The Hindu Business Line : Calculus of the differential

MOST governments make a distinction between tax rates for domestic and foreign companies, and India is no exception. While business profits of foreign companies are taxed at 40 per cent, domestic companies bear a lower 35 per cent tax. For foreign companies, a dual tax system is in place, with royalty and technical service fee taxed at 50 per cent, and `other incomes' at 40 per cent.

If the double taxation avoidance agreement (DTAA) prescribes a lower rate, then that rate will prevail. The crucial difference in the definition of a domestic and foreign company lies in the prescribed arrangements for declaration and payment of dividends within India on Indian incomes. This definition was challenged by a British company, Decca Survey Overseas, on the ground that the differential tax treatment discriminated against foreign companies even though the Explanation to Section 90 protected such discriminatory treatment.

The Bombay Bench of the Appellate Tribunal found that there was no clarity on what the "prescribed arrangement" meant and, therefore, the levy of the higher tax rate based on the Explanation in Section 90 cannot be justified.

The Finance (No. 2 Bill)

The Government had before it three choices:

* Accept the ruling of the Bombay Tribunal in the Decca Case and eliminate the tax differential between domestic and foreign companies;

* Go an appeal against the ruling of the Tribunal before the High Court and Supreme Court; and

* Amend the law.

The Government has chosen the third alternative.

Clause 22 of the Finance (No. 2 Bill), 2004 seeks to amend Section 90 of the Income-Tax Act 1961. As per the existing provisions in the Explanation to Section 90, the charge of tax in respect of foreign company at a rate higher than at which a domestic company is chargeable shall not be regarded as a less favourable charge or levy of tax in respect of such foreign company, where such foreign company has not made the prescribed arrangement for declaration and payment within India of the dividends (including dividends on preference shares) payable out of its income in India.

It is proposed to omit the portion `where such foreign company has not made the prescribed arrangement for declaration and payment within India, of the dividends (including dividends on preference shares) payable out of its income in India' occurring in the Explanation, as the same has become redundant."

The proposed amendment, and that too with retrospective effect from 1962, will have far-reaching implications. Normally, DTAAs contain a non-discrimination provision. The UN Model of tax treaties has the following clause:

"Nationals of a contracting state shall not be subjected in the other contracting state to any taxation or any requirement connected therewith which is other or more burdensome than the taxation and connected requirements to which nations of that other state in the same circumstances are or may be subjected. This provision shall, notwithstanding the provisions of Article 1, also apply to the persons who are not residents of one or both of the contracting states."

Tax competitiveness

Surprisingly, however, successive committees on tax reforms did not find anything wrong in this differential tax treatment of foreign companies. The situation, however, is changing fast and there is a competitive tax environment in a globally integrated fiscal world.

The Government had bestowed a favour on foreign institutional investors (FIIs) by abolishing long-term capital gains tax. The tax rate of 40 per cent on business profits will apply for transnational corporations that intend to set up operations in the real sectors of the economy, such as manufacturing, trading and services.

In fact, the latest Finance Bill amends the law with regard to the taxation of interest payable to the European Investment Bank on developmental loans granted by it.

To honour the commitment given under a sovereign agreement to exempt the interest payable to the European Investment Bank , a new clause is proposed to be inserted in Section.This amendment will take effect from April 1, 2005, and will accordingly, apply in relation to the assessment year 2005-06 and subsequent assessment years.

China's FDI is nearly 10 times higher than that of India's. The amendment may at best be a stopgap arrangement. The entire position of differential in tax treatment will have to be examined in depth.

(The author is a former chief commissioner of income-tax.)