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Category: International Taxation

Tax Relief On Income From Foreign Retirement Funds

INTRODUCTION

Many NRIs and non-residents returning to India maintain retirement savings in various retirement benefit accounts. A large number of such retirement accounts are tax deferred in nature i.e. tax becomes payable in the jurisdiction in which the account is maintained only upon withdrawal from the account.

Retirement benefit accounts in the United States of America (USA), such as Section 401(k) accounts and traditional Individual Retirement Accounts (IRAs) are common examples of tax-deferred retirement benefit accounts.

Similarly, Canada has the Registered Retirement Savings Plan (“RRSP”), which is a government-registered retirement savings arrangement, while the UK has the Self Invested Personal Pension (“SIP”).

This article focuses primarily on the most prevalent retirement benefit accounts relating to the USA.

Retirement Benefit Accounts should not be confused with the social security benefits. Social security in the USA is primarily governed by the Social Security Act, 1935 and administered through Social Security Administration, which provides federal old-age, survivors, and disability insurance, together with unemployment compensation benefits.

In the case of income received by a resident from a US social security account, Article 20(2) of the India-US DTAA provides that social security benefits paid by the USA to a resident of India or to a citizen of the USA shall be taxable only in the USA.

Taxability of the Retirement Benefit Accounts

There are two principal approaches to income taxation i.e. accrual and receipt basis. Under the accrual basis, income is taxed in the year in which it is earned, irrespective of when it is actually received. Under receipt basis of taxation, income is taxed in the year in which it is actually received.

In case of a Resident and Ordinarily resident (ROR), global income is taxable in India in respect of any previous year, including income which accrues or arises outside India during such year.

Accordingly, once a Non-resident returning to India becomes an ROR in India, his global income including income accruing by way of notional growth in the retirement benefit accounts, becomes taxable in India. However, the same income may also be taxed in the USA at the time of withdrawal, thereby resulting in economic double taxation.

Further, while the DTAA does not restrict either India or the United States from taxing such pension income, practical difficulties arise because:

  • tax may become payable in India prior to actual receipt of the income; and
  • foreign tax credit issues may arise since India taxes the income in an earlier year whereas tax in the United States becomes payable only in a subsequent year upon withdrawal.

Section 158 of the Income-tax Act, 2025 (ITA 2025) [Earlier Section 89A of the ITA]

To mitigate such double taxation and to provide tax relief for Indian residents in respect of income accruing in foreign retirement Accounts, section 89A of the Income-tax Act, 1961 (ITA) was inserted by the Finance Act, 2021 w.e.f. 1-4-2022. Correspondingly, Rule 21AAA was inserted by the IT (Sixth Amdt.) Rules, 2022 w.e.f. 4-4-2022.

Section 158 of the Income-tax Act, 2025 continues this framework and provides the benefit of tax deferral to a person who:

  • is resident in India;
  • had opened a specified account in a notified country while being a non-resident in India and resident in that foreign country; and
  • satisfies the prescribed conditions

NOTIFIED COUNTRIES

The Central Government vide Notification No. S.O. 1568(E) dated 4-4-2022 notified (a) Canada; (b) United Kingdom of Great Britain and Northern Ireland; and (c) United States of America, as the notified countries for the purposes of Section 89A of the ITA 1961.

The Income-tax Rules, 2026 and New prescribed Forms were notified on 20th March, 2026. The Income-tax Department, on its official website (incometaxindia.gov.in), has also published FAQs and Guidance Notes under Income-tax Rules, 2026. These materials are intended solely as educational resources to assist taxpayers in navigating the new Forms and do not constitute legal advice.

FAQ No. 1 relating to Form 40 states that

‘The countries notified for this purpose of this relief are USA, UK, Canada and Australia, at present.’

Similarly, the Guidance Note relating to Form 40, in the introductory paragraph under the heading ‘Purpose’ states that

“… income accrued in a foreign retirement account maintained in a notified country (e.g. USA, UK, Canada, Australia).”

However, it may be noted that, as of date no notification has been issued by the central government notifying ‘Australia’ for the purposes of Section 158/earlier Section 89A. Accordingly, the inclusion of Australia in the FAQs and the Guidance Note to Form 40 appears to be inadvertent or erroneous.

SPECIFIED ACCOUNTS – EXAMPLES USA: 

  • 401(k) Accounts: A 401(k) is an employer-sponsored retirement account in which: employee contribute a portion of their salary, generally on a pre-tax basis;
  • employers may provide matching contributions; and
  • the investments grow on a tax-deferred basis until withdrawal.

There are two principal categories of 401(k) accounts:

Traditional 401(k): Contributions are generally made on a pre-tax basis and the accumulated funds grow tax-deferred. Tax in the United States becomes payable upon withdrawal. Early withdrawals prior to the age of 59½ generally attract a 10% penalty in addition to applicable income-tax.

Roth 401(k): Contributions are made from post-tax income, and qualified withdrawals are tax-free in the United States. However, India may nevertheless seek to tax such withdrawals since Indian tax may never previously have been paid on the underlying income.

IRA (Individual Retirement Account): An Individual Retirement Account (“IRA”) is a personal retirement savings arrangement available in the USA.

It is important to note that Section 158 (earlier section 89A) does not apply to 529 Education Plans.

Rule 74 of the Income-tax Rules, 2026 and Form 40

Rule 74 of the IT Rules 2026 (corresponding to Rule 21AAA of the Income-tax Rules, 1962), contains the rules governing taxation of income from retirement benefit accounts maintained in a notified country.

Rule 21AAA(1) inserted from AY 2022-23, provided that income accrued in a specified account may, at the option of the specified person, exercised through the prescribed form earlierForm 10EE and now Form 40 under IT Rules, 2026 be included in the total income of the previous year relevant to the assessment year in which such income is taxed in the notified country upon withdrawal or redemption from the specified account.

In other words, the annual accumulation of income in the specified accounts may either:

  • be taxed in India every year on an accrual basis; or
  • at the option of the taxpayer, be taxed on a receipt basis at the time of withdrawal, subject to fulfilment of the prescribed conditions.

The option is required to be exercised by the specified person in respect of all specified accounts maintained by such person.

EXCLUSION FROM THE TAXABLE INCOME

The income to be taxed shall not include income which –

(a) has already been included in the total income in any of the earlier previous year during which such income accrued and tax thereon has been paid in accordance with the ITA; or

(b) was not taxable in India during the year of accrual because the taxpayer was either a non-resident or a resident but not ordinarily resident during that relevant previous year, or by virtue of the applicability of a DTAA, if any.

Where an income is not included in the total income of the specified person, the foreign tax paid on such income, shall be ignored for the purposes of computation of foreign tax credit under Rule 128 (corresponding to Rule 76 of the IT Rules, 2026).

SALIENT FEATURES OF OPTION U/S 158

a) The option is required to be exercised by the specified person in Form 40 under IT Rules, 2026 (earlier Form 10EE). The form must be furnished electronically on or before the due date prescribed for furnishing the return of income u/s 263(1)(c).

b) Once exercised, shall apply to all subsequent previous years and cannot thereafter be withdrawn.

In Jignesh Naresh Jariwala v. DDIT [2025] 178 taxmann.com 223 (Mumbai-Trib), the ITAT Mumbai held, while deciding in favour of the assessee, that once the option had been exercised in Form 10EE, it would continue to apply to all subsequent years. Consequently, it was not mandatory for assessee to file the form afresh every assessment year in order to claim relief under section 89A, held as follows:

“6. We have heard the rival submissions and perused the documents available on record. The assessee is a resident individual who filed his return of income for the impugned assessment year without furnishing Form No. 10EE. It is an admitted position that the said form had already been filed for A.Y. 2022-23. On a careful reading of Rule 21AAA, particularly sub-rules (1), (4) and (6), we find that once Form No. 10EE has been filed in respect of a previous year, the option exercised therein continues to apply to all subsequent previous years. Consequently, it is not mandatory for the assessee to file the form afresh for every assessment year. Where relief under section 89A of the Act has been granted on the basis of Form No. 10EE already furnished, the same relief cannot be denied merely for the reason that the form has not been filed again in subsequent years. The filing of Form No. 10EE is a procedural requirement and, by virtue of Rule 21AAA(6) of the Rules, once exercised in any previous year, it continues to hold good for all subsequent years. Therefore, the assessee is not obliged to furnish the form afresh every year, and denial of relief under section 89A of the Act on such procedural grounds is not sustainable in law. In our considered view, the finding of the Ld. CIT(A) is contrary to the clear mandate of Rule 21AAA of the Rules. Accordingly, we set aside the impugned appellate order and direct that the relief claimed under section 89A amounting to ₹4,34,661/- be allowed to the assessee.” (Emphasis Supplied)

c) If a specified person becomes a non-resident during any relevant previous year after exercising the option, then:

(i) the option shall be deemed never to have been exercised w.e.f. the relevant previous year; and

(ii) the income accrued in the specified account(s) shall become taxable beginning from the previous year in which option was first exercised and ending with previous year immediately preceding the relevant previous year in which the specified person becomes non-resident. The corresponding tax is required to be paid on or before the due date for furnishing the return of income for the relevant previous year.

d) Form 40

Form 40 is the prescribed form for exercise the option to claim tax relief under section 158 of the ITA 2025 by a person resident in India, in respect of income from a retirement benefit account, maintained in a notified country.

This Form is required to be filed in the first year in which the taxpayer becomes a ROR in India. Although the language of the section 158 and Rule 74 does not expressly provide so, one possible view is that failure to file Form 40 in the first year of becoming an ROR may result in permanent loss of the tax deferral benefit. However, this issue has not yet been judicially tested.

Upon exercise of the option, the Indian resident obtains relief from taxation in India on an accrual basis in respect of income from retirement benefit account, where such income is taxed in the notified country only at the time of withdrawal or redemption. In other words, filing Form 40 permits deferral of taxation in India until the income is withdrawn or redeemed in the foreign country.

e) Documents and details required for Form 40

Mandatory to be attached

Annexure A1- A copy of statement of the specified account having the details of account number, the notified country, and the account balance as on last date of the financial year prior to the tax year for which the option is exercised;

Annexure A2- Documentary evidence to show how the income from specified account has been taxed or is taxable in the notified country. Relevant statutory provision of the notified country or any other relevant document may be attached.

Annexure A3- The computation of income for all the tax years in which the income from specified account has already been included in the total income. The computation has to be reconciled with the return of income for the said tax years. A reconciliation statement of the computation of income, is to be attached.

f) Editing of Form 40: Once Form 40 is validly submitted, after self-declaration by the specified person, and an acknowledgment has been generated, it cannot be edited. It is therefore imperative to ensure that all the details and documents attached are correct before the same are finally submitted.

ITR FORMS AND REPORTING

The Income-tax Return Forms ITR-2, ITR-3 etc. applicable from AY 2022-23, contain updated disclosures in Schedule-S (Details of Income from Salaries), Schedule OS (Income from Other Sources) and the following row items have been added in both the schedules:

– Income from retirement benefit account maintained in a notified country u/s 89A (choose country from dropdown menu)

– Income from retirement benefit account maintained in a country “other than notified county u/s 89A”

– Income taxable during the previous year on which relief u/s 89A was claimed in any earlier previous year.

– Less: Income claimed for relief from taxation u/s 89A

These disclosures taxpayers to claim relief u/s 89A in the prescribed manner. Accordingly, in all applicable cases, while filing ITR, one will need to report the gross accrued income in retirement benefit account(s) like Salary, capital gains, interest, dividend income and claim relief under section 158, to defer tax on the income until withdrawal of the same.

OTHER REPORTING IN THE ITR FORMS

Schedule FA: Where a person qualifies as a Resident and Ordinarily Resident (“ROR”) in India, disclosure of foreign assets and income from sources outside India is mandatory in Schedule FA, even where no withdrawal has been made from the retirement benefit account(s).

Disclosure in the relevant table(s) would generally include:

  • account details;
  • value of the account;
  • contributions;
  • earnings; and
  • other relevant particulars.

Failure to report, or incorrect reporting, may attract penalties of up to ₹10 lakh under Sections 42 and 43 of the Black Money (Undisclosed Foreign Income and Assets) and Imposition of Tax Act, 2015.

It is important to note that filing Form 40 (earlier Form 10-EE) merely defers taxation; it does not dispense with the obligation to disclose such assets in Schedule FA.

Schedule AL – Disclosure in Schedule AL (Assets and Liabilities at the end of the year) is required where the total income exceeds ₹1 crore.

Reporting in the year of withdrawals / tax payment outside India

In the year in which withdrawals are made from the retirement benefit account, or foreign tax becomes payable, additional reporting would be required in:

  • Schedule FSI – Details of Income from outside India; and
  • Schedule TR – Summary of tax relief claimed for taxes paid outside India

Further, in order to claim credit for taxes paid in the United States, the following forms may also be required to be filed, wherever applicable:

  • Form 44 (earlier Form 67 under the Act) – Statement of income from a country or specified territory outside India and claim of Foreign Tax Credit; and
  • Form 45 – Intimation of settlement of dispute regarding foreign tax for which credit has not been claimed.

CONCLUSION

Section 89A of the Income-tax Act, 1961 together with and Form 10EE of the Act (Section 158 and Form 40 under the ITA 2025) introduced by the Finance Act 2021 w.e.f. AY 22-23, have been a significant relief measure for NRIs returning from USA, Canada and UK.

These provisions permit deferral of Indian taxation until actual withdrawal from Retirement Benefit Accounts such as 401(k) accounts in USA thereby aligning Indian taxation more closely with the foreign tax treatment and facilitating smoother availability of foreign tax credit in respect of taxes paid abroad.

It appears that, owing to lack of awareness and limited dissemination, only 977 instances of Form 40 (earlier Form 10EE) have reportedly been filed during the past 5 years.

It is hoped that a larger number of eligible taxpayers will, going forward, be able to avail themselves of these beneficial provisions.

Eligibility of LLCs to Claim Benefit under A Tax Treaty

In the Indian context, Tax authorities often challenge the benefits under a Double Taxation Avoidance Agreement (“DTAA” or “tax treaty”) to fiscally transparent entities (“FTEs”) such as foreign partnership firms, trusts, foundations, limited liability company (“LLC”) etc. on the premise that such entities do not qualify as a tax ‘resident’ of that country and are not ‘liable to tax’ in their home country. Whether an FTE can access the tax treaty has been a contentious issue. In this Article, we are analysing some recent judicial developments in this context.

INTRODUCTION

In order to mitigate double taxation in case of cross-border transaction(s), countries have entered into DTAA or tax treaty, which allocates the taxing rights among the Treaty Countries. One of the main conditions that need to be satisfied to access a tax treaty is that the taxpayer should be a tax ‘resident’ (i.e. taxable unit) of either or both the Treaty Countries and is ‘liable to tax’ therein. An exception to this in certain cases is where it appears that the condition of ‘liable to tax’ is subsumed in determining if the taxpayer is resident and once he is resident, whether liable or not does not matter. For example under the India – UAE DTAA, a person is ‘resident’ of UAE if he stays for 183 days in the calendar year concerned and no relevance is provided to being ‘liable to tax’. For illustrative purposes, in this Article, we have considered the provisions of the India-US DTAA.

Article 1 – Personal Scope (in case of India-US DTAA ‘General Scope’) of a Tax Treaty typically provides that ‘This convention shall apply to persons who are residents of one or both of the Contracting States.’ 

Article 3(1)(e) defines the term ‘person’ as follows – “the term “person” includes an individual, an estate, a trust, a partnership, a company, any other body of persons, or other taxable entity.’

Article 4 – Resident (in case of India-US DTAA ‘Residence’) typically provides that for the purposes of a convention, the definition of the term “resident of a Contracting State”.

Article 4(1) of the India-US DTAA reads as follows:

“For the purposes of this convention, the term “resident of a Contracting State” means any person, who under the laws of that State, is liable to tax therein by reason of his domicile, residence, citizenship, place of management, place of incorporation, or any other criterion of a similar nature, provided, however, that:

(a) This term does not include any person who is liable to tax in that State in respect only of income from the sources in that State; and 

(b) In the case of income derived or paid by a partnership, estate, or trust, this term applies only to the extent that the income derived by such partnership, estate, or trust is subject to tax in that State as income of a resident, either in its hands or in the hands of its partners or beneficiaries.”

FTEs such as partnerships, LLCs and trusts are popular across the world considering the legal requirements for certain professions (such as law firms) as well as the ease of doing business without having to undertake significant compliances (as is required to be undertaken in a corporate structure). For tax purposes, these FTEs allow income to ‘pass through’ them i.e. income is taxed at the level of their partners / members / beneficiaries and there is no taxation at the entity level. Given the pass-through status for tax purposes, this has raised the contentious issue as to whether such entities can claim benefits under tax treaties. Tax authorities contend that such entities do not fall under the definition of ‘person’ under tax treaties and that they are not a ‘resident’ in its state of incorporation / location as they are not ‘liable to tax’ in that country and that it is the partners / members / beneficiaries who are taxed in that country.

In the context of Partnerships, certain countries (like Singapore, China, Netherlands etc.) consider partnerships as FTE whereas some countries (like India, Mexico, Hungary etc.) consider partnership as a taxable unit.

Over the years, jurisprudence has developed on whether FTEs can claim benefits under Indian tax treaties. The SC in Azadi Bachao Andolan case ((2003) 263 ITR 706 SC) laid down the principle that liability to taxation is a legal situation and payment of tax is a fiscal fact. Essentially, the SC held that actual payment of tax is not necessarily needed in order to be ‘liable to tax’. In context of partnerships, the ITAT in case of Linklaters LLP ((2010) 40 SOT 51 Mum) held that considering that one of the fundamental objectives of tax treaties is to provide relief to economic double taxation, even when a partnership firm is taxable in respect of its profits, not in its own hands but in the hands of the partners, as long as the entire income of the partnership firm is taxed in the residence country, treaty benefits cannot be denied.

In context of trusts, the Authority for Advance Ruling (AAR), in case of General Electric Pension Trust ([2005] 280 ITR 425), denied tax treaty benefit to the foreign trust considering that the trust was not subject to tax on account of an exemption under the US tax law.

Thus, while judicial precedents exist on the eligibility of tax transparent partnerships being eligible to avail DTAA, similar guidance on the applicability of similar principle to an LLC, was hitherto not available.

Eligibility of a LLC incorporated in USA to claim benefit under India-US DTAA

The Delhi ITAT’s decision in the case of General Motors Company USA vs. ACIT, IT [2024] 166 taxmann.com 170 (Delhi-Trib.), is the first case where the ITAT has upheld the ability of an LLC to claim treaty benefit under the India-US DTAA.

In this case, the taxpayer, an LLC incorporated in Delaware, US, was classified as a disregarded entity; that is, not regarded to be separate from its owner for US tax purposes. For AY 2014-15 and 2015-16, the taxpayer earned income in the nature of ‘Fees for Included Services’. The taxpayer offered this income to tax in India at the rate of 15% under Article 12 of the India-US DTAA instead of 25% (i.e. the tax rate under section 115A of the Income-tax Act, 1961 (“the Act”) during the relevant assessment years). A tax residency certificate (“TRC”) issued by the US tax authorities was furnished by the taxpayer along with the Form 10F to meet the requirements for availing the benefits under India-US DTAA. The Assessing Officer (“AO”) passed an order denying the India-US DTAA benefits to the taxpayer on the ground that it was an FTE and not subject to tax in the US. Accordingly, the AO levied a tax rate of 25% under section 115A of the Act.

The Dispute Resolution Panel upheld the AO’s order, after which the matter went to Delhi bench of the ITAT.

TAX DEPARTMENT’S VIEW

The Revenue contended that based on the taxpayer’s own claim, the taxpayer is an FTE under US tax laws and accordingly, its income is not subject to tax in its own hands in the US.

The Revenue denied the India-US DTAA benefits to the taxpayer for two reasons. The First reason the Revenue contended is that such LLCs do not qualify as ‘Resident’ for the purpose of Article 4 of the India-US DTAA. Only persons who are ‘liable to tax’ in their country according to the laws of that country can be considered to be a ‘resident’ for the purpose of the India-US DTAA. In the instant case, since the income earned by the taxpayer is not liable to tax in the US in their own hands, as per the arguments put forth by the Revenue, it does not qualify as a person ‘resident’ in the US according to the Article 4 of the India-US DTAA.

Secondly, LLCs are not covered under the ambit of the special clause in Article 4(1)(b) of the India-US DTAA, which provides guidance on tax residency related to tax transparent entities such as partnerships, estates and trusts.

The Revenue also relied on paragraph 8.4 of Article 4 of the Organisation for Economic Cooperation and Development (OECD) commentary on Model Convention, which states that where a country disregards a partnership for tax purposes and treats it to be fiscally transparent, and taxes the partners on their share of the partnership income, the partnership itself is not ‘liable to tax’. Therefore, it may not be considered to be a resident of that country.

Accordingly, it was argued that the income earned by the taxpayer should be subjected to tax at 25% under the Act.

