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 Proposed Amendments:
US Treasury Secretary Timothy Geithner on May 4, 2009 announced a number of proposed steps to amend the US tax code. The proposed amendments would prevent US companies from deferring payment of taxes by keeping profits in foreign jurisdictions rather than repatriating them and recording them in the US. In addition the Treasury Secretary called for greater transparency in bank accounts that US citizens hold overseas.
The plan proposed by the Treasury Department would:
Limit the ability of US businesses to defer US tax on their foreign earned income and to eliminate the “check the box” provision and; Reduce the tax credit for foreign taxes paid.
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.
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.
Check the Box:
One of the most potentially potent amendments would be the repeal of the so-called “check the box”. The rules were designed to allow companies to classify subsidiaries in certain ways for tax efficient purposes. The Treasury Department, however, alleges that the rules have resulted in shifting income to tax havens.
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.
Controlled Foreign Corporation:
A Controlled Foreign Corporation (“CFC”) is a legal entity that exists in one jurisdiction but is owned or controlled primarily by taxpayers of a different jurisdiction. CFC laws were introduced to prevent tax evasion through the use of offshore companies in low-tax or no-tax jurisdictions such as tax havens.
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.
The US does not generally impose tax on a foreign person or foreign corporation unless that person or corporation has US source income. However, the US may impose a tax on the US shareholders of a foreign corporation even if the corporation has no income from US sources.
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.
Corporate inversion involves a company reincorporating itself outside the US mainly for tax purposes. In an Office of Legislative Research (“OLR”) report dated July 19, 2002 (2002-R-0636), the Treasury Department defines an inversion as a transaction that alters the corporate structure of a US based multinational company such that a newly incorporated foreign corporation, typically located in a low- or no-tax country, replaces the existing US parent corporation as the holding parent company. The inversion is usually a legal transaction for incorporation and tax purposes but does not typically change the company’s headquarters, management or operations.
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.
US State Tax Law Proposals:
US State governments are also becoming aggressive about perceived lost tax revenue. Delaware has a special significance as it is a favored jurisdiction of incorporation, including for many venture backed start ups. State tax collections have also fell during the downturn and as a result, states are becoming aggressive about collecting taxes from companies that are conducting business in the state but are incorporated elsewhere.
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.
States are also becoming aggressive about online sales. In April 2008 New York passed a new law targeting online sales and requiring that online retailers collect and remit sales tax to the state. As a result, a lawsuit was filed by Amazon.com, Inc. against the state of New York, alleging violations of the commerce clause of the US Constitution and the due process and equal protection clauses of the NY and US Constitutions.
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:
Indian tax authorities are also becoming more aggressive about the collection of taxes, in particular giving greater scrutiny to cross border and off shore transactions.
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.
According to the facts of the case, E*Trade Mauritius (a Mauritius company), was a subsidiary of E*Trade Financial Corporation (E*Trade US), a Delaware Corporation. E*Trade Mauritius sold shares of IL&FS Investmart Limited (an Indian company) to HSBC Mauritius. In connection with the sale, E*Trade Mauritius sought to obtain a certificate from the tax authorities under section 197 of the Income Tax Act, 1961 (“ITA”) authorizing payment of consideration by HSBC sans any withholding of tax. The tax authorities, however, refused to grant the certificate, in response to which E*Trade filed a writ petition before the Bombay High Court challenging the decision of the Additional Director of Income Tax (“ADIT”).
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.
The Income Tax Department’s argument was that E*Trade Mauritius was a shell company (which was incorporated only several weeks before the sale transaction) and that the shares were actually owned by E*Trade US which made it liable to pay capital gains tax because it would not be entitled to the benefits of India Mauritius Double Taxation Avoidance Treaty.
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 ( 263 ITR 706 (SC)) which held that any Mauritian company having tax residency certificate could benefit from the India-Mauritius tax treaty.
The E*Trade matter is still being decided and E*Trade may challenge the revisional order of the DIT before the High Court. Further, the order is solely in relation to the issue of withholding tax and formal assessment proceedings have not yet commenced in respect of the applicability of capital gains.
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.
While the matter is still being heard, both Vodafone and Hutchison Telecommunications International Limited (“HTIL”) have made disclosures to the SEC regarding potential tax liabilities, with HTIL additionally stating that it may face financial exposure as a result of warranty and indemnity obligations assumed in connection with the sale of the HTIL India assets.
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.
One can therefore expect that tax authorities in both the US and India will continue to focus on aggressive tax collection.
(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 firstname.lastname@example.org)
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.
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