Issue for consideration
The primary right of taxing an income of its subjects is accepted internationally to be that of a country of residence (‘Residence State’ ), irrespective of the time and place of earning an income. This rule does not preclude the country of source (‘Source State’) from taxing an income. To avoid double taxation of the same income, countries enter into agreements, to provide that only one of the two countries shall tax an income and the other shall not do so (Income Elimination or Exemption Method ‘IEM’), or to provide for credit for taxes paid ( Tax Credit Method-‘TCM’) in the country of source while taxing the same income in the country of residence. In cases of some income, for example, royalty, fees for technical services, interest, dividends etc., these agreements provide for taxing income in the country of source at a concessional rate. Income arising from an immovable property is generally taxed in the country of source. Likewise, business income is taxed in the country of source provided the businessman has a permanent establishment(‘PE’) in that country. In the same manner, income of a service provider is taxed in the country of source only, when he has a fixed base in that country or his stay in that country exceeds a certain number of days.
These above general rules of taxation or assumptions underlying international taxation, like any contract, are subject to any agreement to the contrary by the contracting countries. Countries which execute Double Taxation Avoidance Agreements (‘DTAA’) may agree to adhere to the generally accepted principles of taxation or may agree to differ from them by mutual agreements executed to the contrary.
DTAAs, to give effect to the intentions of the countries, employ different terminologies like; ‘shall be taxed’, ‘shall be taxed only’, ‘may be taxed’, ‘may also be taxed’, ‘may be taxed in’, ‘shall be taxed only in’, ‘shall only be taxable’, etc. Different treatments may be provided for different sources of income in the same DTAA by employing suitable language. It is commonly understood that an income will be taxed in one country only when the DTAA employs the terms like ‘shall be taxed’ or ‘shall be taxed only’. The income will be taxed in both the countries where a DTAA uses ‘may also be taxed’. The employment of the term ‘may be taxed’ however has posed serious issues of interpretation in the Indian context. One school of thought is of the view that use of words ‘may be taxed’ mean that the Source State has the exclusive right of taxation leading to complete exclusion of right of taxation for the Residence State . The other school is of the view that the use of the words ‘may be taxed’ preserves the right of taxation of the Residence State while conferring non-exclusive rights on the Source State. Conflicting decisions available on the subject are discussed here.
Ms. Pooja Bhatt’s case
The issue arose before the Mumbai bench of the ITAT in the case of Ms. Pooja Bhatt v. Dy.CIT, 26 SOT 574. In that case, the assessee, an Indian resident, had received income from performing stage shows in Canada on which tax was deducted in Canada. The assessee claimed that such income was not taxable in India in view of the India Canada DTAA, 229 ITR 44 (St.). The issue needed to be examined particularly under Article 18 of the said DTAA , which reads as under:
Article 18 ; Artistes and athletes
Notwithstanding the provisions of Articles 7, 15 and 16, income derived by entertainers, such as theater, motion picture, radio or television artistes and musicians, and by athletes, from their personal activities as such may be taxed in the Contracting State in which these activities are exercised.
……….
Strong reliance was placed by the revenue on Article 23 “Elimination of double taxation”, to contend that the insertion of a specific provision for granting tax credit by the Residence State while taxing the income of the resident confirmed the intention to tax such income in both the states. Paragraph 1 of this Article, providing that the laws in force in either of the Contracting States will continue to govern the taxation of income in the respective Contracting States except where provisions to the contrary were made in the Agreement, was greatly relied upon. (For the sake of brevity, this article is not reproduced here.)
The assessee, a film artiste, participated in an entertainment show performed in Canada and received a sum of USD 6000. Tax was deducted at source in Canada equal to the sum of USD 900. The assessee claimed in the course of assessment proceedings that a sum of Rs. 1,86,000 (US dollars 6000) could not be taxed in India in view of Article 18 of India-Canada Treaty, which contention was rejected by the AO. The AO found that the assessee was a resident of India and consequently, it was held by him that her entire global income was taxable under the provisions of the Income-tax Act, 1961 . It was further observed by him that the assessee was entitled to relief under Article 23(3)(a) of the DTAA. On appeal, the CIT(A) confirmed the order of the AO. Aggrieved by the same, the assessee filed an appeal before the Tribunal.
On behalf of the assessee, it was contended that by virtue of Article 18 of the India-Canada Treaty, the income derived by an artiste or an athlete by performing shows/activities in Canada could not be taxed in India, since Article 18 permitted only the other contracting State, i.e., the source country to tax such income. In support of the proposition, reliance was placed on the decisions of the Hon. Supreme Court in the cases of P.V.A.L. Kulandagan Chettiar 267 ITR 654 and Turquoise Investment & Finance Ltd., 300 ITR 12, and on the decision of the Madras High Court in the case of CIT v. VR. S.R.M. Firm, 208 ITR 400 [affirmed by the Supreme Court in Kulandagan Chettiar’s case (supra)], wherein the expression “may be taxed” was interpreted to mean that the other contracting State was precluded from taxing the income.
On the other hand, the Revenue submitted that the decision of the Supreme Court in Kulandagan Chettiar’s case (supra) was on the issue of domicile, that the expression “may be taxed” was never construed by the court, that the Madras High Court decision was affirmed on different reasoning and, therefore, Supreme Court decision relied on by the assessee was distinguishable. Reliance was placed on the decision in the case of S. Mohan, In re [2007] 294 ITR 177(AAR) wherein the expression ‘may be taxed’ was construed and it was held that such words did not preclude the contracting State of residence taxing the same, if the assessee was liable to tax under the domestic law. According to this judgment, the assessee was only entitled to double taxation relief if tax had been paid in the source country. It was also submitted that the Supreme Court decision in Kulandagan Chettiar’s case (supra) was distinguished by the AAR, observing that the Supreme Court did not express any opinion regarding the scope of the expression “may be taxed”.
