DUAL RESIDENT ENTITIES – ARTICLE 4 OF MLI

1. INTRODUCTION
Section 90(1) of the Income-tax Act, 1961 (the Act) read with Article 253 of the Constitution enables the Central Government to enter into Tax Treaties. Accordingly, India has entered into Tax Treaties with over 90 countries. The overarching preamble to a Tax Treaty is to eliminate double taxation and, vide the Multilateral Instruments (MLI), the same is also extended to prevent double non-taxation, or treaty abuse, or treaty-shopping arrangements.

The Tax Treaty does not impose taxes but distributes taxing rights. It provides substantive rights but relies on the domestic tax law to provide for the rules and procedures to levy tax. As per section 90(2), the beneficial provisions of the Tax Treaty shall override the specific provisions of the Act, subject to the domestic General Anti-Avoidance Rules (GAAR) and issue of Tax Resident Certificate from the tax officer in the foreign country. Thus, it is imperative to understand the treaty entitlement issues.

The taxpayer would certainly apply the Tax Treaty when its income is taxable in its resident state as well as in the source state. In other words, when it is the recipient of income taxable in more than one jurisdiction. Once applicable, its application is dependent on the following:

While the above relates to treaty entitlement, this article is focused on Article 4 of the MLI on Dual Resident Entities (non-individuals) that are usually referred to in Article 4(3) of the relevant Tax Treaty. As a pre-cursor, a Dual Resident Entity (DRE) is defined as such when an entity is deemed to be a resident of more than one jurisdiction under the domestic provisions. For example, when a  UK-incorporated entity is a tax resident of UK as per its domestic tax law (say, because of its incorporation under the UK tax law) and is also deemed to be a resident of India as per the Indian domestic tax law (say, because of the POEM rule under the Income-tax Act, 1961). The present Tax Treaty, without the effect of MLI, dealt with the conflict of dual resident entities and contained a tie-breaker rule for determination of the effective treaty residence.

2. ARTICLE 4(3) OF THE TAX TREATY
In accordance with Article 1(1) of the OECD Model Tax Convention, the Tax Treaty shall apply to persons who are residents of one or both of the Contracting States. Article 2 defines ‘persons’ to include an individual, a company and any other body of persons and defines ‘company’ to mean a body corporate or an entity that is treated as a body corporate for tax purposes, whereas Article 4 defines ‘residence’ for treaty purposes. In relevance, the Tax Treaty allocates or distributes taxing rights on the basis of the treaty residence.

The term ‘residence’ in Article 4(1) of the relevant Tax Treaty refers to the domestic definition of the residence, which, for Indian purposes, is section 6 of the Act. However, for resolving the issue of dual residency for non-individuals, the Tax Treaty refers to its own rule specified in Article 4(3) of the relevant Tax Treaty, i.e., Place of Effective Management (POEM). The OECD does not impose any restrictions or criteria for determination of residence in Article 4(1). In the case of dual residency for non-individuals, Article 4(3) refers to the POEM criterion as a single tie-breaker rule to determine ‘treaty residence’.

The term POEM is not defined in the OECD Model Tax Convention or in the relevant Tax Treaty. An analogy is drawn from the OECD Commentary which in itself does not provide sufficient and reliable guidance on its key determinants. Dual resident non-individuals are known to have abused this guidance gap. The tax authorities, as a last resort, have determined POEM on the basis of their domestic tax law vide Article 3(2) of the OECD Model Tax Convention. Under the Act, section 6 deems a foreign company to be a resident of India if it has its POEM in India. The CBDT Circular 6/2017 further provides guidance on how to determine POEM on the basis of various parameters for active business outside India and in India.

3. MULTILATERAL INSTRUMENTS
In order to curb tax abuse or evasion, article 4(1) of the Multilateral Instruments (MLI) amends the existing article 4(3) of the relevant Tax Treaty for resolving dual residency. It provides that the resolution of dual residence shall be through mutual agreement between the Contracting Jurisdictions concerned. It departs from the current treaty practice1, insofar as the POEM may no longer be the main rule to resolve the dual residence; and that the competent authorities will have the freedom to consider a number of factors to be taken into account while determining treaty residence of Dual Resident Entities (DRE). Article 4(1) of MLI also provides that the benefit of the Tax Treaty shall not be available until and unless the mutual agreement is concluded.

