Breaking Down Tax Scrutiny for Foreign Company in India

A tax scrutiny for foreign company in India needs serious consideration since the consequences can be severe.

Learn with us all about tax scrutiny for foreign companies, why its triggered and how to handle it.

Why Foreign Companies Face Tax Scrutiny in India

Foreign companies doing business in India often get a closer look from the Indian tax authorities due to the following reasons:

Income Sourced from India: They are taxed on income that arises, is received, or accrues in India, even without a physical presence. This includes royalties, dividends, technical service fees, and capital gains.

Permanent Establishment (PE) Disputes: Tax authorities closely examine whether a foreign company’s operations, including digital presence or agent activities, create a taxable presence in India.

Transfer Pricing Risks: Transactions between Indian subsidiaries and related foreign entities must follow fair pricing (arm’s length principle). Authorities monitor for profit shifting through inflated costs or undervalued revenues.

High Documentation Requirements: Companies must maintain extensive transfer pricing documentation (Master File, Local File, CbCR). Gaps or errors can trigger audits and penalties.

Withholding Tax Compliance: Indian payers must deduct tax at source when paying foreign companies. Mistakes in deduction or missing documents (e.g., TRC, Form 10F) can result in higher tax demands or disallowed expenses.

Treaty Misuse and Treaty Shopping: Some companies route investments through low-tax jurisdictions to exploit tax treaties. Indian authorities examine whether there’s real commercial substance.

Characterization of Income: Disputes often arise over how payments are classified—such as royalty, business income, or fees for technical services—which affects tax rates and obligations.

Taxation of Digital Economy: India taxes certain online services (e.g., via Equalisation Levy). Foreign digital companies earning from Indian users may be liable, even without local offices.

High-Risk Sectors Under Tax Scrutiny in India

The Indian tax department pays extra attention to certain industries that have a higher chance of tax evasion or complicated money flows.

These “high-risk” sectors often see:

large cash flows
complex cross-border deals
transfer pricing
related-party transactions

High-Risk Sector	Why It’s Scrutinized
Information Technology (IT) & Software	Transfer pricing of services, royalties, licensing income, cross-border payments
Pharmaceuticals	Patent pricing, technology transfers, manufacturing through related parties
E-commerce	Big cash flows, deep discounts, GST compliance, cross-border transactions
Oil & Gas / Energy	Complex royalty deals, subcontracting, large capital investments
Banking & Finance	High-value transactions, foreign remittances, risk of money laundering
Media & Entertainment	Licensing revenues, advertising payments, international royalties

How the Indian Income Tax Department Targets Foreign Companies?

The Indian Income Tax Department uses a multi-layered approach to target foreign companies, in its efforts to protect India’s tax base from profit shifting and non-compliance.

Here’s a brief look of their key strategies:

Advanced Risk Detection

AI & Data Mining: Uses AI to analyze large datasets—GST filings, Form 15CA/CB, SFTs, customs data, etc.—to detect suspicious patterns.
Risk Profiling: Companies with red flags (e.g. high payments to tax havens, recurring losses, or low tax payments) are prioritized for audits.
Information Sharing: Through treaties like DTAAs, CRS, FATCA, and the BEPS framework, India accesses foreign financial data tied to Indian operations.

Permanent Establishment (PE) Scrutiny

Broad Interpretation: India aggressively examines business presence—agents, service contracts, digital footprints—to determine if a PE exists.
Profit Attribution: If a PE is found, the ITD often attributes significant profits to it using favorable methodologies.

Transfer Pricing Enforcement

Routine Audits: Foreign companies with related-party transactions are regularly audited for transfer pricing compliance.
Adjustments: Authorities scrutinize royalty payments, service fees, and IP-related income for alignment with the arm’s length principle.

Withholding Tax Oversight

Strict on Payers: Indian companies are held liable for under-deducted tax on payments to foreign entities.
Treaty Benefit Verification: The department checks for valid Tax Residency Certificates (TRCs), beneficial ownership, and Limitation of Benefits (LOB) clauses before granting treaty relief.
Reclassification Risks: Payments like software fees or services may be reclassified as taxable royalties or Fees for Technical Services (FTS).

Digital & E-Commerce Focus

Equalisation Levy: A 2–6% levy is imposed on certain online services provided by foreign e-commerce operators.
GST on Digital Supplies: Foreign OIDAR (Online Information Database Access and Retrieval services) providers must register and pay GST on B2C digital supplies.