The Revenue further submitted that the India-Canada Treaty was similar to the OECD Model Convention and, therefore, its meaning should be understood as per the OECD Commentary. It was further submitted that there were two categories of treaties. According to one category, the relief was provided by way of exemption from tax, like in the India-Austria Treaty, and the other category was where relief was given by way of credit in respect of tax paid in other country, such as India-Canada Treaty. Therefore, the assessee was only entitled to credit for the tax paid in Canada as per the provisions of Article 23 of India-Canada Treaty. Reference was also made to page 971 of the Commentary by Klaus Vogel to contend that tax could be levied by both countries. Regarding the judgment of the Supreme Court, it was submitted that India- Malaysia Treaty considered by the Apex Court came into effect from 1-4-1973 when OECD Commentary was not in existence and, therefore, the court refused to look into the commentary. However, in the present case, the OECD Commentary was very much in existence at the time of agreement between the two countries and, therefore, the provisions of treaty should be understood as per the OECD Commentary.
The tribunal noted the undisputed facts that – (i) the assessee was a resident of India, (ii) she was an artiste who performed the entertainment show in Canada for which she was paid US Dollars 6,000 equivalent to Indian Rupees 1,86,000, (iii) tax of 900 US Dollars was deducted at source in Canada; there was also no dispute that as per the domestic law, the assessee was liable to pay tax on her entire global income. The question was whether liability to pay tax under the domestic law could be avoided in view of the provisions of Article 18 of the India-Canada Treaty.
On consideration of the rival contentions, the tribunal held that income derived by the assessee from the exercise of her activity in Canada was taxable only in the source country, i.e., Canada. On an analysis of various Articles contained in Chapter III, the tribunal found that the scheme of taxation was divided in three categories; The first category included Article 7 (Business profits without P.E. in the other State), Article 8 (Air transport), Article 9 (Shipping), Article 14 (capital gains on alienation of ships or aircrafts operated in international traffic), Article 15 (Professional services), Article 19 (Pensions) all of which provided that income shall be taxed only in the State of residence. The second category included Article 6 (Income from immovable property), Article 7 (Business profits where PE is established in other contracting State), Article 15 (Income from professional services under certain circumstances), Article 16 (Income from dependent personal services where employment is exercised in other contracting State), Article 17 (director’s fees), Article 18 (income of Artistes and Athletes), Article 20 (Govt. Service), all of which provided that such income may be taxed in the other contracting State, i.e., State of source. The third category included Article 11(Dividends), Article 12 (Interest), Article 13 (Royalty and fee for technical services), Article 14 (capital gains on other properties) and Article 22 (Other income), all of which provided that such income may be taxed in both the contracting States.
The tribunal noted that this clearly showed that the intention of parties to the DTAA was very clear. Wherever the parties intended that income was to be taxed in both the countries, they had specifically provided in clear terms and as such, it could not be said that the expression “may be taxed” used by the contracting parties gave option to the other contracting State to tax such income. Contextual meaning had to be given to such expression and if the contention of the revenue was accepted, then the specific provisions permitting both the contracting States to levy tax would become meaningless. The conjoint reading of all the provisions of Articles in Chapter III of India-Canada Treaty, led to only one conclusion that by using the expression “may be taxed in the other State”, the contracting parties permitted only the other State, i.e., State of source, to tax such income and by implication, the State of residence was precluded from taxing such income. Wherever the contracting parties intended that income may be taxed in both the countries, they had specifically so provided and the contention of the revenue that the expression “may be taxed in other State” gave the option to the other State and that the State of residence was not precluded from taxing such income, was unacceptable.
The reliance of the revenue on Article 23, the tribunal observed, was also misplaced as this provision had been made in the treaty to cover the cases falling under the third category i.e., the cases where the income might be taxed in both the countries. The cases falling under the first or second categories would be outside the scope of Article 23, since income was to be taxed only in one state.
Reliance placed by the revenue on the commentary by Klaus Vogel was found to be untenable by the tribunal, on the ground that it was now the settled legal position that commentaries could be looked into as a guiding factor only where the language of the treaty was ambiguous. In support of this view, a reference was made to the Supreme Court decision in the case of Kulandagan Chettiar (supra). In the case before them, it was found that the intention of the contracting parties was very much clear from the treaty itself. In any case, the commentaries were not binding on courts, since the same were of persuasive value or indicative of contemporaneous thinking, and the parties to the agreement were always at liberty to deviate from the same. Even assuming that the commentary supported the stand of the revenue, the same could not be accepted, since parties to the agreement had deviated from the same, clearly indicating their intention in the treaty itself.
The tribunal supported its view by referring to the Madras High Court decision in VR. S.R.M Firm (supra) where the assessee was resident of India and had earned profit on sale of immovable property in Malaysia. Article 6 of Indo-Malaysia Treaty provided that such income may be taxed in the State in which such property was situated. The assessee claimed that he was not liable to pay tax on such income in view of Article 6 of the treaty. In the above facts, the court had held that the income was taxable only in Malaysia. The tribunal observed that since the above decision had been affirmed by the Apex Court, there was no scope for taking a different view, though the Apex Court had observed that the decision of the Madras High Court was being affirmed for different reasons; the conclusion, however. remained that income could not be assessed in the State of residence, where the agreement provided that income may be taxed in the source country.
