Double Taxation Avoidance Agreement (DTAA)

What is double taxation?
Double taxation can be defined as the levy of taxes on income / capital in the hands of the same tax payer in more than one country, in respect of the same income or capital for the same period. Double taxation may arise when the jurisdictional connections, used by different countries, overlap or the taxpayer may have connections with more than one country.

What are the different jurisdictional connections used by countries?
Broadly, there are three groups of countries:
Status Jurisdiction- Anglo-Saxon System: Status of the taxpayer is the jurisdictional test. E.g. Citizenship in USA. An American citizen pays US tax on his global income. In the case of India, residence in the country is the jurisdictional test. I.e., if a taxpayer is a resident of India, he will pay tax in India on his world income. In the case of estate duty, the jurisdictional test is domicile. Features of Status jurisdiction:
Jurisdictional connection is the personal status of the taxpayer--rather than the source of his income;
In the case of companies, fiscal domicile (location of the seat of management) and not legal domicile (place of incorporation) is the jurisdictional test;
Tax is paid on global income, i.e., income from domestic and foreign sources are taxed (global in character);
Tax rates are applied on the total global income (canon of equity);
Economically advanced countries like US, UK, Germany, Sweden, and Netherlands follow this system.
Source Jurisdiction: European countries follow source jurisdiction. Income, arising or accruing from a source within the country, is subject to taxation. Features of Source Jurisdiction:
The jurisdictional connection is the source of income;
Only income from domestic sources is taxed (territorial rule of jurisdiction);
A schedular system is followed i.e., income from each source in the country is computed and taxed, separately;
France, Latin American countries and some Middle East countries follow this system.
Both Status and Source Jurisdiction: India follows both the methods. However, unlike source jurisdiction countries, income from each source is not taxed separately, though it is computed under each source. The aggregate income from all sources is taxed, applying the principle of progressive taxation, thus satisfying the canon of equity. However, it results in double taxation in many ways. E.g. ‘A’, an American citizen gets income from his investment in India and pays tax in India since his source of income is in India. He also has to pay tax on this income in the US, since he is an American citizen and, thus, is liable to pay tax on his global income.

What is the need for Double Taxation Avoidance Agreements?
Due to the phenomenal growth in international trade and commerce and increasing interaction among nations, citizens, residents and businesses of one country extend their sphere of activity and business operations to other countries, where income is earned. It is in the interest of all countries to ensure that an undue tax burden is not cast on persons who earn an income, by taxing them twice; once in the country of residence and again, in the country where the income is derived. At the same time, sufficient precautions are also needed to guard against tax evasion and to facilitate tax recoveries.
To avoid hardship to individuals and also with a view to seeing that national economic growth does not suffer, the Central Government, under Section 90 of the Income Tax Act, has entered into double tax avoidance agreements with other countries.
These Tax Treaties serve the following purposes:
Provide protection to tax-payers against double taxation and thus, prevent any discouragement which the double taxation may otherwise create in the free flow of international trade, international investment and international transfer of technology;
Prevent discrimination between the tax-payers in the international field;.
Provide a reasonable element of legal and fiscal certainty within a legal framework;
They also contain provisions for mutual exchange of information and for reducing litigation by providing for mutual assistance procedure.
The Government of India has entered into Double Tax Avoidance Agreement agreements with several countries, including Australia, Austria, Bangladesh, Belgium, Brazil, Bulgaria, Canada, China, Cyprus, (erstwhile) Czechoslovakia, Denmark, Egypt, Finland, France, Germany, Greece, Hungary, Indonesia, Israel, Italy, Japan, Kenya, Korea (South), New Zealand, Norway, Philippines, Poland, Romania, Singapore, Sri Lanka, Sweden, Switzerland, Syria, Tanzania, Thailand, Turkey, U.A.E., United Kingdom, United States of America, U.S.S.R. (Russian Federation) Vietnam and Zambia.

What are the different models for DTA Agreements?
These are essentially the UN (United Nations) and the OECD (Organisation of Economic Co-operation and Development) Models for DTA Agreements. The UN Model for a DTA Agreement takes into consideration the requirements of and the prevailing conditions in the developing countries and safeguards their interests, while the OECD Model is biased in favour of the developed countries. India’s DTA Agreements are mostly based on the UN Model. The US has its own model which issued for DTAs with United States.

Who is covered by a DTA Agreement between India and another country?
A typical DTA Agreement between India and another country usually covers persons who are residents of India or the other contracting country, which has entered into the agreement with India. A person, who is not resident either of India or of the other contracting country, would not be entitled to benefits under DTA Agreements.

