The Chartered Accountant Journal • International Taxation Vol. 69 | No. 2 | August 2020 | Pages 87–91 (Journal pp. 235–239)

Indian Subsidiary Company Abroad: What You Need To Know

By CA. Rudri Mehta  |  (rudripma@gmail.com • eboard@icai.in)

Understanding Compliance Requirements from the Legal, Tax and Accounting Viewpoints

The US-based thinktank, World Population Review reported India as the fifth largest Economy in 2019. This may attract more foreign investors to invest in India and we have witnessed this when more than US$15 billion flooded into the Reliance-Jio. On the other hand, when an Indian Company invests or plans to set up a subsidiary company outside India, what are the compliances and consequences that one needs to be mindful of requires a detailed study from legal, tax and accounting point of view. Here in this article, I am going to discuss the consequences of forming a subsidiary company of an Indian Holding Company outside India from these perspectives.

Company Law Perspective

Defining a Holding Company and a Subsidiary Company

The Companies Act, 2013 (“Act”) provides a definition of the terms ‘holding company’ and ‘subsidiary company’. The Act defines holding company as a company that is in relation to one or more other companies, means a company of which such companies are subsidiary companies.

Section 2(87) of the Act defines a subsidiary of a holding company as a company in reference to any other company (that is to mention the holding company), means a company in which the holding company controls the composition of the Board of Directors or exercises or controls1 more than one-half of the total voting power either at its own or alongside one or more of its subsidiary companies provided that such class or classes of holding companies as may be prescribed shall not have layers of subsidiaries beyond such numbers as may be prescribed.

The act also provides an explanation to this definition as a company shall be deemed to be a subsidiary company of the holding company even if the control is of another subsidiary company of the holding company. It further explains the composition of a company’s Board of Directors is deemed to be controlled by another company if that other company by exercise of some power exercisable by it at its discretion is able to appoint or remove all or a majority of the directors.

1 Control is defined under The Companies Act, 2013 as a term that includes the right to appoint majority of the directors or to control the management or policy decisions exercisable by a person or persons acting individually or in concert, directly or indirectly, including by virtue of their shareholding or management rights or shareholder agreements or voting agreements or in any other manner.

Overview of Foreign Direct Investment - FEMA2

The most adopted argument by companies is that the holding company provides financial assistance to the subsidiary. The question arises of whether such assistance to be considered as Overseas Direct Investment. The overseas investments in Wholly Owned Subsidiary and Joint Ventures are recognized as key strategies for promoting global business. However, there are certain restrictions such as investing in a foreign company which is engaged in real estate or banking business, offering financial products linked to Indian Rupee should be done with prior approval of RBI. There are other restrictive conditions too related to such direct investments.

Such Direct Investment requires compliance to FEMA rules and notifications and circulars issued by RBI from time to time. Certain investments are allowed to be made directly without prior approval while certain other transactions are allowed only with prior approval of RBI which should be considered carefully so as to verify whether any transaction is not falling under the prohibited category of transactions.

2 FEMA stands for Foreign Exchange Management Act, 1999. It is a regulatory system which allows RBI to pass regulations and the Central Government to pass rules relating to foreign exchange in line with the Foreign Trade Policy of India.

Modes of Financial Assistance provided to Subsidiary Companies abroad

  • • Interest-Free Loans: When an Indian Holding Company provides financial assistance to its subsidiary company outside India in the form of a Loan, it often tends to provide the loan free of cost.
  • • Equity Shares: Naturally, majority or wholly, equity shares of a subsidiary company outside India is held by the Indian Parent Company and hence such financial assistance is very common.
  • • Guarantees: One of the ways to provide financial assistance can be by way of Corporate or Personal Guarantees. On the other hand, the apex court held in one of the decisions3 that colourable and dubious instruments cannot be considered as part of legitimate tax planning. Hence, if such financial assistance is provided to the subsidiary which is colourable in nature to avoid the payment of tax by restoring to dubious methods will not be supported by law.
  • • Other Modes: Apart from the above, there are swap of shares, capitalization of exports, the balance held in EEFC4 account of the Indian party, etc.

