Double Taxation Avoidance Agreement

INTRODUCTION

The era we live in is of globalisation where capital and labour move freely. In this era, a country cannot sustain on its own and requires foreign investment, imports and exports to sustain its economy. However, double taxation acts as a major discouragement to engage in inter-border trade.

Organisation for Economic Co-operation and Development (OECD) defines International Juridical Double Taxation

“as the imposition of comparable taxes in two (or more) States on the same taxpayer in respect of the same subject matter and for identical periods”.

To avoid the situation of double taxation and attract foreign investment, countries enter into Double Taxation Avoidance Agreement (DTAA). India presently has DTAA with over 88 countries.

WHAT IS DTAA?

DTAA is the agreement entered into between two countries in order to eliminate taxation by both the countries on the same subject matter. A company, who is carrying on business in two countries, may be required to pay tax in the host country and then again, in the country where such company intends to sell the goods.

To eliminate such situations of double taxation, countries enter into an understanding so as to ensure that the company is mandated to pay tax in only one country.

DTAA is also termed as Double Taxation Convention (DTC). DTC is better term to be used since DTAA reflects the idea that the purpose is to avoid tax when the purpose is also to prevent tax evasion. The most popular models are discussed below:

OECD Model

The Model Tax Convention on Income and on Capital 2017 (OECD Model) provides a way as how the income and capital can be taxed and the situation of double taxation is eliminated.

Article 6 to 22 of the OECD Model prescribes for taxation of income and Article 23 for that of capital. The OECD Model adopts Residence Principle as the general rule, i.e., the contracting state in whose jurisdiction the company is residing should tax.

In case where the states have the right to tax, as in the case of dividend and interest under Article 10 and 11 of the OECD Model, the extent of tax that can be imposed by the source state is limited.

United Nations Model

The general rule prescribed by United Nations (UN) Model Double Tax Convention (UN Model) is that the source state or host investment state will tax the company. The UN Model secures the interest of developing countries as generally, the host state is the developing state and it will be able to tax from a larger portion of profit, ultimately, increasing its national income. The OECD Model was drafted by industrialists’ countries that have more or less same economic standards and therefore, it does not consider the interest of the developing countries.

Apart from OECD Model and UN Model, there exists United States Model Income Tax Convention which is used by Treasury Department to negotiate tax treaties, and Andean Model created under Cartagena Agreement having Colombia, Peru, Chile, Bolivia and Ecuador as its member states.

OBJECTIVES OF DTAA

The main objectives of DTAA are:

To promote and foster economic trade and investment between two countries by providing relief from dual taxation.
To combat tax evasion and avoidance, to provide relief, and to take advantage of tax credits.
To improve collaboration between two taxing authorities. Also, to encourage the trade of goods and services, as well as the mobility of capital and people.
To promote technology transfer and eliminate discrimination among taxpayers.
To offer clarity on the taxation of certain cross-border transactions, as well as to establish particular procedures for revenue sharing between two countries.

DTAA AND INCOME TAX ACT, 1961

Chapter IX of the Income Tax Act, 1961 (the IT Act) enunciates the provision with an objective to provide double taxation relief. Section 90 of the IT Act provides that the Government of India may enter into a DTAA with other country to eliminate double taxation and to exchange information to prevent tax evasion.

Section 90A of the IT Act specifies that a specified association in India may enter into such agreements with specified association in territory outside India for the said purposes. A specified association is an institution, association and body that is incorporated under any law of India or other territory and is notified by the Central Government.

For the residents of a country with which India has not entered into DTAA, Section 91 of the IT Act provides that they will be required to pay a deduced amount of tax in India.

However, if the person is resident of India and can show that the income of earlier year was earned in Pakistan and has been taxed for that income in Pakistan, the person is entitled to reduction of income tax in India. The amount that will be reduced will be that paid in Pakistan or the amount taxable under Indian law on same income, whichever is lower.

BENEFITS OF DTAA

Tax Exemption

DTAAs are designed to make a country more appealing as an investment destination by removing the burden of double taxation. Such relief is provided by exempting income earned abroad from taxation in the resident country or by crediting taxes already paid abroad.

Lower Tax Rate

Even genuine investors may be enticed by the DTAA to route their investments through low-tax jurisdictions to avoid paying taxes. The country loses tax money as a result of this.

Tax Concessions

In some circumstances, DTAAs also provide for tax concessions.

Tax Certainty

Through the unambiguous division of taxation rights between the contracting Governments, the DTAA also gives tax certainty to diverse investors and firms in both countries.

DOUBLE TAXATION TREATIES AND FOREIGN DIRECT INVESTMENT

One of the main objectives of entering into DTAA with other countries is to attract foreign direct investment (FDI). The investors are generally discouraged to invest in unfavourable business environment. Double taxation on the same income acts as a major impediment in attracting foreign investment. It is to avoid this situation and attract FDI that the counties enter into DTAA and exempt persons from tax.

However, the concerns regarding treaty abuse are increasing. An investor, instead of investing directly from the host country, may route funds through another country to enjoy tax benefits. A company may incorporate its shell subsidiary in a tax haven which involves minimal costs to derive huge tax benefits on capital gains.

