PASSIVE INCOMES DIVIDEND, INTEREST & CAPITAL GAINS BASIC CONCEPTS. CA Kusuma Yathish B.Com, LLB, FCA PARTNER M/S. SHEKAR & YATHISH 1/23/2010

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1 DIVIDEND, INTEREST & CAPITAL GAINS BASIC CONCEPTS Workshop on Basics of International Taxation Institute of Chartered Accountants of India CA Kusuma Yathish B.Com, LLB, FCA PARTNER M/S. SHEKAR & YATHISH PASSIVE INCOMES 1

2 OBJECTIVE Jurisdictional Taxing Rights Investment Incomes Dividend Interest Capital Gains UN Model Convention PRINCIPLES OF INTERNATIONAL TAXATION Jurisdiction Exclusivity Resident Country Taxation Source Country Taxation Domestic law 2

3 DIVIDEND DIVIDENDS Meaning of Dividend under International Tax; Taxation thereof; Participatory and Portfolio Dividends; Dividend and PE; Beneficial Ownership; 3

4 DEFINITION OF DIVIDEND - DTAA The term Dividends as used in this article means income from share. Jouissance shares or :Jouissance rights Mining shares, Founders Shares, or Other rights, not being debt-claim, participating in profits, Income from other corporate rights which is subjected to the same taxation treatment as income from shares by the law of [ ]. DIVIDENDS MEANING Distribution of profits or shareholders funds Cash or kind Deemed Dividends / Constructive Dividends 4

5 TAXATION Domestic Tax Laws Gross Dividend / Net Dividend Withholding tax DTAA Resident State Source State DIVIDENDS ARTICLE 10(1) & 10(2) Right is to the Resident State Source State may also Tax This implies that if Domestic Law of Country R taxes foreign dividends derived by its resident share holders, the DTA between Country R and is not going to stop Country R from doing so. OECD Vs. UN model DTAA s 5

6 Participation Dividends Portfolio Dividends a. 5% of the gross amount of dividends if the beneficial owner is a company (other than a partnership) which holds directly at least 25% of the capital of the company paying dividends. b. 15% of the gross amount of Dividends in all other cases. DIVIDENDS AND PERMANENT ESTABLISHMENTS - Art.10(4) of the OECD model DTA provides for special treatment of Dividend received by a permanent establishment of a non resident in the source state. - It provides that the provisions of paragraph 1 and 2 shall not apply if the beneficial owner of the Dividends, being a resident of [Country R], carries on business in [] through a permanent establishment situated [in ] and the holding in respect of which the dividends are paid is effectively connected with such permanent establishment. In such case the provisions of Article 7 shall apply. 6

7 DIVIDENDS AND PE CONTD., o The UN Model DTA extends this provision beyond only permanent establishment to the fixed bases in of taxpayers who provides independent personal services. In which case the Dividends that arise from shareholding that are effectively connected with such fixed bases are taxed in accordance with Art.14 (Independent Personal Services) of the UN model DTA. o Dividends are taxed as business profits of the permanent establishment (Income of the independent personal service provider) on a net income basis (i.e. after allowance for deductible expenditure incurred in producing that income) under Art.7 (or Art.14 of the UN model DTA whichever is applicable) Dividend derived by a PE can give rise to 4 scenarios based on the location of the PE, viz.: SCENARIO - 1 PE receiving dividend from Company S in is in Country R which is the residence of its Parent Co. too SCENARIO 2 SCENARIO 3 SCENARIO 4 PE of Company R, PE receiving dividend from Company S in is located in Country PE of Company R, PE receiving dividend from Company S in is located in Country T PE of Company R, PE receiving dividend from Company T in Country T is located in TAX IMPLICATION UNDER DTAA Art.10(1)&(2) would apply. 10(4) would not apply as PE is not in Art.10(4)would apply as PE is in Art. 10(4) would not apply as the PE is in Country T. Art. 10(1)&(2) would apply going by the concept of beneficial ownership. Provided it is known to Co. S that Co. is the beneficial owner of the PE DTA between Countries R & S not applicable as dividend is not paid to the PE by a Co. Which is resident of. The applicable DTA would be the one between Country R & Country T 7

