7/24/2019 5th unit

1/47

CONTENTS OF 5th UNIT5. INTERNATIONAL TAX ENVIRONMENT....................................................................2

5.1. INTERNATIONAL TAX ENVIRONMENT.......................................................2

5.1.1. INTRODUCTION........................................................................................25.1.2. MEANING OF INTERNATIONAL TAXATION.................................................3

5.1.3. OBJECTIVES OF INTERNATIONAL TAXATION.............................................3

5.1.3.1. Tax Neutrality.................................................................................3

5.1.3.2. Tax Equity........................................................................................4

5.1.4. TYPES OF TAXES...................................................................................... 4

5.1.4.1. Incoe Tax......................................................................................5

5.1.4.2. !it""ol#in$ Tax.............................................................................5

5.1.4.3. Value%A##e# Tax.............................................................................5

5.1.4.4. To&in Tax..........................................................................................5

5.1.5. TAXATION METHODS................................................................................

5.1.5.1. !orl#'i#e A((roac".....................................................................

5.1.5.2. Territorial A((roac"......................................................................!

5.1.. TAX HAVEN..............................................................................................!

5.1.).1. *"aracteri+tic+ o, Tax -aen......................................................."

5.1.).2. Tax -aen /u&+i#iarie+...............................................................1#

5.1.!. INTERNATIONAL OFF$SHORE FINANCIAL CENTERS.................................1#

5.1.". REINVOICING CENTRE............................................................................11

5.1.0.1. A#anta$e+ o, Re%Inoicin$.......................................................13

5.1.0.2. i+a#anta$e+ o, Re%Inoicin$..................................................13

5.1.%. TAX TREATIES........................................................................................13

5.1..1. ou&le Taxation...........................................................................14

5.1.%.1.1.D&'()* T+,+t-& A/&-0+* A***t.........................................15

5.1.%.1.2.D&'()* T+,+t-& R*)-*..................................................................1!

5.1.%.1.3.M*th&06 & E)--+t- D&'()* T+,+t-&.......................................2#

5.1..2. Multilateral Tax Treatie+.............................................................21

5.1.1#. FOREIGN TAX CREDIT............................................................................23

5.1.11. TAXES 7 LOCATION OF FOREIGN OPERATIONS.......................................25

5.1.12. TAX IMPLICATIONS OF DIVIDEND REMITTANCE BY OVERSEAS AFFILIATE3#

5.1.13. TAXES AND ORGANI8ATIONAL FORM.....................................................3#

5.1.13.1.*ontrolle# orei$n *or(oration.................................................32

1

7/24/2019 5th unit

2/47

5.1.14. TAXATION OF FOREIGN SOURCE INCOME IN INDIA.................................32

5.2. TRAN/ER RI*IN..................................................................................34

5.2.1. MEANING OF TRANSFER PRICING 9TP:...................................................34

5.2.2. OBJECTIVES OF TRANSFER PRICING.......................................................34

5.2.3. TYPES OF TRANSFER PRICING................................................................35

5.2.4. TRANSFER PRICING METHODS...............................................................3"

5.2.5. TRANSFER PRICING RULE IN INDIA.........................................................41

5.3. TAX LANNIN..........................................................................................44

5.3.1. INTRODUCTION......................................................................................44

5.3.2. CHARACTERISTICS OF TAX PLANNING....................................................45

5.3.3. OBJECTIVES OF TAX PLANNING.............................................................. 4

5.3.4. METHODS OF TAX PLANNING.................................................................4!

5.3.5. LIMITATIONS OF TAX PLANNING.............................................................4"

5. INTERNATIONAL TAX ENVIRONMENT

5.1. INTERNATIONAL TAX ENVIRONMENT

5.1.1. INTRODUCTIONThe taxation is imposed on the residents of a particular country residing in that country and earning an

income, both as an employee and as self-employee, corporations and commercial organizations based in

2

7/24/2019 5th unit

3/47

O(;*t-/* & It*+t-&+) T+,+t-&

T+, N*'t+)-t$ Lack of Exchange Controls:1any tax havens developed a dual currency control system, under

which residents are subected to both local and foreign currency controls and non-residents, only

to the local currency controls. 0ompanies set up in a tax haven are treated as non-residents for

exchange control purposes and their operations conducted outside the tax haven, in foreign

currency, are not subected to exchange controls. These rules are purposely designed to facilitate

the use of tax havens.?$ Relatie Importance of Banking:In tax havens, the banking sector gives different treatment to

residents and non-residents, suppressing or smoothing controls and imposing lighter or no

taxation on the latter. The existence of a modern and efficient banking system is essential for the

success of a tax haven and, for this reason, greatly stimulated. Thus invariably, the volume of

banking business is totally unrelated to the size and needs of the domestic market. !inancial

activity generates revenue for the tax haven, which also benefits from the generation of

employment and the rental of local facilities, and creates an infrastructure which can be used both

by fraudulent and legitimate business.E$ Comm!nications:Tax havens must be accessible physically and have facilities to deal with

information. Thus, it is necessary an infrastructure that provides good means of transportation

4such as air or sea connections$ and networks such as post, telephone, cable and satellite

communication, which are especially important to financial and banking activities in tax havens.F$ "ther #spects:A tax haven must have political and economic stability. @ack of political or

economic confidence has prevented some places from becoming a tax haven and may endanger

the future of places regarded as tax havens. The existence of tax treaties and double taxation

agreements is other aspect which makes a tax haven attractive. ;aving a good treaty network with

important countries prevents incomes channeled to the tax haven country from being excessively

taxed at the source. The availability of competent professional advisers, such as accountants and

lawyers, is also crucial to a company that wants to set up operations in a tax haven.

%

7/24/2019 5th unit

10/47

5.1.).2. Tax -aen /u&+i#iarie+:ne way for an individual or a company to take advantage of a tax haven is to establish a separate or

subsidiary legal entity 4a company or a common law trust$ in the tax haven. Assets are transferred to the

new company or trust so that gains may be realized, or income earned, which otherwise would be realized

or earned by the beneficial owner.

In other words, in a tax haven country, foreigners may receive income or own assets and pay very low

taxes. 1any companies are situated or have subsidiaries in tax havens for tax avoidance reasons. There

are two obectives for establishing a subsidiary in a tax haven"

#$ A subsidiary can operate as a legitimate operation and generate profits while simultaneously

enoying the tax advantages) and+$ A parent may establish a subsidiary in a tax haven for the purpose of tax avoidance only. The

maor purpose is to shift income from a country with high taxes to a tax haven country by using asubsidiary as an intermediary.

5.1.!. INTERNATIONAL OFF$SHORE FINANCIAL

CENTERSInternational off-shore financial centers outlines the tax-savings techni'ues that can be used when

incorporating an off-shore financial center into international tax planning, focusing on those tax

urisdictions which can be used as tax havensD by international corporations.

Today, international off-shore financial centers 4of f -shore centers) play a vital role in facilitatinginvestment worldwide. In a global economy, off-shore centers are a focal point for the collection and

channeling of wealth into on-shore financial centers.

It is a common perception that an off-shore center is used exclusively because it brings tax advantages to

the investment or financing structure. It is certainly true that most, if not all, off-shore centers"

#$ ;ave no relevant incidence of income or capital gains tax 4i.e., do not tax the proposed activity or

entity$) and=or+$ ;ave a tax regime which is neutral, and=or - .

>$ 2rovide access to double taxation arrangements, and=or?$ Impose no withholdings on distributions and other payments.

It is important, however, not to overlook the significance of other issues relevant to the choice of off-

shore center, including"

#$ The absence of foreign exchange restrictions)+$ 2olitical stability)

1#

7/24/2019 5th unit

11/47

>$ eographical location, including time zone)?$ 0ommunication links)E$ Internal skills infrastructure)F$ 5egulatory infrastructure)8$ /anking secrecy and professional confidentiality generally)9$ Investor perception, and

7$ 2olitical affiliation.

5.1.". REINVOICING CENTRE5einvoicing refers to the process of managing risks related to foreign currency by setting up of a

subsidiary. uch a process necessitates a company to establish a subsidiary, so that it purchases goods

from a subsidiary based in another country and resells the goods to another subsidiary that imports such

goods. The payment in such a case passes through a re-invoicing center that manages the funds from both

the units.

uch a process enables better management of the foreign currency and reduces the parent company from

fluctuation in the currency rates. The process also improves the company6s li'uidity profile by using

leading and lagging modes of payment. It is also efficient in getting the company economies of scale, as

the company trades in large chunks of foreign funds and therefore obtains cheaper foreign exchange rates.

