Month: June

For many years, the concept of domicile has been a cornerstone of the UK tax system. In order to attract wealthy individuals to the UK, the UK Government was happy to grant preferential tax treatment to non-UK domiciled individuals, effectively protecting their overseas assets from UK taxation for an extended period.

However, this privileged status has attracted much debate in recent years, so it was no surprise when the Chancellor announced the abolition of the non-dom regime in the 2024 Spring Budget. We were told that the existing rules would be replaced with a residence-based tax system for income and capital gains tax from April 2025, with new benefits for long-term non-residents lasting for only four years following a move to the UK.

The Government also announced the inheritance tax regime would move to a residence-based test following a period of consultation, leaving many UK resident non-doms having to rethink their plans, whilst new arrivers to the UK will be wondering how they can benefit from the new rules.

UK TAX PRINCIPLES

Domicile

Domicile is a concept in UK general law that is distinct from nationality and residency. It is the country where a person ‘belongs’ and is found by considering the individual’s habitual residence and where they intend to remain indefinitely.

Under UK law, each person has a domicile, and whilst it is possible to be a resident in more than one country, a person can only have one domicile at any given time. There are three different types of domicile:

• A domicile of origin, typically being where the individual’s father was domiciled at the time of their birth;
• A domicile of dependence, where their parent acquired a different domicile before the individual turned 16 years old; and
• A domicile of choice, which occurs if the individual moves away from their home country and resides in a different country with the intention of making the latter their home permanently or indefinitely.

For tax purposes only, the UK also has the concept of ‘deemed domicile’, where an individual who is non-UK domiciled under general law is considered to be UK domiciled for tax purposes where certain conditions are met. Since 2017, this would apply if an individual has been a UK tax resident for 15 of the last 20 tax years or, where someone with a domicile of origin in the UK who had obtained a domicile of choice elsewhere subsequently becomes a tax resident in the UK again.

When an individual is deemed domiciled in the UK, this status is relevant for income, capital gains and inheritance tax purposes, although relief might be available under some double tax treaties in limited circumstances.

Background

The UK first introduced income tax in 1799 in order to fund the Napoleonic Wars. Even then, the rules incorporated an early form of the remittance basis of taxation by limiting a taxpayer’s liability on foreign income to that remitted to the UK. It was not until 1914 that the concept of domicile was linked to the UK’s tax system and the benefits that a UK-domiciled individual could obtain from this ‘remittance basis’ started to be restricted.

This divergence between the taxation of UK and non-UK domiciled individuals increased in the 1940s and 1950s through further restrictions on the reliefs available to those with a UK domicile, and when capital gains tax was introduced in 1965, it was only ‘non-doms’ who were able to use the remittance basis to shelter unremitted overseas gains. The final strands of the remittance basis available to UK domiciled individuals were effectively abolished in 1974, and this disparity continues to this day.

As it stands, the two primary benefits of the non-dom regime are the ability to avoid paying inheritance tax on non-UK situs assets and the option to elect to be taxed on the remittance basis, which avoids the taxation of overseas income and gains.

From a conceptual perspective, aligning tax benefits to an individual’s domicile status could help achieve the long-standing UK objective of encouraging foreign individuals to relocate to the UK to do business and invest in the economy. However, the existing regime has some apparent drawbacks, including the loss of tax revenue on foreign income and gains, a tax charge that can effectively encourage non-doms to keep their wealth outside of the UK, and the discontent of the UK public at the inequity of tax regimes.

The remittance basis remains a popular election for non-doms with the UK’s tax authority, HM Revenue & Customs (HMRC), reporting that in 2022 the combined total of non-domiciled and deemed domiciled taxpayers in the UK stood at a minimum of 78,700. Together this cohort contributed £12.4 billion to the UK in the form of income tax, capital gains tax, and National Insurance Contributions — the highest amount on record.

However, despite these revenue contributions, the regime and its users have remained under significant scrutiny and criticism from both the public and politicians. Anecdotally, the public considers the regime to be a benefit for the rich — at odds with the principle of those with the broadest shoulders contributing most to the economy. Politicians, on the other hand, question whether a regime which motivates taxpayers to keep their wealth out of the UK is counterproductive to what was originally intended. This contrasts with supporters of the existing rules who point to the regime as being one of the reasons individuals and businesses have for decades continued to come to the UK to do business, create wealth and spend money.

From a professional adviser’s perspective, the concept of domicile is very subjective, so it can be difficult to form a definitive opinion on the matter, which has led to many tax disputes. At the time the concept was introduced, it would not have been possible, or at least highly unlikely, to have a permanent home in two different countries but this is now relatively commonplace with modern-day transportation and ever-increasing global mobility. Similarly, moving away from traditional family relationships can cause issues when applying the rules and many people are uncertain where they will remain permanently until very late in life.
Accordingly, since at least 2015, most UK opposition parties, including Labour and Liberal Democrats, have pledged to either abolish the regime altogether or drastically restrict it. In 2017, we saw significant changes to the non-dom regime, including an increase to the annual charge applicable when claiming the remittance basis after 7 years of UK residence, the point at which one is deemed UK domiciled reducing from 17 to 15 of 20 years of UK residence, and income and gains being brought into the deemed domicile rules.

Despite these changes, the remittance basis remained a popular election, and non-doms looked set to continue to utilise the regime prior to the Budget announcements.

THE CURRENT REGIME

As noted, non-UK domiciled individuals are currently able to benefit from a UK inheritance tax exemption on their non-UK situs assets and an exemption from income and capital gains tax on overseas income and gains by electing to be taxed on the remittance basis of taxation. Both of these benefits offer significant benefits and planning opportunities that are not available to UK domiciled individuals.

UK Inheritance Tax (IHT)

IHT can apply when an individual makes certain transfers during their lifetime, but it is primarily a charge on the value of a person’s estate on death. However, the extent to which an individual’s estate is subject to IHT depends on their domicile status.

UK-domiciled and deemed domiciled individuals are subject to IHT on their worldwide assets. To the extent an individual’s estate does not consist of ‘Excluded Property’ or qualifies for any reliefs or exemptions, it will be taxed at the inheritance tax death rate, currently 40 per cent, on any amounts in excess of the nil rate band of £325,000.

This threshold of £325,000 has not been increased since 2009 and is set to remain at this level until 2028. As a result, there has been a significant increase in the number of people who find themselves subject to inheritance tax as the nil rate band has not kept up with inflation or, in particular, the rise in UK property values over the same period.

In contrast, for a non-UK domiciled individual, non-UK situs assets will be Excluded Property with the exception of any assets that derive their value from UK residential property or related loans – for example, foreign companies that own UK residential property. Accordingly, non-doms coming to the UK currently have limited exposure to IHT, provided they do not stay long enough to become deemed domiciled.

Furthermore, as Trusts inherit the IHT status of the settlor, under the current regime non-doms have the ability to settle non-UK situs assets into trust without these assets falling into the Relevant Property Trust regime, which would otherwise subject the trust fund to principal and periodic charges. These trust structures can, therefore, offer long-term IHT protection provided the assets are kept out of the UK.

The Remittance Basis

From an income and capital gains tax perspective, the default position for a UK resident is that they are subject to income tax and capital gains tax on their worldwide income and gains on an arising basis. This means that UK tax is payable on these receipts regardless of where they arise and whether or not they are brought to the UK.

However, non-doms have the ability to limit their UK tax exposure by electing to be taxed on the remittance basis in a given year. The effect of this election is that they will continue to be taxed on their UK source income and gains on an arising basis, but their non-UK income and gains will only be taxable in the UK to the extent that they are brought into, or otherwise enjoyed in the UK.

Non-UK income and gains that have not been taxed in the UK as a consequence of a claim to be taxed on the remittance basis will be subject to UK taxation if they are remitted to the UK at any point in the future. When this occurs, the income loses its character and is taxed as non-savings income at rates of 20 per cent, 40 per cent and 45 per cent (or up to 48 per cent if the individual is a Scottish taxpayer). Capital gains will be taxed at the prevailing capital gains tax rate at the time of the remittance. If the income or gains have suffered tax in another jurisdiction, any Double Tax Treaty between the UK and the source country will need to be considered to determine how much, if any, foreign tax credit relief is available against the UK liability.

