TAX LIABILITY OF FOREIGN COMPANIES DOING BUSINESS IN INDIA
CONTENTS
1. Introduction
a. Meaning of a Foreign Company
2. Part I- Basic Principles Regarding Taxation Of Foreign Bodies
a. Taxation of Foreign Companies under the Income Tax Act
b. Double Taxation Avoidance Agreements and Tax Liability of Foreign Companies
2. Part II- Kinds Of Foreign Operations And Their Tax Treatments
a. Creating one’s Own Setup in India
i. Branch office
ii. Project Office
iii. Wholly Owned Companies (100% Subsidiary)
iv. Joint Venture Companies
v. Liaison Office
b. Outsourcing of work to India
1. Introduction
The New Economic Policy of 1991 drastically changed the face of India and India has seen considerable development since. Perhaps the most significant area of change post 1991 was of foreign investments. The Foreign Exchange Regulations Act (FERA) had some patently retrograde provisions which could not continue if Indian business was to prosper or globalise. After various amendments to FERA, the Government realized that the said Act could still not keep up with the rapid changes taking place. This led to the passing of a new Act in 1999 namely, the Foreign Exchange Management Act (FEMA). FEMA was based on the realization that foreign investment is not merely beneficial for a developing economy but indispensable for an economy to mature and have global aspirations.
Relaxation of the legal framework saw immediate results in terms of increase in foreign investments. The cumulative FDI from 1991-2007 has exceeded USD 54,628 Million (in 2006-2007 alone it was USD 15,726 Million, which represents a 184% increase from the previous year). The forex reserves of India currently stand at over USD 230 billion, while in March 1991 it was just USD 5.8 Billion.
With increased foreign investment, the issue of tax has assumed significance. Various cross-border tax issues have cropped up which had previously not existed.
This article aims to present a bird’s eye view of the general principles of taxation of foreign companies operating in India. The article shall also briefly dwell on the different types of structuring a foreign concern can go for in India, and the tax implications thereof. In this article, the term ‘foreign company’ is used to include all non-domestic entities as well.
a. Meaning of a Foreign Company
In order to be able to understand the complex issues involved in computing tax liability of foreign companies, it is first important to know what is meant by an Indian company and a foreign company. An Indian company is a company which is formed and registered under the Indian Companies Act, 1956[1]. According to the Income Tax Act, 1961 (hereinafter, IT Act) a foreign company is that company, which is not a domestic company[2]. Therefore in order to understand the meaning of foreign company it is first essential to define a domestic company. As per the definition in the Income Tax Act, a domestic company means an Indian company, or any other company which, in respect of its income liable to tax under the Income Tax Act 1961, has made the prescribed arrangements for declaration and payment within India, of dividends (including dividends on preference shares) payable out of such income. [3] In other words if a company is an Indian company, it will automatically be considered a domestic company. In case of any other company, in order to become a domestic company, it is essential that the company has made the prescribed arrangement for declaration and payments within India of dividends out of such income. This condition, regarding the arrangements to be made for declaration and payment of dividend in India is required to be fulfilled only by companies other than Indian companies.[4]
2. Part I- Basic Principles Regarding Taxation Of Foreign Bodies
The tax liability of a foreign company is dependant on (a) its tax liability under the Income Tax Act & (b) The Double Taxation Avoidance Agreement (DTAA) if any, between India and its home country.
a. Taxation of Foreign Companies under the Income Tax Act
Domestic companies in India are taxed on their world income arising from all sources in India as well as outside India in accordance with the provisions of the Income Tax Act. Foreign companies on the other hand, are essentially taxed on the income earned through a business connection in India or from other Indian sources. Therefore if a foreign company does not have any business connection in India, then the income of such company cannot be taxed.
