Casting the tax net wide

In a bid to defend the tax proposals of Budget 2012, in particular the retrospective amendments, the Finance Minister, Mr Pranab Mukherjee, declared that “India is not a tax haven”, nor is it desperate for foreign investment at any cost. He also reminded the Lok Sabha that “when investment was not there we did not eat lizards”.

The Finance Minister's words bring to fore the country's battle to halt the erosion of its national tax base. This is a challenge faced by many developing countries in the global marketplace, where key resources such as labour and capital have increasingly become mobile and are drawn into tax havens, which grant individuals or corporations the opportunity to escape tax in their country of origin.

Today, there is increasing competition between nations over collection of tax. Taxation is a sovereign right. Nations zealously guard their right to tax all entities within their jurisdiction, and India is no exception. For determining tax jurisdiction, two connecting factors have been accepted universally — residence-based taxation, which is favoured by capital exporting countries, and source-based taxation, which is favoured by developing or capital importing countries. India adopts residence-based taxation for its residents (global income is taxed in India) and a source-based taxation for non-residents (only on income received or accruing in India).

This leads to double taxation, resulting in a competition between the resident State and the source State, with multiple nations attempting to claim jurisdiction over the same activity or entity for tax collection. For example, if an engineering consultant in India makes available technical knowledge to a company in Brazil through a Web site housed by a server located in the Cayman Islands, which country has the right to tax the income and in what proportion? If a database service provider incorporates in a zero-tax country with a consumer base exclusively comprising Indian residents who make online payments, would the service provider be subject to tax at all, considering there is no physical presence in India? While international treaties do provide guidance on tax sharing between contracting States, the economy today presents fresh challenges not envisaged by the treaties.

Source-based taxation relies on physical factors such as a fixed-place location or presence of relevant persons in a jurisdiction to establish source. The concept of a Permanent Establishment is used to determine whether a non-resident would be taxed in the source country. Globalisation has rendered the traditional source criteria inadequate, especially in cross-border industries such as e-commerce, financial services, television broadcasting and so on, leading to increased litigation with source countries asserting their right to tax.

Safeguarding the source

To safeguard its source-based taxation base, India is increasingly revisiting the concept of ‘nexus' to bring non-residents residing in tax havens within the tax net.

The transfer pricing code was introduced to curb the practice of MNCs procuring goods/ services from a subsidiary in India at less than market price and selling them at a higher price outside, thereby booking profits overseas.

Every payment from India is now being scrutinised, with revenue authorities questioning whether appropriate taxes have been deducted at source. This has led to litigation where payments for software and broadcasting services are concerned.

Physical presence of an enterprise in a country is no longer required in our technologically advanced world. To ensure that the business income of non-residents that has a nexus with India is taxed here, courts are working overtime in determining a PE and attributing profits to the PE.

The budget proposals, especially the one that requires companies to effectively pay tax on capital gains if they derive value from underlying assets in India even if the ownership changes hands in tax havens, reflect India's commitment to protect its tax base.

This is only the beginning. India is getting ready to cast its tax net far and wide. In its endeavour to protect the revenue yielded from its tax base, it must ensure that the investment climate is not jeopardised. The importance of foreign direct investment in the development of our economy cannot be overlooked.

What is required is increased tax cooperation among countries and clearer laws to enable India to obtain its fair share of tax revenues.

Indraneel R. Chaudhury is Executive Director, Tax and Regulatory Services, PwC India

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