How is the term ‘resident’ defined in a DTA Agreement?A resident: The definition of the term, ‘resident,’ is central to the application of a treaty because treaties often assign the taxing authority to the state of residence. Each contracting state defines ‘residence’ for individuals and companies under its domestic law. However, the definition of residence under a DTAA may be the same as that under the regular tax laws of a contracting state, i.e. based on the number of days’ stay in that country or other such criterion, or on the basis of whether he has a permanent home in both states, or where his personal and economic relations (center of vital interest are greater. If the center of the vital interests cannot be determined, then the ‘habitual abode’ test is applied. In the absence of habitual abode, citizenship may be the determining factor. If the person is a citizen of both/ states or neither, some DTAAs specify that it will be the phase of effective management which is determinative.

If a provision under the domestic Income-tax Act is more beneficial than a corresponding provision in the DTA Agreement, then which will apply?A situation may arise when, originally, the tax provision in the other contracting state gave concessional treatment compared to India at a particular time. However, 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 (2) that beneficial provisions, under the Income Tax Act of India will not be denied to residents of a contracting state, merely because the corresponding provision in a tax treaty are less beneficial. Thus, whichever is more beneficial, betweenthe treaty and (Indian) Income-tax Act provisions, will apply.

What is meant by the term ‘permanent establishment’?One important term that occurs in all the Double Taxation Avoidance Agreements is the term 'Permanent Establishment' (PE), which has not been defined in the Income- tax Act. There is a consensus that the host country can tax income of foreign companies only if it maintains a PE. Normally, a PE includes the following:
a place of management;
a branch;
an office;
a factory.
Thus, a PE takes the form of a facility, a construction site or an agency relationship, all of which require a measure of permanence. India’s approach has been to enlarge the definition of PE, so as to get maximum tax revenue. In general terms, a business connection is deemed to exist if there is any continuous relationship between a business carried on in India and, a non-resident person who derives income through this connection. There must be a continuity of transactions so as to establish a business connection. Normally, the time period to constitute a PE in the host country is six months. Another issue is the scope of income earned by a PE in a country, i.e., what is the portion of the income of PE earned in India that can be taxed. Under the ‘Attribution Rule’, only those profits are taxable which are attributable to the PE, computed on the basis of a hypothesis that the establishment in a country is completely independent of the head office in another country. The profits, which such an independent enterprise might be expected to derive on the amount so ascertained, are taken into account in the computation of the business income of the PE. Under the “force of an attraction rule”, the income, arising from all sources in a country, where a foreign enterprise maintains a PE is subject to tax in that country. This means that in addition to the profits attribution to the PE, those attributable to the sale of goods or merchandise and activities, similar to those carried on through the PE in another country are also taxable in the source country. Thus, in keeping with India’s stand that the country of source has a greater right to tax the profits of all enterprises of the country as compared to what it had in the treaties, based on the OECD model. As an alternative, all income in the source country which is not covered by the PE may be subject to the withholding tax if under the domestic law of the country, the income in question is taxable.
What is meant by the term ‘business income’?As a general rule, each country will tax a non-resident enterprise, engaged in the active pursuit of business in its territory, with a certain degree of intensity and regularity. Historically, the treatment of business income of a taxpayer is governed by a tax convention, which is tied to the ‘permanent establishment’ concept. A business enterprise or undertaking is subject to income tax on its industrial and commercial profits on parity with local enterprises in a treaty country, but only when it is engaged in trade or business in the country through a permanent establishment.
How is income from Air and Shipping Transport, taxed under a DTA agreement?Income, derived from the operation of Air transport in international traffic by an enterprise of one contracting state, will not normally be taxed in the other contracting state. An air transport company will be liable to tax only in the treaty country in which it is incorporated. However, this does not apply to aircraft companies, engaged in domestic traffic. In respect of an enterprise of one contracting state, income earned in the other contracting state from the operation of ships in international traffic, will be taxed in that contracting state, wherein the place of effective management of enterprise is situated. However, some DTA agreements contains provisions to tax the income in the other contracting state also, although, at a reduced rate. These provisions do not apply to coastal traffic.
How are associated enterprises taxed under DTA Agreements?In order to plug loop holes for tax evasion, there is generally a separate article in DTA agreement, which provides for taxing the notional income, deemed to arise on account of an enterprise of one contracting state, participating directly/indirectly in the management of another enterprise in the other contracting state or, where some persons participate directly or indirectly in both the enterprises, under conditions different from those existing between the independent enterprises
