No person would have imagined the scale of disruption caused by the ongoing COVID-19 pandemic in the beginning of the year 2020. Four months into the year, the pandemic has spread into every nook and corner of the world, choking the medical facilities and the economy in equal proportions.

In the absence of a vaccine or a definitive cure to COVID-19, most countries including India were left with the only option of a complete national lockdown – to limit the spread of the deadly virus through social distancing. However, the treatment opted from an economic standpoint seems to be deadlier than the cure.

In a move to provide a cushion to the economy from the adverse impact of a continuous national lockdown spanning a minimum of 40 days (and possibly more), the government has brought about a slew of measures, including relief from taxes and compliance to India Inc. This included introduction of the Taxation and Other Laws (Relaxation Of Certain Provisions) Ordinance, 2020 – which provides relaxation/ relief from various tax compliances (including payment of taxes) having a due date between 20 March 2020 and 29 June 2020.

However, there still are a few open issues in relation which require the government’s attention and needs to be resolved in order to avoid ambiguity and prevent bona-fide tax payers from being adversely affected. We have highlighted some of them as under:

Residential status of individuals under the Income-tax Act, 1961 (“IT Act”)

In terms of Section 6(1), an individual is considered to be a resident if he:

(a) is in India in the financial year for a period or periods amounting in all to 182 days or more; or

(b) has in the preceding 4 years been in India for a period or periods totalling to 365 days and have been in India for 60 days or more in the financial year.

Note: In case of Indian Citizens and Persons of Indian Origin, the above requirement of 60 days is substituted with:

i. 120 days – for them to qualify as residents not ordinarily residents in India (liable to pay tax only on India source income), provided their India sourced income in excess of INR 15 lakhs and stay in India should be less than 182 days, and

ii. 182 days – for them to qualify as ordinarily residents

With the pandemic severely restricting the movement of individuals from one country to the other, there may be situations, where a person is left stranded in India during the period of lockdown on account of which his stay in India exceeds 182 days threshold, thereby changing his residential status to a resident and ordinary residents and making a portion of his (global) income taxable in India which otherwise would have been exempt. Moreover in catch twenty-two situation like these, the double taxation avoidance agreement can come to the rescue of an individual (by way of tie breaker rules) only if he qualifies as a resident in the other country as well – which may not always be the case.

Accordingly, the government may consider taking cue from countries like the United Kingdom, Australia and Ireland who have issued directives for disregarding the number of days of stay within these countries during the lockdown for residence/taxation purposes. Interestingly, the OECD has also issued guidelines to encourage countries to adopt the approach as adopted by countries such as Australia, United Kingdom and Ireland.

Residential status of foreign companies under the IT Act

A foreign company is deemed to be a tax resident of India if its place of effective management (“POEM”) is in India. POEM is defined to mean a place where the key management and commercial decisions that are necessary for the conduct of business of an entity as a whole are in substance made. POEM envisages the concept of substance over form and follows the place where the decisions are made as opposed to a place where the decisions are taken.

Therefore, in a scenario where the person taking the key decision is stranded in India due to COVID-19 there is a possibility that POEM implications may trigger. Similar situation may also arise for offshore fund managers and directors of foreign companies who may be in India due to the pandemic and inadvertently have to take key management/ commercial decisions from their residence/hotel in India - therefore leading to such funds and companies being regarded as Indian tax residents. Not to mention that this may also have an impact on the Permanent Establishment exposure in the hands of such foreign entities.

The OECD whilst recognising the said issue has also issued guidelines for the tax authorities not to change the resident status of an entity owing to a temporary change in location of the key management personnel such as the chief executive officer or other senior officials in a situation such as COVID-19. Accordingly, it is strongly recommended that the Indian government recognises this issue and prevents bona fide foreign entities from being unjustly taxed in India for situations beyond their control.

Stay of demand

Currently 20% of the disputed demand is required to be deposited for grant of stay at the first appellate level.

The pandemic has rendered the judicial wing inoperative and therefore the time period for refund of deposit amount (in favourable cases) has been further elongated. Many assessees have also been prey to high pitched assessments and consequently a sizeable amount has been blocked during appeal to the first appellate authority.

In light of the extraordinary circumstances, the government should consider reducing hardship of the taxpayers seeking stay of demand by reducing the pre-deposit limit to 10% from the current limit of 20%.

Transfer Pricing Provisions under Chapter X of the IT Act

Transfer pricing provisions under the IT Act permit appropriate risk and economic adjustments in order to improve comparability of a controlled transaction with that of an uncontrolled transaction.

The COVID pandemic has caused supply chain disruptions and slump in consumption demand which threatens the existing and future profitability of MNEs. MNEs would be required to revisit their value creation alignment along the supply chain and revisit their intra-group transfer pricing policy. In case of a captive service provider, operating on a full cost plus mark-up model, generally the risk of capacity utilization is borne by the foreign principal. With profitability squeeze, parties may have to revisit their pricing arrangement, leading to shift of capacity utilization risk to the Indian entity, which may be questioned by tax authorities.

In light of the same, the government should come out with clarifications/guidelines directing the tax authorities to accept the capacity utilization risk, being borne by the Indian entity, which is a departure from the routine remuneration model of full cost plus mark-up model for captive service providers

Transfer Pricing Provisions – introduction of ‘term test’

The pandemic is likely to result into significant fluctuations in the operating margins for the entities in future.

The current TP regulations provide for benchmarking the margins of an entity year on year basis without factoring the overall margins of the entity over a period of time. This results in having TP adjustments in one year due to lower margins without any corresponding reversal in subsequent years when the margins exceed the arm’s length margins.

The government should consider introducing concept of ‘term test’ for benchmarking the margins of entities over a range of years, rather on an year to year basis, so as to ensure that a taxpayer earns an arm’s length mark-up on actual costs over a range of years, even though there could be fluctuations in profitability on a year on year basis.

Conclusion

The resolve of the government to reduce hardship to taxpayers in unprecedented times is commendable. However, it will be imperative for the government to plug loopholes and address bona fide issues as and when they are brought to notice. The disease and cure both must be novel!

Amit Singhania and Gouri Puri are Partners and Nimish Malpani is an Associate at Shardul Amarchand Mangaldas & Co. The views expressed by the authors are personal and does not represent of the Firm.