The current crisis has halted the process of negotiating international tax rules that were admittedly under pressure from lack of consensus. Digital tax, that now must wait for restoration of normalcy, may also be undermined by the lack of consensus that may be the fallout of the emerging tensions from the crisis: primarily since the tax base will become even more critical for recovery, and defending such base may divide countries on the way forward. Despite such potential threats, recent developments can reflect the minimum tax that is sustainable and countries that may be in need of an overhaul of their tax regimes.
The crisis also impinges on the design of established laws, as they now do not adequately fulfill their purpose and require temporary amendments. This is particularly true for a country like India that seeks to reform its tax system.
India did in fact make two significant changes to its tax law in 2020. First, with the intent to improve tax reporting by businesses that sell through online platforms, Section 194-O has been introduced to the Income-tax Act, 1961 in India. According to this section it is now mandatory for an online platform to deduct tax at the rate of 1% from payments made to a resident e-commerce participant. Second, the scope of the 6% equalization levy has been expanded to online advertising by a nonresident business.
Tax Residence
This year, the tax residency criteria (Section 6 of the Income-tax Act, 1961) for individuals were tweaked. To prevent nonresident individuals using residence in zero tax jurisdictions to avoid taxes, the Income-tax Act was amended. As per the amendment, an Indian citizen or a person of Indian origin (this has been defined under Section 115, clause (e) of the Act as follows “person shall be deemed to be of Indian origin if he, or either of his parents or any of his grand-parents, was born in undivided India”) spending more than 120 days, would be considered resident in India or if he/she is resident for more than 365 days within the four previous years or more, and is in India for a period or periods amounting in all to 60 days or more in the relevant previous year. Therefore, the earlier threshold of 182 days for residency has been reduced to 120.
Further, individuals with income, other than from foreign sources (income which accrues or arises outside India, except income derived from a business controlled in or a profession set up in India) higher than 1.5 million Indian rupees ($19,770) would be taxable in India. That is, an Indian citizen or a person of Indian origin would be deemed to be resident if no tax is paid in any other jurisdiction. This of course would require robust exchange of information.
Since this amendment will take effect from financial year 2020–21, an important consideration for this year will be the inadvertent increase in stay in India caused by the lockdown, thus creating tax residency. The lockdown was imposed in India on March 22, 2020, and with a notification that it would continue until May 31, it would mean residence for 61 days in the new financial year beginning April 1.
International flights remain inoperative except for evacuation flights which have been operated and their movement has been staggered. If the lockdown continues, this could prolong the stay and will also count toward the calculation of residence in the subsequent year. Given the thresholds have been revised downwards, it was thought it would be useful for the tax department to issue a clarification that excludes the compelled stay. To address this concern, on May 8, 2020 the Central Board of Direct Taxes (CBDT) issued a clarification stating that:
- an individual who came on a visit to India prior to March 22 and was unable to leave on or before March 31, 2020 (period of stay in India from March 22 until March 31) shall not be considered for the purpose of tax residence; or
- in the case of an individual who has departed on an evacuation flight on or before March 31 or an individual who was quarantined on or after March 1 and either departed on an evacuation flight on or before March 31, their period of stay in India from March 22 until March 31 or date of departure will not be considered for the purpose of calculation of tax residence.
The lockdown is expected to have significant bearing on the status of residence during the financial year 2020–21. The CBDT has deferred the announcement of clarifications in this regard until normalization. Extending such clarification to the new financial year may not be as simple. It is possible that for companies where operations continued online, the individual visiting India did carry out work and his intended period of stay may have overlapped with the lockdown.
A more important consideration is that when companies hold virtual meetings and the senior officials of the companies attend these meetings remotely, there is the concern that this could qualify as a place of effective management (POEM) for the company. While there are tie-breakers to resolve dual residency, the continuing of operations remotely will require the competent authorities to examine such issues closely. This will also require detailed documentation by the company.
The Organization for Economic Cooperation and Development (OECD) has issued guidelines to this effect for due consideration of facts (page 4, OECD Secretariat analysis of tax treaties and the impact of the COVID-19 Crisis). While the CBDT has clarified the rules relating to permanent establishment, those related to POEM are not mentioned.
Applying Transfer Pricing
Among the critical issues for transfer pricing is its application in times of business uncertainty. Transfer pricing has been a significant cause of corporate litigation. The application of an arm’s-length price under conditions where businesses may be differently impacted, potentially higher concentration, shrinking profit margins, and more importantly disrupted supply chains, can render all previous analysis incomparable.
This has four important implications:
- the comparables selected in the past may not remain relevant, especially where competitors are highly leveraged and facing relatively acute distress;
- the profit level indicators for industries will be severely affected although the impact may not be even across an Industry. For example, within the IT sector Tech Mahindra’s profits dropped while those of Infosys registered an increase;
- the validity of advance pricing agreements (APAs) may be challenged. This is already being observed in India, where multinational enterprises are looking to renegotiate their APAs;
- where international transactions have not been fulfilled due to disruption of the supply chain, movements in exchange rates may alter the pricing and may require revised assessment.
Many companies, to avoid uncertainty, had filed APAs in previous years. The agreement fixes the tax treatment for five years going forward along with four previous years or the rollback; however, the applicability of the margin to past years may not now be possible. Given the current nature of the crisis, committing to pre-Covid margins may not be ideal as much as those currently prevailing to future years. This creates a peculiar situation, where dipping profits may offer companies an opportunity to negotiate at relatively favorable margins whereas from the revenue standpoint these may not find favor. It may perhaps be useful to revise safe harbor rules applicable to transactions during this period.
Taxation of Capital
An increase in financial distress observed in companies, corroborated by ratings downgrades in India, means debt and equity issuance will become an important source of capital. In the past weeks, companies are considering rights issues as well as issuance of non-convertible debentures; while many other companies are also considering share buy-backs to improve valuations for the purpose of financing.
In the 2020 Budget the Finance Minister brought back the classical system of taxing dividends, which means that these will be taxed at the rates applicable to total income of the investor. This has tax implications for shareholders in top income brackets, which at the prevailing income tax rates would be charged a peak rate of 30% plus a surcharge. This could further encourage companies that are closely held to use profits to buyback, taxed at 20%, or reinvest as opposed to distributing of dividends.
The current tax laws may require a series of carefully thought out clarifications: if not done at the earliest opportunity this may impact dispute resolution machinery. It is possible that the design of the taxation of capital incomes may have an impact on the decisions to finance capital requirements.
Suranjali Tandon is Assistant Professor at the National Institute of Public Finance and Policy, New Delhi.
The author may be contacted at: suranjali. tandon@nipfp.org.in
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
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