/esides reinvoicing, there is internal factoring techni'ue that similar to that of reinvoicing but buys the

exporting unit6s receivable account.

In other words, re-invoicing center is a central financial facility designated by an 1&0 to centralize all

payments and invoicing charges subsidiaries fees for its function. This way, it attempts to reducetransaction exposure by having all home country exports billed in the home currency and then re-invoiced

to each operating affiliate in that affiliate6s local currency.

The re-invoicing center determines which currencies should be used and where, how, and when. This

reinvoicing activity can effectively shift profits to subsidiaries where tax rates are low.

A re-invoicing center is a subsidiary that has no inventory but centralizes invoices and manages operating

exposure in one center. 1anufacturing affiliates ship goods directly to distribution affiliates, but invoice

the reinvoicing center, which then receives title to the goods and involves the affiliate in a separate

currency. Transactions exposure thus resides in the re-invoicing center. &aturally, some of its accounts

receivable and accounts payable will be in the same currency, providing a natural hedge. The invoicing

center thus centralizes the net exposure to each currency.

A re-invoicing center could also transfer profits from a high-tax affiliate to a low-tax affiliate, i.e.,

practice aggressive transfer pricing. This is not the purpose of the re-invoicing center and it violates

11

7/24/2019 5th unit

12/47

T+,+t-&

I/&-*t-t)* - @&I/&-* t-t)* - /*?& Y*

Ph

7/24/2019 5th unit

13/47

combinations are possible. The commission covers the cost of the re-invoicing center but does not shift

profits away from operating subsidiaries.

5.1.0.1. A#anta$e+ o, Re%Inoicin$

There are three basic benefits arising from the creation of a re-invoicing center"

#$ 'anaging (oreign Exchange Expos!re:The formation of the center allows the management of

all foreign exchange transaction exposure for intra company sales to be located in one place. 5e-

invoicing center personnel can develop a specialized expertise in choosing which hedging

techni'ue is best at any moment, and they are likely to obtain more competitive foreign exchange

'uotations from banks because they are dealing in larger transactions.+$ )!aranteeing the Exchange Rate for (!t!re "rders:/y guaranteeing the exchange rate for

future orders, the re-invoicing center can set firm local currency costs in advance. This enables

distribution subsidiaries to make firm bids to unrelated final customers, and to protect against theexposure created by a backlog of unfilled orders. /acklog exposure does not appear on the

corporate books because the sales are not yet recorded. ales subsidiaries can focus on their

marketing activities and their performance can be udged without distortion because of exchange

rate changes.>$ 'anaging Intra*S!+sidiary Cashflows: The center can manage intra-subsidiary cashflows,

including leads and lags of payments. Gith a re-invoicing center, all subsidiaries settle intra-

company accounts in their local currencies. The re-invoicing center need only hedge residual

foreign exchange exposure.

5.1.0.2. i+a#anta$e+ o, Re%Inoicin$The main disadvantage is that the benefits may not ustify the agency cost. :ne additional corporate unit

must be created, and a separate set of books must be kept. The initial set-up cost can be high because

existing order processing procedures must be re-programmed. The center will have an impact on the tax

status and customs duties of all subsidiaries, as well as on the amount of foreign exchange business

directed to local banks in each country. *stablishment of a re-invoicing center is likely to bring increased

scrutiny by tax authorities to be sure that it is not functioning as a tax haven. 0onse'uently, a variety of

professional costs will be incurred for tax and legal advice, in addition to. The costs of personneloperating the center.

5.1.%. TAX TREATIESTax treaties are a bilateral agreement made by two countries to resolve issues involving double taxation of

passive and active income. Tax treaties generally determine the amount of tax that a country can apply to

13

7/24/2019 5th unit

14/47

a taxpayer6s income and wealth. Tax haven countries are the only countries that typically do not enter into

tax treaties. :ne of the most important aspects of a tax treaty is the policy on withholding taxes, which

determines how much tax is levied on income 4interest and dividends$ from securities owned by a non-

resident. (or example, if a tax treaty between country A and country / determined that their bilateral

withholding tax on dividends is #CH, then country A will tax dividend payments that are going to country

/ at a rate of #CH and vice versa. ,

0ountries enter into bilateral tax treaties to avoid double taxation and thus to encourage the free flow of

investments internationally. Treaty countries agree on how taxes will be imposed, shared, or otherwise

eliminated on business income earned in one taxing urisdiction by nationals of another.

Tax treaties are designed to serve the following four purposes"

#$ To prevent double taxation on the same income.

+$ To prevent national tax discrimination against foreign nationals of the other treaty country.>$ To increase predictability for the nationals of the treaty nations by specifying taxable obligations.

2redictability also tends to reduce opportunities for tax evasion or tax fraud.?$ To specify the type of tax subsidies that will be mutually acceptable to both treaty nations.

A network of bilateral tax treaties, many of which are modeled after one proposed by the :rganization for

*conomic 0ooperation and %evelopment 4:*0%$, provides a means of reducing double taxation. Tax

treaties normally define whether taxes are to be imposed on income earned in one country by the

nationals of another, and if so, how. Tax treaties are bilateral, with the two signatories specifying what

rates are applicable to which types of income between them alone.

The individual bilateral tax urisdictions as specified through tax treaties are particularly important for

firms that are primarily exporting to another country rather than doing business there through a

permanent establishmentD. The latter would be the case for manufacturing operations. A firm that only

exports would not want any of its other worldwide income taxed by the importing country. Tax treaties

define permanent establishmentD and what constitutes a limited presence for tax purposes.

Tax treaties also typically result in reduced withholding tax rates between the two signatory countries, the

negotiation of the treaty itself serving as a forum for opening and expanding business relationships

between the two countries. This practice is important both to 1&*s operating through foreign

subsidiaries, earning active income, and to individual portfolio investors who are simply receiving passive

income in the form of dividends, interest, or royalties.

14

7/24/2019 5th unit

15/47

5.1..1. ou&le Taxation%ouble taxation is a condition in which two or more taxes may need to be paid for the same asset)

financial transaction or income is known as double taxation. It generally takes place due to the

overlapping of the tax laws and regulations of different countries. Thus, double taxation occurs when a

taxpayer is charged income tax, both at his country of residence as well as in the country where the

income is generated. Taking into account the laws of income tax in India, a non-resident becomes liable to

tax payment in India, given that it is the place where the income is generated. 1oreover, he has to

additionally bear the burden of tax payment in his own country, by virtue of the inclusion of the same

income in the total world income6, which forms the tax base of the country where he resides.

In other words, double taxation occurs when an individual is re'uired to pay two or more taxes for the

same income, asset,- or financial transaction in different countries. %ouble taxation occurs mainly due to

overlapping tax laws and regulations of the countries where an individual operates his business.

5.1.%.1.1. D&'()* T+,+t-& A/&-0+* A***t%ue to phenomenal growth in international trade and commerce and increasing interactivity among the

nations, residents of one country extend their sphere of business operations to other countries. 0ross-

country flow of capital, services and technology is the order of the day particularly after the country

embarked on the path of globalization of economy. 2resence of double or multiple taxation acts as a maor

determining factor in decisions relating to location of investment, technology etc., as it affects the bottom

line of a business enterprise. The effort is, therefore, to ensure that heavy tax burden is not cast as a result

of double or multiple taxation. The obect is achieved by the overnment entering into agreements with

other countries whereby the respective urisdiction is so identified that a particular income is taxed in one

country only or, in case it is taxed in both the countries, suitable relief is provided in one country to

mitigate the hardship caused by taxation in another urisdiction. uch agreements are known as %ouble

Tax Avoidance AgreementsD 4%TAA$ also termed as Tax TreatiesD.

The Income-Tax Act, #7F# contains explicit statutory provisions to confer on the 0entral overnment the

power to enter into Agreements with foreign countries for Avoidance of %ouble Taxation as contained in

0hapter IJ of the Income Tax Act. ection 7C of this 0hapter reads as under"

#greement with (oreign Co!ntries

The 0entral overnment may enter into an agreement with the overnment of any country outside India"

#$ !or the granting of relief in respect of income on which have been paid both income-tax under

this Act and income-tax in that country, or

15

7/24/2019 5th unit

16/47

+$ !or the avoidance of double taxation of income under this Act and under the corresponding law in

force in that country, or>$ !or exchange of information for the prevention of evasion or avoidance of income- tax

chargeable under this Act or under the corresponding law in force in that country, or investigation

of cases of such evasion or avoidance, or?$ !or recovery of income-tax under this Act and under the corresponding law in force in that

country.

