International Taxation: A User’s Guide

Nilay Baran Som
Additional Commissioner,
Income Tax
(International Taxation), Kolkata
[email protected]

Nilay Baran Som joined the Income Tax Department in the year 1990 as Inspector of Income Tax. He was inducted into the Indian Revenue Service in the year 2005. Presently, he is working as Additional Commissioner of Income Tax (International Taxation) Range -1, Kolkata.

Sri Som has worked in various capacities in Assessment, TDS and Head Quarters Charges and spent majority of his tenure in the Training Sector and International Taxation Charges. He has worked in West Bengal & Sikkim and Tamilnadu region. He was on deputation to the Department of Taxes, Government of Botswana, during 2002 to 2005.

Sri Som has contributed to the booklet on Royality and Fees for Technical Services in the Taxpayer Information Series Booklet brought out by the Directorate of Income Tax (PR, PP&OL) in the year 2013 alongwith Sri Sanjay Kumar, IRS (Retired), who was the then Director of International Taxation, Kolkata. He has also contributed to several of the pamphlets developed by the Directorate in the matter of non-resident taxation.

His area of interest are reading, writing and social networking.

Executive Summary

In today’s globalised world, even officers posted outside the Commissionerate of International Taxation should have working knowledge about basics of International Taxation and the DTAAs. This article tries to develop a working guide to the officers on the issue of payment to non-residents.

The fundamental point to be examined by the Assessing Officers in connection with disallowance under section 40(a)(i) of the Income Tax Act of any payment to a non-resident is whether the sum is taxable under the provisions of the Income Tax Act or not. The next point is whether the non-resident is entitled to treaty benefit to escape source-country taxation or not.

With quick reference to the relevant sections of the Income Tax Act and the relevant articles of a typical treaty, two particular expenses, viz, software payments and export commission are picked up for further analysis. A check list is also prepared for guidance of the Assessing Officers.

The need for co-ordination between the Assessing Unit and the TDS Unit of International Taxation is also highlighted.

(A) Introduction

International taxation refers to the taxation rules that come into play between two or more countries of the world. Since the early days of industrialisation, movement of goods and services across the world was set in place. The movement of goods and services across the borders is ultimately connected to income generating activities. And wherever there is income, there is tax on income as well. In the context where goods and services move from one geographical territory to another, there is further problem since a single income, or limbs of one single income may be taxed in more than one state, leaving the entrepreneur lesser revenue to enjoy.

The above problem becomes clearer if we consider the following issues. The first issue is concerned with bases of taxation. Broadly, countries in the  world impose tax either or the basis of residence or on the basis of source. In residence based taxation, a country taxes its residents on their world income on the footing that the income earning persons should contribute to the national revenue. On the other hand, the source based taxation is imposed on the footing that, countries that offer the scope for economic activities that generate income, must suffer taxation in that country. Such dual bases of taxation give rise to the potential for double taxation of the same income. An example will clarify this.

Let us suppose Mr. X, a ‘Resident’ of country A is earning professional income from a chamber established in country B. Country A would tax professional income on the basis that Mr X is Resident of that country. Country B again would exercise its right to tax the income that is ‘Sourced’ within its boundary. This gives rise to double taxation of the same income.

Another possible issue may be the issue of residence itself. The rules of residence are different for different states. Some countries like India use ‘day counting formula’ for determination of residential status in case of individuals. Some other countries use different criteria such as, availability of ‘permanent place of abode’ or ‘citizenship’ as determinants of residential status. The use of different yardsticks, coupled with the factor that different countries have different tax years ( like our country following April to March as the financial year vis a vis some other country may be following the Calendar year). Such a scenario makes it possible that a single individual Mr X may be resident of two different states, country A and country B. In such an eventuality, a single income earned in a single period may be subject to tax in two different states or jurisdictions. It also gives rise to problem of double taxation.

Although in the examples we used individuals, the problem of double taxation is equally true for body corporates and other taxable entities. In all such cases, the entrepreneur or income earning person is faced with difficulty because he is left with less disposable income.

