IN this column, we have generally welcomed some of the changes suggested by the DTC in the matter of non-resident taxation. We have examined the proposals regarding corporate residence, treaty override and GAAR. The Direct Taxes Code (DTC) is supposed to be a spanking new legislation and there may be many more areas relating to non-resident taxation where there are gaps in the present Income Tax Act that need to be fixed in this supposedly futuristic legislation. For example, it may be necessary to examine as to whether the source rules that we have in the current Income Tax Act and which seem to be carried forward in the DTC are adequate or not. Since we have a treaty network with 78 countries and another dozen at least are in the offing, it is important that the domestic law is made strong. Benefits can thereafter be accorded to treaty partners based on negotiation. But, before one could finish analyzing at least some of the important areas relating to international taxation, the revised discussion draft is out in the public domain giving the Government's views on 11 areas of concern identified by the group that is going through the proposals in the light of the suggestions already received. Comments from the public have been invited and a deadline of June the 30 th has been given. The time given is not adequate enough to do any serious analysis and offer meaningful suggestions. Besides, there may be other areas not considered in the proposed Code which nonetheless should be considered and if found necessary, incorporated in the new Code. One understands the hurry of introducing the Bill in the Monsoon Session. But, we should not take decisions in a hurry to repent at leisure.

One of the vital areas relating to non-resident taxation that has not merited adequate attention is the proposal to have a ‘Branch Profit tax'. The discussions draft of the Original DTC is eloquently silent about it. What is the rationale behind the proposal; what is the vice that is supposed to be remedied by the new provision and how the proposal is going to be beneficial for the Revenue besides not leading to needless litigation, are some of the questions that remain completely unanswered. The revised discussion draft that has now been released is equally guilty of being completely silent in this regard.

Section 100 of the proposed code suddenly mentions that every foreign company shall be liable to branch profits tax at the rate specified. The rate has been proposed in the schedule at 15% but this may obviously vary. Branch profit has been defined as total income as reduced by the income tax thereon. The tax rate proposed for foreign companies is 25%, the same as proposed for domestic companies although, no one is sure what the tax rate ultimately is going to be. Under the current dispensation, domestic companies are taxed at 30% increased by a surcharge of 10% if the income of the company exceeds INR 10 million. The rate is 40% for a foreign company, although the surcharge is less at 2.5%. Effectively, the rate of tax is 33% for domestic companies and 42.5% for foreign companies. This is obviously discriminatory and therefore the move to have same 25% rate of tax for both domestic and foreign company is a move in the right direction. However, the proposal to have a branch profit tax muddies the water.

The way the provision has been drafted, branch profit tax is obviously an additional tax. “Subject to the provisions of this Code, every foreign company shall be liable to branch profit tax, at the rate specified in Paragraph of The Second Schedule, on its branch profits.” What if a foreign company does not have a branch? Or for that matter, it has a branch which has profits in India and the foreign company itself has income in India from interest or dividend or royalty or fees for technical services or even from some other business. Will it still be subjected to the branch profit tax? More importantly what is the definition of ‘branch profits'? The definition section does not throw any light.

If a branch is deemed to be the same as the ‘permanent establishment' as found in the treaties, still it needs to be defined. As anybody dealing with international taxation will know, the definition of the term ‘Permanent Establishment' differs from treaty to treaty although there may be some common thread. The much maligned Income Tax Act, 1961, which we are going to give up, operated on the basis of ‘business connection' which is not the same thing as ‘permanent establishment'. The proposed DTC will also operate on the basis of business connection and not on permanent establishment which is generally a treaty concept although there are a few countries that have defined ‘permanent establishment' in their domestic laws. But, this is generally not the case. Moreover, there are too many variations of this term in the 78 treaties that we have, and it may be difficult to have a generic definition of permanent establishment in the Code. Of course, there is a definition of permanent establishment in section 199 of the proposed Code which, as in the present Income Tax Act, merely says that “a permanent establishment in relation to a non-resident includes a fixed place of business through which the business of the enterprise is wholly or partly carried on.” It is a mere inclusive definition and was inserted in the current Income Tax Act at the time of incorporation of Transfer Pricing regulations.

