TAX LIABILITY OF A FOREIGN COMPANY

The tax liability of a foreign company is dependant on its tax liability under the Income Tax Act and The Double Taxation Avoidance Agreement (DTAA) between India and its home country. Taxation of Foreign Companies under the Income Tax Act

Domestic companies in India are taxed on their world income arising from all sources in India as well as outside India in accordance with the provisions of the Income Tax Act. Foreign companies on the other hand, are essentially taxed on the income earned through a business connection in India or from other Indian sources. Therefore if a foreign company does not have any business connection in India, then the income of such company cannot be taxed. Taxability of income through business connection is provided in section 9(1)(i) of the IT Act which includes a person acting on behalf of the non-resident and who: (a) Habitually exercises in India, an authority to conclude contracts on behalf of the non-resident, unless his activities are limited to the purchase of goods or merchandise for the non-resident; or (b) Has no such authority, but habitually maintains in India a stock of goods or merchandise from which he regularly delivers goods or merchandise on behalf of the non-resident; or (c) Habitually secures orders in India, mainly or wholly for the non-resident or for that nonresident and other non-residents controlling, controlled by, or subject to the same common control, as that non-resident. A relation is treated as a business connection if the relation is real and intimate, and through or from which income must accrue or arise whether directly or indirectly to the foreign company. In order for a business to come within the ambit of Section 9(1)(i), it is necessary that the business relationship between the resident and the foreign company, should be a continuous one and not an isolated transaction.

Double Taxation Avoidance Agreements(DTAA) and Tax Liability of Foreign Companies

Double taxation is a situation in which two or more taxes may need to be paid for the same financial transaction due to overlap between different countries tax laws and jurisdictions. The tax payer may find that he is obliged by domestic laws to pay tax on income locally and pay again in the country in which the income was earned. Since this is inequitable, many countries make bilateral DTAAs with each other. In some cases, this requires that tax be paid in the country of residence and be exempt in the country in which it arises. In the remaining cases, the country where the gain arises deducts taxation at source and the taxpayer receives a compensating tax credit in the country of residence to reflect the fact that tax has already been paid. Section 90 of Income Tax Act empowers the Central Government to enter into agreements with foreign countries which are normally termed as Double Taxation Avoidance Agreement (DTAA). Thus a foreign companys tax liability will be determined by the IT Act, and the DTAA between India and its home country, with the provisions of the DTAA taking precedence over those of the IT Act, in all cases except where the later are more beneficial to the foreign companies. The agreements also provide for concessional rate of tax in respect of royalties, dividend, fees for technical services and interest.

DTAAs require a somewhat permanent nature of presence of the non-resident in India to be able to exercise the jurisdiction of taxing the business income. Such presence is established through the existence of a permanent establishment. Generally a foreign company is treated as having a Permanent Establishment in India if the said foreign company carries on business in India through a branch, sales office, etc., or through an agent (other than an independent agent) who habitually exercises an authority to conclude contracts or regularly delivers goods or merchandise or habitually secures orders on behalf of the non-resident principal. Thus, in short a PE exists when a company has a fixed place of business located in a foreign jurisdiction through which activities of a company are wholly or partially carried on. The term permanent establishment includes a place of management, a branch, an office, a factory, a workshop, a mine, oil well or other place of extraction of natural resources, a building site or construction or assembly project which exist for an agreed period. However the term PE does not include certain activities such as a sales office in which individuals do not have the capacity to contract and whose primary functions are simply advertising the products. Companies that are setting up permanent establishments in India without giving due attention to the tax issues associated with may land up in serious tax problems as double taxation can then take place. In order to avoid the same, the foreign companies should ensure that there exists a relationship of independent agency between the Indian subsidiary and the foreign company. In determining whether there is actually an independent relationship existing, the Indian Courts have derived 6 tests: Were the profits treated as those of the parent company? Were the persons conducting the business appointed by the parent company? Was the parent company responsible for all ideas implemented by the trading venture?

Did the parent company govern the venture and did it decide how much capital should be invested in it? Were the profits made by the parents companys skill and direction? Was the parent company in effectual and constant control?

