Infrastructure is regarded as the most crucial enabler of accelerating the India Growth Story.  While, in the recent past, there has been traction in public spending, private spending is still under cloud.  Increase in private spending in general and more specifically in the infrastructure sector can play a crucial role in pumping up the economy considering the secondary demand the sector creates for the core industries.  Hence, there exist a compelling case for ensuring flow of fresh and regular capital to the currently cash starved infrastructure sector.

Considering the above and with an aim to provide a suitable platform for financing / refinancing infrastructure projects and allow the retail investors to participate in the growth story of infrastructure, the Government introduced a new investment vehicle named Infrastructure Investment Trusts ('InvITs') in 2014.

In order to make InvITs successful and attractive, the Government introduced favourable taxation framework for InvITs in consecutively Finance Budgets for FY 2014-15, FY 2015-16 and FY 2016-17.  In continuation of its efforts to make the InvITs successful, the SEBI has been introducing various amendments to InvITs regulations.  In the recent amendment dated 30 November, 2016, SEBI, inter-alia, allowed two level SPV structure as against holding infrastructure assets either directly or through a single layer SPV structure. While the subject relaxation made by SEBI is recommendable, it would be equally important that enabling changes in the Income-tax Act, 1961 ('the Act') are also made.

Further, having regard to the fact that many infrastructure players have expressed interest in InvITs, it is essential that the Government should also consider ironing out tax inefficiencies with respect to two level structures and other tax aspects listed below in the upcoming Budget:

(a)  Extend the favourable taxation regime to two level SPV structure: As per the current provisions of the Act, dividend distribution tax is exempted on dividend distributed by specified SPV to InvIT in single level SPV structure.  This provision do not cover the two level SPV structure. Under the two layer SPV structure, dividend will travel from SPV to Holding company ('HoldCo') and from Holdco to InvIT.  The dividend paid by SPV to HoldCo will not enjoy the exemption under the current taxation scheme and will be subjected to dividend distribution tax @ 20.358 %. This will result into an additional tax cost and will have a significant adverse impact on the investors return as compared to single level SPV structure.

Further, under the single level SPV (company) structure, interest income earned from SPV is exempted in the hands of InvIT under the current taxation regime. However, there is no provision providing similar exemption to interest income earned by the HoldCo from SPV under the two layer structure.  This additional tax cost could make the structure tax inefficient unless there is a back to back interest pay out by the HoldCo.

In order to provide tax parity with single SPV structure, it is essential that the Government makes necessary amendments in the upcoming Budget to extend the favourable taxation regime to recently introduced two level SPV structure.

In addition to above tax issue, the Government should also provide exemption from applicability of NBFC and CIC regulations to the HoldCo under the two layer SPV structure as InvITs are already regulated by SEBI.

(b)  Extend the interest income exemption to LLP structure: As per the current provisions of the Income-tax Act, interest income in the hands of InvITs received from SPV is exempt under section 10(23FC) of the Act. The SPV is defined to cover only Company and does not cover debt investments made in SPV set up as Limited Liability Partnership ('LLP'). It is pertinent to note that the SEBI regulations permit the SPV to be formed either as a Company or LLP, whereas the benefit of interest exemption under the provisions of the Act is available only to SPV set up as Company. This makes LLP structure tax inefficient.

The Government in the upcoming Budget should make suitable amendments to widen the scope of SPV to include LLPs entity form in order to provide a level playing field.

(c)  Period of holding should be restricted to 12 month period: Currently, long term capital gains arising on sale of units of InvIT is exempted under the provisions of the Act. However, the period of holding of InvIT units to qualify as long term capital asset is 36 months. A larger holding periodicity to qualify as long term capital asset can discourage investors thereby impacting the very success of InvIT. In order to bring parity between units and listed company shares, it is recommended that the holding period of units of InvIT to be reduced to 12 months to qualify for long term capital asset.

(d)  Restriction on carry forward of losses on account of change in shareholding: Where more than 51% of the voting shares of the closely held SPV are transferred to InvIT in exchange of units, the ability to carry forward losses of SPV gets impacted.  The lapse of losses can hamper the proliferation of InvIT since it is will increase the tax burden of SPVs. Accordingly, it is recommended that the restriction on carry forward of losses should not be made applicable to InvIT.

Conclusion

While InvITs are slowly finding its feet and making inroads into the financial system, favourable resolution of the above aspects by the Government would certainly help in realising the true potential of InvITs and enable InvITs to act as catalyst to the growth of Indian Economy.  

2016 has proved to be a watershed year for the real estate sector, with two impactful events. The first was the passing of the RERA, and the second was demonetization. Both these have served to usher in greater transparency in the real estate sector.

While many insiders complain that that these measures have hurt business, in the long run, they are likely to be beneficial for the sector. As they say, sunlight is the best disinfectant. RERA will protect consumers better, and usher in standardized business practices in the industry. The transparency brought in by demonetization will boost investor sentiment.  There is hope that the hurtful impact of RERA and Demonetization is merely transient, and the Government has one eye firmly set on taking concrete steps towards achieving the lofty objective of “housing for all”.  One sign of that is the PM's announcement on 31 December, of interim measures to support affordable housing. These, they see as green shoots for expectation of further measures in the same direction, and in another promising direction - the push for “smart cities”.

Items on the “wish list” of the real estate sector are listed below.

Promote affordable housing - The 2016 Budget had introduced a tax holiday for income of developers from specified housing projects that fulfilled prescribed conditions. Some conditions need to be relaxed to raise the level of interest of developers in this direction, like project completion period of 3 years, FSI utilization, built-up area limit, etc. If there is a project completion period, there should be a single window for expediting approvals.

Eliminate notional taxation - House property that is not self-occupied currently attracts notional tax in the owner's hands. This is a triple whammy for developers-they are finding it difficult to sell homes, they are finding it difficult to rent them out, and then, they have to pay tax on entirely notional rental income. Those who have, in spite of trying, been unable to rent out such properties, should be spared from notional taxation. The removal of such notional taxation may also help individual investors, and remove the disincentive in owning a second home.

Investors need to get more money in their pockets. This could be achieved by :

1. Lowering tax rates and/or raising slab rates, which would reduce the tax bill
2. Increasing deduction of interest on home loans from the current limit of Rs.2 Lakhs

Rationalize anti-abuse provisions in the tax law, in cases where immovable property is sold below the stamp duty value. Currently, this provision results in double taxation when property is sold to an individual or an HUF at below stamp duty value. Taxation in the hands of the recipient should be removed. 

Real Estate Investment Trusts (REITs): In Budget 2016, Dividend Distribution Tax ('DDT') was exempted on dividend paid by portfolio companies to REITs. This was a salutary measure, but was restricted only to single-tier structures. REIT Regulations were subsequently amended to allow flipping even holding companies (which in turn hold the portfolio companies) to REITs (i.e., a two-tier structure). Exempting two-tier structures from DDT will be a measure in the same direction of encouraging listing of REITs in the coming months and years.

We have captured some measures that could help revive the systemically important real estate sector, which provides one of the three basic necessities of life. This will aid the Government in progressing rapidly on the twin objectives of 'housing for all' and 'smart cities'. We wait with bated breath for Budget Day! 

With BEPS gaining significant importance across the globe, will the FM adopt OECD led action plan on curtailing deductions towards interest and other financial payments.  If he does so, equilibrium would have to be maintained to attract investments with the objective of “Make in India” and “Digital India” campaign of our Prime Minister!”