And may, be notification in the :fficial azette, make such provisions as may be necessary for

implementing the agreementD.

0orresponding to section 7C of the Income Tax Act and section ??A of the Gealth tax Act, #7E8 contains

identical provisions to empower the 0entral overnment to enter into agreements for avoidance of double

taxation in regard to the levy of wealth tax or for exchange of information for the prevention of evasion or

avoidance etc. or for recovery of tax etc.

%ouble tax avoidance agreements comprise of consensus between two countries aiming at elimination of

double taxation. %ouble taxation avoidance agreements between two countries would focus on mitigating

the incidence of double taxation. It would promote exchange of goods, persons, services, and investment

of capital among such countries. These are bilateral economic agreements wherein the countries

concerned assess the sacrifices and advantages which the treaty brings for each contracting nation.

"+,ectie of -o!+le Taxation #oidance #greements

The need and purpose of tax treaties were indicated by the :rganization for *conomic 0ooperation and

%evelopment in the 1odel Tax 0onvention on Income and on 0apital6 as standardization and common

solutions for cases of double taxation to the taxpayers who are engaged in industrial, financial or other

activities in other countries. !irstly, treaties must help in avoiding and alleviating the burden of double

taxation prevailing in the international arena. The tax treaties must clarity and help the taxpayer to know

with certainty of his potential tax liability in other country where he is carrying-on industrial or other

activities. Tax Treaties must ensure that there is no discrimination between foreign tax payers who has

permanent establishment in the source countries and domestic tax payers of such countries. Treaties are

made with the aim of allocation of taxes between treaty nations and the prevention of tax avoidance

and=or tax evasion. The treaties must also ensure that e'ual and fair treatment of tax payers having

different residential status, resolving differences in taxing the income and exchange of information and

other details among treaty partners.

1

7/24/2019 5th unit

17/47

D&'()* T+,+t-& R*)-*

B-)+t*+) R*)-*

U-)+t*+) R*)-*

0lassification of %ouble Taxation Avoidance Agreements %ouble taxation avoidance agreements may be

classified into two parts"

#$ Comprehensie #greements:0omprehensive double taxation avoidance agreements provide for

taxes on income, capital gains, and capital investments. 0omprehensive agreements ensure that

the taxpayers in both the countries would be treated on e'uitable manner in respect of the

problems relating to double taxation.+$ Limited #greements: @imited double taxation avoidance agreements denote income from

shipping and air transport or legacy and gifts.>$ "ther #greement:These agreements provides for taxation relief from the double taxation in

respect of incomes by providing exemption and also by providing credits for taxes paid in one of

the countries. These treaties are based on the general principles laid down in the model draft of

the :rganization for *conomic 0ooperation and %evelopment 4:*0%$ with suitable

modifications as agreed to by the other contracting countries.

5.1.%.1.2. D&'()* T+,+t-& R*)-*5elief from double taxation relief can be provided in two ways"

#$ Bilateral Relief .Section 7CK" (nder ection 7C, Indian government provides protection against

double taxation by entering into a mutually agreed tax treaty 4%TAA$ with another country.

(nder bilateral relief, protection against double taxation is provided either by completely

avoidance of overlapping tax or waiving a certain amount of the tax payable in India. The 0entral

overnment is empowered to make agreement in respect of tax administration and managementwith the government of foreign countries.#greement for )ranting Relief .Section /01&23

The 0entral overnment may enter into agreement with the government of a foreign country to

provide relief in respect of income on which tax has been paid in India as well as in that country.

In order to promote mutual economic relations, trade and investment, the 0entral overnment

1!

7/24/2019 5th unit

18/47

may also enter into agreement to grant relief in respect of income which is chargeable to tax in

India as well as in that country.#greement to #oid -o!+le Taxation .Section /01&23

The 0entral overnment may enter into agreement with the government of a foreign country to

avoid double taxation of income in India and in that country.

#greement for Exchange of Information .Section /01&23The 0entral overnment may enter into agreement with the government of a foreign country for

exchange of information to prevent evasion or avoidance of income tax in India and in that

country or to investigate cases of such evasion or avoidance.#greement for Recoery of Tax:The 0entral overnment may enter into agreement with the

government of a foreign country for mutual recovery of income tax of one country in another

country.Beneficial 4roisions of the #ct to S!persede the 4roisions of -o!+le Taxation #oidance

Treaty .Section /01523

Ghere the 0entral overnment has entered into agreement with the government of a foreigncountry to provide relief against double taxation or to prevent avoidance of double taxation, the

provisions of the Income-Tax Act will not apply to an assessee who is covered by double taxation

avoidance treaty. ;owever, if the provisions of the Act are more beneficial to such assessee, such

beneficial provision will supersede the provisions of the double taxation avoidance treaty.Terms not defined to hae the Same 'eaning as #ssigned to it in the Notification .Section

/01623Ghere any term used in Income-Tax Act or double taxation avoidance treaty has not been

defined, such term will have the same meaning as has been assigned to it in the &otification

issued by the 0entral overnment, provided such meaning is not inconsistent with the provisions

of the Act or agreement.It is operative from the assessment year +CC?-+CCE and subse'uent years.Adoption by 0entral overnment of Agreements between pecified Associations for %ouble

Taxation 5elief 4ection 7CA$Any specified association in India may enter into an agreement with any specified association in

the specified territory outside India.The 0entral overnment may, by &otification in the :fficial azette, make such provisions as

may be necessary for adopting and implementing such agreement for"rant of double taxation relief in respect of income on which tax has been paid under this Act and

also in specified territory outside India) ori$. Avoidance of double taxation, of income under this Act and in specified territory outside

India) orii$. *xchange of information for the prevention of exasion or avoidance of income tax) or

iii$. 5ecovery of income tax under this Act and specified territory outside India.

:n notification of such agreement, the provisions of this Act remain applicable to such assessee to the

extent they are more beneficial to him. Any term used but not defined in the Income-Tax Act or, in the

1"

7/24/2019 5th unit

19/47

said agreement will have the same meaning as assigned to it in the &otification by the 0entral

overnment, unless the context re'uires otherwise and it is not inconsistent with the provisions of the

Income-Tax Act or the said agreement.

Terms %efined

i$. pecified AssociationD means any notified institution, association or body, whether

incorporated or not, functioning under any law for the time being in force in India or the

laws of the specified territory outside India.ii$. pecified TerritoryD means any area outside India notified by the 0entral overnment.

Applicability" The aforesaid provisions are applicable w.e.f. # une +CCF.

+$ (nilateral 5elief Lection 7#K" (nder ection 7#, Indian government can relieve an individual

from burden of double taxation, irrespective of whether there is a %TAA between India and the

other country concerned or not, under certain conditions. In other words, where there is no

agreement either to avoid double taxation or provide relief against double taxation with a foreign

country, Indian overnment provides a unilateral relief on doubly taxed income against income

tax payable in India, provided the following conditions for the unilateral relief are satisfied"i$. #ssessee to +e Resident:The assessee is residentD in India during the previous year.

Thus, if the assessee is non-resident during the previous year, no relief can be granted to

him.ii$. #ccr!al of (oreign Income o!tside India: !oreign income, taxable in India, accrues or

arises outside India. Thus, the place of accrual of income must fall outside India.iii$. (oreign Income not to +e deemed to #ccr!e or #rise in India: If foreign income is

deemed to accrue or arise in India under ection 7, no relief is provided against such

doubly taxed income. (or example7 1r. has earned business profits of M+C,CC,CCC in

apan from a business, controlled and managed from there. It includes business profit of M

E,CC,CCC which is from business connection in India. uch profit is deemed to accrue or

arise in India. &o relief is allowed on such doubly taxed income.iv$. 4ayment of Tax on (oreign Income: The assessee has paid tax on such foreign income

outside India either by way of deduction of tax at source or otherwise.

4roced!re of Relief

The relief is allowed against Indian income tax under four steps.

#$ To Ascertain the Amount of %oubly-Taxed Income" The assessee is re'uired to ascertain the

amount of income which has been simultaneously taxed in India as well as in foreign country.

1%

7/24/2019 5th unit

20/47

M*th&06 & E)--+t-& D&'()* T+,+t-&

E,*>t-& M*th&0

C*0-t M*th&0

T+, S>+-

+$ To %etermine the Average 5ate of Indian Income Tax" Average rate of Indian income tax should

be determined. uch average is determined as under"

Tax payableIndia

Total income 100

Tax payable in India is taken after providing any relief due under the provisions of this Act, but before

providing double taxation relief under this section.

