Understanding the Tax Treaties (DTAAs)
Why need of Tax Treaty
Where a taxpayer who is resident of a country i.e. country of residence, earns income in another country i.e. source country, it gives rise to possible double taxation of such income in the hands of the taxpayer, i.e. in the source country as well as in his country of residence. This situation has led to a growth of Double Tax Avoidance Agreements (DTAAs) (or tax treaties) between countries to resolve such cross border tax disputes. India now has tax treaties with approximately 100 countries.
Under the tax treaties there are broadly 2 systems of taxation:
- Source based system, where income earned in a particular country is taxable in that country in the hands of the recipient of the income,
- Residence based system, whereby the worldwide income of a resident of a particular country is taxable in that country
India follow both system of taxation, the residence based system of taxation, coupled with source based taxation of specified India sourced income of non-residents on account of provisions of section 9 of the Income-tax Act, 1961.
Therefore, it can now be seen as to how a typical tax conflict in a cross border transaction arises due to different taxation system being followed by different countries. Let us take an example – a France consulting firm provides technical services to an Indian resident. India may seek to tax the service fees paid by the Indian resident to the France firm under its source rule, while France will also tax such service fees (i.e. the same income) under its residence rule. The France firm cannot be required to pay tax on the same income in both the countries, and therefore, there is a need for specific rules to resolve such conflict. Tax treaties resolve such conflicts – in this context, the India-France tax treaty provides that India has only has a limited right to tax such fees, i.e. at a concessional tax rate of 10%, coupled with France allowing the France firm a credit of the taxes paid in India in respect of such service fees against the France tax liability on such service fees.
Normally, countries will try to ensure increase their tax base, particularly in regard of cross border transactions. This is particularly evident in the present age where a few of the developed countries are likewise confronting a high pay uniqueness and there is a basic need to expand their tax revenueto meet their government assistance and other use. However, balance is required to be made between a favourable investment climate for foreign investors and the tax environment including favourable provisions in tax treaties. This gets further accentuated by competition between countries, especially emerging economies, to attract foreign investment. Hence, Governments continue to use a liberal tax policy (including favourable provisions in their tax treaties) as a tool to attract foreign investment.
Tax treaty models
Models of tax treaty are the basis of tax treaty negotiations between the countries. Currently there are two types of tax treaty models:-
- UN Model – the UN Model tilts towards source based taxation in order to give a tax revenue share to countries within which the income is earned.
- OECD Model – on the other side, OECD being predominantly an association of developed countries, it tilts towards residence based taxation.
In Indian context, existing indian tax treaty’s are based on UN models i.e. source based taxation. It is to be noted that as an outcome of the Base erosion and profit shifting (BEPS) project, to some extent, source based taxation is being incorporated in the OECD Model, given the current economic situation in several developed countries. It is also to be noted that the applicability of tax treaties would change to an extent once the Multilateral Instrument (“MLI”) comes to be widely adopted alongside the tax treaties. Although India has signed MLI in respect of various articles. The common objective of Governments while negotiating tax treaties, irrespective of the Model which is used as a base, is to ensure that tax revenues are shared in a manner most optimal to both countries, so that it ensures free movement of goods/ capital/ services/ technology and persons between countries, without facing issue of double taxation.
Understanding Tax Treaty (Interpretation)
In the Indian law, a tax treaty is not a statute, but an agreement documenting an understanding between two countries to facilitate achieving common goals. Principles around interpretation of treaties are contained in the Vienna Convention on the Law of Treaties (1969).
Under Article 31 of the Vienna Convention, the broad theme around interpretation of treaties is that they need to be interpreted in good faith, in accordance with the ordinary meaning of the language in the context it is used, as per the object and purpose of the treaty.
Tax treaties would also need to be interpreted harmoniously with reference to supplementary material like Protocols and Technical Memoranda. The OECD and UN Commentaries also serve as important aids to interpretation, a proposition that Indian Courts have accepted in cases. Another important concept that is quite unique to tax treaty interpretation is whether a static approach or an ambulatory (i.e. adaptive) approach of interpreting tax treaty provisions (qua the domestic tax law provisions) is to be followed. The static approach involves interpreting the tax treaty provisions with reference to the domestic tax law provisions at they stood at the time the tax treaty was entered into. The ambulatory approach involves interpreting the tax treaty provisions harmoniously with the extant domestic tax law provisions keeping in view the changes therein. The predominant view is that the ambulatory approach is more appropriate except where there is a very significant change in the domestic tax law provisions which makes the tax treaty provisions nugatory if an ambulatory approach is adopted.