The Government of India, in the past budgets, have made attempts to improve investments to India. With the objective of taking India to global platform, several campaigns were started and efforts were made to attract foreign investments in several sectors.  At the same time, in view of globally renewed agenda of tackling profit shifting to low tax jurisdictions, Government of India took major steps in the last budget by introducing provisions related to country-by-country reporting of income, earnings and taxes paid. India has been one of the active members of BEPS initiative and part of international consensus. Accordingly, one will have to wait and watch if the FM is keen on taking additional steps in this direction inter-alia curtailing deductions towards interest and other financial payments in accordance with Action plan 4 of the BEPS project.

The final report on Action 4, Limiting Base Erosion Involving Interest Deductions and Other Financial Payments, recommended that countries implement a “fixed ratio” rule that would limit net interest deductions claimed by an entity (or a group of entities operating in the same country) to a fixed percentage of earnings before interest, taxes, depreciation and amortization (EBITDA). The final report also states that this ratio should be somewhere between 10% and 30% of applicable EBITDA. This range was agreed based on financial data provided to OECD and with the aim of ensuring that majority of groups could deduct their net third party interest expense and it limits the extent to which groups can use intragroup interest expense to claim total net interest deductions in excess of their net third party interest expense. The report also includes factors which countries should take into account in setting their fixed ratio within this range. The range of 10% to 30% was thus described as having been designed to provide meaningful caps on net interest expense.

The report further recommends that countries adopt a “group ratio” rule to supplement the fixed ratio rule, and to provide additional flexibility for highly-leveraged groups or industry sectors. Under the group ratio rule, an entity with net interest expense above a country's fixed ratio could deduct such interest expense up to the level of the net third-party interest/ EBITDA ratio of the worldwide group to which it belongs. Countries could also apply an uplift of up to 10% to the group's net third party interest expense to prevent double taxation. An alternative group ratio rule also could be considered such as an “equity escape” rule, which would allow interest expense so long as an entity's debt-to-equity ratio does not exceed that of its worldwide group.

The final report recommends that countries consider the following:

• using an average of EBITDA for the current year and prior years, to minimize the impact of earnings volatility on interest deductions;
• providing for carryforward and/or carryback of disallowed interest expense and/or unused interest capacity, within limits;
• providing for exclusions for interest paid to third party lenders on loans used to fund public-benefit (infrastructure) projects and for entities with net interest expense below thresholds
• providing targeted rules that would close down any remaining BEPS opportunities

The final report indicates that other limitations on interest expense, such as those arising under a country's application of the arm's-length principle or thin capitalization rules, should be applied first. Moreover, interest disallowed under Action 4 should be subject to withholding tax.

On 22 December 2016, the OECD issued an updated version of its final report on Action 4. The updated Action 4 report contains three parts: i) Limiting base erosion involving interest deductions and other financial payments; ii) Elements of the design and operation of the group ratio rule; and iii) Approaches to address BEPS involving interest in the banking and insurance sectors. While Part I remains same, Part II of the updated report focuses on how to calculate a group's net third party interest expense, how to calculate the group earnings before EBITDA and addresses the impact of entities with negative EBITDA on the operation of the group ratio rule. Part III of the updated report addresses the risks posed by entities engaged in the banking or insurance business and the risks posed by other entities in a group with a bank or insurance company.

The updated report examines regulatory and commercial requirements which constrain the ability of groups to use interest for BEPS purposes, and limits on these constraints. Overall, a number of features reduce the risk of BEPS involving interest posed by banking and insurance groups, but differences exist between countries and sectors and in some countries risks remain. The updated report states that each country should identify the risks it faces, distinguishing between those posed by banking groups and those posed by insurance groups. Where no material risks are identified, a country may reasonably exempt banking and/or insurance groups from the fixed ratio rule and group ratio rule without the need for additional tax rules. Where BEPS risks are identified, the report states that a country should introduce rules appropriate to address these risks, taking into account the regulatory regime and tax system in that country. The updated report considers how these rules may be designed, and includes a summary of selected rules currently applied by countries. In all cases, countries should ensure that the interaction of tax and regulatory rules and the possible impact on groups is fully understood.

The domestic tax laws in India provide for deductions on account of interest payments. Typical disallowance of an interest payment could be on account of related exempt income or application of arm's length interest rate.

While the FM may intend to adopt rules in line with Action 4 of the BEPS plan, special considerations would have to be given for India's current economic policies which are geared toward encouraging greater investment in the country. India needs more capital/debt to complement several flagship programs like “Make in India”, “Digital India”,”Skill India” etc.

In line with the updated report, India may need to undertake risk analysis based on factual data of leveraged indicia of India operating MNEs and existing disallowances under the law. Where it is proposed to bring on elements of the Action plan, liberalised law / carve - outs for certain priority sectors (such as infrastructure) which are typically high debt industries may have to be called for. At the least, the restrictions to be placed, if any, on interest deductions should be limited to intra group payments and should not be levied on third party interest payments. Similarly low BEPS risk entities, certain standalone entities, interest expenses below certain threshold limits etc may call for exemptions!!

A cameo for BEPS in budget 2017

There are many expectations with the Budget 2017 as it is one of the last opportunities for the Government to deliver on its “ache din” promise. It is anticipated that Mr Jaitley may present a taxpayer friendly budget that delivers on tax reforms and relaxations, predominantly to revive the investment and industrial growth sentiment in India, that has decelerated over the last few months on account of demonetization.  

BEPS AND INDIA 

The current international tax standards have not kept pace with the new business models.  Increase in online and digital business has made it possible for multinational companies to plan their tax structures and transactions in a way to achieve low taxation. These sophisticated tax planning structures have led to erosion of tax base in source countries. Towards this end, OECD had launched BEPS initiative at the request of G20 nations encompassing 15 Actions that deliberated on various tax issues.  OECD published its final package on BEPS in October 2015, though certain follow-on work is expected to continue.  

India has been a sincere supporter of BEPS and has also endorsed some of its recommendations.  Budget 2016 witnessed some tax reforms with introduction of some of the recommendations considered under BEPS.

BUDGET 2017 

Whether Budget 2017 has much in store for BEPS or not, is unclear as the focus of this budget is expected to be on delivering taxpayer friendly reforms to revive India's stalled economy.  More so, because the Indian government has already adopted some key BEPS recommendation in Budget 2016 and in parallel is also working on negotiating bilateral tax treaties and Multilateral Instrument (MLI) to adopt some of the remaining suggestions.  These are discussed below:

• BEPS and Budget 2016 (includes recommendation from Action 1, 5, 13)

India in its budget of 2016, unilaterally adopted some of BEPS recommendation such as introduction of equalisation levy on specified digital transactions (Action 1 - addressing tax challenges in the Digital Economy), country-by-country reporting requirements for multinational companies (Action 13 - transfer pricing documentation and country-by-country reporting) and patent box regime providing reduced tax rates for royalty relating to patents based on nexus approach (Action 5 - countering harmful tax practices effectively, taking into account transparency and substance).  India became the first country to introduce equalization levy on digital transactions, at the rate of 6% on the gross consideration for specified services (currently includes online advertisement and related services) provided by foreign companies who do not have a permanent establishment in India.

It is possible that the Budget 2017 may enhance the scope the equalization levy to include many other digital services, as recommended by the Committee on Taxation of Digital Economy.

• Negotiating existing tax treaties (preventing tax treaty abuse - Action 6)

In 2016, India concluded the much anticipated renegotiation of its tax treaties with Mauritius, Singapore and Cyprus - jurisdictions allegedly used for treaty shopping.  These revised tax treaties provide for source based taxation for capital gains arising from alienation of shares. Existing investments have been grandfathered to provide smooth transition. Both principal purpose test and limitation of benefits test are now included in the treaties. The India-Singapore tax treaty specifically includes an article to allow a state to enforce its domestic tax law and measures concerning prevention of tax avoidance or tax evasion. 

