CONSIDERING the ever-increasing globalization of the Indian economy, the Direct Taxes (DTC) contained quite a few welcome proposals in the area of international taxation. Some of such proposals have been watered down in the revised draft (RDTC) which was put in public domain on 15 th June, 2010. In the face of sustained lobbying, the Government has already capitulated and withdrawn the proposal relating to the so-called treaty override. Although not very explicit, the original DTC also contained a proposal relating to thin capitalization. However, except for the proposed General Anti Avoidance Rule (GAAR), the exact contours of which are still not very well known, the proposed new code did not contain any specific measures to fight the menace of tax havens. The revised DTC in chapter IX, dealing with DTAA vis-a –vis domestic law, mentions that DTAA will not have preferential status in the following circumstances - when GAAR is invoked, when Controlled Foreign Corporation provisions are invoked or when Branch Profit Tax is levied. Therefore, by implication, it has to be divined that there will be Controlled Foreign Corporation (CFC) provisions in the new code. CFC is essentially anti-tax haven legislation. Unfortunately however there is no discussion about its merits and demerits. DTC is supposed to be a futuristic legislation. Therefore, there should be proper debate and discussion before any proposal is implemented.

CFC or controlled Finance Corporation is a legislation, which, as the name suggests, is aimed at companies formed outside the territorial jurisdiction of the country but which are controlled by domestic shareholders. These companies, which are controlled from within the country, are normally formed in tax havens or quasi havens, particularly those with strong secrecy laws although it is possible to have them even in high tax jurisdictions using stepping stone techniques. CFCs are formed taking advantage of the myth of separate corporate identity. A company is different from its shareholders and a subsidiary company formed in a different jurisdiction is a different entity, entitled to have different tax treatment of its income. This simple concept is often exploited by people to take advantage of the differing tax rates in various counties around the world.  By way of an example, if royalty income from exploiting patent in the home country is taxed at 30%, it makes sense to from a subsidiary in a tax haven and then transfer the patents to the subsidiary so that income form its exploitation is accumulated in the tax haven without paying any tax. If and when the subsidiary declares dividends, only then the income will be taxed by the home country. CFCs therefore offer prospects of deferral of income, at times indefinitely. To counter this practice, countries, particularly the capital exporting ones, have put in place CFC legislations that will deem a distribution of dividend by the CFC even when there is no actual distribution if the conditions as specified in the respective legislations are satisfied.

The United States under the Kennedy administration was the first country to introduce CFC legislation – the sub-part F in 1962. There was intense debate at the time of its introduction and the final version that was adopted differed substantially from the one proposed by the administration. Currently, almost all OECD countries and China and Brazil have CFC legislation in place.  Although such legislations are inherently complex and the provisions differ in their scope and design, very broadly speaking, their aim is to tax the undistributed income of the foreign corporation on an accrual basis in the hands of the domestic shareholders who have controlling interest in the said foreign corporation. What will be the extent of control to trigger the application of the CFC rule again vary considerably.  Most countries also follow the jurisdictional approach where CFCs located in specific jurisdictions as per a list prepared are targeted even though United States follow a global approach in this regard.

Some common features of CFCs need to be noted to understand if it is the priority legislation required by India in the fight against abuse of tax havens:

• CFC legislations are aimed at domestic investors. These have nothing to do with preventing other abuses of tax treaties like treaty shopping resorted to by MNCs operating in India.
  

• CFC legislations are aimed to prevent deferral of income and not outright evasion of income.
  

• Any CFC legislation is unlikely to tackle the problem of Indians parking money outside India through hawala and such other routes.

