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Webcast on International Taxation Introduction to tax treaties CA Pinakin Desai 19th April 2013 Domestic Law Charging Provision - Sec 4, 5 R & OR R but NOR NR Indian Income: ► Accrued / sourced in India Taxable Taxable Taxable ► Received in India Taxable Taxable Taxable Foreign Income : ► Accrued outside India but deemed to accrue in India by virtue of Section 9 Taxable Taxable Taxable ► Accrued outside India - First receipt in India Taxable Taxable Taxable ► Any other income accruing outside India and received outside India Taxable Not taxable Not taxable Page 2 Introduction to Tax Treaties Overview ► Nation has sovereign right of imposing tax at its discretion, subject to territorial nexus ► Territorial nexus connect may be qua the taxpayer or qua his income ► India : Residence, extensive Source Rule ► USA : Citizenship ► Hong Kong : Territorial Page 3 Introduction to Tax Treaties Potential exposure of multi country taxation ► Fact pattern of Mr A who is deputed by US Co to work in a project of I Co for six months US CO Deputation of Mr A to work in the project of I Co Tax Resident Sweden Citizenship UK Employer US Company Project of US Co India Receipt of salary Netherlands Project of I Co Page 4 Introduction to Tax Treaties Need for Rational Cross Border Taxation ► Multi country taxation injures flow of cross border activities ► Double Tax Avoidance Agreement (DTAA) eliminates or mitigates hardship caused by multi level taxation ► Home country tax is obligation; host country tax is a cost ► Home country is country of residence (COR) ► Host country is country of source (COS) ► Usual for COR to provide unilateral relief ► Mitigation can result in relief from double taxation, but, not refund by COR Page 5 Introduction to Tax Treaties Types of double taxation ► Economic double taxation ► ► ► Same economic stream of income taxed in two or more states but in the hands of different taxpayers [E.g. business profit and dividend in different countries]. Juridical double taxation ► Two or more states levy taxes on same entity on same income for identical periods ► Arises due to overlapping claims of tax jurisdictions Tax treaties largely prevent/mitigate juridical double taxation Page 6 Introduction to Tax Treaties Relief in India from double taxation ► ► Section 90 ► Regulates a case where India has a tax treaty ► Taxpayer has the option to be taxed as per tax treaty or domestic tax laws, whichever is more beneficial [S.90(2)] ► Subject thereto, domestic law has full force ► Domestic law provisions can, at times, be more beneficial Section 91 ► Relief from double taxation if India has no tax treaties ► Person resident in India is allowed credit of foreign taxes paid against amount of Indian taxes Page 7 Introduction to Tax Treaties Tax Residency Certificate (S.90(5) & S.90A(5) w.e.f. 1 April 2013) ► Section 90A(4) provides that treaty benefit will not be available to any NR unless he furnishes TRC from Government of other country including therein particulars as may be prescribed. ► Rule 21AB notified on 17 September 2012 w.e.f 1 April 2013 ► Explanatory Memorandum of FB 2012 had stated that submission of TRC is ‘necessary but not a sufficient condition’ for claiming benefits under DTAA. This is now proposed in S.90(5) of the Act ► Amendment to apply retroactively from A.Y 2013-14 Page 8 Introduction to Tax Treaties Meaning of treaty ► Vienna Convention on Law of Treaties 1969 : “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.” ► The Oxford Companion to Law definition of treaty: "an international agreement, normally in written form, passing under various titles (treaty, convention, protocol, covenant, charter, pact, statute, act, declaration, concordat, exchange of notes, agreed minute, memorandum of agreement) concluded between two or more States, on subjects of international law intended to create rights and obligations between them and governed by international law". Can extend to all walks of national and international life Page 9 Introduction to Tax Treaties Genesis of authority; Article 51 of constitution ► Article 51 of the constitution sets out the following as one of the Directive Principles of State Policy. "The State shall endeavour to (a) promote international peace and security; (b) maintain just and equitable relations between nations; (c) foster respect for international law and treaty obligations in the dealings of organised people with one another; (d) encourage settlement of international disputes by arbitration". Page 10 Introduction to Tax Treaties Genesis of authority: Grant of legislative power ► Power to legislate treaties conferred on the Parliament by Entries 10 and 14 of List I of the Seventh Schedule. Page 11 "10. Foreign affairs; all matters which bring the Union into relation with any foreign country. 