New Indian tax rules: Watch out for implications of Significant Economic Presence

Since 2021, the Organization for Economic Co-operation and Development (OECD) has been tackling tax evasion globally by companies -who shift their profits to low-tax jurisdictions. This so-called BEPS (Base Erosion and Profit Shifting) project focuses specifically on tax challenges of the new, digital economy. India has incorporated the measures from BEPS into its tax code, which may affect your company if you do business in India. 

The key concept that India has adopted from the BEPS project is "Significant Economic Presence" (SEP). We explain the implications of this addition for Indian tax law in this article. 

Significant Economic Presence (SEP).

Significant Economic Presence means that tax should be levied if a company has significant involvement in the market where it will pay the tax, even if it has no physical presence in the country. Under current law, a foreign company in India constitutes an SEP if:

• it enters into a transaction involving goods, services or property with a legal entity in India, including downloading data or software, and the total payments resulting from such transaction(s) exceed 20 million rupees (220,000 euros) in the previous year.

or

• it engages in continuous business recruitment or is in contact with at least 300,000 users.

The implications of SEP for foreign companies in India

The idea behind the SEP provision is to ensure that no one who makes profits in a country avoids taxation there and that all players are valued the same way. Despite the OECD's regulatory focus on the digital economy, the current implementation of SEP in India has a broad scope. Indeed, it covers all transactions involving goods, services or property conducted by foreign companies with a legal entity in India, whether online or offline.  

The SEP has been implemented in a very broad sense in India, with the result that even foreign companies that have no entity in India are already considered SEP by their activities. For example, the one-time export of goods to India by a foreign company, which is not otherwise active in India, can already trigger the SEP provision if it exceeds 20 million rupees (€220,000). 

Thus, Indian law looks at both the regularity with which you as a foreign company operate in India and the income involved. Once the provision takes effect, the foreign company must keep accounts, undergo audits, pay taxes and file tax returns in India.

SEP and the European tax treaties with India

Companies with operations in India that are located in countries with which India has a tax treaty will obviously not be double valued because they are classified as SEP. Indian laws also dictate that for foreign companies, the most favorable provisions of either the Indian tax code or the tax treaty will govern. 

India's tax treaties with Europe do not use the term SEP but the term Permanent Establishment, which has a narrower scope. As long as foreign companies can prove that they do not have a "permanent establishment" in India, they remain outside the scope of the SEP provisions. For this, however, the company must be able to provide documentation, including a certificate of tax residency, a statement that they do not have a 'permanent establishment' and Form 10F.

However, the SEP provisions will always apply to companies coming from countries that do not have a tax treaty with India (all European Union member states have a tax treaty with India). For companies from these countries, it is important to constantly check whether the transactions trigger the SEP provisions. 

Everything you need to know about the tax side of doing business in India

SEP and Permanent Establishment are not the only insidious, tax issues European companies encounter in India. IndiaConnected has been active in India for ten years and annually helps hundreds of companies with their questions about the Indian tax system and other tax issues. To help companies get started, we have therefore compiled all our knowledge and tips into a free guide for CFOs with operations in India.

Everything you need to know as a CFO about: The Indian Tax System

The Indian tax system is often a headache for foreign CFOs with offices in the country. Nevertheless, the Indian tax system has undergone significant reforms in recent years and the paying taxes has become has become a lot clearer and easier. Here is what every foreign CFO should know about the Indian tax system.

Direct and indirect taxes

There are two types of taxes in India: direct taxes and indirect taxes. Direct taxes are levied on the income earned by companies or individuals in a financial year. The income tax paid by individual taxpayers is the Personal Income Tax (PIT). Individuals are taxed based on tax brackets at different rates. The income tax paid by domestic companies and foreign companies on their income in India is the Corporate Income Tax (CIT). The CIT has a specific rate as stipulated in the Indian Income Tax Act.

As the name suggests, indirect tax is not imposed directly on the taxpayer. Instead, this tax is levied on goods and services. Some examples of indirect taxes in India are the Central Excise and Customs Duty, and Value Added Tax (VAT). One of the most important indirect taxes is the Goods and Services Tax (GST), read all about it here.

Corporate Income Tax

In India, both domestic and foreign companies have to pay corporate income tax. According to the Indian Income Tax Act, you are a domestic company if you have a registered office or head office in India. A subsidiary company also falls under this category. You will be assessed as a foreign company if you have a branch office, project office or permanent establishment in India. While a domestic company is taxed on its universal income in India, a foreign company is taxed only on the income made in India. This sounds more advantageous, but it is not always the case. 

