Profits flying overseas can’t escape the taxman’s net

India’s dynamic tax environment challenges investors to assess their return on investment from time to time. Rapidly changing tax laws make a compelling case for validating traditional modes of profit extraction/ repatriation from Indian company to overseas group entities, which typically included payments such as royalty, fee for technical services, dividend, buyback of shares, capital reduction, corporate guarantees, interest and so on.

In the recent past, there has been a visible change in the modus operandi of tax administrators. Enforcement with the aid of permanent account number (PAN) as a tracking tool, strengthening reporting and disclosure from taxpayers (such as remittance certificates in Form 15CB/CA), codification of laws dealing with commercial substance (such as GAAR, payment to notified jurisdictional area), and heavy penalty for defaulters testify to this change.

Repatriation requires a commercial approach, as any scheme of profit extraction is always under the taxman’s scanner. Let us examine the impact of the recent tax amendments on some of the traditional methods of profit extraction from India.

Buyback of shares by an Indian company from its parent — Indian companies with surplus cash and accumulated profits have been buying back their shares. This typically entails capital gains, which is taxable in the hands of the seller; and if India has a favourable treaty with the seller’s country of residence, such as Mauritius or Singapore, then there are no taxes payable as the treaty taxes them in the seller’s country of residence. Countries such as Mauritius and Singapore do not have capital gains.

Budget 2013 proposed 20 per cent tax on the ‘distributed income’ to shareholders through buyback, which is computed as the difference between the amount paid for buying back the unlisted shares and the consideration received by the company for issuing such shares. The tax would be discharged by the company buying back its shares. In turn, such a buyback receipt would be exempt from tax in the hands of the shareholders.

Simply put, taxability in a buyback is proposed to be moved away from the shareholder and shifted to the company, ensuring an added source of revenue for the Government.

With this proposal, the Government has imposed a flat 20 per cent tax on all such transfers, which could have been either nil or 10 per cent in the case of foreign shareholders, depending on their country of residence, and less than 20 per cent (subject to indexation benefits) for domestic shareholders.

Payment of royalty and fees for technical services (FTS) — Indian companies enter into various arrangements with overseas entities for use of brand name, software licensing, technical know-how and processes, technology collaboration and so on, for which a remuneration, more often termed as ‘royalty’, is paid. Likewise, various services are also sourced from overseas companies, for which there is FTS.

Indian companies are required to demonstrate ‘commercial expediency’ and ‘benefits derived’ for paying royalty/ FTS and undertake appropriate tax withholding to ensure their tax deductibility is not challenged.

In 2009, with the removal of the percentage limit on specified royalty payments to a foreign collaborator, Indian companies primarily need to ensure compliance with the transfer pricing (TP) regulations when making such payments outside India.

In 2010, the Government made it mandatory for non-residents to furnish PAN for a lower tax rate, either under the Income Tax Act or the tax treaty. In 2012, an additional requirement for Tax Residency Certificate (TRC) was introduced to get tax treaty benefits such as advantage of narrower treaty definition, lower rate and so on. Even the definition of ‘royalty’ in the Income Tax Act was expanded with retroactive effect. The twin conditions of PAN and TRC have made tax treaty benefit claims a challenge.

In the 2013 Budget, the Government proposed enhancing this tax on royalty and FTS from 10 per cent to 25 per cent, which is higher than the rates provided in most tax treaties with India. This proposal makes PAN and TRC an ‘absolute must’ for preferential treatment under tax treaties.

Cost allocations

Tax administrators have litigated cost allocations charged to Indian companies by their parents and associates, and considered such payments as service fees that require tax withholding in India, similar to FTS.

Taxpayers and, now, tax auditors are being closely monitored for adherence to reporting obligation. These changing tax laws are testimony to the fact that the rules of the game have changed.

The author is a Chartered Accountant