While Article 4(2) of MLI elucidates the manner in which the existing text of the Tax Treaty will change or modify, Article 4(3) of MLI provides an option to the Contracting States to make reservations. Article 4(4) of MLI elucidates the manner in which a Contracting Jurisdiction shall notify its partner Contracting Jurisdiction and thereby the Tax Treaty agreements to be covered under MLI.

4. DUAL RESIDENT ENTITIES – ARTICLE 4 OF MULTILATERAL INSTRUMENTS
4.1 Paragraph 1 of Article 4 of MLI states the following:
Paragraph 1. Where by reason of the provisions of a Covered Tax Agreement a person other than an individual is a resident of more than one Contracting Jurisdiction, the competent authorities of the Contracting Jurisdictions shall endeavour to determine by mutual agreement the Contracting Jurisdiction of which such person shall be deemed to be a resident for the purposes of the Covered Tax Agreement, having regard to its place of effective management, the place where it is incorporated or otherwise constituted and any other relevant factors. In the absence of such agreement, such person shall not be entitled to any relief or exemption from tax provided by the Covered Tax Agreement except to the extent and in such manner as may be agreed upon by the competent authorities of the Contracting Jurisdictions.

1   United Nations’ Manual for the Negotiation of
Bilateral Tax Treaties between Developed and Developing Countries 2019, page 61

The key phrases for discussion are given below:

• ‘A person other than an individual is a resident of more than one Contracting Jurisdiction.’

• ‘shall endeavour to determine by mutual agreement.’

• ‘having regard to its place of effective management, the place where it is incorporated or otherwise constituted and any other relevant factors.’

• ‘shall not be entitled to any relief or exemption from tax.’

• ‘except to the extent and in such manner as may be agreed upon by the competent authorities of the Contracting Jurisdictions.’

MLI provides for a shift in the initial determination of treaty residence, from the taxpayer / tax authority (determination using POEM) to now the Competent Authority of the Contracting Jurisdiction concerned (determination by mutual agreement).

Until its final determination by mutual agreement, the DRE is not entitled to any relief or exemption from tax under the Tax Treaty to which MLI applies. However, the last sentence also contemplates a discretionary power in the hands of the Competent Authority to grant some relief under the relevant Tax Treaty. From the perspective of the Act, with no access to the Tax Treaty, a foreign company shall be deemed to be a domestic resident if its POEM (as per domestic guidance) is in India. A foreign limited liability partnership (being a body corporate) shall be deemed to be a resident in India where the control and management of its affairs is situated wholly or partly in India. Paragraph 52 of the Explanatory Statement to MLI provides the following:

‘Existing “tie-breaker” provisions addressing the residence of persons other than individuals take a variety of forms. For example, some [such as Article 4(3) of the UN Model Tax Convention, and of the OECD Model Tax Convention prior to the BEPS Project] break the tie in favour of the place of effective management, some focus on the place of organisation, and others call for determination by mutual agreement but do not explicitly deny benefits in the absence of such a determination.’

It must be noted that the POEM, being one of the various determinants, is in itself an anti-avoidance measure. It applies the substance-over-form approach in order to determine the location where ‘key management and commercial decisions’ were made. It seems that POEM is the key criterion for Competent Authorities to determine treaty residence and thereby entitlement to the relevant Tax Treaty. MLI or its Explanatory Statement does not provide any guidance on how to determine treaty residence and how to determine POEM or which aspect to consider for ‘any other relevant factor’. It seems that the domestic guidance on determination of POEM may not be relevant for determination of treaty residence as the purpose of section 6(3) is to make a foreign company a resident in India and thereby enabling dual residency, whereas the purpose of Article 4(1) of the MLI is to resolve the conflict of dual residency.