8 SCENARIO - 1 Country R Head Office PE Company R Dividend Company S Dividend derived by a PE can give rise to 4 scenarios based on the location of the PE, viz.: SCENARIO 1 PE receiving dividend from Company S in is in Country R which is the residence of its Parent Co. too SCENARIO - 2 PE of Company R, PE receiving dividend from Company S in is located in Country. SCENARIO 3 SCENARIO 4 PE of Company R, PE receiving dividend from Company S in is located in Country T PE of Company R, PE receiving dividend from Company T in Country T is located in Art.10(1)&(2) would apply. 10(4) would not apply as PE is not in Country S TAX IMPLICATION UNDER DTAA Art.10(4)would apply as PE is in Art. 10(4) would not apply as the PE is in Country T. Art. 10(1)&(2) would apply going by the concept of beneficial ownership. Provided it is known to Co. S that Co. is the beneficial owner of the PE DTA between Countries R & S not applicable as dividend is not paid to the PE by a Co. Which is resident of. The applicable DTA would be the one between Country R & Country T 8

9 SCENARIO - 2 Country R Head Office PE Company R Dividend Company S Dividend derived by a PE can give rise to 4 scenarios based on the location of the PE, viz.: SCENARI O 1 PE receiving dividend from Company S in Country S is in Country R which is the residence of its Parent Co. too Art.10(1)&( 2) would apply. 10(4) would not apply as PE is not in SCENARIO 2 PE of Company R, PE receiving dividend from Company S in is located in Country Art.10(4)would apply as PE is in SCENARIO - 3 PE of Company R, PE receiving dividend from Company S in is located in Country T. TAX IMPLICATION UNDER DTAA Art. 10(4) would not apply as the PE is in Country T. Art. 10(1)&(2) would apply going by the concept of beneficial ownership. Provided it is known to Co. S that Co. is the beneficial owner of the PE SCENARIO 4 PE of Company R, PE receiving dividend from Company T in Country T is located in DTA between Countries R & S not applicable as dividend is not paid to the PE by a Co. Which is resident of. The applicable DTA would be the one between Country R & Country T 9

10 SCENARIO - 3 Head Country R Office Company R Country T PE Dividend Company S Dividend derived by a PE can give rise to 4 scenarios based on the location of the PE, viz.: SCENARIO 1 SCENARIO 2 SCENARIO 3 PE receiving dividend from Company S in is in Country R which is the residence of its Parent Co. too PE of Company R, PE receiving dividend from Company S in Country S is located in Country PE of Company R, PE receiving dividend from Company S in Country S is located in Country T SCENARIO - 4 PE of Company R, PE receiving dividend from Company T in Country T is located in Art.10(1)&(2) would apply. 10(4) would not apply as PE is not in TAX IMPLICATION UNDER DTAA Art.10(4)would apply as PE is in Art. 10(4) would not apply as the PE is in Country T. Art. 10(1)&(2) would apply going by the concept of beneficial ownership. Provided it is known to Co. S that Co. is the beneficial owner of the PE DTA between Countries R & S not applicable as dividend is not paid to the PE by a Co. Which is resident of Country S. The applicable DTA would be the one between Country R & Country T 10

11 SCENARIO - 4 Country T Company T Country R Head Office Company R PE Dividend Beneficial Owner Anti-avoidance measure to avoid treaty abuse This concept has its origin in local laws with the intention to distinguish between the rights held on the same property by different persons, viz, the legal owner and beneficial owner. Beneficial owner is regarded as the one with the greatest ownership rights, while the legal owner generally has a fiduciary obligation to the beneficial owner and not derive any direct benefit out of ownership of the property. 11

12 Illustration Beneficial Owner Country R Company D Company C Dividend WHT 20% Illustration Beneficial Owner Contd., Company D Country R Company C Dividend WHT 0% Country T No Dividend WHT Intermediary T 12

13 Extra Territorial Taxation Article 10(5) prohibits the from taxing the dividends paid by Company R situated in Country R merely because Company R derives its income from its activities in. Further, it also prohibits from taxing the undistributed profits of Company R even if incomes of the Company R consists wholly or partly income arising in. INTEREST 13

14 INTEREST Meaning of Interest - International Tax Interest Payments - PE Interest Arising Interest Payments Associated Parties Source state Taxation ARTICLE 11 11(1) Taxing right to Resident State 11(2) Limited Taxing right to Source State 11(3) Definition of Interest 11(4) Interest and PE 11(5) Interest Arise 11(6) Interest and Associated Parties 14

