How to set up a German company in India

German taxpayers need to make a number of considerations before investing

Over the last couple of years India has witnessed significant foreign direct investment amongst various sectors of the industry. We have witnessed many German companies setting up shop in India. There are various tax, legal and regulatory aspects to be considered from an Indian and German perspective before investing in India.

The investing company, depending upon the choice of the entity, can undertake manufacturing trading or service activity subject to the regulatory requirements

There are various forms of operation in India:

A German parent wanting to establish a WOS may set up a company as a private limited company.

A German parent can set up their operations in India by forging strategic alliances with Indian partners to invest in sectors where 100% FDI is not permitted.

German companies may open a BO in India for the purpose of undertaking export and import of goods, rendering professional or consultancy services etc

Prior permission from the Reserve Bank of India (RBI) is necessary to set up a BO in India. However, the branch cannot carry out any manufacturing operations and retail trading.

The PO is ideal, if the objective is to have a presence for a limited period of time such as for turnkey projects. To establish a PO, general permission is granted by the RBI subject to specified conditions.

Prior permission from the RBI is necessary to set up a LO in India. A LO acts as a communication channel between the parent and the Indian customers and cannot undertake any commercial activity to earn profit. It is required to meet its expenses out of inward remittance from parent company through normal banking channels.

LLP has been allowed in India since April 2009. At present FDI is not allowed in an LLP. A cabinet note has been circulated in March 2011 to allow FDI in LLPs. It is believed that the sector specific rules for FDI will also apply to LLPs and would benefit sectors like manufacturing, IT, hospitality and consultancy.

The capital structure of a company is combination of equity (equity shares with/without voting rights or preference shares) and debt from the parent depending upon the regulatory, tax and legal factors. Debt financing is often restricted by Indian regulation and excludes therefore this standard option for German investors in more cases than one would expect.

If a German entity wants to shift its functions out of Germany then the German entity is liable to exit taxation based on the market value of the function transferred (transfer package). This unique German exit taxation only applies to the transfer of a function by a German entity to a related party abroad. A company is related to another company overseas if (i) it directly or indirectly holds at least 25% of the other company (Indian company), (ii) at least 25% of its shares are directly or indirectly held by the other company (Indian company), or (iii) it exercises a dominant influence on, or is subject to a dominant influence of, the other company (Indian company). Few options are available of avoiding or minimising the exit tax, but it requires proper planning and transfer pricing documentation in detail in Germany.

Hence, for a German entity, one has to bear in mind the cost of exit taxation and/or of planning and documentation efforts while taking a decision of investing in the Indian company.

FDI is allowed under an automatic route in major sectors including the services sector, except in some sectors where FDI is permitted up to certain limits subject to approvals and in some sectors FDI is not permitted.

Foreign investment in shares in any industry up to 100% is permitted, except the following:

• Proposals that require an industrial license

• Investment is more than 24% in the equity capital if the manufacturing items are reserved for the SSI.

• Proposals in which the foreign collaborator has a previous venture/tie-up in India.

• Proposals relating to acquisition of shares in an existing Indian company in favour of a foreign/non-resident Indian investor;

• Proposals falling outside notified sectoral policy/caps or under sectors in which FDI is not permitted.

• Proposed investments that do not qualify for automatic approval must be submitted to the FIPB such as courier services, cigar and cigarettes manufacturing etc.

A German parent can incorporate a company as a private company, under the Companies Act 1956, even though the German parent is a public company under the German laws. A private limited company is one which restricts: (a) the right of the share holders to transfer the shares; (b) the number of shareholders to less than 50, (c) making an invitation to the public to subscribe for shares or debentures of the company: and (d) the acceptance of deposits from the public except from its members, directors and their relatives.

The levy of taxes is monitored by the central government/state government.

A WOS or JV is liable to pay tax at a rate of 32.445%. A foreign company which is operating in India (as BO/ PO or having a permanent Eestablishment (PE) in India is taxed on the income at 42.024%. A foreign company is said to have a PE in India if it is carrying on activities in India and its presence in India through employees or others exceeds the threshold limit laid down under the treaty.The tax year is from April1 to March 31.

If the tax payable under normal provisions is less than MAT it is supposed to pay tax under MAT. Presently, MAT is 20.0078% on the book profits of a company. However, while computing book profits under MAT certain profits are excluded. The tax paid under MAT is allowed as credit against future tax payable.

Every company declaring, distributing or paying dividend to its shareholders has to pay DDT at 16.2225% and exempt for the shareholders. In case of a LLP there should not be any such tax, which would bring down the tax rate significantly for German FDI.

Tax incentives are provided for establishing new industries, encouraging investments in undeveloped areas, infrastructure, promoting exports, etc.

• Tax holidays for manufacturing in north eastern states started before March 31 2017, EOU units (upto FY 2011-12), commercial production or refining of mineral oil setup before March 31 2012 etc.

• Weighted deductions for expenditure incurred on R&D activities;

• Accelerated depreciation for energy saving, environmental protection and pollution control equipment.

• For developers in special economic zones (SEZ) and for units set up in SEZ tax deduction is available at 100% for the first five years; 50% for the next five years; 50% for the next five years subject to the creation of SEZ re-investment allowance reserve.

• Non-resident companies engaged in certain businesses (such as prospecting for, extraction or production of mineral oils, civil construction, operating ships and aircraft, etc) are taxed on presumptive basis.

• Investment-linked incentives for setting up cold chain facilities, warehousing and laying and operating cross-country natural gas or crude or petroleum oil pipeline networks for distribution.

