International taxation: A detailed analysis

By Kaustubh Shukla

Symbiosis Law School, Pune.

Under section 5 of the Income Tax Act, a foreign company or any other non-resident person is liable to tax on income which is received or is deemed to be received in India by or on behalf of such person, or income arises or is deemed to accrue or arise to it in India. Section 9 thereafter specifies certain types of income that are deemed to accrue or arise in India. Some of the important concepts which needed to be understand which are related to the international taxation such as country of residence where the person is tax resident under the relevant tax laws of any country is called the country of residence. Country of source where the person earns income or where the income accrues or arises is the country of source. Country of payment is a country from which the person makes the payment. Where exactly is the tax base for Government of different countries to charge tax. There can only 2 bases for levy of income-tax one is on the bases of residence and other is on the bases of income. For the levy of income-tax, Indian Government can tax the global income of Indian tax residents or the Indian accrued income of tax non-residents of India. Governments cannot tax foreign sourced income of non-residents. There has to be a nexus between the country & its residents or the country & income sourced in that country. Unless & until, there is a nexus between any one of the two, Governments do not have a base/ jurisdiction for taxation.

Sec. 92 F The section says about permanent establishment. "It includes fixed place of business through which the business of the enterprise is wholly or partly carried out.” Article 5 of OECD & UN model conventions also provide for an inclusive definition of the term permanent establishment i.e. "it includes a place of management, a branch, an office, a factory, a workshop and ...".The international consensus has been that the profits should be attributed to a PE on the basis of the "separate enterprise" concept, and the application of the arm's length principle. This is currently encapsulated in Article 7(1) and (2) of the OECD Model Tax Convention. The profits of an enterprise of a Contracting State shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. If the enterprise carries on business as aforesaid, the profits of the enterprise may be taxed in the other State, but only so much of them as is attributable to that permanent establishment. Where an enterprise of a Contracting State carries on business in the other Contracting State through a permanent establishment situated therein, there shall in each Contracting State be attributed to that permanent establishment the profits which it might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment.”.

Section 9 (i) of the Act explains business connection. It says it includes "any business activity carried out through a person who, acting on behalf of the non-resident has and habitually exercises in India, an authority to conclude contracts on behalf of the non-resident, Provided that such business connection shall not include any business activity carried out through a broker, general commission agent or any other agent having an independent status, if such broker, general commission agent or any other agent having an independent status is acting in the ordinary course of his business, further where such broker, general commission agent or any other agent works mainly or wholly on behalf of a non-resident (hereafter in this proviso referred to as the principal non-resident) or on behalf of such non-resident and other non-residents which are controlled by the principal non-resident or have a controlling interest in the principal non-resident or are subject to the same common control as the principal non-resident, he shall not be deemed to be a broker, general commission agent or an agent of an independent status.

Sec. 90 (1) of the Act gives power to the Government to enter into an agreement with the Government of any country outside India for granting relief in respect of double taxation, Since different incomes will have different ways of determining the location of source; different categories have been listed. For e.g.: royalty, interest, dividend, fees for technical services, rental income, etc. Under the DTA, it is necessary to determine the country of source of income. Since different incomes will have different ways of determining the country of source; different categories are useful to determine the source. The house property income is sourced in the country where the property is situated. The dividend income is sourced where the company distributing the dividend is resident. Salary income is taxable where services are performed. Thus for determining the location or the country of source, the Categorisation is useful. Under the domestic law, Categorisation is useful for computation. Different categories of income may have different computation provisions.

