“Arise, awake, and stop not till the goal is reached” said by Swami Vivekanada seems to be the motto of the Indian government which is relentlessly working on bringing India at Global footing as far as the taxation laws are concerned. Year by year India is adopting the international best practices for all the reasons it may have, be it for preventing the abuse of treaty, abuse of income tax regulations or to enhance and accelerate the level of compliance. Adopting, adjusting, readjusting, learning and relearning from the countries with better systems and administration in place.

The budget 2017-18 saw the bringing of more international best practices in force.

In Budget 2016-17 also government made progressive steps towards bringing India as one of evolved jurisdiction with regard to its taxation policies by introduction of equalisation levy on specified digital transactions, country-by-country reporting requirements for multinational companies and Patent box regime providing for reduced tax rates for royalty relating to patents based on nexus approach etc. Infact, India became the first country to introduce equalization levy on digital transactions, at the rate of 6% on the gross consideration for specified services I,e. online advertisement and related services provided by foreign companies which do not have a permanent establishment in India.

Keeping the trend going, in Budget 2017-18 introduced more provisions.

Below we have discussed the relevant new concepts brought in by Budget 2017-18

Thin capitalisation Rules in case of thinly funded entities

A company is typically financed or capitalized through a mixture of debt and equity. The way a company is capitalized often has a significant impact on the amount of profit it reports for tax purposes as the tax legislations of countries typically allow a deduction for interest paid or payable in arriving at the profit for tax purposes while the dividend paid on equity contribution is not deductible. Therefore, the higher the level of debt in a company, and thus the amount of interest it pays, the lower will be its taxable profit. For this reason, debt is often a more tax efficient method of finance than equity. Multinational groups are often able to structure their financing arrangements to maximize these benefits. For this reason, country’s tax administrations often introduce rules that place a limit on the amount of interest that can be deducted in computing a company’s profit for tax purposes. Such rules are designed to counter cross-border shifting of profit through excessive interest payments, and thus aim to protect a country’s tax base.

Under the initiative of the G-20 countries, the Organization for Economic Co-operation and Development (OECD) in its Base Erosion and Profit Shifting (BEPS) project had taken up the issue of base erosion and profit shifting by way of excess interest deductions by the MNEs in Action plan 4. The OECD has recommended several measures in its final report to address this issue.

In view of the above, in Budget 2017 it is proposed to insert a new section 94B, in line with the recommendations of OECD BEPS Action Plan 4, to provide that interest expenses claimed by an entity to its associated enterprises shall be restricted to 30% of its earnings before interest, taxes, depreciation and amortization (EBITDA) or interest paid or payable to associated enterprise, whichever is less.

The provision shall be applicable to an Indian company, or a permanent establishment of a foreign company being the borrower who pays interest in respect of any form of debt issued to a non-resident or to a permanent establishment of a non-resident and who is an ‘associated enterprise’ of the borrower. Further, the debt shall be deemed to be treated as issued by an associated enterprise where it provides an implicit or explicit guarantee to the lender or deposits a corresponding and matching amount of funds with the lender.

The provisions shall allow for carry forward of disallowed interest expense to eight assessment years immediately succeeding the assessment year for which the disallowance was first made and deduction against the income computed under the head “Profits and gains of business or profession to the extent of maximum allowable interest expenditure.

In order to target only large interest payments, it is proposed to provide for a threshold of interest expenditure of one crore rupees exceeding which the provision would be applicable.

Banks and Insurance business are excluded from the ambit of the said provisions keeping in view of special nature of these businesses. This amendment will take effect from 1st April, 2018 and will, accordingly, apply in relation to the assessment year 2018-19 and subsequent years.

Secondary Adjustment in case of Transfer Pricing

“Secondary adjustment” means an adjustment in the books of accounts of the assessee and its associated enterprise to reflect that the actual allocation of profits between the assessee and its associated enterprise are consistent with the transfer price determined as a result of primary adjustment, thereby removing the imbalance between cash account and actual profit of the assessee.

The OECD Transfer Pricing Guidelines for Multinational Corporations and Tax Administrations (“OECD transfer pricing guidelines”) define the term secondary adjustments as “an adjustment that arises from imposing tax on a secondary transaction”. A secondary transaction is further defined as “a constructive transaction that some countries will assert under their domestic legislation after having proposed a primary adjustment in order to make the actual allocation of profits consistent with the primary adjustment.”

As per the OECD’s Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (OECD transfer pricing guidelines), secondary adjustment may take the form of constructive dividends, constructive equity contributions, or constructive loans.

The provisions of secondary adjustment are internationally recognised and are already part of the transfer pricing rules of many leading economies in the world. Whilst the approaches to secondary adjustments by individual countries vary, they represent an internationally recognised method to align the economic benefit of the transaction with the arm’s length position.