14. Entering into treaties and agreements with foreign countries and implementing of treaties, agreements and conventions with foreign countries“. Introduction to Tax Treaties Delegation of power to Central Government ► S. 90(1) authorises Central Government to enter into agreement with Government of other country ► S. 90A(1) authorises entering into an agreement with any specified association in specified territory outside India ► Objectives of the agreement could be : ► Elimination of double taxation ► Promotion of mutual economic relations, trade and investment ► Certainty on nature of income and quantum of tax payable irrespective of tax laws of overseas state ► Establishing the right of a country to tax any income stream ► Exchange of information to combat tax avoidance / tax evasion Page 12 Introduction to Tax Treaties Delegation of power to Central Government ► “The Government cannot bind India in a manner that derogates from Constitutional provisions, values and imperatives.” (SC in Ram Jethmalani) ► “Because treaty negotiations are largely a bargaining process with each side seeking concessions from the other, the final agreement will often represent a number of compromises, and it may be uncertain as to whether a full and sufficient quid pro quo is obtained by both sides.” (SC in ABA) Page 13 Introduction to Tax Treaties Treaty: Agreement between Governments ► Treaties are signed by two national jurisdictions to regulate matters concerning taxes ► Taxpayer is not a party to a tax treaty ► Desire of signatories to make business environment in their jurisdictions tax friendly ► Treaty represents understanding as to rights and obligations of respective country ► ► to forego its right to tax, ► to limit scope or rate of taxation, ► to grant credit of tax paid directly or indirectly in other jurisdiction/s etc. etc. Understanding between Governments is to share tax revenues equitably as between themselves, while mitigating hardship for taxpayers Page 14 Introduction to Tax Treaties Treaty: Agreement between Governments ► Treaties can only relieve tax burden ► Treaties do not create any charge ► Vogel : “A tax treaty neither generates a tax claim that does not otherwise exist under domestic law nor expands the scope or alters the type of an existing claim” Page 15 Introduction to Tax Treaties Categories of Tax Treaties ► Limited treaties – ► Deals with specific subject matter ► DTAA between India and Pakistan is limited to air transport only ► Exchange of information with British Virgin Islands ► Comprehensive treaties – Deals with most sources of income ► Multilateral treaties vs. Bilateral treaties ► EU Directives ► SAARC Income Tax Agreement - Bangladesh; Bhutan; India; Maldives; Nepal; Pakistan; Sri Lanka ( sharing of tax policies, training to tax administration, teachers, students taxation, etc. ) Page 16 Introduction to Tax Treaties Formulation of tax treaty ► Negotiation of a tax treaty (by Ministry of Finance – Department of Revenue) ► Drafting of the articles (by Ministry of Finance – Department of Revenue) ► Signing (typically, by the Chairman of CBDT) ► Ratification (by Ministry of Finance – Department of Revenue) ► Notification (by CBDT) Page 17 Introduction to Tax Treaties Texture of Treaty: OECD Model ► Organisation for Economic Co-operation and Development (OECD) ► Established in 1961 with developed countries as its members ► Essentially a model treaty between two developed nations with comparable tax systems and tax objectives ► Advocates residence principle ► Lays emphasis on the right of state of residence to tax ► Royalty taxation in the state of residence ► Excludes taxation on services in the name of service PE ► Currently 34 countries including Australia, US, UK, France, Germany etc are OECD members ► India not a OECD member ► Page 18 Currently has been granted the “Observer” status Introduction to Tax Treaties Texture of Treaty: UN model ► Tax treaties between countries with unequal economic status - Developed and lesser developed countries, or between developing countries ► Drafted in 1980, designed to encourage flow of investments from the developed to developing countries ► Is a compromise between source principle and residence principle ► Gives more weightage to source principle, i.e., income