3 CTO v. McDowell and Co. Ltd.

4 EEFC is type of a current account that holds foreign currency of authorized foreign exchange dealers and has no interest rate. FEMA allows only Authorized Dealers to have EEFC account.

OECD Guidelines, 1995

These guidelines substantiate the argument of providing commercial assistance to its subsidiary company to a larger extent as a ‘shareholder’s activity’. It should be noted that OECD Guidelines, 1995 are only the recommendations and the multinational enterprises are thus obliged to follow and comply with the domestic rules and regulations.

Tax Perspectives

The taxation part of this situation is what requires a thorough study of various provisions that will be posing restrictions, relaxations, compliance requirements, disclosures or so. After the implementation of the POEM (Place of Effective Management), the tax residency status of a company has to be carefully determined. Similarly, to restrict the motive of tax evasion, GAAR (General Anti-Avoidance Rules) have been made applicable from the A.Y. 2018-19. For the international transactions between parent and subsidiary companies, Transfer Pricing Rules should be referred. The Advanced Pricing Agreement (APA) takes care of the methodology to be followed for transfer pricing that is decided in advance between the two countries to avoid any misconception and confusion.

Applicability of The Place of Effective Management (POEM)

The concept of POEM has been introduced in the Finance Bill, 2015 that suggests that the company will be resident in India if its place of effective management is in India in that year. This means that if for any foreign company if its place of effective management was in India in the year under consideration then that company will be considered a resident and its tax treatment shall be similar to any other resident company in India. The POEM is explained in the bill as a place where key management and commercial decisions are made which are necessary to conduct the business of the entity as a whole. There has been a clarification provided by the CBDT Circular5 that any foreign subsidiary of an Indian Parent company which is merely complying with its group’s policies would not attract the applicability of POEM. However, while considering this one needs to also check the related GAAR provisions.

5 Circular no. 25 of 2017, dated 23 October 2017.

How to Determine a POEM?

The determination of POEM is decided based on two major scenarios namely, if a company has an active business abroad and if it does not have an active business abroad. It is presumed if a company has an active business abroad it will attract POEM however, this should be further studied in detail as to its substance and not merely its form. In case if the company does not have an active business abroad then based on its place where the person who is making the key management and commercial decisions and his place determines the POEM.

Provisions to decide if a company is involved in an Active Business Abroad

Following provisions indicate that a company has an active business abroad:

  • • Less than 50% of its total assets are located in India
  • • Not more than 50% of the total income is passive6 income
  • • Less than 50% of its total employees are in India or Indian Residents
  • • Its payroll expenses of the above employees are less than 50% of its total payroll expense

6 Passive Income: it is an aggregate of a) income from purchase or sell of goods from or to associated enterprises, b) income through royalty, dividend, capital gains, interest or rent.

Applicability of General Anti Avoidance Rules (GAAR)

Applicable from the Assessment Year 2018-19, GAAR deals with ‘Impermissible Avoidance Arrangement’ that results in the tax benefit of more than Rs. 3 crore. The Arrangements are considered Impermissible if the following two conditions are met:

  1. The motive behind entering into an arrangement is to obtain the Tax Benefit, and
  2. If the arrangement:
    • creates rights or obligations that are not covered under Transfer Pricing, or
    • results directly or indirectly in the misuse or abuse of the provisions of the Income Tax Law, or
    • lacks or deemed to be lacking commercial substance, or
    • is entered or carried out in a manner which is not employed for the bonafide purpose.

It should be understood that the rules have an overriding effect if any contradiction is found with the income tax provisions but in case of the contradiction between DTAA and GAAR, the DTAA prevails over these rules.

