As U.S.-based multinational corporations continue to expand global operations, supply chain initiatives are driving production and management functions increasingly to relatively low-cost jurisdictions. India remains among the commonly considered locations to establish operations. In the past, tax holidays and inexpensive yet skilled labor were enough to entice many multinational companies to relocate certain back office functions.
Current market conditions in India, however, are exerting downward pressure on the decision to enter India to implement cost savings measures. In particular, many of India’s previously available tax holidays are expiring. Additionally, inflationary market pressures are forcing costs up, and tight capital controls on repatriation make redeployment of cash difficult once invested. As a result, some of the multinational corporations that are already operating in India are finding it difficult to devise ways to re-invest their money within the region or repatriate it in tax-efficient ways. Still, economically substantive planning is available to help companies already invested in India to extract the value of their committed capital. And newly contemplated supply chain initiatives may still accomplish a degree of cross-border tax efficiency.
Many of the issues now arising for global companies that look to divest or otherwise monetize their Indian investments appear to stem from Indian authorities that are understandably motivated to preserve the country’s tax base. Even transactions outside India, however, may be subject to scrutiny by India courts.
Take the Vodafone case as a cautionary example. Through a Netherlands-based subsidiary, Vodafone Group Plc bought the shares of a Cayman subsidiary from its parent, Hutchison Whampoa Ltd., a Hong Kong-based conglomerate. The Cayman subsidiary indirectly held the operations of Hutchison’s Indian telecom division. After the transaction was consummated, the Indian taxing authorities assessed a capital gains withholding tax assessment on Vodafone, the buyer, arguing that the underlying Indian assets, and not the stock of the Cayman subsidiary, were the subject of the transaction. The Indian court agreed with the Indian taxing authorities, stating that although the transaction was described as a stock transaction involving the Cayman subsidiary of Hutchison, the transaction was motivated by Vodafone’s attempt to gain control of the purely Indian-based assets. Additionally, the Indian court found that the Indian-based operating companies were involved with the negotiations of the transaction and held that the transaction, based on the exchange of correspondence, was consummated in India with the India entities of Hutchison. Using an analysis somewhat similar to the U.S. Supreme Court’s analysis in Court Holding Company, the Indian court held that a transfer of Indian assets occurred in such a manner as to attract a withholding tax responsibility.
Examining this case from the standpoint of economic substance, the existence of operating assets in India provided tax authorities (together with the courts) a sufficient amount of justification to essentially superimpose an asset transaction atop what was formally a stock transaction.
With a tax bill of $2.6 billion, this landmark case is slated to go to the Indian Supreme Court this summer. It remains to be seen whether the Indian Supreme Court will side with its taxing authority or Vodafone.
This might have been avoided if Hutchison’s initial investment into India had been structured differently through the use of certain holding companies that have beneficial treaties with India, in particular with respect to exemptions on capital gains taxes. Going forward, this problem won’t be as easy to solve because of some recent and upcoming changes to the Indian tax code that make careful structuring of investments into India now more important than ever.
With the economic substance, an element necessary to support any U.S. tax planning, behind many companies’ decision to increasingly drive intellectual property development and larger portions of the supply chain to relatively low-cost economies, countries such as India are asserting greater importance with respect to those assets both in a transactional context and a transfer pricing context.
Indian Environment and Trends
In the last year, India has gone through some extraordinary changes to its tax rules and stance on transfer pricing. There will be even more drastic changes in the future with the impending Direct Taxes Code becoming effective one year from now, in April 2012. Some of the more substantive changes that may affect multinational corporations operating in India include:
- Reducing the corporate tax rate to 30 percent for Indian and foreign companies from 33 percent and 40 percent, respectively;
- Introduction of a new branch profit tax at 15 percent for foreign companies;
- Retention of a dividend distribution tax rate at 15 percent;
- Expiration of Special Economic Zones Act (SEZ) tax holidays;
- Emerging and yet-to-be-completed controlled foreign corporation legislation;
- The creation of a foreign tax credit mechanism to accompany controlled foreign corporation legislation; and
- General anti-avoidance rules that will attempt to codify a broader version of our own economic substance doctrine.
Transfer Pricing and Court Cases
Transfer pricing in India is a changing art and perhaps more abstract than what we are used to seeing in the United States. While it is still a relatively new concept in India, the authorities have wasted no time in taking advantage of the rising value of the local Indian subsidiary. In recent years, it has been common to receive a double-digit transfer pricing adjustment on manufacturing activities and even on some lower-level marketing functions. Litigating these adjustments is a multi-year process that can outlast even the most resilient tax director. And while the competent authority process is somewhat quicker, the uncertainty of the litigation process remains.
One issue that directly impacts the amount of the adjustment is the use of non-public comparables by the Indian tax authorities. As the burden of proof is on the taxpayer to prove that expenses borne by the local affiliate or income earned by such entity must be in line with what other local companies are paying or earning, it is often difficult to defend the taxpayer’s position with respect to local companies. Determining what a local company is paying or earning is often difficult and will ultimately lead to huge gaps in comparables. This area of tax is ever evolving and still in its infancy in India, so larger multinationals that do business in India will definitely feel the growing pains.
As recently as last year, the Indian authorities became more aggressive in their stance on transfer pricing — as seen in the Maruti Suzukicase. Suzuki Motor Corporation held a 50 percent stake in Maruti, a local car manufacturer. Suzuki licensed its logo to Maruti and, as a condition of the license, Maruti was obligated to use the Suzuki logo on all Maruti products. The Indian tax authorities asserted that the Suzuki brand was developed in India since Maruti had gone to great expense to develop it. The Indian tax authorities asserted that Maruti had economic ownership rights to the Suzuki brand and should be compensated as such. Ultimately, the assessment of tax on its additional transfer pricing income was overturned by the Indian Supreme Court. The Court held that the benefit of the brand development was really only with the local licensee and that payment for such benefit alone was satisfactory and no additional compensation from Suzuki was necessary. Although the case demonstrates a more aggressive approach by taxing authorities, it is tempered by the Indian Supreme Court’s reversal. It nevertheless created an expensive and time-consuming defense for the taxpayer.
Alvarez & Marsal Taxand Says:
As assessing officers grow increasingly aggressive in finding transfer pricing adjustments, it is almost certain that taxpayers’ transfer pricing positions will be challenged and the decision to litigate will boil down to the dollar amount of the assessment vs. defending the position in court. In this scenario, it is not uncommon now for taxpayers to simply settle in hopes of resolving the matter in a timely fashion.
It is important to note that there is a specific provision in the Indian tax code that exempts transfer pricing adjustments from any income tax holidays to which companies are subject.
With these emerging changes, companies should pay careful attention to existing operations:
- Review and refresh transfer pricing methodologies with respect to all aspects of the supply chain affected by India operations.
- Review and refresh transfer pricing methodologies with respect to intellectual property that is associated with supply chain operations or otherwise.
- Where possible, enter into advance pricing agreements.
- Where companies are structuring conveyances of operations in India, make sure the formalities of the transaction are consistent with the economics of the transaction.
- Where possible, enter and exit India through India’s treaty partners.
- With Vodafone as an example, capital redeployment out of India is possible but requires advance planning and operational support.
- Capital redeployment within India should also be considered through strategic partnerships that may permit parties to identify new revenue streams that are supportable outside India.
Vodafone International Holdings B.V. v.Union of India, WRIT PETITION NO.1325 OF 2010
The High Court of Judicature at Bombay O.O.C.J.
Commissioner v Court Holding Company, 324 US 331 (1943).
Maruti Suzuki v. ACIT, 328 ITR 210 (Delhi 2010).
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