As the Indian tax authorities get tougher, Rajesh Simhan of Nishith Desai, says that foreign investors should be wary but not put off.
Over the past decade, foreign corporations have been queuing up to do business in India. Initially, the Indian government set out to aggressively woo them by providing benefits such as tax holidays for the Software Technology Parks and Export Oriented Units. It also allowed the use of tax treaty benefits for investments into India.
However, the last few years have seen a marked shift in the tax authorities’ approach to international investors. The tax department undertook a volte face in the E*Trade case. They sought to deny the treaty benefits to a Mauritian resident on the grounds that it was actually the US investor which held the shares in the underlying Indian company.
The tax authorities have also taken an aggressive stance in the Vodafone case where they are seeking to tax a transaction between two non-residents on the sale of shares of a non-resident company on the grounds that it was actually a sale of controlling interest and other assets of an Indian company. Similarly, the tax authorities are also challenging the merger between a non-resident and a resident company in the Star case on the grounds that the merger has a tax avoidance motive and hence should not be allowed.
This shift in approach of the Indian tax authorities can, in the larger context, be compared to a similar change in approach in China where the tax authorities are clamping down on the use of tax treaties for investment into China. There, the tax authorities have issued Circulars on the availability of the treaty benefits in the Chinese context.
The use of retrospective amendments to override judgments and existing law is also of serious concern for foreign investors having operations in India or seeking to invest in India.
The recent Budget in India saw a fundamental change to the Indian’s source rules governing non-resident income in the form of royalties, interest and fees for technical services. The government has sought to tax non-residents in respect of such income even where the services are rendered completely offshore. This amendment may be imposed with retrospective effect to 1976 and will override the existing law laid down by the Supreme Court and various High Courts.
This aggressive approach of the tax authorities has been especially marked in transfer pricing. With tax holidays expiring for most units set up in Software Technology Parks, transfer pricing has been seen by the tax authorities to be a key revenue source. Numerous disputes are being seen in relation to the mark up / profits attributed to the Indian undertakings which have dealings outside India.
Also interesting is the actual approach taken by the authorities to tax controversies. In the E*Trade and Vodafone cases, the tax authorities relied on publicly available information and the regulatory filings made in India and abroad to build up their case against the tax payer. This approach is being repeated in many other cases,
As the tax authorities build up their international perspectives, they have also come up with some ingenious arguments. Taxation in India is fraught with tax traps, catching the unwary with a vengeance.
However there is some good news. The Courts have curbed the tax authorities’ tough approach by an active adherence to the letter of the law.
What the future holds
The contours of the tax landscape in India will change with the proposed introduction of the Direct Taxes Code (“Code”) from April 2011. The draft Code, which is supposed to replace the existing income tax and wealth tax law, has been criticised from all quarters, including the tax authorities themselves.
The current draft Code proposes significant changes to the existing law, which can have serious ramifications for foreign investors. It seeks to extend the extra territorial reach of Indian tax laws, provide for treaty override provisions and also introduces General Anti Avoidance Rules. The draft Code is expected to undergo numerous changes and one can only hope that the end legislation will be more palatable for foreign investors.
* The author is a senior associate in the international tax practice at Nishith Desai Associates. The author would like to thank Ms. Bijal Ajinkya, Partner, International tax, Nishith Desai Associates for her input.
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