The Indian transfer pricing provisions are generally in line with the OECD guidelines with some differences such as a wider definition of the term associated enterprise (AE); and the concept of arithmetical mean as opposed to internationally followed statistical measures of median/arm's-length range. The regulations also prescribe rigorous mandatory documentation requirements and impose steep penalties for non-compliance. The Indian transfer pricing regulations require arm's-length price to be determined by adopting the most appropriate method out of following:

• Comparable uncontrolled price (CUP) method

• Resale price method (RPM)

• Cost plus method (CPM)

• Profit split method (PSM)

• Transactional net margin method (TNMM).

In practice, the authorities do attempt to use traditional methods such as CUP, TNMM and CPM, before accepting a profit-based approach. The burden of proving that the international transactions comply with the arm's-length price lies with the taxpayer.

It is mandatory to obtain an accountant's certificate in form no 3CEB for all international transactions between AE and has to file the same by September 30 for non-corporate and November 30 for corporates.

The indirect tax in India consists of various central level taxes like customs duty, excise duty, service tax, central sales tax (CST) and various other state level taxes like value added tax (VAT) etc.

Excise duty is tax levied on production of goods and liability to discharge the same arises on consumption or removal of goods from the factory.

Service tax is a tax levied on provider of service In the case of import of services, the importer is liable to tax in India, rather than overseas service provider under the reverse charge mechanism.

Customs duty is applicable on import of goods/products into Indian territories. The same is chargeable in the hands of Indian Importer.

CST is a tax which is levied on sale of goods originating from one state and sold in another state.

Octroi/entry tax are taxes imposed by jurisdictional state government on entry of specified goods for consumption or sale into the territory of the respective state. The rate of entry tax varies from jurisdiction of one local authority to other local authority.

VAT is a tax which is levied on sale of goods within the same state and the seller is under obligation to charge VAT and collect the same from the buyer.

Expatriate employees are taxable in India if resident in India under the tax act. Under the treaty, expatriates income will be taxed in India only if the employment is exercised in India and his/her stay in India exceeds 182 days in a financial year or such remuneration is borne by employer in India.

Many expats are protected under the tax equalisation policy of their home country. Under this policy, the expat is protected from the incremental tax liability arising by working in the host country than the home country. The amount of tax borne by the employer would be characterised as perquisite under the tax act and salary would have to be grossed up. In case, the expat keeps the German tax residency, full taxation of remuneration in India needs to be shown to the German tax authorities. Otherwise, any (part of) income not taxed in India would not be tax exempt, but subject to German income tax.

India has entered into a social security agreement (SSA) with Germany and employees on an assignment up to 48 months with an extension of 12 months are exempt from social security contribution in India provided they filed an application staying covered by German rules and continue to make social security contribution in Germany.

India has a comprehensive tax treaty network in force with 76 countries and has also entered into 13 tax information exchange agreements with 13 territories.

The India-Germany treaty provides for tax exemption and credit method of eliminating double taxation and allows tax credit in respect of taxes paid, unless the tax exemption applies (such as for business, entrepreneur and employment income).

Appropriate planning in respect of a holding company jurisdiction is necessary to minimise Indian withholding tax and Indian capital gains tax on sale of shares of Indian companies.

The preferred holding company location is dependent not only on numerous tax and non-tax factors but also on attributes of the subsidiary jurisdiction as well. Thus, the holding company location must be analysed taking into account the India domestic law and treaty network. The main sources of income which the parent/holding company can earn from its Indian subsidiary are dividend, interest, capital gains, royalty, FTS, management fees etc.

German taxes can be deferred on the profits from the investments in India through the use of a holding company located in an appropriate jurisdiction. Key factors to be considered while selecting an appropriate holding company jurisdiction are:

• Tax regime: Preferred holding company jurisdictions either follow a participation exemption or a tax credit regime; Further, transaction costs like stamp duty on issue or transfer of shares, thin capitalisation rules norms which govern interest deductibility, ability to carry forward interest costs for set-off against future taxable income, etc.

• Tax treaty network: A good tax treaty network is essential to optimise on withholding tax incidence on dividend and capital gains tax originating from India.

• Economic and political stability

• Regulatory environment: A liberal regulatory environment in the holding company jurisdiction is essential.

• Financial environment: Flexibility in raising funds is of importance for the taxpayer. The financial environment in the holding company jurisdiction should be sound so as to enable fund raising.

Various types of audits to be undertaken:

• Statutory audit under the Indian Companies Act 1956.

• Tax audit under the Income Tax Act 1961.

• VAT audit under the respective state act.

Taxation:

• Filing tax return.

• Paying advance tax.

• Withholding taxes on payments to vendors and filing E-TDS returns.

Indirect tax:

• VAT/CST Act.

• Service tax.

• Excise duty.

Labour laws:

• Provident fund.

• Profession tax.

• Other labour laws.

Exchange control regulations:

• Filing various returns with the RBI.

Company law compliances:

• Filing various returns with the ROC.

A winding up of a company can be either by the court or voluntary. It is observed that winding up by the tribunal it takes at least three years and for voluntary winding about 18-24 months. The assets of the company are sold and capital gains tax on such sale of assets will be liability of the company. The excess of assets over liabilities will be paid off to the contributors (shareholders) on pro-rata basis.

The transfer of shares from non-resident to resident and vice-versa should be valued in accordance with the DCF method. The same is however liable for capital gains.

A foreign investor should be looking at the following before deciding to invest in India or set up shop in India:

• Whether the project is FDI compliant.

• Understand the regulatory framework before investing.

• Decision on choice of the entity.

• Choose the banker.

• Beware of all local registrations which the business has to do.

• Finalise the location of the business.

• Freeze the real estate options.

• Identify a good recruiter.

• Identify authentic suppliers.

• Select and appropriate accountants, tax advisers, lawyers and consultants.