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Taxing Foreign Income of Company

Written By: Karandeep Kaur - 4th year BA LLB - Army Institute of Law
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Taxation of foreign income entails the taxation by one country of income that its residents earn in another country. In the early stages of development every country has to depend to some extent on foreign capital and foreign technicians for the industrial development of the country. The government of India also has been extremely anxious to attract foreign capital and technical know-how. To attract these, certain tax concessions have been granted to foreign investors and technicians and the government has plans to offer still more concessions in the near future. The foreign investors may be Indian National who resides outside India and other foreign investors including corporation. A person who resides outsides India is technically known as “non-resident”. The residential status of an individual does not depend upon the nationality or domicile of that person but it depends upon the stay in India during the previous year. The case of an assessee, other than an individual, the residence depends upon the place from which its affairs are controlled and managed. If the control and management of the affairs of a foreign is, during the previous year, situated wholly in India, it shall be treated as resident in India. Where part of the control and management of the affairs of a foreign company is situated outside India, it shall be treated as non resident company.

Investor Considerations

· Companies resident in India are taxed on worldwide income, whether or not remitted to India.

· Foreign branch losses can be set off against domestic profits.

· Income of foreign affiliates is includable in the Indian company's taxable income only when distributed as dividends.

· Double taxation relief is granted to residents by the credit methods.

To the extent they cannot be credited, foreign taxes are lost permanently.

Company defined under section 2(17) of Income Tax Act 1961

"Company" means- (i) any Indian company, or

(ii) anybody corporate incorporated by or under the laws of a country outside India, or

(iii) any institution, association or body which is or was assessable or was assessed as a company for any assessment year under the Indian Income-tax Act, 1922 (11 of 1922), or which is or was assessable or was assessed under this Act as a company for any assessment year commencing on or before the 1st day of April, 1970, or

(iv) any institution, association or body, whether incorporated or not and whether Indian or non-Indian, which is declared by general or special order of the Board to be a company:

Provided that such institution, association or body shall be deemed to be a company only for such assessment year or assessment years (whether commencing before the 1st day of April, 1971, or on or after that date) as may be specified in the declaration

Income defined under section 2(24)
Dictionary meaning of income is periodical product of one’s work, business, lands or investments (commonly expressed in terms of money); or annual or periodical receipts accruing to a person or a corporation.

Foreign Income

Foreign income means ant income which is neither received or deemed to be received in India nor accrues or arises or deemed to accrue or arise in India i.e. income which accrues or arises or deemed to accrue or arise outside India and also received or deemed to be received outside India. However it includes the following:

(a) Business income where business is wholly and partly controlled in India.
(b) Profession Income where profession was setup in India.
(c) Business income where business was wholly controlled from outside India.
(d) Profession Income where profession was set up outside India.
(e) Any other income (Salary, rent and dividend).

Regarding foreign income is always taxable in case of R/ROR never taxable in case of NR but taxable in case of RNOR in exceptional cases i.e. when it is business income and the business is controlled in India or when it is Profession Income where profession was set up in India.
 

Foreign Income

R/ROR

RNOR

NR

(i) Business income where business is wholly and partly controlled in India

Included and taxable

Included and taxable

Not Included and Not taxable

(ii) Profession Income where profession was setup in India

Included and taxable

Included and taxable

Not Included and Not taxable

(iii) Business income where business was wholly controlled from outside India

Included and taxable

Not Included and Not taxable

Not Included and Not taxable

(iv) Profession Income where profession was set up outside India

Included and taxable

Not Included and Not taxable

Not Included and Not taxable

(v) Any other income (Salary, rent and dividend)

Included and taxable

Not Included and Not taxable

Not Included and Not taxable

Residential Status of A Company

According to section 6(3) of income tax act 1961 a company is said to be resident in India in any previous year, if:
(i) It is an Indian company; or
(ii) During that year, the control and management of its affairs is istutaed wholly in India.

For deciding the residential a status of a company, a company is of two types
(i) Indian Company- always resident in India irrespective of control and management of its business affairs
(ii) Foreign Company – resident in India if control and management of its affairs is situated wholly in India during relevant previous year.

Further, in case of a company “the control and management of its business affairs” lies at the place where meetings of Boards of Directors are held. So a foreign company is said to be resident in India if all the meetings of Board of Directors are generally held in India and important decisions regarding the management are taken in India.

The control and management does not mean carrying on day to day business by agent, servant or employees. Even a partial control of foreign company outside India is sufficient to consider it as non-resident. Similarly mere fact that the company is also resident outside India would not make it non-resident in India.

Basic Concepts Of Taxing Foreign Source Income

Foreign source income refers to income that is deemed to be generated from activities conducted in a foreign jurisdiction.

Worldwide Versus Territorial Taxation Systems

Since foreign income is generally taxed under local laws in the foreign country in which the income arises, the home country of a multinational corporation generally seeks to avoid double taxation of the foreign income by either providing a tax credit for foreign income taxes paid or exempting such income from home country taxation.

