In this blog post, Poonam Sharma, an Advocate in Bangalore and a student pursuing a Diploma in Entrepreneurship Administration and Business Laws from NUJS, Kolkata, analyses the taxation process imposed on an Indian resident starting a USA or Canada based business. 

 

 

Introduction

The Income Tax Act, 1961(“Act“) is the governing law for taxation in India. It provides the mechanism for taxation of a resident and for non-residents (i.e. on the income generated in India or accruing on behalf of a source that is in India). A resident has been defined under Section 6 of the Income Tax Act, 1961. A resident may be an individual or a company or a Hindu Undivided Family or any other person who has its control and management situated in India. The status of residency is important as it determines the taxable income of the person.

 

Resident’ Test

The Act provides for three categories of individuals, resident and ordinarily resident, resident and not ordinarily resident and non-resident. For an individual to be considered as a ‘resident’ the following criteria must be fulfilled:

The first test of mere residency, states that an individual shall be considered a “resident” first if he fulfills the following conditions[1]:

• He is in India in the previous year for 182 days or more; or
• He is in India for 60 days or more during the previous year and 365 days or more during four years immediately preceding the previous year.

However, the period of ’60 days’ as mentioned in clause (b) above shall be extended to a period of ‘182 days’ in cases of an Indian citizen or a Person of Indian Origin (PIO)[2] Who comes on a ‘visit’ to India during the previous year.

Along with satisfying the resident test, if such individual satisfies the following, he shall be considered a resident and ordinarily resident in India:

• He has been resident in India in at least 2 out of 10 previous years immediately preceding the relevant previous year; and
• He has been in India for 730 days or more during seven years immediately preceding the relevant previous year.

If such an individual does not satisfy any of the conditions under the resident test, he shall be considered to be a non-resident.

A company is said to be a resident in India if either of the following is satisfied by such company[3]:

• It is an Indian company;
• It’s place of effective management during the period of assessment is in India.

This change concerning place of effective management has been introduced by Finance Act, 2016. It has been explained to mean a place where key management and commercial decisions that are necessary for the conduct of a business of an entity as a whole are, in substance made.

To set up a business in the USA or Canada, an Indian resident may choose any of the very common options of either a corporation or a Limited Liability Company (“LLC”). One of the most important factors to setting up an entity in a foreign jurisdiction is the tax aspect. An Indian resident may consider setting up a sole proprietorship or a corporation, but such person must understand the tax implications of the type of entity to be able to make an efficient business investment.

Once a business has been incorporated in the USA or Canada, such an Indian resident will be taxed at the standard US corporate tax rates on income from US sources effectively connected with the business and a 30% rate on US source income not effectively connected with the business. This is considered on a case to case basis whether the income earned by an Indian resident abroad would be effectively connected or not.

While India has a system of levying taxes by residency, the US levies its taxes by the source of income. This could lead to multiple levies or taxes on a person and discourage it to undertake any business activity. Hence, to avoid multiple levies of tax on the same income, the Government of India (“Government”) has entered into international treaties with countries outside India to ensure there is no double taxation on the citizens. Such treaties that are entered into with other countries are referred to as Double Taxation Avoidance Agreements (“DTAA”).

 

Double Taxation Avoidance Agreements

DTAA is entered into by the Government for the allocation of fiscal jurisdiction and to avoid double taxation of the same income. Section 90 of the Act provides a benefit to the assessee by the applicability of DTAA and hence avoidance of double taxation implications. One such treaty is the DTAA signed between India and USA on September 12, 1989, and came into force on December 18, 1990[4] (“India-US DTAA”).

The DTAA categorizes income into different heads such as business income, capital gains, royalty, dividend, and a fee for included services, interest, and other income. This article will specifically cover only the heads about business.

• Article 7 of the India-US DTAA (Business Profits) states that the business profits of an enterprise are taxable in the state of residence, unless it carries on business in the other state through a permanent establishment (permanent establishment has been defined in detail, but it briefly means a fixed place of business through which the business of an enterprise is wholly or partly carried on). Profits may be taxed in the state of permanent establishment only to the extent attributable to:
  • that permanent establishment;
  • profits arising from the sale of goods or merchandise in the other state which are same or of a similar kind as those of the permanent establishment; or
  • arising from other business activities carried on in the other state which is same or similar kind as those in the permanent establishment.

Business profits have been defined to mean income derived from any trade or business including income from the furnishing of services other than included services as defined in Article 12 of India-USA DTAA (Royalties and Fees for Included Services) and including income from the rental of tangible personal property other than property described in paragraph 3(b) of Article 12 of India-USA DTAA (Royalties and Fees for Included Services).

• Article 10 of the India-US DTAA (Dividends) in this case, states that dividend paid by a company resident in the US to a resident in India may be taxed in India. But dividend has its specific tax rates subject to which the tax should be paid.
• Article 11 (Interest) states that interest arising in one state and paid to a resident of another state will be taxed in the latter state. In this case, interest arising in the US being paid to an Indian resident will be taxed in India.
• Article 12 (Royalties and Fees for Included Services) states that services are arising in one state and paid to a resident of the other state, may be taxed in that other state.
• Article 13 (Capital Gains) states that each state shall tax its capital gains as per its domestic law. There is a specific exception to this article made for Shipping and Air Transport.

The Government vides the DTAAs has attempted to provide relaxation to persons from the payment of tax on the same income multiple times. Although each country has a different DTAA entered into with India, the intention remains the same. This is also to encourage global business from within India. These are some of the most important heads under which an Indian resident can structure his tax or plan his taxes and profit from his business. The Government has also gone a step further to make it fair to the person in either of the states under a DTAA, that if he feels he is being taxed doubly, he/it may present his case to the competent authorities present in the resident country. This is beside the remedies such person has under domestic law. Such a claim or case must be presented within three years from the date of the notice of such taxation. The competent authorities of each state shall be after that attempt to resolve the dispute by agreement such that it results in the elimination of double taxation.

Therefore, an Indian resident starting a business in the USA or Canada must consider all factors, especially tax before he ventures into an unknown territory.

 

 

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References:

[1] Section 6(1), Income Tax Act, 1961.

[2] Explanation to Section 115C (e) provides that a person shall be deemed to be of Indian origin if he or either of his parents or any of his grand-parents, was born in undivided India.

[3] Section 6(3), Income Tax Act, 1961.

[4], Available at http://www.incometaxindia.gov.in/Pages/international-taxation/dtaa.aspx.