• General anti-avoidance rule (GAAR)

GAAR is slated to be effective from April 1, 2017.  In anticipation of GAAR and on account of shifting tax environment as a result of BEPS, India has already amended its tax treaties with Mauritius, Singapore and Cyprus.  GAAR provisions are grandfathered for income arising from transfer of investments made prior to April 1, 2017, though tax benefits obtained post that date, from an 'arrangement' entered into before April 1, 2017 are likely to attract GAAR.  As mentioned above, the recent protocol to India-Singapore tax treaty states that a state is free to apply its domestic tax law and measures concerning prevention of tax avoidance or tax evasion.  This makes India's intention clear that it would reserve the right to invoke GAAR in abusive cases. 

• MLI for BEPS tax treaty measures (includes recommendation from Action 2, 6, 7, 14)

BEPS sets out various measures to prevent base tax erosion but many of these cannot be addressed without amending the existing tax treaties.  This becomes a tedious process given the sheer number of tax treaties involved.  Action 15 of BEPS thus considers execution of MLI that allows countries to swiftly amend tax treaties for BEPS.  India has been an active player on this front and is also likely to become a party to the MLI.  The first signing of the MLI is expected to take place in June, 2017 which will be entered into force after ratification by at least 5 countries. 

Final draft of the MLI includes recommendations under Action 2 - hybrid mismatch arrangements, Action 7 - artificial avoidance of PE status, Action 6 - treaty abuse in specified circumstances and Action 14 - dispute resolution with following minimum standards:

-       Action 6 - (a) inclusion in the title and preamble of tax treaties that contracting states enter into treaty to avoid creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance, including treaty shopping and (b) include, either a combination of a limitation of benefit and a principal purpose test rule or any one of them supplemented by mechanics that deal with conduit arrangements. 

-       Action 14 - requiring countries to implement in good faith, a dispute resolution mechanism.

Most of the key BEPS recommendations have been already addressed by the Indian Government in some way or the other leaving no need for any specific inclusions in Budget 2017.  Further, some Actions such as Action 7 are regarded more on the administrative front and the measures suggested therein have in some way been adopted by Indian tax authorities.  Therefore, what this budget is likely to bring in is more transparency to and probably certain amendments to the 'already introduced' BEPS recommendations - such as adding more services under the scope of equalisation levy and defining rules on implementation process for country-by-country reporting regime.      -

(with contribution from Barkha Dave, BMR & Associates LLP)

Budget 2017 - Expectations of IT/ ITeS Sector

Information Technology (IT) has transformed not only the way corporates conduct their businesses, but has also, in a big way, redefined consumer preferences/ spending. The Indian IT sector is central to achieving the economic agenda of the Government - having launched initiatives like Digital India, Make in India, and Smart Cities. With the recent demonetisation drive, the digital payment eco-system in India is all set to witness major action. It is a matter of pride that on the global front, India continues to be the largest outsourcing destination for the IT industry. The Indian IT industry has grown manifold - contributing approximately 9.5 per cent of the GDP in FY 2015, from 1.2 per cent in FY 1998.  In FY 2016, revenues of the Indian IT-BPM sector were USD 160 billion, of which exports are estimated at USD 108 billion.      

With this commendable contribution of the IT / ITeS industry and mindful of the uncertain global economic-political environment emerging in the US and European markets, this industry remains hopeful that the Government will roll out tax measures and other policy reforms to help the industry sustain growth and boost investment sentiment. 

Some of the tax challenges faced by the industry, and key tax proposals which the industry would like to see in this Budget, are discussed below.

Putting an end to the controversy of software royalty: Whether payment for right to use computer software can be regarded as payment for use of a copyright, and hence, taxable as royalty, has been subject matter of immense debate for a long time.  The Income-tax Act, 1961 (the Act) was amended retrospectively by the Finance Act, 2012, to treat payment for use of software as royalty. This is not in consonance with the internationally accepted norm, which treats software as a copyrighted article, the payment for which is generally not regarded as royalty. By and large, Courts in India have also held so while analysing the issue under tax treaties entered into by India. Given the protracted litigation on this front, the industry expects the Finance Minister to roll back this amendment or issue a clarification so as to bring royalty taxation vis-à-vis software payments on par with international practices.

Clarifying on applicability of R&D benefits:  Weighted deduction of 200 per cent is currently available for scientific research on in-house R&D facilities approved by DSIR.  The deduction is available to companies engaged in bio-technology and manufacture/ production of any article or thing. There is an ambiguity whether in-house R&D facility for computer software is covered within the ambit of section 35(2AB). Considering that the Government is promoting R&D and innovation in the IT sector in a big way, the Act should explicitly provide that the benefit of the weighted deduction is also available to companies engaged in development of computer software.

Deferral of POEM guidelines: The Finance Act, 2015, had amended the definition of tax residency for a company. Effective financial year 2016-17, a foreign company will be resident in India if its place of effective management (POEM) in that year is in India.  The long overdue guidelines for determination of POEM have finally been issued on 24 January, 2017.  Many IT companies are headquartered in India and have overseas subsidiaries engaged in on-site software development and/ or marketing/ distribution activities. These companies are likely to be impacted by the POEM guidelines.  

Determination of POEM is primarily based on determining whether the foreign company meets the 'active business outside India' (ABOI) test.  This test is met if the foreign company's passive income is not more than 50 per cent of its total income and if certain other parameters are met.  The guidelines have clarified that interest income of financial institutions would not be regarded as passive income.  Similar rationale ought to be applied also to IT companies/ R&D companies, which earn royalty income from their active/core business.  Whilst the guidelines and illustrations therein provide much guidance, there is still a fair bit of subjectivity, and hence, the aspect of POEM could be open to challenge.  If POEM is held to be in India, there could be a whole host of complexities in terms of availability of foreign tax credits, rate of tax, applicability of transfer pricing and withholding tax compliances etc., and the Government should bring about clarity in this regard.  Further, considering that the final guidelines have come out at the end of the year, the Budget should defer POEM by a year, to enable companies to assess its full impact and to make necessary structural changes, if required. 

Transfer pricing (TP) litigation: Indian tax authorities have been increasingly scrutinizing issues like intra-group cost allocations, such as management recharges, compensation for location savings, etc.  There are no specific guiding principles currently in the Indian TP regulations to determine arm's length price for such transactions.  To reduce litigation, the Government should bring out clear guidelines on these aspects.

In the last few years, the Government has taken various steps to reduce TP litigation, like introducing Safe Harbour Rules (SHRs) and implementing Advance Pricing Agreements (APAs).  While the APA route has seen much success, the same is viewed as a relatively high cost and time consuming solution.  While SHRs have been introduced since 2013, they've not met with similar positive response.  The definitions of various eligible transactions under the SHRs, software development services vis-à-vis contract R&D services relating to software development, leave some room for subjective interpretations.  Also, the margins prescribed in the SHRs are on the higher side. It would, therefore, help if margins prescribed under the SHRs are rationalized.

Some other items on the wish list: Besides the above, the industry is also hoping for relief on some of the following long-standing demands:

• Exempting SEZ units from applicability of MAT (which significantly dilutes the benefit granted under Section 10AA);
• Amend section 10AA / issue appropriate clarification to mitigate litigation on various issues surrounding computation of deduction under section 10AA (especially on the aspect of having parity in the definition of export and total turnover) and entitlement to foreign tax credit;
• Including the IT/ ITeS sector in list of industries eligible for deduction under Section 35CCD, considering the need for constant skill development in view of the rapid technological advancements;
• Deferring GAAR to enable corporate India to deal with host of other new regulations like Ind AS, GST, Equalization levy, etc;
• Reducing the corporate tax rate, in line with the proposal announced in the earlier Budget, especially in view of phasing out of exemptions.