Countries frequently are described as having either a worldwide or territorial system with respect to foreign income of their resident companies. Under a worldwide approach, a country taxes resident corporations on all their income whether generated from domestic sources or from overseas activities. Under a territorial system, a country taxes its resident corporations only on income generated from activities within the country, and income generated by foreign subsidiaries generally is not taxed in the parent company's jurisdiction of residence whether or not repatriated.

Generally, worldwide taxing jurisdictions provide tax credits for foreign income taxes, while territorial countries providing an exemption for foreign source dividends will not provide a foreign tax credit on such income.

Most countries do not follow "pure" worldwide or territorial approaches to taxing foreign income. The United States, for example, is considered to follow a worldwide approach, but generally does not tax income of foreign subsidiaries until repatriated. This is referred to as a "deferral" regime, under which tax is deferred until the income is repatriated to the parent company's jurisdiction.

Overview Of Foreign Source Income

Corporations generate income from a range of activities and sources. Broadly, income can be classified as active or passive.

Active income normally arises from the primary business activity of the company and involves more than investing in an asset that generates a return. It often involves a continuous process of designing, producing and selling a good or service to ultimate customers, whether related or unrelated to the company.

Passive income normally is generated by the corporation through acquiring and holding the asset with no additional activity, again regardless of whether the income is received from a related or unrelated party. While the precise definition of passive income differs between countries, interest income, royalty payments from owning intellectual property, dividends from holding shares, and rental income often are classified as passive income. Capital gains realized from the sale of assets that generate passive income (e.g., shares, loans, intellectual property, or buildings) may be considered passive income.

Taxation Of Foreign Income In India

Companies resident in India are subject to Indian tax on their income, generally on an accrual basis, from all sources inside or outside India and whether or not remitted to India.

Branch income

The income of all foreign branches is taxed in India as part of the Indian company's worldwide taxable income. Similarly, the losses of all foreign branches are deductible in computing the worldwide taxable income. In computing the income or loss of a foreign branch, a deduction is generally allowed for all expenses incurred wholly and exclusively for the purpose of the business that are not of a capital or personal nature. Income is taxed whether or not repatriated. If the branch income incurs tax in the foreign country, credit is given in India to the extent of the lesser of the foreign tax paid or the Indian tax on the foreign income, either unilaterally or under treaty.

Foreign subsidiary income

Dividends of foreign subsidiaries when declared (and interim dividends when they are made unconditionally available) are included in the worldwide taxable income of the Indian company. Profits not distributed by the foreign subsidiary are not taxed in the hands of the Indian company. Treaties often provide for lower foreign withholding tax. No credit is given for underlying tax paid by the foreign subsidiary.

Liquidation proceeds

A distribution to an Indian company by a foreign subsidiary upon its liquidation is treated as dividends to the extent it is attributable to accumulated profits up to the date of liquidation. The balance is treated as a return of capital and taken into account in determining the capital gain or loss on the shares held.

Interest

Interest from foreign subsidiaries is fully taxable in the hands of the Indian company, with credit allowed for foreign tax withheld or paid, up to the Indian tax on the interest.

Royalties and fees for technical or professional services

Indian companies and other residents are allowed a deduction equal to 50 percent of the royalties and fees for technical and professional services received in convertible foreign exchange from foreign governments or any foreign enterprise for granting the use of patents, providing technical or professional services abroad, etc. The excess and any other royalties and fees for technical services are taxable in full, subject to credit for the foreign tax withheld or paid up to a maximum of the Indian tax on the royalty or fees.

Foreign exchange gains and losses

Profits and losses of foreign branches, royalties and fees for technical services, and interest (other than interest on securities) arising in foreign currency are translated for inclusion in the worldwide taxable income of the Indian company at the relevant telegraphic transfer buying rate. Dividends from foreign subsidiaries, capital gains and interest on securities are also translated the relevant telegraphic transfer buying rate. Revenue gains or losses in exchange are included or deducted in computing the worldwide taxable income.

Effects Of Taxing Foreign Income – International Scenario

The taxation of foreign income and the tax laws of other countries have the potential to influence a wide range of corporate and individual behavior, including, most directly, the location and scope of international business activity. Studies of behavioral responses to international tax rules find that multinational firms invest less in high-tax countries than they do in otherwise-similar low-tax countries.

There is extensive evidence that firms arrange financial flows and intra firm sales to reallocate taxable income from high-tax countries to low-tax countries. This reallocation is commonly accomplished by concentrating corporate borrowing, and therefore interest deductions, in high-tax countries (Desai, Foley and Hines, 2003) and by adjusting prices paid for intra firm financial transactions and sales of goods and services to minimize income reported in high-tax countries. As a consequence, multinational firms report significantly higher profit rates in low-tax countries than in high-tax countries, and the ability to reallocate taxable income only increases the attractiveness of investing in low-tax countries.

Taxation of foreign income, together with provision of foreign tax credits, dampens incentives to earn income in low-tax countries, since lower foreign tax payments reduce available foreign tax credits and thereby create greater home country tax obligations. Foreign investment in the United States is consistent with these incentives, in that investors from countries that exempt foreign income from taxation concentrate their investments more heavily in low-tax states than do investors from countries that tax foreign income. The taxation of foreign income restricts the attractiveness of investment in low-tax countries to situations either in which ample foreign tax credits are available, or in which investors can profitably defer home-country taxation.