In order to align the transfer pricing provisions in line with OECD transfer pricing guidelines and international best practices , a new section 92CE is inserted which provides that the assessee shall be required to carry out secondary adjustment where the primary adjustment to transfer price, has been made suo motu by the assessee in his return of income; or made by the Assessing Officer has been accepted by the assessee; or is determined by an advance pricing agreement entered into by the assessee under section 92CC; or is made as per the safe harbour rules framed under section 92CB; or is arising as a result of resolution of an assessment by way of the mutual agreement procedure under an agreement entered into under section 90 or 90A.

As in the Finance Bill 2017 lists the following instances of Primary Adjustment:

• made suo moto by the taxpayer on its tax return
• made by the Assessing Officer, accepted by the taxpayer
• determined under an Advance Pricing Agreement (APA)
• made as per Safe Harbour Rules
• arising from a resolution under Mutual Agreement Procedure (MAP)

Kindly have a look at this example to understand the meaning of primary adjustment and secondary adjustment

A Company ABC, is a captive service provider providing services to its holding company, Company PQR. The services are provided on a cost plus basis at the actual transaction price of cost of $1000 + 10% markup = $1100. However computed arm’s length price comes out to be Cost of 1000 + 15% markup = $1150.

In this case

(a) Primary adjustment

Primary adjustment in the hands of Company ABC: $1150 – $1100 = $50 ( arms length price – actual price) on which tax will be paid. But it may be seen that the excess cash in the hands of Company PQR is $50. However, there is no adjustment in the hands of PQR or ABC for the excess cash in hands of PQR and cash deficit in the hands of ABC to the extent of $50.

(b) Secondary Adjustment

Secondary Adjustment seeks to address the following

• the impact of the excess cash of $50 in the hands of Company PQR
• the impact of cash deficit of $50 in the hands of Company ABC.

Had the transaction been conducted at arm’s length originally, the amount of $50 would have been reported in the books of accounts of Company ABC, and collected in the ordinary course of business. Eventually, Company ABC would incur cost related to repatriation of the amount of 50.

Therefore, to address the above issue it is proposed to provide that where as a result of primary adjustment to the transfer price, there is an increase in the total income or reduction in the loss, as the case may be, of the assessee, the excess money which is available with its associated enterprise, if not repatriated to India within the time as may be prescribed, shall be deemed to be an advance made by the assesse to such associated enterprise and the interest on such advance, shall be computed as the income of the assessee , in the manner as may be prescribed.

In the above example, Per Finance Bill 2017, Secondary Adjustment is proposed to operate in the following manner:

– Every company with a Primary Adjustment must capture such amount ($50) in its books of accounts, and also the books of accounts of the related party

– The amount so booked ($50) must be received within a stipulated period, else interest would be applied at a specified rate (to be prescribed)

In other words, if the amount of primary adjustment is not received into the country, such balance would be treated as an advance on which interest would be applied in a manner, yet to be prescribed.

It is also proposed to provide that such secondary adjustment shall not be carried out if, the amount of primary adjustment made in the case of an assessee in any previous year does not exceed one crore rupees and the primary adjustment is made in respect of an assessment year commencing on or before 1st April,2016.

This amendment will take effect from 1st April, 2018 and will, accordingly, apply in relation to the assessment year 2018-19 and subsequent years.

Place of effective Management

Manner of determination of residential status of companies

The provisions of section 6(3) of the Act were amended vide Finance Act, 2015, with effect from 1st April, 2016 to provide that a company is said to be resident in India in any previous year, if-

(i) it is an Indian company; or

(ii) its place of effective management in that year is in India.

Explanation — For the purposes of this clause “place of effective management” means a place where key management and commercial decisions that are necessary for the conduct of business of an entity as a whole are, in substance made.

Although POEM was brought in the Finance Act, 2016 however, it is made effective from 1st April 2017 vide Circular No. 06 of 2017, F. No. 142/11/2015-TPL dated 24^th Jan 2017.

The change was brought in because the extant provisions related to determination of residential status of company allowed tax avoidance opportunities for companies to artificially escape the residential status by shifting insignificant or isolated events related with control and management outside India.

“Place of effective management” is defined in the Act to mean a place where key management and commercial decisions that are necessary for the conduct of the business of an entity as a whole are, in substance, made.

POEM shall impact

It’s a game changer. It has changed the way the residential status of companies is determined. POEM is an internationally well accepted concept, there are well recognised guiding principles for determination of POEM although it is a fact dependent exercise. The set of guiding principles to be followed in determination of POEM was issued vide Circular No. 06 of 2017, F. No. 142/11/2015-TPL, Government of India , Ministry of Finance, Department of Revenue ,Central Board of Direct Taxes , Dated: 24th January, 2017.

The guidelines recognises the concept of Active business outside India for establishment of POEM in India. It lays down the detailed criteria when on when a company shall be construed to have active business outside India and on that basis specifies the establishment of POEM.

Determination of residential status is the key factor in determination of taxability of Income. With the change in section 6(3) given the new definition of corporate tax residence in India, it has become very important for foreign companies, for overseas joint ventures, or subsidiaries of Indian entities to review, analyse and change if required the corporate decision making process presently followed.

