Limitation of Benefits Articles – Concept and its Application in Indian Tax Treaties

1. Introduction :

1.1 While making cross-border investments, a tax-payer usually looks forward to, among others, the following objectives :

(a) protection against double taxation;

(b) achieving certainty in respect of quantum of tax liability, including withholding taxes;

(c) a tax-efficient structure; and

(d) hassle-free tax regulatory environment.

1.2 For achieving the above objectives, many a time appropriate tax treaties are used. Taking advantage of the Double Taxation Avoidance Agreement (DTAA) between two countries by a resident of third country is known as treaty shopping.

Of late, the tax authorities have expressed apprehensions on misuse of tax treaties, whether by way of treaty shopping or otherwise. As a result of the problems created by treaty shopping, strong views are expressed that a tax treaty should not facilitate tax avoidance and therefore, the common practice of treaty shopping should be restrained by incorporating various safeguards.

1.3 There has been a conscious attempt on the part of various countries to incorporate the concept of ‘Limitation of Benefits’ (LOB) in tax treaties, to ensure that their tax base is not eroded by foreign companies taking advantage of tax treaty network by way of treaty shopping, etc. Thus, the concept of LOB assumes lot of significance while studying and interpreting the international tax treaties.

1.4 The Supreme Court (SC) in Union of India v. Azadi Bachao Andolan, (263 ITR 706), observed as under :

“. . . . if it was intended that the national of a third state should be precluded from the benefits of Double Taxation Avoidance Convention, then a suitable term of limitation to that effect should have been incorporated therein . . . . The appellants rightly contend that in the absence of a limitation clause, such as the one contained in Article 24 of the Indo-U.S. Treaty, there are no disabling or disentitling conditions under the Indo-Mauritius Treaty prohibiting the resident of third nation from deriving benefits thereunder . . . . .”

Thus, the SC decision in Azadi Bachao appears to be a catalyst for India to take note and insist on the LOB clause in its tax treaties.

2. Meaning and Concept of Limitation of Benefits :

2.1 The terms ‘Limitation on Benefits’ or ‘Limitation of Benefits’ or ‘Limitation of Relief’ as are used in tax treaties, are generally not defined under the international tax treaties. At times, the relevant Articles/Clauses may not also be titled as such. The LOB provisions are intended to prevent treaty shopping, whereby an entity can be established without any economic connection, so that access can be had and thereby the benefits of treaty obtained. The LOB prevents treaty shopping and thus tax avoidance by denying treaty benefits to unintended beneficiaries who channel their investments through entities formed in a treaty country without being the resident thereof. The concept underlying such a provision is that a contracting state should accord treaty benefits only if the recipient of income has sufficient nexus with the other contracting state.

2.2 The IBFD International Tax Glossary defines the term ‘Limitation on Benefits Provision’ as under :

“Provision which may be included in a tax treaty to prevent treaty shopping e.g., through the use of a conduit company. Such provisions may limit benefits to companies which have a certain minimum level of local ownership (‘look-through approach’), deny benefits to companies which benefit from a privileged tax regime (‘exclusion approach’) or which are not subject to tax in respect of the income in question (‘subject-to-tax approach’), or which pay on more than a certain proportion of the income in tax-deductible form (‘channel approach’ or ‘base erosion rule’) . . . .”

2.3 From the above definition, it is apparent that LOB provisions are included in the tax treaties mainly to put restriction on availment of treaty benefits by a conduit company or an entity formed for the purposes of treaty shopping. However, the concept of LOB could also include the following :

(a) Look-through approach : Such provisions may limit benefits to companies which have certain minimum level of local ownership. Treaty benefit may be denied to a company not owned, directly or indirectly by residents of a state of which the company is resident.

(b) Subject-to-tax approach : Such provision may deny benefits to companies which are not subject to tax in respect of the income in question in the state of residence. Treaty benefits in the state of source are granted if the income in question is subject to tax.

(c) Channel approach : The provisions may deny benefits to companies which pay more than a certain percentage of the income in tax-deductible form to non-qualified entities. The treaty benefits could be denied if substantial interest in the company is owned by the residents of a third country and more than 50% of the income is used to satisfy claims by such persons.

(d) Exclusion approach : Such provisions may include denying treaty benefits (such as dividends, interest or capital gains) to specific type of companies enjoying tax privileges in the state of residence.

(e) Specific condition to be fulfilled with respect to exemption from particular category of income e.g., the Protocol to the India–Singapore DTAA provides for specific condition to be fulfilled by an entity for claiming exemption from capital gains tax in the source country.

(f) Specific LOB Articles dealing in general with conduit entities or treaty shopping or entities attempting to claim double non-taxation e.g., Indian DTAAs with countries such as UAE, Namibia, Kuwait, Saudi Arabia contain specific LOB Articles dealing in general with the treaty shopping or double non-taxation.

(g)OECD Model Convention in Article 10(2)(a) relating to concessional rate of tax on dividends in case of companies, provides for beneficial ownership of the minimum threshold percentage of the capital of the company paying the dividends. Many DTAAs entered into by India contain such clauses with varying threshold limits. Similarly, the interest and royalties and fees for Technical Services Articles restrict the benefit of lower rate of tax provided in those articles to only ‘beneficial owner’ of the respective incomes.

3. LOB Articles in the Model Conventions:

3.1 The OECD and UN Model Conventions do not contain separate Article in respect of LOB clause.

However, Commentary on OECD Model Tax Convention, July, 2008 update in para 20 on page 54, under Commentary on Article 1 provides as under:

“20. Whilst the preceding paragraphs identify different approaches to deal with conduit situations, each of them deals with a particular aspect of the problem commonly referred to as ‘treaty shopping’. States wishing to address the issue in a comprehensive way may want to consider the following example of detailed limitation-of-benefits provisions aimed at preventing persons who are not resident of either contracting states from accessing the benefits of a Convention through the use of an entity that would otherwise qualify as a resident of one of these states, keeping in mind that adaptations may be necessary and that many states prefer other approaches to deal with treaty  shopping:………..”

Thus, in para 20 of Commentary on Article I, the OECD has given example of detailed limitation of benefits provisions, which the states may adopt.

3.2 Article 22 of the United States Model Income-tax Convention of November 15,2006 contains separate article in respect of limitation on benefits. United States Model Technical Explanation accompanying the United States Model Income-tax Convention of November IS, 2006 gives detailed explanation and examples in respect of LOB Article. The reader would greatly benefit by going through the said explanation and examples in this regard. Article 24 of the India-US DTAA contains the provisions relating to limitation on benefits.

4. LOB Clauses in Indian Tax Treaties:

4.1 At present 8 DTAAs entered into by India with Armenia, Iceland, Namibia, Kuwait, Saudi Arabia, Singapore, USA and UAE contain separate articles in respect of LOB.

In addition, India’s recent treaties with Mexico (signed on September, 10, 2007) and Luxemburg (signed on June 2, 2008) contain LOB Articles, although both the treaties are yet to be notified by the Government of India.

4.2 The text of the relevant LOB Articles in the above-mentioned 8 DTAAs, is given below for ready reference .

Conclusion:

From the above, it is clearly evident that the significance of articles relating to Limitation of Benefits clause cannot be undermined. All concerned parties would need to pay specific attention to LOB clauses in India’s Tax treaties. India is increasingly including Limitation of Benefits clause in the new treaties and in some cases including the same in the existing treaties by renegotiating existing treaties through the protocols as in the cases of Singapore and UAE. A taxpayer would be well advised to look for and examine relevant LOB clauses very minutely before taking any decisions ‘in relation to the relevant DTAAs.