How is dividend income taxed under a DTA Agreement?Dividend paid out by a company in country A to a resident of country B could e taxed in both countries. Prior to 1st June 1997, a dividend, received by a shareholder from an Indian company was taxable in India. However, the DTAAs provide for a concessional rate of tax, e.g. 5% or 10%, as against the normal rate of tax of 25% under section 115A of the Income-tax Act. A resident of another contracting State, entitled to the receipts of a DTAA, was therefore entitled to opt for the lower rate of tax to be applied to him in the paying country. In India, with effect from 1st June 1997 to 31st March 2002 a tax on distribution of dividends is to be paid by the Company on distributing the dividends. No tax is levied by India on the recipient of the dividend. However, by virtue of the Finance Act 2002, dividend is again taxable in the hands of the recipient with effect from AY: 2003-2004 and therefore the taxability of dividend under the DTAA assumes significance.
How is interest income taxed under a DTA Agreement?Taxation of Interest Income under DTA agreement: Interest, paid in a Contracting State to a resident of the other Contracting State is chargeable in both the States. Usually, the following are the common features in all DTA Agreements, regarding the taxation of income from interest:
If the payee is the Government or the Central Bank of the Government or a Government agency, the interest would usually be exempt from tax in the country in which the payment is made.
Penalty charges for late payment e.g. for defaults in clearance of dues for purchases will not constitute interest nor will any item be treated as dividend, though styled as dividend by the taxpayer or the person with whom he has the relevant transaction.
There will be no deduction of tax at source if the payee has a permanent establishment in the country from which the payment is made, or if he is engaged in professional services there. In this case, the income will be covered by his assessment to tax in that country in the ordinary course.
Interest will be deemed to arise in that State in which the payer resides.
How is income from royalties taxed under a DTA Agreement? Regarding Royalties, arising in a Contracting State, that are paid to a resident of the other Contracting State:-
Some DTA agreements provide for taxation in the other Contracting State.
Some agreements provide for taxation in the contracting State.
Some agreements provide for taxation in both the States.
How is income from capital gains taxed under a DTA Agreement?Capital Gains will usually be taxed in the state where the capital asset is situated at the time of sale. However, some DTAAs-- e.g. India’s agreements with Mauritius and with Cyprus provide that there will be no Capital gains tax on the sale of shares in one contracting state by a resident of the other Contracting State.
How is income from professional services taxed under a DTA Agreement?Income will be taxed in the state where the person is resident and practicing his profession. However, if he has a fixed base in the other Contracting State, the income, attributable to the fixed base, will be taxed in the other contracting state. Some treaties also specify that a professional will be liable to tax if he stays in another country for more than a specified number of days, (183 days for most treaties but 90 for the US) and derives income in that country, even if he does not have a ‘fixed base’ there.
How are disputes, regarding the interpretation of a DTA Agreement, resolved?If there are any disputes in the interpretation or implementation of the terms of DTA Agreements, normal remedies of appeal, provided in the Income-tax Act, are available to the aggrieved party. The DTA Agreements also contain mutual agreement procedures. 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. The (Indian) Income-Tax Act also 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 or proposed to be undertaken by them. The facilities, available in such provision, can be availed of by Non-residents in the matters regarding Double Taxation of income, also.
What is meant by the term ‘other income’?Any income, not specifically covered in the treaties, is usually subject to tax in the State in which the income arises
What is meant by withholding rate of tax?Usually, taxation of income of an enterprise in any State is on net basis, i.e., after allowing all relatable expenses. However, in case of non-resident recipients, who have no organisation of funds in the country of source, it becomes difficult for the source country to arrive at the taxable income using normal methods. Such income usually relates to dividends, interest, royalties and fees for technical services, shipping profits and aircraft profits. In order to remove uncertainties for both sides, the usual practice now is to specify in domestic laws, the rates of tax on gross basis. This tax is to be charged on dividends, interest and royalties or fees for services, which would be deducted at source from the payments, before they are remitted out of the country. Such retention of tax is termed as ‘withholding tax’.
