One side effect of the global downturn is that governments are increasing their efforts to capture perceived lost tax revenues. For example, tax authorities in both US and India have announced proposals to take action against certain offshore tax havens and alter the practice of establishing subsidiaries or holding companies in jurisdictions with low corporate and capital gains taxes. Many Indian and US companies may be impacted by the tax proposals, particularly those with cross border operations.
US Federal Tax Proposals:
The plan proposed by the Treasury Department would:
Both provisions may result in an increase in taxes of US companies operating globally. Although the US government is yet to announce specific details of proposals regarding the limitation of foreign tax withholding, more details have been announced regarding the limitation on tax deferrals.
Deferral:
Income earned by US companies from foreign operations is generally fully taxed in the jurisdiction where it is first earned. For example, income earned by the subsidiary of a US parent company in Germany is first taxed in Germany. US tax is then imposed in addition to the foreign tax. In order to reduce double taxation, the US allows a tax credit equal to the amount of foreign tax paid in these jurisdictions with which it has in place a double taxation avoidance treaty.
In most instances the US tax is not payable until the money is sent back to the US parent company. This process is called "deferral," as the tax payment is deferred until the income comes to the home jurisdiction, often in the form of a dividend repatriated to the parent company from the subsidiary.
The Treasury Department’s proposal amends the "deferral" rule, which allows US based multinationals to deduct expenses for overseas operations, but defer paying income tax on the profits from such operations until such time as the funds are repatriated to the US. According to reports, the Treasury Department estimates that the change would raise $60.1 billion in revenue over ten years.
A disregarded entity is the result of checking the box on IRS Form 8832 and subsequently electing to treat itself as a pass-through to enjoy tax benefits. A disregarded entity is a business entity that chooses to be “disregarded” as separate entity from the business owner for federal tax purposes. A "disregarded entity" chooses to be considered the same as the shareholders. This allows the entity to be taxed as a "pass-through" entity, on the shareholder’s personal income tax return.
Although it may not be illegal to have a financial or controlling interest in a foreign legal entity, many governments require taxpayers to declare their offshore interests and pay taxes on them although CFC laws (combined with a no-tax jurisdiction or a double taxation agreement) may mean that a company is only taxed in one jurisdiction.
A CFC by US standards is one in which US shareholders own more than 50 percent, by vote or value, of the foreign corporation. A US shareholder, for purposes of determining whether there is a controlled foreign corporation, is one who owns ten percent or more, by vote, of the foreign corporation.
A US person or entity who is a shareholder of a CFC is potentially liable for US tax. The argument made by the Treasury Department in favor of the proposed amendments is that the current “check the box” provisions make it possible to create a CFC but disregard the entity.
In 2002, Stanley Works, a company incorporated in Connecticut and listed on the New York Stock Exchange (“NYSE”) withdrew its plans of reincorporating itself in Bermuda due to a combination of adverse publicity and pressure from the US Congress. Although the plan to reincorporate in Bermuda had narrowly won the shareholders vote, the company had found itself the subject of a Securities and Exchange Commission (“SEC”) inquiry regarding the validity of the shareholders vote and under attack by local members of Congress, pressure by congressional leaders and protests by labor unions.
The Stanley Works example led to the implementation of the American Jobs Creation Act of 2004 which sought to penalize companies undergoing inversion transactions.
Earlier this year, the Supreme Court of Massachusetts affirmed a decision of the Massachusetts Appellate Tax Board that denied a request for abatement of the financial institution excise tax (FIET) from Capital One. The Court held that although Capital One had no physical presence in Massachusetts, FIET could be imposed as long as the company had established, through its activities, substantial nexus with the state.
The suit was dismissed by the New York Supreme Court which held that that the NY law was sufficiently consistent with existing laws requiring retailers to have nexus, or a significant relationship, in the state before imposing sales tax, in particular that advertising affiliates counted as a physical presence, ie. as long as at least one New York State resident generated revenues by placing Amazon ads on his website, New York could collect taxes.
Indian Tax Proposals:
An example is the recent decision of the Bombay High Court in E*Trade Mauritius Limited (“E*Trade Mauritius,”) v. ADIT & Ors where the Bombay High Court disposed the writ petition filed by E*Trade and held that the capital gains tax of INR 245 million deposited with it should be released to the Income Tax Department.
The High Court disposed the writ petition directing E*Trade to file a revision application before the Director of Income Tax (“DIT”) subsequent to the consent of both the parties. The High Court had directed the matter back to the Income Tax Department for revision proceedings. Pending the decision of the DIT, HSBC was directed to deposit a sum of INR 245 million which would be withheld from the consideration paid to E*Trade.
This decision of the Bombay High Court in favor of the Income Tax Department appears to be an attempt to distinguish the decision of the Supreme Court of India in Union of India v. Azadi Bachao Andolan ([2003] 263 ITR 706 (SC)) which held that any Mauritian company having tax residency certificate could benefit from the India-Mauritius tax treaty.
This continued aggressive stance taken by the tax authorities follows the line adopted in the Vodafone case of May 2007 discussed in detail in our earlier article. The Supreme Court of India in January 2009 ordered Vodafone to respond to the show cause notice issued to it by the Income Tax Department.
As the downturn deepens the need to raise taxes will continue both because of the stimulus packages in the US and India and because of deficit shortfalls. According to reports, the US is expected to run an estimated fiscal deficit of $485.2 billion amounting to 12.3% of GDP in 2009, whereas India’s fiscal deficit is projected at 6.4% of GDP in 2009.
(Shantanu Surpure is Managing Attorney at Sand Hill Counsel, a law firm with offices in Mumbai and Silicon Valley. He focuses on venture capital and private equity transactions. Shantanu holds a BA from Brown University/London School of Economics, an MA Juris from Oxford University and a Juris Doctor from Columbia Law School and is admitted to practice law in India, California, New York and England and Wales. He can be reached at ssurpure@sandhillcounsel.com)
Shantanu was assisted by Nisha Mallik and Asha Rajan of Sand Hill Counsel.
This column is meant for public discussion and informational purposes only and is not to be construed as legal advice.