Taxability of income through “business connection” is provided in section 9(1)(i) of the IT Act. The expression “business connection” was not earlier defined in the Act. However, the Finance Act 2003 inserted an explanation to Section 9 of the Income Tax Act thereby clarifying that the expression “business connection” includes a person acting on behalf of the non-resident and who:
(a) Habitually exercises in India, an authority to conclude contracts on behalf of the non-resident, unless his activities are limited to the purchase of goods or merchandise for the non-resident; or
(b) Has no such authority, but habitually maintains in India a stock of goods or merchandise from which he regularly delivers goods or merchandise on behalf of the non-resident; or
(c) Habitually secures orders in India, mainly or wholly for the non-resident or for that non-resident and other non-residents controlling, controlled by, or subject to the same common control, as that non-resident.
The business connection does not include cases where the business activity is carried out through a broker, general commission agent or any other agent having an independent status if such person is acting in the ordinary course of the business[5]
A relation is treated as a “business connection” if the relation is real and intimate, and through or from which income must accrue or arise whether directly or indirectly to the foreign company.[6] In order for a business to come within the ambit of Section 9(1)(i), it is necessary that the business relationship between the resident and the foreign company, should be a continuous one and not an isolated transaction.
A business connection may take several forms: it may include carrying on a part of main business of the foreign company through an agent, or it may merely be a relation between the business of the foreign company and the activity in India, which facilitates or assists the carrying on of that business. It is important to note that, the expression ‘business’ does not necessarily mean trade or manufacture only and also includes within its scope a profession, vocation or any other calling.[7]
b. Double Taxation Avoidance Agreements and Tax Liability of Foreign Companies
Double taxation is a situation in which two or more taxes may need to be paid for the same financial transaction due to overlap between different countries’ tax laws and jurisdictions. The tax payer may find that he is obliged by domestic laws to pay tax on income locally and pay again in the country in which the income was earned. Since this is inequitable, many countries make bilateral Double Taxation Avoidance Agreements with each other (hereinafter DTAA). In some cases, this requires that tax be paid in the country of residence and be exempt in the country in which it arises. In the remaining cases, the country where the gain arises deducts taxation at source and the taxpayer receives a compensating tax credit in the country of residence to reflect the fact that tax has already been paid.
Section 90 of Income Tax Act empowers the Central Government to enter into agreements with foreign countries which are normally termed as Double Taxation Avoidance Agreement (DTAA).
India has entered into DTAAs with about 70 countries. The provisions of these agreements take precedence over the provisions of the IT Act, except insofar as the provisions of the IT Act are more beneficial to the foreign companies. The agreements also provide for concessional rate of tax in respect of royalties, dividend, fees for technical services and interest.
Thus a foreign company’s tax liability will be determined by the IT Act, and the DTAA between India and its home country, with the provisions of the DTAA taking precedence over those of the IT Act, in all cases except where the later are more beneficial to the foreign companies.
DTAA’s require a somewhat permanent nature of presence of the non-resident in India to be able to exercise the jurisdiction of taxing the business income. Such presence is established through the existence of a “permanent establishment”. Generally a foreign company is treated as having a Permanent Establishment in India if the said foreign company carries on business in India through a branch, sales office, etc., or through an agent (other than an independent agent) who habitually exercises an authority to conclude contracts or regularly delivers goods or merchandise or habitually secures orders on behalf of the non-resident principal.[8]
Thus, in short a PE exists when a company has a fixed place of business located in a foreign jurisdiction through which activities of a company are wholly or partially carried on. The term “permanent establishment” includes a place of management, a branch, an office, a factory, a workshop, a mine, oil well or other place of extraction of natural resources, a building site or construction or assembly project which exist for an agreed period. However the term PE does not include certain activities such as a sales office in which individuals do not have the capacity to contract and whose primary functions are simply advertising the products.
Companies that are setting up permanent establishments in India without giving due attention to the tax issues associated with may land up in serious tax problems as double taxation can then take place. In order to avoid the same, the foreign companies should ensure that there exists a relationship of “independent agency” between the Indian subsidiary and the foreign company. In determining whether there is actually an independent relationship existing, the Indian Courts have derived 6 tests:[9]
- Were the profits treated as those of the parent company?
- Were the persons conducting the business appointed by the parent company?
- Was the parent company responsible for all ideas implemented by the trading venture?