What is meant by ‘treaty shopping’?In the present age of economic globalization, both individuals and corporates are ever anxious to find ways and means of minimizing their tax burden. One way to do so is by moving to a tax haven, i.e., a tax jurisdiction, where the tax incidence is very small, sometimes even nil. Another way of doing this is to take the benefit of the double taxation avoidance agreements, entered into by one country with one or more other countries. This amounts to treaty shopping, which is a method of using or misusing the tax treaties by taking advantage by investing in low tax countries. In effect, there may be a situation where a person, resident in a third State, seeks to obtain the benefit of a double tax treaty between two other countries. MNCs shop for DTA Agreements, signed by countries to obtain fiscal advantages. It is used by investors for the following purposes:
to reduce the source country taxation;
to pay a low or zero effective rate of tax in the payee treaty country; and,
to pay a low or zero tax rate on payments from the payee treaty country to the tax-payer.
What is a tax haven?The Organization for Economic Co-operation & Development (OECD) has laid down four determinants for a tax haven. These include the following:
Lack of effective exchange of information;
Lack of transparency;
Attracting business with no substantial activities.
What is a harmful preferential tax regime?
The OECD defines a harmful preferential tax regime as one that:
imposes a low or zero effective tax rate on the relevant income;
the regime is ring-fenced (that is, it does not offer its domestic tax-payers the same incentives for the same activity as are offered to foreigners);
operation of the regime is non-transparent and there is no effective exchange of information with other countries.
What are the salient features of the Indo-Mauritius DTA Agreement?
The DTA Agreement between India and Mauritius was entered into in 1982. Some of the salient features of this treaty are as follows:
Article 4 of the Indo-Mauritius DTA Agreement defines a ‘resident’ of one State to mean "any person, who under the laws of that State is liable to taxation therein by reasons of his domicile, residence, place of management or any other criterion of a similar nature". Many Foreign Institutional Investors and other investment funds, etc., operating in India are incorporated in Mauritius. These entities are’ liable to tax’ under the Mauritius tax law and are, therefore, to be considered as residents of Mauritius in accordance with the DTA Agreement between these two countries. However, it may be noted that a recent ruling Delhi Court quashed the Circular No 789 dated 13th April, 2000 issued by CBDT according to which the production of these residency certificate from authorities in Mauritius were sufficient proof for authorities in India for the residential status in India. Therefore it is now open for assessing officers to determine the residential status after a detailed summary and merely production of tax residency certificate from the Mauritius tax authority is not a sufficient proof to establish the residential status and the beneficial ownership of an entity setup in Mauritius.
Capital gains, derived by a Mauritius shareholder on the sale of his shares in an Indian company, are not taxable in India. However, it is taxable in Mauritius under the Indo-Mauritius treaty and, the Mauritius tax laws do not levy any capital gains tax at present.
Prior to 1st June, 1997, dividends, distributed by domestic companies, were taxable in the hands of the shareholder and tax was deductible at source under the Indian Income Tax Act, 1961, at the rates, specified under S.115A. Under the DTA Agreement, tax was deductible at source on the gross dividend, paid out at the rate of 5% or 15 %, depending upon the extent of the shareholding of the Mauritius resident. India has abolished the withholding of tax on dividend income in the hands of all shareholders (including foreign shareholders). A Mauritius resident company holding portfolio investments in Indian companies will pay only 1.5 per cent on its Indian dividend income.
The normal rate of tax, 30% on royalty income is halved to 15% under the treaty.
Profits, earned by a Mauritian company through a "permanent establishment" in India, are taxable in India. The rates are those applicable under the Indian law.
An offshore entity in Mauritius, now defined as a tax incentive company, which is incorporated after June 30, 1998, is liable to income-tax at 15 per cent. The Income Tax (Foreign Tax credit) Regulation,1996,(of Mauritius) permits such companies to claim credit for actual foreign taxes that are paid. Where proof is not provided, a 'deemed' tax credit of 90 per cent of the Mauritius tax payable, leaving Mauritius tax liability at 1.5 per cent. But in June 2000, the Mauritius Finance Bill proposed to change its ‘deemed tax credit’ to 80%, thus leaving a residual tax liability of 3%. The concept of deemed tax credit mitigates the need of furnishing proof of foreign tax paid and thereby saves time and effort. It also ensures that where a source country gives certain tax exemptions as an incentive for investments into it, such an incentive is preserved in Mauritius. On the other hand, offshore companies, existing prior to June 30, 1998, were given the option to continue with the sliding rate of nil to 35 per cent.
No anti-treaty shopping provision exists in the case of Indo Mauritius Double Taxation Avoidance Agreement.
What needs to be done for Mauritius to avail of the advantages under the Indo-Mauritius DTA Agreement?
To benefit from the treaty concession, a special certificate must be obtained from the Mauritius Offshore Business Authority (MOBA) to that effect.
How is the Indo-Mauritius DTA used for tax avoidance?
Many non-Mauritius companies, investing in the fast growing markets of India, have often structured their deals through a holding company in Mauritius, to take advantage of the India-Mauritius Double Tax Avoidance Agreement (DTAA).
It also may be pointed out that India has entered into several treaties with other countries. In such treaties, there are special provisions for anti-treaty shopping (e.g. Article 24 of Indo-US Double Taxation Avoidance Agreement).

posted by PV