The concept of ‘remittance’ is very broad. In summary, non-UK income and gains are treated as remitted to the UK if they are brought into, received in or used in the UK. This includes income and gains being used to pay for services in the UK, being used in relation to UK debts, or being used to acquire assets that are subsequently brought into the UK.

Additionally, anti-avoidance provisions exist to prevent non-domiciled individuals from making remittances in tax years when they are temporarily non-UK residents — i.e., where they are outside the UK for less than five years. In these circumstances, any remittances in the period of temporary non-residence will be taxed in the year they re-establish residence in the UK.

Where an individual’s unremitted foreign income and gains in a year are less than £2,000, the remittance basis applies automatically without the need to make a claim. Otherwise, the remittance basis must be claimed annually on an individual’s UK tax return. Accordingly, individuals can decide whether to be taxed on the remittance basis on a year-by-year basis by taking into account the potential UK tax due on the overseas income and gains and the amount that has been remitted to the UK in order to determine whether it is beneficial for a given tax year.

Drawbacks of the Remittance Basis

Whilst there can be significant benefits to claiming the remittance basis, there are costs associated with doing so and also potential pitfalls.

Firstly, under the current rules, any foreign income and gains received in a year when a remittance basis election is made will always become taxable in the UK when remitted. This could be the following year or in 10 years — it still becomes taxable when it is brought into the UK. Accordingly, it is necessary to maintain detailed records to demonstrate the source of funds remitted to the UK, which can be very onerous over an extended period of time.

It may also be necessary to maintain multiple offshore accounts in order to avoid different sources of income and gains becoming mixed. A non-dom could have overseas receipts from different sources — investments, property income, asset sales, etc. — which can be difficult or impossible to unpick later down the line. Where money is remitted to the UK from a mixed fund, statutory ordering provisions apply, which deem the remittance to be made up of income or gains from the current tax year in priority to earlier years and, in essence, from income in priority to capital gains. This allows HMRC to tax remittances from mixed funds at the highest rates possible, as income tax rates significantly exceed those for capital gains. Whilst these rules can result in a significant compliance burden, they also provide an opportunity for well-advised individuals to structure their affairs so they are able to remit funds in a tax efficient manner.

Another pitfall is the wide-ranging definition of what constitutes a remittance. Non-doms will typically identify that a direct bank transfer to a UK account is a remittance, but it is not so obvious for indirect transfers — for instance, if they use a UK credit card which is ultimately repaid using overseas income. The acquisition of UK stocks and shares using offshore funds also constitutes a remittance, which is often not identified until after a purchase has been made — the sale of these assets does not remove the remittance, so consideration is required on what to do with these assets or proceeds given the remittance has already been made. At the very least, clear instructions should be given to any investment manager in place, and the taxpayer should monitor their portfolio on an ongoing basis through this lens. Care is also required around gifts to and from close family members and family investment vehicles to avoid unintended tax consequences.

Where a remittance of overseas funds has been made but not immediately identified, non-doms will want to ensure they disclose this to HMRC as soon as possible. As a remittance relates to offshore income or gains, a harsher penalty regime applies — up to 200 per cent of the unpaid tax — but this can usually be significantly mitigated by making a voluntary disclosure, cooperating with HMRC in resolving the matter, and making a full and prompt settlement of the underpaid tax. If the taxpayer fails to secure ‘unprompted disclosure’ status — for instance, if HMRC gets wind of undeclared income or gains and issues a ‘nudge letter’ — the ability to mitigate these penalties is considerably reduced.

As noted, whilst there can be tax benefits to claiming the remittance basis, there is also a ‘cost’ associated with doing so. Whenever a non-dom elects to be taxed on the remittance basis, the individual loses their entitlement to the income tax-free Personal Allowance (currently £12,570) and the capital gains tax Annual Exemption (£3,000 for the 2024/25 tax year).

In addition, a Remittance Basis Charge (‘RBC’) applies to remittance basis users after they have been UK residents for more than seven of the previous nine years. This charge starts at £30,000 and increases to £60,000, where the individual has been resident for more than 12 of the last 14 tax years.
Eventually, after being resident in the UK for 15 of the last 20 years, individuals will become deemed domiciled in the UK and therefore considered to be UK domiciled for all tax purposes. This means that they can no longer benefit from the remittance basis of taxation and that their worldwide estate will be chargeable to IHT on their death, subject only to very limited exceptions found in a handful of old Double Tax Agreements.

THE PROPOSED NEW REGIME

Before considering the proposed changes, it’s worth noting the current state of play in British politics, which will undoubtedly have an impact on what is ultimately enacted by legislation. The current Government has a Conservative majority but opinion polls suggest this is unlikely to be the case come the end of the year. So, whilst we know what a regime introduced by the Conservatives might look like, they may not be in a position to have much of a say on matters after the General Election now set for 4th July.

Based on current polling, the Labour Party is in pole position to take power so it is necessary to consider their take on matters. We know that they are in favour of abolishing the existing non-dom regime, so we can be relatively certain that the old rules will go in April 2025. There also seems to be an acceptance that the concept of domicile has had its’ day, so it is likely the new rules will be based on residence. Beyond that, those affected will need to pay close attention to the party proposals in the run-up to, and decisions made following the General Election.

If we do consider the Conservative Party proposals for the time being, the most significant change is the removal of the remittance basis of taxation from April 2025 and the introduction of a new Foreign Income and Gains Regime (the “FIG regime”). Under the FIG regime, new arrivers — said to be those who have been non-UK residents for the previous ten years — will not suffer income or capital gains tax on their offshore income or gains for the first four years of UK residence, after which point they will be subject to UK taxation on their worldwide income and gains. Similar to claiming the remittance basis, electing into the FIG regime will result in the loss of their Personal Allowance and capital gains tax Annual Exemption. However, unlike the remittance basis, foreign income or gains will not be taxed irrespective of whether they are remitted to the UK.

Transitional Rules

As is often the case with significant changes in tax policy, the proposals included some transitional provisions for those affected:

• For the 2025/26 and 2026/27 tax years, taxpayers who have previously claimed the remittance basis will have access to a Temporary Repatriation Facility, whereby they will be able to remit foreign income and capital gains and suffer tax at a reduced tax rate of 12 per cent (compared to up to 45 per cent under the current rules);
• For the 2025/26 tax year only, those who were claiming the remittance basis but are unable to benefit from the FIG regime will be able to exempt 50 per cent of their foreign income (not gains) from UK taxation; and
• Individuals who have previously been taxed on the remittance basis and are neither UK domiciled nor deemed domiciled on 5th April, 2025 will be able to claim a capital gains tax rebasing uplift to the April 2019 value for assets sold after April 2025.

In addition, the Conservatives have announced that any Excluded Property Trusts — i.e. those established by non-domiciled individuals and are therefore not subject to UK IHT unless they hold UK situs assets — would retain their IHT benefits so long as they were settled before
6th April, 2025.

Some implications of the proposals.

In the first instance, individuals planning to come to the UK might consider the timing of their move. The new regime will be very attractive to new arrivers so they may wish to consider aligning their arrival date to that of the introduction of the new rules so they are able to take full advantage of the FIG regime. Whilst several countries already have a tax regime aimed at attracting wealthy individuals, these often come with a requirement to make a substantial investment in the country or pay a hefty annual charge to benefit from the local regime. As currently proposed, the FIG regime will have no such requirement, so it is very generous for the first four years of UK residence.

Because of this, we may see a rise in individuals using the UK as a temporary place of residence. In particular, the FIG regime will be attractive for business owners looking to realise a gain on or extract dividends from their non-UK business, which they will be able to do without incurring any UK tax. They will, of course, need to carefully consider the interaction of the new rules with tax legislation in the source jurisdiction.

There will also be certain professions where the changes could have a disproportionately large impact — for instance, foreign football players will typically keep their wealth out of the UK as they are generally able to meet their UK spending needs on just their club salary. This will no longer be effective planning after four years of UK residence, so we might see players only willing to sign up to a four-year contract, after which the player moves on to another league.

