How to read DTAA?

What is a Treaty?

Vienna Convention on law of treaties is known as the Bible of Tax Treaties. “Treaty” has been defined by Article 2 of Vienna Convention to mean an international agreement concluded between States in written form and governed by international law, whether embodied in a single instrument or in two or more related instruments and whatever its particular designation. Tax Treaty is also known as Double Taxation Avoidance Agreement (DTAA), or Agreement for Avoidance of Double Taxation (AADT) or as Double Tax Conventions (DTCs). These terms can be used interchangeably.

DTAAs can either be “Comprehensive DTAA” covering all types of incomes or “Limited DTAA” which are limited to certain type of incomes only. India has entered into Comprehensive Agreement with 97 countries and Limited Agreements with 8 countries including Pakistan, Iran, Maldives.

What is the need to enter into treaty between countries?

Let us understand this with the help of an illustration. US Inc., a company incorporated under the laws of USA and tax resident of USA carries on business in India through a branch situated in India. Here, USA is a Country of Residence (“COR”, “Residence State” or “Home Country”) and India is a Country of Source (“COS”, “Source State” or “Host Country”). India and USA are parties to this DTAA and they are called “Contracting States”. The DTAA is executed through the process of negotiation whereby contracting states waive their rights to arrive at a fair agreement. Now, USA will tax Indian profits of the company based on its residency and India will tax the company based on its source. This leads to Double Taxation. To avoid this kind of situation, countries enter into an agreement known as Tax Treaty.

Coming back to the example, the same income is taxed twice in the hands of same person. This is known as Judicial Double Taxation. The purpose of DTAA is to eliminate Judicial Double Taxation. Other type of double taxation is Economic Double Taxation, which generally arises in company shareholder model, where same income is taxed twice to different persons. DTAAs do not relieve Economic Double Taxation.

Interpretation of DTAA

Let us see how the actual text of a DTAA is worded and how to read the same to interpret the meaning. Article 6(1) of India-USA DTAA is worded as “Income derived by a resident of a Contracting State from immovable property (real property), including income from agriculture or forestry, situated in the other Contracting State may be taxed in that other State.” Let us replace the “Contracting State” with actual countries and read again. “Income derived by a resident of USA from immovable property (real property), including income from agriculture or forestry, situated in India may be taxed in India.” This means, first right to tax income from immovable property has been given to the country where the immovable property has been situated; i.e. source taxation.

Let us take another example. Article 8(1) of India-USA DTAA is worded as “Profits derived by an enterprise of a Contracting State from the operation by that enterprise of ships or aircraft in international traffic shall be taxable only in that State.” This will be read as “Profits derived by an enterprise of USA from the operation by that enterprise of ships or aircraft in international traffic shall be taxable only in USA.” This gives exclusive right to tax the income from shipping business to USA.

We can observe that Article 6 uses the words “may be taxed”, whereas Article 8 uses the words “shall be taxable only”. In the former case, the other country does not give up its right to tax income from immovable property, whereas in the latter case, the exclusive right has been given to a particular country.

Who can take benefit under DTAA?

Once the countries enter into a Treaty, it relieves the persons covered by it from double taxation. DTAAs are always relieving in nature. They cannot create a charge. Here, a question arises, who can access a DTAA? Generally, Article 1 provides that a person should be a resident of one of the contracting state to take the benefit of the said DTAA. For example, for accessing the Indo-US DTAA, a person should be resident of either India or USA. Once he is resident as such, he can go ahead with claiming benefits available in the Indo-US DTAA.

The Tie-breaker test

If a person is “Resident” of both the contracting states, it gives rise to uncertainty which needs to be resolved. This is done by applying the “Tie-breaker test”. This tie-breaker is necessary to make sure that the person is Resident of only one of the contracting states. Generally, tie-breaker test of an Individual consists of factors such as his permanent home, center of vital interest, his habitual abode and his nationality. With reference to residency, the India-USA DTAA is a very unique example. Paragraph 3 of Article 4 provides that “Where, by reason of paragraph 1, a company is a resident of both Contracting States, such company shall be considered to be outside the scope of this Convention except for purposes of paragraph 2 of Article 10 (Dividends), Article 26 (Non-Discrimination), Article 27 (Mutual Agreement Procedure), Article 28 (Exchange of Information and Administrative Assistance) and Article 30 (Entry into Force).”

Does DTAA mitigate double taxation?

In home country, tax is an obligation, while in the host country, tax is a cost. Tax Treaties come into play to mitigate hardship caused by subjecting the same income to double taxation. They aim at sharing of tax revenues by concerned states on a rational basis depending on whether it is an Active Income or a Passive Income. Business Profits, Salary Income are examples of an Active Income; whereas Interest, Royalty, Capital Gains are examples of a Passive Income. First right to tax an active income is generally given to source country. Taxation rights of a passive income are shared by both the nations on a fair basis. Further, just because first right has been given to source country, it does not mean that country of residence gives up its right to tax. Then, how the double taxation is mitigated? The article on “Elimination of Double Taxation” comes to the rescue. The relief is provided by this article either by way of exempting a particular income in a particular state or by giving credit of taxes paid in source country. Former is known as “Exemption Method” and the latter as “Tax Credit Method”.

