Protocol to India-UK Tax Treaty – Impact Analysis

During the calendar year 2012, the Indian Government put a lot of focus on improving bilateral relationships with countries across the globe. In this regard, it entered into some new Double Tax Avoidance Agreements (‘Tax Treaty’) by extending its treaty network and entered into Protocols with countries with whom it already had Tax Treaties. Last in this list (but a significant one) is the Protocol entered into with the UK. This Protocol due to Articles on Exchange of Information and Collection of Taxes dealing with procedural aspects, apart from some changes in the aspects of taxation as well is important. In this article, we have tried to broadly capture impact of the Protocol on tax payers from both the countries.

Treaty Benefits to UK Partnerships:

The India-UK Tax Treaty (prior to insertion of the Protocol) specifically excluded ‘partnership’ from the definition of ‘person’ under Article 3(1) (f). However, an Indian partnership, which is a taxable unit under the Indian Income-tax Act, 1961 (‘the Act’), was considered as ‘person’ as per Article 3(2).

Under the UK domestic law, a UK partnership is not treated as an entity separate and distinct from the partners. Hence, the UK partnership is considered as tax transparent or a pass-through entity, and the income of the partnership is directly taxed in the hands of the partners based on their residential status and their share in the partnership income.

Due to the tax transparent status of the partnership in the UK, a UK partnership was specifically excluded from the definition of ‘person’ under Article 3(1)(f) of the India-UK Tax Treaty. The effect of such specific exclusion suggested that in case a UK partnership earns income from India, it was not eligible to have access to the India-UK Tax Treaty, even though such income was taxed in the UK (in the hands of its partners).

In this regard, contrary to the literal interpretation, Mumbai Income-tax Appellate Tribunal (‘Tribunal’) in the case of Linklaters LLP vs. ITO (132 TTJ 20) extended the benefits under the India-UK Tax Treaty to a UK Limited Liability Partnership (‘LLP’). The Hon’ble Tribunal observed that where a partnership is taxable in respect of its profits, not in its own right but in the hands of partners, as long as the entire income of the partnership firm is taxed in the country of residence (i.e. UK), treaty benefits could not be denied. The Article 3(1)(f) of India-UK Tax Treaty clearly excluded a UK partnership from the definition of ‘person’, and hence, the Tribunal had to analyse this aspect in greater detail. By applying legal analogy based on past judicial precedents, it granted the Treaty benefit to a UK LLP. Thus, this aspect was highly debatable and involved an extensive legal analysis of interpretation of the international tax framework.

Similarly, the Mumbai Tribunal in the case of Clifford Chance vs. DCIT (82 ITD 106) [which was subsequently affirmed by the Bombay High Court (318 ITR 237)] also granted benefits of the India-UK Tax Treaty to a UK partnership firm comprising lawyers. However, a detailed evaluation of the eligibility of the UK partnership claiming benefits under the India- UK Tax Treaty was not done in the said decision.

This controversy has now been put to rest by the Protocol, which has proposed to amend the definition of ‘person’ under the India-UK Tax Treaty by deleting the specific exclusion of partnership from the definition.

 Further, an amendment is also proposed in Article 4(1), which defines the term ‘resident of a Contracting State’, to provide that, in case of a partnership, only so much of income as derived by such partnership, which is subject to tax in a Contracting State as the income of the resident of such Contracting State either in its hands or in the hands of its partners, would be eligible for claiming benefits under the India-UK Tax Treaty. Hence, in the case of a UK partnership earning income from India, only so much of income which is subject to tax in the UK as the income of the UK resident partner would be eligible for India-UK Tax Treaty benefits.

It is interesting to note that similar to the UK, US partnerships are also treated as tax transparent entities under the US domestic tax law, and their income is taxed in the hands of partners directly. The definition of the term ‘resident of a Contracting State’ is pari-materia to the India-USA Tax Treaty. In this context, it would be noteworthy to refer to the definition of the term ‘person’ provided under Article 4(1)(b) of the India-USA Tax Treaty and the Technical Explanation thereof issued by the Treasury Department, which acts as guidance for the interpretation of the terms referred in the India-USA Tax Treaty. The Technical Explanation clarifies that to the extent the partners of a US partnership are subject to tax in US as US residents, the income received by such US partnership will be eligible for India-USA Tax Treaty benefit. Hence, the eligibility of a US partnership to access the India- USA Tax Treaty depends upon the residential status of the partners in such partnership.