Consideration will also need to be given to how the new rules work with existing Double Tax Agreements. In many cases, relief from taxation in one jurisdiction is only available where the income or gains are taxed in the other jurisdiction — as the new FIG rules will not bring the income or gains into UK taxation, the taxing rights may fall back to the country where the income or gains are derived from.

For non-doms who are already UK residents and have not previously claimed the remittance basis, they may wish to consider doing so in order to ensure they can benefit from some of the transitional provisions. As noted above, there is likely to be a ‘cost’ to making the claim, so once there is certainty over the incoming rules, they will need to weigh this up against the benefits of doing so.

All that said, at the time of writing, these are still just proposals with no legal authority, and the Labour Party have given some strong suggestions that they would not introduce everything announced in the Spring 2024 Budget. In particular, they have suggested there would be no 50 per cent income exemption for those unable to benefit from the FIG regime and also that Excluded Property Trusts would lose their preferential IHT status. This leaves those affected in a rather unhelpful position with no firm basis on which to make plans.

Inheritance Tax (IHT) (again)

Finally, the Conservatives also announced their intention to move the application of IHT to a residence-based system from April 2025 but have not yet expanded further on this area. It would be extremely harsh to bring an individual’s entire estate into the charge to UK taxation after only four years of residence, so a 10-year period has been suggested as a starting point for discussion. We are advised that the Government will issue a formal Consultation on this matter in the summer, after which we can expect more information on the direction of travel.

WHAT NEXT…

The Government has given advanced notice of a fundamental change to UK taxation. This is helpful insofar as those affected are now aware that a change is coming — the issue is over what the landscape will look like after April 2025 and what actions they should be taking based on their personal circumstances.

The upcoming General Election and the contrasting views of the two main political parties add an element of uncertainty, but there are a few areas that seem to be relatively safe assumptions. Both parties seem to agree that the concept of domicile should be replaced with a residence-based test, indicating the existing non-dom regime is going. There also seems to be agreement that a mechanism which enables remittance basis users to bring funds into the UK is necessary, so we can expect some incarnation of Temporary Repatriation Facility —although it will be interesting to see how this looks when eventually legislated. Beyond that, it would seem that everything is up for debate and we expect this to be a key battleground as the parties draw up their tax policies for the General Election.

So much like Christopher Columbus, we know the direction of travel but not how we will get there or what the landscape will look like on arrival. For those wishing to avoid the new rules, the obvious option is to get off the ship — i.e., leave the UK before April 2025, but this would result in some pretty significant lifestyle changes that may not be attractive to everyone. For those who intend to stay in the UK, they should keep a close eye on developments over the next 6–8 months and, when we eventually have certainty on the incoming rules, be prepared to act swiftly. Accordingly, those with complex affairs will want to review their assets and structures to assess the implications of the changes and give consideration to their long-term objectives. Once the new regime is finalised, there will then be a relatively short window to implement any changes or suffer the consequences of this brave new world.

Transfer Pricing (TP) regulations examine related party transactions as to whether they are undertaken between parties on an arm’s length basis or otherwise from the viewpoint of avoidance of tax leakage, i.e., whether said transactions are priced in a manner as transactions between two independent parties would have been priced. This not only mitigates tax leakage from one country to another but also ensures appropriate corporate governance (especially in listed companies dealing with public money).

In the complex landscape of TP, the issuance of corporate guarantees and letters of comfort (including the potential compensation to be charged thereon) has been a matter of significant controversy in income tax proceedings as well as in audit committee discussions.

BACKGROUND

Essentially, a corporate guarantee / letter of comfort is issued by a holding company to the bankers on behalf of its subsidiary, basis which the bank lends funds to the subsidiary. The borrowings in several cases entail a significant quantum of funds and consequentially, the above controversy has now reached corporate boardrooms and top management.

While the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations 2022 (OECD Guidelines) covers financial guarantees and does not specifically mention corporate guarantees, conceptual reference can be drawn from various paragraphs therein.

Para no. 10.154 of the OECD Guidelines acknowledges the intricacies involved in guarantee-related transactions, stating that “To consider any transfer pricing consequences of a financial guarantee, it is first necessary to understand the nature and extent of the obligations guaranteed and the consequences for all parties, accurately delineating the actual transaction in accordance with Section D.1 of Chapter I.”

Para no. 10.155 of the OECD Guidelines states that “There are various terms in use for different types of credit support from one member of an MNE group to another. At one end of the spectrum is the formal written guarantee and at the other is the implied support attributable solely to membership in the MNE group.”

Para no. 10.158 of the OECD Guidelines states that “From the perspective of a lender, the consequence of one or more explicit guarantees is that the guarantor(s) are legally committed; the lender’s risk would be expected to be reduced by having access to the assets of the guarantor(s) in the event of the borrower’s default. Effectively, this may mean that the guarantee allows the borrower to borrow on the terms that would be applicable if it had the credit rating of the guarantor rather than the terms it could obtain based on its own, non-guaranteed, rating.”

Para No. 10.163 of the OECD Guidelines deals with explicit / implicit support and states that “By providing an explicit guarantee the guarantor is exposed to additional risk as it is legally committed to pay if the borrower defaults. Anything less than a legally binding commitment, such as “letter of comfort” or other lesser form of credit support, involves no explicit assumption of risk. Each case will be dependent on its own facts and circumstances but generally, in the absence of an explicit guarantee, any expectation by any of the parties that other members of the MNE group will provide support to an associated enterprise in respect of its borrowings will be derived from the borrower’s status as a member of the MNE group. For this purpose, whether a commitment from one MNE group member to another MNE group member to provide funding to meet its obligations, constitutes a letter of comfort or a guarantee depends on all the facts and circumstances … The benefit of any such support attributable to the borrower’s MNE group member status would arise from passive association and not from the provision of a service for which a fee would be payable.”

Thus, the factual parameters of each individual guarantee transaction need to be carefully considered and the internationally accepted principle indicates that an “explicit” guarantee with a financial obligation on the guarantor would be regarded as a “transaction” requiring arm’s length compensation. However, an “implicit” support like a “Letter of Comfort” ought not to require any compensation.

Corporate guarantees are typically explicit, i.e., there is a financial obligation on the guarantor in case of the borrower’s default. A “Letter of Comfort” on the other hand is merely a support letter by the Group’s flagship company to the lender confirming the status of the borrower entity as a Group constituent. No financial obligation is cast on the issuer of such a letter.

This is also evidenced by the terminology generally included in corporate guarantee agreements, which revolves around an obligation on the guarantor in the event of default by the borrower. Corporate guarantee agreements usually contain explicit / specific references to:

• “Unconditional / irrevocable / absolute financial obligation which the guarantor agrees to bear”;
• “Obligations binding on the guarantor to pay any defaulted amounts to the lender on behalf of the borrower”;
• “Continuing security for all amounts advanced by the bank”;
• “In the event of any default on the part of Borrower in payment/repayment of any of the money referred to above, or in the event of any default on the part of the Borrower to comply with or perform any of the terms, conditions and covenants contained in the loan agreements / documents, the Guarantor shall, upon demand, forthwith pay to the Bank without demur all of the amounts payable by the borrower under the loan agreements / documents”;
• “The Guarantor shall also indemnify and keep the Bank indemnified against all losses, damages, costs, claims, and expenses whatsoever which the Bank may suffer, pay, or incur of or in connection with any such default on the part of the Borrower including legal proceedings taken against the Borrower.”

In contrast, the nomenclature used in a letter of comfort is far more generic / informative in nature, typically involving:

• “Declarations from the issuer of the letter that they are aware of the credit facility being extended to its subsidiary”;
• “Assurance to the lender that the issuer shall continue to hold majority ownership / control of the business operations of the borrower”;
• “The issuer shall not take any steps whereby the borrower might enter into liquidation or any arrangement due to which rights of the lender could get compromised vis-a-vis other creditors.”

Therefore, corporate guarantees and letters of comfort serve their respective purpose and the rationale behind providing a corporate guarantee or issuing a comfort letter are not directly comparable.