A liaison office (LO) operating in India is a fixed place of business and should be a branch. Under the treaty provisions, if its activities are preparatory and auxiliary, it is not considered to constitute a PE for attribution of any profit to it. What will be branch profits in such cases? In India, there are many branches masquerading as LOs. Will they be covered because in the matter of Branch Profit Tax, the revised discussion paper clarifies that domestic provisions will override treaty provisions.

Besides, what is more important to consider is what the rationale of the branch profit tax proposal is. Is it just to bring parity between tax rates of foreign company and domestic company? In India, we are continuing with a dual rate for domestic company and foreign company for a long time. The logic given is that the domestic companies pay dividends which are again available for taxation whereas foreign companies do not pay dividends. With the replacement of classical system of taxation of dividends with a dividend distribution tax in the hands of the company distributing dividends, this may perhaps be justified but only in those cases where the companies choose to declare dividends.

In all our treaties, we have a non-discrimination clause which basically says that a PE and a domestic corporation should be treated at par. By having a differential rate, we have faced much litigation in this area and had to incorporate an explanation in section 90 saying that charging higher rate of tax does not amount to discrimination when it clearly does.

Most of our new treaties also contain provisions to this effect in the treaties enabling us to charge a differential rate, at times with a cap of 10-15%.

Now, if we want to bring in the branch profit tax, we may again face litigation unless we change the treaty language.

In the USA, the branch tax was introduced in 1986 to bring in parity of doing business by a foreign corporation - whether through a branch or a subsidiary. The dividends paid by subsidiary of a foreign corporation attracted withholding tax whereas remittances made by a branch to the head office did not attract any tax. It was hence a more tax efficient way of doing business. Therefore, a branch tax was introduced. The tax rate for dividends and the branch tax was both kept at 30% which could be reduced by the treaties. The branch tax was also restricted to what is known as ‘dividend equalization amount'. As per section 884 of the IRC, it is levied only when the profits of the branch are not reinvested in the USA.

The Branch Profit tax levied by the USA is considered discriminatory by many. The OECD model Convention in its 2008 version clearly states that where such a tax is expressed as an additional tax payable on the profits of the permanent establishment, such a tax would be considered to be contrary to paragraph 3 of Article 24. The USA has therefore specifically reserved its position in Art 24 saying that “The United States reserves its right to apply its branch tax”. The USA also specifically includes an enabling provision in its treaties.

In the case of India too, we have recently stated our position on the OECD model and reserved our position to have a differential rate of tax in the case of foreign companies. We have also incorporated an enabling provision in this regard in our recent treaties. The provision can be found in our treaties with Armenia, Bangladesh, Belarus, Belgium, Botswana, Bulgaria, Czech Republic, Cyprus, Finland, Germany, Hungary, Kuwait, Israel, Kazakhstan, Kyrgyz Republic Jordan, Luxembourg, Malaysia, Malta, Myanmar, Mongolia, Montenegro, Morocco, New Zealand Qatar, Serbia, Singapore Sweden Sudan, Tajikistan, Turkey, Trinidad and Tobago Turkmenistan UAE, Uganda, UK Uzbekistan and Vietnam.

Therefore, if the idea is to just have parity only in the effective rate of taxation between an Indian company and a foreign company, it is better to continue with the present system. Otherwise, we will have to renegotiate all the treaties to specifically include the new impost as an exception to non-discrimination to which we have committed ourselves. The best course will be not to have any differential rate at all since in any case such a differential rate is in most cases an optical illusion what with all the conditionalities involved in the taxation of income of foreign companies; their effective rate of taxation may turn out to be lower than that of domestic companies.

If, on the other hand, the idea is to achieve neutrality as in the case of the USA, a proper study needs to be done to see what form or structure is actually adopted by foreign companies for doing business in India; why one form is preferred over the other. Ideally, only thereafter, a decision should be taken.