The Hindu Business Line : Need for reforms in international tax

In the absence of specific guidance on computing foreign tax credits, a number of technical as well as practical issues do arise when an Indian company seeks to claim credit for foreign taxes.

Rajendra Nayak

A striking feature of the current Indian economy is its increased integration with the rest of the world.

The growing participation of global companies in the Indian economy as well as the participation of Indian companies in the international economy would put pressure on the Indian international tax system.

The upcoming Budget would be a good opportunity for the Government to initiate some of the long-awaited international tax reforms.

Repatriation of dividends from overseas subsidiaries back to India is not efficient from a tax point of view, as such dividends are generally taxed in India at the full corporate rate of 34 per cent without any credit for underlying foreign taxes paid on the profits of the paying company. This results in the Indian company being exposed to economic double taxation. Further, there is a disparity between domestic and foreign investments as dividends from domestic investments are exempt but dividends from foreign investments are taxed.

The Report of the Working Group on Non-Resident Taxation released in January 2003 recommended the introduction of underlying tax credits to boost outbound investments and encourage repatriation of dividends back into India. The Government should consider acting on the recommendations of the working group.

Inadequate guidance

Even though the domestic tax law and tax treaties contain the general principle for relieving double taxation by way of credit, the provisions do not provide additional guidance on a number of substantive as well as procedural issues relating to foreign tax credit.

In the absence of specific guidance on computing foreign tax credits, a number of technical as well as practical issues do arise when an Indian company seeks to claim credit for foreign taxes.

Inadequate guidance results in ambiguity and litigation and exposes Indian companies to double taxation. The Government should consider providing more detailed guidance on some of these issues.

The tax system relating to dividends paid by an Indian company has been a subject matter of legislative amendments during the last few years.

Up to the year 1997, a “classical system” of dividend taxation was in place. In 1997, India switched over to the Dividend Distribution Tax (DDT) system. The Finance Act, 2002 reintroduced the “classical system”. However, the Finance Act, 2003 once again replaced that with the DDT system.

Reason for introduction of DDT in 1997 was to reward retention of profits for fresh investment and DDT was levied to deter distribution of exorbitant dividends.

The reason for reintroduction of classical system in 2002 was that the 1997 system taxed income in the hands of a person to whom it did not belong and was, therefore, inequitable. From the point of view of a foreign investor, DDT often represents an additional tax cost of doing business in India. Most countries are unclear on whether the DDT levied on the Indian company would be available as a foreign tax credit. Further, a number of countries — especially in Europe — provide participation exemption for dividends. Hence, the Government could consider reviewing the current system of dividend taxation.

In recent times, there have been suggestions on the need to introduce anti-abuse provisions in domestic tax law to counter international tax avoidance. Anti-abuse provisions could take the form of a general anti-avoidance rule that has the effect of invalidating, for fiscal purposes, an arrangement that has been entered into by a taxpayer for obtaining a tax advantage.

Anti-abuse provisions could take the form of a general anti-avoidance rule that has the effect of invalidating, for fiscal purposes, an arrangement that has been entered into by a taxpayer for obtaining a tax advantage.

The provisions could also take the form of specific rules targeted at certain forms of abuse such as anti-tax deferral or thin capitalisation. While the 2003 working group had recommended introduction of such provisions, it would be advisable for the Government to first undertake a detailed assessment of the pros and cons associated with such provisions, including the impact such provisions would have on inbound and outbound investment, before introducing the same. There should also be an open consultative process with the taxpayer and business community on such proposals.

For a vibrant and responsive international tax system, certainty and efficiency are a prerequisite. While tax litigation and issues of interpretation are widespread in a number of countries, the difficulty of uncertainty is compounded where resolution mechanisms are not conducive to timely settlement of disputes.

There is a need for improving the effectiveness of Mutual Agreement Procedure (MAP) provided for in tax treaties, expanding the authority for advance rulings, setting up dedicated appellate authorities on international tax matters, introducing advance pricing agreements for transfer pricing as well as alternative dispute resolution options such as arbitration.

Global best practices

The need for adopting global best practices would be of utmost importance. As the global economy continues to struggle, more and more countries are turning to fiscal stimulus to boost overall demand and restart the flow of credit. While spending measures have received more attention, tax measures actually represent the majority of the net effect of fiscal stimulus, according to recent estimates. The Government should not therefore underestimate the role tax policy can play in fiscal stimulus as it works on the Budget proposal.

(The author is Director, Ernst & Young, India)

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