Section 245 N of the Act helps in avoiding controversies & litigation at a later stage i.e. after the financial transaction is undertaken. In the past, AAR i.e Authorities of Advance Ruling has given several rulings. Unfortunately, with due respect, these rulings have put precedents that differ from the Tribunal, High Court or the Supreme Court decisions. There are also tax heaven countries which are a country which does not charge tax to its residents or charges lower rates of tax. These countries sign the DTAAs with other countries in such a way, that there may not be any tax payable by the assessee in any country. Therefore, a lot many numbers of companies structure their investments so that they are outside the purview of any tax jurisdiction. Countries like Isle of Man, Cayman Islands, Mauritius, Cyprus, Malta, Singapore, etc. are examples such tax heavens because of which there is much of treaty shopping or treaty abuse happen treaty shopping is nothing but shopping of the DTAA. Companies may take the benefit of the most beneficial DTAA. Generally, a treaty shopping arises when a resident of a State other than Contracting States of a tax treaty attempts to capitalize on benefits of the treaty by setting up a company with no economic substance or conducting a bogus transaction. A good example of treaty shopping is that of Malaysia-Korea, India- Mauritius, etc.Treaty shopping can occur in the following two ways: 1) A taxpayer of a country that has no treaty with the a particular country say India seeks the coverage of a favorable treaty,or2) A taxpayer of India treaty partner, prefers the treaty of another country. Round tripping is also one of the methods by which the companies take disadvantages of the treaty it is the act of moving funds outside the country & then channelising them back in the country to change the actual character of funds. Funds earned through illegal sources, etc. may be sent abroad & reinvested in the same country as legal funds. Companies use round tripping for changing the character of domestic funds into foreign funds or illegal funds into legal funds. There are also various hybrid entities which are the different forms of entities say, for example, India gives the status of the firm as a tax resident. It taxes the firm on its income & the income of the firm is exempt in the hands of the partners. In some countries, taxation is transparent i.e. it may not tax the income of the firm in the hands of the firm but it may tax the partners individually on income earned through the firm. There are also several other entities like US LLP, UK LLP, Dutch CV, German KG * Co., trust, partnership, co-operative societies, venture capital funds & collective investment vehicles, etc.; taxation of which may be separate in separate countries. This may give rise to conflict in classification of cross border scenario. Hybrid entities may also give rise to complication in application of treaty provisions. Also there is tax sparing ,developing countries often attempt to attract foreign investors with incentives in the form of reduced rates of taxation or, in some cases, the exemption of certain types of income from tax. In order to preserve the resultant investment revenues to the developing country, the country of residence of the investor (that is, the developed country) "spares" the tax that it would normally impose on the low-taxed or untaxed income earned by its resident abroad by granting foreign tax credits equal to, or possibly greater than, the tax that would otherwise have been eligible in the developing country. Tax sparing is intended to promote economic development among developing nations by ensuring that tax incentives offered to foreign investors by these countries were not eroded through the tax treatment of the income from the advantaged activities in the investor's country of residence.

Underlying Tax Credit is also a concept available in residence country for taxes paid by subsidiaries of companies in foreign countries. The above can be explained with the help of following example, say for e.g.: Company A in India has a wholly owned subsidiary in a foreign country. During the year, foreign subsidiary earns a profit of $ 1,000. Assuming tax rate in foreign country is 35 %, foreign subsidiary is liable to pay $ 350 in foreign country itself & shall remit the balance $ 650 in India. Foreign subsidiary will also have to pay a dividend distribution tax on this, say 15 % i.e. $ 97.5 on $ 650.In India, Co. A will be taxed on its overseas subsidiary's profit. Since corporate taxes in India is, say we assume 30 %, then this translates to a tax of $ 300. But since a tax greater than this has been paid in the foreign country, no taxes are paid in India. In effect, Co. A has paid a tax of 44.75 % ($ 350 + $ 97.50) & tax credits of $ 147.5 is lost. Pooling of foreign tax credits is also done if however India would have permitted pooling of foreign tax credit, then even $ 147.5 would have been available as credit. Many international treaties signed provide for underlying & pooling tax credits.

There is a Non-Discrimination Clause in Article 24 of OECD & UN Model Convention provide for subjecting the residents of one country to taxation & requirement connected therewith in other country similar to that of the residents of that other country i.e. the taxation & connected requirements should not be more burdensome than subjected to residents of that other country.

Many persons were using the provisions of treaties to their own benefits. Some persons have even misused the treaty provisions by forming conduit, shelf, offshore companies or SPVs i.e. Special Purpose Vehicles. Limitations on benefits provisions generally prohibit third country residents from misusing treaty benefits. For example, a foreign corporation may not be entitled to a reduced rate of withholding unless a minimum percentage of its owners are citizens or residents of the treaty country. Article 23 of the UK - USA treaty provides for limitation of benefits clause. Recently Indo- Singapore treaty was amended to insert the limited version of limitation of benefits clause. Indian tax authorities are also trying to re-negotiate tax treaties with UAE, Cyprus, and Mauritius to insert this limitation of benefits clause. Also there are Mutual Agreement Procedure (MAP) under Article 25 of the OECD & UN Model Convention state that where a person considers that the actions of his domestic country or the other country shall result in taxation not in accordance with the treaty provisions, irrespective of the remedies provided by the domestic law of those states, he can present his case to the competent authority in the country of his residence. The competent authority of residence country shall verify the arguments stated whether the arguments are justified & if the case of unable to arrive at a satisfactory solution as regards elimination of the double taxation or interpretation of tax treaty, competent authorities of both the countries shall resolve the difficulties by mutual agreement. Advanced Pricing Arrangements (APA) can also be entered by the parties an APA is an arrangement between a taxpayer and the tax authority wherein the method of determining the transfer pricing for inter-company transactions are set out in advance. Such programmes are designed to resolve actual or potential transfer pricing disputes in a cooperative manner. The tax payer must submit a formal APA application, tax authorities shall review & evaluate the proposal & then negotiate and execute the APA.

