The Reserve Bank Of India ("Rbi") Has Recently Released A Discussion Paper titled "Discussion Paper – Presence of Foreign Banks in India" ("Discussion Paper"), wherein RBI has proposed that the foreign banks which are desirous of having presence in India should, in certain circumstances ("WOS Category"), mandatorily incorporate wholly owned subsidiary ("WOS"). RBI has also preferred that the existing branches of foreign banks and the foreign banks which do not fall under WOS Category should also adopt WOS structure. Further, in the event the said foreign bank chooses branch model as the preferred mode of presence, then, such branch would have to be compulsorily converted into WOS in case (i) any of the conditions for WOS Category materialize, in the judgment of RBI; or (ii) the same becomes systematically important ("Systematically Important") by virtue of the balance sheet size of the branch.
RBI feels that local incorporation of WOS of foreign bank would have the following advantages:
- the same would ensure clear delineation between assets and liabilities of the foreign bank's WOS vis-à-vis that of the foreign bank;
- it may be easier to define laws pertaining to jurisdiction issues;
- separate and focused management to act in the best interest of the foreign bank's WOS;
- local incorporation provides more effective control in a banking crisis; and
- enables authorities of the host country to act more independently, as compared to the branch operations.
RBI has stated that in view of Indian WTO commitments, existing branches of foreign banks in India would not be mandatorily required to convert into WOS. However, it is expected by RBI, that keeping in mind the incentives provided to WOS under the Discussion Paper (as compared to branch of a foreign bank), the existing branches which satisfy parameters for the WOS Category, or which become Systematically Important, would voluntarily convert themselves into WOS. The incentives are briefly stated herein below:
- in terms of national treatment, the WOS of a foreign bank would be on a better footing as compared to branch of a foreign bank (but less than a domestic bank);
- RBI may allow the WOS of a foreign bank to raise rupee resources through issue of non-equity capital instruments in the form of Innovative Perpetual Debt Instruments, Tier I and Tier II preference shares and subordinate debt, as allowed to domestic private sector banks; and
- the branch expansion policy as applicable to the domestic banks may be extended to WOS of the foreign bank which would, in turn, enable the WOS to open branches in Tier 3 to 6 centers (except at a few locations considered sensitive on security considerations).
It may also be highlighted herein that in order to address the issue of market dominance, the RBI has proposed that in case capital and reserves of the foreign banks in India including WOS and branches exceed 25% of the capital of the banking system, then restrictions would be placed by RBI on (i) further entry of new foreign banks, (ii) branch expansion in Tier I and Tier II centres and (iii) capital infusion into the WOS (will require RBI's prior approval).
TAX ISSUES
With regard to the capital gain tax liability, RBI has tried to address the issue by providing in the Discussion Paper the following paragraph:
"It appears that for any Capital Gains Tax arising out of transfer of property, goodwill and other assets of capital nature to its own newly incorporated subsidiary in India the provisions of Section 47(iv) of Income Tax Act, 1961 would be applicable to foreign banks converting their branches into subsidiaries".
In terms of section 47(iv) of the Income Tax Act, 1961, no capital gains is applicable in case of any transfer of a capital asset by a company to its subsidiary company if (a) the parent company or its nominees hold the whole of the share capital of the subsidiary company; and (b) the subsidiary company is an Indian company. However, the Discussion Paper has put a disclaimer that "Foreign banks may approach the appropriate authority for suitable clarification".
RBI has also taken cognizance of the issue with regard to repatriation of profits. As a branch, profits are allowed to be repatriated in the ordinary course of business. However, on conversion of the branch into WOS, profits would have to be distributed by way of dividends, which shall be subject to the minimum prudential requirements laid down by RBI. It may be noted that the dividend declared by a company incorporated under Indian laws is subject to payment of the dividend distribution tax, as levied under section 115 O of the Income Tax Act, 1961. It is suggested in the Discussion Paper that in the initial few years of incorporation, the WOS should be allowed to remit profits like a branch in India. Any such suggestion of RBI, in our opinion, would require suitable amendment in the Income Tax Act, 1961, to exempt levy of dividend distribution tax. At the same time, the decision regarding conversion of branch into WOS would also have to factor in the levy of branch profit tax, proposed in the Direct Tax Code, which provides for levy of additional tax @ 15% in respect of profits of the branch.
It remains to be seen that how far the proposals mooted by RBI would incentivize the foreign banks to adopt WOS structure for operations in India. RBI has invited suggestions / comments pertaining to the same by March 7, 2011.
The complete text of the Discussion Paper can be viewed at http://www.rbi.org.in/scripts/BS_PressReleaseDisplay.aspx?prid=23795
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