Israel is a small country with a relatively small market, so many Israeli businesses and investors look to make money in other countries around the world. Consequently, Israeli investment abroad has surged since exchange control was abolished in Israel in 1998.
Although we live in a global village, we must do our homework in each country. Some of the major questions will not be apparent - let alone the answers. We, therefore, present a series of occasional articles on possible economic opportunities and tax issues for Israelis with overseas interests. In this article we review India. Our remarks are very general and experienced professional advisers should be consulted in each country in specific cases.
The scene in India
India embarked on its journey of economic liberalization in the early '90s. The impact of the steady reform process is evident in the exponential growth that India is now witnessing. India offers a vast potential for overseas investment and is actively encouraging the entrance of foreign players into the market. Armed with a population of 1.1 billion, a vast pool of low cost labor, English-speaking skilled managerial and technical manpower and sustained GDP growth of over 7%, India presents tantalizing prospects for businesses wishing to produce and/or sell products in India.
Foreign investment in India is regulated by the Government of India's Foreign Direct Investment (FDI) policy. The FDI guidelines are administered by the Ministry of Commerce and Industry. With liberalization, FDI in a large number of industries is permitted up to 100%, automatically without any approvals. FDI in sectors like telecom, real estate, retail etc. is permitted, subject to certain restrictions.
FDI up to 100% under automatic route (i.e. no prior approval required from the Foreign Investment Promotion Board or FIPB) is permitted in information technology (IT) services like information technology enabled services (ITES), business process outsourcing (BPO) and software services.
The government has been encouraging foreign investment in the IT-ITES sector. Various attractive export oriented-schemes have been established for the overall development of the IT sector in India. Units set up under these schemes enjoy a host of direct tax benefits (corporate tax exemption up to 2009) along with indirect tax benefits (zero custom duty on imports, exemption from central excise duty for the procurement of indigenous items, etc).
The Income Tax Act, 1961 in India extends certain tax incentives and holidays to Indian companies/ undertakings deriving profits from certain real estate activities in India, subject to certain conditions. A 10 year 100% tax holiday is available to undertakings deriving profits from developing, operating and maintaining an industrial park in India. However, such tax holidays are available only where the industrial park is developed before March 31, 2009, and notified by the Central government.
The Special Economic Zone (SEZ) Act, 2005 governs the development and operation of SEZs in India. The SEZ legislation provides attractive fiscal benefits to units operating in SEZs and SEZ developers, such as exemption from customs duty, sales tax, excise, service tax, income tax holidays, etc.
With regard to real estate, current policy permits FDI up to 100% under automatic route in a range of segments covering townships, housing, built-up infrastructure and construction-development projects (which would include housing, commercial premises, hotels, resorts, hospitals, educational institution, recreational facilities, city and regional level infrastructure)
The FDI policy however specifically prohibits the sale of "undeveloped" land to prevent speculation in real estate by foreign investors. Further, the FDI is permitted only in greenfield projects and is not in developed or partly developed projects.
The Government has recently liberalized the FDI norms in the defense sector, as well. Private sector participation is permitted up to 100%, with FDI up to 26%.
India also offers huge potential in sectors such as retail, automotive, telecom, etc. India's retail sector has an estimated market size of more than US$ 250 billion and is the second-largest employer after agriculture, contributing 14% to India's GDP. India's telecom sector has also seen much activity in the last couple of years. FDI up to 100% is permitted in the case of Internet services (without gateway) and telecom equipment/handset manufacturing activities.
What about structuring a venture in India? Two main structures favored by foreign investors in India are a Wholly Owned Subsidiary (WOS)/Joint Venture Company (JVC) or a branch office. There are several unique characteristics of both these options available from a taxation perspective and the choice of the best structure is dependent upon the proposed activities of the prospective investors in India. As discussed earlier, investment in WOS/JVC is governed by the foreign investment laws and government approvals may be required for certain investments depending upon the activity/industry/quantum of investment.
Where no tax incentives apply (see above), an Indian company (whether WOS or JVC) will be a resident in India on account of being a separate legal entity and shall be taxable at the rate of 33.66%. Minimum Alternative Tax ("MAT") is applicable to companies where tax on adjusted book profits exceeds tax on normal taxable A WOS/JVC is also subject to dividend distribution tax ("DDT") at a rate of 14.025% (for Tax Year 2005-2006) on dividends paid out to its shareholders. This is a tax on the company not the shareholders. Therefore, profits distributed after payment of corporate tax and dividend distribution tax would not be taxable in India in the hands of the investors.