Owing to such concerns the DTAA between India and Mauritius was amended to give India the right to tax capital gains. Similarly, in December 2016, the Government of India announced that it would amend the DTAA with Singapore.

The amended treaty allows India to tax a capital gain arising to a Singapore resident from the transfer of its shares in an Indian company. It also incorporates a Limitation of Benefit (LoB) Clause to the effect that the benefit arising out of DTAA will not be available to transactions of an entity who is a shell/conduit company and whose purpose is to avoid tax.

It further provides that the countries are not restricted from applying domestic law in case of tax evasion or avoidance.

JUDICIAL VIEW

Several disputes arising due to double taxation have been brought before the Supreme Court. The dispute mostly relates to interpretation of provisions of law.

In a recent decision of Engineering Analysis Centre of Excellence v The Commission of Income Tax [2021 SCC OnLine SC 159], the Supreme Court finally settled the controversy concerning payment of tax by Indian resident on purchase of software from non-resident foreign supplier.

The Supreme Court ruled in favour of taxpayers stating that the payment by Indian resident for use or resale of computer software do not classify as royalty payment and therefore, no withholding tax liability under Section 195 of the IT Act can be imposed on the residents.

A batch of 103 appeals was pending before Supreme Court. The appeals aroused in view of conflicting judgment of Karnataka High Court in CIT v. Samsung Electronics Co. Ltd. [(2012) 345 ITR 494]; that of Delhi High Court in Director of Income Tax v. Ericsson A.B. [(2012) 343 ITR 470], CIT v. ZTE Corporation [(2017) 392 ITR 80], and other cases; and the ruling of Authority for Advance Ruling (AAR) in Dassault Systems K.K., In re: [2010] 322 ITR 125 (AAR). While the Karnataka High Court proceeded to hold tax payers liable, the Delhi High Court ruled that since no copyright is being transferred to importers, the payment for computer software could not be considered as royalty.

Interpreting relevant DTAA which were based on OECD Model, provisions of the IT Act and of Indian Copyright Act, 1957, the Supreme Court held that the distributer gets a non-exclusive and non-transferable license to resell the software and the copyright owner do not part away with copyright, hence, there is no transfer of copyright and payment made cannot be classified as royalty.

In 2020, the AAR, New Delhi in the case of Tiger Global International Holdings, Mauritius [Application No. AAR 4, 5 & 7 of 2019], rejected the application claiming tax exemption under India-Mauritius Agreement on the ground that the transaction was structured to avoid tax.

The Applicant, a company in Mauritius, had sold its shares in Flipkart Private Limited to a Luxembourg-based buyer. Since the shares of Flipkart derived their substantial value from assets in India, the transaction was liable to be taxed under IT Act. The Applicant claimed benefit under DTAA.

AAR observed that the control and management of the company was in the hand of US resident who was the real beneficiary, and the structure of the company is such to avoid tax, it would be required to look at the entire transaction from acquisition of shares to sale of shares and would not adopt a narrow approach by only looking at the transfer of concerned shares and determine its taxability. Hence, it denied capital gain exemption to the Applicant.

In Formula One Championship Ltd. v. CIT [(2017) 15 SCC 602], the Supreme Court provided an important ruling concerning Permanent Establishment especially when the foreign entity carried out its operation for a very short period in India.

The brief facts of the case were that Formula One World Championship Limited (FOWC), a UK resident, entered contract with Jaypee Sports International Limited (Jaypee) to organise Formula One Grand Prix racing event in India against payment to FOWC.

The issue before the Supreme Court was whether FOWC constituted permanent establishment under DTAA between India and UK for its income from Jaypee to be taxed under the IT Act.

The Supreme Court held that time is not a relevant consideration and FOWC constituted permanent establishment under Article 5 of DTAA since FOWC had exclusive commercial rights of F1 Championships and the exploitation of such rights in India amounts to presence of business in India; that the rights of Jaypee were restricted and it was FOWC who exercised dominant control over the Buddh International Circuit; and it earned income out of it from Jaypee. As a result, FOWC will be taxed in India.

AMLEGALS REMARKS

Countries commonly enter into Double Taxation Treaties to further ease of doing business. The significance of DTAA becomes manifest with UN and OECD having model taxation treaties. United States and Andean also have their model taxation treaty. However, the double taxation treaties entered into by the countries are largely based on OECD and UN Model.

Though the DTAA offers many benefits, the apprehension of its abuse are becoming clear. In a purely domestic matter, the transaction is taxed under Income Tax Act, 1961. But in a transaction involving foreign resident, the interplay between DTAA and the IT Act comes into play.

Some companies perceive DTAA as a method to evade and avoid taxation. In order to deal with these loopholes, the DTAA between India and Mauritius, and India and Singapore were amended. Such treaties are necessary to ensure that coupled with elimination of double taxation; there is elimination of tax avoidance.

-Team AMLEGALS assisted by Ms. Tanish Gupta (Intern)

For any queries or feedback, please feel free to get in touch with chaitalisadayet@amlegals.com or aditi.tiwari@amlegals.com