ASSESSEE’S CONTENTION

a) The taxpayer contended that under the US domestic tax law, an LLC has an option to either be taxed as a corporation or be considered as a disregarded entity wherein the LLC’s income is clubbed in the hands of its owner who discharges the tax that is assessable in the hands of the LLC in the US. Hence, while the LLC itself is not paying tax, its tax liability is discharged by its owners in the US.

b) The taxpayer contended that the term ‘liable to tax’ has not been defined under the India-US DTAA, and thus, referred to –

i. OECD Commentary 2017 on Article 4, which states that a person is considered to be liable to comprehensive taxation even if the country does not impose a tax.

ii. The commentary of Professor Philip Baker, which states that a person does not have to be actually paying the tax to be liable to tax.

It contended that being ‘liable to tax’ connotes that a person is subject to tax in a country, and whether the person actually pays the tax or not is immaterial.

c) Reliance was also placed on various judicial authorities:

i. UoI vs. Azadi Bachao Andolan [2003] 253 ITR 706 (SC) wherein it noted that for the purposes of the application of Article 4 of a DTAA, the legal situation is relevant—i.e. the liability to taxation—and not the fiscal fact of payment of tax.

ii.Linklaters LLP vs. ITO (ITAT-Mum) [2010] 40 SOT 51 wherein it concluded that while the modalities of taxation may vary from jurisdiction to jurisdiction, what really matters is that income is taxed in the residence jurisdiction. With reference to a fiscally transparent UK partnership firm, it was held that as long as its entire income is taxed in the residence country, the DTAA benefits cannot be denied.

iii. TD Securities (USA) LLC vs. Her Majesty the Queen 12 ITLR 783 of the Tax Court of Canada, Toronto, wherein it was held that an LLC incorporated in Delaware, US, and classified a disregarded entity to be considered as resident of US for the DTAA purpose.

d) Regarding the second aspect raised by the Revenue that Article 4(1)(b) of the India-US DTAA provides specific guidance on the residency of tax transparent entities which covers partnerships, estates and trusts, but does not cover LLCs, the taxpayer made following arguments:

i. the India-US DTAA (executed in 1989) is based on the 1981 US model convention when
the US laws did not recognise single member LLCs as a disregarded entity for the purpose of tax. The concept of disregarded  LLCs was introduced into the US tax laws only in 1996. Hence, disregarded LLCs were not envisaged at the time of entering into the India-US DTAA.

ii. The technical explanation to the US Model Convention issued by US Internal Revenue Services (IRS) has explained that this provision prevents fiscally transparent entities from claiming the DTAA benefits where the owner of such an entity is not subject to tax on the income in its state of residence.

This suggests that, ordinarily, a fiscally transparent entity will be eligible to be treated as a resident who is eligible to claim the benefit under India-US DTAA.

iii. Based on the above guidance from the IRS, it was contended that an ambulatory approach must be adopted while interpreting the India-US DTAA; that is, the meaning of the term prevailing under the US tax laws at the time of applying the India-US DTAA should be adopted and not that at the time when the India-US DTAA was signed. Hence, a disregarded US LLC should be held to be eligible to claim the benefit under India-US DTAA.

e) Basis the above, as the taxpayer is a US tax resident, it should be eligible to claim the benefits under the India-US DTAA.

ITAT DELHI RULING

The ITAT Delhi while deciding the appeal in favour of the taxpayer i.e. permitting the US LLC to access the India-US DTAA and thereby granting the beneficial DTAA rate, inter alia, relied on IRS Publications and Instructions and made below mentioned observations.

US IRS PUBLICATION AND INSTRUCTIONS: 

Publication 3402 on Taxation of LLCs, of the US IRS explains that an LLC is a business entity organized in the United States under state law and may be classified for US federal income tax purposes as a partnership, corporation, or an entity disregarded as separate from its owner by applying the rules in Regulations section 301.7701-3.

Default classification: An LLC with at least two members is classified as a partnership for federal income tax purposes and an LLC with only one member is treated as an entity that is disregarded as separate from its owner for income-tax purposes.

An LLC can elect to be classified as an association taxable as corporation or as an S corporation.

If an LLC has only one member and is classified as an entity disregarded as separate from its owner, its income, deductions, gains, losses, and credits are reported on the owner’s income tax return.

Instruction for Form 8802 (Application for US Residency Certification in Form 6166) issued by US IRS provides that in general, under an income tax treaty, an individual or entity is a resident of the US if the individual or entity is subject to US tax by reason of residence, citizenship, place of incorporation, or other similar criteria. US residents are subject to tax in the US on their worldwide income. It further provides that in general, an FTE organized in the US (that is, a domestic partnership, domestic grantor trust, or domestic LLC disregarded as an entity separate from its owner) and which does not have any US partners, beneficiaries, or owners then such an entity is not eligible for US residency certification in Form 6166.

The Instruction for Form 8802 also provides that the Form 6166 having residency certification is in the form of a letter of US residence certification only certify that, for the certification year (the period for which certification is requested), the applicant were resident of US for purposes of US taxation or, in the case of a FTE, that the entity, when required, filed an information return and its partners/ members/owners/beneficiaries filed income tax returns as resident of United States.

VALIDITY OF TRC 

The ITAT held that the TRC as received from the US IRS in accordance with the requirement of the law as applicable to the assessee, being an LLC, which is organised as body corporate as it fulfills all the requirements of a body corporate in the form of legal recognition of a separate existence of the entity from its Member and a perpetual existence distinct from its Members. Thus, the assessee being a resident under Article 4 of the India-US Tax Treaty by virtue of incorporation and its recognition as a separate existence from its Members qualifies as a ‘person’.

LIABLE TO TAX

The ITAT held that the taxpayer is liable to tax in the resident State by virtue of US Income-tax Law as an LLC is given an option to either be taxed as a corporation or be taxed as a disregarded entity or partnership (depending on number of members) wherein the income of the LLC is clubbed in the hands of its owner who merely discharges the tax that is assessable in the case of the LLC.

The ability of the LLC to elect its classification as well as where the LLC is disregarded as separate from its tax owner and the payment of tax is by the owner(s) of the LLC, supports the legal situation of an LLC being ‘liable to tax’.

The ITAT further held that the phrase ‘liable to tax’ has to be interpreted in the way that the assessee is liable to tax under the authority of the US Income-tax law. The intent of the Indo-US Treaty has to be given precedence wherein the concept of a FTE is recognized for recognizing the phrase ‘liable to tax’.

Accepting the reliance on the decision of the ITAT Mumbai in case of Linklaters LLP vs. ITO [2010] 40 SOT 51, wherein in case of a UK-based limited liability partnership firm which was treated as a FTE in the UK, it was held that while the modalities or mechanism of taxation may vary from jurisdiction to jurisdiction, what really matters is whether the income, in respect of which treaty protection is being sought, is taxed in the treaty partner country or not and thus held that even when a partnership firm is taxable in respect of its profits not in its own right but in the hands of the partners, as long as the entire income of the partnership firm is taxed in the residence country, treaty benefits cannot be declined.

The ITAT also held that Article 4(1)(b) imposes a limitation on eligibility of a partnership to avail the benefits of India-US tax treaty as prescribed, i.e., it seeks to exclude from the eligibility of provisions of India-US tax treaty such income of the partnership which is not ‘subject to tax’ in the US (either in the hands of partnership or partners). Relying on the AAR ruling in case of General Electric Pension Trust (supra) it observed that in this consideration of the matter, it can be concluded that an exclusion provision can only exclude something if it was included at the outset. Hence, a fiscally transparent partnership was already regarded as ‘liable to tax’ for the purposes of India-US tax treaty and this provision determines the scope of eligibility of such fiscally transparent partnership by excluding income which is not ultimately ‘subject to tax’ in the US.

THE OTHER VIEW

In this connection, it is very pertinent to note the recent decision of the Irish Court of Appeal – Civil, dated 27th May, 2025 in the case of Susquehanna International Securities Ltd. & Others vs. The Revenue Commissioners [2025] 175 taxmann.com 1054 (CA – UK) (“the Susquehanna case”). In this case, with respect to Ireland-US DTAA, in the context of entitlement to group relief under section 411 of the Irish Taxes Consolidation Act, 1997 (“TCA”), on the specific and somewhat unusual / peculiar facts of the taxpayer’s group structure, the court concluded that the Taxpayers’ parent company Susquehanna International Holdings LLC (“SIH LLC”), by reason of its fiscal transparency, was not ‘liable to tax’ in the US and accordingly was not resident in the US within the meaning of Article 4 of the Double Taxation Treaty and that the Taxpayers were not entitled to group relief under section 411 of the TCA.

The Court of Appeal ultimately held that SIH LLC was not itself ‘liable to tax’ in the US and consequently, did not meet the definition of “resident of a contracting state” under Article 4.1. In this regard Justice Allen noted that “If – as it is – the purpose of the treaty is to avoid double taxation, it seems to me that it stands to reason that it should only apply to persons who otherwise would be exposed to a liability to pay tax. SIH LLC had no such exposure.”

On the basis that SIH LLC did not satisfy the definition of “resident of a contracting state”, the Court of Appeal held that SIH LLC was not entitled to rely on the anti-discrimination provisions contained in Article 25 of the DTAA.

TD Securities Case: While arriving its conclusion, the court considered the decision of the Tax court of Canada in the case of TD Securities (USA) LLC (supra) in the context of Canada US DTAA and distinguished the same on the basis that the LLC in TD Securities was ultimately held by a corporation which was subject to US tax (as opposed to SIH LLC which was held by other disregarded entities and ultimately US individuals). The Court of Appeal was of the view that TD Securities was based on US and Canadian interpretation of the US-Canada double tax treaty and consequently, its findings were not persuasive in an Irish court.

In para 87 of the decision, the Irish Court of Appeal also referred to the ITAT Delhi’s decision in the case of General Motors Company, USA vs. ACIT (supra) but the Judge did not dwell on it.

The Susquehanna Case is the first Irish case to consider the tax residence of a US LLC. The case confirmed that a disregarded US LLC ultimately owned by individuals who are liable to tax in the US on the income of the LLC should not be regarded as a resident of the US for the purposes of the DTAA. It appears the Susquehanna Case ultimately turned on the specific and somewhat unusual facts of the taxpayer’s group structure.

It remains to be seen whether an Irish court would reach a different conclusion if a US disregarded LLC was held by a corporation who is subject to US tax.

Applicability to other pass-through entities from other jurisdictions

While the General Motors (supra) ruling has focused on the US treatment of LLCs, the question arises is whether one can apply the principle set in the said decision along with other decisions such as Linklaters (supra), etc could apply to other pass-through entities based out of jurisdictions wherein the treaty with India is silent about treatment of partnerships or other pass-through entities. The key difference is that DTAAs such as India – US or India – UK specifically provide treatment for partnerships in Article 3 (dealing with definition of person) and Article 4 (dealing with residence). In the past, the courts have upheld the entitlement to treaty benefits to pass-through entities from other jurisdictions such as Germany as well. Further, it is important to once again point out that the Delhi ITAT in the case of General Motors (supra) held that the reference to partnership in the India – US DTAA is not to provide benefit to partnerships but is to limit the allowability of benefit to partnerships in cases where all the partners are not residents of that jurisdiction. Further, this ruling also follows the general principle of interpretation of treaty that one should not misuse the benefit of a treaty but at the same time if one is paying tax in that jurisdiction either directly or through partners, members or other entities, then one should be able to claim the benefit of the treaties entered into by that jurisdiction. Therefore, in the view of the authors, one may be able to argue that treaty benefits are available to the extent that the partners / members are tax residents of that jurisdiction.

CONCLUSION

Whether an FTE can access a tax treaty has been a contentious issue and in the Indian context the General Motor Company’s ruling strengthen / support the contention that the tax treaty benefit  should not be denied to an FTE especially when its owners / partners / shareholders are from the same country.

While this ruling lays down a precedent on this issue, the same has been challenged before the high court and the final position would depend upon the outcome at the higher appellate level. However, it is also important to obtain appropriate documentation in addition to the TRC to substantiate the share of profit of the partners/members who are residents of the same jurisdiction as the FTE.

From the above discussion, a view can it be taken that the treaty benefit should be given to the “pass through entity”, where all partners / members are residents of the treaty partner country or if some of the partners / members are residents of the treaty partner country, to the extent of partners/members who are resident of the treaty partner country.

International Taxation

In an earlier article, the authors had analysed some of the issues in respect of exchange rates used while computing capital gains in respect of the transfer of shares in a cross-border transaction. While the said article focused on the domestic tax law provisions, there are some interesting issues that arise even in application of tax treaties, especially some specific treaties, due to the language of the said treaties. In this article, the authors seek to analyse an issue in the taxability of capital gains on transfer of shares under India’s DTAAs with Mauritius and Singapore, which relates to the grandfathering provisions.

BACKGROUND

Before the amendment to the tax treaties in 2017, transfer of shares of an Indian company by a resident of Mauritius and Singapore was exempt from tax in India under the respective tax treaties. Both DTAAs have since been amended, which allow the source country (in the above case, being India) the right to tax the income, with investments made before 1 April 2017 being grandfathered. The exemption provided in the Mauritius DTAA (before the amendment) has been subject to significant litigation before the Tribunals and the Courts, with the matter even being examined by the Hon’ble Supreme Court. The Singapore DTAA (before the amendment), while providing the exemption, also had the Limitation of Benefit (‘LOB’) clause, which provided subjective as well as objective criteria for an entity to avail the capital gains benefit in the DTAA. Further, the India–Singapore DTAA also has a unique Limitation of Relief article (‘LOR’) which does not allow treaty benefits in certain situations unless the amount is actually remitted to Singapore.

While the authors seek to analyse the LOB, LOR and other anti-avoidance provisions in these DTAAs in a subsequent article, this article seeks to analyse the issue that arises on account of the grandfathering provisions provided for the capital gains in these 2 DTAAs, which have been examined by the Tribunal in the recent past. In fact, the India – Cyprus DTAA also had a similar exemption as under the India – Mauritius and India – Singapore DTAA. Unlike the Mauritius and Singapore DTAAs, which were amended, India entered into a new DTAA with Cyprus in 2016, which now taxes the capital gains on shares of a company in the country of source. However, the Protocol to the India – Cyprus DTAA also provides the grandfathering clause in a similar manner and therefore, these issues could equally apply to the India – Cyprus DTAA as well.

GRANDFATHERING CLAUSE

Article 13(4A) and (4B) of the India – Singapore DTAA provide as follows,

“(4A) Gains from the alienation of shares acquired before 1 April 2017 in a company which is a resident of a Contracting State shall be taxable only in the Contracting State in which the alienator is a resident.

(4B) Gains from the alienation of shares acquired on or after 1 April 2017 in a company which is a resident of Contracting State may be taxed in that State.”

It may be noted that the language used in the India–Mauritius DTAA in this regard is similar, and therefore, the principles would equally apply therein. Therefore, the distinction between the taxability in the country of source lies in when the shares were ‘acquired’. If the shares were acquired before 1 April 2017, the country of residence of the transferor (or alienator as used in the DTAA) has the exclusive right of taxation, whereas if the shares were acquired on or after 1 April 2017, the country of source has a right to tax the gains (whether such right is an exclusive right is an issue which the authors have examined in the past – one may refer to the April 2025 edition of the Journal on ‘may be taxed’).

SHARES ACQUIRED

The issue that arises in respect of the grandfathering provisions is what does one mean by the term ‘shares acquired’ and whether this term only applies to an actual purchase or acquisition of shares prior to 1 April 2017, or could the term also cover situations wherein the taxpayer receives the shares in a mode which is otherwise exempt from tax.
The first situation is of convertible preference shares. Let us take an example of a Singapore taxpayer who has acquired convertible preference shares (whether compulsorily or otherwise) of an Indian company before 1 April 2017, and the conversion of such shares is undertaken after 1 April 2017, and the Singapore taxpayer is transferring the converted equity shares of the Indian company. In such a case, the conversion is exempt under section 47(xb) of the Income-tax Act, 1961 (‘ITA’). Further, Explanation 1(i) to section 2(42A) of the ITA, which defines the term ‘short-term capital asset’, provides as follows:

“(i) In determining the period for which any capital asset is held by the assessee –

(a)…

(hf) in the case of a capital asset, being equity shares in a company, which becomes the property of the assessee in consideration of a transfer referred to in clause (xb) of section 47, there shall be included the period for which the preference shares were held by the assessee;..”

Similarly, section 49(2AE) of the ITA also provides as follows,

“(2AE) Where the capital asset, being equity share of a company, became the property of the assessee in consideration of a transfer referred to in clause (xb) of section 47, the cost of acquisition of the asset shall be deemed to be that part of the cost of the preference share in relation to which such asset is acquired by the assessee.”

Accordingly, in the case of conversion of a preference share into an equity share, the ITA considers the period of holding as well as the cost of acquisition of the preference share while determining the period of holding and cost of acquisition of the equity share, respectively.

Would such a deeming fiction also apply in the case of a DTAA? The Delhi ITAT in the case of Sarva Capital LLC vs. ACIT (2023) 153 taxmann.com 618 has held that gains on sale of equity shares of an Indian company by a resident of Mauritius would be eligible for grandfathering and exempt from tax even though the equity shares were issued after 1 April 2017 as such shares were issued to the taxpayer on conversion of Compulsorily Convertible Preference Shares which were acquired by the taxpayer before 1 April 2017. The Delhi ITAT arrived at its conclusion on the basis of the following:

“Undoubtedly, the assessee has acquired CCPS prior to 1-4-2017, which stood converted into equity shares as per terms of its issue without there being any substantial change in the rights of the assessee. As rightly contended by learned counsel for the assessee, conversion of CCPS into equity shares results only in qualitative change in the nature of rights of the shares. The conversion of CCPS into equity shares did not, in fact, alter any of the voting or other rights with the assessee at the end of Veritas Finance Pvt. Ltd. The difference between the CCPS and equity shares is that a preference share goes with preferential rights when it comes to receiving dividend or repaying capital. Whereas, dividend on equity shares is not fixed but depends on the profits earned by the company. Except these differences, there are no material differences between the CCPS and equity shares. Moreover, a reading of Article 13(3A) of the tax treaty reveals that the expression used therein is ‘gains from alienation of SHARES’. In our view, the word ‘SHARES’ bas been used in a broader sense and will take within its ambit all shares, including preference shares. Thus, since, the assessee had acquired the CCPS prior to 1-4-2017, in our view, the capital gain derived from sale of such shares would not be covered under Article 13(3A) or 13(3B) of the Treaty. On the contrary, it will fall under Article 13(4)of India-Mauritius DTAA, hence, would be exempt from taxation, as the capital earned is taxable only in the country of residence of the assessee.”

Accordingly, the Delhi ITAT allowed the benefit of the grandfathering on the premise that the DTAA refers to ‘shares’ and that there was no substantial change in the voting rights of the taxpayer after the conversion.

APPLICATION TO OTHER SCENARIOS

Now, the question arises whether one can apply this decision to convertible debentures. Under the ITA, sections 47(x), 49(2A) and Rule 8AA of the Income-tax Rules, 1962 r.w.s 2(42A) of the ITA accord the same treatment of the period of holding and cost of acquisition to conversion of debentures into equity shares as provided to conversion of preference shares into equity shares.
However, given that the Delhi ITAT has held on the basis that the taxpayer held shares (albeit preference shares) before the conversion, arguably, one may not be able to apply the above decision in the context of debentures. On the other hand, if one considers this view, it may result in a peculiar situation wherein if the taxpayer had transferred the debentures prior to conversion, the said debentures would be exempt as they are not shares and would be covered under Article 13(5) of the India – Singapore DTAA but as one is transferring the shares after conversion, the said transaction is taxable in India.

While one may not be able to apply the Delhi ITAT decision to debentures and other situations, the question to be addressed is whether one can consider the shares acquired before 1 April 2017 in situations wherein the ITA, on application of sections 2(42A) and 49, has allowed the pass-through period of holding and cost of acquisition. Some examples, in addition to convertible debentures and preference shares, could be as follows:

a. Shares received as a gift wherein the donor had acquired the shares before 1 April 2017, but the gift is received after 1 April 2017;

b. Shares received on inheritance after 1 April 2017, wherein the testator had acquired the shares before 1 April 2017;

c. Shares of another company received on amalgamation / demerger undertaken after 1 April 2017, wherein the shareholder held the shares of the amalgamating company / demerged company before 1 April 2017;

d. Bonus shares were issued after 1 April 2017 to a taxpayer who had held the original shares prior to 1 April 2017. In such a case, sections 2(42A) and 49 do not apply, and therefore, the period of holding would begin from the date on which the bonus shares are issued, and the cost of acquisition of the shares shall be Nil.