>$ To -etermine the #erage Rate of (oreign Income Tax: Average rate of foreign income tax

should be determined. uch average is determined as follows"

Foreignincome tax

Foreign totalincome100

!oreign income taxD means income tax and super tax actually paid in foreign country in

accordance with corresponding laws in force in the said country after deduction of all relief due

but before deduction of any relief due in the said country in respect of double taxation.?$ To #scertain the #mo!nt of Relief:5elief is allowed on the amount of doubly taxed income

either at the average rate of Indian tax or at the average rate of !oreign Income Tax, whichever is

lower. Thus, if average rate of Indian income tax is +E.8EH and the average rate of !oreign

Income Tax is ++.+EH relief is allowed against Indian Income Tax on the doubly taxed income N

++.+EH.

5.1.%.1.3. M*th&06 & E)--+t- D&'()* T+,+t-&The following methods are used for the elimination of double taxation"

2#

7/24/2019 5th unit

21/47

#$ Exemption 'ethod::ne method of avoiding double taxation is for the residence country to

altogether exclude foreign income from its tax base. The country of source is then given exclusive

right to tax such incomes. This is known as complete exemption method and is sometimes

followed in respect of profits attributable to foreign permanent establishments or income from

immovable property. Indian tax treaties with %enmark, &orway, and weden embody with

respect to certain incomes.+$ Credit 'ethod:This method reflects the underline concept that the resident remains liable in the

country of residence on its global income, however as far the 'uantum of tax liabilities is

concerned credit for tax paid in the source country is given by the residence country against its

domestic tax as if the foreign tax were paid to the country of residence itself.>$ Tax Sparing::ne of the aims of the Indian double taxation avoidance agreements is to stimulate

foreign investment flows in India from foreign developed countries. :ne way to achieve this aim

is to let the investor to preserve to himself=itself benefits of tax incentives available in India for

such investments. This is done through Tax paringD. ;ere the tax credit is allowed by the

country of its residence, not only in respect of taxes actually paid by it in India but also in respect

of those taxes India forgoes due to its fiscal incentive provisions under the Indian Income Tax

Act.Thus, tax sparing credit is an extension of the normal and regular tax credit to taxes that are

spared by the source country, i.e., forgiven or reduced due to rebates with the intention of

providing incentives for investments.

5.1..2. Multilateral Tax Treatie+A multilateral tax treaty might be considered"

#$ As a full or partial replacement for the series of bilateral treaties now used by many countries) or+$ As a mechanism for amending 4updating$ existing bilateral treaties to reflect changes in or

additions to the :*0% 1odel or (& 1odel 4or some other model$, as approved by the body in

charge of that model.

The political feasibility of a multilateral tax treaty as a replacement for bilateral treaties may depend

significantly on the size of the group of countries that conclude such a treaty. !or a small group of

countries with similar tax systems 4e.g., the &ordic countries$, a multilateral treaty seems to be more

feasible than a multilateral treaty applicable to all countries in the world that have tax treaties. A

multilateral tax treaty that is limited in scope also may be more acceptable politically. It may be possible,

e.g., to have a multilateral treaty that deals with many issues arising in a tax treaty but leaves a small

number of sensitive issues for bilateral negotiations. A multilateral treaty among a small number of

countries with closely integrated economies might also permit greater experimentation.

21

7/24/2019 5th unit

22/47

#dantages of a '!ltilateral Tax Treaty

ome of the possible advantages of a multilateral tax treaty are listed below"

#$ 'echanism for Reising Treaties 4romptly: If a multilateral tax treaty is developed by an

international organization, that organization could make periodical revisions of the treaty to deal

with the inevitable emerging issues and the inevitable tax avoidance schemes. 2resumably, some

procedure would have to be established for ratifying the revised treaty because most countries

would not forfeit their right to reect a revised treaty. 0urrently, the :*0% attempts to update and

revise existing tax treaties based on the :*0% 1odel by amending the :*0% commentary and

treating the changes in die commentary merely as interpretations of the :*0% 1odel. In recent

years, the :*0% commentary updates increasingly seem to some observers to strain an ordinary

interpretation of the text of the :*0% model. As a result, the courts of some countries may refuse

to read the updates of the :*0% commentary as improved interpretations of existing treaties.This problem is avoided if the updates of the model are included in a multilateral treaty that is

revised and then ratified.+$ Simplification:A uniform tax treaty applicable to many countries may be easier to interpret and

apply than the current non-uniform bilateral treaties. There is also likely to be increased

consistency in interpretation and increased certainty in application. In some cases, novel rules

inserted into a bilateral treaty can give rise to interpretation and=or application problems. In

theory, the same degree of uniformity might be achieved through a series of identical bilateral

treaties.

>$ Soling Triang!lar Iss!es:ome triangular issues that may arise as a result of the strict bilateral

approach of the existing 4bilateral$ treaties can be solved more effectively by a multilateral treaty.?$ Red!ced Negotiating Time:/ilateral treaties take a year or more to negotiate. A multilateral

treaty offers the prospect of avoiding the need for separate negotiations with each country. This

advantage is of particular importance to small countries that do not have an abundance of

resources.E$ Red!ced Treaty Shopping:A multilateral treaty would provide for uniform treatment of all

residents of the participating states. Treaty shopping to get the best deal among the applicable

treaties would be eliminated. :f course, the problem of persons from non-treaty states improperly

obtaining benefits would not be solved merely by having a multilateral treaty.

-isadantages of a '!ltilateral Tax Treaty

ome of the possible disadvantages of a multilateral treaty are indicated below"

22

7/24/2019 5th unit

23/47

#$ Special 4roisions:In some cases, a country may not be willing to enter into a multilateral treaty

unless it retains the right to make special arrangements with some of its important trading

partners. The simplification gains that might be obtained from a uniform multilateral treaty might

be lotet if many countries entered into side arrangements. Indeed, it is possible that a multilateral

treaty, after its adornment with many side arrangements, could be more complex to interpret than

the .current set of bilateral treaties.+$ "ssification:A multilateral treaty, in practice, may become difficult to amend. /ilateral treaties

are already difficult to amend, and they involve only two parties. If a multilateral treaty ossifies, it

is likely to do more harm than good.>$ Red!ced (lexi+ility: /y its nature, a multilateral treaty is less flexible in dealing with the

particular circumstances of countries than a bilateral treaty. !or example, it seems unlikely that

multilateral treaty could be used to define the taxes of particular countries which 'ualify as

creditable income taxes for treaty purposes.

?$ Capt!re +y 4owerf!l Co!ntries or Special Interests: There is an increased risk that a

multilateral, treaty would be written to protect the interests of the powerful - powerful countries

or powerful interest groups - at the expense of others. uch a capture of an international tax treaty

by the powerful may not be inevitable, but serious steps would need to be taken to prevent it from

happening.

5.1.1#. FOREIGN TAX CREDITIn order to eliminate double taxation of foreign-source earnings " the (nited tates and other home

countries grant a credit against domestic income tax for foreign income taxes already paid. In generalO if

the foreign tax on a dollar earned abroad and remitted to the (nited tates is less than or e'ual to the (..

rate of >?H, then that dollar will be subect to additional tax in order to bring the total tax paid-up to >?

cents. If the foreign tax rate is in excess of >?H, the (nited tates will not impose additional taxes and, in

fact, will allow the use of these excess taxes paid as an offset against (.. taxes owed on other foreign-

source income. These !oreign Tax 0redits 4!T0s$ are"

#$ -irect (oreign Tax Credit:A direct tax is one imposed directly on a (. taxpayer. %irect taxes

include the tax paid on the earnings of a foreign branch of a (.. company and my foreign

withholding taxes deducted from remittances to a (.. investor. (nder ection 7C# of the (..

Internal 5evenue 0ode, a direct foreign tax credit can be taken for these direct taxes paid to a

foreign government.Taxes that are allowable in computing foreign tax credits must be based on income. These taxes

would include foreign income taxes paid by an overseas branch of a (.. corporation and taxes

23

7/24/2019 5th unit

24/47

withheld from passive income 4i.e., dividends, rents, and royalties$. 0redit is not granted for non-

income-based taxes such as a sales tax or 3AT.52 Indirect (oreign Tax Credit: (.. corporate shareholders owning atleast #CH of a foreign

corporation are also permitted under ection 7C+ to claim an indirect foreign tax credit - or

deemed paid credit - on dividends received from that foreign unit, based on an appointment of theforeign income taxes already paid by the affiliate. This indirect credit is in addition to the direct

tax credit allowed for any dividend withholding taxes imposed.The formula for computing the indirect tax credit is,

Indirect tax credit=Dividend (including withholding tax )

earnings net of foreignincome tax foreign tax

The foreign dividend included in (.. income is the dividend received grossed upto include both

withholding and deemed paid taxes.