The tribunal also supported its view by referring to the decision of the Madhya Pradesh High Court in the case of Turquoise Investment & Finance Co. (supra) where the court, following the decision of the Madras High Court in the case of VR.S.R.M. Firm (supra), held that income arising on the sale of immovable property in Malaysia could not be taxed in India. It noted that the similar issue was decided in favour of the assessee by the Karnataka High Court in the case of CIT v. R.M. Muthaiah, 202 ITR 508. In that case also the assessee who was resident in India had earned income in Malaysia and claimed the same as exempt from tax in India in view of DTAA between India and Malaysia.
The AAR decision in the case of S. Mohan (supra) was found by the tribunal to be based on the interpretation of Article 16 in isolation i.e., without considering the scheme of taxation under the treaty, and the tribunal therefore did not follow the said decision.
It was held that the assessee could not be taxed in respect of the sum of Rs. 1,86,000 under the provisions of the Income-tax Act, 1961 in view of the overriding provisions of the India-Canada DTAA.
Telecommunications Consultants India Ltd.’s case
The issue recently arose in the case of Telecommunications Consultants Ltd. , 18 ITR(Trib.) 363, before the Delhi bench of the Tribunal. The assessee, a public sector undertaking owned by the Government of India under the administrative control of the Ministry of Communications, was in the business of providing full range of consultancy, design and engineering services in all fields of telecommunication in India as well as abroad. On the global front, the assessee had executed turnkey/consultancy projects in many countries in Africa and Middle East, besides South and South East Asian and CIS Countries.
The main issue involved in the appeals before the tribunal was regarding the taxability in India of income earned in a foreign country by the assessee, which was a resident of India. The relevant grounds of appeal read as under :-
“5. That on the facts and circumstances of the case and in law, the Learned CIT (Appeal) has erred in confirming the action of the Assessing Officer that the business income amounting to Rs. 10,68,26,533 attributable to the Permanent Establishment(s) of the appellate located in Oman, Mauritius, Netherlands and Tanzania, is exigible to income tax in India under the scheme of the Act.
6. That on the facts and circumstances of the case and in law, the Learned CIT (Appeal) has erred in ignoring that the business income amounting to Rs. 10,68,26,533 is attributable to the Permanent Establishment(s) of the appellate located in Oman, Mauritius, Netherlands and Tanzania, are countries with which India has Comprehensive Agreement for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to taxes on income.”
The assessee claimed that such income was taxable only in the respective countries as per the DTAA and not taxable in India. It submitted that the income attributable to the permanent establishment in the foreign country, with whom DTAA was in existence, should not be considered for the purposes of Indian taxation . It advanced the following contentions in support of its stand;
(i) For the purposes of interpretation of an international treaty, an important aspect that needed to be considered was that treaties were negotited and entered into at a political level and have several considerations as their basis.
(ii) The main function of a DTAA was to provide a bargain between two treaty countries as to the division of tax revenues between them in respect of income falling to be taxed in both jurisdictions. [Azadi Bachao Andolan, 263 ITR 706 (SC)].
(iii) Primary objective of the DTAA entered into by India was avoidance of double taxation and not relief from double taxation. [Sivagami Holdings (P.) Ltd. 20 taxmann.com 166 (Chennai) wherein the ITAT had held that the DTAA was entered into between the countries only for the limited purpose of avoiding the hardship of double taxation and if the income was not taxed in the Contracting State, holding that the same should be taxed in India was an oversimplified statement on the whole regime of DTAA].
(iv) The prime motivating factor in developing the concept of DTAA was the genuine hardship of the international assessee that the same amount of income became the subject of taxation both in the home state and in the Contracting State. It was to alleviate this burden of double taxation that the instrument of DTAA had evolved through the process of law.
(v) The mechanism of providing relief in the form of credit was only when, in accordance with the provisions of the DTAA, double taxation could not be avoided. Article 23 of OECD model convention would be applicable only where income may be taxed in both countries. In the instant case, since the income arising from the permanent establishment (PE) was taxable only in the country of source in accordance with Article 7 of the applicable DTAA, application of Article 23 did not arise. [Vr. S.R.M. Firm 208 ITR 400 (Mad.)].
(vi) Article 4 of the OECD model convention defined “residence” and the determination of residency was not in question. The assessee was a tax resident of India, which was an uncontroverted fact. Therefore, any analysis or reliance on Article 4 of OECD Model Convention (Residence) in respect of residency was not proper and was misplaced.
(vii) Article 7 of the applicable DTAA provided that the profits of an enterprise of the Contracting
State shall be taxable only in the State unless the enterprise carries on business in the other Contracting State through a PE situated therein. Therefore, once the Revenue accepted that there was a PE outside India, its profits would be taxable only in the country of source according to Article 7, and residence would not be a determinative criteria. [Lakshmi Textile Exporters Ltd. 245 ITR 521 (Mad.)].
(viii) The classification of the Articles under the DTAA from the OECD Commentary merits consideration in view of the discussion in Ms. Pooja Bhatt, 26 SOT 574 (Mum.) which clearly stipulated that the language of Article 7 which included the phrase ‘may be taxed’ meant the Contracting States permitted only the other Contracting State i.e. State of source of income, to tax such income.