Applicability of Transfer Pricing Rules

Transfer Pricing under taxation and accounting refers to the rules and methods for pricing the international transactions within and between associated enterprises. Transfer pricing rules provides methods to calculate the fair price of such transactions which take place between unrelated independent enterprises, called the Arm’s Length Price. This is primarily to counter enterprises that shift their profits to low or nil tax countries at inflated prices, resulting in lower taxes in the high tax jurisdictions. The rules provide various methods to calculate Arm’s Length Price, which is listed below:

  • • Comparable Uncontrolled Price Method (CUP)
  • • Resale Price Method (RPM)
  • • Cost Plus Method (CPM)
  • • Profit Split Method (PSM)
  • • Transactional Net Margin Method (TNMM)
  • • Such other method as may be prescribed

The other method may be any method that best describes the price which has been charged for similar or same transactions amongst unrelated enterprises describing similar circumstances. The enterprises are required to select the best suitable method based on nature and class of transaction or associated persons and functions performed.

Documentation under Transfer Pricing Rules – Need of the hour

While dealing with compliance-related procedures, well-documented cases and issues always make the work easier and faster. Here, under the New Transfer Pricing Rules, the Indian Government requires three-tier Transfer Pricing Documentation viz. Country by Country Reporting (CbCR), Master File (MF) and Local File.

• Country-by-Country Reporting (CbCR) – Rule 10DB of the Income Tax Rules, 1962 (the rules)

These regulations apply only to those ‘Constituent Entities’7 or Parent Entities or Alternate reporting Entities that are resident in India. Thus, these regulations exempt those Indian branch offices or project offices of foreign companies which are considered as non-residents. The rules also prescribe the threshold of INR 55,000 million consolidated revenue in the preceding financial year.

As per CbCR rules, in case of Indian Parent Company having Subsidiary Company / Companies abroad are required to file CbCR in Form 3CEAD for each reporting accounting year before the due date of filing of Income-Tax Return if their consolidated revenue exceeds INR 55,000 million in an accounting year.

• Master File Reporting (MF) - Rule 10DA of the Income Tax Rules, 1962 (the rules)

Sub-rule 1 of the rule 10DA of the rules specifies two conditions that set the threshold limit for the master file rules to be applicable. However, irrespective of the threshold every Constituent Entity of an International Group is required to file Part A of the Form 3CEAA. The two conditions are mentioned below:

  1. Consolidated group revenue of the International Group8 for the accounting year exceeds INR 500 crore (USD 75 million) and
  2. The aggregate value of International Transaction during the accounting year as per books of accounts exceeds INR 50 crore (USD 7.5 million) or in respect of purchase, sale, transfer, lease or use of the intangible property during the accounting year, as per the books of accounts, exceeds INR 10 crore (USD 1.5 million)

Form 3CEAA: The rules suggest that the form should be filed in two parts A and B. However, Part A is required to be filed by every Constituent Entity of an International Group whether or not it satisfies the above mentioned two conditions. Part B of the form should be filed only by those Constituent Entities which satisfy both of the thresholds mentioned above.

Form 3CEAB: Where an International Group has more than one Constituent Entities in India, the group may opt to designate one Constituent Entity that shall be obliged to file Form 3CEAA. Therefore, such designated Constituent Entity is required to file Form 3CEAA and an intimation of the same in Form 3CEAB with the Director-General of Income-Tax.

• Local File Reporting

The local file is required to be maintained if the aggregate value of all intercompany transactions during the accounting year exceeds INR 10 million and/or Specified Domestic Transactions9 during the accounting year exceed INR 200 million.

The rules specify that while deriving the value in Indian Rupees for the above-mentioned thresholds, the Telegraphic Transfer Buying Rate10 of relevant currency on the last day of the accounting year shall be used.

7 Constituent Entities of the International Group in India means any entity of the International Group in India whose accounts are included in Consolidated Financial Statements.

8 International Group is defined as a group that operates in two or more jurisdictions.

9 Specified Domestic Transaction include inter unit transfer of profit-linked, tax-eligible units; transactions of profit-linked, tax-holiday-eligible units with other parties; and any other transaction for which an entity may be notified by the CBDT.