In no case can the credit for taxes paid abroad in a given year exceed the (.. tax payable on total

foreign- source income for the same year. This rule is called the overall limitation on tax credit.

In calculating tire overall limitation, total credits are limited to the (.. tax attributable to foreign-source

income 4interest income is excluded$. @osses in one country are set-off against profits in others, thereby

reducing foreign income and the total tax credit permitted. Thus,

Maximumtotal tax credit=Consolidated foreign profitslosses

Worldwidetaxable income Amount of tax liability

If the overall limitation applies, the excess foreign tax credit may be carried back two years and forward

five years. The result of the carry-back and carry-forward provisions is that taxes paid by an 1&0 to a

foreign country may be averaged over an eight-year period in calculating the firm6s (.. tax liability.

5.1.11. TAXES 7 LOCATION OF FOREIGN

OPERATIONS!oreign non-resident business entities may have business activities in India in a variety of ways. In its

simplest form this can take the form of individual transactions in the nature of export or import of goods,

lending or borrowing of money, sale of technical know-how to an Indian enterprise, a foreign air-liner

touching an Indian airport and booking cargo or passengers, and so on. :n the other hand, the activities

may vary in intensity ranging from a simple agency office to that of an independent subsidiary company.

3arious tax issues arise on account of such activities. The first is the determination of income, if any,

earned by the foreign entity from those transactions and operations. This will call for a definition of

income that is considered to have been earned in India and a methodology for 'uantification of the same.

24

7/24/2019 5th unit

25/47

!oreign enterprises having business transactions in India may not be accessible to Indian tax authorities.

This raises the next issue of the mechanism to collect taxes from foreign enterprises. The government

wants to encourage foreign enterprises to engage in certain types of business activities in India which in

its opinion is desirable for achieving a balanced economic growth. This takes us to the topic of tax

incentives. Increasing presence of multinational companies in India creates issues relating to transfer

pricing.

!ollowing are the related issues relating to taxation of foreign enterprise in India"

#$ Taxation of transactions and operations of foreign enterprises in India.+$ Representatie #ssessees .Sections &$/ to &893: !or the purpose of effectuating the provisions

of the Income Tax Act in respect of a non-resident, assessee. Income Tax Act treats the agent of

such assessee as a representative assessee. !or this purpose an agent in relation to a non-resident

includes any person in India"

i$. Gho is employed by or on behalf of the non-resident) orii$. Gho has any business connection with the non-resident) or

iii$. !rom or through whom, the non-resident is in receipt of any income, whether directly or

indirectly) oriv$. Gho is a trustee of the non-resident and also includes any other person who, whether a

resident or nonresident, has ac'uired by means of a transfer, a capital asset in India.

&o person shall be treated as the agent of a non-resident unless he had an opportunity of being heard by

the Assessing :fficer as to his liability to be treated as such.

>$ Tax Incenties:The following amounts shall not be treated as a part of the taxable income of a

nonresident assessee"i$. Income by way of interest on such securities or bonds including premium on redemption

of such bonds as the 0entral overnment may specify in the :fficial azette. Lection

#C4?$K.ii$. Ghere in the case of a foreign company deriving income by way of royalty or fees for

technical services received from overnment or an Indian concern in pursuance of an

agreement made by the foreign company with overnment or the Indian concern after the

>#st day of 1arch, #78F and

a$Ghere the agreement relates to a matter included in the industrial policy for the

time being in force of the overnment of India and such agreement is in

accordance with that policy) andb$ In any other case, the agreement is approved by the 0entral overnment,

the tax on such income is payable under the terms of the agreement by the

25

7/24/2019 5th unit

26/47

overnment or the Indian concern to the 0entral overnment, the tax so paid.

Lection #C 4FA$K.imilar exemption is available in respect of an enterprise deriving income which

is either relatable to an agreement entered into with the government of a foreign

state or an international organization or arises from the operation of aircraft.Lection #C4F/ and F//$K.

iii$. Any income arising to a foreign company, as the 0entral overnment may, by

notification in the :fficial azette, specify in this behalf by way of fees for technical

services received in pursuance of an agreement entered into with that overnment for

providing services in or outside India in proects connected with security of India.

Lection #C4F0$K.iv$. Interest 2ayable < Lection #C4F$K

a$ To any bank incorporated in a country outside India and authorized to perform

central banking functions in that country on any deposits made by it, with theapproval of the 5eserve /ank of India, with any scheduled bank)

b$ /y overnment or a local authority on money borrowed by it from 4or debts

owed by it to$ sources# outside India)c$ /y an industrial undertaking in India on money borrowed by it under a loan

agreement entered into# with any such financial institution in a foreign country

as may be approved in this behalf by the 0entral overnment by general or

special order.d$ /y an industrial undertaking in India on any money borrowed or debt incurred

by it in a foreign country in respect of the purchase outside India of raw

materials 4or components$ or capital plant and machinery, to the extent to

which such interest does not exceed the amount of interest calculated at the rate

approved by the 0entral overnment in this behalf, having regard to the terms

of the loan or debt and its repayment)e$ /y public financial institutions like Industrial !inancial 0orporation of India,

Industrial %evelopment /ank of India, and *xport Import /ank of India as

well as banking company established under /anking 5egulation Act, #7?7 on

any money borrowed by it from sources outside India to the extent such

interest does not exceed the amount of interest calculated at the rate approved

by the 0entral overnment in this behalf, having regard to the terms of loan

and its repayment.f$ /y an industrial undertaking in India on any moneys borrowed by it in foreign

currency from sources outside India under a loan agreement approved by the

0entral overnment having regard to the need for industrial development in

2

7/24/2019 5th unit

27/47

India, to the extent to which such interest does not exceed the amount of

interest calculated at the rate approved by the 0entral overnment in this

behalf, having regard to the terms of the loan and its repayment) andg$ /y a scheduled bank to a non-resident or to a person who is not ordinarily

resident on deposits in foreign currency where the acceptance of such depositsby the bank is approved by the 5eserve /ank of India.

?$ #dance R!ling .Sections 5$ N to 5$;3: (nder this scheme, any non-resident can make an

application in the prescribed form to the Authority for Advance 5uling, a 0ommittee located at

%elhi comprising of a 0hairman, who is a retired udge of the upreme 0ourt, an :fficer of

Indian 5evenue ervice who is 'ualified to be a member of 0entral /oard of %irect Taxes and an

:fficer of the Indian @egal ervice who is 'ualified to be an Additional ecretary to overnment

of India.The applicant has to state the 'uestion on which the advance ruling is sought. The authority can

either allow or reect the application after examining the application and other relevant records.

The authority shall give an opportunity to the applicant to be heard before reecting the

application mid should give the reasons for reection in the order. The authority shall hot allow a

'uestion which"i$. Is pending for disposal with any authority in the applicant6s case) or

ii$. Involve determination of fair market value of any property) oriii$. 5elates to a transaction which is designed on the face of it for the avoidance of income

tax. The ruling given by the authority will be binding"a$ :n the applicant who sought it)b$ In respect of the transaction in relation to which the ruling has been sought) and

c$ :n the 0ommissioner and his subordinates in respect of the applicant and the

said transaction.E$ Transfer 4ricing:There is increasing participation of multinational companies in the economic

activities of a country. The profits derived by such enterprises carrying business in any country

can be controlled by the multinational group. Taxation issue relating to international trade has

become important as business transactions have become very complicated. Transfer pricing is one

such area which has come under scrutiny of tax authorities all over the world. Transfer pricing

has been of great concern to the government as it has cost governments huge tax revenues.This includes the following three heads"

i$. %efinition of Income that is Taxable in India" ection 7 of the Act stipulates the items of

income which are treated as accruing or arising in India from activities of foreign

enterprises in India. These are as follows"a$ All income accruing or arising, whether directly or indirectly, through or from any

business connection in India. The term business connection6 is not defined in the act

and is to be determined based on the facts of each case.

2!