(ix) From a perusal of the judgment of the Hon. Apex Court in Kulandagan Chettiar, [supra], it could not be inferred that the reasons given by the Special Bench of Hon. ITAT were incorrect, merely because the decision of the Hon. Tribunal was upheld by the Hon’ble Supreme Court for different reasons. [Mideast India Ltd. 28 SOT 395 (Delhi)].
(x) The ITAT in this judgment on appreciating Article 7 of the relevant DTAA also held that the profits derived from the business carried on through a PE in a contracting State by a resident or an enterprise of the other contracting State, was liable to be taxed in the first mentioned State to the extent the same was directly or indirectly attributable to the PE and the same thus shall not be taxable in other contracting State. The profit in question was earned by the assessee in USSR through its PE in that country and since it was not the case of the revenue that the assessee company had no PE in USSR or that any portion of the profit earned by it in USSR was not attributable to that PE, it followed that the entire income earned by the assessee in USSR through its PE was chargeable to tax in that country as per Article 7(1) of the DTAA between India and USSR.
(xi) The Bombay High Court in the case of Essar Oil , 345 ITR 443 in the context of India-Oman DTAA has observed that since the taxpayer has a PE in Oman, in view of Article 7 of the DTAA, the profits earned in Oman were rightly excluded in India.
(xii) The case of ITO (OSD) v. Data Software Research Co. (P) Ltd., 288 ITR 289(Mad.), could be regarded as ‘per incuriam’ i.e. was rendered without having been informed about binding precedents that were directly relevant rendered in the matter of S.R.M. Firm (supra) by the jurisdictional High Court. According to the doctrine of ‘per incuriam’, any judgment which had been passed in ignorance of or without considering a statutory provision or a binding precedent was not good law and the same ought to be ignored. [Siddharam Satlingappa Mhetre v. State of Maharashtra AIR 2011 SC 312].
(xiii) Reliance on OECD Commentary on Model Tax Convention had not been accepted by the Courts of India as having a precedent value. [ Pooja Bhatt (supra) and Kulandagan Chettiar (supra)].
(xiv) The AAR ruling in S. Mohan, In re [2007] 294 ITR 177 as adverted during the course of the hearing did not in any way support the contention of the Department, since it had been observed in the ruling that the language of treaty provision in which the expression ‘may be taxed’ was used in Indo-Malaysia DTAA which was under consideration in Kulandagan Chettiar ( supra) was not comparable to the language employed in Article 16(1) of Indo-Norway DTAA, which was the subject matter of S. Mohan’s ruling.
(xv) According to the provisions of Section 255, where an earlier co-ordinate bench had taken a decision, a subsequent bench could not differ from such a decision on similar set of facts. In such cases, the matter had to be referred to the President to refer the case to a larger bench. [Sayaji Iron & Engg Co.,121 Taxman 43 (Guj.)].
On behalf of the Revenue, attention of the tribu-nal was invited to some fundamental principles of international taxation, to emphasise that where a contracting state is given exclusive right to tax a particular kind of income, then relevant article of convention used the phrase ‘shall be taxable only’; that as a rule, such exclusive right was given to state of residence, though there were a few articles where exclusive right to tax was given to state of source also; that the phrase ‘shall be taxable only’ precluded other contracting state from taxing that income’ for an item of income; where attribution of right to tax was not exclusive, the convention used the phrase ‘may be taxed’; regarding ‘dividend’ and ‘interest’ income’, primary right of taxation was given to state of residence, though this was not exclusive right as paragraph 1 of relevant articles 10 and 11 of model OECD convention used the phrase “may be taxed’ and at the same time, paragraph 2 of said articles used phrase ‘may also be taxed’ and gave simultane-ous taxing rights to state of source. For these two items of income, no state was given exclusive right to tax. It was further impressed that where for an item of income the phrase ‘may be taxed’ in state of source was used and nothing was mentioned about taxing right of state of residence in convention itself, then state of residence was not precluded from taxing such income and could tax it using inherent right of state of residence to tax global income of its resident. It was only when the state of source was given exclusive right to tax an item of income by using the phrase ‘shall be taxable only’, then the state of residence was precluded from taxing it and it meant state of residence had voluntarily given up its inherent right to tax.
The Revenue highlighted that the assessee was a resident of India and thus being state of residence, India had inherent right to tax global income of as-sessee as per section 5 of IT Act, 1961; it had a PE in foreign countries with whom India had entered into DTAA and had opted for application of DTAA u/s 90(2) of IT Act; the character of income under issue was business income and therefore,Article 7 of relevant DTAAs was applicable.
The Revenue further contended that the combined reading of Article 7 meant that the state of source had non-exclusive right to tax business income attrib-utable to PE and therefore, it might tax it as per its domestic laws. However, this non-exclusive right of state of source did not extinguish the inherent right of the state of residence to tax global income of its resident. In a situation where state of residence had given up its inherent right, the second sentence of article 7 would have used the phrase ‘shall be taxable only’. Now, in all DTAAs applicable in case of the assessee, the second sentence used the phrase ‘may be taxed’. Therefore, the inherent right of India to tax global income of its resident was not lost. The contention of the assessee was fallacious in view of the discussion above. The proper course on the part of the assessee would have been to claim credit of taxes paid in foreign countries, because the relevant DTAA provided that India shall relieve double taxa-tion by giving credit of taxes paid in state of source.