- Did the parent company govern the venture and did it decide how much capital should be invested in it?
- Were the profits made by the parent’s company’s skill and direction?
- Was the parent company in effectual and constant control?
If the answer to all these questions is in the negetive, and there is an absence of common directors, then an independent relationship is established between the Indian subsidiary and the foreign company.
While determining the income of PE on which tax is to be levied certain guidelines are to be followed. Therefore while calculating the Profit of the PE, the PE will be treated as if it were a separate and wholly independent enterprise. Thus the profits which are to be attributed to a PE are those, which that PE would have made if, instead of dealing with its Head Office, it had been dealing with as an entirely separate enterprise[10] and tax will be levied on such profits. However deductions with regard to expenses incurred for the purposes of the PE including executive and general administrative expenses so incurred, whether in India or elsewhere would be deductible in accordance with the accepted principles of accountancy and the provisions of the Income-tax Act.
3. Part II- Kinds Of Foreign Operations And Their Tax Treatments
A non Indian company, interested in doing business in India has the option of entering the Indian market either by (I) creating its own setup in India or (II) by outsourcing its work to a local company in India.
a. Creating one’s Own Setup in India
If the foreign investors decide to have their own set up, then they can opt for any one of the following:
1. Branch Office
2. Project Office
3. 100% Owned subsidiary
4. Joint Venture
5. Acquisition
6. Liaison Office
i. Branch office
A branch office would mean an establishment carrying on largely the same activity as its Parent office. Foreign companies intending to open a Branch Office in India need to obtain prior permission of RBI (from the apex foreign exchange management authority in India) and are also required to obtain a Certificate of establishment of place of business in India from the Registrar of Companies (ROC). As per the guidelines laid down by the RBI, the Branch Office in India is allowed to carry on only the following activities[11]:
- Undertake export and import trading activities
- Render professional or consultancy services
- Carry out research work, in which the parent company is engaged
- Promote technical or financial collaboration between Indian companies and parent or overseas group companies
- Represent the parent company in India and acting as buying / selling agent in India
- Render technical support to the products supplied by parent / group companies
A branch office can undertake trading activities, but not manufacturing. Further, it cannot expand its activities or undertake any new trading, or commercial activity other than that which is approved by RBI. However, a branch office of a foreign company is not treated as a separate legal entity but is considered to be a part of the foreign company and therefore is liable to tax at 41.82% on income accrued in India. The only respite is if there exists a double taxation avoidance agreement with the country in which the foreign company is incorporated, the tax paid in India can be set off against the total tax payable by the parent company abroad.
ii. Project Office
Foreign Companies can set up temporary Project/Site Offices in India to execute specific projects. Prior approval from the RBI is not required but certain specified conditions have to be fulfilled. Such offices cannot undertake or carry on any activity other than the activity relating and incidental to execution of the project. Like a branch office, a project office is also subject to income tax at the rate of 41.82% (subject to Double Taxation Avoidance Agreement). Project Offices may remit outside India the surplus of the project on its completion, general permission for which has been granted by the RBI.
iii. Wholly Owned Companies (100% Subsidiary)
A foreign company can opt for 100% wholly owned subsidiary in the form of a private company in India. For tax purposes, this subsidiary company is treated as a domestic company and is taxed at the rate of 33.66%. A foreign company can invest up to 100% in shares of an Indian company in those cases where 100% foreign direct investment is permitted under the FDI policy. Where Government has put a sectoral cap on investment, a wholly owned subsidiary can be set up only after approval from Government of India. In case the parent company wishes to take some of the profit earned in India by the subsidiary company, then the parent company can do so by way of dividend. Earlier dividend tax at a rate of 15% was applicable but from 2003 dividend tax is not applicable.