Corporate Income Tax - Domestic Enterprises

The rate of Corporate Income Tax (CIT) applicable to a domestic company for the financial year 2020-21 is as follows: 

Articles 115BAA and 115BAB

In September 2019, the Government of India added a new section, 115BAA, to the existing Income Tax Act, 1961. This section offers domestic companies a reduced corporate tax rate from the 2019-2020 financial year (AY 2020-21) onwards, if these domestic companies meet certain conditions. The tax rate will then no longer be 25 or 30 per cent, but 22 per cent. 

What are the terms of Articles 115BAA and 115BAB?

Firstly, domestic companies must not already be using other exemptions or incentives to qualify for deduction under 115BAA. Therefore, the total income of such companies must be calculated without: 

• Claiming any deduction specifically available to units located in special economic zones (Section 10AA).

• Request for additional depreciation under Article 32

• Allowance for investments in new plants and machinery in designated backward areas of the States of Andhra, Pradesh, Bihar, Telangana and West Bengal under Article 32 AD. 

• Deduction under Article 33AB for tea, coffee and rubber factories.

• Claiming deductions under Section 33ABA for deposits made into land rehabilitation funds by companies engaged in the extraction or production of petroleum, natural gas or both in India.

• Applying for Article 35 deductions for scientific research.

• Claiming deductions for the capital expenditure of specific farms under Section 35 of the Agriculture Act.

• Article 35CCC - Expenditure on agricultural information projects.

• Article 35CCD - Expenditure on a skills development project.

• Claims for deduction under Chapter VI-A (80IA, 80IAB, 80IAC, 80IB, etc.) are not allowed, but deduction under Section 80JJAA is exempted. Section 80JJAA allows an employer to claim part of the salary of new employees through tax. 

• Claiming set-off of any losses carried forward from previous years, if such losses were incurred in relation to the above deductions. 

The conditions for 115BAB are:

• The company was incorporated and registered after 1 October 2019. 

• Production starts before 1 April 2023

• The company shall be engaged in the manufacture or production of any article or product, and/or research relating to such product. The company may also engage in the distribution of the article or product produced by them. 

• The company may not invoke this condition if it is formed by splitting or reconstructing a pre-existing company within the meaning of Article 33B.

• The company cannot apply this condition if it is using a plant or machinery which has been used for any purpose previously. Used imported machinery is allowed if such machinery has never been installed in India and depreciation of such machinery has never been claimed in India.  

Please note!

It is extremely important that companies are certain that they will be better off by opting for the lower tax rate of 115BAA before they actually take that step, because once a company takes advantage of the reduction, it must be continued in subsequent tax years. Since there is no time limit in which the option under section 115BAA can be exercised, it is better to take your time and find out how much benefit other exemptions and incentives can bring to the company. Subsequently, 115BAA can always be opted for, but note that once it is exercised, it must be continued.

Corporate Income Tax - Foreign Corporations

As explained earlier, if you have a branch office, project office or permanent establishment in India, you will be taxed as a foreign company. While a domestic company is taxed on its universal income in India, a foreign company is taxed only on the income earned in India.

The rate of Corporate Income Tax (CIT) applicable to a foreign company for the financial year 2020-21 is as follows: 

These tariffs are higher than the tariffs for domestic companies and you, as a foreign company, cannot claim tariff reductions like the 115BAA either. If you are just starting out in India and your turnover is still low, these high tariffs are manageable. But once you start growing, it is advisable to set up your own entity in India so that you can take advantage of the favourable tax rates for domestic companies. 

Filing your income tax return

Normally, all companies, including foreign companies, must file their income tax returns on or before 30 October each year. Even if the company is incorporated in the same financial year, income tax returns must be filed for the period before 30 October. In addition, companies that have a turnover, profit or gross receipts of more than INR 10 million or about EUR 110,000 are required to have an audit carried out. This audit report must be submitted to the Indian Tax Department along with the income tax return. The audit report should be submitted annually by September 30, if the rule is applicable to your company.

A guide for CFOs in India

Doing business in India can be challenging, especially because the government processes require a lot of time and energy. That is why consultancy firm IndiaConnected wants to offer you insight into the fiscal and financial system every CFO in India has to deal with. From obtaining all necessary documents for your first export from the Netherlands to taking care of the entire back-office of your Indian entity, so you can always fully focus on your activities in India.