For the Revenue, it was important to examine what the Supreme Court had held in Kulandagan Chet-tiar’s case (supra), as that was the source of all the decisions that followed it, to hold that income once taxed outside India was not taxable in India. It was argued that in that case, the Supreme Court had held that; interpretation of phrase ‘may be taxed’ was not required as the assessee was resident of both India and Malaysia as per their respective do-mestic tax laws and the situation of dual residence was to be reduced to situation of single residence by applying tie breaking rules contained in Article 4(2) of treaty; by applying tie breaking rules, the Supreme Court came to the conclusion that the assessee was having closer personal and economic relations with Malaysia and therefore, the assessee became resident of Malaysia; Malaysia being state of residence for the assessee, Malaysia had inherent right to tax global income of the assessee. This is how income of assessee was held not to be taxable in India which is explained by the Supreme Court at pages 671 & 672 of 267 ITR. Closer examination of this Supreme Court decision showed that it had clearly upheld the basic principle that state of residence (in that case, Malaysia) had the right to tax global income of its resident.
It was further argued that the decisions holding that income arising in state where permanent establishment was situated could be taxed in that state only and state of residence was precluded from taxing such income militated against the basics of DTAA and also were not consistent with ratio of the Supreme Court decision in Kulandagan Chettiar’s case (supra) and therefore the ratio therein was not correctly applied in those cases. In all cases relied upon by the assessee, the tax payers were resident of India and there was no situation of dual residence. India remained state of residence and therefore India had inherent right to tax global income of its residents.
Decision in the case of Data Software Research Co. (P.) Ltd. (supra ) was cited to state that the facts therein were exactly the same as were in present case. Reliance was also placed on S. Mohan’s case (supra) in which interpretation of phrase ‘may be taxed’ which was consistent with OECD Commentary had been taken. In that case, issue involved was taxability of salary income under Article 16(1) which used the phrase ‘may be taxable’ for the source state.
In a nutshell, according to the Revenue, if the assessee had paid taxes in foreign countries on income earned from PE in those countries, credit of those taxes could be claimed in India. Therefore, the crux of the controversy was whether India had given up its right to tax under Article 7 of any DTAA applicable to the assessee and if not, India shall give credit for taxes paid in country of source. To give an example, India had given up its right to tax capital gains arising in India to residents of Mauritius under Indo -Mauritius DTAA, but this was not the situation in case of DTAA applicable to present assessee. Reliance was also placed on Manpreet Singh Gambhir (supra) which had also been relied upon by the assessee. In that case, the ITAT had held that assessee was entitled to credit of taxes paid in USA on income earned in USA. Finally, it was prayed that the grounds of assessee’s be dismissed.
The tribunal on hearing the parties in detail and on perusal of the case laws relied upon, observed and held as under;
(i) Since the assessee company was incorporated in India, the provisions of Income-tax Act, being a domestic law, were applicable to the assessee and all the incomes of the assessee, including the global income, were liable to be taxed in India.
(ii) Section 5(1)(c) provided that the total income of any previous year of a person who was a resident, includes all income from whatever source derived which accrued or arose to him outside India during such year.
(iii) As per the provisions of Income-tax Act, the assessee was a resident of India.
(iv) Due to State of residency, India had inherent right to tax the global income of the assessee as per provisions of Section 5 of Income-tax Act, 1961.
(v) The combined reading of the sentences of Article 7 of relevant DTAA meant that the state of source had non-exclusive right to tax business income attributable to permanent establishment. Such income may be taxed as per the domestic laws. The non-exclusive right of state of source did not extinguish the inherent right of state of residency to tax global income of its residents. In the circumstances, where the state of residence of the taxpayer had given up its inherent right to tax the global income, in such situation, the phrase used in Article 7 of the DTAA was “shall be taxable only”. Since all the DTAA applicable in the case of assessee the phrase used “may be taxed”, therefore, inherent right of taxation of global business income in India was not lost.
(vi) Case laws relied upon by assessee were basically based on the decision of the Supreme Court in Kulandagan Chettiar’s case (supra) where conclusions rested on the fact that the personal and economic relations of the assessee in relation to capital asset were far closer in the State of Malaysia than in India. In view of these facts, the residency of India was held to be irrelevant and in that view of matter, issue was so decided. Assessee’s contention that its foreign income was taxable income in foreign countries and it could not be taxed in India was an untenable contention based on wrong interpretation of Article 7 of relevant DTAA.
(vii) Only in the case of use of phrase “shall be taxed only”, the state of residence is precluded from taxing it. In such cases, where the phrase “may be taxed” was used, the state of residence had been given its inherent right to tax.
(viii) The facts of assessee’s case were completely different from the set of facts in Kulandagan Chettiar’s case (supra). In that case, assessee sought a relief under the India-Malaysia DTAA, and the Supreme Court held that it was a case of dual residency. The Supreme Court’s conclusion rested on the fact that personal and economic relations of the assessee in relation to capital assets were far closer in Malaysia than in India and in those facts, the residence of India became irrelevant. The assessee was not having permanent establishment in India in respect of that source of income. On the aspect and scope of the expression “may be taxed”, the Supreme Court had not expressed any opinion. Thus, the facts of that case were completely at variance to the facts of assessee’s case.
(ix) The facts of the several cases relied upon by the assessee were found to be at variance with the facts in the assessee’s case.
The tribunal therefore rejected the assessee’s appeal.
