Taxation of undistributed profits of foreign companies controlled by Indian MNCs’, an evident outcome?

By: Jayesh Sanghvi, Partner & National Leader – International Tax Services, EY India

Multinational groups can create non-resident affiliates in low tax jurisdictions to which income is shifted, wholly or partly for tax reasons rather than for non-tax business reasons. Such overseas profits are not subjected to tax in the hands of shareholders unless distributed/ repatriated to them. Controlled foreign company (“CFC”) rules combat such deferral of taxes on foreign source income by enabling jurisdictions to tax income earned by foreign subsidiaries where certain conditions are met. Many countries already have CFC rules, but it is noted that these rules do not always counter base erosion and profit shifting (BEPS) in a comprehensive manner. In this background, work under Action 3 of OECD and G20’s BEPS Project on strengthening the CFC rules assumes significance.

On 3 April 2015, OECD released its Discussion Draft (DD) on Action 3. The DD recommends the policy considerations and design of CFC rules which can be implemented by countries in its domestic laws. It identifies that the core elements or “building blocks” of CFC rules:

(i) What is a CFC, threshold of control- CFC is a foreign company generally located in low tax jurisdiction, which is controlled by residents of another jurisdiction. CFC should be defined broadly to include both corporate and non-corporate entities [such as partnerships, trusts, and permanent establishments (PEs)] if such entities are taxable separate from their owners. In order to control, residents should hold minimum 50% stake (individually or collectively) in the foreign company. In this regard control could be legal/economic, direct/indirect control, etc.

(ii) What is “CFC income” to be attributed to parent company- Objective of CFC rules is not to hamper genuine business activities but to trace passive income which can be easily parked offshore, especially in a low-tax jurisdiction. Hence, DD recommends that as a general principle, a highly mobile and/or passive income should be covered, such as dividends, interest, royalties, etc. At a minimum, CFC rules should capture income that raises BEPS issues and should not capture income that arises from value-creating activity in the CFC jurisdiction. Several approaches could be adopted in combination to define the CFC income, including form/ substance based analysis.

(iii) CFC income to be computed as per rules of parent jurisdiction. Further, a specific rule with regards to treatment of CFC losses should be laid down.

(iv) Rules for attributing income – Once CFC income is determined, the same is attributed on deemed distribution basis in the hands of residents (shareholders) who exercise control over such CFC. This involves determination of when, how much, whom to attribute and also tax treatment of such attributable income.

(v) Rules to prevent or eliminate double taxation-Under CFC rules, certain situations could lead to double taxation which needs to be eliminated by granting credit or exemption. For instance – Dividends received on actual distribution or gains on disposition of CFC shares should be exempted if the corresponding income has previously been subject to CFC taxation.

Pursuant to a consultative process on the above DD, OECD’s final report on Action 3 is expected to be released shortly on 5 October 2015.

Where does India stand today?

To encourage repatriation of profits, Indian tax law provides a concessional tax rate of 15% on foreign dividends received by an Indian shareholder. However, the Indian tax law doesnot presently contain CFC rules. CFC rules have been debated over last many years in India and Government’s desirability to introduce the same is largely evident. The rules were first proposed as a part of the Direct Tax Code (DTC) in India and CFC regime is one of the last remaining concepts from the DTC to be incorporated in the Indian tax law, which has already adopted several DTC concepts including the definition of Place of Effective Management vide Finance Act 2015.

The draft CFC rules under the DTC (‘draft rules) are at variance on many aspects with the OECD’s recommendations under Action 3. Significantly, the draft rules do not apply to non-corporate foreign entities, though it proposes a broader coverage of CFC income. The draft rules contain a de minimus amount exemption from application of CFC rules and it also provides to consider for a white countries list to which CFC rules will not apply. The draft rules may need to be reconsidered/ modified in light with the final recommendation on Action 3.

As a key stakeholder in OECD/G20 BEPS project, India is committed to implement the OECD’s recommendations in the context of CFC.

However, it needs to be seen how Indian Government will implement the final proposals and one may look at the forthcoming Union budget in this regard.

If CFC rules are introduced in India, it will have significant implications on the taxation of global businesses. Multinationals may proactively consider how the BEPS recommendations may affect them, consider the countries where they operate or invest, and consider engaging in the dialogue with the Government regarding the CFC legislation and the underlying international tax policy issues.