Tax implications of setting up overseas subsidiaries
There is a rising trend that many start-ups incorporate their ultimate holding companies abroad, especially in Singapore for various reasons with tax being one of the top 3 factors for such decisions.
Some of them have restructured the holding structures after few months of direct Indian holding to accommodate requests from investors and VCs. Apart from ease of regulatory environment in the case of overseas companies, the tax implications in such scenarios could be a grey area and potentially a serious cause of concern if not managed amicably.
A typical overseas structure could be:
Let’s now try and understand the tax implications of the above mentioned typical structure:
– Capital gains on sale of shares of Singapore Holding Company (SHC): This seems to be one of the biggest reasons for such a structure especially where the funds investing are registered overseas. In the case of Singapore, Mauritius, Dubai or similar jurisdictions, there is no domestic tax on capital gains hence the shareholders may not be subject to tax on sale of shares in SHC.
However consequent to recent amendments in Income tax law, if SHC derives more than 50% of its value from assets in India and that the sale value exceeds Rs 10 crores, then proportionate capital gains shall still be subject to tax in India irrespective of domestic tax laws in the country of incorporation of SHC.
The case for concern in this scenario is the conflict of interpretation between Double Taxation Avoidance Agreements (DTAA) and Income tax law – since as per DTAA this transaction would continue to be taxed only in Singapore (where capital gains is taxed @ 0%) and as far as Indian laws are concerned, DTAA always prevails over domestic taxation laws.
– Royalty income of SHC: Royalty earned and received by SHC from Indian Selling Company (ISC) would be subject to withholding taxes in India @ 10% provided:
o Tax residency certificates (TRC) of SHC is made available to ISC and o SHC has an Indian PAN
Where one or both the above conditions are not fulfilled the withholding tax rates could be anywhere between 20-40%.
– Software charges of Indian Software Development Company (ISD): ISD receives software development charges from SHC. These could be subject to withholding taxes as Fees for Technical Services (fts) @ 10/15% subject to DTAA. ISD can in turn claim the taxes deducted as foreign tax credit subject to tax credit rules.
– Place of Effective Management (POEM) and Case for Residential Status: A company incorporated outside India would be regarded as a resident if the control and management of the company is wholly situated in India.
However, recently, this law was amended to state that if the POEM is in India, the foreign company (SHC) could be regarded as a resident in India. Hence if SHC is only a shell company based out of Singapore and that none of its board meetings or directors are based out of Singapore with the management being effectively carried out of India, SHC shall be regarded as a resident company in India. In such a scenario, all incomes earned by SHC shall be subject to tax in India with a potential conflict with the DTAA.
– Applicability of Transfer Pricing Rules: Any transaction with an Indian entity with its related person overseas shall fall within the ambit of transfer pricing rules. Accordingly all the transactions which are subject to transfer pricing shall be made at fair market values (technically known as arm’s length price [ALP]).
Hence royalties paid by ISC and software development charges received by ISD shall be subject to transfer pricing. Detailed commercial contracts and invoices need to be prepared for these transactions. There are elaborate rules and regulations provided for determining alp which need to be adhered. Non compliance could lead to serious penalties and tax levies. It is noteworthy to mention that India is one of the popular jurisdictions globally for high value transfer pricing litigations.
– Absence of Angel Tax: Angel tax is a levy on exorbitantly high premiums received by Indian companies from resident investors other than registered VCs and Angels The controversial angel tax which is, unfortunately still prevalent in India could be one of the serious reasons for an overseas holding company as most of these jurisdictions if not all do not have such a draconian levy.
– Taxability of Dividends distributed by ISC and ISD: Indian companies are subject to corporate tax @ 30% plus surcharge (7/12%) and cess @ 3% depending on their income levels. Post tax profits, when distributed are subject to 15% distribution plus surcharge and cess. However dividends distributed by ISC and ISD to SHC are not subject to any further tax in India since dividends from Indian companies are fully exempt in India.
– Capital gains on sale of shares of ISC and ISD: Where there is a potential opportunity to divest stake in any one or both of the Indian subsidiaries, capital gains on sale of shares shall technically arise only in India and could be subject to 20/40% tax based on the period of holding of shares.
However in the case of beneficial treaties like those with Singapore and Mauritius, these gains could be taxed in Singapore/Mauritius and not in India in which case the resultant capital gains may not be taxed at all (both Singapore and Mauritius have 0% capital gains tax rate). However if such treaties have Limitation of Benefits clause (it is currently being negotiated with Mauritius and is prevalent to a limited extent with Singapore) then the benefit of shifting capital gains tax out of India may not be available.
The above mentioned implications would have given you a perspective on the various tax implications which arise consequent to an overseas structure. While it may be attractive to have one, maintaining it and complying with the procedures is certainly an expensive affair vis-a-vis a completely Indian option. However the trade offs, especially in the case of successful startups could be very high which make it certainly worthy to get into such a structure.
Apart from taxation concerns, there are other potentially valid reasons like ease of fund raising, free movement of funds across geographies, ease of geographical expansion etc, which could also be favourably considered while setting up such structures overseas.
