Expanding into foreign markets offers Indian businesses the potential to access larger customer bases, advanced technology, and strategic investment opportunities. However, cross-border operations are governed by a complex framework of domestic tax laws, international treaties, and regulatory compliance obligations. Failure to account for these intricacies can expose companies to double taxation, unexpected liabilities, disputes with tax authorities, and reputational risks. Businesses aiming for sustainable global growth must these challenges by the common international tax traps, their statutory bases, and the latest policy developments.

In this article, CA Manish Mishra talks about International Tax Traps to Avoid When Expanding Overseas.

Risk of Creating Unintended Tax Residency (PoEM)

A frequent but often overlooked danger is the Place of Effective Management (PoEM) rule under Section 6(3) of the Income-tax Act, 1961, which determines when a foreign company becomes an Indian tax resident. PoEM refers to the location where key management and commercial decisions necessary for business operations are made in substance.

The CBDT PoEM Guidelines (Circular No. 6/2017) highlight that even without a foreign company’s physical presence in India, board decisions, strategic policy approvals, and operational control from India can result in worldwide income being taxed in India. Preventing PoEM exposure requires ensuring decision-making occurs in the foreign jurisdiction, maintaining detailed minutes of offshore board meetings, and appointing local directors with genuine authority.

Permanent Establishment (PE) Exposure in Foreign Markets

Permanent Establishment (PE) risk arises when a business’s overseas operations create a taxable presence under Article 5 of DTAAs or the OECD/UN Model Conventions. PE types include Fixed Place PE, Service PE, and Dependent Agent PE.

The Multilateral Instrument (MLI), effective for India since 2019, tightened PE definitions by narrowing “preparatory or auxiliary” exemptions and preventing fragmentation of related activities to avoid PE status. Even warehousing, marketing, or technical support can constitute PE if not structured properly. Companies must evaluate the duration, scope, and control of foreign activities to avoid unintended PE creation.

Treaty Shopping and the Principal Purpose Test (PPT)

India combats treaty abuse through the Principal Purpose Test (PPT) introduced in the MLI and bilateral treaties. PPT empowers tax authorities to deny treaty benefits if one of the main purposes of an arrangement is to obtain benefits contrary to the treaty’s intent.

The CBDT Circular No. 1/2025 (21 January 2025) clarified that PPT applies prospectively from the date it comes into force for each treaty partner. Structures in jurisdictions such as Mauritius, Singapore, or the Netherlands must now demonstrate genuine commercial activity, local employees, office premises, and substantive economic engagement to qualify for reduced tax rates or exemptions.

Withholding Tax (WHT) and Payment Characterisation Errors

Under Section 195 of the Income-tax Act, Indian residents must withhold tax on payments to non-residents if such payments are chargeable to tax in India. Incorrectly categorising payments can cause either under-withholding (leading to interest and penalties) or over-withholding (locking up funds until refund).

Amounts that appear to be business income may fall under Section 9(1)(vi) (royalty) or Section 9(1)(vii) (fees for technical services). The Supreme Court’s ruling in Engineering Analysis Centre of Excellence Pvt. Ltd. v. CIT (2021) established that payments for off-the-shelf software without transfer of copyright do not constitute royalty. However, the application of this principle must be tested against the relevant DTAA and supported by documentation such as Tax Residency Certificates (TRCs), Form 10F, and beneficial ownership declarations.

Transfer Pricing and Secondary Adjustments

Sections 92 to 92F of the Income-tax Act mandate arm’s length pricing for international transactions with associated enterprises. Deviations can trigger primary adjustments and, under Section 92CE, secondary adjustments requiring repatriation of excess amounts to India. If the funds are not repatriated within prescribed timelines, notional interest is imputed.

Businesses should align contracts with actual functions, assets, and risks using the OECD’s DEMPE framework for intangibles. Proactive use of Advance Pricing Agreements (Section 92CC) or Safe Harbour Rules (Section 92CB) can offer multi-year certainty and reduce disputes.

Interest Limitation Rules (Thin Capitalisation)

Section 94B imposes interest deduction restrictions for payments to associated enterprises, limiting them to 30% of EBITDA (with a ₹1 crore threshold). Even loans from third parties can be affected if guaranteed by an associated enterprise.

Companies must plan their capital structure carefully, maintain documentation showing commercial justification for debt levels, and comply with transfer pricing norms for guarantee fees to avoid disallowances.

Digital Nexus and Equalisation Levy Changes

India’s Significant Economic Presence (SEP) rules in Explanation 2A to Section 9(1)(i) enable taxation of income from digital transactions with Indian users above certain thresholds, even without physical presence.

The Equalisation Levy regime has undergone major changes: the 2% levy on e-commerce operators was repealed from 1 August 2024, and the 6% levy on online advertisements will be abolished from 1 April 2025. These changes alter compliance obligations and may necessitate renegotiation of contracts in digital and advertising sectors.

