Double Taxation Avoidance Agreements

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Published: 04th July 2012
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To finance the welfare and the administrative expenditure, governments around the world impose certain taxes on their subjects. The taxation system helps in collecting revenue besides it also provides direction to the economic growth and also brings economic equilibrium amongst various classes. In any taxation system, the residential status of the taxpayer is of crucial significance. Residential status confirms the jurisdiction and the application of taxation accountabilities.

However, in cases, where cross country economic activity is carried out, it is a tricky affair to identify and justify the appropriate jurisdiction of tax authorities. In order to mitigate the hardships of multiple jurisdictions, the Governments enter into bilateral arrangements, which are commonly denoted as “Double Taxation Avoidance Agreements” (DTAA). DTAA refers to an accord between two countries, aiming at elimination of double taxation. These are bilateral economic agreements wherein the countries concerned assess the sacrifices and advantages which the treaty brings for each contracting nation. It would promote exchange of goods, persons, services and investment of capital among such countries.

Indian Government is actively pushing DTAA negotiations with several countries to help its residents in understanding their tax jurisdictions and accountability towards the appropriate authorities. So far India has signed DTAA with 81 countries and discussion is on with many others. The natures of DTAA’s entered by India are greatly diverse in their nature and contents.

The first international initiative regarding DTAA was taken by the Organization for Economic Co-operation and Development. OECD presented the first draft of DTAA in ‘Model Tax Convention on Income and on Capital’. DTAA was proposed as a tool of standardization and common solutions for cases of double taxation to the taxpayers who are engaged in industrial, financial or other activities in other countries. The double tax treaties are negotiated under international law and governed by the principles laid down under the Vienna Convention on the Law of Treaties.

DTAA treaties must help in avoiding and alleviating the burden of double taxation prevailing in the international arena. The tax treaties must clarify the taxpayer to know with certainty of his potential tax liability in the country, where he is carrying on economic activities. Tax Treaties must ensure that there is no prejudice between foreign tax payers who has permanent enterprise in the source countries and domestic tax payers of such countries. Treaties are made with the aim of allocation of taxes between treaty nations and the prevention of tax avoidance. The treaties must also ensure that equal and fair treatment of tax payers having different residential status, resolving differences in taxing the income and exchange of information and other details among treaty partners.

Double taxation avoidance agreements may be classified into comprehensive agreements and limited agreements based on the scope of such agreements. Comprehensive Double Taxation Avoidance Agreements provide for taxes on income, capital gains and capital investments whereas Limited Double Taxation Avoidance Agreements denote income from shipping and air transport or legacy and gifts. Comprehensive agreements ensure that the taxpayers in both the countries would be treated on equitable manner in respect of the issues relating to double taxation.

Active & Passive Income
Passive Income refers to income derived from investment in tangible / intangible assets eg. Immovable property, dividend, interest, royalties, capital gains, pensions etc. Active income is the income derived from carrying on active cross border business operations or by personal effort and exertion in case of employment eg. Business profits, shipping, air transport, employment etc.

Current Scenario in India
The Indian Income Tax Act, 1961 administrates the taxation of income accrued in India. As per Section 5 of the Income Tax Act, 1961 residents of India are liable to tax on their global income and non-residents are taxed only on income that has its source in India. The Provisions of DTAA override the general provisions of taxing statute of a particular country. It is now well settled that in India the provisions of the DTAA override the provisions of the domestic statute. Moreover, with the insertion of Sec.90 (2) in the Indian Income Tax Act, it is clear that assessee have an option of choosing to be governed either by the provisions of particular DTAA or the provisions of the Income Tax Act, whichever are more beneficial. Further if Income tax Act itself does not levy any tax on some income then Tax Treaty has no power to levy any tax on such income. Section 90(2) of the Income Tax Act recognizes this principle.

Govt. of India has entered into DTA agreement with the following countries:

Armenia, Australia, Austria, Bangladesh, Belarus, Belgium, Botswana, Brazil, Bulgaria, Canada, China, Cyprus, Czech Republic, Denmark, Egypt, Finland, France, Germany, Greece, Hashemite Kingdom of Jordan, Hungary, Iceland, Indonesia, Ireland, Israel, Italy, Japan, Kazakstan, Kenya, Korea, Kuwait, Kyrgyz Republic, Libya, Luxembourg, Malaysia, Malta, Mauritius, Mongolia, Montenegro, Morocco, Mozambique, Myanmar, Namibia, Nepal, Netherlands, New Zealand, Norway, Oman, Philippines, Poland, Portuguese Republic, Qatar, Romania, Russia, Saudi Arabia, Serbia, Singapore, Slovenia, South Africa, Spain, Sri Lanka, Sudan, Sweden, Swiss Confederation, Syrian Arab Republic, Tajikistan, Tanzania, Thailand, Trinidad and Tobago, Turkey, Turkmenistan, UAE, UAR (Egypt), UGANDA, UK, Ukraine, United Mexican States, USA, Uzbekistan, Vietnam, Zambia.

