India: Tax issues for foreign banks in an ever changing landscape
Sunil Gidwani, Nehal Sampat and Dipesh Jain of PwC discuss some of the key taxation issues affecting foreign banks in India.
Albert Einstein once said that "the hardest thing in the world to understand is the income tax". More than half a century later, it may still be the case, especially in the Indian context. Ambiguities in the taxation regime are often compounded with an ever changing regulatory landscape, especially for foreign banks operating in India.
Subsidiarisation of foreign banks
After the global financial crisis, the Reserve Bank of India (RBI) indicated its preference for foreign banks to operate in India as subsidiaries as opposed to branches. It announced a framework for foreign banks to set up their presence in India as wholly owned subsidiaries (WOS). Similarly, the Regulator intends to encourage existing foreign banks to convert their branches into subsidiaries.
The decision to operate as a branch or as a subsidiary has income-tax ramifications too. Illustratively, a branch is taxable at a higher rate of 40% as compared to tax at 30% applicable to residents. However, on the flip side, any distribution of profits by a subsidiary to its parent is subject to dividend distribution tax at 15% (as dividends) or 20% (as buyback). Further, there are surcharges and cesses levied on the tax rates that differ for branches and subsidiaries. The effective tax rate for branch and subsidiary may only be marginally different where entire profits are distributed. However, where profits are not fully distributed, a subsidiary form of presence could lead to a tax rate arbitrage over a branch.
Further, the following pros and cons merit attention:-
Lower rate of tax considering that many of the foreign banks have not been repatriating their entire profits and hence the dividend distribution tax would not arise;
Income from offshore loans need not be consolidated with profits from onshore business (this could be a con in case of certain tax deductions based on aggregate income);
The head office need not file its annual tax return if the only source of income is interest income from offshore loans;
Often the head office or overseas branches invest in Indian stock markets as portfolio investors. The issues around consolidation of income and attribution to Indian branch may not arise on subsidiarisation;
Higher allowance for deduction of provision for bad and doubtful debts for a subsidiary; and
The cap on deduction for head office expenses in a branch scenario (discussed subsequently) not applicable to a subsidiary.
Receipt of interest income from foreign parent taxable in the hands of subsidiary; in case of a branch, arguably, such receipt may not be taxable.
Some of the leading global banks have been present in India for decades and have a significant presence. A change in their form of presence could have, among others, the following ramifications from taxation perspective:-
Tax costs on conversion
To facilitate tax neutral conversion of foreign bank branches into subsidiaries, a special set of provisions (ChapterXII-BB and Section 115JG of the Indian Income-tax Act, 1961) were incorporated in the domestic income-tax law with effect from April 1 2013. The provisions seek to exempt capital gains arising from the conversion of a bank branch into subsidiary where such conversion is in accordance with a scheme framed by the RBI. The provisions also discuss the central government notifying conditions for carry forward of tax losses, computation of income and certain other tax aspects. However, no notification has been issued by the central government to date.
With the above backdrop, the following issue merits consideration: If a foreign bank were to convert its branch into a subsidiary, would such conversion be taxable in the hands of the transferor foreign bank?
At the outset, the term conversion may be regarded as vague and may not be the most appropriate term as the process does not involve conversion from a legal perspective. The process involves, among others, the foreign bank setting-up a subsidiary in India followed by amalgamation of the Indian bank branch into the subsidiary upon receipt of necessary regulatory approvals.
Though the intent of the law appears to provide for an exemption for transfers in the context of bank branch subsidiarisation, could the provisions leave room for another interpretation?
Indian law provides for tax neutrality for various forms of mergers and acquisitions and in the relevant provisions the term amalgamation, which has a specific meaning, is frequently used. In the context of bank subsidiarisation, ideally to avoid ambiguities, the term conversion should have been defined to include any manner of succession of banking business from a branch to a subsidiary so long as it is in accordance within the regulatory framework.
In addition, the following points merit consideration:
Could transfer pricing provisions apply given that the transaction would be between a resident (subsidiary) and a non-resident (its parent)?
Could deeming provisions seeking to impute the fair market value in the context of transfer of immovable property apply?
Given the above, an interesting alternative argument that foreign banks can explore is whether the transfer can be regarded as a transfer from a company to its WOS.
To provide for tax neutrality in intra-group transfers, there is a general provision in the income-tax law (section 47(iv)) which stipulates that transfers from a company to its WOS will not be regarded as taxable transfers for income-tax purposes.
Considering the significant nature and impact of bank branch subsidiarisation transactions, it would only be fair for taxpayers to seek more clarity on some of the above issues before implementing the same.
Deductibility of head office expenditure
It is common for foreign bank branches to claim deduction for expenses incurred by the head office (HO). From an income tax law perspective, the deduction for 'executive and general administrative expenses' (HO expenses, in short) is restricted to 5% of the adjusted total income (section 44C). The intent behind capping the deduction was to resolve difficulties in scrutinising and verifying the claims in respect of such expenses. The claim for deduction of HO expenses has been the subject matter of litigation between the taxpayers and the tax authorities.
Some of the key aspects to be considered in this regard are:
General v specific expenditure
The disallowance provision refers to "so much of the expenditure in the nature of head office expenditure as is attributable to the business in India". In other words, an expenditure claimed by the branch could fall within the ambit of the disallowance provisions only if part of the expenditure pertains to business carried outside of India. Where expenditure incurred pertains wholly and exclusively to Indian operations of the branch, such expenses should, arguably, fall outside the ambit of HO expenses' disallowance. This position is supported by several court rulings.
Illustratively, bank branches have expenses such as salaries paid to expatriates deputed to India and technology related expenses, and so on, incurred by the HO for the Indian branch. Where such expenses are exclusively for Indian purposes and there is no element of allocation, one could contend that such expenses, being specific expenses, are not subject to the rigours of the disallowance of HO expenses.
