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Payers$ payess covered under section 195

 

2.1 Payer liable to deduct tax at source u/s 195

The payer covered u/s 195 is “any person responsible for paying”

To a non-resident any sum (other than salaries )chargeable under the Act. The legal status of the payer does not in any way  affect his oblgation u\s 195.Even,individuals and HUFs, who are exempted under certain circumstances from complying with the domastic withholding tax provisions ,are also covered under section 195.

2.2 “person responsible for paying”

The term “person responsible for paying “is defined u\s 204 to refer to the following;

In the case of salary payments –the employer himself.

In the case of payments of income chargeable under the head interest on securities,other than payments made   by or on behalf of central Government of a state-the local authority ,corporation or company,including the principal officer thereof.

In case of consideration paid to a non-resident for the transfer of any foreign exchange asset[as defined u\s115C(b),which is not a short –term capital asset –the authorized dealer responsible for remitting such sum to the non-resident (External)Account maintained in accordance with Exchange control Regulations.

In the case of credit /payment of any other sum chargeable under the provisions of this Act –the payer himself, or, if the payer is a company, the company it self including the principal officer thereof.

The term “principal officer” of a company as defined u\s 2(35) means;

Secretary,treasurer, manager or agent of the company ;or

Any person connected with the management or administration of the company upon whom the Assessing officer has served a notice of his intention of treating him as the principal officer thereof .

Considering the aforesaid definition ,for the purposes of sectio195,”any person responsible for paying “to a non- resident would be the payer himself and if if the payer is a company ,it would include the company itself, including the principal officer there of .

                                                                                                                                                                    

 

2.3 Whether” payer” includes a non – resident u\s195?

Section195 casts an obligation to deduct appropriate tax at source on “any person “responsible for paying to a non-resident .An issue arises as to whether even  a non-resident is covered under the term “any person” and bound by the obligation u\s 195 vis-à-vis any payment to another non-resident.

The taxpayer and the income tax Department are at loggerheads on this ongoing issue of whether the provisions of section 195 also cover a scenario of non-resiiiident making payments to to other non-residents, assuming that such payments are chargeable to tax in india.

The AAR in p-13 of 1995 (228 ITR 487)has held that a non- resident making payment to another non-resident for royalties or fees for technical services , is liable to deduct tax u\s195(1) .in this context , the AAR laid  emphasis on the term “any person”appearing under section195.

Further , Mumbai tribunal in the decision of satellite television Asian Region Ltd.vs.DCIT (2006)99 ITD91 reiterated the view that payments made by one non- resident to another non-resident are covered under section 195 of the Act .

The following extract from the commentary in the book      “the law and practice of income tax”by kanga, palkhiwala and vyas ,9th

 
 
 NEW CAPITAL ALLOCATION RULES FOR PERMANENT ESTABLISHMENTS (ARTICLE 7 AOA)

The 2010 Commentary to the OECD Model contains the new Rules for the Authorised OECD Approach (AOA) for attributing capital of business to Permanent Establishment (PEs). The AOA provides that the profit that should be attributed to a PE is the profit it might be expected to make if it were separate and independent enterprise. The principle underlying it is that the arm’s length principle should be applied to attribute profits to PEs. Put simply, in split of recognizing that a PE is part of the global business enterprise, each part is sought to be treated as a separate and distinct enterprise, and arm’s length pricing between each arm is sought to be introduced, for all transactions. By extending this analogy, even part of the debt at the enterprise level is sought to be allocated  to the PE, and hence the corresponding interest cost is to be considered as deductible. This will significantly reduce the tax base in the developing countries, in favour  of the developed countries, which is analysed in the Article.

