Workshop on Taxation of Foreign Remittances

Transcription

1 THE CHAMBER OF TAX CONSULTANTS 3, Rewa Chambers, Ground Floor, 31, New Marine Lines, Mumbai Tel.: / Fax: office@ctconline.org Visit us at: Website: Workshop on Taxation of Foreign Remittances Overview of the DTA 19 th December, by CA. Rashmin C. Sanghvi We need to understand the provisions of ITA, DTA and their interactions to come to conclusions on Taxation of Foreign Remittances. In this paper, we will deal with conceptual issues and substantial provisions. Some concepts & issues of normal taxation have been listed for the sake of completeness of the relevant paragraph. During the workshop, our focus will be on international taxation. We will not discuss domestic tax. Some paragraphs will not be discussed during the workshop. These titles are marked (*).

2 Contents Page Sr. No. Particulars Page No. Preface 1-3 Main Paper 4-33 Part 1 Income Tax Act Substantial Provisions Connecting Factors Other provision of DTAA 6 3. TDS in International Taxation Ensuring TDS 8 5. Interplay of the above Provisions 8-12 Part 2 Understanding the Basis of DTA Overview of DTA How to read a DTA Common Phrases used in DTA DTA Mechanism Treaty actual operation Objects & Purpose of DTA Treaty Abuse Treaty Categorisation General Vs. Specific Rule Dates appearing in DTA. 20 Part 3 Interaction between DTA and Income Tax Act Treaty Override Part 4 Articles 1 to Article 1 Persons Covered Article 2 Taxes Covered Article 3 General Definition Article 4 Resident or Residential Status 27-29

3 Part 5 G 20, OECD & International Tax Practice Present Practice American Financial Crisis BEPS Illustration: FIIs Indian Government 33 Contents stated in a different manner: Topics for this session Para No. 1. Overview of the DTAA. Preface, Part 1 - Para. 1 Part 2, Para. 1 to 3 2. Application, Scope Articles 1, 2, 3 & 4. Part 1, Para. 1, 2, 3, 4, 5, 6, Part Mechanism of Use of Treaty. Part 2, Para. 4 & 5 4 Interplay between ITA & DTA. Part Priority of Articles. Part 2, Para Tax Credit Mechanism. Part 2, Para 5. Short Forms used in this Paper: BC : Business Connection. CIT : Commissioner of Income Tax. COR : Country of Resident. COS : Country of Source. DTA : Double Tax Avoidance Agreement. DTA=Agreements = Conventions = Treaty. GOI : Government of India. FTS : Fees for Technical Services. FIS : Fees for Included Services. IR : Indian Resident.

4 ITA : Income-tax Act. M/A : Memorandum and Articles of Association. MF : Mutual Fund. MFN : Most Favoured Nation. NR : Non-Resident. NRO : Non-Resident Ordinary Account. PE : Permanent Establishment. ROE : Reimbursement of Expenses. S. : Section. U/s. : Under Section. TDS : Tax Deduction at Source. TDS = Withholding of Tax.

5 Page No. 1 Preface: 1. For any foreign remittance, one has to check the following issues before making the remittance: Is it permissible under FEMA? Is it taxable in India under ITA & DTA? If taxable, what is the rate of TDS? Which rate to apply ITA & DTA. Also see Most Favoured Nation Clause. If not taxable, proper reasoning why it is not taxable. For the purpose of this workshop we ignore FEMA. 2. Indian Income-tax Act: 2.1 Jurisdiction Section 1 High Value Litigation. 2.2 Charging Section Section Scope of taxable income, Basic Provisions Section 5. Extended the scope by deeming provisions Section 9. Anti-Avoidance provisions several sections. 2.4 Residential status section Exemptions section 10(4), 10(15)(iv), etc. 2.6 Transfer Pricing. 2.7 Various special sections sections 44DA, 115A, 172, etc. 2.8 Chapter XII-A for NRIs. 2.9 Agents and Representative assessees sections 160 to TDS sections 115A, 195, 206AA etc Consequences of Non-Deduction of tax S. 40(a)(i) S. 221, Prosecution etc. 3. Structure of the DTA. A summary/ Macro View of the DTA: In this paper references to all Articles are as in OECD Model Individual agreements may have different numbers. Articles 1 & 2 provide for applicability of the DTA.

6 Page No. 2 Articles 3 & 5 provide definitions. Article 4 refers to domestic law for definition of Residence. Articles 6 to 22 provide for different Categories of Income. Primarily COS will determine the tax that it can levy on a NR s income in COS based on the category of income. COR is not concerned with the categorisation of the income. Article 23 provides for Elimination of Double tax if any. This Article provides for two options available to the COR. Article 23A provides for Exemption method. Article 23B provides for Credit method. COS is not concerned with Article 23. Articles 24 to 31 Miscellaneous provisions, Protocols & Termination. 4. Normal process of applying DTA should be as under: st Step: Determine whether the remittance is (fully or partly) income. Income? If it is not income, no further examination is required. Only income (real or deemed section 5 or section 9) can be taxed under Income-tax Act nd Step: Once it is determined that it is Income, see whether it is Taxable? taxable under the Income-tax Act (ITA). If it is not taxable under the ITA, one need not even look at the DTA rd Step: If the remittance is an income, taxable under the ITA, then Elimination apply DTA. At this stage the present paper becomes useful. of Double Once the DTA is applicable, let us understand it fully and Tax not just jump to the applicable rates. 5. Scope of DTA: International tax practice involves several other issues : 6 to DTA does not define or make provisions for: (i) (ii) (iii) (iv) (v) Chargeability of tax; Residential status; Source of Income; Computation Assessment & Tax Recovery; and Consequences of defaults. All these provisions are made under the domestic law.

