certain positive clarifications, as well. For instance, the CBDT expressly mentioned that where a foreign portfolio investor is located in a jurisdiction because of commercial reasons (i.e., for non-tax reasons), and the main purpose of the particular choice of location/residence of the investor is not to obtain a benefit of a tax treaty, the tax authorities should not invoke the GAAR provisions.
Also, the benefit of grandfathering of investments was extended to shares which result from the conversion of any compulsorily convertible instruments which were acquired prior to April 1, 2017, as well as shares which result from any split or consolidation of share capital or bonus issue.
While the GAAR circular sheds some light on how the CBDT intends to apply the GAAR provisions, the use of ambiguous and open-ended language creates a persisting lack of clarity on the practical implementation of these provisions.
This uncertainty is compounded by the signing of the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (MLI) by India, discussed later in this article.
POEM implementation
Historically, a foreign company was regarded as a tax resident of India only if it was “wholly controlled and managed” in India.
This was also the position under the old Income Tax Act, 1922 and, hence, by the year 2015, this position had been in place for around 100 years.
By virtue of being an objective test, this provision was the subject of minimal tax litigation despite being in place for such a long time. This resulted in predictability for non-resident taxpayers.
However, the Finance Act, 2015 amended Section 6(3) to replace this test of corporate residence with a new test which provides that a foreign company will be a tax resident of India if its place of effective management (POEM) is found to be situated in India.
Thus, a long-standing objective test was replaced with a new subjective test for which no judicial guidance exists as of date, causing considerable concern among the taxpayers and practitioners alike. The application of this provision was deferred to April 1, 2017.
In 2017 the CBDT issued multiple circulars regarding the application of the POEM test. The final revised guidelines on the new test were released on January 24, 2017.
Shortly thereafter, the CBDT clarified that the POEM test shall not apply to a company having turnover or gross receipts of INR 500 million or less (approx. USD 7.72 million) in a financial year.
The determination of POEM of each taxpayer is a fact specific exercise and must be undertaken for each year. The POEM guidelines are based on a differentiation between foreign companies that carry on an “active business outside India” and those that do not (passive companies).
A company is considered to have an “active business outside India” if (i) its passive income is less than 50% of its total income, (ii) less than 50% of its assets are situated in India, (iii) less than 50% of its employees are situated in India, and (iv) payroll expenses incurred on such employees comprise less than 50% of its total payroll expenses.
A foreign company which is unable to meet the above conditions is considered to be a passive foreign company. The average of the data of the previous year and two years prior to that is taken into account to determine whether a company is engaged in active business outside India.
The POEM guidelines presume that foreign companies that carry on an “active business outside India” have their POEM outside India as long as the majority of the board meetings take place outside India.
This is, however, a rebuttable presumption and is subject to the active exercise of powers of management by their respective board of directors. If the board of directors of any foreign company having an active business outside India is found to be “standing aside” in favour of any India resident person, the POEM of such a company may be considered to be in India.
For passive foreign companies, the determination of POEM involves two stages. The first stage involves the identification of persons who make the key management and commercial decisions of the company’s business while the second stage involves the determination of the place from where these decisions are made.
Significantly, the CBDT has not ruled out the applicability of GAAR provisions in cases where a foreign company meets the test to be considered a non-resident of India. Such a use of the GAAR provisions would be extremely unfair to taxpayers and may have a massive negative impact on investor sentiment if it comes to pass.
Notwithstanding the CBDT clarifications, the POEM test continues to be fraught with uncertainty as to its application.
Despite requests to rethink the idea of replacing the old test of residence for body corporates, the Indian government is firm on the issue of introducing the POEM test and has quoted the existence of the POEM test as a tie-breaker rule in some of India’s tax treaties to argue that this test is the international standard. From next year onwards, we may see the issue of tax residence, a fundamental question for any taxpayer, come up in tax litigation matters.
Thin-capitalization rules
It has been experienced across the globe that the capital structure of companies is often artificially designed with excessive debt which are generally deductible (as opposed to dividends).