The IT / ITeS industry eagerly awaits the unveiling of Budget 2017, hopeful that the Government will dole out incentives and provide the necessary impetus for the growth of this sector, given the importance accorded to it in the economic development agenda of India.  

Prospects of the much awaited - Union Budget 2017

The Union Budget 2017-18, to be presented by the Finance Minister on February 1, 2017, is one of the most anticipated budgets in recent times, especially on account of the significant measure of demonetization adopted by the Government of India during this fiscal year. Among other things, the Budget 2017-18 is expected to usher in many amendments in the Direct tax regime.    

Rationalization of tax rates 

The Finance Minister during the Union Budget 2015-16 had laid down a path for reduction of the corporate tax rate to 25% in the next four years. No steps have been taken till date in order to reduce tax rates (except for certain specified categories), and therefore, steps will be required to be taken in this Budget. It is also expected that the various exemptions available to companies will be phased out, given the reduction in rates. This may also lead to reduction in the rate of Minimum Alternate Tax ('MAT') which will be gradually phased out.   

On account of the statements made by the Prime Minister, there is an expectation that the tax rate on short term capital gains in case of transfer of listed securities may be increased from 15% to 17.5%, whereas for long term capital assets in case of listed securities, the existing holding period of 12 months may be increased.

Deferral of GAAR

The General Anti Avoidance Rules ('GAAR') introduced by the Finance Act, 2012 will now be effective from AY 2018-19 (FY 2017-18). There is much ambiguity and uncertainly in their practical application. Considering the lack of clarity, GAAR should ideally be deferred by one more year in order for the CBDT to issue sufficient guidelines. In particular, where a specific anti-avoidance rule is enacted to cater to a specific situation (such as transfer pricing, limitation of benefits, etc.), GAAR should not be made applicable.

Equalization levy

The Equalization Levy ('EL'), also known as the 'Google Tax', introduced by the Finance Act, 2016 has opened a Pandora's Box of ambiguities, primarily on account of the fact that it results in double taxation for non-residents. It is expected that some sort of clarity may be brought in during Budget 2017-18 in order to enable the non-resident to avail a credit of the EL deducted. It is also anticipated that the ambit of the specified services subject to the EL may be expanded to bring within its fold other services such as copying or downloading of software, songs, books, games, movies, streaming news, etc.

Ambiguity relating to indirect transfers

The most controversial taxation provision is again in the limelight on account of Circular No 41 of 2016 issued by the CBDT, which has clarified that investors in offshore Funds or FPIs may also be liable to tax, resulting in multiple levels of taxation. The Circular has currently been kept in abeyance; however, it is expected that exemption may be provided to such investors in offshore funds and FPIs. Industry is also looking for the withdrawal of the retrospective law, at least for investors coming through DTAA countries.

Expectations with respect to transfer pricing

In December 2016, the OECD released the BEPS guidance on Country-by-Country Reporting ('CbCR'). CbCR was introduced in India via the Union Budget 2016-17, which requires MNEs to maintain and furnish a three-tier structure for documentation (i.e. the CbCR, the master file and the local documentation file). While the monetary threshold for CbCR was specified, no similar threshold was provided for the master file and local documentation file. It is expected that the Government may prescribe a monetary threshold limit for the master file requirement in the upcoming budget.

Further, with a view to rationalize the Domestic Transfer Pricing provisions (introduced in FY 2012-13), it is expected that these may be discontinued where both companies (related parties) are taxable, and the consequential adjustment may be allowed in the other company.

While several steps have been taken to reduce transfer pricing disputes including the notification of 18 September 2013 pertaining to safe harbour rules, there is an expectation that the Government may prescribe more realistic safe harbour margins in consonance with the general sectoral margins.

Current Indirect taxes and Introduction of GST

On the Indirect tax front, with GST in the offing, it is expected that this Budget will effect limited changes, viz. rationalisation of certain Customs and Excise duty rates (to inter alia address inverted duty structures), an increase in the Service tax rate and withdrawal of certain exemptions as part of the transition to GST. An affirmation of the GST timeline and the broad strategy for implementation is also anticipated.

Ind AS - whether corporate India is ready for tax impact!

As rightly said or someone has rightly said, the only constant thing in the world is 'change and as the Government is working tirelessly to promote investment into India and give a fillip to campaigns such as 'Make in India', 'Skill India', 'Digital India' etc., the need of the hour is to reform the Indian laws in line with globally acceptable standards and step towards convergence with IFRS. The Government's initiative of  introducing Indian Accounting Standards ('Ind AS'), Good and Services Tax ('GST'), introduction of Internal Financial Controls, etc. and making tax laws more robust with the evolving international environment are all set to make India more competent and internationally acceptable. While this is the brighter side of the story, these changes are all happening concurrently and CFOs, advisors and Government are firing all cylinders to understand the impact of the new regimes on the industry before the same can be implemented appropriately.

India Inc's convergence with Ind AS is probably the most important accounting reform. Ind AS has mandatorily become applicable from FY 2016-17 for companies with net worth of more than INR 500 crores. All listed companies and other companies with net worth of more than INR 250 crores would be covered from FY 2017-18 onwards followed by banks and NBFC's. Ind AS will fundamentally change the rules of accounting as it emphasises on time value of money, fair value and substance over form which are going to have significant effect on financial statements.

The Government has also issued a set of tax accounting standards known as Income Computation and Disclosures Standards ('ICDS'), applicable from Financial Year 2016-17. The ICDS are aimed to bring consistency in tax treatment among taxpayers and any variance in books vis-à-vis ICDS will necessitate an adjustment in the tax computation. These ICDS were in the making since year 2010 (much before Ind AS became applicable to the corporates) and hence the base for ICDS was Indian GAAP or ICAI accounting Standards ('IGAAP').

What does this mean from an India tax perspective? For companies following IGAAP, making necessary adjustments to tax computation to bring it in line with ICDS appears relatively straight forward. However, for companies following Ind AS, it is going to be a turbulent ride.

Impact of Ind AS on MAT

Under Ind AS, the statement of profit and loss will comprise of conventional profits and loss items and 'Items of Other comprehensive Income ('OCI')' to arrive at book profit and earning per share. The OCI will contain notional/unrealised incomes/expenses due to fair valuation/revaluation.

Under section 115JB of the Income Tax Act, 1961 ('ITA'), the Minimum Alternate Tax (MAT) is computed by making prescribed adjustments to accounting book profits under the Indian Companies Act. One of the key issue which arise is 'What should be considered as base Book Profit for computing MAT?' and how OCI should be dealt with as the current section 115JB does not prescribe any adjustments towards OCI. Similarly, there could be issues at the time of first time adoption of Ind AS. For instance, Ind AS will be mandatorily adopted for the first time for FY 2016-17 and the companies adopting it will be required to provide comparatives for previous year i.e. FY 2015-16. Thus, the assets and liabilities will be accounted as per the Ind AS from 1 April 2015. The difference in valuation of assets and liabilities will be routed through opening OCI or opening retained earnings. How should these adjustments be treated for MAT?

The Central Board of Direct Taxes ('CBDT') formed a committee (Lohia committee) to suggest a framework for computation of book profit for MAT purposes for companies adopting Ind AS. Lohia committee report suggests that OCI must be excluded from book profit since OCI does not represent distributable profit. Further, items in OCI must be considered at appropriate point in time for MAT purposes, e.g. actuarial Gain/Loss on employee benefit to be considered every year and fair value of investments routed through OCI must be considered at the time of disposal of such investment. It is important that the Government formalises the Lohia committee recommendations in the upcoming Budget 2017.