7 Page No DTA simply provides a mechanism to avoid double taxation. COS levies tax at a lower rate. COR gives credit of taxes paid in COS or exempts income taxed abroad. 5.3 There is no claim that DTA will always succeed in eliminating double tax; or double non-tax. Now under BEPS Action Plan OECD proposes to declare that DTA is NOT an instrument of tax avoidance. 6. Under taxation, every Foreign Remittance has following aspects: (i) (ii) (iii) Taxability in the hands of the Non-Resident recipient; and Deductibility of the expenditure in the hands of the Payer. Recovery of tax by deduction at source. 7. India s jurisdiction/ ability to enforce Indian law on foreigners is an all pervading issue. 8. American Financial Crisis of the year 2008 spread to many countries. This wide scale crisis forced a group of countries G 20. G 20 instructed OECD to review its Model Treaty, to redraft treaty & commentary; and to come out with measures to curb tax avoidance. Now OECD has reversed its own statements made earlier. Many interpretations based on OECD commentary may be reviewed now. This makes study of OECD reports and G20 action very important. There was a time when it seemed that: The sitting finance minister was supporting tax avoidance and secrecy for Participating Notes (PNs). Further allegations were that these PNs were instrument of money laundering. During the tenure of same FM, India agreed on Exchange of Information. Which resulted in the arrest of Hasanali Khan. Can you see the drama in tax practice? Preface Completed Next Part I Imp. Provisions of ITA. We consider provisions of ITA (Part I); then DTA (Part II) and the interaction between ITA & DTA (Part III).

8 Page No. 4 Main Paper Part 1: Income Tax Act Substantial Provisions 1. Connecting Factors: Jurisdiction of ITA Section 1. How does a country get jurisdiction to levy Income-tax? Under Section 1 of the ITA, India s jurisdiction to charge Income-tax extends to India. There must be a connection with India either the assessee should be Indian Resident; or the income should be sourced in India. No connection, no jurisdiction. This position emerges out of Internationally recognised principles of taxation. When we practice the domestic law for regular clients resident in India, we never examine the issue of jurisdiction. All Indian residents are liable to tax in India on their global income. Hence when an Indian resident earns any income - whether from within India or outside India; we take it for granted that the assessee is liable to tax. The moment there is a cross border income, the issue of jurisdiction arises. Jurisdiction to tax is determined by two factors: (i) (ii) Residence of the Assessee; and Source of Income. In international taxation these factors are referred to as Connecting Factors or Nexus. Some also call them Personal Attachment (Residence of Assessee) and Economic Attachment (Source of Income). It is an internationally accepted principle that when an assessee is resident of a country, the Government of that country has the jurisdiction to tax the global income of that assessee. Connecting factor of Residence is applied to the assessee. It is also accepted that if the income is Sourced in a country, then the Government of that country has jurisdiction to tax that income. Connecting factor of Source is applied to the income. These principles of jurisdiction may be stated in different manners: When a person is resident of India and has his income sourced in India, without any doubt the income is taxable in India. When the assessee is a non-resident of India, and the income is sourced outside India, then the income is certainly not taxable in India. India has no jurisdiction to tax such income. This issue was the bone of contention in Vodafone case.

9 Page No. 5 When a non-resident of India has income sourced in India, then Indian Government has the jurisdiction to levy full tax on the income sourced in India. However, wherever India has signed a Double Tax Avoidance Agreement (DTA) with the Country of Residence (COR) of the assessee, India may levy a lower tax than the normal tax..what rate to levy will depend upon the category of income Articles 6 to 22. Connecting Factors Assessee Income World Indian Resident World Income Taxable India Indian Sourced Income, Taxable in India. Irrespective of Status of Assessee. For Non-resident & NORs Only Income Sourced in India is taxable Foreign Sourced Income earned by Non-Resident Not Taxable in India. There is no nexus with India Foreign Sourced Income Taxable ONLY IF Earned by Indian Resident When an Indian resident earns income sourced outside India, then the Country of Source of Income (COS) may levy lower than normal tax. India as the COR will levy full tax. And from the Indian full tax, India will give credit for the taxes paid abroad. This is how the Governments try to eliminate double taxation. And this is how the two concepts of Residence and Source become important. This may be illustrated as under: Mr. Patel is an Indian resident. He earns Rs. 10,000 as interest income from UK. We assume that the rate of Income-tax in India is 30% and in UK also it is 30%.