 

Peculiarities of Taxation of Permanent Establishments (“PEs”)

Taxation of PE has been a problem due to the fact that it is not a legal entity, and therefore there is a gap between tax law and private law. In 2008, the Committee on Fiscal Affairs of OECD published a report on the issue of attribution of profits (or losses) to a PE. Article 7 of the Model Convention (“MC”) provides that the profit that should be attributed to a PE is the profit it might be expected to make if it were a separate and independent enterprise. The principle underlying it is that the arms’ length principle should be applied to attribute profits to PEs. The 2008 report culminated a change in the OECD MC in 2010. While doing so, it extended the limited independence fiction of the 2008 report to the extended independence fiction. Article 7.1 of the MC provides that the profit of  an enterprise of a contracting state shall be taxable only in that state, unless the enterprise carries on business in the other contracting state through a PE situated therein. The profits attributable to the PE, in accordance with Article 7.2 , may be taxed in that state. Further, Article 7.2 provides that the PE shall be seen as a separate and independent enterprise in particular in  dealing with other parts of the enterprise,  when the PE is engaged in the same or similar activities under the same or similar conditions taking into account the functions performed, assets used and risks assumed by the enterprise through the PE and through the other parts of the enterprise.

Article 7 does not seek to allocate the overall income of the whole enterprise to the PE, instead it requires the profits or losses attributable to the PE to be calculated as if it was a separate enterprise. Income may thus be attributed to a PE even though the enterprise has not made any profits and the other way around.

The focus is on formulating the most preferable approach to attribute profits to a PE under Article 7.2 of the MC in a modern way. The report is based upon an analogy to the TP Guidelines. The new approach of the OECD for attribution of profits to a PE is known as the Authorised OCED Approach (“AOA”). In this article, an analysis on the AOA, to the extent it deals with capital attribution, has been made. Some of the conclusions in this regard are also applicable treatment  of royalties between different parts of the same enterprise.

The Authorised OECD Approach (“AOA”)

The AOA is to apply the TP Guidelines by analogy. The profit of the PE is the profit attributable to it according to the arm’s length principle, in particular in dealings with other parts of the enterprise,  as if it was a separate and independent enterprise engaged in the same or similar activities under the same or similar conditions, taking into account the functions performed, assets used and risks assumed by the enterprise through the PE and through other parts of the enterprise.

According to the AOA  a two-step analysis is required for this purpose. Step one consists of a functional and factual analysis, which must identify the economically significant activities and responsibilities  undertaken by the permanent establishment. Step two consists of applying the transfer pricing tools in Article 9 of the MC applied by analogy to dealings between the PE and the rest of the enterprise, by reference to functions performed, assets used and risks assumed. The end result of this two-step analysis is to determine the calculation of profits (or losses) of the PE from all its activities.

 

The focus is on formulating the most preferable approach to attribute profits to a PE under Article 7.2 of the MC in a modern way. The report is based upon an analogy to the  TP Guidelines. The new approach of the OECD for attribution of profits to a PE is known as the Authorised OCED Approach (“AOA”)

Step One – The functional and factual analysis

The functional and factual analysis, in the first step, takes account of the functions performed by the personnel (the people functions) of the enterprise as a whole and assesses what  significance they have in generating profit. Risks and assets must be attributed to the PE on the basis of the functions performed, and an “open minded” approach is required in order to determine to which part of the enterprise the economic ownership of the assets should be attributed. The economic ownership principle is vital to the attribution of profits to the PEs, and is based on the assumption that assets are to be economically attributed to that part of the enterprise that needs them in order to perform its functions, Once the exercise of attribution of assets (which may also include intangible assets, self generated or otherwise) risks based on functional analysis is completed, the next step is to determine and attribute “free capital” to the PE.

 

Measurement of Capital under the AOA

The term “free” capital is defined as an investment which does not give rise to an investment return in the nature of interest that is deductible for tax purposes. According to the AOA, the PE should have an appropriate amount of capital in order to support the functions it performs, the assets it uses and the risks it assumes. The process of attributing “free” capital to the PE involves two stages; the first involves a measurement of the risks and valuation of the assets attributed to the permanent establishment, and the second is to determine the “free” capital the permanent establishment needs to support these risks and assets. This results in a need to draw up a “tax balance sheet” of the PE. The “separate and independent enterprise” hypothesis requires that an appropriate portion of the enterprise’s “free” capital be attributed to its PEs for tax purposes. An attribution of “free” capital in excess of the amounts recorded in or allotted to the PE by the home cothe PE for any other purpose”.

