MLI SERIES -ARTICLE 10 – ANTI-ABUSE RULE FOR PEs SITUATED IN THIRD JURISDICTIONS (Part 2)

1. DIFFERENCE IN LANGUAGE IN BEPS ACTION 6 AND MLI
As mentioned in the first part of this article, there are certain differences between the suggested language in the final report of the BEPS Action Plan 6 and that in Article 10 of the MLI.

The first major difference is in respect of the implication of the application of the Article. In case Article 10 of the MLI applies, the Source State (State S) shall not be restricted by the DTAA and can tax the said income as per the domestic tax law. The draft language in the BEPS Action Report provided that in case the anti-abuse provisions apply, the Source State (State S) can tax income other than dividends, interest or royalties under the domestic tax law. In respect of the specified income, i.e., dividends, interest or royalties, the tax to be charged by the Source State would be restricted to a rate to be determined.

The other difference is in respect of the exemption from application of the anti-abuse rule. This difference is further explained in para 4 of this article.

Another difference between the BEPS Action Plan 6 report and Article 10 of the MLI is in respect of the conditions for triggering of the rule. Article 10 of the MLI applies if the income is exempt in State R and the tax rate in State PE is lower than 60% of the tax rate in State R. The BEPS Report had provided another optional language which can be used, wherein State S can deny the benefits in the treaty if the tax rate in State PE is lower than 60% of the tax rate in State R. In other words, under this optional language the condition that the income should be exempt in State R was not required to be triggered to apply the rule. Similar language has also been provided in the OECD Model Commentary as an optional language that countries can bilaterally negotiate.

While Article 29 of the OECD Model is largely similar to Article 10 of the MLI, there are two significant differences. The first one is discussed in the above paragraph. Another difference is in respect of the 60% threshold. The OECD Model provides that if the tax rate in State PE is less than 60% of the tax rate in State R, the rule would not apply if the tax rate in State PE is higher than a rate which is to be bilaterally agreed.

2. ISSUES ARISING ON ACCOUNT OF DIFFERENCE IN TAX RATES IN STATE PE AND STATE R
Article 10(1) of the MLI provides that in certain circumstances, benefit of the S-R DTAA shall not be available to any item of income on which the tax in State PE is less than 60% of the tax that would be imposed in the State R on that item of income if that PE were situated in State R.

Therefore, the article requires one to first hypothesise a PE of the taxpayer (A Co) in State R and if the rate of tax in State PE on that item of income is less than 60% of the tax on the same item of income in State R, then the benefit of the R-S DTAA shall not be available in State S.

Hypothesising a PE of the taxpayer in State R can result in various issues, some of which are discussed below.

2.1 Which tax rate is to be considered?
This issue is explained by way of an example. Let us assume gross income of 100, expenses of 80 and the tax rate in State R is 30%, the general corporate tax rate on PE in State PE is 20% but due to certain incentives provided by State PE, the tax on income from financing activities is 10%. In such a scenario, the question is should one compare the 30% rate in State R with 20% in State PE or with the actual tax rate of 10% in State PE? If one takes a view that the headline tax rate is to be considered, Article 10 of the MLI may not have an impact as the tax rate in State PE (20%) is more than 60% of the tax rate in State R (30%).

However, in the view of the authors, as Article 10(1) of the MLI refers to tax on an ‘item of income’, one would need to look at the effective tax rate of 10% in this case in State PE and compare the same with that in State R. This view is keeping in mind the objective of the provisions that the State S should not give up its right of taxation to the State R unless the income is taxed by the PE State at a minimum of 60% of the tax which would have been levied in the State R.

A similar view has also been provided in para 166 of the OECD Commentary on Article 29 wherein the mechanism provides that one should compare the ratio of the tax applicable to the net profit of the PE in both states – State PE as well as State R.

2.2 What would be the case if there is a loss in the State PE?
Another issue which arises is what would be the case if there is a loss in a particular year in the State PE. Let us assume the following facts:

In the above case, in Year 1, the tax paid in State PE is Nil on account of the loss. Assuming that the mode of claiming deduction, etc., and the amount of deduction in State R is similar to that in State PE (refer para 3.3.4 for issues arising on account of difference in the mode of computation in both the jurisdictions), no income is taxed in State R and therefore one may be able to argue that in Year 1 Article 10 of the MLI is not triggered as the rate of tax in State PE is more than 60% of the rate of tax in State R on the same item of income.

Now, in Year 2 in State PE the tax payable would be 2 (20% of 10) as one would reduce the loss brought forward from Year 1 while computing the income of Year 2. This would be possible even in the absence of a specific provision in the domestic tax law of State PE on account of Article 24 of the State R-State PE DTAA, dealing with Non-Discrimination, which provides that a PE in a jurisdiction should be taxed in the same manner as a resident of the said jurisdiction1. Now, in State R, assuming that the taxpayer has other income as well, no set-off of loss would be possible as the income of a resident is taxed on a net basis (i.e., by aggregating the income of any PE in that State as well as the head office in that State) and, therefore, there is no loss brought forward. In such a case, the tax paid in State R in Year 2 would be 9 (30% of 30) and as the tax paid in State PE is less than 60% of the tax paid in State R, Article 10 of MLI could trigger even though the tax rate on the item of income in State PE (20%) is more than 60% of the tax rate on the said item of income in State R (30%).