10 Page No. 6 Mr. Patel s interest income in UK: 10,000 UK will deduct tax at source under Article 12 of the 15% Net receipt in India Rs. 1, , Indian tax on total income of Rs. 10,000. 3,000 Less: Credit for UK tax Balance tax payable in India 1, ,500 ===== Total tax suffered by Mr. Patel remains Rs. 3,000. Double tax is avoided by the Credit mechanism. Mr. Patel s interest income from UK is the tax base for two countries (i) India as COR; and (ii) UK as COS. Thus under the existing system of international taxation, Double Tax is built-in in the system. DTA is the mechanism to avoid double taxation. 2. Other important provisions of ITA are listed in Preface, Para 2. We may not discuss ITA in more details. 3. TDS in International Taxation The legal provision related to deduction of tax at source from payments made to non-residents is primarily covered in Section 195. However, in recent times, the procedures connected with deduction of tax at source have increased and changed. The system of TDS is partly legal and partly administrative. CBDT and RBI both provide for TDS. This means a remittance without TDS becomes a violation of ITA & FEMA. 3.1 Deductibility of tax at source - Section 195: Section 195 is a machinery provision, which casts an obligation on the payer to deduct tax at source. Section 195 does not lay down the taxability of the income in the hands of the non-resident. This is determined by the charging provisions of the Income-tax Act Sections 4, 5 & 9 read with Section 6. The taxability determined under ITA is subject to relief under DTA.

11 Page No. 7 Section 195(1) Scope and Applicability Section 195(2) & (7) - Application by Payer - Mandatory Application to AO Section 195(3), (4) & (5) - Applicable to Payee. Section 195 (6) - Reporting Requirements 3.2 What is covered? Payments to NR for business, services & transfer of assets - Incomes taxable in India are covered without any threshold limit. 3.3 As per Section 195, deduction of tax at source is to be done from payments made to a non-resident only if the income is chargeable to tax under the Income-tax Act. There have been controversies raised in the past regarding deduction of tax at source from all payments made to nonresidents, whether or not there is an income element in the same. These controversies have been laid to rest by rulings of the Supreme Court. The land mark judgment in the case of Transmission Corporation of A.P. Ltd. (239 ITR 587) given by Honourable Supreme Court of India has dealt with the provisions of section 195. In this decision it was held that Section 195 gets attracted only when the amount paid to the nonresident bears the character of income' taxable in India. It may be wholly or partly taxable. However, if no part of income is taxable in India, then section 195 has no role to play. Further, there is another decision of the Supreme Court in GE India Technology Centre P. Ltd. (327 ITR 456) which follows the decision given by the Honourable Supreme Court in the case of Transmission Corporation of A.P. Ltd. In section 195(1) of ITA, the Supreme Court has given emphasis to the words "chargeable under the provisions of the Act". Therefore, the provisions of section 195 will apply to only those payments to non-residents which are chargeable to tax in India. If the payment is not chargeable to tax in India, the payer need not deduct tax at source.

12 Page No Detailed provisions of TDS on cross border incomes are covered by other speakers. We shall not discuss further. 4. Ensuring TDS: 4.1 Government of India is working on two processes. (i) Ensuring that an income is chargeable to tax. Anti-Avoidance provisions like Transfer Pricing, GAAR, deeming provisions u/s. 9; Treaty Override u/s. 90 and so on. Persons not entitled to DTA benefits may not claim the benefit - TRC etc. (ii) Ensuring that an income that is liable to tax does not escape TDS. Both these processes together make tax law compliance highly complex. 4.2 Clear purpose of the Indian Income-tax department is to share information with the Income-tax departments of the relevant countries. India has also signed Information Exchange Agreements (IEA) with many countries. Under these agreements Indian Government can obtain information about the Indian assessee directly from other Governments. These provisions have been incorporated into the law after the Government noticed that some companies were hiding information; and submitting different information to different countries. Obtaining PAN, TRC & TAN and giving to the Indian Income-tax department will make things easier for the department. Under G20 pressures more and more countries are going for Automatic, Immediate Exchange of Information. 5. Interplay of the above provisions: As mentioned above there are various provisions which determine the final tax liability. Some of these provisions can lead to a change in rate of tax to be deducted at source if certain conditions are not fulfilled. There can be issues as to which provision should be applied before the other. 5.1 It must be noted that the Income-tax Act determines the income which is taxable in India. The DTA can only provide relief. DTA cannot create tax liability if the income is not within the scope of the Indian Income-tax Act. Hence, in case of any payment to a non-resident logical process is: First examine whether the payment is taxable under the Income-tax Act. If it is not taxable under the Income-tax Act, one need not examine the

13 Page No. 9 DTA. Only when a payment is taxable under the Income-tax Act, one needs to check the DTA provisions. 5.2 Once the liability is determined under the ITA, the DTA provisions should be checked to ascertain if the provisions are beneficial. 5.3 Once the final tax rate is determined, it needs to be checked if the payee complies with the provisions of TRC and PAN discussed above. 5.4 (*) As there can be different implications in different circumstances, an example is provided below for clarification: 5.5 (*) For example, the assesse needs to deduct tax at source on payment to a non-resident. There can be certain situations as follows: Where DTA provisions are applicable and beneficial as compared to ITA: (*) Payee s TRC & PAN both are available: As per Section 90, the beneficial DTA rate can be applied as TRC is available. In most cases, the payment for services will be beyond the definition of FTS. Hence not taxable in India. Hence no TDS. Section 206AA will not have any effect on the tax rate in this case as PAN is available (*) Payee s TRC is not available while PAN is available: If the TRC is not available, the rate will be as per the Income-tax Act, and benefit of DTA will not be available. In case of Royalty & FTS, tax rate will be 25.75% [See Section 115 A (1) (b) (A) & (B)]. Section 206AA will not have any effect on the tax rate as PAN is available (*) Payee s TRC is available, but PAN is not available: While the payer can take benefit of the DTA provisions, as PAN is not available, highest of (i) ITA normal rate as per relevant provision; or (ii) Rates in force for TDS as per Finance Act; or (iii) 20%; will e applicable. Where DTA is not available, or provisions are not beneficial as compared to the ITA: (*) PAN is available: In such a case, rate will be determined as per rates in force provided as per Part II of First Schedule of the Finance Act of the relevant year. The rate prescribed as per this Schedule for FTS payment made by