 

The process of attributing “free capital” to the PE involves two stages; the first involves a measurement of the risks and valuation of the assets attributed to the permanent establishment, and the second is to determine the “free” capital the permanent establishment needs to support these risks and assets.

The purpose of preparing the tax balance sheet and determination of free capital is to determine how much debt of the enterprise as a whole can be considered as attributed to the PE, and consequently how much of the corresponding interest cost can also be so attributed while determining the income of the PE. Till the 2008 report, such interest allocation while computing PE profits was not possible. When it comes to the valuation of assets, there are several options. One option is to use the accounting value of the assets, another is to use the market value of the assets and third is to use the purchase price or cost. While the third method seems to have certain advantages, mainly because if there was a debt incurred for the acquisition of the assets, the debt would also be corresponding to such cost itself, when it comes into measurement of the risks, one may use the enterprise’s own measurement tools. The attribution of “free” capital to the PE needs to be done on an arm’s length basis, i.e. in accordance with where the assets and associated risks have been attributed and should take into account the specific functions, assets and risks of the PE relative to the functions, assets and risks of the enterprise as a whole.

The AOA has several approaches for the  determination of the “free” capital, which are briefly discussed below:

(i) Under the capital allocation approach, “free” capital allocated on the basis of the proportion of assets and risks attributed to the permanent establishment. The problem with this approach is the possibility with this existence of different market conditions, different business activities or that the enterprise itself is thinly capitalized, which may or may not get fructified.

(ii) Under the thin capitalization approach, “free” capital is allocated on the basis of debt-equity ratios of independent enterprises in the host country of the PE, carrying on the same or similar activities under the same or similar conditions. The problem with approach is that it might be hard to apply it outside the financial sector.

(iii) Under the economical capital allocation approach, “free” capital is allocated on the basis of the measurement of the risks. The problem with the approach is that the non-financial enterprise do not have developed system for measurement of risks.

(iv) Under the safe-harbour approach/quasi thin capitalization approach/regulatory minimum capital approach, the free capital is based on local regulatory requirements, especially for banks. This per se is not based on principal of AOA, as the AOA starts with premise that the business and the PE have the same creditworthiness. In practice, it is also difficult to find a objective benchmark which could be applied.

(v) In addition, other method have been discussed for insurance business. Which are not discussed here, as being too specific.

(vi) There are also discussions for thinly capitalized businesses, (the so-called $2 companies, which have $2 as capital, and $1 million as debt). For the same reason as in the processing paragraph, these too are not discussed here.

 

Allocation of Funding Cost/interest Expense.

The AOA acknowledges that the PE needs funding, made up of both “free” capital and interest-bearing debts. Once the amount of funding required is established, based on the foregoing discussion, the “free” capital of PE is determined. The excess of assets attributed to the PE over its “free” capital is the debt attributed to the PE. Cost of such debt needs to beascertained for attributing to the PE, so that its profits can be ascertained.

According to AOA there are two approaches to determine an allowable interest deduction for the PE. These are (i) the tracing approach; where the interest rate on the funds provided to the PE are determined to be the same as the actual interest of the third party provider of the funds; and (ii) the fungibility approach; where the PE is allocated a portion of the whole enterprise’s actual interest rate paid to the third party. Such interest attribution only for the purpose of ascertaining  the profits of the PE, and no actual payment of such interest to the other parts of the enterprise is expected. This being so, in the absence of actual payment of interest from the source country, it will not be able to even collect withholding tax on such interest being reduced while ascertaining the PE profits. The 2010 Report, under certain circumstances, also permits allocation of interest cost on internal debts, i.e. which are not backed by a debt from a lender either in the head office, or in any other part of that enterprise.