Observations
The controversy poses some very fundamental issues in taxation of an income from cross country transactions and is therefore surprising that it has been allowed to remain open for long. The issue is further fuelled by the Notification No.S.O. 2123(E) dated 28 August, 2008 wherein the Central Government, in exercise of its powers under section 90, has clarified that the term ‘ may be taxed’ used in the context of an income shall mean that such income shall be included in the total income chargeable to tax in India in accordance with the provisions of the Income tax Act, 1961, and relief shall be granted in accordance with the method for elimination or avoidance of double taxation provided in an agreement. A similar Notification bearing No.S.O. 2124(E) dated 28th August, 2008 has been issued under section 90A of the Act, the efficacy of which was tested recently by the tribunal in the case of Apollo Hospitality Pvt. Ltd.
The raging controversy requires immediate attention also for the fact that the Indian judiciary has taken a stand that is at variance with the international tax practice.
Internationally, two systems of taxation prevail for bringing to tax the profits arising on cross country transactions. One is Residence based taxation and another is Source based taxation. In the former, the Residence State has the primary right of taxation. Almost all countries follow the residence based taxation under which a country can tax its residents on their global income, wherever it is earned, while non-residents are taxed only on the income sourced inside the country. Such powers of taxation are enshrined in the domestic tax laws of a country. India largely follows the residence based taxation system, a fact that can be gathered from section 5 of the Income-tax Act, 1961.
Under a source based system, a country can tax a person, whether resident or non- resident, only on income sourced inside the country. A country following this system eliminates the need for any DTAA. It is because of the fact that the countries choose to tax a resident on his world income and the source country also needs to tax such an income, that a need arises for DTAA to eliminate double taxation of the same income.
The Model Conventions (MC), while prescribing the model agreements, rely on any of the two rules or adopt both of them to avoid double taxation. One is to allocate taxing rights between contracting states with respect to various kinds of incomes by adopting what is known as the ‘Distributive rule’ – taxing rights are distributed between contracting states. Exclusive rights to taxation in respect of certain incomes are given to one state and the other state is precluded from taxing those incomes and therefore double taxation is avoided. Generally, such exclusive rights are given to Residence State (see paragraph 19 of the OECD Commentary). The Source State is thereby prevented from taxing those items and double taxation is avoided. In the case of other items of income and capital, the right to tax is not an exclusive one. As regards two classes of income (dividends and interest), although both States are given the right to tax, the amount of tax that may be imposed in the State of source is limited.
The Second rule is to put the Residence State under an obligation to give either credit for taxes paid in the Source State or to exempt the income taxed in the Source State. These two rules have been explained in paragraph 19 of OECD commentary titled ‘Taxation of Income and Capital’. It is the stand of the Government of India that it follows credit method for relieving double taxation as a rule and departs from the said rule only under a specific writing to the contrary.
In respect of other types of income, the right to tax is not an exclusive one. The other state may also tax that income and depending upon taxing rights of Source state, incomes are classified into three categories as explained by paragraphs 20 to 23 of the OECD Commentary .
The scheme of taxation is divided in three categories; The first category includes Article 7, 8, 9 14,15, and 19, all of which provide that income shall be taxed only in the Residence State. The second category includes Article 6, 7, 15 ,16, 17, 18 and 20, all of which provides that such income may be taxed in the Source State. The third category includes Article 11, 12 ,13, 14 and 22, all of which provides that such income may be taxed in both the contracting states.
The distributive rules use the words, ‘shall be taxable only’, ‘may be taxed’ and ‘may also be taxed’. Interpretation of these phrases has been provided in paragraphs 6 and 7 of OECD Commentary. The commentary states that the use of words “shall be taxable only” in a Contracting State indicates an exclusive right to tax is given to one of the Contracting States; the words “shall be taxable only” in a contracting State preclude the other Contracting State from taxing. The State to which the exclusive right to tax is given is normally the Residence State, but in some Articles the exclusive right may be given to the Source State. For other items of income or capital, the attribution of the right to tax is not exclusive and the relevant Article then states that the income or capital in question “may be taxed”. Regarding ‘dividend’ and ‘interest’ income’, primary right of taxation is given to state of residence, though this is not exclusive right as paragraph 1 of relevant articles 10 and 11 of model OECD convention uses the phrase “may be taxed’. At the same time, paragraph 2 of said articles uses phrase ‘may also be taxed’ and gives simultaneous taxing rights to state of source. Thus, for these two items of income, no state is given exclusive right to tax.
At this place, it is to be noted that no single method or a uniform formula is adopted in drafting the tax treaties. Varied approaches are seen to be adopted to convey the mutual understandings of the countries that are party to such treaties. Even within the same treaty, different approaches are adopted for income with different characters. Even the intentions of the parties are conveyed through use of different words on different occasions. For example, paragraph 1 of Article 11 provides that dividend income may be taxed in the other contracting State, while paragraph 2 provides that dividend income may also be taxed in the State of residence. Similarly, Article 14(2) and Article 22 provide that income may be taxed in both the countries.
Article 7 of relevant MC provides that the profit of an enterprise of a contracting state shall be taxable only in that state, i.e Residence State, unless the en-terprise carried on business in other contracting state through a permanent establishment situated therein i.e., in the Source State. If the enterprise carried on business as aforesaid, the profits of the enterprises may be taxed in the other Contracting State, but only so much of them as was attributable directly or indirectly to that permanent establishment. The first part of the Article gives an exclusive right to the taxation of business income to the Residence State as the phrase used as “shall be taxable only”. The real debate is about the second part of the Article 7 where the words used are “may be taxed”. Does this part give exclusive right of taxation only to the Source State or does it give the right to the Residence State as well to tax such an income and while doing so to give credit for taxes paid in Source State? As noted, the OECD commentary as also the commentary by Klaus Vogel support the view that the Source State under Article 7 of MC has a non-exclusive right of taxation.