Anti-Avoidance Measures

GAAR & POEM: The Department can disregard arrangements lacking commercial substance or deem foreign companies as Indian residents under Place of Effective Management (POEM) rules.
Thin Capitalization Rules: Excessive interest deductions on related-party loans are disallowed.

Types of Tax Scrutiny for Foreign Company in India

Foreign companies operating in India may face several types of tax scrutiny. Here’s an overview of the key areas:

1. Routine Scrutiny (Summary Assessment)

Triggered by algorithmic risk profiling (e.g., high related-party transactions, losses, treaty claims).

Tax authorities may issue notices asking for clarifications on specific items like withholding tax (WHT), treaty benefits, or carry-forward losses.

It can usually be resolved by submitting documents and rarely escalates if responses are accurate.

2. Comprehensive Audits (Detailed Scrutiny)

This kind of scrutiny arises owing to high-risk factors such as

large international transactions
potential permanent establishment (PE)
persistent losses
aggressive transfer pricing (TP)

Formal notice is issued under Section 143(2). It involves detailed reviews of financials, contracts, TP documentation, and can include on-site inspections.

Areas that are checked include TP adjustments, PE existence, treaty benefits, income characterization, and WHT compliance.

3. Specific Issue Audits

The trigger for such scrutiny is suspected non-compliance in targeted areas such as WHT on royalties, capital gains on share transfers, or software payments.

The scrutiny is focused on review of specific transaction types, often flagged through third-party disclosures (e.g., Form 15CA/CB for remittances).

4. Transfer Pricing Audits

This is mandatory if international transactions exceed ₹10 crore (~USD 1.2 million).

Focus on related-party dealings and TP documentation (Master File, Local File, Country-by-Country Report).

It may result in increasing Indian taxable income by 20–30%.

5. Permanent Establishment (PE) Investigations

This is triggered if the department finds signs of taxable presence through local projects, agents, or employees.

The tax officials may review contracts, [perform employee role analysis, and conduct on-site inspections to find the truth.

If found guilty, it may result in back taxes and penalties.

6. Compulsory Scrutiny Under CBDT Guidelines

Mandatory if returns relate to:

Survey/search cases (Sections 133A/132)
Invalid exemption claims without registration
Recurring tax disputes with confirmed past additions
Intelligence alerts for undisclosed income or benami assets

7. GST Scrutiny

This kind of scrutiny focuses on input tax credit claims, classification of goods/services, reverse charge compliance, and non-resident taxable person operations.

Mismatches in GST returns and high-value claims trigger notices.

8. Withholding Tax and Recovery Proceedings

If an Indian company doesn’t deduct tax on payments, the foreign recipient may owe the tax, interest, and penalties.

Authorities check if the foreign company is the actual beneficiary, not just a conduit.

9. Technology-Driven & Risk-Based Scrutiny

The department uses data and technology to spot issues using:

Sharing of Global Financial Data: Helps find hidden income or assets in other countries.
Risk Profiling: Focuses on businesses with past issues, complex setups, or large transactions.

10. Information-Driven Enquiries

This is a result of data from foreign tax authorities, TDS defaults, or whistleblower reports.

Leads to reopening assessments under Section 147 for unexplained income or assets.

11. Search & Seizure Actions

This is rare and is reserved for serious tax evasion cases like strong evidence of large-scale tax evasion

It involves surprise raids and seizure of physical/digital records, and personnel questioning.

Penalties and Consequences of Failed Scrutiny

Foreign companies that fail scrutiny, may face the following consequences:

Financial Penalties & Tax Demands

Tax authorities may reassess income, including transfer pricing adjustments, PE attribution, and disallowed expenses. Interest up to 24% p.a. can apply, depending on the nature of default.

Penalties include:

50% of tax for under-reporting
200% for misreporting (fraud, false entries)
2% of transaction value for TP documentation failures
₹5,000–₹10,000 for return filing defaults

TDS/TCS violations can lead to 1% monthly interest, equal penalty to the unpaid tax, and denial of expense deduction.

GST-Related Penalties

Late GST filing attracts ₹50/day, capped at 0.04% of turnover (For taxpayers whose turnover is up to Rs 5 crore).
Non-payment leads to 18% interest plus 10% penalty
Fraud or willful evasion can trigger 100% penalty and prosecution.
Unregistered OIDAR suppliers may be fined up to ₹5,000/day.

Legal & Operational Consequences

Willful evasion can lead to severe fines and even imprisonment.