The Model Conventions

Negotiating a Treaty is a long process. However, if countries are given a check list of matters on which they need to negotiate, it becomes a bit easier process. This need for check list is met by “Model Conventions”(MCs). The Model Conventions assist in maintaining uniformity in the format of tax treaties. OECD Model, UN Model, the US Model and the Andean Model are a few of such MCs. Of these, the first three are the most prominent and often used. Indian treaties are based on combination of all these MCs. Peculiarities of these models are that OECD MC is essentially a model treaty between two developed nations. This MC advocates residence principle. It lays emphasis on the right of state of residence to tax the income. On the other hand, UN MC is a compromise between the source principle and residence principle. Most of India’s tax treaties are based on the UN Model. The US MC is different from OECD and UN in many respects. For example, Indo-US treaty provides for Limitation on Benefits (Article 24) and taxing capital gains (Article 13) as per the domestic law. Also, US Model does not have a Tax Sparing Clause. The US MC is used by USA for its treaties with various nations. Lastly, Andean Model is used only by a group of lesser and medium developed Latin American countries, namely, Bolivia, Columbia, Chile, Ecuador, Peru and Venezuela. It provides for almost exclusive taxation in source country except in cases of international traffic. PE concept is not adopted.

Interpretation of terms not defined in the DTAA

Once a person is eligible to access a DTAA as above, now the question arises how to interpret terms which are not defined in the Treaty. If a particular item is not defined in the treaty, its meaning can be ascertained with reference to the domestic tax laws of the source state. If it is not defined in the domestic tax laws of the source state, then the term would be interpreted as per the general law of the source state.

Further, when an interpretation issue arises, Indian Courts have referred Vienna Convention on Law of Treaties, even though India was not a signatory to the Vienna Convention. However, when it comes to application of a tax treaty in the domestic forum, the appellate authorities and the courts are primarily governed by the laws of the respective countries for interpretation. In India, the Income Tax Act, 1961 (“the Act”) provides that where the Indian Government has entered into DTAAs which are applicable to the taxpayer, then the provisions of the Act shall apply to the extent they are more beneficial to the taxpayer (Sec. 90(2) of the Act).

Protocol

Continuing with the example of Indo-US DTAA, another peculiarity of Treaty with USA is that it has incorporated a Memorandum of Understanding concerning Fees for Technical Services (FTS) to explain the provisions with illustrations. Generally, to put certain matters beyond doubt, there is a protocol annexed at the end of the treaty, which clarifies borderline issues. Protocol is like a supplement to the treaty. Another objective of Protocol is to give effect to the Most Favoured Nation (MFN) clause.

What is BEPS and MLI

After the discussion on traditional International Tax to avoid so called “Double Taxation”, let us now move to future of International Taxation, i.e. “Double Non-Taxation”. Multi-National Enterprises (MNEs) started to structure their operations aggressively and engaged in transactions that often lacked economic reality. This leads to Tax-Avoidance, which is legal but harmful. Therefore, OECD and G20 Nations together developed steps against such tax avoidance. Fifteen Action Plans have been developed to conquer the above challenge. These are called BEPS Action Plans (Base Erosion and Profit Shifting). These Action Plans are based on three pillars, namely; Substance, Coherence and Transparency.

Out of many challenges that BEPS Action Plan aim to resolve, let us understand one of such challenge; Digital Economy Taxation. For instance, a person resident in India visits Singapore and orders goods online from a website owned by a business in USA. Orders are received and processed by servers located in Philippines. Delivery takes place from a warehouse located in China. Under this situation, which country has a right to tax income from sale of goods? BEPS intends to overcome such challenges of modern economy. To implement these action plans, more than 3000 tax treaties need to be amended world-wide, which seems almost impossible in short time. Hence, a Multi-Lateral Instrument (MLI) has been developed, which will be read alongwith bilateral tax treaties to implement Anti-BEPS measures. India has signed the MLI on June 7, 2017 and ratified the same on June 25, 2019. Let us hold on tight and enjoy the ride when implementation takes place.

Disclaimer: The content of this document has been prepared by the Author. No assurance is given that the revenue authorities / courts will concur with the views expressed herein. The views of the Author are based on the existing provisions of law and its interpretation, which are subject to change from time to time. The Author does not assume responsibility to update the views consequent to such changes. It is only for the purpose of education providing only general information on the subject and is not an exhaustive treatment of such subject. The Author is not by any means providing any professional advice or service. This information is not intended to be relied upon as the sole basis for any decision which may affect you, your business or any third person. Professional Advice should be sought before making any decision. The Author shall not be liable to any person for any claims, liabilities or expenses whatsoever sustained by any person who relies on the contents of this material.

Co-Authored by:

CA Arun Valera          CA Priten Shah