This position is accepted globally and countries tax the income in the hands of the resident in cases where the relevant Article uses the words ‘ may be taxed’, especially the income of the PE, though taxed in the Source State, and give credit for the taxes paid in the Source State.
It is time to take note of the developed law in India. Is the internationally accepted position ratified by the judiciary in India? The gist of the following decisions reveals the story;
(i) The Karnataka High Court in the case of R.N. Muthaiah, 202 ITR 508 in the context of Indo-Malaysian treaty held that the Malaysian in-come was not taxable in India once it was subject to tax in Malaysia. The court observed that “When a power is specifically recognised as vesting in one, exercise of such a power by others is to be read as not available; such a recognition of power with the Malaysian Government would take away the said power from the Indian Government; the agreement thus operates as a bar on the power of the Indian Government in the instant case. This bar would operate on sections 4 and 5 of the Income-tax Act, 1961, also.”
(ii) In the case of Vr. S.R.M. Firm, 208 ITR 400 (Mad.), the Madras High Court held that an occasion to deal with several cases involving taxation of income earned in Malaysia by Indian residents from different sources mainly capital gains, business income, dividend and interest. The relevant Articles of the said treaty dealing with income with different characteristics, all of them, provided that income may be taxed in Malaysia. In the context of the above facts, the Court held that express conferment of right to tax an income on one of the states conveyed an implied prohibition on the other state to tax the said income. The court observed that “The contention on behalf of the Revenue that wherever the enabling words such as “may be taxed” are used there is no prohibition or embargo upon the authorities exercising powers under the Act, from assessing the category or class of income concerned cannot be countenanced as of substance or merit. As rightly pointed out on behalf of the assessees, when referring to an obvious position such enabling form of language has been liberally used and the same cannot be taken advantage of by the Revenue to claim for it a right to bring to assessment the income covered by such clauses in the agreement, and the mandatory form of language has been used only where there is room or scope for doubts or more than one view possible, by identifying and fixing the position and placing it beyond doubt.” The Court accordingly held that none of the income above mentioned could be taxed in India even though the recipient of income was a resident under the Income Tax Act 1961.
(iii) In Lakshmi Textile Exporters Ltd, 245 ITR 521 (Mad.), in the context of Article 7 of the DTAA between India and Sri Lanka, it was held that once an income of a company resident in India was liable to be taxed in Sri Lanka under the said DTAA, then such income could not have been taxed in India. Article 7 of the said DTAA provided that the profits of an enterprise shall be taxed in the contracting state of which the enterprise was resident, unless it carried on the business in the other contracting state through a PE (Permanent Establishment) situated in that state.
(iv) The Supreme Court in the case of P.V.A.L. Kulandagan Chettiar, 267 ITR 654 was required to examine the true meaning of the words ‘may be taxed’ used in different Articles of the DTAA with Malaysia, 107 ITR 36 (ST). The said case was filed by the revenue against the decision of the Madras High Court to which a reference was made out of the decision of the Special Bench of the ITAT. The Special Bench of the ITAT and the High Court had held that income from a firm, resident of India, by way of capital gains on sale of immovable properties at Malaysia and business income from business of rubber estate in Malaysia was not taxable in India . The Madras High Court had rejected the contention of revenue in that case, to the effect that wherever the enabling words such as ‘may be taxed’ were used, there was no prohibition or embargo upon the authorities from assessing the income in India and had found such contention to be devoid of substance or merit. The Court had also found unsafe or unacceptable to apply the OECD Commentary, on MC 1977 as a guide or an aid for construction. Detailed arguments were made by the contesting parties in support of the rival contentions. The Supreme Court, for reasons different than those of the High Court, held that the income of the resident that was taxable in Malaysia was not taxable in India on the finding that the assessee firm in question was resident of Malaysia and not of India by applying the tie-breaker test contained in Article 4 of the said DTAA. The Court held that the Malaysian income was not taxable in India, unless the assessee firm had a PE in India. The Court refused to enter into an exercise in semantics as to whether the expression ‘may be’ meant allocation of power to tax or was only one of the options and it only granted the power to tax in that state and unless tax was imposed and paid, no relief could be sought. The review petition filed by the revenue against the decision was dismissed by the Supreme Court for inordinate delay and for want of any ground to entertain the petition, 300 ITR 5 (SC).
(v) The Indore Bench of the Madhya Pradesh High Court in the case of Turquoise Investment & Finance Ltd., 299 ITR 143 (MP) held that dividend income earned by a resident of India, from a Malaysian company was not liable to tax in India. In view of this finding of the court, the other question as to whether such dividend income was taxable in India u/s. 5(i)(c) in the hands of the resident assessee, once it was taxed in Malaysia as per Article 11 of the DTAA, was considered by the Court in favor of the assessee. This decision of the MP High Court has been approved by the Supreme Court in the case reported in 300 ITR 1 (SC) by following the decision in the case of Kulandagan Chettiair(supra). The Court approved the findings of the Madras High Court in the case of Vr.S.R.M. Firm, 208 ITR 400 wherein it was held that dividend income from a Malaysian company was not taxable in India.
(vi) The AAR in S.Mohan, In Re, 294 ITR 177 (AAR) distinguished the Supreme Court decision in Kullandagan Chettiair’s case to hold that income of an Indian resident by way of salary for services in Norway was taxable in India. It noted that the use of the words ‘may be taxed’ in Article 16 made it possible to subject to tax such remuneration derived by a resident of India. It noted that the expression ‘may be taxed’ was used in the contradistinction to the expression ‘shall be taxable’ and as such the right of taxation was available to both the contracting states for bringing to tax the employment income.