Apart from pecuniary disadvantage to the entrepreneurs, the incidence of double taxation is an impediment to free flow of capital and trade or free flow of goods and services. Because of increased tax burden, foreign investments in a given country are likely to go down, ceteris paribus. In other words, incidence of double taxation would result in lesser and slower economic and commercial activities which no body will like – governments, investors, entrepreneurs and economists!

(B) Mitigation of Double Taxation

Roy Rohatgi, the noted International Tax Planning Consultant, has put it very nicely is his book (1) that there is no international tax law. There is no international forum for resolution of tax disputes. In fact, there is no other international law also which prohibits double taxation. It is therefore, out of enlightened self interest that countries across the globe has historically tried to avoid the incidence of double taxation.

Double taxation can be avoided in two ways. One way is the system of unilateral tax credit. Under unilateral tax credit system, a country can offer some relief to its residents. The resident X of such a country A can have some ‘foreign income’ which might have suffered tax in a foreign soil, B. While calculating tax on the global income of X under the tax laws of country A, tax paid outside may be adjusted towards the tax computed under its tax laws. Under the unilateral credit system, residents of a particular country get relief from double taxation. However, no relief is possible for non- residents whose income may suffer taxation in such countries.

The other way to avoid the incidence of double taxation is signing of Double Taxation Avoidance Agreements (also called conventions) between two sovereign states. By way of Double Taxation Avoidance Agreements (DTAA), the contracting states try to limit their taxing rights in the following manners:

1. the contracting states may agree that certain income will be taxed only in the country of residence (e.g. income from employment in certain treaties);

2. the contracting states may agree that certain income should be taxed only in the source country (e.g. income from immovable property as in most of the treaties)

3. the contracting states may agree that certain income will be taxed primarily by the country of residence but the source country will tax it at a concessional rate (e.g. interest, royalty etc)

4. certain income may be taxed in both the countries, but the country of residence may allow credit of tax on the income taxed outside.

(C) Historical Perspective of DTAAs

The first attempt to develop a tax treaty dates back to the year 1920, when the International Chamber of Commerce sought the help of the League of Nations to overcome the problem of double taxation. As a result, model drafts were prepared known as the Model Treaty of Mexico and the Model Treaty of London. These models were the starting point of the OECD (Organisation of Economic Cooperation and Development) Model, the model favoured by the developing nations. Another model that has been developed and mostly favoured by the developing countries is the UN (United Nations) Model. The United States of America has its own model (US Model) which it tries to follow while negotiating with other countries. These are the three main models on which most of the treaties between countries have been signed.

(D) Taxation of Foreign Income and Indian Tax Law

The Income Tax Act, 1961, has provisions of taxing foreign income of residents and Indian income of non residents. Sections 4,5,6 & 9 are the sections which deal with the above taxing paradigms. The Indian Tax Law uses residence tax base for taxation of the residents, i.e, residents are taxed both on their Indian income as well as foreign income. In the language of the Act [section 5(1), ITA 1961], residents are taxed on

1. income accruing and arising in India

2. income received in India

3. income deemed to be received in India

4. income deemed to accrue or arise in India

5. income accruing and arising outside India

On the other hand, India taxes non residents on their India sourced income. In the language of the Act [section 5 (2), ITA 1961], non-residents are taxed on

1. income accruing and arising in India

2. income received in India

3. income deemed to be received in India

4. income deemed to accrue or arise in India

An important consideration in the taxation of non- residents is the issue of collection of tax at the time of generation of the income itself. This is because, many a time the non- residents do not have any establishment or assets in India. Therefore, in order to ensure timely collection of tax, there is provision of deduction of tax at source by the payee at the point of remittance of the sum to the non-resident. There is a rider that such sum should constitute income of the non resident in India. Many a time such tax withheld becomes the final charge unless the non-resident denies its taxability in India. In that case, it has to file return of income and claim refund of tax deducted at source.

Apart from the above provisions, the Income Tax Act has certain specific presumptive provisions for taxation of certain types of income under certain conditions for example, taxation of interest, royalty, Fees for Technical Services etc., where the non resident does not maintain a permanent establishment in India (section 115B), taxation of  foreign shipping business [section 44B], taxation of foreign entities providing services to entities engaged in oil exploration business [section 44BB], taxation of business of operation of aircraft by non-residents [section 44BBA], taxation of foreign companies engaged in business of civil construction etc in turn key power projects [section 44BBB], Royalty etc income of non-residents having permanent establishment (PE) in India [section 44DA] etc.