Double Taxation

Most countries subject some types of foreign income to taxation. Since this income is also typically taxed by foreign countries in which it is earned, there is considerable scope for ruinous double taxation.

Double taxation occurs when an individual / company is required to pay two or more taxes for the same income, asset, or financial transaction in different countries. Double taxation occurs mainly due to overlapping tax laws and regulations of the countries where an individual / company operates his business.


When an Indian businessman makes a profit or some other type of taxable gain in another country, he may be in a situation where he will be required to pay a tax on that income in India, as well as in the country in which the income was made! To protect Indian tax payers from this unfair practice, the Indian government has entered into tax treaties, known as Double Taxation Avoidance Agreement (DTAA) with 65 countries, including U.S.A, Canada, U.K, Japan, Germany, Australia, Singapore, U.A.E, and Switzerland. DTAA ensures that India's trade and services with other countries; as well the movement of capital are not adversely affected.

The object of a Double Taxation Avoidance Agreement is to provide for the tax claims of two governments both legitimately interested in taxing a particular source of income either by assigning to one of the two the whole claim or else by prescribing the basis on which tax claims is to be shared between them.

Capital gain tax rates

Under Section 90 and 91 of the Income Tax Act, relief against double taxation is provided in two ways:


Unilateral Relief


Under Section 91, the Indian government can relieve an individual from double taxation irrespective of whether there is a DTAA between India and the other country concerned. Unilateral relief may be offered to a tax payer if:

* The person or company has been a resident of India in the previous year.
* The same income must be accrued to and received by the tax payer outside India in the previous year.
* The income should have been taxed in India and in another country with which there is no tax treaty.
* The person or company has paid tax under the laws of the foreign country in question.
Bilateral Relief

Under Section 90, the Indian government offers protection against double taxation by entering into a DTAA with another country, based on mutually acceptable terms. Such relief may be offered under two methods:

* Exemption method – This ensures complete avoidance of tax overlapping.
* Tax credit method – This provides relief by giving the tax payer a deduction from the tax payable in India.

Indian Policy With Respect To Double Taxation Avoidance Agreements

The policy adopted by the Indian government in regard to double taxation treaties may be worded as follows:

· Trading with India should be relieved of Indian taxes considerably so as to promote its economic and industrial development.

· There should be co-ordination of Indian taxation with foreign tax legislation for Indian as well as foreign companies trading with India.

· The agreements are intended to permit the Indian authorities to co-operate with the foreign tax administration.

· Tax treaties are a good compromise between taxation at source and taxation in the country of residence.

India primarily follows the UN model convention and one therefore finds the tax-sparing and credit methods for elimination of double taxation in most Indian treaties as well as more source-based taxation in respect of the articles on ‘royalties’ and ‘other income’ than in the OECD model convention.

Case Study

In the recent landmark case of Vodafone v. IT department tax British Telecom giant Vodafone paid Hong Kong based Hutchison International over USD 11 billion to buy Hutchison’s 67% stake in Indian telecom company Hutchison Essar. The transaction was done through the sale and purchase of shares of CGP, a Mauritius based company that owned that 67% stake in Hutch Essar. Since the deal was offshore, neither party thought it was taxable in India. But the tax department disagreed. It claimed that capital gains tax most people paid on the transaction and that tax should have been deducted by Vodafone whilst paying Hutch. The matter went to court and was heard over by the court. Vodafone argued that the deal was not taxable in India as the funds were paid outside India for the purchase of shares in an offshore company that the tax liability should be borne by Hutch; that Vodafone was not liable to withhold tax as the withholding rule in India applied only to Indian residence that the recent amendment to the IT act of imposing a retrospective interest penalty for withholding lapses was unconstitutional. However, this far reaching judgement has reflected upon the effective tax enforcement system of India. Moreover, taxability of foreign income of the company has been adequately addressed by the Indian law.

Conclusion

Taxation of foreign income entails the taxation by one country of income that its residents earn in another country. India limits the foreign tax credit to the lesser of foreign tax paid or local tax payable. The government of India also has been extremely anxious to attract foreign capital. There is extensive empirical evidence that the taxation of foreign income influences the magnitude of foreign investment, and the tax avoidance activities of investors. The simple logic implies that governments acting on their own, without regard to world welfare, should want to tax the foreign incomes of their resident companies while permitting only deductions for foreign taxes paid. Such taxation satisfies what is known as national neutrality. Neutral taxation of foreign income entails considerations not only of the volume and location of investment, but also the effects of taxation on capital ownership. From the standpoint of the home country, foreign taxes are simply costs of doing business abroad, and therefore warrant the same treatment as other costs.
______________________
# Radharani Holdings(P) Ltd. v. DIT (2007) 16 SOT 495 (Del)
# Ostime (Inspector of taxes) v. Australian Mutual Provident Society (1960) 39 ITR 210 (HL)

Authors contact info - articles The author can be reached at: karandeep@legalserviceindia.com

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