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Direct Tax Code - Implications for Non-Resident Oil and Gas Service Providers, Shri Chandresh Bhimani, Senior Manager, Tax and Regulatory Services, PricewaterhouseCoopers (PwC)

India faces formidable challenges in meeting its energy needs, with consumption far exceeding supply. The dependence on imports of petroleum and petroleum products has increased and is currently around 80 percent of the total oil consumption in the country.

In order to meet its growing energy requirements and to facilitate discovery of natural resources, the Government of India has provided fiscal impetus under the current law by allowing profit-based tax holidays, allowance of 100 percent deduction of capital expenditure incurred on exploration and drilling, deduction of unsuccessful exploration costs, etc.

The Government of India (GOI) laid down the revised Direct Taxes Code, 2010 Bill (DTC) in the Indian Parliament on August 30, 2010. The DTC is in accordance with the Revised Discussion Paper (RDP) released in June 2010, which made significant changes to the original version of the Direct Taxes Code Bill. Once enacted, it will replace the existing income tax law (Income-tax Act, 1961 (the Act)) in India and will be effective from April 1, 2012.

As originally introduced, the GOI sent shivers through the global investing community by introducing a number of radical proposals such as, treaty override, change in residential status of foreign companies, General Anti-Avoidance Rules, Calculation of Minimum Alternate Tax on gross asset basis, discontinuation of profit-based tax holidays, etc.

However, compelled by widespread criticism, the GOI has diluted certain aspects of its original proposal. These include: the restoration of MAT provisions based on book profit; upholding the supremacy of treaty provisions; appropriate threshold for determining the residency of foreign companies; and the circumstances in which GAAR may be invoked.

There are many key proposals of the DTC which are pertinent to non-resident oil and gas service providers.

One of the most significant proposals is regarding the Corporate Tax Rate. The DTC proposes to reduce the corporate income tax rate for foreign companies to 30 percent. However, the effective rate could be higher, at 40.5 percent, in view of the introduction of Branch Profit Tax (BPT) @ 15 percent. The BPT would apply to foreign companies and will be levied on income attributable directly or indirectly to a Permanent Establishment (PE) or immovable property located in India.

Another feature proposed is Income Classification. The DTC proposes to categorise income into two baskets - Income from Ordinary Sources and Income from Special Sources. Income from ordinary sources includes income from employment, house property, business, capital gains and residuary sources. Such income is proposed to be taxed as per the applicable tax rates. Income from special sources includes, among other things, interest, royalty and fees for technical services for non-residents. Income from special sources is proposed to be taxed at the flat rate of 20 percent. If special source income is attributable to the PE, the income shall be considered income from an ordinary source.

As for Minimum Alternate Tax (MAT), DTC proposes to levy MAT at the rate of 20 percent, which is nearly identical to the current effective tax rate of 19.93 percent. However, the period for availing the tax credit has been extended to 15 subsequent years, as against ten years under the existing law.

Exemption on short stay has also been provided under DTC. Remuneration of a non-resident non-citizen working on a foreign ship is proposed to be not taxable in India so long as his period of stay in India does not exceed 90 days in a financial year. As for the Residential status, the DTC proposes to change the criteria for determining the residence of a company. A foreign company will be treated as 'resident' in India if its place of effective management is located in India at any time during the relevant year. The term 'place of effective management' is defined as:

  • the place where the Board of Directors/Executive Directors make their decisions, or
  • the place where the Executive Directors or Officers of the company carry out their functions and where their commercial and strategic decisions are regularly approved by the Board of Directors.

The provisions of GAAR have been introduced to prevent transactions aimed at tax avoidance by empowering the tax authorities to disregard and recharacterise such transactions. GAAR is triggered under DTC when any person enters into an arrangement which is characterised as impermissible avoidance arrangement under the DTC. An "impermissible avoidance arrangement" has been defined as an arrangement, and its main purpose is to obtain a tax benefit, which

  1. creates rights or obligations not created between persons dealing at arm's length;
  2. results in misuse or abuse of provisions of the DTC;
  3. lacks commercial substance; or
  4. is not for bonafide purposes

DTC empowers the tax authorities (commissioner of income tax) to amend, disregard, re-characterise, or declare impermissible an arrangement. Interestingly, the GAAR would be attracted even if the main purpose of a single part or step of the arrangement was to obtain tax benefits and consequently, the entire arrangement may be considered impermissible. It remains to be seen how these provisions would actually play out in practice.

The DTC also proposes to extend the principles relating to source-based taxation to transfer of shares/interest in a foreign company by a non- resident. However, given the condition that the assets of such foreign company in India (held directly or indirectly) represent at least 50 percent of the fair market value of all assets owned by the foreign company, which is being transferred. If this 50 percent test is met at any point during the 12 months prior to the transfer, the transfer of shares/interest will be taxable in India.