There is also a provision in the Income Tax Act, 1961 (ITA 61) to the effect that certain person(s) may be treated as an agent of the Non-Resident, if certain conditions are fulfilled (section 163 of the ITA 61]. Once a person is treated as an agent of a non resident for certain income, he will be responsible of payment of the relevant tax demand and recovery provisions will apply to him.

The Income Tax Act also has a special provision for taxation of certain incomes of Non- Resident Indians (NRIs) in Chapter XII-A of the ITA61, for certain specific types of income. However, an NRI may opt not to go for the provisions contained in that chapter and continue to be governed by the normal provisions of the Act (ITA61)

(E) Indian Tax Law and Double Taxation Avoidance Agreements

In any country, residents as well as non-residents are primarily subject to the domestic tax act. In case of India, the operative Act is the Income Tax Act, 1961(ITA61). Section 90 of the Act has an important provision which authorises the Government of India to enter into agreements with countries outside India or specified territories outside India. The purposes of such agreements, as mentioned in section 90(1) are:

a. for granting relief in respect of income in which tax has been paid both under the Income Tax Act or the corresponding law in the foreign jurisdiction, to promote mutual economic relations, trade and investments, or,

b. for avoidance of double taxation of the same income under the Act and the corresponding law in the foreign jurisdiction

c. for exchange of information for the prevention of tax evasion in either country or India and the specified territory, or investigation of cases of such evasion or  avoidance

d. for recovery of income tax under the Income Tax Act or the corresponding law in the other country.

Sub section (2) of section 90 is of utmost importance in the operationalisation of treaty benefits. This section provides that, in relation to an assessee to whom a double taxation avoidance agreement applies (i.e., the assessee is a resident of a state with which a DTAA exists), the provisions of the treaty, or the provisions of the Income Tax Act, whichever is more beneficial to the assessee, will prevail. However, it has been clarified that charging a higher rate of tax on foreign companies is not to be construed as a condition less favourable to such assessee.

Apart from section 90, section 91 of the Act provides for granting unilateral tax relief to its residents if they have elements of income accruing or arising or received in countries with which there is no Double Taxation Avoidance Agreements. The following scenario may appear in such a case:

a. Where the foreign tax is equal to Indian tax, the full amount of foreign tax will be given credit to.

b. Where the foreign tax exceeds the tax payable in India, the liability to Indian tax will be nil. However, no refund in respect of the excess amount is allowed, and,

c. Where the foreign tax paid is less than the Indian tax, balance amount after giving credit of foreign tax, would be payable by the taxpayer. The principle is that, the credit allowable will never exceed the amount of Indian income tax, which becomes due or payable in respect of the doubly taxed income.

The procedure of giving tax credit to residents of India having elements of foreign income taxed abroad is now streamlined in accordance with Rule 128 of the Income Tax Rules. A resident of India, desirous of availing foreign tax credit must furnish form 67 and a certificate /statement as detailed in Rule 128 must furnish on or before the due date for furnishing the return of income under section139 of the ITA (1961)

(F) How to Apply Treaty Law vis a vis Domestic Law

The following steps must be taken systematically while considering double taxation issues:

1. First of all, determine whether the person seeking relief is a ‘person’ under the treaty and is ‘resident’ of the other contracting state in terms of the treaty. The article of residence in the treaty most of the time, leaves the issue of determination of residential status to the respective domestic tax laws. If the person qualifies as a resident of the other contracting state, move to step (ii). Otherwise, his tax liability will be final as per the domestic law.

2. Next, characterise the income in accordance with the domestic act. Arrive at the provision for taxation of the item.

3. See the provision of the treaty corresponding to the item of income under question.

4. See which of the above provisions is beneficial to the assessee. If the treaty provision is beneficial, find the tax liability as per the treaty. If the domestic law provision is more beneficial to the assessee, apply the domestic law provision and find the tax liability.

