by Nick Farmer, International Tax Partner at Menzies LLP, and Saionton Basu, Co-Head India Group at Penningtons Solicitors LLP.
With a headline growth rate of almost 9% and a population of 1.2 billion, India is a truly dynamic marketplace. Whilst the economic rationale for doing business in or with India may be sound, entering new geographical markets is never easy, particularly one as challenging as India. There are several issues to take into account when considering investing into India.
Foreign Investment Framework
With respect to bringing foreign investment into India, the Foreign Direct Investment Policy (FDI Policy) provides for two routes:
•The automatic route (where no prior Government approval is required)
•The approval route (where prior Government approval is required), which inter-alia depends on the sector in which foreign investment is sought to be brought in.
The FDI Policy also outlines the sectoral limits, which cap the amount of foreign investment in certain specific sectors like telecommunications, insurance etc. However, several sectors in India are now free for 100% foreign investment.
This removes the need to have a local partner for purely regulatory reasons, but economic and logistical reasons still remain for such an alliance. In addition, there are exchange control regulations, which regulate the price at which shares in an Indian company can be acquired by a foreign investor.
Business Entity Formation
A number of alternative structures can be adopted for carrying out business activities in India. These include:
• Liaison / representative office;
• Branch office;
• Limited Liability Partnership;
• Subsidiary company, being either a public limited company or a private limited company.
The type of office that is appropriate will depend on the nature of the activities being carried out. In most circumstances, prior approval for the office is required from the Reserve Bank of India (RBI). An office has the advantages of being easier to close down, although branch offices are subject to strict exchange control guidelines and do have unlimited liability so may not be appropriate in all circumstances.
Companies provide greater flexibility of operations and benefit from limited liability. The decision as to the type of company to choose will be based on the on-going compliance requirements, which are slightly more onerous for a public limited company, and the end objectives of the entity. By way of illustration, a private limited company is not permitted to raise additional monetary resources from members of the public. In the event that a foreign investor establishes an entity in India only for the purpose of making downstream investments in the country, any foreign investment in such holding company would require prior approval of the Government.
Having set out the foreign investment regime, it is still by no means easy for foreign investors. Often, strong local domain expertise will be needed for a foreign investor to penetrate several market segments, and accordingly a joint venture is often a recommended business tool for market entry. Although several joint ventures have ended in tears, others have stood the test of time and have become case studies for cultural integration. For example, the Maruti-Suzuki joint venture brought the first rush of Japanese technology for the Indian automobile segment.
Due Diligence and Entity Selection
Prior to embarking on a joint venture arrangement, a thorough due diligence exercise on legal, tax and accounting fronts is essential. This allows the parties to identify and understand the issues and risks associated with a joint venture and to be better prepared to exploit the opportunities. Existing Indian companies can bring their own baggage of liabilities and most investors prefer to incorporate a new limited liability company to serve as the joint venture vehicle. The business vehicle used for the joint venture will depend on the benefits and drawbacks of each type of entity, and the local laws, tax and commercial environment in which they operate.
The taxation environment in India is complex and should be assessed at an early stage, particularly in view of the proposed Direct Taxes Code. Due to come into force in April 2012, this will introduce the General Anti-Avoidance Rules and the provisions regarding Controlled Foreign Corporations. Local advice must be sought, and the complexity of the regime and the myriad of taxes are well illustrated by the fact that India ranked 164 out of 183 economies in the paying taxes section of the World Bank Doing Business guide in 2011.
In terms of tax rates, it can be expected that the rate of income tax for branches and companies in India will be higher than in the UK. A branch will suffer an effective tax rate of just over 42%, whereas an Indian company will have an effective tax rate in excess of 33%. However, further tax in the form of a Dividend Distribution Tax (DDT), at an effective rate of 16.6%, will arise when a company distributes its profits back to the UK. This tax structure suggests that a company would be the preferable business vehicle where profits are going to be reinvested in India.
A UK company will be subject to Indian income tax if it has a permanent establishment in India, in accordance with the UK-India double taxation agreement. Included within the treaty is a “service permanent establishment”, which can arise if a UK company carries out services in India for more than 90 days in any 12-month period. UK companies need to be wary of this test and carefully monitor the day count for employees or sub-contractors working in India.
It is also very important to recognize that non-resident companies may still be subject to withholding tax in India, even if they do not have a permanent establishment. For instance, the payment of an invoice for technical services could give rise to a domestic withholding tax being applied in India of 20%. This is a significant issue that UK companies need to focus on, as it can affect not only cash flow but also add a true tax cost to doing business in India.
Withholding taxes can be reduced under the UK-India double taxation agreement, although a Permanent Account Number (PAN), a tax registration number in India, is required to claim these reduced rates. Where a UK company is undertaking business in India, or even with an Indian customer from outside India, consideration should be given to applying for a PAN in order to minimise any withholding tax suffered in India. For instance, where a UK company has a PAN in India, the withholding tax on technical service fees would reduce to 10%. It is important from a UK perspective to minimise the overseas tax suffered, as this is a requirement when double taxation relief is claimed in the UK.
Various tax concessions and tax holidays are available in India, and these should be reviewed when investing into India. However India also has a Minimum Alternative Tax (MAT), which applies to book profits at an effective rate in excess of 19% where the income tax payable is less than this minimum amount.
When entering a new market, it is important to have in mind a suitable exit strategy. This may be particularly relevant with joint venture arrangements in case things were to go awry. Certain exit options commonly used in the Western world such as put options are of dubious enforceability in India, though most joint venture agreements in India still retain them.
It should also be appreciated that Indian tax can arise on the sale of shares in an Indian subsidiary. This has been highlighted in the Vodafone case, which has added a new perspective to the taxability of such transactions. The issues regarding withholding tax on capital gains, royalty payments and tax treaties with the respective countries to avoid double taxation should also be given due consideration when structuring investment into India.
Many more UK companies are looking eastward when seeking out new markets for their business. India offers a rich diversity and huge potential, especially for UK service businesses, which are highly regarded in this part of the world. There are undoubtedly traps for the unwary, but India certainly has a compelling attraction from which a well-advised company can reap its reward.