14 Page No. 10 the Querist is 40%. (See Part A.) Further, as PAN is available, Section 206AA will not be applicable (*) PAN is not available: Rate will be determined as per rates in force. As mentioned above, in the IR s case, this rate will be 40% for FTS payments. As this rate is higher than rate of 20% as per section 206AA, tax will be 40%. A chart summarising the above is as follows: (I have borrowed this chart from Rutvik Sanghvi. Credit goes to him.)

15 Page No (*) Steps to determine tax deductible at source from payments made to Non-residents Is the payment liable to tax under the ITA? Yes No No tax deductible. PAN & TRC not required. Is DTA available? No Yes Is the payment liable to tax under the DTA? No Is TRC available? No Yes Is DTA Rate Beneficial? No Yes No tax deductible. PAN not required. Yes Is TRC available? No Tax as per ITA Is Payee s PAN available? Yes Is Payee s PAN available? No Yes No Yes Section 206AA not applicable: Rate as per DTA Section 206AA applicable: Higher of: - 20% or - Rate as per DTA Section 206AA not applicable: Rate as per Rates & Force Section 206AA applicable: Higher of: 20% or Rate as per Rates & Force Please note that each situation requires appropriate declaration from Payee, especially where no tax is deductible at source.

16 Page No Practical Issues (*) Is Grossing up required if tax has to be borne by Payer? In case of Bosch (28 Taxmann 228 Bangalore ITAT) it was held that grossing up of the amount is to be done at the rates in force for the financial year in which such income is payable and not at rates specified under section 206AA. In case of presumptive tax u/s. 44B, 44BB, 44BBA and 44BBB, section 195A will not apply as those sections are complete code in themselves. This view has been held by Uttaranchal High Court in CIT Vs. ONGC (264 ITR 340). An assessee who wants to avoid litigation may act conservatively Are surcharge and Education Cess leviable? If the applicable rates are as prescribed under the Act; the same are to be increased by surcharge and education cess. However, wherever the TDS rate applies as prescribed under a DTAA, the same would be final and the surcharge and education cess would not be applicable. Part 1. Brief Discussion on Income Tax Provision complete. Next: Part 2 - DTA Provisions.

17 Page No. 13 Part 2: Understanding the Basis of DTA 1. Overview of DTA: 1.1 What is DTA? Vienna Convention on Law of Treaties 1969 defines treaty as - An international agreement concluded between States in written form and governed by international law, whether embodied in a single instrument and whatever its particular designation. Essentially, a Treaty is an agreement between two Governments. A Double Tax Avoidance Treaty is an agreement between two Governments (or two taxing jurisdictions) to avoid double taxation. 1.2 Purposes of the DTA: They sign this agreement (i) to provide relief to their residents from Double Taxation and (ii) for curbing tax evasion. 1.3 How are the purposes achieved? 1.3A The Double Tax is sought to be eliminated by combined action by the two countries: The COS restricts its taxing rights. The COR gives credit for taxes paid in the COS or exempts the income on which tax is paid in COS. 1.3B As far as the purpose of curbing Tax Avoidance & Tax Evasion is concerned, so far, Government of India has actively encouraged Tax Avoidance and done little on curbing Tax Evasion. Countries like USA have done considerable work for curbing tax evasion. 2. How to read a DTA? The language of DTA models are meant to be used by many countries. Hence they use a typical language. Several phrases are combined together in one long Compound sentence. It becomes difficult to read & understand. A simple method of trying to grasp the meaning is to change the two phrases: Contracting State and the other contracting state by specific names of the countries. We take the illustration of India - UK DTA, Article 7. Given below are: (i) Article as it is in the DTA and (ii) Article simplified. (i) Article 7 as it is in the DTA: Business Profits (1) The profits of an enterprise of a Contracting State shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. If

18 Page No. 14 the enterprise carries on business as aforesaid (in U.K.), the profits of the enterprise may be taxed in the other State but only so much of them as is directly or indirectly attributable to that permanent establishment. (2) Where an enterprise of a Contracting State carries on business in the other Contracting State through a permanent establishment situated therein, the profits which that permanent establishment might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment shall be treated for the purposes of paragraph (1) of this Article as being the profits directly attributable to that permanent establishment. (ii) Article 7 simplified: Let us consider an Indian resident has income from UK. Business Profits (1) The profits of an enterprise of India shall be taxable only in India unless the enterprise carries on business in UK through a permanent establishment situated in UK. If the enterprise carries on business as aforesaid (in UK), the profits of the enterprise may be taxed in UK but only so much of them as is directly or indirectly attributable to that permanent establishment. (2) Where an Indian enterprise carries on business in UK through a permanent establishment situated therein, the profits which that permanent establishment might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment shall be treated for the purposes of paragraph (1) of this Article as being the profits directly attributable to that permanent establishment. Remarks: Rules of good English say that a sentence should not have more than 15 words. Avoid Compound & complex sentences. If the legal fraternity accepted these rules, life would be simpler. 3. Some common phrases used in DTA: Treaties define Residential status (Article 4). When the assessee is resident of a particular country, that country is the COR. Any other country trying to tax that Resident s income on the basis of Source is the Other Contracting State ; or Country of Source; or COS. No attempt is made by the DTA to determine whether the other country has a jurisdiction to tax or not. If a Government does not have