As a result, there is an incentive to upstream profits in the form of interest payments. BEPS action plan 4: Limiting Base Erosion Involving Interest Deductions and Other Financial Payments is designed to check this distortion.
In India there is an added incentive to thinly capitalize companies, as in India a company has to pay an approximate 20% dividend distribution tax at the time of distributing profits to its shareholders. Since this is a corporate level tax, non-resident shareholders are often unable to get a tax credit in their country of residence against the tax.
The Finance Act, 2017 introduced thin-capitalization rules for the first time in India to check such distortions. These new rules provide that where an Indian company or permanent establishment (PE) of a foreign company makes interest payments (or similar consideration) to its associated enterprise such interest shall not be deductible at the hands of the Indian company/PE to the extent it is in the nature of “excess interest,”
Excess interest is defined as an amount of interest that exceeds 30% of the earnings before interest, taxes, depreciation and amortization (EBITDA) of the Indian company/PE. These provisions are not applicable to interest payments which are lower than INR 10 million (approx. USD 150,000).
Since the term “associated enterprise” is broadly defined under the transfer pricing provisions of the ITA, these rules also apply to third party lenders whose loan constitutes more than 51% of the total book value of assets of a company.
While carry forward of interest expenditure for next eight assessment years has been allowed, such interest would be deductible from a company’s income only to the extent of 30% of EBITDA.
Also, as previously discussed, the GAAR circular does not rule out the application of GAAR even in cases where a SAAR is available.
Therefore, while the thin-capitalization rules should be sufficient to prevent excessive shifting of profits through interest payments, it is possible that GAAR may also be invoked against taxpayers with the tax authorities choosing to exercise the wide powers available to them under GAAR to treat debt as equity, etc.
Anti-abuse rules and transfers below fair market value
Finance Act, 2017 also expanded the scope of anti-abuse rules which are designed to capture within the tax net transactions undertaken at a price below fair market value.
Under the new provision, listed companies and other recipients become subject to these anti-abuse rules, which tax the difference between purchase price and fair market value in the hands of the recipient.
Since the tax laws of most countries do not include a similar provision for taxing the recipient or acquirer of assets below fair market value, non-resident taxpayers who are not able to obtain treaty relief may be unable to claim foreign tax credits for such taxes in their countries of residence.
This could prevent non-resident investors from participating in distress sales of assets by Indian companies where book value has gone down.
Taxation of indirect transfers
On December 21, 2016, the CBDT had released a circular to provide responses to certain questions raised by stakeholders, particularly the venture capital and private equity industry.
However, this circular was widely regarded as regressive and impractical as the CBDT insisted on a strict interpretation of the provisions. Based on this feedback, the CBDT issued a press release in January 2017 to keep this circular in abeyance.
Subsequently, Finance Act, 2017 specifically exempted Category I and Category II foreign portfolio investors from the purview of India’s indirect transfer provisions. However, Category III foreign portfolio investors, along with other offshore funds, continued to face uncertainty with respect to taxation of any redemption and buy-back of their units/ shares.
On November 07, 2017, the CBDT issued a new circular to provide further clarity regarding the application of the indirect transfer provisions to multi-tier structures.
Certain investment funds which enjoy a tax pass-through status under the ITA (i.e., the investors of these funds are subject to tax as if they had directly invested in the portfolio companies of such funds) have been defined as “specified funds” in the new circular.
The circular states that the indirect transfer provisions shall not apply in respect of gains arising to a non-resident taxpayer on account of redemption or buyback of its share or interest held indirectly in a specified fund if 1.) such income accrues from or in consequence of transfer of shares or securities held in India by the Specified Fund; and 2.) such income is chargeable to tax in India.
While the 2017 circular brings relief for investors who invest through a unified structure, it does not cover offshore funds investing directly into India.
Also, while the circular is prospective in its application, the provisions related to indirect transfers have themselves been made effective with retrospective effect.