REGULATORY AND JUDICIAL HISTORY OF THE ISSUE IN INDIA

One of the first rulings from the Indian judiciary on the issue of applicability of transfer pricing provisions on providing of corporate guarantee by a parent to its subsidiary company was in the case of Four Soft Ltd vs. DCIT, wherein the Hyderabad Income-tax Appellate Tribunal (ITAT) (62 DTR 308) adjudicated that the definition of international transaction did not specifically cover transaction for providing corporate guarantee and hence, in absence of any charging provision enabling application of TP regulations to the said transaction, the same would be outside the purview of TP.

However, in the case of Nimbus Communications Ltd vs. ACIT [2018] 95 Taxmann.com 507 (MUM-TRIB.), Mumbai ITAT held that the provision of corporate guarantee is an international transaction.

To provide more clarity from a regulatory standpoint, Finance Act 2012 retrospectively amended the Income-tax Act, 1961 (the Act) by appending clause “(c)” to Explanation (i) in Section 92B of the Act, specifically including corporate guarantee as an international transaction. Before the said amendment, the matter of contention was the inclusion of corporate guarantee as an international transaction. Post amendment, the issue of eligibility of corporate guarantee as an international transaction continued to evolve, with the addition of newfound arguments centered around the validity of retrospective amendment and interpretation of Explanation (i) to Section 92B of the Act in conjunction with the Section itself. It is pertinent to note that Letter of Comfort has not been specifically included in the purview of Section 92B of the Act vide aforesaid amendment, thereby continuing to remain a bone of contention from the perspective of classification or otherwise as an international transaction under transfer pricing regulations.

Divergent views have been taken in subsequent judicial pronouncements. In the case of Bharti Airtel Limited vs. ACIT [2014] 63 SOT 113 (Del), it was held by the ITAT, Delhi that “there can be a number of situations in which an item may fall within the description set out in clause (c) of Explanation to Section 92B, and yet it may not constitute an International transaction, as the condition precedent with regard to the ‘bearing on profit, income, losses or assets’ set out in Section 92B(1) may not be fulfilled.” Thus, a view can be taken that a corporate guarantee is in the nature of parental obligation or shareholder’s activity for the best interest of the overall group, and if it can be established that providing a corporate guarantee does not involve any cost to the guarantor, then such corporate guarantee is outside the ambit of the “international transaction”.

However, in the case of Redington (India) Ltd [TS-656-HC-2020(MAD)-TP], the Hon’ble Madras High Court held that corporate guarantee is an international transaction and upheld the guarantee commission rate of 0.85 per cent to be at arm’s length. The Hon’ble High Court observed that in case of default, the guarantor has to fulfil the liability and therefore there is always an inherent risk to the guarantor in providing such guarantees. Hence, the Hon’ble High Court adjudicated that there is a service provided to the AE in increasing its credit worthiness for obtaining debt from the market. It was further observed that there may not be an immediate impact on the profit and loss account, but an inherent risk to the guarantor cannot be ruled out in providing such guarantees.

Over time, a multitude of assertions by the tax authorities as well as rulings by judicial authorities providing a variety of views as to whether or not such arrangements qualify as “covered transactions” from a TP perspective have added fuel to the above controversy.

Post the barrage of judicial pronouncements, the general consensus among taxpayers was that in case of an explicit guarantee, taxpayers typically reported it as an international transaction and conducted the arm’s length analysis accordingly.

Another controversy was on the issue of “Letters of Comfort” where the support is more implicit. In case of default, there is no financial obligation on the issuer of such a letter. The tax authorities have always alleged that even if there is no direct financial obligation, the mere fact that such letters of comfort benefit the group entity borrowing funds, compensation would be warranted.

The taxpayers have, however, maintained the position that implicit support could never warrant a fee.

RECENT DEVELOPMENTS

Very recently, the Mumbai ITAT issued two specific rulings on whether or not the issuance of a comfort letter can be considered in the same light as a corporate guarantee, thereby constituting an international transaction. While the rulings were fact-specific, they have shed further light on the debate.

In the case of Asian Paints Limited vs. ACIT [2024] 160 Taxmann.com 214 (MUMBAI-TRIB.) & ACIT vs. Asian Paints Limited (I.T.A. No. 5934/Mum/2017), the ITAT adjudicated that a comfort letter meets the criteria of international transaction even though they cannot be squarely compared to a corporate guarantee. Here, the ITAT focused on the fact that the taxpayer had made a specific disclosure in its financial statements showing it as a “contingent liability” in the same manner as corporate guarantee was disclosed in the financial statements. The ITAT held that since the taxpayer itself has classified it as a contingent liability, the letter of comfort has a bearing on the assets. Accordingly, it meets the specific criteria prescribed under Section 92B of the Act whereby, inter alia, a transaction having a bearing on the profits, income, losses, or assets is an international transaction and hence, compensation is warranted.

However, in the case of Lupin Limited vs. DCIT [2024] 160 Taxmann.com 691 (MUMBAI-TRIB.), the ITAT observed that in order to ascertain whether or not the issuance of a comfort letter constitutes an international transaction, it is important to examine whether any additional financial obligation is cast on the taxpayer. The ITAT held that issuance of a comfort letter is not an international transaction as “Rule 10TA of Safe Harbour Rules for International Transactions defines “corporate guarantee” as explicit corporate guarantee extended by a company to its wholly owned subsidiary being a non-resident in respect of any short-term or long-term borrowing and does not include a letter of comfort, implicit corporate guarantee, performance guarantee or any other guarantee of similar nature.”

Further, in relation to the characterization or otherwise of a letter of comfort as an international transaction, in a recent judgement of Shapoorji Pallonji and Company Private Limited [TS-147-ITAT-2024(Mum)-TP], the Mumbai ITAT held that a letter of comfort does not come under the definition of ‘international transaction’ and there is no necessity for determining the ALP of the said transaction.

A controversy has also recently come to light in the case of Goods and Services Tax (GST) law in India as to whether such guarantee transactions need to be valued and are eligible for GST liability.

Vide Circular No. 204/16/2023-GST dated 27th October, 2023, the Central Board of Indirect Taxes and Customs (CBIC) clarified that where the corporate guarantee is provided by a company to a bank / financial institutions for providing credit facilities to its related party the activity is to be treated as a supply of service between related parties. Further, in case where no consideration is charged for the said activity, it still falls within the ambit of ‘supply’ in line with Schedule I to the CGST Act.

For valuation of the aforesaid ‘supply’, a new sub-rule was inserted to Rule 28 of the CGST Rules, 2017 vide Notification No. 52/2023-Central Tax dated 26th October, 2023, whereby the value of supply of such services was prescribed as 1 per cent of the amount of such guarantee offered, or the actual consideration, whichever is higher.

A petition against the above-mentioned amendment has been filed before the Hon’ble High Court of Delhi, wherein the levy of GST on corporate guarantees has been challenged basis of the alleged fact that guarantees are contingent contracts which are not enforceable until the guarantee is invoked and a financial obligation on the guarantor is triggered, thereby giving rise to the issue of a “taxable service”. The matter is presently sub judice, with the hearing scheduled for July 2024.

KEY TAKEAWAYS FROM THE ABOVE

In a nutshell, the critical differentiator when ascertaining whether or not a consideration needs to be charged would be whether the support in question is explicit or implicit based on the facts of the case. If the support casts a financial liability on the guarantor, compensation may be required. A mere implicit support ought not to warrant compensation from a TP perspective.

PRICING FROM A TP AND GST STANDPOINT

Once it is established that compensation is required, determining the quantum of such compensation becomes critical from a business / operational viewpoint.

From a TP perspective, it is a matter of benchmarking by adopting various methods for conducting such analysis. Globally, the Interest Savings Method (ISM) and Loss Given Default (LGD) approach are widely accepted.

The ISM applies the principle of interest rates being determined based on credit ratings. Since the credit rating of the guarantor gets super imposed on the borrower, the borrower can obtain the funds at a reduced interest rate. Such reduction is the “interest saving” which needs to be compensated. In such cases, it becomes vital to understand the benefit obtained by the borrower through the support / credit rating provided by the guarantor and to quantify the value of said benefit in terms of savings in interest payout.

Broadly, LGD is the estimated amount of money a guarantor is expected to pay without recovery when a borrower defaults on a loan. The LGD method firstly takes into account the probability of default by the borrower triggering payout for the guarantor and subsequently, the likelihood of non-recovery of the said payout by the guarantor from the borrower. The compensation is computed based on the percentage of such default probability on the guaranteed amount.