Step Two – Determination of profits of the PE

This step involves determination of profits of the PE. When it comes to the determination of profit of the separate and independent enterprises, the AOA is to undertake a comparison of dealings between the PE and the rest of the enterprise, with transactions between independent enterprises, which includes allowance for interest incurred at a place other than the PE state.

Example

Particulars

Assets-Enterprise Level

Liabilities -Enterprise Level

Assets–PE Level

Liabilities – PELevel(Capital Allocation + Interest Tracing)

Liabilities – PE

Level (Capital Allocation+ Interest  Fungible)

Various Assets

1000

 

500

 

 

Capital

 

200

 

100

 

100

Debt 1 (@10%)

- for PE

 

300

 

300

}

400

Debt 2 (@ 5%)

 

500

 

 

 

Interest Free

Loan From HO

 

 

 

100

 

Interest Cost

 

55

 

30

27.5

Notes :

1. Capital  at enterprise level is 20% of assets, hence at PE level also taken in same proportion.

2. In interest tracing option debt for PE attributed fully to PE. Excess funding by the Head office, by whatever name called, will not get any interest attribution.

3. In fungible interest option, entire excess of assets over capital treated a composite debt, and interest allocated on proportion of debt a PE (400) to aggregate debt (800) – i.e. 50%.

 

The excess of assets attributed to the PE over its “free” capital is the debt attributed to the PE. Cost of such debt needs to be ascertained for attributing to the PE, so that its profits can be ascertained.

A Critique of the AOA

1. The AOA does not discuss frequency of recalculation of capital, viz. at beginning, or after every transaction, or at year end”

2. Interest cost allocation will generally reduce the profits remaining taxable for the PE. Besides, as noted earlier, the source state will not be able to tax the interest so allowed in the hands of the recipient of interest, loading to base erosion in the PE state.

3. The interest cost allocable to the PE can significantly increase if the “tax balance sheet” is drawn at market values (especially if intangibles are also included), which is one of the permitted methods of drawing it up. This will jack up the assets base to be allocated, and any allocation on such higher base to the PE, will result in higher assets being attributed to the PE, will result in higher assets being attributed to the PE, leading to higher debt being so attributed, and therefore higher interest cost, and so lower profits remaining to the taxes at the PE.

4. As a result of such interest attribution and erosion of tax base in the source country,  what will happen is that that the source state will get less tax. As a corollary, in the residence state, the enterprise will get lower tax credit taxes paid in source states. Consequently, the residence state will get a higher tax quantum. In other words, the taxpayer in  residence country will incur compliance costs to increase the taxes in his country, and not to save his own overall tax liability.

5. The AOA also seeks to recognize royalties between different arms of the same enterprise. This will further erode the tax base in the source country.

6. It is generally known that PEs are located in developing countries, while the business have their residence developed countries. The latter being part of the OECD,  and the former by the UN. Both these organizations have different interest groups to support , and at times conflicting interests are compared with a football match. Looking at the glaring unfairness in the allocation of income to the PE state under the new approach, the developing countries sure hope and pray that the UN wins this game, as even though there are provisions of letting the domestic law prevail, and the recourse to MAP, how many countries will be able to resist the “persuasive” pressure from OECD MC ? will David win over Goliath again? Else the developing countries will be deprived of their share in the pie.

7. This view is based on the concept that is the place of income generating activity rather that the jurisdiction where the income producer resides that economically contributes to the production of income and should be compensated for that contribution.

8. Perhaps if there are so many contradicting views on calculation of profit attribution to a PE, then it is right time that an alternative tax system is conceived, which allocates taxing rights beyond PEs.

 

Interest cost allocation will generally reduce the profits remaining taxable for the PE. Besides, as noted earlier, the source state will not be able to tax the interest so allowed in the hands of the recipient of interest, leading to base erosion in the PE state.

NRI TAX

How the US foreign tax credit rule impacts Indian Americans

28 Jun, 2012, 0204 hrs IST, Deepa Venkatraghvan

http://m.economictimes.com/PDAET/thumb.cms?msid=14320022&width=100&resizemode=4

The Double Taxation Avoidance Agreement that is signed between two countries has a singular objective: to avoid double tax, that is to avoid instances where an individual or company might pay tax in two countries on the same income. 