Further, confusion has been created through the use of the words “chargeable to tax,” as often funds are structured in a manner which enables them to get tax treaty relief and no tax may be payable in India in such cases.
While the CBDT has shown flexibility and a willingness to pay heed to stakeholders’ concerns in the 2017 circular, due to its ambiguous wording and limited scope, this circular also does not fully address the concerns of the taxpayers.
As a result, 2017 ends with the specter of indirect transfer provisions still haunting non-resident investors.
Secondary adjustments in transfer pricing
The Finance Act, 2017 also introduced a new concept of secondary adjustment to the Indian transfer pricing regime. Before this amendment, there were two kinds of adjustments in transfer pricing matters in India: 1.) primary adjustment of income in the hands of an Indian company/ Indian PE of a foreign company to add profits or disallow loss; and 2.) corresponding adjustment in the hands of the AE of the Indian company/PE to deduct the profits attributed to the Indian company/PE.
To remove the imbalance between the accounts of the Indian company and the actual profits earned by it, a third adjustment referred to as a secondary adjustment has been added where profits are actually allocated between an Indian company and its associated enterprise.
Any excess money which was paid by an Indian company to its offshore associated enterprise (as determined during the primary adjustment as the difference between the arm’s length price and the actual consideration paid) is required to be paid back to the Indian company within a prescribed time.
If excess consideration is not repatriated within such time, such consideration is deemed to be an advance paid by Indian company to the associated enterprise on which interest is payable.
The introduction of secondary adjustments in the Indian transfer pricing regime makes it even more important for taxpayers to arrive at an arm’s length price/interest rate with care. Due regard should be paid to the market practice/ industry standard as now primary adjustments will lead to an obligation on non-resident associated enterprises to repatriate profits to India within a prescribed time frame.
PE rulings
2017 has borne witness to two important Supreme Court of India judgments in relation to the existence of a PE in India.
In April 2017, the Supreme Court in the case of Formula One World Championship Ltd. v. Commissioner of Income-tax held that the Buddh International Circuit, Greater Noida, Uttar Pradesh, should be construed as a fixed place PE of Formula One World Championship Limited, a UK based company for the purposes of the India-UK tax treaty.
Since the India-UK tax treaty follows the OECD Model Convention, the Supreme Court referred to the OECD’s commentary to its Model Convention, along with Convention commentaries written by Philip Baker and Klaus Vogel, to arrive at its conclusion that a fixed place would constitute a PE of a non-resident only when such fixed place was “at the disposal” of that non-resident.
A fixed place would be treated as being “at the disposal” of a non-resident enterprise when that enterprise has right to use the place directly and has control over the place. In the instant case, from an analysis of the flow of commercial rights, the Supreme Court came to a conclusion that the taxpayer had the place of business, i.e., the racing circuit, at its disposal and hence, it amounted to a fixed place PE.
Subsequently, in October, the Supreme Court referred to its above judgement to give relief to the taxpayer in the case of Assistant Director of Income-tax-1, New Delhi v. E-Funds IT Solution Inc.
This case involved the question of the determination of a fixed place PE and a service PE in India of two US based companies, e-Funds Corporation and e-Funds IT Solutions Group Inc.
The two companies entered into contracts with offshore clients for the provision of IT enabled services (ITES) and sub-contracted or assigned the same to an Indian group company, e-Funds International India Private Limited (E-Funds India).
Relying upon its own judgement in the Formula One case, the Supreme Court held that a fixed place PE could only come into existence when it was at the disposal and under the control of the non-resident taxpayer. In the instant case, the two US based companies had no control over the physical premises of E-Funds India.
The Supreme Court reiterated that the mere fact that a subsidiary of a foreign parent carries on business in India does not by itself create a PE of that foreign parent in India. It was held that the assignment of a contract or sub-contracting and provision of intangible software free of cost were not relevant for the creation of a PE. The fact that foreign companies may choose to lower costs by shifting business to an Indian subsidiary was also held to not by itself create a fixed place PE.