If the HO is in a jurisdiction that has a Double Taxation Avoidance Agreement (DTAA) with India, the provisions of article 7 need to be examined. Where the DTAA provisions provide specific relief in this regard, they could prevail over the domestic law.
Is charge to profit and loss (P&L) necessary?
Tax treaties often provide that tax deduction of expenditure wherever incurred would be allowed to determine taxable income attributable to Indian branch/permanent establishment. Hence, clearly in the context of treaties, the place of incurring expenditure and charge to local profit and loss account is not necessary or relevant.
Some revenue officers challenge the tax deduction on account of absence of payment by, or charge to, local accounts of Indian branch. Courts have allowed deduction for HO expenses even where such expenses have not been debited to the P&L account of the branch.
Also, as per the Indian transfer pricing regulations, the cross charge of HO expenses would be regarded as an international transaction and would have to be at arm's-length. Few taxpayers have contended that as the provisions incorporate specific restrictions, transfer pricing provisions do not apply.
Interest on loans extended by HO /overseas branches to Indian borrowers
It is common for HO/other overseas branches of foreign banks to give foreign currency loans to Indian borrowers. Such loans are recorded in the books of the HO/overseas branches and the Indian bank branch may or may not be involved in the origination process.
When the borrowers pay interest on such loans, they typically withhold tax at applicable rates. Given that HO/other branches are not separate entities, tax on all such interest payouts is withheld using the permanent account number or tax ID of the overseas HO. With increasing computerisation, the data on taxes withheld is captured in the tax office's records. Interestingly, such interest income, although being subject to tax withholding was at times not disclosed in the income-tax returns in the past for sheer want of availability of information. With such data now available from the records of the tax office, taxpayers may be expected to compile and report such income. The revenue officers in certain cases have adjusted the bank's income where such interest income is not originally disclosed in their filings. This may not have any financial implications if the tax payable has been withheld by the Indian borrower. Also, banks that have exhausted the limit of 5% of adjusted total income for claiming deduction for HO expenses can explore claiming deduction on the enhanced adjusted total income after considering such interest income.
An interesting issue arises where the Indian bank branch is involved in the loan origination process. From the interest earned by the HO/overseas branches, following transfer pricing rules, the Indian bank branch is required to be compensated on an arm's-length basis for its origination effort. Given that such interest would be typically taxable on gross basis, offering the compensation allocated to the Indian branch to tax may effectively result in the same income being taxed twice. An aggressive taxpayer could, after adequate safeguards, challenge such an approach though the industry practice is to follow a conservative view.
Interest payments/receipts between HO/overseas branches and Indian branch
Where there are borrowing and lending activities between HO/overseas branches and the Indian branch, resulting in receipts/payments of interest (for want of a better word), a question arises whether such interest receipt by the HO/overseas branch is taxable in India and, vice versa, interest payout is tax deductible. Judicial precedents on this issue suggest interesting conclusions:
In ABN AMRO Bank NV vs. CIT  343 ITR 31 (Calcutta High Court), in the context of the India Netherlands DTAA, the court held that interest payment to the HO is an allowable deduction because the profits of the branch need to be computed as if it were a distinct and separate enterprise. However, in the context of taxability of such interest and withholding of tax thereon, in the case of Sumitomo Mitsui Banking Corporation vs. DDIT  56 SOT 390 (Mumbai Tribunal), it has been held that such interest cannot be taxed under the domestic law as it is a payment to self.
A discussion on Indian taxation is usually incomplete without a discussion on transfer pricing. In recent times, tax authorities have challenged the attribution made to the Indian bank branches in respect of their role in the offshore loan booking business. The Mumbai Tribunal has also adjudicated on the attribution to be made to the Indian bank branches for their role in such transactions. Besides the above, the tax authorities have also sought to make transfer pricing adjustments with respect to back-to-back derivative transactions entered into by the Indian bank branches with its HO / overseas branches and inter-branch lending and borrowings.
While taxpayers deal with their transfer pricing in these areas, they must plan to review their transfer pricing policies on a regular basis to ensure that they align with evolving market practices / business dynamics. Further, changing business structures such as subsidiary models (versus branch structures) will have a bearing where, for example, aspects such as the approach to allocate a return to capital deployed may play a role in the arm's-length pricing framework.
As a final point, in view of the introduction of stringent penalty provisions (of 2% of transaction values) on failure to report transactions, Indian bank branches may need to evaluate their existing reporting framework for voluminous transactions such as foreign exchange contracts, derivative trading, etcetera.
These are interesting times in India with a recent change in the government at the helm. While issues in taxation cannot be wished away, one can hope for a more taxpayer friendly tax administration.
Sunil Gidwani is an executive director with PwC in tax and regulatory services with a focus on financial services sector.
Sunil specialises in tax and regulatory matters affecting banks, non-banking financial companies, stock brokers, investment banks, asset management companies, mutual funds, sovereign funds and other institutional investors. He has advised clients on structuring investments into India, setting up Indian business presence and obtaining relevant regulatory approvals and advised on several transactions and financial service products from tax and regulatory perspective.
Sunil has delivered talks on the subject of domestic and international taxation at various forums and has contributed articles in various financial papers. He has authored a book on tax and regulatory issues affecting the entertainment industry published by the Bombay Chartered Accountants Society. He was recently awarded the Trivedi Prize by the Bombay Chartered Accountants' Society for his paper on taxation of BPO units.
He is a chartered accountant, company secretary and a law graduate, and has been in the profession for over 18 years. He passed CS examinations with a rank, and topped Mumbai University in the subject of taxation during LLB examinations.