Tax Havens
OECD (Organization for Economic Co-operation and Development) has blacklisted over 25 nations for tax relaxations they offer for parking funds. These include Mauritius, Cyprus, Switzerland and the Netherlands. Tax havens allow easy parking of money either through investments or deposits. They may offer a range of incentives including a nominal capital gains tax for companies to complete financial secrecy of accounts held by individuals and corporate.

Treaty Models
There are different models developed over a period of time based on which treaties are drafted. These models assist in maintaining uniformity in the format of tax treaties. They also serve as checklist for ensuring exhaustiveness or provisions to the two negotiating countries. Some of the popular models are known as OECD Model, UN Model, the US Model and the Andean Model. Of these the first three are the most prominent and often used.

OECD Model – The OECD Model was issued in Double Taxation Convention on Income and Capital in 1977 and amended thereafter in 1992 and 1995. OECD Model is essentially a model treaty between two developed nations. This model advocates residence principle, that is to say, it lays emphasis on the right of state of residence to tax.

UN Model - The UN Model of 1980 gives more weight to the source principle as against the residence principle of the OECD model. As a correlative to the principle of taxation at source the articles of the Model Convention are predicated on the premise of the recognition by the source country that (a) taxation of income from foreign capital would take into account expenses allocable to the earnings of the income so that such income would be taxed on a net basis, that (b) taxation would not be so high as to discourage investment and that (c) it would take into account the appropriateness of the sharing of revenue with the country providing the capital. In addition, the United Nations Model Convention embodies the idea that it would be appropriate for the residence country to extend a measure of relief from double taxation through either foreign tax credit or exemption as in the OECD Model Convention. Most of India’s treaties are based on the UN Model.

Relief to the tax payer
In order to prevent the hardship of double taxation, relief is provided to the tax payer. Such relief is provided by two ways:

Bilateral Relief
Bilateral relief is provided in section 90 and 90A of the Indian Income Tax Act. Bilateral relief is provided through following methods:

(i) Exemption Method
One method of avoiding double taxation is for the residence country to altogether exclude foreign income from its tax base. The country of source is then given exclusive right to tax such incomes. This is known as complete exemption method and is sometimes followed in respect of profits attributable to foreign permanent establishments or income from immovable property. Indian tax treaties with Denmark, Norway and Sweden embody with respect to certain incomes.

(ii) Credit Method
This method reflects the underline concept that the resident remains liable in the country of residence on its global income, however as far the quantum of tax liabilities is concerned credit for tax paid in the source country is given by the residence country against its domestic tax as if the foreign tax were paid to the country of residence itself.

(iii) Tax Sparing
One of the aims of the Indian Double Taxation Avoidance Agreements is to stimulate foreign investment flows in India from foreign developed countries. One way to achieve this aim is to let the investor to preserve to himself/itself benefits of tax incentives available in India for such investments. This is done through “Tax Sparing”. Here the tax credit is allowed by the country of its residence, not only in respect of taxes actually paid by it in India but also in respect of those taxes India forgoes due to its fiscal incentive provisions under the Indian Income Tax Act.

Unilateral Relief
Unilateral Relief is provided in section 91 of the Income Tax Act. The aforesaid method is depending on bilateral activity of both the countries. However, no country will have such an agreement with every country in the world. In order to avoid double taxation in such cases, country of residence itself may provide relief on unilateral basis.

Apart from relief to persons of a country where India has entered in Double Taxation Avoidance Agreement, there is relief given even in cases where the Government of India has not entered into DTA agreement with any foreign country. In such cases if any resident Indian produces evidences to show that, he has paid any tax in any country with which the Government of India has not entered into a DTA agreement, tax relief on that part of his income which suffered taxation in the foreign country, to the extent of tax so paid in such foreign country, or the tax leviable in India under the Income Tax Act on such income whichever is less shall be allowed as deduction u/s 91 while calculating his tax liabilities on such income.