Apart from the above, in case the guarantor / borrower has entered into a similar transaction with an unrelated party on identical terms, the guarantee commission percentage in such transaction could also be adopted. This is referred to as the Comparable Uncontrolled Price (CUP) method. The CUP method mandates strict comparability, and for application of the same, the terms & conditions of the arrangement in question must be almost perfectly identical to the terms & conditions of the comparable arrangement being considered.

In case an actual transaction is not entered into, even quotations for identical transactions can be utilized. Judicial precedents are also considered as references in this regard for providing a reference rate of guarantee commission to be charged, should the transaction be characterized as an international transaction requiring TP benchmarking.

Another reference point in the regulations is the Safe Harbour Rules, which prescribe a range of 1.75 per cent – 2.00 per cent for pricing of corporate guarantee transactions vide Rule 10TD of Income-tax Rules, 1962. The exact pricing is to be determined subject to specific conditions as mentioned in the aforesaid Rule.

Even from a GST perspective, the pricing of the transaction is imperative. The stand taken by the authorities has been that the provision of a guarantee is a service liable for taxation as it is undertaken by the parent company to maximize its returns on investment in the subsidiary.

As mentioned above, as per the aforementioned Circular issued by the GST authorities, a corporate guarantee should be valued at 1 per cent or the actual pricing, whichever is higher.

One key question which is presently under discussion is whether the transaction pricing for accounting, corporate governance, and income tax purposes should be based on actual benchmarking or whether the 1 per cent valuation prescribed by the GST authorities will prevail. In this regard, a better view seems to be that the 1 per cent valuation is merely for the purposes of payment of GST. However, the actual transaction should be undertaken based on the appropriate benchmarking methods. Having said this, the TP rules themselves recognize that Government orders in force need to be taken into account while determining the related party pricing. Hence, one may argue that 1 per cent itself is an appropriate transaction pricing. The issue has not reached finality and is still being debated.

CONCLUSION

Given the significant numbers involved in several cases, compensation or otherwise for corporate guarantees / letters of comfort has now become a boardroom topic. Given the recent rulings, Circulars and assertions by tax authorities, the controversy is far from settled. It is crucial to consider the facts and circumstances involved in each individual case, especially the actual conduct and intent of the parties to establish whether or not compensation is warranted. The nomenclature of the instrument or terminology used in the financial statements can be looked into, but should not be the sole factor for concluding on the nature of support. Having said that, wording the instrument accurately could reduce the questions raised.

Further, whether the 1 per cent guidance provided by the GST Circular should be the transaction pricing or whether a specific TP benchmarking should be the basis of the price determination is also a subject matter of debate. Given that the same is sub judice before the Hon’ble Delhi High Court, guidance in this regard is to provide clarity. Having said that, a better view seems to be that scientifically benchmarked pricing should be adopted, duly considering all the facts and particulars of each case in hand. However, tax professionals are still not ruling out the possibility of determining the guarantee transaction pricing at 1 per cent.

All facts and circumstances, including the Government and judicial views, need to be taken into account in adopting the appropriate positions on the issue. A holistic approach would be recommended.

1. This article is a part of the series of articles on income-tax and FEMA issues faced by NRIs and deals with issues faced by individuals when they change their residential status. A resident who leaves India and turns non-resident is termed as a “Migrating Resident”; while a non-resident of India, who comes to India and becomes a resident of India is termed as a “Returning NRI” in this article.

2. Both Migrating Residents and Returning NRIs have to consider implications under income-tax and FEMA before taking any decision for change of residence. We have come across several instances where such a person has not taken due care before change of residence leading to unnecessary and avoidable legal issues. After the advent of the Black Money Act¹, there are instances where corrective action is quite difficult under law. Further, resolution of violations under FEMA can be difficult or costly to undertake.

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1. Black Money (Undisclosed Foreign Income and Assets) and Imposition of Tax Act, 2015

3. Key to the above concern is the fact that residential status definitions under the Income-tax Act (ITA) and FEMA are separate and different. While under ITA, the definition is largely based on number of days stay of the individual in India; under FEMA, it is based on the purpose for which the person has come to, or left India, as the case may be. An important objective in advising persons who are migrating from India or returning to India, thus, is to determine the date on which the change in residence has been effected and purpose thereof. Any discrepancy in this can lead to assumption of incorrect residential status which can have adverse implications, some of which are as under:

a. Concealment of foreign income which should have been submitted to tax as well as non-disclosure of foreign incomes and assets, which can have severe implications under the Black Money Act;

b. Incorrect claim of benefits under the Double Tax Avoidance Agreements (DTAAs);

c. Holding assets or executing transactions which are in violation of FEMA.

4. The provisions of residential status under the ITA, the DTAA and under FEMA are dealt in detail in th preceding articles of this series — in the December 2023 and January and March 2024 editions, respectively, of The Bombay Chartered Accountant Journal (the Journal) — and hence, not repeated here. Readers will benefit by referring to those articles for issues covered therein. This article deals with income-tax and FEMA issues specifically for Migrating Residents and Returning NRIs² and is divided into three parts as follows:

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2. There is an overlap of several sections under different topics. To prevent repetition and focus on the relevant issues, the sections are not repeated completely. Only the applicable provisions or part thereof, which are relevant to the topic, are referred here.

Issues related to Returning NRIs and other relevant issues common to change of residential status will be covered in Part II of this Article in the upcoming issue of the Journal.

A. Migrating Residents

India has the world’s largest overseas diaspora. In fact, every year, 25 lakh Indians migrate abroad.³ While Indians shift and settle down abroad, it seldom happens that they eliminate their financial ties with India completely. The common reason being that either they continue to own assets or continue their businesses in India, or their relatives stay in India with whom they enter into transactions. Hence, Migrating Residents generally have a continuing link with India even after they have left India. This can create issues under income-tax and FEMA, which are analysed in detail below.

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3. https://www.moneycontrol.com/news/immigration/immigration-where-are-indians-moving-why-are-hnis-leaving-india-12011811.html

A.1 Income-tax issues relevant for Migrating Residents:

1. Continuing Residential status under ITA: An issue that Migrating Residents need to keep in mind in particular is their residential status in the year of migration. Clause (a) of Explanation 1 to Section 6(1)(c) of the ITA provides a relief from the basic “60 + 365 days test”⁴. The relief is available only under two specific circumstances, i.e., a citizen who is leaving India during the relevant previous year for the purposes of employment abroad or as a crew member on an Indian ship. If a person does not fall under either of these circumstances, the “60 + 365 days test” test applies.

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4 “60 + 365 days test” means that the individual has stayed in India for 60 days or more during the relevant previous year and for 365 days or more during the four preceding years.

Hence, in such cases, if a person who was normally residing in India, stays in India for 60 days or more during the year of his or her departure, he or she will meet the “60 + 365 days test” and consequently, be a resident for the whole previous year under ITA and will be classified as ROR. In such cases, following implications should be noted:

1.1 As a resident, scope of total income under Section 5 of the ITA includes all incomes accruing or arising within or outside India. Hence, foreign incomes would be prima facie taxable, subject to relief under the relevant DTAA. However, in the year of migration, even treaty benefits may not be available as the Migrating Resident may not be considered as a resident of the other country. Further, the exposure is not just regarding tax, interest and penalty under the Income-tax Act on concealment of income, but also the penal provisions under the Black Money Act for non-disclosure of foreign incomes and assets.

1.2 The issue gets compounded for a Migrating Resident who would otherwise not need to file a tax return but is now required to file a tax return as they would generally have a foreign bank account abroad. A common example is of students who are leaving India. Fourth proviso to Section 139(1) provides that those persons who are resident and ordinarily resident of India and hold or are beneficiary of any foreign asset are required to file their tax return in India even if they are not required to file a tax return otherwise. The same issue can come up for senior citizens or spouses who generally are not filing tax returns, but now need to do so in the year they are moving abroad. It should be noted that this requirement has no relief even if such person is termed as a non-resident for the purposes of the treaty under the relevant DTAA. Such an error can lead to harsh penalties under the Black Money Act for non-disclosure of foreign incomes and assets.