should be taxed where it arises Page 19 ► Payer of income is considered as the source of taxation ► Reduced threshold of construction PE Introduction to Tax Treaties Tax treaties are not uniform ► Each treaty codifies respective understanding between parties. ► Parties may adopt a standard draft : Say, UN Model, OECD Model ► ► Conditions need not be uniform in all treaties ► ► ► This is hardly the case E.g. LOB covenants in different treaties There are no constraints on terms of agreement ► E.g. Absence of equipment royalty source taxation ► E.g. India Finland treaty : Restrictive scope of source of income There are no strings to originality Page 20 Introduction to Tax Treaties What is an MFN Clause? ► Most Favoured Nation Clause ► Extends similar benefits to one country as extended to certain other countries ► Ensures equal treatment between a subset of countries ► Examples of MFN-in terms of ► Rates of taxes ► Liability to tax ► Deductions permissible Page 21 Introduction to Tax Treaties Example : MFN and the Indo-France DTAA ► MFN CLAUSE IN THE PROTOCOL: “In respect of Dividends, Interest, Royalties, FTS and payment for use of equipments, if under the Convention, Agreement or Protocol signed after 1st Sept 1989 between India and a third State which is a member of the OECD, India limits its taxation at source to a rate lower, or a scope more restricted than the rate or scope provided for in this Convention on the said items of income, the same rate or scope as provided for in that Convention on the said items of income shall also apply under this Convention …” Page 22 Introduction to Tax Treaties Effectiveness of Treaty ► If there is no tax liability under domestic law – treaty cannot impose it ► Treaty, to the extent it is more beneficial in any respect, can override the domestic law ► Payer can consider lower withholding rate in terms of treaty ► Treaty need not always be more favourable than the domestic law ► Dividend exemption in hands of shareholder ► Long term capital gain exemption on sale of listed shares ► Proposed Lower withholding on external borrowing by specified company (FA 2012) Page 23 Introduction to Tax Treaties Effectiveness of Treaty ► ► Use of treaty by taxpayer is optional ► Choice could be qua each source of income ► Choice available on year on year basis Whether a person in India can take advantage of treaty for determining his local tax liability in India? Effectiveness is proposed to be subject to GAAR Page 24 Introduction to Tax Treaties Norms of Treaty Interpretation Vienna convention on interpretation Article 26 : Every treaty in force is binding upon the parties to it and must be performed by them in good faith Article 31(1) : A treaty shall be interpreted in good faith in accordance with the ordinary meaning to be given to the terms of the treaty in their context and in the light of its object and purpose Article 31(2) : Context is defined to include texts and subsequent agreements/instruments related to the treaty Page 26 Introduction to Tax Treaties Vienna convention on interpretation Article 31(4) : Special meaning only if specifically intended by parties Article 32 : Supplementary means to be used only to confirm the meaning Article 34 : A treaty does not create either obligations or rights for a third state without its consent Unilateral treaty override needs strong justification Page 27 Introduction to Tax Treaties Guide to treaty interpretation ► Extracts from SC decision in Ram Jethmalani “While India is not a party to the Vienna Convention, it contains many principles of customary international law, and the principle of interpretation, of Article 31 of the Vienna Convention, provides a broad guideline as to what could be an appropriate manner of interpreting a treaty in the Indian context also.” ……….. “the words ( in the treaty) are to be given their general meaning, general to lawyer and layman alike…….. The meaning of the diplomat rather than the lawyer…………….. The broad principle of interpretation, with respect to treaties, and provisions therein, would be that ordinary meanings of words be given effect to, unless the context requires or otherwise.” Page 28 Introduction to Tax Treaties Guide to treaty interpretation ► Extracts from SC decision in Ram Jethmalani “the fact that such treaties are drafted by diplomats, and not lawyers, leading to sloppiness in drafting also implies that care has to be taken to not render any word, phrase, or sentence redundant would lead to a manifestly absurd situation, particularly from a constitutional perspective. “The