Considering the Technical Explanation to the India- USA Tax Treaty and the wordings of the proposed amendment to the definition of ‘resident of Contracting State’ under the India-UK Tax Treaty, an analogy may be drawn that a UK partnership may not be granted benefits under the India-UK Tax Treaty in respect of income that belongs to a person who is not a tax resident of the UK. In other words, if, a UK partnership firm has a Canadian individual as a partner who is not a tax resident of UK (as his income is not taxable in the UK on account of his residence or similar criteria) then, the income earned by the UK partnership (from India), to the extent of such Canadian partner’s share would not be eligible for the India-UK Tax Treaty benefit.

It is pertinent to note that the Technical Explanation issued with reference to the India-USA Tax Treaty though, not binding while interpretating of the terms under India-UK Tax Treaty, it would be of relevance since, the Indian Government had agreed to such interpretation in the past while signing the Technical Explanation to the India-USA Tax Treaty. Hence, it will have a persuasive value on the application of India-UK Tax Treaty as well.

In light of the above, once the Protocol to India-UK Tax Treaty comes into force, an Indian entity will have to consider the tax residence of the partners of the UK partnership at the withholding stage, while granting Treaty benefits to the UK partnership. In this context, attention is invited to the recently introduced section 90(4) of the Act, which requires a non-resident claiming Treaty benefits in India to obtain a certificate containing prescribed particulars (i.e. Tax Residency Certificate or TRC) from the Government of the home country. It would be interesting to observe how a TRC would be issued by the UK Government to a UK partnership earning income from India (specifically, where one of the partners therein is a non-resident).

Treaty benefits to Trusts and Other Entities

Under the current India-UK Tax Treaty, a ‘trust’ or an ‘estate’ may qualify as a ‘person’ under Article 3(1) (f) of India-UK Tax Treaty, only if they are treated as a separate taxable unit under the taxation laws in force of the concerned country. Hence, in a scenario, where a UK trust is treated as a pass-through entity (and not a separate taxable unit) for taxation purposes in the UK and its income is taxable in the hands of its beneficiaries, then the income derived by such a trust from India may not be eligible for the India-UK Tax Treaty benefits.

Tax Withholding on Dividend:

One of the much discussed benefits proposed to be granted under the Protocol is the reduced rate of tax withholding on payment of dividend by replacing the existing Article 11 of the India UK Tax Treaty. The Protocol has provided for revised withholding tax rate as follows –

a.    15% of the gross amount of dividends where such dividend is paid out of income derived directly or indirectly from immovable property by an investment vehicle which distributes most of its income annually and whose income from such immovable property is exempted from tax;

b.    10% of gross amount of dividends in all other cases.

Dividend by Investment Vehicle Earning Income from Immovable Property
The new Article 11(2)(a) proposed to be introduced by the Protocol provides 15% withholding rate on declaration of dividend by an investment vehicle earning income from immovable property where such income is exempt in its hands. It seems to cover investment vehicle like Real-Estate Investment Trusts (REITs) registered in India, even though the income earned by such REITs are not currently exempted in India. Hence, it does not seem to have any significant impact from the Indian perspective. However, an investment vehicle in the UK (like UK REITs) earning income from immovable property, which is exempt in its hands in UK, may fall within the ambit of this provision.

Dividend in Other Cases
The Protocol proposes to amend the withholding tax on dividend (other than the dividends covered above) to 10% vide Article 11(2)(b) in line with the withholding tax rate applicable for other OECD countries.

This amendment does not appear to bring any impact on the investors from either country (except in certain cases)n due to the current tax regime under the domestic tax laws of India and the UK.

UK Shareholder Earning Dividend from Indian Company
Under the Income-tax Act, 1961, an Indian company declaring dividend has to pay Dividend Distribution Tax (DDT) . Such dividend is tax exempt in India in the hands of resident as well as non-resident share-holder and there is no withholding tax. Hence, under the current domestic tax law, the reduction in with-holding tax rate will not have any impact, though it would be critical if in the future, the DDT regime is withdrawn from the domestic tax law in India.