It is in this background that we need to examine as to whether CFC legislation is the most appropriate anti tax haven legislation that we need at this juncture. Two recent controversies surrounding the sporting world provide the perfect setting for such an analysis. Let us take the Commonwealth Games first. The sum and substance of the allegations that are flying thick and fast these days is that expenses on various projects have been inflated. For example, it has been widely reported that air conditioners, which normally cost Rs 20,000, have been procured for Rs 4,00,000 apiece. There are similar other examples. Those who are in charge of awarding the contracts are most likely to have got their cut form such inflated expenditure. And if the recipient is a foreign entity, it is well nigh impossible for anyone to get to the truth should any enquiry be ordered at any point of time. Mr. Rajiv Gandhi thought that only 20% of India’s development expenditure reached the people for whom it was intended. Over the years, there might have been some improvement because of lesser Government and transparency legislations but the fact remains that expenditure is often inflated both in the Government as also in the private sector. Money can then be taken out through hawala. Money can also be taken out in the form of inflated business expenditures and kept preferably in countries with strong secrecy laws like Switzerland.

Let us now turn our attention to another scandal, which created such headlines on our TV screens not too long ago and seems to have already faded from public memory- the IPL tamasha. Shorn of all the masalas, it all boiled down to investment of money in India to bid for highly lucrative TV rights involving certain cricket teams. The auction of the teams and the players went for humongous amounts. Most of the money reportedly came from abroad and the two countries that are generally mentioned are of course Mauritius and Singapore. Mauritius is the obvious choice because of the ease of forming companies there as also the fact that residency certificates for tax purposes are also granted for the asking and unquestionably accepted by the tax authorities in India because of the now famous CBDT circular no789. Officially, Mauritius is not even a tax haven even though getting any meaningful information from such a jurisdiction is very difficult partly because of the fact that none is asked for in the first place.

India’s problems in dealing with tax havens thus seem to be different. In the situations described above, it is unlikely that CFC legislation will have any effect because no one will willingly put his head on the chopping block by declaring that he has salted money away and kept in a company outside but controlled from India for the purpose of deferral of income. Money begets money and when such money shows up in the form of investments in the guise of foreign investment, nothing can be done unless there is robust information exchange with the suspect jurisdictions.

What we need to fight in the war against tax havens from the point of view of   round tripping and tax evasion by resident Indians is immediate scrapping of the CBDT circular which forces tax officials to unquestionably accept tax residency certificate granted by Mauritius. The database of case laws that we carry in taxindiainternational is replete with cases where courts/Tribunals have given relief merely by relying on this circular. Secondly, we need to have a relook at our treaties with some low or nil tax jurisdictions and review in how many cases useful information could be obtained form them. The state of affairs in this regard seems to be highly unsatisfactory. Thirdly, we can have a very simple legislation in putting the entire burden of proof on the taxpayer whenever a transaction is routed through such non- cooperative jurisdictions. Any expenditure paid to any entity in such jurisdictions can be disallowed unless the bonafide of the transaction is proved. Similar provision can be made for inward remittance as well.

It is only thereafter that we should concentrate on CFCs. India has only just begun to export capital. We still have exchange control regulations in place. Generally speaking, countries are not much bothered about outward investment and are loath to take measures that reduce the competitiveness of domestic companies. We do not have well defined tax credit mechanism and none has been proposed either in the DTC or in the RDTC. A properly defined test of corporate residency can also be used to rope in controlled companies. The extant law under the ITA is wholly inadequate since it requires control and management of a foreign company to be wholly in India to satisfy the test of residency. The DTC had originally proposed a tougher test, which has slightly been diluted by the RDTC. Nevertheless, even if the place of effective management test as suggested by the RDTC is actually implemented, foreign companies, if they are really controlled from India can be caught in the net. It is also to be remembered that CFC legislations are generally meant to catch only passive income and not income from industrial and commercial activities, and most of the genuine Indian investments will not be covered by such legislation anyway. Under the Companies Act, Indian companies are required to incorporate the accounts of all subsidiaries including foreign subsidiaries. A study can be made from the accounts as to the quantum of profit left in such subsidiaries outside to find out the scale of the problem of deferral, if any. Ideally, only thereafter, appropriate legislation should be introduced.