Hence, persons migrating abroad should be careful about their residential status in the year of migration.

1.3 Deemed Resident: Another instance where a Migrating Resident may still be considered as a resident under the ITA is due to the application of Section 6 (1A) of the ITA. This sub-section provides for an individual to be deemed as a resident of India if such individual, being a citizen of India, has total income other than income from foreign sources exceeding ₹15 lakhs during the previous year and is not liable to tax in any other country or territory by reason of domicile or residence or any other criteria of similar nature. While such deemed residents are considered as Resident but Not Ordinarily Resident as per Section 6(6)(d) of the ITA, their foreign incomes derived from a profession setup in India, or a business controlled from India are covered within the scope of income liable to tax in India. Readers can refer to the December 2023 edition of the Journal for an exposition on this provision.

1.4 Recording the change in status: On a person turning non-resident, his or her status should be correctly selected in the tax returns filed starting from the relevant assessment year of change in residence. It should be noted that the change in status recorded in the tax return does not automatically update the person’s status on the income-tax portal. Hence, such status should be changed on the income-tax portal also. Further, as of now, there seems to be no linking between the status updated in the tax return filed or on the income-tax portal with that recorded as per the local ward in the income-tax department. Hence, one should always ensure that such change is recorded in the local ward and the PAN is shifted to a ward which deals with non-residents. This will ensure that the status has been recorded in all manners with the tax department. This can be quite useful when the department issues notices to such persons.

2. Impact on change of residential status under ITA:

On change of residence, following are the important changes to keep in mind as far as ITA is concerned:

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5. Section 5 of ITA. 
6. Proviso to Section 112(1)(a) and 
Proviso to Section 112A (2) of ITA. 
7. Section 115A(1)(A)
8. Section 112(1)(a)(ii)
9. Section 112(1)(c)(iii)
10. Section 10(15)(iv)(fa)
11. Section 10(4)(ii)

3. Transfer Pricing: Transfer Pricing triggers in case of a transaction which can give rise to income (or imputed income) between associated enterprises (parties related to each other as per Section 92 of the Income-tax Act), of which at least one party is a non-resident. All such transactions must be on an arm’s length basis. The implications under Transfer Pricing on the shift of a person from India can lead to unnecessary complications. However, in some cases, such an implication may be unavoidable. Thus, the incomes earned by a Migrating Resident from his related enterprises in India and other International transactions with such enterprises would be subject to Transfer Pricing. There is no threshold on application of Transfer Pricing provisions.

Having considered the issues under the ITA, a Migrating Resident would need to study the impact of the DTAA, too, especially with regard to reliefs available. A detailed study of residential status as per the DTAA has been dealt with in the January 2024 issue of the Journal. Here, we focus on the issues a Migrating Resident needs to be concerned about:

4. Treaty relief:

4.1 A person can access DTAA if he is a resident of at least one of the Contracting States. To consider a person as resident of a Contracting State, DTAAs generally refer to the residential status of the person under domestic tax laws of the respective country. While there are different permutations possible, one important point to note is that while migrating abroad, there can be an overlapping period wherein the person is a resident of India as well as the foreign country during the same period. This leads to dual residency, for which tie-breaker tests are prescribed under Article 4(2) of the DTAA. There could also be a possibility of the concept of split residency under DTAA being applicable. Accordingly, the provisions of the DTAA can be applied. These provisions have been explained in detail in the second article of this series contained in the Journal’s January edition.

4.2 A dual resident status under the treaty can lead to the person being able to claim the status of a non-resident of India as per the relevant treaty even though they are a resident as far as the ITA is concerned. While this would provide them benefits under the treaty as applicable to a non-resident of India, it would not change their status under the ITA. Such persons would still need to file their tax return as a resident of India, and they would be treated as a non-resident only as far as application of the benefits of treaty provisions is concerned.

4.3 It should be noted that the benefit of treaty provisions as a non-resident is not automatic and is subject to conditions on whether such person qualifies as a tax resident of the country of his new residence as per the definition of the respective DTAA. Further, as per Section 90(4), a tax residency certificate should be obtained from the foreign jurisdiction. At the same time, as per Section 90(5), Form 10F needs be submitted online.

4.4 Individuals who claim treaty benefits without proper substance in the country of residence risk exposure to denial of such benefits under the anti-avoidance rules of the treaty like Principal Purpose Test or those of the Act in the form of General Anti-Avoidance Rules (GAAR) where the main purpose of such change of residence was tax avoidance.

A.2 FEMA issues of Migrating Residents:

5. Residential status: The concept of residential status under FEMA has been dealt with in the March 2024 edition of the Journal. FEMA uses the terms “person resident in India”¹² and “person resident outside India”¹³. For simplicity, these terms are referred to as “resident” and “non-resident” in this article.

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12 As defined in Section 2(v) of FEMA
13 As defined in Section 2(w) of FEMA

It is pertinent to note from the said article that only a claim that the person has left India — for or on employment, or for carrying on business or vocation, or under circumstances indicating his intention to stay outside India for an uncertain period — is not sufficient to be considered as a non-resident under FEMA. The facts and circumstances surrounding the claim are more important and should be backed up by documentation as well. For instance, leaving India for the purpose of business should be based on a type of visa which allows business activities and to support the purpose. Similarly, a person claiming to be leaving India for employment abroad should be backed up not only by an employment visa but also a valid employment contract; actual monthly salary payments (instead of just accounting entries); salary commensurate to the knowledge and experience of the person; compliance with labour and other applicable employment laws; etc. In essence, the intent and purpose should be backed by facts substantiated by documents which prove the bona fides of such intent.

6. Scope of FEMA: Once a person becomes non-resident under FEMA, such person’s foreign assets and foreign transactions are outside FEMA purview except in a few circumstances. However, such person’s assets and transactions in India would now come under the purview of FEMA. This can create issues in certain cases.

A common example of this is loans and advances between a Migrating Resident and his family members, companies, etc. On turning non-resident, the person generally does not realise that such fresh transactions can now be undertaken only as allowed under FEMA. A simple loan transaction can be a cause of unintended violations under FEMA — resolution for which is
generally not easy.

7. Existing Indian assets of migrating persons:

7.1 For a Migrating Resident, transacting with his or her own Indian assets after turning non-resident results in capital account transactions and, thus, can be undertaken only as permitted under FEMA. Section 6(5) of FEMA comes to the rescue in such a case. It allows a non-resident to continue holding Indian currency, Indian security or any immovable property situated in India if such currency, security or property was acquired, held or owned by such person when he or she was a
resident of India. In essence, Section 6(5) of FEMA allows non-residents to continue holding their Indian
assets which they acquired or owned when they were residents.

7.2 This also includes such assets or investments which cannot be otherwise owned or made by a non-resident. For instance, non-residents are not allowed to invest in an Indian company which is engaged in real estate trading. However, if a resident individual has invested in such a company and he later becomes a non-resident, he can continue holding such shares even after turning non-resident.

7.3 However, it should be noted that Section 6(5) permits only holding the existing assets. Any additional investment or transaction should conform with the FEMA provisions applicable to such non-residents.

Hence, if such an individual wants to make any further investment in the real estate trading company after turning a non-resident, he can do so only in compliance with FEMA. As investment by an NRI in an entity which undertakes real estate trading in India is not permitted under the NDI Rules¹⁴, such further investment would not be allowed even if the migrating person owned stake in such an entity before they turned non-resident.

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14. Non-debt Instrument Rules, 2019

7.4 Further, incomes earned, or sale proceeds obtained, from such assets can be utilised only for purposes permissible to a non-resident. Thus, incomes earned by a non-resident from assets he held as a resident cannot be utilised, for instance, to invest in a real estate trading company in India. This is in contrast to Section 6(4) of FEMA which applies to Returning NRIs who are permitted to invest and utilise their incomes earned on their foreign assets covered under Section 6(4) or sale proceeds thereof without any approval from RBI even after they turn resident. This concept of Section 6(4) will be explained in detail in the second part of this article dealing with Returning NRIs.

