CFC rules under direct taxes code need relook

The Income-tax Act is proposed to be substi-tuted by the New Direct Taxes Code (DTC). The new DTC contains provision rel-ating to Controlled Foreign Corporates (CFC).

The revised discussion paper on the DTC provides for the objective of the introduction of the CFC provisions as under:

As an anti-avoidance mea-sure, in line with internati-onally accepted practices, it is also proposed to introd-uce Controlled Foreign Cor-poration provisions so as to provide that passive income earned by a foreign company which is controlled directly or indirectly by a resident in India, and where such income is not distributed to sharehol-ders resulting in deferral of taxes, shall be deemed to have been distributed. Consequently, it would be taxable in India in the hands of resident shareholders as dividend received from the foreign company “Controlled Foreign Company” has been defined in clause 5 of the Twentieth schedule to mean a company which satisfies all the following conditions:

 

 

The company is registered in lower tax jurisdiction outside India, and 
 

The shares of the company are not listed in that country, and 
 

Indian resident exercises control over the company, and

The company is not enga-ged in any active trade or business, and The specified income of the company is more than Rs 25 lakh.

It is clear from the aforesaid provisions that the companies which are engaged in active trade or business shall remain outside the purview of CFC Rules. The CFC rules provide that a company shall be deemed to be engaged in active trade or business if and only if the following conditions are satisfied:

The company actively participates in industrial, commercial or financial undertakings through employees in the territory of which it is a tax resident; and

The company’s income from dividend, interest, income from house property, capital gains, annuity payment, royalty etc. etc. is less than 50 per cent of its total income.

A close analysis of the above rule will indicate that if the foreign company recei-ves 50 per cent or more than 50 per cent of income from certain specified sources like dividend, interest, capital gain, etc. etc., then the said company shall not be deemed to be engaged in active trade or business, and therefore would be covered in CFC regime.

The rule for determining the active trade or business is not only harsh and impractical but the same is likely to severely hit outbound investment by Indian companies. Some of the reasons are as under:

Income criteria has been used in the rules for the purpose of determining whet-her the company is actively engaged in the trade or busi-ness or not. It is quite possible that a company, which has been newly established, may not generate sufficient income from its normal business activities despite being actively involved in the trade or business operations. Under the circumstances, despite being actively engaged in trade or business, it will be deemed that the foreign company is not engaged in active trade or business and accordingly, will fall within the purview of CFC regime.

The aforesaid provision may adversely affect investment by Indian companies in investment or banking activities outside India. This is because the major income of such companies will be from interest, dividend, and capital gain etc. It has often remained disputed whether such income is ‘business income’ or ‘income from other sources’.

Therefore, the aforesaid provisions need a relook. It is strongly felt that the Government should not take any hasty step in this direction. It is to be kept in mind that outbound investment from India is very small compared to inbound investment. Infact CFC Rules have generally been adopted by developed countries whose outbound investments far exceed the capital inflows. There is no comparison between India and such other developed countries. It appears that while framing CFC rules the Government has been driven by tax considerations rather than by what is good for globalization of Indian economy.

The author is a Sr. Partner in S.S. Kothari Mehta & Co.

E-mail: hp.agrawal@sskmin.com