If the answer to all these questions is in the negative, and there is an absence of common directors, then an independent relationship is established between the Indian subsidiary and the foreign company. While determining the income of PE on which tax is to be levied certain guidelines are to be followed. Therefore while calculating the Profit of the PE, the PE will be treated as if it were a separate and wholly independent enterprise. Thus the profits which are to be attributed to a PE are those, which that PE would have made if, instead of dealing with its Head Office, it had been dealing with as an entirely separate enterprise and tax will be levied on such profits. However deductions with regard to expenses incurred for the purposes of the PE including executive and general administrative expenses so incurred, whether in India or elsewhere would be deductible in accordance with the accepted principles of accountancy and the provisions of the Income-tax Act. The relevant provisions of the DTAA between India and the USA are as follows: Article 7| Business Profits: The profits of an enterprise of a contracting state shall be taxable only in that state unless the enterprise carries on business in other contracting state through a PE situated therein. If the enterprise carries on business as aforesaid, the profits of the enterprise may

be taxed in the other state but only so much of them as is attributable to (a) that PE; (b) sales in the other state of goods or merchandise of the same or similar kind as sold through that PE; (c) other business activities carried on in the other state of the same of similar kind as those effected through that PE. Article 10 | Dividends: Dividends paid by a company which is a resident of a contracting state to a resident of the other contracting state may be taxed in that other state. However, such dividends may also be taxed in the contracting state of which the company paying the dividends is a resident, and acc. to the laws of the state, but if the beneficial owner of the dividends is a resident of the other contracting state, the tax so charged shall not exceed 15% of the gross amount of the dividends, if the beneficial owner is a company which owns at least 10% of the voting stock of the company paying the dividends and 25% of the gross amount of dividends in all other cases. Article 11 | Interest: Interest arising in a contracting state and paid to the resident of the other contracting state may be taxed in that other state. However, such interest may also taxed in the contracting state in which it arises, and acc. to the laws of that state, but if the beneficial owner of the interest is a resident of the other Contracting State, the tax so charged shall not exceed 10 % of the gross amount of the interest if such interest is paid on a loan granted by a bank carrying on a bona fide banking business or by a similar financial institution (including an insurance company); and 15 % of the gross amount of the interest in all other cases. Notwithstanding the above, if the interest arising in a contracting state is derived and beneficially owned by the govt. of the other contracting state; or with respect to loans or credits extended or endorsed by the Export Import Bank of US (when India is the first-mentioned contracting state) or by the EXIM Bank of India (when US is the first-metioned contracting state); and to the extent approved by the govt. of that state, shall be exempt from tax in the first-mentioned contracting state. Article 14 | Permanent Establishment Tax: A company which is a resident of India may be subject in the US to a tax in addition to the tax allowable under the other provisions of this convention. Such tax may be imposed only on the portion of business profits of the company subject to tax in the US which represents the dividend equivalent amount. A company which is a resident of the US may be subject to tax in India at a rate higher than that applicable to the domestic companies. The difference in the tax rate shall not exceed the existing difference of 15 percentage points. Article 25 | Relief from Double Taxation: In accordance with the provisions and subject to the limitations of the law of the US, the US shall allow to a resident or citizen of the US as a credit against the US tax on income the income-tax paid to India by or on behalf of such citizen or resident ; and the income-tax paid to India by or on behalf of the distributing company with respect to the profits out of which the dividends are paid (in the case of a US company owning at least 10% of the voting stock of a company which is a resident of India and from which the US company receives dividends)

Further, where such resident is a company by which a surtax is payable in India, the deduction in respect of income-tax paid in the United States shall be allowed in the first instance from income-

tax payable by the company in India and as to the balance, if any, from surtax payable by it in India. Where a resident of India derives income which, in accordance with the provisions of this Convention, may be taxed in the US, India shall allow as a deduction from the tax on the income of that resident, an amount equal to the income-tax paid in the US, whether directly or by deduction. Such deduction shall not, however, exceed that part of the income-tax (as computed before the deduction is given) which is attributable to the income which may be taxed in the US. Article 26 | Non-discrimination: Nationals of a Contracting State shall not be subjected in the other Contracting State to any taxation requirements connected therewith which is more burdensome than the taxation requirements to which nationals of that other State in the same circumstances are or may be subjected.