7/24/2019 5th unit

28/47

b$ alary is deemed to be earned in India if it is either payable for services rendered in

India or payable by Indian overnment to a citizen of India for services rendered

outside India Lection 7 a Jii$, 4ii$, and 4iii$K.c$ %ividend paid by Indian 0ompany outside India Lection 7 4i$, 4iv$K.d$ Income by way of interest payable by"

Indian overnment) or A person who is a resident, except where the interest is payable in respect of any

debt incurred, of moneys borrowed and used for the purposes of a business or

profession carried-on by such person outside India or for the purposes of making

or earning any income from any source outside India) or

A person who is a non-resident, where the interest is payable in respect of any

debt incurred or money borrowed and used for the purposes of a business or

profession carried-on by such a person in India Lection 7 4i$, 4v$K.e$ Income by way of royalty including lumpsum consideration payable by"

Indian overnment) or A person who is a resident, except where the royalty is payable in respect of any

right, property, or information used or services utilized for the purposes of a

business carried-on by such person outside India or for the purposes of making or

earning any income from any source outside India) or

A person who is a non-resident, where the royalty is payable in respect of any

right, property, or information used or services utilized for the purposes of a

business or profession carried-on by such person in India or for the purposes of

making or earning any income from any source in India Lection 7 / 4iv$K.

f$ Income by way of fees for technical services including lumpsum consideration

payable by"

Indian overnment) or

A person who is a resident, except where the fees are payable in respect of

services utilized in a business or profession carried-on by such person outside

India or for purposes of making or earning any income from any source outside

India) or

A person who is a non-resident, where the fees are payable in respect of services

utilized in a business or profession carried-on by such person in India or for the

purposes of making or earning any income from any source in India Lection 7 4i$,

4vii$K.g$ Income embedded in the transaction of supply of machinery or plant to an Indian

company located in India for which the consideration is to be discharged by allotment

of shares of the Indian company, will be taxed in India as income received in India

though the income may accrue or arise outside India.

2"

7/24/2019 5th unit

29/47

ii$. Puantification of Taxable Income" 3arious provisions dealing with 'uantification of

income are stated here under"a$ In the case of business of which all the operations are not carried out in India, only

that part of the income as is reasonably attributable to the operations carried out in

India can be treated as income accruing or arising in India. Ghen the operations of anon-resident are confined to purchase of goods in India for purpose of export, no

income is deemed to accrue or arise in India 4ection 74# J:$.b$ In the case of an assessee being a foreign company, no deduction in respect of any

expenditure or allowance as stipulated in the Act for computing income from business

or professional shall be allowed in respect of royalty or fees for technical services

rendered, received from government or an Indian concern4ection ??%$.iii$. Tax 5ates" 3arious types of incomes accruing or arising in India in respect of various

categories of non-resident assesses are taxed at different rates as mentioned below"

a$ Income by way of interest on money borrowed or debt incurred in foreign currencyarid income from units of approved mutual funds under ection #C4+> %$ purchased in

foreign currency of any foreign company is taxed at +CH4ection ##E A4l$$.b$ Income by way of interest on bonds of an Indian company, issued in accordance with

such scheme as the 0entral overnment may, by notification in :fficial azette,

specify in this behalf, and purchased in foreign currency as well as long-term capital

gains arising from the transfer of such bonds accruing to any non-resident assessee is

taxed at the rate of #CH of such income 4ection ##E A0$.

5.1.12. TAX IMPLICATIONS OF DIVIDENDREMITTANCE BY OVERSEAS AFFILIATE

:verseas dividend remittance is an important vehicle for 1ultinational 0orporations 41&0s$ to move

funds among their global subsidiaries. 0oncerns that residence-based, 4e.g., (..$ and territorial 4e.g.,

*uropean countries$ tax systems distort dividend repatriations decisions have led countries such as

Taiwan to adopt an imputation system. (nder this system, double taxation is avoided through a credit for

income tax paid at the corporate level to offset shareholders6 personal tax.

%ividend remittances by a large panel of foreign affiliates of (.. multinational firms. The dividend

policies of foreign affiliates resemble those used by publicly held companies in paying dividends to

diffuse common shareholders, in that firms set target payout ratios and partially adust dividends to

changes in net income. %ividend remittances by foreign affiliates are little affected by dividend payouts

of their parent companies, or parent company exposure to public capital markets. ystematic differences

in the payout behavior of affiliates that differ in organizational form and those that face differing tax

2%

7/24/2019 5th unit

30/47

costs of paying dividends reveal the importance of tax factors) nevertheless, policies are not solely

determined by tax considerations. 2arent companies impose, more rigid policies and are more willing to

incur tax penalties by simultaneously investing funds while receiving dividends, when their foreign

affiliates are partially owned, located far from the (nited tates, or in urisdictions with inefficient

udicial systems. This evidence suggests that dividend repatriation policies inside the multinational firm

are designed, in part, to control managers of foreign affiliates.

5.1.13. TAXES AND ORGANI8ATIONAL FORMThere are four basic forms of business ownership - the sole proprietorship, the partnership, the

corporation, and the limited liability company. *ach form of ownership has various advantages and

disadvantages. 2erhaps the greatest advantage of the sole proprietorship, which is the most fre'uently

encountered form of organization in terms of total numbers of businesses, is the ease with which it is

formed. As the name implies, the sole proprietorship is owned and operated by a single individual.

!ormation of a sole proprietorship is extremely simple, and the profit earned by the proprietor is normally

treated as ordinary income for tax purposes. The principal disadvantage of a sole proprietorship is that the

owner is solely liable for all obligations of the business. Thus, if the business is sued, the owner is solely

responsible for any liability resulting from the outcome of the suit. This liability extends to the owner6s

personal assets as well as business assets. Additional disadvantages of the sole proprietorship include

certain tax disadvantages. !or example, many fringe benefits such as medical insurance are not regarded

by the Internal 5evenue ervice as a business expense to the sole proprietorship.

A proprietor shares most of the advantages and disadvantages of the sole proprietorship. The main

difference between a partnership and a sole proprietorship is that the partnership has two or more owners,

each of whom owns a given percentage of the company. As one might expect, the addition of more

owners often complicates matters. In the absence of a written agreement to the contrary, all partners share

e'ually in the profits or losses of the company. imilarly, important decisions are also shared, sometimes

complicating the decision-making process somewhat. An additional complicating factor is that, from a

legal viewpoint, the partnership is terminated if one partner dies or withdraws from the partnership. The

partnership must then be reconstituted as a new partnership following settlement of the terminated

partner6s account. 4uch settlements are occasionally complex and difficult.$ !rom an income tax point of

view, partnership income is taxed the same as sole proprietorship income, i.e., each partner6s share in the

profits of the partnership is treated as ordinary income for tax purposes.

The corporate form of organization is by far the most significant in terms of dollars of sales, assets,

profits, and contribution to the gross national product. The most important legal aspect of the corporation

is its limited liability. A corporation is a legal personD. It exists independently of its owners under the

3#

7/24/2019 5th unit

31/47

law. 2ersonal assets of corporate stockholders 4owners$ generally cannot be seized to settle claims against

the corporation, and capital can be raised in the corporation6s name. hares of stock are transferable

among owners, and the corporation continues independently of stock sales or stockholder deaths. The

limited liability and perpetual life characteristics of the corporation make this form of organization almost

mandatory for large firms.

@imited @iability 0ompanies 4@@0s$ are relatively new entities, the creation of new state laws passed

over the past two decades. An @@0 has the advantage of the flexibility and tax treatment of a partnership,

e.g., no double taxation$, while conferring limited liability upon the @@06s owners 4which are generally

called membersD$. @@0s are fre'uently used for start-up companies and real estate ventures, as they

allow tax losses to flow to the members, subect to any passive loss limitations.

!rom an income tax point of view, the most important differences among the organizational forms relate

to the way in which the income from a given business is taxed. The profits from sole proprietorships,partnerships, and limited liability companies are taxed as personal income to the proprietor, partners, or

members. 0orporate profits, however, are taxed at the corporate rate independently of the individual

owners6 income.

5.1.13.1. *ontrolle# orei$n *or(orationA controlled foreign company is an entity in another nation used by investors to lower the tax burden in

his or her native country. 0ontrolled !oreign 0orporation 40!0$ rules are features of an income tax

system designed to limit artificial deferral of tax by using offshore low taxed entities. The rules are

needed only with respect to income of entities that is not currently taxed to the owners of the entity.

In other words, 0ontrolled foreign corporation 40!0$ laws work alongside tax treaties to dictate how

taxpayers declare their foreign earnings. A 0!0 is advantageous for companies when the cost of setting

up a business, foreign branches or partnerships in a foreign country is lower even after the tax

implications, or when the global exposure could help the business grow.