While analysing the grandfathering provisions under the DTAA, it may be worthwhile to also consider the grandfathering provided in the GAAR provisions in the ITA. Rule 10U of the Income-tax Rules provides as follows,

“The provisions of Chapter X-A shall not apply to –

(a)…

(d) any income accruing or arising to, or deemed to accrue or arise to, or received or deemed to be received by, any person from transfer of investments made before the 1st day of April, 2017, by such person”

Further, CBDT Circular No. 7 of 2017 dated 27 January 2017 in respect of certain clarifications on implementation of GAAR provides as follows,

“Question No. 5: Will GAAR provisions apply to (i) any securities issued by way of bonus issuances so long as the original securities are acquired prior to 1 April 2017 (ii) shares issued post 31st March, 2017, on conversion of Compulsorily Convertible Debentures, Compulsorily Convertible Preference Shares (CCPS), Foreign Currency Convertible Bonds (FCCBs), Global Depository Receipts (GDRs), acquired prior to 1 April 2017; (iii) shares which are issued consequent to split up or consolidation of such grandfathered shareholding?

Answer: Grandfathering under Rule 10U(1)(d) will be available to investments made before 1st April 2017 in respect of instruments compulsorily convertible from one form to another, at terms finalised at the time of issue of such instruments. Shares brought into existence by way of split or consolidation of holdings, or by bonus issuances in respect of shares acquired prior to 1st April 2017 in the hands of the same investor would also be eligible for grandfathering under Rule 10U(1)(d) of the Income Tax Rules.”

The question arises whether one can apply the same principle as provided under the GAAR provisions and rules to the DTAA grandfathering provisions. One may wait for the legal jurisprudence in this matter.

However, in the view of the authors, one needs to interpret the language in the DTAA in the context of the relief that the grandfathering provisions seek to provide. It is a well-settled principle as upheld even by the Hon’ble Supreme Court in the case of Union of India vs. Azadi Bachao Andolan (2003) 263 ITR 706 that treaties are not to be interpreted in the same manner as statutory legislation as the treaties are entered into at a political level.1

1 One may also refer to the article by Shri Pramod Kumar on Bonus Shares & Tax Treaty Grandfathering: 
Investor Conundrum Dissected! dated 24 September 2024 published on 
www.taxsutra.com which has discussed this issue in detail in the context of 
applicability of grandfathering provisions to bonus shares

Arguably, the DTAAs have provided for a grandfathering provision to ensure that a person who had invested before the DTAAs were amended should not be adversely affected due to the change that has occurred after such investment has been made.

In other words, one may need to read the term ‘shares acquired’ in the same manner as ‘investments made’ and therefore, so long as the taxpayer had invested in a particular manner prior to 1 April 2017, the change in the mode of investment ought to be grandfathered. While an argument could be made that one should not read the GAAR provisions, which are in domestic law, into the DTAA, in the authors’ view, this is not the case here, as one is merely providing an objective and contextual interpretation of the term ‘acquired’ and not necessarily under the domestic tax law.

This is evident from the Press Release of the Finance Ministry dated 29 August 2016, while notifying the Protocol of the India – Mauritius DTAA, which states as under,

“The Protocol provides for source-based taxation of capital gains arising from alienation of shares acquired on or after 1st April, 2017, in a company resident in India with effect from financial year 2017-18. Simultaneously, investments made before 1st April, 2017 have been grandfathered and will not be subject to capital gains taxation in India.”

From the above, it is clear that the intention of the Government while amending the DTAA was to exempt ‘investments made’. However, the Press Release dated 23 March 2017 in respect of the Protocol to the India – Singapore DTAA states as follows,

“In order to provide certainty to investors, investments in shares made before 1st April, 2017 have been grandfathered, subject to fulfilment of conditions in the Limitation of Benefits clause as per 2005 Protocol.”

While the Press Release in respect of the India – Singapore DTAA amendment does not cover ‘investments’ but covers ‘shares acquired’, given the objective of a grandfathering clause, as explained above, in the view of the authors, one may still be able to apply the same principle as in the India – Mauritius DTAA as the language in the DTAAs is similar.

Therefore, in respect of bonus shares or conversion of preference shares/ debentures into equity shares should be grandfathered under the DTAA if the original shares/ preference shares/ debentures were acquired prior to 1 April 2017.
A similar view may also apply in cases of amalgamation/ demerger as one had already invested in the amalgamating company/ demerged company prior to 1 April 2017.

However, in respect of shares received as a gift after 1 April 2017, wherein the donor had acquired the shares before such date, in the view of the authors, such an exemption may not apply as the investment was not made by the taxpayer (donee) prior to 1 April 2017. Even under GAAR provisions, Rule 10U(1)(d) refers to investment made by such person, and therefore, grandfathering should be permitted only if the investment was made by that specific person. On the other hand, shares ‘acquired’, in the view of the authors, would also mean shares acquired by way of gift. Therefore, if one had received the gift prior to 1 April 2017, even though such receipt may not be a transfer under the ITA, the shares received should be eligible for grandfathering.

In respect of inheritance under a Will, there could be an additional argument that the shares were acquired by the taxpayer by way of application of the law as a transmission and not a transfer itself.

However, one cannot rule out litigation on this issue, and one may need to wait for some jurisprudence before it can settle down.

CONCLUSION

While the Delhi ITAT has not examined the issue in detail, keeping in mind the overall objective of providing grandfathering under the DTAAs with Singapore, Mauritius and Cyprus, in the view of the authors, there is a good case to argue that the original investment made prior to 1 April 2017 should be grandfathered even if the nature or form of the investment changes after 1 April 2017, provided that the taxpayer is the same before such date. Therefore, in respect of conversion of preference shares or debentures into equity shares, issue of bonus shares or issue of shares on amalgamation or demerger, in the view of the authors, the benefit of grandfathering may be available. However, in the authors’ view, gift received on or after 1 April 2017 may not be eligible for the grandfathering benefit. In any case, one may need to consider the facts and circumstances of each case, and the issue is not free from litigation. Further, there are various other considerations one may need to keep in mind while analysing the grandfathering provisions, such as the treaty entitlement and anti-abuse provisions, etc.

Issues Relating To ‘May Be Taxed’ In Tax Treaties

The term ‘may be taxed’ has been commonly used in tax treaties since before the OECD  Model Tax Convention was first published in 1963. In India, there has been significant litigation on whether the term indicates an exclusive right of taxation. While the CBDT vide Notification in  2008 has clarified the issue, certain ambiguities still exist.

In this article, the authors seek to analyse the said issue on whether the term ‘may be taxed’ in tax treaties refers to an exclusive right of taxation to any Contracting State.

BACKGROUND

The allocation of taxing rights in respect of various streams of income in DTAAs can generally be bifurcated into 3 categories:

a. Category I – May also be taxed:

Some articles provide that the particular income may be taxed in a particular jurisdiction (typically the country of residence) and also states that the income ‘may also be taxed’ in the other Contracting State, typically with some restrictions in terms of tax rates, etc. The articles on dividend, interest, royalty / fees for technical services, generally provide for such type of allocation of taxing right.

For example, Article 10(1) of the India – Singapore DTAA, dealing with dividends provides as follows,

“1. Dividends paid by a company which is a resident of a Contracting State to a resident of the other Contracting State may be taxed in that other State.

2. However, such dividends may also be taxed in the Contracting State of which the company paying the dividends is a resident and according to the laws of that State, but if….” (emphasis supplied);

b. Category II – Shall be taxable only:

Some articles provide that the particular income ‘shall be taxable only’ in a particular Contracting State indicating an exclusive right of taxation to the particular Contracting State (typically the country of residence). Generally, this type of allocation of taxing right is found in the article of business profits (where there is no permanent establishment) or capital gains (in respect of assets other than those specified).

For example, Article 13(5) of the India – Singapore DTAA provides as under,

“Gains from the alienation of any property other than that referred to in paragraphs 1, 2, 3, 4A and 4B of this Article shall be taxable only in the Contracting State of which the alienator is a resident.” (emphasis supplied);

c. Category III – May be taxed:

Some articles simply state that the particular income ‘may be taxed’ in a particular Contracting State (in most cases, the source State) without referring to the taxation right of the other Contracting State.

An example of such taxing right is in Article 6 of the India – Singapore DTAA which provides as under,

“Income derived by a resident of a Contracting State from immovable property situated in the other Contracting State may be taxed in that other State.” (emphasis supplied)

In the above Article, the right of the source State is provided but no reference is made whether the State of residence can tax the said income or not.

While the allocation of taxing right in the first two categories is fairly clear, there is ambiguity in the third category i.e. whether in such a scenario, the country of residence has a right to tax in case the DTAA is silent in this regard.

Given the language in the DTAA, the question which arises is whether the income from rental of an immovable property situated in Singapore by an Indian resident can be taxed in India or would such income be taxed exclusively in Singapore under the India – Singapore DTAA.

DECISIONS OF THE COURTS

While some courts held that the term ‘may be taxed’ in a Contracting State, not followed by the term ‘may also be taxed’ in the other Contracting State meant that exclusive right of taxation was granted to the first-mentioned Contracting State, some courts held that ‘may be taxed’ is to be interpreted differently from ‘shall be taxed only’ and therefore, does not infer exclusive right of taxation. One of the most notable decision which provided the former view i.e. ‘may be taxed’ is equated to ‘shall be taxed only’, is the Karnataka High Court in the case of CIT vs. RM Muthaiah (1993) (202 ITR 508).

The issue before the Hon’ble Karnataka High Court in the above case was whether income earned from an immovable property situated in Malaysia was taxable in India in the hands of an Indian resident under the India – Malaysia DTAA. Article 6(1) of the earlier India – Malaysia DTAA provided,

“Income from immovable property may be taxed in the Contracting State in which such property is situated.”

In the said case, the Revenue argued that the DTAA did not provide for an exclusive right of taxation to Malaysia and India had a right to tax the income. The High Court, while not analysing the specific language of the DTAA, held as under,

“The effect of an ‘agreement’ entered into by virtue of section 90 would be: (i) if no tax liability is imposed under this Act, the question of resorting to the agreement would not arise. No provision of the agreement can possibly fasten a tax liability where the liability is not imposed by this Act; (ii) if a tax liability is imposed by this Act, the agreement may be resorted to for negativing or reducing it; (iii) in case of difference between the provisions of the Act and of the agreement, the provisions of the agreement prevail over the provisions of this Act and can be enforced by the appellate authorities and the Court.”

The High Court, therefore, held that as the DTAA did not specifically provide for India, being the country of residence, to tax the said income, it would be taxable only in Malaysia.

The Mumbai Bench of the Tribunal in the case of Ms. Pooja Bhatt vs. DCIT (2009) (123 TTJ 404) held that,

“Wherever the parties intended that income is to be taxed in both the countries, they have specifically provided in clear terms. Consequently, it cannot be said that the expression “may be taxed” used by the contracting parties gave option to the other Contracting States to tax such income. In our view, the contextual meaning has to be given to such expression. If the contention of the Revenue is to be accepted then the specific provisions permitting both the Contracting States to levy the tax would become meaningless. The conjoint reading of all the provisions of articles in Chapter III of Indo-Canada treaty, in our humble view, leads 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 income source 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 have specifically so provided. Hence, the contention of the Revenue that the expression “may be taxed in other State” gives the option to the other State and the State of residence is not precluded from taxing such income cannot be accepted.”

Similarly, the Madras High Court in the case of CIT vs. SRM Firm & Others (1994) (208 ITR 400) also held on similar lines. The above Madras High Court decision was affirmed by the Apex Court in the case of CIT vs. PVAL KulandaganChettiar (2004)(267 ITR 654), albeit without analyzing the controversy of ‘may be taxed’ vs ‘shall be taxed only’. The Supreme Court held that,

“13. We need not to enter into an exercise in semantics as to whether the expression “may be” will mean allocation of power to tax or is only one of the options and it only grants power to tax in that State and unless tax is imposed and paid no relief can be sought. Reading the Treaty in question as a whole when it is intended that even though it is possible for a resident in India to be taxed in terms of sections 4 and 5, if he is deemed to be a resident of a Contracting State where his personal and economic relations are closer, then his residence in India will become irrelevant. The Treaty will have to be interpreted as such and prevails over sections 4 and 5 of the Act. Therefore, we are of the view that the High Court is justified in reaching its conclusion, though for different reasons from those stated by the High Court.”

This view was further upheld by the Supreme Court in the cases of DCIT vs. Torqouise Investment & Finance Ltd. (2008) (300 ITR 1) and DCIT vs. Tripti Trading & Investment Ltd (2017) (247 Taxman 108). In both the above cases, it was held that dividend received by an Indian assessee from Malaysia was exempt from
tax in India by virtue of the India – Malaysia DTAA following the earlier decision of Kulandagan Chettiar (supra).

NOTIFICATION OF 2008 AND SUBSEQUENT DECISIONS

Section 90(3) of the ITA, inserted by the Finance Act 2003 with effect from Assessment Year 2004-05, provides that any term not defined in the DTAA can be defined through a notification published in the Gazette. Subsequently, the CBDT Notification No. 91 of 2008 dated 28th August, 2008 under section 90(3) was issued, which states as under,

“In exercise of the powers conferred by sub-section (3) of section 90 of the Income-tax Act, 1961 (43 of 1961), the Central Government hereby notifies that where an agreement entered into by the Central Government with the Government of any country outside India for granting relief of tax or as the case may be, avoidance of double taxation, provides that any income of a resident of India “may be taxed” in the other country, such income shall be included in his total income chargeable to tax in India in accordance with the provisions of the Income-tax Act, 1961 (43 of 1961), and relief shall be granted in accordance with the method for elimination or avoidance of double taxation provided in such agreement.”

Therefore, the CBDT, vide its above notification, provided that the term ‘may be taxed’ is not required to be equated to ‘shall be taxable only’ and India would still have the right of taxation, unless the tax treaty specifically provides that the income ‘shall be taxed only’ in the other State.

There are two possible views regarding implications of the aforesaid Notification issued by the CBDT.

View 1: The Notification clarifies the right of taxation in respect of ‘may be taxed’

The view is that the Notification now changes the position of taxability and that income of a resident of India shall be taxable in India unless the income is taxable only in the country of source as per the respective DTAA, has been upheld by the Mumbai ITAT in the cases of Essar Oil Ltd. vs. ACIT (2014) 42 taxmann.com 21 and Shah Rukh Khan vs. ACIT (2017) 79 taxmann.com 227, the Delhi ITAT in the case of Daler Singh Mehndi vs. DCIT (2018) 91 taxmann.com 178 and the Jaipur ITAT in the case of Smt. IrvindGujral vs. ITO (2023) 157 taxmann.com 639.

View 2: The Notification does not clarify all situations involving ‘may be taxed’

The alternative view is that Notification No. 91 of 2008 will have application only in a case where the primary right to tax has been given to the state of residence and such state has allowed the source State also to charge such income to tax at a concessional rate.

The relevant provisions in a DTAA could be divided into three broad categories:

i) where the right to tax is given to the State of source (e.g. Article 6 dealing with income derived from immovable property);

ii) where such right to tax is given to the State of residence (e.g. Article 8 dealing with income derived from International Shipping and Air Transport); and

iii) where the primary right to tax is with the State of residence. However, such State has ceded and allowed the State of source also to charge such income to tax, but, at a concessional rate (e.g. Article 7 dealing with business profits, Article 10 dealing with dividends, Article 11 dealing with interest and Article 12 dealing with royalties and fees for technical services).

Under this view, one may argue that the said notification has been issued to clarify the position of the Government of India only with respect to the category (iii) of income as it does not refer to a situation where the right of State of Residence to tax the said income, is silent. The said clarifications should not apply to incomes referred to in category (i) and category (ii) above. This is because, with respect to category (iii) income as explained above, the primary right to tax is with the state of Residence which has partially ceded such right in favour of the State of source by enabling such State to tax the income at a concessional rate of tax. If one reads the said notification in the above context, one may conclude that the Notification only covers income covered in category (iii) above.

Another aspect one may consider is that section 90(3) of the Act, itself provides that the meaning to be assigned to a term in the notification issued by the Central Government shall apply unless the context otherwise requires and such meaning is consistent with the provisions of the Act or the DTAA.

Further, interestingly, readers may refer to the January 2021 edition of this Journal1 wherein the authors of the said article have analysed that while section 90(3) of the ITA empowers the Government to define an undefined term, the above Notification goes beyond the scope of the section as it does not define any term but only clarifies the stand of the Government on the said issue without actually defining the term.

The authors of the said article have also questioned whether ‘may be taxed’ is a term or a phrase.

In this regard, one may also refer to the Mumbai ITAT in the case of Essar Oil (supra), wherein the issue of whether it is a term or a phrase was analysed and concluded as under,

“The phrases “may be taxed”, “shall be taxed only” and “may also be taxed” have a definite purpose and a definite meaning which is conveyed. Whether it is a term, phrase or expression does not make any significant difference because the contracting parties have given a definite meaning to such a phrase and once the Government of India have clarified such an expression, then it cannot be held that it does not fall within the realm of the word “term” as given in section 90(3). Thus, we do not feel persuaded by the argument taken by the learned Sr. Counsel.”

UNILATERAL AMENDMENTS

The India – Malaysia DTAA which was the subject matter of litigation in the matter before the High Courts and Supreme Courts for the meaning of the term, was amended in 2012. Interestingly, the new DTAA now specifically provides the following in the Protocol,

“It is understood that the term “may be taxed in the other State” wherever appearing in the Agreement should not be construed as preventing the country of residence from taxing the income.”

Therefore, in respect of the India – Malaysia DTAA now, there is no ambiguity about the interpretation of the phrase. However, the question does arise as to whether, the fact that this similar language is not provided in any other DTAA (in the main text or in the Protocol), another meaning has to be ascribed to the term in the other DTAAs.

Though the Notification is part and parcel of the Act, a DTAA is a thoughtfully negotiated economic bargain between two sovereign States and any unilateral amendment cannot be read into the DTAA such that the economic bargain is annulled, until and unless the DTAA itself is amended.

As mentioned above, the authorities being aware of the aforesaid fact, amended the India-Malaysia DTAA on 09-05-2012 to incorporate the unilateral amendment put forth by the aforesaid Notification into the DTAA by way of inserting paragraph 3 to the Protocol of the India-Malaysia DTAA. Similarly, paragraph 2 to the Protocol dated 30-01-2014 of the India-Fiji DTAA states that the term “may be taxed in the other State” wherever appearing in the Agreement should not be construed as preventing the country of residence from taxing the income. Paragraph 1 of India-South Africa DTAA provides that ‘With reference to any provision of the Agreement in terms of which income derived by a resident of a Contracting State may be taxed in the other Contracting State, it is understood that such income may, subject to the provisions of Article 22, also be taxed in the first-mentioned Contracting State.

In the earlier India-Malaysia DTAA (Notification No. GSR 667(E), dated 12th October, 2004), Clause 4 of the Protocol was agreed on between the two contracting States with reference to paragraph 1 of Article 6 to the effect that the said paragraph should not be construed as preventing the Country of Residence to also tax the income under the said Article.

It would be relevant to note that Article 6 of the India-Malaysia DTAA and that of other DTAAs on taxation of income from immovable property are worded alike. However, the aforesaid Protocol agreed between India and Malaysia in the India-Malaysia DTAA is not found for example, in the India-UK or India-France DTAA. It becomes all the more conspicuous when protocols under other DTAAs have been signed after the Notification No. 91/2008 issued under Section 90(3). An example can be considered of the India – UK DTAA wherein the Protocol is signed on 30th October, 2012 but there is no agreement with regard to interpretation of the expression “may be taxed”, which is used inter alia in Articles 6, 7, 11, 12 and 13. Thus, one may argue that the expression “may be taxed” required an understanding under the India-Malaysia DTAA that varied with the earlier judicial understanding of the said expression in other DTAAs.

In certain DTAAs where expression ‘may be taxed’ has been used in Article 6 or Article 13, it has been clarified through Protocols that income and capital gains relating to immovable properties may be taxed in both the contracting states. Some of these DTAAs with India are: Hungary, Serbia, Montenegro and Slovenia.

However, in certain other DTAAs where expression ‘may be taxed’ has been used in Article 6 or Article 13, it has been clarified through Protocols that income and / or capital gains relating to immovable properties may be taxed in the Contracting State where the immovable property is situated. For example, India’s DTAAs with Estonia and Lithuania.

A DTAA is a product of bilateral negotiation of the terms between two sovereign States which are expected to fulfill their obligations under a DTAA in good faith. This includes the obligation for not defeating the purpose and object of the DTAA. Therefore, while the amendment to the India-Malaysia DTAA was consciously made on the lines of the Notification, it is apparent that the same was deliberately not extended to other DTAAs in probable consideration of larger macro issues which could have had a bearing upon the bilateral trade relations.

It is to be noted that in the case of Essar Oil Limited (supra), the ITAT was interpreting Article 7 of the India-Oman DTAA and India-Qatar DTAA dealing with business profits. Article 7(1) clearly provides that the profits of an enterprise of a contracting State shall be taxable only in that State. The exception carved out is only to enable the “PE country” to tax the profits attributable to the PE. Profits attributable to a PE may be larger than the profits sourced within the PE State, which is not the case for Article 6 dealing with income from immovable properties, where the source is undisputedly within the State in which the immovable property is located. Contextually, the expression “may be taxed” lends itself to different meanings under Article 7 and Article 6. This distinction has not been brought to the attention of the Hon’ble Tribunal. Clarifications, if any, would serve the intended purpose only when incorporated in the respective DTAA. The same was done through a Protocol entered under the India-Malaysia DTAA in the context of the expression “may be taxed”.

