Deferring the anti-deferral tax regime

Anurag Chaturvedi

As the green shoots begin to sprout after the hard-hitting global financial crisis, the Indian financial system has also started showing signs of recovery, with a GDP growth rate of 7.9 percent in the second quarter of 2009-10. A recent survey conducted by the Reserve Bank of India (RBI) has made bullish projections for 2010-11, with a GDP growth forecast of up to a maximum of 8.8 percent. Although the numbers seem promising, India still needs to make quantum leaps of progress in various fields. India’s outbound foreign direct investment (FDI) showed an unprecedented growth in 2007. However, the figures which went as high as USD 21.4 billion in 2007-08 were pulled down to USD 18.8 billion in 2008-09 due to the global recession. For last few years, there has been news of introduction of Controlled Foreign Company (CFC) regime under the Indian Income-tax law. The legislators may justify introduction of CFC regulation as a means to counter the deferral of taxes on funds of Indian controlled foreign entities parked outside India. While the industry experts feel that the time may be right to ‘strike the iron’, one must be careful enough to see if ‘it’s hot’. What is CFC? CFC is a legal entity, generally a corporate subsidiary or an affiliate, that exists in one jurisdiction but is owned or controlled by an entity of different jurisdiction. The need for the introduction of CFC regulations arises from India’s current tax structure. Presently, companies incorporated in India are taxed on their global income, and foreign companies are taxed only on their Indian sourced income. Accordingly, foreign sourced income of overseas subsidiaries can be taxed in India only upon its repatriation to its Indian parent. Consequently, if an Indian parent routes its investments through overseas subsidiaries located in tax-favourable jurisdictions, it can ensure that earnings from such subsidiaries are retained outside India, thereby, deferring Indian tax liability that would arise upon repatriation of such earnings to India. Naturally, low-tax jurisdictions continue to be the leading destinations for India’s outward FDI. As per recent data published in the RBI Bulletin, the direction of investment proposals during July-September 2009 indicated that Singapore, Mauritius, Cyprus and Netherlands together accounted for 64 percent of the amount of proposals for outward FDI (USD 5 million and above). This situation not only results in a loss of revenue by deferral of taxes but also has an adverse impact on the foreign exchange inflows as the investments continue to flow out from India but the consequential returns from such investments do not flow back in. Introduction of CFC regulation would aim at eliminating the benefits of deferral by taxing the consolidated income of the Indian parent, whether the foreign sourced income of its overseas subsidiaries is being repatriated or not. Because of this deferment of tax due to non repatriation of profits, CFC regime is also known as ‘anti-deferral tax regime’.Implications The proponents of CFC regime firmly believe that its introduction would be consistent with the existing anti-avoidance legislations, help shore up the tax revenue collections and most importantly, compel the overseas subsidiaries to repatriate profits, thus, curbing the transfer of funds and earnings to tax-favourable foreign jurisdictions. However, one cannot ignore the flip side of introducing CFC regulation in India at this stage. To begin with, countries like the UK, the US, Germany etc. which have introduced CFC regime as part of their tax structure have liberal foreign exchange regime as opposed to India which still does not have full capital account convertibility. Needless to say, introduction of CFC regulations would necessitate subsequent relaxation of domestic exchange control rules. Further, it will give rise to unnecessary complexities, undue tax costs and compliance requirements and protracted litigation resulting in unwarranted hardship. The Indian outbound M&A activity has faced a severe blow from the global meltdown in the past two years. Although, we are well on our road to recovery, one cannot ignore the fact that in 2007, Indian firms made USD 22.6 billion of overseas buys standing not far behind China. However, India’s outbound M&A in 2009 was just USD 1.3 billion as opposed to China which spent USD 42.7 billion. A natural conclusion which comes to every mind is that introduction of CFC regulation at a time like this will adversely affect India’s outbound investments and corporate India’s competitive edge vis-à-vis global companies.Alternative Recourse It is an accepted fact that repatriation of dividends to India is not efficient from a tax point of view. This is primarily because dividends received from overseas subsidiaries are generally taxed in India at the corporate tax rate of 33.99 percent as against 16.996 percent on dividends distributed by domestic companies. It is pertinent to note that sub-section (1A) of section 115-O, which was introduced with the aim of removing cascading effect of taxes paid on dividends, provides some relief to the domestic companies while distributing dividends. On the contrary, no provision exists in Indian Income-tax law for credit of underlying foreign taxes paid on profits of overseas subsidiaries against the taxes paid by domestic parent on receipt of the same in form of dividends. Global business organisations have observed that price for protection of national tax base through CFC regulation is a loss of economic efficiency for a country in the longer term. Therefore, before implementing CFC regulation, Indian government must carefully weigh its short term advantages against the competitive disadvantages which India Inc. may have to face in establishing presence in global markets. What is required is that the Indian government should strive to create a conducive environment so as to encourage Indian overseas subsidiaries to remit profits for domestic investment in India, instead of compelling them to do so by introduction of stringent norms. To begin with, a comprehensive double tax credit system should be introduced so as to enable domestic parent companies to avail credit for any tax on underlying profits of foreign subsidiaries out of which dividends are being repatriated. Fiscal incentives should be introduced in relation to repatriation of funds into India in convertible foreign exchange. Further, dividends received from overseas subsidiaries should be taxed in India at a suitable rate in line with the taxation of distribution of dividends by domestic subsidiaries. These measures will give an opportunity to overseas subsidiaries to voluntarily repatriate their income to India and offer the same to tax which could possibly defer the introduction of an anti-deferral tax regime.