With increase in globalization, geographical boundaries of countries have become blurred and many multinational groups try to get benefit of their global presence to minimize their overall tax costs by using low tax jurisdictions for tax planning. One of such measures used by multinational groups is to park profits in no/ low tax countries without actually bringing such profits to ultimate parent company located in relatively higher tax jurisdiction. This practice sometimes results in substantial/ perpetual deferral of tax payments on such profits.
Controlled Foreign Corporation ("CFC") Rules aim at taxation of such profits, which are parked in foreign companies in low or no tax jurisdictions, in the parent company's home jurisdiction. CFC Rules not only help in taxation of profits in the residence country of ultimate parent, to which such profits actually belong to, but such rules also have positive effects in source countries because taxpayers have no (or much less of an) incentive to shift profits into a third, low-tax jurisdiction.
Position of CFC Rules Globally
Benefits and importance of CFC rules are now recognized globally. CFC rules have been recognized as a key action plan in OECD's Action Plan on Base Erosion and Profit Shifting ("BEPS"). BEPS refers to tax avoidance strategies by multinational companies that exploit gaps and mismatches in tax rules to artificially shift profits to low or no-tax locations. Under the inclusive framework, over 100 countries and jurisdictions are collaborating to implement the BEPS measures and tackle BEPS. Many developed countries have a detailed CFC regime which clearly lay down parameters for invocation and implementation of CFC Rules.
CFC Rules in India
In India, concept of CFC was first introduced to Indian taxation regime as part of proposed Direct Tax Code, 2010, which was retained in revised draft of Direct Tax Code, 2013.
As per CFC Rules introduced in Direct Tax Code, profits earned by a Controlled Foreign Company, located in territory with a lower rate of taxation, will be included in taxable profits of parent company located in India. For this purpose, Controlled Foreign Company shall be a company;
a) Which is a resident of a territory with lower rate of taxation;
b) Shares of which are NOT traded on any recognized stock exchange in such territory;
c) Which is controlled by Indian residents, individually or collectively; and
d) Which is not engaged in active trade or business and more than 25% of whose income comes from passive sources such as dividend, interest, capital gains, income from house property, royalty, annuity payments, etc.
Further, appropriate provisions have been made in Direct Tax Code to ensure that profits of CFC, which are taxed in hands of parent company once, are not taxed again when such profits are actually repatriated in form of dividend by CFC to parent company.
However, Direct Tax Code is yet to become law in India and presently there are no statutory provisions in existing Income Tax Act for enactment of CFC Rules.
CFC Rules vs POEM under Indian Income tax law
Under existing Income tax Act, the Government has recently introduced concept of Place of Effective Management ("POEM"). As per POEM, even a foreign company can be said to be resident in India and its global income can be subject to tax in India, if place of its effective management is held to be in India. POEM has been further defined as a place where key management and commercial decisions, that are necessary for conduct of business of an entity, are in substance made. As per existing provisions of Income tax Act, POEM is set to come into effect w.e.f. 01 April 2017, and Statutory Guidelines by Government of India for determination of POEM have been issued recently on 24 January 2017.
POEM gives a wide power to Indian tax authorities to allege that all foreign companies, whose parent company is an Indian company and key business decisions are taken by promoters/ directors located in India, be treated as Indian resident and their global income be taxed in India, irrespective of:
i) Whether such foreign company is located in a tax haven/ territory of lower taxation or not;
ii) Whether such foreign company is formed for bona-fide global business expansion of Indian multinationals or merely for treaty abuse and parking global profits in low tax jurisdictions outside India.
Further, whether place of effective management of a foreign company is in its country of residence or in India can be subject to wide interpretations and has a potential to open a Pandora's box in Indian tax litigation.
The wide concept of POEM and its potential of being misused for unnecessary harassment/ litigation by tax authorities can be a big deterrent for Indian multinationals from setting up genuine business operations outside India. Further, its non-distinguishing approach towards low tax jurisdictions and other jurisdictions which promote genuine businesses without giving such tax haven benefits, is also unreasonable.
POEM is also be seen as a threat by foreign companies, executing large projects in India through Project Offices, especially in Oil & Gas and infrastructure sector or having majority of their Global business operations in India or those having other forms of Permanent Establishment in India, as Indian tax authorities may allege these foreign companies to be residents in India and tax their global income in India.
For the reasons mentioned above, POEM has not been received well by Indian corporates having operations outside India or foreign multinational having substantial business in India.
In our view, introducing CFC rules in existing Income tax Act can be a better alternative to prevent Indian multinationals avoid/ defer their tax liability on foreign income by parking such income in low tax jurisdictions, instead of implementing concept of POEM. This will also be in line with OECD's Action Plan against BEPS, to which India is a keen participant.
Indian economy is still in the developing stage and Indian government has been taking several measures to increase business investments in India. In these circumstances, implementation of POEM may be detrimental to Government's stated objective.
Implementation of CFC rules and withdrawing concept of POEM may create a fine balance between Government's objective of earning tax revenues from profits earned by Indian companies outside India and at the same time by a considerably less uncertain and less litigative means.
Rakesh Nangia, Managing Partner of chartered accountancy firm Nangia & Co