Therefore, one may be able to argue that Notification No. 91/2008 should have no application in respect of cases covered under category I i.e. similar to Article 6.

INTERPLAY WITH ARTICLE ON TAX CREDIT

Another aspect which also needs to be considered is the language of Article 25 of the India – Singapore DTAA, dealing with Elimination of Double Taxation (foreign tax credit or relief). It provides as under,

“2. Where a resident of India derives income which, in accordance with the provisions of this Agreement, may be taxed in Singapore, India shall allow as a deduction from the tax on the income of that resident an amount equal to the Singapore tax paid, whether directly or by deduction.”

In the present case, if one argues that income from immovable property situated in Singapore shall be taxable only in Singapore as the Article states that such income ‘may be taxed’ in Singapore, the question of tax credit does not arise. However, Article 25(2), as discussed above, specifically provides that when the DTAA states that income may be taxed in Singapore, India should grant foreign tax credit to eliminate double taxation. The said credit can be provided only after India has taxed the income in the first place.

It may, however, be highlighted that the Mumbai ITAT in the case of Pooja Bhatt vs. DCIT (2009) 123 TTJ 404 did not accept this argument and held as under,

“8. The reliance of the Revenue on Article 23 is also misplaced. It has been contented that Article 23 gives credit of tax paid in the other State to avoid double taxation in cases like the present one. In our opinion, such provisions have been made in the treaty to cover the cases falling under the third category mentioned in the preceding para i.e., the cases where the income may be taxed in both the countries. Hence, the cases falling under the first or second categories would be outside the scope of Article 23 since income is to be taxed only in one State.”

ROLE OF OECD MODEL COMMENTARY

The OECD Model Commentary has explained the various types of allocation of taxing rights used in a DTAA. The OECD Model Commentary 2017 on Article 23A dealing with Elimination of Double Taxation provides as under,

“6. For some items of income or capital, an exclusive right to tax is given to one of the Contracting States, and the relevant Article states that the income or capital in question “shall be taxable only” in a Contracting State. The words “shall be taxable only” in a Contracting State preclude the other Contracting State from taxing, thus double taxation is avoided. The State to which the exclusive right to tax is given is normally the State of which the taxpayer is a resident within the meaning of Article 4, that is State R, but in Article 19 the exclusive right may be given to the other Contracting State (S) of which the taxpayer is not a resident within the meaning of Article 4.

7. 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” in the Contracting State (S or E) of which the taxpayer is not a resident within the meaning of Article 4. In such case the State of residence (R) must give relief so as to avoid the double taxation. Paragraphs 1 and 2 of Article 23 A and paragraph 1 of Article 23 B are designed to give the necessary relief.”

The above Commentary makes it clear that where the Model wanted to provide an exclusive right of taxation to a particular country, it has provided that with the words “shall be taxable only”. In other scenarios both the countries shall have the right to tax the income.

It may be noted that the Hon’ble Supreme Court in the case Kulandagan Chettiar (supra) did not consider the validity of the OECD Model Commentary on the basis of which the DTAAs are entered into. In the said case, the Supreme Court held as under,

“16. Taxation policy is within the power of the Government and section 90 of the Income-tax Act enables the Government to formulate its policy through treaties entered into by it and even such treaty treats the fiscal domicile in one State or the other and thus prevails over the other provisions of the Income-tax Act, it would be unnecessary to refer to the terms addressed in OECD or in any of the decisions of foreign jurisdiction or in any other agreements.”

However, subsequent decisions of the Supreme Court including that of Engineering Analysis Centre of Excellence (P) Ltd vs. CIT (2021) 432 ITR 471 have held that the OECD Model Commentary shall have persuasive value as the DTAAs are based on the OECD Model.

Impact of Multilateral Convention to Implement Tax Treaty related measures to prevent Base Erosion and Profit Shifting [MLI]

India is a signatory to MLI. The DTAAs have to be read along with the MLI. Article 11 of the MLI deals with Application of Tax Agreements to Restrict a Party’s Right to Tax its Own Residents. Article 11(1)(j) provides that a Covered Tax Agreement (CTA) shall not affect the taxation by a Contracting Jurisdiction of its residents, except with respect to the benefits granted under provisions of the CTA which otherwise expressly limit a Contracting Jurisdiction’s right to tax its own residents or provide expressly that the Contracting Jurisdiction in which an item of income arises has the exclusive right to tax that item of income.

India has not reserved Article 11 of the MLI. The following countries have chosen Article 11(1) with India: Australia, Belgium, Colombia, Denmark, Croatia, Fiji, Indonesia, Kenia, Mexico, Mongolia, Namibia, New Zealand, Norway, Poland, Portugal, Russia, Slovak Republic, South Africa and UK. In respect of these countries, in absence of an express provision, the right of the resident country to tax its residents cannot be taken away under the DTAA. However, the same cannot be applied to countries which have not chosen Article 11(1) or which have not signed the MLI.

CONCLUSION

Even after the 2008 Notification under section 90(3), two strong views still exist as to whether the term ‘may be taxed’ grants exclusive right of taxation to the source State particularly in the case of the Article 6 where, unless otherwise expressly stated in the DTAA, it is clearly intended to allocate right of taxation exclusively to the source state where the immovable property is situated. This view would depend on the role of the tax treaties read with MLI in taxation – that is whether one considers that the country of residence always has the right to tax all income unless specifically restricted by the tax treaty or does the right of taxation of the country of residence need to be specifically provided in the tax treaty.

Issues Relating To Grandfathering Provisions In The Mauritius And Singapore DTAA

The global economic environment in the context of India has resulted in various cross-border investments with many foreign investors investing in Indian companies as well as Indian investors investing overseas. These investments have also benefitted from largely liberal exchange control regulations, which allow cross-border investments in most sectors without requiring prior approval from the Government. Further, in the past, some DTAAs, such as those with Mauritius and Singapore, allowed an investor to invest in shares of an Indian company without any tax arising on the capital gains at the time of transfer, resulting in an increase in investment activity.

Even though the said DTAAs have now been amended to allow India to tax the capital gains arising on the sale of shares of an Indian company, various issues arise in applying the DTAA provisions to the cross-border transfer of shares. The amended DTAAs provide a grandfathering for certain investments. This grandfathering clause, as well as the interplay with the existing Limitation of Benefits (‘LOB’) clauses in the DTAAs, has resulted in some interesting issues. In this article, the authors have sought to analyse some of the issues to evaluate when does one apply the grandfathering clause as well as the respective LOB clause in these two DTAAs.

BACKGROUND

India’s DTAAs with Mauritius and Singapore, entered into in 1982 and 1994, respectively, provided for an exemption from capital gains on the sale of shares in the source country and gave an exclusive right of taxation to the country of residence. Interestingly, the Singapore DTAA initially did not have such an exemption and the gains arising on the sale of shares were taxable in the country of source. However, the Protocol in 2005 amended the DTAA, exempting the gains. Further, the 2005 Protocol also provided that the exemption was available so long as the Mauritius DTAA gave such exemption and also introduced a LOB clause in the Singapore DTAA for claiming exemption of capital gains under the DTAA.

The LOB clause in the India – Singapore DTAA, which applied only in the case of exemption claimed on capital gains under the DTAA, provided that such exemption was not available if the affairs were arranged with the primary purpose of taking advantage of the DTAA and that a shell / conduit company shall not be entitled to benefits of the capital gains exemption. The LOB clause also provides that a company shall be deemed to be a shell / conduit company if its annual expenditure on operations in the Contracting State is less than ₹50,00,000 (if the company is situated in India) or SGD 200,000 (if the company is situated in Singapore) and such company is not listed on a recognised stock exchange in that country.

While various interpretational issues arise in the LOB clause, the said issues have not been analysed in this article, which focuses mainly on when the LOB clause should be applied and which investments are grandfathered under the DTAA.

The India – Mauritius DTAA, prior to its amendment in 2016, did not provide for any LOB clause or any other restriction while exempting the capital gains arising on the sale of shares in the country of source, giving exclusive right of taxation to the country of residence.

The exemptions provided under the India – Mauritius as well as the India – Singapore DTAA have been subject to numerous litigations in the past. In 2016, both the DTAAs were amended, and the capital gains exemption was withdrawn.

AMENDED ARTICLES ON CAPITAL GAINS AND LOB CLAUSE

Article 13 of the India – Mauritius DTAA, as amended by the 2016 Protocol, now provides as under:

“3A. Gains from the alienation of shares acquired on or after 1st April 2017 in a company which is a resident of a Contracting State may be taxed in that State.

3B. However, the tax rate on gains referred to in paragraph 3A of this Article and arising during the period beginning on 1st April 2017 and ending on 31st March 2019 shall not exceed 50% of the tax rate applicable on such gains in the State of residence of the company whose shares are being alienated.

4. Gains from the alienation of any property other than that referred to in paragraphs 1,2,3, and 3A shall be taxable only in the Contracting State of which the alienator is a resident.”

Similarly, Article 13 of the India – Singapore DTAA has also been amended as follows:

“4A. Gains from the alienation of shares acquired before 1 April 2017 in a company which is a resident of a Contracting State shall be taxable only in the Contracting State in which the alienator is a resident.

4B. Gains from the alienation of shares acquired on or after 1st April 2017 in a company which is a resident of a Contracting State may be taxed in that State.

4C. However, the gains referred to in paragraph 4B of this Article which arise during the period beginning on 1st April 2017 and ending on 31st March 2019 may be taxed in the State of which the company whose shares are being alienated is a resident at a tax rate that shall not exceed 50% of the tax rate applicable on such gains in that State.

5. Gains from the alienation of any property other than that referred to in paragraphs 1, 2, 3, 4A and 4B of this Article shall be taxable only in the Contracting State of which the alienator is a resident.”

As can be seen above, the language used in both the DTAAs is similar and provides the following:

a. Capital gains on sale of shares acquired before 1st April, 2017 shall continue to be exempt in the country of source [under Articles 13(5) and 13(4A) of the India – Mauritius DTAA and India – Singapore DTAA, respectively].
b. Capital gains on shares acquired after 1st April, 2017 shall be taxable in the country of source as well as the country of residence.

c. Capital gains on shares acquired after 1st April, 2017 and sold before 31st March, 2019 shall be taxable at 50 per cent of the tax rate applicable.

APPLICATION OF LOB CLAUSE

The 2016 Protocol to both the DTAAs has also introduced a LOB clause wherein benefits of the exemption are denied if the primary purpose of the arrangement is to obtain the benefits of the exemption or if the company is a shell / conduit company. However, the major difference between the LOB clauses in the DTAAs with Mauritius and Singapore is that the LOB clause in the Singapore DTAA applies to all capital gains exemption, i.e., those undertaken before 1st April, 2017 as well as after (if it is exempt) whereas the LOB clause in the Mauritius DTAA applies only in respect of Article 13(3B), i.e., only in situations where the shares are acquired after 1st April, 2017 and sold before 31st March, 2019.

In other words, the LOB clause in the Mauritius DTAA does not apply to any capital gains exemption claimed in respect of investments made before 1st April, 2017, nor any other gains being exempt in respect of shares acquired after 1st April, 2017 (if such gains are exempt).

For example, gains derived by a resident of Singapore on the sale of preference or equity shares of an Indian company which were acquired before 1st April, 2017 shall be exempt as well as be subject to the LOB clause. On the other hand, gains derived by a resident of Mauritius on the sale of preference or equity shares of an Indian company which were acquired before 1st April, 2017 shall be exempt in India but shall not be subject to the LOB clause.

APPLICATION OF PRINCIPAL PURPOSE TEST (‘PPT’)

Another aspect one may need to also keep in mind is that while India – Singapore DTAA is a Covered Tax Agreement under the OECD Multilateral Instrument (‘MLI’) and, therefore, the PPT test of the MLI may apply, India – Mauritius DTAA currently is not a Covered Tax Agreement and hence, not subject to the PPT test. While the MLI does not modify the Mauritius DTAA, a similar PPT test provision may be introduced in the amended DTAA (while the draft was circulated, the same is not notified and final).

GRANDFATHERING CLAUSE

Both the amended DTAAs provide for grandfathering for shares acquired before 1st April, 2017. An interesting question arises whether the said grandfathering would apply in scenarios where one is not holding shares of the Indian company as on 1st April, 2017 but has been acquired or received on account of an interest held in some form before 1st April, 2017.

Let us take a scenario of compulsorily convertible preference shares, which were acquired by the Mauritius or Singapore resident before 1st April, 2017 but were converted into equity shares of the Indian company after 1st April, 2017 and are now being sold. The conversion of the CCPS (it need not necessarily be compulsorily convertible but even optionally convertible) into equity shares is not considered a taxable transfer by virtue of section 47(xb) of the Income-tax Act, 1961 (‘the Act’). Further, the period of holding of the preference shares shall also be considered to determine whether the asset is a long-term or short-term capital asset under clause (hf) of Explanation 1 to section 2(42A).

The question which arises is when the equity shares are sold, would the exemption under the Mauritius or Singapore DTAA apply as the asset being sold came into existence only after 1st April, 2017, although such asset was received in exchange for an asset acquired before 1st April, 2017.

This issue was examined by the Delhi ITAT in the case of Sarva Capital LLC vs.. ACIT (2023) 153 taxmann.com 618, where the facts were similar to the example explained above and in the context of the India – Mauritius DTAA. In the said case, the Delhi ITAT allowed the claim of exemption on the sale of the converted equity shares of the Indian company under Article 13(4) of the DTAA and not under Article 13(3A) or 13(3B).

The Delhi ITAT held as follows:

“Undoubtedly, the assessee has acquired CCPS prior to 1-4-2017, which stood converted into equity shares as per terms of its issue without there being any substantial change in the rights of the assessee. As rightly contended by learned counsel for the assessee, conversion of CCPS into equity shares results only in qualitative change in the nature of rights of the shares. The conversion of CCPS into equity shares did not, in fact, alter any of the voting or other rights with the assessee at the end of Veritas Finance Pvt. Ltd. The difference between the CCPS and equity shares is that a preference share goes with preferential rights when it comes to receiving dividend or repaying capital. Whereas, dividend on equity shares is not fixed but depends on the profits earned by the company. Except these differences, there are no material differences between the CCPS and equity shares. Moreover, a reading of Article 13(3A) of the tax treaty reveals that the expression used therein is ‘gains from alienation of SHARES’. In our view, the word ‘SHARES’ bas been used in a broader sense and will take within its ambit all shares, including preference shares. Thus, since, the assessee had acquired the CCPS prior to 1-4-2017, in our view, the capital gain derived from sale of such shares would not be covered under Article 13(3A) or 13(3B) of the Treaty. On the contrary, it will fall under Article 13(4) of India-Mauritius DTAA, hence, would be exempt from taxation, as the capital earned is taxable only in the country of residence of the assessee.”

In the said decision, the Delhi ITAT allowed the claim of exemption under Article 13(4) on the following grounds:

a. There is no material difference between CCPS and equity shares except with respect to dividends and repayment of capital; and

b. The assessee had acquired CCPS, which are also shares under Article 13, prior to 1st April, 2017

While one may deliberate on the arguments of the ITAT in reaching the conclusion, there is an additional argument to consider — that of purposive interpretation.One may be able to argue that the intention of the grandfathering provision is to protect a taxpayer who had undertaken a transaction prior to the change in law to not be affected by the change in law. In the case of conversion of preference share into equity share, there is no additional investment undertaken and the investment was undertaken prior to April 2017, and therefore, this investment is to be protected in substance, even if the form of the investment undergoes a change. Further, this argument is also the reason the General Anti-Avoidance Rules under the Act have grandfather investments made before
1st April, 2017. This question has arisen in the context of GAAR as well.

In that case, the CBDT vide Circular No. 7 of 2017 dated 27th January, 2017 has provided as under:

“Q. 5. Will GAAR provisions apply to (i) any securities issued by way of bonus issuances so long as the original securities are acquired prior to 1st April 2017 (ii) shares issued post 31st March 2017, on conversion of Compulsorily Convertible Debentures, Compulsorily Convertible Preference Shares, …. Acquired prior to 1st April 2017; (iii) shares which are issued consequent to split up or consolidation of such grandfathered shareholding?

Answer: Grandfathering under Rule 10U(1)(d) will be available to investments made before 1st April 2017 in respect of instruments compulsorily convertible from one form to another, at terms finalised at the time of issue of such instruments. Share brought into existence by way of split or consolidation of holdings, or by bonus issuances in respect of shares acquired prior to 1st April 2017 in the hands of the same investor would also be eligible for grandfathering under Rule 10U(1)(d) of the Income Tax Rules.”

While the language in the DTAA is ‘shares acquired’ as against ‘investments made’ under Rule 10U(1)(d) of the Income Tax Rules for GAAR purposes, and hence the language used in the GAAR rules is broader than the DTAA can one apply the principle of the CBDT Circular above to the DTAA.

CONCLUSION

One may be able to take a view that the principle emanating from the CBDT Circular above can also be applied to the DTAA, especially given the intention of the grandfathering provisions of protecting the taxpayers from the change in the law in respect of an investment made before the law came into force. Therefore, the taxpayer may be able to take a view that in situations where one already has an interest in an entity prior to 1st April, 2017 and that interest in the entity in substance continues albeit in a different form after 1st April, 2017, one should be able to apply the grandfathering principles. However, readers are advised to consider the facts of each case before applying the principles discussed above.

Exchange Rate to Be Used For Computation of Capital Gains In The Case Of Cross-Border Transactions Involving Transfer of Shares

With the removal of exemption for capital gains arising on transfer of shares under the Indian tax treaties (DTAA) with Mauritius, Singapore and Cyprus, gains arising on such transfer, in most cases, would now be taxed in the country of source. Further, there have been certain significant judgments which raise pertinent issues in respect of computation of capital gains arising on the transfer of shares in a cross-border scenario. Some of these judgments are in respect of domestic provisions in the Income Tax Act, 1961 (ITA) related to the computation of capital gains in a cross-border scenario whereas some are related to computation or eligibility of claim under the DTAA.

In this article, the authors have sought to analyse the issues related to the exchange rate to be used for computation of capital gains in the case of a cross-border scenario. These issues are dealing with the domestic provisions under the ITA and the Income Tax Rules, 1962 (Rules).

EXCHANGE RATE FOR COMPUTATION OF CAPITAL GAINS

An important issue in recent times has been related to the exchange rate to be used for the purpose of computing capital gains. There have been a couple of recent judgments, both by the Mumbai bench of the ITAT, which have discussed these issues at length. The issue of exchange rate to be used in the case of capital gains arises in both type of transactions — when a resident sells the shares of a foreign company as well as when a non-resident sells the shares of an Indian company. However, while the broad principle would apply in both the transactions, as the provisions of the ITA differ slightly in each of the above transactions, each transaction has been analysed separately.

a. Inbound

In this type of transaction, a non-resident is selling shares of an Indian company. The main issue in this type of transaction is the interplay of sections 48 and 112 of the ITA and Rule 115/115A of the Rules.

Let us take an example to understand this issue further. US Co, a US company, had acquired shares of I Co, an Indian unlisted private company, in 2014 when the exchange rate was 1 USD = INR 60. During FY 2024–25, these shares are sold to a UK-based company, when the exchange rate is 1 USD = INR 85. The computation of capital gains would be as follows:

Particulars Amount in USD Exchange Rate Amount in INR
Sales consideration 80,000 85 68,00,000
(-) Cost of acquisition 100,000 60 60,00,000
Capital Gains (20,000) 8,00,000

As can be seen from the computation above:

a. If one computes the capital gains in USD terms there is a loss; whereas

b. If one computes the capital gains by converting the cost of acquisition and the sales consideration at the exchange rate prevalent at the time of acquiring or transfer of the shares, respectively, it results in a gain.

Therefore, one can say that the gain is primarily on account of the difference in the exchange rates on both the dates.

The first proviso to section 48 of the ITA, which provides the mode of computation of capital gains, states as follows:

“Provided that in the case of an assessee, who is a non-resident, capital gains arising from the transfer of a capital asset being shares in, or debentures of, an Indian company shall be computed by converting the cost of acquisition, expenditure incurred wholly and exclusively in connection with such transfer and the full value of the consideration received or accruing as a result of the transfer of the capital asset into the same foreign currency as was initially utilised in the purchase of the shares or debentures, and the capital gains so computed in such foreign currency shall be reconverted into Indian currency, so, however, that the aforesaid manner of computation of capital gains shall be applicable in respect of capital gains accruing or arising from every reinvestment thereafter in, and sale of, shares in, or debentures of, an Indian company:..”

Therefore, the proviso requires one to convert the cost of acquisition as well as the sales consideration into foreign currency, compute the capital gains in foreign currency and then recompute the gains arrived in this manner, into INR.

Rule 115A of the Rules provides further guidance in case of sale of shares by a non-resident Indian. Rule 115A requires one to compute the capital gains in this manner:

(i) Convert the cost of acquisition into foreign currency at the rate as on the date of acquisition (USD 100,000 in the said example).