General Features of a Model DTAA
1) Language used by Treaties - Tax Treaties employ standard International language and standard terms. This is done in order to understand and interpret the same term in the same manner by both assessee as well as revenue. Language employed is technical and stereotyped. Some of the terms are explained below:

I. Contracting State – country which enters into Treaty.
II State of Residence- Country where a person resides.
III. State of Source- Country where income arises.
IV. Enterprise of a Contracting State- Any taxable unit including individuals.
V. Permanent Establishment – A fixed base of an enterprise

Components of DTAA
1) The date of DTAA.
2) DTAA applies to all individual / person who is resident of either of countries entering into DTAA. The definition of resident is differently composed in different countries.
Definitions – Article 3 of DTAA generally covers definitions of various terms used in DTAA. eg. person, company, contracting state, enterprise of contracting state, immovable property, dividend, business profits, royalty, technical fees, salaries etc.
The nature and category of taxes to be considered under DTAA as different countries use different descriptions for defining tax levies in their revenue system. Tax treaties may cover income taxes, inheritance taxes, value added taxes, or other taxes.
3) DTAA contains a clause to describe permanent establishment. PE means the place from where the business of the enterprise is carried on. PE includes place of management, branch, office, factory, workshop, mine, quarry, an oil or gas well, a construction site for long duration, a service location for a long duration etc.
4) Tax-sharing method / depending upon the residential statute, permanent establishment, fixed base.
5) Method of relief either by way of exempting income or where it is taxable, taxing it at stipulated rate.
6) Exchange of information about associated enterprises principally to deal with diversion of income to avail treaty benefit or evasion.
7) Proviso for removal of double taxation.
8) Proviso for non- discrimination etc.
9) Other clauses may be added as per the specific requirements of the participating countries.

Indian Income Tax Act and DTAA
It has come to the notice of the Board that sometimes effect to the provisions of double taxation avoidance agreement is not given by the Assessing Officers when they find that the provisions of the agreement are not in conformity with the provisions of the Income-tax Act, 1961. The correct legal position is that where a specific provision is made in the double taxation avoidance agreement, that provisions will prevail over the general provisions contained in the Income-tax Act. In fact that the double taxation avoidance agreements which have been entered into by the Central Government under section 90 of the Income-tax Act, also provide that the laws in force in either country will continue to govern the assessment and taxation of income in the respective countries except where provisions to the contrary have been made in the agreement.

Thus, where a double taxation avoidance agreement provides for a particular mode of computation of income, the same should be followed, irrespective of the provisions in the Income-tax Act. Where there is no specific provision in the agreement, it is basic law, i.e., the Income-tax Act that will govern the taxation of income.

Harmonization of Tax Rates
Tax treaties usually specify the same maximum rate of tax that may be imposed on some types of income. As an example, a treaty may provide that interest earned by a nonresident eligible for benefits under the treaty is taxed at no more than five percent (5%). However, local law in some cases may provide a lower rate of tax irrespective of the treaty. In such cases, the lower local law rate prevails.

Resolving of Disputes in Interpretation
If there are any disputes in the interpretation/ implementation of the terms of DTA Agreements, normal remedies of appeal etc. provided in the Income-tax Act are available to the aggrieved party. The DTA Agreements also contain mutual agreement procedure. The aggrieved party may approach the Competent Authority of the contracting State wherein he is a resident, who, if he is unable to resolve the dispute by himself will approach the competent Authority of the other Contracting State to arrive at a solution after mutual discussion.

Advance Ruling
In respect of interpretation of terms contained in DTA Agreement the Indian Income-tax Act contains a special provision which is offered to those Non- residents who would like to have advance ruling on a matter of law or fact in relation to a transaction undertaken/proposed to be undertaken by them. The facilities available in such provision can be availed of by the Non-residents in the matters regarding Double Taxation of income also.

Tax Information Exchange Agreement
The purpose of this agreement is to promote international co-operation in tax matters through exchange of information. It was developed by the OECD Global Forum Working Group on Effective Exchange of Information (“the Working Group”). The Working Group consisted of representatives from OECD Member countries as well as delegates from Aruba, Bermuda, Bahrain, Cayman Islands, Cyprus, Isle of Man, Malta, Mauritius, the Netherlands Antilles, the Seychelles and San Marino. The Agreement grew out of the work undertaken by the OECD to address harmful tax practices. The lack of effective exchange of information is one of the key criteria in determining harmful tax practices. The mandate of the Working Group was to develop a legal instrument that could be used to establish effective exchange of information. The Agreement represents the standard of effective exchange of information for the purposes of the OECD’s initiative on harmful tax practices. This Agreement, which was released in April 2002, is not a binding instrument but contains two models for bilateral agreements. A number of bilateral agreements have been based on this Agreement.

Salient general Features of DTA agreements between India & others countries
A typical DTA Agreement between India and another country covers only residents of India and the other contracting country who have entered into the agreement with India. A person who is not resident either of India or of the other contracting country cannot claim any benefit under the said DTA Agreement. Such agreement generally provides that the laws of the two contracting states will govern the taxation of income in respective states except when express provision to the contrary is made in the agreement.