Thus, if a foreign company has more than 50 percent of its assets, in terms of value, located in India, and the shares of such company are proposed to be transferred, then the gains arising on the transfer of the said shares will be taxable in India. In addition, interest accrued from a non-resident that is used for earning any income from any source in India will also be taxable in India.

As for the tax treaty benefits, the DTC proposes to retain the beneficial provisions of tax treaties, except in cases where GAAR or Controlled Foreign Corporation rules are invoked or BPT is levied.

Also, presumptive scheme of taxation for non-resident oil and gas service providers has also been retained by the DTC. It proposes to retain the presumptive scheme regarding non-resident service providers engaged in the business of providing services, facilities or plant and machinery on hire to be used in the prospecting for, extraction or production of mineral oil or natural gas. However, certain revisions will apply.

Some of the important features of the scheme are: Increase in effective tax rate, increase in actual income, option of claiming lower profits, and presumptive scheme versus income from special sources.

Regarding increase in effective tax rate, DTC proposes to increase presumptive income for non-resident oil and gas service providers from the current 10 percent of gross receipts (under section 44BB) to 14 percent. The table below provides a comparison of the effective tax rates under existing law and under the DTC:

Particulars Act DTC
Gross Receipts 1,000 1,000
Deemed income @ 10% current and 14% proposed 100 140
Tax Rate 42.23% 30%
Tax Liability 42.23 42
Branch Profit Tax @ 15% (if income attributable to PE) Not applicable 14.7 (On 140-42)
Total tax liability 42.23 56.7
Effective tax liability 4.223 5.67

The above table shows that the tax cost will increase from 4.223 percent to 5.67 percent of the gross receipts.

The DTC proposes to further increase the amount of income determined under the presumptive basis by the excess of the amount of any income actually earned by the assessee. Therefore, if the actual income earned by the service provider can be determined (whether through maintenance of books of accounts by the assessee or otherwise) and such actual income exceeds the deemed income computed @ 14 percent of the gross receipts, then the excess will be added to the presumptive income computed by the assessee.

Of crucial importance is the determination of actual income. No guidelines have been provided for determination of such income. If the assessee is maintaining the accounts not in India but say, in its home country, then whether the tax officer can call for such books for accounts and determine the actual income needs to be seen. This is likely to increase compliance and litigation costs.

It also provides an option of claiming lower profits. The DTC proposes to retain the option of taxation on either a presumptive or net income basis. If the net income basis is selected, then the assessee will be required to maintain books of accounts and have these audited.

Putting presumptive scheme in comparison to income from special sources, the DTC specifies that the presumptive scheme shall not apply to any income from a special source. Accordingly, if the income earned by the non-resident service provider is considered special source income (for example, Royalty or Fees for Technical Services (FTS)), then the presumptive scheme will not apply to such income.

Note that the definition of `Royalty' under existing law, specifically, excludes any consideration received for Industrial, Commercial or Scientific (ICS) equipment used in prospecting for, extraction or production of mineral oil or natural gas in India. The DTC's definition of `Royalty' does not appear to retain this exception for oil and gas service providers. Thus, under the DTC any consideration for provision of ICS equipment is likely to be considered `Royalty' and therefore, `income from special sources'.

However, the definition of `FTS' under the DTC is similar as under the existing law, with the general exception for any `mining' or `like project' retained. Accordingly, the ongoing controversy under the existing law as to whether services provided in connection with prospecting for, extracting or producing mineral oil or natural gas would be covered by the presumptive scheme or would be considered as FTS is likely to continue.

Having said the above, the silver lining is that if special source income is attributable to a non-resident assessee's PE in India, then the said income will be considered as income from an ordinary source and not from a special source. As discussed earlier, the term `PE' has been defined in a broad manner and includes one day Service PE, (substantial) equipment PE and insurance agent PE.

In view of the above, Royalty or FTS income of the non-resident service provider attributable to its PE in India can be arguably said to be eligible for the presumptive scheme. Where the presumptive tax regime does not apply and the income is taxable as royalty or FTS, the tax rate has been increased from 10 percent to 20 percent.

Therefore, in conclusion we can say that although DTC proposes to retain the presumptive scheme for non-resident service providers, certain ambiguities still remain. Certain provisions like, exclusion of special source income from presumptive scheme and the addition of the excess of actual income over deemed income are capable of multifarious interpretations and run counter to the spirit behind introduction of DTC, which was to create simplicity and transparency in the tax system.

It is important for the service providers to watch developments and actively present their viewpoint to the GOI. At the same time, it is also important to assess the impact of DTC proposals on current structures and business models.