But there is a particular US tax rule with respect to certain capital gains taxes that comes in the way of the DTAA provision. This rule applies to capital gains from the sale of 'personal property' such as certain shares, mutual funds, debentures, bonds etc. It does not apply to real estate. And this tax law may impact high networth Indian Americans quite significantly. Let us take a detailed look. 

Tax in India 

As an NRI in the US, you may have several of your investments in securities in India - equity shares, mutual funds, debentures, private equity investments etc. First let us look at how these investments are taxed in India. 

Equity mutual funds and listed equity shares: Long term capital gain on sale of equity shares (that is if you sell after one year of holding) is tax free in India. Therefore, there will be no tax implication. Short term capital gain is taxed at a flat rate of 15%. For an NRI, the tax is deducted at source (TDS) before you receive your sale proceeds. 

Debt mutual funds and listed debentures: Long term capital gain on sale of debt mutual funds (that is if you sell after one year of holding) is taxed at 20% (or 10% without indexation). TDS on this gain will be 10%. Short term capital gain on debt mutual funds is taxed at the taxpayer's regular tax slab. TDS will be 30%. In case of debentures, when they are sold in the secondary market, the same rules for capital gains tax apply. 

Private equity investments (unlisted equity shares): Long term capital gain on sale is taxed at 10%. Short term capital gain is taxed at the taxpayer's regular tax slab. TDS will be 30%. 

Tax in the US 

As a resident or citizen of the US, you are required to pay tax in the US on your global income. So any income from sale of shares, mutual funds or debentures in India must be declared in your US tax return and you must pay tax in the US on that income. 

Double Taxation Avoidance Agreement and Foreign tax credit 

According to Article 25 of the DTAA, the US shall allow its residents or citizens to claim a tax credit in the US on income tax paid to India. Therefore, according to this Article 25, taxes paid in India on capital gains on shares and securities (in the form of TDS or otherwise) should be allowed to be claimed as tax credit in the US. However, there is more to this. 

Article 25 further states that 'the determination of the source of income for purposes of this Article shall be subject to such source rules in the domestic laws of the Contracting States as apply for the purpose of limiting the foreign tax credit.' 

 

And here is where the trouble begins. "According to the US tax code, in order to claim a tax credit of taxes paid in another country, the income must be 'foreign sourced.' According to IRC Sec 865, 'income from sale of personal property by a US resident shall be sourced in the U.S.'," explains Rahul Ranadive, a tax attorney with Florida based Global Tax and Estate Counsel LLP. 

What this means is that irrespective of the country of investment, any sale by a US person, of personal property would be treated as US sourced and therefore, foreign tax credit would not be available. 

So if you are a US person (that is US citizen, resident or green card holder) and you sell securities in another country, they will be treated as US sourced because you are a US person. So foreign tax credit will not be available on such income. What this means is that you will pay tax in India on your capital gains (wherever applicable). You will also end up paying tax in the US on this income with no benefit of tax credit. 

When will this impact you? 

Obviously this will impact you only if you are paying taxes in India. Since there is no long term capital gains tax on equity shares and equity mutual funds in India, you will not be impacted in those cases. However, you will feel the pinch in case of short term capital gains on equity shares and mutual funds and long or short term gains on other securities like debt mutual funds, listed debentures and private equity funds. 

Tax planning 

"If you can take proper pre-investment tax planning, you may be able to face this situation. The most common planning technique is using a holding company in a treaty jurisdiction like Mauritius or Cyprus and routing your investments in Indian companies through these companies," advices Ranadive. 

However, this method comes with certain costs such as incorporation and maintenance of the holding company. So you would need to weigh the tax advantage against the costs. Naturally, this strategy might make sense for high networth investors. Small investors would, in most cases, just need to bear the taxes.

  

 

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