Saturday, March 5, 2011

LO vs. Branch vs. Subsidiary: Tax Implications

Typically, a foreign company can set up its presence in India in one of the following forms:

·  Liaison Office;
·  Branch Office;
·  Wholly-owned subsidiary

A Liaison Office is suitable for foreign companies that wish to set up a representative office in India to act as a facilitator between the parent/holding company and its operations/proposed markets within India while a branch office can be set up in India only to undertake certain specific activities. The activities of a wholly owned subsidiary in India are governed by the terms of the investment approval under the exchange control regulations of India and the provisions of the Companies Act, 1956 and other applicable Acts.

Liaison office

The setting up of a Liaison Office (“LO”) or branch in India by a foreign company is governed by the Foreign Exchange Management (Establishment in India of a Branch or Office or Other Place of Business) Regulations, 2000 notified by the Reserve Bank of India under Foreign Exchange Management Act, 1991 (FEMA).

However, The LO cannot have any income in India, and the expenses of the LO are required to be borne by the foreign company. Therefore, there would be no income tax implications for the LO in India.

Indian branch office

As per section 2(9) of the Indian Companies Act, 1956 (“Companies Act”), a branch office in relation to a company means:
·  any establishment described as a branch by the company; or
·  any establishment carrying on either the same or substantially the same activity as that carried out by the head office of the company; or
· any establishment engaged in any production, processing or manufacture.

As per section 9(1)(i) of the Indian Income Tax Act, 1961 (“ITA”), the business profits of a foreign company could be subject to tax in India at the rate of 42.23% if, there exists a “business connection” of the foreign company in India, to which such profits are attributable.

However, as per section 90(2), if there exists a double taxation avoidance agreement (“Treaty”) between India and the country in which the foreign company is resident, the provisions of the ITA would only apply to the extent that they are more beneficial to the taxpayer. As per many Indian Treaties, including the India-Singapore Treaty, the business profits of a foreign company are taxable in India, only if they are attributable to a permanent establishment (“PE”) of the foreign company in India.

PE is a narrower concept than “business connection”, however, a branch of a foreign company is considered to be a part of the foreign company, and is considered the PE of the foreign company in India. Branch profits are taxable at the rate of 42.23%[1]. However, India does not levy any branch profits tax.  Further, for transfer pricing purposes, the branch and the head office will be considered to be associated enterprises. Any transactions between the two entities will be required to be at arm’s length.

Indian subsidiary

·         A subsidiary of a foreign company is treated at par, in almost all respects, with a company having resident Indian shareholders. Establishing a subsidiary in India is generally preferable vis-à-vis setting up of a branch in India, as generally there is more flexibility in relation to the activities that can be carried on in India by a subsidiary.
·       The subsidiary could be incorporated under the Companies Act either as a private limited company or a public limited company.  We would advise you to incorporate the company as a private company rather than a public company primarily because under the Companies Act, a private limited company has to comply with fewer regulations and compliance requirements. Here it would be pertinent to note that if the Indian company is the subsidiary of a foreign public company then the Indian company would be deemed to be a public company. In such a situation, in order for the Indian company to be treated as a private company, the entire share capital of the Indian company should be held by corporate entities situated outside India.

A corporate tax rate is applicable to domestic Indian companies. A dividend distribution tax (“DDT”) is payable upon distribution of dividends to the shareholders. However, such dividend income is then tax exempt in the hands of the shareholders irrespective of their residential status. DDT is payable irrespective of whether the company making the distributions is otherwise chargeable to tax.

Further,  as per the Indian transfer-pricing regulations, the Indian subsidiary and the foreign parent would be considered “associated enterprises” and any transactions between them would be required to be conducted on an arm’s length basis.

The foreign company could make investments into the Indian subsidiary through an intermediate holding company set up in a favourable jurisdiction. India has a wide Treaty network and the judicious use of an appropriate offshore jurisdiction could result in benefits for the foreign company such as a reduced or nil rate of tax on capital gains income, reduction in withholding tax rates etc. The choice of an offshore entity would depend on the benefits available under the treaty between India and the offshore jurisdiction and the domestic tax laws of the offshore jurisdiction.