Be prepared for tax controversies in India
Time-consuming litigation in India makes it crucial for global investors to be aware of key tax issues in order to help them plan their Indian business operations.
Given the history of tax litigation in India, it is imperative for foreign companies to carefully plan their operations in India so as to steer clear of litigation, and save tax and related litigation costs. Appropriate disclosures are necessary to prevent penal consequences that generally result from revenue audits. A number of controversies arising in the tax courts are discussed below.
The Indian tax courts have provided a number of different views with regard to payments to non-residents for purchases of software. One set of courts has considered the transfer of ‘off-the-shelf’ and ‘shrink-wrapped’ software as a transfer of a copyrighted article, not taxable as royalty. However, other rulings have held that software purchase results in the transfer of some copyrights, and hence is taxable as royalty in India.
The Indian tax authorities have been paying particular attention to expatriates based in India and raising issues regarding the permanent establishment (PE) of foreign companies. Recent rulings have discussed the concept of an economic employer versus a legal employer. The tax authorities have held that where the economic employer is a foreign company, the employee may be considered as a PE of the foreign company in India.
The tax authorities have also challenged the reimbursement of salary by an Indian company (to its overseas group company) and taxed it as Fees for Technical Services (FTS), considering this to be rendering of services by the foreign company to the Indian company.
Going by recent trends, it has become crucial to plan an expatriate’s entry and related documentation, to avoid controversy.
Permanent establishment issues
A recent Tax Tribunal ruling held that an Indian subsidiary acting as a captive service provider for its US parent company, constitutes a PE of the latter. Accordingly, a portion of the foreign parent company’s profits were attributed to the Indian PE, although no revenues were earned from Indian customers. On the principle of profit allocation in India, this ruling could affect companies operating in India through subsidiaries that are captive service providers.
The tax authorities have examined the advertising expenditure of a number of Indian subsidiaries of foreign companies. They have alleged that the Indian subsidiaries are developing marketing intangibles for their overseas Associated Enterprises (AEs), as the brands are not owned by the Indian subsidiary. The authorities have imputed a cost reimbursement with a mark-up to be received by the Indian entity for any such spending for the benefit of their overseas AEs. The Tax Tribunal has confirmed this approach in the case of LG India. This is an important area of concern for multinational companies where market penetration is achieved through the marketing efforts of their Indian entities.
Indian tax authorities are also questioning the valuation method adopted while issuing shares to group companies. Recent rulings have taxed the difference between the issue price and fair price in the hand of the Indian company. This controversy has affected Vodafone and Shell India, in the latest round of revenue audits.
Some potential issues for foreign investors
Indirect transfer of shares
The transfer of shares of a foreign company deriving substantial value from India is subject to tax in India. Also, the meaning of substantial holding, computation mechanism, etc. could become the basis of litigation in India.
Tax treaty benefits
Tax rates for royalty and FTS have been increased to 25%; accordingly, accessing tax treaty benefits is critical. Furthermore, various amendments have led to a substantial increase in the requirements to be fulfilled by a foreign payee for claiming treaty benefits. It is, therefore, critical for foreign companies to prove eligibility to access tax treaty benefits and beneficial ownership of income.
Specified domestic transactions
Transfer pricing provisions now also apply to certain specified domestic transactions among domestic entities. Transactions between group companies in India require benchmarking, and tax disputes, similar to those that have arisen in relation to transfer pricing in international transactions, could well follow.
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