Government cannot bind India in a manner that derogates from Constitutional provisions, values and imperatives.” Page 29 Introduction to Tax Treaties Aids to Interpretation ► OECD/UN MC or Commentary represents “international tax language” and has generally received ‘due respect’ ► India reservation on OECD Commentary ► References by Courts to “reinforce” or “confirm” conclusion; in some cases, even “followed” the commentaries ► Foreign Court decisions ► Protocols / MOUs ► ► Generally provides amendments to the existing treaties, or, explanations to the Treaty Provision Parallel treaty interpretation Page 30 Introduction to Tax Treaties Construct of a Tax Treaty Articles of a Treaty SUBSTANTIVE PROVISIONS DEFINITION PROVISIONS SCOPE PROVISIONS 1. Article 3 - General definitions 2. Article 4 - Residence 3. Article 5 - Permanent Establishment 1. Article 1 - Personal Scope 2. Article 2 - Taxes covered 3. Article 29 - Entry into force 4. Article 30 - Termination MISCELLANEOUS PROVISIONS 1. Article 24 - Non-discrimination 2. Article 27 - Diplomats 3. Article 28 - Territorial Extension ELIMINATION OF DOUBLE TAXATION 1. Article 23 - Elimination of double taxation 2. Article 25 - Mutual Agreement Page 32 ANTI-AVOIDANCE 1. Art 9 - Associated Enterprise 2. Art 26 - Exch of Info Introduction to Tax Treaties 1. Article 6 - Immovable property 2. Article 7 - Business Profits 3. Article 8 - Shipping, etc 4. Article 10 - Dividends 5. Article 11 - Interest 6. Article 12 - Royalties & FTS 7. Article 13 - Capital gains 8. Article 14 - Independent Personal Services 9. Article 15 - Dependent Personal Services 10. Article 16 - Directors 11. Article 17 - Artistes & Sports persons 12. Article 18 - Pensions 13. Article 19 - Government service 14. Article 20 - Students 15. Article 21 - Other income 16. Article 22 - Capital Scope of convention To whom does the treaty apply? ► Article 1 provides for application of tax treaty to persons resident of one or both the Contracting States ► Does not apply to person who is not resident in both the Contracting States ► ► Permanent Establishment (e.g. branch) is not a person “Persons” defined in Article 3 of the Model Convention ► Page 33 See India-UK DTAA article 3(1)(f) Introduction to Tax Treaties Tax treaty – Residency Rules ► A person is a resident of a country if it is ‘liable to tax’ in the country by virtue of : ► Domicile ► Residence ► Place of management ► Any other criterion of a similar nature ► Term ‘liable to tax’ is not same as actual payment of tax [SC in ABA] ► In case a person is resident of both countries ► In case of an individual – tie breaker rule determines residency ► In any other case – the place of effective management Page 34 Introduction to Tax Treaties Illustrative allocation of Distributive Rights : Exclusive right to Country of Residence (COR) ► Capital gains Article, other income Article, India-Mauritius DTAA Exclusive right to Country of Source (COS) ► PE income in India-Bangladesh Treaty Exclusive right to COR – but, restraint by COS on subject to tax condition ► Capital gains Article in India-Sweden DTAA ► Passive sources of income (i.e. say, royalties, interest) Concurrent right of taxation to both the countries : ► Subject to upper cap on rate of tax in COS ► Without any limitation as to rate of tax ► in COS Say, PE taxation ► Shipping income Exclusive right to country of effective management Page 35 Introduction to Tax Treaties Concluding thoughts ► International Taxation has emerged as a robust area of Practice in recent times ► Unlike Act, law does not change frequently – challenge lies in interpreting law to modern ways of doing business ► To sum up : "Any piece of knowledge I acquire today has a value at this moment exactly proportioned to my skill to deal with it. Tomorrow, when I know more, I recall that piece of knowledge and use it better." - Mark Van Doren Page 36 Introduction to Tax Treaties Thank you This Presentation provides certain general information existing as at the time of production. This Presentation does not purport to identify all the issues or developments pursuant to the transaction. Accordingly, this presentation should neither be regarded as comprehensive nor sufficient for the purposes of decision-making. Presenter does not undertake any legal liability for any of the contents in this presentation. The information provided is not, nor is it intended to be an advice on any matter and should not be relied on as such. Professional advice should be sought before taking action on any of the information contained in it.