The 0!0 structure was created to help prevent tax evasion, which was done by setting up offshore

companies in urisdictions with little or no tax. *ach country has its own 0!0 laws, but most are similar

in that they tend to target individuals over multinational corporations when it comes to how they are

taxed. !or this reason, having a company 'ualify as independent will exempt it from 0!0 regulations.

0ountries differ in how they define the independence of a company. The determination can be based on

how many individuals have a controlling interest in the company, as well as the percentage they control.

31

7/24/2019 5th unit

32/47

!or example, minimums can range from fewer than #C to over #CC people, or ECH of voting shares, or

#CH of the total outstanding shares.

5.1.14. TAXATION OF FOREIGN SOURCE INCOME IN

INDIAThe Indian Income Tax Act 4IT Act$ provides for the levy of income tax on the income of foreign

companies and non-residents, but only to the extent of their income sourced from India. (nder ection E

of the Act, a foreign company or any other non-resident person is liable to pay tax on income which is

received or is deemed to be received in India by or on behalf of such person, or income which accrues or

arises or is deemed to accrue or arise to it in India. ection 7 thereafter, specifies certain types of income

that are deemed to accrue or arise in India in certain circumstances. These two sections embody the

source rule of income taxation in the domestic law. &o income of a non-resident can be taxed in India

unless it falls within the four comers of ection E read with ection 7 of the Income Tax Act.

/roadly speaking, the business income of a foreign company or other non-resident person is chargeable to

tax to the extent it accrues or arises through a business connection in India or from any asset or source of

income located in India, and to the extent such income is attributable to the operations carried-out in

India. Income in the nature of salary is taxable in India if it is earned for services rendered in India.

Income in the nature of interest, royalty, and fees for technical services is taxable in India, if such income

is received from the overnment) or from a person resident in India except where such income is

connected with a business or profession carried on outside India or with any other source of income

outside India. Income in the nature of interest, royalty, and fees for technical services received from a

non-resident is also taxable in India if it is connected with a business or profession carried on in India or

with any other source of income in India.

The IT Act contains a number of special provisions relating to the income of non-residents, including

provisions under ection #C of the Act exempting certain categories of income. It also contains provisions

prescribing a presumptive basis of taxation of certain types of income, so as to simplify the computation

of income and tax in cases where the nature of activity makes such computation difficult. The Act also

re'uires the deduction of tax at source from certain types of income, and for withholding tax on all

chargeable income remitted outside India.

This source-based taxation often gives rise to the problem of double taxation, where the same income

could be taxed twice - in India, and also in the country of residence of the taxpayer. India has entered into

%ouble Tax Avoidance Agreements 4%TAAs$ with a large number of countries, to resolve this problem.

*ssentially, these %TAAs lay-down the extent to which one country has a right to tax income of a resident

32

7/24/2019 5th unit

33/47

of the other country that is sourced from the first-mentioned country. The overnments of the two

countries, having regard to the source rules contained in their respective domestic laws, have negotiated

this extent. The IT Act provides that the provisions of such a %TAA, if they are more favorable to a

taxpayer, will override the provisions of the domestic tax law.

Gith a view to impart certainty of taxation in the cases of non-residents, a mechanism for obtaining

timely advance rulings on the tax, implications of transactions undertaken or proposed to be undertaken

by them, is available. Applications for obtaining such rulings, which are binding on the tax department as

well as the taxpayer, can be made to an independent udicial body, namely, the Authority for Advance

5ulings.

5.2. TRAN/ER RI*IN

5.2.1. MEANING OF TRANSFER PRICING 9TP:A transfer price is a price used to measure the price of goods or services furnished by a profit centre to

other responsibility centres within a company.D The evaluation of managerial performance within the

company through profit centres is impossible without determining transfer process in case various profit

centres of the company exchange goods and services. In such situations, there is a need to determine the

monetary values, called transfer price, at which the transfer should take place so that costs and revenues

could be properly assigned. The implication of the transfer price is that for the transferring division=centre

it will be a source of revenue, whereas for the division to which transfer is made will be an element of

cost. Thus, there is a need to determine proper transfer price for the successful implementation of

responsibility accounting.

ome companies have the problem of pricing goods and services which are transferred to other

divisions=units of the same company) such pricing is referred to as intra-company6, intra-divisional6 or

transfer pricing6. It is the pricing of goods and services exchanged in intra-corporate purchase

transactions.

The appropriate basis for intra-company transfers often depends on the nature of subsidiaries, the market

conditions and government policies and regulations.

In view of the above, the T2 is an important element in the performance evaluation of a division. o, in

fixing the T2, the following points are worth noting"

#$ T2 should not have any detrimental effect on the motivation of the divisional managers.+$ It should help in measuring the real performance of a division.

33

7/24/2019 5th unit

34/47

>$ @ess and less discretion and subectivity should be allowed to creep in the fixation of T2. T2

should be compatible with the obective of overall firm, though the interest of any division need

not be undetermined.

5.2.2. OBJECTIVES OF TRANSFER PRICINGThe main obectives of intra-company transfer pricing are summarized below"

#$ 4rofita+ility:To foster a commercial attitude in those who are responsible for the performance of

profit centres. The main emphasis here is on profitability. This obective forces the units to

improve their profit position.+$ 'axim!m !tili$ "ptimi

7/24/2019 5th unit

35/47

-isadantages of Cost*Based Transfer 4ricing

!ollowing are the disadvantages of cost-based transfer pricing"

i$. Inefficiencies of selling divisions are passed on to the buying divisions with little

incentive to control costs. The use of standard costs is recommended to prevent this

possibility.ii$. The cost-based method treats the divisions as cost centers rather than profit or investment

centers. Therefore, measures such as 5:I and 5I cannot be used for evolution purposes.+$ 'arket +ased Transfer 4ricing: (nder the cost-based methods of transfer pricing, it was

assumed that departments or units of a company would not be treated as a separate profit centre

for efficiency measurement. (nder market price method, the transfer prices to other divisions are

based on market prices. A competitive market implies the existence of buyers and sellers. uch a

market provides an incentive to efficient production because excessive costs cannot be passed on

to buyers. ince market prices will, by and large, be determined by demand and supply in the

long run, it is claimed that profits, which result under this method, will provide a good indicator

of the overall efficiency of the various units.In certain cases, the division may not be trading externally. In such circumstances, the market

price is determined on the market reports, which may be an inaccurate guide to the actual prices.

In view of this, the measure of efficiency generated may be distorted. There are circumstances

when the actual costs will be more than the market prices. elling division will thus be inefficient

and user division will be treated as efficient one. 0ompetitive market prices, thus, provide reliable

measure of divisional income because these prices are established independently.#dantages of 'arket +ased Transfer 4ricing!ollowing are the advantages of market based transfer pricing"

i$. The use of market price stimulates the competitive characteristics of the open market and

may lead to appropriate decision-making.ii$. The profit achieved in this system can be considered more obectively as it is based on

external factors and not distorted by internal factors.iii$. A discounted market price or market price less savings will be fair to both transferor and

transferee.

-isadantages of 'arket +ased Transfer 4ricing

!ollowing are the disadvantages of market based transfer pricing"

i$. 0ollection of market prices presents a lot of difficulty. There may not be any market price

at all when the goods are manufactured for captive consumption only.ii$. In the spell of rising prices, market price method is very difficult to be used because

prices become obsolete in short span of time.

35

7/24/2019 5th unit

36/47

iii$. The use of market price method demands that company should attempt inter-unit

elimination of profits. This exercise may be easy to look at but it is very difficult to

operate in practice.iv$. 1arket price consists of cost elements like packing, selling and distribution expenses, the

selling unit do not incur all these expenses. As such adoption of market price may not bea satisfactory process.

v$. RGhen this method is used, stock is valued at market price and, therefore, elimination of

unearned profit relating to closing stock becomes necessary.>$ Negotiated Transfer 4ricing:A negotiated transfer pricing is one that is determined by the

bargaining between buyer and seller. %ivisional managers have full freedom to go for outside

purchase if the prices 'uoted by other divisions are not acceptable to them. A system negotiate

prices will foster the commercial attitude amongst divisions of the company. ;owever, the cost of

freedom may be that the profit of one division is earned at the expense of other divisions. The

buying division may be tempted to purchase from outside source if the outside prices are lower

than the internal division6s price. In order to avoid the danger of overall profits,, SGhich may be

reduced in this way, the top management may impose constraints on external trading. In order to

have an effective system of intra-company transfer pricing, the following points should be kept in

view"i$. 2rices of all inter-division transfers should be determined by negotiation between buyers

and sellers.ii$. &egotiators should have access to full data on alternative sources or markets.

iii$. /uyers and sellers should be completely free to purchase from outside the company.