Impact of Ind AS on normal tax

Ind AS emphasises on principles such as time value of money, fair valuation, substance over form; etc. the same is bound to have tax repercussions e.g. discounting of provisions is required under Ind AS but not permitted under ICDS. Fair valuation is prescribed under Ind AS, whereas ICDS prescribes historical cost subject to provision for loss. Likewise, there will be many instances where the value considered for the Ind AS will be significantly different than the value considered for tax by applying the traditional method of accounting. Thus, companies would be required to keep complex reconciliations between adjustments as per Ind AS vis a vis ICDS adjustments.

One important area, which is going to give rise to tax differences is reclassification of financial instruments. Under Ind AS, financial instruments would be accounted for in light of their inherent nature, e.g. Compulsory Convertible Debentures (CCD) may be treated as equity and redeemable preference shares (RPS) would be treated as debt. In such a scenario, interest paid on CCD would or may be accounted as dividend and dividend paid on RPS would or may be accounted as interest. This can clearly give rise to issues such as applicability of Dividend Distribution Tax, deductibility of interest, applicability of Indian withholding tax, etc.

Take another case, where the sale of a component consists of a free service to be provided over a period of time usual in case of all motor vehicles or appliances which come with 1-2 years of free warranty. As per Ind AS, the sale will have to be bifurcated into service and component value and the income from services will be deferred over future period. The sale of revenue from the maintenance is deferred to the time when the maintenance services are actually rendered and the cost for rendering the services are incurred. This could lead to a difference in revenue recognition as per Ind AS vis-à-vis ICDS and a resultant impact on income-tax as well as transaction tax e.g. Applicability of service tax or GST/ VAT (as applicable), as the case may be on service income.

Ind AS will also have an impact from an Indian transfer pricing perspective. A question arises whether the results of companies following Ind AS and other companies can be compared for benchmarking purposes, given that the fundamental accounting policies are different.

Clearly, the sailing is not going to be smooth and brace yourself for a litigaive ride with tax authorities, who will also take time in understanding the new ways of accounting. There will be many more tax issues as we embark on the Ind AS journey. Various representations have been made to CBDT to provide clarifications on these tax issues and hopefully, with the Government's commitment to provide clarity and certainty in administration of tax laws, we can expect that Government will provide much needed clarity in the upcoming Budget 2017.

Providing a fillip to Highway Development - 'Litigation freeway' introduction for TOT-model

Backdrop:

Highway development has been one of the focused area for the NDA Government since the past few years. Given the challenges encountered under BOT Model, the Government resorted back to the erstwhile EPC Model for developing new Highways, which entail huge funding requirement. To tide over this funding issue, the Cabinet Committee of Economic Affairs authorised the National Highways Authority of India ('NHAI') in August 2016 to monetize public funded Highway projects and generate corpus for new projects.

This development led to evolution of new model in the Indian Highway arena - Toll-Operate-Transfer ('TOT') Model. Under this Model, the public funded NHAI projects which are operational and generating toll revenues for at least two years after the Commercial Operations Date ('COD') would be transferred to the Bidder for an upfront concession fee.  Currently, 75 operational National Highway projects totaling 4,500 kms completed under public funding have been preliminarily identified for potential monetization. Going forward, the existing projects under BOT Model could also get covered under the TOT Model.

The TOT Model is likely to open up new business opportunities for existing players as well as new entrants such as institutional investors including pension & insurance funds, sovereign funds, etc. 

As per the  Concession Agreement[1] under TOT Model, NHAI shall invite private operators for undertaking operation and maintenance of Highways that are already developed by NHAI through Engineering Procurement Construction ('EPC') / Item rate / Build-Operate-Transfer ('Annuity BOT') models. 

Tax issues for consideration of the Government:

While the Government is yet to invite its first bid under TOT Model, it is essential that the following tax clarifications and incentives are introduced under the Income-tax Act, 1961 ('the Act') in order to make TOT Model more attractive and ensure its successful implementation.

1. Providing profit linked income-tax holiday under TOT Model:

• Currently, profit linked income-tax holiday for 10 consecutive years out of 20 years is available only to enterprise which starts the development or operation and maintenance of the highway projects on or before 31 March 2017.  Further, under the existing provisions of the Act, the tax holiday would not be available to the EPC contractors.

• Under the TOT Model, the following two scenarios arise for claiming profit linked tax holiday to the Concessionaire:

Scenario I: Where highway projects was developed by NHAI under BOT (Annuity) Model and the developer is currently operating the highway project:

In this case, the developer would be claiming / or has completed claiming profit linked income-tax holiday for developing the highway project under the provisions of the Act. Now, since the said highway project would be transferred to a new TOT Concessionaire under TOT Model for operation and maintenance activity, a question arises whether the new concessionaire under TOT Model would be eligible to claim the profit linked income-tax holiday for a fresh or balance period out of 10 years. 

As per the Proviso to section 80-IA(4)(i), in case of transfer of the project, the transferee is entitled to the said tax holiday for the balance period for operation and maintenance of the project subject to fulfillment of conditions. In view of this enabling Proviso, the TOT Concessionaire should be eligible for the income-tax holiday for the balance period.

In order to provide fillip to the TOT Model, it is recommended that the fresh tax holiday period should be provided for the TOT Concessionaire irrespective of period of the tax holiday claimed by the BOT operator in the past.

Scenario II: Where highway projects were developed by NHAI under EPC Model

In this case, the EPC Contractor would not have claimed profit linked tax holiday under the provisions of the Act.  Further, the TOT Concessionaire would also not be eligible to claim profit linked tax holiday if it starts operating and maintaining a highway project post 1 April 2017 (assuming that the bidding process will be completed post 1 April 2017).  

Considering the fact, that the EPC Contractor was not eligible for profit linked tax incentives on the said highway project, it is recommended that the profit linked tax holiday should be granted to the TOT Concessionaire under Section 80-IA of the Act even after the allotment of the Highway project to TOT Concessionaire and with appropriate relaxation in the sub-set date. 

2. Providing for alternate deduction for capital expenditure under Section 35AD 

• As an alternate to profit linked tax holiday, the Government has provided the investment linked incentive for highway projects under section 35AD of the Act, where the development or operation and maintenance activity of highway project is undertaken after 1 April 2017 (i.e. after 80-IA window is closed). Under this section, investment linked deduction is available to new infrastructure facility, whereby capital expenditure incurred post 1 April 2017 is available deduction in the year of incurrence.

• Considering that under the TOT Model, the Concessionaire would operate and maintain an existing infrastructure facility and not a 'new' infrastructure facility in its literal sense, the benefit under Section 35AD could be litigated. Hence, it is necessary that clarity should be provided that operational projects under the TOT Model should be treated as 'new' infrastructure facility for claiming deduction under Section 35AD of the Act.

• In order to avoid litigation and incentivize TOT Concessionaire, the Government should provide that profit linked tax holiday would be available to TOT Concessionaire or alternatively, the benefit of claiming capital expenditure would be available under Section 35AD of the Act by treating such highway project as a “new infrastructure facility”.  

3. Treatment of upfront fee paid by TOT Concessionaire

• As per the Concession Agreement under TOT Model, NHAI shall grant exclusive right, license and authority to the successful TOT Concessionaire to operate & maintain the Highway project and collect toll fee.
• The CBDT vide Circular 09/2014 has clarified the treatment of expenditure incurred for development of roads / highways under BOT model, whereby the said expenses may be amortized and claimed as deferred revenue business expenditure over the period of concession agreement.
• It is recommended that appropriate provisions are introduced in the Act in relation to TOT Model providing for - the upfront fee paid to be regarded as intangible asset eligible for depreciation under Section 32 of the Act or expenditure be allowed on amortization basis similar to above CBDT circular. Introduction of this provisions would avoid any litigation in future.

