While the Government is strongly pitching reform of tax laws to make them more business friendly, there are certain tax speed breakers which are making the business highways a rough ride. Here are some of the tax speed breakers that need to be smoothened.
When Indian companies set up businesses abroad, there is a need to finance their offshore subsidiaries in a way that does not unduly burden these subsidiaries. Other than investment in the shares, another option being explored to fund these subsidiaries is by way of debt instruments or loan. Stringent transfer pricing regulations in India, which govern intra group funding transactions, require Indian companies to mandatorily charge arm’s length interest on loans given to their offshore subsidiaries. Indian companies run the risk of being taxed on deemed interest income on failure to charge arm’s length interest on such loans.
In some cases it may not be commercially viable for an Indian company to charge interest to its offshore subsidiary due to reasons such as significant setting up costs, long gestation period, etc. due to which the subsidiary would in all likelihood be making losses and would be paying interest to its parent from the capital! Thus, by charging such interest though the taxable income of the Indian parent increases, the profitability and value of the group as a whole suffers and is skewed. The subsidiary in fact suffers artificial loss and leads to longer gestation period. Therefore given the broader and long term objective of the Government, this situation calls for an alignment of the transfer pricing laws with business realities and suitable amendments need to be made to give some respite to Indian companies.
A moratorium period to Indian companies setting up offshore subsidiaries from charging interest may be considered. Another option could be to charge accelerated interest at a later stage after charging nominal or ‘nil’ interest in the initial years, such that over a long term the total interest income from the subsidiary achieves the arm’s length result. This approach is justifiable since the objective of these companies is not per se to avoid taxes but only to provide finance to their subsidiaries in an economical manner.
Given the Government’s intention to attract investments into India, it could consider a couple of changes to give a fillip to M&A activities. The first one being applicability of ‘Minimum’ Alternate Tax (MAT). Though the matter is pending before the Supreme Court, the Government should consider and clarify the applicability or otherwise of MAT to foreign companies. Foreign companies which do not carry on business in India through a place of business in India such as FIIs, investment holding companies, etc., and mainly derive income in the nature of capital gains should not be subjected to MAT. Where India has entered into bilateral tax treaties under which India has given up the right to levy tax on capital gains derived by a resident of the other contracting state, levy of MAT on such capital gains in the hands of the residents of the other country under the domestic tax laws of India would be contrary to and violative of the Vienna Convention on the Law of Treaties.
Also, the term ‘Minimum’ Alternate Tax has become some sort of a misnomer. At the current rate of MAT, set at around 20% (including surcharge and education cess), it is two thirds of the rate of full tax rate of 30%! There is certainly a case to rationalize the MAT rate for it to be truly a ‘minimum’ tax. The rationale for introduction of MAT was that companies which paid zero tax on their income were distributing significant dividends which was considered unacceptable in as much as if they can reward their investors, they must certainly have income on which government can have a tax claim. Levy of MAT on companies or undertakings which are given specific tax exemptions to incentivize them, such as SEZs, infrastructure projects, power projects, etc. effectively takes away the incentive given to them and is therefore, a disappointing surprise to foreign investors who evaluate the investment based on tax holiday to such sectors.
The second change from an M&A perspective is for the Government to consider a commercial and practical reality. In several M&A transactions, the acquirer and the seller agree to deferral of certain portion of the sale consideration. This is agreed with a view to ensure that on the one hand seller is able to claim true valuation of the business based on the projections (as they are achieved) and on the other hand, the acquirer is not required to shell out an exorbitant price unless the projections are indeed fructified. The milestones for this purpose are identified and agreed between the parties. Due to its very nature, such deferred consideration may not become payable to the seller.
However, there is no provision under the current tax laws to defer the levy of capital gains tax on such deferred consideration. It is taxable in the year of the transaction. The capital gains of the seller is computed under the current provisions, taking into consideration the maximum amount that may be receivable by him (but may never be received) in future and the capital gains tax is payable on such higher gains computed including the deferred consideration. If the seller does not receive the deferred consideration, there is also no mechanism to claim back the excess tax paid in the year of transaction, if the time for filing of revised return has lapsed. This certainly acts as a dampener for M&A transactions to be done at their real value. The Government may consider introducing a mechanism to either levy capital gains tax upon receipt of consideration as per the terms of the agreement or provide for carry forward of credit for excess tax paid under the current system to the future years so as to utilize it against future income. Alternatively, allowing reassessment of the year of excess tax to enable claiming refund.
Another tax bottleneck is in relation to withholding tax provisions under the Indian tax laws. This provision inter alia obligates a payer (resident/non-resident) to deduct applicable tax on the taxable sum paid to a non-resident payee. If the payer fails to do so, the tax officer is empowered to recover such tax from the payer and levy interest and penalty for the said default. Even in circumstances, where the non-resident payee has paid the tax, the current provisions do not bar the Indian tax authorities from recovering the tax/interest/penalty from the payer. Withholding tax provisions were put in place only for administrative convenience, easy collection and recovery of tax.
Therefore, a question arises as to whether it is justifiable to recover interest from the payer when the payee has discharged its tax liabilities in India. While it may be fair to hold the payer responsible for the penalty (if there is reasonable cause to do so), making the payer responsible even for tax / interest despite the non-resident paying the tax leads to double taxation. Thus, it is vital that Government rectifies this incongruity and makes suitable amendments to reduce the withholding tax woes of the payers.
Bringing in some of the above changes and clarifications, will go a long way in making the tax administration and compliance much more friendly and easy for the tax payers, encouraging them to do business in India and promoting India as a business friendly jurisdiction! One hopes that some of the Government’s plans will see light of the day in the upcoming budget.
Disclaimer – The views expressed in this article are the personal views of the author and are purely informative in nature.