Alternatively, a branch office is an extension office of the foreign company and hence is a permanent establishment (PE) for tax purposes. If the company chooses to set up a branch office, it must secure prior approval from the Reserve Bank of India. The PE will be taxed at a rate of 41.82% (on account of being a non-resident in India) and the provisions relating to MAT would apply to the branch office also. The existing provisions of Indian tax laws do not stipulate any branch profit remittance tax. Therefore, profits after tax can be remitted without any further Indian tax.
It should be noted that a WOS/JVC is required to retain about 10% of its profits as a reserve and such a reserve is not available for distribution on a current basis. Therefore, from a cash flow perspective, the total remittable amount to the shareholders as dividends is less than the remittable profits of the branch, since the branch is not required to maintain any such statutory reserve.
Foreign investors may also choose to set up intermediary/regional holding companies to invest in the Indian WOS/JVCs. Certain regimes offer favorable tax results on capital gains earned on sale of shares of an Indian company, which could provide tax efficiency for the investor in case of divestment from the Indian WOS/JVC if the gains will be re-invested outside Israel. Nevertheless, Israeli investors should review the costs as well as Israeli reporting and tax implications.
How will Indian taxes interact with Israeli taxes for Israeli investors? This will depend mainly on individual circumstances - see, for example, our article "Tax issues to consider when investing abroad" (Jerusalem Post October 18, 2006). Key issues typically may include: the entity structure; the business model; intellectual property and research and development; finance aspects; income repatriation; exit strategy; management and employees; double tax relief; tax planning and anti-avoidance rules.
Israel has a tax treaty with India as well as foreign tax credit rules in the domestic Israeli tax law. Under the treaty, India generally withholds 10% tax at source from interest, royalties, management fees and technical fees paid to Israeli residents if they are not deemed to have a permanent establishment (primarily, a fixed place of business or branch) in India. India has strict withholding tax and income source rules, so each case must be checked out in advance.
Subject to this, if an Israeli company with no permanent establishment in India simply trades from Israel with an unrelated Indian company, it should only pay tax in Israel.
If an Israeli company has a permanent establishment in India it will report the resulting profit or loss to the Israel Tax Authority as well as the Indian authorities. Israel generally will tax the Israeli company on its worldwide profits, including Indian source profits, at the regular rate - 29% in 2007. However, there may be no Israeli company tax balance to pay after crediting the Indian tax (41.82% Indian tax if no Indian tax incentives apply) on the Indian source profits.
Any excess foreign tax credit (41.82% Indian taxes minus 29% Israeli tax equals 12.82% excess in this example) may be used in the following five tax years against other income of the same type from the same country (India).
If an Israeli resident company or individual invests in the shares of an active Indian company (WOS or JVC), it may be able to defer Israeli tax until it receives a dividend from the Indian company. At that time, the Israeli tax would generally be 25% of the dividend paid but there would be a fixed foreign tax credit of 15% under special provisions in the India-Israel tax treaty, resulting in a net Israeli tax liability of 10% of the dividend. Alternatively, if an Israeli company (not individual) holds at least 25% in an Indian company, the Israeli company may choose to pay the regular rate of Israeli company tax (29% in 2007) on its share of the pre-tax profit of the Indian company and claim a credit for the corporate taxes paid in India - this should eliminate altogether the Israeli company tax if the Indian company paid Indian corporate taxes of 41.82%, i.e. if no Indian tax incentives apply.
To sum up:
* If the Indian investee company enjoys Indian tax incentives, the net Israeli tax rate of 10% on dividends from the Indian company would seem a good result to the Israeli investor - company or individual.
* If the Indian investee company does not enjoy Indian tax incentives (e.g. real estate), the net Israeli tax rate of zero would seem a good result for Israeli corporate investors holding at least 25% of the Indian company. Nevertheless, that is after paying Indian taxes of 41.82%. Additional planning may be possible.
* Capital gains, loan interest, royalties, management and technical fees and so forth will be taxable in both countries at various rates under domestic legislation and the treaty - specific advice should be obtained. India has a system of foreign exchange control, so its formalities should be followed.
India used to be known as the jewel in the British crown, but it went global and Israeli investors are welcome to check it out.
Leon Harris is an international tax specialist at Ernst & Young Israel
Adya Gupta is an international tax specialist at Ernst & Young India.