4.2.7.4 EVALUATION OF THE PROPOSED REMEDY- THE DIRECT TAX CODE (DTC)
An option for India would be to modify its current domestic law to unilaterally cancel out the effect of the DTAT. The Direct Taxes Codes (DTC) Bill passed in 2009 is an attempt to amend the tax system in India. The proposals below in the DTC may probably impact on the functioning of all the 75 tax treaties of India9:
When there is bilateral agreement between the government of India and the government of another country, the actual Indian tax law grants tax reliefs or if subject to double taxation, a taxpayer eligible to the benefits of the treaty, has the possibility to abide by the domestic tax law to the point to which it is advantageous for the taxpayer. Consequently, a non-resident taxpayer with income generated in India has the choice to be ruled by either the Indian domestic tax law or the relevant tax treaty, whichever is more advantageous to the taxpayer.
The DTC also enables the central government to come to an agreement with another government to avoid double taxation and for the motive of exchanging information to prevent income tax evasion or avoidance. The DTC, nevertheless, states that neither the treaty agreement nor the code will have favoured treatment based on its being a treaty or law and if there is a divergence between the provisions of a treaty and that of the code, the one later in time will be applicable9. This is indeed a major change from current regulations. India, having tax treaties with 75 countries, enacted the DTC in 2010 and will be in for on 1 April 2011, which would affect all its tax treaties including that with Mauritius. Implying that after the 1st April 2011, Mauritius-based Company transferring shares of an Indian company would be liable for taxation in India without any exemption from the treaty.
It is worth noting that the revised draft code encloses the general anti-avoidance rule (GAAR).
The GAAR would be activated whenever the taxpayer enters into an arrangement covered by one the following conditions10:
-The main purpose was to obtain tax benefits
-characterise misuse or abuse of the provisions of the DTC
-lacks commercial substance
-went through or conducted in a manner not normally employed for bona fide business purposes
-not created between person dealing at arm's length
India's Revenue Authority would assess and declare whether an arrangement is a permissible or impermissible avoidance arrangement. If declared impermissible, the tax official could disregard the tax treaty as well as the intermediary holding corporation and subsequently tax the income belonging to the parent company. For example, an arrangement would apparently have been gone through principally to be exempted of tax and the hurdle of the taxpayer is to prove that the use of the arrangement was not to obtain tax benefits. Notably, the GAAR provision would not be concerned with, and could overrule, the tax treaties provisions.
If the Direct Tax Code is enforced, investors using the Mauritius route to invest in India would find themselves in a complex situation as depending on the nature of their business, the new code may prevail over the Bilateral Tax Treaty. The ability to demonstrate to satisfactory level to the Indian Revenue Authority that the underlying arrangement is employed for bona fide business purposes and is a permissible avoidance arrangement would be a key factor to obtain tax relief.
3. The terms enclosed in Section 5(1) of the Direct Tax Code states the following: "The Income shall be deemed to accrue in India, if it accrues, whether directly or indirectly, through or from8:
(a) a business connection in India;
(b) a property in India;
(c) an asset or source of income in India; or
(d) the transfer, directly or indirectly, of a capital asset situated in India.
The insertion of the word "indirectly" in the current terms of the Income Tax Act 1961 is an effort from the authority to capture the "indirect transfer" of assets funds located in India. However, the following discussion will show that altering the current provisions of section 5(1)(d) of the tax Code to bridge the gap in the Act will not be the right way to proceed8.
Consider this simple and familiar holding structure of a company8:
(a) Company A, a French-based corporation, has the fully ownership of a subsidiary in Hong Kong, S1
(b) S1 has a full ownership of a subsidiary in Mauritius, S2
(c) S2 possesses 51% shares in an Indian Company X, with two Indian companies holding the rest of the shares
(d) Company X has full-ownership of a various subsidiaries in India.
Suppose that Company A sell some of his share in S1 at a gain to another French Company B. Tax-wise, there will be three concerns from this transaction, namely:
The liable chargeable expense of the capital gains
The accounting calculation of the capital gain
The receipts of tax on capital gains
The first issue in this case is "identifying assets located in India", that to determine whether we are transferring the assets of Company X or the shares of Company X or the assets of the Company X's subsidiaries. Legally, a company's shareholder has no control over the company's assets and one good reason for this rule is that estimating the costs and profits of shares is not treated the same way for physical assets.
The second issue is to observe whether taxing Company A or even Company B would be "fair", moreover, had S2 shifted its 51 percent of Company X, based on the Indo-Mauritius Treaty, capital gains tax would not be chargeable. To back this point, we can refer to the case of E-trade by stretching on the verdict of the Supreme Court in the Azadi Bachao Andolan Case where the Authority for Advance Rulings confirmed the Treaty position.
The third issue, Section 5 (1) (d) of the Code would require the corporate veil to be taken away at each stage starting from the subsidiaries of Company X to Company A, which to my mind is very unlikely as per existing law. The removal of the corporate veil is only allowed by the Case Law in limited circumstances.
The veil will be lifted if the structure is a "Fraudulent" but without evidence of the opposite, the company's holding structure does not represent a "sham" (Upheld in case KSPG Netherlands Holding B.V.).
The fourth issue is that the Code does not come with a process mapping explaining how the gains on the "indirectly transferred funds" would be computed, especially when there is no method of figuring the "cost" of the "asset" and therefore creates the inability to figure the "taxable profit" (Decision upheld in CIT v. B.C.Srinivasa Setty 128 ITR 294). This issue would be more evident had S2 held more shares in corporation based in countries other than India and the buying price could not, as one would expect, assign a value to each entity.
Assuming that Company A's capital gains are taxable in India, the problem that comes up for the Revenue Authority is how to get the receipts of the capital gains tax from Company A, which does not have any assets in India. Collection of the tax revenue from Company A would not be possible and nor is the tax collectable from Company X without any provisions of this matter in the Act. The only recourse left for the Revenue Authority is to pursue Company B B u/s 201 of the Act for failing to subtract tax when paying Company A and hold it to be an assessee deemed in default. Again, as Company B has its assets outside India, this would be difficult.
The above discussion shows that the provisions made on the Section (1) (d) of the Direct Tax Code are unclear and also worth mentioning is that the above arguments are only some of the delicate concerns involve in the proposed Code. It is very likely that these provisions will cause adverse consequence on the overseas investment flow in India.