However, in the said fact pattern, in the view of the authors, Article 10 of the MLI should not trigger as the difference is only on account of the losses incurred in State PE and due to the fact that other income earned in State R is used to set-off the loss of the PE in Year 1, resulting in no carry forward of the loss.

Alternatively, a better view of the matter would be to hypothesise the PE as a separate entity in State R and then compare the tax payable in State R and State PE. This view is in line with the objective of the provisions, which is to deny treaty benefits if the tax rate in State PE is less than 60% of the tax rate in State R on that item of income.

2.3 Whether tax credit in State PE or State R of taxes paid in State S to be considered?
The question arises whether one should compare the taxes in State R and State PE or should one ignore the tax credit for such comparison. Let us consider the following illustration:

In the above illustration, if one does not consider the tax credit, the tax rate in State PE (20%) is more than 60% of the tax rate in State R (30%) and therefore Article 10 of the MLI should not be triggered. However, assuming that State PE applies the Non-Discrimination article as mentioned in the first part of this article, and grants credit for the taxes paid in State S, the actual tax paid in State PE would be 2.

Further, while State R would actually not provide any tax credit (as it follows the exemption method), when one hypothesises a PE in State R, tax credit for taxes paid under the R-S DTAA would also be considered. In such a scenario, the hypothetical tax payable in State R after tax credit would be 4 and if one now compares the taxes in State PE (2) with that of State R (4), Article 10 of the MLI could be triggered.

However, in the view of the authors, given the objective of the provisions, the comparison should be in respect of the taxes before the tax credit as one is trying to evaluate if the tax in State PE is substantially lower than the tax in State R. One may also draw a similar conclusion from para 166 of the OECD Commentary on Article 29 which refers to ‘tax that applies’ to the relevant item of income and not tax paid.

2.4 Issue relating to difference in the mode of computation of income in State R vs. in State PE
Given that each country has a different set of rules for computing income, there may be a difference in the tax applicable on an item of income on account of the difference in the mode of computation in these jurisdictions.

Let us first take an illustration wherein the income is taxed on a net basis in State PE, but on gross basis in State R. This could be possible, say in the case of dividend received from a foreign company and taxed on gross basis akin to section 115BBD of the Act. The facts of the illustration are as follows:

In the above illustration, the tax payable in State PE would be 4 (20% of 20). On the other hand, if one hypothesises a PE in State R, given that State R taxes the income on gross basis (irrespective of whether the resident has a PE in the Residence State or not), the hypothetical tax payable in State R would be 10 (10% of 100).

In such a scenario, even though the headline tax rate in State PE is in fact higher than the tax rate in State R, given that State PE taxes the PE on a net basis whereas State R taxes the income on gross basis, Article 10 of the MLI could be triggered as the tax applicable on the item of income in State PE (4) is less than that applicable in State R (10).

Another issue arises where the amount of deduction allowable is different in both the jurisdictions. Let us take an illustration wherein the facts are as follows:

In the above illustration, the tax payable in State PE is 4 (20% of 20) whereas the tax payable in State R if the PE was in State R is 12 (30% of 40). Therefore, even though the headline tax rate in State PE (20%) is more than 60% of that in State R (30%), Article 10 of the MLI would trigger as one needs to compare the tax applicable on an item of income in accordance with the provisions applicable in the respective jurisdictions.

This is also in line with the objective of the provisions.

3. PARA 2 OF ARTICLE 10 OF MLI – WHAT IS CONSIDERED AS ACTIVE CONDUCT OF BUSINESS
Para 2 of Article 10 of the MLI provides that the anti-abuse provisions of Article 10 of the MLI shall not apply if the income is derived in connection with or is incidental to the active conduct of a business carried out through the PE. The exception to the exemption is the business of making, managing or simply holding investments for the enterprise’s own account. However, if the business of making, managing or holding investments represents banking, insurance or securities activities carried on by a bank, insurance enterprise or registered securities dealer, respectively, it would be covered under the exemption from the application of the anti-abuse rules.

Paras 167, 74, 75 and 76 of OECD Commentary on Article 29 provide some guidance on what would be considered as income derived in connection with or incidental to the active conduct of business. The Commentary provides that whether an item of income is derived in connection with active business it must be determined on the basis of the facts and circumstances of the case.