In the Indian context, Tax treaty overrides the provision of income tax, subject to some safeguards provided by the Indian income tax law. Further, the benefits of tax treaty shall be available in good faith and not just to avoid taxation. (As applicability of GAAR Provisions may apply). Further, the explanations provided under the domestic law may not be applicable on definitions as per the tax treaty.
Contents of UN Model Tax Treaty
Since Indian tax treaties are based of UN Model tax convention, the summary of contents is listed below for quick view:-
Title and Preamble
Chapter I
Scope of the Convention
Article 1 Persons covered
Article 2 Taxes covered
Chapter II
Definitions
Article 3 General definitions
Article 4 Resident
Article 5 Permanent establishment
Chapter III
Taxation of income
Article 6 Income from immovable property
Article 7 Business profits
Article 8 International shipping and air transport (alternative A and B)
Article 9 Associated enterprises
Article 10 Dividends
Article 11 Interest
Article 12 Royalties
Article 12A Fees for technical services
Article 13 Capital gains
Article 14 Independent personal services
Article 15 Dependent personal services
Article 16 Directors’ fees and remuneration of top-level managerial officials
Article 17 Artistes and sportspersons
Article 18 Pensions and social security payments (alternative A and B)
Article 19 Government service
Article 20 Students
Article 21 Other income
Chapter IV
Taxation of capital
Article 22 Capital
Chapter V
Methods for elimination of double taxation
Article 23 A Exemption method
Article 23 B Credit method
Chapter VI
Special provisions
Article 24 Non-discrimination
Article 25 Mutual agreement procedure (alternative A and B)
Article 26 Exchange of information
Article 27 Assistance in the collection of taxes
Article 28 Members of diplomatic missions and consular posts
Article 29 Entitlement to benefits
Chapter VII
Final provisions
Article 30 Entry into force
Article 31 Termination
Implementation of MLI
Base erosion and profit shifting (BEPS) refers to corporate tax planning strategies used by multinationals to “shift” “profits” from higher-tax jurisdictions to lower-tax jurisdictions, thus “eroding” the “tax base” of the higher-tax jurisdictions. The aim of the OECD’s BEPS project was to streamline taxation of profits across countries so that governments can collect their due taxes. The project culminated with the creation of the Multilateral Instrument (MLI) framework, which is an overarching instrument that modifies bilateral tax treaties signed between various countries in a manner that is compliant with the aims of the BEPS project. MLI becomes effective with respect to India’s tax treaties, from 1st April 2020, the bilateral tax treaties between India and various countries stands modified to the extent prescribed in the MLI depending on the permissible elections made by India as well its treaty partners on the exact manner of application of the MLI. This would have an impact on the tax consequences of cross border transactions. However, United States of America has generally kept itself away from the OECD BEPS project.
India’s Position with respect to MLI
India’s position in respect of MLI article wise is as under:-
| Article of MLI | Description of Article
|
India’s Position |
| Article 2: Interpretation
of terms |
Notification of tax treaties covered by MLI convention | India has notified 93 tax treaties except China and Marshall Islands |
| Article 3: Transparent entities | Tax treaty benefits to be allowed to fiscally transparent entities for the income earned to the extent that such income is taxed in the jurisdiction in which the entity is a resident | India has made a reservation and thus, not applicable to its CTAs |
| Article 4: Dual resident entities | CAs of both jurisdictions to mutually agree on the manner to determine the residential status of dual resident non-individuals regarding place of effective management, place of incorporation or constitution, and any other relevant factors. In the absence of such agreement, treaty benefits to be denied to such a person, unless otherwise agreed by them. | India has opted for application of such provision; said provision to apply to all its CTAs unless reservation is made by other CTA partner. |
| Article 5: Application of methods to eliminate double taxation | Recommends three options for elimination of double taxation inter-alia including “Option C”, which prescribes application of credit method | India has chosen to apply Option C i.e., credit method; the said option to apply to all its CTAs for its own residents Indian tax treaties generally contains credit method except in select cases. For e.g., tax treaty with Bulgaria, Greece, Egypt, Slovak Republic that contains exemption method. Therefore, exemption method in such select cases to be replaced by “credit method”. |
| Article 6: Purpose of CTA (minimum standard) | Introduces preamble text in CTA stating that the jurisdictions intend to avoid creation of opportunities for non-taxation or reduced taxation through tax evasion or avoidance, and through treaty shopping | India is silent on its position. Being minimum standard, such MLI provision to apply to all its CTAs |
| Article 7: Prevention of treaty abuse (minimum standard) | Envisages following three anti-abuse measures to meet the minimum requirement:
