Foreign investments have been in the news a lot lately. However, the discourse has ignored many crucial aspects. Any non-resident Indian who returns to India is allowed to hold bank accounts, investments and assets in foreign countries. He is not required to file any disclosures with the Reserve Bank of India (RBI), unless his assets are located in an enemy country.
However, it is imperative that he complies with Indian tax laws and discloses all foreign assets in his tax return. Also, under the liberalised scheme of RBI, a resident Indian who has invested in foreign countries must declare his foreign investments in his income tax return.
Section 139 of Income Tax Act, 1961, precisely states that a person who is an ordinary resident, holding foreign assets or any financial interest in any foreign entity or is a signing authority in an account abroad or a beneficiary of any foreign assets or beneficiary of any financial interest in any foreign entity must file his tax return in India irrespective of whether he does or does not have taxable income in India. However, non-resident or non-ordinary residents need not disclose their foreign assets and bank accounts in their tax return in India.
Section 115G also provides “it is not necessary for a non-resident Indian to furnish a return of his income under Section 139(1), if his total income consists of investment income or long-term capital gain on which tax deductible is deducted.”
An individual who is an ordinary resident having foreign income or assets, fails to file tax returns under Section 139 or does not report the same in his tax return, he may receive notice under the Black Money Act, 2015, and could be liable to pay tax on undisclosed income and assets at the rate of 30 per cent under Section 10 as well as penalty of three times of taxes payable under section 41 of the Act. He will also be subject to prosecution. It is always advisable to maintain appropriate records of the source of foreign assets and to disclose the same in tax returns. Even assets held as a beneficiary in any overseas entity or trust must be declared.
One must not only declare all foreign assets but also all overseas income, including income from house property i.e. if you are holding residential property overseas, you have to declare your rent received in your tax returns. Even if the property is not let out, it will be treated as deemed let out and you will be liable to disclose fair rent receivable.
Now what happens in a scenario, where before returning to India a person forms a company or an entity in a tax haven with share capital of few dollars and gives away all his savings as an interest-free loan to that company. The directors in the company are his NRI relatives and 75 per cent of shares are held by them and balance 25 per cent by that person. The loan is invested by the company which earns income on that in a foreign country. Company pays no income tax in the foreign country as the company is registered in a tax haven. Section 6(3) of Income tax Act 1961, as amended from assessment year 2017-18 provides: “A foreign company will be resident in India if its place of effective management (POEM) during the relevant period is in India. For this purpose, POEM means a place where key management and commercial decisions that are necessary for the conduct of the business of an entity as whole are, in substance made.”
Under Section 5 of Income Tax Act, 1961, that person who is not resident in India is not liable to pay tax on his foreign income in India. As the status of the company under Section 6(3) is not resident in India, one need not pay tax in India on its foreign income.
It also complies with the guidelines provided under circular issued by CBDT. If money invested by a firm belongs to a resident but the income is earned by the company being resident outside India, the income is not taxable in India. The first question is whether authorities can tax on notional interest on the interest-free loan given? The answer is no as the loan is not borrowed but own money. If one refers to various case laws by higher appellate authorities, one comes to the conclusion that notional interest on interest-free loan cannot be subject to tax as source of loan is not borrowed capital.
The possibility of legal dispute arises when a loan is given to a foreign entity registered at a tax heaven. Authorities may take an adverse view if it considers the whole arrangement as sham with the aim of tax evasion. Authorities may disregard the legal personality of the company if there are facts to substantiate that the company is formed with few dollars of capital, managed on paper and earning income from a fund, which is solely provided by a resident Indian.
It is not only important to report foreign assets in tax return but equally important to make proper disclosure of income earned on foreign assets in tax return.