(ii) Convert the expenditure incurred in connection with the transfer as well as the full value of consideration into foreign currency at the rate as on the date of transfer of the capital asset (USD 80,000 in the said example).

(iii) Reconvert the capital gains into INR at the rate as on the date of transfer (loss of USD 20,000 converted to loss of INR 17,00,000).

While Rule 115A applies only to non-resident Indians and not all non-residents or foreign companies, in the view of the authors, one may be able to apply the same principle in the case of all non-residents.

Section 112(1)(c) of the ITA, which provides the rate of tax on long-term capital gains in the hands of a non-resident (other than a company) or a foreign company, states as follows:

“(1) Where the total income of an assessee includes any income, arising from the transfer of a long-term capital asset, which is chargeable under the head ‘Capital gains’, the tax payable by the assessee on the total income shall be the aggregate of, –

(a)..

(c) in the case of a non-resident (not being a company) or a foreign company, –

(i) …

(ii) …

(iii) the amount of income-tax on long-term gains arising from the transfer of a capital asset, being unlisted securities or shares of a company not being a company in which the public are substantially interested, calculated at the rate of ten per cent on the capital gains in respect of such asset as computed without giving effect to the first and second proviso to section 48;” (emphasis added)

Therefore, in the case of transfer of unlisted shares of an Indian company by a non-resident or a foreign company, section 112 provides that the tax is to be computed on an income without giving effect to the first and second proviso to section 48 of the ITA. If one computes the gains without giving effect to the first proviso to section 48 of the ITA in the above example, it will result in taxable long-term capital gains of INR 8,00,000.

The question which arises is which section should one apply while computing the capital gains in the case of a non-resident or a foreign company, which is transferring unlisted shares of an Indian company — section 48 or 112(1)(c) of the ITA?

This issue has been evaluated by the Mumbai ITAT in the case of Legatum Ventures Ltd vs. ACIT (2023) 149 taxmann.com 436, wherein, on similar facts as our example above, the ITAT held that in such a situation, section 112 would apply and not section 48. The relevant extracts of the reasoning provided by the ITAT is as follows:

“17. From the perusal of section 112 of the Act, forming part of Chapter XII – Determination of Tax in Certain Special Cases, we find that though the said section deals with the determination of tax payable by the assessee on the total income which includes any income arising from the transfer of a long-term capital asset chargeable under the head ‘capital gains’. However, in the case of a non-resident (not being a company) or a foreign company, sub-clause (iii) of clause (c) to sub-section (1) also provides the mode of computation of capital gains. As per section 112(1)(c)(iii) of the Act, in case of a non-resident, capital gains arising from the transfer of a long-term capital asset, being unlisted securities or shares of a company in which public are not substantially interested, shall be computed without giving effect to 1st and 2nd proviso to section 48 of the Act. The aforesaid section further provides a tax rate of 10% on the capital gains so computed. Therefore, we are of the considered opinion that section 112(1)(c)(iii) is a special provision for the computation of capital gains, in case of a non-resident, arising from the transfer of unlisted shares and securities. While, on the other hand, section 48 of the Act is a general provision, which deals with the mode of computation of capital gains in all the cases of transfer of capital assets. Further, section 112(1)(c)(iii) of the Act does not provide for ‘re-computation’ of capital gains for levying tax rate of 10%. Since section 112(1)(c)(iii) is the specific provision, therefore, in case the ingredients of the said section, i.e. (i) in case of non-resident or foreign company; (ii) long-term capital gains arise; (iii) from the transfer of unlisted shares or securities of a company not being a company in which public are substantially interested, are fulfilled, capital gains is required to be computed as per the manner provided under the said section. It is a well-settled rule of interpretation that if a special provision is made respecting a certain matter, that matter is excluded from the general provision under the rule which is expressed by the maxim ‘Generallia specialibus non derogant’. Further, it is also a well-settled rule of construction that when, in an enactment, two provisions exist, which cannot be reconciled with each other, they should be so interpreted that, if possible, the effect should be given to both. Therefore, if the submission of the assessee that in the present case the income chargeable under the head ‘capital gains’ is to be computed only as per section 48 of the Act is accepted, then the same would render the computation mechanism provided in section 112(1)(c)(iii) of the Act completely otiose and redundant.

18. In view of the above, we also find no merits in the assessee’s submission that if the case of the assessee is governed under two provisions of the Act, then it has the right to choose to be taxed under the provision which leaves him with a lesser tax burden. In the present case, the capital gains has to be computed only by reference to provisions of section 112(1)(c)(iii) of the Act. Further, it cannot be disputed that if as per section 112(1)(c)(iii), the 1st and 2nd proviso to section 48 of the Act are not given effect, the assessee will have a long-term capital gains of Rs. 17,13,59,838 from the sale of unlisted shares of the Indian company. Therefore, we find no infirmity in the orders passed by the lower authorities taxing the long-term capital gains of Rs. 17,13,59,838 as per section 112(1)(c)(iii) of the Act.”

Therefore, the ITAT held that section 112 is a special provision and would override section 48, which is a general provision under the ITA.

With utmost respect to the Hon’ble ITAT, in the view of the authors, the above decision did not consider a few aspects, discussed in detail in the ensuing paragraphs, which could have an impact on the issue at hand.

i. At the outset, section 48 lays down the computation mechanism whereas section 112 prescribes the rate of tax. As both sections operate on different aspects and one needs to give impact to both the sections when one is finally computing the tax payable. Therefore, if one takes a harmonious reading of the law, one cannot state that either section should override the other.

ii. Section 112 of the ITA begins with the language “Where the total income of an assessee includes any income, arising from the transfer of a long-term capital asset, which is chargeable under the head ‘Capital gains’”. Therefore, for section 112 of the ITA to apply, there needs to be income which is chargeable under the head “Capital gains”. For the purpose of computing the capital gains, one would need to consider section 48 of the ITA, including the first proviso. If after computing the capital gains in accordance with the ITA, there is a loss, the question of applying section 112 of the ITA does not apply as the total income of the assessee does not include any income chargeable under the head “Capital gains”.

One may refer to the CBDT Circular 721 dated 13th September, 1995, wherein the application of section 112 in the set-off of losses under the other heads of income was discussed in detail. The relevant extracts of the said Circular are reproduced below:

“The above phraseology contains two significant expressions, ‘total income’ and ‘includes any income’. The total income is to be computed in the manner prescribed in the Income-tax Act. Set-off of loss as per the provisions of sections 70 to 80 is a stage which is part of this procedure. When this procedure is adopted for computing gross total income or total income, only the amount of income after set-off remains under a head as part of gross total income or total income. Only that amount of long-term capital gains which is included in the total income would be subject to tax at a prescribed flat rate. Thus, if there was a loss of Rs. 10,000 from business and there is long-term capital gains of Rs. 30,000, then after setting off of loss of Rs. 10,000 with long-term capital gains, only Rs. 20,000 would remain under the head ‘Capital gains’ to be included in the gross total income or total income. The flat rate of tax will be applicable in respect of Rs. 20,000 and not Rs. 30,000, since the amount of long-term capital gains included in that total income is Rs. 20,000. (Here it is assumed that the total income ignoring, long-term capital gains, is above the exemption limit).”

In the view of the authors, while the above circular is in the context of application of section 112 after set-off of the losses, it clearly lays down the manner of interpreting section 112 (the relevant portion of which has not been amended after this Circular), i.e., section 112 applies after the computation provisions have been given effect to. Therefore, the principles emanating from the Circular should also apply in the case interplay of section 112 and section 48 and allows one to give a harmonious reading of both the sections.

iii. Further, the ITAT applied the principle of “Generallia specialibus non derogant”, i.e., special provisions shall override the general provisions. While using this interpretation, it held that section 112(1)(c) specifically applies to non-residents whereas section 48 applies to all transfers. However, what should be considered is that the first proviso to section 48 is also a specific provision and applies only in the case of a non-resident transferring shares or debentures of an Indian company. In other words, both the sections [the first proviso to section 48 and section 112(1)(c)] are special provisions and not general provisions under the ITA.

iv. Another aspect to be considered while evaluating the above decision of the ITAT above is to compare it with the treatment provided to transfer of shares listed on a recognised stock exchange under section 112A of the ITA. In case of such gains also, the first and second proviso to section 48 of the ITA do not apply. However, the manner in which such exclusion has been implemented is by adding a separate proviso to section 48 itself and not in the taxing section 112A. The third proviso to section 48 of the ITA states as below:

“Provided also that nothing contained in the first and second provisos shall apply to the capital gains arising from the transfer of a long-term capital asset being an equity share in a company or a unit of an equity oriented fund or a unit of a business trust referred to in section 112A:”

If a similar carve-out in section 48 was also provided for unlisted shares, taxable under section 112(1)(c), the ITAT decision could have been better appreciated. However, the fact that the legislature, in its wisdom, decided to carve-out the benefit of the first and second proviso in the section dealing with tax rate instead of that dealing with the computation would mean that its intention was different and has to be interpreted in a manner different than one would for section 112A.

v. If one follows the view of the ITAT, it could result in an absurdity wherein a situation of loss in foreign currency but gains in INR would be dealt with differently than loss in foreign currency as well as INR. In case of a loss in foreign currency as well as in INR, the provisions of section 112 of the ITA do not apply and for the purpose of the carry forward of the loss under section 74 of the ITA, one would consider the first proviso of section 48 for carrying forward such loss. Therefore, in the case of a profit due to exchange fluctuation, one would not apply the first proviso to section 48 whereas in the case of a loss, one would apply the first proviso to section 48, resulting in two different outcomes in two similar situations (loss in foreign currency).

vi. Lastly, if one views purely from a non-resident’s perspective, i.e., from the perspective of the US Co in this case, there is clearly a loss. In the above example, US Co had invested in I Co at USD 100,000 and received USD 80,000 in return. Therefore, while the value of the investment may have grown on account of the exchange rate fluctuation, it does not result in an actual profit or gain from US Co’s point of view.

Therefore, in the view of the authors, the only way one would be able to harmoniously apply both the sections without making either obsolete would be to first compute capital gains in accordance with section 48 (including the first proviso) and if the income in accordance with the said section is positive, apply the provisions of section 112 by recomputing the gains without giving effect to the first proviso to section 48. If the income, after computing in accordance with section 48, is a loss, then one need not apply section 112 of the ITA.

b. Outbound

Having analysed the case of a non-resident transferring the shares of an Indian company, one should also evaluate the issues arising in the transfer of shares of a foreign company by a resident. The main issue in this type of transaction is the interpretation of Rule 115 of the Rules.

Let us take a similar example as that above to understand this issue further. In this example, I Co, an Indian company, had acquired shares of US Co, a company incorporated in the US, in 2014 when the exchange rate was 1 USD = INR 60. During FY 2024–25, these shares are sold to a UK-based company, when the exchange rate is 1 USD = INR 85. The computation of the capital gains would be similar to above and as follows:

Particulars Amount in USD Exchange Rate Amount in INR
Sales consideration 80,000 85 68,00,000
(-) Cost of acquisition 100,000 60 60,00,000
Capital Gains (20,000) 8,00,000

Similar to the earlier example, I Co has made a loss in USD terms but a profit if one considers the exchange rate fluctuation.

In this situation, the first proviso to section 48 of ITA does not apply as it applies only in the case of a non-resident transferring the shares of an Indian company and not in the case of a resident transferring the shares of a foreign company. Similarly, section 112(1)(c) of the ITA also does not apply to this transaction.

Rule 115 of the Rules, which deals with the exchange rate to be used for conversion into INR of income expressed in foreign currency, provides as under:

“(1) The rate of exchange for the calculation of the value in rupees of any income accruing or arising or deemed to accrue or arise to the assessee in foreign currency or received or deemed to be received by him or on his behalf in foreign currency shall be the telegraphic transfer buying rate of such currency as on the specified date.

Explanation.—For the purposes of this rule,—

(1) ‘telegraphic transfer buying rate’ shall have the same meaning as in the Explanation to rule 26;

(2) ‘specified date’ means—

(a) …
(b)…

(c) in respect of income chargeable under the heads ‘Income from house property’, ‘Profits and gains of business or profession’ not being income referred to in clause (d) and ‘Income from other sources’ (not being income by way of dividends and ‘Interest on securities’), the last day of the previous year of the assessee

(f) in respect of income chargeable under the head ‘Capital gains’, the last day of the month immediately preceding the month in which the capital asset is transferred:

Provided that the specified date, in respect of income referred to in sub-clauses (a) to (f) payable in foreign currency and from which tax has been deducted at source under rule 26, shall be the date on which the tax was required to be deducted under the provisions of the Chapter XVII-B.

(2) Nothing contained in sub-rule (1) shall apply in respect of income referred to in clause (c) of the Explanation to sub-rule (1) where such income is received in, or brought into India by the assessee or on his behalf before the specified date in accordance with the provisions of the Foreign Exchange Regulation Act, 1973 (46 of 1973).”

The issue which arises is whether Rule 115 shall apply in a situation where the income accruing as a result of a transfer has been received in India — whether the exchange rate for the currency in which the transfer was effectuated and therefore, income accruing, is to be considered or does Rule 115 not apply as the income is received in India.

One of the key decisions on Rule 115 is that of the Supreme Court in the case of CIT vs. Chowgule & Co. Ltd (1996) 218 ITR 384, wherein the Apex Court held as follows:

“Rule 115 merely lays down that ‘for the calculation of the value in rupees of any income accruing or arising or deemed to accrue or arise to the assessee in foreign currency or received or deemed to be received by him or on his behalf in foreign currency’, the rate of exchange shall be the telegraphic transfer buying rate of such currency as on the specified date. Explanation (2) has clarified that the ‘specified date’ will mean in respect of income chargeable under the heading of ‘Profits and gains of business or profession’, the last day of the previous year of the assessee. This only means that if an assessee is assessable in respect of any income accruing or arising or deemed to have accrued or arisen in foreign currency or has received or deemed to have received income in foreign currency, then such foreign currency shall be converted into rupees notionally at the telegraphic transfer buying rate of such currency as on the last day of the previous year of the assessee. If on the last day of the previous year, the assessee does not have any foreign currency in his hand or the assessee is not entitled to receive any foreign currency, then there is no question of conversion of such foreign currency into rupees. It is only the foreign currency which will have to be converted into rupees. But, if the foreign currency received by an assessee has been converted into rupees before the specified date, question of application of rule 115 does not arise. Rule 115 does not lay down that all foreign currencies received by an assessee will be converted into rupees only on the last day of the accounting period. Rule 115 only fixes the rate of conversion of foreign currency. If there is no foreign currency to convert on the last day of accounting period, then no question of invoking rule 115 will arise. The assessee in this case is agreeable to have the outstanding amount of foreign currency payable to him at the rate of exchange prevalent on the last day of the previous year of the assessee. But this rule cannot apply to the amounts received by the assessee in course of the accounting period in rupees. Clause (2), which was introduced on 1-4-1990, is really clarificatory and does not bring about any change in rule 115.”

Therefore, the SC held that Rule 115 would have no implication if the income has been brought into India as on the last day of the previous year. The SC further held that Rule 115(2) of the Rules is merely clarificatory and does not bring about any change in Rule 115. This would, therefore, mean that in the case of capital gains, if the sales consideration (of which the income is a part) is brought into India before the last date of the previous year, the rate at which the income was brought into India would be considered for computing the capital gains.

In the view of the authors, the above SC decision is to be read in the context of the facts which were before the Apex Court. The facts of that case were in respect of business income, wherein the Rule itself provides for the exchange rate on the last date of the previous year to be applied. Therefore, one may be able to distinguish that the principle laid down by the SC in the above decision would not apply to other streams of income where a different date for considering the exchange rate is to be considered — for example, in the case of capital gains, on the last date of the month preceding the month of transfer.

Another point which needs to be considered is the language of Rule 115 which deals with exchange rate for “income accruing or arising or deemed to accrue or arise to the assessee in foreign currency or received or deemed to be received by him or on his behalf in foreign currency”. Therefore, when the Rule itself distinguishes between income accrued and income received, considering the rate at which the income was brought into India and not at which the income was accrued, may not be in line with the Rule. Similarly, if one takes a view that the observation of the SC, that Rule 115(2) is clarificatory, should apply to all streams of income and not just business income, it may be considered as against the intention of the Rule which provides for the rate at which income was brought into India only for business income, income from house property, income from other sources (other than dividend) and interest on securities.

Therefore, in the view of the authors, the above SC decision may not apply to the case of capital gains. Secondly, even if one needs to consider the above SC decision and take the exchange rate as on the date on which it was brought into India, the said exchange rate would apply on the ‘income’ component, which is capital gains and therefore, one need not convert the cost of acquisition and sales consideration separately.

In the context of capital gains, one may refer to the recent decision of the Mumbai ITAT in the case of ICICI Bank Ltd vs. DCIT (2024) 159 taxmann.com 747. In the said case, the assessee had invested in foreign subsidiaries and some of the subsidiaries had been sold while some of the investments were redeemed during the year. As per the limited facts provided in the judgement, the sales consideration was accruing in foreign currency and received in India. The Pr. CIT, while passing an order under section 263, held that indexation of cost is available only when capital assets are acquired in Indian currency. The Pr. CIT further computed the income by converting the cost of acquisition and sales consideration at the exchange rate on the date of acquisition and date of sale, respectively, and held that the investment was made in INR and, therefore, indexation was computed on the gains computed in INR as stated above. The ITAT upheld the order under section 263 and held as follows:

“…. The assessee has sold the shares of the subsidiary company to another entity for a consideration of Russian rubles Rs. 122,49,51,818. This was purchased by the assessee for Russian ruble Rs. 183,12,16,035…..Undisputedly, all these acquisitions have been made by the assessee in Indian currency and sold and ultimately consideration was received in India in Rupees. The acquisition cost in INR was converted in to FC and sale in foreign currency was received in INR. The learned PCIT has given a reason that the order of the learned assessing officer is not in accordance with the concept of cost inflation index. In fact, assessee has not invested in foreign currency but in INR. Even the second proviso to section 48 is only with respect to Non-resident Assessee. By computing long term capital gain by incorrect method assessee has got the benefit of Foreign Exchange Fluctuation as well as cost inflation index both, which is not in accordance with Income-tax Act.”

While no detailed reasoning is provided, it seems that the ITAT has held that as ultimately the acquisition was made by converting INR into foreign currency and as the sales consideration, though in foreign currency, was received in India, the capital gains is to be computed by converting the cost of acquisition and sales consideration at the exchange rate prevailing on the date of purchase and sale, respectively.

Therefore, the ITAT effectively read Rule 115(2) even for capital gains and did not distinguish between “income accruing” and “income received”. As has been analysed above, in the view of the authors, such a position, with utmost respect of the ITAT, may need to be reconsidered on the basis of the arguments provided above. If the same is not reconsidered, in the view of the authors, the provisions of Rule 115 may become obsolete as income, would at some point of time, in the case of a resident, always be repatriated to India, in accordance with the rules under Foreign Exchange Management Act, 1999.

Therefore, in the view of the authors, if the income accruing as a result of transfer, is expressed in foreign currency, such income, being capital gains, would need to be converted in accordance with Rule 115, i.e., there would be a loss of USD 20,000 in the above example.

However, care needs to be taken that the income should be accruing in foreign currency and not in INR. The Bombay High Court in the case of CIT vs. E.R.Squibb & Sons Inc (1999) 235 ITR 1 held, while in an inbound scenario, where the sale price of the shares of an Indian company by a non-resident, as well as the RBI approval for the sale, was in INR, the income would not be said to be accruing in foreign currency and hence, Rule 115 would not apply. Therefore, for Rule 115 to apply in the case of capital gains, it is essential that the agreement in form as well as in substance, refer to the consideration to be received in foreign currency and not INR.

CONCLUSION

While the arguments provided above could help in distinguishing the decisions of the ITAT in the case of inbound investments as well as outbound investments, one may need to consider the possibility of litigation on this aspect as there is no favourable judicial precedent on the subject directly, taking the above arguments. Further, the Mumbai ITAT in the case of ICICI Bank (supra) has held, by upholding the order of the Pr. CIT under section 263, that indexation should apply only to investments in INR and not in case of income expressed in foreign currency. Such a view, not coming clearly from language of the second proviso to section 48 (which seems to apply to all transactions other than capital gains in the hands of a non-resident on sale of shares or debentures of an Indian company), would need a detailed evaluation.

Residential Status – Whether Employment Includes Self Employment

In the context of determination of the residential status of an individual, a question or dispute arises as to whether for the purposes of Explanation 1(a) section 6(1) of the Income-tax Act, 1961 (“the Act”), the term ‘employment’ in the phrase ‘for the purposes of employment outside India’ includes ‘self-employment’ or not.

In this article, we are discussing certain nuances relating to the above dispute.

A. BACKGROUND

Section 6(1) of the Act deals with the residential status of an individual and provides for alternative physical presence tests for residents in India.