With high discretion in the hands of the Competent Authority, there is no obligation on the Competent Authority to reach a mutually acceptable agreement. Further, the DRE may not have any say in the matter and may not have any right to appeal or arbitrate a negative decision on treaty residence.

Lastly, the CBDT has in Rule 44G of the Income-tax Rules, 1962 provided for the manner in which an Indian resident can apply to the Competent Authority in India for initiation of MAP. It also provides for a suggestive timeline (not mandatory) of 24 months for arriving at a mutually agreeable resolution of the tax dispute. However, a foreign entity is not allowed to apply to the Competent Authority in India.

4.2 Paragraph 2 of Article 4 of MLI states the following:
Paragraph 1 shall apply in place of or in the absence of provisions of a Covered Tax Agreement that provide rules for determining whether a person other than an individual shall be treated as a resident of one of the Contracting Jurisdictions in cases in which that person would otherwise be treated as a resident of more than one Contracting Jurisdiction. Paragraph 1 shall not apply, however, to provisions of a Covered Tax Agreement specifically addressing the residence of companies participating in dual-listed company arrangements.

The key phrases for discussion are given below:

• ‘in place of or in the absence of.’

• ‘companies participating in dual-listed company arrangements.’

This Paragraph is the compatibility clause that describes the interaction between Article 4(1) of the MLI and the existing Article 4(3) of the relevant Tax Treaty (also known as the Covered Tax Agreement). The effect of ‘in place of or in the absence of’ is as provided below:

 

4.3 Paragraph 3 to Article 4 of MLI states the following:
A party may reserve the right:
a) for the entirety of this Article not to apply to its Covered Tax Agreements;
b) for the entirety of this Article not to apply to its Covered Tax Agreements that already address cases where a person other than an individual is a resident of more than one Contracting Jurisdiction by requiring the competent authorities of the Contracting Jurisdictions to endeavour to reach mutual agreement on a single Contracting Jurisdiction of residence;
c) for the entirety of this Article not to apply to its Covered Tax Agreements that already address cases where a person other than an individual is a resident of more than one Contracting Jurisdiction by denying treaty benefits without requiring the competent authorities of the Contracting Jurisdictions to endeavour to reach mutual agreement on a single Contracting Jurisdiction of residence;
d) for the entirety of this Article not to apply to its Covered Tax Agreements that already address cases where a person other than an individual is a resident of more than one Contracting Jurisdiction by requiring the competent authorities of the Contracting Jurisdictions to endeavour to reach mutual agreement on a single Contracting Jurisdiction of residence, and that set out the treatment of that person under the Covered Tax Agreement where such an agreement cannot be reached;
e) to replace the last sentence of paragraph 1 with the following text for the purposes of its Covered Tax Agreements: ‘In the absence of such agreement, such person shall not be entitled to any relief or exemption from tax provided by the Covered Tax Agreement’;
f) for the entirety of this Article not to apply to its Covered Tax Agreements with parties that have made the reservation described in sub-paragraph e).

This Paragraph relates to the reservation which can be entirely, partially or in a modified format. The signatories are free to express their reservation and restrict the extent of the application of Article 4 of MLI. It may opt out of Article 4 of MLI in the manner stated above and continue with the existing provisions of the Tax Treaty, without giving effect of MLI.

For example, in the India-Austria Tax Treaty, Austria has reserved the right for the entirety of Article 4 of MLI not to apply to its Covered Tax Treaty. India has notified India-Austria Tax Treaty and has not provided any reservation. Accordingly, Article 4 would not apply.

Likewise, in the India-Australia Tax Treaty, Australia has reserved the right to deny treaty benefits in absence of mutual agreement in accordance with Article 4(3)(e) of MLI above. Both India and Australia have notified the relevant article in the India-Australia Tax Treaty. India has not provided any reservation [including reservation as per Article 4(3)(f)]. Accordingly, Article 4(1) of MLI shall replace the existing Article 4(3) of the India-Australia Tax Treaty, with the last sentence of Article 4(1) of MLI to be modified by Article 4(3)(e) of the MLI.