5. If the issue is of giving foreign tax credit to a resident Indian, Rule 128 is to be followed.

(G) Structure of a Typical Treaty and its Typical Coverage

A typical treaty between two sovereign countries sets out the scope of the treaty, taxes covered, the allocation rules for avoidance of double taxation, rules for relief from double taxation, non discrimination provisions, provision for exchange of information, date of entry into force of the treaty, etc. Some of the treaties provides for Mutual Agreement Procedure in case of disputes. The treaty may be followed by signing of protocols or memorandum of understanding between two contracting states. Treaties are signed between sovereign nations on the spirit of ‘Pacta sunt servenda’ (Every treaty in force is binding upon the parties to it and must be performed by them in good faith), emanating from the Geneva Convention on International Laws. However, treaties once signed may be re-negotiated if the situation so demands. It may also be noted that, treaties are signed for various economic, commercial and political reasons, apart from the immediate taxing reasons.

Generally long process of negotiations is involved before a treaty is signed.

So far as classification of income is concerned, the terminologies used in a treaty may be different from that used in the domestic law of a country. For example, as against ‘income from salary’ in the Indian Income Tax Act (it may be termed something different in some other country), treaties use the term ‘income from dependent personal service’. Two items of income typically found in Indian treaties are those relating to Royalty and Fees for Technical Services. This is because, historically, India has been a technology importing country. So payments relating to intellectual property rights (reflected in royalties) and technical services always find place in respect of taxation of non residents and consequently, in the treaties. Typically, a treaty encompasses several articles dealing with various sources of income, the allocation rules and the
procedure in which the terms of the treaty may be implemented. A few Articles appearing in the India -France DTAA are listed below, by way of an example:

• Article 2 (Taxes Covered)
• Article 3 (Definitions )
• Article 4 (Residence)
• Article 5 (Permanent Establishment)
• Article 7 (Business Income)
• Article 11(Interest Income)
• Article 13 (Royalties and Fees for Technical Services)
• Article 15/16 (Dependent Personal Services
• Article 25 (Elimination of Double Taxation)
• Article 28 (Exchange of Information)

Recalling the discussion on DTAAs, (paragraph 3 of this article), primarily there are two models of treaties. The OECD Model was drafted keeping the interest of developed nations and it lays more stress on residence based taxation. The UN Model, on the other hand, was drafted keeping the interest of developing nations. It lays more emphasis on source based taxation and has certain rules like ‘Force of Attraction Rule’ which favour such countries.

In practice, treaties are drafted after a lot of hard ball game and besides taxation considerations;

political and diplomatic environment, economic and investment climate etc play a major role in finalising the give and take decisions.

(H) DTAAs—A Few Common Terminologies

Permanent Establishment

This term is found in all the treaties and is concerned with the taxation of business income of a non resident. Generally, the business profits of a non resident will be subject to tax in a source country only if the non resident has a permanent establishment in that country. A permanent establishment is a fixed place of business through which business of an enterprise is carried on. In most of the treaties, the term ‘permanent establishment’ also has some special inclusions. For example, a place of management, a branch, an office, a factory, a construction site etc can be typically included as permanent establishment. In taxing the business profit of a non resident, the source country can only tax ‘profit attributable to the permanent establishment ‘that accrues or arises within that country.

Mutual Agreement Procedure

Sometimes a person who is a resident of one state and who has some tax issues in the other contracting state, may feel that the actions of one or both of the contracting states may result in taxation not in accordance with the provisions of the DTAA. In such a case, in addition to approaching the appropriate forums in the other contracting state for adjudication of disputes, he may approach the Competent Authority of his country of residence for revoking the provisions of Mutual Agreement Procedure (MAP). This is a consultative process between the Competent Authorities of the two contracting states for resolution of the disputed issues. The following issues are commonly resolved under MAP-

1. Determination of Permanent Establishment or residency

2. Attribution of income and administrative expenses to PE

3. Transfer pricing ( in respect of transactions between two arms of an MNC)

(I) A Few Commonly used Terminologies in International Taxation

Tie Breaker Rule

The ‘tie breaker rule’ is used in determination of residential status of individuals who may be residents of both the contracting states. In simple terms, the authority finds out the country with which the concerned person has more economic and social attachment. Accordingly, the residential status of the individual is determined.

