Tax policy for Indian MNCs

A few years ago, any pre-budget column on tax policy would have just focused on removing tax distortions (and pleaded for not introducing new ones such as the fringe benefit tax) and perhaps getting rid of the hundreds of exemptions on excise and customs. While those are still valid concerns, what has become pretty pressing, given how India is now creating its own MNCs who’re trying to attain global scale by taking over companies overseas (outward FDI from India, is today larger than inward FDI) like Daewoo Motors and Flag Telecom, is the whole issue of tax policy that penalises such actions. Yes, believe it or not, while most countries are trying to fashion their policies to encourage investors to use them as financial hubs, our tax policies even encourage our own wannabe-MNCs to park their money overseas and make investments from there. By the way, I’m not talking of sops offered by tax havens, just of inadequate tax laws.

The best way to explain the point, needless to say, is through an example or two. Take the case of an Indian company which sets up a wholly-owned subsidiary in Country A which has a tax treaty with India providing the concept of underlying tax credit (under this concept, the income earned by the overseas subsidiary is considered as the income of the Indian company and credit is allowed for taxes paid overseas including on the income of the subsidiary and dividend repatriation, in India). Now, assume this subsidiary earns $1,000 in Country A. So, it will pay a tax of $350, assuming a 35 per cent tax rate there, and repatriate the remaining $650 to India. Based on Country A’s laws, it will also have to pay a withholding tax on this, usually at a rate of 15 per cent, which means $97.5. In India, in turn, the company will be taxed on the income of its overseas subsidiary, and since corporate taxes are currently 33.66 per cent, which translates into a tax of $336—but since a tax greater than this has already been paid in Country A, no taxes are to be paid in India. In effect then, the Indian company has paid a tax of 44.75 per cent ($350+$97.50), and tax credits of $111.5 have been lost.

Now, assume the company also earned another $1,000 in Country A through royalties. So, when this is repatriated to India, there’s another $150 of withholding taxes to be paid. And in India, the company will have to pay $336 (based on the 33.66 per cent corporate tax rate), but since $150 has already been paid, a net $186 will have to be paid. If, however, India permitted what’s called pooling of foreign tax credits, even the $111.5 would have been available as a credit.

The situation gets worse when it comes to investing in countries with whom India does not have tax treaties, or where the concept of underlying tax credits does not apply—this, by the way, is true of most countries! So, if the same company now earns $1,000 on its Country B subsidiary, it will pay a tax of $350 in Country B and a tax of $97.5 on the repatriation of dividend. In India, the company will have to pay a 33.66 per cent tax on the dividend it receives ($219), but since a tax of $97.5 has been paid on dividend already, it will pay $121.5. So, the effective tax paid on the $1,000 income is a whopping 56.9 per cent.

Vishal Malhotra, who’s a Partner in Ernst & Young’s tax practice, however, argues that the problem lies in India’s domestic tax laws and not the tax treaties. Domestic tax laws, he says, do not have elaborate foreign tax credit provisions including the mechanism to claim underlying foreign tax credits. Besides, they do provide for, amongst others, pooling of foreign tax credits or carry forward of unutilised tax credits.

In which case, if an Infosys or a Tata has invested overseas, and plans to use the income from here to fund further acquisitions, one of the most foolish things for it to do would be to bring the money back home since its tax liability on such incomes would go up dramatically.

Of course, if the Indian company sets up a branch office in Country B, there’s no problem since all incomes that accrue in Country B are added to the local income in India. So, a tax of $350 is paid in Country B on the $1,000 earned there and there is no withholding tax when the money is repatriated to India. Tax payable on the income of $1,000 in India is $336, and hence there is no additional tax to be paid, although there will be a marginal tax-credit loss of $14 ($350-$336). But while an Infosys can still set up a branch office when it is venturing abroad on its own, surely a takeover of a US firm cannot be then converted into a branch office? Having a tax policy that actually discriminates against local companies trying to become global giants is surely something that needs to be changed. Hopefully this is something that will get fixed next February.