19 Page No. 15 jurisdiction to tax a particular income, the assessee may take up appellate proceedings under that Country s domestic law. We may notice that even for COR, the DTA does not determine which country is the COR. If a country claims jurisdiction to tax on assessee s foreign income by the Connecting Factor of Residence, and if the assessee accepts the jurisdiction, that country is COR. If the assessee does not accept the jurisdiction, he may take up appellate proceedings under the domestic law. Mutual Agreement Procedure (MAP) is an alternative to appellate proceedings. 4. DTA Mechanism: DTA simply tries to eliminate double taxation. It does not grant any tax jurisdiction to any Government nor take away any jurisdiction already existing. Elimination of Double taxation is attempted by the simple mechanism of COS restricting its rights to tax & COR giving credit for COS taxes or exemption for incomes taxed abroad. All other provisions of the domestic law apply. For example: computation of income, assessment, appeals, recovery, etc. Even the most basic issues of definitions of Residence and Source are not given in the treaty. DTA does not take away the basic jurisdiction from COR. Normally, under the Classical system of taxation (which is adopted by India, UK, Germany, USA, etc.) the COR has full right to tax the global income of its residents. When its resident gets taxed in the COS, COR will give credit for the taxes paid abroad. The fact that the income has been taxed by COS does not mean that it cannot be taxed by COR. In my respectful submission, Chettiar s case decided by Honourable SC has an error. It states that since Chettiar s income has been taxed in Malaysia, it cannot be taxed again in COR (India). The fact that all review petitions have been dismissed by Honourable SC means that Honourable SC has not taken into consideration the mechanism of DTA. Taxing jurisdiction is granted by the Constitution and domestic tax laws of a country. DTA does not give or add rights to taxation. For example, Singapore does not tax capital gains. DTA between India & Singapore Article 13 (4) provide that capital gains on movable properties shall be taxable only in the COR. Let us say, an FII from Singapore earned capital gains in India. As per DTA, India cannot tax

20 Page No. 16 these gains. In Singapore, domestic law does not tax the same. Singapore Income-tax officer cannot say that since the DTA provides, he will tax the FII s Indian capital gains. Issue is: DTAs do not grant any taxing rights. If there is a Double Non-Taxation, so be it. If a genuine resident of Singapore earns capital gains which are not taxed in any country, that is OK. However, when a Non-Resident of Singapore resorts to Treaty Shopping and obtains a tax benefit which is not due to him, it is not OK. 5. Treaty actual operation: When the resident of a country (say, India) has income taxable in another country COS, say (UK), DTA will be invoked. The Indian resident understands that UK Income-tax department - HMRC (Her Majesty s Revenue & Customs department) cannot levy full income-tax on his British income. Considering the category of his income, he will file appropriate income-tax return and claim the relief. If his return is found to be correct, HMRC will accept his claim of DTA relief. The Indian Resident will also file his Income-tax return in India. He has to disclose his global income in his Indian return. This will include his UK income. From the Indian tax payable in India; he will claim credit for the taxes paid/ payable in UK. If the Indian AO finds his claim to be correct, he will grant credit for the taxes paid/ payable in UK. This is the manner in which double tax is avoided. Normally, the assessee will end up paying tax at the higher of the COS or COR rate. In other words If the UK tax rate is higher, the Indian tax will be reduced to zero. If the UK tax is lower, balance will be paid in India. Illustration 1: Mr. Patel from India has purchased a residential house in UK. He earns rental income of GBP 1,000. Let us assume, the UK tax rate is 40%. Under Article 6 of India UK DTA, UK can levy full tax on the rent. Hence, Mr. Patel would pay GBP 400 as tax in UK. His Indian tax on the income is 30% or GBP 300. When he claims credit in India for the UK tax, his tax liability in India gets reduced to zero. Indian Government will not give him refund of the excess tax paid in the UK.

21 Page No. 17 Illustration 2: Mr. Patel has a Permanent Establishment (PE) in USA. He earns $ 1000 from the PE. Under Article 7 of the India US DTA, the PE income is fully taxable in USA. Assume further that in USA he will be liable to pay following taxes: Federal Income-tax $ 400. State Income-tax $50. City Municipal Income-tax $ 50. Social security charges $ 60. Mr. Patel will end up paying $ 560 to different Governments in the USA.) (Note: This is only an illustration. I do not know the U.S. tax law. Actual U.S. taxes payable by a Non-Resident of U.S.A. may be different.) Under Article 2(1)(a), only the Federal US tax is covered by the DTA. All other taxes levied in the USA are not available for credit against the Indian taxes. Hence Mr. Patel will get credit for $ 400. All other taxes paid in the USA are simply costs of earning income from USA. Indian tax is only $ 300. So even from federal tax, $ 100 will not be available as credit. His tax liability in India will get reduced to zero. 6. The declared Objects & Purposes of the DTA are: (i) (ii) To avoid double taxation; and To Curb Tax avoidance, tax evasion, etc. Hence any interpretation of a DTA, that permits abuse of the DTA, treaty shopping etc., is ab-initio incorrect interpretation. In my humble submission and with respect, the decision of Honourable Supreme Court in Azadi Bachao Andolan is incorrect. 7. Treaty Abuse: DTA is meant to curb tax evasion and tax avoidance. DTA is not to be abused to avoid taxes. So when a country amends its laws to prevent abuse, it does not amount to Treaty Override. It actually is carrying out the objectives of the DTA. UN & OECD both commentaries support this view. Unfortunately in India the authorities do not understand this position. Some vocal people make a campaign to build people opinion. And they do win. 8. Treaty Characterisation or Categorisation Issues:

22 Page No Objective of Categorisation: Categorisation is different under ITA & DTA. Under the ITA, different categories of income have different rules for computation of taxable income. Under DTA different categories determine which country will get how much right to tax. For example, business income under Article 7 will attract Zero tax in COS. But immovable property income & PE income will attract full tax. Royalties, FTS, Dividend etc. attract a fixed rate of 10% to 15% on gross basis. This structure of DTA has created a vested interest. Assessees always want to claim that their income is business income, they have no PE & hence no tax in COS. AO would always like to categorise the income under some head which attracts tax in India. Significant amount of litigation arises because of disputes on Categorisation. 8.2 Who decides Categorisation? Categorisation of income is neither the assessee s choice nor the AO s choice. Application of legal provisions to particular facts of the case determines the categorisation of income. Consider the following: (i) (ii) Some FIIs from Mauritius claim that they earn capital gains in India, they are resident in Mauritius and under India - Mauritius DTA, their capital gains are not taxable in India. This stand has been accepted at appellate level. In similar circumstances, another FII claims that it is doing a business of running a mutual fund, it has no PE in India and hence its business income is not liable to tax in India. Consider that the facts in both cases are- The FII itself invests around 5% of total funds. It attracts 95% of the funds from several investors. The FII appoints researchers, brokers, custodians and other service providers. It employs top brains to manage the funds. It is a fully commercial, organised business activity. As per settled principles of law, it is carrying on business activities. How could its ground of capital gains be accepted? More important, how two contradictory grounds get accepted simultaneously?

23 Page No. 19 Whichever is more beneficial concept applies to (i) rates, and (ii) also to categorisation for treaty purposes. Categorisation will determine tax rates. This concept does not apply for categorisation under Indian law, for computations of income, for tax avoidance schemes. 9. Priority of Articles (General rule Vs. Specific rule): An Illustration PE & Article Under Article 8, profits of an airline are to be taxed only in the country of management (COM) in other words, the profits are not to be taxed in COS. Illustration: Air India s global profits can be taxed only in India. Air India has an office in London which transacts full business. It issues tickets and collects revenue. Hence it is a Permanent Establishment. 9.2 The profits of a permanent establishment under article 7 are to be taxed in the COS. What happens when there is a conflict of article 7 & article 8? In other words, if the airline has a permanent establishment in another country, how is the tax jurisdiction to be shared? 9.3 Similarly, let us assume that the British Airways has a travel agent in India. The agent has an authority to book seats and he is a agency PE of British Airways. Profits attributable to the Indian PE for the year are, say, GBP 100. Out of these, the profits derived by the PE are GBP 20 the balance being derived by the British Airways. 9.4 In the above facts, can the Indian PE claim that its profits also have the character of the profits of an airline? And hence it cannot be taxed in India? Article Can the assessing officer claim that the GBP 80 derived by the British Airways is taxable in India under article 7? Hence he will tax full GBP 100 being profits attributable to the Indian PE? 9.6 Apparently, there is a conflict between the provisions of article 7 & article 8. Which will prevail in what circumstances? 9.7 See Prof. Vogel s commentary on pages 482 & 483 paragraphs 22 to 26 under article 8. Article 8 being a special provision, overrides the general provision under article 7. In other words, the concept of PE does not apply under Article 8. No profits of British Airways can be taxed in India. However,

24 Page No. 20 this benefit is available only to the airline & not to the travel agent. The agent is not earning from the Operation of aircraft. In any case, most probably the agent would be an Indian resident. His income would always be taxable in India. In the illustration of Air India, its London branch will not pay any income-tax in U.K. 10. Different dates appearing in DTA: 10.1 Date of Convention Date on which Convention is signed. Mentioned on every Treaty Date of Ratification Ratification of Treaty by legislative/executive consent in each Contracting State in accordance with domestic laws Date of Exchange of Notes Notes are exchanged between Contracting States confirming ratification of treaty in each State Date of Entry in to Force Treaty enters into force either upon the date of exchange of notes or a period thereafter as specified in relevant treaty. (Illustration of Cyprus) 10.5 Effective Date Treaty provision become effective in respective Contracting States on the dates specified in relevant treaty. Cyprus Agreement signed at Nicosia on 13 th July Notified on W.e.f Part 2. Brief Discussion on Understanding the basis of DTA complete. Next: Part 3 Interaction of DTA & Income Tax Provision