10 Telegraphic Transfer Buying Rate (TTBR): As per the explanation to Rule 26, TTBR in relation to foreign currency means the rate or rates of exchange adopted by the State Bank of India constituted under the State Bank of India Act, 1955 (23 of 1955), for buying such currency, considering the guidelines specified by from time to time by RBI for buying such currency, where such currency is made available to that bank through a telegraphic transfer.

Advance Pricing Agreement (APA)

The tax authorities of many countries have issued methodologies on transfer pricing which is called Advance Pricing Agreement. This agreement is usually between two countries where the tax authorities of the two countries decide which methodology to be used when Associated Enterprises of these two countries enter into any international transaction. There are three types of agreements as stated below:

  1. 1) An Independent Agreement: This is an agreement where a taxpayer and the tax authority of the taxpayer’s country agree on the method to be used for the international transaction.
  2. 2) Two-Sided or Bilateral Agreement: This is a type of agreement where the two tax authorities of countries where associated enterprises are located agree on the methodology to be used for any associated enterprises of such countries should follow.
  3. 3) Multilateral Agreement: Such type of an agreement includes the taxpayer, two or more Associated Enterprises of the taxpayer located in different countries, the tax authority of the country where the taxpayer is located and the tax authorities of the Associated Enterprises.

Accounting Perspective

The Companies Act, 2013 mandates11 presentation of Consolidated Financial Statements (CFS) in accordance with Schedule III of the Act and the applicable Accounting Standard if a Company has one or more subsidiary companies. Ind AS 110 on Consolidated Financial Statements sets out the accounting requirements for the preparation of CFS. However, if an Ind AS specifically exempts certain companies from the preparation of the CFSs, then compliance to the Schedule III of the Act would be sufficient.

11 Vide Section 129 (3) of the Companies Act, 2013.

The Exception to Preparation of CFS by Ind AS 110:

  1. 1) A Holding Company is not required to present consolidated financial statements if it meets all the following conditions:
    • It is a wholly-owned subsidiary company or it is a partially-owned subsidiary company of another company and all its other owners, including those not otherwise entitled to vote have been informed about, and do not object to, the Holding Company not presenting CFS
    • Its debt or equity instruments are not publically traded (be it either a domestic or foreign stock market or an over-the-counter market, including local and regional markets)
    • It neither files nor is in the process of filing the financial statements with a securities commission or other regulatory organisation in order to issue any class of instruments publically
    • Its ultimate or any intermediate Holding Company produces CFSs that are available for public use and comply with Ind ASs.
  2. 2) Post-employment benefit plans or other long-term employee benefit plans that are covered under Ind AS 19 Employee Benefits.
  3. 3) An investment entity need not present CFSs if it is required in accordance with paragraph 31 of Ind AS 110 to measure all of its subsidiary companies at fair value through profit or loss.

The Accounting perspective of forming a subsidiary company abroad requires accounting treatment of the transactions according to the rules set under Ind ASs. Some of the key Ind ASs that will be crucial to apply are Ind AS 110 on Consolidated Financial Statements (as mentioned above), Ind AS 21 The Effects of Changes in Foreign Exchange Rates, Ind AS 24 Related Party Disclosures, Ind AS 28 Separate Financial Statements. Apart from these, the other Ind AS will always be applicable as generally it would be applicable to other companies.

Closing Thoughts

The bottom line of the entire discussion is that the Indian subsidiaries situated outside India have a lot of consequences from not only legal and accounting viewpoints, but a major portion of compliance requirements comes from the taxation viewpoint. This article attempts to cover the major provisions with an overall understanding.

When setting up an overseas subsidiary, Indian enterprises must holistically align corporate governance under the Companies Act, capital flow approvals under FEMA, residency risk under POEM, anti-abuse checks under GAAR, transfer pricing documentation, and Ind AS consolidation standards.