7.5 Other assets: Section 6(5) of FEMA specifies only three assets: Indian currency, Indian security or any immovable property situated in India. A person would generally own several other assets. For instance, the person may have an interest in a partnership firm, LLP, AOPs or may own gold, jewellery, paintings, etc. There is no clarity provided in FEMA or its notifications and rules on continued holding of such other assets. However, as a practice, a person is eligible to continue holding all the Indian assets after turning non-resident which he owned or held as a resident. In fact, even the business of all entities can continue.

7.6 Repatriation of sale proceeds and incomes: On the migrating person turning non-resident, assets in India are considered to be held on a non-repatriable basis. That is, the sale proceeds obtained on transfer of such assets are not freely repatriable outside India. This is because transfer of an asset held in India by a non-resident is a capital account transaction and full remittance of sale proceeds of such assets covered under Section 6(5) is not specifically allowed.

However, separately, on turning non-resident, NRIs (including PIOs and OCI card holders) are allowed to remit up to USD 1 million per financial year from their funds lying in India¹⁵. It should be noted that such remittances can be only from one’s own funds. Remittances in excess of this limit would be only under approval route and there are low chances of the RBI providing any relief in such cases. Thus, in essence, a Migrating Resident would have limited repatriability as far as sale proceeds of their assets in India covered under Section 6(5) are concerned.

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15. Regulation 4(2) of Foreign Exchange Management (Remittance of Assets) Regulations, 2016

Incomes generated from such investments, say dividend, interest, etc., can be freely repatriated from India without any limit as these are considered as they are current account transactions for which there are no limits on repatriation under FEMA for a non-resident.

7.7 Applicability of Section 6(5) of FEMA:

Section 6(5) of FEMA reads as under:

(5) A person resident outside India may hold, own, transfer or invest in Indian currency, security or any immovable property situated in India if such currency, security or property was acquired, held or owned by such person when he was resident in India or inherited from a person who was resident in India.

The first limb of Section 6(5) of FEMA allows non-residents to hold specified Indian assets which they owned or held as a resident. The second limb of Section 6(5) further allows the non-resident heir of such a migrating person also to inherit and hold such assets in India.

Thus, Section 6(5) allows both the Migrating Resident and his or her non-resident heirs to continue holding the Indian assets. It should be noted this provision covers only one level of inheritance, i.e., from the migrating person who has become non-resident to his non-resident heir. Later, if say the heir of such non-resident heir acquires such assets by way of inheritance, it is not covered under Section 6(5). The relevant notifications, rules, etc., under FEMA corresponding to the concerned assets need to be checked for the same. The permissibility for holding and inheritance under Section 6(5) can be summarised as follows:

An area of interpretation arises on a plain reading of the second limb of Section 6(5) which suggests that it covers inheritance by a non-resident heir only from a resident as the phrase reads as “a person who was resident in India”. However, the intention is to cover inheritance by a non-resident heir from another non-resident who had acquired the Indian assets when he was resident and later turned non-resident. Hence, if a non-resident acquires any asset in India by way of inheritance from a resident, the relevant notifications, rules, etc., under FEMA corresponding to the concerned assets need to be checked if they are permitted. For instance, if a non-resident is going to acquire an immovable property situated in India from a resident, it needs to be checked whether such inheritance is permitted under the NDI Rules¹⁶. Under Rule 24(c) of NDI Rules, an individual, who is non-resident, is permitted to acquire an immovable property situated in India by way of inheritance only if such person is an NRI or OCI cardholder. Hence, in this case, if the non-resident is an NRI or OCI cardholder, only then he is permitted to inherit an immovable property situated in India from a resident. This case will not be covered under Section 6(5).

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16. Non-debt Instrument Rules, 2019

Apart from the general relief under Section 6(5) of FEMA, there are certain specific assets and transactions which are dealt with separately under the notifications as explained below.

7.8 Bank and Demat Accounts: Bank and demat accounts normally held by persons staying in India are Resident accounts. When a resident individual turns non-resident, he is required¹⁷ to designate all his bank and demat accounts to Non-Resident (Ordinary) account – NRO account. One must note that there is no specific procedure under FEMA for a person to claim or to even intimate to the authorities that they have turned non-resident on migrating abroad. Unlike OCI card, there is no NRI card. Further, there is no concept of a certificate under FEMA like a Tax Residency Certificate under ITA. The simplest manner this claim can be put forward is by designating their bank account as a Non-Resident (Ordinary) account (NRO) account. Thus, it is important that a Migrating Resident does not delay in designating their bank account as an NRO account. This becomes the primary account of the person for Indian transactions and investments. It should be noted that banks will ask for related documents which substantiate the change in residential status of the individual for designating the account as NRO. In fact, the redesignation of account as NRO is the most widely accepted recognition of a person as an NRI under FEMA, and therefore, it is important for the Migrating Resident to intimate his banker about the change of residential status.

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17. Para 9(a) of Schedule III to FEMA Notification No. 5(R)/2016-RB. FEM (Deposit) Regulations, 2016.

Once the Migrating Resident becomes a non-resident as per FEMA, they are permitted to open different type of accounts like NRE account, FCNR account, etc., which provide permission to hold foreign currency in India, flexibility of making inward and outward remittances without limit or compliances, etc. Once a person becomes non-resident, he can take benefit of opening such accounts. (The provisions pertaining to the same will be dealt with in detail in the upcoming parts of this series of articles.)

7.9 Loans:

i. Loan taken by a Migrating Resident from bank: If a loan is taken by a resident from a bank and he later turns non-resident, the loan can be continued. This is subject to terms and conditions as specified by RBI, which have not been notified. However, in practice, banks are allowing non-residents to continue the loans taken by them when they were residents.

ii. Loan between resident individuals: Where a loan is given by one resident individual to another, FEMA would not apply. If the lender becomes a non-resident later, repayment of the same can be done by the resident borrower to the NRO account of the lender. There is no rule or provision in FEMA for a situation where the borrower becomes a non-resident. However, in such case, the borrower can repay the loan from his Indian or foreign funds. It should not be an issue.

7.10 Immovable properties: NRIs and OCIs are permitted to acquire immovable property in India, except agricultural land, farmhouse or plantation property¹⁸. However, what if a person owned such property as a resident and later turned non-resident. Section 6(5) covers any type of immovable property which was acquired or held as a resident. Hence, one can continue holding any immovable property after turning non-resident including agricultural land.

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18. Rule 24(a) of FEM (Non-debt Instruments) Rules, 2019

7.11 Insurance: Almost every Migrating Resident would have existing insurance contracts covering both life and medical risks. While there is no specific clarification on continuance of such policies, a Migrating Resident can take recourse to the Master Direction on Insurance¹⁹ which provides that for life insurance policies denominated in rupees issued to non-residents, funds held in NRO accounts can also be accepted towards payment of premiums apart from their other accounts. Settlement of claims on such life insurance policies will happen in foreign currency in proportion to the amount of premiums paid in foreign currency in relation to the total amount of premiums paid. Balance would only be in rupees by credit to the NRO account of the beneficiary. This would also apply in cases of death claims being settled in favour of residents outside India who are assignees or nominees on such policies.

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19. FED Master Direction No. 9/ 2015-16 - last updated on 7th December, 2021

7.12 PPF account: Non-residents are not permitted to open PPF accounts. However, residents who hold PPF account and turn NRIs (and not OCIs) are permitted to deposit funds in the same and continue the account till its maturity on a non-repatriation basis.²⁰ While extension is not permitted, as a practice, the account is permitted to be held after maturity but additional contributions are not allowed.

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20. Notification GSR 585(E) issued by Ministry of Finance dated 25th July 2003.

7.13 Privately held investments: Migrating person who holds investments in entities like unlisted companies, LLPs, partnership firms, etc. should intimate such entities about change in residential status.

8. Remittance facilities for non-residents: The remittance facilities for non-residents are generally higher and more flexible than for residents. These will be dealt with in detail in the upcoming editions of the Journal. However, an important point pertaining to the year of migration is highlighted below.

The bank, broker, etc., should be intimated about the change in residential status. Once the resident accounts are designated as NRO, the remittance facilities available for non-residents can be utilised.