A. PPT B. PPT supplemented with either SLOB or detailed LOB clause C. Detailed LOB provision, supplemented by a mutually negotiated mechanism to deal with conduit arrangements not already dealt with in CTA |
India has opted for PPT + SLOB. PPT being minimum standard, it will apply to all its CTAs. India has accepted to apply PPT as an interim measure and intends where possible to adopt LOB provision, in addition or replacement of PPT, through bilateral negotiation. Not opted for competent authority route under Article 7(4) of MLI and thus, not applicable. SLOB to be applicable only where other CTA partner has adopted it or allowed India to apply SLOB asymmetrically. |
| Article 8: Dividend transfer transactions | Introduces additional criteria of “365 days minimum holding period” for the shareholder to avail concessional tax rates under CTA | India has opted to apply such provision (except in case of India-Portugal tax treaty, which already contains similar provision). Thus, said MLI provision to apply to all its CTA except India-Portugal treaty (unless reservation is made by other CTA partner) |
| Article 9: Capital gains from alienation of shares or interest of entities deriving their value principally from immovable property | Introduces additional criteria of “365 days minimum holding period” in case of gains arising from alienation of shares or other participation rights if such shares or rights derive more than a specified percentage of their value from immovable property situated in the source jurisdiction. Optional provision of inserting a minimum value derivation criterion of 50 percent of their value directly or indirectly from immovable property. | India has opted to apply minimum holding
period threshold along with minimum value derivation criterion of 50 percent. The said provision to apply to CTA only if other CTA partner has chosen to apply the said provision |
| Article 10: Anti-abuse rule for PE in third jurisdiction | Addresses abuse of CTAs in a triangular situation | India is silent on its position; the said provision to apply to all its CTA, unless reservation is made by any other CTA partner. |
| Article 11: Application of tax agreement to restrict a party’s right to tax its own residents | Preserves the right of jurisdiction to tax its own residents | India is silent on its position; the said provision to apply to all its CTA, unless reservation is made by any other CTA partner. |
| Article 12: Artificial avoidance of PE status through commissionaire and similar strategies | Widens the definition of PE given in tax treaties to include cases where a person habitually concludes contracts or plays a principal role in conclusion of contracts of another enterprise | India has opted to apply the said provision; the said provision to apply to a CTA only if any other CTA partner has chosen to apply the said provision |
| Article 13: Artificial avoidance of PE through specific activity exemptions | Provides two options to counter artificial avoidance of PE status through specific activity exemptions. “Option A” states that exemption from PE is available only if the activities carried on are of preparatory and auxiliary nature. Additionally, it provides for anti-fragmentation rule | India has chosen to apply Option A; the said option to apply to CTA only if other CTA partner has chosen same option. India has chosen to apply antifragmentation rule; the said rule to apply to a CTA only if other CTA partner has chosen to apply the said provision |
| Article 14: Splitting up of contracts | Addresses avoidance of PE by splitting the contracts between related enterprises to circumvent the threshold of PE creation. | India is silent on its position; the said provision to apply to all its CTA, unless reservation is made by any other CTA partner. |
| Article 15: Definition of a person “closely related to an enterprise” | Defines the term “person closely related”, in the context of Articles 12, 13, and 14 of the MLI | India is silent on its position; the said provision to apply to all its CTA, unless reservation is made by any other CTA partner. |
| Article 16: Mutual agreement procedure (Minimum standard) | Requires MAP request to be made to either state, or implement a bilateral notification or consultation process. | India has reserved its right for not adopting the modified MLI provisions on the basis that it will meet the minimum standard by allowing MAP access in the resident state and implementing bilateral notification or consultation process. |
| Article 17: Corresponding adjustments | Requires jurisdictions to make appropriate corresponding adjustments in transfer pricing cases | India has chosen to apply the said provision except for CTAs where the provisions already exist. Bilateral APA and MAP allowed even in absence of Article 9(2) – as clarified by CBDT vide press release dated 27 November 2017. |
| Article 18-26: Mandatory binding arbitration | Provides mandatory binding arbitration in cases where competent authorities are unable to reach an agreement to resolve a case under MAP | India has not opted for mandatory arbitration. |
| Article 35: Entry into effect | Effect of provisions of the MLI | India has chosen to substitute “calendar year” with “taxable period”. If other CTA partner opts for calendar year, date of applicability of MLI provision for such other CTA partner will differ via-a-vis as for India |
The term CAs referred to Competent Authorities and CTAs s referred to Covered Tax Agreement.
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