Make India more investment friendly

So, what should Budget 2008 be like and what are the aspects that deserve the finance minister's attention?

A lot has been written about the key issues that MNCs face when transacting with India, ranging from withholding tax issues - especially when the payments made from India are in the nature of Royalties and Fees for Technical Services; or even transfer pricing issues.

However, with the fast pace of globalisation today, more and more Indian companies are adopting a global ideology and making major acquisitions overseas. This indeed, has also transformed the spectrum of international tax issues that one speaks of in the Indian context.

While Tata's may have made headlines with their overseas acquisitions, there is heightened and continued activity by Indian business entities, including medium sized entities, as regards overseas acquisitions.

Given the stakes involved, it has been witnessed internationally that investing companies have used investment structuring through tax-friendly jurisdictions as an effective business-planning tool. Structuring can offer treaty advantages to minimize source country withholding tax, the possibility of achieving tax deferral in the home country on profit repatriation/subsequent disposals of shares and tax-efficient circulation of cash within the group structure.



Currently, India has a residence based taxation system. Thus, Indian global companies incur taxation on income earned abroad and received in India (be it in the form of dividend, interest etc.) as well as income earned in India. However, Indian companies do receive a tax credit for taxes paid to foreign governments, but this is limited to the Indian tax liability.

Taxation in India only occurs when income is repatriated; thus, there is an incentive to accumulate income in low-tax countries, which can be used for further overseas expansions

However, such a system of taxation, also know as the classical or separate system of company taxation, could create economic distortions. Under this system, companies would be encouraged to retain profits outside India rather than repatriating the same to India. Secondly, there are two levels of double taxation involved, double taxation of company shareholder income and international double taxation (that is, taxation in more than one country).

In recent years, various countries have considered a change in company shareholder tax systems and a major reason for the change has been a shift of emphasis to consider both forms of potential double taxation together. With the increase in outbound investments by Indian companies, it would be worthwhile to review the shareholder taxation system in light of the above discussion. A possible relief on the international double taxation would encourage Indian companies to repatriate their profits from global operations back to India for productive re-investment which consequentially would fuel economic growth.

Possible Relief Mechanism

Relief can be provided, primarily, in two forms i.e. either by following an exemption system for the foreign sourced investment income or maximizing the possibility of claiming tax credits.

Exemption System: Some jurisdictions exempt foreign income from taxation; this is referred to as territorial system of international taxation. In addition, several countries have hybrid systems that lie in between this territorial system and the above discussed classical system; for instance, foreign income may be exempt from taxation in the home country provided that the foreign country's tax system is sufficiently "similar" to that in the home country.

For e.g. Singapore exempts the foreign country source dividend if the headline tax rate in foreign jurisdiction from which dividend is received is at least 15 per cent and the dividend income has been subject to tax in foreign jurisdiction from which it is received.

Cyprus and Hong Kong do not tax foreign source income while some European Union countries such as Belgium, Denmark, Netherlands, Luxembourg, Spain fully/partially exempt foreign sourced dividend, provided, conditions of 'participation exemption' are satisfied. While the conditions normally laid down for recognizing the 'participation exemption' vary from country to country, the typical requirements are a minimum shareholding of 5%-25% and shares not being held as 'portfolio investments'.

Credit System: Some countries (such as the United States and the United Kingdom) which do not follow an exemption method for taxing foreign source investment income, use a tax credit system. For example, US multinational firms incur taxation on income earned abroad as well as income earned in United States. However, US firms receive a tax credit for taxes paid to foreign governments. This tax credit is limited to the US tax liability although firms may (in some cases) use excess credits from income earned in high tax countries to offset US tax due on income earned in low tax countries.

The above concept is similar to underlying tax credits available under select tax treaties which India has entered into (e.g. Mauritius and Singapore). Allowing underlying tax credits in the domestic law could be a mechanism to reduce the tax implications on Indian multinational companies in respect of the foreign sourced dividend income.

Underlying tax credit is the credit of the corporate tax paid by the company paying the dividend on the profit out of which the dividends are distributed by it. The recipient, in addition to the foreign tax credit i.e. credit of withholding taxes paid in foreign country, is entitled to claim a credit of such taxes against the tax payable by it on foreign sourced dividend. Accordingly, the recipient is benefited by higher tax credit available to it.
Other Trends

American Job Creation Act, United States

In the United States, in sync with the objective of encouraging US companies to bring the profits back to the US (which are being accumulated outside US due to low tax rates), the IRS introduced the provisions to provide relief from domestic taxation in respect of foreign sourced dividend in the hands of US companies. The provisions, contained in American Jobs Creation Act, provided for allowing US companies to select a one year window during which they may deduct 85% of cash dividends received from controlled foreign companies.

Australia as a regional holding company location - Conduit Foreign Income Rules

On December 14, 2005 the Australian Government adopted Conduit Foreign Income (CFI) Rules as part of the reforms of Australia's international tax arrangements. The CFI measures aim to enhance the perception of Australia as a good location for regional holding companies of foreign groups and also improve Australia's attractiveness as an investment destination for multinational companies.

Conduit foreign income is basically foreign income that is not assessable in Australia when derived by an Australian qualifying entity. It includes, non portfolio dividends, gains on sale of shares of a foreign company with an underlying active business etc.

Conclusion

It might just be the right time, with large acquisitions by Indian companies becoming more frequent, for the Indian government to provide incentives to Indian companies to bring the overseas profits back into India and make India more investment friendly. Needless to say, given the sheer quantum of such money, it can go a long way in adding fuel to the Indian growth story.