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Subsidiarization of foreign banks — tax issues - EY - India

Finesse: March-June 2011

Subsidiarization of foreign banks — tax issues

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The RBI released a discussion paper on the presence of foreign banks in India on 21 January 2011.

  • The paper outlines the broad contours of the proposed policy on the mode of presence of foreign banks in the country. The experience of the sub-prime crisis has underlined the virtues of exercising caution in the liberalization of the banking sector.
  • It evaluates the relative merits and demerits of a foreign bank setting a branch in India vis-à-vis a wholly owned subsidiary (WOS).
  • It concludes that the advantages of a WOS outweigh its downside, and therefore this should be the preferred mode for the presence of foreign banks in the country.

The RBI has invited public comment on the paper, and its final guidelines are expected to be announced shortly. The proposal, once finalized, is expected to significantly alter the way foreign banks operate in India.

While regulatory and commercial issues will be the key drivers of the choice made by foreign banks on the preferred operating models they prefer to adopt, they will also need to evaluate the tax issues involved. At a broad level, there are two types of tax issues that need to be considered — (a) tax issues associated with the conversion of existing branches into WOS and (b) the tax aspects of operating as a branch vis-à-vis a WOS. Furthermore, while looking at tax issues, banks will need to not only examine current taxation laws, i.e., the Indian Income-tax Act, 1961 (Act), but also keep an eye on the implications of the proposed Direct Taxes Code Bill, 2010 (DTC 2010), which is expected to be effective
from 1 April 2012.

Tax issues on conversion

In the case of foreign banks that already have a presence in India, the tax issues associated with their conversion into a WOS need detailed examination. Conversion will entail a transformation of the business of a non-resident company to a resident one. Given that this will be a transfer of business within group entities, there will be no real income arising to the group. It is therefore important that the transaction is accorded tax neutrality.

The largest tax exposure, for foreign banks that have had a presence in India for a sufficiently long period, is in respect to their goodwill, given that the fair value of the business of a branch could be significantly in excess of its book value.

The discussion paper does not provide the required clarity on the tax treatment of the conversion of a branch into a WOS. It states that the provisions of section 47(iv) of the Act appears to be applicable and foreign banks can approach the appropriate authority for suitable clarification.

Section 47(iv) of the Act provides for an exemption from capital gains tax if a company transfers a capital asset to its WOS. While section 47(iv) of the Act does not seem to be specifically intended to cover a situation of conversion of this kind, going on judicial precedents, a business that is transferred as a running concern is regarded as a capital asset, and therefore, comes within the ambit of section 47(iv) of the Act.

The exemption under section 47(iv) of the Act is subject to the limitation that exemption from levy of capital gains tax will be withdrawn if the WOS ceases to be wholly owned by the transferor company within a period of eight years. This limiting condition thus locks the parent from diluting its stake in the subsidiary for a period of eight years. Thus, although the regulations may permit foreign banks to tap Indian capital markets to mobilize funds during the lock-in-period, and the discussion paper also alludes to this, dilution of even 1% during the lock-in period would trigger a capital gains tax liability. Furthermore, in the event of a dilution, the capital gains tax liability would be calculated, based on a fair valuation of the branch assets under transfer pricing provisions, irrespective of the price at which the business is to be transferred.

Furthermore, given the requirements of section 47(iv) of the Act, it will not be possible for a foreign bank to own a WOS through another legal entity of the group, other than the transferor entity (the head office), without triggering a capital gains tax liability, despite there being commercial drivers or home country regulations, which require that such ownership should lie with another legal entity.

DTC 2010 contains a provision that is similar to section 47(iv) of the Act, and includes withdrawal of the exemption in the event of a dilution within eight years.

While the benefits obtained due to a conversion, if any, should ordinarily be regarded as the gain of the head office and not of the branch (and should therefore not figure in the accounts of the latter), it will be important for foreign banks to get clarity on this issue.

There is therefore a need for the Government to provide a specific exemption under the tax law for such a reorganization or conversion, made in accordance with the RBI’s directions. Precedence on this already exists under the Act, which make reorganization tax neutral (e.g., in the case of cooperative banks, stock exchanges and limited liability partnerships). Most of these provisions provide for an exemption from capital gains tax upon conversion, while deferring the point of taxation to the eventual transfer by the transferee.

In addition to the certainty relating to capital gains taxation, transitional provisions are also needed to confirm carry-over of tax attributes and reliefs from a branch to a WOS, e.g., deductions for write off of debts (incurred by the branch) in the hands of the WOS, deduction for expenses accrued by the branch but paid by the WOS, utilization of Cenvat credit of the branch in the hands of the WOS.

Another significant tax cost in the process of conversion is with respect to stamp duties and VAT and the forthcoming GST. Stamp duties may be levied on business transfer agreements, and in addition, on individual assets transferred (movable and immovable). Stamp duty and VAT are taxes levied by the states and their rates depend on the state in which the assets of a branch are located and where the documents are executed. Generally speaking, the transfer of the business of a branch to a WOS that is a going concern should not give rise to VAT on the basis that the business does not include goods for the purpose of VAT.


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