This article was first published in the January 2011 China edition of Accounting and Business magazine
The ripple effects of the financial crisis continue to hound economies around the world. Asian economies have suffered too, although some and in particular India, are witnessing a turnaround while the Western economies are still battling to find the rebound point.
Many believe the slowdown in the US and European Union could provide an opportunity for Asian economies to shine through. Certainly, the raft of reforms introduced across Asia including new tax treaties, the introduction of the Direct Taxes Code (DTC) and goods and services tax (GST) in India and advance pricing arrangement (APA) developments in Japan, China, Indonesia and Malaysia are illustrating a dynamism not prevalent elsewhere. Multinational corporations (MNCs) operating in Asia need to pay heed and maximise the opportunities available through this period of change.
Bilateral tax treaties, an important framework for international cooperation, have recently drawn the attention of Asian governments, partly with a view to encourage foreign investment activities and to enhance international recognition for transparency standards in crossborder transactions.
The number of international tax treaties has steadily increased over the past 24 months, since the Organisation for Economic Co-operation and Development (OECD)threatened to blacklist countries not implementing, or not agreeing to implement, such standards.
This marks a positive trend for Asian countries. Countries like India and China have renegotiated existing tax treaties and introduced robust standards and regulations to prevent treaty shopping.
India has championed the cause by initiating treaty renegotiations with 65 countries to broaden the scope of provisions governing exchange of banking information. An official communiqué by the Indian finance minister confirmed that India has already concluded 14 tax information exchange agreements (TIEAs) and completed negotiations or renegotiations of double taxation agreements (DTAs) with 36 countries in 2011.
Other Asian nations have also been active in signing a number of bilateral treaties over this period: Japan has signed 12 new tax treaties over the past three years; Indonesia signed four new tax treaties over the same period; China has signed 15 new treaties over the past four years; Hong Kong has signed 10 new fully-fledged tax treaties and has completed negotiation with 14 other states.
The growing trend to implement the OECD’s transparency standards and increase international cooperation for information exchange has led to an upsurge in the number of bilateral treaties.
India: tax legislation
Lately the Indian judiciary’s irrepressible penchant to investigate ‘substance’ over ‘form’ in crossborder transactions has been intriguing. Vodafone’s dispute with the Indian Revenue Service (IRS) has become the bellwether for similar disputes winding their way to judiciary. While arguments in the Vodafone case are underway before the Supreme Court, it remains to be seen if the court’s verdict will set the tone for international investors.
Aggressive tax administration and new tax legislation mooted by Indian policymakers promise to keep international investors on alert. The DTC will replace 50-year-old legislation and will prompt fundamental changes in the taxpayers’ approach.
The DTC will usher in explicit yet general anti-avoidance rules in the statute. Proposals of treaty override and taxation of offshore operations of Indian residents under the controlled foreign corporation (CFC) regime will integrate the Indian tax system with international best practices.
However, there lies a catch; plain reading of the proposed anti-avoidance rules will send a shudder down taxpayers’ spines as the IRS is likely to assume unfettered powers to challenge transactions.
The transition to the new regime will be anything but smooth, as the administration tries to manage taxpayers’ concerns around the implementation of untested pieces of legislation.
The introduction of the GST is the second of two key tax reform agendas being pursued by Indian policymakers. Once implemented, the GST is tipped to completely overhaul the current indirect tax regime, replacing multiple taxes with a comprehensive, unified tax regime. However, introduction of the GST, unlike the DTC, has many more hurdles to cross before becoming law; the most significant being the constitutional amendment allowing goods and services to be taxed at both federal and state level.
Given the fabric of the Indian democracy, the changeover to the GST will require synergies between political parties (ruling and opposition) as the federal government continues to woo state governments, which have huge stakes to safeguard against the federal right to tax goods. If it does come into force earlier than anticipated, the GST will be a positive move for Indian tax reform.
Increasing significance of APAs
With tax evasion coming into sharper focus, the emphasis on transfer pricing in international controlled transactions has also assumed importance. Recent trends in transfer pricing audits paint a worrying picture. For instance, the IRS detected mispricing of international transactions to the tune of US$500m, as it mopped up another US$500m from other international transactions.
To thwart the growing magnitude of shifting tax bases through abusive transfer pricing practices, India has proposed to introduce APAs effective from April 2012 (under the DTC). APAs will facilitate the advance audit of international transactions wherein the IRS will be able to direct the appropriate transfer price for international transactions.
APAs are already prevalent in other Asian countries, such as Japan, China, Indonesia and Malaysia. While Japan has a mixed approach to bilateral and unilateral APAs, China is aligned to bilateral APAs. Rough statistics indicate that Japan concluded more than 150 APAs (out of which more than 100 were bilateral APAs), whereas China concluded close to 20 bilateral APAs.
As India looks to align to international APA standards, the approach of the IRS towards unilateral v bilateral APAs is keenly anticipated. Robust documentation and the efficacy of planning exercises are also important in transfer pricing. The IRS’s audits in recent years underline the growing significance of sound planning for determining the appropriate transfer pricing methodology and the transfer price in international transactions.
The current global trend of economic reforms is a huge positive for economies. The dynamism of Asian economies in particular poses a potential watershed where East may beat West. It is important in this fast-paced environment that MNCs operating in Asia keep abreast of change, maximise their opportunities and minimise their risk.
By being fully aware of the latest legislative change in Asia and the impact these developments will have on their international tax strategies and commercial objectives, MNCs can ensure a smooth ride until the global economy begins to turn around.
Mukesh Butani is Managing Partner of BMR Legal and non-executive Chairman of the firm.