The signatory party to the MLI that has not made a reservation of this article is required to notify the Depository of its Covered Tax Treaty purported to be covered or already covered in its existing treaty. The procedure is discussed in Article 4(4) of the MLI discussed below.

4.4 Paragraph 4 to Article 4 of MLI states the following:
Each party that has not made a reservation described in sub-paragraph a) of paragraph 3 shall notify the Depository of whether each of its Covered Tax Agreements contains a provision described in Paragraph 2 that is not subject to a reservation under sub-paragraphs b) through d) of Paragraph 3, and if so, the article and paragraph number of each such provision. Where all Contracting Jurisdictions have made such a notification with respect to a provision of a Covered Tax Agreement, that provision shall be replaced by the provisions of Paragraph 1. In other cases, Paragraph 1 shall supersede the provisions of the Covered Tax Agreement only to the extent that those provisions are incompatible with Paragraph 1.

This Paragraph complements the application of Article 4(2) of MLI. Refer to the diagram illustrated in Paragraph 2 above, wherein each party has to notify the Depository of whether each of its Covered Tax Agreements contains an existing provision that is not subject to a reservation under Paragraph 3(b) through (d). Such a provision would be replaced by the provisions of Article 4(1) of MLI where all parties to the Covered Tax Agreement have made such a notification. In all other cases, 4(1) of MLI would supersede the existing provisions of the Covered Tax Agreement only to the extent that those provisions are incompatible with Article 4(1) of MLI.

Paragraph 52 of the Explanatory Statement to MLI provides that ‘Where a single provision of a Covered Tax Agreement provides for a tie-breaker rule applicable to both individuals and persons other than individuals, Paragraph 1 would apply in place of that provision only to the extent that it relates to a person other than an individual.’

5. EXCEPTION
Paragraph 2 of Article 4 of MLI provides an exception to this Article, i.e., ‘Paragraph 1 shall not apply, however, to provisions of a Covered Tax Agreement specifically addressing the residence of companies participating in dual-listed company arrangements.’

The above clause has a restricted effect from the Indian perspective as it refers to the existing treaty clause addressing the residence of companies participating in dual-listed company arrangements, e.g., the UK-Netherlands Tax Treaty. In the dual-listed company arrangement, like merger, two listed companies operating in two different countries enter into an alliance in which these companies are allowed to retain their separate legal identities and continue to be listed and traded on the stock exchanges of the two countries. It is a process that allows a company to be listed on the stock exchanges of two different countries. In a typical merger or acquisition, the merging companies become a single legal entity, with one business buying the other. However, ‘a dual-listed company arrangement’ is a corporate structure in which two corporations function as a single operating business through a legal equalisation agreement but retain separate legal identities and stock exchange listings2. The arrangement reflects a commonality of management, operations, shareholders’ rights, purpose and mission through an agreement or a series of agreements between two parent companies, operating as one business.

2   http://www.legalservicesindia.com/article/1580/Dual-Listing-of-Companies.html
and Explanatory Statement in respect of Article 4(2) of MLI

6. WAY FORWARD
MLI is seeking to replace / supersede the existing framework of the Tax Treaty. While MAP was a well-known measure present in the Tax Treaty to resolve tax conflicts, Article 4 of MLI purports to use this measure for determining the Treaty Entitlement, more particularly the issue on treaty residence. Until the coming into force of Article 4(1) of MLI, the treaty entitlement was never doubted in the existing Article 4 of the relevant Tax Treaty [except in rare cases like in article 4(3) of the Indo-USA DTAA]. However, post-amendment through MLI, the DRE would be entitled to Tax Treaty only on conclusion of MAP, the outcome of which is uncertain. The MAP pursuant to Article 4(3) of MLI should not be confused with the MAP pursuant to Article 25 of the OECD Model Tax Convention.

For example, Article 27 of the India-UK Tax Treaty provides that ‘Where a resident of a Contracting State considers that the actions of one or both of the Contracting States result or will result for him in taxation not in accordance with this Convention, he may, notwithstanding the remedies provided by the national laws of those States, present his case to the competent authority of the Contracting State of which he is a resident.’