With respect to the question of service PE, the Supreme Court held that since none of the clients were located in India, services had not been furnished “within India,” which was an essential ingredient for a service PE. Further, E-Funds India only provided auxiliary services to facilitate the provision of ITES by the two US based companies to offshore clients and hence, no service PE within the meaning of the India-US tax treaty could come into existence.
These judicial pronouncements of the Supreme Court have brought India’s legal position with respect to PEs in line with the international standards set by OECD.
Google AdWords ruling – break from precedents
Google offers an online advertising service called Google AdWords where advertisers pay to display text-search base ads, graphic ads, and video content within the Google ad network to internet users.
The program uses the keywords to place advertisements on pages they might be most relevant according to Google. Advertisers only pay when users divert their browsing to click on an advertisement. Google India received an adverse ruling from the Income Tax Appellate Tribunal where payments made by Google India Private Limited to Google Ireland Limited for purchase of advertisement space on Google AdWords were characterized as royalties instead of business income. Google India provides IT services and ITES to Google Ireland under a service agreement while also acting as a distributor for Google AdWords in India under a separate distribution agreement.
The Tribunal considered both the above-mentioned agreements together to come to a conclusion that there was utilization of intellectual property of Google Ireland by Google India and hence, classified the income of Google Ireland as being in the nature of “royalty,’
This reading of the two agreements together is unusual and an aggressive move by the Tribunal but may become more common as GAAR has now come into force. This ruling is a break from past precedents where the Indian courts have generally held payments for advertisements to be in the nature of business income which were not taxable in India unless there existed an Indian PE of the non-resident taxpayer.
The Tribunal also did not follow the views of the OECD Technical Advisory Group and the CBDT’s high powered Committee on this point. This judgment is of serious import for non-resident taxpayers as utilization of intellectual property by Indian group companies is a fairly common practice. This ruling could, however, be reversed on appeal by higher courts as Google India has announced its intention to challenge the same.
India and MLI
The BEPS action 6 requires tax treaties to include as a minimum standard any one of the following tests to prevent treaty abuse: 1.) A simplified or detailed LOB combined and supplemented by a principal purpose test (PPT); or 2.) The PPT only; or 3.) A detailed LOB along with a mechanism to deal with conduit financing arrangements not already included in tax treaties.
This has been enshrined under Article 7 of the MLI which offers this option to the parties with the PPT being the default test. India is one of only twelve countries which have chosen to apply a simplified LOB along with a PPT in their notified tax treaties.
Since very few countries have chosen this option, it is more likely that only a PPT will apply to India’s covered tax treaties as most of India’s treaty partners have not allowed an asymmetric application of a simplified LOB. Further, India has not made any reservation to negotiate a detailed LOB with treaty partners which have not opted for a simplified LOB.
It will also be interesting to see the interplay of MLI with India’s GAAR provisions. While obtaining a tax benefit has to be the main purpose of the arrangement for it to qualify as an impermissible tax avoidance arrangement under the GAAR provisions, a lower threshold has been provided under the MLI (one of the main or principal purpose).
This increases the risk posed to non-resident investors and may be the subject of tax litigation in the future.
Conclusions
In 2017, India seems to have made some strides towards bringing its tax laws in harmony with the BEPS agenda. This is evident from the signing of the MLI and the introduction of the thin-capitalization rules.
True to this government’s promise, we have not seen any retrospective amendments being passed and a genuine attempt to respond to investor and taxpayer concerns is apparent in the manner in which the CBDT has issued new circulars on a diverse range of subjects to clarify issues and remove uncertainty.
However, many of these attempts have not been very successful due to the use of ambiguous language in the CBDT clarifications. We hope that the government will continue to demonstrate its willingness to listen to stakeholders and will pass additional amendments to the ITA as part of the Union Budget, 2018 in view of the feedback it has received from taxpayers and practitioners alike.
– Mansi Seth is US practice leader at Nishith Desai Associates, New York. Mansi can be reached at [email protected].
– Shashwat Sharma is an associate with Nishith Desai Associates in Mumbai. Shashwat can be reached at [email protected]
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