25 Page No. 21 Part 3: Interaction of DTA & Income Tax Provision 1. (*) Treaty Override 1.1 Core Issues in Treaty Override: 1. What is Treaty Override? OECD s definition of treaty override: The term Treaty Override refers to a situation where the domestic legislation of State overrules provisions of either a single treaty or all treaties hitherto having had effect in that state. 1.2 Vienna Convention Articles 26 & 31 provide that a Double Tax Avoidance Treaty (Treaty) should be implemented in good faith. Article 27 provides that a Government may not invoke its internal law as justification for its failure to perform a treaty. With these provisions, how can a Government override a treaty! (a) Is the obligation of Implementation in good faith applicable only to the Governments; or does it apply to the tax payers also! (b) A treaty is a contract between two Governments. The tax payer is not a party to the contract. Is he bound by a contract signed by the Government! When the tax payer claims relief permitted by a contract signed by the Government, does he also attract the obligations attached with the relief! 1.3 What are the consequences of a Treaty Override? 1.4 GOI has permitted treaty shopping through several tax havens for more than 20 years. Now if GOI proposes to disallow treaty shopping, is it treaty override? Is it permissible? Isn t GOI prevented by Promissory Estoppel! 1.5 In case of Treaty Override, what are the recourses available? Is the recourse available to the Government of Mauritius only or even to the tax payer? 1.6 A Double Tax Avoidance Treaty is a Contract between two Sovereign Governments. It is on a different footing as compared to the contract signed by a businessman. If he commits a breach of contract, other party to the contract has recourse to the court of law or other enforcement agencies of the Government. When a Government violates a contract signed by it, what is the recourse?

26 Page No. 22 Since practically there is no recourse available to the aggrieved party, contracts between Governments have to be considered at a different level altogether. For maintenance of good international relations, it is expected that a Government would follow the contract that it signs, in letter and in spirit. It will implement the contract In Good Faith. When the words In Good Faith are used, it necessarily means looking at the spirit of the contract, at the substance of the contract and not merely at the letters of the contract. There is NO room for hyper technical interpretations; twisting of meanings and deriving meanings that were never intended by the parties to the agreement. And there is no going back on one s promises whether in writing; or apparent by conduct. Treaty Override violates all these principles. And yet, treaty override does happen. 1.7 Amendments in domestic law can be of two different kinds. Let us consider illustrations to understand differences between a Treaty Override (non-permissible); and permissible amendments. (i) T.D.S. Rate: India signs a treaty with another country. The treaty provides that if a non-resident of India earns interest income from India, India will enforce deduction of income-tax at source at a rate not higher than 10%. Government of India (GOI), after signing the treaty, amends the Income-tax Act specifically to provide that tax will be deducted at 15% - notwithstanding the treaty. This would be a clear treaty override. This is not permissible under International Law. (ii) Countering Treaty Abuse: Government of India amends Indian Income-tax Act to prevent treaty shopping. This is Anti-Treaty Abuse. Such Amendments in law are clearly permissible. They are not even considered as Treaty Override. 1.8 Treaty is a bilateral contract. It is a contract signed between two Governments. Hence it should normally mean that the contract has been signed with full knowledge, understanding and free consent of both the Governments. (And yet, countries have signed treaties with ignorance of international tax law.) Domestic Income-tax Act is a unilateral legislation. When India passes the Indian Income-tax Act, it does not need any permission from Mauritius or other Governments. Treaty Override would mean that: the Government sends CBDT commissioners to Mauritius to sign a treaty; then the Government goes ahead and passes a law contrary to the treaty!

27 Page No. 23 It does not need an expert lawyer or the Vienna Convention to say that Treaty Override is wrong. It is wrong because it amounts the Government going back on its own promise. It is unfair, unethical and hence wrong. Illustration: A Pvt. Ltd. company has its own M/A and other internal authority schedules. A Pvt. Ltd. can change all these rules by following appropriate procedures. Director Mr. A of A Pvt. Ltd. enters into a Contract with B Pvt. Ltd. When A & B signed the contract, it was permissible as per their rules. After some time A Pvt. Ltd. wants to change its M/A and provide with retrospective effect that the contract it entered into requires Board approval. And can A be allowed to do so? No. This is similar to Doctrine of Indoor Management. Same is the situation when two countries enter into a contract. A country cannot be allowed to say that its internal contracts do not permit the contract, which it has knowingly signed. Note: This position is different from the position discussed in paragraph 1.1. If someone tries to abuse the DTA & get undue advantage; relevant Government is in its right to prevent the abuse. If necessary, it can pass relevant laws & prevent the abuse. Part 3. Brief Discussion on Interaction between DTA & ITA complete. Next: Part 4 DTA Articles 1 to 4.

28 Page No. 24 Article 1: Persons Covered: Part 4: DTA Articles 1 to 4. DTA is an agreement to provide tax relief to tax payers. To get the relief he should be a resident of one of the countries that have signed the agreement. A person who is not a resident of any country to the DTA; cannot claim relief under DTA. For example, India Singapore DTA is beneficial for capital gains to a NR investing in India. To get the benefit the investor should be resident of either India or Singapore or both. But a resident of U.K. or U.S.A. cannot claim benefit of India Singapore DTA. If a U.K. investor artificially tries to claim the benefit of India Singapore DTA by incorporating an SPV in Singapore; it is called Treaty Shopping. Limitations of Benefits (LOB) clause is a clause drafted to curb Treaty Shopping. For more discussion on Residential Status, please see para 2 on Article 4 of the DTA. Article 2. Taxes Covered: Essentially, Income-tax, Wealth-tax and Estate Duty may be covered under DTA. Most of the agreements signed by India cover only Income-tax. In the past (Before 1985) India had Estate Duty law. At that time, India had signed separate agreements for estate duty. Important agreement is with U.K. A person may be tax resident of U.K. He may be employed there. However, if his intention is to settle down in India on retirement, he can claim to be domiciled in India. Under the India UK DTA for estate duty, such a persons estate gets substantial relief from U.K. Inheritance tax. This is a complex subject mentioned here only as an illustration. India has abolished estate duty in Hence there is no question of double tax. In this situation, can the estate of an Indian domiciled person claim DTA relief?