Clause (a) of section 6(1) provides that an individual is said to be resident in India in any previous year if he is in India in that year for a period or periods amounting in all to 182 days or more.

Alternatively, clause (c) of section 6(1) provides that an individual is said to be resident in India in any previous year if he has, within 4 years preceding the relevant year, been in India for a period of 365 days or more and, is in India for a period or periods amounting in all to 60 days or more in the relevant year.

Explanation 1(a) to Section 6(1) extends the period of 60 days to 182 days in case of a citizen of India who has left India in any previous year as a member of the crew of an Indian ship or for the purposes of ‘employment’ outside India.

It is pertinent to note that the original Explanation was inserted by the Finance Act, 1978, w.e.f. 1st April, 1979. At that time, the Explanation only covered a situation wherein a citizen of India was visiting India on a leave or vacation in the previous year and did not cover a situation where an Indian citizen left India for the purpose of employment outside India. The extension of the number of days from 60 to 182 for an Indian citizen leaving India for the purposes of ‘employment’ outside India was first introduced by substituting the Explanation vide the Finance Act, 1982 w.e.f. 1st April, 1982, wherein it now stated as follows:

(a) “Explanation.-In the case of an individual, being a citizen of India,-

Who leaves India in any previous year for the purposes of employment outside India, the provisions of sub-clause (c) shall apply in relation to that year as if for the words “sixty days”, occurring therein, the words “one hundred and eighty-two days” had been substituted;

(b) …”

The scope and effect of the above amendments were explained by the Memorandum to the Finance Bill, 1982, which provided as follows:

“33. Relaxation of tests of “residence” in India….

34….

35. With a view to avoiding hardship in the case of Indian citizens who are employed or engaged in avocations outside India, the Bill seeks to make the following modifications in the tests of “residence” in India: –

(i) ….

(ii)…

(iii) It is proposed to provide that where an individual who is a citizen of India leaves India in any year for the purposes of employment outside India, he will not be treated as a resident in India in that year unless he has been in India in that year for 182 days or more. The effect of this amendment will be that the “test” of residence in (c) above will stand modified to this extent in such cases.” (emphasis added)

Para 7.3 of the CBDT in Circular No. 346 dated 30th June, 1982 has also provided similar reasoning and is reproduced as under: “7.3 With a view to avoiding hardship in the case of Indian citizens, who are employed or engaged in other avocations outside India, the Finance Act has made the following modifications in the tests of residence in India:

1. The provision relating to the maintenance of a dwelling place coupled with a stay in India of 30 days or more referred to in (b) above has been omitted.

2. In the case of Indian citizens who come on a visit to India, the period of 60 days or more referred to in (c) above will be raised to 90 days or more.

3. Where an individual who is a citizen of India leaves India in any year for the purposes of employment outside India, he will not be treated as a resident in India in that year unless he has been in India in that year for 182 days or more. The effect of this amendment will be that the test of residence in (c) above will stand modified to that extent in such cases.”

The Direct Tax Laws (Second Amendment) Act, 1989 substituted the Explanation to section 6(1) w.e.f.
1st April, 1990. However, the language in the amended Explanation is the same as was introduced in 1982 and this limb of the Explanation relates to the substitution of 182 days in case of a citizen of India who has left India in any previous year for the purposes of ‘employment’ outside India, remained the same.

B. WHETHER THE TERM ‘EMPLOYMENT’ INCLUDES THE ‘SELF-EMPLOYMENT’

The moot point is what is meaning of the term ‘employment outside India’ is covered by Explanation 1(a) to Section 6(1).

One view that the Assessing Officers (“AOs”) have been taking is that ‘employment outside India’ covered by the Explanation 1(a) does not include undertaking business by oneself and an assessee will be entitled to the benefit of the Explanation only if such assessee went outside India in the previous year to take up ‘employment’ and not for undertaking business. Under this view, a restrictive meaning is given to the term ‘employment’ to only cover a situation where an employer-employee relationship exists with terms of employment and not a broader meaning.

The other view which assessees have been contending is that the term ‘employment’ in the context of Explanation 1(a) includes self-employment and taking up and continuing business is also ‘employment’ for the purposes of Explanation 1(a) to Section 6(1).

C. JUDICIAL PRECEDENTS

1. CIT vs O. Abdul Razak [2011] 198 Taxman 1 (Kerala)

In this case, the Kerala High Court relying upon the above Circular No. 346 dated 30th June, 1982, has interpreted the term ‘employment’ in wide terms. The relevant findings of the Kerala High Court are as under:

“Similarly the Central Board of Direct Taxes issued Circular No. 346, dated 30-6-1982, which reads as follows:

“7.3 With a view to avoiding hardship in the case of Indian citizens, who are employed or engaged in other avocations outside India, the Finance Act has made the following modifications in the tests of residence in India:

(i) & (ii) ******

(iii) Where an individual who is a citizen of India leaves India in any year for the purposes of employment outside India, he will not be treated as a resident in India in that year unless he has been in India in that year for 182 days or more. The effect of this amendment will be that the test of residence in (c) above will stand modified to that extent in such cases.”

7. What is clear from the above is that no technical meaning is intended for the word “employment” used in the Explanation. In our view, going abroad for the purpose of employment only means that the visit and stay abroad should not be for other purposes such as a tourist, or for medical treatment or for studies or the like. Going abroad for the purpose of employment therefore means going abroad to take up employment or any avocation as referred to in the Circular, which takes in self-employment like business or profession.

So much so, in our view, taking up their own business by the assessee abroad satisfies the condition of going abroad for the purpose of employment covered by Explanation (a) to section 6(1)(c) of the Act. Therefore, we hold that the Tribunal has rightly held that for the purpose of the Explanation, employment includes self-employment like business or profession taken up by the assessee abroad.”

Therefore, the Kerala High Court has held that:

a) No technical meaning is intended for the word “employment” used in Explanation 1(a);

b) Going abroad for the purpose of employment only means that the visit and stay abroad should not be for other purposes such as a tourist, for medical treatment, for studies or the like; and

c) Going abroad for the purpose of employment therefore means going abroad to take up employment or any avocation as referred to in the Circular, which takes in self-employment like business or profession.

2. K. Sambasiva Rao vs. ITO [2014] 42 taxmann.com 115 (Hyd — Trib.)

In this case, the ITAT Hyderabad referred to the decision of the Supreme Court in the case of CBDT vs. Aditya V. Birla [1988] 170 ITR 137 (SC) where in the context of section 80RRA, the SC considered that employment does not mean salaried employment but also includes self-employed/professional work. Further referring to the view expressed by the decision of the Kerala High Court in the case of CIT vs. O. Abdul Razak (supra) and also Circular No.346 of the CBDT, the ITAT held that the assessee’s earnings for consultancy fees from foreign enterprise and visit abroad for rendering consultancy can be considered for the purpose of examining whether the assessee is a resident or not.

3. ACIT vs. Jyotinder Singh Randhawa [2014] 46 taxmann.com 10 (Delhi — Trib.)

The ITAT Delhi, in this case, relating to a professional golfer, while deciding the issue in favour of the assessee held as under:

“7. We thus find that going abroad for the purpose of employment also means going abroad to take up employment or any avocation which takes in self-employment like business or profession. The facts of the present case suggest that the assessee was in self-employment being a professional golfer. We thus do not find reason to deviate from the finding of the Ld. CIT(A) which is based on the decision of the Hon’ble Kerala High Court in the case of O. Abdul Razak (supra) and others that the assessee being a professional golfer is a self-employed professional who carries his talent as a sportsperson by participating in golf tournaments conducted in various countries abroad. For such an Indian citizen in employment outside India the requirement for being treated as resident of India is his stay of 182 days in India in the previous year, as per Explanation (a) to section 6(1)(c) of the I.T. Act 1961.”

Thus, the ITAT Delhi also relying on the decision of the Kerala High Court has held that for the purposes of Explanation 1(a) of Section 6(1), employment would cover self-employed professionals.

4. ACIT vs. Col. Joginder Singh [2014] 45 taxmann.com 567 (Delhi — Trib.)

In this case of an assessee, a retired Government servant, providing consultancy services outside India, while deciding the issue in favour of the assessee, the ITAT Delhi held as follows:

“11. In view of the above, we are of the considered view that the Assessing Officer misinterpreted the provisions of section 6(1)(c) and Explanation (a) attached thereto. On the other hand, the Commissioner of Income Tax(A) rightly held that the assessee has to be treated as non-resident as per Explanation (a) attached to section 6(1)(c) of the Act. The Commissioner of Income Tax (A) also rightly held that in the case of the individual, a citizen of India who left India during the previous year for the purpose of employment outside India and in a peculiar circumstance, when his stay in India during the relevant period was only 68 days which is much less than the period of 182 days as per statutory provisions of the Act, then the assessee cannot be treated as resident of India and his status would be of non-resident Indian for the purpose of levying of tax as per provisions of the Act.”

Thus, in this case, going out of India for the purposes of providing consultancy services, has been considered to be eligible for the extended period of 182 days under Explanation 1(a) to section 6(1).

5. ACIT vs. Nishant Kanodia [2024] 158 taxmann.com 262 (Mumbai — Trib.)

In a recent decision of the ITAT-Mumbai the important facts were as follows:

a) The assessee stayed in India for 176 days and went to Mauritius during the year.

b) From the work permit issued by the Government of Mauritius, it was observed that the assessee went to Mauritius on an occupation permit to stay and work in Mauritius as an investor and not as an employee.

c) It was submitted by the assessee that he went to Mauritius for the purpose of employment, on the post of Strategist – Global Investment of the company (in which he held 100% of the shares) for a period of three years. Therefore, it was claimed that the assessee was a non-resident as per the provisions of section 6(1)(c) read with Explanation 1(a) to section 6(1).

d) The AO held that the assessee left India in the relevant financial year as an ‘Investor’ on a business visa which was usually taken by an investor and not by an employee who leaves India for employment and accordingly, the assessee was not entitled to take benefit of Explanation -1(a) to section 6(1). Therefore, the AO held the residential status of the assessee for the year under consideration to be ‘resident’ as per the provisions of clause (c) of section 6(1) and income received by the assessee from offshore jurisdiction was added to the total income of the assessee.

e) While admitting that the assessee had submitted an employment letter, the AO alleged that as the assessee held 100% of the shares of the employer company, it had considerable control over the affairs of the company and the appointment letter and salary slips submitted were self-serving documents, especially in view of the fact that the permit obtained in Mauritius was not for employment but for business/investor.

f) The Commissioner (Appeals) agreed with the submissions of the assessee and held that the assessee was away from India for the purpose of employment outside India and was accordingly entitled to take the benefit of Explanation -1(a) to section 6(1)(c).

g) On revenue’s appeal, the ITAT, relying on the decision of the Kerala High Court in case of CIT vs. O. Abdul Razak (supra), other ITAT decisions mentioned above and Circular 346 dated 30-6-1982, dismissed the appeal of the Revenue and held as follows:

“14. Therefore, even if the taxpayer has left India for the purpose of business or profession, in the aforesaid decisions, the same has been considered to be for the purpose of employment outside India under Explanation-1(a) to section 6(1) of the Act. Accordingly, even if it is accepted that the assessee went to Mauritius as an Investor in Firstland Holdings Ltd., Mauritius, in which he holds 100% shareholding, we are of the considered view that by applying the ratio of aforesaid decisions the assessee is entitled to claim the benefit of the extended period of 182 days, as provided in Explanation-1(a) to section 6(1) of the Act, for the determination of residential status. Since it is undisputed that the assessee has stayed in India only for a period of 176 days during the year, which is less than 182 days as provided in Explanation 1(a) to section 6(1) of the Act, the assessee has rightly claimed to be a “Non-Resident” during the year for the purpose of the Act. Accordingly, we find no infirmity in the findings of the learned CIT(A) on this issue. As a result, the grounds raised by the Revenue are dismissed.”

D. IMPORTANT CONSIDERATIONS

From the above-mentioned judicial precedents, while taking into consideration ‘employment outside India’ and while considering the benefit of an extended period of 182 days as per Explanation 1(a) to section 6(1) of the Act, the following important points should be kept in mind:

a) The visit and stay abroad should not be for other purposes such as a tourist, or for medical treatment or for studies or the like.

b) ‘Employment’ would include self-employment i.e. acting as Consultant, leaving India for the purpose of business or profession including professional activities of a sportsman, carrying on activities of an investor etc.

c) The status in the Occupation Permit of being an ‘investor’ or not having a permit for employment in a country outside India or having a business visa instead of employment visa, may not be relevant considerations for this purpose. However, depending on the facts of the case, the type of visa obtained may also have persuasive value in the intention of the assessee to stay for a longer duration outside India.

E. OTHER VIEW

There is another point of view, according to which the difference between ‘Employment’ and ‘Business or Profession’ is well known and therefore ‘employment’ should not include ‘self-employment’ i.e. business or professions.

The CBDT Circular cannot travel beyond the scope of section 6 which mentions ‘employment’ and includes in its ambit ‘avocations’, which in turn has been relied upon by the Kerala High Court and ITAT benches.

Interestingly, while the section refers only to ‘employment’, the Memorandum to the Finance Bill as well as the CBDT Circular clearly states that the amendment is seeking to avoid hardship to Indian citizens employed or engaged in other avocations outside India. In our view, given the intention of the legislature to provide the benefit to a person who leaves India permanently or for a long duration, which is clear in the Memorandum to the Finance Bill and the CBDT Circular, this other view of giving a restricted meaning to the term “employment” may not find favour with the courts.

F. CONCLUSION

In view of the Memorandum, CBDT Circular and judicial opinion, it appears to be a settled position that for the purposes of Explanation 1(a) to Section 6(1) of the Act, the term ‘employment’ includes self-employment i.e. carrying on business and profession. However, it is important that the assessee maintains appropriate documentation to substantiate the facts of the case.

Underlying tax credit Concept and its significance

 

1. Overview :

 

The taxation of dividends has its origin in the classical
system of taxation, which in fact taxes corporate profit twice: once at the
company level and again at the shareholder level where the company’s profits
after tax are distributed by way of dividend to its shareholders. This is known
as economic double taxation as distinct from juridical double taxation. In
simple words, economic double taxation means double taxation of the same items
of economic income in the hands of different taxpayers.

 

 

From a tax policy perspective, economic double taxation
distorts investment decision making, and therefore the optimally efficient
allocation of resources, by inducing tax payers to invest by means of channel
that provides the best after-tax return, rather than by means of the most
appropriate commercial route to achieve the best pre-tax return.

 

 

2. Meaning of underlying Tax Credit :

 

Underlying tax credit relieves the economic double taxation
on foreign dividend income. The underlying tax credit is given for the pro-rata
share of the corporate tax paid by the foreign dividend distributing company. It
is computed as percentage of the corporate tax paid by the company that the
gross dividend distribution bears to the after-tax profits. The net dividend
received plus the withholding tax, if any, is taken as percentage of the related
after-tax profits of the paying company and multiplied by the corporate tax
paid. Dividend is grossed up by the underlying tax credit to compute the foreign
income subject to tax in home country. The ordinary credit limitation is applied
on the grossed-up dividend.

 

 

The underlying tax (or indirect) credit system on foreign
dividends is found in several countries under their domestic laws or tax
treaties. These countries include Argentina, Australia, Austria, Canada,
Denmark, Estonia, Finland, Germany, Greece, Ireland, Japan, Korea, Malta,
Mauritius, Mexico, Namibia, Nigeria, Singapore, Spain, Poland, the UK and the
US. It typically only applies if :

 

  • The shareholder has a significant shareholding in the dividend distributing
    company (e.g. in the UK, 10% is needed), and

 

  • The shareholder is a company.

 

  

Upon receipt of a dividend by the shareholder, the pre-tax
income of the distributing company is included as a taxable income. The
shareholder jurisdiction’s normal rate of company tax is then applied, but the
resulting tax (mainstream tax) is reduced by the company tax paid by the
dividend distributing company (i.e., reduced by the underlying tax). If
the underlying tax exceeds the amount of mainstream tax then there will be no
further tax to pay by the shareholder, who will, thus, receive tax-free
dividends.

 

 

The result is that the group will always pay the higher of
the two taxes — the dividend distributing company tax or the shareholder country
tax.

 

 

It is referred to as underlying tax credit because credit is
given for the tax paid in the underlying entity. It is also referred to as the
‘Indirect tax credit’ method because shareholder receives credit for tax which
it has only paid indirectly. In the U.S. Internal Revenue Code the same is
referred to a ‘Deemed paid credit’. The concept of ‘Imputation Credit’ is almost
similar to underlying tax credit.

 

 

In addition, most jurisdictions provide for a tax credit to
the parent company for the foreign tax paid by the subsidiary when its
undistributed income is attributed under the Controlled Foreign Corporation
Rules. In this article the focus is on underlying tax credit in respect of
dividend income.

 

 

3. Example of the underlying tax credit :

 

Company X is a resident of the UK and owns 60% share capital
of Company Y, a resident in India. Tax rate in India is assumed to be 34% and
tax rate in the UK is assumed to be 28%. Company X has no other taxable income
in the UK.

Since the dividends may be paid out of both current and past profits, domestic law or practice generally provides the ‘ordering rules’. These rules relate the dividends to the relevant post-tax profit out of which the distribution has been made and the creditable tax is determined by the effective tax rate imposed on those profits. In the US, the dividends are deemed to be distributed from a pool of retained profits and the underlying foreign tax is the average effective tax rate.

The computation is also affected by the exchange rate used to translate the creditable foreign tax. It could be either the rate prevailing at the time of payment of the foreign tax (historical rate), or the rate when the dividend was distributed (current rate). The US law requires that the foreign tax be translated at the historical rate, while the United Kingdom generally applies the current rate.

4. Underlying tax credit in respect of taxes paid by the lower tier companies:

In the context of International business structuring, it is quite common for the Multinational Enterprises (MNEs) to structure their business operations in various countries by way of creating various subsidiaries  of the same parent  company and to have further downward subsidiary companies of its subsidiary companies, to achieve their business objective in most efficient and profitable manner. The subsidiaries and the subsidiaries of the subsidiary companies are commonly referred to as ‘lower tier companies’.

Many countries allow the underlying tax credit computation to include taxes paid by lower tier companies. For example, Australia, Ireland, Mauritius, South Africa, and the UK allow the credit for taxes suffered by all lower tier companies, provided prescribed minimum equity or voting rights are maintained at each tier. Similarly Argentina, Japan and Norway permit the underlying tax credit upto two tiers of subsidiaries, Spain gives the underlying tax credit for taxes paid upto three tiers and the United States grants them upto 6 tiers, of qualifying foreign subsidiaries.

Thus, for example, a UK parent company investing in a Mauritian subsidiary, which in turn invests in its Indian subsidiary, subject to fulfillment of the shareholding percentage and other relevant conditions and compliance with regulations, would be eligible to take credit of underlying corporate taxes paid by the Indian subsidiary, to the extent of dividends paid by Indian Company, which are forming part of the dividends paid by the Mauritian Company, against the tax payable in respect of dividends received by the UK Company in UK.

5. Significance of underlying tax credit :
Foreign tax credit planning plays a major role in structuring investments in a foreign tax jurisdiction, in case of various multi-nationals based in jurisdictions such as the UK, the US and Ireland etc., where the credit system predominates and where the underlying tax credit is given. India’s Double Taxation Avoidance Agreements (DTAAs) with ten countries contains the provisions regarding underlying tax credit in respect of dividends paid by a company resident of India. Similarly India’s DTAAs with Mauritius and Singapore contain the provisions regarding underlying tax credit in respect of dividends paid by a Mauritian or Singaporean company.

In respect of planning  for all inbound  investment into India, from the countries  where the respective DTAAs with India/ domestic law contain the underlying tax credit provisions,  it is very important  to keep  in mind  the  exact  operation   of respective -1 underlying  tax credit  provisions  in the DTAAs/ domestic  law, to arrive  at the net tax cost of the MNE/Group  in respect  of dividend  income.  This will facilitate a proper decision-making in respect of investments into India. However, it is important to note that a detailed knowledge of the domestic law provisions of the underlying tax credit in the respective jurisdictions is of utmost importance. Therefore, wherever required, the services of the local consultants/tax experts may be utilised to know the law and practice in respect of exact operations of the underlying tax credit provisions.

In respect of outbound investments also, a proper consideration of the underlying tax credit would be of great help in properly arriving at the actual net tax cost of the enterprise/ group in respect of dividends and thus making the right investment decisions.

6. Underlying tax credit under Indian Scenario:

India does not have any domestic regulations in respect of underlying tax credit. However, as mentioned above, India’s DTAAs with ten countries contain the provisions relating to underlying tax credit. The relevant provisions relating to underlying tax credit contained in various articles are given below for ready reference:

In most of the above mentioned DTAAs, the definition of the term ‘Indian tax payable’ include provisions relating to tax sparing for the ordinary tax credit. However, in respect of DTAA with Ireland, the provisions relating to tax sparing are includible only in respect of clause relating to underlying tax credit.