15 TAXING RIGHTS UNDER DTAA ARTICLE 11(1) AND 11(2) 1. Interest arising in a Contracting State (India) and paid to a resident of the other Contracting State (A foreign Country) may be taxed in that other State (A foreign Country). 2. However, such interest may also be taxed in the Contracting State (India) in which it arises and according to the laws of that State (India), but if the beneficial owner of the interest is a resident of the other Contracting State (A foreign Country), the tax so charged shall not exceed per cent of the gross amount of the interest. The competent authorities of the Contracting States shall by mutual agreement settle the mode of application of this limitation. MEANING OF INTEREST ARTICLE 11(3) The term interest as used in this article means income from debt claims of every kind, whether or not secured by mortgage and whether or not carrying a right to participate in the debtor s profits, and in particular, income from government securities and income from bonds or debentures, including premiums and prizes attaching to such securities, bonds or debentures. Penalty charges for late payment shall not be regarded as interest for the purpose of this article. 15

16 INTEREST AND PERMANENT ESTABLISHMENTS The provisions of paragraphs 1 and 2 shall not apply if the beneficial owner of the interest, being a resident of a Contracting State, carries on business in the other Contracting State in which the interest arises, through a permanent establishment situated therein, or performs in that other State independent personal services from a fixed base situated therein, and the debt claim in respect of which the interest is paid is effectively connected with (a) such permanent establishment or fixed base, or with (b) business activities referred to in (c) of paragraph 1 of article 7. In such cases the provisions of article 7 or article 14, as the case may be, shall apply. SCENARIO - 1 Country R Head Office PE Company R Interest Company S 16

17 SCENARIO - 2 Country R Head Office PE Company R Interest Company S SCENARIO - 3 Country R Head Office Company R Country T PE Interest Company S 17

18 INTEREST ARISE Interest shall be deemed to arise in a Contracting State when the payer is a resident of that State. Where, however, the person paying the interest, whether he is a resident of a Contracting State or not, has in a Contracting State a permanent establishment or a fixed base in connection with which the indebtedness on which the interest is paid was incurred, and such interest is borne by such permanent establishment or fixed base, then such interest shall be deemed to arise in the State in which the permanent establishment orfixed base issituated. INTEREST PAYMENT ASSOCIATED ENTERPRISES Article 11(6) - Where, by reason of a special relationship - between the payer and the beneficial owner or - between both of them and some other person, - the amount of the interest, having regard to the debt claim for which it is paid, exceeds the amount which would have been agreed upon by the payer and the beneficial owner in the absence of such relationship (arms length interest), - the provisions of this article shall apply only to the last-mentioned amount. - In such case, the excess part of the payments shall remain taxable according to the laws of each Contracting State, due regard being had to the other provisions of this Convention. 18

19 IMPACT OF INTEREST PAYMENT TO ASSOCIATED ENTERPRISES USD Annual Interest (5% of USD 1,000,000) 50,000 Tax on interest income derived by M/s. Parent co (10% of USD 50,000) Art.11(2) (A) Tax Benefit to M/s. Sub co of deduction of interest paid to M/s. Parent co (30% of USD 50,000) - (B) 5,000 (15,000) Net Tax Benefit to Group (A) (B) (10,000) IMPACT OF INTEREST PAYMENT TO ASSOCIATED ENTERPRISES USD Annual Interest (15% of USD 1,000,000) 150,000 Tax on interest income derived by M/s. Parent co (10% of USD 150,000) Art.11(2) (A) Tax Benefit to M/s. Sub co of deduction of interest paid to M/s. Parent co (30% of USD 150,000) - (B) 15,000 (45,000) Net Tax Benefit to Group (A) (B) (30,000) 19

20 ASSOCIATED ENTERPRISES Anti-avoidance measure Excess interest how treated? CAPITAL GAINS 20

21 CAPITAL GAINS Alienation of Property Movable Immovable Ships and Aircraft Shares Other Gains Capital Gains and PE Article 13 (1) to 13(5) ALIENATION OF PROPERTY Gains from partial / full alienation of property Expropriation of property Transfer of property in exchange for shares Sale of right Gift of property Transmission Property includes Liabilities as well as Assets 21

22 ALIENATION OF IMMOVABLE PROPERTY Situs Test Resident Country has right to Tax Source Country may tax Treaties Treaties with US and UK provide that the capital gains should be taxed in accordance with the domestic law of the respective countries which countries domestic law to be applied Source Country or Residence Country? Treaties with Japan and Russia state that transfer of shares not covered by the immovable property criterion or the prescribed share holding criterion will be taxed in the Source Country. 22

23 CAPITAL GAINS SUMMATION Source of gain from alienation Immovable property Shares: >50% value = immovable property Movable property - permanent establishment - ships, aircraft, boats Residence state P P Taxing Right Source state Other property (movable or immovable) P X P X P P P X State of place of effective management P REFERENCE MATERIAL Basic International Taxation Roy Rohatgi International Tax Policy and Double Tax Treaties Kevin Holmes 23

24 THANK YOU 24