4. Clarity on taxability of consideration received by existing developers

• If highway constructed under the BOT Annuity Model is proposed to be transferred under the TOT Model, then the developer that constructed the highway project would be compensated by NHAI for premature transfer of its rights under the highway project.
• In this situation, a question would arise on taxability or otherwise of receipt of such compensation and the same could depend on the tax treatment applied by the developer in the past years. In case the developer has treated the concession arrangement as capital asset and claimed depreciation under Section 32, then the captioned receipt could be subjected to tax technically as short term capital gain (ideally should be treated business income) under Section 50 of the Act. In case the developer has been acclaiming the development amount as revenue expenditure by amortizing it in terms of CBDT Circular, then such receipt could be taxed as business income.
• In either case, since the consideration is received in the course of the business, it is recommended that the Government should provide that the compensation is eligible for deduction under section 80-IA of the Act. 

Conclusion

The TOT Model appears to be a viable option for the Government to raise funds for further development and an opportunity for developers and financial investors. In order make the model successful and avoid any tax controversy highlighted above, the Government should make appropriate amendments in the Act as suggested above and provide a litigation free tax framework. This is crucial to enable the TOT Model to take off in the manner planned and become a successful one.    

[1] Uploaded on Ministry of State for Road Transport and Highways roads website

Taking the start-up agenda forward

The “Start-up India Action Plan” which the Government introduced in January 2016 was a positive first step towards establishing a start-up friendly environment.   The Action Plan aimed at a holistic approach with a slew of proposals seeking to target tax, regulatory and funding concerns of start-ups.  

To take the start-up agenda further, the focus should be on putting in place a stable, clear and rational tax and regulatory environment.    

Start-ups thrive on innovative business models.  However, the country's regulatory framework which was drawn up in the context of more traditional businesses, often falls short.  The application of such “legacy” regulations to the innovative business models employed by start-ups results in multiple grey areas and inconsistencies.  The battles which taxi-aggregators such as Uber and Ola had to fight with State Transport Departments are a prime example in this regard.

To address such issues early, the Government could consider setting up a dedicated Department or Ministry for Start-ups.  This Department can be tasked with working along-side respective Ministries and sector-regulators to put in place a suitable tax and regulatory framework for emerging business models.  Through this, it should be possible to adopt a more holistic approach towards regulation and taxation of these emerging business models.  This Department should also facilitate Start-ups to connect with different Government bodies / regulators and assist in obtaining clarifications or approvals in a time-bound fashion.  The Department can provide a single-window for grievance redressal.

A more risk-based, “light-touch” approach to corporate law would also benefit start-ups.  Many of the restrictions and compliance requirements mandated by the Companies Act 2013 are primarily aimed at protection of unsophisticated minority shareholders - they make little sense in the context of closely-held private companies with knowledgeable, institutional shareholders such as VC firms.  The Government should instead consider introducing a much simplified and liberal corporate law regime for such closely-held companies. 

From a tax standpoint, there are particular areas where rationalization and clarity could be of importance for start-ups. 

One particular issue which continues to plague start-ups in India is the so called “start-up tax” - the provisions of section 56(2)(viib) of the Income Tax Act, under which consideration received towards share subscription in excess of “fair market value” of the shares is treated as taxable income of the company.  Determination of the “fair market value” is a very subjective affair, especially in the case of start-ups where making estimates of future business potential is extremely difficult.  Overzealous Assessing Officers have in many instances challenged valuation reports furnished by start-ups, and have sought to tax investments received by start-ups as “income”. 

Pursuant to the Start-up India Action Plan, the Government has issued a notification exempting start-ups from the rigours of section 56(2)(viib).   However, this exemption is restricted only to qualifying start-ups which are inter-alia approved by the “Inter-Ministerial Board”.   Till date, only eight start-ups across the country have been able to secure approvals for this exemption.

Instead of such a restricted approach, the Government should consider doing away with section 56(2)(viib) entirely.  Tax authorities can invoke General Anti-Avoidance Rules instead, to address cases involving abusive structures.

Start-ups typically incur significant losses in their initial years, as they develop their business and scale up.  A “start-up friendly” tax framework should enable start-ups fully utilize their brought forward losses as they become profitable.  As part of the Budget, suitable amendments should be introduced address the practical issues which start-ups typically face in this context. 

Losses incurred by start-ups typically have only a small depreciation element, with bulk of their losses consisting of business losses.  The Minimum Alternative Tax (MAT) provisions however permit only the lower of unabsorbed depreciation and brought forward business loss to be set-off while determining “book profits”.   Practically, this has meant that when start-ups become profitable, they are subjected to MAT even though they have substantial brought forward losses.  MAT provisions should be amended to permit the entire brought forward loss to be set-off while computing “book profits”.

In the case of an amalgamation, accumulated depreciation and business loss of the transferor company are transferred to the amalgamated company only if the transferor is engaged in certain specified businesses.  The provisions of section 72A should be amended to apply to all start-ups, irrespective of the sector they operate in.

The shareholding patterns of start-ups typically see considerable changes as they raise funding from multiple investors.  A change in the shareholding pattern beyond 49 percent would however trigger the provisions of section 79, due to which the start-up's brought forward losses lapse.  Given this, restricting the operation of section 79 to cases involving a transfer of shares alone can be considered.

Another troublesome area has been ESOP taxation. Presently, the tax regime provides for taxation of ESOPs on exercise i.e. when the shares are allotted.  This treatment leads to a cash flow mismatch, since the employee is required to pay tax upon exercise of ESOPs, out of his pocket. To encourage ESOPs, the Government should instead consider deferring the tax liability in respect of ESOPs to the event of actual sale of the shares.  For this purpose, a mechanism similar to section 45(2) of the Income Tax Act which deals with conversion of capital assets into stock-in-trade could be considered.

From an indirect tax perspective, a mechanism for speedy and time-bound processing of refund claims should be introduced.  Doing so would help start-ups release “dead” working capital, which could instead be deployed in developing their nascent businesses.  Speedy introduction of GST would also be much appreciated.

To boost the start-up ecosystem, a two-pronged approach should be followed.  The Government should, as part of the upcoming Budget, introduce tweaks to the tax law to address pain-points being faced by start-ups today.  On a longer term, steps should be taken to address matters such as a simplification and rationalization of the corporate law, and establishment of a nodal Department / Ministry for start-ups.

(Views expressed are personal)

Media and Entertainment industry - Key tax issues and expectations from Government

Demonetization, Cashless India, Digital India and with so many such buzz words trending now a days, there is lot to look up to the Government from the upcoming Budget. With the Government's bold decision to move the wheels of the economy to cleanse it of the tainted money, there are wide ranging expectations that the Government will deliver pain-balm vide Budget 2017 to soothe the common man, who has been subjected to immense inconveniences on account of the demonetization drive. Indeed, this Budget will prove to be a litmus test for the Government.

Speaking about the Media and Entertainment (M&E) sector, this year has been quite an eventful one. As per certain estimates, the Indian M&E sector is expected to grow at a CAGR of 14.3%. Having regard to the demonetization drive, while the sector did witness pressure on revenues during the last quarter, things are once again looking bright. Demonstrating its resilience, the Indian M&E industry is on the cusp of a strong phase of growth, backed by rising consumer demand and improving advertising revenues. The industry has been largely driven by increasing digitisation and higher internet usage over the last few years. Internet has almost become a mainstream medium for entertainment for most of the people.

Whilst the success story of the M&E sector continues, the industry is facing the heat on various tax aspects that need to be immediately addressed. It is marred by various direct and indirect taxes viz. Income-tax, Entertainment Tax, Service Tax, VAT, customs duty, etc. Most of the issues on indirect tax front should hopefully get addressed once GST comes into effect. Having said that, GST is likely to bring with it some novel issues, which need to be addressed. On the direct tax front, there are several controversial issues that the industry is grappling with. Some of the key tax issues affecting the industry are set out below.