A situation may arise when originally the tax provision in the other contracting state gave concessional treatment compared to India at a particular time but Indian laws were subsequently amended to bring incidence of tax to a level lower than the tax rate existing in the other contracting state. Since the tax treaties are meant to be beneficial and not intended to put tax payers of a contracting state to a disadvantage, it is provided in Sec. 90 that beneficial provisions under the Indian Income Tax Act will not be denied to residents of contracting state merely because the corresponding provision in tax treaty is less beneficial. Some Double Taxation Avoidance agreements provide that income by way of interest, royalty or fee for technical services is charged to tax on net basis.

This may result in tax deducted at source from sums paid to Non-residents which may be more than the final tax liability. The Assessing Officer has therefore been empowered u/s 195 to determine the appropriate proportion of the amount from which tax is to be deducted at source. There are instances where as per the Income-tax Act, 1961 tax is required to be deducted at a rate prescribed in tax treaty. However this may require foreign companies to apply for refund. To obviate such difficulties Sec. 2(37A) provides that tax may be deducted at source at the rate applicable in a particular case as per section 195 on the sums payable to non-residents or in accordance with the rates specified in D.T.A. Agreements.

European Union savings taxation
In the European Union, member states have concluded a multilateral agreement on information exchange. This means that they will each report (to their counterparts in each other jurisdiction) a list of those savers who have claimed exemption from local taxation on grounds of not being a resident of the state where the income arises. These savers should have declared that foreign income in their own country of residence, so any difference suggests tax evasion.

Cyprus double tax treaties
Cyprus has concluded 34 double tax treaties which apply to 40 countries. The main purpose of these treaties is the avoidance of double taxation on income earned in any of these countries. Under these agreements, a credit is usually allowed against the tax levied by the country in which the taxpayer resides for taxes levied in the other treaty country and as a result the tax payer pays no more than the higher of the two rates. Further, some treaties provide for tax sparing credits whereby the tax credit allowed is not only with respect to tax actually paid in the other treaty country but also from tax which would have been otherwise payable had it not been for incentive measures in that other country which result in exemption or reduction of tax.

German taxation avoidance
If a foreign citizen is in Germany for less than a relevant 183-day period (approximately six months) and is tax resident (i.e. and paying taxes on his or her salary and benefits) elsewhere, then it may be possible to claim tax relief under a particular Double Tax Treaty. The relevant 183 day period is either 183 days in a calendar year or in any period of 12 months, depending upon the particular treaty involved. So, for example, the Double Tax Treaty with the UK looks at a period of 183 days in the German tax year (which is the same as the calendar year); thus, a citizen of the UK could work in Germany from 1 September through the following 31 May (9 months) and then claim to be exempt from German tax (whilst still paying the UK tax).

United States
The U.S. requires its citizens to file tax returns reporting their earnings wherever they reside. However, there are some measures designed to reduce the international double taxation that results from this requirement. First, an individual who is a bona fide resident of a foreign country or is physically outside the United States for an extended time is entitled to an exclusion (exemption) of part or all of their earned income (i.e. personal service income, as distinguished from income from capital or investments.) That exemption is $91,400 for 2009, pro-rated. Second, the United States allows a foreign tax credit by which income taxes paid to foreign countries can be offset against U.S. income tax liability attributable to foreign income. This can be a complex issue that often requires the services of a tax advisor. The foreign tax credit is not allowed for taxes paid on earned income that is excluded under the rules described in the preceding paragraph (i.e. no double dipping).

DTAA - India and Mauritius
India has comprehensive Double Taxation Avoidance Agreements (DTAA) with 81 countries. This means that there are agreed rates of tax and jurisdiction on specified types of income arising in a country to a tax resident of another country. Under the Income Tax Act 1961 of India, there are two provisions, Section 90 and Section 91, which provide specific relief to taxpayers to save them from double taxation. Section 90 is for taxpayers who have paid the tax to a country with which India has signed DTAA, while Section 91 provides relief to tax payers who have paid tax to a country with which India has not signed a DTAA. Thus, India gives relief to both kinds of taxpayers.

A large number of foreign institutional investors who trade on the Indian stock markets operate from Mauritius. According to the tax treaty between India and Mauritius, capital gains arising from the sale of shares are taxable in the country of residence of the shareholder and not in the country of residence of the company whose shares have been sold. Therefore, a company resident in Mauritius selling shares of an Indian company will not pay tax in India. Since there is no capital gains tax in Mauritius, the gain will escape tax altogether.

The Indian and Cypriot tax treaty is the only other such Indian treaty to provide for the same beneficial treatment of capital gains. It must be noted that India has and is making attempts to revise both the Mauritius and Cyprus tax treaties to eliminate this favorable treatment of capital gains tax. The Indian government periodically checks for its DTAA with many countries and come up with amendments.

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