Let us look at the following examples to understand whether income in the form of dividend, interest or royalty can be considered as derived in connection with the active conduct of business of the PE:
a. A Co, resident of State R, is in the business of trading securities through its office situated in State PE. As a part of the trading activity, it invests in shares of B Co, a company resident of State S, which pays dividends to A Co. Such dividends may be considered as income derived in connection with the active conduct of business by the PE of A Co in State PE and therefore the anti-abuse provisions in Article 10 would not apply.
b. Similar to the facts above except that instead of investing in shares, A Co invests in debt securities of B Co and trades in such debt securities… In such a scenario, interest earned by A Co may be considered as income derived in connection with the active conduct of the business by the PE of A Co.
c. A Co, a resident of State R, sets up a research and development centre in State PE. It licences the intangible arising out of such R&D to B Co, a company resident of State S, which pays royalty to A Co. Such royalty would be considered as income derived in connection with the active conduct of business by the PE of A Co in State PE.

The draft language in the final BEPS Action Plan 6 report also specifically exempted from the application of the anti-abuse provisions, royalties received as compensation for the use of, or the right to use, intangible property produced or developed by the enterprise through the PE. However, given that such an activity would in any case constitute an active conduct of business by the PE, such language is not provided in the final provisions in the MLI.

4. PRACTICAL APPLICATION OF MLI ARTICLE 10 FOR INDIA TREATIES
4.1 Treaties impacted
The Table below highlights the countries and their position with India in relation to applicability of Article 102:

4.2 India as a country of source
Article 10 of the MLI gives the Source State an unhindered right of taxing the income if certain conditions are triggered. As the Source State is denying the benefits of the DTAA, it is important to evaluate from a payer perspective whether the particular provision of the DTAA shall apply in the Source State or not.

Unlike the other TDS provisions in the Act, in most cases section 195 of the Act, in theory, results in the finality of the tax being paid to the Government in the case of payment to a non-resident.

Therefore, the Act places a significant onerous responsibility on the payer to ensure that the due tax is duly deducted u/s 195 of the Act in the case of payments to a non-resident. Keeping this in mind, it is therefore necessary for the payer to evaluate the application of Article 10 of the MLI before granting treaty benefits at the time of deduction of tax u/s 195 of the Act.

Generally, in the background of the application of MLI, a conservative view is to always approach the tax authorities u/s 195(2) or u/s 197 before making any payment. However, from a practical perspective, the same may not be feasible given the timelines for obtaining such a certificate.

On the other hand, while Article 10 of the MLI provides objective tests and does not contain subjective tests such as the Principal Purpose Test, there are certain practical challenges for a payer to apply these objective tests. The payer of the income is expected to analyse the following:
a. Whether the recipient has a PE in a third State;
b. Whether the amount paid by the payer is effectively connected to such PE in the third State;
c. Whether the Residence State exempts such profits of the PE;
d. Whether the tax rate in the third State of PE is less than 60% of the tax rate of the Residence State if such PE were situated in the Residence State.

The above questions would require the payer of income to interpret the tax laws of the third State in which the PE is constituted as well as the Residence State, which may not be possible. It may not be possible for the local consultant to interpret such foreign laws as well.

Therefore, it may be advisable for the payer to obtain a suitable declaration from the recipient while making such payment.

4.3 India as a country having PE
Prior to introduction of the MLI, Article 5 of the DTAA was referred to in order to establish the PE status. However, post introduction of the MLI, the PE status is governed by Articles 12 to 15 which are regarding PE status based on Action 7 of Base Erosion and Profit Shifting (BEPS).

Articles from 12 to 15 are not minimum standards. Thus, each country has an opportunity to reserve or notify applicability of these standards. The provisions of the above mentioned Articles widens the scope of PE as compared to that of the DTAA.

However, India has notified the provisions of Articles 12 to 15. Thus, in cases where the other country’s notification matches with India and India is a third state having PE, one will have to check the DTAA after giving effect to Articles 12 to 15 of the MLI.

However, Indian tax rates are very high, discouraging a potential abuse using India as a third state (State PE). Consequently, Article 10 is likely to have minimal applicability with India as a third state (State PE).

It is important to note that Article 10 does not, in any way, affect India’s right to tax the income attributable to the PE of the non-resident in India in accordance with the relevant DTAA.

4.4 India as a country of residence
As per the existing provisions of the DTAA, India has been following the credit method and not the exemption method. Further, India has reserved its rights regarding the applicability of Article 5 (Application of Methods for Elimination of Double Taxation) of the MLI.

Thus, in cases where India is a Resident State, paragraph 1 of Article 10 may not be of much relevance as India does not follow the exemption method.

5. CONCLUSION
Anti-abuse rules are necessary to prevent abuse of tax treaty provisions. However, when there are multiple anti-abuse rules under the Act as well as treaty, cohesive, coordinated and appropriate application of these anti-abuse rules becomes very necessary to avoid any uncertainty or hardships to the taxpayer. Rational interpretation of these anti-abuse provisions has become of utmost importance so that genuine business structures are not affected and stuck with litigations.

From a payer’s perspective, Article 10 of the MLI can have serious consequences. Further, as highlighted in the earlier paras, there are practical challenges a payer might face while evaluating the application of this Article, particularly as one would need to interpret the tax laws and treaties of other jurisdictions which may not always be possible. A practitioner who is certifying the remittances in Form 15CB may also need to evaluate the impact and, at the very least should seek a suitable declaration from the recipient of the income.