Withholding tax is additional tax imposed by the country of source when various types of remuneration (dividends, interest, royalties etc.) are paid in favour of non-residents of that country. The principle of a withholding tax is that it is withheld (retained) by the payer and given directly to the taxation authorities. The payee is given only the balance after the withholding tax amount. The primary motivation is to reduce tax evasion or failure to pay. Force of Attraction rule normally applies were business profits are taxed in the country of residence except when the entity functions or performs business in the other country with the help of a dependent agent or a permanent establishment. In such cases, income attributable to the permanent establishment is taxed in the country of source. The Contracting States will attribute to a permanent establishment the profits that it would have earned had it been an independent enterprise engaged in the same or similar activities under the same or similar circumstances. As the name suggests, the force of attraction approach focuses on the actual economic connection between a particular item of income and the permanent establishment. Under the "force of attraction" approach, all domestic sourced income is attributed to the permanent establishment, irrespective of whether the relevant item of income is in fact economically connected with the activity of such a permanent establishment. Controlled Foreign Corporations (CFC) rules is a were income from a foreign source is taxed usually after it is accrued or received as income in the country of residence of the taxpayer. The use of intermediary entities in a tax-free or low-tax jurisdiction enables a tax resident to defer (or avoid) the domestic tax on the income until it is repatriated to the residence state. This tax deferral could lead to an unjustifiable loss of domestic tax revenue.
A CFC is a legal entity that exists in one jurisdiction but is owned or controlled primarily by taxpayers of a different jurisdiction. CFC laws can be introduced to stop tax evasion through the use of offshore companies in low-tax or no-tax jurisdictions such as tax havens. It is rarely illegal to have a financial or controlling interest in a foreign legal entity; however, many governments require taxpayers to declare their interests and pay taxes on them, and CFC laws (combined with a no-tax jurisdiction or a double taxation agreement) sometimes mean that a company is only taxed in one jurisdiction. The CFC rules are designed to stop companies avoiding tax in residence country by diverting income to subsidiaries situated in low tax regimes. Students are requested to read articles, books written by Professor Klaus Vogel, OECD Model Tax Convention & Commentary, UN MTC & Commentary, League of Nations report, Vienna Convention reports, IFA reports, etc. Students are also requested to read the recent AAR & Supreme Court decisions for thorough understanding of International Taxation.

At the end I would like to put forward some of the reforms which I think are needed in India international taxation are :-

1. A number of Indian companies have established subsidiaries worldwide. These companies, however, do not bring into India their dividends or capital gains from the sale thereof, as that is taxable in the hands of Indian holding companies at the normal rates, of course, subject to the credit of tax paid by them overseas, which at times is lesser particularly in tax heaven countries. With a view to encouraging them to repatriate their earnings into India, the receipt of dividend and capital gains should be tax exempt or at least taxed on a concessional basis in India.

2. Under the provisions of section 195, any sum payable to a non-resident and chargeable to tax, is subject to a withholding tax by the payer. Though, the deductor or recipient can apply for a lower / nil rate, delays occur in the issuance of such certificates. It would be in fitness of things to provide an option to the deductor to remit 80% of the amount sought to be remitted and to furnish a certificate from the bank for holding 20% of the balance amount as 'good for payment' towards the tax liability, which may be paid later to the extent ultimately determined payable.

3. Under the existing provisions, a person is eligible for tax credit paid outside India in respect of doubly taxed income, equivalent to the tax at the Indian rate of tax or the rate of tax of the said country, which ever is lower. In all fairness there should be a consolidation of tax liability and in case the tax paid to the foreign country on income from outside sources is more than what it would be payable in India, the assessee should be eligible for tax credit deduction in respect of the excess part of the tax liability as well, as is in vogue in many other countries.

4. In today's competitive environment many countries including Netherlands, Singapore, Luxembourg, Ireland, Spain, Austria have redesigned their taxation laws, to have low tax preferred jurisdiction with a view to attracting outbound investments. This is what we normally call 'participation exemption'. At a time when we are restructuring our fiscal Statutes and enacting altogether new Income Tax law, I feel it would be appropriate to introduce the said concept of 'participation exemption' on the lines of provisions prevalent in other countries.

5. Dividend Distribution Tax (DDT) needs to be brought within the ambit of DTAA to enable the overseas holding companies, having their subsidiaries in India, to offset the distribution taxes paid in India from tax payable by them in their respective countries. It is equally important to reduce the rate of Dividend Distribution Tax.

6. The present provision which requires the taxpayer to take the arithmetic mean of prices may be modified to use other statistical methods such as median of prices. Our law should be flexible enough to adapt with the emerging developments in the Group's business, taking into consideration the enterprise's perception of the risks of adverse tax assessment, as also considering both planning opportunities and risk management and weighing effective tax rate optimization against fiscal authority challenges and the cost compliance. Further, the provisions with regard to penalties need a relook.

7. The issue of ESOPs has assumed added significance in the recent past particularly for the IT and knowledge based industries. We have to ensure that FBT on ESOPs is eligible for tax credits under the DTAA and overseas stock exchanges are recognized on selective basis at par with our recognized stock exchanges for ESOPs valuation purposes.