The administration of intra-company transfer pricing is the sole responsibility of top management. All

pricing disputes which are not settled at divisional level will have to be referred to the top management

for decision. 1anagement by exception will have to be followed in such cases. :verall company6s

:bective should be kept in view while regulating such prices.

Advantages of &egotiated Transfer 2ricing !ollowing are the advantages of negotiated transfer pricing"

i$. It preserves the autonomy of the divisions)ii$. &o cost price disputes arise.

iii$. Ghile negotiating the price each division becomes aware of the problems of others and a

consensus may bring benefit to the organization as a whole.

%isadvantages of &egotiated Transfer 2ricing !ollowing are the disadvantages of negotiated transfer

pricing"

i$. The price depends on the negotiating ability of the participants.

3

7/24/2019 5th unit

37/47

T+6* P-- M*th&06

P&t S>)-t M*th&0

C&>++()* U&t&))*0 P-* M*th&0

C&6t P)'6 M*th&0

R*$S+)* P-* M*th&0

T+6+t-&+) N*t M+- M*th&0

ii$. The buyer may take undue advantage of the idle capacity ip the selling division and bring

down the price.iii$. The relative profitability of the two divisions shows some anomalies.iv$. The substantial amount of manager6s time is spent in negotiations.v$. There may be conflicts between the divisions if the negotiations fail.

?$ -!al 4ricing:In this situation there is no single transfer price being used. !or example, thesupplying division could be credited with the market price and the buying division could be

charged with the variable cost of production. The advantage this particular techni'ue has over

other systems is that it enables the organization to achieve goal congruence more easily by setting

prices individually for both parties, so motivating them both to act in the best interests of the

organization and at the same time to charge prices which will be competitive for each unit and so

enable fair performance measurement. ;owever, a problem with dual pricing systems is that they

are rather complex. Adustments have to be made centrally when reconciling divisional accounts

to take into account duplication of profits. There is also a feeling that the figures that are arrivedat are fairly artificial.

5.2.4. TRANSFER PRICING METHODSThere are five methods of transfer pricing which are as follows"

#$ Compara+le =ncontrolled 4rice 'ethod:0omparable uncontrolled price method is a methodby which" $

i$. The price charged or paid for property transferred or services provided in a comparable

uncontrolled transaction, or a number of such transactions, is identified)ii$. uch price is adusted to account for differences, if any, between the international

transaction and the comparable uncontrolled transactions or between the enterprises

entering into such transactions which could materially affect the price in the open market)

3!

7/24/2019 5th unit

38/47

iii$. The adusted price arrived at under sub-clause 4ii$ is taken to be an arm6s length price in

respect of the property transferred or services provided in the international transaction.+$ Re*Sale 4rice 'ethod:5esale price method is a method by which"

i$. The price at which property purchased or services obtained by the enterprise from an

associated enterprise are resold or are provided to an unrelated enterprise, is identified.

ii$. uch resale price is reduced by the amount of a normal gross profit margin accruing to

the enterprise or to an unrelated enterprise from the purchase and re-sale of the same or

similar property or from obtaining and providing the same or similar services, in a

comparable uncontrolled transaction, or a number of such transactions.iii$. The price so arrived at is further reduced by the expenses incurred by the enterprise in

connection with the purchase of property or obtaining of services.iv$. The price so arrived at is adusted to take into account the functional and other

differences, including differences in accounting practices, if any, between the

international transaction and the comparable uncontrolled transactions, or between the

enterprises entering into such transactions, which could materially affect the amount of

gross profit margin in the open market.v$. The adusted price arrived at under sub-clause 4iv$ is taken to be an arm6s length price in

respect of the purchase of the property or obtaining of the services by the enterprise from

the associated enterprise.>$ Cost 4l!s 'ethod:0ost plus method is a method by which"

i$. The direct and indirect costs of production incurred by the enterprise in respect of

property transferred or services provided to an associated enterprise, are determined.ii$. The amount of a normal gross profit mark-up to such costs 4computed according to the

same accounting norms$ arising from the transfer or provision of the same or similar

property or services by the enterprise, or by an unrelated enterprise, in a comparable

uncontrolled transaction, or a number of such transactions, is determined.iii$. The normal gross profit mark-up referred to in sub-clause 4ii$ is adusted to take into

account the functional and other differences, if any, between the international transaction

and the comparable uncontrolled transactions, or between the enterprises entering into

such transactions, which could materially affect such profit mark-up in the open market.iv$. The costs referred to in sub-clause 4i$ are increased by the adusted profit mark-up arrived

at under sub clause 4iii$.

v$. The sum so arrived at is taken to be an arm6s length price in relation to the supply of the

property or provision of services by the enterprise.?$ 4rofit Split 'ethod: 2rofit split method is a method which may be applicable mainly in

international transactions involving transfer of uni'ue intangibles or in multiple international

transactions which are so interrelated that they cannot be evaluated separately for the purpose of

determining the arm6s length price of any one transaction, by which"

3"

7/24/2019 5th unit

39/47

i$. The combined net profit of the associated enterprises arising from the international

transaction, in which they are engaged, is determined.ii$. The relative contribution made by each of the associated enterprises to the earning of

such combined net profit, is then evaluated on the basis of the functions performed, assets

employed or to be employed and risks assumed by each enterprise and on the basis ofreliable external market data which indicates how such contribution would be evaluated

by unrelated enterprises performing comparable functions in similar circumstances.iii$. The combined net profit is then split amongst the enterprises in proportion to their

relative contributions, as evaluated under sub-clause 4ii$.iv$. The profit thus apportioned to the assessee is taken into account to arrive at an arm6s

length price in relation to the international transaction.E$ Transactional Net 'argin 'ethod:Transactional net margin method is a method by which"

i$. The net profit margin realized by the enterprise from an international transaction entered

into with an associated enterprise is computed in relation to costs incurred or sales

affected or assets employed or to be employed by the enterprise or having regard to any

other relevant base.ii$. The net profit margin realized by the enterprise or by an unrelated enterprise from a

comparable uncontrolled transaction or a number of such transactions is computed having

regard to the same base.iii$. The net profit margin referred to in sub-clause 4ii$ arising in comparable uncontrolled

transactions is adusted to take into account the differences, if any, between the

international transaction and the comparable uncontrolled transactions, or between the

enterprises entering into such transactions, which could materially affect the amount of

net profit margin in the open market.iv$. The net profit margin realized by the enterprise and referred to in sub-clause 4i$ is

established to be the same as the net profit margin referred to in sub-clause 4iii$.

The net profit margin thus established is then taken into account to arrive at an arm6s length price in

relation to the international transaction.

5.2.5. TRANSFER PRICING RULE IN INDIATill recently, the important sections relating to transfer pricing in the Income Tax Act #7F# were section

?CA 4+$, section 9C #A 47$ and section 9C IA 4#C$. The first enables tax authorities to disallow any

expenditure made to a related party, which they feel is excessive. Tax benefits are available under section

9C IA in the form of tax holiday for certain number of years. If misuse of transfer pricing is suspected

then the tax authorities can reduce or deny such benefits.

3%

7/24/2019 5th unit

40/47

The !inance Act, +CC#, made amendments of far reaching nature in respect of transfer pricing by

inserting ections 7+ A to 7+ ! in the Income Tax Act, #7F#. This is applicable from the financial year

+CC#.

&2 Comp!tation of Income from International Transaction haing Regard to #rm>s Length

4rice.Section /53

i$. Any Income Arising from an International Transaction shall be 0omputed having 5egard

to the Arm6s @ength 2rice Lection 7+4#$K" !or the removal of doubts, it is hereby

clarified that the allowance for any expense or interest arising from an international

transaction shall also be determined having regard to the arms length price.ii$. haring=0ontribution of 0ost or *xpenses of Any /enefit, etc., shall also be Arm6s

@ength 2rice Lection 7+4+$K" Ghere in an international transaction, two or more

associated enterprises enter into a mutual agreement or arrangement for the allocation or

apportionment of, or any contribution to, any cost or expense incurred or to be incurred inconnection with a benefit, service or facility provided or to be provided to any one or

more of such enterprises, the cost or expense allocated or apportioned to, or, as the case

may be, contributed by, any such enterprise shall be determined having regard to the

arm6s length price of such benefit, service or facility, as the case may be.iii$. 2rovisions of Arm6s @ength 2rice not to Apply if these 5esult into 5eduction of Income

Increase of @oss Lection 7+4>$K" The provisions of this section shall not apply in a case

where the c