Interestingly, the Protocol does not throw any light on tax credit to UK shareholder in the UK with respect to DDT suffered on distribution of dividend by an Indian company. It has been over a decade now since the concept of DDT has been in place under the Income-tax Act. Issue of credit for the DDT paid in India in the hands of foreign investor in their home country is unclear and has been a matter of debate. In the past, while entering into a Protocol with Hungary, some clarity has been provided to this effect.

It is pertinent to note that the UK domestic tax law provides for the underlying tax credit for taxes paid on income earned in overseas country (i.e. corporate tax). Hence, the UK shareholder earning dividend from an Indian company would be entitled to tax credit for corporate tax paid by the Indian company on its profits from which dividends are distributed. Hence, uncertainty on the tax credit for DDT practically does not have a serious bearing.

Indian Shareholder Earning Dividend from a UK Company
Under the current UK domestic tax laws; in most of the cases, there is no tax withholding on distribution of dividend by a UK Company (subject to satisfaction of certain conditions).

In a scenario, where the Indian shareholder does not satisfy any of the prescribed conditions and is unable to claim exemption under the UK domestic tax laws, he suffers tax withholding in the UK. Only in such case, the UK company will have to withhold tax on distribution of dividend to Indian shareholder. Currently, the tax withholding rate on dividend as per the India-UK Tax Treaty is 15% which is proposed to be reduced to 10% by the Protocol.

Article on Limitation of Benefits (LOB):

UK government as well as the Indian government intend to introduce General Anti-Avoidance Rules (GAAR) under their respective domestic tax laws. UK is intending to implement the same from the next fiscal year and the Indian gvernment has recently deferred the implementation of GAAR by two years and is proposed to be introduced with effect from 1st April, 2016. Pending this, GAAR provisions have been introduced under the Protocol. Article 28C on LOB clause proposes to deny the Treaty benefits with respect to a transaction if the main purpose or one of the main purposes of the transaction was to obtain benefits under the India-UK Tax Treaty. Further, it is also provided, that the treaty benefits may also be denied if the main purpose or one of the main purpose of creation or existence of any entity in either of the country was to obtain benefits under the India-UK Tax Treaty.

This type of LOB clause is also inserted in many recently concluded Indian Tax Treaties, for example, treaties with Georgia, Uzbekistan, Nepal, Iceland, Finland, etc. The effect of the LOB clause can be far-reaching and its implementation would depend largely upon the implementation of GAAR provisions by both the countries in their domestic tax laws.

Exchange of Information and Assistance in Collection of Taxes:

The Protocol also proposes to introduce certain other measures to curb tax evasion practices by introducing Article 28 on Exchange of Information, Article 28A on Tax Examinations Abroad and Article 28B on Assistance in Collection of Taxes in the India-UK Tax Treaty.

As one of the purposes of double tax avoidance agreements is to enable and facilitate the exchange of information between the tax authorities, Article 28 on Exchange of Information gives a statutory recognition to the formal process of information exchange between the competent authorities. The information that can be exchanged under this Article is that which enables the carrying out the provisions of the Treaty or enforcement of domestic law of the Contracting States effectively. However, inspite of exchange of information, under the principle of procedural autonomy, collection of taxes by one Contracting State from the residents of the other Contracting state remains a difficult task. Thus, to overcome this, Protocol proposes to introduce Article 28B on Assistance in Collection of Taxes in the Treaty for smoothing the process of recovery of taxes. This Article is also found in tax treaties entered into by India with countries like Norway, Denmark, Sweden, Ukraine, South Africa, etc.

Entry into force:

The provisions of this Protocol will take effect only when both the governments complete the necessary implementing measures by notification to this effect.

Conclusion:

The clarity on allowability of Treaty benefits to the UK partnerships and other tax transparent entities (like trust, estates, etc.) is a welcome step; though the Indian Judicial Authorities have evaluated this aspect in the past. The reduced withholding rate on dividend seems to suggest very limited applicability. However, the implementation of LOB clause with respect to invocation of GAAR may have a far reaching impact and guidelines under the domestic tax laws on this aspect would bring in more clarity.

The procedural amendments like Article on exchange of information and assistance in collection of taxes would help to bring more transparency for the Governments of both the countries.