Tax Deduction at Source (TDS) on various payments: In the past, there was a controversy and immense litigation on whether payment for production of TV programs / content is in the nature of consideration for carrying out 'work' liable to TDS @ 2% under section 194C or is in the nature of fees for technical services liable to TDS @ 10% under section 194J. Appellate authorities have consistently held this issue in favor of the taxpayer that the payment is liable to TDS @ 2% under section 194C. Despite that, the Revenue Authorities continued to maintain their position that tax ought to deducted @ 10% under section 194J, thereby resulting into protracted litigation on the issue. With a view to curb the ongoing litigation, in a welcome move, on 29 February 2016, the Central Board of Direct Taxes (CBDT) issued a circular clarifying that payment for production of program / content shall attract TDS @ 2% as it would amount to consideration for carrying out 'work'.

Also, there was a controversy in past on whether the 15% discount offered to the advertising agencies on the face of the invoice raised by media companies is in the nature of commission liable to TDS @ 5% / 10% under section 194H. This controversy has also been put to rest by the CBDT vide its circular dated 29 February 2016. It was clarified that such discount is not liable to TDS under section 194H.

The above clarifications will bring the unnecessary litigation on both the issues to an end, thereby providing a major respite to taxpayers.

The industry now awaits clarity on the aspect of TDS rate on payment for carriage fees / placement charges to MSOs/ cable operators, which are also a subject matter of significant controversy. The Tax Authorities have been contending that such payments are towards technical services / royalty, liable for TDS @ 10% as against the tax payers' view that such payments attract TDS @ 2%, as they are consideration for 'work'. With the appellate authorities consistently holding in favor of the taxpayers on this issue, a suitable clarification by the Government to the effect that tax needs to be deducted @ 2% would put the controversy to rest and bring in the much needed element of certainty.

Another controversy is with respect to deduction of tax on payment of transponder hire charges. The courts have held that such payment, not being in the nature of royalty under tax treaties entered into by India, is not liable to TDS in the absence of a PE of the recipient in India. However, the Tax authorities have been taking a contrary view thereon. A clarification to the effect that transponder hire charges are not in the nature of royalty / technical services and thus not liable to TDS would provide much needed relief to the M&E industry.

Applicability of TDS on discount on the sale of Set Top Boxes / Recharge Coupon Vouchers has been a major pain point for the DTH industry, with huge amounts locked up in litigation on this count. The Tax Authorities have been taking a view that the discount is in the nature of commission and hence subject to TDS @ 10%. It would do well to the Industry if the Government comes out with a suitable clarification that discount is not subject to TDS, so as to avoid protracted litigation thereon.

Benefit of carry forward of loss on amalgamation: Carry forward and set off of accumulated loss and depreciation on amalgamation of companies is currently not allowable to the M&E sector. This disparity in tax benefit is adversely affecting the growth and consolidation of the sector. Considering the intense competition in the M&E sector, consolidation has become the need of the day. Extending this tax benefit would provide momentum to such consolidation activities in the industry.

Entertainment Tax: High levy of entertainment tax ranging from 30% to 50% on exhibition of films in theatres and television exhibition by way of DTH/ cable has been acting as a dampener as it considerably enhances the cost of doing business. The industry will breathe a sigh of relief when GST gets enacted, since it is likely to subsume Entertainment Tax.

Dual levy of Service Tax (ST) & Value Added Tax (VAT): Licensing of copyright in content (other than for theatrical exhibition) as well as making available set-top boxes for providing DTH and cable services is liable to ST as also VAT, thereby resulting in double taxation of the same transaction, which is against the basic tenets of law. This issue is also likely to be addressed in the GST regime.

Goods & Service Tax (GST) roll out: The industry is expecting clarity on the roll out date of GST in this Budget and a clear roadmap for implementation thereof.

As India pumps up its growth engine to maintain its position as one of the fastest growing economies in the world, it is time that the Government provides the much needed boost to the M&E sector by providing clarity / relief on the above issues. 

Budget 2017: Setting the stage for GAAR

The GAAR first introduced as a part of the Direct Taxes Code 2009 is all set to make its debut this year with effect from 1 April 2017.  The GAAR is perhaps the most radical change in India's tax history.  The very 'generality' of GAAR makes it grey and uncertain.  Whenever GAAR has been introduced in other countries, Governments have tried to provide detailed guidance and clarifications on its applicability and implementation.  In line with the Indian Government's commitment to providing certainty, the CBDT vide Circular No 7 of 2007 issued a FAQ clarifying some aspects on the implementation of GAAR.

The Good part

The good part of the FAQ is that it provides the much-needed clarity on the 'grandfathering' provisions. Grandfathering will be available to investments made before 1 April 2017 in respect of instruments compulsorily convertible from one to another.  Bonus shares, consolidation and stock splits in respect of shares acquired prior to 1 April 2017 in the hands of the same investor will also be eligible for grandfathering (FAQ 5). 

Apart from the above, the other clarifications on binding nature of AAR; reassurances on having adequate safeguards in place for invoking GAAR in a uniform, fair and rational manner; GAAR not to be invoked merely on ground that an entity is located in tax efficient jurisdiction helps in allaying fears of tax payers.  The CBDT has preserved the fundamental right of a tax payer to plan tax affairs by clarifying that GAAR will not interplay the right of the tax payer to select / choose a method of implementing a transaction.  The Grey part

Co-existence of SAAR and GAAR; GAAR vs LOB 

The co-existence of SAAR and GAAR, GAAR overriding LOB does not resonate with the right to tax planning and certainly leaves an element of grey.  It is a well-settled principle that where there is a specific provision, the general provisions will not apply.  The Shome Committee had in its report on GAAR discussed the concerns arising out of interplay between GAAR and SAAR.  The Committee recommended that where SAAR is applicable to a particular aspect / element, then GAAR shall not be invoked to look into that aspect / element. 

In the international context, in the case Geransky v. The Queen, in the context of the Canada GAAR, the Court observed that: 

… Where a taxpayer applies those provisions, and manages to avoid the pitfalls, the Minister cannot say “Because you have avoided the shoals and traps of the Act and have not carried out your commercial transaction in a manner that maximizes your tax, I will use GAAR to fill in any gaps not covered by the multitude of specific anti-avoidance provisions … That is not what GAAR is all about”

The Supreme Court in the case of CIT vs. Walfort Share & Stock Brokers (P.) Ltd. observed that prior to insertion of Section 94(7) in the Income tax Act, it was established that if there was a 'sale' and the sale price was received by the tax payer and the tax payer did receive dividend, the fact that the dividend received was tax-free was the position recognized under Section 10(33) of the Act.  The taxpayer had made use of the said provision of the Act.  Such use cannot be called as 'abuse of law'. 

How far these observations will apply under a GAAR regime will be an interesting question. Use of the provisions of the Act for tax planning ought not be covered within the ambit of GAAR if it does not involve use of colorable devices.  The Circular however, takes a contrary position, and this could make it a precursor to long drawn litigation.  Power of making GAAR adjustments

The FAQ states that in the event of a particular consequence being applied in the hands of one of the participants as a result of GAAR, corresponding adjustment in the hands of another participant will not be made.  This again militates against the principle of uniformity, consistency and fairness leading to double taxation situations.  Specifically, there may be a need to provide for corresponding adjustments and the need for the consequences to correspond to the changed economic positions of the parties (for e.g. if a merger or other form of corporate restructuring is disregarded for tax purposes under GAAR, how will that reconcile with the fact that, in law, the merger or restructuring has actually taken place?).