Documentation is the key to showcase of substance. It is compulsory to properly document the process and demonstrate adherence thereto in substance at the ground level to mitigate any potential tax risks arising from the change in the definition.

General Anti Avoidance Rule (GAAR):

Declaration of impermissible avoidance arrangement

CBDT on 27th Jan 2017 has issued clarification via Circular No 7 of 2017 that the provisions of Chapter X-A of the Income Tax Act, 1961 relating to General Anti-Avoidance Rule will come into force from 1st April, 2017.

GAAR stands for General Anti Avoidance Rules. It was first introduced by Pranab Mukherjee as finance minister in the budget of 2012. General Anti Avoidance Rules (GAAR) caused immense insecurity among foreign investors in India, leading the government to defer its implementation till April 2015. When it was finance minister Arun Jaitley’s turn to decide on the fate of GAAR in 2015, he further deferred it to April 2017 to give industry as well as the tax department more time to adjust to this sophisticated tax regime.

GAAR provisions are contained in chapter XA of the Income Tax Act, 1961 section 95 to Section 102. It empowers officials to deny the tax benefits on transactions or arrangements which do not have any commercial substance or consideration other than achieving tax benefit. It contains a provision allowing the government to retroactively tax overseas deals involving local assets.

GAAR contains provisions to stop misuse of treaties that India has with other countries for tax avoidance. These are rules targeted at businesses that are structured solely for avoiding tax in India, such as routing investment into the country through tax havens. Transactions that fail the GAAR test will be subject to tax. Although effective from May 2016 as a step towards avoidance of treaty abuse the treaty between India and Mauritius (being considered as most abused) had been amended.[1]

As per GAAR provisions an arrangement entered into by an assessee may be declared to be an impermissible avoidance arrangement and the consequence in relation to tax arising therefrom may be determined. An impermissible avoidance arrangement means an arrangement, the main purpose of which is to obtain a tax benefit, and it creates rights, or obligations, which are not ordinarily created between persons dealing at arm’s length or results, directly or indirectly, in the misuse, or abuse, of the provisions of this Act or  lacks commercial substance or is deemed to lack commercial substance under section 97 of the Income Tax Act, 1961, in whole or in part; or is entered into, or carried out, by means, or in a manner, which are not ordinarily employed for bona fide purposes.

If an arrangement is declared to be an impermissible avoidance arrangement, then, the consequences, in relation to tax, of the arrangement, including denial of tax benefit or a benefit under a tax treaty, shall be determined, in such manner as is deemed appropriate, in the circumstances of the case, including by way of but not limited to the following, namely: —

(a)  disregarding, combining or recharacterizing any step in, or a part or whole of, the impermissible avoidance arrangement;

(b)  treating the impermissible avoidance arrangement as if it had not been entered into or carried out;

(c)  disregarding any accommodating party or treating any accommodating party and any other party as one and the same person;

(d)  deeming persons who are connected persons in relation to each other to be one and the same person for the purposes of determining tax treatment of any amount;

(e)  reallocating amongst the parties to the arrangement—

 (i)  any accrual, or receipt, of a capital nature or revenue nature; or

 (ii)  any expenditure, deduction, relief or rebate;

 (f)  treating—

 (i)  the place of residence of any party to the arrangement; or

 (ii)  the situs of an asset or of a transaction,

at a place other than the place of residence, location of the asset or location of the transaction as provided under the arrangement; or

(g)  considering or looking through any arrangement by disregarding any corporate structure.

Conclusion

It may be noted that the introduction above anti abuse provisions does not does not bring halt to the tax planning or any thinking on bringing about savings in taxes.  However, it certainly calls for a paradigm shift in thinking and in mindset, about what would now be acceptable as tax planning and more importantly as to how that would be demonstrated. Documentation should come as life saver –  meticulous maintenance of clear and consistent documentation demonstrating the business purpose and intent will acquire critical significance as never before. All these amendments will lead to real substance-based planning, closely aligned with the businesses and operating model.

The present business decisions are largely based on Tax consideration. Infact it can be put that the whole of the business structuring is based on the Tax benefits. With the provisions like GAAR, POEM, thin capitalisation being introduced tax will not be seen to be driving businesses any more and it shall be the commercial consideration of business which shall become important. So, it is not the tax driving business it should be business driving the taxes. Business reasons and commercial rationale will be central to any planning in a new ecosystem created by this system.

In the above background it has become imperative for business houses to review, analyse and change, if required their business strategies, decision making process and rationale behind it.

[1] The Erstwhile double tax agreement between India and Mauritius (the “India-Mauritius treaty”) provided, inter alia, an exemption from tax in India on capital gains earned by a tax resident of Mauritius. Such capital gains are subject to tax based on residency rules, thereby giving taxation right to Mauritius. Tax on capital gains was nearly zero in Mauritius, making it an attractive destination for investors looking to invest in India. Government of India on 10^th May 2016, India and Mauritius have signed a protocol amending the India-Mauritius treaty, giving India the right to tax capital gain on the alienation of shares in an Indian company.