India: Are You Getting Properly Taxed In Two Sovereigns?

"Wise men trod on unchartered territories to bring glory unto themselves and their country."

Introduction:

With the liberalization of the Indian economy in the post 1991 scenario, there is a growing importance to the subject of taxing e-commerce and international tax treaties both with the Government and the taxpayers. The Double Taxation Avoidance Agreement (DTAA) has been entered into with most of the trade partners numbering 72 so far and the appetite is growing. The Indian DTAA is based on OECD model, U N Model and U S Model Tax Conventions. Basically a tax treaty facilitates capital and trade-flows, defines cross border operations, prevents tax evasion and tax avoidances across the border, eases tax collection mechanisms, contributes to the international development and minimises the rigour of taxing the same income in more than one country and promotes bi-lateral cooperation in tax collection machinery. In this article, it is proposed to present this subject in a broad canvas so as to gain a proper exposure to the concepts, principles, legal recourses and to provide a broad guidance in arranging the tax affairs.

Scope For Double Taxation:

There are three cases in which international double taxation may arise:

  1. A person may be subjected to tax on his world income in more than one country. This is called concurrent full liability to tax. While one country may tax on the basis of nationality, the other may tax on the basis of residence.
  2. Because of divergence of rules for determining the source of income, a person may be taxed both in the country of residence as well as in the country where the income is generated.
  3. A person may be liable to tax in both the countries even if he owns a permanent establishment in one country and through it derives income from the other country.

Chapter IX of the Income Tax Act – Sections 90 & 91 describes in detail the main objectives of the DTAAs entered into with various countries and also provides guidance in respect of countries with which no such agreement exists.

The main objective in such agreements is:

  1. To provide relief where a particular income is taxed in both countries.
  2. To avoid double taxation of income.
  3. To exchange information on tax evasion / tax avoidance and to facilitate tax investigation.
  4. To provide for recovery of income tax.

Cross Border Taxation:

  1. The following incomes are taxed in the country of residence:
    1. Interest
    2. Dividend
    3. Royalty
    4. Fees for technical services

The rate of taxation is on gross receipts without deduction of expenses. The source country is also given the right but such taxation in the source country has to be limited to the rates prescribed under the agreement. The Finance Act 1997 has exempted in India income from dividend declared after June 1, 1997 in the hands of the beneficiaries.

  1. Income from capital gains is taxed in the country where such properties are situated. Where the ownership the property is with a Permanent Establishment (PE) or a fixed place of business, the income is taxed in the country where such PE or fixed place of business is situated. Different provisions exist for taxation of capital gains arising from transfer of shares. In a number of agreements the right to tax is given to the state of which the company is a resident. In some others the residence of the majority shareholders has been recognized.
  2. The source country gets the right of taxation for the business income where the PE or the fixed place of business is located.
  3. Income derived from profession or any other similar activities are taxed in the country of residence except in case where the professional owns a fixed place in the other country from where such services are offered. Such income is also taxable in the source country, if his stay exceeds 183 days in that financial year.
  4. Income from dependant personal services i.e., from employment is taxed in the country of residence unless the employment is exercised in the other state. Even if the employment is exercised in any other state, the remuneration will be taxed in the country of residence provided:
    1. The recipient is present in the source state for a period not exceeding 183 days and
    2. The remuneration is paid by a person who is not a resident of that state and
    3. The remuneration is not borne by a PE or a fixed base.
  1. The agreements provide for jurisdiction to tax director’s fees, remunerations of persons in Government service, payments received by students and apprentices, income of entertainers and athletes, pensions and social security payments and other incomes.
  2. The agreements also contain clauses for non-discrimination of the nationals of a contracting state in the other state vis-à-vis the nationals of the other state.
  3. The agreements generally empower authorities to resolve any tax disputes without getting embroiled in litigation.
  4. The agreements also facilitate information sharing for carrying out the purpose of the agreement and effective tax compliance. Information about residents getting payments in other contracting states, necessary to be known for proper assessment of total income of such individuals is thus facilitated.
  5. Since the object of the tax treaties is to benefit the non-residents, normally an option is given to be assessed either as per the provisions of the treaty or the local laws whichever is lower in situations where there is a reduction in local tax rates after the treaty has been entered into.
  6. In order to improve the efficiency of tax collections, the tax is normally deducted at source out of payments made to non-residents at the same rates at which the particular income is made taxable under the treaty. Consequent upon the amendment through the Finance Act 1997, the income from dividend declared is exempt from June 1, 1997.
  7. Section 91 of the Income Tax Act grants unilateral relief where there is no general agreement for avoidance of double taxation by allowing relief for the lower of the two taxes payable. However this relief is available only to resident assesses and not to NRIs.
  8. Sections 44A of the Wealth Tax Act 1957 provides relief with respect to wealth tax in respect of countries where tax treaties exist and section 44B covers other cases.
  9. Tax planning is possible through incorporation of companies in more than one country. Where operations are required in any country, an affiliate company is set up in a country that enjoys the maximum advantage with the country in which the operations are to be carried out. However the anti-avoidance provisions are to be kept in mind.
  10. An expert knowledge of the treaties is essential not only to minimize the tax burden but also to eliminate taxes in certain cases. To illustrate, a resident of Sweden with high taxes would advance a loan to an industrial undertaking in India duly approved by the Government and enjoy the tax immunity on the interest income earned in India in both the countries due to Article IX of the DTAA in Sweden and section 10 (15) (iv) of the local tax laws in India.