In the international context, the UK HMRC guidance on GAAR permits that when tax liabilities are adjusted, it will be necessary to ensure that these adjustments do not involve any element of double taxation (whether in the hands of the taxpayer who carried out the abusive transaction, or when taking account of the tax liabilities of other persons).  Relying on best practices, the need for making corresponding adjustments should be provided to ensure consistency and fairness.  Basis of identification of 'arrangement', 'main purpose', 'tax benefit'

The primary test for applying GAAR is that there must be an 'impressible avoidance arrangement' - i.e an 'arrangement', the 'main purpose' of which is to obtain a 'tax benefit' and fulfills 'tainted elements' test.  In the context of FPI and , the Circular states that if the jurisdiction of FPI is finalized on non-tax commercial consideration and the main purpose pf the arrangement is not to obtain tax benefit, GAAR will not apply.  Whilst some terms are defined in the law, there is bound to be some uncertainty and therefore litigation on issues such as - whether a particular matter is an 'arrangement' or not, how is the 'main purpose' to be determined, how is the existence of a 'tax benefit' to be ascertained etc. still needs to be clarified.  Under Section 101 of the Act, the Government is to frame guidelines on the applicability of GAAR.  It is expected that more clarity on some of these issues will be available once the guidelines are issued. 

Budget, 2017 will prove to a landmark year with the coming into force of GAAR.  As India enters into a GAAR regime, the need for certainty in uncertainty will only accentuate.  The 'generality' of GAAR itself leads to subjectivity and the detailed guidelines could help in providing further clarity and certainty.

Pre Budget Expectations on Transfer Pricing

Finance Minister Mr. Arun Jaitley would unveil the Finance Bill on February 1, 2017. On the Transfer Pricing (“TP”) front very few changes are expected at the broader level after the slew of measures adopted in the last few budgets like introduction of the concept of range, Advanced Pricing Agreements etc.  Some of our budget expectations pertaining to TP are discussed below: 

1.Comparable Data challenges under the Indian Accounting Standards (Ind-AS)

Ind-AS is applicable to companies in a phased manner starting FY 2016-17.  In many areas of accounting this is a tectonic shift as compared to the existing positions.  The challenge that is foreseen is with regard to the comparability analysis.  A brief elucidation may be helpful here. 

Let's assume that a company (A Co) in its comparability analysis has been accepting another company (B Co) as a functionally comparable company every year.  Both the companies have been making payment on account of leases and treating them as an operational expense in the past years.  Ind-AS is now applicable to B Co from FY 2016-17.  Accordingly, B Co will restate its financials and capitalize the lease payments as per the requirement of Ind-AS.  To further complicate the matter if A Co is not mandated by law to draw up its books as per Ind-AS for the year under consideration and follows the old accounting standards.  This may cause significant change in operating results without any material change in the way business functions.  Under Ind-AS there are significant changes in the way accounting is done for provision of debts, valuation of assets etc.   All this will require appropriate clarification / guidelines.  

2. Secondary Adjustment 

Currently the Indian Income Tax Act, 1961 (“Act”) does not have any specific provisions on the issue of Secondary Adjustment.  At this juncture it is important to understand the meaning of the terms “primary adjustment” and “secondary adjustment”. 

Primary Adjustment - The primary adjustment is the adjustment to the taxable income of the taxpayer. It would invariably result in additional taxable income.  Assume, for example, that an Indian company had provided services to an Associated Enterprise (Foreign related party) and had not charged for those services. It is determined that the value of those services, during a specific tax year, was INR 100. The Indian taxpayer is required to make a primary adjustment of INR 100 - resulting in additional taxable income of that amount. 

Secondary Adjustment - Apart from the primary adjustment, there is also a secondary adjustment which is required to be made. This is in recognition of the fact that, by virtue of the non-arm's length transaction, something of value has, in effect, been distributed by the Indian company to the Foreign related party.  

Normally two approaches are followed by countries around the world with respect to Secondary Adjustment.  In the above example of INR 100 - either it is treated as deemed dividend or loan on which notional interest is computed.  Indian taxpayers facing primary adjustment and bringing in actual monies post the primary adjustment are at a disadvantage (since they will have to pay Dividend Distribution Tax (“DDT”) when the monies are remitted back to the foreign related party by way of dividend). Currently, taxpayers not bringing in monies post the primary adjustment do not face DDT and have an advantageous position.

3.Applicability of TP to non-residents

The Hon'ble Special Bench of the Kolkata Income-tax Appellate Tribunal in the case of Instrumentarium Corporation Limited (“Foreign Company”) ruled against the taxpayer in respect of applicability of section 92(3) of the Act. 

Briefly explaining the facts, the taxpayer a Foreign Company, had advanced an interest free loan to its wholly owned Indian subsidiary.  The tax authorities imputed notional interest in the hands of the foreign company. The taxpayer argued that such non charging of interest by it was a beneficial approach from an Indian perspective (since if interest was charged on the loan advanced by foreign lender company the same would have been claimed as a deduction by the Indian subsidiary thereby reducing the taxable income / increasing the loss incurred in the statement of total income - advocating the concept of base erosion from an Indian perspective). 

However, the Hon'ble Special Bench rejected the arguments and ruled against the taxpayer by applying the TP provisions qua the taxpayer and not the international transaction.

This ruling can significantly increase disputes.  The government should clarify its position on the applicability of TP to non-residents.  Bearing in mind the intent of the TP provisions it is suggested that the base erosion concept should be recognized qua the transaction and not the taxpayer (with all due respect to the Hon'ble Special Bench).

Further, if the compliance for transactions has already been done by the Indian company, the government can consider alleviating non-residents from audit.  

4. Linking the penalty to taxes sought to be evaded

Indian TP penalty provisions are regarded as one of the most stringent ones when compared globally.  Currently, the TP penalty in relation to non-reporting, failure to maintain TP study report, furnishing incorrect information, failure to furnish TP study report is linked to the value of the transaction (2% of the value of the transaction). Considering TP is maturing in India and there are many vexed issues which are subject to multiple interpretations by taxpayer and tax authorities, it is expected that penalty provisions should be eased, and linked to the tax amount of the disputed transaction. This would go long way in decreasing the financial burden of the taxpayer.  

 5. Some other issues: 

1. Admission of Bilateral Advance Pricing Agreements / Mutual Agreement Procedure applications in absence of Article 9(2) in the Double Taxation Avoidance Agreements. For example - France & Germany
2. Notification of rules in relation to preparation of Master File - while the Finance Act 2016 broadly laid out the three tier documentation concept to be in line with the OECD BEPS Action Plan 13 - detailed rules are still awaited by the taxpayers.
3. Rationalising / lowering the margins prescribed in Safe Harbour Rules (“SHR”) making them an attractive option to the industry. Present SHR margins are too high and hence the response to SHR has been tepid.  Taxpayers opting for SHR need to maintain the prescribed detailed documentation under section 92D of the Act. Globally the documentation requirement is less stringent for taxpayers opting for SHR.  This was also a recommendation of the Rangachary Committee. 
4. Allowing taxpayers to opt for an Advanced Pricing Agreement for SDT transactions also. 
5. Currently, the Indian TP regulations do not allow a corresponding adjustment for transactions between two entities (in the same tax bracket) in case there is a TP adjustment in one of the entities in Specified Domestic Transaction cases. Accordingly, it is suggested that corresponding adjustment should be permitted in order to do away with economic double taxation.

Conclusion

Addressing the aforesaid will resolve the practical difficulties faced by taxpayers while conducting the TP analysis or TP audit defense. It will also bring in a level of certainty to the TP issues and attest the Governments motto statement of a non-adversarial tax regime.  

Views are personal.  

This article is written by Samir Gandhi, Mehul Shah and Chintan Mehta, Deloitte Haskins & Sells