iv. Joint Venture Companies
Most foreign investors opt for this form of a company as it allows the Foreign Investor and the Indian partner to do what each does best - the foreign partner brings in technology, systems and products and the Indian partner takes care of Human resources, marketing, legal and tax issues. Establishing a joint venture in India has the advantage of having the financial resources and established contacts of the Indian partners, therefore in general the setting up of the company in the market becomes relatively easier. Moreover there are no separate laws for joint ventures in India. The companies incorporated in India are treated as domestic companies and therefore they would be taxed at the rate of 33.66%. The foreign partner however would have to pay tax under different heads such as royalty, technical fees, interest and dividend (no tax on dividend from 2003).
v. Liaison Office
A Liaison Office is in the nature of a representative office which is essentially set up to explore market opportunities and understand the business and investment climate. Any foreign company intending to open a liaison Office in India is required to obtain prior approval from the RBI. Approval is usually granted for three years and can be renewed on expiry thereof. In addition to above, the foreign company is also required to obtain a Certificate of establishment of place of business in India from the Registrar of Companies (ROC). A liaison Office is not permitted to undertake any commercial / trading/ industrial activity, directly or indirectly and therefore it cannot earn any income in India. It is required to maintain itself out of inward remittances received from abroad through normal banking channels and is therefore not liable to any income tax in India.
b. Outsourcing of work to India
In case the foreign investor decides not to set up his own business in the country, then the other option is, to outsource work to Indian companies. This has growingly become a very popular choice and BPO’s (Business Process Outsourcing units) have come up all over the country. India has become a cost-effective option for foreign companies as the country has a huge educated and English speaking workforce with the majority of workforce consisting of young college graduates wanting to earn quick money. India has built a huge BPO industry, and has become a prime outsourcing destination among Philippines, China, Mexico, Ireland, Poland, Australia, Hong Kong, Russia and New Zealand. India is becoming synonymous with outsourced services in the same way that China has become with outsourced manufacturing.[12] Earlier the Indian tax department, was looking at imposing tax on these BPOS’s but the Supreme Court in the Morgan Stanley Advantage Services case has ruled that BPO’s of foreign firms operating in India are not liable to be taxed in the country. It also ruled that Morgan Stanley Advantage Services MSAS would not amount to a Permanent Establishment, as it was only performing back office operations and was not an agency PE as it did not have any authority to enter into contracts. Further the court also held that the Indian subsidiary’s income arising from global operations will not be taxed in the country and only that income which arises from Indian operations will be taxed on the basis of transfer pricing principle.[13] Thus with this judgement, the tax liability of such BPO’s has become clear and has come as a huge relief to the foreign companies like GE, HSBC, Standard Chartered Bank which outsource their back office work to India. Thus the judgment will help attract foreign investment in the BPO sector from MNC’s which plan to outsource their work as once the arm’s length principle is established by the MNC, no further tax liability would arise with regard to that BPO.
[1] Section 2(26) Income Tax Act, 1961
[2] Section 2(23A) Income Tax Act, 1961
[3] Section 2(22A) Income Tax Act, 1961
[4] S.C. Dani Research Foundation (P.) Ltd. V. Asstt. CIT (1996) 56 ITJ (pune) 654
[5] First proviso to Explanation 1 of section 9(1) (i) of the Income Tax Act, 1961
[6] Commissioner Income Tax v. R.D. Aggarwal & Co. AIR 1965 SC 1526
[7] Barendra Prasad Ray v. ITO [1981] 129 ITR 295 (SC).
[8] Dr. Vinod K. Singhania & Dr. Kapil Singhania, Taxman’s Direct Taxes, Law & Practice, 38th edition, 2007.
[9] Naresh Makhijani, Permanent tax burden?, www.fDimagazine.com
[10] Dr. Vinod K. Singhania & Dr. Kapil Singhania, Taxman’s Direct Taxes, Law & Practice, 38th edition, 2007.
[11] http://www.charteredaccountantdelhi.com/company-law-service.html
[12] Naresh Makhijani, Permanent tax burden?, www.fDimagazine.com
[13] Captive BPOs of MNCs not liable to pay tax, The Hindu, Tuesday, Jul 10, 2007
About the Author
Sajni Patel
Final Semester,
B.Com LLB (Hons)
Gujarat National Law University, India.
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