Principles Of Interpretation Of Bilateral Tax Treaties:

The laws in force in either of the contracting states will continue to govern the taxation of income in respective contracting states except where the provisions to the contrary are made in any agreement. Generally the following rules of interpretation will apply:

  1. The provisions of the tax treaty overrides the provisions of the Income Tax Act i.e., HO expenses are deductible in full in the case of a French company despite section 44 C of the Indian Income Tax Act.
  2. The jurisdiction of a domestic court like Tribunal is not ousted in view of Article XVIII of the DTAA between Federal Republic of Germany and India.
  3. The profit from business of a company is exempt if they are covered by DTAA in spite of the business connection as the provisions of section 90 of the DTAA with Germany overrides section 4, 5 and 9 of the Income Tax Act as was held by Andhra Pradesh High Court.
  4. Mere supply of a plant by the foreign company and the local erection and assembly by the purchaser under the technical supervision of the foreign engineer does not amount to Permanent Establishment (PE) in India within the meaning of Article II (1) (aa) / (bb) of the agreement.
  5. Even appointment of a sub-contractor in India by foreign company to effect delivery of plant in India and deputation of engineer to supervise erection of plant would not amount to a foreign company having an agent or a person acting on its behalf in India within the meaning of Article II (1) (i) (dd) of the agreement.
  6. The interest payable on unpaid purchase money agreed to be part of the sale consideration could not be regarded as a debt and hence an income within Article VIII of the agreement as the words "any other form of indebtedness" and "from sources in the territory" could only mean interest arising or accruing as a separate source.

Tie-Breaking Rule:

The DTAA agreement with other states provide for determination of the residence when the fiscal status of the concerned person warrants him to be treated as a resident. The following principles generally apply in their order of importance:

  1. Situation of permanent home
  2. Situation of personal and economic relations (Centre of vital interest)
  3. Situation of habitual abode
  4. Nationality

Tax Sparing:

One of the aims of the Indian tax treaties is to stimulate capital inflows from developed countries. This is achieved by allowing the investors to retain all the tax incentives on such investments in India. The tax credit is allowed by the country of its residence not only in respect of taxes paid in India but also in respect of those taxes forgone due to tax incentives. Thus Tax Sparing credit is an extension of the normal and regular tax credit to taxes that are spared by the source country. The tax sparing credit extends the relief granted by the source country to the investor in the residence country and does not seek reciprocal arrangements.

Treaty Shopping:

The advantage taken of a DTAA between two countries by a resident of a third country is known as treaty shopping. The scope of a tax treaty determines the person who is entitled to its benefits. It is therefore to be established in the first place whether an individual or an entity is a person and that person is liable to tax in a contracting state due to his domicile, residence, place of management or other similar criterion. A resident of a third state is not entitled to its benefit by manipulating through treaty shopping.

Thin Capitalisation:

Incorporation of low equity companies and financing the entire business mostly through debt and declaring high rates of dividend is normally a known business practice. This is done primarily because interest is tax-deductible expense and dividend is not. The OECD tax treaty model does not prevent enacting local rules allowing the tax authorities to treat the interest income also as dividend in such cases. This business practice of financing business mostly through debt capital is known as thin capitalisation.

Arm’s Length And Shifting Of Profit:

Any business relationship between buyer and seller, each seeking his own best economic interest and agreeing on a price on a commercial basis and dealing with or as though dealing with independent, unrelated persons, competitive, straight-forward, involving no favouritism or irregularity is an arm’s length transaction. The aim of the doctrine is to curb the natural tendency of shifting profits from one jurisdiction to another. Most of the multinational companies resort to various techniques such as the following using the tax havens in order to evade tax:

  1. Transfer pricing
  2. Income splitting and splitting of contract
  3. Treaty shopping
  4. Royalty and technical fees
  5. Capitalisation and loan financing.

Definition Of Permanent Establishment (PE):

The fixation of PE is the basic step in the taxation activity and the taxation of a business transaction in cyberspace. With the development of e-commerce, the following broad principles have emerged:

  1. The website is not a place of business.
  2. Internet service provider is not a PE.
  3. The server on which the website is stored is a PE as there is an equipment having a physical location.
  4. If the business enterprise owns the server, it would be a PE.
  5. The server needs to be located at a certain place for a sufficient period of time so as constitute a PE.
  6. Preparatory or auxiliary activities such as providing telephone links between suppliers and consumers, advertisements, gathering market data where such activities are a core part of the commercial activity and where equipment is a fixed place of business, it would constitute a PE.

Is India A Tax Haven?

To certain extent the above statement is true in the case of NRIs as illustrated hereunder:

  1. Deposits in NRE accounts and FCNR (B) accounts – exempt from income and wealth tax.
  2. Dividend income and income from units of Mutual Funds (MFs) are exempt from taxation.
  3. Income from foreign exchange assets is taxed at 20% flat and long-term capital gain from such asset is taxed at 10%.
  4. There is no wealth tax on bank deposits, units of MFs, company shares, Gilts, NSC and foreign exchange assets.
  5. There are several concessions and tax advantages for setting up industries such as in:
    1. Free trade zones
    2. 100% EOUs
    3. NE region
    4. Backward areas
    5. Small scale units in certain areas
    6. Housing projects in certain areas
    7. Export business
    8. Software exports
    9. Export of film software
    10. Industrial undertaking in certain areas

Thus for NRIs India is a minor tax haven for their declared income and wealth and a strong incentive to stay away from other tax havens which may require concealments.

The author places on record the invaluable contribution made by Ms R Nirmala, B.Com. A.C.A., partner RSN & Associates, Chartered Accountants in making this article possible.

© Copyrights reserved by RSN & Associates, Chartered Accountants, Chennai, India.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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