Whereas Paragraph 58 of the Explanatory Statement to MLI states that where Article 4(1) of MLI denies the benefits of the Covered Tax Agreement, in the absence of the concluded MAP for treaty residence, such denial cannot be viewed as ‘taxation that is not in accordance’ with the provisions of the Covered Tax Agreement.

Accordingly, Article 27 of the India-UK Tax Treaty would not apply for two reasons: (a) by referring to ‘resident of a contracting state’, it is referring to treaty residence and not domestic residence. Since treaty residence is not yet determined, the said clause is not applicable; (b) by referring to taxation that is ‘not in accordance with this Convention’, the said clause is not applicable when Paragraph 58 of the Explanatory Statement is read along with this clause.

Furthermore, MAP concluded under one Tax Treaty (e.g. UK-India Tax Treaty) would not have any precedence when contemplating another Tax Treaty (e.g. Netherlands-India Tax Treaty) and would be time-consuming and exhaustive for the DRE, especially when the MAP discussion fails under one Tax Treaty and it might be late for the DRE to initiate MAP for past years under another Tax Treaty.

Secondly, there is no obligation on the competent authorities to actually reach an agreement. The wording used in Article 4(1) of MLI is ‘shall endeavour’ to agree in MAP, pending which the taxpayer’s treaty entitlement is at stake. The discretion afforded to the Competent Authorities under Article 4 of MLI is wider in scope than the domestic General Anti-Avoidance Rule. Possibly, it was intentional to curtail treaty abuse and provide powers in the hands of the contracting state. Further, if POEM is the key determinant for the Competent Authority, it should be based on a regulated guidance, not at the free discretion of the respective Competent Authorities who may give different relevance to a particular factor. Howsoever it may be, the lifting of corporate veil under a cross-border scenario should be avoided in genuine cases and should be used only as a tool to prevent tax abuse or tax evasion. The form and governance of DRE should be respected to the extent it is appropriate and reasonable.

Thirdly, the DRE would not be entitled to the Tax Treaty, in the absence of mutual agreement, even if MAP discussion is ongoing, where the last sentence of Article 4(1) of MLI is replaced by the specific sentence in Article 4(3)(e) of MLI, or where the DRE would not be entitled to the Tax Treaty except to the extent the Competent Authorities grant some relief to it [assuming Article 4(3)(e) is not applicable]. In the absence of guidelines, the questions that may arise are: That once the MAP is concluded, whether the outcome shall apply to the DRE retrospectively or prospectively? Whether the person who is responsible for payment (payer) to DRE is obliged to withhold taxes without considering the benefit from Tax Treaty, considering that it may not be privy to the MAP or tax conflict? Whether the right to deny treaty entitlement is for the DRE and not for the payer who is obliged to withhold taxes at the applicable Tax Treaty rate or the Act rate, whichever is more beneficial? As a way forward, in order to reduce the hardship, the Competent Authorities should suspend or defer the collection of taxes while MAP discussions are ongoing and provide rules for the taxpayer to comply with withholding tax issues in these scenarios.

Lastly, the DRE should have a right to contest the conclusions drawn under the MAP in an international court or in its resident Contracting Jurisdiction, or under a multilateral arbitration. At present, MLI assumes that the MAP would be concluded in the right manner with right determinants, giving full discretionary power to the Competent Authorities to decide which determinants would be key to determine treaty residence, as against the guidance given in the OECD Commentary for, say, POEM, wherein it has discussed various determinants with examples. As a way forward, the Contracting Jurisdictions that participated in MAP should permit DRE a legal remedy to contest MAP in its domestic forum and, if successful, to allow the court decision to become an addendum to the concluded MAP. Further, if the MAP is not concluded, the DRE is not entitled to the Tax Treaty. DRE should not suffer from permanent fracture for the rigidness of the Competent Authorities. DRE should be provided with legal remedy to resolve the impending dispute.