(vii) The Bombay High Court recently in the case of Essar Oil Ltd, 345 ITR 443 (Bom.) dealt with a case of an Indian company with a PE in Oman. Interpreting Article 7 of the Indo-Oman DTAA, the court, following Kullandagan Chettiair’s decision, held that the profit earned by the company from the PE in Oman was to be excluded in computing income liable to Indian tax.
(viii) In the case of Mideast India Ltd, 28 SOT 395 (Delhi), the assessee company, resident in India derived income from business operations in the USSR that were carried out through its PE in that country. The company had claimed that the said income was not taxable in India by virtue of Article 7(1) of the Indo-USSR treaty which provided that the profits derived through a PE by an Indian Enterprise, in the USSR may be taxed in the USSR only. The Tribunal, following the Supreme Court decision in Kullandagan Chettiar’s case held that such income was not taxable in India. It observed that “The learned DR has also contended that although the final operative decision of the Special Bench of ITAT has been upheld by the Hon’ble Supreme Court, the reasoning given by the Hon’ble Supreme Court while affirming the said decision is entirely different from the reasoning given by the Special Bench of the Tribunal. However, as rightly submitted by the learned counsel for the assessee, a perusal of the judgment of the Hon’ble Apex Court shows that there is nothing contained therein to indicate that the reasons given by the Special Bench of ITAT to come to a conclusion as it did were disapproved by the Hon’ble Supreme Court or the same were found to be inappropriate or incorrect… In our opinion, the decision of Special Bench of IT AT in the case of P.V.A.L. Kulandagan Chettiar (supra) thus still holds the field and the same being squarely on the point in issue involved in the present case and is binding on us, we respectfully follow the same and uphold the impugned order of the learned CIT(A) deleting the addition made by the Assessing Officer to the total income of the assessee on account of income earned by it in the form of profits of business earned in USSR which was entirely attributable to the permanent establishment in that country.”
(ix) In Data Software Research Co. (P) Ltd., 288 ITR 289(Mad.), the tribunal on similar facts held that the income from PE in …………. earned by an Indian resident was taxable in India.
(x) In Apollo Hospital Enterprises Ltd., the Chennai bench of the tribunal held that the income from capital gains from sale of shares of the Sri Lankan company by an Indian company was not taxable in India, in view of the Indian-Sri Lankan treaty which provided for taxing such an income in Sri Lanka only through the use of the words ‘may be taxed’. The tribunal rejected the contention of the revenue that the term ‘ may be taxed’ indicated the non-exclusive right of taxation of the Sri Lankan Government in view of the Notification issued in 2008 u/s 90A. It noted that section 90A had a limited application to certain jurisdictions and did not apply to nations. The revenue made a wrong reference, and should have relied on the no-tification issued u/s 90 of the Act, which was not brought to the notice of the Tribunal.
It is apparent from a reading of the above decisions that the income of a PE in the hands of a person resident in India, is taxable in the Source State only and cannot be subjected to tax in India.
There is accordingly a clear cut divide between the international tax practice and the Indian one. The case in support of the Indian understanding is unambiguous and clear, when it comes to treaties containing Articles with use of both the phrases, namely, ‘may be taxed’ and ‘may also be taxed’. This confirms that wherever the countries intended, they have provided for specific right on Residence State by inserting an additional phrase ‘may also be taxed’ to secure the right of the taxation for the Residence State. This by implication confirms that the Article using the phrase ‘may be taxed’ alone confers an exclusive right of taxation on the Source State. In such a case, the income from Source state will not be taxed in India. This is best brought out by the learned members in Ms. Pooja Bhatt’s case. The tribunal in that case has relied upon the contextual interpretation to hold that the Source State had an exclusive right of taxation. In the India Canada treaty, wherever the contracting parties intended that income may be taxed in both the countries, they have specifically so provided and this fact clearly confirms that wherever it was not so provided, there arose an exclusive right in favour of the Source State even where the phrase used is “may be taxed in other State”.
As regards the treaties where such a clear cut distinc-tion is not possible by use of the two phraseologies, one will still be supported by a good number of decisions, including that of the high courts, which have taken a view that the Source State alone has an exclusive right of taxation. Some of these decisions, mainly in Mutthaiah and Vr. S.R.M.’s cases, have been delivered independent of the Kulandagan Chettiar’s decision and have provided the sound rationale for doing so. They may also rely upon the decision of the Special Bench of the tribunal in the case of P.V.A.L. Kulandagan Chettiar , though the validity of the said decision may be debatable in view of the fact that the said decision may be treated as the one delivered on facts rendered, irrelevant by the Supreme court.
Whether the Notifications issued under section 90(3) and 90A(3) by the Government under the valid powers can be binding or not is another hurdle one will have to pass through, before heaving a sigh of relief. The Notifications, if found to be binding with retrospective effect, will take the steam out of most of the decisions. The recent insertion of explanation 3 to section 90 by the Finance Act 2012, with effect from 1st October 2009, provides that such notifications shall come into force from the date on which the DTAA was entered into. The issue is whether one country, out of two countries which have signed the DTAA, can independently assign its own meaning to the DTAA. It is felt that it may be difficult for the Government to support the validity of the concerned notification, as the same may be considered to provide a meaning that is inconsistent with the provisions of the agreement.