29 Page No. 25 This question is similar to the question of a Dubai resident claiming DTA relief on his income from India. When there is no double tax, what is the purpose of a double tax avoidance agreement? It is said that U.K. income-tax department does grant relief. Indian Government has gone out of its way and signed a protocol to grant DTA relief to UAE residents. - Result is: UAE has started a large scale business of tax havens. Article 3. General Definitions: Only eight definitions are given in Article 3. There are definitions in individual Articles Royalty- Article 12; Dividend Article 10; and so on. For all other terms definitions under domestic tax law will be applicable. 1. Illustration: Dividend has a special meaning under ITA u/s. 2 (22). It has a different meaning under the Companies Act. Quite likely, the definition of dividend under the ITA of the other country would be different. Consider for illustration, India UK DTA and consider the tax on dividend (a) before 1997 (when Section 115O was introduced) and (b) after A U.K. resident Mr. UKR had invested in the shares of our Indian company - I Pvt. Ltd. in the year For this illustration, references to Articles are to India UK DTA; OECD & UN models. 2. Before Tax on Dividend: 2.1 I Pvt. Ltd. declares dividend. Indian normal tax rate (including surcharge & education cess) is 33%. However, under the DTA (Article 11) the maximum rate is reduced to 10% (15 % in certain cases). Hence I Pvt. Ltd. will deduct 10% including surcharge and education cess. (See definition of tax under Article 2. It covers surcharge and education cess.) 2.2 I Pvt. Ltd. gives a loan of Rs. 100 to Mr. UKR. This is deemed dividend u/s. 2 (22). Hence India will levy tax on the same. It is not a dividend under DTA. Hence it will not get relief under Article 11. Since it is deemed income; and does not fall under any category from Article 6 to Article 22; it will be Other Income entitled to relief under Article 23.

30 Page No. 26 Under OECD model (Article 21) such income cannot be taxed in COS. Quite likely, UK will not tax such a loan. Hence the loan would go tax free. COR. Under UN model (Article 21) such income can be taxed in COS and 3. After Tax on Dividend: Indian IT department will tax IPR Ltd. u/s. 115O. The dividend is exempt from income-tax u/s. 10 (34) in the hands of the shareholder. Indian Government is not bound by DTA Article (11) to a specific rate of tax. Because here, the assessee is the Indian company, an Indian resident. Not the share-holder who is UK resident. Will the U.K. Government give credit for the tax paid by IPR Ltd.? U/s. 115O (4) & (5) Indian Government has separated the shareholder from the tax U/s. 115O. Considering the intent of the law and substance of the provision, the COR should give credit for such tax. It is said that U.S. & U.K. Governments to give this credit. Mauritius Government of course gives the credit. Issues highlighted in this illustration: 1. Definitions can be different under ITA and DTA. 2. Wherever DTA provides definition, for the purposes of DTA, such definition will prevail. Except for the limited purpose of elimination of double tax, for all other purposes under ITA; the definition under ITA will prevail. 3. DTA relief is available on almost all incomes. 4. Definition under other laws. (like Companies Act, General clauses Act, etc.) have the last priority in applicability for DTA.)

31 Page No. 27 III. Article 4 Resident or Residential Status. Let us consider text of Article 4 (1). (1) For the purposes of this Convention, the term resident of a Contracting State means any person who, under the law of that State, is liable to tax therein by reason of his domicile, residence, place of management or any other criterion of a similar nature. Now analyse this sentence: (1) For the purposes of this Convention, (2) the term resident of a Contracting State means (3) any person who, (4) UNDER THE LAW OF THAT STATE, (5) is liable to taxation. (6) therein (7) by reason of (8) his domicile, resident, place of management. (9) or any other criterion of a similar nature. Rules of Good writing: Now the issue is: For defining a Resident (Phrase 2 above), the treaty uses the word Residence (phrase 8 above). This raises the question: Is this something like a circular calculation in an excel sheet! Such circular calculations are not workable. It is a rule of good English writing that: When you are defining a word, you cannot use the same word in the definition. Real fact is, the definition is not using the same word twice. The word Resident in the 2 nd phrase refers to Resident as per the treaty. And the word Residence in the fourth phrase refers to the residence under the domestic legislation. (2) Where by reason of the provisions of paragraph (1) of this Article an individual is a resident of both Contracting States, then his status shall be determined in accordance with the following rules: (a) he shall be deemed to be a resident of the Contracting State in which he has a permanent home available to him. If he has a permanent home available to him in both Contracting States, he shall be deemed to be a resident of the Contracting State with which his personal and economic relations are closer (centre of vital interests); (b) If the Contracting State in which he has his centre of vital interests cannot be determined, or if he has not a permanent home available to him