One must note that, conservatively, the remittance facilities are to be considered for a full financial year and hence cannot be utilised as applicable for residents as well as non-residents in the same financial year. For instance, let’s say, a resident individual has utilised the maximum LRS limit of USD 250,000 available to him. In the same year, he migrates abroad and wishes to remit USD 1 million as a non-resident under FEMA. However, since the person had already remitted USD 250,000 during the year, albeit as a resident, he cannot remit another USD 1 million after turning non-resident. He can remit only up to USD 750,000 during that year. From the next financial year, the person can remit up to USD 1 million per year.

9. Foreign assets directly held by Migrating Residents:

9.1 More and more residents today own assets abroad. Generally, a resident individual could be holding overseas investment by way of Overseas Direct Investment (ODI), Overseas Portfolio Investment (OPI) or an Immovable Property (IP) abroad as per the Overseas Investment Rules, 2022. Let us consider that such an individual migrates abroad. Does FEMA apply to these foreign assets after such person becomes a non-resident? There is no express provision in the law or any clarification from RBI regarding applicability of FEMA in such cases.

9.2 The general rule is that FEMA does not apply to the foreign assets and foreign transactions of a non-resident. Hence, prima facie, where an individual turns non-resident, his foreign assets are out of FEMA purview. Thus, foreign investments and foreign immovable property obtained under the LRS route would go out of the purview of FEMA once a person turns non-resident.

9.3 However, there is a grey area for investments made under the ODI route by resident individuals. This is because investments under the LRS-ODI route stand on a footing different from other foreign assets of resident individuals. Many Resident Individuals set up companies abroad under the LRS-ODI route²¹, establish their overseas business and then migrate abroad. What gets missed out is to determine whether FEMA continues to apply even after they have turned non-resident.

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21 Route adopted for overseas direct investment by Resident Individuals as per Rule 13 of Overseas Investment Rules, 2022 or as per erstwhile Reg. 20A of FEM (Transfer or Issue Of Any Foreign Security) Regulations, 2004.

Under LRS-ODI route, the investment and disinvestment need to be done as per pricing guidelines; all incomes earned on the investment and the sale proceeds thereof need to be repatriated to India within 90 days; reporting of every investment or disinvestment is required, etc. It is not clear whether these disinvestment norms and reporting requirements continue to apply after the person turns non-resident.

It is understood that when an intimation is provided that all the residents owning the foreign entity under the LRS-ODI route have turned non-resident, the RBI suspends the associated UIN²² but does not cancel it. This is done so that there is no trigger from the system for filing of Annual Performance Report (APR). In case the Migrating Residents decide to return to India in future and turn resident again, the suspension on the UIN would be removed and compliance requirements would restart.

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22. Unique Identification Number provided for each ODI investment.

Apart from the compliance requirements, there are other rules that apply to investments under the LRS-ODI Route like pricing guidelines, repatriation of incomes and disinvestment proceeds, reporting of modifications in the investment, etc. There is no clarity on whether these rules continue to apply to such overseas investments once the Migrating Resident turns non-resident. One view is that in such a case the Resident should follow the applicable ODI rules. This is because the facility provided for making investments abroad under ODI route is with the underlying purpose that incomes and gains earned on such foreign investments would be repatriated back to India as and when due. Another reason seems to be that when the investment is made under LRS-ODI, the individual has used foreign exchange reserves of India and therefore, he or she is required to give the account of use of such funds till the investment is divested and compliances are completed. The alternate view is that FEMA does not apply to a foreign asset held by a non-resident individual. Hence, no compliance with rules under FEMA is required. Both views can be considered valid. However, without any clarification under the law, one should seek clarification from the RBI and then proceed in the alternate case.

10. Overseas Direct Investment (ODI) made by Indian entities of Migrating Residents: One more common structure is where the Indian entities owned by resident individuals make ODI in foreign entities. Later, the individuals migrate abroad. Since they have turned non-residents, FEMA does not apply to such individuals. However, sometimes these non-residents also consider that their overseas entities are also free from FEMA provisions.

Hence, they enter into several transactions like borrowing funds from such foreign entity, directing such entity to undertake portfolio investments, utilise the funds lying in such entity for personal purposes of the shareholders or directors, etc. All such transactions are not permitted under the ODI guidelines. It should be noted that once an investment is made in a foreign entity under ODI route by an Indian entity, the ODI guidelines need to be followed by the foreign entity irrespective of the residential status of its ultimate beneficial owners. Such a foreign entity can only do the specified business for which it has been set up abroad. Thus, if such an entity enters into any transaction outside its business requirements, it would be considered as a violation under FEMA.

A.3. Change of citizenship — FEMA & Income-tax issues: Apart from change of residence, a few Migrating Residents also end up changing their citizenship. Such people obtain citizenship of foreign countries for varied reasons: to avail better opportunities in such countries; to avoid regular visa issues, for ease of entry in other countries, etc. Since India does not allow dual citizenship, such people need to revoke their Indian citizenship. Between 2018 to June 2023, close to 8,40,000 people renounced their Indian citizenship.²³ Further, India has allowed such individuals access to a special class of benefits as an Overseas Citizen of India. Several benefits have been conferred to OCI cardholders under FEMA and are treated almost at par with NRIs (who are Indian citizens but non-resident of India). The concepts of PIO and OCI have been explained in detail in the March edition of the Journal. Further, Indian residents and those coming on a visit to India, who have obtained foreign citizenship, also need to keep certain issues in mind. These issues are highlighted below.

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23. Answer by Ministry of External Affairs in Rajya Sabha to Question No. 2466 dated 10th August, 2023

11. OCI vs PIO card: It should be noted that the PIO scheme has been replaced with OCI scheme. Under the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019, Foreign Exchange Management (Debt Instruments) Regulations, 2019 and Foreign Exchange Management (Borrowing & Lending) Regulations, 2018, only OCIs are recognised and not PIOs. Hence, this creates issues for borrowing and lending, investments in India, etc., if the individual, though of Indian origin, has not obtained an OCI card. An important point that may not miss the attention of PIOs is that inheritance of immovable properties and Indian securities is also permitted under these notifications only to OCI Cardholders and not PIOs. Most PIOs should be eligible for OCI status and hence, they should obtain OCI cards if they have, or will have, financial links with India.

12. Applicability of Section 6(1A) of the ITA: Section 6(1A) of the Income-tax Act which deems persons as Not Ordinarily Residents under certain circumstances applies only to Indian citizens. Hence, it does not apply to those who are not Indian citizens.

13. Leaving for the purpose of employment abroad: The benefit of leaving for employment outside India provided under Expl. 1(a) of Section 6(1)(c) is available only to Indian citizens. Hence, a person who is not an Indian citizen, cannot take this benefit.

14. Donations: Indian charitable trusts are not allowed to accept donations from foreign citizens unless they have obtained approval under the Foreign Contribution Regulation Act (FCRA). This prohibition is irrespective of whether the person is a PIO or an OCI. While it is a violation for the trust to accept the donation, even the donor should keep this in mind to not be a party to any contravention. At the same time, the FCRA prohibition does not apply to a non-resident who is a citizen of India. Hence, NRIs can continue to donate to Indian charitable trusts.

15. Citizenship-based taxation: In certain countries like the USA, the domestic tax laws have citizenship-based taxation whereby its citizens are taxed on their global incomes, irrespective of where they stay during the year. Even green card holders are taxed in a similar manner in the USA. Such persons when they return to India become dual residents on account of their physical stay in India and their foreign citizenship. Hence, such persons will be liable to tax on their global incomes both in India and the foreign country. Several issues of Double Tax and foreign tax credit arise in such cases and hence, proper planning is required.

16. Relief of disclosure of foreign assets: There is a limited and conditional relief from reporting of foreign assets under Schedule FA of the income-tax return forms for foreign citizens who have become tax residents while they are in India on a business, employment or student visa.

The above analysis intends to highlight the various issues that a Migrating Resident should be aware of. They should not be considered as a comprehensive list of issues that apply to a Migrating Resident. Issues relevant to “Returning NRIs” and other relevant but common issues of concern related to change of residence including inheritance tax, anti-avoidance rules under ITA, succession planning, documentation and record-keeping, etc., will be dealt with in the forthcoming issue of the Journal as Part II of this article.