Global Minimum Tax (Pillar Two)

The OECD/G20 Pillar Two initiative establishes a 15% global minimum corporate tax for multinational groups with revenues over €750 million, implemented through Qualified Domestic Minimum Top-up Taxes (QDMTTs) and the Income Inclusion Rule (IIR) in many countries.

Although India has not yet implemented Pillar Two fully, Indian multinational groups must evaluate effective tax rates in all operating jurisdictions to anticipate possible top-up taxes and optimise holding structures accordingly.

General Anti-Avoidance Rules (GAAR)

India’s GAAR provisions, in Sections 95–102, allow tax authorities to deny benefits from arrangements whose main purpose is obtaining a tax benefit and which lack commercial substance. GAAR applies even where a Specific Anti-Avoidance Rule (SAAR) is satisfied.

To withstand GAAR challenges, companies must provide evidence of genuine business purposes, operational substance, and alignment between contractual terms and actual commercial activity.

FEMA and Overseas Investment Compliance

Overseas expansion is also regulated under the Overseas Investment Rules and Regulations, 2022 framed under FEMA. These rules govern outbound investments, guarantees, and step-down subsidiaries.

Non-compliance can lead to penalties, forced restructuring, and indirect tax consequences. Coordination between tax planning and FEMA compliance is critical to ensure cross-border structures are legally sustainable.

Dispute Resolution Preparedness

Cross-border tax operations frequently give rise to disputes due to differing interpretations of laws and treaties by tax authorities in various jurisdictions. Mechanisms such as Advance Pricing Agreements (APAs) under Section 92CC, Safe Harbour Rules under Section 92CB, and the Mutual Agreement Procedure (MAP) available under DTAAs are effective in providing certainty and avoiding double taxation. APAs allow taxpayers to agree in advance on pricing methods for international transactions, ensuring multi-year clarity. Safe Harbour Rules simplify compliance by prescribing standard margins for eligible transactions, reducing transfer pricing disputes. MAP enables competent authorities of treaty countries to resolve taxation issues in a cooperative manner. Engaging early with these tools helps mitigate risks, reduce prolonged litigation, and foster smoother cross-border business operations.

Conclusion

International expansion offers tremendous opportunities, but without thorough tax and regulatory planning, companies risk falling into traps that can erode profits and delay growth. From PoEM and PE issues to treaty access, WHT errors, transfer pricing compliance, thin capitalisation, and evolving global tax norms, the challenges are multi-layered.

The solution lies in proactive compliance maintaining substantive economic presence, robust documentation, and periodic review of structures against evolving legal frameworks. With the right preparation, Indian businesses can expand globally while staying tax-efficient and legally compliant.

Frequently Asked Questions (FAQs)

Q1. What is PoEM and how can it affect my overseas entity?

Ans. PoEM under Section 6(3) determines Indian tax residency based on where strategic decisions are made. If the PoEM is in India, global income is taxed here. Avoid by holding board meetings abroad, appointing empowered foreign directors, and documenting offshore decision-making in line with CBDT Circular No. 6/2017.

Q2. How is a Permanent Establishment (PE) determined in foreign markets?

Ans. PE, defined in Article 5 of DTAAs, includes fixed place, service, and dependent agent PEs. The MLI narrows exemptions and prevents fragmentation. PE risk arises if operations are substantial or agents habitually conclude contracts abroad. Structure activities carefully to avoid unintended PE unless strategically beneficial, ensuring compliance with treaty rules.

Q3. What is the Principal Purpose Test (PPT) and why is it important?

Ans. PPT denies treaty benefits if one principal purpose is obtaining such benefits contrary to the treaty’s object. Introduced via the MLI, it applies prospectively per CBDT Circular No. 1/2025. Maintain genuine economic substance—local staff, office space, and active operations—to safeguard reduced tax rates or capital gains exemptions under treaties.

Q4. What are common mistakes in withholding tax (WHT) compliance?

Ans. Section 195 requires withholding on chargeable sums paid to non-residents. Mischaracterising royalties under Section 9(1)(vi) or FTS under Section 9(1)(vii) can cause disputes. Supreme Court rulings like Engineering Analysis guide classification. Always obtain TRCs, Form 10F, and beneficial ownership proof to secure treaty benefits and avoid penalties or interest.

Q5. How do transfer pricing rules apply to overseas expansion?

Ans. Sections 92–92F mandate arm’s length pricing for cross-border associated enterprise transactions. Secondary adjustments under Section 92CE require repatriation of excess profits or attract notional interest. Align contracts with OECD’s DEMPE principles. Consider Advance Pricing Agreements under Section 92CC or Safe Harbour Rules to gain certainty and reduce litigation exposure.