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Placing India at par with the World – Expectations from Union Budget 2023
In order to bring the entire world on a level playing field, the Organization for Economic Cooperation and Development (OECD) has taken active initiatives in the last few years to draft and implement two pillar solutions. While Pillar 1 scrutinizes digital taxation, Pillar 2 focuses on implementing global minimum tax at 15%. South Korea is the first nation to pass Pillar 2 global minimum tax rules in its domestic legislation. Most Favoured Nation (MFN) Clause, scope of Significant Economic Presence (SEP) and taxation of license fees has created quite a buzz in the last one year. One may, therefore, expect more announcements on these in the upcoming budget session. in
This article includes a list of our apprehensions and recommendations with respect to International Taxation and Transfer Pricing in the upcoming budget. It highlights the asymmetry and conflict between different provisions that require deliberation to bring clarity to the law. It also discusses certain provisions of the Income-tax Act, 1961 (the IT Act) that need alteration to be in consonance with the OECD objective of ensuring a fairer distribution of profits and taxing rights among countries; and ultimately improving the world ranking of ease of doing business in India.
Effect of OECD two pillar solutions
On October 2021, the OECD agreed a two-pillar solution to address the tax challenges arising from the digitalization of the economy. It is expected that the Government may amend the IT Act to rationalize it with the OECD two pillar solutions.
Pillar 1 provisions are applicable to multinational enterprises (MNEs) with a global turnover of above EUR 20 billion and profitability above 10%. The multilateral convention requires parties to remove all digital services taxes and other relevant similar measures with respect to all companies. In India, equalization levy was introduced vide Finance Act, 2016 with the intention of taxing digital transactions i.e., the income accruing to foreign e-commerce companies from India. With the introduction of Pillar 1, it is expected that the Government may provide a sunset period for the application of equalization levy.
SEP introduced vide Finance Act, 2018, expands the scope of “business connection” provisions, which are akin to, but much broader than the concept of Permanent Establishment in tax treaties. SEP includes within its ambit:
The payment limit is INR 20 million for the transactions in India, or a threshold of 0.30 million users, considering the consumer base in India is substantially low. The threshold limit for applicability of SEP related provisions may be increased to bring it at par with the new nexus rules provided in the Pillar 1. Additionally, clarification may be provided on identifying such users in India, whether it will be basis the IP address in India, or the user has to be a resident Indian or even passive users will be included for determining the threshold.
Pillar 2 imposes a global minimum corporate tax of 15% on MNEs that meet the EUR 750 million threshold. In case a jurisdiction has a tax rate lower than 15%, the draft rules provide for Income Inclusion Rule (IIR), which imposes top-up tax on a parent entity in respect of the low taxed income of the group entity. From India inbound perspective, the said rules are unlikely to affect the foreign holding entity since the corporate tax rate in India is anyway more than 15%. Accordingly, there is little hope that the tax rate for new domestic companies engaged in manufacturing could be further reduced from the current headline rate of 15% plus applicable surcharge and education cess. Further, businesses carried out from International Financial Services Centre (IFSC) in India enjoy a tax holiday for specified period. Being a flagship project of the Government, the IFSC has attracted a lot of foreign investments in India. It would be interesting to watch how the Finance Minister strikes a balance between retaining the IFSC tax holiday and yet not forgoing revenue under the Pillar 2 proposal.
Application of MFN Clause
Tax treaties entered into by India with certain jurisdictions including France, the Netherlands, and the Swiss Confederation contain a MFN clause. By virtue of the MFN clause, typically, India has restricted its right to tax certain income viz. interest, dividend, fees for technical services, etc. to a rate lower or a scope more restricted than the scope provided for those items of income in the DTAA which India would have entered into with a third state which is a member of OECD.
India has agreed for a reduced rate of tax on dividend (5%) inter-alia with its treaties with Slovenia, Columbia and Lithuania. Though these jurisdictions are members of OECD at present, however, such jurisdictions were not members of OECD at the time when their tax treaties with India were signed. In view of the above, some foreign countries have issued unilateral decrees in favour of the taxpayers by accepting lower rate of tax as provided in the tax treaties entered with India.
The Delhi High Court in Concentrix Services Netherlands B.V. [2021] 127 taxmann.com 43 (Delhi) held that dividend received by a Netherland-based company would be taxed at a beneficial rate of 5% even though the India-Netherland tax treaty provides taxing dividend at 10%, in view of the MFN clause in the protocol appended to India-Netherlands tax treaty.