Company officers can be held personally liable
Unpaid dues may lead to asset seizure or account freezes
Non-compliance may also result in IEC suspension and PE reclassification, leading to retroactive tax

Reputational & Strategic Risks

Public tax disputes harm credibility.
Visa delays or rejections may affect expat staff.
Lower ESG ratings and deter investors.
Repeat offenses raise audit risk and regulatory scrutiny

How Can PKC Help Foreign Companies With Taxation Matters in India?

✅Zero tax additions achieved in international scrutiny cases

✅Expert transfer pricing documentation and arm’s length compliance

✅Proactive withholding tax advisory for foreign payments

✅DTAA optimization strategies for double taxation avoidance

✅Permanent establishment risk assessment and mitigation services

✅Up-to-date expertise in latest international tax regulations

✅End-to-end tax dispute resolution for foreign entities

✅Strategic tax planning aligned with global business objectives

✅Comprehensive foreign tax credit optimization and filing

✅Multi-jurisdictional tax coordination through international network partnerships

✅Real-time regulatory updates and compliance monitoring systems

Strategies to Minimize Tax Scrutiny for Foreign Company in India

Although scrutiny cannot be eliminated entirely, the following measures can reduce red flags, and build defensibility for foreign companies:

Proactive Compliance

Stay ahead by timely filing all tax returns, payments, and disclosures as per Indian tax laws.

Proactive compliance reduces the chances of triggering tax audits or penalties. It shows the company’s intent to follow regulations, earning credibility with tax authorities.

Robust Substance & Documentation

Maintain clear documentation proving that the company’s activities in India align with its stated business model and structure.

Demonstrating real business substance—like office space, employees, and local operations—helps avoid suspicion of tax avoidance. Good records also support claims during assessments or disputes.

Proactive PE (Permanent Establishment) Risk Assessment

Regularly assess whether your business activities in India may create a taxable presence (PE) under Indian or treaty rules.

If a PE exists, profits attributable to it must be taxed in India. Identifying and addressing this early helps manage exposure and avoids surprises during audits.

Advance Pricing Agreements (APAs)

An APA is a formal agreement with Indian tax authorities on how transfer pricing will be handled for future transactions.

It provides certainty and reduces the risk of disputes over intercompany pricing. This is especially useful for companies with significant cross-border transactions.

Advance Rulings

Obtain an advance ruling from Indian tax authorities to clarify the tax treatment of a proposed transaction.

This offers legal certainty and helps avoid future litigation. It’s a strategic tool for complex or high-value transactions.

Good Bookkeeping

Maintain clean, organized, and accurate financial records that are audit-ready. Proper bookkeeping helps defend the company’s tax position and speeds up assessments.

It also demonstrates professionalism and transparency to tax authorities.

Engage Qualified Tax Consultants

Hire experienced tax advisors like PKC Management Consulting, who are familiar with Indian tax laws and international tax principles.

They can guide the company in structuring operations compliantly and representing it effectively before authorities. This minimizes errors and helps manage tax risks efficiently.

Periodic Internal Reviews

Conduct regular internal audits and tax health checks to identify and fix issues before they escalate.

These reviews ensure continued compliance and preparedness for any tax inspections. They also help align the company’s operations with evolving tax regulations.

Operational Vigilance

Monitor business activities in India to ensure they align with the declared business model and tax position.

Any operational changes, such as hiring or contract modifications, should be evaluated for tax implications. This vigilance prevents accidental creation of tax liabilities.

Be Transparent

Maintain openness in communication with Indian tax authorities. Avoid aggressive tax positions and disclose relevant facts fully when required.

Transparency builds trust and reduces the likelihood of detailed scrutiny or prolonged disputes.

Frequently Asked Questions

1. What is tax scrutiny for foreign companies in India?

Tax scrutiny means the Indian tax department examines a foreign company’s transactions, returns, and accounts to check if taxes are properly paid. It helps the government prevent tax evasion.

2. Why do foreign companies face more tax audits in India?

Foreign businesses often have cross-border deals, related-party pricing, and complex structures. These factors make them higher-risk targets for Indian tax officers.

3. How can a foreign company reduce the risk of tax scrutiny in India?

They should keep clear and accurate documentation, file on time, and get local tax advice. Transparency helps avoid red flags.

4. What triggers tax scrutiny for a foreign company?

Unusual transactions, related-party dealings, or sudden revenue jumps often trigger scrutiny. High-risk sectors also get closer checks.

5. How long can Indian tax officers reopen a foreign company’s past assessments?

Generally, they can go back up to 10 years if they find large amounts of unreported income. Otherwise, it is usually up to 3–6 years.