Treaty Shopping

‘Treaty shopping’ refers to a situation where a resident in one country (say the “home” country) earns capital gains or other income from another country (say the “source” country) and is able to benefit from a tax treaty between the source country and a third country. A typical example may be given in terms of India- Mauritius DTAA, in its version prior to the re- negotiation in the year 2016(Vide Amendment by Notification NO. SO 2680(E) {NO.68/2016 (F.NO.500/3/2012-FTD-II)}, Dated 10-8- 2016]. Prior to amendment, capital gains on transfer of moveable properties like shares in a corporation would be taxable only in the state of residence of the transferor. At that time, a US resident (R) could intend to invest in an Indian Company(say X) with an ultimate object to sell the investments for a profit. As per India -US DTAA, such profit on capital gains would be taxable in both the states with the scope of tax credit available in the country of residence.

However, the US Resident R was aware that as per the provisions of the then-existing India Mauritius Treaty, capital gains is taxable only on the country of residence.However, the domestic law of Mauritius does not tax profit on sale of shares. With such knowledge, he could float a company (say Y) which would be tax resident in Mauritius. The newly floated company Y could invest in the shares of company X. Subsequently, Y Company could disinvest the shares of the Indian company X on which no capital gains tax would become payable. In this case the US resident R gets the benefit of the DTAA between India and Mauritius, although the treaty was negotiated for the benefits of the residents of either India or Mauritius only. This is a simplistic example of Treaty Shopping.

Withholding Taxes

Withholding taxes are, loosely speaking, the global counterpart of tax deduction at source (TDS). This is despite the fact that some experts make certain distinction between Withholding Tax and TDS in as much as is a final charge, but in practice, the terms may be used interchangeably.

Tax Havens

A ‘Tax Haven’ refers to a country which offers foreign individuals and business entities little or no tax liability in a politically and economically stable environment. Tax havens also divulge little or no financial information about such investments to foreign authorities. Individuals and business entities that do not reside in a tax haven can take advantage of these countries’ tax regimes to avoid paying taxes in their home countries.

The OECD publishes list of tax haven countries from time to time. Bahamas, Hong Kong, Panama, The British Virgin Islands, Netherlands Antilles, Cayman Islands etc. are examples of typical tax havens. Ireland in the recent past has become a preferred jurisdiction for many MNCs for its typical low rates of corporate taxation and is also being regarded as a tax haven in that sense.

The tax avoidance through tax havens generally takes place by two methods, viz., Profit Diversion and Profit Extraction. Under Profit Diversion, business profit of a corporation is diverted from a high tax jurisdiction to a tax haven. For example, Company X, which is a MNC, may sell its product or services at a low price to its subsidiary in a tax haven country. In turn, the subsidiary sells the same product or service worldwide at a high price. On the other hand, under Profit Extraction, a company in a tax haven country renders services to a company in a high tax jurisdiction. In this way, it extracts money from that jurisdiction in the form of consultancy fees, licensing fees, technology fees, royalty etc. In this way, money is effectively brought into the tax haven while its sister concern operating from the high tax jurisdictions claims these amounts as deductible expenses. Obviously, transfer pricing issues is an essential ingredient of any scrutiny or audit of such enterprises in the jurisdictions they operate. The ITA 61 has a separate Transfer Pricing Code incorporated from sections 92 to 92F.

(J) Conclusion

The basics of section 4,5, 6 and 9 read with section 90 of the Income Tax Act (1961) are fundamental to the understanding of international taxation and how domestic income of non-residents are taxed in India and foreign income of residents are given foreign tax credit.The ground rules of taxation and application of treaty law as laid down in Paragraph 6 of this article are expected to help the officers of the department determining taxable income.

Bibliography & Web-Source

[1] Basic International Taxation(Vol1): Roy Rohtagi (Taxmann Publications)

[2] Indian Double Taxation Avoidance Agreements Tax Laws (Vol 1: 5th Edition) D.P. Mittal (Taxmann Publications)

[3] www. incometax.gov.in

Source- Taxaloguue – Volume 1- Issue 2- OCT-Dec 2019 Issued by Directorate of Legal & Research -Central Board of Direct Taxes