It is interesting to note that in case of India’s DTAAs with 9 counties (except Singapore), the relevant provisions of the Articles mention about the under-lying tax credit where a dividend paid by a company which is a resident of India to a company which is a resident of the other state. However, in case of Singapore in Article 25(4) of the India-Singapore DTAA, it is mentioned that a dividend paid by a company which is a resident of India to a resident of Singapore. Thus apparently, in case of Singapore underlying tax credit would be available even if the shares in Indian company are not held by any Singaporean Company but are held by any other resident of Singapore.

7. Domestic regulations in respect of underlying tax credit in some of the important jurisdictions:

(a) Mauritius:

Provisions relating to underlying foreign tax credit are contained in Regulation 7 of the Income-tax (Foreign Tax Credit) Regulations, 1996. These regulations have been made by the Ministry u/s.77 and u/s.161 of the Income-tax Act, 1995.

(b)  Credit  for underlying taxes

As regards dividends received from subsidiary, the state in which the parent company is a resident gives credit as provided for in paragraph 2 of Article 23A or in paragraph 1 of Article 23B, as appropriate, not only for the tax on dividends as such, but also for the tax paid by the subsidiary on the profits distributed (such a provision will frequently be favoured by States applying as a general rule the credit method specified in Article 23B).”

(c) United States:
The provisions relating to underlying tax credit referred to in the Internal Revenue Code of 1986, as ‘Deemed Paid Credit’ are contained in section 78 and 902 of the Code.

8. OECD Commentary:
Paras 49 to 54 and para 69 of the commentary on Articles 23A & 23B summarise the OECD approach towards tax credit in respect of dividends from substantial holdings by a company. It recognises that recurrent corporate taxation on the profits distributed to parent company: first at the level of subsidiary and again at the level of the parent company, creates very important obstacle to the development of international investments. Many states have recognised this and have inserted in the domestic laws provisions designed to avoid these obstacles. Moreover, provisions to this end are frequently inserted in double taxation conventions. In view of the diverse opinions of the states and the variety of the possible solutions, it preferred to leave the states free to choose their own solution to the problem. For states preferring to solve the problem in their conventions, the solutions would most frequently follow one of the principles i.e. credit for underlying taxes.

Paragraph 52 of OECD Commentary on Article 23A & 23B mentions as under:

“(b) Credit for underlying taxes
As regards dividends received from subsidiary, the state in which the parent company is a resident gives credit as provided for in paragraph 2 of Article 23A or in paragraph 1 of Article 23B, as appropriate, not only for the tax on dividends as such, but also for the tax paid by the subsidiary on the profits distributed (such a provision will frequently be favoured by States applying as a general rule the credit method specified in Article 23B).”

9. Dividend Distribution Tax:
It is important to note that the Dividend Distribution Tax (DDT) paid by the Indian company u/s.115-0 of the Indian Income-tax Act, 1961 may not be the same as “the Indian tax payable by the company in respect of the profits out of which such dividend is paid” as used in relevant articles of the various DTAAs mentioned above containing underlying tax credit provisions. Whether the DDT will be available as ordinary tax credit, is an issue not free from doubt and litigation. We have been given to understand that U.S. allows credit for DDT in USA under the provisions of S. 904 of the Internal Revenue Code. Similarly, we understand that Mauritian authorities have issued a circular clarifying that DDT credit would be available in Mauritius.

10. Conclusion:
From the above, it is evident that the concept of underlying tax credit is very important in mitigating the economic double taxation of dividends paid to companies. This is equally important in planning both inbound and outbound investments. However, in view of the complexities, one will have to carefully understand the provisions of the domestic laws of the applicable foreign tax jurisdictions and treaties before applying the same.

Bibliography:
1. Basic International Taxation, Second edition, Volume-l : Principles, by Roy Rohatgi, Chapter 4, Para 8.4.3 page 281.

2. International Tax Policy and Double Tax Treaties – An introduction to Principles and Application by Kevin Holmes. Chapter 2, page 37 to 38.

3. Interpretation and Application of Tax Treaties, by Ned Shelton. Chapter 2, Para 2.52, page 101.

 

Underlying tax credit — Concept and its significance

International Taxation

1. Overview :


The taxation of dividends has its origin in the classical
system of taxation, which in fact taxes corporate profit twice: once at the
company level and again at the shareholder level where the company’s profits
after tax are distributed by way of dividend to its shareholders. This is known
as economic double taxation as distinct from juridical double taxation. In
simple words, economic double taxation means double taxation of the same items
of economic income in the hands of different taxpayers.

From a tax policy perspective, economic double taxation
distorts investment decision making, and therefore the optimally efficient
allocation of resources, by inducing tax payers to invest by means of channel
that provides the best after-tax return, rather than by means of the most
appropriate commercial route to achieve the best pre-tax return.

2. Meaning of underlying Tax Credit :


Underlying tax credit relieves the economic double taxation
on foreign dividend income. The underlying tax credit is given for the pro-rata
share of the corporate tax paid by the foreign dividend distributing company. It
is computed as percentage of the corporate tax paid by the company that the
gross dividend distribution bears to the after-tax profits. The net dividend
received plus the withholding tax, if any, is taken as percentage of the related
after-tax profits of the paying company and multiplied by the corporate tax
paid. Dividend is grossed up by the underlying tax credit to compute the foreign
income subject to tax in home country. The ordinary credit limitation is applied
on the grossed-up dividend.

The underlying tax (or indirect) credit system on foreign
dividends is found in several countries under their domestic laws or tax
treaties. These countries include Argentina, Australia, Austria, Canada,
Denmark, Estonia, Finland, Germany, Greece, Ireland, Japan, Korea, Malta,
Mauritius, Mexico, Namibia, Nigeria, Singapore, Spain, Poland, the UK and the
US. It typically only applies if :

  • The shareholder has a significant shareholding in the dividend distributing
    company (e.g. in the UK, 10% is needed), and


  • The shareholder is a company.




Upon receipt of a dividend by the shareholder, the pre-tax
income of the distributing company is included as a taxable income. The
shareholder jurisdiction’s normal rate of company tax is then applied, but the
resulting tax (mainstream tax) is reduced by the company tax paid by the
dividend distributing company (i.e., reduced by the underlying tax). If
the underlying tax exceeds the amount of mainstream tax then there will be no
further tax to pay by the shareholder, who will, thus, receive tax-free
dividends.

The result is that the group will always pay the higher of
the two taxes — the dividend distributing company tax or the shareholder country
tax.

It is referred to as underlying tax credit because credit is
given for the tax paid in the underlying entity. It is also referred to as the
‘Indirect tax credit’ method because shareholder receives credit for tax which
it has only paid indirectly. In the U.S. Internal Revenue Code the same is
referred to a ‘Deemed paid credit’. The concept of ‘Imputation Credit’ is almost
similar to underlying tax credit.

In addition, most jurisdictions provide for a tax credit to
the parent company for the foreign tax paid by the subsidiary when its
undistributed income is attributed under the Controlled Foreign Corporation
Rules. In this article the focus is on underlying tax credit in respect of
dividend income.

3. Example of the underlying tax credit :


Company X is a resident of the UK and owns 60% share capital
of Company Y, a resident in India. Tax rate in India is assumed to be 34% and
tax rate in the UK is assumed to be 28%. Company X has no other taxable income
in the UK.

Since the dividends may be paid out of both current and past profits, domestic law or practice generally provides the ‘ordering rules’. These rules relate the dividends to the relevant post-tax profit out of which the distribution has been made and the creditable tax is determined by the effective tax rate imposed on those profits. In the US, the dividends are deemed to be distributed from a pool of retained profits and the underlying foreign tax is the average effective tax rate.

The computation is also affected by the exchange rate used to translate the creditable foreign tax. It could be either the rate prevailing at the time of payment of the foreign tax (historical rate), or the rate when the dividend was distributed (current rate). The US law requires that the foreign tax be translated at the historical rate, while the United Kingdom generally applies the current rate.

4. Underlying tax credit in respect of taxes paid by the lower tier companies:

In the context of International business structuring, it is quite common for the Multinational Enterprises (MNEs) to structure their business operations in various countries by way of creating various subsidiaries  of the same parent  company and to have further downward subsidiary companies of its subsidiary companies, to achieve their business objective in most efficient and profitable manner. The subsidiaries and the subsidiaries of the subsidiary companies are commonly referred to as ‘lower tier companies’.

Many countries allow the underlying tax credit computation to include taxes paid by lower tier companies. For example, Australia, Ireland, Mauritius, South Africa, and the UK allow the credit for taxes suffered by all lower tier companies, provided prescribed minimum equity or voting rights are maintained at each tier. Similarly Argentina, Japan and Norway permit the underlying tax credit upto two tiers of subsidiaries, Spain gives the underlying tax credit for taxes paid upto three tiers and the United States grants them upto 6 tiers, of qualifying foreign subsidiaries.

Thus, for example, a UK parent company investing in a Mauritian subsidiary, which in turn invests in its Indian subsidiary, subject to fulfillment of the shareholding percentage and other relevant conditions and compliance with regulations, would be eligible to take credit of underlying corporate taxes paid by the Indian subsidiary, to the extent of dividends paid by Indian Company, which are forming part of the dividends paid by the Mauritian Company, against the tax payable in respect of dividends received by the UK Company in UK.

5. Significance of underlying tax credit :
Foreign tax credit planning plays a major role in structuring investments in a foreign tax jurisdiction, in case of various multi-nationals based in jurisdictions such as the UK, the US and Ireland etc., where the credit system predominates and where the underlying tax credit is given. India’s Double Taxation Avoidance Agreements (DTAAs) with ten countries contains the provisions regarding underlying tax credit in respect of dividends paid by a company resident of India. Similarly India’s DTAAs with Mauritius and Singapore contain the provisions regarding underlying tax credit in respect of dividends paid by a Mauritian or Singaporean company.

In respect of planning  for all inbound  investment into India, from the countries  where the respective DTAAs with India/ domestic law contain the underlying tax credit provisions,  it is very important  to keep  in mind  the  exact  operation   of respective -1 underlying  tax credit  provisions  in the DTAAs/ domestic  law, to arrive  at the net tax cost of the MNE/Group  in respect  of dividend  income.  This will facilitate a proper decision-making in respect of investments into India. However, it is important to note that a detailed knowledge of the domestic law provisions of the underlying tax credit in the respective jurisdictions is of utmost importance. Therefore, wherever required, the services of the local consultants/tax experts may be utilised to know the law and practice in respect of exact operations of the underlying tax credit provisions.

In respect of outbound investments also, a proper consideration of the underlying tax credit would be of great help in properly arriving at the actual net tax cost of the enterprise/ group in respect of dividends and thus making the right investment decisions.

6. Underlying tax credit under Indian Scenario:

India does not have any domestic regulations in respect of underlying tax credit. However, as mentioned above, India’s DTAAs with ten countries contain the provisions relating to underlying tax credit. The relevant provisions relating to underlying tax credit contained in various articles are given below for ready reference:

In most of the above mentioned DTAAs, the definition of the term ‘Indian tax payable’ include provisions relating to tax sparing for the ordinary tax credit. However, in respect of DTAA with Ireland, the provisions relating to tax sparing are includible only in respect of clause relating to underlying tax credit.

It is interesting to note that in case of India’s DTAAs with 9 counties (except Singapore), the relevant provisions of the Articles mention about the under-lying tax credit where a dividend paid by a company which is a resident of India to a company which is a resident of the other state. However, in case of Singapore in Article 25(4) of the India-Singapore DTAA, it is mentioned that a dividend paid by a company which is a resident of India to a resident of Singapore. Thus apparently, in case of Singapore underlying tax credit would be available even if the shares in Indian company are not held by any Singaporean Company but are held by any other resident of Singapore.

7. Domestic regulations in respect of underlying tax credit in some of the important jurisdictions:

(a) Mauritius:

Provisions relating to underlying foreign tax credit are contained in Regulation 7 of the Income-tax (Foreign Tax Credit) Regulations, 1996. These regulations have been made by the Ministry u/s.77 and u/s.161 of the Income-tax Act, 1995.
 

(b)  Credit  for underlying taxes

As regards dividends received from subsidiary, the state in which the parent company is a resident gives credit as provided for in paragraph 2 of Article 23A or in paragraph 1 of Article 23B, as appropriate, not only for the tax on dividends as such, but also for the tax paid by the subsidiary on the profits distributed (such a provision will frequently be favoured by States applying as a general rule the credit method specified in Article 23B).”

(c) United States:
The provisions relating to underlying tax credit referred to in the Internal Revenue Code of 1986, as ‘Deemed Paid Credit’ are contained in section 78 and 902 of the Code.

8. OECD Commentary:
Paras 49 to 54 and para 69 of the commentary on Articles 23A & 23B summarise the OECD approach towards tax credit in respect of dividends from substantial holdings by a company. It recognises that recurrent corporate taxation on the profits distributed to parent company: first at the level of subsidiary and again at the level of the parent company, creates very important obstacle to the development of international investments. Many states have recognised this and have inserted in the domestic laws provisions designed to avoid these obstacles. Moreover, provisions to this end are frequently inserted in double taxation conventions. In view of the diverse opinions of the states and the variety of the possible solutions, it preferred to leave the states free to choose their own solution to the problem. For states preferring to solve the problem in their conventions, the solutions would most frequently follow one of the principles i.e. credit for underlying taxes.

Paragraph 52 of OECD Commentary on Article 23A & 23B mentions as under:

“(b) Credit for underlying taxes
As regards dividends received from subsidiary, the state in which the parent company is a resident gives credit as provided for in paragraph 2 of Article 23A or in paragraph 1 of Article 23B, as appropriate, not only for the tax on dividends as such, but also for the tax paid by the subsidiary on the profits distributed (such a provision will frequently be favoured by States applying as a general rule the credit method specified in Article 23B).”

9. Dividend Distribution Tax:
It is important to note that the Dividend Distribution Tax (DDT) paid by the Indian company u/s.115-0 of the Indian Income-tax Act, 1961 may not be the same as “the Indian tax payable by the company in respect of the profits out of which such dividend is paid” as used in relevant articles of the various DTAAs mentioned above containing underlying tax credit provisions. Whether the DDT will be available as ordinary tax credit, is an issue not free from doubt and litigation. We have been given to understand that U.S. allows credit for DDT in USA under the provisions of S. 904 of the Internal Revenue Code. Similarly, we understand that Mauritian authorities have issued a circular clarifying that DDT credit would be available in Mauritius.

10. Conclusion:
From the above, it is evident that the concept of underlying tax credit is very important in mitigating the economic double taxation of dividends paid to companies. This is equally important in planning both inbound and outbound investments. However, in view of the complexities, one will have to carefully understand the provisions of the domestic laws of the applicable foreign tax jurisdictions and treaties before applying the same.

Bibliography:
1. Basic International Taxation, Second edition, Volume-l : Principles, by Roy Rohatgi, Chapter 4, Para 8.4.3 page 281.

2. International Tax Policy and Double Tax Treaties – An introduction to Principles and Application by Kevin Holmes. Chapter 2, page 37 to 38.

3. Interpretation and Application of Tax Treaties, by Ned Shelton. Chapter 2, Para 2.52, page 101.

Taxation of ‘Fees for Technical Services’ : Application of the concept of ‘Make Available’

In this article the concept of ‘Make Available’ used in the Article in the Tax Treaties relating to ‘Fees for Technical Services (FTS)’ or ‘Fees for Included Services’ has been discussed and analysed. In the second part of the Article to be published next month we shall deal with the Indian Judicial decisions dealing with the subject.

A. Concept of ‘Make Available’ and historical background :The expression ‘make available’ used in the Article in the Tax Treaties relating to ‘Fees for Technical Services (FTS)’ has far reaching significance since it limits the scope of technical and consultancy services in the context of FTS.

India has negotiated and entered into tax treaties with various countries where the concept of ‘make available’ under the FTS clause is used. India’s tax treaties with Australia, Canada, Cyprus, Finland, Malta, Netherlands, Portuguese Republic, Singapore, UK and USA contain the concept of ‘make available’ under the FTS clause. Further, the concept is also applicable indirectly due to existence of Most Favored Nation (MFN) clause in the protocol to the tax treaties with Belgium, France, Israel, Hungary, Kazakstan, Spain, Switzerland and Sweden.

It is interesting to note that India-Australia tax treaty does not have separate FTS clause but the definition of Royalty which includes FTS, has provided for make available concept. An analysis of the countries having the concept of make available directly or indirectly in their tax treaties with India reveals that almost all of these countries are developed nations and they have successfully negotiated with India the restricted scope of the definition of FTS as almost all of them are technology exporting countries.

In view of the above, while deciding about taxability of any payment for FTS, the reader would be well advised to examine the relevant article and the protocol of the tax treaty to examine whether the concept of make available is applicable to payment of FTS in question and accordingly whether such a payment would be not liable to tax in the source country. He would also be well advised to closely examine the relevant judicial decision to determine the applicability of the concept of ‘make available’ to payment of FTS in question.

B. Explanation of the concept in the MOU to the India-US Tax Treaty :

Article 12(iv)(b) of the India US tax treaty reads as follows :

“4. For purposes of this Article, ‘fees for included services’ means payments of any kind to any person in consideration for the rendering of any technical or consultancy services (including through the provision of services of technical or other personnel) if such services :

(a) . . . .

(b) make available technical knowledge, experience, skill, know-how, or processes, or consist of the development and transfer of a technical plan or technical design.”

As per Article 12(4)(b) of the India US tax treaty, payment of any kind in consideration for rendering of services results in FTS if :

(a) Such services are technical or consultancy services;

(b) They ‘make available’ knowledge, experience, skill, know how, or processes or alternatively, consist of development and transfer of a plan or design; and

© Such knowledge, experience, plan, design etc. is technical.

The three conditions above are cumulative and not alternative. In order to fall under the Article 12(4)(b) of the India US tax treaty, it is essential that services should make available knowledge, experience, skill, know-how, or processes.

The Memorandum of Understanding (MoU) to the India-US Tax Treaty, Technical Explanation to India-US Tax Treaty, Technical Explanation to India-Australia Tax Treaty, and various Indian Judicial Pronouncements, have laid down different tests for considering whether or not services ‘make available’ knowledge, experience, skill, know-how, or processes.

The concept of ‘make available’ is interpreted and explained with concrete illustrations in the ‘Memorandum of Understanding concerning Fees for Included Services in Article 12’ appended to the said India-US DTAA. The concept is explained as under in the Memorandum of Understanding :

“Paragraph 4(b) of Article 12 refers to technical or consultancy services that make available to the person acquiring the service technical knowledge, experience, skill, know-how, or processes, or consist of the development and transfer of a technical plan or technical design to such person. (For this purpose, the person acquiring the service shall be deemed to include an agent, nominee, or transferee of such person.) This category is narrower than the category described in paragraph 4(a) because it excludes any service that does not make technology available to the person acquiring the service. Generally speaking, technology will be considered “made available” when the person acquiring the service is enabled to apply the technology. The fact that the provision of the service may require technical input by the person providing the service does not per se mean that technical knowledge, skills, etc., are made available to the person purchasing the service, within the meaning of paragraph 4(b). Similarly, the use of a product which embodies technology shall not per se be considered to make the technology available.” (Emphasis supplied)

“Typical categories of services that generally involve either the development and transfer of technical plans or technical designs, or making technology available as described in paragraph 4(b), include :

1 Engineering services (including the sub-categories of bio-engineering and aeronautical, agricultural, ceramics, chemical, civil, electrical, mechanical, metallurgical, and industrial engineering);

2 Architectural services; and

3 Computer software development.

Under paragraph 4(b), technical and consultancy services could make technology available in a variety of settings, activities and industries. Such services may, for example, relate to any of the following areas :

1 Bio-technological services;

2 Food-processing;

3 Environmental and ecological services;

4. Communication  through  satellite or otherwise;

5. Energy  conservation;

6. Exploration or exploitation of mineral oil or natural gas;

7. Geological  surveys;

8. Scientific services;  and

9. Technical  training.”

This concept is further explained by Examples 3 to 7 in the MoU which are as follows:

Example (3) :

Facts:

A U.S. manufacturer has experience in the use of a process for manufacturing wallboard for interior walls of houses which is more durable than standard products of its type. An Indian builder wishes to produce this product for his own use. He rents a plant and contracts with the U.S. company to send experts to India to show engineers in the Indian company how to produce the extra-strong wall-board. The U.S. contractors work with the technicians in the Indian firm for a few months. Are the payments to the U.S. firm considered to be payments for ‘included services’ ?

Analysis:

The payments would be fees for included services. The services are of a technical or consultancy nature; in the example, they have elements of both types of services. The services make available to the Indian company technical knowledge, skill, and processes.

Example  (4) :

Facts:

A U.S. manufacturer operates a wallboard fabrication plant outside India. An Indian builder hires the US. company to produce wallboard at that plant for a fee. The Indian company provides the raw materials and the US. manufacturer fabricates the wall-board in its plant, using advanced technology. Are the fees in this example payments for included services?

Analysis:

The fees would not be for included services. Al-though the U.S. company is clearly performing a technical service, no technical knowledge, skill, etc., are made available to the Indian company, nor is there any development and transfer of a technical plan or design. The U.S. company is merely performing a contract manufacturing service.