However, soon after Budget 2022, the Central Board of Direct Taxes (CBDT) issued Circular 3/2022 dated 3 February 2022 stating that such jurisdictions with low tax rates should be an OECD member at the time of signing of tax treaty with India. Further, the Circular stated that for importing the benefits w.r.t MFN clause from another treaty which contains lower rate of tax, a separate notification is to be issued by the Government. CBDT was not appreciative of taxpayers availing the benefit of the MFN clause unilaterally.
In order to avoid litigations at lower levels, it is expected that the Government may do away with the pre-requisite condition of issuance of separate notification for availing the benefit of MFN clause; particularly, with regard to such tax treaties where the benefit of the MFN clause is already an integral part of the treaty and notified after negotiations by both the contracting states. This position is settled in taxpayers favour by various judicial precedents.
Cross-border merger
Generally, transfer of any capital asset is subject to capital gains tax in India. However, certain types of mergers enjoy tax-neutrality with respect to capital gains taxes.
In an inbound merger, a foreign company merges with an Indian company and the resulting amalgamated entity is an Indian company. An inbound merger enjoys tax-neutrality with respect to capital gains taxes on transfer of capital asset by the amalgamating company to the amalgamated company. Further, shareholders of amalgamating company enjoy tax-neutrality with respect to capital gains taxes on transfer of shares in the amalgamating company, where the entire consideration comprises of shares in the amalgamated company.
An outbound merger is where an Indian company merges with a foreign company and the amalgamated entity is a foreign company. At present no tax exemption is provided in case of outbound merger, w.r.t transfer of capital asset by amalgamating company and transfer of share of amalgamating company. Thus, capital gains tax is attracted on the aforesaid transfer.
Under the amended Companies Act, 2013, corporate reorganizations involving amalgamations of two or more companies require the approval of the National Company Law Tribunal. In this regard, the Indian regulatory authorities have notified provisions facilitating cross-border mergers/ amalgamations/ arrangements between Indian and foreign companies. The merger of an Indian company with a foreign company in a specified jurisdiction is now permitted as per Section 234 of the Companies Act, 2013 read with rule 25A of the Companies Merger Rules. These rules enable an inbound merger as well as an outbound merger subject to certain conditions.
However, cross-border mergers would not be attractive till the time there exists tax liability or ambiguity around taxability for such transactions. The income tax provisions, therefore, need to be aligned with the corporate law to achieve the objective of increasing the ease of winding up operations in India. The IT Act presently grants tax exemptions on mergers only if the amalgamated company is an Indian company but does not recognize a situation where the resulting amalgamated company is a foreign company. Therefore, with the introduction of cross-border mergers under the Companies Act, 2013, the Government may rationalise the provisions of the IT Act by undertaking the following amendments:
Capital gain on indirect transfer
Section 9(1)(i) of the IT Act, that provides for taxation of indirect transfer, states that shares of a foreign company which derives its substantial value, directly or indirectly, from all the assets located in India shall be deemed to be situated in India, and hence gain earned on transfer of such capital asset shall be charged to tax in India. Section 47(vicc) of the IT Act provides that, subject to fulfilment of certain conditions, transfer of shares of a foreign company (which directly or indirectly derives its value substantially from shares of an Indian company) by the demerged foreign company, to the resulting foreign company under a scheme of demerger will not be regarded as transfer.
Contrary to Section 9(1), Section 47(vicc) provides exemption only if the shares of foreign company derive substantial value from shares of an Indian company. While the intent may be to exempt all cases of demerger where foreign company derives substantial value from assets located in India, the literal reading of Section 47(vicc) of the IT Act indicates that the said exemption would be available only in cases where the shares of the foreign company derive substantial value from shares of Indian company and not any other asset.
It is expected that the Government may extend the scope of Section 47(vicc) of the IT Act to include exemption for transfer of shares of a foreign company which directly or indirectly derives its value substantially from the assets located in India, by the demerged foreign company to the resulting foreign company under a scheme of demerger.
Certain category of services to be out of scope from Royalty / FTS as well as Equalisation levy
Section 165 of the Finance Act, 2016 fastened an equalisation levy at the rate of 6% on “specified services” provided by non-resident to the:
(a) resident in India and carrying on business or profession or
(b) a non-resident having permanent establishment in India.
“Specified service” has been defined to mean online advertisement, any provision for digital advertising space or any other facility or service for the purpose of online advertisement.
Further, consideration received or receivable for “specified services” shall not include the consideration, which are taxable as royalty or fees for technical services in India under the IT Act, read with the relevant tax treaty of the country. However, there are transactions which are not taxable as royalty or fees for technical services in India because of the restricted definition in tax treaties. Despite such transactions not being taxable as royalty or fees for technical services, they are still covered within the ambit of equalisation levy. The Government may amend the definition of “specified service” to exclude not just transactions taxable as royalty or fees for technical services, but also those that are not chargeable to tax, mainly because of the nature of transaction.
TCS on sale of unlisted shares to non-resident
Section 206C(1H) of the IT Act requires a specified seller to collect from the buyer, tax at source (TCS) @ 0.1% of the sale consideration exceeding INR 50 lakhs. There are no TCS liability on import of goods into India or export of goods from India. Section 194Q of the IT Act requires a buyer to withhold taxes @ 0.1% while making payment to resident seller for purchase of goods for value exceeding INR 50 lakhs. CDBT vide Circular No. 13 of 2020 dated 30 June 2021, clarified that, provisions of section 194Q shall not apply to non-resident, whose purchase of goods from seller resident in India is not effectively connected with the permanent establishment of such non-resident in India. Subsequently, CBDT vide Circular No. 17 of 2020 dated 29 September 2020, clarified that the TCS provision would not apply to transactions carried out through various exchanges (i.e., listed securities). Thus, it appears that unlisted securities are not excluded, and could be covered by Section 206C(1H) of the IT Act.
It is expected that, to remove difficulties being faced by the taxpayers, following amendments may be carried out:
Provisions for limitation of interest benefit
It was observed that non-resident associated enterprises of Indian companies used debt/ borrowings instead of equity investment to fund operations in India. In order to curb such companies from enjoying deduction of excess interest, the Government introduced ‘Thin capitalisation rules’ (Section 94B). For the purpose of computing limitation of interest, excess interest is stipulated to mean
(a) Total interest paid or payable in excess 30% of EBITDA, or
(b) Interest paid or payable to associated enterprise, whichever is less.
Section 94B(2) of the IT Act, refers to ‘total interest paid or payable’. It is unclear whether for purpose of determining amount of excess interest, interest paid to third party lenders (i.e., other than associated enterprises) should be included in ‘total interest paid or payable’. The literal reading of the section does not create any limitation on inclusion of interest paid or payable to associated enterprises only. This expands the scope of the term ‘total interest paid or payable’ to a great extent.
It is expected that for the purpose of computing ‘excess interest’, the term ‘total interest paid or payable’ may be defined to include only interest paid to the associated enterprises.
Expectations regarding compliance procedures in transfer pricing
| Section | Existing provisions | Expectations |
| Section 92C read with rule 10CA | For determining arm’s length price, the range concept is from 35th percentile to 65th percentile for 6 or more comparables and arithmetic mean for less than 6 comparables.
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The interquartile range of 25th percentile – 75th percentile be allowed to justify the arm’s length standards and to be consistent with various other tax administrations. |
| Section 92D | Persons entering into international transaction, aggregate value of which exceeds INR 1 crore, are required to maintain, keep and furnish information and document. | Threshold for maintaining TP documents is increased to INR 10 crores. |
| Section 92E | Non-residents are not required to file income tax return in India if their income comprises of specified category such as interest, dividend, royalty and fees for technical services and taxes have been deducted as stipulated therein.
However, such non-residents are required to file transfer pricing audit report. They are also required to maintain TP documentation w.r.t the transaction for which return of income is not required to be filed. |
Taxpayers that are not required to furnish return of income are exempted from furnishing transfer pricing report and maintaining TP documentation.
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Time limit for passing order under various provisions
| Section | Existing provisions | Expectations |
| Section 195 | A person may make an application before the tax authorities for determining the whether the sum being paid to a non-resident is chargeable to tax or not. However, no time limit is prescribed for passing such order. This causes undue hardship in genuine cases. | An appropriate time limit of 30 days may be imposed for passing such order by the tax authorities. |
| Section 201 | Where a taxpayer does not comply with the withholding tax provisions, no time limit is provided for passing an order under Section 201 of the IT Act which makes him an “assessee in default”.
Presently, a review petition is filed in the Supreme Court against the verdict in case of Engineering Analysis Centre of Excellence Pvt Ltd [2021] 125 taxmann.com 42 (SC) which dealt with the long pending matter w.r.t purchase of software, whether royalty or license fees. Since the review petition has not been disposed off as on date, order under Section 201 has not been passed for the last 2-3 years in matters dealing with similar issue. |
Limitation period of 2-4 years from the end of the year in which the transaction has taken place may be introduced for passing order under Section 201. |
Disclaimer: The information contained in this document is intended for informational purposes only and does not constitute legal opinion or advice. This document is not intended to address the circumstances of any individual or corporate body. Readers should not act on the information provided herein without appropriate professional advice after a thorough examination of the facts and circumstances of a situation. There can be no assurance that the judicial/quasi-judicial authorities may not take a position contrary to the views mentioned herein.