Limburg SME in India: in five years from start to successful exit

Building a company and selling it successfully in just five years: few foreign companies in India manage to do that. Geert Litjens, CFO of Syntech International in Limburg, looks back on the sale of subsidiary Logicash. 

LogiCash's transport vehicles in Mumbai (Photo: LogiCash)

Logicash is a prime example of a successful Dutch company in India. The money management and transport company that opened its doors in 2012 managed to grow into a top 3 player in India within five years. In February 2017, the company had 15,000 ATMs under management and four thousand employees. In recent years, the company benefited from the Indian government's desire to greatly expand the number of ATMs. In a 2015 interview with IndiaConnected, CFO Geert Litjens explains that Logicash's explosive growth is only hindered by a lack of growth capital. Dutch banks don't dare - only government fund Dutch Good Growth Fund wants to finance Logicash's growth. The conditions, however, are anything but favorable. Not only is the financing expensive, the Dutch parent company must also guarantee the loan.

That unfavorable financing was ultimately one of the reasons for selling Logicash early, Litjens now explains. "The company was running well, but a large part of the profits went to our financiers. We were left with relatively little. On top of that, the Indian subsidiary became very large in relation to our activities in the Netherlands."

The Indian subsidiary did become very large in relation to our activities in the Netherlands.

In addition, there was another reason to sell Logicash. The previous Indian government's mission to rapidly expand the number of ATMs was given less priority under the Modi government. "Modi actually wants Indians to pay less cash and more digitally," Litjens says. "For the middle class in the big cities, that is indeed an option, but for most of the country, that is not at all realistic." To accelerate that shift from cash to digital payments, Modi made his infamous demonetization decision on November 8. All 500 and 1000 rupee bills were withdrawn from circulation in one fell swoop. That first week, Logicash was very busy, but in the months that followed, the money supply stalled. "We had to work in total chaos," Syntech International top executive Pierre Hermans previously told FD about this. 

Syntech International CFO Geert Litjens (photo: Syntech International)

At the time, talks on the sale of Logicash were already in full swing. The buyer, Mumbai-based Nisa Security, had known Litjens for some time. "Nisa employs more than 50 thousand guards who secure banks and ATMs throughout India, among other things. They have the same customer base as Logicash and were keen to expand their services." At first Litjens had a good impression of the company, but over time it became apparent that the company was inexperienced in the area of acquisitions. "We have a lot of experience with acquisitions and had a good Indian lawyer and tax advisor on our side - an absolute must - but the professionalism on their side was disappointing. For example, the company had no real CFO. In many Indian SMEs, the most senior financial man is the accountant. As a result, there were many misunderstandings and the process took forever. Moreover, Nisa wanted to negotiate every detail. On February 9, 2017, it was finally done. After 21 months."

The official transfer was also a lot more complex than Litjens is used to in the Netherlands. "Here you go to the notary and after an hour you're outside again. In India, there is no notary. There you spend a whole day with lawyers and banks from both parties going through all the steps. But at the end of the day, the purchase price is on its way to your bank account in the Netherlands." 

We are certainly not leaving India.

Litjens has two tips for Dutch people who want to sell their business in India. "In India you pay tax on the profit from the sale of your shares. Thanks to the tax treaty between the Netherlands and India, you are entitled to a lower tax assessment, but you do need a certificate from the Indian tax authorities. You must apply for this certificate in good time. In addition, you must agree in advance with your bank on the rate at which the exchange rate the acquisition price will be transferred. That can save a lot of money."

LogiCash employee refills ATM machine in India (photo: LogiCash

Ultimately, Logicash has been a nice investment for Syntech international. "We made a reasonable profit from the sale. Still, we didn't make as big a hit as we thought at one point because the Indian government didn't follow through on its plans to expand the number of ATMs in smaller cities and rural areas." The DGGF was very pleased with this project, Litjens states. "With Logicash, we created four thousand jobs in India, we contributed to knowledge transfer, the entire investment was returned, and the fund also made a good profit. For good reason, they would have liked us to remain the owner even longer."

After the sale of Logicash, Syntech International is still active in India with two other companies. Moreover, it is already working on another Indian venture. Litjens: "We have adjusted our strategy. Syntech has become big with machines that destroy banknotes. At first we wanted to generate more business from the money cycle, but now we are back to our roots: building machines. In the Netherlands we focus on machines for the circular economy, recycling machines for example. We are now investigating whether we can market these Dutch solutions in India - with an Indian sauce, of course. No, we are certainly not leaving India."