Example  (5) :

Facts:

An Indian firm owns inventory control software for use in its chain of retail outlets throughout India. It expands its sales operation by employing a team of travelling salesmen to travel around the countryside selling the company’s wares. The company wants to modify its software to permit the salesmen to access the company’s central computers for information on products available in inventory and when they can be delivered. The Indian firm hires a U.S. computer programming firm to modify its software for this purpose. Are the fees which the Indian firm pays to be treated as fees for included services?

Analysis:

The fees are for included services. The U.S. company clearly, performs a technical service for the Indian company, and transfers to the Indian company the technical plan (i.e., the computer program) which it has developed.

Example  (6) :

Facts:

An Indian vegetable oil manufacturing company wants to produce a cholesterol-free oil from a plant which produces oil normally containing cholesterol. An American company has developed a process for refining the cholesterol out of the oil. The Indian company contracts with the US. company to modify the formulae which it uses so as to eliminate the cholesterol, and to train the employees of the Indian company in applying the new formulae. Are the fees paid by the Indian company for included services?

Analysis:

The fees are for included services. The services are technical, and the technical knowledge is made available to the Indian company.

Example  (7) :

Facts:

The Indian vegetable oil manufacturing firm has mastered the science of producing cholesterol-free oil and wishes to market the product worldwide. It hires an American marketing consulting firm to do a computer simulation of the world market for such oil and to advise it on marketing strategies. Are the fees paid to the U.S. company for included services?

Analysis:

The fees would not be for included services. The American company is providing a consultancy service which involves the use of substantial technical skill and expertise. It is not, however, making available to the Indian company any technical experience, knowledge or skill, etc., nor is it transferring a technical plan or design. What is transferred to the Indian company through the service contract is commercial information. The fact that technical skills were required by the performer of the service in order to perform the commercial information service does not make the service a technical service within the meaning of paragraph 4(b).

It is important to note that in the protocol to the said DTAA the Government of India has also accepted the interpretation of Article 12 (Fees for included services) in the following words:

“This memorandum of understanding represents the current views of the United States Government with respect to these aspects of Article 12, and it is my Government’s understanding that it also represents the current views of the Indian Government.” (emphasis supplied)

C.  Application of concept of ‘make available’ – Relevant  and  irrelevant  tests:

In ‘The Law and Practice of Tax Treaties: An Indian Perspective’ (2008 edition), the learned authors Shri Rajesh Kadakia and Shri Nilesh Modi, have culled out the relevant and irrelevant tests (on pages 569-571) as under  :

Relevant  tests:

1. The expression ‘make available’ is used in the sense of one person supplying or transferring technical knowledge or technology to another.

2. Technology is considered to be ‘made available’ when the service recipient is enabled to apply the technology contained therein. [Bharat Petroleum Corporation v. DfT, (200) 14 SOT 307(Mum.)]

3. If the services do not have any technical knowledge, the fees paid for them do not fall within the meaning of FTS as per Article 12(4).

4. The service recipient is able to make use of the technical knowledge, skill etc. by himself in his business or for his own benefit and without recourse to the performer of the services, is able to make use of the technical knowledge, etc. by himself in his business or for his own benefit and without recourse to the performer of the services in future. The technical knowledge, experience, skill, etc. must remain with the person utilising the services even after the rendering of the services has come to an end. A transmission of the technical knowledge, experience, skill, etc. from the person rendering the services to the person utilising the same is contemplated by the article. Some sort of durability or permanency of the result of the ‘rendering of services’ is envisaged which will remain at the disposal of the person utilising the services. The fruits of the services should remain available to the person utilising the services in some concrete shape such as technical knowledge, experience, skill, etc.

5. The service recipient is at liberty to use the technical knowledge, skill, know-how and processes in his own right.

6. The technical knowledge, experience, skill, know-how, etc. must remain with the service recipient even after the rendering of the service has come to an end.

ii) Irrelevant  tests:

1. Provision of service may require technical input by the service provider;

2. Use of a product  which  embodies  technology;

3. The service recipient gets a product and not the technology itself;

4. Merely allowing somebody to make use of services, whether actually made use of or not;

5. Service recipient acquires some familiarity or in-sights into the manner of provision of services.

D. Concept of ‘make available’ as explained in various judicial pronouncements:

The concept of make available has been examined, explained and applied by various judicial authorities in India in the following cases (which shall be summarised in the next part of the Article) :

E. Application of explanation and examples given in MoU to the India-US Treaty to other Treaties:Although the abovementioned interpretation is given in the context of the DTAA between India and the USA, considering that identical terminology is used in other DTAAs between India and other countries, the Government can be considered to have contemplated the same meaning to be assigned to the .same term in the other DTAAs. This proposition, has found judicial recognition.

E.1 The above interpretation of the concept of ‘make available’ has now gained acceptance even with the Indian judicial authorities in the context of a variety of DTAAs India has entered into with different countries. In Raymond Ltd. v. Deputy CIT, [2003] 86 ITD 791 (Mum.), the assessee made an issue of Global Depository Receipts (GDRs) to in-vestors outside India, and it paid, inter alia, com-mission to the managers to the GDR issue, who were residents outside India, for rendering a vari-ety of services outside India for the successful completion of the GDR issue. The question before the Tribunal, among others, was whether the com-mission paid for such services rendered outside India could be taxed in India as ‘fees for technical services’ in the light of the provisions of S. 9(1)(vii) of the Act read with Article 13(4) of the DTAA with the UK. It is noteworthy that the terminology used in Article 13(4)(c) of the DTAA with the UK is the same as that used in Article 12(4)(b) of the DTAA with the USA. Although in this case the Tribunal was concerned with the interpretation of Article 13(4)(c)of the DTAA between India and the UK, the Tribunal made a reference to the identically worded Article 12(4)(b) of the DTAA between India and the USA, took into consideration the interpretation and the illustrations given in the Memorandum of Understanding appended to the said DTAA, and observed that the same can be used as an aid to the construction of the DTAA with the UK because they deal with the same subject (namely, fees for technical services). The Tribunal also observed that merely because these treaties are with different countries does not mean that different meanings are to be assigned to the same words, especially when both have been entered into by the same country on one side, namely, India. It it is difficult to postulate that the same country (India) would have intended to give different types of treatment to identically defined services rendered by entrepreneurs from different countries. On the facts of the case, the Tribunal held that the commission paid by the assessee for the various services rendered by the non-resident manager to the GDR issue did not fall within the definition of ‘fees for technical services’ given in Article 13(4) of the DTAA between India and the UK because no technical knowledge, experience, skill, know-how or process, etc. was ‘made available’ to the assessee by the managers to the GDR issue. After referring to the grammatical purpose of the word ‘which’ used in Article 13(4)(c) of the DTAA with the UK, the Tribunal gave its inter-pretation of the expression ‘make available’ in the following clear-cut words (paragraphs 92 and 93) :

“92. We hold that the word ‘which’ occurring in the article after the word ‘services’ and before the words ‘make available’ not only describes or defines more clearly the antecedent noun (‘services’) but also gives additional information about the same in the sense that it requires that the services should result in making available to the user technical knowledge, experience, skill, etc. Thus, the normal, plain and grammatical meaning of the language employed, in our understanding, is that a mere rendering of services is not roped in unless the person utilising the services is able to make use of the technical knowledge, etc. by himself in his business or for his own benefit and without recourse to the performer of the services in future. The technical knowledge, experience, skill, etc. must remain with the person utilising the services even after the rendering of the services has come to an end. A transmission of the technical knowledge, experience, skill, etc. from the person rendering the services to the person utilising the same is contemplated by the article. Some sort of durability or permanency of the result of the ‘rendering of services’ is envisaged which will remain at the disposal of the person utilising the services. The fruits of the service should remain available to the person utilising the services in some concrete shape such as technical knowledge, experience, skill, etc.

93.  In the present case, … after the services of the managers . . . came to an end, the assessee-company is left with no technical knowledge, experience, skill, etc. and still continues to manufacture cement, suitings, etc. as in the past.” (emphasis supplied)

The Tribunal also noted the language employed in the definition of ‘fees for technical services’ in Article 12(4)(b) of the DTAA between India and Singapore to the effect “if such services … make available technical knowledge, experience, skill, know-how or processes, which enables the person acquiring the services to apply the technology contained therein”, and opined that these words, though not found in the DTAAs with the UK and the USA, merely make explicit what is embedded in the words ‘make available’ appearing in the DTAAs with the UK and the USA.

E.2 In the decision    in CESC  Ltd. v. Deputy CIT [2005] 275 ITR (AT) 15 (Kol) (TM) this interpretation of the concept of ‘make available’ used in Article 13(4)(c) of the DTAA between India and the UK got the stamp of judicial approval. In this case, a UK company acted as a technical adviser to cer-tain financial institutions in India and the assessee, CESC, paid some fees to the UK company for the services rendered in respect of the technical appraisal of the assessee’s power project. One of the questions before the Tribunal was whether the fees paid to the UK company fell within the sweep of the expression’ fees for technical services’ as understood in Article 13(4)(c) of the DTAA between India and the UK. As noted earlier also, the terminology used for defining the expression’ fees for technical services’ in the DTAA between India and the UK is the same as that used in, among many others, the DTAA between India and the USA. The Tribunal held that the fees paid by the assessee to the UK company did not fall within the expression ‘fees for technical services’ as it did not result in making available to the assessee any technical knowledge, skill, etc. The Tribunal made a reference to Article 12 of the DTAA between India and the USA and to the Memorandum of Understanding appended thereto, discussed above, as also to the Protocol attached thereto wherein it is stated, inter alia, that the Memorandum of Understanding with regard to the interpretation of Article 12 (Royalties and fees for included services) also represents the views of the Government of India, and observed that under Article 12(4)(b) of the DTAA between India and the USA, which is pari materia with Article 13(4)(c) of the DTAA with the UK, technology would be considered made available when the person acquiring the services is enabled to apply the technology; that the mere fact that the provision of services may require technical input to the person providing the services does not per se mean that technical knowledge, skill, etc. are made available to the person purchasing the services. Since in this case the role of the engineers providing the services was of mere reviewing and opining rather than designing and directing the project, the Tribunal held that no technical knowledge, etc. was made available to the assessee and therefore the fees paid to the UK company did not fall within the scope of ‘fees for technical services’ under Article 13(4)(c) of the DTAA with the UK. It is pertinent to note that the Tribunal made certain observations at page 25, which, in effect, mean that the interpretation adopted by the Tribunal of the term ‘fees for technical services’ with reference to the DTAA between

India and the UK, particularly of the concept of ‘make available’, relying upon the definition and interpretation of the term ‘fees for included services’ used in the DTAA with the USA, should apply to several subsequent DTAAs India has entered into using the same phraseology, including specifically the DTAA between India and the UK.

E.3 In NQA Quality Systems Registrar Ltd. v. Deputy CIT, (2005) 92 TTJ (Del.) 946, wherein the above-referred decision in Raymond Ltd. v. Deputy CIT (supra) is followed and similar views are expressed in the context of the DTAA with the UK. In this case, the assessee, an Indian company, made payments to certain non-resident companies in the UK for certain services rendered by those UK companies. The assessee was in the business of ISO audit and certification. The nature of services provided by the UK companies to the assessee included providing the assessee with assessors to assess the quality assurance systems existing with the assessee’s customers, visits to the assessee’s customers, providing of training, etc. The question was whether while remitting the fees to the UK companies the assessee was required to deduct tax at source there from. The Tribunal analysed the definition of the term ‘fees for technical services’ given in Article 13 of the DTAA with the UK, noted the similar provisions of Article 12 of the DTAA with the USA, the Memorandum of Understanding appended thereto, and concluded that the nature of services provided by the UK companies to the assessee did not make available any technical knowledge, experience, skill, etc. to the assessee and therefore the fees paid by the assessee to the UK companies do not fall within the definition of the term ‘fees for technical services’ and that, therefore, the assessee was under no ob-ligation to deduct tax therefrom u/s.195 of the Act.

E.4 In National Organic Chemical Industries Ltd. v. Deputy CIT, (2005) 96 TT] (Mum.) 765, this interpretation of the concept of ‘make available’ is reiterated by the Tribunal in the context of Article 12(4) of the old DTAA between India and Switzerland. It is in effect observed by the Tribunal that when there is mere rendering of services without the transfer of technology it cannot be said that technology, etc. are ‘made available’ within the meaning of Article 12(4) of the DTAA between India and Switzerland and therefore payment for such services is not liable to tax in India.

E.5 In Dy. CIT v. Boston Consulting Group Pte. Ltd., [2005] 94 ITD 31 (Mum.) reiterates similar views. In this case, the non-resident company, a resident of Singapore, was in the business of ‘strategy consulting’. One of the issues before the Tribunal was whether the fees paid for such services fell within the term ‘fees for technical services’ under Article 12(4)(b) of the DTAA between India and Singapore where more or less the same language is employed as in the DTAA with the USA, the UK, etc. Noting the above-referred decision in Raymond Ltd. v. Deputy CfT (supra), the language of Article 12 of the DTAA with the USA, the Memorandum of Understanding appended to the said DTAA and the illustrations given therein, the concept of ‘make available’, etc., discussed above, the Tribunal concluded that the fees paid for such strategy consulting do not fall within the scope of ‘fees for technical services’ used in Article 12(4)(b) of the DTAA with Singapore. However, interestingly, it seems that the Tribunal has given an altogether different dimension to this issue by making a very broad observation at page 57 that so far as the DTAA with the USA is concerned, consultancy services which are not technical in nature cannot be treated as fees for included services. Though not clear, perhaps this view is influenced by a more general or profound statement made in the Memorandum of Understanding appended to the DTAA between India and the USA, under the paragraph titled ‘Paragraph 4 (in general)’, regarding the interpretation of the term ‘fees for included services’ given in Article 12(4)(b) of the said DTAA, which statement runs as follows:

“Thus, under paragraph 4(b), consultancy services which are not of a technical nature cannot be included services.”

F. Indian Treaties where the concept of ‘make available’ is used and differences in the wordings used in the relevant Articles:

Detail of DT AA with different countries having ‘make available’ phrase in FTS clause or indirectly made applicable through Protocol

Underlying tax credit — Concept and its significance

International Taxation

1. Overview :


The taxation of dividends has its origin in the classical
system of taxation, which in fact taxes corporate profit twice: once at the
company level and again at the shareholder level where the company’s profits
after tax are distributed by way of dividend to its shareholders. This is known
as economic double taxation as distinct from juridical double taxation. In
simple words, economic double taxation means double taxation of the same items
of economic income in the hands of different taxpayers.

From a tax policy perspective, economic double taxation
distorts investment decision making, and therefore the optimally efficient
allocation of resources, by inducing tax payers to invest by means of channel
that provides the best after-tax return, rather than by means of the most
appropriate commercial route to achieve the best pre-tax return.

2. Meaning of underlying Tax Credit :


Underlying tax credit relieves the economic double taxation
on foreign dividend income. The underlying tax credit is given for the pro-rata
share of the corporate tax paid by the foreign dividend distributing company. It
is computed as percentage of the corporate tax paid by the company that the
gross dividend distribution bears to the after-tax profits. The net dividend
received plus the withholding tax, if any, is taken as percentage of the related
after-tax profits of the paying company and multiplied by the corporate tax
paid. Dividend is grossed up by the underlying tax credit to compute the foreign
income subject to tax in home country. The ordinary credit limitation is applied
on the grossed-up dividend.

The underlying tax (or indirect) credit system on foreign
dividends is found in several countries under their domestic laws or tax
treaties. These countries include Argentina, Australia, Austria, Canada,
Denmark, Estonia, Finland, Germany, Greece, Ireland, Japan, Korea, Malta,
Mauritius, Mexico, Namibia, Nigeria, Singapore, Spain, Poland, the UK and the
US. It typically only applies if :

  • The shareholder has a significant shareholding in the dividend distributing
    company (e.g. in the UK, 10% is needed), and


  • The shareholder is a company.




Upon receipt of a dividend by the shareholder, the pre-tax
income of the distributing company is included as a taxable income. The
shareholder jurisdiction’s normal rate of company tax is then applied, but the
resulting tax (mainstream tax) is reduced by the company tax paid by the
dividend distributing company (i.e., reduced by the underlying tax). If
the underlying tax exceeds the amount of mainstream tax then there will be no
further tax to pay by the shareholder, who will, thus, receive tax-free
dividends.

The result is that the group will always pay the higher of
the two taxes — the dividend distributing company tax or the shareholder country
tax.

It is referred to as underlying tax credit because credit is
given for the tax paid in the underlying entity. It is also referred to as the
‘Indirect tax credit’ method because shareholder receives credit for tax which
it has only paid indirectly. In the U.S. Internal Revenue Code the same is
referred to a ‘Deemed paid credit’. The concept of ‘Imputation Credit’ is almost
similar to underlying tax credit.

In addition, most jurisdictions provide for a tax credit to
the parent company for the foreign tax paid by the subsidiary when its
undistributed income is attributed under the Controlled Foreign Corporation
Rules. In this article the focus is on underlying tax credit in respect of
dividend income.

3. Example of the underlying tax credit :


Company X is a resident of the UK and owns 60% share capital
of Company Y, a resident in India. Tax rate in India is assumed to be 34% and
tax rate in the UK is assumed to be 28%. Company X has no other taxable income
in the UK.

Since the dividends may be paid out of both current and past profits, domestic law or practice generally provides the ‘ordering rules’. These rules relate the dividends to the relevant post-tax profit out of which the distribution has been made and the creditable tax is determined by the effective tax rate imposed on those profits. In the US, the dividends are deemed to be distributed from a pool of retained profits and the underlying foreign tax is the average effective tax rate.

The computation is also affected by the exchange rate used to translate the creditable foreign tax. It could be either the rate prevailing at the time of payment of the foreign tax (historical rate), or the rate when the dividend was distributed (current rate). The US law requires that the foreign tax be translated at the historical rate, while the United Kingdom generally applies the current rate.

4. Underlying tax credit in respect of taxes paid by the lower tier companies:

In the context of International business structuring, it is quite common for the Multinational Enterprises (MNEs) to structure their business operations in various countries by way of creating various subsidiaries  of the same parent  company and to have further downward subsidiary companies of its subsidiary companies, to achieve their business objective in most efficient and profitable manner. The subsidiaries and the subsidiaries of the subsidiary companies are commonly referred to as ‘lower tier companies’.

Many countries allow the underlying tax credit computation to include taxes paid by lower tier companies. For example, Australia, Ireland, Mauritius, South Africa, and the UK allow the credit for taxes suffered by all lower tier companies, provided prescribed minimum equity or voting rights are maintained at each tier. Similarly Argentina, Japan and Norway permit the underlying tax credit upto two tiers of subsidiaries, Spain gives the underlying tax credit for taxes paid upto three tiers and the United States grants them upto 6 tiers, of qualifying foreign subsidiaries.

Thus, for example, a UK parent company investing in a Mauritian subsidiary, which in turn invests in its Indian subsidiary, subject to fulfillment of the shareholding percentage and other relevant conditions and compliance with regulations, would be eligible to take credit of underlying corporate taxes paid by the Indian subsidiary, to the extent of dividends paid by Indian Company, which are forming part of the dividends paid by the Mauritian Company, against the tax payable in respect of dividends received by the UK Company in UK.

5. Significance of underlying tax credit :
Foreign tax credit planning plays a major role in structuring investments in a foreign tax jurisdiction, in case of various multi-nationals based in jurisdictions such as the UK, the US and Ireland etc., where the credit system predominates and where the underlying tax credit is given. India’s Double Taxation Avoidance Agreements (DTAAs) with ten countries contains the provisions regarding underlying tax credit in respect of dividends paid by a company resident of India. Similarly India’s DTAAs with Mauritius and Singapore contain the provisions regarding underlying tax credit in respect of dividends paid by a Mauritian or Singaporean company.

In respect of planning  for all inbound  investment into India, from the countries  where the respective DTAAs with India/ domestic law contain the underlying tax credit provisions,  it is very important  to keep  in mind  the  exact  operation   of respective -1 underlying  tax credit  provisions  in the DTAAs/ domestic  law, to arrive  at the net tax cost of the MNE/Group  in respect  of dividend  income.  This will facilitate a proper decision-making in respect of investments into India. However, it is important to note that a detailed knowledge of the domestic law provisions of the underlying tax credit in the respective jurisdictions is of utmost importance. Therefore, wherever required, the services of the local consultants/tax experts may be utilised to know the law and practice in respect of exact operations of the underlying tax credit provisions.

In respect of outbound investments also, a proper consideration of the underlying tax credit would be of great help in properly arriving at the actual net tax cost of the enterprise/ group in respect of dividends and thus making the right investment decisions.

6. Underlying tax credit under Indian Scenario:

India does not have any domestic regulations in respect of underlying tax credit. However, as mentioned above, India’s DTAAs with ten countries contain the provisions relating to underlying tax credit. The relevant provisions relating to underlying tax credit contained in various articles are given below for ready reference: