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Category: International Taxation

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:

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 Part-I of the Article published in November 2009, 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 and third parts of the Article published
in December 2009 and January 2010, we have analysed in brief some of the Indian
judicial decisions dealing with the subject. In the fourth part of the Article,
we are analysing in brief, the remaining Indian judicial decisions as of date
dealing with the subject.



A.
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. A gist of some of the
relevant cases was given in Parts II & III of the Article published in the
December, 2009 and January 2010 issues of BCAJ. A gist of the remaining relevant
cases as of date is given below. It is important to note that in the gist of
cases given below, we have only considered and analysed the aspect relating to
the ‘Make Available’ concept. Other aspects relating to royalty, PE, etc. have
not been discussed or analysed here. For this, the reader should consider
and refer to the text of
the decisions.

Sr.   No.


Decisions/Citation/Tax  Treaty

Gist of the
decision relating to              concept of ‘Make Available’ aspect

32.  

Raymond Ltd.
vs. DCIT

 

[2003] 86 ITD 791 (Mum.)

 

 

DTAA – UK

  

Nature of services and
payments :

 

Payment of management
commission, underwriting commission and selling commission in respect of GDR
issues.

 

Issue(s) :

 

 

(i) Is the selling
commission, underwriting commission and management commission paid by the
assessee to Merrill Lynch “fees for technical services”; and whether the
same is chargeable as income in India with reference to the provisions of
Section 9(1)(vii) of the Income-tax Act and the provisions of the double
tax agreement with UK?

(ii) Assuming that the
services fall within the above mentioned Section, can they be considered
as “technical services” within the meaning of the relevant article in the
Double Tax Agreement with UK?

 

Held :

 

Whereas Section 9(1)(vii)
stops with the ‘rendering’ of technical services, the DTA goes further and
qualifies such rendering of services with words to the effect that the
services should also make available technical knowledge, experience, skills,
etc., to the person utilizing the services. The ‘making available’ in the
DTA refers to the stage subsequent to the ‘making use of’ stage. The
qualifying word is ‘which’ and the use of this relative pronoun as a
conjunction is to denote some additional function the ‘rendering of
services’ must fulfil. And that is that it should also ‘make available’
technical knowledge, experience, skill, etc. Thus, the normal, plain and
grammatical implication of the language employed 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 technical knowledge, experience,
skills, etc., from the person rendering the services to the person utilising
the same is contemplated in 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, skills, etc.

In the instant case, after
the services of the managers came to an end, the assessee-company was left
with no technical knowledge, experience, skill, etc., and still continued to
manufacture cement, suitings, etc., as in the past.

For the above reasons, the
DTA with UK applied to the instant case, and no technical knowledge,
experience, skills, know-how or process, etc., was ‘made available ‘to the
assessee-company by the non-resident managers to the GDR issue within the
meaning of article 13.4(c).

Since the DTA was held
applicable then, no part of the fees for ‘managerial services’ could be
considered as fees for technical services, since the word ‘managerial’ does
not find a place in the article concerned. Therefore, the ‘management
commission’ could not be charged to tax in the hands of MLI, to whom the
same was paid. MLI, to whom the same was paid. The assessee-company, consequently, was under no obligation to deduct tax under Section 195.As regards the ‘underwriting commission’, since no technical knowledge, etc., was made available to the assessee company by the rendering of the underwriting services, the definition in the DTA was not applicable. As regards selling concession or selling commission relying on Circular No. 786 dated 7-2-2000, it was contended that it was not income in the hands of the recipient. In view of the import of words ‘make available’ appearing in the DTA with UK, it was unnecessary to dilate on the circular further. Therefore, neither the management commission nor the underwriting commission or even the selling commission/concession would amount to fees for technical services within the meaning of the DTA with UK and, consequently, there was no obligation on the part of the assessee-company to deduct tax under Section 195.

 

[ 2002]
82 ITD 239

Payment
for installation and commissioning of machines purchased

(Kol.)

DTAA –
France

Issue(s)

 

 

Whether
such payments for installation and commissioning are liable for

 

TDS u/s
195?

 

Held

 

Installation
and commissioning of machineries constituted services that

 

were
ancillary and subsidiary, as well as inextricably and essentially

 

linked
to the sale of the machines. Therefore, these services, rendered to

 

the
assessee, were not covered by the scope of ‘fees for technical services’

 

referred
to in Article 13 of the India France DTAA. Hence, installation

 

and
commissioning fees, on the facts of the present case, were not exigible

 

to tax
in India.

 

Note

 

It is
important to keep in mind that contrary to the popular belief, the

 

ITC’s
case does not deal with the ‘make available’ clause of the treaty,

 

and
instead deals with the importance and relevance of the Protocol to the

 

India
French Treaty for application of the restricted meaning of FTS.

 

 

34.   Pro-Quip Corpora-

Nature of services and payments

tion
vs. CIT (AAR)

Payment
for supply of engineering drawings and designs for the setting

[2002]
255 ITR 0354

up of
the plant.

DTAA –
US

Issue(s) Involved

 

 

Whether
the applicant is liable to tax on the amount received towards

 

consideration
for the sale of engineering drawings and designs received.

 

Whether
the payment is to be treated as fee for included service covered

 

by
clause (b) paragraph 4 of Article 12.

 

Held

 

The facts of this case are very similar to the
facts of the first part of ex–

 

ample 8
given in the MoU to the India-US Tax Treaty. The engineering

 

services
were being rendered as a part of the purchase agreement as a

 

composite
whole. This service was essentially linked with the sale of

 

drawings
and designs. It is not an agreement for long-term service to be

 

rendered
after the sale of the machinery. The case is a case of out and

 

out
sale of property.

 

The AAR
held that the payments made to the American company will

 

not
fall within the ambit of Article 12 of the Indo-US Treaty for Double

 

Taxation.

 

 

 

 

 

 

 

 

 

 

Sr.

Decisions/Citation/Tax

Gist of
the decision relating to concept of ‘Make Available’ aspect

 

No.

Treaty

 

 

 

 

 

 

 

 

 

35 .

Sahara
Airlines Ltd.

Nature of services and payments

 

 

vs. Dy
CIT

Payment
for providing training to the crew members

 

 

[2002]
83 ITD 11

 

 

 

 

 

 

(Delhi)

Issue(s)

 

 

DTAA –
UK

 

 

 

 

 

 

 

 

Whether such payments amounted to fee for
technical services as defined

 

 

 

 

in
Explanation 2 of Section 9(1)(vii) of the Act, as well as Article 13(4) of

 

 

 

 

DTAA
with UK.

 

 

 

 

Held

 

 

 

 

The
ITAT was of the view that it was an agreement for training of asses-

 

 

 

 

see’s
personnel and not for mere use of simulator. Training can be given

 

 

 

 

to the
trainees either directly or through customer’s instructors. Clause 14

 

 

 

 

of the
agreement clearly provides for free training to assessee’s instructors,

 

 

 

 

who, in
turn, had provided the same to its personnel. Since training to

 

 

 

 

assessee’s
instructors was free of charge, the payment in the invoice was

 

 

 

 

shown
for use of simulator alone but that does not mean that technical

 

 

 

 

knowledge
was not provided by the UK company. The simulator is a

 

 

 

 

highly
sophisticated machine which cannot be operated unless requisite

 

 

 

 

technical
knowledge is given to the user of the machine. Therefore, we

 

 

 

 

are
unable to accept the main contention of assessee’s counsel that no

 

 

 

 

technical knowledge was given. Apart from
this, flight training personnel

 

 

 

 

are experts
and experienced persons, who have shared their experiences

 

 

 

 

with
the assessee’s instructors and, therefore, on this account also, it would

 

 

 

 

fall within the definition of technical
services as provided in Article 13

 

 

 

 

of DTAA
with UK, in as much as it not only includes making available

 

 

 

 

of
technical knowledge but also the experience. Therefore, it is held that

 

 

 

 

the
agreement was for providing of training to assessee’s personnel and

 

 

 

 

consequently,
the payment for the same was fee for technical services and,

 

 

 

 

therefore,
chargeable to tax in the hands of the recipient under section 9(1)

 

 

 

 

(vii)
of the Act as well as under the provisions of DTAA with UK.

 

 

 

 

 

 

 

36.

P. No.
28 of 1999 In

Nature of services and payments

 

 

re vs.
(AAR)

Payment
for services to make available executive personnel for develop-

 

 

[2000]
242 ITR 0208

 

 

ment of general management, finance and
purchasing, service, marketing

 

 

DTAA –
USA

 

 

and
assembly/manufacturing activities under the management provision

 

 

 

 

agreement.

 

 

 

 

Issue(s)

 

 

 

 

Whether
any part of the amount invoiced by the foreign company in terms

 

 

 

 

of the
management provision agreement is liable to tax in India.

 

 

 

 

Held

 

 

 

 

These
clauses envisage transfer of information by “XYZ” [Foreign Com-

 

 

 

 

pany]
to “AB” [Indian JV Company] (whether independently of or through

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Sr.

Decisions/Citation/Tax

Gist of
the decision relating to concept of ‘Make Available’ aspect

No.

Treaty

 

 

 

 

 

 

 

 

 

 

 

the
personnel employed) and also confer on “AB” the right to use and

 

 

 

disclose
the technology and knowledge developed by the employees in

 

 

 

the
course of their work. Reference has also been made to the letter of

 

 

 

approval
of the Government of India which shows that the government

 

 

 

was
informed that these personnel were being deputed for a period of

 

 

 

up to
three years for providing management and technical service to the

 

 

 

joint
venture, so that the services of these employees could eventually

 

 

 

be replaced by Indian personnel. It is,
therefore, difficult to accept the

 

 

 

plea
that no technology, information, know-how or processes were made

 

 

 

available
to “AB” by “ XYZ”.

 

 

 

The AAR
concluded that the services of the nominees of “XYZ” are “mana-

 

 

 

gerial”
and not “technical or consultancy” services within the meaning of

 

 

 

Article 12, and in the result, the Authority
finds, on the facts available to

 

 

 

it, that the services of the five nominees of “XYZ”
are not covered by the

 

 

 

expression
“included services” in Article 12.

 

 

 

 

 

37.

Bovis  Lend
Lease

Nature of services and payments

 

(India)
Pvt. Ltd. vs.

Assistance
with respect to administrative matters between the appellant

 

ITO(IT), Bangalore

 

 

 

and
LLAH [Foreign Company based in Singapore]; Assistance with respect

 

2009-TIOL-666-ITAT-

to personal matters, legal matters, finance
and accounting information,

 

marketing
support, insurance matters; Assistance in operation of the busi-

 

Bang

 

ness;
Treasury Management; Information Technology.

 

 

 

 

DTAA –
Singapore

Issue(s)

 

 

 

 

 

 

(a)  Whether the reimbursements made to the
foreign company be not

 

 

 

 

considered
as fees for technical services or income chargeable to tax

 

 

 

 

in
India;

 

 

 

(b) At
any rate, since the in situs of the services was outside India, no

 

 

 

 

part of
the payment be held as deemed to accrue or arise in India.

 

 

 

Held

 

 

 

The
ITAT, in respect of the payment to be considered as reimbursement

 

 

of
expenses, laid down the following tests:

 

 

 

a)

The actual liability to pay should be of the
person who reimburses

 

 

 

 

the
money to the original payer.

 

 

 

b)

The liability ought to have been clearly
determined. It should not be

 

 

 

 

an
approximate or varying amount.

 

 

 

c)

The liability ought to have crystallized. In
other words, payments

 

 

 

 

which
were never required to be done, but were done just to avoid

 

 

 

 

a
potential problem, may not qualify.

 

 

 

d)

There should be a clear ascertainable
relationship between the

 

 

 

 

paying
and reimbursing parties. Thus, an alleged reimbursement by

 

 

 

 

an
unconnected person may not qualify.

 

 

 

e)

The
payment should first be made by somebody else whose liability

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Sr.

Decisions/Citation/Tax

Gist of
the decision relating to concept of ‘Make Available’ aspect

 

No.

Treaty

 

 

 

 

 

 

 

 

 

 

 

 

it never
was, and the repayment should then follow to that person to

 

 

 

 

square
off the account.

 

 

 

 

f)  There should be clearly three parties
existing: the payer, the payee

 

 

 

 

and the
reimbursing party.

 

 

 

 

The
transactions tested, fail to meet the criteria that would enable the

 

 

 

 

payments
to be treated as reimbursements.

 

 

 

 

The
dictionary meaning of the word ‘make available’ is ‘able to use or

 

 

 

 

obtain’.
It does not mean that the recipient should equally use the tech-

 

 

 

 

nology.
In a case like this where a group owns a number of companies

 

 

 

 

and
certain companies provide services to the companies belonging to

 

 

 

 

the
group, then it becomes the policy of the group to get services of that

 

 

 

 

company
though other group companies might be able to perform the same

 

 

 

 

functions
on the basis of the services already provided to them. Therefore,

 

 

 

 

in the
instant case, Section 195 will b e applicable because reimbursement

 

 

 

 

of
expenses relates to the fee for technical services. Hence, we hold that

 

 

 

 

the authorities below were justified in
holding that tax was not required

 

 

 

 

to be
deducted on the ground that the appellant company reimburse the

 

 

 

 

expenses,
as the amounts payable were to be taxed in the hands of the

 

 

 

 

recipient
as fees for technical services as per DTAA.

 

 

 

 

The
jurisdictional High Court, in the case of Jindal Thermal Power Company

 

 

 

 

vs.
DCIT, had an occasion to consider the taxability of income deeming to

 

 

 

 

accrual
and arising in India as mentioned in section 9(1)(vii). The Hon’ble

 

 

 

 

High
Court has considered the explanation introduced in Section 9(2) of

 

 

 

 

the I T
Act. Before the Hon’ble High Court it was argued that the ratio of

 

 

 

 

Supreme
Court in Ishikawajma Harima Heavy Industries Ltd. vs Director

 

 

 

 

of
Income Tax 288 ITR 408 regarding twin criteria of rendering of services

 

 

 

 

and its
utilization in India has not been done away with by the incorpo-

 

 

 

 

ration
of Explanation to section 9(2). It was also argued that the objects

 

 

 

 

and
reasons stated in introducing explanations are only external aids, to

 

 

 

 

be used
only when the text of the law is ambiguous. After considering

 

 

 

 

the
submission, the Hon’ble High Court held that “however, in respect

 

 

 

 

of
technical services, the rendering of services being purely off-shore and

 

 

 

 

outside
India, the remuneration, whatever paid towards technical services,

 

 

 

 

does
not attract tax liability”. In the instant case, from the perusal of the

 

 

 

 

certificate from the auditor, it is clear that
services have been provided

 

 

 

 

offshore.
Hence, in view of the decision of the jurisdictional High Court,

 

 

 

 

the
appellant will not incur any liability to deduct tax towards the amount

 

 

 

 

paid in
respect of the services. Hence, it is held that the appellant was not

 

 

 

 

required
to deduct tax at source in respect of the payments.

 

 

 

 

 

38.

Federation of Indian

Nature of services and payments

 

 

Chambers
of  Com-

Non-resident
service provider acting as a facilitator and technical consultant

 

 

merce and Industries

 

 

(FICCI) in re AAR

for the purpose of commercialisation of
identified technologies; screening

 

 

2009-TIOL-30-ARA-IT

and
assessment of technologies by deploying the expertise and resources

 

 

and
preparing technical reports including market analyses.

 

 

DTAA

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Sr.

Decisions/Citation/Tax

Gist of
the decision relating to concept of ‘Make Available’ aspect

No.

Treaty

 

 

 

 

 

 

 

 

 

 

Issue(s)

 

 

 

Whether
on the facts and circumstances of the case, the non-resident is

 

 

 

not
liable to pay income tax in India out of the payments received by it

 

 

 

from
FICCI in instalments.

 

 

 

Held

 

 

 

Explaining
broadly the principles involved in technology commercializa-

 

 

 

tion
and making the participants familiar with various aspects of the

 

 

 

programme,
does not prima facie amount to making available technical

 

 

 

knowledge
or expertise possessed by the instructors of University of Texas

 

 

 

[UT].
At any rate, it seems to be merely incidental to the implementation

 

 

 

of the programme which does not fall within
the definition of ‘included

 

 

 

services’.
It is not possible to split up this segment of service and appor-

 

 

 

tion a part of consideration received to ‘training’,
even if it has the flavour

 

 

 

of ‘included
services’.

 

 

 

Expression
of opinion, formulation of recommendation, and rendering

 

 

 

assistance
to DRDO in connection with ATAC programmes do not really

 

 

 

make
available the technical knowledge or know-how to DRDO, except

 

 

 

perhaps
in an incidental or indirect manner. UT’s services and the con-

 

 

 

sideration
received, therefore, cannot be brought within the ambit of Art

 

 

 

12.4 of
DTAA.

 

 

 

 

 

39.

International
Tire

Nature of services and payments

 

Engineering

Granting
a perpetual irrevocable right to use the know-how as well as to

 

Resources LLC. in

 

Re AAR

transfer
the ownership in tread and side-wall designs and patterns required

 

2009-TIOL-25-ARA-

for the
manufacture of radial tyres for a lump sum consideration.

 

 

 

 

IT

Issue(s)

 

DTAA –
USA

 

 

 

 

 

 

Whether
on the stated facts in the “Technology Transfer Agreement” en-

 

 

 

tered
into between the applicant and M/s. CEAT Limited, and in law, the

 

 

 

consideration
for the transfer of documentation payable by M/s. CEAT

 

 

 

Limited
to the applicant is exigible to tax under the Act, in the hands of

 

 

 

the
applicant.

 

 

 

Whether
on the stated facts, and in law, the consideration for consultancy

 

 

 

and assistance
receivable by the applicant from M/s. CEAT Limited is

 

 

 

taxable
in the hands of the applicant in India under the Act.

 

 

 

Held

 

 

 

Whether or not the first limb of Art 12(4)
applies, undoubtedly, the second

 

 

 

limb is
attracted in the instant case. The consultancy, assistance and train-

 

 

 

ing
services make available to CEAT the technical knowledge, experience,

 

 

 

know-how
and processes, so that transferee CEAT will be able to derive

 

 

 

full
advantage from the know-how supplied by the applicant and equip

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Sr.

Decisions/Citation/Tax

Gist of
the decision relating to concept of ‘Make Available’ aspect

 

No.

Treaty

 

 

 

 

 

 

 

 

 

 

 

 

itself
with the requisite knowledge and expertise so that the transferee

 

 

 

 

will be
able to utilize the same even in future ventures on its own and

 

 

 

 

without
reference to the transferor. The importance of consultancy and

 

 

 

 

assistance
services is highlighted by an express declaration in the ‘Agree-

 

 

 

 

ment’
which we may, at the risk of repetition, notice at this stage. The

 

 

 

 

“transferor
acknowledges that the transferee will not be able to use the

 

 

 

 

know-how
unless the transferor trains the transferee’s personnel in the

 

 

 

 

plant
in order to be capable of designing, developing and manufacturing

 

 

 

 

the
products in accordance with the know-how.” In the MOU concerning

 

 

 

 

fees for included services appended to
US-India Treaty, it is thus clarified:

 

 

 

 

“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 knowl-

 

 

 

 

edge,
skills, etc., are made available to the person purchasing the service,

 

 

 

 

within the meaning of paragraph 4(b).” This
test is satisfied in the instant

 

 

 

 

case.
The fee received by the applicant under clause 8 of the Agreement,

 

 

 

 

therefore, falls within the scope of fee for
included services as defined in

 

 

 

 

paragraph
4 of the Art 12 of the ‘Treaty’. The position, in regard to the

 

 

 

 

liability under the Act, is equally clear. The
definition of fee for technical

 

 

 

 

services
in Explanation 2 to clause (vii) of Section 9(1) is even wider in

 

 

 

 

its
scope and amplitude than the corresponding provision in the ‘Treaty’.

 

 

 

 

The
restrictive phrase “make available” is not there in the Act. In fact, the

 

 

 

 

learned
counsel for the applicant has not disputed that the fee received

 

 

 

 

by
virtue of clauses 7 and 8 of the Agreement constitute fee for technical

 

 

 

 

services
or included services as per the Act and the Treaty.

 

 

 

 

Thus,
for more than one reason, the AAR held that paragraph 5 of Art

 

 

 

 

12 of
the Treaty cannot be invoked by the applicant.

 

 

 

 

The
consideration received for consultancy, assistance and training as per

 

 

 

 

clauses
7 and 8 of the Agreement is liable to be taxed as fee for included

 

 

 

 

services
under the Treaty, and as fee for technical services under the

 

 

 

 

Income-tax
Act, 1961.

 

 

 

 

 

40.

ADIT
(IT), Mumbai

Nature of services and payments

 

 

vs.
McKinsey & Co

Strategic
consultancy and other services; Advisories do not include any

 

 

Inc., UK & others

 

 

2009-TIOL-728-ITAT-

transfer
of technical know-how or specialised knowledge.

 

 

Mum

Issue(s)

 

 

DTAA –
USA

 

 

 

 

 

 

 

 

Whether
such payments made can be considered as fees for included

 

 

 

 

services
as per the India-USA Treaty.

 

 

 

 

Held

 

 

 

 

The assessing officer should not be prevented
from calling for details,

 

 

 

 

under
the pretext of “the world knows what McKinsey & Co, Inc does”.

 

 

 

 

Even if the burden is on the assessing officer
to prove that a particular

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

 

Sr.

Decisions/Citation/Tax

Gist of
the decision relating to concept of ‘Make Available’ aspect

No.

Treaty

 

 

 

 

 

 

 

 

 

 

item of
income is taxable, and at the same time the assessee does not

 

 

 

co-operate
or give any information or documentation whatsoever when

 

 

 

specifically asked for and when it is
undisputed that these documents

 

 

 

are in
its exclusive possession and only relies on its history and facts that

 

 

 

were submitted in the earlier assessments, the
assessing officer can draw

 

 

 

an
adverse inference.

 

 

 

Nobody
can refuse to furnish any information which is exclusively in

 

 

 

its possession
and then argue that the revenue has not discharged the

 

 

 

burden
of proof. The onus is also on the assessee to lead the evidence to

 

 

 

prove
that the receipt is not taxable because it falls within a provision or

 

 

 

it is
exempt.

 

 

 

Accepting
the assessee’s plea that the case be decided on the basis of in-

 

 

 

formation
furnished in 1997, would amount to laying down a very wrong

 

 

 

precedent.
The departmental representative was correct in pointing out that

 

 

 

if such
a view is taken by the Tribunal, in future also the assessees would

 

 

 

not produce any document before any assessing
officer on the argument

 

 

 

that
the facts are same as in the earlier years and the proposition for the

 

 

 

law
laid down by the Tribunal in earlier years should be followed.

 

 

 

Note

 

 

 

Please
also refer to the decision of the ITAT Mumbai in the case of McK-

 

 

 

insey
and Co., Inc (Philippines) vs. ADIT (IT) (ITAT-Mum) [2006] 284 ITR

 

 

 

(A.T.)
0227 discussed at Sr. No. 20 of the Part III of the Article.

 

 

 

 

 

41.

ITO vs.
Sinar Mas

Nature of services and payments

 

Pulp
& Paper (India)

Fees
for preparing feasibility study on the project to be used for  presen-

 

Limited

 

ITAT –
Delhi

tation of the project to the foreign investors
and financial institutions.

 

 

 

 

2003-TIOL-19-ITAT-

Issue(s)

 

DEL

 

 

 

DTAA –
Singapore

Whether
payment for said services liable to tax in India as “Fees for

 

 

 

Technical Services” as defined in Article 12
of India-Singapore Double

 

 

 

Taxation
Agreement?

 

 

 

Held

 

 

 

Held
that the payment made, clearly and unquestionably comes under

 

 

 

clause
(b) of Para 4 of the Article 12. The ITAT have taken note of the fact

 

 

 

that
the concerned party has clearly made available technical knowledge,

 

 

 

experience,
skill by way of the ‘Project Report’ which was used to woo

 

 

 

the
foreign investors, and the detailed project report not only provides

 

 

 

the
rough road map but virtually provides the entire detailed design and

 

 

 

map
work. At the cost of reiteration, the project report not only lays down

 

 

 

the
mill site and infrastructure but also deals with mill organization and

 

 

 

training;
it takes care of the grades to be produced; and the markets which

 

 

 

will supply fibre to the mill.  The technology and environment aspects

 

 

 

 

 

 

Sr.

Decisions/Citation/Tax

Gist of
the decision relating to concept of ‘Make Available’ aspect

 

No.

Treaty

 

 

 

 

 

 

 

 

 

 

 

 

memorandum
of understanding, is `communication through satellite or

 

 

 

 

otherwise`,
and relying on the same, learned special counsel for the Rev-

 

 

 

 

enue
has contended that the interface between the reservation system of

 

 

 

 

the
assessee-company and that of the Indian hotels/clients was covered

 

 

 

 

in this category.” We, however, find it
difficult to agree with this conten–

 

 

 

 

tion of
the learned special counsel for the Revenue. First of all, it is the

 

 

 

 

area which has been specified in the
Memorandum of Understanding for

 

 

 

 

ascertaining
the services relating thereto being of technical and consultancy

 

 

 

 

nature
making technology available, whereas the services rendered by the

 

 

 

 

assessee
in the present case are in the hotel industry and such services

 

 

 

 

are in
relation to advertisements, publicity and sales promotion which are

 

 

 

 

not in
the nature of technical and consultancy services involving making

 

 

 

 

of
technology available. Secondly, the interface between the computerized

 

 

 

 

reservation
system of the assessee and the computerized reservation system

 

 

 

 

of the
Indian hotels/ clients was provided to facilitate the reservation of

 

 

 

 

hotel
rooms by the customers worldwide as an integral part of the inte-

 

 

 

 

grated
business arrangement between the assessee and the Indian hotels/

 

 

 

 

clients.
This interface thus was not separable from and independent of

 

 

 

 

the
main integrated job undertaken by the assessee-company of render-

 

 

 

 

ing
services in relation to marketing, publicity and sales promotion; and

 

 

 

 

the
same, in any case, was not in the nature of technical and consultancy

 

 

 

 

services,
making any technology available to the Indian hotels/clients in

 

 

 

 

the field/area of communication through
satellite or otherwise. Moreover,

 

 

 

 

as pointed
out by the learned counsel for the assessee before us, no com-

 

 

 

 

munication
through satellite was involved in the interface between the

 

 

 

 

computerized
reservation system of the assessee and that of the Indian

 

 

 

 

hotels/clients.

 

 

 

 

What is
transferred to the Indian company through the service contract

 

 

 

 

is
commercial information and the mere fact that technical skills were re-

 

 

 

 

quired
by the performer of the service in order to perform the commercial

 

 

 

 

information
services does not make the service a technical service within

 

 

 

 

the
meaning of paragraph (4)(b) of article 12. Since the facts of the present

 

 

 

 

case
are almost similar to the facts of this case given in Example 7 of the

 

 

 

 

Memorandum of Understanding, it leaves no doubt
that the payment in

 

 

 

 

question
received by the assessee-company from the Indian hotels/clients

 

 

 

 

or any
part thereof could not be treated as ` fees for included services`

 

 

 

 

within
the meaning of paragraph (4)(b) of Srticle 12.”

 

 

 

 

For the
sake of ready reference, we shall provide in the next part of the

 

 

 

 

Article,
the list of various comprehensive DTAAs entered into by India

 

 

 

 

with
all other countries. We shall also indicate those countries which are

 

 

 

 

members
of OECD and the date of coming into effect of the treaties and

 

 

 

 

protocols
with countries having the restricted scope in respect of Fees for

 

 

 

 

Technical
Services by incorporating the ‘make available’ clause, and also

 

 

 

 

discuss
other relevant aspects.

 

 

 

 

 

 

 

 

 

 

 

 

Protocol to India-Mauritius Tax Treaty, 2016 – An Analysis

fiogf49gjkf0d
On 10 May, 2016, the Governments of India and Mauritius signed a
Protocol for amending the treaty dated 24 August, 1982, between India
and Mauritius. The key features of the Protocol are the introduction of
source-based taxation for capital gains on the transfer of Indian
companies’ shares acquired on or after 1 April, 2017, and the
sourcebased taxation of interest income of Mauritian banks, and of fees
for technical services. The treaty between India and Mauritius was
signed in 1982 and was in force from 1 April, 1983. As per the treaty,
India does not have the right to tax capital gains arising to a
Mauritius tax resident on sale of shares of Indian companies. This, made
Mauritius a favourable jurisdiction for investing into India. A number
of tax disputes have arisen on the issue of availability of treaty
benefits relating to capital gains as the Indian tax authorities have
sought to deny the benefits on the grounds of ‘treaty shopping’.
However, the Courts have mostly not accepted the contentions of the tax
authorities.

The Indian Government has been negotiating a
revision of the treaty with the Mauritius government for a long time.
The Protocol is a result of the negotiations.

1. Background:

The
Mauritius Treaty has been in existence since 1983 and, over a period of
time, played a critical role in attracting investments into India.
Right from the inception, the focus of the Mauritian government has been
to develop a robust offshore financial centre regime that attracted
reputed financial investors to use Mauritius as a platform for
investment into India. The Indian government was also instrumental in
promoting the Mauritius route and vehemently defended the Mauritius
route before the Supreme Court in the Azadi Bachao Andolan case, besides
issuing circulars to ensure that treaty benefits on capital gains were
provided to Mauritian companies.

It must be recalled that during
the 1990s, when the treaty first began to be extensively used, the
capital gains tax rates in India were significantly higher than they are
today. Investors, especially those from the US, were concerned about
direct investment into India due to a credit mismatch issue that arose
due to differences in the source rules in India and US. The concern for
US investors was that the taxes paid in India on capital gains were not
available as a credit in the US. With time and the lowering of the
Indian tax rates, this has become less of an issue for investors

With
passage of time, the stance of the government in respect of the
Mauritius treaty has undergone a change and everyone has been expecting
an amendment to the treaty for quite some time. Therefore, the amendment
to the India-Mauritius Tax Treaty has not come as an absolute bolt out
of the blue.

The longest running saga in the Indian tax history
may well be at an end. After years of re-negotiations, the over
three-decade-old tax treaty between India and Mauritius has finally been
amended to remove the capital gains exemption, albeit in a phased
manner. In the last two decades, the world has changed considerably.
Then treaty shopping was the established norm, so much so that its
validity was upheld even by the Supreme Court in the Azadi Bachao
Andolan case. Global sentiment has decidedly changed, with the OECD
coming out strongly against treaty abuse in its Base Erosion and Profit
Shifting (BEPS) project. There is an increasing recognition that tax
treaties are intended to avoid double taxation, and that they should not
be used as a basis for double non-taxation (where income ends up not
being taxed in either the Source State or the State of Residence). The
modification of the India-Mauritius treaty seems to be in sync with the
global trends.

Further, despite the Supreme Court upholding the
availability of treaty benefits under the India-Mauritius treaty,
investors continued to face significant challenges in obtaining treaty
benefits at the grass root level. Litigation too, continued to fester on
this issue, which led to the provisions of the treaty being undermined
in practice. This led to significant uncertainty.

Significantly,
the 2016 Protocol has included a number of provisions for enhancing
source country taxation rights, such as inclusion of a Service Permanent
Establishment (Service PE) provision, fees for technical services
(FTS), source country taxation rights on capital gains from shares,
interest income of banks and other income. At the same time, a
limitation on source country taxation rights in respect of interest
income has been provided at the rate of 7.5%.

Importantly, the
2016 Protocol also provides for carving out of shares acquired on or
before 31 March 2017 from source country taxation rights. Transitory
provisions for reduced taxation by the source country on capital gains
from alienation of shares (taxation at 50% of domestic tax rates) has
also been provided for a limited period from 1 April 2017 to 31 March
2019. However, a limitation of benefits (LOB) provision has also been
included for availing transitory provisions. A carve-out (i.e. an
exclusion) has also been included for interest earned by banks from debt
claims existing on or before 31 March 2017. Provisions relating to
exchange of information (EOI) have been revamped in order to bring them
in line with existing international standards. Additionally, an Article
on “Assistance in collection of taxes” has been introduced. Let us now
discuss the Contents of the Protocol in some greater detail in the
following paragraphs:

2. Contents of the Protocol

2.1 Amendment of Article 5 – Insertion of Service PE Clause

Article
1 of the Protocol amends Article 5 (Permanent Establishment) of the
Treaty by inserting in paragraph 2 the following new sub-paragraph:

“(j)
the furnishing of services, including consultancy services, by an
enterprise through employees or other personnel engaged by the
enterprise for such purpose, but only where activities of that nature
continue (for the same or connected project) for a period or periods
aggregating more than 90 days within any 12-month period.”

Impact of the Amendment:

The
service PE clause, while not included in the OECD Model Tax Convention
and expressly promoted by the UN Model Tax Convention, has been included
in a number of tax treaties concluded by India including tax treaties
with USA, UK and Singapore. While some of India’s tax treaties (for
instance with USA, UK, Singapore etc) specifically carve out an
exception for technical / included services from the service PE clause,
no such concession has been provided under the Protocol to the Mauritius
Tax Treaty. To this extent, the proposed clause is similar to the
Service PE clause provided in tax treaties with Iceland, Georgia, Mexico
and Nepal.

With increasing mobility of employees in
multinational organizations, this clause has been a matter of dispute in
a number of cases where employees are sent on secondment or deputation.

It is important to note that the words ‘within a contracting
State’ are missing from the service PE clause. The implication of this
could be that the source state could assert a service PE even if
services are rendered entirely from outside that state but cross the
period threshold. In 2008, OECD added paragraph 42.11 to 42.48 to the
Commentary on its Model Tax convention, dealing with taxation of
services.

Simultaneously, India expressed its position that it
reserves a right to treat an enterprise as having a Service PE without
specifically including the words ‘within a contracting state’. Hence,
this omission seems to be in line with the position taken by India on
the OECD commentary and could even expose taxpayers without any physical
presence to net income taxation in the source state and the resultant
challenges. However, depending upon the facts and circumstances of each
case, such a position would raise many issues regarding calculation of
no. of such days and hence, ensue litigation.

As a result of
inclusion of clause 5(2)(j), the term “PE” will include furnishing of
services, including consultancy services, by an enterprise of one State
through its employees or other personnel engaged by the enterprise for
such purposes, where such activities continue for the same or a
connected project for a period or periods aggregating more than 90 days
within any 12 month period. The United Nations Model Convention (UN MC)
includes this requirement in its Service PE provision contained in
Article 5(3)(b) of the UN MC. Additionally, the threshold is much lower
in the 2016 Protocol at 90 days, whereas it is 183 days in the UN MC.

2.2 Amendment of Article 11 – Taxability of Interest Income

Article 2 of the Protocol amends Article 11 (Interest) of the Treaty as under:

(i)
replacing paragraph 2 with the following: “However, subject to
provisions of paragraphs 3, 3A and 4 of this Article, such interest may
also be taxed in the Contracting State in which it arises, and according
to the laws of that State, but if the beneficial owner of the interest
is a resident of the other Contracting State, the tax so charged shall
not exceed 7.5 per cent of the gross amount of the interest,”;

(ii) deleting the paragraph 3(c); and

(iii)
inserting a new paragraph 3A as follows: “Interest arising in a
Contracting State shall be exempt from tax in that State provided it is
derived and beneficially owned by any bank resident of the other
Contracting State carrying on bona fide banking business. However, this
exemption shall apply only if such interest arises from debt- claims
existing on or before 31st March, 2017.”

Impact of the Amendment:

The
existing DTAA exempted interest income beneficially owned by taxpayers
engaged in a bona fide banking business of one State sourced from the
other State. The 2016 Protocol removes this generic exemption. However, a
carve-out has been included to continue to provide exemption from
taxation in the Source State on interest income arising from debt claims
existing on or before 31 March 2017.

Further, the existing DTAA
provided for unlimited taxation rights for source country on
non-exempted interest income. The 2016 Protocol restricts the source
country taxation rights on interest (including interest earned by banks)
to a maximum of 7.5% on the gross amount of interest. This is the
lowest tax rate cap agreed to by India on interest income for source
country taxation rights amongst all its DTAA s.

A tabular representation of the relevant changes is given below:

Ceiling
of tax rate on interest arising in the source state, coupled with the
additional requirement of such interest being ‘beneficially owned’ by
the resident state owner is in line with OECD and UN model tax
conventions. Further, most tax treaties entered into by India are on
similar lines. Indian tax treaties typically provide for a ceiling of
tax rate in the source state higher than 7.5 %. Currently, interest
income on instruments like compulsorily convertible debentures,
non-convertible debentures, or loans granted by a Mauritius entity to a
person resident in India was subject to tax at the full rate of 40% in
case of INR denominated debt or beneficial rate of 20% / 5% in specified
cases. Therefore, this is certainly a welcome development, and gives
the Mauritius treaty an edge above other treaties which India has signed
with other countries including Singapore, Cyprus and USA, where the
ceiling on rate of tax on interest income is in the range of 10% to 15%.

Earlier Mauritius was not a preferred jurisdiction for making
loans or debt investments as compared to other countries, except to the
extent of loans from a Mauritius resident bank. Thus, the change in the
tax rate to 7.5% on interest income should provide Mauritius a
competitive edge over other countries.

2.3 Insertion of New Article 12A – Taxability of Fees for Technical Services:

Article
3 of the Protocol inserts a New Article 12A concerning Taxation of Fees
for Technical Services as under:

“Article 12A
Fees for Technical Services

1.
Fees for technical services arising in a Contracting State and paid to a
resident of the other Contracting State may be taxed in that other
State.

2. However, such fees for technical services may also be
taxed in the Contracting State in which they arise, and according to the
laws of that State, but if the beneficial owner of the fees for
technical services is a resident of the other Contracting State the tax
so charged shall not exceed 10 per cent of the gross amount of the fees
for technical services.

3. The term “fees for technical
services” as used in the Article means payments of any kind, other than
those mentioned in Articles 14 and 15 of this Convention as
consideration for managerial or technical or consultancy services,
including the provision of services of technical or other personnel.

4.
The provisions of paragraph 1 and 2 shall not apply if the beneficial
owner of the fees for technical services being a resident of a
Contracting State, carries on business in the other Contracting State in
which the fees for technical services arise, through a permanent
establishment situated therein, or performs in that other State
independent personal services from a fixed base situated therein, and
the right or property in respect of which the fees for technical
services are paid is effectively connected with such permanent
establishment or fixed base. In such case the provisions of Article 7 or
Article 14, as the case may be, shall apply.

5. Fees for
technical services shall be deemed to arise in a Contracting State when
the payer is that State itself, a political sub-division, a local
authority, or a resident of that State. Where, however, the person
paying the fees for technical services, whether he is a resident of a
Contracting State or not, has in a Contracting State a permanent
establishment or a fixed base in connection with which the liability to
pay the fees for technical services was incurred, and such fees for
technical services are borne by such permanent establishment or fixed
base, then such fees for technical services shall be deemed to arise in
the Contracting State in which the permanent establishment or fixed base
is situated.

6. Where, by reason of a special relationship
between the payer and the beneficial owner or between both of them and
some other person, the amount of the fees for technical services exceeds
the amount which would have been agreed upon by the payer and the
beneficial owner in the absence of such relationship, the provisions of
this Article shall apply only to the lastmentioned amount. In such case,
the excess part of the payments shall remain taxable according to the
laws of each Contracting State, due regard being had to the other
provisions of this Convention.”

Impact of the Insertion of Article 12A:

As
per this new Article, both the Resident State as well as the Source
State will have the right to tax FTS. However, the Source State taxation
will be limited to 10% of the gross amount of FTS, where the FTS income
is beneficially owned by a resident of the other State. The rate of tax
is specified in the amended Treaty is at par with the tax rate
specified in Section 115A(1)(b)(B) of the Income-tax, 1961 For the
purposes of this Article, FTS has been defined in a wide manner as any
payment made as a consideration of “managerial or technical or
consultancy services”. It also includes payments made for the provision
of services of technical or other personnel. The definition of FTS is
broadly at par with the definition of the term FTS given in Section
9(1)(vii) of the Income-tax Act, 1961. The OECD MC does not have an FTS
Article.

Thus, the provisions of Article 12A are similar to the
provisions of other Indian tax treaties specifically including income by
way of FTS. It is pertinent to note that neither the OECD nor the UN
Model Tax Convention postulates taxability of FTS under a separate
Article. In the absence of a separate Article dealing with FTS, such
income would typically not be taxed in the source state, unless the
recipient of the income had a permanent establishment in that state.
With this change, any income paid by an Indian resident, to a resident
of Mauritius as FTS would now be taxable in India.

It is
pertinent to note that the new article does not incorporate the ‘make
available’ criteria for characterization as FTS, unlike tax treaties
with the USA, UK, Singapore etc. resulting in widening the scope of
taxable FTS income to be at par with the provision of Income-tax Act,
1961.

Reading the new Article 12A along with the new service PE
clause, it seems that in the event services in the nature of managerial,
technical or consultancy are rendered by a Mauritius entity for a
period less than 90 days, income arising from such services would be
taxed as per the provisions of Article 12A. In other cases, income
arising from rendering of all types of services for a period exceeding
90 days would be taxable under Article 7 of the Mauritius Tax Treaty,
provided the services are for the same or connected projects. The
interpretation and implementation of these provisions may lead to
litigation.

2.4 Amendment of Article 13 and Introduction of LO B Clause – Rationalization of Capital Gains Tax Exemption

Article 4 of the Protocol amends Article 13 of the Treaty w.e.f. 01.04.2017 by inserting new paragraphs 3A and 3B as under:

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

3B. However, the tax rate on the 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”; and

Further, the Protocol replaces the existing paragraph 4 as follows:

“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.”

Impact of the Amendment

Capital
gains arising from the transfer of shares, until now, were subject only
to residence based taxation under the existing Treaty. The Protocol now
proposes to restrict this exemption for investments in shares acquired
up to 31 March 2017. The exemption will apply irrespective of the date
of subsequent transfer of such shares. Accordingly, taxation rights are
now also provided to the State of residence of the company whose shares
are alienated (Source State) on gains from alienation of shares acquired
on or after 1 April 2017. The Protocol also provides for a transitory
provision for gains arising during a window period of 1 April 2017 to 31
March 2019 in respect of shares acquired on or after 1 April 2017. Such
gains arising during the transitory period will be subjected to tax at
50% of the domestic tax rates as applicable in the Source State.

After
the amendment of the India-Mauritius DTAA by the 2016 Protocol, the
position of taxability of Capital Gains on Transfer of Shares may be
summarized as under:

However,
the new LOB Article 27A (inserted by the Article 8 of the Protocol)
applies only for transitory period benefit on capital gains income.
The LOB Article denies the transitory provision benefit in respect of
capital gains arising between 1 April 2017 and 31 March 2019, where the
LOB conditions are not fulfilled. The following tests are provided in
the LOB clause for a taxpayer to be eligible to claim the transitory
period benefits:

  • Primary purpose/Motive test – Under
    this test, transitory period benefit is not available where the affairs
    of the taxpayer are arranged with the primary purpose of taking
    advantage of the transitory period benefit accorded by the 2016
    Protocol. It has also been clarified that legal entities not having bona
    fide business activities will be considered as having its affairs
    arranged with the primary purpose of availing the transitory period
    benefit.
  • Activity test – This test requires that the
    transitory period benefit will not be available to a shell or conduit
    company. For this purpose, a shell or conduit company means a company
    which is a resident of a Contracting State, but which has almost
    negligible or nil business operations or no real and continuous business
    activities in such Resident State.
  • Expenditure test
    – This test provides the circumstances in which a taxpayer would be
    deemed to be a shell or conduit company in its Resident State. As per
    the expenditure test, the taxpayer would be considered as a
    shell/conduit company if its expenditure on operations in the Resident
    State is less than Mauritian Rs. 1,500,000 or INR 2,700,000, as the case
    may be, in the 12 months immediately preceding the date on which the
    capital gain arises.

However, where the taxpayer is listed
on a recognized stock exchange of the Resident State or where its
expenditure on operations in the Resident State exceeds the above
threshold in the 12 months immediately preceding the date on which
capital gain arises, then such taxpayer will not be treated as a shell
or conduit company.

Impact of the amendment on other types of Capital Gains:

The
finance ministry has clarified that under the revised India-Mauritius
tax treaty, capital gains tax (or tax on profit made) would apply only
in the case of share transactions in India, leaving out derivatives and
non-share securities such as debentures from its purview.

Mr.
Shaktikanta Das, Economic Affairs Secretary, also clarified that the
Derivatives and other forms of securities, such as compulsory
convertible debentures (CCDs) and optionally convertible debentures
(OCDs), will continue to be governed by the existing provision of being
taxed in Mauritius. He added that India had gained a source-based
taxation right only for shares (equity) under the treaty.
Residence-based taxation will continue for derivatives under the
Mauritius pact. Meaning, non-equity securities would be taxed in
Mauritius if routed through there. Since Mauritius does not have a
short-term capital gains tax, it would mean that investors using these
instruments would continue to escape paying taxes in both countries.
(Source: Business Standard dated 14.05.2016)

In addition, there
are also questions as to the potential interplay of General Anti
Avoidance Rules (“GAAR”) with the tax treaties, as well as issues around
grandfathering of treaty benefits in respect of shares acquired after
April 1, 2017 on account of conversion of convertible instruments like
convertibles preference shares and debentures. These issues need to be
clarified by the Finance Ministry to provide clarity and certainty, and
to avoid litigation on this score. There were also concerns on whether
Protocol could be used to bring transfer of Participatory Notes
(“P-Notes”) under tax net. In order to allay concerns regarding
taxability of P-Notes due to Mauritius Tax Treaty amendment, Revenue
Secretary Hasmukh Adhia, in an interview to Press Trust of India,
clarified that, ‘there is no linkage of Mauritius treaty with P-Notes.
P-Notes are issued by foreign companies and not Indian companies’.

Impact on India-Singapore DTAA

Article
6 of the protocol to the India-Singapore DTAA states that the benefits
in respect of capital gains arising to Singapore residents from sale of
shares of an Indian Company shall only remain in force so long as the
analogous provisions under the India-Mauritius DTAA continue to provide
the benefit. Now that these provisions under the India-Mauritius DTAA
have been amended, a concern that arises is that while the Protocol in
the Mauritius DTAA contains a grandfathering provision which protects
investments made before April 01, 2017, it may not be possible to extend
such protection to investments made under the India-Singapore DTAA .
Consequently, alienation of shares of an Indian Company (that were
acquired before April 01, 2017) by a Singapore Resident after April 01,
2017, may not necessarily be able to obtain the benefits of the existing
provision on capital gains as the beneficial provisions under the
India-Mauritius DTAA would have terminated on such date.

In this
respect, a senior official of the Government of India has stated that
the Indian government intends to renegotiate the treaty with Singapore
to bring it on par with the India-Mauritius treaty.

2.5 Amendment of Article 22 – Introduction of Source Rule for Taxation of “Other Income”

Article
5 of the Protocol amends Article 22 by inserting a new paragraph 3 as
under: “3. Notwithstanding the provisions of paragraphs 1 and 2, items
of income of a resident of a Contracting State not dealt with in the
foregoing Articles of this Convention and arising in the other
Contracting State may also be taxed in that other State.”

Impact of the Amendment:

Income
from sources which is not expressly dealt with any of the Articles in
the existing DTAA is presently subjected only to taxation in the
resident country, except in cases where such income is effectively
connected with the PE/ fixed base of the recipient in the other State.
The Protocol expands the source country taxation rights by providing
that such income can also be taxed in the Source State if it arises in
the Source State.

2.6 Replacement of Article 26 – On Exchange of Information

Article
6 of the Protocol replaces existing Article 26 with a new Article 26.
The same is not reproduced here for the sake of brevity.

Salient features of the new Article 26 vis-à-vis the existing provisions are given below:

  • In
    addition to the taxes covered under tax treaty, scope for EOI has been
    enhanced to ‘taxes of every kind and description’, insofar as such taxes
    are not contrary to the provisions of the tax treaty ?
  • The
    information may not anymore be ‘necessary’ but it would be sufficient
    if it is ‘foreseeably relevant’ for the purpose of the tax treaty
  • Information
    / documents received under the tax treaty, can also be shared with
    authorities or persons having an ‘oversight’ over the assessment,
    collection and enforcement of taxes or prosecution in respect of such
    taxes or appeals in relation thereto. Information so disclosed can also
    be used for ‘other’ purposes if permitted by laws of both states and
    authorized by the supplying state. The provision enabling disclosure of
    information to the person to whom it relates has been deleted.
  • The
    requested state cannot deny collection or supply of information on the
    ground that it does not need such information for its own tax purposes.
    Further, a requested state cannot decline to supply information solely
    because the information is held by a bank, other financial institution,
    nominee or person acting in an agency or a fiduciary capacity or because
    it relates to ownership interests in a person.

Suffice it
to say that the scope of the EOI Article in the existing DTAA has been
enhanced to fall in line with international standards on transparency.
The EOI Article is largely in line with the 2014 OECD MC and extends to
information relating to taxes of every kind and description imposed by a
State or its political subdivisions or local authorities, to the extent
that the same is not contrary to the taxation as per the existing DTAA .
EOI would also be possible in respect of persons who are not residents
of the Contracting State, as long as the information requested is in
possession of the concerned State. Specifically, information held by
banks or financial institutions can be exchanged under the EOI Article.

2.7 Insertion of new Article 26A on “Assistance in Collection of Taxes”

Article
7 of the Protocol inserts a New Article 26A on “Assistance in
Collection of Taxes”. The same is not reproduced here for the sake of
brevity. Some salient features are as under:

  • Both countries shall lend assistance to each other in the collection of ‘revenue claims’ arising out of any taxes.
  • ‘Revenue
    claims’ means amount owed in respect of taxes of every kind and
    description (including interest, administrative penalties and costs of
    collection or conservancy related to such taxes), insofar such taxation
    is not contrary to the provisions of the tax treaty or any other
    instrument signed by both.
  • Both countries will be obliged
    to accept and collect revenue claims of the other and take measures for
    conservancy, subject to fulfillment of certain conditions.
  • Revenue
    claims accepted by a country shall not be subject to time limits or
    accorded any priority applicable to a revenue claim under the laws of
    such country or accorded any priority applicable in the other country.
    No proceedings with respect to the existence, validity or the amount of a
    revenue claim can be brought before courts etc in the country accepting
    the revenue claim.

This new Article is largely in line
with the one provided in the 2014 OECD MC. Broadly, this Article enables
the revenue claims of one State to be collected through the assistance
of the other Contracting State, subject to fulfilment of certain
conditions and requirements. Revenue claims for this purpose means the
amount payable in respect of taxes of every kind and description and
which is not contrary to the existing DTAA or any other instrument to
which the States are a party. Assistance would also involve undertaking
measures of conservancy by freezing assets located in the requested
State, subject to the laws therein.

In an era of globalization,
traditional attitudes towards assistance in the collection of taxes have
changed. This change was to some extent influenced by the development
of electronic commerce and the concerns about the ability to collect VAT
on such activities. The 1998 OECD report, Harmful Tax Competition: an
Emerging Global Issue, also highlighted concerns about increased tax
evasion if one country will not enforce the revenue claims of another
country. The Report thus recommended that ‘countries be encouraged to
review the current rules applying to the enforcement of tax claims of
other countries and that the Committee on Fiscal Affairs pursue its work
in this area with a view to drafting provisions that could be included
in tax conventions for that purpose’.

As a result of such
concerns, the OECD Council approved the inclusion of a new Article 27 on
assistance in tax collection in the 2003 update of the OECD model tax
Convention. The new Article 26A is in pari materia with Article 27 of
the OECD model tax convention and can help the Indian Government to
recover tax dues from willful defaulters. India has also inserted a
similar provision for assistance in collection of taxes in recent tax
treaties with Sri Lanka, Fiji, Bhutan, Albania, Croatia, Latvia, Malta,
Romania and Indonesia. Further, tax treaties with UK and Poland have
been amended to insert such an Article.

Both India and Mauritius
have also signed the ‘Convention on Mutual Administrative Assistance in
Tax Matters’. Moreover, similar to the proposed Article 26 on EOI,
assistance in collection of taxes is not restricted by Article 1 and 2
of the tax treaty.

2.8 Effective Date

Article 9 of the Protocol provides as under:

1.
“Each of the Contracting States shall notify to the other the
completion of the procedures required by its law for the bringing into
force of this Protocol. This Protocol shall enter into force on the date
of the later of these notifications.

2. The provisions of Article 1, 2, 3, 5 and 8 of the Protocol shall have effect:

a)
in the case of India, in respect of income derived in any fiscal year
beginning or after 1 April next following the date on which the Protocol
enters into force;

b) in the case of Mauritius, in respect of
income derived in any fiscal year beginning on or after 1 July next
following the date on which the Protocol enters into force;

3.
The provisions of Article 4 of this Protocol shall have effect in both
Contracting States for assessment year 2018-19 and subsequent assessment
years.

4. The provisions of Article 6 and 7 of this Protocol
shall have effect from the date of entry into force of the Protocol,
without regard to the date on which the taxes are levied or the taxable
years to which the taxes relate.”

 Thus, the Protocol will be
effective in India and Mauritius only after completion of the procedures
in both the countries for bringing it into force.

Once the procedures are completed, the various clauses of the 2016 Protocol would apply in India as follows:

  • Changes to the Capital Gains Article for assessment year 2018-19 and onwards.
  • Article on EOI and inclusion of assistance in collection of taxes, from the date of entry into force of the 2016 Protocol.
  • Other
    provisions for fiscal year beginning on or after the first day of the
    fiscal year (i.e., 1 April for India) following the year in which the
    2016 Protocol enters into force.

3. Concluding Remarks

This
is a landmark move by the Indian Government which finally claims
victory over the long drawn negotiations of the Mauritius Tax Treaty,
over last several years. Taking a myopic view, as a result of the
proposed amendment, Mauritius may lose its sheen as a preferred
jurisdiction for investments into India with additional tax cost for
Mauritius investors. However, in the larger scheme of things and in the
long run, the foreign investors would welcome the certainty of tax
regime and to that extent, grandfathering of capital gains under
India-Mauritius protocol sends out a positive signal that India is not
going to introduce any retroactive taxing provisions.

Both the
governments need to be complimented for ensuring that there is an
orderly phasing out of the capital gains tax exemption over a period of
three years without unduly burdening the investors who invested in India
relying on the treaty. This has ensured that there is no knee-jerk
reaction, unlike in the past, due to the revisions in the treaty.

Thus,
the manner in which the capital gains exemption has been withdrawn/
rationalized is indeed commendable. Instead of an abrupt shift in tax
policy, the Protocol proposes to grandfather all existing investments.
This means that only investments made after April 1, 2017 will be
subject to capital gains tax (that too after a two year transition
period during which a concessional rate at 50% of the prevailing
domestic tax rate will apply subject to satisfying Limitation on
Benefits (LoB) criteria contained in Article 8 of the Protocol). This
provides significant reassurance to existing investors and provides a
clear roadmap for the taxation of future investments. One area where
further clarity is needed is with regard to the position under the
India-Singapore treaty. This treaty provides for a capital gains
exemption, which is co-terminus with the capital gains exemption under
the India-Mauritius treaty. Given the proposed grandfathering of
pre-2017 investments from Mauritius and the twoyear transition period,
there is an urgent need to clarify whether these will apply to
investments from Singapore as well. The government seems to be cognizant
of this and hopefully, one can expect clarity on this soon. Another
area which the government would do well to clarify is that the
provisions of the General Anti Avoidance Rule (GAAR) will not apply if
the LoB conditions are satisfied.

The changes to the treaty
will, of course, lead to some short-term impact on investments in India.
There are unresolved tax issues that especially arise in the context of
P-Notes issued by FPIs/FIIs. Further, today, unfortunately, there is an
artificial characterisation of business income of the FPI/FIIs being
treated as capital gains. This leads to a situation where even portfolio
trading investors who would have otherwise not been taxable in India
are being subject to tax here. Hopefully, the government will revisit
this issue and align the position with other countries so that mere
trading in Indian securities should not give rise to tax implications in
the country, absent a permanent establishment in India. This
artificiality is unfair and also gives rise to possible non-availability
of tax credits in the home country. While the government has
renegotiated the treaty with Mauritius, it is also hoped that they
continue on the path of tax reforms to ensure that investors are not put
off by constant adverse changes to tax policy.

MFN Clause — Some Nuances and Applications

INTRODUCTION

As one enters the month of tax filing for entities subject to transfer pricing, the international tax world has seen some major developments in the last few weeks, which could impact the way one analyses cross-border transactions. Globally, the world is getting closer to the implementation of a two-pillar solution. Closer home, there was a significant buzz in the international tax community in India after the Hon’ble Supreme Court delivered its decision in the case of AO vs. M/s Nestle SA (TS-616-SC-2023) on 19th October, 2023, on the application of the Most Favoured Nation (‘MFN’) clause in the context of tax treaties (‘DTAA’).

While an in-depth analysis of the above decision of the Apex Court is not within the scope of this article, given the landmark ruling with far-reaching implications, the authors have sought to cover some of the nuances of the MFN article in the background of this ruling.

BACKGROUND

Before one understands the matter before the Supreme Court, it is important to understand what is MFN and the various versions of the MFN that are found in DTAAs entered into by India. The MFN clause is generally typically found in Bilateral Investment Agreements, Trade Agreements and Tax Treaties. The clause generally seeks to extend preferential treatment, given to a country, to another country. In the context of tax treaties, the MFN clause generally seeks to extend preferential benefits negotiated in a DTAA with a third country to the existing DTAA. For example, if Country A and Country B have entered into a DTAA and have an MFN clause and if Country A’s DTAA with Country C satisfies the conditions as required in the MFN clause of the A – B DTAA, the beneficial provisions (to the extent provided for in the MFN clause) in the A – C DTAA would be imported into the A-B DTAA.

India has entered into MFN clauses in many of its DTAAs. However, the MFN clauses in those DTAAs are not the same, and there are certain subtle differences in each of those clauses. Further, while the MFN clause is generally found in the Protocol to the relevant DTAA, it is not always so. For example, the MFN clause in the India – UK DTAA is provided in the main text of the DTAA itself and not the Protocol. Article 7(6) of the India – UK DTAA, dealing with Business Profits, provides:

“Where the law of the Contracting State in which the permanent establishment is situated imposes a restriction on the amount of the executive and general administrative expenses which may be allowed, and the restriction it relaxed or overridden by any Convention between that Contracting State and a third State which is a member of the Organisation for Economic Cooperation and Development or a State in a comparable stage of development, and that Convention enters into force, after the date of entry into force of this Convention, the competent authority of that Contracting State shall notify the competent authority of the other Contracting State of the terms of the relevant paragraph in the Convention with that third state immediately after the entry into force of that Convention and, if the competent authority of the other Contracting State so requests, the provisions of this Convention shall be amended by protocol to reflect such terms.”

In the case of Indian DTAAs, the MFN clause does not apply to all the streams of income but is generally specified in the relevant clause itself. In most cases, where Indian DTAAs have an MFN clause, the said clause applies to dividend income, interest income and income from royalties or fees for technical services (‘FTS’). However, as can be seen from the above example of the India – UK DTAA, it may not always be so. Further, while most of the MFN clauses in Indian DTAAs give benefit to OECD member countries, it is not always so. For example, the India – Philippines DTAA extends to any third country with respect to income from shipping and air transport. Similarly, the MFN clause is not always reciprocal. In certain DTAAs (such as the India – France DTAA, the India – Netherlands DTAA, the India – Belgium DTAA, etc.), India is obligated to pass on the benefit of a DTAA with a third country to the existing DTAA, and in some cases (such as the India – Philippines DTAA), the treaty partner is obligated to provide the benefit of its DTAA with a third country.

APPLICATION OF MFN CLAUSE IN INDIAN DTAAs (PRIOR TO SUPREME COURT DECISION)

One of the most commonly used MFN clauses (before 2020) was the India – France DTAA, in the context of FTS as well as royalty. The Protocol to the India – France DTAA, signed in 1992 and which came into force in 1994, contains two clauses pertaining to MFN: para 7 of the Protocol in respect of dividend, interest, royalties and FTS, and para 10 in respect of levies by India other than those covered under Article 2 of the DTAA.

Para 7 of the Protocol of the India – France DTAA provides:

“In respect of articles 11 (Dividends), 12 (Interest) and 13 (Royalties, fees for technical services and payments for the use of equipment), if under any Convention, Agreement or Protocol signed after 1-9-1989, between India and a third State which is a member of the OECD, India limits its taxation at source on dividends, interest, royalties, fees for technical services or payments for the use of equipment to a rate lower or a scope more restricted than the rate of scope provided for in this Convention on the said items of income, the same rate or scope as provided for in that Convention, Agreement or Protocol on the said items income shall also apply under this Convention, with effect from the date on which the present Convention or the relevant Indian Convention, Agreement or Protocol enters into force, whichever enters into force later.”

Therefore, on a plain reading of the MFN clause, it applies in the following manner:

a. If India has entered into a DTAA or Protocol with another OECD member after 1st September, 1989; and

b. If the said DTAA or Protocol limits India’s right of taxation in the case of dividends, interest, royalties or FTS to a rate lower than or a scope more restricted than the rate or scope as provided in the India – France DTAA; then

c. The lower rate or the restrictive scope of the said DTAA would apply to the India – France DTAA,

It may be noted that these conditions above are only in respect of the position as it was generally interpreted by courts prior to the decision of the Hon’ble Supreme Court in the case of Nestle SA (supra), which has been covered in detail in the subsequent paragraphs.

When the India – France DTAA was entered into in 1992, the right of taxation of the country of source in the case of dividends was restricted to 15 per cent, and in the case of interest (other than paid to banks or financial institutions) was restricted to 15 per cent and in the case of royalties / FTS were restricted to 20 per cent.

Subsequent to this, India entered into a DTAA with Germany in 1995, wherein the right of taxation on dividends, interest, royalties and FTS in the country of the source was restricted to 10 per cent. Therefore, such a lower rate of tax under the India – Germany DTAA could be imported into the India – France DTAA from the date on which the India – Germany DTAA entered into force.

Similarly, India also entered into a DTAA with the USA, a member of the OECD, on 12th September, 1989, and the said DTAA entered into force in 1990. While the rates of tax in respect of dividend, interest, royalties or FTS in the India – USA DTAA were not lower than the India – France DTAA, the definition of the term ‘Fees for included services’ in the India – USA DTAA could be considered to be more restrictive than the India – France DTAA.

Article 13(4) of the India – France DTAA provides as follows:

“The term ‘fees for technical services’ as used in this Article means payments of any kind to any person, other than payments to an employee of the person making the payments and to any individual for independent personal services mentioned in Article 15, in consideration for services of a managerial, technical or consultancy nature.”

Therefore, the scope of FTS under the India – France DTAA was services of a managerial, technical or consultancy nature. Article 12(4) of the India – USA DTAA defines the term as follows:

“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) are ancillary and subsidiary to the application or enjoyment of the right, property or information for which a payment described in paragraph 3 is received; or

(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 can be seen from the definition above, the India – USA DTAA covers only technical or consultancy services and only if they are ancillary to the application or enjoyment of intangible property or make available technical knowledge, experience, skill, know-how or process. Therefore, ‘managerial’ services which are covered under the definition of the India – France DTAA are not covered under the definition of the India – USA DTAA. Similarly, if a technical or consultancy service does not make available technical knowledge, experience, skill, etc., it is not considered as FTS under the India – USA DTAA but is considered as such under the India – France DTAA.

This would mean that the scope of taxation of the India – USA DTAA is restrictive as compared to the India – France DTAA and, therefore, by virtue of the MFN clause in the India – France DTAA, the more restrictive scope of India – USA DTAA would be imported into the India – France DTAA. This view was upheld by the Delhi High Court in the case of Steria (India) Ltd vs. CIT (2016) 386 ITR 290, wherein the taxpayer sought to apply the restrictive scope (definition) of FTS under the India – UK DTAA (language is similar to the India – USA DTAA) to the India – France DTAA. Accordingly, one could apply the more restrictive definition of FTS under the India – USA or India – UK DTAAs while making a payment to a resident of France, and this view was accepted by the Delhi High Court. It may be highlighted that this Delhi High Court decision has been overruled by the Hon’ble Supreme Court in the case of Nestle SA (supra), albeit with respect to an automatic application of the MFN without notification.

The payment for the use of, or the right to use, industrial commercial or scientific equipment is taxable in the country of source under Article 13 of the India – France DTAA. However, the India – Sweden DTAA, another member of the OECD, entered into in 1997, does not grant the country of source the right of taxation for such payment, as the definition of royalties under Article 12 of the India – Sweden DTAA does not cover such payments. Accordingly, one could import the restrictive scope of taxation on such payments under the India – Sweden DTAA to the India – France DTAA on account of the MFN clause in the India – France DTAA.

Similar to the India – France DTAA, some other DTAAs negotiated by India such as with Belgium, Netherlands, Spain, Sweden and Switzerland also contain MFN clauses. It is important to read each MFN clause separately as the MFN clause in each DTAA has its own set of nuances.

WHETHER APPLICATION OF MFN IS AUTOMATIC?

Having understood the application of the MFN clause in the context of Indian DTAAs, it is important to understand whether the MFN clause can be applied automatically or whether it needs to be notified.

The types of MFN clause, which are a part of the DTAAs India has entered into, can be categorised into three categories as explained in detail in para 18 of the decision of the Mumbai ITAT in the case of SCA Hygiene Products AB vs. DCIT (2021) 187 ITD 419, which have been summarised below:

(a) Requiring fresh negotiations between the treaty partners (such as the India – Switzerland DTAA prior to the amendment);

(b) Requiring notification to the treaty partner (such as the India – Philippines DTAA); and

(c) Automatic wherein no notification to the treaty partner to be given (such as India’s DTAA with France, Netherlands, Sweden, etc).

Further, in the case of the India – Finland DTAA, there is a requirement of informing the treaty partner and issuing a notification in this regard. The Protocol to the India – Finland DTAA provides as follows:

“…The competent authority of India shall inform the competent authority of Finland without delay that the conditions for the application of this paragraph have been met and issue a notification to this effect for application of such exemption or lower rate.”

This requirement of notification is absent in the DTAAs with France, Netherlands, Belgium, etc.

However, the CBDT vide its Circular No. 3/2022 dated 3rd February, 2022, stated that a separate notification was required.

In the case of Steria (India) Ltd., In re (2014) 364 ITR 381, the AAR held that the restrictive scope of FTS in the India – UK DTAA could not be imported into the India – France DTAA unless the Government had notified such language to be imported into the India – France DTAA. The Delhi High Court (supra) held that such notification was not needed after considering the language of the MFN clause in the India – France DTAA and the restrictive scope of the India – UK DTAA would automatically apply.

This Delhi High Court ruling has been overruled by the Supreme Court in the case of Nestle SA (supra). The Hon’ble Supreme Court held as follows:

“88. In the light of the above discussion, it is held and declared that:

(a) A notification under Section 90(1) is necessary and a mandatory condition for a court, authority, or tribunal to give effect to a DTAA, or any protocol changing its terms or conditions, which has the effect of altering the existing provisions of law.

(b) The fact that a stipulation in a DTAA or a Protocol with one nation, requires same treatment in respect to a matter covered by its terms, subsequent to its being entered into when another nation (which is member of a multilateral organization such as OECD), is given better treatment, does not automatically lead to integration of such term extending the same benefit in regard to a matter covered in the DTAA of the first nation, which entered into DTAA with India. In such event, the terms of the earlier DTAA require to be amended through a separate notification under Section 90.”

The Hon’ble Supreme Court referred to the Constitution of India, which gives powers to the Parliament to enter into a treaty. It referred to various decisions and concluded as follows:

“44. The holding in the decisions discussed above may thus be summarized:

(i) The terms of a treaty ratified by the Union do not ipso facto acquire enforceability;

(ii) The Union has exclusive executive power to enter into international treaties and conventions under Article 73 [read with corresponding Entries – Nos. 10, 13 and 14 of List I of the VIIth Schedule to the Constitution of India] and Parliament, holds the exclusive power to legislate upon such conventions or treaties.

(iii) Parliament can refuse to perform or give effect to such treaties. In such event, though such treaties bind the Union, vis a vis the other contracting state(s), leaving the Union in default.

(iv) The application of such treaties is binding upon the Union. Yet, they ‘are not by their own force binding upon Indian nationals’.

(v) Law making by Parliament in respect of such treaties is required if the treaty or agreement restricts or affects the rights of citizens or others or modifies the law of India.

(vi) If citizens’ rights or others’ rights are not unaffected, or the laws of India are not modified, no legislative measure is necessary to give effect to treaties.

(vii) In the event of any ambiguity in the provision or law, which brings into force the treaty or obligation, the court is entitled to look into the international instrument, to clear the ambiguity or seek clarity.”

The Supreme Court also referred to its decision in the case of Union of India & Ors. vs. Azadi Bachao Andolan & Ors. (2003) 263 ITR 706, wherein section 90 of the Income-tax Act, 1961 (‘the Act’) was held to give power to the Central Government to implement the treaty.

Further, the Hon’ble Supreme Court also analysed India’s treaty practice in relation to DTAAs and Protocols and compared them with those of the treaty partners in question (in the said decision, the DTAAs with France, Netherlands and Switzerland were discussed). While evaluating the treaty practice, it observed as follows:

a. Pursuant to entering into DTAAs with Germany and the USA, a notification was issued, importing the lower rates of tax under those DTAAs (albeit not the restrictive scope) into the India – France DTAA vide notification No. SO 650(E) dated 10th July, 2000;

b. Pursuant to entering into DTAAs with Sweden, Switzerland and the USA, a notification was issued in 1999, importing the lower rates of tax under those DTAAs (albeit not the restrictive scope) into the India – Netherlands DTAA;

c. The above two actions clearly showed that there is an “established and clear precedent of behaviour, in relation to treaty practice and interpretation”1;

d. The omission of certain benefits, such as the restrictive scope in these notifications, is another indication that India does not intend to grant automatic benefits of other DTAAs without notification2;

e. This practice was compared with the treaty practice of the treaty partners wherein treaty ratification required a process to be followed in the constitution of those respective countries3.

Keeping the above observations in mind, the Supreme Court held as follows:

“72. In the opinion of this court, the status of treaties and conventions and the manner of their assimilation is radically different from what the Constitution of India mandates. In each of the said three countries, every treaty entered into the executive government needs ratification. Importantly, in Switzerland, some treaties have to be ratified or approved through a referendum. These mean that after intercession of the Parliamentary or legislative process/procedure, the treaty is assimilated into the body of domestic law, enforceable in courts. However, in India, either the treaty concerned has to be legislatively embodied in law, through a separate statute, or get assimilated through a legislative device, i.e. notification in the gazette, based upon some enacted law (some instances are the Extradition Act, 1962 and the Income Tax Act, 1961). Absent this step, treaties and protocols are per se unenforceable.”

Therefore, taking the example of the case of Steria (supra), the Supreme Court held that a separate notification was required to import the definition from the India – UK DTAA into the India – France DTAA even though the respective DTAAs were already individually notified.

1 Refer Para 55 of the Supreme Court decision
2 Refer Para 60 of the Supreme Court decision
3 Refer Paras 69–71 of the Supreme Court decision

 

TIMING OF APPLICATION OF THE MFN

Another issue before the Supreme Court in the case of Nestle SA (supra) was when does one evaluate if the third country with whom India has entered into a DTAA, is a member of the OECD. For a detailed analysis of this controversy, one may refer to the May 2021 issue of the Journal.

The India – Netherlands DTAA signed on 13th July, 1988, provided for a 10 per cent tax on dividends in the country of source. Pursuant to signing the DTAA with the Netherlands, India entered into a DTAA with Slovenia on 13th January, 2003. Article 10(2) of the India – Slovenia DTAA provides for a lower rate of tax at 5 per cent in case the beneficial owner is a company which holds at least 10 per cent of the capital of the company paying the dividends.

While the DTAA between India and Slovenia was signed in 2003, Slovenia became a member of the OECD only in 2010. In other words, while the Slovenia DTAA was signed after the India – Netherlands DTAA, Slovenia became a member of the OECD after the DTAA was signed.

Therefore, the question before the Supreme Court was whether one was required to evaluate the OECD membership as on the date of signing the DTAA or the date of application of the DTAA, i.e., the date of taxation of dividend income.

The Protocol to the India – Netherlands DTAA provides as under:

“If after the signature of this convention under any Convention or Agreement between India and a third State which is a member of the OECD India should limit its taxation at source on dividends, interests, royalties, fees for technical services or payments for the use of equipment to a rate lower or a scope more restricted than the rate or scope provided for in this Convention on the said items of income, then as from the date on which the relevant Indian Convention or Agreement enters into force the same rate or scope as provided for in that Convention or Agreement on the said items of income shall also apply under this Convention.” (emphasis supplied)

In this regard, the Delhi High Court in the case of Concentrix Services Netherlands BV vs. ITO (TDS) (2021) [TS-286-HC-2021(DEL)] held that the term “is a member of the OECD” would require an ambulatory approach to interpretation, and one would need to evaluate whether Slovenia is a member of the OECD when the DTAA is being applied and not when the India – Slovenia DTAA was entered into.

This argument has been overruled by the Supreme Court in the case of Nestle SA (supra) wherein after considering the meaning of the term “is” in the context of various laws, it was held that:

“88. The interpretation of the expression ‘is’ has present significance. Therefore, for a party to claim benefit of a ‘same treatment’ clause, based on entry of DTAA between India and another state which is member of OECD, the relevant date is entering into treaty with India, and not a later date, when, after entering into DTAA with India, such country becomes an OECD member, in terms of India’s practice.”

This controversy, therefore, has been put to rest by the Supreme Court by holding that one needs to evaluate if the third country was an OECD member when India entered into a DTAA with such a country.

CONCLUSION

The recent Supreme Court ruling has laid down the complete law on the application of the MFN clause. While the issue of the timing of OECD membership is a fairly new issue (since the abolishment of the DDT regime in 2020), the application of the MFN clause in the case of restrictive scope has been commonly applied in many cases in the past. Interestingly, when the CBDT vide its circular in 2021 sought to clarify that an MFN clause is not enforceable unless notified, the Pune ITAT in the case of GRI Renewable Industries S.L vs. ACIT (2022) 140 taxmann.com 448 held:

“Notwithstanding the above, it can be seen that the CBDT has panned out a fresh requirement of separate notification to be issued for India importing the benefits of the DTAA from second State to the DTAA with the first State by virtue of its Circular, relying on such requirement as supposedly contained in section 90(1) of the Act. In our considered opinion, the requirement contained in the CBDT circular No. 03/2022 cannot primarily be applied to the period anterior to the date of its issuance as it is in the nature of an additional detrimental stipulation mandated for taking benefit conferred by the DTAA. It is a settled legal position that a piece of legislation which imposes a new obligation or attaches a new disability is considered prospective unless the legislative intent is clearly to give it a retrospective effect. We are confronted with a circular, much less an amendment to the enactment, which attaches a new disability of a separate notification for importing the benefits of an Agreement with the second State into the treaty with first State. Obviously, such a Circular cannot operate retrospectively to the transactions taking place in any period anterior to its issuance.”

However, it is common knowledge that the law laid down or interpreted by the Supreme Court is applicable from the date on which such law was enacted. Further, this issue is exacerbated due to the fact that it was only in 2021 that the CBDT clarified that a notification was required for the MFN clause to apply. Therefore, unless the DTAAs with restrictive scope are not notified, there could be significant litigation on this issue by the foreign recipient companies as well as the Indian tax deductors.

Another issue that one may consider is that the Supreme Court has decided the matter purely on the powers given under the Constitution and the practice followed by India in DTAAs without discussing in detail the language used in the respective MFN clauses. For example, the India – France DTAA MFN provides for automatic application whereas the India – Finland DTAA MFN requires notification. The question which may need to be answered is how does one give effect to the differing language in light of the decision.

In any case, the Supreme Court decision provides guidance on how tax treaties are to be interpreted, which gives a tax professional a lot to ponder on and one may need to revisit the principles understood earlier in light of the said decision.

OECD — RECENT DEVELOPMENTS — AN UPDATE

International Taxation

In March, 2008 issue of BCAJ, we had covered various
important developments at OECD till then. In this issue, we have attempted to
pick up further major developments after the publication of 2008 Edition of OECD
Model Tax Convention (‘MC’) and developments in the field of Transfer Pricing
and work being done at OECD in various other related fields and have included
the same in this update. We shall endeavour to update the readers on major
developments at OECD at shorter intervals. Various news items included here are
sourced from various OECD Newsletters.



A. Re : Amendments to OECD Model Tax Convention :


1. Discussion draft on the application of Article 17
(Artistes and Sportsmen) of the OECD Model Tax Convention (23rd April, 2010) :


The OECD invites public comments on draft changes to the
Commentary on Article 17 of the OECD Model Tax Convention, which deals with
cross-border income derived from the activities of entertainers and sportsmen.

Under Article 17 (Artistes and Sportsmen) of the OECD Model
Tax Convention, the State in which the activities of a non-resident entertainer
or sportsman are performed is allowed to tax the income derived from these
activities. This regime differs from that applicable to the income derived from
other types of activities making it necessary to determine questions such as
what is an entertainer or sportsman, what are the personal activities of an
entertainer or sportsman as such and what are the source and allocation rules
for activities performed in various countries.

The Committee on Fiscal Affairs, through a subgroup of its
Working Party 1 on Tax Conventions and Related Questions, has examined these and
other questions related to the application of Article 17. This public discussion
draft includes proposals for additions and changes to the Commentary on the OECD
Model Tax Convention resulting from the work of that subgroup, which have
recently been presented to the Working Party for discussion.

The Committee intends to ask the Working Party to examine
these proposed additions and changes to the OECD Model Tax Convention for
possible inclusion in the OECD Model Tax Convention (these changes will not,
however, be finalised in time for inclusion in the next update, which is
scheduled to be published in the second part of 2010). It therefore invites
interested parties to send their comments on this discussion draft before 31st
July 2010. These comments will be examined at the September 2010 meeting of the
Working Party.

Comments should be sent electronically (in Word format) to
jeffrey.owens@oecd.org.

2. Revised discussion draft of a new Article 7 (Business
Profits) of OECD Model Tax Convention (24th November, 2009) :


On 24th November 2009, the OECD approved the release, for
public comment, of a revised draft of a new Article 7 (Business Profits) of the
OECD Model Tax Convention and of related Commentary changes. The first version
of the new Article and Commentary changes was released on 7 July 2008, (the
‘July 2008 Discussion Draft’). As was explained at the beginning of that earlier
draft, the new Article and its Commentary constitute the second part of the
implementation package for the Report on Attribution of Profits to Permanent
Establishments that the OECD adopted in 2008.

Public comments were carefully reviewed and a consultation
meeting was held with their authors on 17th September 2009. The Committee’s
subsidiary body responsible for drafting the new Article 7 has concluded that
changes should be made to accommodate many of these comments. This revised
discussion draft (issued on 24th November 2009) includes the changes that have
been made
for that purpose as well as a few minor clarifications, editing changes and
corrections. All the changes made to the earlier draft are identified in the
revised draft.

The most important change proposed in this
revised draft is the replacement of paragraph 3, as it appeared in the July 2008
Discussion Draft, by a broader provision that provides a corresponding
adjustment mechanism similar to that of paragraph 2 of Article 9, which applies
between associated enterprises.

The revised draft was released for the purpose of inviting
comments from interested parties. It does not necessarily reflect the final
views of the OECD and its member countries.

It is expected that once finalised, the new Article and the
Commentary changes will be included in the next update to the OECD Model Tax
Convention, tentatively scheduled for the second part of 2010.

3. Comments on the public discussion draft ‘The Granting
of Treaty Benefits With Respect to the Income of Collective Investment Vehicles’
(10th February, 2010) :


On 9th December 2009, the OECD released for public comment a
Public Discussion Draft of a Report which contains proposed changes to the
Commentary on the OECD MC dealing with the question of the extent to which
either collective investment vehicles (CIVs) or their investors are entitled to
treaty benefits on income received by the CIVs. The OECD has now published the
comments received on this consultation draft on to the website. The reader who
wishes to study the comments may visit the OECD’s website.

4. Comments on the public discussion draft ‘Tax Treaty
Issues related to Common Tele-communications Transactions’ (10th February, 2010)
:


On 25th November 2009, the OECD released for public comments
a Draft Report which contains proposed changes to the Commentary on the OECD
Model Tax Convention dealing with tax treaty issues related to common
telecommunication transactions. The OECD has now published the comments received
on this consultation draft on its website.

5. Comments on the public discussion draft ‘The
application of tax treaties to state-owned entities, including Sovereign Wealth
Funds’ (10th February, 2010) :


On 25th November 2009, the OECD released for public comments
a Draft Report which contains proposed changes to the Commentary on the OECD
Model Tax Convention dealing with the application of tax treaties to state-owned
entities, including Sovereign Wealth Funds. The OECD has now published the
comments received on this consultation draft on its website.

6. Draft documentation for cross-border tax claims (9th
February, 2010) :


The OECD has released for public comment draft documentation (Implementation Package) for implementing a streamlined procedure for portfolio investors to claim reductions in withholding rates pursuant to tax treaties or domestic law in the source country. This release represents the continuation of work that was begun by the Informal Consultative Group on the Taxation of Collective Investment Vehicles and Procedures for Tax Relief for Cross -Border Investors (ICG). The ICG was established in 2006 by the OECD’s Committee on Fiscal Affairs (CFA) to consider legal questions and administrative barriers that affect the ability of collective investment vehicles (CIVs) and other portfolio investors to effectively claim the benefits of tax treaties. On 12th January 2009, the OECD released two reports prepared by the ICG in fulfilment of this mandate. The ICG’s first Report, on the ‘Granting of Treaty Benefits with respect to the Income of Collective Investment Vehicles’, addresses the legal and policy issues relating specifically to CIVs. A modified version of that Report was released by the OECD for public comment on 9th December 2009.

The report by the ICG on ‘Possible Improvements to Procedures for Tax Relief for Cross-Border Investors’, discusses the procedural problems in claiming treaty benefits faced by portfolio investors generally and makes a number of recommendations on ‘best practices’ regarding procedures for making and granting claims for treaty benefits for intermediated structures. The Implementation Package was developed by the Pilot Group on Improving Procedures for Tax Relief for Cross-Border Investors (Pilot Group) to provide standardised documentation that could be used by countries that wish to adopt the ‘best practices’ described in the ICG’s report. The Pilot Group includes representatives of the tax administrations of some OECD member countries as well as representatives from the financial services industry.

The Implementation Package provides a system for claiming treaty benefits that allows authorised intermediaries to make claims on behalf of portfolio investors on a ‘pooled’ basis. One of the major benefits of such a system is that information regarding the beneficial owner of the income is maintained by the authorised intermediary that is nearest to the investor, rather than being passed up the chain of intermediaries. Although a source country may be willing to provide benefits on the basis of pooled information, it may want to maintain the ability to confirm that benefits that have been provided were in fact appropriate. In addition, when a residence country’s investor obtains income from abroad, the residence country has a compliance interest in knowing the details of that. For those reasons, the Implementation Package also recommends that those financial institutions that wish to make use of the ‘pooled’ treaty claim system be required to report on an annual basis directly to source countries (i.e., not through the chain of intermediaries) investor-specific information regarding the beneficial owners of the income.

The Implementation Package is the work of the Pilot Group; neither the views expressed in the ICG reports nor the ‘best practices’ reflected in the Implementation Package should be attributed to the OECD or any of its member states. The CFA will be deciding whether and how the work on improving procedures should be carried forward. Because the development of standardised documentation is useful only if the documentation is widely accepted by businesses and governments, the CFA has decided to invite comments from all interested parties before further consideration of the Implementation Package. Interested parties are therefore invited to send their comments on the Implementation Package before 31st August 2010. Comments should be sent electronically in Word format to : jeffrey. owens@oecd.org

    Amendments to OECD Transfer Pricing Guidelines :
On 9th September 2009, the OECD released for public comments a proposed revision of Chapters I-III of the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (hereafter ‘TPG’). This follows from the release in May 2006 of a discussion draft on comparability issues and in January 2008 of a discussion draft on transactional profit methods, and from discussions with commentators during a two-day consultation that was held in November 2008. This represents an important update of the existing guidance on comparability and profit methods which dates back to 1995. The main proposed changes are as follows :

  •     Hierarchy of transfer pricing methods : In the existing TPG, there are two categories of OECD-recognised transfer pricing methods : the traditional transaction methods (described at Chapter II of the TPG) and the transactional profit methods (described at Chapter III). Transactional profit methods (the transactional net margin method and the profit split method) currently have a status of last resort methods, to be used only in the exceptional cases where there are no or insufficient data available to rely solely or at all on the traditional transaction methods. Based on the experience acquired in applying transactional profit methods since 1995, the OECD proposes removing exceptionality and replacing it with a standard whereby the selected transfer pricing method should be the ‘most appropriate method to the circumstances of the case’. In order to reflect this evolution, it is proposed to address all transfer pricing methods in a single chapter, Chapter II (Part II for traditional transaction methods, Part III for transactional profit methods).

  •     Comparability analysis : The general guidance on the comparability analysis that is currently found at Chapter I of the TPG was updated and completed with a new Chapter III containing detailed proposed guidance on comparability analyses.

  •     Guidance on the application of transactional profit methods : Proposed additional guidance on the application of transactional profit meth-ods was developed and included in Chapter II, new Part III.

  •     Annexes : Three new Annexes were drafted, containing practical illustrations of issues in relation to the application of transactional profit methods and an example of a working capital adjustment to improve comparability.

3.2009 edition of OECD’s Transfer Pricing Guidelines (9th September, 2009) :

On 7th September 2009, the OECD released the 2009 edition of its Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (hereafter ‘TP Guidelines’).

The TP Guidelines provide guidance on the application of the arm’s-length principle to the pricing, for tax purposes, of cross-border transactions between associated enterprises. In a global economy where multinational enterprises (MNEs) play a prominent role, governments need to ensure that the taxable profits of MNEs are not artificially shifted out of their jurisdiction and that the tax base reported by MNEs in their country reflects the economic activity undertaken therein. For taxpayers, it is essential to limit the risks of economic double taxation that may result from a dispute between two countries on the determination of the arm’s-length remuneration for their cross-border transactions with associated enterprises.

Since their adoption by the OECD Council in 1995, the TP Guidelines have been under constant monitoring by the OECD. They were complemented in 1996-1999 with guidance on intangibles, cross-border services, cost contribution arrangements and advance pricing arrangements. In this 2009 edition, amendments were made to Chapter IV, primarily to reflect the adoption, in the 2008 update of the Model Tax Convention, of a new paragraph 5 of Article 25 dealing with arbitration, and of changes to the Commentary on Article 25 on mutual agreement procedures to resolve cross-border tax disputes. References to good practices identified in the Manual for Effective Mutual Agreement Procedures were included and the Preface was updated to include a reference to the Report on the Attribution of Profits to Permanent Establishments adopted in July 2008.

The OECD is currently undertaking an important further update to the TP Guidelines, focussing on comparability issues and on the application of transactional profit methods3.

    4. Discussion Draft on the Transfer Pricing Aspects of Business Restructurings (19th September, 2008) :

The OECD has released for public comments a discussion draft on the Transfer Pricing Aspects of Business Restructurings4.

Business restructurings by multinational enterprises have been a widespread phenomenon in recent years. They involve the cross-border redeployment of functions, assets and/or risks between associated enterprises, with consequent effects on the profit and loss potential in each country. Restructurings may involve cross-border transfers of valuable intangibles, and they have typically consisted of the conversion of full-fledged distributors into limited-risk distributors or commissionnaires for a related party that may operate as a principal; the conversion of full-fledged manufacturers into contract-manufacturers or toll-manufacturers for a related party that may operate as a principal; and the rationalisation and/or specialisation of operations.

As evidenced by a January 2005 OECD Centre on Tax Policy and Administration Roundtable, these restructurings raise difficult transfer pricing and treaty issues for which there is currently insufficient OECD guidance under both the OECD Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (the ‘TP Guidelines’) and the OECD Model Tax Convention on Income and on Capital (the ‘Model Tax Convention’) (see outcome of the January 2005 CTPA Roundtable). These issues involve primarily the application of transfer pricing rules upon and/or after the conversion, the determination of the existence of, and attribution of, profits to permanent establishments (‘PEs’), and the recognition or non-recognition of transactions. In the absence of a common understanding on how these issues should be treated, they may lead to significant uncertainty for both business and governments as well as possible double taxation or double non-taxation. Recognising the need for work to be done in this area, the Committee on Fiscal Affairs (‘CFA’) decided to start a project to develop guidance on these transfer pricing and treaty issues.

In 2005 the CFA created a Joint Working Group (‘the JWG’) of delegates from Working Party No. 1 (responsible for the Model Tax Convention) and Working Party No. 6 (responsible for the TP Guidelines) to initiate the work on these issues. At the end of 2007, having taken stock of the progress made to that point, the CFA referred the work on the transfer pricing aspects of business restructurings to Working Party No. 6 and the work on the PE threshold aspects to Working Party No. 1. The discussion draft released on 19th September, 2008 has resulted from the work done on the transfer pricing issues by the JWG and Working Party No. 6. Working Party No. 1 intends to consider PE definitional issues under Article 5 of the Model Tax Convention, both in the context of business restructurings and more broadly, as part of its 2009-2010 programme of work, which will result in a separate discussion draft.

This discussion draft only covers transactions between related parties in the context of Article 9 of the Model Tax Convention and does not address the attribution of profits within a single enterprise on the basis of Article 7 of the Model Tax Convention, as this was the subject of the Report on the Attribution of Profits to Permanent Establishments which was approved by the Committee on Fiscal Affairs on 24th June 2008 and by the OECD Council for publication on 17th July 2008. The analysis in this discussion draft is based on the existing transfer pricing rules. In particular, this discussion draft starts from the premise that the arm’s-length principle and the TP Guidelines do not and should not apply differently to post-restructuring transactions than to transactions that were structured as such from the beginning.

The discussion draft is composed of four Issues Notes.

In light of the importance of risk allocation in relation to business restructurings, the first Issues Note provides general guidance on the allocation of risks between related parties in an Article 9 context and in particular the interpretation and application of paragraphs 1.26 to 1.29 of the TP Guidelines.

The second Issues Note, “Arm’s-length compensation for the restructuring itself”, discusses the application of the arm’s-length principle and TP Guidelines to the restructuring itself, in particular the circumstances in which at arm’s length the restructured entity would receive compensation for the transfer of functions, assets and/or risks, and/or an indemnification for the termination or substantial renegotiation of the existing arrangements.

The third Issues Note examines the application of the arm’s-length principle and the TP Guidelines to post-restructuring arrangements.

The fourth Issues Note discusses some important notions in relation to the exceptional circumstances where a tax administration may consider not recognising a transaction or structure adopted by a taxpayer, based on an analysis of the existing guidance at paragraphs 1.36-1.41 of the TP Guidelines and of the relationship between these paragraphs and other parts of the TP Guidelines.

    5. The OECD pursues dialogue with the business community on comparability and profit methods for transfer pricing purposes (19th September, 2008) :

In May 2006 and January 2008, respectively, the OECD released for public comment a series of issues notes on comparability and a series of issues notes on transactional profit methods. These two discussion drafts6, which related to the OECD’s Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations, attracted very detailed responses from the business community (see comments received on the May 2006 discussion draft on comparability and comments7 received on the January 2008 discussion draft on transactional profit methods).

Working Party No. 6, which is the OECD body responsible for the Transfer Pricing Guidelines, started discussing the comments received. Given the comments’ extent and complexity, delegates felt that the reviews of comparability and profit methods could greatly benefit from a face-to-face discussion with the commentators. Accordingly, it was decided to organise a consultation with the organisations that provided written comments.

C.   Tax Transparency and Exchange of Information Agreements :

1.  Tax Transparency — Global Forum launches country-by-country reviews (18th March, 2010)
The international fight against cross-border tax evasion has entered a new phase with the launch by countries participating in the Global Forum on Transparency and Exchange of Information of a peer review process covering a first group of 18 jurisdictions : Australia, Barbados, Bermuda, Botswana, Canada, Cayman Islands, Denmark, Germany, India, Ireland, Jamaica, Jersey, Mauritius, Monaco, Norway, Panama, Qatar, Trinidad and  Tobago.

The reviews are a first step in a three-year process approved in February by the Global Forum in response to the call by G20 leaders at their Pittsburgh Summit in September 2009 for improved tax transparency and exchange of information. In addition to a complete schedule of forthcoming reviews, the Global Forum also published three other key documents8 :

  •     the Terms of Reference explaining the information exchange standard countries must meet;
  •     the Methodology for the conduct of the reviews;
  •     the Assessment criteria explaining how countries will be rated.

Welcoming this new step forward for the international tax compliance agenda, OECD Secretary-General Angel Gurría said : “The Global Forum has been quick to respond to the G20 call for a robust peer review mechanism aimed at ensuring rapid implementation of the OECD standard on information exchange. This is the most comprehensive peer review process in the world, and it is based on decades of experience at the OECD of conducting reviews of this kind in many other areas of policy making. I look forward to seeing the first results later this year”.

The Global Forum brings together 91 countries and territories, including both OECD and non-OECD countries. At a meeting in Mexico in September 2009, participants agreed that all members as well as identified non-members will undergo reviews on their implementation of the standard. These reviews will be carried out in two phases: assessment of the legislative and regulatory framework (phase 1) and assessment of the effective implementation in practice (phase 2).

The review reports will be published once they have been adopted by the Global Forum, whose next meeting will take place in Singapore at the end of September 2010.

Mike Rawstron, chair of the Global Forum, stated :
“This is the most comprehensive, in-depth review on international tax co-operation ever. There has been a lot of progress over the past 18 months, but with these reviews we are putting international tax co-operation under a magnifying glass. The peer review process will identify jurisdictions that are not implementing the standards. These will be provided with guidance on the changes required and a deadline to report back on the improvements they have made”.

For more information, contact Jeffrey Owens, Director of the OECD’s Centre for Tax Policy and Administration, (jeffrey.owens@oecd.org) or Pascal Saint-Amans, Head of the Global Forum Secretariat (pascal.saint-amans@oecd.org or) or visit www.oecd.org/tax/transparency and www.oecd.org/tax/evasion.

  2.  Progress on exchange of information in the Caribbean (24th March, 2010) :
Saint Kitts and Nevis, Saint Vincent and the Grenadines and Anguilla, an overseas territory of the United Kingdom, have signed a total of 14 tax information exchange agreements. These signings bring the total number of agreements signed by each jurisdiction to at least 12 that meet the internationally agreed tax standard. Accordingly, Anguilla, St. Kitts and Nevis and St. Vincent and the Grenadines become the 23rd, 24th and 25th jurisdictions to move into the category of jurisdictions that are considered to have substantially implemented the standard since April 2009. Since that time almost 370 agreements have been signed or brought up to the internationally agreed tax standard.

St. Kitts and Nevis and St. Vincent and the Grenadines signed agreements with Faroe Islands, Finland,  Greenland, Iceland, Norway and Sweden. These agreements add to agreements St. Kitts and Nevis had already signed with Australia, Monaco, The Netherlands, The Netherlands Antilles, Aruba, United Kingdom, Denmark, Belgium, New Zealand and Liechtenstein, bringing their total to 16 agreements. St. Vincent and the Grenadines has now signed 16 agreements that meet the standard, including its existing agreements with Australia, Austria, Denmark, the Netherlands, Aruba, Liechtenstein, Belgium, Ireland, the United Kingdom and New Zealand.

Anguilla, which signed an agreement with Australia and Germany on 19th March, had previously signed 11 other agreements — including agreements with the United Kingdom, Ireland, the Netherlands, New Zealand and the seven Nordic economies — and this signing brings their total to 13 agreements that meet the internationally agreed tax standard.

Each of these jurisdictions is a member of the Global Forum on Transparency and Exchange of Information for Tax Purposes and has agreed to participate in a peer review of their laws and practices in this area. According to the schedule of reviews published by the Global Forum, they will undergo reviews of their legal and regulatory framework for exchange of information in 2011 and reviews of their information exchange practices in 2013.

Jeffrey Owens, Director of the OECD’s Centre for Tax Policy and Administration said, “We continue to see a great deal of progress as jurisdictions move to sign agreements. With Anguilla, St. Kitts and Nevis and St. Vincent and the Grenadines now reaching this benchmark, almost all of the Caribbean jurisdictions have substantially implemented the standard, and we will be working with the remaining jurisdictions— both in the Caribbean and elsewhere — to encourage them to follow this trend and provide whatever assistance we can. The real test will come with the peer review process, when the Global Forum can evaluate the quality of these agreements and the extent of the implementation of the standards in practice.”

For further information visit www.oecd.org/tax/ transparency or www.oecd.org/tax and www.oecd.org/tax/evasion.

    D. Other Developments at OECD :

    1. Draft Guidelines on the application of VAT/ GST to the international trade in services and intangibles for public consultation (9th February, 2010) :

The OECD Committee on Fiscal Affairs invites public comments on the draft Chapter II of the International VAT/GST Guidelines that deal with customer location in the context of identifying the jurisdiction of taxation.

These draft Guidelines build on the consultation documents that were issued by the Committee in 2008. They consider which jurisdiction has the taxing rights in cases where services and intangibles are supplied internationally. The Committee has already agreed the principle that the jurisdiction with the taxing rights is the one in which consumption takes place but there frequently need to be proxies to determine consumption. The draft Guidelines propose that, as a Main Rule, the location of the customer is the most appropriate proxy to determine consumption for business-to-business supplies. The draft assumes that all supplies are legitimate and with economic substance and that there is no artificial tax avoidance or tax minimisation taking place. Further, the Guidelines address services and intangibles received by enterprises with a single location only.

The Committee, through its Working Party 9 on Consumption Taxes and the Working Party’s Technical Advisory Group (TAG) comprising government, academic and business representatives, will work on the development of further Guidelines on enterprises with multiple locations and will deal with artificial avoidance and minimisation issues later. It will also consider appropriate exceptions to the Main Rule. Given that this further work may require the Committee to review this current draft, these Guidelines should be regarded as provisional.

The Committee invites interested parties to send their comments on this draft before 30th June 2010. Comments should be sent electronically (in Word format) to jeffrey.owens@oecd.org.

2. OECD Global Forum consolidates tax evasion revolution in advance of Pittsburgh (2nd September, 2009) :

On the eve of the Pittsburgh G20 meeting, the Global Forum on Transparency and Exchange of Information dealing with tax matters, took major steps to confirm the end of the era of banking secrecy as a shield for tax evaders.

Hailing the breakthrough OECD Secretary General Angel Gurria said “what we are witnessing is nothing short of a revolution. By addressing the challenges posed by the dark side of the tax world, the campaign for global tax transparency is in full flow. We have equipped ourselves with the institutional means to continue the campaign. With the crisis, global public opinion’s expectations are high, their tolerance of non-compliance is zero and we must deliver”.

Representatives from the Forum which now numbers almost 90 jurisdictions around the world and a host of International Organisations gathering in Mexico, took concrete steps to empower the Global Forum to play the leading role in the global campaign to fight tax evasion.

Building on the extraordinary progress made in the last few months to incorporate the globally accepted standards developed by the OECD in both new and existing agreements, the Forum took the following key decisions :

  •     Teeth : to put in place a robust, comprehensive and global monitoring and peer review process to ensure that members implement their commitments; a Peer Review Group has been established to examine the legal and administrative framework in each jurisdiction and practical implementation of these standards. A first report on monitoring progress will be issued by end 2009.

  •     Extended Global Reach : to further expand its membership and to enshrine the principle that all members enjoy equal footing.

  •     Faster Agreements : to speed up the process of negotiating and concluding information exchange agreements including exploring new multilateral avenues.

  •     Developing country assistance : to put in place a coordinated technical assistance programme to assist smaller jurisdictions to implement the standards rapidly.

In its Assessment of Tax Co-operation in 2009 issued earlier (‘OECD assessment shows bank secrecy as a shield for tax evaders coming to an end’) the Global Forum highlighted that the standards on transparency and exchange of information pioneered by the OECD are now almost universally accepted and that extraordinary progress has already been made towards their full implementation.

The Forum also agreed on the need to convene regularly, with the next meeting scheduled for 2010.

Background :

The Global Forum on Transparency and Exchange of Information was created in 2000 to provide an inclusive forum for achieving high standards of transparency and exchange of information in a way that is equitable and permits fair competition between all jurisdictions, large and small, developed and developing. The initial group of jurisdictions numbered 32. It now brings together almost 90 jurisdictions. It has been the driving force behind the development and acceptance of these international standards. The 2009 Global Forum meeting was its fifth, the last taking place in 2005.

In 2002, Global Forum members worked together to draft a Model Agreement on Exchange of Information on Tax Matters which is now used as a basis for bilateral agreements. Since 2006, the Global Forum has published annual assessments of the legal and administrative frameworks for transparency and exchange of information in more than 80 countries.

Its most recent assessment, Tax Co-operation 2009
    Towards a Level Playing Field based on information available up until 31st July 2009, was published on 31st August 2009.

Since the London G20 meeting in April, 2009, over 50 new Tax Information Exchange Agreements have been signed (doubling the total number of Agreements signed since 2000) and over 40 double taxation conventions have been signed.

As a consequence, a further 6 jurisdictions have since substantially implemented the internationally agreed tax standards.

OECD — RECENT DEVELOPMENTS — AN UPDATE

International Taxation

In June, 2010 issue of BCAJ, we covered various important
developments at OECD till then. In this issue, we have covered further major
developments after publication of the last Edition of OECD Model Tax Convention
(‘MC’) and developments in the field of Transfer Pricing and work being done at
OECD in various other related fields and have included the same in this update.
We shall endeavor to update the readers on major developments at OECD at regular
intervals. Various news items included here are sourced from various OECD
Newsletters.

A. Amendments to OECD Model Tax Convention :


1. Draft contents of the 2010 update to the Model
Tax Convention — 21st May, 2010 :


The OECD Committee on Fiscal Affairs has just released the
draft contents of the 2010 update to the OECD Model Tax Convention prepared by
Working Party 1 of the Committee. The update will be submitted for approval of
the Committee in June and the OECD Council in July.

The 2010 update will include the changes that were previously
released for comments in the following discussion drafts :

  •  The
    granting of treaty benefits with respect to the income of Collective Investment
    Vehicles :


The draft report was released on 9th December 2009 (see
http://www.oecd.org/dataoecd/47/3/44211901.pdf). It was based on an earlier
report by the Informal Consultative Group on the Taxation of Collective
Investment Vehicles and Procedures for Tax Relief for Cross-Border Investors,
which itself was released for comments on 12th January 2009 (see http://www.oecd.org/dataoecd/34/26/41974553.pdf).
The changes to the Commentary on Article 1 included in the report were slightly
modified, based on the comments received at the February 2010 meeting of Working
Party 1 (WP1) on Tax Conventions and Related Questions (the CFA subsidiary body
responsible for changes to the OECD Model Tax Convention).

  •  
    Revised discussion draft of a new Article 7 of the OECD Model Tax Convention :


The draft was released on 24th November, 2009 (see http://www.oecd.org/dataoecd/30/52/44104593.pdf).
That revised draft reflected a number of changes made to the first version of
the new Article released on 7th July, 2008 (see http://www.oecd.org/dataoecd/37/8/40974117.pdf).
A few additional changes were made, based on the comments received on the
revised draft, at the February 2010 meeting of WP1.

  •  
    Application of tax treaties to State-owned entities, including Sovereign Wealth
    Funds :


The draft was released on 25th November 2009 (see http://www.oecd.org/dataoecd/59/63/44080490.pdf).
The changes included in this note reflect a few modifications made at the
February 2010 meeting of WP1 in light of the comments received on the changes
proposed in that draft.

  •  Tax
    treaty issues related to common telecommunication transactions :


The draft was released on 25th November, 2009 (see http://www.oecd.org/dataoecd/59/62/44148625.pdf).
The changes included in this note reflect a few modifications made at the
February 2010 meeting of WP1 in light of the comments received on the changes
proposed in that draft.

  •  
    Revised changes to the Commentary on paragraph 2 of Article 15 :


The first draft of these changes was released in April, 2004
(see http://www.oecd.org/dataoecd/52/61/31413358.pdf). Based on the comments
received and a public consultation meeting with business representatives and
other interested parties held on 30th January, 2006, a number of modifications
were made and revised proposals were released for comments on 12th March, 2007
(see http://www.oecd.org/dataoecd/36/32/38236197.pdf). The final version of the
changes included in this note reflects a number of additional changes made
following the comments received on that second discussion draft.

As all the substantive contents of the 2010 update have
previously been released for comments through these discussion drafts, this
draft is released for information only and not for additional comments. The
introduction to the draft summarises how the main comments received on these
discussion drafts have been dealt with.

The update will also include a number of changes to OECD
countries’ reservations and observations and to non-OECD countries’ positions,
which will be added to the update in the next few weeks. Among these will be the
elimination of all reservations and positions on Article 26 (Exchange of
Information), which the OECD Council has already approved.

The Committee on Fiscal Affairs has been asked to discuss and
approve the draft update at its June, 2010 meeting. A revised version of the
Model Tax Convention that will incorporate the changes made through the update
is expected to be released in September, following the approval by the OECD
Council.

2. OECD Releases Report on Granting of Treaty
Benefits with respect to the Income of
Collective Investment Vehicles — 31st May,
2010 :


The OECD Committee on Fiscal Affairs has released a Report on
‘The Granting of Treaty Benefits with respect to the Income of Collective
Investment Vehicles’ which contains proposed changes to the Commentary on the
OECD Model Tax Convention dealing with the question of the extent to which
either collective investment vehicles (CIVs) or their investors are entitled to
treaty benefits on income received by the CIVs. These changes are expected to be
included in the 2010 update to the Model Tax Convention (the draft contents of
which were released on 21st May, 2010) and the Report would then be included in
volume II of the loose-leaf and electronic versions of the Model.

The Report is a modified version of the Report ‘Granting of Treaty Benefits with respect to the Income of Collective Investment Vehicles’ of the Informal Consultative Group on the Taxation of Collective Investment Vehicles and Procedures for Tax Relief for Cross-Border Investors (‘ICG’) which was released on 12th January 2009. In that original Report, the ICG addressed the legal and policy issues specific to CIVs and formulated a comprehensive set of recommendations addressing the issues presented by CIVs in the cross-border context. The Committee referred the recommendations by the ICG to its Working Party 1 (‘WP1’) on Tax Conventions and Related Questions (the Committee’s subsidiary body responsible for changes to the OECD Model Tax Convention) for further consideration. The WP1 Report was issued as a discussion draft on 9th December 2009 and modified in response to public comments.

The main conclusions and recommendations of the Report are similar to those in the ICG Report, with some modifications that reflect the varied experiences of the tax authorities of the OECD countries. Like the ICG Report, the Report therefore analyses the technical questions of whether a CIV should be considered a ‘person’, a ‘resident of a Contracting State’ and the ‘beneficial owner’ of the income it receives under treaties that, like the OECD Model Tax Convention, do not include a specific provision dealing with CIVs (i.e., the vast majority of existing treaties). Further, the Report includes changes to the Commentary on the Model Tax Convention to reflect the conclusions of the Committee with respect to these issues.

Although these changes to the Commentary will clarify the treatment of CIVs, it is clear that at least some forms of CIVs in some countries will not meet the requirements to claim treaty benefits on their own behalf. Accordingly, the Report also considers the appropriate treatment of such CIVs under both existing treaties and future treaties.

With respect to existing treaties, the Report concludes that, if a CIV is not entitled to claim benefits in its own right, its investors should in principle be able to claim treaty benefits. The Report reflects different views regarding whether such a right should be limited to investors who are residents of the Contracting State in which the CIV is organised, or whether that right should be extended to treaty-eligible residents of third States. In any event, administrative difficulties in many cases effectively prevent individual claims by investors. Accordingly, the Report concludes that countries should adopt procedures to allow a CIV to make the claim on behalf of investors.

With respect to future treaties, the Report endorses the ICG recommendation that the Commentary on Article 1 of the Model Tax Convention should be expanded to include a number of optional provisions for countries to consider in their future treaty negotiations. Inclusion of one or more of these provisions in bilateral treaties would provide certainty to CIVs, investors and intermediaries. The favoured approach for such a provision would treat a CIV as a resident of a Contracting State and the beneficial owner of its income, at least to the extent that its investors would themselves be eligible for benefits from the source country, rather than adopting a full look-through approach. Because different views were expressed on the issue of whether treaty-eligible residents of third countries should be taken into account in determining the extent to which the income of a CIV should be entitled to treaty benefits, the proposed Commentary includes alternative provisions that adopt different approaches with respect to the treatment of treaty-eligible residents of third countries. The proposed Commentary also includes an alternative provision that would adopt a full look-through approach, under which the CIV would make claims on behalf of its investors rather than in its own name. The look-through approach would be appropriate in cases where the investors, such as pension funds, would have been eligible for a lower, or zero, rate of withholding had they invested directly in the underlying securities.

B.    Amendments to OECD Transfer Pricing Guidelines:

1.    OECD invites comments on the Transfer Pricing Aspects of Intangibles — 2nd July, 2010:

The OECD is considering starting a new project on the Transfer Pricing Aspects of Intangibles and is inviting comments from interested parties on the scoping of such a project. Comments should be sent before 15th September 2010 to Jeffrey Owens, Director, CTPA (jeffrey.owens@oecd.org).

The OECD’s Committee on Fiscal Affairs is now completing its work on two transfer pricing projects which the OECD Council will be asked to approve by the end of July in the form of revisions to the Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (TPG)?: its review of Comparability and Profit Methods and its report on the Transfer Pricing Aspects of Business Restructuring.

In these two projects, transfer pricing issues pertaining to intangibles were identified as a key area of concern to governments and taxpayers, due to insufficient international guidance, in particular on the definition, identification and valuation of intangibles for transfer pricing purposes.

OECD guidance on the transfer pricing aspects of intangibles is currently found in the TPG, especially in Chapters VI and VIII. Further and updated guidance will be available in the revised Chapters I-III of the TPG and in the final report on the Transfer Pricing Aspects of Business Restructuring once those are approved by the Council and publicly released. Intangibles are also addressed in the July 2008 Report on the Attribution of Profits to Permanent Establishments and in the Commentary on Article 12 of the Model Tax Convention.

The OECD is now considering starting a new project on the Transfer Pricing Aspects of Intangibles which could result in a revision of Chapters VI and VIII of the TPG. Working Party No. 6 of the Committee on Fiscal Affairs is still at the stage of scoping such a possible new project and would welcome the views of interested parties on?: what they see as the most significant issues encountered in practice in relation to the transfer pricing aspects of intangibles; what shortfalls, if any, they identify in the existing OECD guidance; what the areas are in which they believe the OECD could usefully do further work; and what they believe the format of the final output of the OECD work should be. Comments should be sent before 15th September 2010 in Word format to Jeffrey Owens, Director, CTPA (jeffrey.owens@ oecd.org).

Selected business commentators will be invited to meet with Working Party No. 6 on 9th November 2010 in Paris.

C.    Tax Transparency and Exchange of Information Agreements:

1.    OECD updates — Brazil, Indonesia ranked as implementing International Information Standard — 3rd June 2010?:

As a result of details provided to the Global Forum on Transparency and Exchange of Information for Tax Purposes, Brazil and Indonesia are now ranked in the category of jurisdictions that have substantially implemented the internationally agreed tax standard.

The OECD said it had updated its progress report, first issued in conjunction with the G20 London summit in April 2009, to take account of communications from Brazil and Indonesia on their legal and regulatory frameworks for exchange of information.

According to the information provided, Brazil has more than 25 bilateral tax treaties that provide for exchange of information in tax matters to the internationally agreed standard while Indonesia has 53 agreements that meet the standard. The two countries joined the Global Forum last September.

A full description of the two countries’ legal and regulatory frameworks will be included in the Global Forum’s 2010 annual assessment to be published later this year. As with all members of the Global Forum, both the countries will undergo peer reviews of their exchange of information laws and practices, Brazil in 2011 and 2012 and Indonesia in 2011 and 2013. Brazil is a member both of the Forum’s Steering Group and of its Peer Review Group.

Since April 2009, more than 500 bilateral tax information exchange agreements have been signed worldwide, with 28 jurisdictions joining those ranked as having substantially implemented the internationally agreed standard.

For more information, visit the following sites:
www.oecd.org/tax
www.oecd.org/tax/transparency
www.oecd.org/tax/evasion

B.    Amendments to OECD Transfer Pricing Guidelines:

2.    A boost to multilateral tax cooperation: 15 countries sign updated Convention on Mutual Administrative Assistance in Tax Matters — 27th May, 2010:

In April 2009, the G20 called for action “to make it easier for developing countries to secure the benefits of the new cooperative tax environment, including a multilateral approach for the exchange of information.” In response, the OECD and the Council of Europe developed a Protocol amending the multilateral Convention on Mutual Administrative Assistance in Tax Matters to bring it in line with the international standard on exchange of information for tax purposes and to open it up to countries that are neither members of the OECD, nor of the Council of Europe.

On 27th May 2010, the updated Convention was presented to Ministers and Ambassadors attending the annual OECD Ministerial meeting held in Paris and was signed by 11 countries already Parties to the Convention (Denmark, Finland, Iceland, Italy, France, the Netherlands, Norway, Sweden, Ukraine, the United Kingdom and the United States). In addition, Korea, Mexico, Portugal and Slovenia signed both the Convention and the amending Protocol.

The Convention provides for a wide range of tools for cross-border tax co-operation including exchange of information, multilateral simultaneous tax examinations, service of documents, and cross-border assistance in tax collection, while imposing extensive safeguards to protect the confidentiality of the information exchanged (see background brief for more information). Once the Protocol has entered into force, the Convention will become a more powerful tool for multilateral tax cooperation as it will enable a wider group of countries to become parties and will require full exchange of information on request in all tax matters without regard to a domestic tax interest requirement or bank secrecy for tax purposes.

3.    Three Caribbean jurisdictions move up on OECD progress report — 19th May, 2010:

Dominica, Grenada and Saint Lucia have been moved into the category of jurisdictions considered to have substantially implemented the standard on transparency and exchange of information, having now all signed at least 12 exchange of information agreements conforming to the standard.

This brings to 28 the number of jurisdictions that have moved into this category since April 2009. The move affecting Dominica, Grenada and Saint Lucia follows the signature of a series of agreements involving these three jurisdictions plus Antigua and Barbuda, which had already reached 12 agreements on 7th December 2009, and the Nordic countries (Denmark, Faroe Islands, Finland, Greenland, Iceland, Norway and Sweden).

Following these signatures, Antigua and Barbuda has now signed a total of 20 agreements meeting the international standard. Dominica and Grenada have now signed 13 agreements each, and Saint Lucia has signed 15 agreements.

As members of the Global Forum on Transparency and Exchange of Information for Tax Purposes, each of these jurisdictions agreed to participate in a peer review of their laws and practices in this area. According to a schedule published by the Global Forum, Antigua and Barbuda, Grenada and Saint Lucia will undergo reviews of their legal and regulatory framework for exchange of information in 2011 and reviews of their information exchange practices in 2013. Dominica’s peer reviews will take place in 2012 and 2014.

For more information, visit: www.oecd.org/tax/transparency/ www.oecd.org/tax and www.oecd.org/tax/evasion.

OECD – RECENT DEVELOPMENTS – AN UPDATE

In this issue,
we have covered major developments in the field of International Taxation from
July 2018 till date and work being done at OECD in various other related
fields. It is in continuation of our endeavour to update the readers on major
developments at OECD at regular intervals. Various news items included here are
sourced from OECD Newsletters available on its website.


In this
write-up, we have classified the developments into 5 major categories viz.:


1)    BEPS Action Plans


2)    Transfer Pricing


3)    Common Reporting Standard (CRS)


4)    Multilateral Convention on Mutual
Administrative Assistance in Tax Matters


5)    Exchange of Information

 

1)  BEPS ACTION PLANS


OECD and IGF
release first set of practice notes for developing countries on BEPS risks in
mining industries


For many
resource-rich developing countries, mineral resources present a significant
economic opportunity to increase government revenue. Tax base erosion and
profit shifting (BEPS), combined with gaps in the capabilities of tax
authorities in developing countries, threaten this prospect. The OECD’s Centre
for Tax Policy and Administration and the Intergovernmental Forum on Mining,
Minerals, Metals and Sustainable Development (IGF) are collaborating to address
some of the challenges developing countries face in raising revenue from their
mining sectors. Under this partnership, a series of practice notes and tools
are being developed for governments.


Three practice notes have now been finalised
in October 2018. In addition, interested parties were invited to provide
comments on preliminary versions of these reports. OECD has also published the
public comments submitted. Building on BEPS Action 4, this practice note guides
government policy-makers on how to strengthen their defences against excessive
interest deductions in the mining sector.

 

2)  TRANSFER PRICING (BEPS ACTIONS 8 TO 10)


i)     BEPS discussion draft on the transfer
pricing aspects of financial transactions


In July, 2018, OECD
had invited Public comments on a discussion draft on financial transactions,
which deals with follow-up work in relation to Actions 8-10 (” Aligning
transfer pricing outcomes with value creation”) of the BEPS Action Plan.


The 2015 report on
BEPS Actions 8-10 mandated follow-up work on the transfer pricing aspects of financial
transactions. Under that mandate, the discussion draft, which does not yet
represent a consensus position of the Committee on Fiscal Affairs or its
subsidiary bodies, aims to clarify the application of the principles included
in the 2017 edition of the OECD Transfer Pricing Guidelines, in particular, the
accurate delineation analysis under Chapter I, to financial transactions. The
work also addresses specific issues related to the pricing of financial
transactions such as treasury function, intra-group loans, cash pooling,
hedging, guarantees and captive insurance.


ii)    OECD releases new guidance on the
application of the approach to hard-to-value intangibles and the transactional
profit split method under BEPS Actions 8-10


The OECD released
on 21.06.2018 two reports containing Guidance for Tax Administrations on the
Application of the Approach to Hard-to-Value Intangibles, under BEPS Action
8; and Revised Guidance on the Application of the Transactional Profit Split
Method, under BEPS Action 10.


In October, 2015,
as part of the final BEPS package, the OECD/G20 published the report on
Aligning Transfer Pricing Outcomes with Value Creation (OECD, 2015), under BEPS
Actions 8-10. The Report contained revised guidance on key areas, such as
transfer pricing issues relating to transactions involving intangibles;
contractual arrangements, including the contractual allocation of risks and
corresponding profits, which are not supported by the activities actually
carried out; the level of return to funding provided by a capital-rich MNE
group member, where that return does not correspond to the level of activity
undertaken by the funding company; and other high-risk areas. The Report also
mandated follow-up work to develop.


Guidance for Tax
Administrations on the Application of the Approach to Hard-to-value Intangibles
(BEPS Action 8)


The new guidance
for tax administration on the application of the approach to hard-to-value
intangibles (HTVI) is aimed at reaching a common understanding and practice
among tax administrations on how to apply adjustments resulting from the
application of this approach. This guidance should improve consistency and
reduce the risk of economic double taxation by providing the principles that
should underlie the application of the HTVI approach. The guidance also
includes a number of examples to clarify the application of the HTVI approach
in different scenarios and addresses the interaction between the HTVI approach
and the access to the mutual agreement procedure under the applicable tax
treaty.


This guidance has
been formally incorporated into the Transfer Pricing Guidelines as an annex to
Chapter VI.


Revised Guidance
on the Application of the Transactional Profit Split Method (BEPS Action 10)


This report
contains revised guidance on the profit split method, developed as part of
Action 10 of the BEPS Action Plan. This guidance has been formally incorporated
into the Transfer Pricing Guidelines, replacing the previous text on the
transactional profit split method in Chapter II. The revised guidance retains
the basic premise that the profit split method should be applied where it is
found to be the most appropriate method to the case at hand, but it
significantly expands the guidance available to help determine when that may be
the case.


It also contains more guidance on how to apply the method, as well as numerous
examples.


3)   COMMON REPORTING STANDARDS


i)     OECD releases further guidance for tax
administrations and MNE Groups on Country-by-Country reporting (BEPS Action 13)


In September, 2018,
the Inclusive Framework on BEPS has released additional interpretative guidance
to give certainty to tax administrations and MNE Groups alike on the
implementation of Country-by-Country (CbC) Reporting (BEPS Action 13).


The new guidance
includes questions and answers on the treatment of dividends received and the
number of employees to be reported in cases where an MNE uses proportional
consolidation in preparing its consolidated financial statements, which apply
prospectively. The updated guidance also clarifies that shortened amounts
should not be used in completing Table 1 of a country-by-country report and
contains a table that summarises existing interpretative guidance on the
approach to be applied in cases of mergers, demergers and acquisitions.


The complete set of guidance concerning the interpretation of BEPS
Action 13 issued so far is presented in the document released in September
2018. This will continue to be updated with any further guidance that may be
agreed.


ii)    OECD clamps down on CRS avoidance through
residence and citizenship by investment schemes


Residence and
citizenship by investment (CBI/RBI) schemes, often referred to as golden
passports or visas, can create the potential for misuse as tools to hide assets
held abroad from reporting under the OECD/G20 Common Reporting Standard (CRS).


In particular,
Identity Cards, residence permits and other documentation obtained through
CBI/RBI schemes can potentially be abused to misrepresent an individual’s
jurisdiction(s) of tax residence and to endanger the proper operation of the
CRS due diligence procedures.


Therefore, and as
part of its work to preserve the integrity of the CRS, the OECD has published
the results of its analysis of over 100 CBI/RBI schemes offered by CRS-committed
jurisdictions, identifying those schemes that potentially pose a high-risk to
the integrity of CRS.


Potentially
high-risk CBI/RBI schemes are those that give access to a low personal tax rate
on income from foreign financial assets and do not require an individual to
spend a significant amount of time in the jurisdiction offering the scheme.
Such schemes are currently operated by Antigua and Barbuda, The Bahamas,
Bahrain, Barbados, Colombia, Cyprus, Dominica, Grenada, Malaysia, Malta,
Mauritius, Monaco, Montserrat, Panama, Qatar, Saint Kitts and Nevis, Saint
Lucia, Seychelles, Turks and Caicos Islands, United Arab Emirates and Vanuatu.


Together with the results of the analysis, the OECD is also publishing
practical guidance that will enable financial institutions to identify and
prevent cases of CRS avoidance through the use of such schemes. In particular,
where there are doubts regarding the tax residence(s) of a CBI/RBI user, the
OECD has recommended further questions that a financial institution may raise
with the account holder.


Moreover, a number
of jurisdictions have committed to spontaneously exchanging information
regarding users of CBI/RBI schemes with all original jurisdiction(s) of tax
residence, which reduces the attractiveness of CBI/RBI schemes as a vehicle for
CRS avoidance. Going forward, the OECD will work with CRS-committed
jurisdictions, as well as financial institutions, to ensure that the guidance
and other OECD measures remain effective in ensuring that foreign income is
reported to the actual jurisdiction of residence.


4) MULTILATERAL CONVENTION ON MUTUAL ADMINISTRATIVE ASSISTANCE IN TAX MATTERS


i) Multilateral
Convention to Implement Tax Treaty Related Measures to Prevent BEPS


In November, 2016,
over 100 jurisdictions concluded negotiations on the Multilateral Convention to
Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit
Shifting (“Multilateral Instrument” or “MLI”) that will
swiftly implement a series of tax treaty measures to update international tax rules
and lessen the opportunity for tax avoidance by multinational enterprises. The
MLI already covers over 75 jurisdictions and has entered into force on 1st
July, 2018. Signatories include jurisdictions from all continents and all
levels of development.


A number of jurisdictions have also expressed their intention to sign the MLI
as soon as possible and other jurisdictions are also actively working towards
signature.


ii)   Signatories
and Parties (MLI Positions)


The MLI offers
concrete solutions for governments to close the gaps in existing international
tax rules by transposing results from the OECD/G20 BEPS Project into bilateral
tax treaties worldwide. The MLI modifies the application of thousands of
bilateral tax treaties concluded to eliminate double taxation. It also
implements agreed minimum standards to counter treaty abuse and to improve
dispute resolution mechanisms while providing flexibility to accommodate
specific tax treaty policies.


The text of the
Multilateral Instrument (MLI) and its Explanatory Statement were developed
through a negotiation involving more than 100 countries and jurisdictions and
adopted on 24th November, 2016, under a mandate delivered by G20
Finance Ministers and Central Bank Governors at their February 2015 meeting.
The MLI and its Explanatory Statement were adopted in two equally authentic
languages, English and French.


iii)     Translation
in Other Languages


Members of the ad
hoc Group have prepared translations of the MLI in Chinese, Dutch, German,
Italian, Japanese, Serbian, Spanish and Swedish. The OECD Secretariat has
prepared a translation of the MLI in Arabic. Other MLI translations, including
translations in Greek and Russian, are being prepared by members of the ad hoc
Group and will be made available shortly and further MLI translations are
expected by year end. The translations of the MLI in other languages are
provided only for information purposes. Only the signed English and French MLI
are the authentic MLI texts applicable.


iv)     Saudi
Arabia signs landmark agreement to strengthen its tax treaties


Saudi Arabia has
signed the Multilateral Convention to Implement Tax Treaty Related Measures to
Prevent Base Erosion and Profit Shifting (the Convention) on 18.09.2018. It has
become the 84th jurisdiction to join the Convention, which now
covers over 1,400 bilateral tax treaties.


5)   EXCHANGE OF INFORMATION


i)  Major enlargement of the global network for
the automatic exchange of offshore account information as over 100
jurisdictions get ready for exchanges


The OECD has
published on 05.07.2018, a new set of bilateral exchange relationships
established under the Common Reporting Standard Multilateral Competent
Authority Agreement (CRS MCAA).

 

In total, the international legal network for
the automatic exchange of offshore financial account information under the CRS
now covers over 90 jurisdictions, with the others expected to follow suit in
due course. The network has allowed over 100 committed jurisdictions to
exchange CRS information from September 2018 under more than 3200 bilateral
relationships that are now in place.


The full list of automatic exchange relationships that are currently in
place under the CRS MCAA is available online.


There has been a
significant increase of jurisdictions participating in the multilateral
Convention on Mutual Administrative Assistance in Tax Matters, which is the
prime international instrument for all forms of exchange of information in tax
matters, including the exchange upon request, as well as the automatic exchange
of CRS information and Country-by-Country Reports. The total number of
participating jurisdictions now amount to 124. These recent developments show
that jurisdictions are completing the final steps for being able to commence
CRS exchanges from September 2018, therewith delivering on their commitment
made at the level of the G20 and the Global Forum.


ii)    Global Forum publishes compliance ratings on
tax transparency for further seven jurisdictions


The Global Forum is
the leading multilateral body mandated to ensure that jurisdictions around the
world adhere to and effectively implement both the standard of transparency and
exchange of information on request and the standard of automatic exchange of
information. This objective is achieved through a robust monitoring and peer
review process. The Global Forum also runs an extensive technical assistance
programme to provide support to its members in implementing the standards and
helping tax authorities to make the best use of cross-border information
sharing channels. The Global Forum also welcomed Oman as a new member. This
takes its membership to 154 members who have come together to cooperate in the
international fight against cross border tax evasion.


The Global Forum on
Transparency and Exchange of Information for Tax Purposes published on
15-10-2018 seven peer review reports assessing compliance with the
international standard on transparency and exchange of information on request
(EOIR).


These reports
assess jurisdictions against the updated standard which incorporates beneficial
ownership information of all relevant legal entities and arrangements, in line
with the definition used by the Financial Action Task Force Recommendations.


Two jurisdictions –
Bahrain and Singapore – received an overall rating of “Compliant”. Five others
– Austria, Aruba, Brazil, Saint Kitts and Nevis and the United Kingdom were
rated “Largely Compliant”.


The jurisdictions
have demonstrated their progress on many deficiencies identified in the first
round of reviews including improving access to information, developing broader
EOI agreement networks; and monitoring the handling of increasing incoming EOI
requests as well as taking measures to implement the strengthened standard on
the availability of beneficial ownership.


Note: The reader
may visit the OECD website and download various draft reports and Public
Comments referred to in this article for his further studies.  

 

OECD – Recent Developments – An Update

In this issue, we have
covered major developments in the field of International Taxation in the
Calendar year 2018 till date and work being done at OECD in various other
related fields. It is in continuation of our endeavour to update the readers on
major developments at OECD at regular intervals. Various news items included
here are sourced from various OECD Newsletters as available on its website.

 

In this write-up, we have
classified the developments into 6 major categories viz.:

 

1)   Tax Treaties

2)   BEPS Action Plans

3)   Transfer Pricing 

4)   Common Reporting Standard (CRS)

5)   Multilateral Convention on Mutual
Administrative Assistance in Tax Matters

6)   Others

 

1) Tax Treaties

 

(i) Major step forward in international tax
co-operation as additional countries sign landmark agreement to strengthen tax
treaties

 

24/01/2018 – Ministers and
high-level officials from Barbados, Jamaica, Malaysia, Panama and Tunisia have
today signed the BEPS Multilateral Convention bringing the total number
of signatories to 78.

 

In addition to those
signing today, Algeria, Kazakhstan, Oman and Swaziland have expressed their
intent to sign the Convention, and a number of other jurisdictions are actively
working towards signature by June 2018. So far, four jurisdictions – Austria,
the Isle of Man, Jersey and Poland – have ratified the Convention, which will
enter into force three months after a fifth jurisdiction deposits its
instrument of ratification.

 

The text of the Convention,
the explanatory statement, background information, database, and position of
each signatory are available at http://oe.cd/mli.

 

2) 
BEPS Action Plans

 

(i) OECD releases decisions on 11 preferential
regimes of BEPS Inclusive Framework Members

 

17/05/2018 – Governments
are continuing to make swift progress in bringing their preferential tax
regimes in compliance with the OECD/G20 BEPS standards to improve the
international tax framework.

 

Today, the Inclusive
Framework released the updates to the results for preferential regime reviews
conducted by the Forum on Harmful Tax Practices (FHTP) in connection with BEPS
Action 5:

 


–  Four new regimes were
designed to comply with FHTP standards, meeting all aspects of transparency, exchange of information, ring fencing and
substantial activities and are found to be not harmful (Lithuania, Luxembourg,
Singapore, Slovak Republic).

 

– Four regimes were abolished or amended to remove harmful features
(Chile, Malaysia, Turkey and Uruguay).

–  A further three regimes do not relate to geographically mobile
income and/or are not concerned with business taxation, as such posing no BEPS
Action 5 risks and have therefore been found to be out of scope (Kenya and two
Viet Nam regimes).

 

Eleven new preferential
regimes are identified since the last update, bringing the total to 175 regimes
in over 50 jurisdictions considered by the FHTP since the creation of the
Inclusive Framework. Of the 175, 31 regimes have been changed; 81 regimes
require legislative changes which are in progress; 47 regimes have been
determined to not pose a BEPS risk; 4 have harmful or potentially harmful
features and 12 regimes are still under review.

 

This update shows the
determination of the Inclusive Framework to comply with the international
standards. For the updated table of regime results, see www.oecd.org/tax/beps/update-harmful-tax-practices-2017-progress-report-on-preferential-regimes.pdf.

 

(ii) The United Arab Emirates and Bahrain joins the
Inclusive Framework on BEPS.

 

(iii) OECD releases additional guidance on the
attribution of profits to a permanent establishment under BEPS Action 7

 

22/03/2018 – Today, the
OECD released the report Additional Guidance on the Attribution of
Profits to Permanent Establishments (BEPS Action 7).

 

In October 2015, as part of
the final BEPS package, the OECD/G20 published the report on Preventing
the Artificial Avoidance of Permanent Establishment Status. The Report
recommended changes to the definition of permanent establishment (PE) in
Article 5 of the OECD Model Tax Convention, which is crucial in determining whether
a non-resident enterprise must pay income tax in another State. In particular,
the Report recommended changes aimed at preventing the use of certain common
tax avoidance strategies that have been used to circumvent the existing PE
definition.

 

(iv) OECD and IGF invite comments on a draft
practice note that will help developing countries address profit shifting from
their mining sectors via excessive interest deductions

18/04/2018 – For many
resource-rich developing countries, mineral resources present an unparalleled
economic opportunity to increase government revenue. Tax base erosion and
profit shifting (BEPS), combined with gaps in the capabilities of tax
authorities in developing countries, threaten this prospect. One of the avenues
for international profit shifting by multinational enterprises is the use of
excessive interest deductions.

 

Building on BEPS Action
4, this practice note has been prepared by the OECD Centre for Tax
Policy and Administration under a programme of co-operation with the
Intergovernmental Forum on Mining, Minerals, Metals and Sustainable Development
(IGF), to help guide tax officials on how to strengthen their defences against
BEPS.

 

It is part of wider efforts
to address some of the challenges developing countries are facing in raising
revenue from their mining sectors. This work also complements action by the Platform
for Collaboration on Tax and others to produce toolkits on top priority tax
issues facing developing countries.

 

(v) OECD releases third round of peer reviews on
implementation of BEPS minimum standards on improving tax dispute resolution
mechanisms and calls for taxpayer input for the fifth round

 

12/03/2018 – As the BEPS
Action 14 continues its efforts to make dispute resolution more timely,
effective and efficient, eight more peer review reports have been released
today. These eight reports highlight how well jurisdictions are implementing
the Action 14 minimum standard as agreed to in the OECD/G20 BEPS Project.

 

The third round reports
released today relate to implementation by the Czech Republic, Denmark,
Finland, Korea, Norway, Poland, Singapore and Spain. A document addressing
the implementation of best practices is also available on each jurisdiction
that chose to opt to have such best practices assessed. These eight reports
contain over 215 specific recommendations relating to the minimum standard. In
stage 2 of the peer review process, each jurisdiction’s effort to address the
recommendations identified in its stage 1 peer review report will be assessed.

3) Transfer Pricing 

 

(i)      OECD
and Brazil launch project to examine differences in cross-border tax rules

 

 28/02/2018 – The OECD and Brazil today
launched a joint project to examine the similarities and gaps between the
Brazilian and OECD approaches to valuing cross-border transactions between
associated firms for tax purposes. The project will also assess the potential
for Brazil to move closer to the OECD’s transfer pricing rules, which are a
critical benchmark for OECD member countries and followed by countries around
the world.

 

(ii) OECD invites public comments on the scope of
the future revision of Chapter IV (administrative approaches) and Chapter VII
(intra-group services) of the Transfer Pricing Guidelines

 

09/05/2018 – The OECD is
considering starting two new projects to revise the guidance in Chapter IV
(administrative approaches) and Chapter VII (intra-group services) of the
Transfer Pricing Guidelines.

 

Public comments are invited
on:

 

– the future revision of Chapter IV, “Administrative Approaches to
Avoiding and Resolving Transfer Pricing Disputes” of the Transfer Pricing
Guidelines, and

 

– the future revision of Chapter VII, “Special Considerations for
Intra-Group Services”, of the Transfer Pricing Guidelines.

 

(iii) OECD releases 14 additional country profiles
containing key aspects of transfer pricing legislation

 

09/04/2018 – The OECD has published
new transfer pricing country profiles for Australia, China (People’s
Republic of), Estonia, France, Georgia, Hungary, India, Israel, Liechtenstein,
Norway, Poland, Portugal, Sweden and Uruguay respectively. These new
profiles reflect the current transfer pricing legislation and practices of each
country. The profiles of Belgium and the Russian Federation have also been
updated. The country profiles are now available for 45 countries.

 

4) Common Reporting Standard (CRS)

 

(i) OECD addresses the misuse of
residence/citizenship by investment schemes

 

19/04/2018 – Today’s
revelations from the “Daphne Project” on the Maltese residence and
citizenship by investment schemes underline the crucial importance of the
OECD’s work to ensure that the integrity of the OECD/G20 Common Reporting
Standard (CRS) is preserved and that any circumvention is detected and
addressed.

 

Over the last months, the
OECD has been taking a set of actions to ensure that all taxpayers maintaining
financial assets abroad are effectively reported under the CRS, including by:

 

–  issuing new model disclosure rules that require lawyers,
accountants, financial advisors, banks and other service providers to inform
tax authorities of any schemes they put in place for their clients to avoid
reporting under the CRS. The adoption of such model mandatory disclosure rules
will have a deterrent effect on the promotion of CBI/RBI schemes for
circumventing the CRS and provide tax authorities with intelligence on the
misuse of such schemes as CRS avoidance arrangements. The EU Member States have
already agreed to implement these rules as part of a wider directive on
mandatory disclosures;

 

–  reaching out to individual jurisdictions, including Malta, to
make them aware of the risk of abuse of their CBI/RBI schemes and offer
assistance in adopting mitigating measures; and

 

–  establishing a list of high risk schemes in order to further
raise awareness amongst stakeholders of the potential of such schemes to
undermine the CRS due diligence and reporting requirements.

 

In addition, on 19th
February 2018, the OECD issued a consultation document, outlining potential
situations where the misuse of CBI/RBI schemes poses a high risk to accurate
CRS reporting and seeking public input both to obtain evidence on the misuse of
CBI/RBI schemes and on effective ways for preventing such abuse.

 

The substantial amount of
input received in response to the consultation further underlines the
importance of the OECD’s actions in this field. It also contains a wide range
of proposals for further addressing the misuse of RBI/CBI schemes, including:
1) comprehensive due diligence checks to be carried out as part of the RBI/CBI
application process, 2) the spontaneous exchange of information about
individuals that have obtained residence/citizenship through such a CBI/RBI
scheme with their original jurisdiction(s) of tax residence; and 3)
strengthened CRS due diligence procedures on financial institutions with
respect to high risk accounts. 

 

(ii)     Global
network for the automatic exchange of offshore account information continues to
grow; OECD releases new edition of the CRS Implementation Handbook

 

05/04/2018 – Today, the
OECD published a new set of bilateral exchange relationships established under
the Common Reporting Standard Multilateral Competent Authority Agreement (CRS
MCAA) which for the first time includes activations by Panama.

 

In total, there are now
over 2700 bilateral relationships for the automatic exchange of offshore
financial account information under the CRS in place across the globe. The full
list of automatic exchange relationships that are currently in place under the CRS
MCAA is available online.

 

The OECD today also
released the second edition of the Common Reporting Standard Implementation
Handbook.

 

The Handbook provides
practical guidance to assist government officials and financial institutions in
the implementation of the CRS and to provide a practical overview of the CRS to
both the financial sector and the public at-large.

 

(iii)    Game
over for CRS avoidance! OECD adopts tax disclosure rules for advisors

 

09/03/2018 – Responding to
a request of the G7, today, the OECD has issued new model disclosure rules
that require lawyers, accountants, financial advisors, banks and other service
providers to inform tax authorities of any schemes they put in place for their
clients to avoid reporting under the OECD/G20 Common Reporting Standard (CRS)
or prevent the identification of the beneficial owners of entities or trusts.

As the reporting and
automatic exchange on offshore financial accounts pursuant to the CRS becomes a
reality in over 100 jurisdictions this year, many taxpayers that held
undeclared financial assets offshore have come clean to their tax authorities
in recent years, which has already led to over 85 billion of additional tax
revenue.

 

At the same time, there are
still persons that, often with the help of advisors and financial
intermediaries, continue to try hiding their offshore assets and fly under the
radar of CRS reporting. The new rules released today target these persons and
their advisers, by introducing an obligation on a wide range of intermediaries
to disclose the schemes to circumvent CRS reporting to the tax authorities. The
new rules also require the reporting of structures that hide beneficial owners
of offshore assets, companies and trusts.

 

These model disclosure
rules will be submitted to the G7 presidency and are part of a wider strategy
of the OECD to monitor and act upon tendencies in the market that try to avoid
CRS reporting and hide assets offshore. As part of this work the OECD is also
addressing cases of abuse of golden visas and similar schemes to circumvent CRS
reporting.

 

(iv) OECD releases consultation document on misuse
of residence by investment schemes to circumvent the Common Reporting Standard

 

19/02/2018 – More and more
jurisdictions are offering “residence by investment” (RBI)
or “citizenship by investment” (CBI) schemes, which
allow foreign individuals to obtain citizenship or temporary or permanent
residence rights in exchange for local investments or against a flat fee.
Individuals may be interested in these schemes for a number of legitimate
reasons, including greater mobility thanks to visa-free travel, better
education and job opportunities for children, or the right to live in a country
with political stability. At the same time, information released in the market
place and obtained through the OECD’s CRS public disclosure facility,
highlights the misuse of RBI and CBI schemes to circumvent reporting under the
Common Reporting Standard (CRS).

 

 As part of its CRS loophole strategy, the OECD
is releasing a consultation document that (1) assesses how these schemes are
used in an attempt to circumvent the CRS; (2) identifies the types of schemes
that present a high risk of abuse; (3) reminds stakeholders of the importance
of correctly applying relevant CRS due diligence procedures in order to help
prevent such abuse; and (4) explains next steps the OECD will undertake to
further address the issue, assisted by public input.

 

(v) Panama joins international tax co-operation
efforts to end bank secrecy

 

15/01/2018 – Today, at the
OECD Headquarters in Paris, the Director-General of Revenue and the delegated
Competent Authority of Panama, Publio Ricardo Cortés, has signed the CRS Multilateral Competent Authority Agreement?
(CRS MCAA), in presence of OECD Deputy Secretary-General Masamichi Kono. Panama
is the 98th jurisdiction to join the CRS MCAA, which is the prime
international agreement for implementing the automatic exchange of financial
account information under the Multilateral Convention on Mutual Administrative
Assistance. 

 

5) Convention on Mutual Administrative
Assistance in Tax Matters

 

The Convention on Mutual
Administrative Assistance in Tax Matters (“the Convention”) was
developed jointly by the OECD and the Council of Europe in 1988 and amended by
Protocol in 2010. The Convention is the most comprehensive multilateral
instrument available for all forms of tax co-operation to tackle tax evasion
and avoidance, a top priority for all countries.

 

The Convention was amended
to respond to the call of the G20 at its 2009 London Summit to align it to the
international standard on exchange of information on request and to open it to
all countries, in particular to ensure that developing countries could benefit
from the new more transparent environment. The amended Convention was opened
for signature on 1st June 2011.

 

122 jurisdictions currently
participate in the Convention, including 17 jurisdictions covered by territorial
extension*. This represents a wide range of countries including all G20
countries, all BRIICS, all OECD countries, major financial centres and an
increasing number of developing countries.

 

* In May 2018, the People’s
Republic of China extended the territorial scope of the Convention to the Hong
Kong and Macau Special Administrative Regions pursuant to Article 29. As such,
The Convention will enter into force for  
both   Hong Kong (China)   and  
Macau  (China)  on 1st September
2018.

 

6) Others

 

(i) Global Forum issues tax transparency compliance
ratings for nine jurisdictions as membership rises to 150

 

04/04/2018 – The Global
Forum on Transparency and Exchange of Information for Tax Purposes (the Global
Forum) published today nine peer review reports assessing compliance with international
standards on tax transparency.

 

Eight of these reports
assess countries against the updated standards which incorporate beneficial
ownership information of all legal entities and arrangements, in line with the
Financial Action Task Force international definition.

 

Four jurisdictions – Estonia,
France, Monaco and New Zealand – received an overall rating of “Compliant.”
Three others – The Bahamas, Belgium and Hungary were rated “Largely
Compliant.” Ghana was rated “Partially Compliant.”

 

Progress for Jamaica
were recognised through a Supplementary Report
which attributes a “Largely Compliant” rating.

 

The Global Forum now
includes 150 members on an equal footing as Montenegro has just joined the
international fight against tax evasion. Members of the Global Forum already
include all G20 and OECD countries, all international financial centres and
many developing countries.

 

The Global Forum also runs
an extensive technical assistance programme to provide support to its members
in implementing the standards and helping tax authorities to make the best use
of cross-border information sharing channels.

 

(ii) Governments should make better use of energy
taxation to address climate change

 

14/02/2018 – Taxing
Energy Use 2018 describes patterns of energy taxation in 42 OECD and G20
countries (representing approximately 80% of global energy use), by fuels and
sectors over the 2012-2015 period.

 

New data shows that energy
taxes remain poorly aligned with the negative side effects of energy use. Taxes
provide only limited incentives to reduce energy use, improve energy efficiency
and drive a shift towards less harmful forms of energy. Emissions trading
systems, which are not discussed in this publication, but are included in the
OECD’s Effective Carbon Rates, are having little impact on this broad picture.

 

Meaningful tax rate
increases have largely been limited to the road sector. Fuel tax reforms in
some large low-to-middle income economies have increased the share of emissions
taxed above climate costs from 46% in 2012 to 50% in 2015. Encouragingly, some
countries are removing lower tax rates on diesel compared to gasoline. However,
fuel tax rates remain well below the levels needed to cover non-climate
external costs in nearly all countries.

 

Coal, characterised by high
levels of harmful emissions and accounting for almost half of carbon emissions
from energy use in the 42 countries, is taxed at the lowest rates or fully
untaxed in almost all countries.

 

While
the intense debate on carbon taxation has sparked action in some countries,
actual carbon tax rates remain low. Carbon tax coverage increased from 1% to 6%
in 2015, but carbon taxes reflect climate costs for just 0.3% of emissions.
Excise taxes dominate overall tax rates by far.

 

Note:
The reader may visit the OECD website and download various reports referred to
in this article for his further studies.  

 

UAE’s Corporate Tax Law – An Update

In the earlier article published in BCAJ February, 2023, authors had provided an overview of the United Arab Emirates’ [UAE] newly introduced Corporate Tax Law [CT Law].

In this article, the authors endeavor to cover further developments in this respect of the CT Law since the issue of Federal Decree Law No. 27 of 2022 on 9th December, 2022. Since the CT Law has become effective for financial years starting on or after 1st June, 2023, these developments assume lot of significance.

A. RECENT DEVELOPMENTS RELATED TO CT LAW

The Federal Decree Law No. 27 of 2022 on Taxation of Corporations and Businesses was signed on 3rd October, 2022 and was published in Issue #737 of the Official Gazette of the UAE on 10th October, 2022. The UAE CT Law can be found at the link https://mof.gov.ae/corporate-tax/.

FAQs

The law has been supplemented with FAQs originally released on 9th December, 2022 comprising of 158 questions and answers, by the Ministry of Finance [Ministry]. The FAQs have been updated and the current Corporate Tax FAQs contain 209 questions and answers that provide guidance on the UAE CT Decree-Law. The FAQs on the CT Law can be found at the link https://mof.gov.ae/corporate-tax-faq/.

‘EXPLANATORY GUIDE’ ON CT LAW

The UAE’s Ministry has on 11th May, 2023 issued the ‘Explanatory Guide on Federal Decree-Law No. 47 of 2022 on the ‘Taxation of Corporations and Businesses’.The CT Law provides the legislative basis for imposing a federal tax on corporations and business profits in the UAE. It comprises of 20 Chapters and 70 Articles, covering, inter alia, the scope of Corporate Tax, its application, rules pertaining to compliance and the administration of the Corporate Tax regime etc.

The Explanatory Guide has been prepared by the Ministry, and provides an explanation of the meaning and intended effect of each Article of the CT Law. It may be used in interpreting the CT Law and how particular provisions of the CT Law may need to be applied.

The Explanatory Guide has to be read in conjunction with the CT Law and the relevant decisions issued by the Cabinet, the Ministry and the Federal Tax Authority [FTA] (The information on the Corporate Tax topics can be found at the link https://tax.gov.ae/en/taxes/corporate.tax/corporate.tax.topics.aspx) for the implementation of certain provisions of the CT Law. It is not, and is not meant to be, a comprehensive description of the CT Law and its implementing decisions. The Explanatory Guide on the CT Law can be found at the link https://mof.gov.ae/explanatory-guide-for-federal-decree-law/.

CABINET DECISIONS

The CT Law in 18 of the total 70 articles, contains enabling powers to prescribe various conditions, determine persons, list entities, prescribe relevant dates, etc. in a decision issued by the Cabinet at the suggestion of the Minister.Accordingly, the following Cabinet decisions for the purposes of Federal Decree-Law No. 47 of 2022 on the Taxation of Corporations and Businesses have been issued by the Prime Minister of the UAE:

Sr. No. Cabinet Decision No. Cabinet Decision regarding Issued on Relevant Article of CT Law
1. 37 of 2023 Regarding the Qualifying Public Benefit Entities 7th April,2023 Article 9 – Qualifying Public Benefit Entity
2. 49 of 2023 On Specifying the Categories of Businesses or Business Activities Conducted by a Resident or Non-Resident Natural Person subject to Corporate Tax 8th May, 2023 Article 11 – Taxable Person
3. 55 of 2023 Determining Qualifying Income for the Qualifying Free Zone Person 30th May, 2023 Article 18 – Qualifying Free Zone Person
4. 56 of 2023 Determination of a Non-Resident Person’s Nexus in the State 30th May, 2023 Article 11 – Taxable Person

The Cabinet Decisions contain a Standard Article ‘Implementing Decisions’ which provides that ‘The Minister shall issue the necessary decisions to implement the provisions of this Decision.’ Accordingly, necessary Ministerial Decisions are issued for implementation of the Cabinet Decisions, in addition to other Ministerial decisions prescribing, determining, specifying, etc under various articles of the CT Law.

MINISTERIAL DECISIONS

The Office of the Minister, Ministry of Finance of the UAE, for the purposes of Federal Decree-Law No. 47 of 2022 on the Taxation of Corporations and Businesses, has issued the undermentioned Ministerial Decisions:

Sr. No. Ministerial Decision No. Ministerial Decision regarding Issued on
1. 43 of 2023 Concerning Exception from Tax Registration 10th March, 2023
2. 68 of 2023 On the treatment of all businesses and business activities of a government entity as a single taxable person 29th March, 2023
3. 73 of 2023 Small Business Relief 03rd April, 2023
4. 82 of 2023 On the Determination of Categories of Taxable Persons required to prepare and maintain audited Financial Statements 10th April, 2023
5. 83 of 2023 On the Determination of the Conditions under which the presence of a Natural Person 10th April, 2023
in the state would not create a PE for a Non-Resident Person
6. 97 of 2023 On requirements for maintaining TP Documentation 27th April, 2023
7. 105 of 2023 On the Determination of the Conditions under which a person continue to be deemed as an Exempt Person  4th May, 2023
8. 114 of 2023 On Accounting Standards and Methods 9th May, 2023
9. 115 of 2023 On Private Pension Funds and Private Social Security Funds 10th May, 2023
10. 116 of 2023 On Participation Exemption 10th May, 2023
11. 120 of 2023 On the adjustments under the transitional rules 16th May, 2023
12. 125 of 2023 On tax group 22th May, 2023
13. 126 of 2023 On the general interest deduction limitation rule 23rd May, 2023
14. 127 of 2023 On unincorporated partnership foreign partnership and family foundation 24th May, 2023
15. 132 of 2023 On transfers within a qualifying group for corporate tax purposes 25th May, 2023
16. 133 of 2023 On business restructuring relief for corporate tax purposes 25th May, 2023
17. 134 of 2023 On the general rules for determining taxable income for corporate tax purposes 29th May, 2023
18. 139 of 2023 Regarding qualifying activities and excluded activities 1st June, 2023

The Cabinet and Ministerial Decisions on the CT Law can be found at the link https://mof.gov.ae/tax-legislation/.

B. FREE ZONE CORPORATE TAX REGIME [FZCT REGIME]

In this Article, we have analysed and focused on the Cabinet Decision No. 55 of 2023 on ‘Determining Qualifying Income’ and on 1st June, 2023 issued Ministerial Decision No. 139 of 2023 on ‘Qualifying Activities and Excluded Activities’ related to FZCT Regime.The FZCT Regime is a form of UAE Corporate Tax relief which enables Free Zone companies and branches that meet certain conditions to benefit from a preferential 0 per cent Corporate Tax rate on income from qualifying activities and transactions.

Free zones are an integral part of the UAE economy that continue to play a critical role in driving economic growth and transformation both in the UAE and internationally. In recognition of their continued importance and the tax-related commitments that were made at the time the Free Zones were established, Free Zone companies and branches that meet certain conditions can continue to benefit from 0% corporate taxation on income from qualifying activities and transactions.

Natural persons, unincorporated partnerships and sole establishments cannot benefit from the FZCT Regime. Only juridical persons can benefit from the FZCT Regime. This includes any public or private joint stock company, a limited liability company, limited liability partnership and other types of incorporated entities that are established under the rules and regulations of the Free Zone. A branch of a foreign or domestic juridical person that is registered in a Free Zone would also be considered a Free Zone Person [FZP].

A foreign company can become a FZP by transferring its place of incorporation to a UAE Free Zone and continue to exist as an entity incorporated or established in a Free Zone.

The FZCT Regime does not impose any limitations or restrictions with regards to who can establish or own a FZP.

The FZCT Regime does not restrict or prohibit a Qualifying Free Zone Person [QFZP] from operating outside of a Free Zone either in the mainland UAE or in a foreign jurisdiction. However, the income attributable to a domestic or foreign branch or Permanent Establishment [PE] of the QFZP, outside the Free Zone, will be subject to the regular UAE Corporate Tax rate of 9 per cent.

In the case of a foreign PE, the QFZP can claim relief from any double taxation suffered under the Corporate Tax Law or the applicable double tax treaty.

FREE ZONE PERSON

Chapter 5 of the CT Law comprising of Articles 18 and 19 contains relevant provisions relating to FZP.A FZP is a legal entity incorporated or established under the rules and regulations of a Free Zone, or a branch of a mainland UAE or foreign legal entity registered in a Free Zone. A foreign company that transfers its place of incorporation to a Free Zone in the UAE would also be considered a FZP.

The FZCT Regime is available only to FZPs, and this term is also used to determine what income can benefit from the regime by treating income from transactions with other FZPs as Qualifying Income.

QUALIFYING FREE ZONE PERSON [QFZP]

Article 18(1) of the CT Law provides that a QFZP is a FZP that meets all the five conditions mentioned therein i.e.
a) maintains adequate substance in a Free Zone;
b) derives Qualifying Income;
c) has not made an election to be subject to the regular UAE Corporate Tax regime;
d) comply with arm’s length principle and transfer pricing rules and documentation requirements;
e) Prepare and maintain audited financial statements.

Failure to meet any of the conditions results in a QFZP losing its qualifying status and not being able to benefit from the FZCT Regime for five (5) Tax Periods.

On 30th May, 2023, the UAE Ministry of Finance issued Cabinet Decision No. 55 of 2023 on ‘Determining Qualifying Income’ and on 1st June, 2023 issued Ministerial Decision No. 139 of 2023 on ‘Qualifying Activities and Excluded Activities’. These two decisions seek to clarify the application of the UAE corporate tax framework to UAE Free Zone businesses, and whether a taxable person qualifies to be treated as a QFZP under Article 18 of the UAE CT law.

Where a taxpayer is classified as a QFZP, Article 3(2) of the UAE CT law states that the QFZP would be subject to tax at 0 per cent on its Qualifying Income, and at a 9 per cent rate on non-Qualifying Income that it receives.

The FZCT Regime apply automatically. A QFZP that continues to meet all relevant conditions will automatically benefit from the FZCT Regime. There is no need to make an election or submit an application to the FTA.

A QFZP that does not want to benefit from the FZCT Regime can elect to apply the standard UAE Corporate Tax regime instead.

A QFZP will need to maintain documents to evidence compliance with the conditions of the FZCT Regime. In addition to maintaining audited financial statements and adequate transfer pricing documentation, a QFZP will need to maintain all relevant documents and records to evidence its compliance with the conditions to be considered a QFZP. This includes documentation in relation to the substance maintained in a Free Zone and the types of activities performed and income earned.

A QFZP is responsible for ensuring that it continues to meet all the conditions to benefit from the FZCT Regime and for filing its Corporate Tax return on this basis.

The FTA is responsible for the administration and enforcement of UAE Corporate Tax. In this capacity, the FTA can verify and make a final determination of whether a QFZP has complied with all the conditions of the FZCT Regime.

QUALIFYING INCOME

Article (3)(1) of the Cabinet Decision 55 provides that for the purposes of application of Article 18 of the CT law, ‘Qualifying Income’ of the QFZP shall include income derived from transactions with:

1. Other FZPs (except income derived from Excluded Activities);
2. A Non-Free Zone person, only in respect of ‘Qualifying activities’ that are NOT Excluded Activities;
3. Any other income (i.e. income from Excluded Activities) provided that it is below the de minimis threshold.
However, such qualifying income should not be attributable to a Domestic PE or a Foreign PE or to the ownership or exploitation of immovable property in accordance with the Article (5) and (6), respectively, of the Cabinet Decision 55.

INCOME DERIVED FROM TRANSACTIONS WITH OTHER FZPS

Income will be considered as derived from transactions with a FZP where that FZP is the ‘Beneficial Recipient’ i.e. a person who has the right to use and enjoy the service or the goods and does not have a contractual or legal obligation to pass such service or goods to another person.

QUALIFYING ACTIVITIES

Article (2)(1) of the Ministerial Decision 139 states that the following activities conducted by a QFZP shall be considered as Qualifying Activities:
(a) Manufacturing of goods or materials.
(b) Processing of goods or materials.
(c) Holding of shares and other securities.
(d) Ownership, management and operation of Ships.
(e) Reinsurance services that are subject to the regulatory oversight of the competent authority in the State.
(f) Fund management services that are subject to the regulatory oversight of the competent authority in the State.
(g) Wealth and investment management services that are subject to the regulatory oversight of the competent authority in the State.
(h) Headquarter services to Related Parties.
(i) Treasury and financing services to Related Parties.
(j) Financing and leasing of Aircraft, including engines and rotable components.
(k)Distribution of goods or materials in or from a Designated Zone to a customer that resells such goods or materials, or parts thereof or processes or alters such goods or materials or parts thereof for the purposes of sale or resale.
(l) Logistics services.
(m) Any activities that are ancillary to the activities listed in paragraphs (a) to (l) of this Clause.

EXCLUDED ACTIVITIES

Excluded Activities are defined in Article (3)(1) of the Ministerial Decision 139 which states that the following activities shall be considered as Excluded Activities:

(a) Any transactions with natural persons, except transactions in relation to the Qualifying Activities specified under paragraphs (d), (f), (g) and (j) of Clause (1) of Article (2) of the Decision.
(b) Banking activities subject to the regulatory oversight of the competent authority in the State.
(c) Insurance activities subject to the regulatory oversight of the competent authority in the State, other than the activity specified under paragraph (e) of Clause (1) of Article (2) of the Decision.
(d) Finance and leasing activities subject to the regulatory oversight of the competent authority in the State, other than those specified under paragraphs (i) and (j) of Clause (1) of Article (2) of the Decision.
(e) Ownership or exploitation of immovable property, other than Commercial Property located in a Free Zone where the transaction in respect of such Commercial Property is conducted with other FZPs.
(f) Ownership or exploitation of intellectual property assets.
(g) Any activities that are ancillary to the activities listed in paragraphs (a) to (f) above.

An activity shall be considered ancillary where it serves no independent function but is necessary for the performance of the main Excluded Activity.

The activities referenced in Clause (1) of the Article shall have the meaning provided under the respective laws regulating these activities.

Where income falls within Excluded Activities this will not be treated as Qualifying Income (irrespective of where this income is derived from).

DE MINIMIS THRESHOLD

Article (4) of the Ministerial Decision 139, contains provisions related to De Minimis Requirements.A QFZP can earn Non-qualifying income from (i) Excluded Activities or (ii) activities that are non-Qualifying Activities where the other party is a Non-Free Zone Person, provided that this does not exceed the De Minimis threshold, being the lower of either (i) 5 per cent of total revenue of the QFZP in the tax period or (ii) United Arab Emirates Dirham [AED] 5 million.

Certain revenue shall not be included in the calculation of non-qualifying Revenue and total Revenue. This includes revenue attributable to certain immovable property located in a Free Zone (non-commercial property, and commercial property where transactions are with Non-Free Zone Persons). It also includes revenue attributable to a Domestic PE (e.g., a UAE mainland branch) or a Foreign PE.

OTHER CONDITIONS

Where the De Minimis threshold is breached or the QFZP does not satisfy the eligibility conditions of Article 18 of the UAE CT law or any other conditions prescribed, then the FZP shall cease to be a QFZP for the current tax period and then the subsequent four (4) tax periods i.e. they will be treated as a Taxable Person subject to 9 per cent CT rate for a minimum of five years.The implication of the FZP ceasing to be a QFZP is that all of the Taxable Income of the FZP would be subject to 9 per cent (on the Taxable Income that exceeds AED 375,000).

DOMESTIC PE

The Decisions introduce the concept of a Domestic PE where a QFZP has a place of business or other form of presence outside the Free Zone in the State.Income attributable to a Domestic PE should be calculated as if the establishment was a separate and independent person and shall be subject to CT at 9 per cent. However, it will not disqualify the FZP from benefitting from a 0 per cent CT rate on Qualifying Income, or be factored into the de minimis test (as above).

For the purposes of determining whether a QFZP has a Domestic PE, the normal PE rules of Article 14 of the CT Law shall apply. A mainland branch of a QFZP will therefore generally constitute a Domestic PE and be subject to CT at 9 per cent.

REQUIREMENT TO MAINTAIN ADEQUATE SUBSTANCE

Article 18(1)(a) of the UAE CT law requires that, in order to be treated as a QFZP, the FZP has to have adequate substance in the UAE.

Article (7) of Cabinet Decision No. 55 provides that a QFZP is required to undertake its core income-generating activities in a Free Zone and having regard to the level of activities carried out, have adequate assets and an adequate number of qualifying employees, and incur an adequate amount of operating expenditures.

It is possible for this substance requirement to be outsourced to a related party in a Free Zone or a third party in a Free Zone, provided that there is adequate supervision of the outsourced activity by the QFZP. Therefore, it would not be possible for these activities to be outsourced to a UAE mainland party.

The FZCT Regime does not prescribe any minimum investment, job creation or business expansion requirements. However, a QFZP must have adequate staff and assets and incur adequate operating expenditure in a Free Zone relative to the Qualifying Income it earns.

This requirement is in line with the existing UAE economic substance regulations.

AUDITED FINANCIAL STATEMENTS

Article (5)(1)(b) of Ministerial Decision No. 139 confirms the requirement that if a FZP is seeking to be treated as a QFZP it is required to prepare audited financial statements for the tax year in accordance with any decision issued by the Minister on the requirements to prepare and maintain audited financial statements for the purposes of the CT law.Article 54(2) of the CT Law dealing with Financial Statements provides that the Minister may issue a decision requiring categories of taxable persons to prepare and maintain audited or certified financial statements.

Ministerial Decision No. 82 of 2023 on the Determination of Categories of Taxable Persons required to prepare and maintain audited Financial Statements, provides that the following categories of taxable persons shall prepare and maintain audited Financial Statements:
A Taxable Person deriving Revenue exceeding AED 50,000,000 (fifty million United Arab Emirates dirhams) during the relevant Tax Period.
1. A Qualifying Free Zone Person.
2. Thus, each QFZP is to prepare and maintain audited Financial Statements.

CONCLUSION

The release of Cabinet Decision No. 55 on Determining Qualifying Income and Ministerial Decision No. 139 on Qualifying Activities and Excluded Activities provide some clarity on the nature of a Free Zone Person’s income that will be taxed at 0 per cent, as well as the income that would disqualify the FZP (completely) from claiming the 0 per cent tax rate.The released Decisions present a huge shift in understanding of the Free Zone regime within the UAE CT framework. Notably, the introduction of a de minimis threshold will have an impact on Free Zone entities as they could be fully taxable under the new rules.

The definition of ‘Qualifying Activity’ captures a large number of domestic business activities and the provision of services to entities that are located outside of a Free Zone, as well as preserves a beneficial tax regime for the UAE headquarters functions (with headquarters and treasury services falling within the definition).

For Free Zone entities that earn income from individuals (such as earnings from e-commerce sales to individuals, retail businesses, restaurants, hotels, and to an extent professional service/consultancy firms) and UAE businesses that hold or exploit intellectual property (e.g., royalty and license fees from copyrights, trademarks), these income streams are included in the definition of ‘Excluded Activity’ income. This will result in the businesses needing to assess if this income falls within the De Minimis exclusion (being the lower of (i) 5per cent of total revenue or (ii) AED 5 million).

The regulations suggest that if the level of the Excluded Activity income falls outside the De Minimis threshold, then the entity affected would not be eligible to be treated as a QFZP and all of its income would be subject to tax at 9 per cent (under the UAE mainland tax regime). Furthermore, such a business would also be excluded from seeking to be treated as QFZP (i.e., claiming the 0 per cent rate) for the following four (4) tax periods.

It is, therefore, critical that a FZP assesses whether and the extent to which their income streams can be viewed as Qualifying Activity income (i.e., including if their Excluded Activity income falls within the De Minimis exclusion).

Free Zone businesses should ensure that they satisfy all of the requirements of Article 18 of the UAE CT law (which also includes the preparation of audited financial statements) to ensure that they continue to satisfy the conditions to be viewed as a QFZP.

With the release of these Cabinet and Ministerial decisions, and with UAE CT law now effective (accounting periods starting on or after 1 June 2023), businesses that are yet to assess the impact of UAE CT should commence this assessment, at the earliest. With the clarity now available on CT law for Free Zone, time is of essence for Companies to assess their readiness to register and comply with the new regime.

Select Practical Issues in Certification of Taxability of Foreign Remittances in Form 15CB – Part 1

BACKGROUND

The certification of taxability of foreign remittances in Form 15CB remains one of the most practiced areas in international taxation for a Chartered Accountant (‘CA’) in India. While the entire gamut of tax treaties and interplay with domestic tax provisions would apply while analysing the taxability of foreign remittances, there are various practical issues a CA faces while issuing Form 15CB. While it is impossible to cover all such practical issues, the authors, through this article, divided into multiple parts, seek to cover some issues that one comes across, and possible practical solutions for such issues. At the outset, it may be highlighted that as in the case of legal issues, multiple views and solutions may be possible on a particular issue.

With the increase in the rate of tax for royalty and FTS, the claim for treaty benefit becomes a far more crucial issue. In the first part of the article, the authors seek to cover some of the issues related to the tax residency certificate and the issue of Form 10F.

ISSUES RELATING TO TAX RESIDENCY CERTIFICATE (‘TRC’)

Issue 1: Whether TRC is mandatory?

Section 90(4) of the Income Tax Act, 1961 provides that the benefit of a Double Taxation Avoidance Agreement (‘DTAA’) shall be available to a non-resident only in case such non-resident obtains a TRC from the tax authorities of the relevant country in which such person is a resident.

While the provision seeks to deny benefits of a DTAA to a non-resident who does not provide a valid TRC, the Ahmedabad Tribunal, in the case of Skaps Industries India (P) Ltd vs. ITO [2018] 94 taxmann.com 448, held as follows,

“9. Whatever may have been the intention of the lawmakers and whatever the words employed in Section 90(4) may prima facie suggest, the ground reality is that as the things stand now, this provision cannot be construed as a limitation to the superiority of treaty over the domestic law. It can only be pressed into service as a provision beneficial to the assessee. The manner in which it can be construed as a beneficial provision to the assessee is that once this provision is complied with in the sense that the assessee furnishes the tax residency certificate in the prescribed format, the Assessing Officer is denuded of the powers to requisition further details in support of the claim of the assessee for the related treaty benefits. …..

10….. Our research did not indicate any judicial precedent which has approved the interpretation in the manner sought to be canvassed before us i.e. Section 90(4) being treated as a limitation to the treaty superiority contemplated under section 90(2), and that issue is an open issue as of now. In the light of this position, and in the light of our foregoing analysis which leads us to the conclusion that Section 90(4), in the absence of a non-obstante clause, cannot be read as a limitation to the treaty superiority under Section 90(2), we are of the considered view that an eligible assesse cannot be declined the treaty protection under section 90(2) on the ground that the said assessee has not been able to furnish a Tax Residency Certificate in the prescribed form.”

Therefore, the ITAT held that section 90(4) of the ITA does not override the DTAA. In a recent decision, the Hyderabad Tribunal in the case of Sreenivasa Reddy Cheemalamarri vs. ITO [2020] TS-158-ITAT-2020 has also followed the ruling of the Ahmedabad Tribunal of Skaps (supra). Similar view has also been taken by the Hyderabad ITAT in the cases of Vamsee Krishna Kundurthi vs. ITO (2021) 190 ITD 68 and Ranjit Kumar Vuppu vs. ITO (2021) 190 ITD 455.

However, it is also important to highlight that in the absence of a TRC, the onus is on the recipient taxpayer to substantiate that the said taxpayer is a resident of a particular country. Therefore, if the taxpayer can substantiate, through any other document, the eligibility to claim the benefit under the DTAA, the said benefit should be granted. An example of the document to be provided would be the certificate of incorporation wherein the domestic law of the particular country treats companies incorporated in that jurisdiction to be tax residents of that jurisdiction such as Germany, UK, etc. Similarly, in the case of individuals, one may consider the number of days one has stayed in a particular jurisdiction if the test of residence of that jurisdiction is the number of days stay in that jurisdiction.

However, the deductor, who is required to evaluate the eligibility of the recipient for treaty benefit, would need to exercise caution while considering a document other than the TRC as proof of tax residency as the ITA places an onerous responsibility, of withholding the tax due from the non-resident recipient, on the payer.

Further, it is also important to highlight that in Form 15CB, one is required to clearly state as to whether TRC is available. Given the fact that a CA is certifying the taxability of the foreign remittance and in the absence of any provision in the form to provide an explanation, in the view of the authors, the CA would clearly need to state whether TRC is available or not and in the absence of a TRC, one will need to select ‘No’ in the said form.

Issue 2: Is the TRC sufficient to claim the benefits of the DTAA?

Having analysed whether TRC is mandatory to avail the benefits of the DTAA, the next issue which needs to be addressed is whether TRC is sufficient to avail the benefits of the DTAA. In other words, can the beneficial provisions of the DTAA be availed only on the basis of the DTAA. In the context of the India – Mauritius DTAA, there are various judicial precedents which have followed the CBDT Circular No. 789 of 2000 which provides that a TRC issued by the Mauritius tax authorities will constitute sufficient evidence for accepting the status of residence as well as beneficial ownership or to avail the exemption of tax on capital gains.

However, in today’s post-BEPS world, it is extremely important to satisfy the economic substance in claiming the benefits of a DTAA. Further, there is also a school of thought that such requirement to satisfy substance over form through conditions such as the Principal Purpose test (‘PPT’) could also apply even where such DTAA is not modified by the Multilateral Instrument (‘MLI’). This school of thought has been followed in a number of judicial precedents wherein the courts have sought to apply the substance over form approach even prior to the implementation of the MLI or the General Anti-Avoidance Rules (‘GAAR’).

Therefore, in such a scenario, in the view of the authors, while TRC, which merely provides that the said taxpayer is a tax resident of the said country, is mandatory, it may not be sufficient on its own to justify claim of beneficial provisions of a DTAA. In other words, one would need to satisfy the other tests such as beneficial ownership test, PPT, GAAR, Limitation of Benefit test, as may be applicable, to justify the claim of the benefit of the DTAA. However, it is also important to note that as a payer or as a CA issuing Form 15CB, one may not have sufficient information to evaluate the application of the above anti-avoidance measures. Therefore, one should consider obtaining an appropriate declaration from the recipient after having reasonable care and undertaken analysis on the basis of the facts available. One may also refer to an article by the authors in the February 2021 edition of this Journal wherein the issue of application of subjective measures such as PPT test to section 195 of the ITA have been discussed in detail.

Issue 3: Period covered under TRC

Generally, the TRC provides a specific period for which it is applicable. While the TRC of some jurisdictions provide the period for which the taxpayer may be considered as a resident of that jurisdiction, some provide the residential status as on a particular date. While India follows April to March as the financial year, most countries follow the calendar year as the tax year and therefore, the question arises is which period should the TRC cover.

Section 90(2) of the ITA enables the taxpayer to choose between the provisions of the DTAA and the ITA, whichever is more beneficial. Further, section 90(4) of the ITA provides that a non-resident is not entitled to claim the benefit of the DTAA unless TRC has been obtained.

Similarly, section 195 of the ITA provides that tax has to be deducted at source at the rates in force at the time of payment or credit, whichever is earlier. Therefore, on a combined reading of the above sections, one can reasonably conclude that the TRC should cover the period when one is applying the  beneficial provisions of a DTAA i.e. at the time when tax has to be deducted at source on the particular transaction.

This is important as the requirement for furnishing the certificate in Form 15CB under section 195(6) of the ITA is only at the time of payment.

Let us take an example of payment of consultancy fees to a French company for consultancy services rendered in the month of September 2022 where the invoice is provided in the month of October 2022, expense is booked in the same month and the payment for such fees is made in the month of February 2023. As France follows the calendar year for tax purposes, the TRC required would be of 2022, even though the Form 15CB would be issued in February 2023 at the time of payment.

Now, the next question which arises is how one should deal with a situation where the TRC is of an earlier period and the TRC of the relevant period is not available with the vendor or the vendor has applied for the TRC and is awaiting the same. This could typically be in situations where the tax deduction is made in the beginning of the calendar year where most taxpayers would be in the process of applying for the TRC for that year with their tax authorities and hence, the latest TRC may not be available.

In such a situation, so long as one is able to justify the tax residency by way of any other document, the payer can consider providing the benefit of the DTAA to the recipient following the decisions of the Ahmedabad and Hyderabad ITAT mentioned above.

However, similar to the above situation, as a CA who is certifying the taxability in Form 15CB, it is important that the correct TRC is obtained before the issue of the certificate as one is required to state whether TRC has been obtained and in the context of the form, the TRC would need to be the one which is corresponding to the date of deduction of TDS. If the applicable TRC is not available, it may be advisable for the CA to certify that ‘No’ TRC is available and deny treaty benefits or alternatively it may be advisable to obtain a lower withholding certificate from the tax authorities under section 197 or section 195 of the ITA.

ISSUES RELATING TO FORM 10F

Issue 4: Interplay of requirement of TRC and Form 10F

Section 90(5) of the ITA read with Rule 21AB of the Income Tax Rules, 1962 (‘Rules’) provide that the taxpayer who wishes to apply the beneficial provisions of the DTAA shall also submit a self-declaration in Form 10F in case the TRC obtained from the tax authorities of the country of residence does not contain all the necessary information required. Namely, the legal status of the taxpayer, the nationality or country of incorporation / registration, the unique tax identification number in the country of residence, the period for which the TRC is applicable and the address of the taxpayer.

Generally, the TRC issued by most countries contains most of the information such as unique tax identification number, period for which the TRC is applicable and the address of the taxpayer. Further, the TRC issued by a few countries such as the Netherlands, Germany, Mauritius, etc. contain all the information as required in Rule 21AB. Therefore, the need for obtaining a Form 10F in the case of taxpayers who are residents of such countries does not arise.

It is important to highlight that Form 10F is to be used to supplement the TRC by providing information in addition to that provided in the TRC, and it is not to be used as a replacement for the TRC itself. In other words, Form 10F without the TRC has no value. On the other hand, beneficial provisions of a DTAA can be applied even in the absence of a Form 10F if the TRC contains all the necessary information (such as the case with the countries mentioned above).

Further, in the view of the authors, even if the TRC does not contain all the required information, benefits of the DTAA may still be availed even in the absence of Form 10F if one can substantiate on the basis of any other documents, the said information. However, such a situation may be more from a theoretical perspective than a practical one, as Form 10F is a self-declaration from the taxpayer.

Issue 5: Requirement of furnishing Form 10F online

Prior to July 2022, Form 10F, being a self-declaration, was to be issued physically. However, CBDT vide Notification No. 3/2022 dated 16th July, 2022 mandated online furnishing of the said form. This issue has been dealt with in detail in the September 2022 edition of this Journal and therefore, not being discussed here.

Subsequently, in December 2022, the CBDT exempted the mandatory online furnishing of Form 10F to 31st March, 2023. Now, the said exemption has been extended till 30th September 2023 vide Notification No. F. No. DGIT(S)-ADG(S)-3/e-Filing Notification/ Forms/2023/13420 dated 28th March, 2023.

However, it is important to note that this relaxation only applies to those taxpayers who do not have a PAN and are not required to obtain PAN. Section 139A of the ITA mandates every person having income in excess of maximum amount not chargeable to tax, to obtain a PAN in India. Therefore, the Notification above only exempts those non-residents from mandatory furnishing Form 10F online, who do not have income in excess of maximum amount not chargeable to tax.

In order to understand the impact of the above Notification and the situations wherein the exemption applies, one can consider the following scenarios:

a.    Scenario A – Income taxable under the Act and taxable under the DTAA at the same rate of tax i.e. no benefit available in the DTAA – such as capital gains on sale of shares in the case of India – US DTAA .In this situation, as there is no treaty benefit availed, the question of furnishing Form 10F itself does not arise.

b.    Scenario B – Income not taxable under the ITA itself. In this situation as well, in the absence of any treaty benefit availed, Form 10F need not be furnished.

c.    Scenario C – Income taxable under the ITA but exempt under the DTAA – such as fees for technical services rendered by a resident of the US and which do not make available technical know-how, skill, experience, etc. In this situation, due to the exemption under the DTAA, the income of the taxpayer does not exceed the maximum amount not chargeable to tax and therefore, the taxpayer is not required to obtain PAN. Here, one would be able to apply the exemption as provided in the Notification and need not furnish Form 10F online till 30th September, 2023. However, one may also need to consider the recent amendment vide Finance Act 2020, wherein a non-resident earning certain income such as dividend, interest, royalty or FTS, is exempt from filing the return of income only if tax has been deducted at the rates prescribed in section 115A of the ITA.

d.    Scenario D – Income taxable under the ITA as well as the DTAA with a lower rate of tax under the DTAA – such as dividends in most DTAAs have a rate of tax lower than the 20% under section 115A of the ITA. In this situation, while the DTAA benefit is claimed, the taxpayer is still liable to tax (albeit at a lower rate of tax) in India and therefore, if the income exceeds the maximum amount not chargeable to tax, the exemption in the said Notification may not apply and one may need to furnish Form 10F online only.

Issue 6: Whether Form 10F is required in case of no PAN

As discussed above, Form 10F supplements the TRC by providing additional information. However, TRC is used not only for availing benefits under the DTAA but is also one of the prescribed documents/ information required to be furnished by a non-resident who is taxable in India; and does not have a PAN under section 206AA of the ITA read with Rule 37BC of the Rules. With the increase in the tax rate for royalty and FTS, there could be limited situations wherein the provisions of section 206AA would apply in the case of payments to non-residents or foreign companies.

Nevertheless, the question arises is whether Form 10F is required to be obtained for satisfying the conditions as provided in Rule 37BC, in case the TRC obtained does not contain all the necessary information. In this regard, as highlighted earlier, the genesis for furnishing Form 10F arises from section 90(5) of the ITA and therefore, its application should only be limited to claim the benefits of the DTAA and not to the provisions of section 206AA of the ITA. In other words, if the TRC does not contain all the necessary information, one may still provide the balance information as required in Rule 37BC and in such a situation, the higher tax rate under section 206AA should not apply even if Form 10F is not furnished, while Form 10F may be required to obtain the treaty benefits, if any.

CONCLUSION

Section 161 r.w.s 163 of the ITA places an onerous responsibility on the payer for recovery of the taxes due from a non-resident recipient. It means, taxes can be recovered from a payer if the payee fails to discharge his obligation. This is in addition to the disallowance of expenses for non-deduction of tax at source. Further, section 271J of the ITA also provides for a penalty on a CA in respect of any incorrect information provided in any certificate including in Form 15CB. On the one hand, the complexities in the international tax world are increasing. On the other hand, one sees a significant increase in litigation in India on international tax issues. Therefore, it is extremely important for a CA to remain updated and to independently analyse the taxability of the foreign remittances before issuing Form 15CB. In the subsequent part of the article, the authors shall cover various practical issues which arise while issuing Form 15CB such as multiple dates of deduction of tax at source, the role and responsibility of CA in issuing Form 15CB, precautions to be taken, etc.

Overview of the United Arab Emirates’s Corporate Tax Law

In a recent important development on the international tax front, United Arab Emirates (“UAE”) has issued its Decree-Law introducing taxation of Corporations and Businesses on their income.

In this article the authors endeavour to make the readers aware of the salient features and provide an overview of the UAE’s new Corporate Tax (“CT”) law. It is expected that further information and guidance on the technical details and other specifics of the UAE’s CT Regime will be made available in due course by the Federal Tax Authority (“FTA”) and Ministry of Finance (“MoF”) of the UAE. Accordingly, the authors have not touched upon the areas which are yet to be clarified.

INTRODUCTION

The UAE has been one of the few countries in the world with no taxes on income for most of the taxpayers, with the exception of a few industries. However, keeping the changing international tax landscape of global minimum tax in mind, the UAE has sought to introduce income tax on Corporations and Businesses. The MoF of UAE had issued a Public Consultation Document 28th April, 2022 seeking comments by 19th May, 2022.

Following the comments received, the Federal Decree-Law No. 47 of 2022 on the Taxation of Corporations and Businesses (“CT Law” or “CT Decree-Law”) was issued by the UAE on 9th December, 2022. The CT Law is materially aligned with the Public Consultation Document and expands on many of the key provisions.

The CT Law provides the legislative basis for the introduction and implementation of a Federal Corporate Tax in the UAE. CT is a form of direct tax levied on the net income of corporations and other businesses. The CT Law was published in the Official Gazette on 10th October, 2022 and became effective on 25th October, 2022 and will apply to Taxable Persons for financial years commencing on or after 1st June, 2023.

The law has been supplemented with CT FAQs comprising of 158 questions and answers, also released on 9th December, 2022 to provide guidance on the UAE CT Decree-Law. The reader is advised to refer to the same for a detailed study and understanding.

The UAE CT regime appears to build from best practices globally and incorporates principles internationally known and accepted, with a minimal compliance burden placed on businesses as compared to other regimes internationally, to ensure efficiency, fairness, transparency and predictability in the design and execution of the proposed CT regime.

On 16th May, 2018, the UAE became the 116th jurisdiction to join the Inclusive Framework on Base Erosion and Profit Shifting (“BEPS”). The CT Law lays the foundation for the UAE to align with the global minimum tax initiative as proposed under Pillar Two of the OECD BEPS project. The introduction of a CT regime helps provide the UAE with a framework to adopt the Pillar Two rules.

OVERVIEW OF THE UAE CT LAW

The CT Law has 20 chapters and 70 articles covering a wide range of areas and provisions. A brief outline of the same is given for a better understanding of the overall contents of the Law.

Chapter Articles
One –
General provisions		 Article 1 – Definitions
Two –
Imposition of Corporate Tax and Applicable Rates		 Article 2 – Imposition of Corporate Tax

Article 3 – Corporate Tax Rate
Three –
Exempt Person		 Article 4 – Exempt Person

Article 5 – Government Entity

Article 6 – Government Controlled Entity

Article 7 – Extractive Business

Article 8 – Non-Extractive Natural Resource Business

Article 9 – Qualifying Public Benefit Entity

Article 10 – Qualifying Investment Fund
Four –
Taxable Person and Corporate Tax Base		 Article 11 – Taxable Person

Article 12 – Corporate Tax Base

Article 13 – State Sourced Income

Article 14 – Permanent Establishment

Article 15 – Investment Manager Exemption

Article 16 – Partners in an Unincorporated Partnership

Article 17 – Family Foundation
Five –
Free Zone Person		 Article 18 – Qualifying Free Zone Person

Article 19 – Election to be Subject to Corporate Tax
Six –
Calculating Taxable Income		 Article 20 – General Rules for Determining Taxable Income

Article 21 – Small Business Relief
Seven –
Exempt Income		 Article 22 – Exempt Income

Article 23 – Participation Exemption

Article 24 – Foreign Permanent Establishment Exemption

Article 25 – Non-Resident Person Operating Aircraft or Ships in
International Transportation
Eight –
Reliefs		 Article 26 – Transfers Within a Qualifying Group

Article 27 – Business Restructuring Relief
Nine –
Deductions		 Article 28 – Deductible Expenditure

Article 29 – Interest Expenditure

Article 30 – General Interest Deduction Limitation Rule

Article 31 – Specific Interest Deduction Limitation Rule

Article 32 – Entertainment Expenditure

Article 33 – Non-deductible Expenditure
Ten –
Transactions with Related Parties and Connected Persons		 Article 34 – Arm’s Length Principle

Article 35 – Related Parties and Control

Article 36 – Payments to Connected Persons
Eleven –
Tax Loss Provisions		 Article 37 – Tax Loss Relief

Article 38 – Transfer of Tax Loss

Article 39 – Limitation on Tax Losses Carried Forward
Twelve –
Tax Group Provisions		 Article 40 – Tax Group

Article 41 – Date of Formation and Cessation of a Tax Group

Article 42 – Taxable Income of a Tax Group
Thirteen
– Calculation of Corporate Tax Payable		 Article 43 – Currency

Article 44 – Calculation and Settlement of Corporate Tax

Article 45 – Withholding Tax

Article 46 – Withholding Tax Credit

Article 47 – Foreign Tax Credit
Fourteen
– Payment and Refund of Corporate Tax		 Article 48 – Corporate Tax Payment

Article 49 – Corporate Tax Refund
Fifteen
– Anti-Abuse Rules		 Article 50 – General anti-abuse rule
Sixteen
– Tax Registration and Deregistration		 Article 51 – Tax Registration

Article 52 – Tax Deregistration
Seventeen
– Tax Returns and Clarifications		 Article 53 – Tax Returns

Article 54 – Financial Statements

Article 55 – Transfer Pricing Documentation

Article 56 – Record Keeping

Article 57 – Tax Period

Article 58 – Change of Tax Period

Article 59 – Clarifications
Eighteen
– Violations and Penalties		 Article 60 – Assessment of Corporate Tax and penalties
Nineteen
– Transitional Rules		 Article 61 – Transitional Rules
Twenty –
Closing provisions		 Article 62 – Delegation of Power

Article 63 – Administrative Policies and Procedures

Article 64 – Cooperating with the Authority

Article 65 – Revenue Sharing

Article 66 – International Agreements

Article 67 – Implementing Decisions

Article 68 – Cancellation of Conflicting Provisions

Article 69 – Application of this Decree-Law to Tax Periods

Article 70 – Publication and Application of this Decree-Law

SALIENT FEATURES AND IMPORTANT PROVISIONS OF THE CT LAW

Effective Date

The CT Law will become effective for financial years starting on or after 1st June, 2023. Accordingly, for F.Y. 1st July, 2023 – 30th June, 2024, the effective date would be 1st July, 2023. However, if the F.Y. is 1st January, 2023 – 31st December, 2023 then the effective date would be 1st January, 2024 and if the F.Y. is 1st April, 2023 – 31st March,2024, then the effective date would be 1st April, 2024 [FAQ 4].

CT is imposed on Taxable Income, at the rates determined under this Decree-Law, and payable to the Authority under CT Decree-Law and the Tax Procedures Law.

CT RATE [ARTICLE 3]

CT will be levied at a headline rate of 9 per cent on Taxable Income exceeding AED 375,000. Taxable Income below this threshold will be subject to a 0 per cent (zero per cent) rate of CT.

CT will be charged on Taxable Income as follows:

A. Resident
Taxable Persons		 Rate of Tax
1 Taxable Income not exceeding AED 375,000

(this amount is to be confirmed in a Cabinet Decision )

 0%
2 Taxable Income exceeding AED 375,000 9%
B. Qualifying
Free Zone Persons (“QFZP”)
1 Qualifying Income 0%
2 Taxable Income that does not meet the Qualifying Income
definition		 9%

TAXABLE PERSON AND CT BASE, ETC [ARTICLES 11 TO 17]

CT applies to the following “Taxable Person”:

  • UAE companies and other juridical persons that are incorporated or effectively managed and controlled in the UAE;
  • Natural persons (individuals) who conduct or undertake a business activity in the UAE as specified in a Cabinet Decision to be issued in due course; and
  • Non-resident juridical persons (foreign legal entities) that have a Permanent Establishment (“PE”) in the UAE, derive a UAE-sourced income and have a nexus in the UAE.

The main purpose of the PE concept in the UAE CT Law is to determine if and when a foreign person has established a sufficient physical presence in the UAE to warrant the business profits of that foreign person to be subject to CT.

The definition of PE in the CT Law has been designed on the basis of the definition provided in Article 5 of the OECD Model Tax Convention on Income and Capital and the position adopted by the UAE under the Multilateral Instrument to implement tax treaty related measures to prevent base erosion and profit shifting. This allows foreign persons to use the relevant Commentary of Article 5 of the OECD Model Tax Convention when assessing whether or not a PE has been constituted in the UAE. This assessment should consider the provisions of any bilateral tax agreement between the country of residence of the non-resident person and the UAE.

Juridical persons established in a UAE Free Zone are also within the scope of CT as “Taxable Person” and need to comply with the requirements set out in the CT Law. However, a Free Zone Person that meets the conditions to be considered a QFZP can benefit from a CT rate of 0 per cent on their Qualifying Income only.

In order to be considered a QFZP, the Free Zone Person must:

  • maintain adequate substance in the UAE;
  • derive ‘Qualifying Income’;
  • not have made an election to be subject to CT at the standard rates; and
  • comply with the transfer pricing requirements under the CT Law.

The Minister may prescribe additional conditions that a QFZP should meet. If a QFZP fails to meet any of these conditions, or makes an election to be subject to the regular CT regime, he will be subject to the standard rates of CT from the beginning of the Tax Period where he failed to meet the conditions.

Non-resident persons who do not have a PE in the UAE or who earn UAE-sourced income not related to their PE may be subject to Withholding Tax (at the rate of 0 per cent). Withholding tax is a form of CT collected at source by the payer on behalf of the recipient of the income. One of the reasons for the payment being subject to a Withholding Tax at 0 per cent is to bring such income within the scope of the income tax law while not taxing it. Therefore, one may be able to argue that such an income is subject to tax in the UAE even though no tax has actually been paid on the same.

For the purposes of the CT Law, a distinction is made between a Resident Person and a Non-Resident Person and the applicable tax base will depend on the nature of the taxable person.

In line with the tax regimes of most countries, the CT Law taxes income on both residence and source basis. The applicable basis of taxation depends on the classification of the Taxable Person.

  • A “Resident Person” is taxed on income derived from both domestic and foreign sources (i.e. a residence basis).
  • A “Non-Resident Person” will be taxed only on income derived from sources within the UAE (i.e. a source basis).

Residence for CT purposes is not determined by where a person resides or is domiciled but instead by specific factors set out in the CT Law. If a person does not satisfy the conditions for being either a resident or a non-resident person then he will not be a Taxable Person, and will not therefore be subject to CT.

Briefly, the following aspects should be considered when determining the nature of a Taxable Person as well as the applicable tax base:

Resident Person Tax base
An entity that is incorporated in the UAE (including a Free Zone
entity)		 Worldwide income
A foreign entity that is effectively managed and controlled in
the UAE		 Worldwide income
A natural person/individual who conducts a business or
undertakes business activity in the UAE		 Worldwide income
Non-resident Person Tax base
Has a PE in the UAE Taxable income attributable to the PE
Derives UAE-sourced income The UAE-sourced income not attributable to the PE
Has a nexus in the UAE Taxable income attributable to such a nexus

EXEMPT PERSON [ARTICLES 4 TO 10]

Certain types of businesses or organizations are exempt from CT given their importance and contribution to the social fabric and economy of the UAE. Exempt Persons include:

Exemption Category Entities covered
Automatically exempt a) Government Entities

Government Controlled Entities specified in a Cabinet Decision
Exempt if notified to the Ministry of Finance (and subject to
meeting certain conditions)		 a) Extractive Businesses

b) Non-Extractive Natural Resource Businesses
Exempt if listed in a Cabinet Decision a) Qualifying Public Benefit Entities
Has a PE in the UAE Taxable income attributable to the PE
Exempt if applied to and approved by the FTA (and subject to
meeting certain conditions)		 a) Public or private pension and social security funds

b) Qualifying Investment Funds

c) Wholly-owned and controlled UAE subsidiaries of a Government
Entity, a Government Controlled Entity, a Qualifying Investment Fund, or a
public or private pension or social security fund.
Has a nexus in the UAE Taxable income attributable to such a nexus

In addition to not being subject to CT, Government Entities, Government- Controlled Entities specified in a Cabinet Decision, Extractive Businesses and Non-Extractive Natural Resource Businesses may also be exempted from any registration, filing and other compliance obligations imposed by the CT Law, unless they engage in an activity which is within the charge of CT.

Resident and Non-resident Persons

Insofar as foreign incorporated entities effectively managed and controlled in the UAE are concerned, no additional guidance is provided in the CT Law. Therefore, taxpayers should rely on guidance from the OECD’s international tax commentaries, which provide detailed guidance on determination of ‘effective management and control’.

NON-RESIDENT PERSONS

Certain UAE sourced income of a Non-Resident Person that is not attributable to a PE in the UAE will be subject to withholding tax @ 0 per cent.

It will be subject to UAE CT on any Taxable Income attributable to the PE of the non-resident, or any UAE sourced income where the income is not attributable to the PE, or any Taxable Income attributable to the nexus of the non-resident in the UAE.

Both Resident Persons and Non-Resident Persons are regarded as Taxable Persons for purposes of the CT Law, meaning that the tax compliance obligations for these persons should be carefully considered.

DETERMINATION OF TAXABLE INCOME [ARTICLE 20]

CT is imposed on Taxable Income earned by a Taxable Person in a Tax Period. CT would generally be imposed annually, with the CT liability calculated by the Taxable Person on a self-assessment basis. This means that the calculation and payment of CT is done through the filing of a CT Return with the FTA by the Taxable Person.

The starting point for calculating the Taxable Income is the Taxable Person’s accounting income (i.e. net profit or loss before tax) as per their financial statements. The Taxable Person will then need to make certain adjustments to determine his Taxable Income for the relevant Tax Period. For example, adjustments to accounting income may need to be made for income that is exempt from CT and for expenditure that is wholly or partially non-deductible for CT purposes.

For this purpose, the financial statements should be prepared in accordance with accounting standards accepted in the UAE. The UAE does not have its own Generally Accepted Accounting Principles (“GAAP”) and International Financial Reporting Standards (“IFRS”) are commonly used by businesses in the UAE.

In order to arrive at Taxable Income, expenditure incurred wholly and exclusively for the purposes of the Taxable Person’s Business, not capital in nature, may be deductible in the Tax Period in which it is incurred. However, the CT Law disallows/restricts the deduction of certain expenses. This is to ensure that relief can only be obtained for expenses incurred for the purpose of generating Taxable Income, and to address possible situations of abuse or excessive deductions.

The CT Law prescribes a number of key adjustments to the accounting net profit (or loss) in order to compute the Taxable Income. These include; unrealised gains/losses (Taxable Persons now have an election to make on how to treat it), exempt income, certain tax reliefs, non-deductible expenditure, Transfer Pricing (“TP”) adjustments, tax loss reliefs, other incentives or special reliefs for a Qualifying Business Activity (as specified in a future Cabinet Decision), and any other income or expenditure as may be specified in a Cabinet Decision at a later stage.

The CT law makes reference to certain incentives and special relief for qualifying business on which further detail will be provided in a subsequent cabinet decision. The CT law is also silent on the tax treatment of depreciation, adjustments in respect of revenue and expense items accounted for in Equity or Other Comprehensive Income and Leases.

SMALL BUSINESS RELIEF [ARTICLE 21]

Article 21 provides that a tax resident person may elect to be treated as not having derived any Taxable Income where the revenue for the relevant and previous tax periods do not exceed a threshold and meet certain conditions, set or prescribed by the Minister.

If a tax resident person applies for “small business relief”, certain provisions of the CT Law will not apply such as exempt income, reliefs, deductions, tax loss relief, TP compliance requirements, as specified in the relevant chapters of the CT Law. The Authority may request any relevant records or supporting information to verify the compliance within a timeline, to be prescribed.

EXEMPT INCOME [ARTICLES 22 TO 25]

The CT Law also exempts certain types of income from CT. This means that a Taxable Person will not be subject to CT on such income and cannot claim a deduction for any related expenditure. Taxable Persons who earn exempt income will be subject to CT on their Taxable Income.

The main purpose of a certain income being exempt from CT is to prevent double taxation on certain types of income. Specifically, dividends and capital gains earned from domestic and foreign shareholdings will generally be exempt from CT. Furthermore, a Resident Person can elect, subject to certain conditions, to not take into account income from a foreign PE for UAE CT purposes.

The following income and related expenditure shall not be taken into account in determining the Taxable Income:

1. Dividends and other profit distributions received from a juridical person that is a Resident Person.

2. Dividends and other profit distributions received from a Participating Interest in a foreign juridical person as specified in Article 23.

3. Any other income from a Participating Interest as specified in Article 23.

4. Income of a Foreign PE that meets the condition of Article 24.

5. Income derived by a Non-Resident Person from operating aircraft or ships in international transportation that meets the conditions of Article 25.

RELIEFS [ARTICLES 26 & 27]

Article 26 contains provisions for relief in respect of Transfers within a Qualifying Group and provides that no gain or loss needs to be taken into account in determining the Taxable Income in relation to the transfer of one or more assets or liabilities between two Taxable Persons that are members of the same Qualifying Group.

Two Taxable Persons shall be treated as members of the same Qualifying Group where all of the following conditions are met:

a) The Taxable Persons are juridical persons that are Resident Persons, or Non- Resident Persons that have a PE in the UAE.

b) Either the Taxable Person has a direct or indirect ownership interest of at least 75 per cent (seventy-five per cent) in the other Taxable Person, or a third Person has a direct or indirect ownership interest of at least 75 per cent (seventy-five per cent) in each of the Taxable Persons.

c) None of the Persons qualify as an Exempt Person.

d) None of the Persons qualify as a QFZP.

e) The Financial Year of each of the Taxable Persons ends on the same date.

f) Both Taxable Persons prepare their financial statements using the same accounting standards.

Article 27 contains provisions for Business Restructuring Relief and provides tax relief on mergers, spin-offs and other corporate restructuring transactions where whole or independent part of business is being transferred in exchange of shares or other ownership interest provided the following conditions are met:

a) The transfer is undertaken in accordance with, and meets all the conditions imposed by, the applicable legislation of the UAE.

b) The Taxable Persons are Resident or Non-Resident Persons that have a PE in the UAE.

c) None of the Persons qualify as an Exempt Person.

d) None of the Persons qualify as a QFZP.

e) The Financial Year of each of the Taxable Persons ends on the same date.

f) The Taxable Persons prepare their financial statements using the same accounting standards.

g) The transfer is undertaken for valid commercial or other non-fiscal reasons which reflect economic reality.

DEDUCTIONS [ARTICLES 28 TO 33]

In principle, all legitimate business expenses incurred wholly and exclusively for the purposes of deriving a Taxable Income will be deductible, although the timing of the deduction may vary for different types of expenses and the accounting method applied. For capital assets, expenditure would generally be recognized by way of depreciation or amortization deductions over the economic life of the asset or benefit.

Expenditure that has a dual purpose, such as expenses incurred for both personal and business purposes, will need to be apportioned with the relevant portion of the expenditure treated as deductible if incurred wholly and exclusively for the purpose of the taxable person’s business.

Certain expenses deductible under general accounting rules may not be fully deductible for CT purposes. These will need to be added back to the Accounting Income for the purposes of determining the Taxable Income. Examples of expenditure that is or may not be deductible (partially or in full) include:

Types of Expenditure Limitation to deductibility
•  Bribes

•  Fines and penalties (other than amounts
awarded as compensation for damages or breach of contract).

•  Donations, grants or gifts made to an entity
that is not a Qualifying Public Benefit Entity

•  Dividends and other profits distributions

•  Corporate Tax imposed under the CT Law

•  Expenditure not incurred wholly and
exclusively for the purposes of the Taxable person’s Business

 No deduction
•  Expenditure incurred in deriving income that
is exempt from CT
•  Entertainment Expenditure Partial deduction of 50% of the amount of the expenditure
•  Interest Expenditure Deduction of net interest expenditure exceeding a certain de
minimis threshold up to 30 per cent of the amount of earnings before the
deduction of interest, tax, depreciation and amortization (except for certain
activities).

Further, there are certain exclusions, for example, expenses incurred in deriving an exempt income will not be tax deductible.

WITHHOLDING TAX [ARTICLE 45]

A 0 per cent withholding tax may apply to certain types of UAE-sourced income paid to non-residents insofar as it is not attributable to a PE of the non-resident. Because of the 0 per cent rate, in practice, no withholding tax would be due and there will be no withholding tax related registration and filing obligations for UAE businesses or foreign recipients of UAE sourced income.

Withholding tax does not apply to transactions between UAE resident persons.

TAX LOSSES [ARTICLES 37 TO 39]

Businesses will be able to carry forward tax losses indefinitely, subject to certain conditions. These losses can be used to offset up to 75 per cent of the taxable income of future tax periods. Losses incurred before the effective date of CT will not be eligible for relief.

TAX GROUP [ARTICLES 40 TO 42]

Two or more Taxable Persons who meet certain conditions can apply to form a “Tax Group” and be treated as a single Taxable Person for CT purposes.

To form a Tax Group, both the parent company and its subsidiaries must be resident juridical persons, have the same Financial Year and prepare their financial statements using the same accounting standards.

Additionally, to form a Tax Group, the parent company must:

  • own at least 95 per cent of the share capital of the subsidiary;
  • hold at least 95 per cent of the voting rights in the subsidiary; and
  • is entitled to at least 95 per cent of the subsidiary’s profits and net assets.

The ownership, rights and entitlement can be held either directly or indirectly through subsidiaries, but a Tax Group cannot include an Exempt Person or QFZP.

Forming a Tax Group may be more efficient from a tax standpoint when compared to each legal entity in a group filing on a standalone basis. This is mainly due to reduced administration costs, offsetting tax losses and profits within the group and the fact that inter-company balances and transactions between group entities should typically be eliminated on consolidation, thus reducing TP compliance obligations.

With regards to the offsetting tax losses and profits within the group, pre-grouping tax losses of any joining member will be the carried forward losses of the Tax Group; however, the offset of such pre-grouping loss is limited by the attributable income of the new joining member.

TAXABLE INCOME OF A TAX GROUP

To determine the Taxable Income of a Tax Group, the parent company must prepare consolidated financial accounts covering each subsidiary and member of the Tax Group for the relevant Tax Period. Transactions between the parent company and each of the group member and transactions between them would be eliminated for calculating the Taxable Income of the Tax Group.

TAX REGISTRATION AND DEREGISTRATION, RETURNS, CLARIFICATIONS, VIOLATIONS AND PENALTIES [ARTICLES 51 TO 60]

All Taxable Persons (including Free Zone Persons) will be required to register for CT and obtain a CT Registration Number. The FTA may also request certain Exempt Persons to register for CT.

Taxable Persons are required to file a CT return for each Tax Period within 9 months from the end of the relevant period. The same deadline would generally apply for the payment of any CT due in respect of the Tax Period for which a return is filed.

TRANSACTIONS WITH RELATED PARTIES AND CONNECTED PERSONS I.E. “TP” [ARTICLES 34 TO 36 AND 55]

The TP provisions will also take effect for financial years starting on or after 1st June, 2023.

The term ‘Related Parties’ has been defined in a very broad manner. When a legal entity or individual has more than 50 per cent of direct or indirect ownership or control over a taxable person, this falls within the related party definition. In addition to ‘related parties’ and ‘connected persons’, the law also defines ‘control’ as ‘the ability of a person, whether in their own right or by agreement or otherwise, to influence another person’.

TP rules seek to ensure that transactions between Related Parties are carried out on Arm’s Length Price (“ALP”), as if the transaction was carried out between independent parties and the consideration of transactions with Related Parties and Connected Persons needs to be determined by reference to their “Market Value”. The market value may represent an arm’s length range of financial results or indicators, subject to certain conditions.

Transactions between domestic related parties as well as between mainland and free zone entities are all covered within the scope of the Law.

A non-resident person, through a PE in the UAE, would also be subject to the UAE TP provisions, and therefore would be required to maintain and submit the relevant TP documentation.

Transactions carried out between different business lines of an Exempt Person (e.g. an exempt business and a non-exempt business of an Exempt Person) should also be carried out in accordance with the ALP.

Methods: For the purpose of the application of the ALP, the Law sets forth 5 TP methods (by applying one or a combination), broadly in line with the OECD TP Guidelines. The 5 methods are (a) Comparable Uncontrolled Price Method; (b) Resale Price Method; (c) Cost Plus method; (d) Transactional Net Margin Method; and (e) Transactional Profit Split Method.

In case neither of these methods can be reasonably applied, the Law allows for the application of any other TP method to the extent that it would lead to an arm’s length result.

Documentation: Certain businesses will be required to submit a disclosure containing information regarding their transactions with Related Parties and Connected Persons along with their tax return.

Certain businesses may be requested to maintain a master file and a local file.

The FTA may seek a taxpayer to provide a copy of their Master File or Local File or any information to support the arm’s length nature at any time by issuing a notice of not less than 30 days.

Threshold and format of the master file and a local file to be prescribed by the FTA.

The CT FAQs state that businesses which claim small business relief will not have to comply with the TP documentation rules.

Corresponding Adjustment: In the event of an adjustment imposed by a foreign tax authority which impacts a UAE entity, an application must be made to the FTA for a corresponding adjustment to provide the UAE Company with relief from double taxation. A corresponding adjustment related to a domestic transaction does not require this type of application.

TP Adjustment: While making any TP adjustments to the tax base of taxable persons, the FTA would need to rely on information that can or will be made available to the Taxable Person.

Advanced Pricing Agreements (APAs): An APA is an approach that attempts to prevent TP disputes from arising by determining criteria for applying the ALP to transactions in advance of those transactions taking place. The law provides that APAs will be exploitable, through the regular clarification process that is already in place.

The CT Law does not provide any materiality thresholds, but it is expected that the MoF will issue further guidance /clarification in this respect.

Penalties: Presently, no specific penalties for non-compliance of TP documentation requirements or non-submission of such information have been set out in the Law.

GENERAL ANTI-ABUSE RULE (‘GAAR’) [ARTICLE 50]

Article 50 applies to a transaction or an arrangement if, having regard to all relevant circumstances, it can be reasonably concluded that the entering into or carrying out of the transaction or arrangement, or any part of it, is not for a valid commercial or other non-fiscal reason which reflects economic reality; and the main purpose or one of the main purposes of the transaction or arrangement, or any part of it, is to obtain a CT advantage that is not consistent with the intention or purpose of CT Law.

Where the GAAR applies, the Authority may make a determination that one or more specified CT advantages are to be counteracted or adjusted. If such a determination is made, the Authority must issue an assessment giving effect to the determination and can make compensating adjustments to the UAE CT liability of any other person affected by the determination.

For the purpose of determining whether the GAAR applies to a transaction or arrangement, specific facts and circumstances should be analysed, such as form and substance, the manner in which entered into, the timing, whether the transaction or arrangement has created rights or obligations which would not normally be created between persons dealing with each other at arm’s length, changes in the financial position of the Taxable person or of another person etc.

In any proceeding concerning the application of the GAAR, the Authority must demonstrate that the determination made is just and reasonable.

Considering that GAAR aims to counteract any abusive tax arrangements, taxpayers should ensure that all their transactions have a bona fide business purpose and are properly documented.

CONCLUSION

With the CT law and FAQs in place, businesses should assess what impact the new CT law will have on their operations and legal structure. One should consider the law carefully and areas that are yet to be clarified by the MoF by way of separate Cabinet Resolutions / Ministerial decisions.

In this connection it would be advisable to (a) read the CT Law and the supporting information available on the websites of the MoF and the FTA; (b) use the available information to determine whether the business will be subject to CT and if so, from what date; (c) understand the requirements for business under the CT Law, including, for registration, determination of the accounting / tax Period, applicable due date for filing CT return, elections or applications may or should make and financial information and records needed to be kept for CT purposes. Further, regularly visiting the websites of the MoF (https://mof.gov.ae/) and the FTA (https://www.tax.gov.ae/en/) for further information and guidance on the CT regime will be useful.

Select Tax and Transfer Pricing Issues in Case of Transactions between the Head Office and its Permanent Establishment

BACKGROUND

With
the ever-evolving tax world, in light of the BEPS Project and the
resultant Multilateral Instrument, transactions involving physical
presence in India would be under greater scrutiny for the constitution
of a Permanent Establishment (‘PE’). Once it has been concluded that a
PE exists in a particular jurisdiction, one of the key issues to be
navigated is in respect of the profit attributable to the PE. The
concept of a PE deems the PE to be considered as a separate taxable
entity from the Head Office (‘HO’) for limited specific purposes. In
this article, the authors analyse some of the interesting issues which
arise due to ‘transactions’ between the PE and the HO. The topic of
profit attribution to the PE and the interplay between the tax treaties
and domestic law as well as transfer pricing provisions is a vast topic
in itself and in this article only the limited issues of ‘transactions’
between the PE and the HO are considered.

WHETHER TRANSACTIONS BETWEEN PE AND HO WOULD TRIGGER INCOME TAX IMPLICATIONS IN THE HANDS OF THE HO

Article 7(2) of the UN Model Tax Convention 2021 provides as follows:

“Subject
to the provisions of paragraph 3, where an enterprise of a Contracting
State carries on business in the other Contracting State through a
permanent establishment situated therein, there shall in each
Contracting State be attributed to that permanent establishment the
profits which it might be expected to make if it were a distinct and
separate enterprise engaged in the same or similar activities under the
same or similar conditions and dealing wholly independently with the
enterprise of which it is a permanent establishment.”

Therefore, Article 7(2) forms the genesis behind treating a PE of a taxpayer as an independent and separate entity.

Further,
while Article 7(3) of the UN Model restricts the claim of deduction in
respect of certain payments such as royalty, fees, commission, or
interest by the PE to its HO, while computing the profits attributable
to the PE, the language differs in various DTAAs entered by India. For
example, one would not find such restriction in Article 7 of the India –
Singapore DTAA.

Similarly, Para 7(2) of the OECD Model 2017 provides as follows:

“For
the purposes of this Article and Article [23 A] [23 B], the profits
that are attributable in each Contracting State to the permanent
establishment referred to in paragraph 1 are the profits it might be
expected to make, in particular in its dealings with other parts of the
enterprise, if it were a separate and independent enterprise engaged in
the same or similar activities under the same or similar conditions,
taking into account the functions performed, assets used and risks
assumed by the enterprise through the permanent establishment and
through the other parts of the enterprise.”

The question
which arises in the case of the constitution of PE of a non-resident
taxpayer in India, is whether the expenses which are deducted while
computing the profits attributable to a PE and which are paid by the PE
to the HO, would result in taxable income in the hands of the HO in
India?

Let us take an example of an entity, resident in
Singapore (‘SingCo’), which undertakes activities through a branch in
India, which constitutes a PE in India. In this case, there could be two
types of expenses, which one would consider for the purpose of
computing the profits attributable to the PE of SingCo in India:

a)
Expenses incurred outside India by the HO, which are directly related
to the activities undertaken by the PE in India and therefore deductible
in the hands of the PE, say fees of a consultant who has been employed
exclusively in respect of the activities undertaken in India.

b)
Expenses which, if the PE was a distinct and independent entity, would
have entailed using certain resources of the HO and therefore, a cost
thereof, such as royalty or interest paid to the HO and therefore,
deductible in the hands of the PE.

In respect of point (a)
above, arguably one may be able to take a position that the income of
the consultant (assumed that it is considered as fees for technical
services) would be considered as deemed to accrue or arise in India by
virtue of section 9(1)(vii)(c) of the Act. Further, if the payment is
not considered as fees for technical services or royalty, in any case,
in the absence of deeming provisions such as section 9(1)(vi) and
9(1)(vii) of the Act, the income of the consultant does not accrue or
arise in India and therefore, the question of taxability of any income
in India in the hands of the HO or the consultant does not arise.

In
respect of point (b) above, the issue arises is given the fact that
deduction is claimed for the payments (or deemed payments in accordance
with Article 7 of the relevant DTAA) while computing the profits
attributable to the PE in India, would such payments be considered as
income in the hands of the HO in India?

In this regard, the
cardinal principle to apply would be that one cannot make profit/ income
out of oneself. This principle has been held by the Supreme Court in
the case of Sir Kikabhai Premchand vs. CIT (1953) 24 ITR 506 and various other judgments as well.

In the context of interest received by the PE from the HO, the Bombay High Court in the cases of DIT vs. American Express Bank Ltd (2015) 62 taxmann.com 349, DIT vs. Oman International Bank S.A.O.G (2017) 80 taxmann.com 139 and DIT vs. Credit Agricole Indosuez (2015) 377 ITR 102
has held that such interest or interest received from other branches of
the same entity would not be taxable as the same cannot constitute
income. While the above decisions are in the context of interest
received by an Indian PE, the same principles would apply even in the
case of interest received by the HO.

Similarly, while there are
various ITAT decisions on the issue of taxability of amounts received by
the HO from its PE, recently the Mumbai ITAT in the case of Shinhan Bank vs. DDIT (2022) 139 taxmann.com 563
has succinctly explained the issue of the dichotomy of claiming the
expenses (notional) in the hands of the PE on the one hand and not
taxing the notional income in the hands of the HO (General Enterprise or
‘GE’ in the case law) on the other. The relevant extracts are
reproduced below:

“32. The approach so adopted by the revenue
authorities, on the first principles, is simply contrary to the scheme
of the tax treaties. The fiction of hypothetical independence of a PE
vis-a-vis it’s GE and other PEs outside the source jurisdiction is
confined to the computation of profits attributable to the permanent
establishment and, in our considered view, it does not go beyond that,
such as for the purpose of computing profits of the GE. Article 7(2) of
the then Indo-Korea tax treaty specifically provides that when an
enterprise of a treaty partner country carries out business through a
permanent establishment, “there shall be in each Contracting State be
attributed to that permanent establishment the profits which it might be
expected to make if it were a distinct and separate enterprise engaged
in the same or similar activities under the same or similar conditions
and dealing wholly independently with the enterprise of which it is a
permanent establishment”. This fiction of hypothetical independence
comes into play for the limited purposes of computing profits
attributable to permanent establishment only and is set out under the
specific provision, dealing with the computation of such profits, in the
tax treaties, including in the then Indo-Korean DTAA. There is nothing,
therefore, to warrant or justify the application of the same principle
in the computation of GE profits as well. Clearly, therefore, the
fiction of hypothetical independence is for the limited purpose of
profit attribution to the permanent establishment.

33. To that
extent, this approach departs from the separate accounting principle in
the sense that the GE, to which PE belongs, is not seen in isolation
with it’s PE, and a charge, in respect of PE – GE transactions, on the
PE profits is not treated as income in the hands of the GE.”

Interestingly,
the CBDT Circular 740 dated 17 April 1996 sought to tax this notional
income in the hands of the HO. Para 3 of the Circular provided:

“It
is clarified that the branch of a foreign company/concern in India is a
separate entity for the purposes of taxation. Interest paid/payable by
such branch to its head office or any branch located abroad would be
liable to tax in India and would be governed by the provisions of
section 115A of the Act. If the Double Taxation Avoidance Agreement with
the country where the parent company is assessed to tax provides for a
lower rate of taxation, the same would be applicable. Consequently, tax
would have to be deducted accordingly on the interest remitted as per
the provisions of section 195 of the Income-tax Act, 1961.”

This
view of the CBDT was duly struck down by the various ITAT judgments
which have held that in the absence of any income, such payments cannot
be taxed.

The Finance Act, 2015 has sought to tax these types of
payments in the hands of the HO in the case of banking companies by
inserting an Explanation to section 9(1)(v) of the Act as follows:

“For the purposes of this clause, –

(a) it
is hereby declared that in the case of a non-resident, being a person
engaged in the business of banking, any interest payable by the
permanent establishment in India of such non-resident to the head office
or any permanent establishment or any other part of such non-resident
outside India shall be deemed to accrue or arise in India and shall be
chargeable to tax in addition to any income attributable to the
permanent establishment in India and the permanent establishment in
India shall be deemed to be a person separate and independent of the
non-resident person of which it is a permanent establishment and the
provisions of the Act relating to computation of total income,
determination of tax and collection and recovery shall apply
accordingly;..”

While the above amendment may now create a
deeming fiction to tax the notional income of the HO in the case of
banking companies, the authors are of the view that such deeming
provisions cannot be read into the DTAAs and therefore, following the
principles laid down by the various judicial precedents, such notional
income should not be taxable in India.

Another argument in
favour of the non-taxability of such notional transactions under the
DTAAs is that generally Article 11 and Article 12 of the DTAAs, dealing
with Interest and Royalty respectively refer to the respective income
‘arising’ in a Contracting State and ‘paid’ to a resident of the other
Contracting State. Under general parlance, the term ‘paid’ would require
two distinct entities or persons and therefore, in the absence of a
deeming provision such as that in the Explanation to section 9(1)(v)
which deems a PE and the HO to be distinct for tax purposes under the
Act, the notional income should not be taxable in India.

The
next scenario which one needs to consider is whether transactions
between an Indian HO and its Overseas PE would result in any tax
implications in India?

In this scenario, as the HO being a
resident of India is already subjected to worldwide taxation under
section 5 of the Act, the question of separately taxing the transaction
between the Indian HO and its overseas PE would not arise.

WHETHER TRANSACTIONS BETWEEN PE AND HO WOULD BE SUBJECT TO TRANSFER PRICING IN INDIA

One
of the questions which arises is whether transactions between the HO
and its Branch (i.e., PE) would be subject to transfer pricing?

This
issue arises as section 92A of the Act, dealing with the term
‘associated enterprises’ (‘AEs’), refers to ‘enterprises’ instead of
‘entities’, and the term ‘enterprise’ is defined in section 92F(iii) of
the Act to include a permanent establishment, thereby considering a PE
as a separate entity for transfer pricing provisions.

In this
regard, one may need to analyse the provisions in respect of
transactions between a branch (which is a PE) and HO under two distinct
scenarios – the first one where an Indian company has a branch overseas
and the second scenario wherein the foreign company has a branch in
India.

In the first scenario, the Delhi ITAT in the case of Aithent Technologies Pvt Ltd vs. ITO [TS-38-ITAT-2015(DEL)-TP]
held that the transactions between a foreign branch and the Indian HO
cannot be an international transaction as a branch is not a separate
entity and one cannot undertake a transaction with oneself.

Further, in the case of the same assessee for another year, the Delhi ITAT in Aithent Technologies Pvt Ltd vs. DCIT [TS-752-ITAT-2016(DEL)-TP]
also held that even if one ignores the argument that the branch is not a
separate entity, given that section 5 of the Act provides that the
global income of a resident is taxable in India, increasing the income
of the HO in India would result in a corresponding increase in the
expense of the overseas branch and as such income would be consolidated,
the net impact of such adjustment would be Nil. It explained the same
by way of the following example:

“Suppose the Indian head
office purchases goods worth Rs.95 and transfers the same to foreign
branch office at Rs.100, which are in turn sold by the branch office for
a sum of Rs.120. The profit of the head office will be Rs.5 (Rs.100
minus Rs.95) and the profit of the branch office will be Rs.20 (Rs.120
minus Rs.100). The Indian general enterprise will be chargeable to tax
in India on its world income of Rs.25 (Rs.5 plus Rs.20). If for a
moment, it is presumed that the ALP of the goods transferred to the
branch office is Rs.110 and not Rs.100 and the figure is accordingly
altered, the profit of the head office will become Rs.15 (Rs.110 minus
Rs.95) and that of the branch office at Rs.10 (Rs.120 minus Rs.110).
Again the Indian general enterprise will be chargeable to tax in India
on its world income of Rs.25 (Rs.15 plus Rs.10). There can never be any
reason for an Indian enterprise to over or under invoice the goods or
services to its foreign branch office because by virtue of section 5(1),
it is its world income which is going to be charged to tax in India,
which in all circumstances will remain same at Rs.25 in the above
example.”

Therefore, one can conclude that the transactions
between an Indian company and its overseas branch would not be
considered as international transactions and therefore, would not be
subject to transfer pricing in India.

Interestingly, while the
facts were related to an Indian company having an overseas branch, the
Delhi ITAT in the above decision also evaluated the transfer pricing
provisions in the second scenario i.e., a foreign company having a
branch in India. It held as follows:

“The rationale in not
applying the provisions of Chapter-X on transactions between the head
office and branch office is limited only on an Indian enterprise having
branch office abroad. It is not the other way around. If a foreign
general enterprise has a branch office in India, such Indian branch
office will be considered as an `enterprise’ u/s 92F(iii) and the
transactions between the foreign head office and the Indian branch
office will be `International transactions’ in terms of section 92B.
This is for the reason that the total income of a non-resident in terms
of section 5(2) includes all income from whatever source derived which
(a) is received or is deemed to be received in India in such year by or
on behalf of such person; or (b) accrues or arises or is deemed to
accrue or arise to him in India during such year. Thus, it is only the
Indian income of a non-resident, which is chargeable to tax in India. In
such circumstances, there can be an allurement to some non-resident
assesses to resort to under or over-invoicing so as to mitigate the tax
burden in India. It is with this background in mind that the legislature
introduced Chapter X with the caption `Special provision relating to
avoidance of tax’ so to ensure that the international transactions are
reported at ALP.

Some foreign associated enterprise instead of
having an Indian enterprise may opt to have a branch office in India and
then claim that since the Indian branch office is not a separate
enterprise, the transfer pricing provisions should not be applied.
Section 92F(iii) has been incorporated to ensure that not only the
transactions between the foreign enterprise and its Indian associated
enterprise but also the transactions between the foreign enterprise and
its branch office in India are also determined at ALP so that the Indian
tax kitty is not deprived of the rightful amount of tax due to it.
Thus, the definition of `enterprise’ as per section 92F(iii) as also
including its permanent establishment for the transfer pricing
provisions is confined only in respect of a foreign general enterprise
having a branch office in India and not vice versa.”

Therefore,
the Delhi ITAT has held that given the objective of the transfer
pricing provisions, transactions between a foreign entity and its Indian
branch would be considered as international transactions and would be
subject to transfer pricing.

However, one of the aspects which
is not considered by the Hon’ble ITAT in the above case, is whether the
HO and branch would be considered as AEs.

Section 92A(1)(a) of the Act provides that an AE means an enterprise:

“which
participates directly or indirectly, or through one or more
intermediaries, in the management or control or capital of the other
enterprise.”

The term ‘associated enterprises’ has been
defined in section 92A of the Act. While sub-section (1) provides the
broad principles for determining whether an enterprise is as AE,
sub-section (2) lists various scenarios wherein two enterprises shall be
deemed to be AEs. The ensuing paragraphs analyse the broad principles
of determination of AE as well as the scenarios wherein two enterprises
are deemed to be AEs.

The broad principles in section 92A(1)
refer to direct or indirect participation in capital, control or
management. The instances of deemed AEs enumerated in section 92A(2)
include holding shares carrying voting rights, significant loan
advanced, significant guarantee provided, right to appoint members of
the board of directors or governing board, ownership of intangibles for
manufacture of goods, significant purchase of raw materials and holding
by relatives or member of HUF.

Participation in the capital would
mean holding shares in a company or interest in any other entity.
While, the term ‘control’ or ‘management’ is not defined in the Act, the
term ‘control and management’ is referred to in sections 6(2), 6(3)(ii)
[prior to the amendment vide Finance Act 2015] and 6(4), to determine
the residential status of HUF, firm, AOP, companies (prior to the
amendment as referred above) and every other person. In that context,
various judicial precedents have held that ‘control and management’ of
the affairs would mean where the key decisions are taken. In the context
of companies, various Courts have held that the ‘control and
management’ is situated where the meeting of the Board of Directors is
held and where they make the key decisions. These principles are
explained in the Supreme Court decision in the case of CIT vs. Nandlal Gandalal [(1960) 40 ITR 1]
wherein it was held that the term ‘control and management’ means
controlling and directive power – ‘the head and brain’ of the entity.

Therefore,
participation in management or control could also signify the ability
to exercise decision-making authority over an enterprise. In this
regard, one may refer to the decision of the Mumbai ITAT in the case of Kaybee Pvt Ltd vs. ITO [(2015) 171 TTJ 536]
which held that holding a key position of making decisions such as the
Chief Operating Officer would signify the exercise of ‘control or
management’ of an entity.

In the case of a branch and HO, there
is no investment in the capital by the HO in the Branch and therefore,
one would need to evaluate if there is exercise of any control or
management between the enterprises.

In this regard one may be
able to argue that the HO exercises some level of control over the
branch and therefore, there is an element of ‘control’. However, the
question is whether one would also need to satisfy the conditions as
provided in section 92A(2) of the Act in order to be considered as AEs.

The
Memorandum to the Finance Bill, 2002, while amending section 92A(2) of
the Act has provided the reasoning for such amendment as follows:

“It
is proposed to amend sub-section (2) of the said section to clarify
that the mere fact of participation by one enterprise in the management
or control or capital of the other enterprise, or the participation of
one or more persons in the management or control or capital of both the
enterprises shall not make them associated enterprises, unless the
criteria specified in sub-section (2) are fulfilled.”

Therefore,
the intention of the Legislature is clear that merely satisfying the
conditions in section 92A(1) of the Act is not sufficient and one needs
to fulfill one of the criteria laid down in section 92A(2) in order to
qualify as an AE.

The above principle has been upheld by the Ahmedabad ITAT in the case of ACIT vs. Veer Gems [(2017) 183 TTJ 588],
wherein it was held that the conditions as prescribed in section 92A(1)
are restricted to the conditions or illustrations provided in section
92A(2) and such illustrations are exhaustive. In other words, the
Ahmedabad ITAT held that if the case is not covered under section 92A(2)
of the Act, the enterprises would not be considered as AEs and one
cannot apply section 92A(1) of the Act.

Interestingly, while the Gujarat High Court, in the case of PCIT vs. Veer Gems [(2018) 407 ITR 639],
did not specifically deal with the issue of section 92A(2) vis-à-vis
section 92A(1), it upheld the decision of the Ahmedabad ITAT above and
held that since the conditions of section 92A(2) were not satisfied, the
entities would not be considered as AEs. In our view, therefore, the
Gujarat High Court has also upheld the above principles. Moreover, the
Supreme Court also dismissed the SLP filed by the Revenue in the case of
PCIT vs. Veer Gems [(2018) 256 Taxman 298], thereby bringing the issue to an end.

In
the present scenario, therefore, one would need to evaluate whether any
of the specific scenarios as stated in section 92A(2) of the Act are
triggered in the case of a HO and Branch.

If one evaluates the
scenarios as provided in section 92A(2) of the Act, one may reach a
conclusion that the scenarios refer to situations where there are two
separate entities and not where they are a part of the same entity.

CONCLUSION

Section
92A(2) provides that two enterprises shall be deemed to be AEs if, at
any time during the previous year the prescribed conditions in clauses
(a) to (m) are fulfilled. This may mean that the inclusion of PE in the
definition of ‘enterprise’ in section 92F becomes non-operational. The
court may therefore take a view that the condition of two enterprises as
prescribed under section 92A(2) would not be applicable in the case of
an Indian PE of a foreign enterprise.

Further, given that in any
case, one would need to compute the profits attributable to the PE in
accordance with transfer pricing provisions, and that this issue may be
more from a perspective of whether the compliance under the transfer
pricing provisions needs to be undertaken, a better and more
conservative view would be to undertake such compliance. Another aspect
to be considered may be what ‘transactions’ should be covered in the
transfer pricing report. In this regard, one may typically cover both
types of transactions, one where the HO incurs certain expenses which
are directly related to operations of the PE and the second where there
are transactions for payment of interest, royalties etc. to HO.

Taxation and FEMA aspects of Cross-Border Employees’ Stock Options

Employees’ Stock Option Plans (“ESOPs”) play a significant role in motivating and retaining key employees of companies / multinational groups. In many cases, employees of the Indian subsidiaries are offered/given ESOPs of the parent company / other group companies. Various tax and regulatory issues arise for consideration and proper implementation of such schemes in India.

In this article, the authors have examined the important Taxation, FEMA and Accounting aspects in such situations, by way of a case study. For the sake of completeness, certain FEMA and accounting aspects have also been discussed in addition to taxation issues.

INTRODUCTION

Over the last few decades, the global movement of capital and the growth of multinational enterprises (“MNEs”) have increased significantly. With this, the recruitment and retention of key and high-performing employees have emerged as important challenges for the MNEs. ESOPs, with their various variants, have been used to achieve the goal of attracting and retaining talent. MNEs offer ESOPs of parent companies to the employees of their various subsidiaries/associates across the globe to incentivise them.

In an Indian scenario, this raises various regulatory issues relating to Foreign Exchange Management Act, 1999 (“FEMA”), taxation, withholding obligations and accounting.

In order to better understand the issues and their probable impact and resolutions, it has been thought appropriate to deal with the same by way of a case study.
 

FACTS OF THE CASE STUDY

  • ABC Pte Ltd. is a company (referred to as “ABCPL”) incorporated in Singapore, which has framed Employee Stock Options Plan (ESOP) to issue Employee Stock Options globally to its employees and employees of its subsidiary where its holding is more than 51 per cent.

  • The scheme is applicable to all employees who qualify as per the ESOPs and as per the discretion of the Committee set up by the company for the implementation of ESOPs.

  • XYZ India Pvt Ltd (referred to as “XYZIPL”) is a subsidiary of ABCPL.

  • Employees of XYZIPL are eligible to participate in the ESOP scheme of ABCPL (the Parent Company) and therefore granted shares w.e.f. 1st October, 2022.

  • The details of options (shares) granted, exercised and vested at various dates are assumed to be given in the ESOP.

ISSUES THAT ARISE FOR CONSIDERATION

  • What are the implications on the Indian Subsidiary Company and Singapore Holding Company of ESOPs given by the Singapore holding company to the employees of the Indian Subsidiary Company with respect to FEMA/ RBI, Companies Act and Income Tax?

  • What are the accounting treatments of such ESOPs in the books of the Singapore company and Indian company?

  • While exercising option, employees will need to make payment to the Singapore company for the acquisition price. Whether they should opt for Liberalised Remittance Scheme (“LRS”) or Overseas Direct Investment (“ODI”) route for making payment? Further what compliances under FEMA and Income-tax, Employees / Indian Company / Singapore Company will need to comply?

  • If employees opt for buyback of shares by Singapore company, then what will be the best legal way to route the payment, which will be beneficial to all stakeholders, namely, employees, Indian company and Singapore company?

  • Any other reporting / filing requirement under any Statute like FEMA / Income tax / Company law etc.?

FEMA PROVISIONS

Foreign Exchange Management (Overseas Investment) Rules, 2022 (“OI Rules”) have come into force from 22nd August, 2022 in supersession of erstwhile Foreign Exchange Management (Transfer or Issue of Any Foreign Security) Regulations, 2004.

Rule 13 of the OI Rules provides that a Resident individual may make overseas investment in the manner and subject to the terms and conditions prescribed in Schedule III.

Clause 1(2)(iii)(h) of Schedule III of OI Rules provides that a resident individual may make or hold overseas investment by way of, ODI or Overseas Portfolio Investment (“OPI”), as the case may be, by way of acquisition of shares or interest under ESOP or Employee Benefits Scheme (“EBS”).

Clause 3 of Schedule III contains provisions relating to the acquisition of shares or interest under ESOP or EBS or sweat equity shares. It provides that a resident individual, who is an employee or a director of an office in India or a branch of an overseas entity or a subsidiary in India of an overseas entity or of an Indian entity in which the overseas entity has direct or indirect equity holding, may acquire, without limit, shares or interest under ESOP or EBS or sweat equity shares offered by such overseas entity, provided that the issue of ESOP or EBS is offered by the issuing overseas entity globally on a uniform basis.

For this purpose, indirect equity holding means indirect foreign equity holding through a special purpose vehicle or step-down subsidiary. Further, the Employee Benefits Scheme means any compensation or incentive given to the directors or employees of any entity which gives such directors or employees ownership interest in an overseas entity through ESOP or any similar scheme.

A.P. (DIR) Circular 12 dated 22nd August, 2022 explaining provisions relating to ESOPs

Para 1(ix)(f) of the Circular explains that Resident individuals may make OPI within the overall limit for LRS in terms of Schedule III of the OI Rules. Further, shares or interest acquired by the resident individuals by way of sweat equity shares or minimum qualification shares or under ESOP/EBS up to 10 per cent of the paid-up capital/stock, whether listed or unlisted, of the foreign entity and without control shall also qualify as OPI.

Para 22(2) explains that Overseas Investment by way of capitalisation, swap of securities, rights/bonus, gift, and inheritance shall be categorised as ODI or OPI based on the nature of the investment. However, where the investment, whether listed or unlisted, by way of sweat equity shares, minimum qualification shares and shares/interest under ESOP/EBS does not exceed 10 per cent of the paid-up capital/stock of the foreign entity and does not lead to control, such Investment shall be categorised as OPI.

In Para 22(5) to (7), it is explained that shares/interest under ESOP/EBS – AD banks may allow remittances, towards acquisition of the shares/interest in an overseas entity under the scheme offered directly by the issuing entity or indirectly through a Special Purpose Vehicle (SPV) /SDS. Where the investment qualifies as OPI, the necessary reporting in Form OPI shall be done by the employer concerned in accordance with regulation 10(3) of OI Regulations. Where such investment qualifies as ODI, the resident individual concerned shall report the transaction in Form FC.

Foreign entities are permitted to repurchase the shares issued to Residents in India under any ESOP Scheme provided (i) the shares were issued in accordance with the rules/regulations framed under FEMA, 1999, (ii) the shares are being repurchased in terms of the initial offer document, and (iii) necessary reporting is done through the AD bank.

Though there is no limit on the amount of remittance made towards the acquisition of shares/interest under ESOP/EBS or acquisition of sweat equity shares, such remittances shall be reckoned towards the LRS limit of the person concerned.


ANALYSIS OF FEMA PROVISIONS

Acquisition of Shares under ESOP

From the above provisions of FEMA, it is clear that the employees of XYZIPL, being an Indian subsidiary of ABCPL, a Singapore company issuing ESOPs, are eligible to participate in the ESOP and acquire shares by way of general permission under OI Rules. There is no requirement for any specific percentage of holding of shares.

However, for making remittances for the purchase of shares under the ESOP Scheme, the same must be offered by ABCPL globally on a uniform basis.

Acquisition under which route – ODI or OPI?

Overseas investment by an individual can be made either as an ODI or as OPI. For deciding that one needs to examine the terms of the ESOP and if the aggregate number of shares that may be acquired by an employee does not exceed 10 per cent of the enlarged share capital of the company, then the same would be considered as OPI for that employee.

The investments by Indian employees under the ESOP would be without any controlling stake and would fall under the category of OPI, which would not require the filing of an ODI form. If the remittance sought is within the overall limit of USD 250,000 per annum under LRS, there should not be an issue.

Sale of shares acquired under ESOP

Prior to OI Rules, Indian resident employees were permitted to transfer the shares acquired (pursuant to exercising options) by way of sale, provided that the sale proceeds are repatriated to India within 90 days from the date of such sale.

It is expected that in the Master Direction to be issued after coming into force of OI Rules, appropriate clarity in this regard would be provided.

Repurchase of shares by the Company

ABCPL being a foreign entity can repurchase shares issued under the ESOP from the Indian resident employees subject to the fulfilment of the following conditions:

(i)    the shares were issued in accordance with the rules/regulations framed under FEMA, 1999.

One of the conditions of ESOPs under FEMA is that the shares must be issued by the company globally on a uniform basis. The management of both companies has to make sure of fulfilment of this condition.

(ii)    the shares are being repurchased in terms of the initial offer document.

Repurchase of shares by the company in terms of the initial offer document would be considered as fulfilment of the condition.

(iii)    Necessary reporting is done through the AD bank.


INCOME TAX PROVISIONS AND THEIR ANALYSIS
Following four events are triggered under any ESOP Scheme:

(i)    Grant of Options: An eligible person is invited to participate in an ESOP.

(ii)    Vesting of Options: Shares are vested as per the eligibility criteria and a person becomes eligible to exercise the option to buy the shares.

(iii)    Exercise of Options: Exercising options to buy the shares at an offered price (which is usually at a discount than its fair market value).

(iv)    Sale of Shares: Sale of shares purchased under ESOP either to a third party or to the company under a buy-back scheme.

Granting and vesting of options: There is no tax implication in the first two events, i.e., granting and vesting of options as there are no actual transactions, but only a probability of future transactions is created.

Exercise of option: The difference between Fair Market Value (FMV) and the exercise price is taxed as a perquisite in hands of the employees in the year of exercise of options and buying of shares. Thereafter, the FMV becomes the cost of shares in hands of the employees.

Sale of shares: At the time of sale of shares, the difference between the sale price and the cost (which is a FMV in the hands of the employees), would be taxed as capital gains. The incidence of tax would depend upon the period of holding.

Taxability of ESOPs as per provisions of the Income-tax Act, 1961 (the “Act”)

Normally, ESOPs are taxed as perquisite u/s 17 of the Act under the head “Salaries”.

However, in the instant case employees of the Indian subsidiary of the foreign parent company are receiving ESOPs. There is no direct employer-employee relationship between the Indian employees and the Singapore company. Under the circumstances, an issue for consideration arises i.e., whether the difference between the FMV and the exercise price would be taxed as a perquisite u/s 17 or as other income u/s 56 of the Act.


JUDICIAL PRECEDENTS
In Sumit Bhattacharya vs. ACIT, [2008] 112 ITD 1 (Mumbai) (SB), on 3rd January, 2008 the Special Bench of the ITAT held that amount in question is received from a person other than the employer of the assessee, and that in order for an income to be taxed under the head ‘income from salaries’ it is a condition precedent that the salary, benefit or the consideration must flow from employer to the employee, the amount received by the assessee on redemption of stock appreciation rights will still be taxable-though under the head ‘income from other sources’. It further held that the plea raised by the assessee that the amount in question cannot be taxed as ‘income from salaries’ is thus irrelevant.

Once the SC comes to a conclusion that an employment-related benefit received from a person other than the employer, is to be taxed as an income from other sources, it cannot be open to ITAT to take any other view of the matter.

The above view of the Mumbai ITAT was based on the Bombay High Court’s decision in the case of Emil Weber vs. CIT 114 ITR 515, which was later on upheld by the SC.

In the case of Emil Weber, the question before the Hon’ble Bombay High Court was “whether, on the facts and in the circumstances of the case, the amount of tax paid by Ballarpur (a person other than assesses employer) on behalf of the assessee is income taxable under the head income from other sources”.

It is interesting to note the observations of the SC in the case of Emil Weber, while reaffirming the decision of the Bombay HC, where the SC observed that “The question then arises as to under which head of income the said income should be placed. In as much as the assessee is not an employee of Ballarpur which made the payment, it cannot be brought within the purview of Section 14 of the Act, It must necessarily be placed under sub-section (1) of Section 56, “income from other sources”. According to the said sub-section, income of every kind which is not to be excluded from the total income under the Act shall be chargeable to income-tax under the head “Income from other sources”, if it is not chargeable to income-tax under any of the other heads specified in Section 14, items A to E. It is not the case of the assessee that any provision of the Act exempts the said income from the liability to tax.”

It may be noted that the decision of the Mumbai Tribunal in case of Sumit Bhattacharya (supra) was reversed by the Bombay HC on a different point, which is not relevant here.


TAXABILITY UNDER THE HEAD “INCOME FROM OTHER SOURCES”
Based on the above, it can be concluded that since there are no employer-employee relationships between ABCPL, Singapore and the employees of its Indian subsidiary, the difference between the exercise price and the FMV would be taxed in hands of the Indian employees under the head “Income from Other Sources”. In such a case, the following options are available for deduction of tax at source or to discharge the tax liability by the employees directly:

(a)    the Singapore company deducts tax at source at the time of allotment of shares, for which it would be required to take TAN in India and do necessary compliances.

(b)    Indian employees file a statement of particulars of income taxable under the head “Income from other Sources” as prescribed in section 192(2B) read with Rule 26B to XYZIPL, which can take cognisance of this and deduct appropriate tax at source.

(c)    Indian employees pay applicable advance tax on the income offering it under the head “Income from other Sources” and submit the proof of such payment to ABCPL. In that event, ABCPL would not be held as an assessee-in-default u/s 201 of the Act, provided all conditions laid down in that section are satisfied. The conditions are as follows:

(i)    The employee has furnished his return of income u/s 139;

(ii)    The employee has taken into account such sum for computing income in such return of income;

(iii)    The employee has paid the tax due on the income declared by him in such return of income; and

(iv)    The employee furnishes Accountant’s (CA) Certificate in Form No. 26A read with Rule 31ACB.

However, ABCPL will still be liable for a simple interest from the date of withholding tax obligation to the date of filing of the income-tax return by the employee.


INCOME TAXABLE UNDER THE HEAD “SALARIES”
The Hon’ble SC’s five judge bench judgment in the case of Justice Deoki Nandan Agarwal vs. Union of India 237 ITR 872 has, inter alia, held that what Hon’ble Judges receive, as salary, is reward for their services and it is for this reason that such reward is brought within the scope of salary. This decision thus has the effect of expanding the scope of head of income ‘salary’ as it holds that what is relevant is the salary being a reward for employment rather than existence of an employer in conventional sense of the expression. The question of reward of employment flowing from employer to employee, in order to be bring the same within the ambit of taxability under the head ‘income from salaries’, is thus redundant.

Thus, though there is no direct employer-employee relationship between the ABCPL and the employees of the XYZIPL, there is a close nexus between the two.

The close nexus is on account of employment with the XYZIPL, which is a subsidiary of the ABCPL in India. The grant of options is due to employees’ employment with and performance at the XYZIPL. But for their employment with XYZIPL, ABCPL would not have granted ESOPs to the employees of XYZIPL.

It is, therefore, logical and natural for the Indian employer (XYZIPL), to carry out employer related compliances. One may draw a reference from the CBDT Circular No. 9/2007 dated 20th December, 2007 which was issued in the context of the erstwhile Fringe Benefit Tax (FBT).

In the context of applicability of FBT for shares awarded by the foreign holding company to the employees of the Indian subsidiary for the employment period in India, in answer to question 3, it was mentioned that the Indian subsidiary would be liable to pay FBT in respect of the value of the shares allotted or transferred by the foreign holding company if the employee was based in India at any time during the period beginning with the grant of the option and ending with the date of vesting of such option (hereafter such period is referred to as ‘grant period’), irrespective of the place of location of the employee at the time of allotment or transfer of such shares.

In the case of P. No. 15 of 1998 [1999] 235 ITR 565 AAR, (Microsoft’s case) which has a similar fact pattern, as in the instant case study, the AAR held that the American parent company was making the offer with a view to give an incentive to employees of the Indian company. There would have been no problem had the stock option been offered by the Indian company. But the position in law will not be different only because the stock option is offered not by the Indian company but by its parent company. If the “salary” is paid for or on behalf of the employer that will also have to be included in the “salary” income by virtue of Clause (b) of Section 15.

It was further held that in a case like this, the corporate veil will have to be lifted to see the real nature of the transaction. The only possible explanation for the offer of stock options by the American company to the employees of the Indian company can be that it regards its business and the business of the Indian company as one. There is no difficulty in law in recognizing the reality of the transaction and treating the benefit to be given to the Indian employees as one by the employer himself or by the American company for or on behalf of the employer. In either view of the matter, this additional remuneration or profit will have to be treated as income from “salary”.

By devising the stock option scheme, the American company has taken upon itself the responsibility for paying, what must be regarded as “salary” to the employees of the Indian company. They are under an obligation u/s 192 to deduct income tax at source on the amount payable to the employees.

Thus, the better view seems to be to that income from ESOPs should be taxable under the head ‘Salaries’ instead of ‘Income from Other Sources’.


COMPLIANCES BY THE INDIAN COMPANY (XYZIPL)

Taxability of ESOPs in hands of Indian Employees

As per the provisions of the Act, the taxation of ESOPs triggers at two stages. The first point of taxation is when the shares are allotted to the employees under the ESOP and the second stage is when the employee ultimately sells the shares.

Taxability at the time of Exercising/Allotment of Shares
The Indian company’s (XYZIPL) obligation is to deduct tax at source u/s 192 read with Rule 26A, at the time of exercising/allotment of shares. The difference between the exercise price and the FMV would be taxed in the hands of the employees as perquisites u/s 17(2)(vi) of the Act. Rule 3(8) of the Act, contains the rules for determining the FMV of ESOPs.

Reporting in Form 16 and 12BA

XYZIPL has to report the value of the perquisite on which tax is withheld in Form 16 along with other salaries, and Form 12BA issued to the employee.

A question arises as to whether the buyback amount can be routed through the Indian company (XYZIPL) by ABCPL. In this regard, it is important to keep in mind that if the amount is routed through the XYZIPL, then the Indian employees would be surrendering (or selling) foreign security (shares) to the foreign company but receiving payments in Indian currency. This situation is not covered by general permission under FEMA, and therefore, specific prior approval from RBI would be required to implement this kind of scheme.

COMPLIANCES BY INDIAN EMPLOYEES

At the time of exercising Options – Taxable as a Perquisite

It is advisable for Indian employees to make a declaration to XYZIPL about the exercise/allotment of shares by ABCPL in accordance with the ESOP on the lines of declaration under Form 12B of the Act and request XYZIPL to deduct the appropriate amount of tax at source.

Any perquisite arising to any employee in respect of an employment exercised in India would be taxable in India, irrespective of his residential status or place of receipt of income. The reason being salaries and related perquisites will be deemed to accrue or arise in India, if the employment is exercised in India, even in the case of a non-resident.
 
During the holding period – Disclosure in IT Returns

Indian Employees, who have exercised the options, are required to report the details of their foreign shares and foreign-sourced income (dividend income, capital gains, etc.) in their Indian Tax Returns throughout the period of holding (i.e., until the year of sale).

At time of Sale – Taxable as Capital Gains   

If ABCPL undertakes the buyback of shares from Indian employees, then capital gains will be chargeable to tax in the hands of Indian employees u/s 46A of the Income Tax Act. Capital gains will be computed as the difference between buyback prices decided by ABCPL and FMV on the date of allotment which shall be considered as the cost of acquisition as per provisions of section 49(2AA).

Tax on capital gains arising out of buyback of shares in the hands of Indian Employees in Singapore, if subject to tax in Singapore, can be claimed as a credit under the provisions of India – Singapore Double Tax Avoidance Agreement (DTAA), which also provides for the right of taxation in Singapore.

RELIEF FROM DOUBLE TAXATION – ARTICLE 25 OF THE INDIA-SINGAPORE DTAA
Article 13 of the DTAA between India and Singapore provides that Capital 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.

Capital gains arising to an employee who is a resident and ordinary resident will be taxed in India on a worldwide taxation basis and would also be taxed in Singapore. Double taxation can be avoided by resorting to the provisions of Article 25 of the DTAA.

Paragraph 2 of the said Article 25 provides for relief of double taxation for an Indian resident and provides that 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.

IMPLICATIONS UNDER THE COMPANIES ACT, 2013
The Companies Act, 2013 has specific regulations covering employees’ stock options plans, but they do not apply to a foreign entity issuing ESOPs to Indian employees.

ABCPL, being a foreign company provisions of the Companies Act, 2013 pertaining to ESOPs are not applicable to it.


ACCOUNTING OF ESOPS
Since XYZIPL is an unlisted company, provisions of Accounting Standards would apply instead of Ind AS, assuming that it is not meeting the net worth criteria for the applicability of IndAS. In this regard, Accounting Standards are notified under Companies (Accounting Standards) Rules, 2021.

In the instant case study provisions of Rule 3(1) would be applicable to  XYZIPL. That Rule lists AS in annexure B to the AS Rules 2021. From that list AS -15 dealing with “Employee Benefits” is the closest AS applicable. However, the scope of the AS-15 clearly states that the Standard should be applied by an employer in accounting for all employee benefits, except employee share-based payments and the Standard does not deal with accounting and reporting by employee benefit plans.

Thus, there is no prescribed Accounting Standard for accounting for Share-Based Payments. However, there is a Guidance Note issued by the ICAI, which deals with the Accounting for Share-Based Payments.

Provisions of Guidance Note on Accounting for Share-Based Payment – September 2020 Edition

Since the Accounting Standards do not contain provisions relating to share-based payments, the only reliance the Indian Company can have is on the Guidance Note issued by the ICAI in this regard. The introduction page of the Guidance Note (GN) on Accounting for share-based payments issued by the ICAI states that this is applicable for enterprises that are not required to follow Indian Accounting Standards (Ind AS). Paragraph 2 of the Introduction to the said GN clarifies that the GN is applicable to companies following Accounting Standards under Companies (Accounting Standards) Rules, 2021 read with section 133 of the Companies Act, 2013. Companies following Companies (Indian Accounting Standards) Rules, 2015, as amended, shall continue to follow Ind AS 102 – Accounting for Share-Based Payments.

The Effective Date is provided in paragraph 87 of the said GN, which states that the GN applies to share-based payment plans the grant date in respect of which falls on or after 1st April, 2021. An enterprise is not required to apply this GN to share-based payment to equity instruments that are not fully vested as at 1st April, 2021.

Whether Guidance Note is Mandatory?

Guidance Notes are primarily designed to provide guidance to members on matters which may arise in the course of their professional work and on which they may desire assistance in resolving issues, which may pose difficulty and are recommendatory in nature.

As the Guidance note on share-based payment is not mandatory in nature, XYZIPL (Indian Company) may follow the generally accepted accounting policy.

However, in case XYZIPL decides not to follow the guidance note and account for the ESOP to its employees by ABCPL, then it is advisable for the Auditor of XYZIPL to make necessary disclosure in the Notes to the Accounts.

Repercussions in case the Guidance Note is followed

If XYZIPL chooses to follow the Guidance Note on Share-Based Payments, then it needs to pass the necessary accounting entries.


CONCLUSION
Various practical issues commonly faced in respect of some of the cross-border ESOPs are broadly discussed in this write-up. The readers are well advised to minutely analyse the facts and other features of ESOPs before considering the application of some of the aspects discussed in this article.

Practically, it will be easier for the Indian company (XYZIPL) to comply with withholding tax obligations at the time of exercising options by its employees. Therefore, XYZIPL may opt for the solution discussed above. In either case, there would be no difference in the amount of withholding tax, however, the compliance would be easier if XYZIPL opts to deduct tax at source.

Taxability of Subscription to Database Paid to Non-Resident

Digitalisation has changed the way we conduct business in the last few years. In this article, the authors seek to analyse the tax implications arising from paying a subscription to a database to a non-resident.

1. BACKGROUND
Payment for the subscription to an online database is one of the most common remittances for businesses in India. The taxability of this payment has been a litigative issue, especially when it comes to TDS. The nature of the payment is such that one would need to look at various provisions under the Act and the DTAA to determine its taxability. The issue of whether payments for the use of an online database constitute royalty has been covered in the May, 2017 edition of BCAJ in the ‘Controversies’ feature. Further, the authors also covered this issue in the March, 2007 edition of BCAJ.

However, in the context of payment for the use of the software, the Hon’ble Supreme Court has laid down the law in its recent decision in Engineering Analysis Centre of Excellence (P.) Ltd vs. CIT (2021) 432 ITR 471. Further, India has introduced Equalisation Levy provisions for E-commerce operators as well as extended the definition of ‘income deemed to accrue or arise in India’ with the introduction of the Significant Economic Presence provisions (Explanation 2A to section 9(1)(i)) and extended source rule provisions (Explanation 3A to section 9(1)(i)). Therefore, the authors have sought to provide an overview of the taxability of such payments in view of the recent amendments in law and the judicial precedents.  

A database is an organised collection of data and information. From a business-user perspective, it can broadly cover the publicly available information provided in an organised manner, such as the price of certain commodities, a legal database covering various judgements, business information reports etc., or cover opinions on various issues provided by various experts or a mix of both.

When subscribing to a database, one generally gets access to view various reports/ data available on the database. Such a database may further, in some cases, be modified in a certain manner (such as granting access to only certain modules) depending on the need of the user organisation. In most End User Licence Agreements (‘EULA’) granting  access to the database, the right to view the information is provided. The main copyright of the database and the data in the database continue to be with the database owner (except in cases where the data in the database is publicly available information).

Some aspects that one needs to consider while determining the taxability of payment for subscription of an online database, especially in a cross-border transaction and which the authors have sought to analyse in this article are as follows:

  • Whether the payment would constitute  Royalty under the provisions of the Income Tax Act, 1961 (‘the Act’) or the relevant Double Taxation Avoidance Agreement (‘DTAA’)?

  • Whether the payment constitutes ‘Fees for Technical Services’ under the provisions of the Act or the relevant DTAA?

  • Whether the provisions of Explanation 2A to section 9(1)(i) of the Act, i.e. Significant Economic Presence (‘SEP’) would, apply to such a payment?

  • Would the Equalisation Levy on E-commerce Operators, introduced by the Finance Act, 2020, apply to such a payment?

2. TAXABILITY UNDER THE ACT

In the ensuing paragraphs, we have analysed the provisions of the Act. The activities of the database service provider are generally undertaken outside India, and therefore, arguably, income earned from granting access to the database may not be considered as accruing or arising in India u/s 5 of the Act. One needs to consider if the income would be considered ‘deeming to accrue or arise in India’ u/s 9 of the Act. Under the domestic tax provisions of the Act, one would also need to evaluate whether the payment qualifies as ‘royalty’ or ‘fees for technical services’ or whether the SEP provisions are attracted.

2.1. Whether taxable as royalty?

The term ‘royalty’ has been defined in Explanation 2 to section 9(1)(vi) of the Act. In this regard, we would like to bring the attention of the readers to the feature in BCAJ in May, 2017, mentioned above, wherein the applicability of the definition of the term to the payment for access to an online database has been analysed. In the said feature, the authors have concluded that the payment towards the use of the database would not constitute royalty under the provisions of the Act as well as the relevant DTAA. While, to give a holistic view on the matter, in this article, we have covered the applicability of the provisions of the term ‘royalty’, the reader may refer to the May, 2017 article for further in-depth analysis.

The term ‘royalty’ is defined to mean consideration for the following:

“(i) the transfer of all or any rights (including the granting of a licence) in respect of a patent, invention, model, design, secret formula or process or trade mark or similar property;

(ii) the imparting of any information concerning the working of, or the use of, a patent, invention, model, design, secret formula or process or trade mark or similar property;

(iii) the use of any patent, invention, model, design, secret formula or process or trade mark or similar property;

(iv) the imparting of any information concerning technical, industrial, commercial or scientific knowledge, experience or skill;

(iva) the use or right to use any industrial, commercial or scientific equipment but not including the amounts referred to in section 44BB;

(v) the transfer of all or any rights (including the granting of a licence) in respect of any copyright, literary, artistic or scientific work including films or video tapes for use in connection with television or tapes for use in connection with radio broadcasting ; or

(vi) the rendering of any services in connection with the activities referred to in sub-clauses (i) to (iv), (iva) and (v).”

In the ensuing paragraphs, we have sought to analyse each and every aspect of the above definition.  

2.1.1. Whether software?

Explanation 4 to section 9(1)(vi) of the Act further extends the definition to include consideration in respect of any right, property or information and also includes the transfer of right for use or right to use computer software (including granting of a licence).

Explanation 3 to section 9(1)(vi) defines the term ‘computer software’ as follows:

“For the purposes of this clause, “computer software” means any computer programme recorded on any disc, tape, perforated media or other information storage device and includes any such programme or any customized electronic data.”

As the expression ‘means’ has been used for defining ‘computer software’, one would need to interpret the provisions strictly within the confines of the definition. In other words, a database would be considered ‘computer software’ only if it falls within any of the aspects covered above.

In the case of an online database, it is not a computer programme recorded on any disc, tape, perforated media or other information storage device. The question that arises is whether it would be considered as ‘customized electronic data’. In this regard, one may refer to the decision of the Chennai ITAT in the case of ITO vs. Accurum India Pvt Ltd (2010) 126 ITD 69, wherein this term was analysed, albeit in the context of section 80HHE for the definition of ‘computer software’1. The ITAT held that for the data to be ‘customised’ it would need to be suitable for a specific customer only. In the present case, the data is available to all subscribers to the database and, therefore, cannot be considered customised.

1. Taxation of Copyright Royalties in India – Interplay of Copyright Law and Income Tax by Ganesh Rajgopalan published by Taxsutra and Oakbridge, 2nd edition.

Therefore, a database cannot be considered ‘computer software’, and the provisions of Explanation 3 and 4 of section 9(1)(vi) shall not apply in this case.

2.1.2. Whether patent, invention, model, design, secret formula or process or trade mark or similar property?

While the online database would not be considered a patent, invention, model, design or trade mark (the process is discussed in ensuing paragraphs), the question arises what does one mean by ‘similar property’.

Various Courts have referred to the Copyright Act, 1957 (‘CA 1957’) in this regard to determine whether ‘software’ can be considered copyright and, therefore, payment for the use of the same be considered as ‘royalty’ under the Act. The Karnataka High Court in the case of CIT vs. Wipro Ltd. (2013) 355 ITR 284, held that payment for the use of the database would constitute royalty. In this case, the Court relied on its earlier ruling in the case of CIT vs. Samsung Electronics Co. Ltd (2012) 345 ITR 494,  and after relying on the definition of copyright under the CA 1957 had held that the payment for the use of computer software would constitute payment towards the use of copyright and therefore, taxable as ‘royalty’.

Section 2(o) of the CA 1957 provides as follows:

“‘literary work’ includes computer programmes, tables and compilations including computer databases;”

Further, section 14 of the CA 1957 provides as follows:

“For the purposes of this Act, “copyright” means the exclusive right subject to the provisions of this Act, to do or authorise the doing of any of the following acts in respect of a work or any substantial part thereof, namely:—

(a) in the case of a literary, dramatic or musical work, not being a computer programme,—

(i) to reproduce the work in any material form including the storing of it in any medium by electronic means;

(ii) to issue copies of the work to the public not being copies already in circulation;

(iii) to perform the work in public, or communicate it to the public;

(iv) to make any cinematograph film or sound recording in respect of the work;

(v) to make any translation of the work;

(vi) to make any adaptation of the work;

(vii) to do, in relation to a translation or an adaptation of the work, any of the acts specified in relation to the work in sub-clauses (i) to (vi);

(b) in the case of a computer programme,—

(i) to do any of the acts specified in clause (a);

(ii) to sell or give on commercial rental or offer for sale or for commercial rental any copy of the computer programme:

Provided that such commercial rental does not apply in respect of computer programmes where the programme itself is not the essential object of the rental;”

Recently, we had the landmark ruling in the context of the taxability of computer software as royalty. The Supreme Court in the case of Engineering Analysis Centre of Excellence (P.) Ltd vs. CIT (2021) 432 ITR 471, held that payment towards the use of the computer software would not constitute ‘royalty’ under the relevant DTAA, effectively overruling the decision of the Karnataka High Court in the case of Samsung Electronics (supra).

The relevant paragraphs of this landmark decision of the Apex Court, applicable to our analysis of taxability of online database, have been reproduced below:

“46. When it comes to an end-user who is directly sold the computer programme, such end-user can only use it by installing it in the computer hardware owned by the end-user and cannot in any manner reproduce the same for sale or transfer, contrary to the terms imposed by the EULA.

47. In all these cases, the “licence” that is granted vide the EULA, is not a licence in terms of section 30 of the Copyright Act, which transfers an interest in all or any of the rights contained in sections 14(a) and 14(b) of the Copyright Act, but is a “licence” which imposes restrictions or conditions for the use of computer software. Thus, it cannot be said that any of the EULAs that we are concerned with are referable to section 30 of the Copyright Act, inasmuch as section 30 of the Copyright Act speaks of granting an interest in any of the rights mentioned in sections 14(a) and 14(b) of the Copyright Act. The EULAs in all the appeals before us do not grant any such right or interest, least of all, a right or interest to reproduce the computer software. In point of fact, such reproduction is expressly interdicted, and it is also expressly stated that no vestige of copyright is at all transferred, either to the distributor or to the end-user. A simple illustration to explain the aforesaid position will suffice. If an English publisher sells 2000 copies of a particular book to an Indian distributor, who then resells the same at a profit, no copyright in the aforesaid book is transferred to the Indian distributor, either by way of licence or otherwise, inasmuch as the Indian distributor only makes a profit on the sale of each book. Importantly, there is no right in the Indian distributor to reproduce the aforesaid book and then sell copies of the same. On the other hand, if an English publisher were to sell the same book to an Indian publisher, this time with the right to reproduce and make copies of the aforesaid book with the permission of the author, it can be said that copyright in the book has been transferred by way of licence or otherwise, and what the Indian publisher will pay for, is the right to reproduce the book, which can then be characterised as royalty for the exclusive right to reproduce the book in the territory mentioned by the licence. ….

52. There can be no doubt as to the real nature of the transactions in the appeals before us. What is “licensed” by the foreign, non-resident supplier to the distributor and resold to the resident end-user, or directly supplied to the resident end-user, is in fact the sale of a physical object which contains an embedded computer programme, and is therefore, a sale of goods, which, as has been correctly pointed out by the learned counsel for the assessees, is the law declared by this Court in the context of a sales tax statute in Tata Consultancy Services (supra) (see paragraph 27).”

The Supreme Court has distinguished the rights in the software and held that the right to use the software is different from the right in the copyright in the software, and the former would not constitute royalty.

Using the same analogy for an online database, one does not get a right to use the copyright in the database itself but only the right to use the database and therefore, such a payment would not constitute royalty under the first limb of the definition.

Similar principles, that payment for the use of database would not constitute payment for the use of copyright in the database and therefore not royalty, are also emanating from the following recent decisions (albeit rendered before the above-referred decision of the Supreme Court):

  • Mumbai ITAT in the case of American Chemical Society vs. DCIT (2019) 106 taxmann.com 253.

  • Delhi ITAT in the case of Dow Jones & Company Inc vs. ACIT (2022) 135 taxmann.com 270.

  • Ahmedabad ITAT in the cases of DCIT vs. Welspun Corporation Ltd (2017) 183 TTJ 697 and ITO vs. Cadila Healthcare Ltd (2017) 184 TTJ 178.

Further, there are various rulings such as that of the AAR in the cases of Dun & Bradstreet Espana, S.A., In re (2005) 272 ITR 99, Factset Research System Inc. and In re (2009) 317 ITR 169 or the Delhi ITAT in the case of McKinsey Knowledge Centre India (P.) Ltd. vs. ITO (2018) 92 taxmann.com 226, wherein it has been held that payment towards the use of database which only collates publicly available information, cannot be considered as ‘royalty’ under the Act or the DTAA.

2.1.3. Whether Process Royalty?

The term ‘process’ has been defined in Explanation 6 to section 9(1)(vi) of the Act as follows:

“For the removal of doubts, it is hereby clarified that the expression “process” includes and shall be deemed to have also included transmission by satellite (including up-linking, amplification, conversion for down-linking of any signal), cable, optic fibre or by any other similar technology, whether or not such process is secret;”

In the view of the authors, process would mean the way a particular activity is undertaken, and Explanation 6 merely extends the meaning of the term to cover the various modes of transmission of the process and to overrule certain judicial precedents which held that under the Act, for payment towards the process to be considered as ‘royalty’, such process should be secret.

In this scenario, the payment is not towards any process relating to the database. Therefore, this limb of the definition of ‘royalty’ is also not satisfied in the case of payment towards access to an online database.

2.1.4. Whether Equipment Royalty?

The term ‘royalty’ includes payment for the use or right to use industrial, commercial or scientific equipment.

In this regard, one may refer to the decision of the AAR in the case of Cargo Community Network (P.) Ltd, In re (2007) 289 ITR 355 wherein it has been held that amounts received towards the access granted to use an internet-based air cargo portal would constitute payment towards the use of ‘equipment’ and therefore, taxable as royalty under the Act. In the said case, the AAR concluded that it is not possible to use the portal without the server, and therefore, payment was made towards an integrated commercial-cum-scientific equipment, being the server on which the portal operates.

A similar view was also taken by the AAR in the case of IMT Labs (India) (P.) Ltd, In re (2006) 287 ITR 450.

However, in a subsequent decision of Dell International Services India (P) Ltd, In Re (2009) 305 ITR 37, the AAR has held that payment towards the use of a facility which uses sophisticated equipment would not be considered as payment towards the use of the equipment itself.

In the view of the authors, the decision of the AAR in the case of Dell (supra) presents a better view of the matter, and if one pays for access to the database, it cannot be said that one is paying for the use of the server on which such database is operated. Therefore, such a payment would not be considered towards the use or right to use industrial, commercial or scientific equipment.

2.1.5. Whether Experience Royalty?

Clause (iv) of Explanation 2 to section 9(1)(vi), defining the term ‘royalty’ includes payment towards the imparting of any information concerning technical, industrial, commercial or scientific knowledge, experience or skill.

The OECD Model Commentary on Article 12 explains the term as follows:

“11. In classifying as royalties payments received as consideration for information concerning industrial, commercial or scientific experience, paragraph 2 is referring to the concept of “know-how”. Various specialist bodies and authors have formulated definitions of know-how. The words “payments … for information concerning industrial, commercial or scientific experience” are used in the context of the transfer of certain information that has not been patented and does not generally fall within other categories of intellectual property rights. It generally corresponds to undivulged information of an industrial, commercial or scientific nature arising from previous experience, which has practical application in the operation of an enterprise and from the disclosure of which an economic benefit can be derived….

11.1 In the know-how contract, one of the parties agrees to impart to the other, so that he can use them for his own account, his special knowledge and experience which remain unrevealed to the public. It is recognised that the grantor is not required to play any part himself in the application of the formulas granted to the licensee and that he does not guarantee the result thereof……”

There is further guidance on this subject in the UN Model Commentary on Article 12, which provides as follows:

“16. Some members from developing countries interpreted the phrase “information concerning industrial, commercial or scientific experience” to mean specialized knowledge, having intrinsic property value relating to industrial, commercial, or managerial processes, conveyed in the form of instructions, advice, teaching or formulas, plans or models, permitting the use or application of experience gathered on a particular subject. “

The term ‘knowledge, experience or skill’ has been held to be referring to those intangibles or know-how which are acquired on undertaking a particular activity, but which may not necessarily be registered as an intangible.

If one refers to the meaning of the term, there are various decisions, such as the Hyderabad ITAT in the case of GVK Oil & Gas Ltd vs. ADIT (2016) 158 ITD 215, Mumbai ITAT in the case of Dy. DIT vs. Preroy AG (2010) 39 SOT 187, the AAR in the case of Real Resourcing Ltd, In re (2010) 322 ITR 558 and the Bombay High Court in the case of Diamond Services International (P) Ltd vs. Union of India (2008) 304 ITR 201, wherein the distinction between a contract for imparting know-how, experience or skill has been differentiated from a contract where such know-how, experience, skill has been used to provide services. There are various decisions which have been referred to above wherein the Courts have held that payment towards the use of publicly available information would not amount to imparting of any knowledge, experience or skill and, therefore, would not be considered ‘royalty’.

In this regard, it would be important to highlight the decision of the AAR in the case of ThoughtBuzz (P.) Ltd, In re (2012) 21 taxmann.com 129, wherein it has been held that income of a social media monitoring service, providing a platform for a subscription for users to engage with their customers, brand ambassadors, etc., would constitute payment for the use of commercial or industrial knowledge and therefore, taxable as royalty. In the said case, the taxpayer obtained information from blogs, forums, social networking sites, review sites, questions and answers sites and Twitter and collated the same for its users. The AAR did not provide detailed reasoning for arriving at this conclusion.

However, in the authors’ view, this may not be the better view as the information, which is collated by the database in question, was public information.

In most cases, the payment towards access to the database would not be considered ‘royalty’ as the payment would be towards information which is publicly available, but collated for the benefit of the users. However, one may need to evaluate, on the basis of the facts, if any knowledge or experience (whether belonging to the database service provider or otherwise) is imparted through the database, payment towards the use of such database, and if such experience is imparted, the transaction may be considered as ‘royalty’.

In view of the above, one may be able to take the view that the payment towards access to an online database would not constitute royalty under the Act.

2.2. Whether taxable as Fees for Technical Services?

The term ‘fees for technical services’ has been defined in Explanation 2 to section 9(1)(vii) of the Act to mean the following:

“For the purposes of this clause, ‘fees for technical services’ means any consideration (including any lump sum consideration) for the rendering of any managerial, technical or consultancy services (including the provision of services of technical or other personnel) but does not include consideration for any construction, assembly, mining or like project undertaken by the recipient or consideration which would be income of the recipient chargeable under the head “Salaries”;”

The first question which arises is whether such a payment would constitute ‘towards services’. While the term is not specifically defined in the Act, one may look at the general meaning of the term and such payment would constitute ‘towards services’. Arguably, such services would not be considered managerial or consultancy services. Further, such services do not involve any human intervention, and therefore, following the decision of the Supreme Court in the case of CIT vs. Kotak Securities Ltd (2016) 383 ITR 1, such services would not be considered ‘technical services’.

In the specific context of online databases, a similar view was taken by the Mumbai ITAT in the case of Elsevier Information Systems GmbH vs. DCIT (2019) 106 taxmann.com 401, wherein it was held that in the absence of any interaction between the customer/user of the database and the employees of the assessee, or any other material on record to show any human intervention while providing access to the database, such a payment could not be considered towards technical services.

Therefore, a subscription to an online database would not be considered as ‘fees for technical services’ u/s 9(1)(vii) of the Act.

2.3. Applicability of SEP provisions

The Finance Act, 2018 has introduced  Significant Economic Presence (‘SEP’) provisions in India. Explanation 2A to section 9(1)(i) extends the definition of business connection to include SEP and SEP has been defined to mean the following:

(a) transaction in respect of any goods, services or property carried out by a non-resident with any person in India including provision of download of data or software in India, if the aggregate of payments arising from such transaction or transactions during the previous year exceeds such amount as may be prescribed; or

(b) systematic and continuous soliciting of business activities or engaging in interaction with such number of users in India, as may be prescribed.

Further, the Proviso to the Explanation also provides that the transactions or activities shall constitute SEP, whether or not:

(i) the agreement for such transactions or activities is entered in India; or

(ii) the non-resident has a residence or a place of business in India; or

(iii) the non-resident renders services in India.

In other words, the SEP provisions would apply even if such services are rendered outside India, if it is undertaken with any person in India and if the aggregate payments during the year exceed the threshold prescribed.

The CBDT vide Notification No. 41/2021/F.No.370142/11/2018-TPL dated 3rd  May, 2021, has notified the thresholds to mean Rs. 2 crores in the case of payments referred to in clause (a) above and 3 million users in clause (b) above.

In the case of an online database, the question first arises is which of the above clauses of the Explanation would apply – whether the payment threshold or the number of users. As discussed above, the provision of access to the database may be considered a service, even if no human intervention is involved. Therefore, such services, not being FTS and rendered by a non-resident to any person in India, would trigger the SEP provisions if the payment threshold is exceeded. Further, if the number of users in India of such a database exceeds the number prescribed, SEP provisions could apply.

In other words, both the clauses of Explanation 2A could apply simultaneously, and even if one of the conditions prescribed is met, SEP provisions may apply to the said transactions.

2.4. Applicability of Explanation 3A of section 9(1)(i)

The Finance Act, 2020 extended the Source Rule for income attributable to operations carried out in India by inserting Explanation 3A to Section 9(1)(i), which reads as under:

“Explanation 3A.—For the removal of doubts, it is hereby declared that the income attributable to the operations carried out in India, as referred to in Explanation 1, shall include income from—

(i) such advertisement which targets a customer who resides in India or a customer who accesses the advertisement through internet protocol address located in India;

(ii) sale of data collected from a person who resides in India or from a person who uses internet protocol address located in India; and

(iii) sale of goods or services using data collected from a person who resides in India or from a person who uses internet protocol address located in India.’’

At the outset, in the authors’ view, and as explained in detail in our article in the March 2021 issue of BCAJ, Explanation 3A does not create a new source or nexus for the income of a non-resident in India, but it merely extends the source, which a non-resident may already have to tax the income specified above. Therefore, if the non-resident is otherwise not having a business connection in India, Explanation 3A would not impact the income of such taxpayers in India. On the other hand, if a non-resident has a business connection in India, say on account of the SEP provisions, the income as mentioned above would also be considered attributable to operations undertaken in India irrespective of whether they are attributable to the business connection or not.

In the case of an online database, income from providing access of database would not be covered under clause (i) above. Further, one may also be able to argue that the database is not selling the data but merely providing access to view the data, and therefore, clause (ii) may also not apply.

The database service provider is providing services and if the data used in those services from a person who resides in India or from an ISP located in India, clause (iii) may trigger and if such non-resident already has a business connection in India, the income from the provision of such services (even to other non-residents) may be taxed in India. However, if the database collects information from all over the world (say for example, a global legal database covering judicial precedents on a particular issue from all over the world including India), it may not be possible to attribute a particular value to the data collected from India.

3. TAXABILITY UNDER DTAA

In the above paragraphs, we have analysed that the payments received towards the provision of access to database would not be taxable as Royalty or FTS under the domestic provisions of the Act itself. Generally, the definition of ‘Royalty’ or FTS in a DTAA is similar or narrower than the definition of the term under the Act, and therefore, such payments would also not be taxable as Royalty or FTS under the DTAA.

Further, even if the SEP provisions are triggered on account of the payments received from persons in India or the number of users in India, such online database service provider, in the absence of any physical presence in India, may also not have a Permanent Establishment (PE) in India under the DTAA and therefore, may not be liable to tax in India under the DTAA.

4. TAXABILITY UNDER EQUALISATION LEVY PROVISIONS

The Finance Act, 2020 introduced Equalisation Levy (‘EL’) in the hands of a non-resident E-commerce operator on E-commerce supply or services (‘EL ESS’). The earlier provisions of EL applied in the case of online advertisement services, which would not apply in the case of payment for access to a database. However, one may need to evaluate whether the provisions of EL ESS may apply in this scenario.

Section 165A of the Finance Act, 2016 (inserted vide Finance Act, 2020 with effect from 1st April, 2020) provides that EL ESS provisions shall apply at the rate of 2% on the amount of consideration received or receivable by an E-commerce operator (‘EOP’) from E-commerce supply or services (‘ESS’) made or provided or facilitated by it if the turnover or sales from such ESS exceeds Rs. 2 crores during the previous year. The first question which arises is whether an online database service provider would be considered  an EOP.

4.1. Whether database service provider would be considered as an E-commerce operator

Section 164(ca) of the Finance Act, 2016 (inserted vide Finance Act, 2020 with effect from 1st April, 2020) defines an EOP to mean as follows:

“‘e-commerce operator’ means a non-resident who owns, operates or manages digital or electronic facility or platform for online sale of goods or online provision of services or both;”

In the case of an online database service provider, the database would constitute an electronic facility or platform. The issue to be addressed is whether such a platform would be for the online provision of services. In this regard, we have discussed above, that provision of an online database would constitute a service, and such services are provided through the database and hence would be considered as having been provided online.

Therefore, an online database service provider would be considered an EOP.

4.2. Whether services would qualify as E-commerce supply or services

As discussed above, as the services rendered by the EOP would be considered an online provision of services, such services would also satisfy the definition of ESS u/s 164(cb) of the Finance Act, 2016.

Section 165A of the Finance Act, 2016 provides as follows:

“On and from the 1st day of April, 2020, there shall be charged an equalisation levy at the rate of two per cent of the amount of consideration received or receivable by an e-commerce operator from e-commerce supply or services made or provided or facilitated by it—

(i) to a person resident in India; or

(ii) to a non-resident in the specified circumstances as referred to in sub-section (3); or

(iii) to a person who buys such goods or services or both using internet protocol address located in India.”

Having concluded that the services qualify as ESS and the database service provider would be considered as EOP, the EL ESS provisions would apply if the access to the database is provided to a person resident in India, a person using an IP address located in India.

In this regard, it would be important to highlight that in the case of EL ESS, the liability to discharge the tax is on the non-resident recipient, and no deduction of EL is required to be undertaken by the resident payer.

The specified circumstances, as provided in clause (ii) above, would apply only in case the data is collected from a person resident in India or a person who uses an IP address located in India. If the data is not collected from such a person, and if the access is provided to a non-resident, the EL ESS provisions will not apply even if the data collated is in respect of India.

5. CONCLUSION

In view of the above discussion, payment for subscription of an online database may not be considered  Royalty or FTS under the Act or the DTAA. If the amount of payment or the number of users in India is exceeded, SEP provisions may be triggered, and the online database service provider may be considered as having a business connection in India. However, the income from subscription to the database would not be taxable in the absence of a PE in India under the relevant DTAA. Further, if the income from Indian users exceeds Rs. 2 crores, the EL ESS provisions may apply to such an online database service provider.

TAXABILITY OF EXPORT COMMISSION PAID TO A NON-RESIDENT AGENT

Rapid globalisation and the increasing use of technology has resulted in a significant increase in foreign remittances from India. Given the onerous responsibility of a practitioner to certify the tax liability of the non-resident recipient to a foreign remittance, it is imperative that one is aware of the various interpretations available, and takes an informed view while issuing Form 15CB.

Over a series of articles, the authors seek to analyse the withholding tax implications and some of the issues arising on some of the common remittances. While all forms of remittances may not be covered in this article, the authors’ objective is to provide comprehensive coverage of the limited types of remittances.

In this first part of the series, we have analysed payments regarding export commission.

1. BACKGROUND
Let us consider the payment of export commission to an agent situated outside India. The activities undertaken by such an agent would typically include marketing the goods in the country of sale, identifying the buyer, coordinating with the buyer on the logistical aspects of the sale, and placing the order for the goods with the buyer. The activities of such an agent may also include receiving goods from the principal and delivering it to the buyer. For such activities, the agent may charge a fixed commission to its principal situated in India.

2. WHETHER THE INCOME OF SUCH AGENT WOULD ACCRUE OR ARISE IN INDIA?
Section 5 of the Income Tax Act, 1961 (‘the Act’) provides that income of a non-resident would be taxable in India if such income:

a. Is received or is deemed to be received in India; or

b. Accrues or arises or is deemed to accrue or arise in India.

In the case of export commission paid to a non-resident agent, generally such income is paid outside India and is therefore, not received in India. Therefore, one would need to evaluate whether such income is accruing or arising in India or is deemed to accrue or arise in India.

In this regard, Circular No. 23 of 1969 throws some light on the matter by providing the following:

“3.4 A foreign agent of Indian exporter operates in his own country and no part of his income arises in India..”

Therefore, the Circular provided that in respect of a non-resident agent, commission income from export would not be considered as accruing or arising in India.

While the Circular has since been withdrawn, the principle emanating from the Circular should apply even after the withdrawal.

There are various judicial precedents which have held that the income of such agent would not be considered as accruing or arising in India.

The Delhi ITAT in the case of Welspring Universal vs. JCIT [2015] 56 taxmann.com 174, held:

“4…….In the context of rendering of services for procuring export orders by a non-resident from the countries outside India, there can be no way for considering the actual export from India as the place for the accrual of commission income of the non-resident. One should keep in mind the distinction between the accrual of income of exporter from exports and that of the foreign agent from commission. As a foreign agent of Indian exporter operates outside India for procuring export orders and further the goods in pursuance to such orders are also sold outside India, no part of his income can be said to accrue or arise in India.”

Interestingly, in the above case, the Tribunal distinguished between the source of income for the foreign agent vis-à-vis that for the exporter. The source of income for the exporter, as held by the Chennai ITAT in the case of DCIT vs. Alstom T & D India Ltd. (2016) 68 taxmann.com 336, would be the place where the manufacturing activities are undertaken or where the export contract has been entered into. On the other hand, for the foreign agent, the source of his income i.e. commission on the sale of goods would depend on where the services are rendered by such agent.

Prior to the amendment in Explanation to section 9(1)(vii) of the Act, the Supreme Court in the case of Ishikawajima-Harima Heavy Industries Ltd. vs. DCIT (2007) 288 ITR 408 held that even if the services are considered as fees for technical services (‘FTS’), if such services are not rendered in India, the income arising from such services would not be considered as accruing or arising in India. While the above decision of the Apex Court has been overruled by the amendment vide Finance Act 2010 (with retrospective effect from 1st June, 1976), the principle arising from the decision would still apply in the case of services rendered (to the extent the same is not considered as FTS) outside India.

The Karnataka High Court in the case of PCIT vs. Puma Sports India (P.) Ltd. (2021) 434 ITR 69 held that commission paid to a non-resident agent for placing orders with manufacturers outside India would not be liable to tax in India as such services were rendered as well as utilized outside India. Therefore, no taxing event had taken place within the territories of India. The Supreme Court dismissed the SLP filed by the Revenue against the above High Court order (2022) 134 taxmann.com 60.

3. WHETHER SUCH INCOME IS DEEMED TO ACCRUE OR ARISE IN INDIA UNDER SECTION 9(1)(i)
The next question which arises is whether such income is deemed to accrue or arise in India under section 9 of the Act. While the question as to whether such income is considered as FTS under section 9(1)(vii) of the Act has been analysed in the ensuing paragraphs, let us first evaluate whether section 9(1)(i) of the Act could bring the commission income of a non-resident agent from services rendered to the principal outside India, to tax in India.

Section 9(1)(i) of the Act deems the following income to accrue or arise in India:

a.    Income accruing or arising, directly or indirectly, through or from any business connection in India;

b.    Income accruing or arising, through or from any property in India;

c.    Income accruing or arising, through or from any asset or source of income in India; or

d.    Income accruing or arising, through the transfer of a capital asset situated in India.

With regards to the first limb, the Supreme Court in the case of CIT vs. R.D. Aggarwal and Co. (1965) 56 ITR 20, has laid down the broad principle for defining the term ‘business connection’. In the context of section 42(1) of the Income Tax Act, 1922, similar to the provisions of section 9(1)(i) of the Act, the Apex Court held as follows:

“The expression “business connection” undoubtedly means something more than “business”. A business connection in section 42 involves a relation between a business carried on by a non-resident which yields profits or gains and some activity in the taxable territories which contributes directly or indirectly to the earning of those profits or gains. It predicates an element of continuity between the business of the non-resident and the activity in the taxable territories: a stray or isolated transaction is normally not to be regarded as a business connection. Business connection may take several forms: it may include carrying on a part of the main business or activity incidental to the main business of the non-resident through an agent, or it may merely be a relation between the business of the non-resident and the activity in the taxable territories, which facilitates or assists the carrying on of that business. In each case the question whether there is a business connection from or through which income, profits or gains arise or accrue to a non-resident must be determined upon the facts and circumstances of the case.

A relation to be a “business connection” must be real and intimate, and through or from which income must accrue or arise whether directly or indirectly to the non-resident. ….

….  Income not taxable under section 4 of the 1922 Act of a non-resident becomes taxable under section 42(1) of the 1922 Act, if there subsists a connection between the activity in the taxable territories and the business of the non-resident, and if through or from that connection income directly or indirectly arises.”

Therefore, in order for business connection [other than the provisions of Significant Economic Presence (‘SEP’), which have been discussed subsequently in this article] to exist, there needs to be a business activity continuously undertaken in the country. In other words, in the absence of any business activities undertaken in India, a business connection may not be constituted.

This is also evident from Explanation 1 to section 9(1)(i) of the Act which provides as follows:

“(a) in the case of a business, other than the business having business connection in India on account of significant economic presence, of which all the operations are not carried out in India, the income of the business deemed under this clause to accrue or arise in India shall be only such part of the income as is reasonably attributable to the operations carried out in India ;”

Therefore, except in the case of a business connection on account of the SEP provisions, only such part of the income as is reasonably attributable to operations carried out in India can be considered as income deemed to accrue or arise in India.

In this regard, the Supreme Court, in the case of CIT vs. Toshoku Ltd. (1980) 125 ITR 525, had analysed whether the export commission paid to non-resident agents would be considered as income deemed to accrue or arise in India.

In that case, the assessee was an exclusive sales agent of tobacco in Japan and France for an Indian exporter. The assessee, for its services rendered, received commission from the Indian exporter. Without evaluating whether ‘business connection’ of the non-resident assessee was constituted in India, the Supreme Court held that in the absence of any activities undertaken by the non-resident assessee in India, no income could be considered as attributable to any operations in India and therefore, no income could be considered as deemed to accrue or arise in India.

The second limb of section 9(1)(i) of the Act refers to income accruing through or from a property situated in India. Arguably, sale of goods may not be considered as sale of property. Moreover, even in case such sale of goods is considered as sale of property, one may be able to argue that section 9(1)(i) refers to income accruing through or from a property situated in India and income from the sale of such property would not qualify as income from a property (such as rental income) nor as income through a property. Additionally, one can also argue that the commission income, being income from services rendered in relation to the sale of goods, is one step further away from income from sale of property and income through or from property.

The third limb of section 9(1)(i) of the Act refers to income accruing or arising through or from any asset or source in India. As discussed above, income from services rendered towards sale of goods may not be considered as income accruing or arising through or from any asset in India. Interestingly, the AAR in the case of Rajiv Malhotra, In re (2006) 284 ITR 564, held that export commission would be considered as income accruing or arising through or from a source of income in India.

In that case, the assessee was organising an exhibition in India and had appointed foreign agents to furnish information to foreign participants about the exhibition and for booking space in the exhibition. Such agents would be rendering the services outside India, and no services by the agents were rendered in India. The agents were responsible for planning, directing and executing the sales campaign for the assessee and the exhibition in the foreign jurisdictions. The agent would receive the commission only on participation by the exhibitors in the exhibition in India.

The AAR held that the fact that the income of the agent was dependent on the participation by the exhibitors (customers) in India would mean that the source of income for the non-resident agent would be considered to be in India. The AAR further also held that the fact that the services by the agents were rendered outside India would be of no consequence.

The above decision of the AAR was also followed in the decision by the same authority in the case of SKF Boilers and Driers (P.) Ltd., In re (2012) 343 ITR 385.

In the view of the authors, with the utmost respect to the AAR, the above decisions of the AAR may not be considered as an appropriate analysis of the matter on account of the following reasons:
a. The AAR did not consider the decision of the Supreme Court in the case of Toshoku Ltd. (supra), wherein the commission received by non-resident agents was considered to be accruing or arising outside India and hence not taxable; and

b. The AAR did not consider the impact of Explanation 1(a) to section 9(1)(i) of the Act. Even if the decision of the AAR is considered, the fact that no operations of the agent are actually undertaken in India would result in no attribution of income of the agent to be deemed to accrue or arise in India.

Therefore, subject to the applicability of the SEP provisions, analysed in para 6 below, export commission earned by a non-resident agent would not be deemed to accrue or arise in India under section 9(1)(i) of the Act.

4. WHETHER THE SERVICES RENDERED BY THE AGENT CAN BE CONSIDERED AS FEES FOR TECHNICAL SERVICES
The other sub-clauses of section 9(1) of the Act – dealing with salary, interest and royalty would not be applicable in this case. One would now need to analyse whether the services rendered by the commission agent would be considered as FTS under section 9(1)(vii) of the Act. There are various decisions discussing various facets of the FTS clause, and this article does not cover all such case laws on the matter. This article covers those case laws relevant to the type of payment, i.e. export commission and the taxability thereof.

The crux of the matter is whether the consideration received by a commission agent would be considered as towards rendering of services. In this regard, one may refer to the Ahmedabad ITAT in the case of DCIT vs. Welspun Corporation Ltd. (2017) 77 taxmann.com 165, wherein it has been held that the agent receives the commission on securing order and not for the provision of the services. The reasoning provided by the ITAT is as under:

“Even proceeding on the assumption that these non-resident agents did render the technical services, which, is an incorrect assumption any way, what is important to appreciate is that the amounts paid by the assessee to these agents constituted consideration for the orders secured by the agents and not the services alleged rendered by the agents. The event triggering crystallization of liability of the assessee, under the commission agency agreement, is the event of securing orders and not the rendition of alleged technical services. In a situation in which the agent does not render any of the services but secures the business any way, the agent is entitled to his commission which is computed in terms of a percentage of the value of the order. In a reverse situation, in which an agent renders all the alleged technical services but does not secure any order for the principal i.e. the assessee, the agent is not entitled to any commission. Clearly, therefore, the event triggering the earnings by the agent is securing the business and not rendition of any services. In this view of the matter, the amounts paid by the assessee to its non-resident agents, even in the event of holding that the agents did indeed render technical services, cannot be said to be ‘consideration for rendering of any managerial, technical or consultancy services’…..The work actually undertaken by the agent is the work of acting as agent and so procuring business for the assessee but as the contemporary business models require the work of agent cannot simply and only be to obtain the orders for the product, as this obtaining of orders is invariably preceded by and followed by several preparatory and follow up activities. The description of agent’s obligation sets out such common ancillary activities as well but that does not override, or relegate, the core agency work. The consideration paid to the agent is also based on the business procured and the agency agreements do not provide for any independent, standalone or specific consideration for these services.”

Therefore, the Ahmedabad ITAT in the above case held that the consideration received by the agent is towards the procurement of business and not for services rendered.

However, generally, the revenue authorities also seek to tax the export commission as FTS, given the sheer number of judicial precedents on the issue. Therefore, it is important to analyse whether such commission can be classified as FTS under section 9(1)(vii).

The term ‘fees for technical services’ broadly covers the following categories of services:

• Managerial services;

• Technical services; and

• Consultancy services.

The terms ‘managerial’, ‘technical’ or ‘consultancy’ have not been defined in the Act, and therefore, one would need to understand these terms in common parlance.

4.1 MANAGERIAL SERVICES
Black’s Law Dictionary defines the terms ‘manage’ to mean the following:

“To conduct; to carry on the concerns of a business or establishment.”

Further, the term ‘manager’ is defined to mean the following:

“One who has charge of corporation and control of its business or branch establishment, and who is vested with a certain amount of discretion and independent judgment.”

Having looked at the dictionary meaning of the term ‘manage’, the question arises as to what is meant by managerial services, specifically – managing a particular function of an entity such as purchase or sales or managing the entity as a whole, akin to a director of a company.

The issue as to what is meant by ‘managerial services’ and whether the services rendered by a commission agent would constitute managerial services have been analysed by the Mumbai ITAT in the case of Linde AG vs. ITO (1997) 62 ITD 330, albeit in the context of a procurement agent. In the said case, the assessee procured certain materials and spares required to set up a fabrication plant in Gujarat. These purchases were charged from the Indian concern, i.e. Gujarat State Fertilizers Company, at cost plus 4% procurement charges. Referring to the decision of the Delhi High Court in the case of J.K. (Bombay) Ltd. vs. CBDT & Anr. (1979) 118 ITR 312 in the context of section 80-O of the Act, the ITAT held as under:

“Their Lordships of Delhi High Court referred to an article on ‘Management Sciences’ in 14 Encyclopaedia 747, wherein it is stated that the management in organisations include at least the following:

(a) discovering, developing, defining and evaluating the goals of the organisation and the alternative policies that will lead towards the goals;

(b) getting the organisation to adopt the policies;

(c) scrutinising the effectiveness of the policies that are adopted and

(d) initiating steps to change policies when they are judged to be less effective than they ought to be.

The third category is managerial service. The managerial service, as aforesaid, is towards the adoption and carrying out the policies of a organisation. It is of permanent nature for the organisation as a whole. In making the stray purchases, it cannot be said that the assessee has been managing the affairs of the Indian concern or was rendering managerial services to the assessee.”

Therefore, while holding that procurement services would not constitute managerial services, the ITAT explained that managerial services would refer to carrying out the organisation’s policies as a whole.

In this regard, as the broad range of services rendered by an export agent as well as a procurement agent is similar, albeit, for two different ends of a transaction, their taxability would also be similar. Therefore, any decision in respect of taxability of income of a procurement agent (for procurement outside India) would equally apply to the export commission earned by an agent.

The Authority for Advance Rulings in the case of Intertek Testing Services India (P.) Ltd., In re (2008) 307 ITR 418 held the term ‘managerial services’ to mean the following:

“Thus, managerial services essentially involves controlling, directing or administering the business.”

In the context of export commission, the Delhi High Court in the case of DIT (International Taxation) vs. Panalfa Autoelektrik Ltd. (2014) 272 CTR 117, held as follows:

“The services rendered, the procurement of export orders, etc. cannot be treated as management services provided by the non-resident to the respondent-assessee. The non-resident was not acting as a manager or dealing with administration. It was not controlling the policies or scrutinising the effectiveness of the policies. It did not perform as a primary executor, any supervisory function whatsoever.”

This differentiation between ‘execution’ and ‘management’ has also been explained by the Mumbai ITAT in the case of UPS SCS (Asia) Ltd. vs. ADIT (2012) 50 SOT 268, wherein it has been held that:

“Ordinarily the managerial services mean managing the affairs by laying down certain policies, standards and procedures and then evaluating the actual performance in the light of the procedures so laid down. The managerial services contemplate not only execution but also the planning part of the activity to be done. If the overall planning aspect is missing and one has to follow a direction from the other for executing particular job in a particular manner, it cannot be said that the former is managing that affair. It would mean that the directions of the latter are executed simplicity without there being any planning part involved in the execution and also the evaluation of the performance. In the absence of any specific definition of the phrase “managerial services” as used in section 9(1)(vii) defining the “fees for technical services”, it needs to be considered in a commercial sense. It cannot be interpreted in a narrow sense to mean simply executing the directions of the other for doing a specific task. …….. On the other hand, ‘managing’ encompasses not only the simple execution of a work, but also certain other aspects, such as planning for the way in which the execution is to be done coupled with the overall responsibility in a larger sense. Thus it is manifest that the word ‘managing’ is wider in scope than the word ‘executing’. Rather the latter is embedded in the former and not vice versa.”

The Chennai ITAT in the case of DCIT vs. Mainetti (India) P. Ltd. (2011) 46 SOT 137 held that canvassing for orders would not constitute managerial services.

Similarly, Madras High Court in the case of Evolv Clothing Co. (P.) Ltd. vs. ACIT (2018) 407 ITR 72 held that market survey undertaken incidental to the services of a commission agent would also not be considered as fees for technical services under section 9(1)(vii).

Further, as regards whether one can argue that one is providing managerial services if one is managing the purchase/sales function, the ITAT in the case of Linde AG (supra) held as under:

“The Learned Departmental Representative brought to our notice a concept of ‘marketing management’ but such marketing services are to be, as aforesaid, on a regular basis, i.e. when the purchases of the assessee on a permanent or semi-permanent or at regular interval basis. It does not include the purchases made only to be utilised for a particular venture taken up by the assessee, which in this case is fabrication of a new scientific plant. It being a one-time job and not marketing management of making purchases by the assessee for the new concern.”

Therefore, one can conclude based on the above observation by the Mumbai ITAT that if the purchase or sales function of the entire organisation has been completely outsourced to an agent, then the services rendered by such agent may be considered as managerial services. For example, if an entity within the entire MNE group is in charge of undertaking the entire purchase or sales function of all the entities within the MNE and such entity is also deciding the policies of such function, one may possibly consider such services managerial services.

4.2 TECHNICAL SERVICES
The second limb of the definition of FTS is ‘technical service’. The Merriam – Webster dictionary defines the term ‘technical’ to mean “as having special and usually practical knowledge especially of a mechanical or scientific subject”

Similarly, the Collins dictionary defines the term as “of, relating to, or specializing in industrial, practical, or mechanical arts and applied sciences”.     

Therefore, in common parlance, one may say that technical services would mean services which require application of industrial, mechanical or applied sciences.

The Madras High Court in the case of Skycell Communications Ltd. & Anr. vs. DCIT & Ors (2001) 251 ITR 53 has provided guidance as to what would be considered as ‘technical services’ as under:

“Thus while stating that “technical service” would include managerial and consultancy service, the Legislature has not set out with precision as to what would constitute “technical” service to render it “technical service”. The meaning of the word “technical” as given in the New Oxford Dictionary is adjective 1. of or relating to a particular subject, art or craft or its techniques: technical terms (especially of a book or article) requiring special knowledge to be understood: a technical report. 2. of involving, or concerned with applied and industrial sciences: an important technical achievement. 3. resulting from mechanical failure: a technical fault. 4. according to a strict application or interpretation of the law or the rules: the arrest was a technical violation of the treaty.

Having regard to the fact that the term is required to be understood in the context in which it is used, “fee for technical services” could only be meant to cover such things technical as are capable of being provided by way of service for a fee. The popular meaning associated with “technical” is “involving or concerning applied and industrial science”.”

Interestingly, the Memorandum of Understanding to the DTAA between India and US provides as follows:

“Article 12 includes only certain technical and consultancy services. But technical services, we mean in this context services requiring expertise in a technology.”

While the term ‘technology’ refers to machines and processes, the term ‘technical’ would be wider and would cover applied and mechanical sciences and would mean a kind of specialized or complex knowledge.

Therefore, the meaning under the MOU in the India – US DTAA may be restricted in application to the India – US DTAA only as it provides a narrower meaning than used in common parlance.

Having understood the meaning of the term ‘technical services’, the issue arises is whether the services rendered by a commission agent could be considered as ‘technical services’. In this regard, the Delhi High Court in the case of Panalfa Autoelektrik Ltd. (supra) held as follows:

“The non-resident had not undertaken or performed “technical services”, where special skills or knowledge relating to a technical field were required. Technical field would mean applied sciences or craftsmanship involving special skills or knowledge but not fields such as arts or human sciences.”

On the other hand, the Cochin ITAT in the case of ITO vs. Device Driven (India) (P.) Ltd. (2014) 29 ITR (T) 263 held that export commission in case of software was considered as technical services. In this regard, the ITAT held as under:

“Software is a highly technical product and it is required to be developed in accordance with the requirements of the customers. Even after the development, it requires constant monitoring so that necessary modifications are required to be carried out in order to make it suitable to the requirements. The work of the assessee company also does not end upon developing and installing the software at the client’s site. As stated earlier, it requires on-site monitoring, especially when the customized software is developed. Hence, in our view, it cannot be equated with the commodities, where the role of the Commission agent normally ends after supply of goods and receipt of money. Hence, in the case of software companies, the sales agent should also possess required technical knowledge and then only he could procure orders for the company by understanding the needs of clients and further convincing them..….. As per the clauses of the agreement, which are extracted above, the Commission agent is responsible in securing orders and for that purpose only he has to assist the assessee company in all respects including identifying markets, making introductory contacts, arranging meeting with prospective clients, assisting in preparation of presentations for target clients. His duty does not end on securing the orders, but he has to monitor the status and progress of the project, meaning thereby the Commission agent is responsible for ensuring supply of the software and also for receiving the payments. All these activities, in our view, could be carried on only by a person who is having vast technical knowledge and experience. Hence, we agree with the tax authorities’ view that the payment made to Shri Balaji Bal constitutes the payment made towards technical services.”

Interestingly, the Cochin ITAT equated the nature of product sold by the agent with the nature of services rendered by the agent. With due respect to the Cochin ITAT, the authors are of the view that it may not be appropriate to equate the product sold with the service rendered. The ITAT in the above case did not list out any specific services required to be rendered by an agent distributing software that would be different from that distributing other commodities. For example, even if one sells an iron rod, one is required to have certain knowledge of the product sold to enable him to match the client’s requirement with the product and sell the product. Further, identifying markets, arranging meeting with prospective clients, preparing presentations for target clients, and ensuring that the product is smoothly delivered is something an agent selling any product may be required to undertake.

In this regard, the Ahmedabad ITAT in the case of Welspun Corporation Ltd. (supra) has succinctly segregated the nature of service from the nature of product sold. It has held as follows:

“Just because a product is highly technical does not change the character of activity of the sale agent. Whether a salesman sells a handcrafted souvenir or a top of the line laptop, he is selling nevertheless. It will be absurd to suggest that in the former case, he is selling and the latter, he will be rendering technical services. The object of the salesman is to sell and familiarity with the technical details, whatever be the worth of those technical details, is only towards the end of selling. In a technology driven world that we live in, even simplest of day to day gadgets that we use are fairly technical and complex. Undoubtedly when a technical product is being sold, the person selling the product should be familiar with technical specifications of the product but then this aspect of the matter does not any way change the economic activity.”

On the other hand, it is also important to highlight that the above Cochin ITAT decision was upheld by the Kerala High Court in the case of the same assessee in Device Driven (India) P Ltd. vs. CIT (2021) 126 taxmann.com 25. However, the Kerala High Court did not analyse the services rendered by the agent to determine whether the services were ‘technical services’ but relied more on the argument that the services were rendered for earning source outside India, and therefore, not accruing or arising in India.

4.3 CONSULTANCY SERVICES
The last limb of the definition of the term FTS is ‘consultancy services’.

In common parlance, ‘to consult’ would mean ‘to advise’. With regards to the overlap with technical services, the MOU in the India – US DTAA provides as under:

“By consultancy services, we mean in this context advisory services. The categories of technical and consultancy services are to some extent overlapping because a consultancy service could also be a technical service. However, the category of consultancy services also includes an advisory service, whether or not expertise in a technology is required to perform it.”

The Supreme Court in the case of GVK Industries Ltd. & Anr. vs. ITO & Anr. (2015) 371 ITR 453 evaluated the meaning of ‘consultancy services’ under section 9(1)(vii). In the said case, a non-resident company rendered services related to raising finance for the assessee, which included, inter alia, financial structure and security package to be offered to the lender, making an assessment of export credit agencies worldwide and obtaining commercial bank support on the most competitive terms, assisting the appellant loan negotiations and documentation with lenders and structuring, negotiating and closing the financing for the project in a co-ordinated and expeditious manner.

“The word ‘consultation’ has been defined as an act of asking the advice or opinion of someone (such as a lawyer). It means a meeting in which a party consults or confers and eventually it results in human interaction that leads to rendering of advice. The NRC had acted as a consultant. It had the skill, acumen and knowledge in the specialized field i.e. preparation of a scheme for required finances and to tie-up required loans. The nature of service rendered by the NRC, can be said with certainty would come within the ambit and sweep of the term ‘consultancy service’ and, therefore, it has been rightly held that the tax at source should have been deducted as the amount paid as fee could be taxable under the head ‘fees for technical services’.”

Similarly, the AAR in the case of Guangzhou Usha International Ltd., In re (2015) 378 ITR 465 held that where the agent was not only identifying new products but also generating new ideas for the principal after market research, evaluating credit, finance, organisation, production facility, etc. and on the basis of the evaluation, giving advice to the principal, the services rendered by such agent would be considered as ‘consultancy services’.

However, the Delhi High Court in the case of Panalfa Autoelektrik Ltd. (supra) as well as the Mumbai ITAT in the case of Linde AG (supra) have held that services rendered by an agent would not constitute ‘consultancy services’.

On similar lines, the Delhi High Court in the case of CIT vs. Grup Ism (P.) Ltd. (2015) 378 ITR 205 held that export commission would not be considered as ‘consultancy services’ even though the nomenclature of the transaction as per the agreement was of ‘consultancy services’. It held as follows:

“‘Consultancy services’ would mean something akin to advisory services provided by the non-resident, pursuant to deliberation between parties. Ordinarily, it would not involve instances where the non-resident is acting as a link between the resident and another party, facilitating the transaction between them, or where the non-resident is directly soliciting business for the resident and generating income out of such solicitation. The mere fact that CGS confirmed that it received consultancy charges from the assessee would not be determinative of the issue. The actual nature of services rendered by CGS and MAC needs to be examined for this purpose.”

From the above jurisprudence, it is clear, in the view of the authors, that export commission by itself would not be considered as ‘consultancy services’. However, if the agent provides advisory services along with the export commission, one may need to evaluate the predominant nature of services to determine the characterisation of the transaction.

5. WHETHER THE WITHDRAWAL OF CIRCULAR NO. 23 OF 1969 WOULD RESULT IN TAXABILITY

As discussed above, the CBDT Circular No. 23 of 1969 had clarified non-taxability in India for commission earned by a foreign non-resident agent. This Circular was subsequently withdrawn stating that it did not reflect the correct position under section 9 of the Act. In this regard, the question therefore, arises is whether the withdrawal of the Circular can result in the taxation of the commission earned by a foreign agent.

In this regard, the Delhi ITAT in the case of Welspring Universal vs. JCIT (supra) held as follows:

“11. ….The legal position contained in section 5(2) read with section 9, as discussed above about the scope of total income of a non-resident subsisting before the issuance of circular nos. 23 and 786 or after the issuance of circular no. 786 has not undergone any change. It is not as if the export commission income of a foreign agent for soliciting export orders in countries outside India was earlier chargeable to tax, which was exempted by the CBDT through the above circulars and now with the withdrawal of such circulars, the hitherto income not chargeable to tax, has become taxable. The legal position remains the same de hors any circular in as much as such income of a foreign agent is not chargeable to tax in India because it neither arises in India nor is received by him in India nor any deeming provision of receipt or accrual is attracted. It is further relevant to note that the latter Circular simply withdraws the earlier circular, thereby throwing the issue once again open for consideration and does not state that either the export commission income has now become chargeable to tax in the hands of the foreign residents or the provisions of section 195 read with sec. 40(a)(i) are attracted for the failure of the payer to deduct tax at source on such payments.

12. Ex consequenti, we hold that the amount of commission income for rendering services in procuring export orders outside India is not chargeable to tax in the hands of the non-resident agent and hence no tax is deductible under section 195 on such payment by  the payer.”

The authors are also of a similar view that the legal position upheld by various courts does not change, and the export commission earned by a non-resident agent may still not be liable to tax in India.

6. WHETHER THE PROVISIONS OF SEP CAN TRIGGER IN THE CASE OF EXPORT COMMISSION
The Finance Act, 2018 has introduced the significant economic presence (‘SEP’) provisions in India. Explanation 2A to section 9(1)(i) of the Act extends the definition of business connection to include SEP and SEP has been defined to mean the following:

(a) transaction in respect of any goods, services or property carried out by a non-resident with any person in India including provision of download of data or software in India, if the aggregate of payments arising from such transaction or transactions during the previous year exceeds such amount as may be prescribed; or

(b) systematic and continuous soliciting of business activities or engaging in interaction with such number of users in India, as may be prescribed:

Further, the Proviso to the Explanation also provides that the transactions or activities shall constitute SEP, whether or not:

(i) the agreement for such transactions or activities is entered in India; or

(ii) the non-resident has a residence or a place of business in India; or

(iii) the non-resident renders services in India

In other words, the SEP provisions apply even if such services are rendered outside India if it is undertaken with any person in India and if the aggregate payments during the year exceed the threshold prescribed.

Further, the CBDT vide Notification No. 41/2021/F.No.370142/11/2018-TPL dated 3rd May, 2021, has notified the thresholds to mean INR 2 crore in the case of payments referred to in clause (a) above and 3 million users in clause (b) above.
The authors have analysed the SEP provisions in detail in their article in the March, 2021 edition of BCAJ Journal.

Therefore, now, if the services rendered by the commission agent exceed INR 2 crore in a financial year, such non-resident agent may be considered as having a business connection in India due to the SEP provisions under section 9(1)(i) of the Act.

7. CONCLUDING REMARKS
In this article, the authors have analysed the taxability of export commission in detail. To summarize, the commission earned by a non-resident in respect of agency services rendered for exports, where no activities are undertaken in India, would not be taxable in India under the Act. However, one would need to evaluate if there are any additional services rendered by such an agent, such as managing the entire purchase or sale function of an organisation which could result in taxability under the Act or the relevant tax treaty as FTS. Moreover, one may need to also evaluate if the payments to the agent during the year exceed INR 2 crore, in which case the SEP provisions may apply, resulting in taxability of the commission earned by such non-resident agent on account of the business connection being constituted in India. In such a scenario, one may still be able to apply the provisions of the DTAA and such income may not be taxable in the absence of a PE of such agent in India, subject to the requirement of documents such as tax residency certificate, etc as well as fulfilling the conditions as may be provided in the OECD Multilateral Instrument, if applicable.
 

SAFE HARBOUR RULES – AN OVERVIEW (Part 2)

In this concluding Part 2 of the Article (the first Part appeared in the December issue of the BCAJ), we focus on dealing with Indian Safe Harbour Rules by providing an overview of the Indian Safe Harbour Rules and their important aspects, including certain judicial pronouncements

1. RELEVANT PROVISIONS AND RULES
1.1 Section 92CB – Power of Board to make safe harbour (SH) rules
(1) The determination of –
(a) income referred to in clause (i) of sub-section (1) of section 9; or
(b) arm’s length price u/s 92C or u/s 92CA,
shall be subject to SH rules.
(2) The Board may, for the purposes of sub-section (1), make rules for safe harbour.

Explanation – For the purposes of this section, ‘safe harbour’ means circumstances in which the income-tax authorities shall accept the transfer price or income, deemed to accrue or arise under clause (i) of sub-section (1) of section 9, as the case may be, declared by the assessee.

Section 92CB(1) provides that the determination of Arm’s Length Price [ALP] u/s 92C or u/s 92CA shall be subject to SH rules. It has been substituted with effect from A.Y. 2020-21 to provide that apart from the determination of ALP, the determination of the income referred to in section 9(1)(i) shall also be subject to SH rules.

Section 9(1)(i) covers various types of income, e.g., income through or from any business connection in India, any property in India, etc. Further, it has various Explanations including
(a) Explanation 2 (Agency business connection),
(b) Explanation 2A (Significant economic presence or SEP),
(c) Explanation 3A (Extended source rule for income from advertisements, etc.).

Explanation to section 92CB defining SH is amended to provide that SH would also include circumstances in which income tax authorities shall accept the income u/s 9(1)(i) declared by the assessee. The amendment is effective from A.Y. 2020-21. Rules 10TA to 10TG contain the relevant SH rules relating to international transactions.

1.2 Application of SH rules prior to their introduction w.e.f. 18th September, 2013
In the following cases, inter alia, it has been held that the SH provisions in respect of TP were not applicable to the A.Ys. prior to the introduction of section 92CB / rules thereunder:
(a) PCIT vs. B.C. Management Services (P) Ltd. [2018] 89 taxmann.com 68 (Del)
(b) PCIT vs. Fiserv India Pvt. Ltd. ITA No. 17/2016, dated 6th January, 2016 (Del)
(c) PCIT vs. Cashedge India Pvt. Ltd. ITA No. 279/2016, dated 4th May, 2016 (Del)
(d) Delval Flow Controls (P) Ltd. vs. DCIT [2021] 128 taxmann.com 260 (Pun-Trib)
(e) Rolls Royce India (P) Ltd. vs. DCIT [2018] 97 taxmann.com 651 (Del-Trib)
(f) Rampgreen Solutions (P) Ltd. vs. DCIT [2015] 64 taxmann.com 451 (Del-Trib).

1 However, in DCIT vs. Minda Acoustic Ltd. it was held that the SH rules can always be adopted as guidance in respect of the A.Ys. prior to their insertion.

 

1   [2019] 107
taxmann.com 475 (Del-Trib)

1.3 Application of definitions provided in Rule 10TA – Whether or not the assessee opts for the safe harbour
An important point to be kept in mind is that the definitions provided in rule 10TA shall not be applicable for the determination of ALP u/s 92C as per rule 10B. 2 The Pune bench of the ITAT in the case of Delval Flow Controls (P) Ltd. vs. DCIT (Supra) has held that unless an assessee opts for SH rules, rule 10TA cannot have across–the-board application. The ITAT in this regard observed as follows:
‘13. The emphatic contention of the Learned DR that section 92CB providing that the arm’s length price u/s 92C or u/s 92CA shall be subject to safe harbour rules and hence the application of rule 10TA(k) across the board is essential whether or not the assessee opts for the safe harbour, in our considered opinion does not merit acceptance. Section 92CB unequivocally states that the arm’s length price u/s 92C or u/s 92CA shall be subject to safe harbour rules. It only means that if there is an eligible assessee who has exercised the option to be governed by the safe harbour rules in respect of an eligible international transaction after complying with the due procedure, then the determination of the ALP shall be done in accordance with the safe harbour rules in terms of section 92CB of the Act and ex consequenti, the application of other rules will be ousted. The sequitur is that where such an option is not availed, neither section 92CB gets triggered nor the relevant rules including 10TA(k). In that scenario, determination of the ALP is done de hors the safe harbour rules.’

1.4 Reference to rule 10TA(k) – Exclusion of gains on account of foreign currency fluctuations relating to revenue transactions
Rule 10A contains certain definitions for the purposes of the said rule and rules 10AB to 10E. The said rule does not contain the definitions of ‘operating expense’, ‘operating revenue’ and ‘operating profit margin’. Rule 10TA for the purposes of the said rule and rules 10TB to 10TG, inter alia, contains the definitions of the aforesaid terms in rule 10TA(j), (k) and (l), respectively, w.e.f. 18th September, 2013.

Rule 10TA(k)(ii) provides that the term operating revenue does not include income arising on account of foreign currency fluctuations.

The assessees have taken a stand for long that foreign exchange gains arising out of revenue transactions form part of operating revenue and should accordingly be considered while computing operating profit margins for the purposes of computation of ALP under rules 10A to 10E. It has been argued that in the absence of any clear definition of operating revenue, the explicit exclusion of foreign exchange gain under rule 10TA(k)(ii) relating to SH cannot be applied for the computation of ALP under rules 10A to 10E.

The Tax Department, on the other hand, has been arguing that section 92CB provides that the ALP determination shall be subject to SH rules and the explicit exclusion of foreign exchange gain under rule 10TA(k)(ii) makes foreign exchange gains as non-operating. Further, for computation of operating margin, the said exclusion should be applied even in respect of transactions entered into prior to 18th September, 2013.

The ITAT and High Courts in a catena of cases have held that the SH rules have no retrospective application and are applicable prospectively only in respect of transactions entered into after 18th September, 2013. Further, in cases where the assessees have not opted for SH rules, the exclusion provided in rule 10TA(k)(ii) is not applicable and the foreign exchange gains should be considered as part of the operating margins. The issue of exclusion of foreign exchange gain / loss for the purposes of computing ALP in TP proceedings is no more res integra in view of, inter alia, the following judicial precedents:
a) Fiserv India Pvt. Ltd. [TS-437-HC-2016 (Del)-TP]
b) Ameriprise India Pvt. Ltd. [TS-174-HC-2016 (Del)-TP]
c) DCIT vs. GHCL Ltd. ITA No. 976/Ahd/2014 dated 5th March, 2021 (ITAT Ahd)
d) NEC Technologies India Ltd. [TS-221-ITAT-2016 (Del)-TP]
e) Subex Ltd. [TS-181-ITAT-2016 (Bang)-TP]
f) Visa Consolidated Support & Services [TS-162-ITAT-2016 (Bang)-TP]
g) SAP Labs India (P) Ltd. vs. ACIT [2012] 17 taxmann.com 16 (Bang)
h) Four Soft Ltd. (ITA No. 1495/HYD/2010) (Hyd ITAT)
i) Trilogy E Business Software India Pvt. Ltd. vs. DCIT [23 ITR(T) 464) (Bang ITAT)]
j) Capital IQ Information Systems (India) (P) Ltd. vs. DCIT [2013] 32 taxmann.com 21 (Hyd-Trib)
k) S. Narendra vs. ACIT [2013] 32 taxmann.com 196 (Mum-Trib)
l) Cordys R&D (India) (P) Ltd. vs. DCIT [2014] 43 taxmann.com 64 (Hyd-Trib)
m) Techbooks International (P) Ltd. vs. ACIT [2014] 45 taxmann.com 528 (Del-Trib).

In the above cases, the courts have held that if the foreign exchange gain / loss is related to the operations undertaken by the assessee, such gain / loss would be considered as part of operating revenue or operating expenses. It is to be noted that foreign exchange gain / loss in respect of capital transactions cannot be considered as part of operating revenue or operating expenses.

 

2   [2021]128
taxmann.com 260 (Pun-Trib)

1.5 Issue relating to interpretation of KPO / BPO / ITeS
Rule 10TA(e) contains the definition relating to ‘information technology-enabled services’ and rule 10TA(g) defines ‘knowledge process outsourcing services’. Rule 10TA does not contain a separate definition relating to ‘business process outsourcing services’ (BPO). Interpretational issues have arisen in respect of characterisation of transactions into various categories of services like ITeS, KPO and BPO which have a very thin line of distinction.

3 In this connection, the Special Bench of the ITAT Mumbai in the case of Maersk Global Centres (India) (P) Ltd. vs. ACIT, after analysing the relevant definitions in rule 10TA, held as under:
‘73. On a careful study of the material placed before us to highlight the distinction between BPO services and KPO services, we are of the view that even though there appears to be a difference between the BPO and KPO services, the line of difference is very thin. Although the BPO services are generally referred to as the low-end services while KPO services are referred to as high-end services, the range of services rendered by the ITeS sector is so wide that a classification of all these services either as low end or high end is not always possible. On the one hand, KPO segment is referred to as a growing area moving beyond simple voice services suggesting thereby that only the simple voice and data services are the low-end services of the BPO sector, while anything beyond that are KPO services. The definition of ITeS given in the safe harbour rules, on the other hand, includes inter alia data search integration and analysis services and clinical data-base management services, excluding clinical trials. These services which are beyond the simple voice and data services are not included in the definition of KPO services given separately in the safe harbour rules. Even within the KPO segment, the level of expertise and special knowledge required to undertake different services may be different.’

4 However, the Delhi High Court in the case of Rampgreen Solutions (P) Ltd. vs. CIT after considering the Special Bench decision of Maersk Global Centres (India) (P) Ltd. (Supra), held as follows:
‘34. We have reservations as to the Tribunal’s aforesaid view in Maersk Global Centres (India) (P) Ltd. (Supra). As indicated above, the expression “BPO” and “KPO” are, plainly, understood in the sense that whereas BPO does not necessarily involve advanced skills and knowledge, KPO, on the other hand, would involve employment of advanced skills and knowledge for providing services. Thus, the expression “KPO” in common parlance is used to indicate an ITeS provider providing a completely different nature of service than any other BPO service provider. A KPO service provider would also be functionally different from other BPO service providers, inasmuch as the responsibilities undertaken, the activities performed, the quality of resources employed would be materially different. In the circumstances, we are unable to agree that broadly ITeS sector can be used for selecting comparables without making a conscious selection as to the quality and nature of the content of services. Rule 10B(2)(a) of the Income Tax Rules, 1962 mandates that the comparability of controlled and uncontrolled transactions be judged with reference to service / product characteristics. This factor cannot be undermined by using a broad classification of ITeS which takes within its fold various types of services with completely different content and value. Thus, where the tested party is not a KPO service provider, an entity rendering KPO services cannot be considered as a comparable for the purposes of Transfer Pricing analysis. The perception that a BPO service provider may have the ability to move up the value chain by offering KPO services cannot be a ground for assessing the transactions relating to services rendered by the BPO service provider by benchmarking it with the transactions of KPO services providers. The object is to ascertain the ALP of the service rendered and not of a service (higher in value chain) that may possibly be rendered subsequently.

35. As pointed out by the Special Bench of the Tribunal in Maersk Global Centres (India) (P) Ltd. (Supra), there may be cases where an entity may be rendering a mix of services some of which may be functionally comparable to a KPO while other services may not. In such cases a classification of BPO and KPO may not be feasible. Clearly, no straitjacket formula can be applied. In cases where the categorisation of services rendered cannot be defined with certainty, it would be apposite to employ the broad functionality test and then exclude uncontrolled entities, which are found to be materially dissimilar in aspects and features that have a bearing on the profitability of those entities. However, where the controlled transactions are clearly in the nature of lower-end ITeS such as Call Centres, etc., for rendering data processing not involving domain knowledge, inclusion of any KPO service provider as a comparable would not be warranted and the transfer pricing study must take that into account at the threshold.’

Thus categorisation of services as BPO, KPO or ITeS could pose a problem in application of appropriate SH rates. In addition, there could be an ambiguity as to what is covered within the term ‘market research’ included in the definition of KPO services. In view of the distinct SH rates for each category, an inappropriate classification could result in larger tax implications.

1.6 Eligible assessee for the purpose of SH
Eligible assessee has been defined under rule 10TB to mean a person who has exercised a valid option for application of SH rules in accordance with rule 10TE, and
(i) is engaged in providing software development services or ITeS or KPO services, with insignificant risk, to a foreign principal;
(ii) has advanced any intra-group loan;
(iii) has provided a corporate guarantee;
(iv) is engaged in providing contract R&D services wholly or partly relating to software development, with insignificant risk, to a foreign principal;
(v) is engaged in providing contract R&D services wholly or partly relating to generic pharmaceutical drugs, with insignificant risk, to a foreign principal;
(vi) is engaged in the manufacture and export of core or non-core auto components and where 90% or more of total turnover during the relevant previous year is in the nature of original equipment manufacturer sales; or
(vii) is in receipt of low value-adding intra-group services from one or more members of its group.

Foreign principal referred to above means a non-resident associated enterprise. Various factors have also been provided which the A.O. or the TPO shall have regard to in order to identify an eligible assessee with insignificant risk [referred to in points (i), (iv) and (v) above] which are as follows:

a) The foreign principal performs most of the economically significant functions involved along with those involved in research or the product development cycle, as the case may be, including the critical functions such as conceptualisation and design of the product and providing the strategic direction and framework, either through its own employees or through its other associated enterprises, while the eligible assessee carries out the work assigned to it by the foreign principal;
b) The capital and funds and other economically significant assets including the intangibles required are provided by the foreign principal or its other associated enterprises, while the eligible assessee is provided remuneration for the work carried out;
c) The eligible assessee works under the direct supervision of the foreign principal or its associated enterprise which not only has the capability to control or supervise but also actually controls or supervises the activities carried out or the research or product development, as the case may be, through its strategic decisions to perform core functions, as well as by monitoring activities on a regular basis;
d) The eligible assessee does not assume or has no economically significant realised risks, and if a contract shows that the foreign principal is obligated to control the risk but the conduct shows that the eligible assessee is doing so, the contractual terms shall not be the final determinant;
e) The eligible assessee has no ownership right, legal or economic, on any intangible generated or on the outcome of any intangible generated or arising during the course of rendering of services or on the outcome of the research, as the case may be, which vests with the foreign principal as evident from the contract and the conduct of the parties.

2. PROCEDURE TO BE FOLLOWED TO APPLY SH RULES
In order to apply SH rules, the procedure as provided in rule 10TE needs to be followed, a summary of which is given below:
a) Application in Form 3CEFA to be furnished to the A.O. on or before the due date for furnishing of return of Income.
b) The assessee should make sure that the return of income for the relevant A.Y. or the first of the A.Ys. is furnished before making an application in Form 3CEFA.
c) The assessee needs to clarify whether he is applying for one A.Y. or more than one A.Y. Such option exercised will continue to remain in force for a period of five years or the period specified in the form, whichever is less. It is to be noted that in respect of option for SH exercised under rule 10TD(2A), i.e., w.e.f. 1st April, 2017, the period of five years is reduced to three years.
d) The assessee needs to furnish a statement to the A.O. with respect to the A.Y. after the initial A.Y. providing details of eligible transactions, their quantum and the profit margins or the rate of interest or commission shown. Such statement needs to be furnished before furnishing the return of income of that particular year.
e) The SH option shall not remain in force for the A.Y. after the initial A.Y. if
i. The eligible assessee opts out of SH by furnishing a declaration to the A.O.; or
ii. The same has been held to be invalid by the respective authority, i.e., TPO or the Commissioner, as the case may be.
f) Upon receipt of the Form 3CEFA, the A.O. shall verify whether the assessee is an eligible assessee and the transaction is an eligible international transaction.
g) In case the A.O. doubts the eligibility, he shall make a reference to the TPO for determination of the eligibility.
h) The TPO may require the assessee to furnish necessary information or documents by notice in writing within a specified time.
i) If the TPO finds that the option exercised is invalid, he shall serve an order regarding the same to the assessee and the A.O. However, an opportunity of being heard is to be given to the assessee before passing the order declaring the option invalid.
j) If the assessee objects to the same, he shall file an objection within 15 days of receipt of the order with the Commissioner to whom the TPO is subordinate.
k) On receipt of the objection, the Commissioner shall pass appropriate orders after providing an opportunity of being heard to the assessee.
l) Where the option is valid, the A.O. shall verify that the Transfer Price in respect of the eligible international transactions is in accordance with the circumstances specified in rules 10TD(2) or (2A), and if the same is not in accordance with the said circumstances, the A.O. shall adopt the operating profit margin or rate of interest or commission specified in said sub-rules, as applicable.
m) In the A.Y. after the initial A.Y., if the A.O. has reasons to doubt the eligibility of an assessee or the international transaction for any A.Y. due to change in facts and circumstances, he shall make a reference to the TPO for determining the eligibility.
n) The TPO on receipt of a reference shall determine the eligibility and after providing an opportunity of being heard to the assessee, pass an order and serve the copy of the same on the assessee and the A.O.
o) For the purposes of rule 10TE:
i. No reference to the TPO by the A.O. shall be made after two months from the end of the month in which Form 3CEFA is received by him;
ii. No order shall be passed by TPO after two months from the end of the month in which reference from the A.O. is received by him;
iii. Order shall be passed within a period of two months from the end of the month in which objection filed by the assessee is received by the Commissioner.
p) If no reference is made or order has been passed within the time limit specified above, the option for SH exercised by the assessee shall be treated as valid.

The SH rules provide for a time-bound procedure for determination of the eligibility of the assessee and the international transactions. In case the action is not taken by any of the Income Tax authorities within the prescribed time lines as provided in the rules, the option exercised by the assessee shall be treated as valid.

In a case where the Commissioner passes an order against an assessee by holding that the option of SH is invalid (after providing a reasonable opportunity of being heard), in absence of clarity in rule 10TE, it appears that the only recourse available with the assessee is to either determine the ALP as per the normal TP assessment route or to file a writ petition in the High Court.

3. OBSERVATIONS REGARDING REVISED SH
The erstwhile TP SH thresholds, especially for IT and ITeS (20% / 22%), Contract R&D (30%) were set so high that it was not commercially viable for most companies to show any interest in the SH and therefore there were hardly any taxpayers opting for it, leaving the SH as having largely failed to achieve its purpose.

In contrast, the APA Scheme introduced in 2012 has been a roaring success even though it is a lot more intensive and a time-consuming negotiation process than opting for the SH, which works on a self-declaration basis. The APA route is preferred as it calls for lesser annual compliance requirements and determination of the agreed TP method which is a closer approximation of the ALP and the option of converting to a bilateral APA route which would avoid any economic double taxation for the multinational group.

3.1 No comparability adjustment and allowance
Rule 10TD(4) provides that no comparability adjustment and allowance under the 2nd proviso to section 92C(2) [reference to the 3rd proviso to section 92C(2) seems to have remained inadvertently] shall be made on the transfer price declared by the eligible assessee and accepted under rules 10TD(1) and (2), or (2A), as the case may be.

For international transactions undertaken for the period up to 31st March, 2014, the 2nd proviso to section 92C(2) provided that if the variation between ALP determined as per the MAM and the price at which the international transaction has actually been undertaken does not exceed notified percentage (not exceeding 3%), the price at which the international transaction is actually undertaken shall be deemed to be the ALP.

For international transactions undertaken from 1st April, 2014, the 3rd proviso to section 92C(2) was inserted to employ a ‘range’ concept for determination of ALP where more than one price is determined by the MAM. It provides that if more than one price is determined by the MAM, the ALP in relation to an international transaction shall be computed in the prescribed manner, i.e., rule 10CA(7). The proviso to rule 10CA(7) provides that the variation between ALP determined under the rule and the actual price does not exceed the notified percentage, then the actual price shall be deemed to be the ALP.

For the A.Y. 2020-21, Notification No. 83/2020 dated 19th October, 2020 provides the manner and limits of price variation (not exceeding 1% of the actual price in respect of wholesale trading and 3% of the actual price in all other cases).

Thus, the objective of rule 10TD(4) is that in cases where the option of the SH has been accepted, there would be no further allowance on account of comparability adjustment.

3.2 Maintenance, keeping and furnishing of information and documents
It is important to keep in mind that the provisions of rule 10TD(5) provide that section 92D relating to maintenance, keeping and furnishing of information and documents by certain persons, i.e., (i) One who has entered into an international transaction, as prescribed in rule 10D; and (ii) a constituent entity of an international group in respect of an international group as prescribed in rule 10DA, will be applicable irrespective of the fact that the assessee exercises his option for SH in respect of any such transaction.

3.3 Furnishing of report from an accountant by persons entering into international transactions
Rule 10TD(5) also provides that provisions of section 92E relating to a report from an accountant to be furnished by persons entering into international transactions will be applicable irrespective of the fact that the assessee exercises his option for SH in respect of any such transaction.

3.4 Non-applicability of SH rules in certain cases
Rule 10TF provides that SH rules contained in rules 10TA to 10TE shall not apply in respect of eligible international transactions entered into with an AE located in:
(a) any country or territory notified u/s 94A; or
(b) in a no-tax or low-tax country or territory.

Section 94A(1) containing enabling powers provides that the Central Government may, having regard to the lack of effective exchange of information with any country or territory outside India, specify by Notification in the official Gazette such country or territory as a notified jurisdictional area in relation to transactions entered into by any assessee.

In exercise of its powers, earlier the Central Government had, vide Notification No. 86/2013 dated 1st November, 2013 notified Cyprus as a ‘notified jurisdictional area’. However, subsequently the said Notification was rescinded vide Notification No. 114/2016 dated 14th November, 2016 and Notification No. 119/2016 dated 16th December, 2016 with effect from the date of issue of the Notification. CBDT, vide Circular No. 15 of 2017 dated 21st April, 2017, clarified that Notification No. 86/2013 had been rescinded with effect from the date of issue of the said Notification, thereby removing Cyprus as a notified jurisdictional area with retrospective effect from 1st November, 2013. Thus, no such Notification is in operation now.

Rule 10TA(i) defines ‘no-tax or low-tax country or territory’ to mean a country or territory in which the maximum rate of income-tax is less than 15%.

3.5 Applicability of the Mutual Agreement Procedure
OECD TP Guidelines in para 4.117 have recommended modification of the SH outcome in individual cases under mutual agreement procedures (MAPs) to mitigate the risk of double taxation where the SH are adopted unilaterally.

However, Indian SH rules have taken an opposite view as compared to OECD TP Guidelines and have provided that MAPs shall not apply.

Rule 10TG provides that where transfer price in relation to an eligible international transaction declared by an eligible assessee is accepted by the Income-Tax Authorities u/s 92CB, the assessee shall not be entitled to invoke MAP under a Double Taxation Avoidance Agreement.

3.6 Impact of TP litigations in the preceding years on the choice for SH
In the Indian scenario, the existing SH as an alternate dispute resolution mechanism has not proved itself as an attractive option. SH, as compared to other available options, has showcased bleak growth. This is evident as the Indian taxpayers have maintained a safe distance from SH over the years.

There are a number of dispute resolution mechanisms available for a taxpayer in India which, although time–consuming, generally yield the desired outcome for the taxpayer. Further, the price / margin to be offered under the Indian SH is perceived to be on the higher side compared to the benchmarks and outcome obtained via other mechanisms.

In some cases, where SH rates were relied upon by the TPO without performing any benchmarking, the same have been rejected by the ITAT and the lower margin of the taxpayer is accepted. This is another reason that makes the SH route less lucrative and the reason for the taxpayer’s reluctance to opt for the SH, as the margins lower than those prescribed by the SH in certain segments are well accepted.

However, in many cases where prolonged TP litigation has been going on for many years and the differential tax impact is not significant, the assessees have opted for the SH regime in order to avoid long litigation and have certainty.

4. IMPLICATIONS OF SECONDARY ADJUSTMENTS
As per section 92CE, secondary adjustment means an adjustment in the books of accounts of the assessee and its AE to reflect that the actual allocation of profits between the assessee and its AE are consistent with the transfer price determined as a result of primary adjustment, thereby removing the imbalance between the cash account and the actual profit of the assessee. Such secondary adjustment is now mandated under the following scenarios where primary adjustment to transfer price
(i) has been made suo motu by the assessee in his return of income;
(ii) made by the A.O. has been accepted by the assessee;
(iii) is determined by an APA entered into by the assessee u/s 92CC on or after 1st April, 2017;
(iv) is made as per the SH rules framed u/s 92CB; or
(v) is arising as a result of resolution of an assessment by way of the MAP under an agreement entered into u/s 90 or u/s 90A for avoidance of double taxation.

Primary adjustment has been defined in section 92CE(3)(iv) to mean the determination of transfer price in accordance with the arm’s length principle resulting in an increase in the total income or reduction in the loss of an assessee.

4.1 Significant hardships and issues that can arise due to secondary adjustment
The stated purpose of secondary adjustment is to remove the imbalance between the cash account and the actual profit of the taxpayer and to reflect that the actual allocation of profit is consistent with the ALP determined as a result of the primary adjustment. The issues that can arise due to the same are as follows:
a. Enforcing the recording of such adjustment in the books of accounts of the AE would be difficult for the Indian taxpayer, especially in cases where the primary adjustment is on account of the SH option, or suo motu offering to tax. The Government had clarified that SH margins are not necessarily ALP but only an option to avoid litigation. In such cases, to mandate the AE to record the adjustment would be unfair.
b. The taxpayer may be prompted not to accept the primary adjustment in the first place but instead litigate the same. The provisions provide that secondary adjustment should be made if primary adjustment made by the A.O. is accepted by the taxpayer. This would discourage the taxpayer from making suo motu adjustments or opting for SH provisions. When the Government is looking at reducing litigation, these new proposals are not going to help achieve that objective.

4.2 Impact of secondary adjustment on adoption of SH
As provided in the 1st proviso to section 92CE, secondary adjustment will not be required in cases where the primary adjustment made in any previous year does not exceed Rs. 1 crore. In view of the same, where the scale of operations of an assessee is small and likely primary adjustment as per the SH rules does not exceed Rs. 1 crore, the secondary adjustment will not be applicable. In such cases, there will not be any impact on adoption of SH rules even if there is a primary adjustment.

Example
In the case of two assessees who are engaged in the manufacture and export of core auto components (where the SH rules provide that the operating profit margin declared in relation to operating expenses should not be less than 12%), the impact of secondary adjustment on adoption of SH will be as follows:

Amount in crores

Sr. No.

Particulars

Assessee A

Assessee B

1.

Operating Revenue (in crores)

Rs. 80

Rs. 20

2.

Operating Expense (in crores)

Rs. 75

Rs. 18.5

3.

Operating Profit (in crores)

Rs. 5

Rs. 1.5

4.

Operating Profit margin (3 ÷ 2)

6.67%

8.12%

5.

SH margin required

12%

12%

6.

Operating profit as per SH rules (5 x 2) (in crores)

Rs. 9

Rs. 2.22

7.

Primary adjustment to be made (6 – 3) (in crores)

Rs. 4

Rs. 0.72

8.

Whether secondary adjustment required

Yes

No

As we can observe from the above example, in case of assessee A the primary adjustment to be made is Rs. 4 crores. Accordingly, secondary adjustment will be required and this will have an impact on the decision of assessee A to opt for SH. On the other hand, in case of assessee B the primary adjustment to be made does not exceed Rs. 1 crore. Accordingly, secondary adjustment will not be applicable and it will not have any impact on the adoption of SH.

Further, section 92CE(2A) provides that where the excess money or part thereof has not been repatriated within the prescribed time [on or before 90 days from the due date of filing of return u/s 139(1)], the assessee may at his option pay additional income tax @ 18% on such excess money or part thereof as the case may be.

Where the additional income tax as specified above is paid by the assessee, section 92CE(2D) provides that such assessee shall not be required to make secondary adjustment under sub-section (1) and compute interest under sub-section (2) from the date of payment of such tax.

5. PRACTICAL DIFFICULTIES AMIDST COVID-19
CBDT vide Notification dated 24th September, 2021 has notified the SH margins for F.Y. 2020-21 and they are the same margins which were applicable for F.Ys. 2016-17 to 2019-20.

Enterprises which have undertaken international transactions during F.Y. 2019-20 and F.Y. 2020-21 may have to perform a pilot analysis for verifying whether their margins are in compliance with the margins prescribed by the SH rules. If not, they can always opt out of SH rules for the relevant A.Y. by making a declaration to that effect to the A.O. as envisaged under rule 10TE.

SH rules were introduced by the CBDT to establish a simpler mechanism to administrate companies undertaking international transactions and also to reduce the amount of litigation. Prescribing the same margins for the coming years would work against the purpose for which they were introduced.

The Covid-19 pandemic has given rise to a number of problems, posing great challenges at least from a TP perspective. Due to the changing business risk environment and difficulty in determining the ALP, it was hoped that the SH margins would be reduced to provide more breathing space to businesses. However, the CBDT vide Notification No. 117/2021, dated 24th September, 2021, extended the validity of the provisions of the SH rules to A.Y. 2021-22 without making any changes or adjustments on account of the pandemic.

6. SAFE HARBOUR RULES FOR SPECIFIED DOMESTIC TRANSACTIONS
Rules 10TH and 10THA to 10THD contain the provisions relating to SH rules for Specified Domestic Transactions.

Rule 10THA defines the eligible assessee to mean a person who has exercised a valid option for application of SH rules in accordance with the provisions of rule 10THC and (i) is a Government company engaged in the business of generation, supply, transmission or distribution of electricity; or (ii) is a co-operative society engaged in the business of procuring and marketing milk and milk products.

In view of the limited application of SH rules for specified domestic transactions only to specified businesses relating to electricity and milk and milk products, the same is not elaborated in this article.

7. CONCLUDING REMARKS
Introduction of SH was a crucial step towards reduction of TP litigations, allowing the Department to focus its resources on significant issues and improving the ease of doing business ranking and investment climate in India from a tax perspective. It has also ensured the reduction of the compliance burden on the taxpayers, enabling them to focus more on their core activities.

In order to make SH rules more attractive to the assessees, the requirement to still maintain detailed TP documentation (TP Study), including benchmarking, may be dispensed with. Only a brief note about the business and ownership structure with brief FAR details should be enough. That will reduce cost of compliance and make this SH simpler to comply with. Where later on the eligibility for SH is questioned, there can be a requirement made to the taxpayer to compile and present more detailed information at that point in time.

In view of the Covid-19 pandemic where the business entities have been impacted adversely to a great extent, a reduction in the compliance burden along with reasonable SH margins would enable them to get back on their feet. However, given the recent CBDT Notification to extend the validity of the SH margins without any adjustment on account of the pandemic, it may be advisable for the taxpayers to evaluate the comparable margins of the industry and the impact of Covid-19 on the industry, before opting for the SH application.

_________________________________________________________________
3    [2014] 43 taxmann.com 100 (Mum-Trib) (SB)
4    [2015] 60 taxmann.com 355 (Del)

ISSUES IN TAXATION OF DIVIDEND INCOME, Part – 2

In the first of this two-part article published in April, 2021, we had analysed the various facets of the taxation of dividends from a domestic tax perspective as well as the construct of the dividend Article in the DTAAs. In this second part, we analyse some specific international tax issues related to dividends, such as applicability of DTAA to the erstwhile dividend distribution tax (‘DDT’) regime, application of the Most Favoured Nation clause in a few DTAAs, some issues relating to beneficial ownership, application of the Multilateral Instrument to dividends and some issues relating to underlying tax credit.

1. APPLICATION OF DTAA TO THE ERSTWHILE DDT REGIME
From A.Y. 2004-05 to A.Y. 2020-21, India followed the DDT system of taxation of dividends. Under that regime, the company declaring the dividends was liable to pay DDT on the dividends declared. One of the issues in the DDT regime was whether the DTAAs would restrict the application of the DDT. While this issue may no longer be relevant for future payments of dividends, with the Finance Act, 2020 reintroducing the classical system of taxation of dividends, this may be relevant for dividends paid in the past.

This controversy has gained significance because of a recent decision of the Delhi ITAT in the case of Giesecke & Devrient (India) (P) Ltd. vs. Add. CIT [2020] (120 taxmann.com 338). However, before considering the above decision, it would be important to analyse two decisions of the Supreme Court which, while not specifically on the issue, would provide some guidance in analysing the issue at hand.

The first Supreme Court decision is that of Godrej & Boyce Manufacturing Company Limited vs. DCIT (2017) (394 ITR 449) wherein the question before the Court was whether section 14A applied in the case of dividend income (under the erstwhile DDT regime). The issue to be addressed was whether dividend income was income which does not form part of the total income under the Act. In the said case, the assessee argued that DDT was tax on the dividends and, therefore, dividends being subject to tax in the form of DDT, could not be considered as an income which does not form part of the total income of the shareholder. The Supreme Court did not accept this argument and held that the provisions of section 115-O are clear in that the tax on dividends is payable by the company and not by the shareholders and by virtue of section 10(34) the dividend income received by the shareholder is not taxable. Therefore, the Apex Court held that the provisions of section 14A would apply even for dividend income in the hands of the shareholders.

Interestingly, in the case of Union of India & Ors. vs. Tata Tea Co. Ltd. & Anr. (2017) (398 ITR 260), the Supreme Court was asked to adjudicate on the constitutional validity of DDT paid by tea companies as the Constitution of India prohibits taxation of profits on agricultural income. In this case the Court held that DDT is not a tax on the profits of the company but on the dividends and therefore upheld the constitutional validity of DDT.

Now the question arises, how does one read both the above decisions of the Supreme Court, delivered in different contexts, to give effect to both the orders in respect of DDT. One of the interpretations of the application of DDT, keeping in mind the above decisions of the Supreme Court, is that while DDT is not a tax on the shareholders but the company distributing dividends, it is a tax on the dividends and not on the profits of the company distributing dividends.

One would need to evaluate whether the above principle emanating from both the above judgments could be applied in the context of a DTAA. Article 10 of the UN Model Convention reads as under:

‘(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 the beneficial owner of the dividends is a resident of the other Contracting State, the tax so charged shall not exceed:…..’ (emphasis supplied).

Therefore, the UN Model Convention as well as the DTAAs which India has entered into provide for taxation of the stream of income and do not refer to the person in whose hands such income is to be taxed. Accordingly, one may be able to take a view that a DTAA restricts the right of taxation of the country of source on dividend income and this restriction would apply irrespective of the person liable for payment of tax on the said dividend income. In other words, one may be able to argue that DTAA would restrict the application of DDT to the rates specified in the DTAA.

Interestingly, the Protocol to the India-Hungary DTAA provides as under,

‘When the company paying the dividends is a resident of India the tax on distributed profits shall be deemed to be taxed in the hands of the shareholders and it shall not exceed 10 per cent of the gross amount of dividend.’

In other words, the Protocol deems the DDT to be a tax on the shareholders and therefore restricted the DDT to 10%.

Further, as Hungary is an OECD member and the DTAA between India and Hungary was signed in 2003, one could also have applied the Most Favoured Nation clause in the Protocols in India’s DTAAs with Netherlands, France and Sweden to apply the above restriction on shareholders resident in those countries.

The Delhi ITAT in the case of Giesecke & Devrient (India) Pvt. Ltd. (Supra) also held that the DDT would be restricted to the tax rates as prescribed under the relevant DTAA. The argument that the Delhi ITAT has considered while applying the tax treaty rate for dividends is that the introduction of the DDT was a form of overriding the treaty provisions, which is not in accordance with the Vienna Convention of the Law of Treaties, 1969 and hence the DTAA rate should override the DDT rate.

Now, the question is whether one can claim a refund of the DDT paid in excess of the DTAA rate applying the above judicial precedents and, if so, which entity should claim the refund – the company which has paid the dividends or the shareholder? In respect of the second part of the question, the Supreme Court in the case of Godrej & Boyce (Supra) is clear that DDT is a tax on the company declaring the dividends and not on the shareholders. Therefore, the claim of refund, if any, for DDT paid in excess of the DTAA rates should be made by the company which has paid the dividends and not by the shareholders.

In order to evaluate whether one can claim refund of the excess DDT paid, it is important to analyse two scenarios – where the case of the taxpayer company is before the A.O. or an appellate authority, and where there is no outstanding scrutiny or appeal pending for the taxpayer company.

In the first scenario, where the taxpayer is undergoing assessment proceedings or is in appeal before an appellate authority, such a refund may be claimed by making such a claim before the A.O. or the relevant appellate authority. While the A.O. may apply the principle of the Supreme Court in the case of Goetze (India) Ltd. vs. CIT (2006) (284 ITR 323), the appellate authorities are empowered to consider such a claim even if not claimed in the return of income following various judicial precedents, including the Bombay High Court in the case of CIT vs. Pruthvi Brokers & Shareholders (P) Ltd. (2012) (349 ITR 336).

In the second scenario, the options are limited. One may evaluate whether following certain judicial precedents this could be considered as a mistake apparent from record requiring rectification u/s 154 or whether one can obtain an order from the CBDT u/s 119.

In the view of the authors, if the taxpayer falls in the category as mentioned in the first scenario, one should definitely consider filing a claim before the A.O. or the appellate authority as even if such claim is rejected or subsequently the Supreme Court rules against the taxpayer on this issue, given that the DDT has already been paid by the taxpayer company, there may not be any penal consequences.

2. ISSUE IN APPLICATION OF MFN CLAUSE IN SOME TREATIES
Another recent issue is the application of the MFN clause to lower the rate of taxation of dividends. While application of the MFN clause is not a new concept, this issue has been exacerbated with the reintroduction of the classical system of taxation.
Article 10(2) of the India-Netherlands DTAA provides for a 10% tax in the country of source. Paragraph IV(2) of the Protocol to the India-Netherlands DTAA provides as follows,

‘If after the signature of this Convention under any Convention or Agreement between India and a third State which is a member of the OECD, India should limit its taxation at source on dividends, interests, royalties, fees for technical services or payments for the use of equipment to a rate lower or a scope more restricted than the rate or scope provided for in this Convention on the said items of income, then as from the date on which the relevant Indian Convention or Agreement enters into force the same rate or scope as provided for in that Convention or Agreement on the said items of income shall also apply under this Convention’ (emphasis supplied).

The India-Netherlands DTAA was signed on 13th July, 1988. Pursuant to this, India entered into a DTAA with Slovenia on 13th January, 2003. Article 10(2) of the India-Slovenia DTAA provides for a lower rate of tax at 5% in case the beneficial owner is a company which holds at least 10% of the capital of the company paying the dividends.

While the DTAA between India and Slovenia was signed in 2003, Slovenia became a member of the OECD only in 2010. In other words, while the Slovenia DTAA was signed after the India-Netherlands DTAA, Slovenia became a member of the OECD after the DTAA was signed.

Therefore, the question arises whether one can apply the MFN clause in the Protocol of the India-Netherlands DTAA to restrict India from taxing dividends at a rate not exceeding 5%.

In this context, the Delhi High Court in a recent decision, Concentrix Services Netherlands BV vs. ITO (TDS) (2021) [TS-286-HC-2021(Del)] has held that one could apply the rates as provided under the India-Slovenia DTAA by applying the MFN clause in the India-Netherlands DTAA. In this case, the assessee sought to obtain a lower deduction certificate from the tax authorities u/s 197 by applying the rates under the India-Slovenia DTAA. However, the tax authorities issued the lower deduction certificate with 10% as the tax rate. Following the writ petition filed by the taxpayer, the Delhi High Court upheld the view of the taxpayer. The Delhi High Court relied on the word ‘is’ in the India-Netherlands DTAA in the term ‘….which is a
member of the OECD…’ of the Protocol. The High Court held that the said word describes a state of affairs that should exist not necessarily at the time when the subject DTAA was executed but when the DTAA provisions are to be applied.

Interestingly, the High Court also referred to the contents of the decree issued by the Netherlands in this respect wherein the India-Slovenia DTAA was made applicable to the India-Netherlands DTAA on account of the Protocol. In this regard, the Court followed the principle of ‘common interpretation’ while applying the interpretation of the issue in the treaty partner’s jurisdiction to the interpretation of the issue in India.

Therefore, one may be able to apply the lower rates under the India-Slovenia DTAA (or even the India-Colombia DTAA or India-Lithuania DTAA which also provide for a 5% rate) to the India-Netherlands DTAA by virtue of the MFN clause in the latter.

Similarly, India’s DTAAs with Sweden and France also contain a similar MFN clause and both the DTAAs are also signed before the India-Slovenia DTAA. Therefore, one can apply a similar principle even in such DTAAs.

However, it is important to consider the practical aspects such as how should one disclose the same in Form 15CB or in the TDS return filed by the payer as the TDS Centralised Processing Centre may process the TDS returns with the actual DTAA rate without considering the Protocol.

3. SOME ISSUES RELATING TO BENEFICIAL OWNER
In the first part of this article, we analysed the meaning of the term ‘beneficial owner’ in the context of DTAAs. This article seeks to identify some other peculiar issues around beneficial owner in DTAAs.

Firstly, it is important to understand that the term ‘beneficial owner’ is used in relation to ownership of income and not of the asset. Therefore, in respect of dividends one would need to evaluate whether the recipient is the beneficial owner of the income. The fact that the recipient of the dividends is a subsidiary of another company may not have any influence on the interpretation of the term. If, however, the recipient is contractually obligated to pass on the dividends received to its holding company, it may not be considered as the beneficial owner of the income.

Article 10 relating to dividends in most of India’s DTAAs requires the recipient of the dividends to be a beneficial owner of the income. For example, Article 10(2) of the India-Singapore DTAA provides as follows,

‘However, such dividends may also be taxed in the Contracting State …… but if the recipient is the beneficial owner of the dividends, the tax so charged shall not exceed….’ (emphasis supplied).

On the other hand, some of India’s DTAAs require the beneficial owner to be a resident of the Contracting State as against the recipient being the beneficial owner. For example, Article 10(2) of the India-Belgium DTAA provides as follows,

‘However, such dividends may also be taxed in the Contracting State ….. but if the beneficial owner of the dividends is a resident of the other Contracting State, the tax so charged shall not exceed….’ (emphasis supplied).
 
Now, the question arises whether the difference in the above languages would have any impact. In order to understand the same, let us consider an example wherein I Co pays dividends to A Co which is a resident of State A and A Co is obligated to transfer the dividends received to its holding company HoldCo, which is also a resident of State A. In other words, the recipient of the income is A Co and the beneficial owner of the income is HoldCo, and both are tax residents of State A.

In case the DTAA between India and State A is similar to that of the India-Singapore DTAA, the benefit of the lower rate of tax under the DTAA may not be available as the lower rate applies only if the recipient is the beneficial owner of the dividends, and in this case the recipient, i.e., A Co, is not the beneficial owner of the dividends.

On the other hand, if the DTAA between India and State A is similar to that of the India-Belgium DTAA, the benefit of the lower rate of tax under the DTAA would be available as the beneficial owner of the dividends, i.e., HoldCo, is a resident of State A. Therefore, one should also carefully consider the language in a particular DTAA before applying the same.

Another peculiar issue in respect of beneficial owner is the consequences of the recipient not being considered as the beneficial owner. The issue is further explained by way of an example.

Let us consider a situation where I Co, a resident of India, pays dividend to A Co, a resident of State A, and A Co is obligated to transfer the dividends received to its holding company B Co, a resident of State B.

In this scenario, the benefit of the DTAA between India and State A would not be available as the beneficial owner is not a resident of State A. This would be the case irrespective of whether the language is similar to the India-Singapore DTAA or the India-Belgium DTAA. Now the question is whether one can apply the DTAA between India and State B as the beneficial owner, B Co, is a resident of State B. While B Co is the beneficial owner of the income, the dividend is not ‘paid’ to B Co. Therefore, the Article on dividend of the DTAA between India and State B would not apply. Moreover, in the Indian context, the entity in whose hands the income would be subject to tax would be A Co and therefore evaluating the application of the DTAA between India and State B, wherein A Co is not a resident of either, would not be possible. Accordingly, in the view of the authors, in this scenario the benefit of the lower rate of tax on dividends in both the DTAAs would not be available.

4. APPLICATION OF THE MULTILATERAL INSTRUMENT (‘MLI’)
Pursuant to the Base Erosion and Profit Shifting Project of the OECD, India is a signatory to the MLI. The MLI modifies the existing DTAAs entered into by India. Some of the Indian DTAAs are already modified, with the MLI being effective from 1st April, 2020. We have briefly evaluated the relevant articles of the MLI which may apply in the context of dividends.

(a) Principal Purpose Test (‘PPT’) – Article 7 of the MLI
Article 7 of the MLI provides that the benefit of a Covered Tax Agreement (‘CTA’), i.e., DTAA as modified by the MLI, would not be granted if it is reasonable to conclude that obtaining the benefit of the said DTAA was one of the principal purposes of any arrangement or transaction, unless it is established that granting the benefit is in accordance with the object and purpose of the relevant provisions of the said DTAA.

In respect of dividends, therefore, the benefit under a DTAA may be denied in case it is reasonable to conclude that the transaction or arrangement was structured in a particular manner with one of the principal purposes being to obtain a benefit of that DTAA.

For example, US Co, a company resident in the US, wishes to invest in I Co, an Indian company. However, as the tax rate on dividends in the India-US DTAA is 15%, it interposes an intermediate holding company in the Netherlands, NL Co, with an objective to apply the India-Netherlands DTAA to obtain a lower rate of tax on dividends (5% after applying the MFN clause and the India-Slovenia DTAA as discussed above). In such a scenario, the tax authorities in India may deny the benefit of the dividend article in the India-Netherlands DTAA as one of the principal purposes of investment through the Netherlands was to obtain the benefit of the DTAA.

The PPT is wider in application than the General Anti-Avoidance Rules (‘GAAR’). Further, as it is a subjective test, there are various issues and challenges in the interpretation and the application of the PPT.

(b) Dividend transfer transactions – Article 8 of the MLI
Article 10(2) of some of the DTAAs India has entered into provide two rates of taxes as the maximum amount taxable in the country of source, with a lower rate applicable in case a certain holding threshold is met. For example, Article 10(2) of the India-Singapore DTAA provides for the following rates of tax as a threshold beyond which the country of source cannot tax:
(i) 10% of the gross amount of dividends in case the beneficial owner is a company which owns at least 25% of the shares of the company paying dividends; and
(ii) 15% in all other cases.

Such DTAAs provide a participation exemption by providing a lower rate of tax in case a certain holding threshold is met.

Article 8 of the MLI provides that the participation exemption which provides for a lower rate of tax in case a holding threshold is met would not apply unless the required number of shares for the threshold are held for at least 365 days, including the date of payment.

Therefore, in case of an Indian company paying dividends to its Singapore shareholder which holds more than 25% of the shares of the Indian company, the tax rate of 10% would be available only in case the Singapore company has held the shares of the Indian company for a period of at least 365 days.

One of the issues in the interpretation of Article 8 of the MLI is that the Article does not specify the manner of computing the period of holding – whether the period of 365 days should be considered for the period immediately preceding the date of payment of dividends, or can one consider the period after the dividend has been paid as well. While one may be able to take a view that as the Article does not require the holding period to be met on the date of the payment of the dividend, the period of holding after the payment of dividend may also be considered. However, there may be practical challenges, especially while undertaking withholding tax compliances for payment of such dividend.

5. ISSUES RELATED TO TAX CREDIT ON DIVIDENDS RECEIVED
Having analysed various aspects in the taxation of dividends in the country of source, we have also analysed some specific issues arising in respect of dividends in the country of residence. India follows the credit system of relieving double taxation.

One of the issues in respect of tax credit is that of conflict of interpretation between both the Contracting States. Let us take an example; F Co, a resident of State A, pays dividend on compulsorily preference shares to I Co, an Indian company. Assume that under the domestic tax law of State A such a payment is considered as interest. Assume also that the tax rate for interest and dividends is 15% and 10%, respectively, under the DTAA between India and State A.

In this scenario, State A would withhold tax at the rate of 15%. Now the question is whether India would provide a credit of 15% or would the tax credit be restricted to 10% as India considers such payment as dividends? The Commentary on Article 23 of the OECD Model Convention provides that in the case of a conflict of interpretation, the country of residence should permit credit for the tax withheld in the country of source even if the country of residence would treat this income differently. The only exception to this rule provided by the Commentary is when the country of residence believes that the country of source has not applied the provisions of a DTAA correctly, would the country of residence deny such higher tax credit.

In the present case, one may be able to contend that the country of source, State A, has correctly applied the DTAA in accordance with its domestic tax law and therefore India would need to provide tax credit of 15% subject to other rules relating to foreign tax credit.

Another peculiar aspect in respect of tax credit for dividends received from a foreign jurisdiction is that of the underlying tax credit. Some of the DTAAs India has entered into provide for an underlying tax credit.

For example, Article 25(2) of the India-Singapore DTAA, dealing with tax credit, provides as under,

‘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. Where the income is a dividend paid by a company which is a resident of Singapore to a company which is a resident of India and which owns directly or indirectly not less than 25 per cent of the share capital of the company paying the dividend, the deduction shall take into account the Singapore tax paid in respect of the profits out of which the dividend is paid.’

Therefore, tax credit would include the corporate tax paid by the company which has declared the dividend. This is explained by way of an example. Let us consider that I Co, an Indian company, is a 50% shareholder in Sing Co, a tax resident of Singapore. Assuming that Sing Co has profits (before tax) of 100 which are distributed (after payment of taxes) as dividend to the shareholders, the tax credit calculation in the hands of I Co would be as follows:
 

 

Particulars

Amount

A

Profit of Sing Co

100

B

(-) Corporate tax of 17% in Singapore

(17)

C

Dividend payable (A-B)

83

D

Dividend paid to I Co (50% of C)

41.5

E

(-) Tax on dividends in Singapore

(0)

F

Net amount received by I Co (D-E)

41.5

G

Tax in India u/s 115BBD (15% of F)

6.2

H

(-) Tax credit for taxes paid in Singapore (=E)

0

I

(-) Underlying tax credit for taxes paid by Sing Co (50% of B)

(8.5)

J

Actual tax credit [(H + I ) subject to maximum to G]

(6.2)

K

Tax payable in India (G – J)

0

L

Net amount received in India (net of taxes) (F –
K)

41.5

6. CONCLUSION

Each DTAA may have certain peculiarities. For example, the India-Greece DTAA provides for an exclusive right of taxation of dividends to the country of source, and the country of residence is not permitted to tax the dividends. With the reintroduction of the classical system of taxation of dividends, therefore, it is important to understand and evaluate the DTAA in detail in cross-border payment of dividends.

It is also important to evaluate the tax credit article in respect of dividends received from foreign companies in order to examine whether one can apply underlying tax credit as well.

TDS UNDER SECTION 195 IN POST-MLI SCENARIO

In our earlier articles of June, August and September, 2018, we had covered the various facets of TDS under section 195 of the Income-tax Act, 1961 (the Act), including some practical issues on the same. With the increase in global trade, TDS on payments to non-residents has gained importance in recent years. The year 2020 was unforgettable for various reasons – the ongoing pandemic and the lockdown that followed being one of them. However, the international tax landscape in India also underwent a significant change in 2020 with the Multilateral Instrument (MLI) coming into effect on 1st April, 2020. The MLI has modified various DTAAs. Further, the return to the classical system of taxing dividends and the abolishment of the Dividend Distribution Tax regime in the Finance Act, 2020 also extended the scope of TDS u/s 195 as dividend payments hitherto were not subject to such TDS by virtue of the exemption u/s 10(34).

Given the host of changes that the world, particularly the tax world, has undergone in 2020, this article attempts to analyse the impact of these changes on compliance u/s 195 especially for a practitioner who is certifying the taxability of foreign remittances in Form 15CB.

1. BACKGROUND

Section 195 requires tax to be deducted at the ‘rates in force’ in respect of interest or ‘other sum chargeable under the provisions of this Act’ in respect of payment to a non-resident. Further, section 2(37A), defining the term ‘rates in force’ in respect of income subject to TDS u/s 195 refers to the rate specified in the Finance Act of the relevant year, or the rate as per the respective DTAA in accordance with section 90. Therefore, TDS u/s 195 in theory results in the finality of the tax deducted on the income chargeable to tax in India in respect of a non-resident recipient as against the TDS under the other provisions of the Act, wherein TDS is only a form of collection of tax in advance and does not signify the final amount of tax payable in the hands of the deductee. This finality of the tax places a higher responsibility on a professional certifying the taxability u/s 195(6) in Form 15CB. Further, given the penal provisions for furnishing inaccurate information u/s 195, it is extremely important for a practitioner issuing Form 15CB to keep himself updated on the various changes in the international tax world. The ensuing paragraphs seek to address the practical issues arising on account of the recent changes in the international tax arena.

2. UNDERTAKING TDS COMPLIANCE BEFORE MLI

Before evaluating the impact of MLI on undertaking TDS compliances u/s 195, it may be worthwhile to briefly evaluate some of the best practices a professional would follow to avail the benefit under the DTAA before the MLI was effective.

While our earlier articles have covered most of these practices, in order to get a holistic view of the matter the same have been briefly covered below.

i. Tax Residency Certificate (TRC)
Section 90(4) provides that the benefit of a DTAA shall be available to a non-resident only in case such non-resident obtains a TRC from the tax authorities of the relevant country in which such person is a resident.

While the provision seeks to deny benefits of a DTAA to a non-resident who does not provide a valid TRC, the Ahmedabad Tribunal in the case of Skaps Industries India (P) Ltd. vs. ITO [2018] 94 taxmann.com 448 (Ahmedabad – Trib.) held that section 90(4) does not override the DTAA and, therefore, if the taxpayer can substantiate through any other document his eligibility to claim the benefit under the DTAA, the said benefit should be granted to him. One may refer to our article in the August, 2018 issue of this Journal for a detailed discussion on the ruling. In a recent decision, the Hyderabad Tribunal in the case of Sreenivasa Reddy Cheemalamarri vs. ITO [2020] TS-158-ITAT-2020 (Hyd.) has also followed the ruling of the Ahmedabad Tribunal in Skaps (Supra).

However, from the perspective of deduction u/s 195, it is always advisable to follow a conservative approach and therefore in a scenario where the recipient has not provided a valid TRC, the benefit under the DTAA may not be granted. The recipient would always have the option of filing a return of income and claiming refund and substantiating the eligibility to claim the benefit of the DTAA before the tax authorities, if required.

Further, if the TRC does not contain all the information as required in Rule 21AB of the Income-tax Rules, 1962 (Rules), one needs to also obtain a self-declaration from the recipient in Form 10F.

As TRC generally contains the residential status of the recipient as on the date of certificate or for a particular period, it is important that one obtains the TRC and Form 10F which is applicable for the period in which the transaction is undertaken.

ii. Declarations
In addition to the TRC, one generally also obtains the following declarations before certifying the taxability of the transaction u/s 195:
a.    Declaration that the recipient does not have a PE in India and if a PE exists, the income from the transaction is not attributable to such PE;
b.    Declaration that the main purpose of the transaction is not tax avoidance. However, one also needs to evaluate the transaction in detail and not merely rely on the declaration under GAAR as one needs to be fairly certain of the taxability before certifying the same;
c.    Declaration in respect of specific items of income that the recipient is the beneficial owner of the income and that it is not contractually or legally obligated to pass on the said income to any other person;
d.    Declaration that the Limitation of Benefits (LOB) clause, if any, in the DTAA has been met. Similar to the above declarations, one needs to evaluate the transaction in detail to ensure that the transaction or the recipient, as the case may be, satisfies the conditions mentioned in the LOB clause and not merely rely on the declaration.

3. IMPACT ON ACCOUNT OF MLI


i. Background of the MLI
Following the recommendations in the Base Erosion and Profit Shifting (BEPS) Project of the OECD in which discussion more than 100 countries participated, the MLI, a document which seeks to modify more than 3,000 bilateral tax treaties (modified tax treaties are called Covered Tax Agreements or CTAs), was released for ratification. India is one of the nearly 100 countries which are signatories to the MLI.

India signed the MLI on 7th June, 2017 and deposited the ratified document along with a list of its Reservations and Options on 25th June, 2019. Article 34(2) of the MLI provides that the MLI shall enter into force for a signatory on the first day of the month following the expiration of a period of three calendar months from the date of deposit of the ratified instrument. In the case of India, therefore, the MLI entered into force on 1st October, 2019.

Further, Article 35(1)(a) of the MLI provides that the MLI shall come into effect in respect of withholding taxes on the first day of the calendar year (or financial year in the case of India) that begins after the latest date on which the MLI enters into force for each of the Contracting Jurisdictions to the CTA. In other words, the MLI shall have an effect of modifying a particular DTAA on the first day of a calendar year (or financial year) beginning after the MLI has entered into force for both the countries which are signatory to the DTAA.

As the MLI has entered into force for India in October, 2019, it has come into effect and would result in the modification to the DTAA from 1st April, 2020 where the MLI has entered into force for the other signatory to the DTAA prior to 1st April, 2020 as well. The MLI had entered into force for many Indian treaty partners in 2019 or earlier and therefore the MLI has come into effect for those DTAAs from 1st April, 2020.

India has listed 93 of its existing DTAAs to be modified by the MLI. However, as the MLI works on a matching concept, the respective DTAA would be modified only if both the countries, signatories to the DTAA, have included the said DTAA in their final list of treaties to be modified. For example, while India has included the India-Germany DTAA in its final list, Germany has not and therefore the India-Germany DTAA will not be modified by the MLI. Some of the other notable Indian DTAAs which are not modified by the MLI are those with the USA, Brazil and Mauritius. Similarly, out of the 95 signatories to the MLI, as on date 59 countries have deposited the ratified document. Moreover, out of the 59 countries which have deposited the document, some of them have done so only recently and therefore it is important at the time of undertaking compliance of section 195 and dealing with a DTAA to verify whether the DTAA has been modified by the MLI and, if so, from which date. One can use the MLI Matching Database on the OECD website to know whether a particular DTAA has been modified and from which date.

Treaty
Partner

Whether
modified by MLI

Effective
date for withholding taxes from when MLI modifies DTAA 1

Albania

Yes

1st April, 2021

Armenia

No

NA

Australia

Yes

1st April, 2020

Austria

Yes

1st April, 2020

Bangladesh

No

NA

Belarus

No

NA

Belgium

Yes

1st April, 2020

Bhutan

No

NA

Botswana

No

NA

Brazil

No

NA

Bulgaria

No

NA

Canada

Yes

1st April, 2020

China (People’s Republic of)

No

NA

Colombia

No

NA

Croatia

No

NA

Cyprus

Yes

1st April, 2021

Czech Republic

Yes

1st April, 2021

Denmark

Yes

1st April, 2020

Egypt

Yes

1st April, 2021

Estonia

Yes

1st April, 2022

Ethiopia

No

NA

Fiji

No

NA

Finland

Yes

1st April, 2020

France

Yes

1st April, 2020

Georgia

Yes

1st April, 2020

Germany

No

NA

Greece

No

NA

Hong Kong (China)

No

NA

Hungary

No

NA

Iceland

Yes

1st April, 2020

Indonesia

Yes

1st April, 2021

Iran

No

NA

Ireland

Yes

1st April, 2020

Israel

Yes

1st April, 2020

Italy

No

NA

Japan

Yes

1st April, 2020

Jordan

Yes

1st April, 2021

Kazakhstan

Yes

1st April, 2021

Kenya

No

NA

Korea

Yes

1st April, 2021

Kuwait

No

NA

Kyrgyz Republic

No

NA

Latvia

Yes

1st April, 2020

Libya

No

NA

Lithuania

Yes

1st April, 2020

Luxembourg

Yes

1st April, 2020

Macedonia

No

NA

Malaysia

No

NA

Malta

Yes

1st April, 2020

Mauritius

No

NA

Mexico

No

NA

Mongolia

No

NA

Montenegro

No

NA

Morocco

No

NA

Mozambique

No

NA

Myanmar

No

NA

Namibia

No

NA

Nepal

No

NA

Netherlands

Yes

1st April, 2020

New Zealand

Yes

1st April, 2020

Norway

Yes

1st April, 2020

Oman

Yes

1st April, 2021

Philippines

No

NA

Poland

Yes

1st April, 2020

Portugal

Yes

1st April, 2021

Qatar

Yes

1st April, 2020

Romania

No

NA

Russian Federation

Yes

1st April, 2020

Saudi Arabia

Yes

1st April, 2021

Serbia

Yes

1st April, 2020

Singapore

Yes

1st April, 2020

Slovak Republic

Yes

1st April, 2020

Slovenia

Yes

1st April, 2020

South Africa

No

NA

Spain

No

NA

Sri Lanka

No

NA

Sudan

No

NA

Sweden

Yes

1st April, 2020

Switzerland

Yes

1st April, 2020

Syria

No

NA

Tajikistan

No

NA

Tanzania

No

NA

Thailand

No

NA

Trinidad & Tobago

No

NA

Turkey

No

NA

Turkmenistan

No

NA

Uganda

No

NA

Ukraine

Yes

1st April, 2020

United Arab Emirates

Yes

1st April, 2020

United Kingdom

Yes

1st April, 2020

Uruguay

Yes

1st April, 2021

USA

No

NA

Uzbekistan

No

NA

Vietnam

No

NA

Zambia

No

NA

As highlighted earlier, the above list of DTAAs modified is only as on 15th January, 2021, therefore it is advisable to review the latest list and positions as on the date of the transaction.

The MLI has introduced various measures to combat tax avoidance in DTAAs. While some of the measures are objective, there are certain subjective measures as well and can lead to some ambiguity for a payer who is required to deduct TDS as one needs to evaluate various factual aspects of the income as well as the recipient, which may not always be available with the payer to conclude on the applicability of such measures to a particular payment.

While MLI is a vast subject, the ensuing paragraphs seek to evaluate the impact of the MLI on undertaking compliance u/s 195 and the challenges thereof. Accordingly, there may be some provisions of the MLI, for example, the clause relating to method to be employed for elimination of double taxation, which would not have an impact on TDS u/s 195 and therefore have not been covered in this article. Another similar example is the modification relating to dual resident entities (other than individuals), wherein the provisions of section 195 would not apply as payment to such a dual resident entity (thereby meaning a resident of India under the Act as well as the other country under its domestic tax law) would be considered as payment to a resident and not to a non-resident under the Act.

ii. Principal Purpose Test (PPT)
Article 7 of the MLI provides that ‘Notwithstanding any provisions of a Covered Tax Agreement, a benefit under the Covered Tax Agreement shall not be granted in respect of an item of income or capital if it is reasonable to conclude, having regard to all relevant facts and circumstances, that obtaining that benefit was one of the principal purposes of any arrangement or transaction that resulted directly or indirectly in that benefit, unless it is established that granting that benefit in these circumstances would be in accordance with the object and purpose of the relevant provisions of the Covered Tax Agreement.’

Therefore, the PPT test acts as an anti-avoidance provision in a treaty scenario and seeks to deny a benefit under a DTAA if it is reasonable to conclude that obtaining the said benefit was one of the principal purposes of the arrangement or transaction. However, it may be highlighted that the PPT and GAAR, although having similar objectives, operate differently. Further, the PPT has a wider coverage as compared to GAAR and therefore a transaction which satisfies GAAR may not satisfy the PPT, resulting in denial of the benefit under the DTAA.

a. Issue 1: How does the PPT impact the compliance u/s 195
The first issue one needs to address is whether the PPT has any impact on the TDS u/s 195. As the PPT seeks to address the issue of eligibility of a taxpayer to obtain the benefit of a CTA, it would impact the tax to be deducted in cases where the DTAA benefit is claimed at the time of deduction.

In other words, if one is applying a DTAA (which has been modified by the MLI, thereby making it a CTA) on account of the beneficial provision under the DTAA at the time of undertaking TDS, one would need to ensure that the PPT test is satisfied to claim the benefit of the DTAA / CTA.

The second aspect that needs to be addressed in this issue is whether the payer needs to evaluate the applicability of the PPT at the time of deduction of tax u/s 195 or can one argue that the PPT needs to only be applied by the tax authorities at the time of assessment of the recipient of the income.

In order to address this aspect, one would need to refer to section 163(1)(c) which makes the payer an agent of the non-resident recipient. Moreover, as highlighted earlier, unlike the other TDS provisions in the Act, in most cases section 195 in theory results in the finality of the tax being paid to the government in the case of payment to a non-resident.

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

b. Issue 2: How can one apply the PPT while undertaking compliances u/s 195
Once it is determined that the PPT needs to be evaluated at the time of application of section 195, the main issue which arises is that the PPT being a subjective intention-based test to determine treaty eligibility, how can one apply the same while undertaking compliance u/s 195 and what documentation should one obtain while certifying the taxability of the said transaction? As highlighted earlier, the major challenge in application of a subjective test at the time of withholding is that the payer and the professional certifying the taxability of the transaction u/s 195 are not aware of all the facts to conclude one way or another.

There are three views to address this issue.

View 1: Given the onerous responsibility tasked on the payer to collect the tax due on the transaction in the hands of the non-resident recipient and the subjective nature of the PPT, one can consider following a conservative approach by not providing any benefit under the DTAA at the time of deducting tax u/s 195 and asking the recipient to claim a refund of the excess tax deducted by filing a return of income. This would ensure that if any benefit under the DTAA is eventually claimed (by way of the recipient seeking a refund), the payer and the professional certifying the taxability are not responsible and the tax authorities can verify the subjective PPT in the hands of the recipient, who can provide the necessary information to satisfy the PPT directly to the tax authorities.

While this view is a conservative view, it may not always be practically possible as in many cases the recipient may not be willing to undertake additional compliance of filing a return of income, especially in a scenario where there is no tax payable under the DTAA.

View 2: Another conservative view is to approach the tax authorities to adjudicate on the issue by following the provisions of section 195(2) or section 197. This would eliminate any risk that the payer or the professional may undertake. However, this may not always be practically possible as there would be a delay in the remittance and this process is time-consuming, especially in scenarios where the payer makes many remittances to various parties during the year as this would entail approaching the tax authorities before every remittance.

View 3: Alternatively, as is the case with other declarations such as a ‘No PE declaration’ or a beneficial ownership declaration, one can take a declaration that obtaining the benefit under the DTAA is not one of the principal purposes of the arrangement or the transaction.

As per this view, the question arises whether such a declaration is to be obtained from the payer or from the recipient. The PPT needs to be tested qua the transaction as well as qua the arrangement. While the payer would in most cases be aware whether the principal purpose of a transaction is to avail DTAA benefits, an arrangement being a wider term may not entail the payer in necessarily being aware of all the details. Therefore, one must ensure that the declaration is to be obtained from the recipient of the income which is claiming the DTAA benefits.

This view is a practical one and follows the doctrine of impossibility, whereby in the absence of facts to the contrary it is not possible for a professional to certify that the transaction is designed to avoid tax and, therefore, the benefit of the DTAA should not be granted. While the payer would be aware whether the principal purpose of the transaction (not necessarily the arrangement) is to obtain benefit of the DTAA, in the absence of any facts provided to the professional, it is not possible for a professional to suspect otherwise.

Further, the Supreme Court in the case of GE India Technology Centre (P) Ltd. vs. CIT [2010] 193 Taxman 234 (SC) held, ‘(7)….where a person responsible for deduction is fairly certain then he can make his own determination as to whether the tax was deductible at source and, if so, what should be the amount thereof.’

Therefore, where the payer is ‘fairly certain’ having regard to the facts and circumstances about the taxability of a particular transaction, one need not approach the tax authorities.

However, it is advisable for a professional certifying the taxability of the transaction to question the nature of the transaction from an anti-avoidance perspective before taking the declaration or management representation. For example, if the transaction is towards payment of dividend by an Indian company to a Mauritian company, if such Mauritian company was set up at the time when the DDT regime was applicable, it may give credence to the fact that the investment through Mauritius was not made with the principal purpose of obtaining the DTAA rate on dividends paid.

In other words, the professional would need to question and evaluate, to the extent practically possible, as to why a particular transaction was undertaken in a particular manner and with adequate documentation to substantiate such reasoning. Such an evaluation may be required as unlike an audit report, where one provides an ‘opinion’ on a particular aspect, Form 15CB requires a professional to ‘certify’ the taxability after examination of relevant documents and books of accounts.

iii. Holding period for dividends
Article 8(1) of the MLI provides that, ‘Provisions of a Covered Tax Agreement that exempt dividends paid by a company which is a resident of a Contracting Jurisdiction from tax or that limit the rate at which such dividends may be taxed, provided that the beneficial owner or the recipient is a company which is a resident of the other Contracting Jurisdiction and which owns, holds or controls more than a certain amount of the capital, shares, stock, voting power, voting rights or similar ownership interests of the company paying the dividend, shall apply only if the ownership conditions described in those provisions are met throughout a 365-day period that includes the day of the payment of the dividends….’

Accordingly, Article 8(1) of the MLI restricts the participation exemption or benefit granted to a holding company receiving dividends to cases where the shares have been held by the holding company for at least 365 days, including the date of payment of dividends. Such provision, therefore, denies the benefit of the lower tax rate to a company shareholder who has acquired the shares for a short period only to meet the minimum holding requirement for availing such benefit.

This provision, being an objective factual test to avail the benefit of lower tax rate on dividends under the DTAA, can be examined by the professional certifying the tax u/s 195 as this information, being information regarding the shareholding of the Indian payer company, is readily available with the payer company.

However, it may be highlighted that the provision requires the holding period to be maintained for any period which includes the date on which the dividend is paid and not necessarily the period preceding the date of payment of dividend.

For example, Sing Co acquires 50% of the shares of I Co on 1st January, 2021. The dividend is declared by I Co on 30th June, 2021. In this case, while the 365-day holding period has not been met on the day of payment or declaration of dividend, the holding period requirement under Article 8(1) of the MLI would still be satisfied if Sing Co continued holding the said shares till 31st December, 2021 and would still be eligible for the lower rate of tax.

This gives rise to an issue to be addressed as to whether the lower rate of tax under Article 10(2)(a) of the India-Singapore DTAA should be considered at the time of undertaking the TDS compliance at the time of payment of dividend.

In our view, as on the date of the dividend payment the number of days threshold has not been met, the benefit of the lower rate of tax under Article 10(2)(a) of the DTAA should not be granted and TDS should be deducted in accordance with Article 10(2)(b) of the DTAA. In such a scenario, Sing Co can always file its return of income claiming a refund of the excess tax deducted once it satisfies the holding period criterion.

iv. Permanent Establishment (PE)
The MLI has extended the scope of the definition of a PE under a DTAA to include the following:
a.     A dependent agent who does not conclude contracts on behalf of the non-resident will still constitute a PE of the non-resident if such agent habitually plays a principal role in the conclusion of contracts of the non-resident.
b.     The exemption from the constitution of a PE provided to certain activities undertaken in a Source State through a fixed place of business would not be available if the activities along with activities undertaken by a closely-related enterprise in the Source State are not preparatory or auxiliary in nature.
c.     In the case of a construction or installation PE, the number of days threshold that needs to be met will include connected activities undertaken by closely-related enterprises as well.

Now the question arises, how does a professional identify the applicability of the extended scope of the definition of PE in remittances to non-residents and whether a mere declaration that a PE is not constituted would be sufficient.

With regard to point (a) above, for the extended scope of PE in respect of the transaction itself, one should be able to identify the facts of the said transaction before certifying the taxability thereof and a mere declaration on this aspect may not be sufficient.

Similarly, with regard to points (b) and (c) above, one may be able to analyse the applicability of the MLI in case of transactions undertaken by the non-resident recipient himself in India as they would relate to the transaction the taxability of which is to be certified. However, with regard to the activities undertaken by the closely-related enterprises, one may be able to follow the doctrine of impossibility and obtain a declaration from the recipient provided one has gone through all the relevant documents related to the transaction itself.

4. STEP-BY-STEP EVALUATION
Having understood the impact of the MLI on the compliances to be undertaken u/s 195, the table below provides a brief guidance on the step-by-step process that a professional needs to follow before certifying
the transaction in Form 15CB once it is determined that the DTAA is more beneficial than the taxability under the Act:

Step
number

Particulars

1

Obtain TRC from recipient (check whether TRC is a valid TRC for
the period in which the transaction is undertaken)

2

Obtain Form 10F if TRC does not contain information as required
in Rule 21AB of the Rules (check whether Form 10F is for the period in which
the transaction is undertaken)

3

Check whether GAAR provisions apply to the said transaction and
obtain suitable declaration

4

Check whether any specific LOB clause in the DTAA applies. If
so, whether the conditions for LOB have been met and obtain suitable
declaration

5

Check whether DTAA modified by MLI as on date of transaction
(follow steps 6 to 7 if MLI modifies DTAA)

6

Check whether the conditions of PPT are satisfied and obtain
suitable declaration

7

In case of dividend income earned by a company, verify if the
holding period for the shares is met as on date of transaction

8

Check if the transaction constitutes a PE for the recipient in
India or if income from the transaction can be attributable to the profits of
any PE of the recipient in India and obtain suitable declaration (in case MLI
modifies DTAA, the declaration should include the modified definition of PE)

9

In case of dividend, interest, royalty or income from fees for
technical services, check if the recipient is the beneficial owner or if the
beneficial owner is a resident of the same country in which the recipient is
a resident and obtain suitable declaration

5. CONCLUSION
The introduction of the MLI has added complexities to the process of undertaking compliance u/s 195. A professional who is certifying the taxability would now need to evaluate various other aspects in relation to the transaction to satisfy himself, with documentary evidence, that the various provisions of the MLI have been duly complied with. Further, merely obtaining declarations may not be sufficient as one needs to be fairly certain, after going through the relevant documents, of the taxability of the transaction u/s 195 before certifying the same.

 

1   The effective date for withholding taxes has been provided
from an Indian
perspective and may vary in the other jurisdiction

ISSUES IN TAXATION OF DIVIDEND INCOME, Part – 1

The Finance Act, 2020 has reintroduced the classical system of taxation on dividends moving away from the Dividend Distribution Tax (‘DDT’) system. The DDT tax system was first introduced by the Finance Act, 1997, abolished by the Finance Act, 2002 and reintroduced by the Finance Act, 2003 before being abolished in 2020. This reintroduction of the earlier, traditional system of taxation, while not necessarily more beneficial to a resident shareholder, can be more favourable to a non-resident shareholder on account of the benefit of the tax treaty as compared to the erstwhile DDT system of taxing dividends. For example, under the DDT regime the dividends were subject to tax at the rate of 15% plus surcharge and education cess. Under the classical system of taxation, this rate of tax can now be reduced to a lower DTAA rate, depending on the DTAA.

Article 10 of the DTAAs, dealing with dividends, was not of much significance in the past. However, now one would need to understand the intricacies of the benefits available for dividends in tax treaties and the various issues arising therefrom. It is important to note that the Multilateral Instrument (MLI), of which India is a signatory and which modifies various Indian DTAAs, also contains certain clauses which impact the taxation of dividends. In this two-part article we seek to analyse part of the international tax aspects of the taxation of dividends. In the first part we analyse the taxation of dividends under the domestic tax law and the construct of the DTAAs in the case of dividend income. The second part would contain various specific issues arising in the taxation of dividends in an international tax scenario.

1. INTRODUCTION

Debt and equity are two main options available to a company to raise capital, with various forms of hybrid instruments having varying degrees of characteristics of each of these options. The return on investment from such capital structure is generally termed as ‘dividend’ or ‘interest’ depending on the type of structure, i.e., whether classified as a primarily equity or a debt instrument.

‘Dividend’ in its ordinary connotation means the sum paid to or received by a shareholder proportionate to his shareholding in a company out of the total sum distributed. Dividend taxation in a domestic scenario typically involves economic double taxation – the company is taxed on the profits earned and the shareholders are taxed on such profits when they are distributed by the company by way of dividends.

While DTAAs generally relieve juridical double taxation, some DTAAs also relieve economic double taxation to a certain extent, in cases where underlying tax credit is provided.

The ensuing paragraphs evaluate various domestic tax as well as DTAA aspects of inbound as well as outbound dividends, specifically from the international tax perspective. In other words, tax implications on dividends paid by a foreign subsidiary to an Indian resident and on dividends paid by Indian companies to foreign shareholders are sought to be analysed.

Most DTAAs as well as both the Model Conventions – the OECD as well as the UN Model – follow a similar pattern in terms of the language of the article on dividends. For the purposes of this article, the UN Model Convention (2017) is used as a base.

2. TAXATION OF DIVIDEND AS PER DOMESTIC TAX LAW

There are various options available to a country while formulating its tax laws for taxation of dividends. In the past India was following the DDT system of taxing dividends. From A.Y. 2021-22 India has moved to the classical system of taxing dividends. Under the classical system of taxation, the company is first taxed on its profits and then the shareholders are taxed on the dividends paid by the company.

2.1    Definition of the term ‘dividend’
The term ‘dividend’ has been defined in section 2(22) of the Income-tax Act, 1961. It includes the following payments / distributions by a company, to the extent it possesses accumulated profits:
a.    Distribution of assets to shareholders;
b.    Distribution of debentures to equity shareholders or bonus shares to preference shareholders;
c.    Distribution to shareholders on liquidation;
d.    Distribution to shareholders on capital reduction;
e.    Loan or advance given to shareholder or any concern controlled by a shareholder.

The domestic tax definition of dividend as compared to the definition under the DTAA has been analysed subsequently in this article.

2.2    Outbound dividends
Dividend paid by an Indian company is deemed to accrue or arise in India by virtue of section 9(1)(iv).

Section 8 provides for the period when the dividend would be added to the income of the shareholder assessee. It provides that the interim dividend shall be considered as income in the year in which it is unconditionally made available to the shareholder and that the final dividend shall be considered as income in the year in which it is declared, distributed or paid.

The timing of the taxation of interim dividend as per the Act, i.e., when it is made unconditionally or at the disposal of the shareholder, is similar to that provided in the description of the term ‘paid’ above. However, the timing of the taxation of the final dividend may not necessarily match with that of the description of the term.

For example, in case of final dividend declared by an Indian company to a company resident of State X in September, 2020 but paid in April, 2021, when would such dividends be taxed as per the Act?

In this regard, it may be highlighted that the source rule for taxation of dividends ‘paid’ by domestic companies to non-residents is payment as per section 9(1)(iv) and not declaration of dividend. The Bombay High Court in the case of Pfizer Corpn. vs. Commissioner of Income-tax (259 ITR 391) held that,

‘….but for 9(1)(iv) payment of dividend to non-resident outside India would not have come within 5(2)(b). Therefore, 9(1)(iv) is an extension to 5(2)(b)……. in case where the question arises of taxing income one has to consider place of accrual of the dividend income. To cover a situation where dividend is declared in India and paid to non-resident out of India, 5(2)(b) has to be read with 9(1)(iv). Under 9(1)(iv), it is clearly stipulated that a dividend paid by an Indian company outside India will constitute income deemed to (be) accruing in India on effecting such payment. In 9(1)(iv), the words used are “a dividend paid by an Indian company outside India”. This is in contradiction to 8 which refers to a dividend declared, distributed or paid by a company. The word “declared or distributed” occurring in 8 does not find place in 9(1)(iv). Therefore, it is clear that dividend paid to non-resident outside India is deemed to accrue in India only on payment.’

Therefore, one can contend that dividend declared by an Indian company would be considered as income in the hands of the non-resident shareholder only on payment.

Earlier, dividends declared by an Indian company were subject to DDT u/s 115O payable by the company declaring such dividends. The rate of DDT was 15% and in case of deemed dividend the DDT rate from A.Y. 2019-20 (up to A.Y. 2020-21) was 30%. Further, section 115BBDA, referred to as the super-rich tax on dividends, taxed a resident [other than a domestic company, an institution u/s 10(23C) or a charitable trust registered u/s 12A or section 12AA] earning dividends (from Indian companies) in excess of INR 10 lakhs. In case of such a resident, the dividend in excess of INR 10 lakhs was taxed at the rate of 10%.

From A.Y. 2021-22, dividends paid by an Indian company to a non-resident are taxed at the rate of 20% (plus applicable surcharge and education cess). Further, with the dividend now being taxed directly in the hands of the shareholders, section 115BBDA is now inoperable.

Payment of dividend to non-residents or to foreign companies would require deduction of tax at source u/s 195 at the rates in force on the sum chargeable to tax. The rates in force in respect of dividends for non-residents or foreign companies as discussed above is 20% (plus applicable surcharge or education cess) or the rate as per the relevant DTAA (subject to fulfilment of conditions in respect of treaty eligibility), whichever is more beneficial.

2.3    Inbound dividends
Dividends paid by foreign companies to Indian companies which hold 26% or more of the capital of the foreign company are taxable at the rate of 15% u/s 115BBD. Further, such dividends, when distributed by the Indian holding company to its shareholders, were not included while computing the dividend distribution tax payable u/s 115O. However, section 80M also provides such a pass-through status to the dividends received to the extent the said dividends received by an Indian company have been further distributed as dividend within one month of the date of filing the return of income of the Indian company. The tax payable would be further reduced by the tax credit, if any, paid by the recipient in any country.

Let us take an example, say F Co, a foreign company in country A distributes dividend of 100 to I Co, an Indian company which further distributes 30 as dividend to its shareholders (within the prescribed limit). Assuming that the withholding tax on dividends in country A is 10, the amount of tax payable would be computed as below:

 

Particulars

Amount

A

Dividend received from F Co

100

B

(-) Deduction u/s 80M for dividends distributed by I Co

(30)

C

Dividend liable to tax (A-B)

70

D

Tax u/s 115BBD (C * 15%)

10.5

E

(-) Tax credit for tax paid in country A (assuming full tax
credit available)

(10)

F

Net tax payable (D-E) (plus applicable surcharge
and education cess)

0.5

Dividends received by other taxpayers are taxable at the applicable rate of tax (depending on the type of person receiving the dividends).

2.4 Taxation in case the Place of Effective Management (‘POEM’) of foreign company is in India
a. Dividend paid by foreign company having POEM in India to non-resident shareholder
As highlighted earlier, section 9(1)(iv) deems income paid by an Indian company to accrue or arise in India. In the present case, as the deeming fiction only refers to dividend paid by an Indian company, one may be able to take a position that the deeming fiction should not be extended to apply to foreign companies even if such foreign companies are resident in India due to the POEM of such companies in India. One may be able to argue that if the Legislature wanted such dividend to be covered, it would have specifically provided for it as done in respect of the existing source rules for royalty and fees for technical services in section 9, wherein a payment by a non-resident would deem such income to accrue or arise in India. Accordingly, the dividend paid by the foreign company to a non-resident shareholder may not be taxable in India even though the foreign company, declaring such dividend, is considered as a resident of India due to the POEM of the foreign company in India.

b. Dividend paid by foreign company having a POEM in India to resident shareholder
Such dividend would be taxed in India on account of the recipient of the dividend being a resident of India. Further, section 115BBD provides a lower rate of tax on dividends paid by a foreign company to an Indian company, subject to the Indian company holding at least 26% in nominal value of the equity share capital of the foreign company. Accordingly, such lower rate of tax would apply to dividends received by an Indian company from a foreign company (subject to the fulfilment of the minimum holding requirement) even if such foreign company is considered as a resident in India on account of its POEM being in India.

c. Dividend received by a foreign company
The provisions of section 115A apply in the case of receipt by a non-resident (other than a company) and a foreign company. Accordingly, dividend received by a foreign company would be taxed at the rate of 20% (plus applicable surcharge and education cess) even if the foreign company is considered as a tax resident of India on account of its POEM being in India.

3. ARTICLE 10 OF THE UN MODEL CONVENTION OR DTAAs DEALING WITH DIVIDENDS
As discussed above, dividends typically give rise to economic double taxation. However, the dividends may also be subject to juridical double taxation in a situation where the income, i.e., dividend is taxed in the hands of the same shareholder in two different jurisdictions. Article 10 of a DTAA typically provides relief from such juridical double taxation.

Article 10 dealing with taxation of dividends is typically worded in the following format:
a.    Para 1 deals with the bilateral scope for the applicability of the Article;
b.    Para 2 deals with the taxing right of the State of source to tax such dividends and the restrictions for such State in taxing the dividends;
c.    Para 3 deals with the definition of dividends as per the DTAA or Model Convention;
d.    Para 4 deals with dividends paid to a company having a PE in the other State;
e.    Para 5 deals with prohibition of extra-territorial taxation on dividends.

4. ARTICLE 10(1) OF THE UN MODEL CONVENTION OR DTAAs
Article 10(1) of a DTAA typically provides the source rule for dividends under the DTAA and also provides the bilateral scope for which the Article applies.

Article 10(1) of the UN Model (2017) reads as under: ‘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.’

4.1. Bilateral scope
Paragraph 1 deals with the bilateral scope for applicability of the Article. In other words, for Article 10 to apply the company paying the dividends should be a resident of one of the Contracting States and the recipient of the dividends should be a resident of the other Contracting State.
4.2. Source rule
Paragraph 1 also provides the source rule for the dividends, which helps in identifying the State of source for the Article. The paragraph is applicable to dividends ‘paid by a company which is a resident of a Contracting State’. Therefore, the State of source in the case of dividends shall be the State in which the company paying the dividends is a resident.
4.3. The term ‘paid’
Article 10 provides for allocation of taxing rights of dividends paid by a company. Therefore, it is important to understand the meaning of the term ‘paid’.

The description of the term in the OECD Commentary is as follows, ‘The term “paid” has a very wide meaning, since the concept of payment means the fulfilment of the obligation to put funds at the disposal of the shareholder in the manner required by contract or by custom.’

The issue of ‘paid’ is extremely relevant in the case of a deemed dividend u/s 2(22).

Section 2(22)(e) provides that the following payments by a company, to the extent of its accumulated profits, shall be deemed to be dividends under the Act:
a.    Advance or loan to a shareholder who holds at least 10% of the voting power in the payee company;
b.    Advance or loan to a concern in which the shareholder is a member or partner and holds substantial interest (at least 20%) in the recipient concern.

While a loan or advance to a shareholder, constituting deemed dividend u/s 2(22)(e), would constitute dividend ‘paid’ to the shareholder and, therefore, covered under Article 10(1) (subject to the issue as to whether deemed dividend constitutes dividend for the purposes of the DTAA, discussed in subsequent paragraphs), the question arises whether, in case of advance or loan given to a concern in which the shareholder has substantial interest, would be considered as ‘dividend paid by a company’.

Let us take the following example. Hold Co, a company resident in Singapore has two wholly-owned subsidiaries in India, I Co1 and I Co2. During the year, I Co1 grants a loan to I Co2. Assuming that neither I Co1 nor I Co2 is in the business of lending money, the loan given by I Co1 to I Co2 would be considered as deemed dividend.

The Delhi High Court in the case of CIT vs. Ankitech (P) Ltd. & Ors. (2012) (340 ITR 14) held that while section 2(22)(e) deems a loan to be dividend, it does not deem the recipient to be a shareholder. This view was upheld by the Supreme Court in the case of CIT vs. Madhur Housing & Development Co. & Ors. (2018) (401 ITR 152).

Therefore, the deemed dividend would be taxed in the hands of the shareholder, i.e., Hold Co in this case, and not I Co2, being the recipient of the loan, as I Co2 is not a shareholder. Would the dividend then be considered to be ‘paid’ to Hold Co as the funds have actually moved from I Co1 to I Co2 and Hold Co has not received any funds?

The question to be answered here is how does one interpret the term ‘paid’? In this context, Prof. Klaus Vogel in his book, ‘Klaus Vogel on Double Tax Conventions’ (2015 4th Edition), suggests,

‘“Payment” cannot depend on the transfer of money or “monetary funds”, nor does it depend on the existence of a clearly defined “obligation” of the company to put funds at the disposal of the shareholder; instead, in order to achieve consistency throughout the Article, it has to be construed so as to cover all types of advantages being provided to the shareholder covered by the definition of “dividends” in Article 10(3) OECD and UN MC, which include “benefits in money or money’s worth”. It has been argued that the term “payment” requires actual benefits to be provided to the shareholder, so that notional dividends would automatically fall outside the scope of Article 10 OECD and UN MC. This view has to be rejected, however, in light of the need for internal consistency of the provisions of the OECD and UN MC, which rather suggests that the terms “paid to”, “received by” and “derived from” serve only the purpose to connect income that is dealt with in a certain Article to a certain taxpayer, so that any income that falls within the definition of a “dividend” of Article 10(3) OECD and UN MC needs to be considered to be so “paid”. Indeed, it would make little sense to define a “dividend” with reference to domestic law of the Source State only to prohibit taxation of certain such “dividends” because they have not actually been “paid”.’

Accordingly, one may take a view that in such a scenario dividend would be considered as ‘paid’ under the DTAA.

4.4.    The term ‘may be taxed’
The paragraph provides that the dividend ‘may be taxed’ in the State of residence of the recipient of the dividends. It does not provide an exclusive right of taxation to the State of residence.

The interpretation of the term ‘may be taxed’ still continues to be a vexed issue to a certain extent even after the CBDT Notification No. 91 of 2008 dated 28th August, 2008. This controversy would be covered by the authors in a subsequent article.

5. ARTICLE 10(2) OF THE UN MODEL CONVENTION OR DTAAs
Article 10(2) of a DTAA typically provides the taxing right of the State of source for dividends under the DTAA.

Article 10(2) of the UN Model (2017) reads as under:
‘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 the beneficial owner of the dividends is a resident of the other Contracting State, the tax so charged shall not exceed:
a. __ per cent of the gross amount of the dividends if the beneficial owner is a company (other than a partnership) which holds directly at least 25 per cent of the capital of the company paying the dividends throughout a 365-day period that includes the day of the payment of the dividend (for the purpose of computing that period, no account shall be taken of changes of ownership that would directly result from a corporate reorganisation, such as a merger or divisive reorganisation, of the company that holds the shares or pays the dividend);
b. __ per cent of the gross amount of the dividends in all other cases.
The competent authorities of the Contracting States shall by mutual agreement settle the mode of application of these limitations.
This paragraph shall not affect the taxation of the company in respect of the profits out of which the dividends are paid.’

While the UN Model does not provide the rate of tax for paragraphs 2(a) and 2(b) and leaves the same to the individual countries to decide at the time of negotiating a DTAA, the OECD Model provides for 5% in sub-paragraph (a) and 15% in sub-paragraph (b).

5.1. Right of taxation to the source State
Paragraph 2 provides the right of taxation of dividends to the source State, i.e., the State in which the company paying the dividends is a resident. The first part provides the right of taxation to the source State and the second part of the paragraph restricts the right of taxation of the source State to a certain percentage on the applicability of certain conditions.
5.2. The term ‘may also be taxed’
Paragraph 2 provides that dividends paid by a company may also be taxed in the State in which the company paying the dividends is a resident.
5.3. Beneficial owner
The benefit of the lower rate of tax in the source State is available only if the beneficial owner is a resident of the Contracting State. Therefore, if the beneficial owner is not a resident of the Contracting State, the second part of the paragraph would not apply and there would be no restriction on the source State to tax the dividends.

The beneficial ownership test is an anti-avoidance provision in the DTAAs and was first introduced in the 1966 Protocol to the 1945 US-UK DTAA. The concept of beneficial ownership was first introduced by the OECD in its 1977 Model Convention. However, the Model Commentary did not explain the term until the 2010 update.

The term ‘beneficial owner’ has not been defined in the DTAAs or the Model Conventions.

However, the OECD Model Commentary explains the term ‘beneficial owner’ to mean a person who, in substance, has a right to use and enjoy the dividend unconstrained by any contractual or legal obligation to pass on the said dividend to another person.

In the case of X Ltd., In Re (1996) 220 ITR 377, the AAR held that a British bank was the beneficial owner of the dividends paid by an Indian company even though the shares of the Indian company were held by two Mauritian entities which were wholly-owned subsidiaries of the British bank. However, the AAR did not dwell on the term beneficial owner but stressed on the fact that
the Mauritian entities were wholly-owned by the British bank.

Some of the key international judgments in this regard are those of the Canadian Tax Court in the cases of Prevost Car Inc. vs. Her Majesty the Queen (2009) (10 ITLR 736) and Velcro Canada vs. The Queen (2012) (2012 TCC 57) and of the Court of Appeal in the UK in the case of Indofood International Finance Ltd. vs. JP Morgan Chase Bank NA (2006) (STC 1195).

In the case of JC Bamford Investments vs. DDIT (150 ITD 209), the Delhi ITAT held (in the context of royalty) that the ‘beneficial owner’ is he who is free to decide (i) whether or not the capital or other assets should be used or made available for use by others, or (ii) on how the yields therefore should be used, or (iii) both.

Similarly, the Mumbai Tribunal in the case of HSBC Bank (Mauritius) Ltd. v. DCIT (International Taxation) (2017) (186 TTJ 619) has explained the term ‘beneficial owner’, in the context of interest as, ‘“Beneficial owner” can be one with full right and privilege to benefit directly from the interest income earned by the bank. Income must be attributable to the assessee for tax purposes and the same should not be aimed at transmitting to the third parties under any contractual agreement / understanding. Bank should not act as a conduit for any person, who in fact receives the benefits of the interest income concerned.’

The question that arises is, how does one practically evaluate whether the recipient is a beneficial owner of the dividends? In this case, generally, dividends are paid to group entities wherein it is possible for the Indian company paying the dividends to evaluate whether or not the shareholder is merely a conduit. A Chartered Accountant certifying the taxation of the dividends in Form 15CB can ask for certain information such as financials of the non-resident shareholder in order to evaluate whether the recipient shareholder is a conduit company, or whether such shareholder has substance. In the absence of such information or such other documentation to substantiate that the shareholder is not a conduit company, it is advisable that the benefit under the DTAA is not given. It is important to highlight that an entity, even though a wholly-owned subsidiary, can be considered as a beneficial owner of the income if it can substantiate that it is capable of and is undertaking decisions in respect of the application of the said income.

6. ARTICLE 10(3) OF THE UN MODEL CONVENTION AND DTAAs
Article 10(3) of a DTAA generally provides the definition of dividends.

Article 10(3) of the UN Model (2017) reads as under: ‘The term “dividends” as used in this Article means income from shares, “jouissance” shares or “jouissance” rights, mining shares, founders’ shares or other rights, not being debt claims, participating in profits, as well as income from other corporate rights which is subjected to the same taxation treatment as income from shares by the laws of the State of which the company making the distribution is a resident.’

Therefore, the term ‘dividends’ includes the income from the following:
a.    Shares, jouissance shares or jouissance rights, mining shares, founders’ shares;
b.    Other rights, not being debt claims, participating in profits;
c.    Income from corporate rights subjected to the same tax treatment as income from shares in the source State.

6.1 Inclusive definition
The definition of the term ‘dividends’ in the DTAA as well as the OECD and UN Model is an inclusive definition. Further, it also gives reference to the definition of the term in the domestic law of the source State. The reason for providing an inclusive definition is to include all the types of distribution by the company to its shareholders.

6.2 Meaning of various types of shares and rights
The various types of shares referred to in the definition above are not relevant under the Indian corporate laws and, therefore, have not been further analysed.

6.3 Deemed dividend
The OECD Commentary provides that the term ‘dividends’ is expansively defined to include not only distribution of profits but even disguised distributions. However, the question that arises is whether such deemed dividend would fall under any of the limbs of the definition of dividends in the Article.

The Mumbai ITAT in the case of KIIC Investment Company vs. DCIT (2018) (TS – 708 – ITAT – 2018) while evaluating whether deemed dividend would be covered under Article 10(4) of the India-Mauritius DTAA (having similar language to the UN Model), held,

‘The India-Mauritius Tax Treaty prescribes that dividend paid by a company which is resident of a contracting state to a resident of other contracting state may be taxed in that other state. Article 10(4) of the Treaty explains the term “dividend” as used in the Article. Essentially, the expression “dividend” seeks to cover three different facets of income; firstly, income from shares, i.e. dividend per se; secondly, income from other rights, not being debt claims, participating in profits; and, thirdly, income from corporate rights which is subjected to same taxation treatment as income from shares by the laws of contracting state of which the company making the distribution is a resident. In the context of the controversy before us, i.e. ‘deemed dividend’ under section 2(22)(e) of the Act, obviously the same is not covered by the first two facets of the expression “dividend” in Article 10(4) of the Treaty. So, however, the third facet stated in Article 10(4) of the Treaty, in our view, clearly suggests that even “deemed dividend” as per Sec. 2(22)(e) of the Act is to be understood to be a “dividend” for the purpose of the Treaty. The presence of the expression “same taxation treatment as income from shares” in the country of distributor of dividend in Article 10(4) of the Treaty in the context of the third facet clearly leads to the inference that so long as the Indian tax laws consider “deemed dividend” also as “dividend”, then the same is also to be understood as “dividend” for the purpose of the Treaty.’

Therefore, without dwelling on the issue as to whether deemed dividend can be considered as income from corporate rights, the Mumbai ITAT held that deemed dividend would be considered as dividend under Article 10 of the DTAA.

In this regard it may be highlighted that the last limb of the definition of the term in the India-UK DTAA does not include the requirement of the income from corporate rights and therefore is more open-ended than the OECD Model. It reads as follows, ‘…as well as any other item which is subjected to the same taxation treatment as income from shares by the laws …’

7. ARTICLE 10(4) OF THE UN MODEL CONVENTION AND DTAAs


Article 10(4) of a DTAA provides for the tax position in case the recipient of the dividends has a PE in the other Contracting State of which the company paying the dividends is resident.

Article 10(4) of the UN Model (2017) reads as under, ‘The provisions of paragraphs 1 and 2 shall not apply if the beneficial owner of the dividends, being a resident of a Contracting State, carries on business in the other Contracting State of which the company paying the dividends is a resident, through a permanent establishment situated therein, or performs in that other State independent personal services from a fixed base situated therein, and the holding in respect of which the dividends are paid is effectively connected with such permanent establishment or fixed base. In such case the provisions of Article 7 or Article 14, as the case may be, shall apply.’

The difference between the OECD Model and the UN Model is that the OECD Model does not provide reference to Article 14 as the Article dealing with Independent Personal Services is deleted in the OECD Model.

7.1 Need to tax under Article 7 or Article 14
The paragraph states that once the bilateral scope in Article 10(1) is met, if the beneficial owner of the dividends has a PE in the source State and the holding in respect of which the dividends are paid is effectively connected to such PE, then the provisions of Article 7 or Article 14 shall override the provisions of Article 10.

To illustrate, A Co, resident of State A, has a subsidiary, B Co, as well as a branch (considered as a PE in this example) in State B. If the holding of B Co is effectively connected to the branch of A Co in State B, Article 7 of the A-B DTAA would apply and not Article 10.

The reason for the insertion of this paragraph is that once a taxpayer has a PE in the source State and the dividends are effectively connected to such PE, they would be included in the profits attributable to the PE and taxed as such in accordance with Article 7 of the DTAA. Therefore, taxing the same dividends on a gross basis under Article 10 and on net basis under Article 7 would lead to unnecessary complications in State B. In order to alleviate such unnecessary complications, it is provided that the dividends would be included in the net profits attributable to the PE and taxed in accordance with Article 7 and not Article 10.

7.2 The term ‘effectively connected’
The OECD Model Commentary provides a broad
guidance as to when the holdings would be considered as being ‘effectively connected’ to a PE and provides the following circumstances in which it would be considered so:
a.    The economic ownership of the holding is with the PE;
b.    Under the separate entity approach, the benefits as well as the burdens of the holding (such as right to the dividends attributable to ownership, potential exposure of gains and losses from the appreciation and depreciation of the holding) is with the PE.

8. ARTICLE 10(5) OF THE UN MODEL CONVENTION AND DTAAs
Article 10(5) of a DTAA deals with prevention of extra-territorial taxation.

Article 10(5) of the UN Model (2017) reads as under, ‘Where a company which is a resident of a Contracting State derives profits or income from the other Contracting State, that other State may not impose any tax on the dividends paid by the company, except insofar as such dividends are paid to a resident of that other State or insofar as the holding in respect of which the dividends are paid is effectively connected with a permanent establishment or a fixed base situated in that other State, nor subject the company’s undistributed profits to a tax on the company’s undistributed profits, even if the dividends paid or the undistributed profits consist wholly or partly of profits or income arising in such other State.’

Each country is free to draft source rules in its domestic tax law as it deems fit. Paragraph 5, therefore, prevents a country from taxing dividends paid by a company to another, simply because the dividend is in respect of profits earned in that country, except in the following circumstances:
a.    The company paying the dividends is a resident of that State;
b.    The dividends are paid to a resident of that State; and
c.    The holding in respect of which the dividends are paid is effectively connected to the PE of the recipient in that State.

Let us take an example where A Co, a resident of State A, earns certain income in State B and out of
the profits from its activities in State B (assume constituting PE of A Co in State B), declares dividend to X Co, a resident of State C. This is provided by way of a diagram below.

While State B would tax the profits of the PE of A Co, State B can also seek to tax the dividend paid by A Co to X Co as the profits out of which the dividend is paid is out of profits earned in State B. In such a situation, the DTAA between State C and State B may not be able to restrict State B from taxing the dividends if the Article dealing with Other Income does not provide exclusive right of taxation to the country of residence. In such a scenario, Article 10(5) of the DTAA between State A and State B will prevent State B from taxing the dividends on the following grounds:
a.    A Co, the company paying the dividends, is not a resident of State B;
b.    C Co, the recipient of the dividends, is not a resident of State B; and
c.    The dividends are not effectively connected to a PE of C Co (the recipient) in State B.

9. CONCLUSION
With the return to the classical system of taxing dividends, dividends may now be a tax-efficient way of distributing the profits of a company, especially if the shareholder is a resident of a country with a favourable DTAA with India. In certain cases, distribution of dividend may be a better option as compared to undertaking buyback on account of the buyback tax in India.

However, it is important to evaluate the anti-avoidance rules such as the beneficial ownership rule as well as the MLI provisions before applying the treaty benefit. As a CA certifying the remittance in Form 15CB, it is extremely important that one evaluates the documentation to substantiate the above anti-avoidance provisions and, in the absence of the same, not provide benefit of the DTAA to such dividend income. In the next part of this article, relating to international tax aspects of taxation of dividends, we would cover certain specific issues such as whether DDT is restricted by DTAA, MLI aspects and underlying tax credit among other issues in respect of dividends.

TAXATION OF DIGITISED ECONOMY – SIGNIFICANT ECONOMIC PRESENCE AND EXTENDED SOURCE RULE

In our earlier articles of January and May, 2020, we had covered the proposals discussed between the countries participating in the Inclusive Framework to tax the digitised economy. Closer home, India has introduced several provisions to bring into the tax net the income of the digitised economy – Equalisation Levy (EL), Significant Economic Presence (SEP) and Extended Source Rule for business activities undertaken in or with India.

This article seeks to analyse the provisions introduced in the Income-tax Act, 1961 (the Act) to tax the income in the digitised economy era – Explanation 2A, i.e., SEP, and Explanation 3A, i.e., the extended source rule, to section 9(1)(i). While there are other measures and provisions relating to taxation of the digitalised economy, such as EL and provisions related to deduction and collection of taxes, this article does not deal with such provisions.

1. BACKGROUND

Taxation of the digitised economy has been one of the hotly debated topics in the international tax arena in the recent past, not just amongst tax practitioners and academicians but also amongst governments and revenue officials. The existing tax rules are not sufficient to tax the income earned in the digital economy era. The existing rules of allocation of taxing rights in DTAAs between countries rely on physical presence of a business in a source country to tax income. However, with the advent of technology, the way businesses are conducted is different from that a few years ago. Today, it is possible to undertake business in a country without requiring any physical presence, thereby leading to no tax liability in the country in which such business is undertaken.

The urgency and importance of this topic became evident when OECD included taxation of the digital economy as the first Action Plan out of 15 in the BEPS Project. More than 130 countries, as part of the Inclusive Framework of the OECD, have been seeking to arrive at a consensus-based solution to tax the transactions in the digitised economy era for the past few years. In this regard, a two-pillar Unified Approach has been developed and the blueprints for both the Pillars were released for public comments in October, 2020.

While countries in the Inclusive Framework are hopeful of arriving at a consensus amongst all members this year, there are various policy considerations which need to be taken into account. Further, the UN Committee of Experts on International Co-operation in Tax Matters has also tabled a proposal seeking to insert a new article in the UN Model Double Tax Convention to tax the digitised economy.

India has been a key player in the global discussions to tax the digitised economy. While BEPS Action Plan 1 dealing with taxation of the digital economy did not provide a recommendation in the Final Report released in October, 2015 on account of the lack of consensus amongst the participating countries, the Report analysed (without recommending) three options for countries until consensus was arrived at – withholding tax, a digital permanent establishment in the form of SEP, or equalisation levy. It was also concluded that member countries would continue to work on a consensus-based solution to be arrived at at the earliest.

DEVELOPMENTS IN INDIA

India was one of the first countries to enact a law in this regard and EL was introduced as a part of the Finance Act, 2016. The EL applicable to online advertisement services was not a part of the Act and therefore, arguably, not restricted by tax treaties. The Finance Act, 2018 introduced the SEP provisions in the Act. Further, the scope of ‘income attributable to operations carried out in India’ was extended by the Finance Act, 2020. While introducing the extended scope, the Finance Act, 2020 also amended the SEP provisions and postponed the application of these provisions till the F.Y. 2021-22. Further, the Finance Act, 2020 also expanded the scope of the EL provisions.

Unlike the EL provisions, SEP by insertion of Explanation 2A to section 9(1)(i) and the Extended Source Rule by insertion of Explanation 3A to section 9(1)(i), were introduced in the Act itself and hence the taxation of income covered under these provisions may be subject to the beneficial provisions of the tax treaties.

In other words, the application of these provisions would be required in a scenario where the non-resident is from a jurisdiction which does not have a DTAA with India, or where the non-resident is not eligible to claim benefits of a DTAA, say on account of application of the MLI provisions, or due to the non-availability of a Tax Residency Certificate (TRC).

In addition to scenarios where benefit of the DTAA is not available, it is important to note that one of the possible methods for implementation of Pillar 1 of the Unified Approach is the modification of the existing DTAAs through another multilateral instrument (MLI 2.0) to provide for a nexus and the amount to be taxed in the Country of Source or Country of Market. Therefore, the reason for introduction of these provisions in the Act is to enable India to tax such transactions once the treaties are modified because without charge of taxation in the domestic tax law, mere right provided by a tax treaty may not be sufficient.

2. EXPLANATION 2A TO SECTION 9(1)(I) (SEP)

The SEP provisions were introduced by way of insertion of Explanation 2A to section 9(1)(i) of the Act. It reads as follows:

‘Explanation 2A. – For the removal of doubts, it is hereby declared that the significant economic presence of a non-resident in India shall constitute “business connection” in India and “significant economic presence” for this purpose, shall mean –
(a) transaction in respect of any goods, services or property carried out by a non-resident with any person in India, including provision of download of data or software in India, if the aggregate of payments arising from such transaction or transactions during the previous year exceeds such amount as may be prescribed; or
(b) systematic and continuous soliciting of business activities or engaging in interaction with such number of users in India, as may be prescribed:

Provided that the transactions or activities shall constitute significant economic presence in India, whether or not –
(i) the agreement for such transactions or activities is entered in India; or
(ii) the non-resident has a residence or place of business in India; or
(iii) the non-resident renders services in India:
Provided further that only so much of income as is attributable to the transactions or activities referred to in clause (a) or clause (b) shall be deemed to accrue or arise in India.’

Therefore, Explanation 2A seeks to extend the definition of ‘business connection’ to certain transactions where the business is undertaken ‘with’ India as against the traditional method of creating a business connection only in cases of transactions undertaken ‘in’ India.

The thresholds in respect of the amount of payment for goods and services and in respect of the number of users have not yet been prescribed, therefore the provisions of SEP, although applicable from A.Y. 2022-23, are not yet operative.

2.1 Whether SEP would apply only in case of digital transactions
It is important to note that under Explanation 2A, the definition of SEP is an exhaustive one and therefore a transaction which does not satisfy the above criteria would not be considered as constituting an SEP.

It is also important to note that the definition of SEP is not restricted to only digital transactions but seeks to cover all transactions which are undertaken with a person in India. This is in line with the proposed provisions of Pillar 1 of the Unified Approach and the discussion of the same in the Inclusive Framework. Pillar 1 of the Unified Approach seeks to bring to tax automated digital businesses as well as consumer-facing businesses. On the other end of the spectrum, the proposed Article 12B in the UN Model Tax Convention seeks to tax only automated digital businesses and does not cover consumer-facing businesses.

Further, at the time of introduction of the SEP provisions in the Finance Act, 2018, the Memorandum explaining the provisions of the Finance Bill (Memorandum) referred to taxation of digitalised businesses and thus the intention seems to be to tax transactions undertaken only through digital means. However, the language of the section does not suggest the taxation only of digital transactions. This is also evident in the CBDT Circular dated 13th July, 2018 (2018) 407 ITR 5 (St.) inviting comments from the general public and stakeholders, specifically comments on revenue threshold for transactions in respect of physical goods.

Further, with regard to clause (a) what needs to be prescribed is the threshold for the amount of payment and not the type of transactions covered. Therefore, even a transaction undertaken through non-digital means would constitute an SEP in India and hence a business connection in India if the aggregate transaction value during the year exceeds the prescribed amount.

An example of a transaction which may possibly be covered subject to the threshold could be the service provided by a commission agent in respect of export sales, wherein no part of the service of such agent is undertaken in India. Various judicial precedents have held that export sales commission is neither attributable to a business connection in India in such a scenario, nor does it constitute ‘fees for technical services’ u/s 9(1)(vii) of the Act. However, now the activities of such an agent, providing services to a person residing in India (the seller), could possibly constitute an SEP in India.

Further, clause (b) above refers to systematic and continuous soliciting of business or engaging in interaction with a prescribed number of users. At the time of the introduction of the SEP provisions by the Finance Act, 2018, this activity was required to be undertaken ‘through digital means’ in order to constitute an SEP. This additional condition of the activity being undertaken ‘through digital means’ was removed by the Finance Act, 2020. Accordingly, any activity which is considered
as soliciting business or engaging with a prescribed number of users could result in the constitution of an SEP in India.

For example, a call centre of a bank outside India which deals with a number of Indian customers could result in the entity owning the call centre to be considered as having an SEP in India if the number of customers solicited exceeds the prescribed threshold.

Accordingly, every type of transaction undertaken with India may be covered as constituting an SEP in India, not in accordance with what is provided in the Memorandum.

2.2 Transaction in respect of any goods, services or property carried out by a non-resident with any person in India
The first condition for constitution of an SEP is a transaction in respect of any goods, services or property carried out by a non-resident with any person in India, the payments for which exceed the prescribed threshold.

The term ‘goods’ has not been defined in the Act. While one may be able to import the definition of the term from the Sale of Goods Act, 1930, it may not be of much relevance as the SEP provisions also apply to transactions in respect of ‘property’. Therefore, all assets, tangible as well as intangible, would be covered under this clause subject to the discussion below regarding SEP covering only transactions whose income is taxed as business profits.

Thus, offshore sale of goods to a person in India may now be covered under the SEP provisions (subject to the fulfilment of the threshold limit). Interestingly, the Supreme Court in the case of Ishikawajima-Harima Heavy Industries Ltd. vs. DIT [2007] 288 ITR 408, held that income from sale of goods by a non-resident concluded outside India would not be considered as income accruing or arising in India. The SEP provisions, specifically covering such transactions, could now override the decision of the Apex Court in cases where the SEP provisions are triggered.

Another question that arises is whether a transaction of sale of shares is covered. Let us take as an example the sale of shares of a US Company by a US resident to a person in India. Such a sale, not being sale of shares of an Indian company, assuming that the US Company does not have an Indian subsidiary to trigger indirect transfer provisions, was not considered as accruing or arising in India and therefore is not taxable in India.

In the present case, one may be able to argue that even if the transaction value exceeds the threshold limit, the SEP provisions would not be triggered if the sale is not a part of the business of the US resident seller. This would be so as the constitution of an SEP results in the constitution of a business connection. Therefore, for SEP to be constituted, the transaction needs to be in respect of business income and not in respect of a capital asset. Section 9(1)(i) clearly differentiates between business connection and an asset situated in India.

In other words, SEP would only apply to transactions, the income from which would constitute business income. Accordingly, income from sale of shares, not being the business income of the US resident seller, would not trigger SEP provisions.
It is important to highlight that what is sought to be covered under the SEP provisions is business income and a transaction of sale of property which is not a part of the business of the non-resident seller may not be covered. However, this does not mean that a single transaction is outside the scope of SEP provisions. Let us take the example of a heavy machinery manufacturer in Germany who sells his machines globally. If the price of a single machine exceeds the threshold value, a single sale by the German manufacturer to a person in India may trigger the SEP provisions as the income from such sale is a part of his business income. While the Supreme Court in the case of CIT vs. R.D. Aggarwal & Co., (1965) (56 ITR 20, 24), held that a stray or isolated transaction is normally not to be regarded as a business connection, this position may no longer hold good for transactions triggering SEP as the SEP provisions require fulfilment of subjective conditions.

But then, what is meant by a ‘person in India’? While most of the sections in the Act refer to a ‘person resident in India’, Explanation 3A refers to a ‘person who resides in India’. Given the intention to tax a non-resident on account of the economic connection with India, there needs to be a semblance of permanent connection of the transaction with India. This permanent connection may not be satisfied in the case of a person who is visiting India for a short visit and is, say, availing the services from the non-resident. Therefore, one may argue that a person in India in Explanation 2A would mean a person resident in India. Further, the term ‘resides’ may connote a continuous form of residence and, therefore, in such a scenario also, one may be able to argue that the term refers to a person resident in India.

2.3 Systematic and continuous soliciting of business activities or engaging in interaction with such number of users in India
The second condition for the constitution of an SEP is systematic and continuous soliciting of business activities or engaging in interaction with a prescribed number of users in India.

There are two types of transactions which would be covered under the condition (subject to the fulfilment of the number of users in India threshold):
a) Systematic and continuous soliciting of business activities; and
b) Engaging in interaction.

There is ambiguity as to what constitutes ‘users’, ‘soliciting’ as well as ‘engaging in interaction’. As highlighted earlier, while the conditions required the above activities to be undertaken through digital means at the time SEP provisions were introduced by the Finance Act, 2018, the Finance Act, 2020 removed the requirement of digital means, thereby possibly expanding the scope of the transactions covered.

We need to wait and see how the threshold limits along with conditions, if any, are prescribed.

Some of the activities which may be covered under this condition would be social media companies, support services which engage with multiple users in India, online advertisement services, etc.

2.4 Profits attributable to SEP
The second proviso to Explanation 2A provides that only so much of income as is attributable to the transactions or activities referred to in clause (a) or clause (b) shall be deemed to accrue or arise in India. Explanation 1(a) to section 9(1)(i), on the other hand, seeks to cover income attributable to operations carried out in India.

Given the peculiar language used in the 2nd proviso to Explanation 2A, this may result in a scenario where the entire income arising out of a transaction or activity would be considered as accruing or arising in India.

Let us take an example to understand the impact and such a possible absurd outcome in detail. A non-resident who manufactures certain goods outside India sells such goods in India under two scenarios – through a sales office in India and directly without any physical presence in India. Assuming that in both scenarios the sale of the goods is concluded outside India, in the first scenario the activities undertaken by the sales office could result in the constitution of business connection under Explanation 2 if the employees in the sales office habitually play a principal role in the conclusion of contracts of the non-resident in India. In such a scenario, Explanation 3 provides that only the income as is attributable to the activities of the sales office would be deemed to accrue or arise in India. Therefore, only a part of the profits of the non-resident, which represents the amount attributable to the activities of the sales office, let us say xx% on the basis of various judicial precedents, would be taxable in India.

However, in the second scenario, assuming that the threshold as prescribed in Explanation 2A is met, the transaction of the sale of goods to a person resident in India could constitute an SEP in India. In such a scenario, the moot question that arises for consideration is whether on a literal reading of the 2nd proviso to Explanation 2A, it can be said that in such a transaction the entire income is attributable to the ‘transaction’ and shall be deemed to accrue or arise in India?

In other words, if a business connection is constituted on account of operations carried out in India, only part of the profits would be taxed in India, whereas if the business connection is constituted on account of the SEP in India, it is open to question as to whether the entire income of the non-resident could be attributed and deemed to accrue or arise in India.

Similarly, the entire income of a social media company outside India engaging with a large number of users in India could be taxed in India if the number of users exceeds the threshold and results in the constitution of an SEP in India.

Such a view, on a literal interpretation of the amended provisions, would not be in consonance with the global discussion on the subject currently in progress at various international fora.

Such a view would also not be in line with the discussion contained in the BEPS Action Plan 1 Report which provides:
‘Consideration must therefore be given to what changes to profit attribution rules would need to be made if the significant economic presence option were adopted, while ensuring parity to the extent possible between enterprises that are subject to tax due to physical presence in the market country (i.e., local subsidiary or traditional PE) and those that are taxable only due to the application of the option.’

Further, the BEPS Action Plan 1 Report analyses three options while attributing profits to the SEP:
a) Replacing functional analysis with an analysis based on game theory that would allocate profits by analogy with a bargaining process within a joint venture. However, the Report appreciates that this method would mean a substantial departure from the existing standard for allocation of profits on the basis of functions, assets and risks and, therefore, unless there is a substantial rewrite of the rules for the attribution of profits, alternative methods would need to be considered;
b) The fractional apportionment method wherein the profits of the whole enterprise relating to the digital presence would be apportioned either on the basis of a predetermined formula or on the basis of variable allocation factors determined on a case-by-case basis. However, this method is not pursued further as it would mean a departure from the existing international standard of attributing profits on the basis of separate books of the PE;
c) The deemed profit method wherein the SEP for each industry has a deemed net income by applying a ratio of the presumed expenses to the taxpayer’s revenue derived in the country. While this option is relatively easier to administer, it has its own set of challenges, such as, if the entity on a global level has incurred a loss, would the deemed profit method still allocate a notional profit to the SEP?

Similarly, the draft Directive, introduced by the European Commission on ‘significant digital presence’, provided for a modified profit-split as the method to attribute the profits to the SEP. The draft Directive, introduced in 2018, was not enacted due to lack of consensus amongst the members of the European Union.

In both the examples above, in the context of profits attributable to the SEP, one may be able to argue that taxing activities undertaken outside India result in extra-territorial taxation by India and, therefore, go beyond the sovereign right of the country to tax such income.

The CBDT has recognised this need to provide clarity for profit attribution to the SEP and has included a chapter on the same in its draft report on Profit Attribution to Permanent Establishments (CBDT Press Release F 500/33/2017-FTD.I dated 18th April, 2019) (draft report).

The draft report provides that in the case of an SEP, in addition to the traditional equal weightage given to assets, employees and sales, one can consider giving weightage to users as well in the case of digitised businesses depending on the level of user intensity. The draft report proposes the weight of 10% to users in business models involving low / medium user intensity and 20% in business models involving high user intensity.

It is important to note that the report, when finalised and notified, would be forming a part of the Rules and in the absence of any reference to attribution of profits to the SEP in Explanation 2A, one may need to further analyse the application on finalisation of the rules.

2.5 Summary of SEP provisions
The SEP provisions have been summarised below:

3. EXPLANATION 3A TO SECTION 9(1)(i) (EXTENDED SOURCE RULE)
Following global discussions, the Finance Act, 2020 extended the source rule for income attributable to operations carried out in India by inserting Explanation 3A to section 9(1)(i), which reads as under:
‘Explanation 3A. – For the removal of doubts, it is hereby declared that the income attributable to the operations carried out in India, as referred to in Explanation 1, shall include income from –
(i)    such advertisement which targets a customer who resides in India or a customer who accesses the advertisement through an internet protocol address located in India;
(ii)    sale of data collected from a person who resides in India or from a person who uses an internet protocol address located in India; and
(iii)    sale of goods or services using data collected from a person who resides in India or from a person who uses an internet protocol address located in India.’

The following proviso has been inserted in Explanation 3A to clause (i) of sub-section (1) of section 9 by the Finance Act, 2020 w.e.f. 1st April, 2022:
‘Provided that the provisions contained in this Explanation shall also apply to the income attributable to the transactions or activities referred to in Explanation 2A.’

3.1 Whether Explanation 3A creates nexus?
Unlike Explanation 2A, which equates SEP to a business connection, the language used in Explanation 3A is different.

Explanation 3A to section 9(1)(i) provides,
‘For the removal of doubts, it is hereby declared that the income attributable to the operations carried out in India, as referred to in Explanation 1, shall include….’

Explanation 1 provides that in the case of a business of which all the operations are not carried out in India, only part of the income as is reasonably attributable to the operations carried out in India shall be deemed to accrue or arise in India.

Further, the nexus for income deemed to accrue or arise in India in the form of business connection in India or property in India or source of income in India, etc., is provided in the main section 9(1)(i).

Now, the question arises whether Explanation 1 can be applied without a nexus in section 9(1)(i)? One may argue that having established a nexus in the form of business connection, asset or source of income in India, Explanation 1 merely provides the amount of income attributable to the said nexus and, therefore, in the absence of a nexus u/s 9(1)(i), Explanation 1 cannot be applied.

In this regard, the role of ‘Explanation’ in a tax statute has been explained by the Karnataka High Court in the case of N. Govindraju vs. ITO (2015) (377 ITR 243) in the context of Explanation vs. proviso, wherein it was held,
‘37. Insertion of “Explanation” in a section of an Act is for a different purpose than insertion of a “proviso”. “Explanation” gives a reason or justification and explains the contents of the main section, whereas “proviso” puts a condition on the contents of the main section or qualifies the same. “Proviso” is generally intended to restrain the enacting clause, whereas “Explanation” explains or clarifies the main section. Meaning, thereby, “proviso”’ limits the scope of the enactment as it puts a condition, whereas “Explanation” clarifies the enactment as it explains and is useful for settling a matter or controversy.
38. Orthodox function of an “Explanation” is to explain the meaning and effect of the main provision. It is different in nature from a “proviso” as the latter excepts, excludes or restricts, while the former explains or clarifies and does not restrict the operation of the main provision. It is true that an “Explanation” may not enlarge the scope of the section but it also does not restrict the operation of the main provision. Its purpose is to clear the cobwebs which may make the meaning of the main provision blurred. Ordinarily, the purpose of insertion of an “Explanation” to a section is not to limit the scope of the main provision but to explain or clarify and to clear the doubt or ambiguity in it.’

The above decision lends weight to the argument that in the absence of a nexus in section 9(1)(i), Explanation 1 cannot apply. Having taken such a view, one may therefore possibly conclude that as Explanation 1 does not create a nexus and as Explanation 3A merely extends the scope of Explanation 1 in terms of income as is attributable to the operations carried out in India, Explanation 3A shall not apply unless the non-resident has a business connection. In other words, Explanation 3A merely acts like a ‘force of attraction’ provision in the Act and does not create a nexus by itself.

It may be highlighted that the above view that in the absence of a nexus u/s 9(1)(i), Explanation 1 shall not apply, is not free from doubt. Another possible view is that Explanation 1 refers to the income which is deemed to accrue or arise in India and therefore creates a nexus by itself irrespective of the fact as to whether or not there exists a business connection. One will have to wait for the judicial interpretation in this regard to see whether the judiciary reads down the extended source rule in Explanation 3A.

3.2  What is sought to be taxed through Explanation 3A
Explanation 3A seeks to extend the scope of income attributable to operations carried out in India in the case of three scenarios:
a) Sale of advertisement;
b) Sale of data; and
c) Sale of goods or services using data.

In respect of (a) and (b) above, the same is also covered by the extended EL provisions as applicable to e-commerce supply or services. Further, section 10(50) of the Act, as proposed to be amended by the Finance Bill, 2021, provides that income other than royalty or fees for technical services shall be exempt under the Act if the said transaction is subject to EL. Therefore, in respect of transactions covered under (a) or (b), the provisions of EL would apply and Explanation 3A may not be applicable.

Therefore, only the provisions of (c) have been analysed.

While Explanation 2A seeks to cover a transaction of a non-resident with a person residing in India, Explanation 3A does not require such conditions. In other words, even transactions between two non-residents may be subject to tax under Explanation 3A if the transaction:
a)    In the case of sale of advertisement, targets a customer residing in India;
b)    In the case of sale of data, is in respect of data collected from a person residing in India; or
c) In the case of sale of goods or services, is using data collected from a person residing in India.

For example, ABC, a foreign company owning a social media platform having various users all over the world, including India, is engaged by FCo, a foreign company engaged in the business of apparels, to provide data analytics services to enable FCo to understand the consumption pattern in Asia in order to enable it to target customers in Europe. It is assumed that the data analytics service is undertaken outside India.

In this scenario, as ABC is providing a service to FCo, both non-residents, using data collected from persons residing in India in addition to other countries, Explanation 3A may apply and, therefore, deem the income from sale of services to be accruing or arising in India. While, arguably, only the portion of the income which relates to the data collected from India should be taxed in India, it may be practically difficult, if not impossible, in such a scenario to bifurcate such income on the basis of data collected from every country.

Moreover, as this would be a transaction between two non-residents, the question of extra-territoriality as well as the practical difficulty of implementing the taxation of such transactions may need to be evaluated in detail.

The issues relating to the attribution of income – whether the entire income is deemed to accrue or arise in India or is only a part of the income (and if so, how is the same to be computed) is to be taxed, as explained above in the context of SEP would equally apply here as well. In fact, as the CBDT draft report on profit attribution to PE was released before the Finance Act, 2020, there is no guidance available to provide clarity in this matter.

4. CONCLUSION


Currently, the provisions of SEP are not yet operative as the thresholds have not yet been prescribed. Further, the SEP provisions as well as those related to extended scope have limited application due to the benefit available in the DTAAs. However, with treaty eligibility being questioned in various transactions in the recent past and with the application of the MLI, these provisions may be of greater significance. Therefore, it is imperative that some of the aforementioned ambiguities, such as the amount of income attributable to the SEP and extended scope, be clarified at the earliest by the authorities.

EQUALISATION LEVY ON E-COMMERCE SUPPLY AND SERVICES, Part – 1

The taxation of digitalised economy is a hotly debated topic in the international tax arena at present, with the OECD and its Inclusive Framework trying to come to a consensus-based solution and with the United Nations recently introducing a new article 12B on taxation of Automated Digital Services in the UN Model Tax Convention. In our earlier article (BCAJ, March, 2021, Page 24), we had covered the provisions relating to Significant Economic Presence (‘SEP’) and the extended source rule, introduced by India in order to tax the digitalised economy. While the provisions relating to SEP have now been operationalised vide Notification No. 41/2021 issued on 3rd May, 2021, the Equalisation Levy (‘EL’) was the first provision introduced by India to tackle the issues in the taxation of the digitalised economy. After their introduction in the Finance Act, 2016 to cover online advertisement services (‘EL OAS’), the EL provisions have been extended vide the Finance Act, 2020 to bring more transactions within their scope. Similarly, while the application of the SEP provisions would be limited, in case of non-applicability of the DTAA or absence of a DTAA, the EL provisions may be applied widely. In this two-part article, we seek to analyse some of the intricacies and issues in respect of the Equalisation Levy as applicable to E-commerce Supply or Services (‘EL ESS’).

1. BACKGROUND
The rapid advancement of technology has transformed the digital economy and it now permeates all aspects of the economy; therefore, it is now impossible to ring-fence the digital economy. Today, technology plays an extremely significant role in the way business is conducted globally. This is clearly evident in the on-going pandemic wherein one is able to work within the confines of one’s home without visiting the office in most of the sectors thanks to the use of technology and the various tools available today. However, this technological advancement has also resulted in enabling an entity to undertake business in a country without requiring it to be physically present in the said country. For example, advertising which was done through physical hoardings or boards, can now be done on social media targeting the residents of a particular country without physically requiring any space in that country. Similarly, traditional theatres are being replaced by various Over-the-Top (‘OTT’) platforms which enable a viewer to watch a movie on her device without having to physically visit a theatre.

Another example is the replacement of the physical marketplace by e-commerce sites wherein sellers can sell their goods or services to buyers without having to go to the physical marketplace. Countries realised that the tax rules, which are more than a century old, do not envisage undertaking a business in a country without having physical presence and therefore do not provide for taxing rights to the source or market jurisdictions. ‘Addressing the Tax Challenges of the Digital Economy’ was identified as the 1st Action Plan out of the 15 Action Plans of the OECD Base Erosion and Profit Shifting (‘BEPS’) Project. This signifies the importance given to the issue by the OECD and other countries participating in this Project.

Interestingly, the workflow on digital economy was not included in the BEPS Project as endorsed by the G20 at the Los Cabos meeting on 19th June, 20121. However, it was considered as Action Plan 1 when it released the Action Plans in July, 2013 even though it did not fit under any of the structural headings of the OECD’s Plan of Action of ‘establishing international coherence of income taxation’, ‘restoring the full effects of the international standards’, ‘ensuring tax transparency’ of ‘developing a tool for swift implementation of the new measures’2. In other words, while the other Action Plans specifically dealt with countering BEPS measures, Action 1 seeks to re-align the tax rules irrespective of the fact that such rules give rise to any BEPS concerns.

BEPS Action Plan 1 did not result in a consensus and therefore it was agreed that more work would be done on this subject. However, the Action Plan shortlisted three alternatives for countries to implement as an interim measure. India was one of the first countries to enact a unilateral measure when it introduced the EL OAS in the Finance Act, 2016. Subsequently, several countries introduced similar measures in their domestic tax laws. India introduced the EL ESS in the Finance Act, 2020 to bring to tax e-commerce transactions. Interestingly, while the EL OAS was introduced at the time of introduction of the Finance Bill, 2016 during the annual Union Budget, the EL ESS provisions were not a part of the Finance Bill, 2020 and were introduced only at the time of its enactment. The absence of a Memorandum explaining the provisions of the EL ESS has resulted in a lot of confusion regarding the intention of certain provisions which is an important aspect one needs to consider while interpreting the law. While the Finance Act, 2021 did clarify a few issues, some of the issues are still unresolved. Moreover, the clarification in the Finance Act, 2021, which was made retrospective from 1st April, 2020, has also resulted in some issues. In the first part of this two-part article, the provisions of the EL ESS are analysed. However, before analysing the EL ESS provisions, given the interplay and overlap with the EL OAS, the ensuing paragraph briefly covers the EL OAS provisions.

___________________________________________________________________
1 B. Michel, ‘The French Crusade to Tax the Online Advertisement Business:
Reflections on the French Google Case and the Newly Introduced Digital
Services Tax,’ 59 Eur. Taxn. 11 (2019), Journal Articles & Papers IBFD
(accessed 28th January 2020)
2 Ibid
2. EQUALISATION LEVY ON ONLINE ADVERTISEMENT SERVICES

Recognising the need of the hour and the significance of the issues relating to the taxation of the digital economy, the Finance Ministry constituted the Committee on Taxation of E-commerce. It consisted of members of the Department of Revenue, representatives of some professional bodies, representatives from industry and other professionals, expert in the field. The Committee examined the Action 1 Report as well as the literature from several well-known authors on the subject and released its proposal in February, 2016.

The Finance Act, 2016 introduced the provisions of EL OAS. Unlike the SEP provisions and the extended source rule, the EL OAS (as well as EL ESS) is not a part of the Income-tax Act, 1961 (‘ITA’). EL OAS applies on specified services rendered by non-residents to a person resident in India or to a non-resident having a Permanent Establishment (‘PE’) in India. Specified service for the purpose of EL OAS has been defined in section 164(i) of the Finance Act, 2016 as follows:
‘“specified service” means online advertisement, any provision for digital advertising space or any other facility or service for the purpose of online advertisement and includes any other service as may be notified by the Central Government in this behalf.’

Under the EL OAS provisions, a person resident in India or a non-resident having a PE in India shall deduct EL at the rate of 6% on payment for specified service to a non-resident if it satisfies the following conditions:
a. The service rendered is not effectively connected to a PE of the non-resident service provider;
b. The payment for the specified service exceeds INR 100,000 during the previous year; and
c. The payment is in respect of the specified services utilised in respect of a business or profession carried out by the payer.

Therefore, the EL OAS applies only in respect of Online Advertisement Services or any facility or service for the purpose of online advertisement. Further, EL OAS provisions place the onus of responsibility of collection of the levy on the payer being a resident or on the payer being a non-resident having a PE in India.

While there are various issues and intricacies in relation to the EL OAS, we have not covered the same as the objective of this article is to cover the EL ESS provisions and the issues arising therefrom. However, some of the common issues, such as whether EL provisions are restricted by a tax treaty, have been covered in the second part of this two-part article.

3. EQUALISATION LEVY ON E-COMMERCE SUPPLY OR SERVICES

3.1 Scope and coverage
The Finance Act, 2020 extended the scope of EL to cover consideration received by non-residents on E-commerce Supply or Services (‘ESS’) made or facilitated on or after 1st April, 2020.

EL ESS applies at the rate of 2% on the consideration received by a non-resident on ESS, which has been defined in section 164(cb) of the Finance Act, 2016 to mean:
(i) Online sale of goods owned by the e-commerce operator; or
(ii) Online provision of services provided by the e-commerce operator; or
(iii) Online sale of goods or provision of services, or both, facilitated by the e-commerce operator; or
(iv) Any combination of activities listed in clauses (i), (ii) or (iii).

Further, the Finance Act, 2021 has also extended the definition of ESS for this clause to include any one or more of the following online activities, namely,
(a) Acceptance of offer for sale; or
(b) Placing of purchase order; or
(c) Acceptance of the purchase order; or
(d) Payment of consideration; or
(e) Supply of goods or provision of services, partly or wholly.

Moreover, EL ESS applies for consideration received or receivable by a non-resident in respect of ESS made or provided or facilitated by it to the following persons as provided in section 165A(1) of the Finance Act, 2016 as amended by the Finance Act, 2020:
(i) A person resident in India; or
(ii) a person who buys such goods or services, or both, using an internet protocol (IP) address located in India; or
(iii) a non-resident under the following specified circumstances:
a. sale of advertisement which targets a customer who is resident in India, or a customer who accesses the advertisement through an IP address located in India;
b. sale of data collected from a person who is resident in India, or from a person who uses an IP address located in India.

Further, the provisions of EL ESS shall not apply in the following circumstances:
(i) Where the non-resident e-commerce operator has a PE in India and the ESS is effectively connected to the PE;
(ii) Where the provisions of EL OAS apply; or
(iii) Whether the sales, turnover, or gross receipts of the e-commerce operator from the ESS made or provided or facilitated is less than INR 2 crores during the previous year.

Lastly, section 10(50) of the ITA provides an exemption from tax on the income which has been subject to EL OAS and EL ESS.

3.2 Non-resident
EL ESS applies in respect of consideration received or receivable by a non-resident from ESS made or provided or facilitated. The term ‘non-resident’ has not been defined in the Finance Act, 2016.

However, section 164(j) of the Finance Act, 2016 provides that words and expressions not defined in it but defined in the ITA shall have the meanings assigned to them in the Finance Act, 2016 as well. In other words, in respect of undefined words and expressions, the meaning as ascribed in the ITA would apply here as well.

Accordingly, one would import the meaning of the term ‘non-resident’ from section 2(30) read with section 6 of the ITA.

3.3 Online sale of goods
The EL ESS provisions apply in respect of ESS which has been defined in section 164(cb) of the Finance Act, 2016 as provided in paragraph 3.1 above. Accordingly, EL ESS applies in respect of consideration on online sale of goods made or facilitated by a non-resident. The term ‘online sale of goods’ has not been defined in the Finance Act, 2016 and therefore some of the issues in respect of various aspects of the term have been provided in the paragraphs below.

3.3.1 What is meant by ‘online’
The first condition in respect of the term ‘online sale of goods’ is that the goods have to be sold ‘online’. The term ‘online’ has been defined in section 164(f) of the Finance Act, 2016 to mean the following,
‘…a facility or service or right or benefit or access that is obtained through the internet or any other form of digital or telecommunication network.’

Therefore, the term is wide enough to cover most types of transactions undertaken through means other than physically. Thus, goods sold through a website, email, mobile app or even through the telephone would be considered as sales undertaken ‘online’.

3.3.2 What is meant by ‘goods’
The term ‘goods’ has not been defined in the Finance Act, 2016 or in the ITA. Therefore, the question arises as to whether one can import the term from the Sale of Goods Act, 1930 (‘SOGA’).

Section 2(7) of the SOGA provides that
‘“goods” means every kind of movable property other than the actionable claims and money; and includes stock and shares, growing crops, grass, and things attached to or forming part of the land which are agreed to be severed before the sale or under the contract of sale;’

On the other hand, section 2(52) of the Goods and Services Tax Act, 2017 (‘GST Act’) refers to a different definition of the term as follows,
‘“Goods” means every kind of movable property other than money and securities but includes actionable claims, growing crops, grass and things attached to or forming part of the land which are agreed to be severed before supply or under a contract of supply.’

The issue in this regard is whether one should consider the definition of the term under the SOGA or the GST Act, with the major difference in the definition under both the laws being that SOGA includes shares and stock as ‘goods’, whereas the GST Act does not do so. This issue is relevant while evaluating the applicability of the EL ESS provisions to the sale of shares and stock. While an off-market sale of shares may not trigger the EL provisions as there may be no consideration paid or payable to an e-commerce operator, one may need to evaluate whether the provisions could apply to a transaction undertaken on an overseas stock exchange (assuming that the overseas stock exchange is considered as an e-commerce operator).

In the view of the authors, it may be advisable to consider the definition under SOGA as this is the principal law dealing with the sale of goods, whereas the GST Act is a law to tax certain transactions. In other words, the transaction of sale of shares and stock on a stock exchange may be considered as an online sale of goods and may be subject to the provisions of EL provided that the stock exchange satisfies the definition of ‘e-commerce operator’ and other conditions are also satisfied. An analysis of whether an overseas stock exchange would be considered as an ‘e-commerce operator’ has been undertaken in paragraph 3.5.3 below.

However, in respect of an aggregator for booking hotel rooms or a hotel situated outside India providing online facility for booking hotel rooms, it would not be considered as undertaking or facilitating sale of goods as rooms would not be considered as ‘goods’. The issue of whether the said facility would constitute a covered provision of services for the application of the EL provisions in respect of booking of hotel rooms is discussed in subsequent paragraphs.

3.3.3 What is meant by ‘online sale of goods’?
Having analysed the meaning of the terms ‘online’ and ‘goods’, the crucial aspect that one may need to consider is whether the ‘sale’ of the goods has been undertaken online as the EL ESS provisions refer to consideration received or receivable for online ‘sale’ of goods made or facilitated by the non-resident e-commerce operator. This term has been generating a lot of confusion and uncertainty as one needs to understand as to whether the goods have been sold online. In other words, the issue that needs to be addressed is whether the EL provisions could apply in a situation where the goods are sold online but the delivery of the goods is undertaken offline.

In this regard, section 19 of the SOGA provides,
‘(1) Where there is a contract for the sale of specific or ascertained goods, the property in them is transferred to the buyer at such time as the parties to the contract intend it to be transferred.’

Therefore, SOGA provides that the title in the goods is transferred when the parties to the contract intend it to be transferred. Moreover, the terms and conditions of various e-commerce sites provide that the risk of loss and title passes to the buyer upon delivery to the carrier.

Hence, one could possibly argue that in such situations there is no online sale of goods made or facilitated by the e-commerce operators which merely facilitate the placement of the order for the said goods, and therefore the provisions of EL do not apply.

One could also take a similar view in the case of certain sites which offer e-bidding services for the goods.

However, this issue has been covered in the Finance Act, 2021 with retrospective effect from 1st April, 2020 wherein it has been provided that for the purpose of the definition of ESS, ‘online sale of goods’ shall include any one or more of the following online activities (‘extended activities’):
a. Acceptance of offer for sale; or
b. Placing of purchase order; or
c. Acceptance of the purchase order; or
d. Payment of consideration; or
e. Supply of goods or provision of services, partly or wholly.

Therefore, now, if any of the above activities are undertaken online, the transaction may be considered as ESS and may be subject to the provisions of EL (refer to the discussion in paragraph 3.5 as to whether the definition of e-commerce operator is satisfied in case the non-resident only undertakes the above activities online).

3.4 Online provision of services
The provisions of EL ESS apply in case of online sale of goods or online provision of services. Having analysed some of the nuances regarding the online sale of goods, let us now consider some of the nuances of online provision of services. Generally, the applicability of EL ESS to online provision of services may pose complexities which are significantly higher than those related to online sale of goods.

Some of the issues have been explained by way of an example in two scenarios.

(Scenario 1) Let us first take the example of a person resident in India booking a room in a hotel outside India (the ‘Hotel’), owned and managed by a non-resident, through its website. Let us assume that payment for the booking of the room is made immediately on booking itself. Now, the question arises whether the said transaction would be considered as an online provision of services by the Hotel and whether the provisions of EL would apply on the same.

The first question is whether there is any sale of goods or provision of services. Arguably, the renting out of rooms may be considered as a service rendered by the Hotel. Now, the question is whether any service is rendered online.

In this case, one may be able to argue, and rightfully so, that the service rendered by the Hotel of rental of rooms is not provided online but is rendered offline and, therefore, this is not a case of online provision of services. However, it is important to note that the Hotel is also providing a facility for booking the rooms online, which in itself is a service, independent of the rental of the rooms. This booking service is rendered online and, therefore, may be considered as an online provision of service by the Hotel to the person resident in India.

On the other hand, one may be able to argue that no consideration is received by the Hotel for providing the online facility and that the entire consideration received is that for the letting out of the rooms (this may be the case, for example, if the rate for the rooms is the same irrespective of whether booked online or directly at the hotel). In such a case, one may be able to argue that in the absence of consideration received or receivable, the provisions of EL cannot apply. Further, even if one were to counter-argue that the consideration received towards the rental of the room includes consideration towards providing the service of provision of online booking and the same can be allocated on some scientific basis, the dominant nature of the activities for the composite service is that of letting out of the hotel room, which is not provided online. Accordingly, in the view of the authors, the provisions of EL shall not apply in such a scenario.

(Scenario 2) Let us now take the same example wherein a person resident is booking a room in a hotel, situated outside India, but the same is booked through a room aggregator called ABC. Let us further assume that the entire consideration for the room is paid by the customer to ABC at the time of booking and then ABC, after deducting its commission or fees, pays the balance amount to the hotel.

Now, the first question to be evaluated here is whether the service rendered by ABC falls under sub-clause (ii) or (iii) of section 164(cb) of the Finance Act, 2016. Sub-clause (ii) of section 164(cb) refers to online provision of services by the e-commerce operator, whereas sub-clause (iii) of section 164(cb) refers to facilitation for online provision of services.

One may take a view that given that there is a specific clause relating to facilitation, which is what is provided by the aggregator ABC, one should apply sub-clause (iii). However, the said sub-clause applies only in respect of facilitation of online provision of services and the services which are being facilitated are in respect of letting out of the rooms of the hotel which are not rendered online. Therefore, the provisions of sub-clause (iii) may not apply.

Alternatively, one could argue that the service rendered by ABC is through an online facility and therefore it would fall under sub-clause (ii) relating to online provision of services. In such a case, the question arises whether the service is rendered to the customer booking the room or to the hotel. In case the service is considered as rendered to the hotel, the provisions of EL may not apply as it may be considered as a case of services rendered to a non-resident. However, in the view of the authors, the service rendered by ABC, of facilitating the letting out of the rooms of the hotel, is a service rendered by ABC to both, to the hotel and the customer who is booking the rooms. This would be the case even though the commission / fees for the services rendered by ABC is paid for by the hotel and the customer is not aware of the commission payable to ABC for facilitation out of the total amount paid by her.

3.5 E-commerce operator
Having analysed some of the issues relating to online sale of goods or online provision of services, this paragraph covers some issues in respect of the e-commerce operator.

3.5.1 Who is considered as an e-commerce operator?
An e-commerce operator is defined in section 164(ca) of the Finance Act, 2016 to mean the following:
‘“E-commerce operator” means a non-resident who owns, operates or manages digital or electronic facility or platform for online sale of goods or online provision of services, or both;’

Therefore, in order for a non-resident to be considered as an e-commerce operator, the following cumulative conditions are required to be satisfied:
a. There should be a digital or electronic facility or platform; and
b. The said facility or platform should be for online sale of goods or online provision of services, or both; and
c. The non-resident should own, operate or manage the said facility or platform.

3.5.2 Will sale of goods or providing services via e-mail be subject to the provisions of EL?
The biggest concern most non-residents were facing at the time of the introduction of the EL ESS provisions was whether the sale of goods concluded over exchange of emails could be subject to the provisions of EL ESS.

If such a transaction were to be covered under the provisions of EL ESS, there could be major repercussions for a lot of MNCs as a lot of intra-group transactions are undertaken over email. The confusion increased significantly after the amendments undertaken in the Finance Act, 2021 wherein the definition of ‘online sale of goods’ or ‘online provision of services’ has been extended to include acceptance of offer, placing of purchase order, acceptance of purchase order, payment of consideration, etc.

In this case, while ‘email’ may be considered as an online facility, the seller of the goods is not operating, owning or managing the email facility which is managed by the IT company (such as Microsoft or Google). Further, even if one considers that the seller is operating the facility, it is a facility for communication and it is not a facility for online sale of goods or for online provision of services. Moreover, it is important to highlight that there is a difference in the operation of the facility or platform and the operation of an account on the platform. Therefore, if one is operating an email account, it may not be appropriate to contend that one is operating the entire facility.

Accordingly, in the view of the authors, the transactions undertaken through email may not be subject to EL ESS as the seller of goods over exchange of emails may not come within the definition of ‘e-commerce operator’.

This would also be the case for services rendered through email, say an opinion given by a foreign lawyer to a client on email. In such a scenario, the lawyer cannot be considered as an ‘e-commerce operator’.

The absurdity of considering transactions undertaken through email as subject to EL is magnified in the case of transactions undertaken through a telephone. As telecommunication is considered as an online facility u/s 164(f) of the Finance Act, 2016, would one consider goods ordered through a telephone as being subject to the provisions of EL?

In this regard, it may be highlighted that even if one takes a view as explained in paragraph 3.5.4 below that the extended activities list should also apply to the definition of ‘e-commerce operator’, the argument that email is a facility or platform for communication and not for online sale of goods or provision of services, including the extended activities, should hold good.

Similarly, in the case of teaching services rendered online by universities, or conferences organised by various organisations online, the question arises whether the said services rendered by the universities or the organisations could be subject to the provisions of EL ESS. If the platform through which the services are rendered is owned, operated or managed by the university or organisation, such entities may be considered as e-commerce operators, and therefore the fees received by them may be subject to the provisions of EL ESS. However, if these entities are merely using the platform or facility owned and managed by a third party and only operate as users of the platform, then such entities cannot be considered as owning, managing or operating the facility or platform but merely operating or managing an account on the platform. In such cases, they may not be considered as e-commerce operators and the consideration received by them shall not be subject to the provisions of EL.

3.5.3 Will sale of shares on a stock exchange be subject to the provisions of EL?
As evaluated in paragraph 3.3.2 above, ‘shares’ may be considered as ‘goods’. Further, the platform through which the sale is undertaken in most overseas stock exchanges could be considered as an online facility as it would be undertaken through the internet, digital or telecommunication network. Now the question arises whether the platform is for the purpose of online sale of goods, the answer to which would be in the affirmative.

Therefore, if the platform or facility is owned, operated or managed by the overseas stock exchange, the non-resident owning the overseas stock exchange may be considered as an ‘e-commerce operator’ and the transaction may be subject to the provisions of EL.

3.5.4 Can a transaction be subject to EL only because the payment of consideration is undertaken online?
In this regard an interesting point to note is that while the terms ‘online sale of goods’ and ‘online provision of services’ have been extended to include certain online activities as provided in the Explanation to section 164(cb) (extended activities), the terms are provided in two clauses in section 164, namely:
a) Clause (ca) of section 164 defining the term ‘e-commerce operator’ wherein the facility or platform is for online sale of goods or online provision of services, or both.
b) Clause (cb) of section 164 defining the term ESS which means online sale of goods or online provision of services made or facilitated by the e-commerce operator.

The Finance Act, 2021 extended the terms ‘online sale of goods’ and ‘online provision of services’ only in respect of clause (cb), dealing with definition of e-commerce supply or services and not in clause (ca). The Explanation to clause (cb) provides as follows,
‘For the purposes of this clause “online sale of goods”…..’

Further, the definition of the term ‘e-commerce operator’ in clause (ca) does not include the term ‘e-commerce supply or services’ which is defined in clause (cb). Therefore, on a literal reading of the language, one may be able to argue that for a non-resident to be considered as an e-commerce operator, the sale of goods or the provision of services needs to be undertaken online. Moreover, the provisions of EL ESS may not apply in a scenario where only the extended activities are undertaken online without the actual sale of goods or provision of services undertaken online as the extended definition of the term ‘online sale of goods’ or ‘online provision of services’ applies only for the definition of ESS and not for an e-commerce operator.

While this is a literal reading of the provision, the above view may be extremely litigious and may not be accepted by the courts as it may result in the above amendment in the Finance Act, 2021 being made infructuous and would be against the intention of the Legislature.

However, if one takes a view that the extended activities would apply even to the definition of ‘e-commerce operator’ and therefore can result in the application of the EL ESS provisions, it may result in a scenario where EL ESS provisions could possibly apply even when none of the activities of the provision of services or sale of goods is undertaken online but only the payment is done online.

Let us take the earlier example of a foreign lawyer rendering advisory services over email to an Indian client, who would make the payment online through an app operated by a non-resident. In this regard, as discussed in paragraph 3.5.2, as the lawyer would not be considered as an ‘e-commerce operator’, the transaction may be subject to EL ESS as one of the extended activities, i.e., payment of consideration is undertaken online and the e-commerce operator is providing an online service of facilitating the payment. However, in this case the e-commerce operator would be the non-resident operating the app through which the payment is made and not the lawyer.

3.5.5 Can there be multiple e-commerce operators for the same transaction?
If one takes a view that the extended activities shall apply to the definition of ‘e-commerce operator’ as well, the question arises whether there can be multiple e-commerce operators for the same transaction?

One can evaluate this with an example. Let us consider a scenario where the goods of ABC, a non-resident, are sold through its website and the payment for the goods is done by the resident customer through a payment gateway, owned by XYZ, another non-resident. In this case, both ABC and XYZ would be considered as e-commerce operators. Further, the same amount may be subject to EL in the hands of multiple e-commerce operators. Continuing the above example, the consideration paid by the resident customer to ABC through the payment gateway would be subject to EL ESS. Further, if one considers that the payment gateway of XYZ has rendered services to both, the resident customer as well as ABC, the consideration received by XYZ from ABC would also be subject to EL ESS as it is consideration received by an e-commerce operator for services rendered to a resident.

3.6 Amount on which EL to be levied
EL ESS applies on consideration received or receivable by an e-commerce operator from ESS. The ensuing paragraphs deal with some of the issues in respect of consideration.

3.6.1 Whether EL to be applied on the entire amount
One of the key issues that require to be addressed is what would be the amount which would be subject to EL. The issue is explained by way of an illustration.

Let us take an example wherein goods are sold online by the e-commerce operator. Further, while the sale of the goods is concluded online, the e-commerce operator does not own the goods but merely facilitates the online sale of the goods. Let us assume that the price of the goods is 100 and the commission of the e-commerce operator is 15. In this scenario, the e-commerce operator may receive 100 from the Indian buyer of the goods and transfer 85 to the seller of the goods after retaining its fees or commission. The question which arises is, as EL is applicable on the consideration received, would the EL apply on the 100 received by the e-commerce operator, or would it apply on the 15 which is the income earned by the e-commerce operator?

Earlier, one could take a view that the EL ESS provisions seek to tax the e-commerce operator and the consideration is compensation paid to the e-commerce operator for his services and, therefore, the EL ESS provisions should apply on the 15 and not the entire 100. Another argument for this view was that the 85 received by the e-commerce operator does not belong to it and by the principles of diversion of income by overriding title, one can argue that the amount of 85 is not consideration which is subject to EL ESS.

However, the Finance Act, 2021 has provided, with retrospective effect from 1st April, 2020, that the consideration which is subject to EL ESS would include the consideration for sale of goods irrespective of whether or not the goods are owned by the e-commerce operator. Therefore, in the above example, now the entire 100 would be subject to EL ESS.

This may result in a scenario wherein offshore sale of goods, not sold through an e-commerce operator or facility, would not be subject to tax in India on account of the decision of the Supreme Court in the case of Ishikawajima-Harima Heavy Industries Ltd. (2007) 288 ITR 408, goods sold through an e-commerce operator would now be subject to EL on the entire amount.

Further, this may result in various practical challenges as the margin of the e-commerce operator may not be sufficient to bear the levy on the entire consideration received.

3.6.2 Consideration received in respect of sale of goods by a resident
When the EL ESS provisions were introduced for F.Y. 2020-21, the provisions of section 10(50) of the ITA provided an exemption to any income arising from ESS which has been subject to EL ESS.

The provisions did not specify to whom the exemption belonged. Therefore, one could possibly take a view that if a resident is selling goods through a non-resident e-commerce operator and the entire consideration for the sale of goods is subject to EL ESS, the exemption u/s 10(50) would exempt the income of the resident seller as well. This is due to the fact that while the consideration is changing hands twice – once from the customer to the e-commerce operator and then from the e-commerce operator to the resident seller – there is only one transaction, sale of goods by the resident seller to a resident buyer through the e-commerce operator.

On the other hand, there was concern that if the resident seller is taxed on the income and the exemption u/s 10(50) does not apply, it could result in double taxation for the same transaction.

The Finance Act, 2021 has amended the provisions of the Finance Act, 2016 with retrospective effect from 1st April, 2020 to provide that the consideration which is subject to EL ESS shall not include the consideration towards the sale of goods or the provision of services if the seller or service provider is a resident or is a non-resident having a PE in India and the sale or provision of services is effectively connected to the PE.

Therefore, in such a situation now, only the consideration as is attributable to the e-commerce operator would be subject to EL ESS.

3.6.3 Levy on consideration received by e-commerce operator
It is important to highlight that for the EL ESS provisions to apply, consideration needs to be received or receivable by the e-commerce operator. While the amendment in the Finance Act, 2021 extends the coverage of the term ‘consideration’ to include the consideration for the sale of goods as well (100 from the example in paragraph 3.6.1), the extended scope would apply only if the entire consideration is received by the e-commerce operator. Therefore, even after the amendment, if the entire consideration (100 in the example used in paragraph 3.6.1) is paid by the buyer directly to the non-resident seller, who pays the fees or commission to the e-commerce operator, EL ESS shall apply only on the amount of commission or fees received by the e-commerce operator (15). This is due to the fact that EL ESS applies on consideration received or receivable by the e-commerce operator, and if the e-commerce operator does not receive the entire consideration for the sale of goods or provision of services but only receives a sum as facilitation fees or commission, EL ESS shall apply only on the portion received by the e-commerce operator.

4. CONCLUSION
Due to the absence of the Memorandum at the time of introduction of the EL ESS provisions, a lot of ambiguity and confusion exists in respect of various aspects. While the Finance Act, 2021 has made certain amendments with retrospective effect in order to clarify certain issues, the ambiguity in various other aspects continues to exist. In the next part of this two-part article, we shall seek to cover various other issues in respect of the EL ESS such as issues relating to residence and the situs of the consumer, issues relating to the turnover threshold, issues relating to the sale of advertisement and the sale of data, interplay of the EL ESS provisions with various other provisions such as the SEP provisions, EL OAS provisions, royalty / FTS and section 194-O of the ITA.

SAFE HARBOUR RULES – AN OVERVIEW (Part 1)

Over the years, Safe Harbour Rules in the context of Transfer Pricing have assumed significance. In this two-part article, we deal with Safe Harbour Rules under Transfer Pricing Regulations In Part 1 of this article, we focus on giving an overview of the Safe Harbour Rules, including background, objective and various other important aspects relating to them

1. BACKGROUND
Determination of Arm’s Length Price [ALP] is often time-consuming, burdensome and costly if an Associated Enterprise [AE] provides a range of intra-group services. It may impose a heavy administrative burden on taxpayers and tax administrations that can be intensified by both complex rules and resulting compliance requirements in respect of Transfer Pricing [TP]. Further, in recent times we have seen a substantial increase in litigation on transfer pricing issues, especially in developing countries like India. This has led to consideration of Safe Harbour(s) [SH] in the services sector like KPO services, Contract R&D services, ITES, certain low value-adding services, etc., along with the manufacture and export of core and non-core auto components (which is not a service) in the TP arena to provide certainty for the taxpayers and tax administrators. As per the amended Indian SH rules, low value-adding intra-group services have also been added in the eligible international transactions. SH rules have generally been applied to smaller taxpayers and / or less complex transactions. They are generally evaluated favourably by both tax administrations and taxpayers, which indicates that the benefits of SH outweigh the related concerns when such rules are carefully targeted and prescribed and when efforts are made to avoid the problems that could arise from poorly designed SH regimes.

A substantial number of cases in litigation on transfer pricing issues in India are in respect of selection of comparables while determining the ALP. An SH may significantly ease the compliance burden, reduce compliance costs for eligible taxpayers in determining and documenting appropriate conditions for qualifying controlled transactions and eliminating the need to undertake benchmarking exercises and selection of comparables which may be questioned by the tax authorities. It will also provide certainty to the taxpayers by ensuring that the price charged or paid on qualifying transactions will be accepted by the tax administrations with a limited audit or even without an audit, increase the level of compliance by small taxpayers and enable the tax authorities to use their resources to concentrate on TP review in which the tax revenue at stake is more significant.

2. OBJECTIVES OF SAFE HARBOUR
The importance of SH in TP has increased because of the following reasons:
a) Globalisation of markets and firms,
b) Development of powerful IT and efficient communication systems leading to increasing amounts of intercompany transactions,
c) Tax disputes on account of Base Erosion and Profit Shifting,
d) Complex regulatory compliances,
e) Documentation requirements, complexity in application, deadlines, stringent penalties in case of non-compliance, burden of audit and various other factors to be taken care of by the taxpayer,
f) Resource constraints of tax authorities and assessment of risk by them in order to focus their limited resources on large and significant cases.

SH has been introduced with the objective of assisting the tax authorities as well as reducing the compliance burden on the taxpayers. It has also been designed to reduce the amount of litigations in cases where there is a difference of opinion between the tax authorities and the taxpayers and also to provide certainty.

3. SAFE HARBOURS AS PER OECD TP GUIDELINES
As per the OECD, SH are expected to be most appropriate when they are directed at taxpayers and / or transactions which involve low TP risks and when they are adopted on a bilateral or multilateral basis, as against unilateral SH which may have a negative impact on the tax revenues of the country implementing them, as well as on the tax revenues of the countries whose AEs engage in controlled transactions with taxpayers electing a SH. A bilateral or multilateral SH would involve multiple countries agreeing on a fixed set of SH, thereby enabling the taxpayer to select and implement the SH without undertaking a risk of transfer pricing adjustment in all such jurisdictions.

Some of the difficulties that arise in applying the ALP may be avoided by providing circumstances in which eligible taxpayers may elect to follow a simple set of prescribed TP rules in connection with clearly and carefully defined transactions, or may be exempted from the application of the general TP rules. In the former case, prices established under such rules would be automatically accepted by the tax administrations that have expressly adopted such rules. These elective provisions are often referred to as ‘safe harbours’.

4. DEFINITION AND CONCEPT OF SAFE HARBOUR
4.1 OECD TP Guidelines
As per OECD TP Guidelines 2017, an SH in a TP regime is a provision that applies to a defined category of taxpayers or transactions and that relieves eligible taxpayers from certain obligations which are otherwise imposed by a country’s general TP rules. An SH provides simpler obligations in place of those under the general TP regime. Often, eligible taxpayers complying with the SH provisions will be relieved from burdensome compliance obligations, including some or all associated TP documentation requirements.

Such a provision could, for example, allow taxpayers to establish transfer prices in a specific way, e.g., by applying a simplified TP approach provided by the tax administration. Alternatively, an SH could exempt a defined category of taxpayers or transactions from the application of all or part of the general TP rules.

4.2 UN TP Manual
The UN TP manual defines SH as follows:
‘A provision in the tax laws, regulations or guidelines stating that transactions falling within a certain range will be accepted by the tax authorities without further investigation.’

As per the UN TP Manual, a practical alternative for a tax authority is to provide taxpayers with the option of using an SH for certain low value-adding services, provided it results in an outcome that broadly complies with the ALP. The SH may be based on acceptable mark-up rates for services. Several countries provide an SH option for certain services.

4.3 Toolkit for addressing difficulties in accessing comparables data for Transfer Pricing analyses [Toolkit]
The Toolkit prepared in 2017 in the framework of the Platform for Collaboration on Tax under the responsibility of the Secretariats and staff of the four mandated organisations, namely, International Monetary Fund, OECD, United Nations and World Bank Group, explains SH as follows:

‘An SH in a TP regime is a simplification measure through a provision that applies to a defined category of taxpayers or transactions and that relieves eligible taxpayers from certain obligations otherwise imposed by a country’s general TP rules. One of the merits of a well-framed SH is that it can reduce the need to find data on comparables and to perform a benchmarking study in every case.’

An SH may refer to two types of provisions:
‘Safe Harbour for TP’ – A mechanism to allow a tax administration to specify an appropriate TP method and an associated level or range of financial indicators that it considers to fulfil the requirements of the TP rules. Such an SH is applicable only in respect of a defined category of transactions.
‘TP Safe Harbour on process’ – The specification by a tax administration of a process that, when applied in respect of a defined category of transactions, is considered to produce a result that fulfils the requirements of the TP rules.

Both types of SH provide potential benefits to the tax administration and to taxpayers. In practice, SH may be appropriate in respect of a wide range of transactions, including:
* Manufacturing, especially in cases where the manufacturer does not have a right to valuable intangibles and does not assume significant risk. This is likely to include manufacturers that are in substance toll manufacturers or contract manufacturers;
* Sales and distribution entities, including sales agents, again in cases where the function does not exploit valuable intangibles or assume significant risk;
* Provision of services that do not involve the exploitation of valuable intangibles or the assumption of significant risk.

5. BENEFITS OF SAFE HARBOUR
5.1 Compliance relief
Application of the ALP may require collection and analysis of data that may be difficult or costly to obtain and / or evaluate. In certain cases, such compliance burdens may be disproportionate to the size of the taxpayer, its functions performed, and the TP risks inherent in its controlled transactions. A properly designed SH may significantly ease compliance burdens by eliminating data collection and associated documentation requirements in exchange for the taxpayer pricing qualifying transactions within the parameters set by the SH. Especially in areas where TP risks are small, and the burden of compliance and documentation is disproportionate to the TP exposure, such a trade-off may be mutually advantageous to both taxpayers and tax administrations.

5.2 Certainty
Another advantage of an SH is the certainty that the taxpayer’s transfer prices will be accepted by the tax administration, provided they have met the eligibility conditions of, and complied with, the SH provisions. The tax administration would accept, with limited or no scrutiny, transfer prices within the SH parameters. Taxpayers could be provided with relevant parameters which would provide a transfer price deemed appropriate by the tax administration for the qualifying transaction.

5.3 Administrative simplicity
An SH would result in a degree of administrative simplicity for the tax administration. Once eligibility for the SH has been established, qualifying taxpayers would require minimal examination with respect to the transfer prices of controlled transactions qualifying for the SH. This would enable tax administrations to secure tax revenues in low-risk situations with a limited commitment of administrative resources and to concentrate their efforts on the examination of more complex or higher risk transactions and taxpayers. An SH may also increase the level of compliance among small taxpayers that may otherwise believe their TP practices will escape scrutiny.

6. ADVERSE CONSEQUENCES
The availability of SH for a given category of taxpayers or transactions may have adverse consequences such as:
6.1 Divergence from the Arm’s Length Principle
Where an SH provides a simplified TP approach, it may not correspond in all cases with the Most Appropriate Method [MAM] applicable to the facts and circumstances of the taxpayer under the general TP provisions. SH involves a trade-off between strict compliance with the ALP and administrability. They are not customised to fit exactly the varying facts and circumstances of individual taxpayers and transactions. Any potential disadvantages to taxpayers diverging from ALP by electing SH are avoided when taxpayers have the option to either elect the SH or price transactions in accordance with the ALP. With such an approach, taxpayers that believe the SH would require them to report an amount of income that exceeds the ALP could apply the general TP rules. While such an approach can limit the divergence from ALP under an SH regime, it would also limit the administrative benefits of the SH to the tax administration.

The question of whether to opt for SH regime would actually depend on the scale of operations vis-à-vis the resultant tax impact.

Example
In the case of two assessees A & B who are engaged in the provision of Contract R&D relating to software development (where the SH Rules provide that the operating profit margin declared in relation to operating expense should not be less than 24%), the decision to opt for the SH regime may have to be considered based on the following:

Amount in crores

Sr. No.

Particulars

A

B

1.

Operating Revenue

Rs. 50

Rs. 190

2.

Operating Expense

Rs. 42

Rs. 160

3.

Operating Profit

Rs. 8

Rs. 30

4.

Operating Profit margin (3 ÷ 2)

19.05%

18.75%

5.

SH margin required

24%

24%

6.

Operating profit as per SH Rules (5 x 2)

10.08

38.40

7.

Assumed margin likely to be approved by the ITAT

22%

22%

8.

Operating profit as per assumed margin (7 x 2)

9.24

35.20

9.

Incremental cost for opting SH (6 – 8)

0.84

3.20

As we can observe from the above example, assessee A might consider opting for operating profit margin of 24% as provided in the SH Rules since the incremental cost which he might bear in India for opting for SH in exchange of having peace and certainty in a scenario where he could have got a resolution from the ITAT at, say, 22% of operating expenses, may not be quite large, being Rs. 0.84 crore approximately

However, for assessee B the situation may not warrant opting for the SH regime as the incremental costs based on the same assumptions as mentioned above could be quite significant over the years. It is, therefore, unlikely that the large captive payers would opt for such SH Rules.

Further, as the scale of operation increases and in cases where the data of comparable transactions is easily available, the determination of ALP would not be difficult, thus making the SH option less lucrative in such cases.

6.2 Risk of double taxation, double non-taxation and mutual agreement concerns
One major concern raised by an SH is that it may increase the risk of double taxation. If a tax administration sets SH parameters at levels either above or below ALP in order to increase reported profits in its country, it may induce taxpayers to modify the prices that they would otherwise have charged or paid to controlled parties in order to avoid TP scrutiny in the SH country. The concern of possible overstatement of taxable income in the country providing the SH is greater where that country imposes significant penalties for understatement of tax or failure to meet documentation requirements, with the result that there may be added incentives to ensure that the TP is accepted in that country without further review.

If the SH causes taxpayers to report income above arm’s length levels, it would work to the benefit of the tax administration providing the SH, as more taxable income would be reported by such domestic taxpayers. On the other hand, the SH may lead to less taxable income being reported in the tax jurisdiction of the foreign AE that is the other party to the transaction. The other tax administrations may then challenge prices derived from the application of an SH, with the result that the taxpayer would face the prospect of double taxation. Accordingly, any administrative benefits gained by the tax administration of the SH country would potentially be obtained at the expense of other countries, which in order to protect their own tax base would have to determine systematically whether the prices or results permitted under the SH are consistent with what would be obtained by the application of their own TP rules.

For example, let us consider Assessee A engaged in the provision of Contract R&D relating to software development to its AE in the US, where the SH provides that the operating profit margin declared in relation to operating expense should not be less than 24%. If the US considers 20% to be an appropriate ALP for payment by the US entity to Assessee A and if Assessee A opts for SH and offers a margin of 24%, such margin may not be accepted by the tax authorities in the US and may result in litigation there.

Where SH are adopted unilaterally, care should be taken in setting SH parameters to avoid double taxation, and the country adopting the SH should generally be prepared to consider modification of the SH outcome in individual cases under mutual agreement procedures to mitigate the risk of double taxation. Obviously, if an SH is not elective and if the country in question refuses to consider double tax relief, the risk of double taxation arising from the SH would be unacceptably high and inconsistent with the double tax relief provisions of treaties.

6.3 Possibility of opening avenues for tax planning
SH may also provide taxpayers with tax planning opportunities. Enterprises may have an incentive to modify their transfer prices in order to shift taxable income to other jurisdictions. This may also possibly induce tax avoidance, to the extent that artificial arrangements are entered into for the purpose of exploiting the SH provisions. For instance, if SH apply to ‘simple’ or ‘small’ transactions, taxpayers may be tempted to break transactions into parts to make them seem simple or small.

6.4 Equity and uniformity issues
SH may also raise equity and uniformity issues. By implementing an SH, one would create two distinct sets of rules in the TP area. Insufficiently precise criteria could result in similar taxpayers receiving different tax treatment: one being permitted to meet the SH rules and thus to be relieved from general TP compliance provisions, and the other being obliged to price its transactions in conformity with the general TP compliance provisions. Preferential tax treatment under SH regimes for a specific category of taxpayers could potentially entail discrimination and competitive distortions. The adoption of bilateral or multilateral SH could, in some circumstances, increase the potential of a divergence in tax treatment, not merely between different but similar taxpayers but also between similar transactions carried out by the same taxpayer with AEs in different jurisdictions.

7. EXAMPLES OF SAFE HARBOUR IN RESPECT OF INTRA-GROUP SERVICES
As per the UN TP Manual, two SH that may be used by tax authorities in respect of intra-group services are as follows:

(a) Low value services that are unconnected to an AE’s main business activity. This SH is usually available for low value-adding services. The rationale for an SH is that there may be difficulties in finding comparable transactions for low value-adding services and the administrative costs and compliance costs may be disproportionate to the tax at stake.
(b) Safe harbours for minor expenses (i.e., amounts below a defined threshold). These are for situations in which the costs of services provided or received are relatively low, so the tax authority may agree to not adjust the transfer prices provided they fall within the acceptable range. The rationale for this SH is that the cost of a tax authority making adjustments is not commensurate with the tax revenue at stake and therefore the taxpayer should not be expected to incur compliance costs to determine more precise ALP.

8. SAFE HARBOUR FOR LOW VALUE-ADDING SERVICES
Low value-adding services are services which are not part of an MNE group’s main business activities from which it derives its profits but are services that support the AE’s business operations. A determination of an AE’s low value-adding services would be based on a functional analysis of the enterprise which would provide evidence of the main business activities of an AE and the way in which it derives its profits.

Low value-adding intra-group services are services performed by one or more than one member of an MNE group on behalf of one or more other group members which:
a) Are of a supportive nature;
b) Are not part of the core business of the MNE group (i.e., not creating the profit-earning activities or contributing to economically significant activities of the MNE group);
c) Do not require the use of unique and valuable intangibles and do not lead to the creation of unique and valuable intangibles;
d) Do not involve the assumption or control of substantial or significant risk by the service provider and do not give rise to the creation of significant risk for the service provider.

Some common examples of low value-adding services for most MNE groups (i.e., provided they do not constitute the core business of the group) are human resources services, accounting services, clerical or administrative services, tax compliance services and data processing.

For an AE that is a distributor and marketer of an MNE’s products, marketing services would fail to qualify as administrative services as they are directly connected to the enterprise’s main business activity. Similarly, for an MNE whose core business is recruitment and human resources management, human resources services of a kind similar to those provided to independent customers would not qualify for the low value-adding SH despite the mention of human resources services in the section above.

9. MINOR EXPENSE SAFE HARBOUR
In the Minor Expense SH option, a tax authority agrees to refrain from making a TP adjustment if the total cost of either receiving or providing intra-group services by an AE is below a fixed threshold based on cost and a fixed profit mark-up margin is used.

The aim is to exclude from TP examinations services for which the charge is relatively minor. The rationale is that the costs of complying with the TP rules would outweigh any revenue at stake. It also considers the potential administrative savings for a tax authority by avoiding TP examinations of minor expenses. An important requirement is that the same fixed profit margin should be used for inbound and outbound intra-group services for a country. The SH provides taxpayers and tax authorities with certainty. The minor expense SH may contain the following requirements:
* A restriction on the relative value of the service expense (e.g., less than X per cent of total expenses of the AE receiving the services) or alternatively, a restriction on the absolute value of the service expense,
* A fixed profit margin,
* The requirement that the same profit margin is used in the other country,
* The documentation requirements that are expected.

An example of an SH for services is set out as follows.

For inbound intra-group services:
a) The total cost of the services provided is less than X per cent of the total deductions of the AEs in a jurisdiction for a tax year, or less than a defined absolute amount in the local currency;
b) The transfer price is a fixed profit mark-up on total costs of the services (direct and indirect expenses); and
c) Documentation is prepared to establish that the SH requirements have been satisfied.

For outbound intra-group services:
a) The cost of providing the services is not more than X per cent of the taxable income of the AE providing the services, or not more than a defined absolute amount in the local currency;
b) The transfer price charged is based on a fixed profit mark-up on the total costs of the services (direct and indirect expenses);
c) The same profit margin is used in the other country; and
d) Documentation is created to establish that these SH requirements have been satisfied.

At present there is no minor expense safe harbour rule prescribed as part of the SH regime in India.

10. RECOMMENDATIONS ON USE OF SAFE HARBOUR AS PER OECD TP GUIDELINES
TP compliance and administration is often complex, time-consuming and costly. Properly designed SH provisions, applied in appropriate circumstances, can help to relieve some of these burdens and provide taxpayers with greater certainty.

SH provisions may raise issues such as potentially having perverse effects on the pricing decisions of enterprises engaged in controlled transactions and a negative impact on the tax revenues of the country implementing the SH, as well as on the countries whose AEs engage in controlled transactions with taxpayers electing an SH. Further, unilateral SH may lead to the potential for double taxation or double non-taxation.

However, in cases involving smaller taxpayers or less complex transactions, the benefits of SH may outweigh the problems raised by such provisions. Making such SH elective to taxpayers can further limit the divergence from ALP. Where countries adopt SH, willingness to modify SH outcomes in mutual agreement proceedings to limit the potential risk of double taxation is advisable.

Where SH can be negotiated on a bilateral or multilateral basis, they may provide significant relief from compliance burdens and administrative complexity without creating problems of double taxation or double non-taxation. Therefore, the use of bilateral or multilateral SH under the right circumstances should be encouraged.

It should be clearly recognised that an SH, whether adopted on a unilateral or bilateral basis, is in no way binding on or precedential for countries which have not themselves adopted the SH.

For more complex and higher risk TP matters, it is unlikely that SH will provide a workable alternative to a rigorous, case-by-case application of the ALP under the provisions of these Guidelines.

11. RANGACHARY COMMITTEE – INDIAN SAFE HARBOUR COMMITTEE
The Prime Minister’s Office issued a press release on 30th July, 2012 announcing the constitution of a Committee to Review Taxation of Development Centres and the IT Sector under the Chairmanship of Mr. N. Rangachary, former Chairman, CBDT & IRDA (the Rangachary Committee), for seeking resolution of tax issues through an arm’s length exercise in the form of a review by the Committee including, inter alia, SH provisions announced but yet to be operationalised having the advantage of being a good risk mitigation measure and provide certainty to the taxpayer.

The Committee was mandated to engage in sector-wide consultations and finalise the SH provisions announced sector-by-sector. The Committee was also to suggest any necessary circulars that may need to be issued.

The Committee has submitted six reports including specific sector-wise / activity-wise reports for the following:
1) IT Sector,
2) ITES Sector,
3) Contract R&D in the IT and Pharmaceutical Sector,
4) Financial Transactions-Outbound Loans,
5) Financial Transactions-Corporate Guarantees,
6) Auto Ancillaries-Original Equipment Manufacturers.

12. OVERVIEW OF INDIAN SAFE HARBOUR
Businesses flourish only if there is certainty and SH provisions offer that certainty. These SH provisions of the Income-tax Act, 1961 [the Act] specify that from the perspective of TP provisions, if the assessee fulfils certain defined conditions, the Tax Authorities shall accept the TP declared by the taxpayer.

SH Rules benefit assessees by allowing them to adopt a TP mark-up in the range prescribed, which would be acceptable to the Income Tax Department with benefits of compliance relief, administrative simplicity and certainty and hence would avoid protracted litigation.

After its enactment vide the Finance (No. 2) Act 2009, the first set of rules was notified on 18th September, 2013 – Rules 10TA to 10TG and Form 3CEFA (for international transactions), and Rules 10TH to 10THD and Form 3CEFB (for domestic transactions) for a period of three years, followed by a revision in 2017 in the SH Rules, which were made applicable till F.Y. 2018-19.

The CBDT vide Notification No. 25/2020 dated 20th May, 2020 extended the applicability of Rule 10TD(1) and (2A) (applicable for A.Y. 2017-18 to A.Y. 2019-20) for A.Y. 2020-21 also. Of the categories of the eligible international transactions, the category of software development, ITES and KPO appears to have been popularly opted for.

The CBDT has issued Notification No. 117/2021 dated 24th September, 2021 to extend the applicability of SH Rules under Rule 10TD of the Income-tax Rules to A.Y. 2021-22. The amended rule is deemed to come into force from 1st April, 2021.

Considering that the TP References in smaller cases has substantially reduced, it would have been good to revise these SH limits downward by around 2 per cent points to make it a more attractive option.

A comparison of the erstwhile and revised SH is given below:

Sr. No.

Eligible International
Transactions

Old SH Rules for

01-04-12 to 31-03-17

Revised SH Rules for

01-04-16 to 31-03-21

Threshold

Margin

Threshold

Margin

1

Provision of software development services and information
technology-enabled services

Up to Rs. 500 crores

Not less than 20% on total operating costs

Up to Rs. 100 crores

Not less than 17% on total operating costs

Above Rs. 500 crores

Not less than 22% on total operating costs

Above Rs. 100 crores up to
Rs. 200 crores

Not less than 18% on total operating costs

2

Provision of KPO services

NA

Not less than 25% on operating costs

Up to Rs. 200 crores

Not less than 24% and employee cost at least 60%

Not less than 21% and employee cost is 40%
or more but less than 60%

Not less than 18%, and employee cost up to 40%

3

Advancing of intra-group loans where loan is denominated in
Indian Rupees

Loan up to
Rs. 50 crores

Base rate of State Bank of India + 150 basis points

One year marginal cost of funds lending rate
of SBI as on 1st April of relevant previous year plus:

CRISIL rating between AAA to A or its equivalent

175 basis points

3

 

(continued)

 

CRISIL rating of BBB-, BBB, BBB+ or its equivalent

325 basis points

Loan above Rs. 50 crores

Base rate of State Bank of India + 300 basis points

CRISIL rating of BB to B or its equivalent

475 basis points

CRISIL rating between C & D or its equivalent

625 basis points

Credit rating is not available, and amount of loan does not exceed
Rs. 100 crores as on 31st March of relevant previous year

425 basis points

4

Advancing of intra-group loans where loan is denominated in
foreign currency

NA

NA

6 month LIBOR interest rate as on
30th September of relevant previous year plus:

CRISIL rating between AAA to A

150 basis points

CRISIL rating of BBB-, BBB, BBB+

300 basis points

CRISIL rating of BB to B

450 basis points

CRISIL rating between C & D

600 basis points

Credit rating is not available, and amount of loan does not
exceed equivalent of Rs. 100 crores as on 31st March of relevant previous
year

400 basis points

5

Providing corporate guarantee

Up to Rs. 100 crores

Not less than 2% p.a.

NA

Not less than 1% p.a. on the amount guaranteed

Above Rs. 100 crores

Not less than 1.75% p.a.

6

Provision of contract R&D services relating to software
development

NA

Not less than 30% on operating expense

Up to Rs. 200 crores

Not less than 24% on the operating expense

7

Provision of contract R&D services relating to generic
pharma drugs

NA

Not less than 29% on operating expense

Up to Rs. 200 crores

Not less than 24% on the operating expense

8

Manufacture and export of core auto components

NA

Not less than 12% on operating expense

NA

Not less than 12% on operating expense

9

Manufacture and export of non-core auto components

NA

Not less than 8.5% on operating expense

NA

Not less than 8.5% on operating expense

10

Receipt of low value-adding intra-group services (New)

NA

NA

Up to Rs. 10 crores including mark-up

– 5% mark-up; and

– Cost pooling method, exclusion of shareholders cost, duplicate
costs and reasonableness of allocation keys is certified by an accountant

A.Y. 2017-18 is the overlapping year for which the taxpayers had an option to exercise either of the two SH rules depending upon whichever was most beneficial to them.

The downward revision of SH margins in case of software development and ITES, Contract R&D and KPO in the revised SH Rules was long overdue and a welcome move. The revised margins are also closer to the margin range being concluded in the vast majority of APAs concluded in the IT-ITES space. As a result of the reduction in the margins, the expected savings of taxpayers due to avoidance of litigation is likely to outweigh the premium paid (if any) due to higher than arm’s length margins especially for small and medium taxpayers with lower cost bases.

This move also highlights the Indian Revenue’s intention to attract appropriate cases to the SH scheme and away from the APA scheme thereby covering the higher value and non-routine cases for the more complex cases that need a deeper understanding and negotiation by the Indian Revenue.

Another interesting feature of the revised SH rules is the gradation of the SH margin thresholds for the KPO sector based on the percentage of employee cost incurred rather than covering all the KPO activities under a single umbrella. The streamlining of margins prescribed for KPO on the basis of employee cost ratio may not be the best course of action but it does seek to align with the premise that a technically skilled workforce would lead to a higher employee cost and signify a higher value addition commanding a higher operating margin. The employee cost has been defined comprehensively.

The definitions of ITES and KPO are very broad and general and the revised SH rules did not modify / clarify them. Keeping in view the litigations that have occurred, detailed definitions would have been welcome as they would have set a clearer line of distinction between KPO and ITES. The applicability of SH for transactions of software development and ITES, contract R&D and KPO has been reduced to Rs. 200 crores. Hence, after F.Y. 2016-17, taxpayers having transaction values greater than Rs. 200 crores cannot opt for SH but can only opt for APAs to attain certainty.

13. CONCLUDING REMARKS
Complying with the ALP can be burdensome. Even good faith efforts to ensure compliance result in uncertainty because the Tax Authorities may analyse the transaction in a different way and come to a different conclusion. Though it is important for the Government to be diligent, and the enterprises to be honest, easing out more on compliance procedures would enable enterprises to focus more on their core activities and in turn generate more business and profits, thereby keeping the wheel of taxation turning and intact.

A fair and transparent SH regime goes a long way in plugging tax leakage and leads to significant tax certainty. Country tax administrations should carefully weigh the benefits of and concerns regarding safe harbours, making use of such provisions where they deem it appropriate.

In Part 2 of this Article, we will deal with the remaining aspects of Indian SH Rules and jurisprudence.

TWO-PILLAR SOLUTION TO ADDRESS THE TAX CHALLENGES ARISING FROM THE DIGITALISATION OF THE ECONOMY – AN OVERVIEW

1. HISTORICAL PERSPECTIVE AND BACKGROUND
Digitalisation and globalisation have had a profound impact not only on the world economy, but also on the lifestyles of people. Digitalisation and the advent of Artificial Intelligence have further accelerated the impact in the 21st century. These changes have brought with them challenges to the age-old taxing rules of international business income which have resulted in multinational enterprises (MNEs) not paying their fair share of tax despite their huge profits.

In 2013, the OECD ramped up efforts to address the challenges in response to growing public and political concerns about tax avoidance by large multinationals. Implementation of the 15 Action Plans of the BEPS package, agreed to 2015, is well underway, but gaps remain. Globalisation has aggravated unhealthy tax competition.

In March, 2018, the OECD released the document Tax Challenges Arising from Digitalisation — Interim Report, 2018 as a follow-up to the 2015 final report on Action 1 of the project on Base Erosion and Profit Shifting. The 2018 Interim Report did not include any specific recommendations, indicating instead that further work would be carried out to understand the various business models in existence in the digital economy.

In January, 2019, the OECD released a Policy Note for renewed international discussions to focus on two ‘pillars’: one pillar addressing the broader challenges of the digitalization of the economy and the allocation of taxing rights, and a second pillar addressing remaining BEPS concerns. Following the Policy Note in February, 2019, the OECD released a Public Consultation Document describing the two-pillar proposals at a high level. The OECD received extensive comments from stakeholders and held a public consultation in March, 2019.

At the end of January, 2020, the OECD released a Statement by the Inclusive Framework on BEPS on the Two-Pillar Approach. With respect to both pillars, the documents included new details on the proposed approaches and identified key issues under consideration and areas where more work was to be undertaken.

In October, 2020, the OECD released detailed reports on the Blueprints on Pillar One and Pillar Two; an Economic Impact Assessment of the Pillar One and Pillar Two proposals; a Cover Statement by the Inclusive Framework on the work to date; future steps and a Public Consultation Document requesting comments on the Blueprints on both pillars.

On 1st July, 2021, the OECD released a Statement on a Two-Pillar Solution to Address the Tax Challenges Arising From the Digitalisation of the Economy (July Statement), reflecting the agreement of 130 of the member jurisdictions of the Inclusive Framework on some key parameters with respect to both pillars.

On 8th October, 2021, the OECD published an updated Statement (October Statement) regarding the conceptual agreement on the Two-Pillar Solution and the framework for the implementation of the same. And 136 out of 140 jurisdictions of the Inclusive Framework have agreed to the October Statement. The four jurisdictions which did not join the October Statement are Pakistan, Kenya, Nigeria, and Sri Lanka.

The 136 jurisdictions which have joined the Two-Pillar Solution represent more than 90% of the world’s GDP. An agreement is reached on a Detailed Implementation Plan that envisages implementation of the new rules by 2023.

The Two-Pillar Solution will ensure reallocation of excess profits of the large and profitable companies based on ‘nexus approach’ and that the MNEs will pay a minimum tax rate of 15%. This solution also aims to address concerns of the developing countries of having a fair share of tax revenue from MNEs who have a large customer base in these countries.

2. ISSUES UNDER THE EXISTING INTERNATIONAL TAXATION RULES
A key part of the OECD / G20 BEPS Project is addressing the tax challenges arising from the digitalisation of the economy which has undermined the basic rules that have governed the taxation of international business profits for the last one century.

The existing international tax rules are based on agreements made in the 1920s and are enshrined in the global network of bilateral tax treaties.

There are two main issues:
(1) The old rules provide that the profits of a foreign company can only be taxed in another country where the foreign company has a physical presence. One hundred years ago, when digital technologies were non-existent and business revolved around factories, warehouses and movement of physical goods, this made perfect sense. However, in today’s digitalised world, MNEs often conduct large-scale business in a jurisdiction with little or no physical presence in that jurisdiction.
(2) Secondly, most countries only tax the domestic business income of their MNEs but not foreign income on the assumption that foreign business profits will be taxed where they are earned.

The growth of importance of intangibles like brands, copyrights and patents, and companies’ ability to shift profits to jurisdictions that impose little or no tax, means that MNE profits often escape taxation. This is further complicated by the fact that many jurisdictions are engaged in unfair tax competition by offering reduced taxation, and even zero taxation, to attract foreign direct investment and its attendant economic benefits.

OECD estimates that corporate tax avoidance costs anywhere from USD 100 to 240 billion annually, or from four to ten percent of global corporate income tax revenues. Developing countries are disproportionately affected because they tend to rely more heavily on corporate income taxes than advanced economies. Lack of global consensus on taxing MNE profits has given rise to unilateral measures at the national level, such as Digital Services Taxes (DST) and the prospect of retaliatory tariffs.

Such an outcome could cost the global economy up to 1% of its GDP. Again, this would hit developing countries harder than more advanced economies. The implementation of the Two-Pillar Solution aims to avoid trade wars, provide certainty and prevent unilateral domestic tax measures that would adversely impact trade and investment.

3. EVOLVING TWO-PILLAR SOLUTION
3.1 Pillar One
Pillar One aims to ensure a fairer distribution of profits and taxing rights among countries with respect to the largest MNEs which are the beneficiaries of globalisation. Tax certainty is a key aspect of the new rules, which include a mandatory and binding dispute resolution process for Pillar One, but with the caveat that developing countries will be able to benefit from an elective mechanism in certain cases, ensuring that the rules are not too onerous for low-capacity countries. The agreement to re-allocate profit under Pillar One includes the removal and standstill of DST and other relevant, similar measures, bringing an end to trade tensions resulting from the instability of the international tax system. It will also provide a simplified and streamlined approach to the application of the arm’s length principle in specific circumstances, with particular focus on the needs of low-capacity countries.

Pillar One would bring dated international tax rules into the 21st century, by offering market jurisdictions new taxing rights over MNEs, whether or not there is a physical presence.

a) Under Pillar One, 25% of profits of the largest and most profitable MNEs above a set profit margin (residual profits) would be reallocated to the market jurisdictions where the MNE’s users and customers are located; this is referred to as Amount A.
b) Pillar One also provides for a simplified and streamlined approach to the application of the arm’s length principle to in-country baseline marketing and distribution activities, referred to as Amount B.
c) Pillar One includes features to ensure dispute prevention and dispute resolution in order to address any risk of double taxation, but with an elective mechanism for some low-capacity countries.
d) Pillar One also entails the removal and standstill of DST and similar relevant measures to prevent harmful trade disputes.

3.2 Certain aspects of Amount A and Amount B
a) Computation of Amount A
Amount A would be computed for in-scope MNEs (i.e., ‘covered entities’ to which Pillar One applies), as 25% of residual profit (residual profit is defined as profit in excess of 10% of revenue) will be allocated to market jurisdictions with nexus using a revenue-based allocation key.

Revenue will be sourced to the end jurisdiction where the goods or services are ultimately used or consumed.

The base profit or loss of the in-scope MNE to be used for computation of Amount A will be determined by reference to the financial accounting income, with a few adjustments. (These rules are yet to be prescribed.)

b) Computation of Amount A in a case where marketing and distribution activities are undertaken in the relevant jurisdiction
In case the relevant market jurisdiction is already allocated a portion of the residual profit, a safe harbour will apply to cap the total residual profits allocated to such marketing jurisdiction under Amount A. Further work is expected to be undertaken to determine this safe harbour.

c) How would tax certainty be achieved for Amount A?
A dispute prevention and resolution mechanism will be introduced to avoid double taxation of Amount A. Such dispute resolution mechanism is expected to be mandatory and binding on jurisdictions. An elective binding dispute resolution mechanism will be made available on issues related to Amount A for developing economies which are eligible for deferral of their BEPS Action 14 review and have no or low levels of dispute. Interestingly, India has agreed to this Clause in the context of Pillar One, despite its consistent resistance to mandatory arbitration.

d) Computation of Amount B
Amount B would be based on the arm’s length return for in-country baseline marketing and distribution activities. The work on simplifying the computation of Amount B and streamlining the same is expected to be completed by the end of 2022. A safe harbour rate or other guidance may be provided for determining arm’s length return to compute Amount B. However, till such time one needs to follow the general principles enshrined in the Transfer Pricing Regulations.

e) How would Pillar One be implemented?
Amount A will be implemented through a Multilateral Convention (MLC) which will be developed and opened for signature in 2022, and Amount A is expected to come into effect in 2023. Unlike the MLI, which although multilateral, amends bilateral tax treaties, the MLC will operate multilaterally and along with the MLI.

3.3 Important elements of Pillar One
i) The scope of Amount A is restated without change as MNEs with a global turnover above €20 billion and profitability above 10% of profit before tax. These thresholds will be calculated using an average mechanism (yet to be described in detail).
ii) Amount A will allocate 25% of ‘residual profits’, which is defined as profit before tax in excess of 10% of revenue, to market jurisdictions with nexus using a revenue-based allocation key.
iii) A mandatory and binding dispute resolution mechanism will be available for all issues related to Amount A. For certain developing countries, an elective binding dispute resolution mechanism will be available. The eligibility of a jurisdiction for the elective binding dispute resolution mechanism will be regularly reviewed. If a jurisdiction is found to be ineligible, it will remain ineligible in all subsequent years.
iv) The removal of all DSTs and other relevant similar measures with respect to all companies will be required by the Multilateral Convention (MLC) through which Amount A is to be implemented. No newly-enacted DSTs or other relevant similar measures will be imposed on any company from 8th October, 2021 and until the earlier date of 31st December, 2023 or the coming into force of the MLC.
v) The October Statement reiterates that the MLC through which Amount A is implemented will be developed and opened for signature in 2022, with Amount A coming into effect in 2023.

3.4 Pillar Two
Pillar Two aims to discourage tax competition on corporate income tax through the introduction of a global minimum corporate tax rate of 15% that countries can use to protect their tax bases (the GloBE rules). Pillar Two does not eliminate tax competition, but it does set multilaterally agreed limitations on it. Tax incentives provided to spur substantial economic activity will be accommodated through a carve-out. Pillar Two also protects the right of developing countries to tax certain base-eroding payments (like interest and royalties) when they are not taxed up to the minimum rate of 9%, through a ‘subject to tax rule’ (STTR).

Governments worldwide agree to allow additional taxes on the foreign profits of MNEs headquartered in their jurisdictions at least to the agreed minimum rate. This means that tax competition will now be supported by a minimum level of taxation wherever an MNE operates.

A carve-out allows countries to continue to offer tax incentives to promote business activity with real substance, like building a hotel or investing in a factory.

3.5 Pillar Two seeks to reduce tax competition and protect tax base by introducing a minimum global corporate tax. It consists of the following:
i) An Income Inclusion Rule (IIR) which imposes a top-up tax on a parent entity in respect of the low-taxed income of a constituent entity;
ii) An Undertaxed Payment Rule (UTPR) which denies deduction or requires an adjustment to the extent the low-taxed income of a constituent entity is not subject to tax under the IIR. IIR and UTPR together are called the Global anti-Base Erosion Rules (GloBE);
iii) A treaty-based STTR that allows jurisdictions to impose limited source taxation on certain related party payments subject to tax below a minimum rate.

The IIR is to be applied in the country in which the parent is situated, whereas the UTPR and the STTR apply in the case of the subsidiary.

3.6 Which entities are covered?
MNEs that meet the €750 million revenue threshold under BEPS Action 13 (Country-by-Country Reporting) would be subject to the GloBE rules. However, even if the above thresholds are not met, countries are free to apply the IIR to MNEs headquartered in their States.

The exclusion from the GloBE rules also includes Government entities, international organisations, pension funds or investment funds that are Ultimate Parent Entities (UPE) of an MNE Group or any holding vehicles used by such entities.

UTPR will not apply to MNEs in the initial phase of their international activity, i.e., those MNEs whose tangible assets abroad do not exceed €50 million and who do not operate in more than five jurisdictions. Such exclusion is limited for a period of five years after the MNE comes within the scope of the GloBE rules for the first time. For MNEs which are covered by the GloBE rules when they come into effect, UTPR will not apply for five years and the period of five years shall commence at the time the UTPR Rules come into effect.

3.7 Income Inclusion Rule
The IIR will operate to impose a top-up tax using an Effective Tax Rate (ETR) test that is calculated on a jurisdictional basis. The minimum tax rate specified is 15%. Accordingly, in a situation where the constituent entity has not been subjected to tax of at least 15%, the jurisdiction of the parent entity will collect top-up tax.

3.8 Undertaxed Payment Rule
The UTPR applies in a situation where the transaction is not subject to IIR. It allocates top-up tax from low-tax constituent entities. The minimum ETR for the UTPR is 15%.

3.9 Subject To Tax Rule
The members have agreed on a minimum rate of 9% for the STTR and therefore covered payments, which are subjected to tax in the residence jurisdiction at a rate lower than 9%, will be subject to STTR in the payer jurisdictions. [This is a bilateral solution applicable in case of Interest, Royalties and other specified payments. Where a treaty partner country taxes such income below the STTR rate of 9% in its jurisdiction, then the other partner may tax the differential rate so as to ensure that such payments are taxed minimum at the STTR rate.]

3.10 Implementation
As the GloBE rules relate to amendments in domestic tax laws, model rules will be developed by the end of November, 2021 defining the scope and setting out the mechanics of the rules. It is expected that Pillar Two will be brought into law in 2022, to be effective in 2023 and UTPR to apply from 2024. Implementation of the GloBE rules is not mandatory on jurisdictions. However, if such rules are implemented, a common approach is to be followed and the rules and implementation are to be undertaken in the manner provided in Pillar Two.

A model treaty provision will be developed by the end of November, 2021 incorporating the STTR.

3.11 Important Elements of Pillar Two
i) It is restated that Inclusive Framework members are not required to adopt the GloBE rules but if they choose to do so, they should implement and administer the rules in a way that is consistent with the outcomes provided for under Pillar Two, including the model rules and guidance agreed to by the Inclusive Framework. It is also restated that Inclusive Framework members accept the application of the GloBE rules applied by other Inclusive Framework members.
ii) The design of Pillar Two is restated, including the GloBE rules, consisting of the IIR and the UTPR, and the STTR. Exclusion from the UTPR will be available for MNEs in the initial phase of their international activity (i.e., MNEs with a maximum of €50 million tangible assets abroad that operate in no more than five other jurisdictions). This exclusion is limited to five years after the MNE comes into the scope of the GloBE rules for the first time. In respect of existing distribution tax systems, there will be no top-up tax liability if earnings are distributed within four years and taxed at or above the minimum level.
iii) The minimum tax rate for purposes of the IIR and UTPR will be 15%.
iv) The substance-based carve-out is modified from the July Statement, with a transition period of ten years. (Detailed guidelines are provided for the same.)
v) A de minimis exclusion is provided for those jurisdictions where the MNE has revenues of less than €10 million and profits of less than €1 million.
vi) The nominal tax rate used for the application of the STTR will be 9%.
vii) Pillar Two will apply a minimum rate on a jurisdictional basis. Consideration will be given to the conditions under which the United States Global Intangible Low-Taxed Income (GILTI) regime will co-exist with the GloBE rules, to ensure a level playing field.
viii) The October Statement reiterates that Pillar Two generally should be brought into law in 2022, to be effective in 2023. However, the entry into effect of the UTPR has been deferred to 2024.

4. LIKELY IMPACT OF TWO-PILLAR SOLUTION
Under Pillar One, taxing rights on more than USD 125 billion of profit are expected to be reallocated to market jurisdictions each year. With respect to Pillar Two, with a minimum rate of 15%, the global minimum tax is estimated to generate around USD 150 billion in additional global tax revenues per year. The precise revenue impact will depend on the extent of the implementation of Pillar One and Pillar Two, the nature and scale of reactions by MNEs and Governments and future economic developments.

In terms of the investment impact, the Two-Pillar Solution is expected to provide a favourable environment for investment and growth. The absence of an agreement may have led to a proliferation of uncoordinated and unilateral tax measures (e.g., Digital Services Taxes and Equalisation Levy) and an increase in tax and trade disputes which would have undermined tax certainty and investment and resulted in additional compliance and administration burdens. It is estimated that these disputes could reduce global GDP by more than 1%.

5. FURTHER COURSE OF ACTION
Model rules to implement Pillar Two will be developed in 2021 with an MLC to implement Pillar One finalised by February, 2022. Inclusive Framework members have set an ambitious deadline of 2023 to bring the new international tax rules into effect.

6. IMPORTANT ASPECTS OF TWO-PILLAR SOLUTION
6.1 Impact of the Two-Pillar Solution on tax payments by MNEs
Each Pillar addresses a different gap in the existing rules that allows MNEs to avoid paying taxes. First, Pillar One applies to about 100 of the biggest and most profitable MNEs and reallocates part of their profit to the countries where they sell their products and provide their services, where their consumers are located. Without this rule, these companies can earn significant profits in a market jurisdiction without paying much tax there.

Under Pillar Two, a much larger group of MNEs (any company with over €750 million of annual revenue) would now be subject to a global minimum corporate tax of 15%.

6.2 Coverage of MNEs in Two-Pillar Solution
The BEPS Project aims to ensure that all taxpayers pay their fair share of tax. While it is true that the reallocation of profit under Pillar One would apply to only about 100 companies now, these are the largest and most profitable ones.

There is also a provision to expand the scope after seven years once there is experience with implementation. Pillar One also includes a commitment to develop simplified, streamlined approaches to the application of transfer pricing rules to certain arrangements, with particular focus on the needs of low-capacity countries which are very often the subject of tax disputes.

The objective of Pillar Two is to ensure that a much broader range of MNEs (those with a turnover of at least €750 million, which will be several companies) pay a minimum level of tax, while preserving the ability of all companies to innovate and be competitive.

For other smaller companies, the existing rules continue to apply and the Inclusive Framework has a number of other international tax standards like the BEPS actions to reduce the risks of tax avoidance and ensure that they pay their fair share.

6.3 Developing Countries – Beneficial Impact
Developing countries make up a large part of the Inclusive Framework’s membership and their voices have been active and effective throughout the negotiations. The OECD estimates that on average, low-, middle- and high-income countries would all experience revenue gains as a result of Pillar One, but these gains would be expected to be larger (as a share of current corporate income tax revenues) among low-income jurisdictions. Overall, the GloBE rules will relieve pressure on developing countries to provide excessively generous tax incentives to attract foreign investment; at the same time, there will be carve-outs for activities with real substance. Specific benefits aimed at developing countries include:

i) Protecting their tax base by implementing the Subject to Tax Rule in their bilateral tax treaties ensuring minimum overall 9% tax on income from interest and royalties to MNEs (refer para 3.9 for further details).
ii) The simplified and streamlined approach to the application of the arm’s length principle to in-country baseline marketing and distribution activities, as low-capacity countries often struggle to administer transfer-pricing rules and will benefit from a formulaic approach in those cases.
iii) A lower threshold for determining the reallocation of profit under Pillar One to smaller economies.

The Two-Pillar Solution acknowledges the calls from developing countries for more mechanical, predictable rules and generally provides a redistribution of taxing rights to market jurisdictions based on where sales and users are located, often in developing countries. It also provides for a global minimum tax which will help put an end to tax havens and lessen the incentive for MNEs to shift profits out of developing countries. Developing countries can still offer effective incentives that attract genuine, substantive foreign direct investments. Importantly, this multilaterally agreed solution avoids the risk of retaliatory trade sanctions that could result from unilateral approaches such as digital services taxes.

6.4 Impact on profit-shifting by MNEs via tax havens, etc.
Harmful tax competition and aggressive tax planning have done great harm to the world economy. Tax havens have thrived over the years by offering secrecy (like bank secrecy) and shell companies (where the company doesn’t need to have any employees or activity in the jurisdiction) and no or low tax on profits booked there. The work of the G20 and the OECD-hosted Global Forum on Transparency and Exchange of Information for Tax Purposes has ended bank secrecy (including leading to the automatic exchange of bank information), and the OECD BEPS Project requires companies to have a minimum level of substance to put an end to shell companies along with important transparency rules so that tax administrations can apply their tax rules effectively. Pillar Two will now ensure that those companies pay a minimum effective tax rate of 15% on their profits booked there (subject to carve-outs for real, substantial activities). Many countries including the UAE have introduced Economic Substance Regulations and related reporting each year to avoid shell companies.

6.5 Exclusions for certain business activities
There are four exclusions from the Two-Pillar solutions; these are, mining companies, regulated financial services, shipping companies and pension funds. The OECD Document clarifies that the exclusions that are provided for ‘relate to types of profit and activities that are not part of this problem either because the profit is already tied to the place where it is earned (for example, regulated financial services and mining companies will have to have their operations in the place where they earn their income), or the activity benefits from different taxation regimes due to their specific nature (such as shipping companies and pension funds).’ In any case, these types of businesses are still subject to all the other international tax standards on transparency and BEPS to ensure that tax authorities can tax them effectively.

7. IMPLEMENTATION TIMELINES
A detailed Implementation Plan has also been agreed upon. It contains ambitious deadlines to complete work on the rules and instruments to bring the Two-Pillar Solution into effect by 2023.

PROPOSED TIMELINES
A. Pillar One
a) Early 2022 – Text of a Multilateral Convention and Explanatory Statement to implement Amount A of Pillar One;
b) Early 2022 – Model rules for domestic legislation necessary for the implementation of Pillar One;
c) Mid-2022 – High-level signing ceremony for the Multilateral Convention;
d) End 2022 – Finalisation of work on Amount B for Pillar One;
e) 2023 – Implementation of the Two-Pillar Solution.

B. Pillar Two
a) November, 2021 – Model rules to define scope and mechanics for the GloBE rules;
b) November, 2021 – Model treaty provision to give effect to the subject to tax rule;
c) Mid-2022 – Multilateral Instrument for implementation of the STTR in relevant bilateral treaties;
d) End 2022 – Implementation framework to facilitate coordinated implementation of the GloBE rules;
e) 2023 – Implementation of the Two-Pillar Solution.

The detailed Implementation Plan provides for a clear and ambitious timeline to ensure effective implementation from 2023 onwards. On Pillar One, model rules for domestic legislation will be developed by early 2022 and the new taxing right in respect of re-allocated profit (Amount A) will be implemented through a multilateral convention with a view to allowing it to come into effect in 2023. India and many other countries may see changes in their domestic tax laws to include provisions of Pillar One. Similarly, one may see the end of unilateral measures such as the Equalisation Levy once the agreement is finalised, as stated by our Finance Minister recently. Meanwhile, work will be developed on Amount B and the in-country baseline marketing and distribution activities in scope, by the end of 2022. As for Pillar Two, model rules to give effect to the minimum corporate tax will be developed by November, 2021, as well as the model treaty provision to implement the subject to tax rule. A multilateral instrument will then be released by mid-2022 to facilitate the implementation of this rule in bilateral treaties.

8. CONCLUDING REMARKS
The October Statement marks an important milestone in the BEPS 2.0 project on fundamental changes to the global tax rules, with all OECD and G20 countries (including the European Union) now supporting the agreement on key parameters. However, more work will be required to reach agreement on some key design elements of the two Pillars. In addition, there is significant work to be done to fill in the substantive and technical details in the development of the planned model rules, treaty provisions and explanatory material. That work will need to be completed quickly in order to meet the timelines reflected in the implementation plan. It should be noted that while the October Statement provides that the work will continue to progress in consultation with stakeholders, the implementation plan provides limited time to policymakers to engage with businesses and other stakeholders.

It is said that technology has made our life simple in many respects but extremely complicated when it comes to determination of source rules for taxation. The Two-Pillar Solution is anything but a simplified, zero-defect multi-prong solution. The OECD Document admits that even the minimum corporate tax rate of 15% is a compromise, as a majority of jurisdictions have a higher corporate tax rate. But then it is said that we all live in an imperfect world, striving towards perfection which is nothing but a mirage.

Acknowledgement: The authors have relied upon various OECD publications and statements, etc., in July and October 2021 for this write-up.)

 

EQUALISATION LEVY ON E-COMMERCE SUPPLY AND SERVICES, PART – 2

In the first of this two-part article published in June, 2021, we analysed some of the issues relating to the Equalisation Levy on E-commerce Supply and Services (‘EL ESS’) – what is meant by online sale of goods and online provision of services; who is considered as an E-commerce Operator (‘EOP’); and what is the amount on which the Equalisation Levy (‘EL’) is leviable.

In this part, we attempt to address some other issues relating to EL ESS such as those relating to the situs of the recipient, turnover threshold and specified circumstances under which EL ESS shall apply. We also seek to understand the interplay of the EL ESS provisions with tax treaties, provisions relating to Significant Economic Presence (‘SEP’), royalties / Fees for Technical Services (‘FTS’) and the exemption u/s 10(50) of the ITA.

1. ISSUES RELATING TO RESIDENCE AND SITUS OF CONSUMER

Section 165A(1) of the Finance Act, 2016 as amended (‘FA 2016’) states that the provisions of EL ESS apply on consideration received or receivable by an EOP from E-commerce Supply or Services (‘ESS’) made or provided or facilitated by it:
a) To a person resident in India; or
b) To a non-resident in specified circumstances; or
c) To a person who buys such goods or services or both using an internet protocol (‘IP’) address located in India.

The specified circumstances under which the ESS made or provided or facilitated by an EOP to a non-resident would be covered under the EL ESS provisions are:
a) Sale of advertisement, which targets a customer who is resident in India, or a customer who accesses the advertisement through an IP address located in India; and
b) Sale of data collected from a person who is resident in India or from a person who uses an IP address located in India.

Therefore, the EL ESS provisions apply to a non-resident EOP if the consumer, to whom goods are sold or services either provided to or facilitated, is a person resident in India, or one who is using an IP address located in India.

Interestingly, the words used in the EL provisions are different from those used in the provisions relating to SEP and the extended source rule in Explanations 2A and 3A to section 9(1)(i) of the ITA, respectively. The EL ESS provisions refer to the recipient of the ESS being a ‘person resident in India’, whereas the SEP provisions in Explanation 2A refer to the recipient of the transaction being a ‘person in India’. Similarly, the extended source rule in Explanation 3A refers to certain transactions with a person ‘who resides in India’.

While the terms ‘person in India’ and person ‘who resides in India’ referred to in Explanations 2A and 3A, respectively, refer to the physical location of the recipient in India, the term ‘person resident in India’ used in the EL provisions would refer to the tax residency of a person. While the EL ESS provisions do not define the term ‘resident’, one would interpret the same on the basis of the provisions of the ITA, specifically section 6.

This may lead to some challenging situations which have been discussed below.

Let us take the example of an EOP who is selling goods online. While such an EOP may have the means to track its customers whose IP address is located in India, how would it be able to keep track of customers who are residents in India but whose IP address is not located in India? This would be typically so in a case where a person resident in India goes abroad and purchases some goods through the EOP. Further, it would also be highlighted that unlike citizenship, the residential status of an individual is based on specific facts and, therefore, may vary from year to year and one may not be able to conclude with surety, before the end of the said previous year, whether or not one is a resident of India. A similar issue would also arise in the case of a company, especially a foreign company having its ‘Place of Effective Management’ in India and, therefore, a tax resident of India.

Similarly, let us take the example of a foreign branch of an Indian company purchasing some goods from a non-resident EOP. In this case, as the branch is not a separate person but merely an extension of the Indian company outside India, the provisions of EL ESS could possibly apply as the goods are sold by the EOP to ‘a person resident in India’.

While one may argue that nexus based on the tax residence of the payer is not a new concept and is prevalent even in section 9 of the ITA, for example in the case of payment of royalty or fees for technical services (‘FTS’), the main challenges in applying the payer’s tax residence-based nexus principle to EL are as follows:
a) While the payments of royalty and FTS may also apply for B2C transactions, the primary application is for B2B transactions. On the other hand, the EL provisions may primarily apply to B2C transactions. Therefore, the number of transactions to which the EL provisions apply would be significantly higher;
b) In the case of payment of royalty and FTS, the primary onus is on the payer to deduct tax at source u/s 195, whereas the primary onus in the case of EL ESS is on the recipient. The payer would be aware of its tax residence in the case of payment of royalty and FTS and, hence, would be able to determine the nexus, whereas in the case of EL the recipient may not be in a position to determine the tax residential status of the payer.

Given the intention of the provisions to bring to the tax net, income from transactions which have a nexus with India and applying the principle of impossibility for the non-resident EOP to evaluate the residential status of the customer, one of the possible views is that one may need to interpret the term ‘person resident in India’ to mean a person physically located in India rather than a person who is a tax resident of India.

However, in the view of the authors, from a technical standpoint a better view may be that one needs to consider the tax residency of the customer even though it may seem impossible to implement in practice on account of the following reasons:
a) Section 165A(1) of the FA 2016 has three limbs – a person resident in India, a non-resident in specified circumstances, and a person who uses an IP address in India. The reference in the second limb to a non-resident as against a person who is not residing in India indicates the intention of the law to consider tax residency.
b) The third limb of section 165A(1) of the FA 2016 refers to a person who uses an IP address in India. If the intention was to cover a person who is physically residing in India under the first limb, this limb would become redundant as a person who uses an IP address in India would mean a person who is physically residing in India at that time. This also indicates the intention of the Legislature to consider a person who is a tax resident rather than a person who is merely physically residing in India under the first limb.
c) Section 165 of the FA 2016 dealing with Equalisation Levy on Online Advertisement Services (‘EL OAS’) applies to online advertisement services provided to a person resident in India and to a non-resident person having a PE in India. Given that the section refers to a PE of a non-resident, it would mean that tax residence rather than physical residence is important to determine the applicability of the EL OAS provisions. In such a case, it may not be possible to apply two different meanings to the same term under two sections of the same Act.

2. SALE OF ADVERTISEMENT

As highlighted above, one of the specified circumstances under which ESS made or provided or facilitated by an EOP to a non-resident would be covered under the EL ESS provisions, is of sale of advertisement which targets a customer who is resident in India, or a customer who accesses the advertisement through an IP address located in India.

The question which arises is in respect of the possible overlap of the EL ESS and the EL OAS provisions. In this respect, section 165A(2)(ii) of the FA 2016 provides that the provisions of EL ESS shall not apply if the EL OAS provisions apply. In other words, the EL OAS application shall override the application of the EL ESS provisions.

EL OAS provisions apply in respect of payment of online advertisement services rendered by a non-resident to a resident or to a non-resident having a PE in India. However, the application of EL ESS provisions is wider. For example, the EL ESS provisions can also apply in the case of payment for online advertisement services rendered by a non-resident to another non-resident (which does not have a PE in India), which targets a customer who is a resident in India or a customer who accesses the advertisement through an IP address located in India.

3. ISSUES IN RESPECT OF TURNOVER THRESHOLD

Section 165A(2)(iii) of the FA 2016 provides that the provisions of EL shall not be applicable where the sales, turnover or gross receipts, as the case may be, of the EOP from the ESS made or provided or facilitated is less than INR 2 crores during the previous year. Some of the issues in respect of this turnover threshold have been discussed in the ensuing paragraphs.

3.1 Meaning of sales, turnover or gross receipts from the ESS

The first question which arises is what is meant by ‘sales, turnover or gross receipts’. The term has not been defined in the FA 2016 nor in the ITA. However, given that the term is an accounting term, one may be able to draw inference from the Guidance Note on Tax Audit u/s 44AB issued by the ICAI (‘GN on tax audit’). The GN on tax audit interprets ‘turnover’ to mean the aggregate amount for which the sales are effected or services rendered by an enterprise. Similarly, ‘gross receipts’ has been interpreted to mean all receipts whether in cash or kind arising from the carrying on of business.

The question which needs to be addressed is this – in the case of an EOP facilitating the online sale of goods, what should be considered as the turnover? To understand this issue better, let us take an example of goods worth INR 100 owned by a third-party seller sold on the portal owned by an EOP whose commission or fees for facilitating such sales is INR 5. Let us assume further that the buyer pays the entire consideration of INR 100 to the EOP and the EOP transfers INR 95 to the seller after reducing the facilitation fees.

In such a case, what would be considered as the turnover for the purpose of determining the threshold for application of EL ESS? As the EL provisions provide that the consideration received or receivable from the ESS shall include the consideration for the value of the goods sold irrespective of whether or not the goods are owned by the EOP, can one argue that the same principle should apply in the case of the computation of turnover as well, i.e., turnover in the above case is INR 100?

In the view of the authors, considering the facilitation fee earned by the EOP as the turnover of the EOP may be a better view, especially in a scenario where the EOP is merely facilitating the sale of goods and is not undertaking the risk associated with a sale. One may draw inference from paragraph 5.12 of the GN on tax audit which, following the principles laid down in the CBDT Circular No. 452 dated 17th March 1986, provides as below:

‘A question may also arise as to whether the sales by a commission agent or by a person on consignment basis forms part of the turnover of the commission agent and / or consignee, as the case may be. In such cases, it will be necessary to find out whether the property in the goods or all significant risks, reward of ownership of goods belongs to the commission agent or the consignee immediately before the transfer by him to third person. If the property in the goods or all significant risks and rewards of ownership of goods belong to the principal, the relevant sale price shall not form part of the sales / turnover of the commission agent and / or the consignee, as the case may be. If, however, the property in the goods, significant risks and reward of ownership belongs to the commission agent and / or the consignee, as the case may be, the sale price received / receivable by him shall form part of his sales / turnover.’

Moreover, section 165A(2)(iii) of the FA 2016 also refers to sales, turnover or gross receipts of the EOP.

Therefore, in the view of the authors, in the above example the turnover of the EOP would be INR 5 and not INR 100.

3.2 Whether global turnover to be considered

Having evaluated the meaning of the term ‘turnover’, a question arises as to whether the global turnover of the EOP is to be considered or only that in relation to India is to be considered. Section 165A(2)(iii) of the FA 2016 provides that the turnover threshold of the EOP is to be considered in respect of ESS made or provided or facilitated as referred to in sub-section (1). Further, section 165A(1) of the FA 2016 refers to ESS made or provided or facilitated by an EOP to the following:
(i) to a person resident in India; or
(ii) to a non-resident in the specified circumstances; or
(iii) to a person who buys such goods or services or both using an IP address located in India.

Accordingly, the section is clear that the turnover in respect of transactions with a person resident in India or an IP address located in India is to be considered and not the global turnover.

3.3 Issues relating to application of threshold of INR 2 crores

Another question is whether the turnover threshold of INR 2 crores applies to each person referred to in section 165A(1) independently or should one aggregate the turnover for all the persons who are covered under the sub-section.

This issue is explained by way of an example. Let us assume that an EOP sells goods to the following persons during the F.Y. 2021-22:

Person

Value of goods sold
(in lakhs INR)

Applicable clause of
section 165A(1)

Mr. A, a person resident in India

50

(i)

Mr. B, a person resident in India

125

(i)

Mr. C, a non-resident under specified circumstances

100

(ii)

Mr. D, a non-resident but using an IP address located in India

25

(iii)

Total

300

 

In the above example, the issues are as follows:
a) As each clause of section 165A(1) refers to ‘a person’, whether such threshold is to be considered qua each person. In the above example, the transactions with each person do not exceed INR 2 crores.
b) As each clause of section 165A(1) is separated by ‘or’, does the threshold need to be applied qua each clause, i.e., in the above example the transactions with persons under each individual clause do not exceed INR 2 crores.

In other words, the question is whether one should aggregate the turnover in respect of sales to all the persons which are covered u/s 165A(1). In the view of the authors, while a technical view that the turnover threshold of INR 2 crores applies to each buyer independently and not in aggregate is possible, the better view may be that the turnover threshold applies in respect of all transactions undertaken by the EOP in aggregate.

Interestingly, the Pillar One solution as agreed amongst the majority of the members of the OECD/G20 Inclusive Framework on BEPS, provides for a global turnover of the entity of EUR 20 billion.

4. INTERPLAY BETWEEN PE AND EL ESS

One of the exemptions from the application of the EL ESS is in a scenario where the EOP has a PE in India and the ESS is effectively connected to such PE. The term ‘permanent establishment’ has been defined in section 164(g) of the FA 2016 to include a fixed place through which business is carried out, similar to the language provided in section 92F(iii) of the ITA. The question arises whether the definition of PE under the FA 2016 would include only a fixed place PE or whether it would also include other types of PE such as service PE, dependent agent PE, construction PE, etc.

In this regard, one may refer to the Supreme Court decision in the case of DIT (International Taxation) vs. Morgan Stanley & Co. Inc.1 wherein the Apex Court held that the definition of PE under the ITA is an inclusive definition and, therefore, would include other types of PE as envisaged in tax treaties as well.

However, in the view of the authors, ‘Service PE’ may not be considered under this definition under the domestic tax law as the duration of service period for constitution of Service PE is different under various treaties and the definition under a domestic tax law cannot be interpreted on the basis of the term given to it under a particular treaty when another treaty may have a different condition. A similar view may also be considered for construction PE where under different tax treaties the threshold for constitution of PE also is different.

5. INTERPLAY BETWEEN EL ESS AND ROYALTY / FEES FOR TECHNICAL SERVICES

Section 163 of the FA 2016 provides that the EL ESS provisions shall not apply if the consideration is taxable as royalty or FTS under the ITA as well as the relevant tax treaty. Similarly, section 10(50) of the ITA also exempts income from ESS if such income has been subject to EL and is otherwise not taxable as royalty or FTS under the ITA as well as the relevant tax treaty.

Accordingly, one would need to apply the royalty / FTS provisions first and the EL ESS provisions would apply only if the income were not taxable as royalty / FTS under the ITA as well as the tax treaty.

Interestingly, when the EL provisions were introduced, the exemption u/s 10(50) of the ITA applied to all income and this carve-out for royalty / FTS did not exist. This amendment of taxation of royalty / FTS overriding the EL provisions was introduced by the Finance Act, 2021 with retrospective effect from F.Y. 2020-21.

Prior to the amendment as mentioned above, one could take a view that transactions which, before the introduction of the EL provisions, were taxable under the ITA at a higher rate, would be subject to EL ESS at a lower rate.

In order to understand this issue better, let us take an example of IT-related services provided by a non-resident online to a resident. Such services may be considered as FTS u/s 9(1)(vii) of the ITA as well as under the tax treaty (assuming the make available clause does not exist). Prior to the amendment made vide Finance Act, 2021, one could take a view that such services may be subject to EL (assuming that the service provider satisfies the definition of an EOP) and therefore result in a lower rate of tax in India at the rate of 2% as against the rate of 10% as is available in most tax treaties. However, with the amendment vide the Finance Act, 2021, one would need to apply the royalty / FTS provisions under the ITA and tax treaty first and only if such income is not taxable, can one apply the EL ESS provisions. Therefore, now such income would be taxed at the FTS rate of 10%.

An interesting aspect in the royalty vs. EL debate is in respect of software. Recently, the Supreme Court in the case of Engineering Analysis Centre of Excellence (P) Ltd. vs. CIT (2021) (432 ITR 471) held that payment towards use of software does not constitute royalty as it is not towards the use of the copyright in the software itself. In fact, the Court reiterated its own view as in the case of Tata Consultancy Services vs. the State of AP (2005) (1 SCC 308) that the sale of software on floppy disks or CDs is sale of goods, being a copyrighted article, and not sale of copyright itself.

It is important to highlight that the facts in the case of Engineering Analysis (Supra) and the way business is at present undertaken are different as software is no longer sold on a physical medium such as floppy disks or CDs but is now downloaded by the user from the website of the seller. A question arises whether one can apply the principles laid down by the above judgment to the present business model.

In the view of the authors, downloading the software is merely a mode of delivery and does not impact the principle emanating from the Supreme Court judgment. The principle laid down by the judgment can still be applied to the present business model wherein the software is downloaded by the user as there is no transfer of copyright or right in the software from the seller to the user-buyer.

Accordingly, payment by the user to the seller for downloading the software may not be considered as royalty under the ITA or the relevant tax treaty.

The next question which arises is whether such download of software can be subject to EL ESS.

Assuming that the portal from which the download is undertaken is owned or managed by the seller, the first issue which needs to be addressed is whether sale of software by way of download would be considered as ESS.

Section 164(cb) of the FA 2016 defines ESS to mean online sale of goods or online provision of services or online facilitation of either or a combination of activities mentioned above.

While the Supreme Court has held that the sale of software would be considered as sale of copyrighted material, the ‘goods’ being referred to by the Court are the floppy disk or CD – the medium through which the sale was made. In the view of the authors, the software itself may not be considered as goods.

Further, such download of software may not be considered as provision of services as well.

One may take inference from the SEP provisions introduced in Explanation 2A of section 9(1)(i) of the ITA, wherein SEP has been defined to mean the following,
‘(a) transaction in respect of any goods, services or property carried out by a non-resident with any person in India including provision of download of data or software in India…’

In this case, one may be able to argue that if the download of software was considered as sale of goods or services, there was no need for the Legislature to specifically include the download of data or software in the definition and a specific mention was required to be made, is on account of the fact that download of software does not otherwise fall under transaction in respect of goods, services or property.

Accordingly, it may be possible to argue that download of software does not fall under the definition of ESS and the provisions of EL, therefore, cannot apply to the same. However, this issue is not free from litigation.

In this regard, it is important to highlight that in a scenario where the transaction is in the nature of Software as a Service (‘SaaS’), it may not be possible to take a view that there is no provision of service and such a transaction may, therefore, either be taxed as FTS or under the EL ESS provisions, as the case may be, and depending on the facts.

6. INTERPLAY BETWEEN EL AND SEP PROVISIONS

Section 10(50) of the ITA exempts income arising from ESS provided the same is not taxable under the ITA and the relevant tax treaty as royalty or FTS and chargeable to EL ESS. Therefore, while the provisions of SEP under Explanation 2A of section 9(1)(i) of the ITA may get triggered if the threshold is exceeded, such income would be exempt if the provisions of EL apply.

In other words, the provisions of EL supersede the provisions of SEP.

7. ORDER OF APPLICATION OF EL ESS

A brief chart summarising the order of application of EL ESS has been provided below:

8. WHETHER EL IS RESTRICTED BY TAX TREATIES

One of the fundamental questions which arises in the case of EL is whether such EL is restricted by the application of a tax treaty. The Committee on Taxation of E-commerce, constituted by the Ministry of Finance which recommended the enactment of EL in 2016, in its report stated that EL which is enacted under an Act other than the ITA, would not be considered as a tax on ‘income’ and is a levy on the services and, therefore, would not be subject to the provisions of the tax treaties which deal with taxes on income and capital.

However, due to the following reasons, one may be able to take a view that EL may be a tax on ‘income’ and may be restricted by the application of the tax treaties:
a. The speech of the Finance Minister while introducing EL in the Budget 2016, states, ‘151. In order to tap tax on income accruing to foreign e-commerce companies from India, it is proposed that …..’;
b. While EL is enacted in the FA 2016 itself and not as part of the ITA, section 164(j) of the FA 2016 allows the import of definitions under the ITA into the relevant sections of the FA 2016 dealing with EL in situations where a particular term is not defined under the FA 2016. Further, the FA 2016 also includes terms such as ‘previous year’ which is found only in the ITA;
c. In order to avoid double taxation, section 10(50) of the ITA exempts income which has been subject to EL. Now, if EL is not considered as a tax on ‘income’, where is the question of double taxation in India;
d. While under a separate Act the assessment for EL would be undertaken by the Income-tax A.O. Further, similar to income tax, appeals would be handled by the Commissioner of Income-tax (Appeals) and the Income Tax Appellate Tribunal, as the case may be;
e. The Committee, while recommending the adoption of EL, stated that such an adoption should be an interim measure until a consensus is reached in respect of a modified nexus to tax such transactions. Therefore, it is clear that the EL is merely a temporary measure until India is able to tax the transactions and EL would take the colour of a tax on ‘income’.

This view is further strengthened in a case where Article 2 of a tax treaty covers taxes which are identical or substantially similar to income tax. Most of the tax treaties which India has entered into have the clause which covers substantially similar taxes. In such a scenario, one may be able to argue that even if one considers EL as not an income tax, it is a tax which is similar to income tax on account of the reasons listed above and therefore would get the same tax treatment.

Further, one may consider applying the principles of the Vienna Convention on the Law of Treaties (VCLT) to determine whether EL would be restricted under a tax treaty. Article 31(1) of the VCLT provides that:
‘A treaty shall be interpreted in good faith in accordance with the ordinary meaning to be given to the terms of the treaty in their context and in light of its object and purpose.’

The object of a tax treaty is to allocate taxing rights between the contracting states and thereby eliminate double taxation. In case EL is held as not covered under the ambit of the tax treaty, it would defeat the object and purpose of the tax treaty and lead to double taxation. In this regard, it may be important to highlight that while India is not a signatory to the VCLT, VCLT merely codifies international trade practice and law.

However, courts would also take into account the intention of the Legislature while adopting EL. EL has been adopted in order to override the tax treaties as such treaties were not able to adequately capture taxing rights in certain transactions.

9. CONCLUSION


On 1st July, 2021, more than 130 countries out of the 139 members of the OECD / G20 Inclusive Framework on BEPS released a statement advocating the two-pillar solution to combat taxation of the digitalised economy and unfair tax competition. While the details are yet to be finalised, it is expected that the implementation of Pillar One would result in the withdrawal of the unilateral measures enacted, such as the EL. However, given the high threshold agreed for application of Pillar One, it is expected that less than 100 companies would be impacted by the reallocation of the taxing right sought to be addressed in the solution. Therefore, whether such unilateral measures would be fully withdrawn or only partially withdrawn to the extent covered by Pillar One, is still not clear. Further, the multilateral agreement proposed under Pillar One would be open for signature only in the year 2022 and is expected to be implemented only from the year 2023. Accordingly, EL provisions would continue to be applicable, at least for the next few years.

OVERVIEW OF BENEFICIAL OWNERSHIP REGULATIONS (INCLUDING RECENT UAE REGULATIONS)

1. INTRODUCTION

Tax
transparency continues to be a key focus of governments and the public, as
demonstrated by the continuing media coverage surrounding data leaks in recent
years. The availability of beneficial ownership information, i.e., the natural person
behind a legal entity or arrangement, is now a key requirement of international
tax transparency and the fight against tax evasion and other financial crimes.

 

The recent
movement towards transparency has its origins in international standards adopted
primarily to combat cross-border money laundering, corruption and financial
crimes.

 

One of the most
pressing corporate governance issues today is the growing trend towards
increased corporate transparency. Public and private companies around the world
are being mandated to identify and disclose the details of their Ultimate
Beneficial Owners (‘UBOs’) i.e., the individuals who ultimately own or control
them. Corporate transparency has also made its way into mainstream discourse.

 

Data leaks such
as the Panama Papers in 2016 and the Paradise Papers in 2017 have thrown the
spotlight on complex corporate structures, the identity of ‘true’ owners and
general tax avoidance.

 

In April, 2016 the public as well as media commentators were taken by
surprise by the leak of over 11.5 million confidential documents from Mossack
Fonseca, a Panamanian law firm. The so-called ‘Panama Papers’ scandal serves as
an example of how the rich and powerful in some cases may have used complex
legal structures to conceal their beneficial ownership in offshore
subsidiaries. The Panama Papers scandal has provided an opportunity to
policy-makers the world over to call for stricter rules to promote the
disclosure of ultimate beneficial ownership.

Legislators and
regulators have renewed their focus on corporate transparency, extending their
reach beyond anti-money laundering measures solely applicable to the financial
sector.

 

GLOBAL MEASURES TO IMPROVE TRANSPARENCY

The G8 Summit
in 2013, as a part of the fight against money laundering, tax avoidance and
corruption, exerted enormous pressure on countries to improve transparency to
ensure that the true owners of a corporate body or other entities can be
traced, instead of remaining hidden behind complex structures.

 

The Financial
Action Task Force (FATF), which is playing a significant role in respect of the
establishment of beneficial ownership regulations in various jurisdictions
across the globe, is an independent inter-governmental body that develops and
promotes policies to protect the global financial system against money
laundering, terrorist financing and the financing of weapons of mass
destruction. The FATF currently comprises 37 member jurisdictions and two
regional organisations, i.e., the European Commission and the Gulf Co-operation
Council, representing major financial centres in all parts of the world. India
is also a member of the FATF.

 

The ‘International
Standards on Combating Money Laundering and the Financing of Terrorism &
Proliferation’ issued by the FATF (FATF Recommendations) are recognised as
the global Anti-Money Laundering (AML) and Counter-Terrorist Financing (CFT)
standards. Various amendments have been made to the FATF recommendations since
the text was adopted by the FATF Plenary in February, 2012, the latest
amendments being made in October, 2020. In addition, in respect of ‘Beneficial
Ownership’ the FATF has also published the following:

 

a) Best
Practices on Beneficial Ownership for Legal Persons (in October, 2019);

b) The Joint
FATF and Egmont Group Report on Concealment of Beneficial Ownership (July,
2018);

c) The FATF
Horizontal Study: Enforcement and Supervision of Beneficial Ownership
Obligations (2016-17); and

d) FATF
Guidance on Transparency and Beneficial Ownership (October, 2014).

 

‘FATF Recommendation
# 24’ requires jurisdictions to ‘ensure that there is adequate, accurate and
timely information on the beneficial ownership and control of legal persons
that can be obtained or accessed in a timely fashion by competent authorities’.

 

OECD VIEW

OECD considers
beneficial ownership information at the heart of the international tax
transparency standards: both the exchange of information on request (the EOIR
Standard) and the automatic exchange of information (the AEOI Standard).

 

OECD considers
that from a tax perspective, knowing the identity of the natural persons behind
a jurisdiction’s legal entities and arrangements not only helps that
jurisdiction preserve the integrity of its own tax system, but also gives
treaty partners a means of better achieving their own tax goals. Transparency
of ownership of legal entities and arrangements is also important in fighting
other financial crimes such as corruption, money laundering and terrorist
financing so that the real owners cannot disguise their activities and hide
their assets and the financial trail from law enforcement authorities using
layers of legal structures spanning multiple jurisdictions.

 

In this regard
OECD has published ‘A Beneficial Ownership Toolkit’ prepared by the Secretariat
of the Global Forum on Transparency and Exchange of Information for Tax
Purposes.

 

However, in the
context of beneficial ownership referred to in Articles 10, 11 and 12 of the
Model Tax Convention, OECD’s view on ‘beneficial ownership’ is a little
different. For example, in the context of the Commentary on Article 10,
paragraph 12.6 explains as under:

 

‘12.6 The above
explanations concerning the meaning of “beneficial owner” make it clear that
the meaning given to this term in the context of the Article must be distinguished
from the different meaning that has been given to that term in the context of
other instruments1 that concern the determination of the persons
(typically the individuals) that exercise ultimate control over entities or
assets. That different meaning of “beneficial owner” cannot be applied in the
context of the Article. Indeed, that meaning, which refers to natural persons
(i.e. individuals), cannot be reconciled with the express wording of
subparagraph 2 a), which refers to the situation where a company is the
beneficial owner of a dividend. In the context of Article 10, the term
“beneficial owner” is intended to address difficulties arising from the use of
the words “paid to” in relation to dividends rather than difficulties related
to the ownership of the shares of the company paying these dividends. For that
reason, it would be inappropriate, in the context of that Article, to consider
a meaning developed in order to refer to the individuals who exercise “ultimate
effective control over a legal person or arrangement.”’

 

Let us look at
specific measures taken by some key jurisdictions for improving transparency
through enhanced disclosures regarding beneficial ownership and control of
legal ownership.

 

2. DISCLOSURE REQUIREMENTS IN CERTAIN KEY JURISDICTIONS

One key measure
introduced by various countries is the requirement to prepare and maintain a
register identifying the ‘owners’ of the company. Specific reporting and
disclosure requirements vary by jurisdiction, with some countries requiring the
register to be publicly filed and others allowing for the register to be
privately held but accessible to government authorities.

 

a)         India

Section 89(10)
of the Companies Act, 2013 defining ‘beneficial interest’ was inserted and
section 90 dealing with the Register of Significant Beneficial Owners (‘SBOs’)
in a company was substituted by the Companies (Amendment) Act, 2017 w.e.f. 13th
June, 2018. Section 90 as amended by the Companies (Amendment) Act, 2019
contemplates a statutory piercing of the corporate veil to find out which
individuals are SBOs of the reporting company. Section 90 has an
extra-territorial operation and would apply to foreign registered trusts and
persons who are residents outside India. Hence, its remit is very broad and
affects a number of stakeholders.

 

The Companies
(Significant Beneficial Owners) Rules, 2018 were prescribed effective from 13th
June, 2018 and have been substantially amended by the Companies
(Significant Beneficial Owners) Amendment Rules, 2019 w.e.f. 18th February,
2019. Whilst the amended SBO Rules are a marked improvement over the previous
ones, there still exists a considerable amount of ambiguity with regard to
determination of the SBO in certain situations.

 

b) Mauritius

The Mauritian
Companies Act, 2001 was amended in 2017 to provide that the share register of
companies should disclose the names and last known addresses of the beneficial
owners / ultimate beneficial owners where shares are held by a nominee. By the
Finance (Miscellaneous Provisions) Act, 2019 the requirement was further
amended to provide that the company shall also keep an updated record of (a)
beneficial ownership information, and (b) actions taken to identify a
beneficial owner or an ultimate beneficial owner. The 2019 definition is far-reaching
and brings thereunder persons who would otherwise not have been considered as
beneficial owners under the 2017 definition.

 

The Registrar
of Companies issued Practice Direction (No. 3 of 2020) pursuant to sections
12(8) and 91(8) of the Companies Act, 2001 on 16th March, 2020
regarding Disclosure of Beneficial Owner or Ultimate Beneficial Owner to the
Registrar of Companies and to assist stakeholders to better understand the
provisions of the law relating to Beneficial Owners.

 

c) Singapore
(private register)

In Singapore,
the measures to improve the transparency of ownership and control are included
in legislation regulating all entities having a separate legal personality,
such as companies, limited liability partnerships and trusts and are contained
in the latest versions of the Companies Act, Limited Liability Partnerships Act
and the Trustees Act.

 

The disclosure
requirements came into force on 31st March, 2017. Under the Companies
Act the disclosure requirements require Singapore companies to maintain a
Register of Registrable Controllers (‘RORC’) and a Register of Nominee
Directors (‘ROND’). Foreign companies registered to carry on business in
Singapore (which includes Singapore branches of foreign companies) are also
required to maintain an RORC as well as a Singapore-based Register of Members.

 

The term controller
refers to an individual or legal entity that has a ‘significant interest’ or
‘significant control’ over a company. Controllers have an obligation to provide
their data for the Register.

 

The RORC is a
private company document listing all controllers and beneficial owners of a
company. It is not available to the public. The Register must include the
beneficial owners’ names and identifying details, as well as information about
their citizenship or places of registration in the case of legal entities.

 

The Accounting
and Corporate Regulatory Authority (ACRA), the national regulator of business
entities, has issued guidelines to help companies understand and comply with
the requirements pertaining to the RORC.

 

d) United
Kingdom (public register)

Since April,
2016 most companies incorporated in England and Wales have been required to
keep a register of ‘people with significant control’ and to file a copy of the
same with Companies House, the local registrar. These requirements were first
introduced in the Companies Act, 2006 and the Register of People with
Significant Control Regulations, 2016, before being extended to comply with
the EU Directive through the Information about People with Significant
Control (Amendment) Regulations, 2017. Each company’s register is public
and there is no charge to access the register.

 

e) The EU
Directive

The Fourth
Money Laundering Directive [(EU) 2015/849] as supplemented and amended by
the Fifth Money Laundering Directive [(EU) 2018/843] (together, the ‘EU
Directive’) came into force in the European Union in 2017. The EU Directive
leads the largest multinational effort to harmonise measures against money
laundering and financial crime across the member states. Article 30, in
particular, requires member states to ensure that companies incorporated within
their jurisdiction obtain and hold adequate, accurate and current information
on their beneficial owners, including details of the beneficial interests held.
Such information should be held in a central register (in the relevant member
state) and be accessible to specified authorities, firms carrying out customer
due diligence and any other person or organisation able to demonstrate a
legitimate interest. The EU Directive also provides that mechanisms to verify
that such information is adequate, accurate and current should be put in place
and breaches should be subject to effective, proportionate and dissuasive
measures or sanctions.

 

Although the EU
Directive applies to all member states, as a minimum harmonising directive,
each member state must adopt national implementing legislation that is equally
or more stringent than the EU Directive. The majority of member states have yet
to implement adequate centralised registers and for those countries that have
implemented the registers, the regime looks slightly different in each
jurisdiction.

 

f) France
(private register)

The EU Directive
was transposed into French law by Ordinance No. 2016-1635 in December,
2016, clarified by the Decree No. 2017 – 1094 in June, 2017 and
re-enforced by Decree No. 2020-118 in February, 2020. Companies and
other entities registered with the Trade and Companies Registry (Registre du
Commerce et des Societes) have to obtain and maintain up-to-date and
accurate information on their UBOs. This information must then be sent to the
court clerk office.

 

g) United
States of America (no register)

There are
currently no specific requirements to disclose information on ‘beneficial
owners’ of US corporations or limited liability companies. However, on 22nd
October, 2019 the US House of Representatives passed the Corporate
Transparency Act of 2019 (HR 2513) (CTA). If passed in the Senate, the CTA
would bring the US in line with international standards governing the
disclosure of beneficial ownership and would require applicants seeking to form
a corporation or limited liability company to file a report with the Financial
Crimes Enforcement Network (FinCEN) listing the beneficial owners of the entity
and to update this report annually.

 

If enacted, the
CTA would cover any corporation or limited liability company formed under any
state law as well as any non-US entity eligible to register to do business
under any state law. Certain exceptions would apply for entities such as
issuers of registered securities.

 

The CTA defines
a beneficial owner as ‘a natural person who, directly or indirectly, through
any contract, arrangement, understanding, relationship or otherwise exercises
substantial control over a corporation or limited liability company, or owns
25% or more of the equity interests of a corporation or limited liability
company, or receives substantial economic benefits from the assets of a
corporation or limited liability company’. The definition excludes certain
natural persons, including employees of corporations or limited liability
companies whose control of the entity is a result of their employment.

 

h) Canada
(private register)

By way of
background, Canadian corporations can be governed under the federal corporate
statute in Canada, the Canada Business Corporations Act (CBCA),
or under the corporate statute in any province or territory in Canada.
Corporations organised and existing under the CBCA are required to prepare and
maintain a register of individuals with significant control since June, 2019.

 

i) China
(private register)

The Measures
for the Reporting of Foreign Investment Information issued by the Ministry
of Commerce (MOFCOM) and the State Administration for Market Regulation (the
AMR) effective from January, 2020 (the Measures) prescribe disclosure
requirements for the ‘ultimate actual controller’ of a foreign-investment
entity in the People’s Republic of China. Details of the ultimate actual
controller must be provided using the AMR’s online enterprise registration
system. The information will then be shared with the MOFCOM.

 

j) Brazil
(private register)

Provisions
similar to the EU Directive came into force in May, 2016 through the Normative
Instruction No. 1,634 (NI 1,634/2016) as amended by Normative
Instruction No. 1,863 (NI 1,863/2018) (the Normative Instruction). Pursuant
to the Normative Instruction, upon enrolment with the National Corporate
Taxpayers Registry (Cadastro Nacional da Pessoa Juridica or CNPJ) or
upon request by the tax authorities, certain entities must disclose old and new
registers of UBOs.

 

k) British
Virgin Islands

The Beneficial
Ownership Secure Search System Act, 2017 (the BOSS Act) came into force in the
BVI on 30th June, 2017. The BOSS Act was almost immediately amended
by the Beneficial Ownership Secure Search System (Amendment) Act, 2017, which
also came into force on 30th June, 2017.

 

This BOSS Act
facilitates the effective storage and retrieval of beneficial ownership
information for all BVI companies and legal entities using the Beneficial
Ownership Secure Search system.

 

The BVI Government signed an exchange of notes agreement with the UK
Government in April, 2016. The Beneficial Ownership Secure Search system is
built to ensure that the BVI can efficiently exchange that information in
relation to the exchange of notes. The beneficial ownership information in the
system will also be available to other authorities in the BVI to ensure that
they are able to meet their international obligations. Importantly, the system
will not be accessible by the public.

 

Under section
9(6) of the BOSS Act, the obligation to provide updated beneficial ownership
information rests on the BVI company. A BVI company that fails to comply with
this section commits an offence and may be subject to a fine of up to US
$250,000 or to imprisonment for a term not exceeding five years, or both.

 

l) Jersey

Jersey adopted
the Financial Services (Disclosure and Provision of Information) (Jersey) Law
2020 (Disclosure Law) on 14th July, 2020 and registered it in the
Royal Court of Jersey on 23rd October, 2020.

 

The intention
of the Disclosure Law is to place on a statutory footing the ‘FATF’s
Recommendation # 24’ relating to the beneficial ownership of legal persons. The
Disclosure Law seeks to maintain the current situation whereby the Jersey
Financial Services Commission (Commission) collects and makes public certain
information, but enables the State of Jersey to make regulations which
determine additional information which may be made public.

 

The Disclosure
Law will come into effect on 6th January, 2021 and, consequently,
the filing deadline for the new annual confirmation statement will be 30th
April, 2021.

 

m) Cayman
Islands

Under the Cayman Islands beneficial ownership legislation, i.e., The Companies
Law (Revised), The Limited Liability Companies Law (Revised), The Beneficial
Ownership (Companies) Regulations, 2017, The Beneficial Ownership (Companies)
(Amendment) Regulations, 2018, The Beneficial Ownership (Limited Liability
Companies) Regulations, 2017 and The Beneficial Ownership (Limited Liability
Companies) (Amendment) Regulations, 2018 (the Legislation), certain Cayman
Islands companies are required to maintain details of their beneficial owners
and relevant legal entities on a beneficial ownership register. The registers
are not publicly available, although they can be searched in limited
circumstances by the competent authority in the Cayman Islands.

 

n) Isle of Man

The Isle of
Man’s ‘Beneficial Ownership Act, 2017’ (the Act) came into effect on 21st
June, 2017 repealing the previous 2012 legislation. Subsequently, the new
central database for the storage of the data to be collected under the Act (the
Isle of Man Database of Beneficial Ownership) went live on 1st July,
2017. The Act has been introduced in response to the global initiative to
improve transparency as to asset ownership and control, similar to legislation
introduced in other jurisdictions. The Act introduces important changes which
affect legal entities incorporated in the Isle of Man, the main objective of
which is to ensure that the beneficial ownership of Isle of Man bodies
(companies) can be traced back to the ‘ultimate beneficial owners’.

 

The Beneficial
Ownership (Civil Penalties) Regulations, 2018 contain civil penalties for
contravention of the various provisions of the Act.

 

o) Guernsey

The Beneficial
Ownership of Legal Persons (Guernsey) Law, 2017 came into force on 15th
August, 2017. Since that date, all Guernsey companies have been required to
file beneficial ownership information. New companies must file beneficial
ownership information on incorporation. All companies must ensure that any
changes in the beneficial ownership information are submitted to the Registry
within 14 days. Resident-agent exempt entities are not required to file a
beneficial ownership declaration.

 

The definition
of beneficial ownership for the purposes of registration is set out in The
Beneficial Ownership (Definition) Regulations, 2017.

 

From the above
discussion it is evident that most of the tax heavens have done away with
bearer securities and now the disclosure of the BO is mandatory.

 

3. UNITED ARAB EMIRATES (UAE)

A. UAE
Anti-Money Laundering Law

The UAE Federal
Decree law No. (20) of 2018 dated 23rd September, 2018 (which was
issued on 30th October, 2018) on Anti-Money Laundering and Combating
the Financing of Terrorism and Financing of Illegal Organisations (UAE
Anti-Money Laundering Law) together with Cabinet Decision No. (10) of 2019
concerning the implementing regulation of Decree law No. (20) of 2018 comprises
the UAE Anti-Money Laundering Law.

 

Article 9 of
the Cabinet Decision No. (10) of 2019 placed an obligation on corporate
entities to disclose any individual ownership (whether beneficial or actual) in
an entity which owns 25% or more of the company, to the relevant regulator.

 

B. Regulation
of the Procedures of the Real Beneficiary

(i)         The UAE on 24th
August, 2020 issued Cabinet Resolution No. 58 of 2020 (Resolution 58) on the Regulation
of the Procedures of the Real Beneficiary (RB Regulations).

 

Let us study
some of the salient features of these Regulations.

 

(ii)        Entry into effect

The RB
Regulations came into effect on 28th August, 2020. Article (19) of the
Regulations repealed the earlier Cabinet Resolution No. 34 of 2020 on the
Regulation of the Procedures of the Real Beneficiary (issued earlier in 2020)
as well as any provision that violates or contradicts the provisions of the
Resolution No. 58.

 

One of the main
drivers for the introduction of the RB Regulations is the above-referred
Federal Decree Law No. 20 of 2018 and its implementing regulation, Cabinet
Decision No. (10) of 2019, which deals with anti-money laundering crimes and
combating the financing of terrorism and of unlawful organisations and is
generally in accordance with the UAE’s recent legislation to increase
transparency in its business environment.

 

(iii)       Objectives of the Regulations

The stated aim
and objective of the RB Regulations is (a) to contribute to the development of
the business environment, the state’s capabilities and its economic standing in
accordance with international requirements, by organising the minimum
obligations of the registrar and legal persons in the state, including
licensing or registration procedures, and organising the real beneficiary
register and the partners or shareholders register, and (b) develop an
effective and sustainable implementation and regulatory mechanism and
procedures for the real beneficiary data.

 

The RB Regulations address the disclosure requirements at the corporate
registration stage as well as the requirement to subsequently maintain ‘The
Partners or Shareholders Register’ and the ‘Real Beneficiary Register’.

 

(iv) Compliance
requirements

Article 8(1) of
the RB Regulations provides that ‘The Legal Person shall, within sixty (60)
days from the date on which this Resolution is effective or the date the Legal
Person’s presence, keep the information of each Real Beneficiary in the Real
Beneficiary Register he creates. The Legal Person shall also update this
Register and include any change occurring thereto within fifteen (15) days from
the date of being aware thereof.’

Further,
Article 11(1) provides that a legal person shall, within 60 days from the date
of the publication of the Resolution, i.e., 28th August, 2020 or the
date of the Legal Person’s registration or license, provide the Registrar with
the information of the Real Beneficiary Register or the Partners or Shareholders
Register. The Legal Person shall take reasonable measures to preserve its
registers from damage, loss or destruction.

 

Since the
Resolution 58 became effective from 28th August, 2020, within 60
days therefrom, i.e., by 27th October, 2020, all the existing
companies were required to file the beneficial ownership information with the
relevant Registrar.

 

(v) Scope of
the Regulations

The RB
Regulations cover all corporate entities that are licensed or registered in the
UAE (including in any commercial free zones) (an Entity / a legal person).

 

The only
entities that are not covered by the RB Regulations are wholly-owned government
entities (and their subsidiaries) and entities that are established within the
UAE’s two financial free zones, i.e., the Dubai International Financial Centre
and the Abu Dhabi Global Market. However, corporate entities licensed in these
financial free zones should nevertheless take note of the disclosure
requirements of Resolution 58 if they have shareholdings in onshore or other
commercial free zone companies in the UAE.

 

The RB
Regulations provide a more robust and prescriptive regime to record and
disclose ultimate beneficial ownership of UAE entities.

 

(vi) Meaning of
‘Real Beneficiary’

Article 1
defines the term ‘Real Beneficiary’ as follows:

‘A Legal Person who has the ultimate ownership or exercises ultimate control over a
Legal Person, directly or through a chain of ownership or control, or other
indirect means, as well as the Natural Person who conducts transactions
on behalf thereof, or who exercises
ultimate effective control over a Legal Person, that is determined according
to the provision of Article (5) hereof.’

 

Thus, the term
Real Beneficiary is used in the RB Regulations to describe an Ultimate Beneficial
Owner.

 

Article 5
contains the provisions relating to Real Beneficiary Identification. Article
5(1) provides that whoever either

(i)         owns or finally controls 25% or more of
an entity’s shares directly or indirectly; or

(ii)        has the right to vote representing 25% or
more of an entity’s shares directly or through a chain of ownership and
control; or

(iii)       controls the entity through any other
means, such as by appointing or dismissing the majority of directors

shall be
considered as the Legal Person’s Real Beneficiary.

 

While
determining whether someone is a ‘real beneficiary’, it is important to look
through any number of legal persons or arrangements of any kind, intermediaries
or other entities that are used in a chain of ownership / control so as to
identify the ultimate natural person.

 

It is
worthwhile to note that the term ‘Legal Person’ is not defined in the Federal
Law No. 2 of 2015 on Commercial Companies, or the UAE Anti-Money Laundering
Law, or the RB Regulations. Therefore, it has to be understood in its ordinary
meaning as compared to a natural person and meaning as companies or corporate
entities.

 

However, in the
context of Article 5(2) for real beneficiary identification which uses the term
legal ‘arrangements’, in Article 1 of the UAE Anti-Money Laundering Law, the
term ‘Legal Arrangement’ has been defined as under:

 

‘Legal
Arrangement: A relationship established by means of a
contract between two or more parties which does not result in the creation of a
legal personality such as trust funds or other similar arrangements.’

 

Further, ‘real
beneficiary’ includes any joint or co-owners of particular shares (such as
family members holding shares through a trust or similar structure). The RB
Regulations are clear that it is both direct and indirect ownership / control
that are to be considered.

 

If it is not
possible to ascertain whether anyone is considered to be a ‘real beneficiary’
based on any of the tests set out above, then the natural person who occupies
the senior management position (i.e., the decision-making authority of an
entity) will be deemed to be the ‘real beneficiary’ under the RB Regulations.

 

Given the
breadth of the RB Regulations, specifically, the definition of ‘real
beneficiary’, there is a view that a beneficiary under a nominee arrangement
would be within the scope of the RB Regulations, i.e., the beneficiary would be
considered as holding shares or exercising control in spite of it doing so
through a nominee.

(vii)
Disclosure requirements and registers

As per Articles
8 and 10 of the RB Regulations, from 27th October, 2020 all entities
covered within the scope of the Regulations must keep the Real Beneficiary
Register and Partners or Shareholders Register (the Registers).

 

a) Real
Beneficiary Register

However,
Article (8)(2) of the RB Regulations sets out specific information that should
now be maintained in relation to each Real Beneficiary. The Real Beneficiary
Register must include the following information for each Real Beneficiary of an
entity:

  •             the name,
    nationality, date and place of birth;
  •             the place of
    residence or address to which notifications can be sent;
  •             the Emirates ID
    number or passport number and its date of issuance and expiration;
  •             the basis for, and
    the date upon which, the individual became a real beneficiary; and if
    applicable, the date upon which the individual ceases to be a real
    beneficiary.

 

b) Partners or
Shareholders Register

The requirement
to keep a Shareholder Register is not new in the UAE as Article 260 of the UAE
Federal Law No. 2 of 2015 on Commercial Companies provides that ‘Private
Joint Stock Companies shall have a register where the names of the shareholders,
the number of shares held by them and any dispositions of the shares are
entered. Such register shall be delivered to the shares register secretariat.’

 

Now under the
RB Regulations, the following information is required to be kept in the
Partners or Shareholders Register:

  •             the number and
    class of shares held and the voting rights associated with such shares;
  •             the date on which
    the partner / shareholder became the owner of such shares;
  •          For every partner /
    shareholder who is a person:

•           the nationality;

•           address;

•           place of birth;

•           name and address of employer; and

•           a true copy of a valid Emirates ID or
passport.

  •          For every partner /
    shareholder that is a legal entity:

•           the name, legal form and a copy of
its Memorandum of Association;

•           the address of the main office or
headquarters of the entity, and if it is a foreign entity, the name and address
of its legal representative in the UAE and the supporting documentation
providing proof of such information;

•           the ‘statute’ or any other similar
documents approved by the relevant authorities concerned with the
implementation of the UAE’s anti-money laundering laws and regulations; and

•           the details of the person(s) who hold
senior management positions.

 

(viii) Trustees
and nominal management members

In addition to
the details of partners / shareholders, a legal person, i.e., corporate entity,
must also maintain the same information required for real beneficiaries, for
any trustees or board nominal members (nominal members) as part of its Partners
or Shareholders Register.

 

The RB
Regulations broadly define a ‘Board nominal member’ as a natural member
acting in accordance with the guidelines, instructions or will of another
person. A ‘Trustee’ means a natural or legal person enjoying the rights
and powers granted to him by the testator or the trust fund under which he
manages, uses and disposes of the testator’s funds in accordance with the
conditions imposed on him by any of them.

 

As per the
provisions of Article 9(1), all nominal members must notify and submit the
required information to the legal person within 15 days of being appointed as a
nominal member. In addition, a legal person is required to disclose the details
concerning the interests or shares and identity of the holders of any shares
issued in the names of persons or nominee members within 15 days of such
issuance to the relevant authority.

 

All existing
nominal members are required to notify the legal person and submit the relevant
information for recording their data in the Partners or Shareholders Register
within 30 days of the RB Regulation’s publication date, 28th August,
2020, i.e., by 27th September, 2020.

 

Any changes to
nominee members (including their particulars) must be notified by the nominee
members to the Entity within 15 days of such a change taking place.

 

(ix)
Compliances deadlines

The Registers
need to be created and filed with the Registrar from 27th October,
2020 onwards. Newly-incorporated legal persons will need to file the Registers
with the Registrar within 60 days of incorporation.

 

A legal person
is primarily responsible for maintaining and filing the Registers and must take
reasonable measures to obtain accurate and updated information regarding its
real beneficiaries on an ongoing basis. However, if a real beneficiary is
licensed or registered in the UAE or is listed (or owned by a company that is
listed) on a reputable exchange that has adequate disclosure and transparency
rules, then a legal person can rely on the information that such a company may
have filed or disclosed to the relevant regulators without having to make
further investigations as to the validity of such information.

 

Any change to
the information contained in the Registers must be updated and notified to the
Registrar within 15 days of such change. A legal person must also appoint, and
subsequently notify the Registrar, of a person who is resident in the UAE and
is authorised by the legal person to submit all information and Registers
required under the RB Regulations.

 

It is worth
noting that there is a positive obligation on legal persons to act if they
become aware of a person that could be a real beneficiary but who is not listed
as such in the Registers.

 

In those
circumstances, a legal person must send an inquiry to the suspected real
beneficiary and, if they do not receive a response within 15 days, must send a
formal notice (with certain prescribed information included) asking the person
to confirm whether he is a real beneficiary. If the suspected real beneficiary
fails to respond to such notice within 15 days, then the details of that person
must be entered on the Registers. If a person/s thinks they have been
incorrectly recorded as a real beneficiary on a legal person’s register, then
an application to a competent court in the UAE can be made to correct the
information.

 

Article 11(5)
of the RB Regulations provides that no legal person who is licensed or
registered in the UAE may issue bearer share guarantees.

 

In regard to
companies that are under dissolution or liquidation, the appointed liquidator
has an obligation to provide a true copy of the updated Real Beneficiary
Register to the Registrar within 30 days of the liquidator’s appointment.

 

(x)
Confidentiality

The Registrar
is required to keep information that is disclosed to it under the RB
Regulations confidential and not to disclose such information without approval
from the person involved. However, the UAE Government may disclose information
it receives under the RB Regulations to third parties in order to comply with
international laws and agreements that are in place, in particular those aimed
at countering money laundering and the financing of terrorism.

 

(xi) Penalties

At present, the
RB Regulations do not include specific penalties for violations. However,
Article 17 provides that the Minister of Economy or the delegated authorities
may impose one or more sanctions from the Administrative Sanctions Regulations.

 

It is expected
that a list of penalties and sanctions for non-compliance will be issued soon
along with a framework and additional guidance on how information is to be
collected and submitted.

 

(xii) Local and
international co-operation

Article 16 of
the RB Regulations provides that the Ministry of Economy will share the
information and data provided by a legal person, including from the legal
person’s Real Beneficiary and Partners or Shareholders Register, with the
Government entities tasked with enforcing the UAE anti-money laundering regime.

 

Besides, the Ministry of Economy will facilitate international
co-operation by allowing foreign authorities access in certain circumstances to
the data from the Real Beneficiary Register and the Partners or Shareholders
Register.

 

4. THE ROAD AHEAD – RECOMMENDED STEPS FOR THE MNES

It is undeniable that there is a trend towards increased corporate
ownership transparency around the world. However, despite the international
push towards transparency, local frameworks for determining and reporting
beneficial ownership remains inconsistent, with specific requirements varying
from jurisdiction to jurisdiction.

The current
lack of consistency poses unique challenges for multinationals managing the
various compliance requirements in different jurisdictions, including the
different information that needs to be provided and timelines imposed for
reporting.

 

In addition,
the underlying legislation in many jurisdictions remains new and subject to
refinement through interpretative guidance and accompanying regulations that
have yet to be published.

 

As with all
disclosure obligations, companies need to strike a balance between providing
sufficient and accurate information while avoiding over-disclosure that can
cause confusion.

 

5.  CONCLUSION

UAE’s RB
Regulations’ objective is to bring the country’s company registration process
in line with international standards and further enhance the State’s
co-operation with its international counterparts in the common effort of
combating money laundering, terrorism and criminal financing. It does not seek
to recognise or regulate a new legal concept such as equitable interests but
merely acknowledges that such type of interest exists and is recognised under
the legal framework of some of its international counterparts.

 

In this article
we have given brief information about some of the illustrative jurisdictions
where beneficial ownership regulations have been introduced / expanded. While
incorporating any entity in any foreign jurisdiction, it would be advisable to
keep in mind the beneficial ownership regulations in those jurisdictions.

 

Readers would be well advised to carefully look into applicable
Beneficial Ownership Regulations along with Guidance, clarifications, etc.,
provided thereon, before taking necessary action in respect of the same.

 

 

 

2020
Returns in US Markets

Tesla $TSLA: +743%

Peloton $PTON: +434%

Moderna $MRNA: +434%

Zoom $ZM: +396%

Bitcoin: +304%

 

$AAPL: +82%

$AMZN: +76%

Nasdaq 100 $QQQ: +49%

$MSFT: +43%

$GOOGL: +31%

 

Gold: +24%

Small Caps $IWM: +20%

S&P $SPY: +18%

LT Treasuries $TLT: +18%

Oil: -21%

 

— via @charliebilello

 

 

 

TRANSFER PRICING – BENCHMARKING OF CAPITAL INVESTMENTS AND DEBTORS

1.   INTRODUCTION

Benchmarking of
financial transactions is an integral part of the Transfer Pricing Regulations
of India (TPR). The Finance Act, 2012 inserted an Explanation to section 92B of
the Income-tax, Act 1961 (the ‘Act’) with retrospective effect from 1st
April, 2002 dealing with the meaning of international transactions. Interestingly,
the Notes on Clauses of the Finance Bill, 2012 is silent on the intent and
purpose of inclusion of such transactions within the definition of
‘international transaction’. Clause (i)(c) of the said Explanation reads as
follows:

 

‘Explanation. –
For the removal of doubts, it is hereby clarified that –

(i) the
expression “international transaction” shall include –

(a) ….

(b) ….

(c) capital
financing, including any type of long-term or short-term borrowing, lending or
guarantee, purchase or sale of marketable securities or any type of advance,
payments or deferred payment or receivable or any other debt arising during the
course of business;

(d) ….

(e) ….’

 

Since financial
transactions are peculiar between two enterprises, it is hard to find comparables
in many cases. In this article we shall deal with some of the possible options
to benchmark some of these transactions to arrive at an arm’s length pricing
and / or discuss controversies surrounding them.

 

It may be noted
that Clause 16 of the Annexure to Form 3CEB requires the reporting of
particulars in respect of the purchase or sale of marketable securities, issue
and buyback of equity shares, optionally convertible / partially convertible /
compulsorily convertible debentures / preference shares. A relevant extract of
the Clause is reproduced herein below:

 

Particulars in respect of international
transactions of purchase or sale of marketable securities, issue and buyback of
equity shares, optionally convertible / partially convertible / compulsorily
convertible debentures / preference shares:

 

Has the
assessee entered into any international transaction(s) in respect of purchase
or sale of marketable securities or issue of equity shares including
transactions specified in Explanation (i)(c) below section 92B(2)?

 

If ‘yes’, provide the following details

(i) Name and address of the associated
enterprise with whom the international transaction has been entered into

(ii) Nature of the transaction

(a) Currency in which the transaction was
undertaken

(b) Consideration charged / paid in
respect of the transaction

(c) Method used for determining the arm’s
length price [See section 92C(1)]

 

It may be noted
that the Bombay High Court in the case of Vodafone India Services Pvt.
Ltd. vs. UOI [2014] 361 ITR 531 (Bom.) clearly stated that the issue of
shares at a premium is on capital account and gives rise to no income and,
therefore, Chapter X of the Act dealing with Transfer Pricing provisions do not
apply. (Please refer to detailed discussion in subsequent paragraphs.)

 

However, even after
the acceptance of the Bombay High Court judgment by the Government of India,
international transactions relating to marketable securities are still required
to be reported / justified in Form 3CEB. And therefore, we need to study this
aspect.

 

Of the various
financial transactions, this article focuses on Capital Investments and
Outstanding Receivables (Debtors). Other types of transactions will be covered
in due course.

2.   Benchmarking of capital
instruments under Transfer Pricing Regulations

2.1  Investments in share capital and CCDs

Cross-border
investment in capital instruments of an Associated Enterprise (AE), such as
equity shares, compulsory convertible debentures (CCDs), compulsory convertible
preference shares (CCPs) and other types of convertible instruments are covered
here.

     

Since CCDs and CCPs
are quasi-capital in nature, the same are grouped with capital
instruments. Even under FEMA, they are recognised as capital instruments.
Collectively, they are referred to as ‘Equity / Capital Instruments’ hereafter.

 

2.2. FEMA Regulations

(i)   Inbound investments – FDI or foreign
investments

Inbound investment
in India is regulated by the Foreign Exchange Management (Non-Debt Instruments)
Rules, 2019. The said Rules define ‘Capital Instruments’ as equity shares,
debentures, preference shares and share warrants issued by an Indian company.

 

‘FDI’ or
‘Foreign Direct Investment’ means investment through equity instruments by a
person resident outside India in an unlisted Indian company; or in ten per cent
or more of the post-issue paid-up equity capital on a fully-diluted basis of a
listed Indian company;

‘foreign
investment’ means any investment made by a person resident outside India on a
repatriable basis in equity instruments of an Indian company or to the capital
of an LLP;’

 

The NDI Rules define Foreign Portfolio Investment (FPI) as any investment
made by a person resident outside India through equity instruments where such
investment is less than 10% of the post-issue paid-up share capital on a
fully-diluted basis of a listed Indian company, or less than 10% of the paid-up value of each series of equity
instruments of a listed Indian company.

 

Since cross-border
investment of 26% or more in an entity would trigger the TPR [section 92
A(2)(a)], investments under FPI would not be subjected to benchmarking under
TPR. However, FDI and Foreign Investments in India would be required to be
benchmarked under TPR.

 

(ii)  Pricing guidelines for inbound investments

Rule 21 of the NDI
Rules provides pricing or valuation guidelines for FDI / foreign investments as
follows:

(a) For issue of equity instruments by a company to
a non-resident or transfer of shares from a resident person to a non-resident
person, it shall not be less than the price worked out as
follows:

For listed
securities ? the price at which a preferential allotment of shares can be made
under the Securities and Exchange Board of India (SEBI) Guidelines, as
applicable, in case of a listed Indian company, or in case of a company going
through a delisting process as per the Securities and Exchange Board of India
(Delisting of Equity Shares) Regulations, 2009;

For unlisted
securities ? the valuation of
equity instruments done as per any internationally-accepted pricing methodology
for valuation on an arm’s length basis duly certified by a Chartered
Accountant or a merchant banker registered with SEBI or a practising Cost
Accountant.

 

(b) For transfer of equity instruments from a
non-resident person to a person resident in India,it shall not exceed the
price worked out as mentioned in (a) above. The emphasis is on valuation as
per the provisions of the relevant SEBI guidelines and provisions of the
Companies Act, 2013 wherever applicable.

 

The interesting
point here is that the pricing guidelines under NDI rules emphasise on the
valuation of equity instruments based on an arm’s length principle.

 

The Rule provides
the guiding principle as ‘the person resident outside India is not
guaranteed any assured exit price at the time of making such investment or
agreement and shall exit at the price prevailing at the time of exit.’

 

(c)  In case of swap of equity
instruments, irrespective of the amount, valuation involved in the swap
arrangement shall have to be made by a merchant banker registered with SEBI or
an investment banker outside India registered with the appropriate regulatory
authority in the host country.

 

(d) Where shares in an Indian company are issued to
a person resident outside India in compliance with the provisions of the
Companies Act, 2013, by way of subscription to Memorandum of Association,
such investments shall be made at face value subject to entry route and
sectoral caps.

 

(e) In case of share warrants, their pricing and
the price or conversion formula shall be determined upfront, provided that
these pricing guidelines shall not be applicable for investment in equity
instruments by a person resident outside India on a non-repatriation basis.

(iii) Outbound investments      

Valuation norms for
outbound investments are as follows:

 

In case of partial
/ full acquisition of an existing foreign company where the investment is more
than USD five million, share valuation of the company has to be done by a
Category I merchant banker registered with SEBI or an investment banker /
merchant banker outside India registered with the appropriate regulatory
authority in the host country, and in all other cases by a Chartered Accountant
/ Certified Public Accountant.

 

However, in the
case of investment by acquisition of shares where the consideration is to be
paid fully or partly by issue of the Indian party’s shares (swap of shares),
irrespective of the amount, the valuation will have to be done by a Category I
merchant banker registered with SEBI or an investment banker/ merchant banker
outside India registered with the appropriate regulatory authority in the host
country.

 

In case of
additional overseas direct investments by the Indian party in its JV / WOS,
whether at premium or discount or face value, the concept of valuation, as
indicated above, shall be applicable.

 

As far as the
actual pricing is concerned, one must follow the guidelines mentioned at
paragraph (ii)(b) above, i.e., the transaction price should not exceed the
valuation arrived at by the valuer concerned.

 

2.3. Benchmarking of equity
instruments under transfer pricing

From the above discussion it is clear that for any cross-border capital
investments one has to follow the pricing guidelines under FEMA. However, as
mentioned in the NDI Rules, the valuation of equity / capital instruments must
be at arm’s length. Thus, the person valuing such investments has to bear in
mind the principles of arm’s length.

 

One more aspect that one has to bear in mind while doing valuation is to
use the internationally accepted pricing methodology. Pricing of an equity /
capital instrument is a subjective exercise and would depend upon a number of
assumptions and projections as to the future growth, cash flow, investments by
the company, etc. Therefore, the traditional methods of benchmarking as
prescribed in the TPR may not be appropriate for benchmarking investments in
equity / capital instruments.

2.4. Whether investments in
equity instruments require Benchmarking under TPR?

In this connection,
it would be interesting to examine the Bombay High Court’s decision in the case
of Vodafone India Services Pvt. Ltd. vs. Union of India(Supra).

     

Brief facts of the
case are as follows:

VISPL is a wholly-owned subsidiary of a non-resident company, Vodafone
Tele-Services (India) Holdings Limited (the holding company). VISPL required
funds for its telecommunication services project in India from its holding
company during the financial year 2008-09, i.e., A.Y. 2009-10. On 21st
August, 2008, VISPL issued 2,89,224 equity shares of the face value of Rs. 10
each at a premium of Rs. 8,509 per share to its holding company. This resulted
in VISPL receiving a total consideration of Rs. 246.38 crores from its holding
company on issue of shares between August and November, 2008. The fair market
value of the issue of equity shares at Rs. 8,519 per share was determined by
VISPL in accordance with the methodology prescribed by the Government of India
under the Capital Issues (Control) Act, 1947. However, according to the A.O.
and the Transfer Pricing Officer (TPO), VISPL ought to have valued each equity
share at Rs. 53,775 (based on Net Asset Value), as against the aforesaid
valuation done under the Capital Issues (Control) Act, 1947 at Rs. 8,519, and
on that basis the shortfall in premium to the extent of Rs. 45,256 per share
resulted in a total shortfall of Rs. 1,308.91 crores. Both the A.O. and the TPO
on application of the Transfer Pricing provisions in Chapter X of the Act held
that this amount of Rs. 1,308.91 crores is income. Further, as a consequence of
the above, this amount of Rs. 1,308.91 crores is required to be treated as a
deemed loan given by VISPL to its holding company and periodical interest
thereon is to be charged to tax as interest income of Rs. 88.35 crores in the
financial year 2008-09, i.e., A.Y. 2009-10.

 

The Bombay High
Court,while ruling on the petition filed by VISPL, among other things observed
as follows:

‘(i)   The tax can be charged only on income and in
the absence of any income arising, the issue of applying the measure of arm’s
length pricing to transactional value / consideration itself does not arise.

(ii)   If it’s income which is chargeable to tax,
under the normal provisions of the Act, then alone Chapter X of the Act could
be invoked. Sections 4 and 5 of the Act brings / charges to tax total income of
the previous year. This would take us to the meaning of the word income under
the Act as defined in section 2(24) of the Act. The amount received on issue of
shares is admittedly a capital account transaction not separately brought
within the definition of income, except in cases covered by section 56(2)(viib)
of the Act. Thus, such capital account cannot be brought to tax as already
discussed herein above while considering the challenge to the grounds as
mentioned in impugned order.

(iii)  The issue of shares at a premium is on capital
account and gives rise to no income. The submission on behalf of the Revenue
that the shortfall in the ALP as computed for the purposes of Chapter X of the
Act is misplaced. The ALP is meant to determine the real value of the
transaction entered into between AEs. It is a re-computation exercise to be
carried out only when income arises in case of an international transaction
between AEs. It does not warrant re-computation of a consideration received /
given on capital account.’

     

In an interesting
development thereafter, on 28th January, 2015, the Ministry of
Finance, Government of India, issued a press release through the Press
Information Bureau accepting the order of the Bombay High Court. Relevant
excerpts of the said press release are as follows:

 

‘Based on the
opinion of Chief Commissioner of Income-tax (International Taxation),
Chairperson (CBDT) and the Attorney-General of India, the Cabinet decided to:

i.)   accept the order of the High Court of Bombay
in WP No. 871 of 2014, dated 10th October, 2014 and not to file SLP
against it before the Supreme Court of India;

ii.)   accept orders of Courts / IT AT / DRP in cases
of other taxpayers where similar transfer pricing adjustments have been made
and the Courts / IT AT / DRP have decided /decide in favour of the taxpayer.

The Cabinet
decision will bring greater clarity and predictability for taxpayers as well as
tax authorities, thereby facilitating tax compliance and reducing litigation on
similar issues. This will also set at rest the uncertainty prevailing in the
minds of foreign investors and taxpayers in respect of possible transfer pricing
adjustments in India on transactions related to issuance of shares and thereby
improve the investment climate in the country. The Cabinet came to this view as
this is a transaction on the capital account and there is no income to be
chargeable to tax. So, applying any pricing formula is irrelevant.’

 

CBDT has also
issued Instruction No. 2/2015 dated 29th January, 2015 clarifying
that premium on shares issued was on account of capital account transaction and
does not give rise to income. The Board’s instruction is reproduced as follows:

‘Subject
Acceptance of the Order of the Hon’ble High Court of Bombay in the case of
Vodafone India Services Pvt. Ltd.-reg.

In reference to
the above cited subject, I am directed to draw your attention to the decision
of the High Court of Bombay in the case of Vodafone India Services Pvt. Ltd.
for AY 2009-10 (WP No. 871/2014), wherein the Court has held, inter alia, that the premium on share issue was on account of a
capital account transaction and does not give rise to income and, hence, not
liable to transfer pricing adjustment.

2. lt is hereby informed that the Board has
accepted the decision of the High Court of Bombay in the above-mentioned writ
petition. In view of the acceptance of the above judgment, it is directed that the
ratio decidendi of
the judgment must be adhered to by the field officers in all cases where this
issue is involved. This may also be brought to the notice of the ITAT, DRPs and
CslT(Appeals).’

 

The above decision
has been referred to in the following decisions:

 

On different facts,
the Supreme Court in case of G.S. Homes and Hotels P. Ltd. vs. DCIT
[Civil Appeal Nos. 7379-7380 of 2016 dated 9th August, 2016]
ruled that ‘we modify the order of the High Court by holding that the amount
(Rs. 45,84,000) on account of share capital received from the various
shareholders ought not to have been treated as business income.’ Thus, the Apex
Court reversed the order of the Karnataka High Court.

 

In ITO vs. Singhal General Traders Private Limited [ITA No.
4197/Mum/2017 (A.Y. 2012-13) dated 24th February, 2020],
following the decisions of the Bombay High Court in the case of VSIPL
(Supra) and the Apex Court in the case of G.S. Homes and
Hotels Ltd. (Supra), the Tribunal upheld the decision of the CIT(A) of
treating the receipt of share capital / premium as capital in nature and that
it cannot be brought to tax u/s 68 of the Act.

 

In light of the above discussion, the question arises, is it necessary to
benchmark the transactions of investments in capital / equity instruments? As
Form 3CEB still carries the reporting requirement, it is advisable to report
such transactions. One can use the valuation report to benchmark the
transaction under the category of ‘any other method’. This is out of abundant
precaution to avoid litigation. Ideally, the Form 3CEB should be amended to
bring it on par with the CBDT’s Instruction 2/2015 dated 29th
January, 2015 and the Government’s intention expressed through the press
release dated 28th January, 2015.

 

3.   Benchmarking of
outstanding receivables (debtors)

Debtors are
recorded in the books in respect of outstanding receivables for the exports
made to an AE. The underlying export transactions would have been benchmarked
in the relevant period and, therefore, is there any need to benchmark the
receivables arising out of the same transaction?

     

As mentioned in paragraph 1, the Explanation to section 92B dealing with
the meaning of international transactions was inserted, inter alia, to
include ‘receivable or any other debt arising during the course of business’
with retrospective effect from 1st
April, 2002. Therefore, apparently even the receivables need to be reported and
benchmarked.

 

 

However, recently
in the case of Bharti Airtel Services Ltd. vs. DCIT, the Delhi
ITAT [ITA No. 161/Del/2017 (A.Y. 2011-12) dated 6th October,
2020] ruled that outstanding debtors beyond an agreed period is a
separate international transaction of providing funds to its associated
enterprise for which the assessee must have been compensated at an arm’s
length. In the instant case there was a service agreement between Bharti Airtel
Services Ltd. and its overseas AE for payment of invoices within 15 days of
their receipt. However, the same remained outstanding beyond the stipulated
time of 15 days. The working capital adjustment was denied to the assessee in
the absence of any reliable data and therefore the same was not taken into
account while determining the arm’s length price of the international transaction
of provision of the services. On the facts and circumstances of the case, the
Tribunal held that outstanding debtors beyond an agreed period is a separate
international transaction of providing funds to its associated enterprise for
which the assessee must have been compensated in the form of interest at LIBOR
+ 300 BPS as held by CIT(A).

 

In this context the
Tribunal held as under:

‘9. Coming to the various decisions relied upon by
the learned authorised representative, we find that they are on different
facts. The decision of the honourable Delhi High Court in ITA number 765/2016
dated 24th April, 2017 in case of Kusum Healthcare Private Limited
(Supra), para number eight clearly shows that assessee has undertaken working
capital adjustment for the comparable companies selected in its transfer
pricing report which has not been disputed by the learned transfer pricing
officer and therefore the differential impact of working capital of the
assessee vis-à-vis
is comparable had already been factored in pricing profitability and therefore
the honourable High Court held that adjustment proposed by the learned TPO
deleted by the ITAT is proper. In the present case there is no working capital
adjustment made by the assessee as well as granted by the learned TPO. The
facts in the present case are distinguishable. Further, same are the facts in
case of Bechtel India where working capital adjustment was already granted. In
case of 91 taxmann.com 443 Motherson Sumi Infotech and Design Limited non-charging
of interest was due to business and commercial reasons and no interest was also
charged against outstanding beyond a specified period from non-related parties.
No such commercial or business reasons were shown before us. The facts of the
other decisions cited before us are also distinguishable. Therefore, reliance
on them is rejected.’

 

From the above
ruling it is clear that one must ensure the receipt of outstandings within a
stipulated time, else it would call for transfer pricing adjustment.

 

Benchmarking

Once it is
established that the receivables are beyond due date, the benchmarking has to
be done as if it is a loan transaction. Such a transaction needs to be
benchmarked using the Libor rate of the same currency in which the export
invoice is raised.

 

3.1. FEMA provisions for
receipt of outstanding receivables

It may be noted
that the time limit for realisation of export proceeds is the same for export
of goods as well as services.

 

The normal time
limit for realisation of exports is nine months from the date of exports.
However, it was extended to 15 months for exports made up to 31st
July, 2020 due to the Covid-19 pandemic [RBI/2019-20/206 A.P. (DIR Series)
Circular No. 27, dated 1st April, 2020].

 

Thus, ideally,
parties can provide mutual time limit for settlement of export invoices within
the overall time limit prescribed by RBI under FEMA.

 

4.   CONCLUSION

Benchmarking of financial transactions is an important aspect of
transfer pricing practice in India. Not much judicial / administrative guidance
is available for the two types of financial transactions referred to in this
article.

 

However,
detailed jurisprudence and guidance is available for benchmarking of financial
transactions in the nature of loans and guarantees. Readers may refer to the detailed articles published in the  May, 2014 and June, 2014 issues of the BCAJ dealing with benchmarking of
loans and guarantees, respectively.

ECONOMIC SUBSTANCE REQUIREMENTS REGULATIONS – AN OVERVIEW

1.0 
Introduction

‘Substance
over Form’ is an evergreen debate now tilting in favour of the former. Can a
legal form justify weak substance, or can a strong substance without a legal form be relevant or
practical? Does one score over the other? Are they interdependent or independent
of each other? How does one determine substance in a given transaction or
arrangement? Is it necessary to lift the corporate veil each time to examine
substance? Can a perfectly legal structure within the four corners of the law
be challenged and ignored for want of (or say, apparent lack of) substance? Is
every case of double non-taxation or lower taxation attributable to lack of
substance? There are a host of questions in this arena, some with answers, many
with grey areas and some without an answer. The easiest answer, perhaps, could
be that each case is fact-specific. However, in this uniqueness we need to have
certain rules and regulations and / or patterns to determine substance and give
tax certainty to businesses.

Recently, many jurisdictions introduced
Economic Substance Requirements Regulations (or ESR Regulations) for
enterprises carrying on business activities in / from that jurisdiction in any
form.

In this Article, we shall attempt to
understand what are the provisions of a typical ESR Regulations regime, their
significance and how does one comply with them.

 

2.0 
Genesis of substance requirements

Way back in 1998, OECD published a Report
on ‘Harmful Tax Competition: An Emerging Global Issue’ expressing
concern about the preferential regimes that lack in transparency and that are
being used by Multi-National Enterprises (MNEs) for artificial profit shifting.
OECD created the Forum on Harmful Tax Practices (FHTP) to review and monitor
compliances by preferential tax regimes with respect to transparency and other
aspects of tax structuring.

One of the twelve factors set out in the
1998 Report to determine whether a preferential regime is potentially harmful
or not was, ‘The regime encourages operations or arrangements that are purely
tax-driven and involve no substantial
activities’.

Fifteen Action Plans to prevent BEPS are
based on the following three main pillars:

(1) coherence of corporate tax at the
international level,

(2) realignment of taxation and substance,
and

(3) transparency, coupled with certainty
and predictability.

BEPS Action Plan 5 dealing with ‘Countering
Harmful Tax Practices More Effectively, Taking into Account Transparency and
Substance,’ intends to achieve the objectives of the second pillar of
realigning taxation with substance to ensure that taxable profits are not
artificially shifted away from countries where value is created. 

FHTP identified many harmful preferential
tax regimes that were providing an ideal atmosphere for profit-shifting with no
or low effective tax rates, lack of transparency and no effective exchange of
information.

To counter such harmful regimes more
effectively, BEPS Action Plan 5 requires FHTP to revamp the work on harmful tax
practices, with priority and renewed focus on requiring substantial activity
for any preferential regime and on improving transparency, including compulsory
spontaneous exchange on rulings related to preferential regimes1.

_____________________________________________________________

1 Paragraph 23 of the BEPS Action Plan 5


3.0 
FHTP’s approaches

FHTP has provided three approaches to
address the issue of substance in an Intellectual Property (IP) regime. They
are as follows:

(i)   Value Creation:
This approach requires taxpayers to undertake a set number of significant
development activities in the jurisdiction to claim tax benefits;

(ii)  Transfer Pricing:
This approach would require a taxpayer to undertake a set level of important
functions in the jurisdiction concerned to take advantage of lower tax regime.
These functions could include legal ownership of assets or bearing economic
risks of the assets, giving rise to the tax benefits.

(iii) Nexus Approach:
This approach has been agreed to by FHTP and endorsed by G20. It looks at
whether an IP regime makes its benefits conditional on the extent of R&D
activities of taxpayers in its jurisdiction. The Nexus Approach not only
enables the IP regime to provide benefits directly to the expenditures incurred
to create the IP, but also permits jurisdictions to provide benefits to the
income arising out of that IP, so long as there is a direct nexus between the
income receiving benefits and the expenditures contributing to that income.

In other words, when the Nexus Approach is
applied to an IP regime, substantial activity requirements establish a link
between expenditures, IP assets and IP income. The expenditure criterion acts
as a proxy for activities and IP assets are used to ensure that the income that
receives benefits does, in fact, arise from the expenditures incurred by the
qualifying taxpayer. The effect of this approach is therefore to link income and
activities.

Based on the above approach for the IP
regime, the Action Plan suggests applying this method to non-IP regimes as
well. Thus, a preferential regime should provide the substance requirement with
a clear link between income qualifying for benefits and core activities
necessary to earn the income.

What constitutes a Core Activity depends
upon the type of regime. However, the Action Plan has given certain indicative
Core Income Generating Activities (CIGA) for different types of preferential regimes,
such as Headquarters regimes, Distribution and service centre regimes,
Financing or leasing regimes, Fund management regimes, Banking and Insurance
regimes, Shipping regimes and Holding company regimes. (Paragraphs 74 to 87
of the BEPS Action Plan 5.) 

Under each of these regimes the Plan
identifies how preferential regimes give benefits and related concerns arising
from these regimes. Two common concerns under each regime are: (i)
‘Ring-fencing’, whereby foreign income is ring-fenced from domestic income to
provide tax exemption to the foreign-sourced income, and (ii) ‘Artificial
definition of the tax base’, whereby a certain fixed percentage or amount of
income is taxed, irrespective of the actual income of the taxpayer.

In order to address the above concerns, the
Action Plan provides CIGA in respect of each of the regimes mentioned above. A
taxpayer is expected to undertake CIGA commensurate with the nature and level
of activities. The idea underlying this is to tax income where value is
created. And value creation is determined by looking at the CIGA and also the
expenditure incurred to earn relevant income. 

Another major concern about preferential
regimes is lack of transparency. This concern is addressed through Automatic
Exchange of Information through Common Reporting Standard (CRS)2.
Besides this, when information is sought on request, the international standard
on information exchange covers the provision not only of exchange of
information, but also availability of information, including ownership,
banking, and account information. The Global Forum on Transparency and Exchange
of Information for Tax Purposes monitors implementation of international
standards on transparency and exchange of information for tax purposes and
reviews the effectiveness of their implementation in practice.

________________________________________________________________________________________________

2 The Common Reporting Standard (CRS), developed in response to the
G20 request and approved by the OECD Council on 15th July, 2014 calls
on jurisdictions to obtain information from their financial institutions and
automatically exchange that information with other jurisdictions on an annual
basis. It sets out the financial account information to be exchanged, the financial
institutions required to report, the different types of accounts and taxpayers
covered, as well as common due diligence procedures to be followed by
financial institutions. [Source: OECD (2017), Standard for Automatic Exchange
of Financial Account Information in Tax Matters]

 

4.0  Economic Substance Requirements Regulations
(ESR Regulations)

ESR Regulations require economic substance
in a jurisdiction where an entity reports relevant income. The underlying
objective of ESR Regulations is to ensure that entities report profits in a
jurisdiction where economic activities that generate them are carried out and
where value is created.

In December, 2017, the European Union Code
of Conduct Group (EU COCG) assessed preferential tax regimes with nil or only
nominal tax to identify harmful practices and enforce substance requirements.
The EU COCG also published a list of ‘non-co-operative jurisdictions for tax
purposes’ which were engaged in harmful tax practices such as ring-fencing
(through offshore tax regimes), artificial definition of tax base and lacked
transparency. Many countries promised to revamp their tax systems to curb
harmful tax practices and introduce substance requirements to avoid being
blacklisted. The work of EU COCG has been strengthened by BEPS Action Plan 5,
with similar objectives and wider applicability.

BEPS Action Plan 5 is also a Minimum
Standard which requires all G20 Nations and countries in the inclusive group
(over 135 countries) who are signatories of the BEPS Project to mandatorily
implement the same. 

To comply with the above, the following
countries enacted legislation to introduce the Economic Substance Regulations
for tax purposes with effect from 1st January, 2019 or an accounting
period commencing thereafter:

(i)    Bahamas

(ii)   Bermuda

(iii)  British Virgin Islands (BVI)

(iv)  Cayman Islands

(v)   Guernsey

(vi)  Jersey

(vii)  Isle of Man

(viii) Mauritius

(ix)  Seychelles

(x)   United Arab Emirates (UAE) (implemented with
amendments effective from 10th August, 2020).

In this Article we shall look closely at
the ESR Regulations as implemented in the UAE. However, it may be noted that
ESR Regulations as introduced by the above-mentioned countries are by and large
similar as they are based on the guidance and requirements issued by the EU as
well as by the OECD; the requirements of CIGA for different regimes are almost
identical. 

Broadly, ESR Regulations in every
jurisdiction would require resident entities to prove economic substance with
respect to the following criteria:

 

4.1 
Management test

The entity should be directed and managed
from the jurisdiction concerned. This can be proved by having physical board
meetings at regular frequency, maintaining minutes and accounts in the tax
jurisdiction concerned, directors having domain expertise of the activities of
the company, handling day-to-day operations and banking transactions, etc.

4.2 
CIGA test

The entity will have to clearly demonstrate
that Core Income Generating Activities are undertaken in the relevant
jurisdiction and such activities are commensurate with the level of income
generated therefrom. What is CIGA will depend upon the nature of income or the
regime. CIGA can be outsourced to a corporate service provider in the
jurisdiction, subject to oversight by the entity (e.g., monitoring and
control). In such cases, the relevant resources of the service providers will
be taken into account when determining whether the CIGA test is satisfied.

 

4.3 
Adequacy test

The entity will have to prove that it has
adequate number of qualified employees and infrastructure to carry out CIGA. It
has to also demonstrate that adequate expenditure is incurred to generate the
relevant income in that jurisdiction. ‘Adequacy’ of expenditure, employees or
infrastructure would depend upon the nature of the CIGA.

 

4.4  Summary of tests for Economic Substance
Requirements

1. The management and direction of the entity
should be located in the offshore jurisdiction concerned;

2. Core Income Generating Activities with respect to
the relevant activity must be undertaken in the offshore jurisdiction
concerned;

3. The entity should have a physical presence in
the offshore jurisdiction;

4. The entity should have full-time employees with
suitable qualifications in the jurisdiction concerned; and

5. The entity should have incurred operating
expenditure in the offshore jurisdiction concerned in relation to the relevant
activity.

 

5.0 
ESR Regulations in UAE

On 30th April, 2019, the Cabinet
of Ministers of the UAE issued Cabinet Resolution No. 31 of 2019 concerning
Economic Substance Requirements Regulations (Resolution 31). On 10th
August, 2020 amendments were introduced to Resolution 31 by the Cabinet of
Ministers by way of Resolution No. 57 of 2020 (ESR Regulations), which repealed
and replaced Resolution 31.

The UAE ESR Regulations contain 22
articles, a list of which is given below.

 

Article
No.

Description

1.

Definitions

2.

Objective of the Resolution

3.

Relevant Activity and Core Income Generating Activity

4.

Regulatory Authorities

5.

National Assessing Authority

6.

Requirement to meet Economic Substance Test

7.

Assessment of whether Economic Substance Test is met

8.

Requirement to provide Information

9.

Provision of Information by the Regulatory Authority

10.

Provision of Information by the National Assessing Authority

11.

Exchange of Information by Competent Authority

12.

Co-operation by other Governmental Authorities

13.

Offences and Penalties for failure to provide a Notification

14.

Offences and Penalties for failure to submit an Economic
Substance Report and for failure to meet the Economic Substance Test

15.

Offences and Penalties for providing inaccurate information

16.

Period for imposition of Administrative Penalty

17.

Right of Appeal against Administrative penalty

18.

Date of Payment of Administrative Penalties

19.

Power to enter Business Premises and Examine Business
Documents

20.

Executive Regulations

21.

Revocation

22.

Entry into Force
 

Ministerial Decision No. 100 for the year
2020 dated 19th August, 2020 is intended to provide further guidance
and direction to entities carrying out one or more Relevant Activities. An
entity subject to ESR Regulations shall have regard to this Decision for the
purposes of ensuring compliance with ESR Regulations.

           

5.1 
Basis of ESR Regulations

The basis of ESR Regulations in UAE as
stated in its ‘Ministerial Decision No. 100 for the year 2020 on the Issuance
of Directives for the implementation of the provisions of the Cabinet Decision
No. 57 of 2020 concerning Economic Substance Requirements’ (hereafter referred
to as ‘Ministerial Directives’) is as follows:

‘The ESR Regulations are issued pursuant
to the global standard set by the Organisation for Economic Cooperation and
Development (“OECD”) Forum on Harmful Tax Practices, which requires entities
undertaking geographically mobile business activities to have substantial
activities in a jurisdiction. In addition to the work of the OECD, the European
Union Code of Conduct Group (“EU COCG”) also adopted a resolution on a code of
conduct for business taxation which aims to curb harmful tax practices. The
Cabinet of Ministers enacted the ESR Regulations taking into account the
relevant standards developed by the OECD and the EU COCG.’

 

5.2 
Applicability

Article 3 of the Ministerial Directives
deals with the Licensees required to meet the Economic Substance test and
provides that ESR Regulations are applicable to Licensees. The term ‘Licensee’
is defined in Article 1 of the ESR Regulations to mean any of the following two
entities:

 

‘i. a juridical person (incorporated inside
or outside the State, i.e., UAE); or

ii. an Unincorporated Partnership;

registered in the State, including a Free
Zone and a Financial Free Zone and carries on a Relevant Activity.’

A juridical person is defined to mean a
corporate legal entity with a separate legal personality from its owners.

An Unincorporated Partnership is defined
under ESR Regulations to include those forms of partnerships that may operate
in the UAE without having a separate legal personality and are thereby
identified separately under the ESR Regulations. 

In other words, the regulations cover all
Licensees (natural and juridical person) having the commercial license,
certificate of incorporation, or any other form of permit necessarily taken
from the licensing authority to do business. Going by the spirit of the ESR
Regulations, it is interpreted that entities in Free Zone (including offshore
companies) would also be covered.

 

Branches

Branch of a foreign entity in the UAE

Since a licensee could be in the form of a
UAE branch of a foreign entity (juridical person incorporated outside UAE is
covered in the definition), Article 3 of the Ministerial Directives
specifically covers them for compliance of ESR Regulations. 

Similarly, a branch of a foreign entity
registered in the UAE that carries out a Relevant Activity is required to
comply with the ESR Regulations, unless the Relevant Income of such branch is
subject to tax in a jurisdiction outside the UAE.

Branch of a UAE entity outside UAE

Where a UAE entity carries on a Relevant
Activity through a branch registered outside the UAE, the UAE entity is not
required to consolidate the activities and income of the branch for purposes of
ESR Regulations, provided that the Relevant Income of the branch is subject to
tax in the foreign jurisdiction where the branch is located. In this context, a
branch can include a permanent establishment, or any other form of taxable
presence for corporate income tax purposes which is not a separate legal
entity.

 

5.3 Licensees exempted from ESR Regulations

The following entities which are registered
in the UAE and carry out a Relevant Activity are exempt from ESR Regulations:

(a)  an Investment Fund,

(b)  an entity that is tax resident in a
jurisdiction other than the UAE,

(c)  an entity wholly owned by UAE residents and
which meets the following conditions:

      (i)    the
entity is not part of an MNE Group;

      (ii)   all
of the entity’s activities are only carried out in the UAE;

(d)  a Licensee that is a branch of a foreign
entity, the Relevant Income of which is subject to tax in a jurisdiction other
than the UAE. 

 

(a) Investment Funds

The ESR Regulations define an Investment
Fund as ‘an entity whose principal business is the issuing of investment
interests to raise funds or pool investor funds with the aim of enabling a
holder of such an investment interest to benefit from the profits or gains from
the entity’s acquisition, holding, management or disposal of investments and
includes any entity through which an investment fund directly or indirectly
invests (but does not include an entity or entities in which the fund
invests).’

The above definition would include the
Investment Fund itself and any entity through which the Fund directly and indirectly
invests, but not the entity or entities in which the Fund ultimately invests.
It is clarified that the words ‘through which an investment fund directly or
indirectly invests’ refers to any UAE entity whose sole function is to
facilitate the investment made by the Investment Fund. The exemption for
Investment Funds is distinct from the Investment Fund Management Business as
regulated under ESR Regulations. The Investment Fund itself is not considered
an Investment Fund Management Business unless it is a self-managed fund (the
Investment Manager and the Investment Fund are part of the same entity).

 

(b) Tax resident in a jurisdiction other
than the State

An entity which is tax resident in a
jurisdiction outside the UAE need not comply with the ESR Regulations. However,
in order for such an entity to avail this exemption, the entity must be
subjected to corporate tax on all of its income from a Relevant Activity by
virtue of being a tax resident in a jurisdiction other than the UAE. It should
be noted that an entity that pays withholding tax in a foreign jurisdiction
will not be considered as tax resident in a foreign jurisdiction other than the
UAE solely on that basis.

 

(c) An entity wholly owned by UAE
residents

An entity that is ultimately wholly and
beneficially owned (directly or indirectly) by UAE residents is exempt from the
Economic Substance Test only where such entity is: (i) not part of an MNE
Group; (ii) all of its activities are exclusively carried out in the UAE; and
(iii) UAE resident owners of the entity reside in the UAE. The entity must
therefore not be engaged in any form of business outside the UAE. In this
context, ‘UAE residents’ means UAE citizens and individuals holding a valid UAE
residency permit, who reside in the UAE. 

(d) A
UAE branch of a foreign entity the Relevant Income of which is subject to tax
in a jurisdiction other than the State

An entity is not required to meet the
Economic Substance Test if such entity is a branch of a foreign entity and its
Relevant Income is subject to corporate tax in the jurisdiction where such
foreign entity is a tax resident. 

Evidence
to be submitted to claim exemption from ESR Regulations

A Licensee that claims to be exempt on the
basis of being a tax resident in a foreign jurisdiction is required to submit
one of the following documents along with its Notification in respect of each
relevant Financial Year:

(a)  Letter or certificate issued by the competent
authority of the foreign jurisdiction in which the entity claims to be a tax
resident stating that the entity is considered to be resident for corporate
income tax purposes in that jurisdiction; or

(b)  An assessment to corporate income tax on the
entity, a corporate income tax demand, evidence of payment of corporate income
tax, or any other document, issued by the competent authority of the foreign
jurisdiction in which the entity claims to be a tax resident.

It is further provided that where an entity
fails to provide sufficient evidence to substantiate its status as an Exempted
Licensee, the entity will be regarded as a Licensee for the purposes of ESR
Regulations and shall be subject to the requirements of ESR Regulations as
applicable to a Licensee, including the requirement to meet the Economic
Substance Test.

5.4 First reportable Financial Year

It is provided that all Licensees and
Exempted Licensees are subject to ESR Regulations from the earlier of (i) their
financial year commencing on 1st January, 2019, or (ii) the date on
which they commence carrying out a Relevant Activity (for a Financial Year
commencing after 1st January, 2019).

5.5 What are the Relevant Activities?

Article 3(1) of ESR Regulations identifies
any of the following activities to be a Relevant Activity: (i) Banking
Business, (ii) Insurance Business, (iii) Investment Fund Management Business,
(iv) Shipping Business, (v) Lease-Finance Business, (vi) Distribution and
Service Centre Business, (vii) Headquarters Business, (viii) Intellectual
Property Business, and (ix) Holding Company Business.

Entities are expected to use a ‘substance
over form’ approach to determine whether or not they undertake a Relevant
Activity and as a result will be considered Licensees for the purposes of ESR
Regulations, irrespective of whether such Relevant Activity is included in the
trade licence or permit of the entity. A Licensee may have undertaken more than
one Relevant Activity during the same financial period. In such a case, the
Licensee would be required to demonstrate economic substance in respect of each
Relevant Activity. 

Any form of passive income from a Relevant
Activity can also bring the entity within the scope of the ESR Regulations.

 

5.6 Relevant Income

The Economic Substance Test has to be
satisfied by a Licensee having regard to the level of Relevant Income derived
from any Relevant Activity. For the purposes of the ESR Regulations, ‘Relevant
Income’ means entity’s gross income from a Relevant Activity as recorded in its
books and records under applicable accounting standards, whether earned in the
UAE or outside, and irrespective of whether the entity has derived a profit or
loss from its activities. 

For the purposes of ‘Relevant Income’,
gross income means total income from all sources, including revenue from sales
of inventory and properties, services, royalties, interest, premiums, dividends
and any other amounts, and without deducting any type of costs or expenditure.
It appears that even capital gains are to be included while computing gross
income. 

In the context of income from sales or
services, gross income means gross revenues from sales or services without
deducting the cost of goods sold or the cost of services. It is further
clarified that gross income does not mean taxable or accounting income or
profit.

 

5.7
Liquidation or otherwise ceasing to carry on Relevant Activities

A Licensee and an Exempted Licensee shall
be subject to ESR Regulations as long as such an entity continues to exist.

 

5.8
The Economic Substance Test – How to substantiate economic substance in the
UAE?

In order for a Licensee to demonstrate that
it has adequate substance in the UAE in a given financial year, an entity must
meet the following tests:


(a) Core Income Generating Activities
(CIGA) Test

The Licensee
should conduct Core Income Generating Activities in the UAE. The CIGAs are
those activities that are of central importance to the Licensee for the
generation of the gross income earned from its Relevant Activity.

 

The CIGAs
depend upon the nature of the Relevant Activity. The list given in Article 3(2)
of the ESR Regulations is an indicative list and not exhaustive3. A
Licensee is not required to perform all of the CIGAs listed in the ESR
Regulations for a particular Relevant Activity. However, it must perform any of
the CIGAs that generate Relevant Income in the UAE. It is clarified that
activities that are not CIGAs can be undertaken outside the UAE.

 

(b) Directed and Managed Test

The ‘directed and managed’ test aims to
ensure that a Relevant Activity is directed and managed in the UAE and requires
that, inter alia, there are an adequate number of board meetings held
and attended in the UAE. A determination as to whether an adequate number of
board meetings are held and attended in the UAE will depend on the level of
Relevant Activity being carried out by a Licensee.

 

Consideration must also be given to more
onerous requirements in respect of board meetings prescribed under the applicable
law regulating the Licensee or as may be stipulated in the constitutional
documents of the Licensee.

 

The ‘directed and managed’ test further
requires that:

(i)   meetings are recorded in written minutes and
that such minutes are kept in the UAE;

(ii)  quorum for such meetings is met and those
attendees are physically present in the UAE; and

(iii) directors have the necessary knowledge and
expertise to discharge their duties and are not merely giving effect to
decisions being taken outside the UAE.

 

The minutes of the board meetings must
record all the strategic decisions taken in relation to Relevant Activities and
must be signed by the directors physically present. The quorum shall be
determined in accordance with the law applicable to the Licensee setting out
quorum requirements, or as may be set out in the constitutional documents of
the Licensee (or both).

 

It is clarified that for the purposes of
ESR Regulations the ‘directed and managed’ requirement does not prescribe that
board members (or equivalent) be resident in the UAE. Rather, the board members
(or equivalent) are required to be physically present in the UAE when taking
strategic decisions. In the event that the Licensee is managed by its
shareholders / owners / partners, an individual manager (e.g., general manager
or CEO), or more than one manager, the above requirements will apply to such
persons to the fullest extent possible.

 

(c) Expenditure Test


Having regard to the level of Relevant
Income earned from a Relevant Activity, the Licensee should ensure that it (i)
has an adequate number of qualified full-time (or equivalent) employees in
relation to the activity who are physically present in the UAE (whether or not
employed by the Licensee or by another entity and whether on temporary or long-term
contracts), (ii) incurs adequate operating expenditure by it in the UAE, and
(iii) has adequate physical assets (e.g. premises) in the UAE.

 

What is adequate or appropriate for each
Licensee will depend on the nature and level of Relevant Activity being carried
out by such Licensee. A Licensee will have to ensure that it maintains
sufficient records to demonstrate the adequacy and appropriateness of the
resources and assets utilised and expenditure incurred.

 

It is provided that the National Assessing
Authority shall review such records and other supporting documentation
submitted in assessing whether a Licensee has demonstrated the adequacy and
appropriateness of resources and assets utilised and expenditures incurred.

 

The requirement for adequate employees is
aimed at ensuring that there are a sufficient number of suitably qualified
employees carrying out the Relevant Activity. The requirement for adequate
physical assets is intended to ensure that a Licensee has procured appropriate
physical assets to carry out a Relevant Activity in the UAE. Physical assets
can include offices or other forms of business premises (such as warehouses or
facilities from which the Relevant Activity is being conducted) depending on
the nature of the Relevant Activity. Such premises may be owned or leased by
the Licensee, provided that the Licensee is able to produce the lease
agreement, etc., to prove the right to use the premises for the purposes of
carrying out the Relevant Activity.

 


__________________________________________________________________________________

3 The indicative list of CIGAs is based on the recommendations of the BEPS
Action Plan 5 (paragraphs 74 to 87).


5.9 Outsourcing

Article 6(2)
of the ESR Regulations provides that a Licensee may conduct all or part of its
CIGAs for a Relevant Activity through an Outsourcing Provider. For the purposes
of ESR Regulations, an Outsourcing Provider may include third parties or
related parties. The substance (e.g., employees and physical assets) of the
Outsourcing Provider in the UAE will be taken into account when determining the
substance of the Licensee for the purpose of the Economic Substance Test,
subject to certain conditions.

 

5.10 Notification Filings


Every Licensee and Exempted Licensee is
required to submit a Notification to their respective Regulatory Authorities
setting out the following for each relevant financial year:

i.   the nature of the Relevant Activity being
carried out;

ii.  whether it generates Relevant Income;

iii.  the date of the end of its financial year;

iv. any other information as may be requested by
the Regulatory Authority.

 

A Notification submitted by an Exempted
Licensee must be accompanied by sufficient evidence to substantiate the
Exempted Licensee’s status for each category in which it claims to be exempt.
Failure to provide sufficient evidence to this effect will result in the
Exempted Licensee not being able to avail itself of the exemption and having to
comply with the full requirements of the ESR Regulations, including meeting the
Economic Substance Test.

 

The time frames for compliance with the
requirement to submit a Notification are different from the time frames to
submit an Economic Substance Report as discussed in paragraph 5.11 below.

 

The Notification must be submitted within
six months from the end of the financial year of the Licensee or Exempted
Licensee. The Notification must be submitted electronically on the Ministry of
Finance Portal.

 

 

5.11 Submission of Economic
Substance Report

Every Licensee shall be required to meet
the applicable Economic Substance Test requirements and submit an Economic
Substance Report containing the requisite information and documentation
prescribed under the ESR Regulations within 12 months from the end of the
relevant financial year.

 

The Economic
Substance Report of the
Licensee will be assessed by the National Assessing Authority within a
period of six years from the end of the relevant financial year. The
National
Assessing Authority will issue its decision as to whether a Licensee has
met
the Economic Substance Test. This six-year limitation period shall not
apply if
the National Assessing Authority is not able to make a determination
during
this period due to gross negligence, fraud, or deliberate
misrepresentation by
the Licensee or any other person representing the Licensee.

 

5.12
Exchange of information with foreign authorities


The Competent Authority will spontaneously
exchange information with relevant Foreign Competent Authorities under the ESR
Regulations pursuant to an international agreement, treaty or similar
arrangement to which the UAE is a party in the following circumstances:

i)   where a Licensee fails to satisfy the
Economic Substance Test;

ii)  where a Licensee is a high-risk IP Licensee;

iii)  where an entity claims to be tax resident in a
jurisdiction outside the UAE; and

iv) where a branch of a foreign entity claims to be
subject to tax in a jurisdiction outside the UAE.

 

Every Licensee that is carrying out a
Relevant Activity must identify the jurisdiction in which the Parent Company,
Ultimate Parent Company and Ultimate Beneficial Owner claim to be tax resident.
An Exempted Licensee that is either (i) tax resident in a jurisdiction other
than the UAE; or (ii) a UAE branch of a foreign company of which all the income
of the UAE branch is subject to tax in a jurisdiction other than the UAE must,
in addition to identifying the foregoing, also identify the jurisdiction in
which such Exempted Licensee claims to be (a) a tax resident or (b) the
jurisdiction of the foreign company of the UAE branch (as may be relevant).

 

5.13 Penalties


Stringent penalties are prescribed for
non-compliance with ESR Regulations, which are as follows:

 

Article No.

Nature of offence

Penalty

Remarks

13

Failure to provide Notification

AED 20,000

 

14

Failure to submit Economic Substance Report and any other
information or documents in accordance with ESR Regulations or Failure to
meet the Economic Substance Test

AED 50,000

AED 4,00,000 for a repeat offence in the subsequent year

15

Providing inaccurate information

AED 50,000

 

 

5.14
Summary of the Relevant Activities, related CIGAs and the Regulatory Authority4


One may refer to the Text of ‘Schedule 1 –
Relevant Activities Guide’, of the Ministerial Directives referred to in
Paragraph 5.1 infra, for detailed explanations and examples.


Relevant Activity
pursuant to Article 3.1 of Cabinet Resolution No. (57) of 2020

Core Income
Generating Activities (non-exhaustive) Article 3.2 of Cabinet Resolution No.
(57) of 2020

Regulatory Authority
pursuant to Article 4 of Cabinet Resolution No. (57) of 2020

Banking Business

(a) Raising funds, managing risk
including credit, currency and interest risk.

(b) Taking hedging positions.

(c) Providing loans, credit or other
financial services to customers.

1. UAE Central Bank

2. The competent authority in the
Financial Free Zone for the Banking Businesses

Insurance Business

(a) Predicting and calculating risk.

(b) Insuring or re-insuring against risk
and providing Insurance Business services to clients.

(c) Underwriting insurance and
reinsurance.

1. Securities and Commodities Authority

2. The competent authority in the Free
Zone and Financial Free Zone for the Insurance Business

Investment Fund Management Business

(a) 
Taking decisions on the holding and selling of investments.

(b) Calculating risk and reserves.

(c) Taking decisions on currency or
interest fluctuations and hedging positions.

(d) Preparing reports to investors or
any government authority with functions relating to the supervision or
regulation of such business.

1. Securities and Commodities Authority

2. The competent authority in the Free
Zone and Financial Free Zone for the Investment Fund Management Business

Lease-Finance Business

(a) Agreeing funding terms.

(b) Identifying and acquiring assets to
be leased (in the case of leasing).

(c) Setting the terms and duration of
any financing or leasing.

(d) Monitoring and revising any
agreements.

(e) Managing any risks.

1. UAE Central Bank

2. The competent authority in the Free
Zone and Financial Free Zone for the Lease-Finance Business

 

Headquarter Business

(a) Taking relevant management
decisions.

(b) Incurring operating expenditures on
behalf of group entities.

(c) Coordinating group activities.

1. Ministry of Economy

2. The competent authority in the Free
Zone and Financial Free Zone for the Headquarter Business

Shipping Business

(a) Managing crew (including hiring,
paying and overseeing crew members).

(b) Overhauling and maintaining ships.

(c) 
Overseeing and tracking shipping.

(d) Determining what goods to order and
when to deliver them,

(e) Organising and overseeing voyages.

1. Ministry of Economy

2. The competent authority in the Free
Zone and Financial Free Zone for the Shipping Business

Holding Company Business

Activities related to a Holding Company Business.

1. Ministry of Economy

2. The competent authority in the Free
Zone and Financial
Free Zone for the Holding Company Business

Intellectual Property Business

Where the Intellectual Property Asset is
a

(a) Patent or similar Intellectual
Property Asset: Research and development.

(b) Marketing intangible or a similar
Intellectual Property Asset: Branding, marketing and distribution.

In exceptional cases, except where the
Licensee is a High-Risk IP Licensee, the Core Income Generating Activities
may include:

(i) taking strategic decisions and
managing (as well as bearing) the principal risks related to development and
subsequent exploitation of the intangible asset generating income.

(ii) taking the strategic decisions and
managing
(as well as bearing) the principal risks relating to acquisition by third
parties and subsequent exploitation and protection of the intangible asset.

(iii) carrying on the ancillary trading
activities through which the intangible assets are exploited leading to the
generation of income from third parties.

1. Ministry of Economy

2. The competent authority in the Free
Zone and Financial Free Zone for the Intellectual Property Business

Distribution and Service Centre Business

(a) Transporting and
storing component parts, materials or goods ready for sale.

(b) Managing inventories.

(c) Taking orders.

(d) Providing consulting or other
administrative services.

1. Ministry of Economy

2. The competent authority in the Free
Zone and Financial Free Zone for the Distribution and Service Centre Business

 

 

_____________________________________________________________________

4 Source:https://www.mof.gov.ae/en/StrategicPartnerships/Document/Economic%20Substance%20Relevant%20Activities%20Summary.pdf

                      5.15  Flow-chart of the Applicability of ESR
Regulations5

 

 

 ________________________________________________________________________

5.Source: https://www.mof.gov.ae/en/StrategicPartnerships/Pages/ESR.aspx



6.0.
Relevance of ESR Regulations for Indian Entities


Many Indian companies have their
subsidiaries, branches, project offices or other forms of entities operating in
the UAE. Every such entity needs to strictly follow the ESR Regulations as
stringent penalties are prescribed. The provisions of the ESR Regulations are
stricter than Limitation of Benefits under a Tax Treaty. Therefore, each structure
would need a reassessment, review and restructuring if need be. As the
Regulations are applicable to each type of Licensee, including Free Trade
Zones, Proprietorships, etc., even individual investments need to be examined
and should comply with ESR Regulations.


7.0 Epilogue


There is a well-known saying, ‘Don’t judge
a book by its cover’. It means, a beautiful cover cannot determine the worth of
a book. It can enhance its visual appeal but not the underlying (inherent)
value. In a lighter vein, an old Bollywood song also gives us some guidance… Dil
ko dekho, chehera na dekho, chehere ne lakhon ko loota… Dil sachcha aur chehera
jhutha.

 

So, there is no doubt that one needs to
have a substance and purpose in whatever structure one enacts, whichever
jurisdiction one chooses or whatever business activities / transactions one
undertakes. One has to justify every action from the perspective of non-tax
evasion, while one can always take benefits and advantages of favourable tax
treaties / regimes with good business substance.

 

It is equally important for Indian
entrepreneurs to bear in mind the ESR Regulations in different jurisdictions,
their reporting requirements while structuring or undertaking any outbound
investments / activities. They may also need to revisit their existing
structures to fall in line with the stringent substance requirements of various
jurisdictions. It may be noted that genuine businesses need not worry, but they
will have to prove their bona fides.

 

TAXABILITY OF A PROJECT OFFICE OR BRANCH OFFICE OF A FOREIGN ENTERPRISE IN INDIA

In our last article
published in the August, 2020 issue of the BCAJ, we discussed various
aspects relating to taxability of a Liaison Office (LO) in India, including the
recent decision of the Supreme Court in the case of the U.A.E. Exchange Centre.

In addition to a Liaison
Office (LO), Project Offices (PO) and Branch Offices (BO) of foreign
enterprises have also been important modes of doing business in India for many
foreign entities.

Issues have arisen for
quite some time as to under what circumstances a PO / BO has to be considered
as a Permanent Establishment (PE) of a foreign enterprise in India and then be
subjected to tax here.

In this article, we
discuss various aspects relating to taxability of a PO / BO in India, including
the recent decision of the Supreme Court in the case of Samsung Heavy
Industries Ltd.

 

BACKGROUND


The determination of tax
liability of a foreign enterprise has been a contentious subject in the Indian
tax regime for a very long time. And whether a foreign enterprise has a PE in
India has been a highly debatable issue, though it is very fact-intensive. The
ITAT and the courts have been taking different views based on the facts of each
case.

 

A Project Office means a
place of business in India to represent the interests of the foreign company
executing a project in India but excludes a Liaison Office. A Site Office means a
sub-office of the Project Office established at the site of a project but does
not include a Liaison Office.

 

A foreign company may open
project office(s) in India provided it has secured from an Indian company a
contract to execute a project in India, and (i) the project is funded directly
by inward remittance from abroad; or (ii) the project is funded by a bilateral
or multilateral international financing agency; or (iii) the project has been
cleared by an appropriate authority; or (iv) a company or entity in India
awarding the contract has been granted term loan by a public financial
institution or a bank in India for the project.

 

A Branch Office in
relation to a company means any establishment described as such by the company.

 

As per Schedule I read
with Regulation 4(b) of the FEM (Establishment in India of a Branch Office or a
Liaison Office or a Project Office or any Other Place of Business) Regulations,
2016 [(FEMA 22(R)], a BO in India of a person resident outside India is
permitted to carry out the following activities:

(i)  Export / import of goods.

(ii) Rendering
professional or consultancy services.

(iii) Carrying out
research work in which the parent company is engaged.

(iv) Promoting technical
or financial collaborations between Indian companies and parent or overseas
group company.

(v) Representing the
parent company in India and acting as buying / selling agent in India.

(vi) Rendering services in
Information Technology and development of software in India.

(vii) Rendering technical
support to the products supplied by parent / group companies.

(viii) Representing a
foreign airline / shipping company.

 

Normally, a branch office
should be engaged in the same activity as the parent company. There is a
difference between the PO / BO and LO, both in terms of their models and, more
importantly, their permitted activities. As per the FEMA 22(R), an LO is
permitted to carry out very limited activities and can only act as a
communication channel between the source state and the Head Office; whereas a
PO / BO is permitted to carry out commercial activities, but only those
specified activities as per the RBI Regulations.

 

Thus, under FEMA 22(R) a PO
is allowed to play a larger role as compared to an LO in India. Further, the
scope of permitted activities of a BO provided in Schedule I of FEMA 22(R) is
much larger than the scope of permitted activities of an LO provided in
Schedule II of FEMA 22(R).

 

In National
Petroleum Construction Company vs. DIT (IT) [2016] 66 taxmann.com 16 (Delhi),
the Delhi High Court, after referring to the definitions of LO and PO in the
Foreign Exchange Management (Establishment in India of Branch or Office or
Other Place of Business) Regulations, 2000, held that ‘It is apparent from
the plain reading of the aforesaid definitions that whereas a liaison office
can act as a channel of communication between the principal place of business
and the entities in India and cannot undertake any commercial trading or
industrial activity, a project office can play a much wider role. Regulation (6)(ii)
of the aforesaid regulations mandates that a “project office” shall not
undertake or carry on any other activity other than the “activity relating
and incidental to execution of the project”. Thus, a project office can
undertake all activities that relate to the execution of the project and its
function is not limited only to act as a channel of communication.’

 

WHETHER A PO / BO CONSTITUTES A PE IN INDIA?


As mentioned above, as per
the prevailing FEMA regulations a PO / BO can carry out activities which may
not be limited to acting as a communication channel between the parent company
and Indian companies.

 

An issue that arises for
consideration is whether just because the scope of the permitted activities of
a PO / BO is much wider as compared to an LO under FEMA 22(R), would that be an
important consideration in determining the existence of a PE of a foreign
enterprise in India?

 

Due to the difference in
scope of activities to be carried out by an LO and a PO / BO, the assessing
officers many a times take a stand that the PO / BO is a PE of a foreign
enterprise as they are permitted to carry out commercial activities as compared
to an LO. This perception leads to the conclusion of a PO / BO being a PE in
India.

 

In order to decide whether
a PO / BO constitutes a PE in the source state, the actual activities carried
out by them in India need to be minutely analysed irrespective of the fact
whether such activities were carried out in violation of FEMA regulations and
RBI approval.

 

RELEVANT
PROVISIONS OF THE INCOME-TAX ACT, 1961 (the ITA) and the (DTAAs) relating to
PEs


Definition
under the ITA


Section 92F(iiia) defines
a PE as follows: ‘permanent establishment’, referred to in clause (iii),
includes a fixed place of business through which the business of the
enterprise is wholly or partly carried on.’

 

Section 94B defines a PE
as a ‘permanent establishment’ and includes a fixed place of business
through which the business of the enterprise is wholly or partly carried on.

 

Similarly, Explanation (b)
to section 9(1)(v), Explanation (c) to sections 44DA, 94A(6)(ii) and 286(9)(i)
defines a PE by referring to the definition given in section 92F(iiia).

 

It is important to note
that under the ITA a PE is defined in an inclusive manner. It has two limbs,
i.e. (a) it has to be a fixed place of business, and (b) through such fixed
place the business of the enterprise is wholly or partly carried on.

 

Definition of
Fixed Place PE and exceptions under the OECD Model Conventions


Since the publication of
the first ambulatory version of the OECD Model Convention in 1992, the Model
Convention was updated ten times. The last such update which was adopted in
2017 included a large number of changes resulting from the OECD / G20 Base
Erosion and Profit Shifting (BEPS) Project and, in particular, from the final
reports on Actions 2 (Neutralising the Effects of Hybrid Mismatch
Arrangements), 6 (Preventing the Granting of Treaty Benefits in
Inappropriate Circumstances), 7 (Preventing the Artificial Avoidance
of Permanent Establishment Status), and 14 (Making Dispute
Resolution Mechanisms More Effective), produced as part of that project.

 

Article 5(1) of the OECD
Model Convention 2017 update defines the term ‘permanent establishment’ as
follows:

 

‘1. For the purposes of
this Convention, the term ‘‘permanent establishment’’ means a fixed
place of business through which the business of an enterprise is wholly
or partly carried on.

 

Article 5(2) of the OECD
Model Convention 2017 provides that the term ‘permanent establishment’
includes, especially, (a) a place of management; (b) a branch; (c) an
office; (d) a factory; (e) a workshop; and (f) a mine, an oil or gas well,
a quarry or any other place of extraction of natural resources.

 

Thus, on a plain reading
of Articles 5(1) and 5(2), a branch or an office is normally considered as a PE
under a DTAA.

 

The updated Article 5(4)
provides that the term PE shall be deemed not to include:

(a) the use of facilities
solely for the purpose of storage, display or delivery of goods or
merchandise belonging to the enterprise;

(b) the maintenance of a
stock of goods or merchandise belonging to the enterprise solely for the
purpose of storage, display or delivery;

(c) the maintenance of a
stock of goods or merchandise belonging to the enterprise solely for the
purpose of processing by another enterprise;

(d) the maintenance of a
fixed place of business solely for the purpose of purchasing goods or
merchandise or of collecting information for the enterprise;

(e) the maintenance of a
fixed place of business solely for the purpose of carrying on, for the
enterprise, any other activity;

(f) the maintenance of a
fixed place of business solely for any combination of activities mentioned
in sub-paragraphs (a) to (e), provided that such activity or, in the
case of sub-paragraph (f), the overall activity of the fixed place of
business is of a preparatory or auxiliary character.

 

Paragraph 4.1 of Article 5
provides for exception to paragraph 4 as under:

‘4.1 Paragraph 4 shall not
apply to a fixed place of business that is used or maintained by an
enterprise if the same enterprise or a closely related enterprise
carries on business activities at the same place or at another place in
the same Contracting State, and

(A) that place or other
place constitutes a permanent establishment for the enterprise or the
closely related enterprise under the provisions of this Article, or

(B) the overall
activity resulting from the combination of the activities carried on by the
two enterprises at the same place, or by the same enterprise or closely related
enterprises at the two places, is not of a preparatory or auxiliary
character, provided that the business activities carried on by the two
enterprises at the same place, or by the same enterprise or closely related
enterprises at the two places, constitute complementary functions that are
part of a cohesive business operation.’

 

It is important to note
that the UN Model Convention 2017 contains a modified version of Article 5 to
prevent the avoidance of PE status which is on the same lines as Articles 5(4)
and 5(4.1) of the OECD MC mentioned above, except that in Articles 5(4)(a) and
5(4)(b) of the UN MC 2017, the word ‘delivery’ is missing. This is due to the
fact that the UN MC does not consider activity of ‘delivery’ of goods as of
preparatory or auxiliary character.

 

Determination
of existence of PE in cases of non-carrying on of ‘business’ or ‘core business’
of the assessee


On a proper reading and
analysis of Article 5(1), it would be observed that it contains two limbs and
to fall within the definition of a fixed place PE both the limbs have to be
satisfied. Therefore, in case of a PO / BO, normally the first limb is
satisfied, i.e., there is a ‘fixed place of business’ in India but if the second
limb ‘through which the business of an enterprise is wholly or partly
carried on’ is not satisfied, then a fixed place PE cannot be said to be in
existence.

 

The Tribunal and courts
have, based on the facts of each case, often held that if the actual activities
of a PO / BO did not tantamount to carrying on the business of an enterprise
wholly or partly, then a fixed place PE cannot be said to have come into
existence.

 

Recently, the Supreme
Court in the case of DIT vs. Samsung Heavy Industries Limited (SHIL)
[2020] 117 taxmann.com 870 (SC) after in-depth analysis of the facts
held that the Mumbai Project Office of SHIL cannot be said to be a fixed place
of business through which the ‘core business’ of the assessee was wholly or
partly carried on. Relying on a number of judicial precedents of the Supreme
Court in the cases of CIT vs. Hyundai Heavy Industries Co. Ltd., [2007] 7
SCC 422; DIT (IT) vs. Morgan Stanley & Co. Inc., [2007] 7 SCC 1;
Ishikawajima-Harima Heavy Industries Ltd. vs. DIT, [2007] 3 SCC 481;
and ADIT vs. E-Funds IT Solution Inc. [2018] 13 SCC 294, the
Court in paragraphs 23 and 28 held as follows:

 

‘23. A reading of the aforesaid judgments makes it clear that
when it comes to “fixed place” permanent establishments under double
taxation avoidance treaties, the condition precedent for applicability of
Article 5(1) of the double taxation treaty and the ascertainment of a
“permanent establishment” is that it should be an establishment
“through which the business of an enterprise” is wholly or partly
carried on. Further, the profits of the foreign enterprise are taxable only where the said enterprise carries on its core
business through a permanent establishment. What is equally clear is
that the maintenance of a fixed place of business which is of a preparatory or
auxiliary character in the trade or business of the enterprise would not be
considered to be a permanent establishment under Article 5. Also, it is
only so much of the profits of the enterprise that may be taxed in the other
State as is attributable to that permanent establishment.

 

28. Though it was pointed out to the ITAT that there were
only two persons working in the Mumbai office, neither of whom was qualified to
perform any core activity of the assessee, the ITAT chose to ignore the
same. This being the case, it is clear, therefore, that no permanent
establishment has been set up within the meaning of Article 5(1) of the DTAA, as
the Mumbai Project Office cannot be said to be a fixed place of business
through which the core business of the assessee was wholly or partly carried
on. Also, as correctly argued by Shri Ganesh, the Mumbai Project Office,
on the facts of the present case, would fall within Article 5(4)(e) of the
DTAA, inasmuch as the office is solely an auxiliary office, meant to act as a
liaison office between the assessee and ONGC. This being the case, it is
not necessary to go into any of the other questions that have been argued
before us.’

 

In the context of a fixed
place PE, in the SHIL case the Supreme Court mentioned and summarised the
aforesaid aspect in the decision in the case of Morgan Stanley & Co.
Inc. (Supra) as under:

 

‘17. Some of the judgments of this Court have dealt with
similar double taxation avoidance treaty provisions and therefore need to be
mentioned at this juncture. In Morgan Stanley & Co. Inc. (Supra),
the Double Taxation Avoidance Agreement (1990) between India and the United
States of America was construed. …..Tackling the question as to whether a
“fixed place” permanent establishment existed on the facts of that
case under Article 5 of the India-US treaty – which is similar to Article 5 of
the present DTAA – this Court held:

 

“10. In our view, the second requirement of Article 5(1) of DTAA is not
satisfied as regards back office functions. We have examined the
terms of the Agreement along with the advance ruling application made by MSCo
inviting AAR to give its ruling. It is clear from reading of the above
Agreement / application that MSAS in India would be engaged in supporting the
front office functions of MSCo in fixed income and equity research and in
providing IT-enabled services such as data processing support centre and
technical services, as also reconciliation of accounts. In order to
decide whether a PE stood constituted one has to undertake what is called as a
functional and factual analysis of each of the activities to be undertaken by
an establishment. It is from that point of view we are in agreement with the
ruling of AAR that in the present case Article 5(1) is not applicable as the
said MSAS would be performing in India only back office operations. Therefore
to the extent of the above back office functions the second part of Article
5(1) is not attracted.”

 

14. There is one more
aspect which needs to be discussed, namely, exclusion of PE under Article 5(3).
Under Article 5(3)(e) activities which are preparatory or auxiliary in
character which are carried out at a fixed place of business will not
constitute a PE. Article 5(3) commences with a non obstante clause. It states that notwithstanding what is stated in
Article 5(1) or
under Article 5(2) the term PE shall not include maintenance of a fixed place
of business solely for advertisement, scientific research or for activities
which are preparatory or auxiliary in character. In the present case we are
of the view that the abovementioned back office functions proposed to be
performed by MSAS in India falls under Article 5(3)(e) of the DTAA. Therefore,
in our view in the present case MSAS would not constitute a fixed place PE
under Article 5(1) of the DTAA as regards its back office operations.’

 

The Supreme Court further
mentioned about the decision in the case of E-Funds IT Solution Inc. (Supra)
as follows:

 

‘22. Dealing with “support services” rendered by an Indian
Company to American Companies, it was held that the outsourcing of such
services to India would not amount to a fixed place permanent establishment
under Article 5 of the aforesaid treaty, as follows:

 

“22. This report
would show that no part of the main business
and revenue-earning activity of the two American companies is carried on
through a fixed business place in India which has been put at their
disposal. It is clear from the above that the Indian company only renders
support services which enable the assessees in turn to render services to their
clients abroad. This outsourcing of work to India would not give rise to a
fixed place PE and the High Court judgment is, therefore, correct on this
score.”’

 

In view of above
discussion, to constitute a fixed place PE it is particularly important to
determine what constitutes the ‘Business’, ‘Core Business’ or the ‘Main
business’, as referred to by the Supreme Court, of the assessee foreign
enterprise. This determination is going to be purely based on the facts and
hence an in-depth functional and factual analysis of the activities being
actually performed by the PO / BO would be required to be carried out in each
case.

 

The term ‘business’ is
defined in an inclusive manner in section 2(13) of the ITA as follows:
‘Business’ includes any trade, commerce, manufacture or any adventure or
concern in the nature of trade, commerce or manufacture.

 

Article 3(1)(h) of the
OECD MC provides that the term ‘business’ includes the performance of
professional services and of other activities of an independent character.

 

From
an overall analysis of the decisions, it appears that if the activities of the
PO / BO are purely in the nature of back office activities or support services
which enables the assessee foreign enterprise in turn to render services to
their clients abroad or performing mere coordination and executing delivery of
documents, etc., then the same would not be considered as the core or main
business of the assessee, and accordingly a PO / BO performing such activities
would not constitute a fixed place PE in India.

 

It is not quite clear as
to whether to constitute Core or Main business of the assessee foreign
enterprise there has to be revenue-earning activity in India, i.e., having
customers or clients in India to whom goods are sold or for whom services are
rendered, invoiced and revenue generated in India, is necessary for the same to
be constituting a fixed place PE in India and consequently be taxable in India.

 

RELIANCE OF RELEVANT DOCUMENTS


Since the determination of
a fixed place PE is predominantly an in-depth fact-based exercise, the ITAT and
the courts have to rely on various relevant documents.

 

It has been observed that
in the application to the Reserve Bank of India (RBI) for obtaining approval of
PO / BO, the relevant Board resolution of the foreign enterprise to open a PO /
BO, the approval given by the RBI, the accounts maintained by the PO / BO in
India, etc., are very relevant for arriving at the determination of the
existence of a PE in India.

 

The ITAT in SHIL vs.
ADIT IT [2011] 13 taxmann.com 14 (Delhi), largely relied upon (a)
SHIL’s application to RBI for opening the PO; (b) SHIL’s Board Resolution for
opening the PO; and (c) RBI’s approval for opening the PO. In respect of the
Board Resolution, the ITAT focused on its first paragraph alone and in
paragraph 71 of the order observed as follows:

 

‘71. There is a force in the contention of Learned DR that
the words “That the Company hereby open one project office in Mumbai,
India for co-ordination and execution of Vasai East Development Project for Oil
and Natural Gas Corporation Limited (ONGC), India” used by the assessee company
in its resolution of Board of Directors meeting dated 3-4-2006 makes it
amply clear that the project office was opened for coordination and execution
of the impugned project. In the absence of any restriction put by the assessee
in the application moved by it to the RBI, in the resolutions passed by the
assessee company for the opening of the project office at Mumbai and the
permission given by RBI, it cannot be said that Mumbai project office was not a
fixed place of business of the assessee in India to carry out wholly or partly
the impugned contract in India within the meaning of Article 5.1 of DTAA.
These documents make it clear that all the activities to be carried out in
respect of impugned contract will be routed through the project office only.’

 

All these gave a prima
facie impression that the PO was opened for coordination and execution of
the entire project and was thus involved in the core business activity of SHIL
in India.

 

However, the Supreme Court
delved deeper and looked at various other factors which the ITAT had ignored or
dismissed. In paragraphs 27 and 28, the Court, relying on the second paragraph
of the Board Resolution which clarified that the PO was established for
coordinating and executing delivery of certain documents, and not for the
entire project, the fact that the accounts of the PO showed no expenditure
incurred in relation to execution of the contract and that the only two people
employed in the PO were not qualified to carry out any core activity of SHIL,
concluded that no fixed place PE has been set up within the meaning of Article
5(1) read with Article 5(4)(e) of the India-Korea DTAA.

 

The
above indicates that the determination of the existence of a fixed place PE of
a foreign enterprise in India requires a deep factual and functional analysis
and the same cannot be determined on mere prima facie satisfaction.

 

Even in the case of Union
of India vs. U.A.E. Exchange Centre [2020] 116 taxmann.com 379 (SC)
dealing with the question relating to a Liaison Office being considered as a
fixed place PE in India, the Court relied on the approval letter given by the
RBI. In paragraph 9 of the judgment. the Supreme Court mentioned that ‘keeping
in mind the limited permission and the onerous stipulations specified by the
RBI, it could be safely concluded, as opined by the High Court, that the
activities in question of the liaison office(s) of the respondent in India are
circumscribed by the permission given by the RBI and are in the nature of
preparatory or auxiliary character. That finding reached by the High Court is
unexceptionable.’

 

In Hitachi High
Technologies Singapore Pte Ltd. vs. DCIT [2020] 113 taxmann.com 327
(Delhi-Trib.) the ITAT held that whether the assessee violated the
conditions of RBI or FEMA is not relevant in determining the LO as a PE under
the I.T. Act.

 

It appears
that there is an increasing reliance by the ITAT and courts, inter alia, on the application and related documents
and the approval of the RBI in considering whether an LO / PO / BO can
constitute a fixed place PE in India.

 

INITIAL ONUS REGARDING EXISTENCE OF A FIXED PLACE PE IN
INDIA


An important question
arises as to whether the onus is on the assessee or the tax authorities to
first show that a PO / BO is a fixed place PE in India.

 

The ITAT in the SHIL
case (Supra) held that the initial onus was on the assessee and not the
Revenue. However, the Supreme Court in the SHIL case reiterated the fact
that the initial onus lies on the Indian Revenue, and not the assessee, to
prove that there is a PE of the foreign enterprise in India before moving
further to determine the Indian tax liability of that enterprise. While
reversing the finding of the ITAT, the Supreme Court stated that ‘Equally
the finding that the onus is on the Assessee and not on the Tax Authorities to
first show that the project office at Mumbai is a permanent establishment is
again in the teeth of our judgment in E-Funds IT Solution Inc. (Supra).’

 

The Supreme Court in E-Funds
IT Solution Inc. (Supra) stated that the burden of proving the fact
that a foreign assessee has a PE in India and must, therefore, suffer tax from
the business generated from such PE, is initially on the Revenue. The
Court observed as follows:

 

‘16. The Income-tax Act,
in particular Section 90 thereof, does not speak of the concept of a PE. This
is a creation only of the DTAA. By virtue of Article 7(1) of the DTAA, the
business income of companies which are incorporated in the US will be taxable
only in the US, unless it is found that they were PEs in India, in which event
their business income, to the extent to which it is attributable to such PEs,
would be taxable in India. Article 5 of the DTAA set out hereinabove provides
for three distinct types of PEs with which we are concerned in the present
case: fixed place of business PE under Articles 5(1) and 5(2)(a) to 5(2)(k);
service PE under Article 5(2)(l) and agency PE under Article 5(4). Specific and
detailed criteria are set out in the aforesaid provisions in order to fulfil
the conditions of these PEs existing in India. The burden of proving the
fact that a foreign assessee has a PE in India and must, therefore, suffer tax
from the business generated from such PE is initially on the Revenue. With
these prefatory remarks, let us analyse whether the respondents can be brought
within any of the sub-clauses of Article 5.’

 

In view of above referred
two Supreme Court decisions, it can be said that the initial onus is on the
Revenue and not on the assessee.

 

PREPARATORY OR AUXILIARY ACTIVITIES TEST


As mentioned above,
Article 5(4) of the OECD MC provides exclusionary clauses in respect of a fixed
place PE provided the activities of a PE, or in case of a combination of
activities the overall activities, are of a preparatory or auxiliary
character. In this connection, the readers may refer to extracts of the
OECD Commentary in this regard discussed in paragraph 4 of the article
published in the BCAJ of August, 2020 in respect of Taxability of the
Liaison Office of a Foreign Enterprise in India.

 

Further, in the context of
activities of an ‘auxiliary’ character, in National Petroleum
Construction Company vs. DIT (IT) (Supra) the Delhi High Court in paragraph
28 explained as follows:

 

‘28. The Black’s Law Dictionary defines the word “auxiliary”
to mean as “aiding or supporting, subsidiary”. The word “auxiliary”
owes its origin to the Latin word “auxiliarius” (from auxilium meaning help).
The Oxford Dictionary defines the word auxiliary to mean “providing
supplementary or additional help and support”. In the context of Article
5(3)(e) of the DTAA, the expression would necessarily mean carrying on
activities, other than the main business functions, that aid and support the
Assessee. In the context of the contracts in question, where the main
business is fabrication and installation of platforms, acting as a
communication channel would clearly qualify as an activity of auxiliary
character – an activity which aids and supports the Assessee in carrying on its
main business.’

 

BEPS Report on Action 7 – Preventing
the Artificial Avoidance of Permanent Establishment Status


When the exceptions to the
definition of PE that are found in Article 5(4) of the OECD Model Tax
Convention were first introduced, the activities covered by these exceptions
were generally considered to be of a preparatory or auxiliary nature.

 

Since the introduction of
these exceptions, however, there have been dramatic changes in the way that
business is conducted. Many such challenges of a digitalised economy are
outlined in detail in the Report on Action 1, Addressing the Tax Challenges
of the Digital Economy. Depending on the circumstances, activities
previously considered to be merely preparatory or auxiliary in nature may nowadays
correspond to core business activities. In order to ensure that profits derived
from core activities performed in a country can be taxed in that country,
Article 5(4) is modified to ensure that each of the exceptions included therein
is restricted to activities that are otherwise of a ‘preparatory or auxiliary’
character.

 

BEPS concerns related to
Article 5(4) also arose from what is typically referred to as the
‘fragmentation of activities’. Given the ease with which multinational
enterprises may alter their structures to obtain tax advantages, it was
important to clarify that it is not possible to avoid PE status by fragmenting
a cohesive operating business into several small operations in order to argue
that each part is merely engaged in preparatory or auxiliary activities that
benefit from the exceptions of Article 5(4).

 

Article 13 of
Multilateral Instrument (MLI) – Artificial avoidance of Permanent Establishment
status through the Specific Activity Exemptions


MLI has become effective
in India from 1st April, 2020 and it will affect many Indian DTAAs
post MLI because, wherever applicable, MLI will impact the covered tax
agreements. Article 13 of MLI deals with the artificial avoidance of PE through
specific activity exemptions, i.e., activities which are preparatory or
auxiliary in nature, and provides two options, i.e. ‘Option A’ and ‘Option B’.

 

India
has opted for ‘Option A’, which continues with the existing list of exempted
activities from (a) to (e) in Article 5(4), but has added one more sub-clause
(f) which states that the maintenance of a fixed place of business solely for
any combination of activities mentioned in sub-paragraphs (a) to (e) is covered
in the exempt activities, provided all the activities mentioned in sub-clauses
(a) to (e) or a combination of these activities must be preparatory or
auxiliary in nature. Therefore, as per modified Article 5(4), in order to be
exempt from fixed place PE, each activity on a standalone basis as well as a
combination of activities should qualify as preparatory or auxiliary activity
test.

 

INDIAN JUDICIAL PRECEDENTS


On the issue of whether a
PO / BO constitutes a fixed place PE in India, there are mixed judicial
precedents, primarily based on the facts of each case. In addition to various Supreme
Court cases mentioned and discussed above, there are many other judicial
precedents in this regard.

 

BO Cases


In a few cases, based on
the peculiar facts of each case, the Tribunals and courts have held that a BO
does not constitute a fixed place PE in India. In this regard, useful reference
can be made to the following case: Whirlpool India Holdings Ltd. vs. DDIT
IT [2011] 10 taxmann.com 31 (Delhi).

 

However, in the following
case it has been held that a BO constitutes a fixed place PE in India: Hitachi
High Technologies Singapore Pte Ltd. vs. DCIT [2020] 113 taxmann.com 327
(Delhi-Trib.).

 

In the case of Wellinx
Inc. vs. ADIT IT [2013] 35 taxmann.com 420 (Hyderabad-Trib.), where it
was contended by the assessee that the income of the BO is not taxable in
India, the ITAT held that services performed by a branch office are on account
of outsourcing of commercial activities by its head office, and income arising
out of such services rendered would be taxable under article 7(3) of the
India-USA DTAA.

 

PO Cases


Similarly, in the case of
POs, based on the factual matrix the following cases have been decided in
favour of assessees as well as the Revenue:

 

In favour of the
assessees:

Sumitomo
Corporation vs. DCIT [2014] 43 taxmann.com 2 (Delhi-Trib.);

National
Petroleum Construction Company vs. DIT (IT) [2016] 66 taxmann.com 16 (Delhi);

HITT Holland
Institute of Traffic Technology B.V. vs. DDIT (IT) [2017] 78 taxmann.com 101
(Kolkata-Trib.).

 

In favour of the Revenue:

Voith Paper
GmbH vs. DDIT [2020] 116 taxmann.com 127 (Delhi-Trib.);

Orpak Systems
Ltd. vs. ADIT (IT) [2017] 85 taxmann.com 235 (Mumbai-Trib.).

 

KEY POINTS OF JUDGMENT OF THE SUPREME COURT IN SHIL


The Supreme Court in this
case has clearly established that facts are important in deciding about the
existence of a fixed place PE in India, while principles of interpretations
more or less remain constant. It is imperative that one must minutely look into
the facts and actual activities to decide existence of a fixed place PE in case
of a PO / BO.

 

The key points of this
judgment can be summarised as under:

  •  In deciding whether a
    project office constitutes a fixed place PE, the entire set of documentation
    including the relevant Board resolutions, application to RBI and approval of
    the RBI, should be read minutely and understood in their entirety.
  •  The detailed factual and
    functional analysis of the actual activities and role of PO / BO in India is
    crucial in determining a PE. It would be necessary to determine whether the PO
    / BO carries on business / core business or the main business of the foreign
    enterprise in India.
  • The nature of expenses
    debited in the accounts of the PO / BO throws light and cannot be brushed aside
    on the ground that the accounts are entirely in the hands of the assessee. They
    do have relevance in determining the issue in totality.
  •  It reiterates that the
    initial onus is on the Revenue to prove the existence of a fixed placed PE in
    India.

 

Even post-MLI, the Supreme
Court ruling in SHIL’s case should help in interpretation on a fixed place PE
issue.

 

CONCLUSION


The issue of existence of
a fixed place PE in case of a PO / BO has been a subject matter of debate
before the ITAT and courts for long. The ruling of the Supreme Court in SHIL’s case
endorses the settled principles on fixed place PE in the context of a PO of a
turnkey project. The Supreme Court reiterated that a fixed place PE emerges
only when ‘core business’ activities are carried on in India. The Court brings
forth more clarity on the existence of a fixed place PE or otherwise in case of
a PO / BO and should instil confidence in multinationals to do business in
India and bring much needed certainty in this regard.  

 

TAXABILITY OF THE LIAISON OFFICE OF A FOREIGN ENTERPRISE IN INDIA

A liaison
office (LO) has been an important mode of entry into India of many foreign entities
wishing to do business and make investments here.

A dispute
has been going on for quite some time about whether an LO has to be considered
as a Permanent Establishment (PE) of the non-resident in India and be subjected
to tax.

In this
article we have discussed various aspects relating to the taxability of an LO
in India, including the recent decision of the Supreme Court in the case of the
U.A.E. Exchange Centre.

 

1. BACKGROUND

In many
cases, an enterprise usually tests the waters outside its domestic jurisdiction
in an endeavour to expand business. In the initial phase of establishment of
business in the host country, a multinational corporation (MNC) conducts market
research, develops strategies to explore the foreign market, formulates plans, maintains
liaison with the government officials, etc. After such preliminary activities,
it commences operations in the foreign market, controlled or managed either
from the home country or in the foreign host country.

 

To undertake
such exploratory or precursory activities, MNCs establish an LO in the host
country. The RBI
also permits this, subject to the condition that it is venturing into certain
limited areas of permitted activities only. Undertaking any activity beyond the
rigours of the permitted activities requires an application for conversion of
such LO into a Branch Office or Project Office, or any other body corporate, as
the case may be.

 

Thus, an MNC
/ foreign company can do business in India either by opening an LO or a branch
office, or a limited liability partnership ?rm, or a subsidiary or wholly-owned
subsidiary, depending upon its business requirements in India. Each of the
above modes of setting up business presence in India is governed by the Foreign
Exchange Management Regulations.

 

As per
Schedule II read with Regulation 4(b) of the FEM (Establishment in India of a
Branch Office or a Liaison Office or a Project Office or any Other Place of
Business) Regulations, 2016 [FEMA 22(R)], an LO in India of a person resident
outside India is permitted to carry out the following limited activities:

(i)  Representing the parent company / group
companies in India.

(ii)  Promoting export / import from / to India.

(iii)
Promoting technical / financial collaborations between parent / group companies
and companies in India.

(iv) Acting
as a communication channel between the parent company and Indian companies.

 

Thus, an LO
is not permitted to carry out, directly or indirectly, any trading or
commercial or industrial activity in India. The LO can operate only out of
inward remittance received from the parent company in India. When a foreign
company operates through an LO in India, there is no income that is taxable in
India as it is not permitted to earn any income here. The activities mentioned
above are essentially of a preparatory or auxiliary nature.

 

2. WHETHER AN LO CONSTITUTES A PE IN INDIA?

As mentioned
above, as per the prevailing FEMA regulations, an LO cannot carry on any
activity in India other than activities permitted as per FEMA 22(R). However,
in practice it is observed in some cases that LOs carry out activities which
may not be limited to acting as a communication channel between the parent
company and Indian companies.

 

Thus, time
and again doubts arise in respect of the business activities carried out by a
foreign company in India through an LO and whether the said activities can be
taxable in India. The actual activities could vary from case to case. It may be
difficult to presume that an LO will not constitute a PE merely because RBI has
given permission for setting up an LO in India on specific terms and
conditions.

 

To determine
whether an LO constitutes a PE and consequent taxability of the same in India,
it is very important to examine whether it is carrying out an important part of
the business activities of the foreign company, or only the preparatory and
auxiliary activities as permitted under FEMA 22(R).

 

3. RELEVANT PROVISIONS OF THE INCOME-TAX ACT, 1961 AND
THE DOUBLE TAXATION AVOIDANCE AGREEMENTS (DTAAs)

Section 9 of
the ITA, 1961 contains provisions relating to income deemed to accrue or arise
in India and includes all income accruing or arising, whether directly or
indirectly, through or from any business connection in India. Explanation 1(a)
to section 9(1)(i) provides that in case of a business of which all the
operations are not carried out in India, the income of the business deemed u/s
9(1)(i) to accrue or arise in India shall be only such part of the income as is
reasonably attributable to the operations carried out in India.

 

Further,
Explanation 1(b) to section 9(1)(i) provides that in the case of a
non-resident, no income shall be deemed to accrue or arise in India to him
through or from operations which are confined to the purchase of goods in India
for the purposes of export.

 

Under
Article 5(1) and (2) of the DTAAs, an LO may be treated as ‘fixed place of
business’ and accordingly a PE in India. However, relief is provided under
Article 5(4) to exclude the activities which are ‘preparatory or auxiliary’ in
nature.

 

4. PREPARATORY OR AUXILIARY ACTIVITIES TEST – OECD
COMMENTARY

The terms
‘preparatory’ or ‘auxiliary’ have not been defined under the ITA or under the
DTAAs. Various judicial decisions have attempted to define the same. The term
‘preparatory’ has been explained to mean something done before or for the
preparation of the
main task. Similarly, the term ‘auxiliary’ has been interpreted to mean an
activity ‘aiding’ or supporting the main activity.

 

The OECD
Commentary on the Model Tax Convention on Income and on Capital dated 21st
November, 2017 in relevant paragraphs 59, 60 and 71 deals with various aspects
of preparatory auxiliary activities. The said paragraphs read as under:

 

‘59.  It is often difficult to distinguish between
activities which have a preparatory or auxiliary character and those which have
not. The decisive criterion is whether or not
the activity of the fixed place of business in itself forms an essential and
significant part of the activity of the enterprise as a whole. Each individual
case will have to be examined on its own merits. In any case, a fixed place of
business whose general purpose is one which is identical to the general purpose
of the whole enterprise does not exercise a preparatory or auxiliary activity.

           

60.  As a general rule, an activity that has a
preparatory character is one that is carried on in contemplation of the
carrying on of what constitutes the essential and significant part of the
activity of the enterprise as a whole. Since a preparatory activity
precedes another activity, it will often be carried on during a relatively
short period, the duration of that period being determined by the nature of the
core activities of the enterprise. This, however, will not always be the case
as it is possible to carry on an activity at a given place for a substantial
period of time in preparation for activities that take place somewhere else.
Where, for example, a construction enterprise trains its employees at one place
before these employees are sent to work at remote work sites located in other
countries, the training that takes place at the first location constitutes a
preparatory activity for that enterprise. An activity that has an auxiliary
character, on the other hand, generally corresponds to an activity that is
carried on to support, without being part of, the essential and significant
part of the activity of the enterprise as a whole. It is unlikely that an
activity that requires a significant proportion of the assets or employees of
the enterprise could be considered as having an auxiliary character.

 

71. Examples
of places of business covered by sub-paragraph e) are fixed places of business
used solely for the purpose of advertising or for the supply of information or
for scientific research or for the servicing of a patent or a know-how
contract, if such activities have a preparatory or auxiliary character.
Paragraph 4 would not apply, however, if a fixed place of business used for the
supply of information would not only give information but would also furnish
plans, etc. specially developed for the purposes of the individual customer.
Nor would it apply if a research establishment were to concern itself with
manufacture. Similarly, where the servicing of patents and know-how is the
purpose of an enterprise, a fixed place of business of such enterprise
exercising such an activity cannot get the benefits of paragraph 4. A fixed
place of business which has the function of managing an enterprise or even only
a part of an enterprise or of a group of the concern cannot be regarded as
doing a preparatory or auxiliary activity, for such a managerial activity
exceeds this level. If an enterprise with international ramifications
establishes a so-called “management office” in a State in which it maintains
subsidiaries, permanent establishments, agents or licensees, such office having
supervisory and coordinating functions for all departments of the enterprise
located within the region concerned, sub-paragraph e) will not apply to that
“management office” because the function of managing an enterprise, even if it
only covers a certain area of the operations of the concern, constitutes an
essential part of the business operations of the enterprise and therefore can
in no way be regarded as an activity which has a preparatory or auxiliary
character within the meaning of paragraph 4.’

 

In order to
determine whether an LO of an MNC constitutes its PE in India, an in-depth
analysis is required to be done based on the factual information available, for
example, considering the nature of the activities undertaken by the LO, the
business of the MNC and the overall facts and circumstances of the case. In
this it is very important to consider the various judicial precedents on the
subject.

 

5. INDIAN JUDICIAL PRECEDENTS

On the issue
of whether an LO constitutes a PE in India, there are mixed judicial
precedents, primarily based on the facts of each case.

 

In a few
cases, the Tribunals and Courts have held that an LO does not constitute a
fixed place PE in India because the LO was carrying on activities / operations
within the framework of permitted activities by the RBI, i.e. preparatory or
auxiliary activities. In this regard, useful reference can be made
to the following cases:

• IAC vs.
Mitsui & Co. Ltd. [1991] 39 ITD 59 (Delhi)(SB);

• Motorola
Inc. vs. DCIT [2005] 95 ITD 269 (Delhi)(SB);

• Western
Union Financial Services Inc. vs. ADIT [2007] 104 ITD 40 (Delhi)

• Sumitomo
Corporation vs. DCIT [2008] 114 ITD 61 (Delhi);

• Metal One
Corporation vs. DDIT [2012] 52 SOT 304 (Delhi);

• DIT vs.
Mitsui & Co. Ltd. [2018] 96 taxmann.com 371 (Delhi);

• Nagase
& Co. Ltd. vs. DDIT [2019] 109 taxmann.com 288 (Mumbai-Trib.);

• Kawasaki
Heavy Industries Ltd. vs. ACIT [2016] 67 taxmann.com 47 (Delhi-Trib.).

 

However, in
a few other cases, Tribunals / Courts have, based on the specific facts of the
cases, held that an LO constitutes a fixed place PE in India because it was
carrying on certain activities which were in the nature of commercial / core
activities of the taxpayer. A list of such cases is
given below:

• U.A.E.
Exchange Centre [2004] 139 Taxman 82 (AAR);

• Columbia
Sportswear Co. (AAR) [2011] 12 taxmann.com 349 (AAR);

• Jebon
Corporation India vs. CIT(IT) [2012] 19 taxmann.com 119 (Karnataka);

• Brown
& Sharpe Inc. vs. ACIT [2014] 41 taxmann.com 345 (Delhi-Trib.) affirmed in
Brown & Sharpe Inc. vs. CIT [2014] 51 taxmann.com 327 (All.);

• GE Energy
Parts Inc. vs. CIT(IT) [2019] 101 taxmann.com 142 (Delhi);

• Hitachi
High Technologies Singapore Pte Ltd. vs. DCIT [2020] 113 taxmann.com 327
(Delhi-Trib.).

 

Some other
relevant judicial precedents in this regard are as under:

• Gutal
Trading Est., In re [2005] 278 ITR 643 (AAR);

• Angel
Garment Ltd., In re [2006] 287 ITR 341(AAR);

• Cargo
Community Network PTE Ltd., In re [2007] 289 ITR 355 (AAR);

• Sojitz
Corporation vs. ADIT [2008] 117 TTJ 792 (Kol.);

• Mitsui
& Co. Ltd. vs. ACIT [2008] 114 TTJ 903 (Delhi);

• K.T.
Corpn. [2009] 181 Taxman 94 (AAR);

• IKEA
Trading (Hong Kong) Ltd. [2009] 308 ITR 422 (AAR);

• Mondial
Orient Ltd. vs. ACIT [2010] 42 SOT 359 (Bang.);

• M.
Fabricant & Sons Inc. vs. DDIT [2011] 48 SOT 576 (Mum.);

• Nike Inc.
vs. ACIT [2013] 125 ITD 35 (Bang.);

• Linmark
International (Hong Kong) Ltd. vs. DDIT (IT) [2011] 10 taxmann.com 184 (Delhi);

• CIT vs.
Interra Software India (P.) Ltd. [2011] 11 taxmann.com 82 (Delhi).

 

6. A BRIEF ANALYSIS OF SOME OF THE DECISIONS based on the nature of the activities of the
LOs is given below to understand the judicial thinking on the subject.

(A) Routine
functions of LO

Earlier, the
ITAT, Mumbai considering the specific facts in the case of Micoperi Spa
Milano vs. DCIT [2002] 82 ITD 369 (Mum.) had held that maintenance of a
project office in India and incurring expenses for maintaining such office,
cost of postage, telex, etc., indicates that the MNC has a PE in India.

 

However,
where routine functions are performed by the LO in India and for the purposes
of performing such routine functions the LO has been given limited powers, it
cannot be held that a MNC has a PE in India in the form of its LO.

 

In Kawasaki
Heavy Industries Ltd. vs. ACIT [2016] 67 taxmann.com 47 (Delhi- rib.),
the ITAT held that:

(a) The
powers / rights granted by an MNC to its LO in India such as (i) Signing of
documents for renting of premises, equipment, services with any person,
including Municipal bodies, governments, etc., as may be required for the
operation of the LO; (ii) Execution of contracts for purchase of items for
operation of the LO, etc. are specific to the operations of the LO and the
stand of the A.O., that the power of attorney is an ‘open document’ giving
unfettered powers to the LO, would be outside the scope of the initial approval
granted by the RBI.

(b) Prima
facie, a reading of the power of attorney does not demonstrate that the
employees of the assessee at the LO are authorised to do core business activity
or to sign and execute contracts, etc.

(c) The A.O.
has not brought on record any material, other than his interpretation of the
terms of the power of attorney, to demonstrate that the LO is carrying on core
business activity warranting his conclusion that the assessee has a PE in
India.

 

Thus, in
respect of routine functions of the LO, the same may not be considered as
constituting a PE in India.

 

(B)  Purchase activities for the purposes of
exports

Under
Explanation 1(b) of section 9(1)(i), purchase
functions or a part thereof, performed by an LO in India has been consistently
held as outside the purview of such LO having any taxable income in India.

 

In Ikea
Trading (Hong Kong) Ltd. [2009] 308 ITR 422 (AAR), the AAR has held that
where the LO’s activities are confined only to facilitate the purchase of goods
in India for the purposes of export outside India, such activities are covered
by restriction / relief provided under Explanation 1(b) to section 9(1)(i) of
the Act and, accordingly, no income is deemed to accrue or arise in India with
respect to the operations carried out by the LO in India. A similar view has
been taken in ADIT (IT) vs. Tesco International Sourcing Ltd. [2015] 58
taxmann.com 133 (Bang.-Trib.).

 

The Karnataka
High Court in Columbia Sportswear Co. vs. DIT (IT) [2015] 62 taxmann.com
240, reversing the decision of the AAR in Columbia Sportswear Co.
[2011] 12 taxmann.com 349 (AAR), held that all the activities
undertaken by the LO of an MNC such as designing, manufacturing, identifying
vendors, negotiating with vendors, ensuring quality control of the products
manufactured by vendors, quality assurance, on-time delivery, acting as a
conduit or ‘go between’ between the vendors in India / Egypt / Bangladesh and the
MNC situated outside India, are ‘activities necessary’ for carrying out a
purchase function in India, as otherwise the goods purchased from India would
not find any customer outside India. Accordingly, such activities are not the
‘activities other than sale of goods’ as held by AAR, rather, they are an
extension / necessary part of the purchase function itself, so carried out by
the LO in India. Accordingly, appropriate relief as provided under Explanation
1(b) to section 9(1)(i) of the Act is required to be extended to the taxpayer.

 

(C) Information collection, research and
aiding activities

Initial
research, information collection and preliminary advertising undertaken by an
LO in India has been held to be in the nature of ‘preparatory’ or ‘auxiliary’
activity, and thus it has been held that the LO does not constitute the PE of
its MNC in India.

 

The AAR in
the case of K.T. Corporation [2009] 181 Taxman 94 (AAR) held that
the activities in the nature of:

(i)   Holding seminars, conferences;

(ii)
Receiving trade inquiries from the customers;

(iii)
Advertising about the technology being used by the MNC in its products /
services and answering the queries of the customers;

(iv)
Collecting feedback from the customers / prospective customers, trade
organisations and not playing any role in pre-bid survey, etc., before entering
into the agreement with its customers, nor involving itself in the technical
analysis of the products / services, are in aid or support of the ‘core
business activity’ of the MNC and, thus, fall under the exclusionary clauses
(e) and (f) of Article 5(4) of the DTAA between India and Korea. It is
pertinent to note that the AAR also noted that the LO is confined to carrying
out preparatory or auxiliary activities only.

 

The AAR also
said, ‘However, we may add here that if the activities of the liaison office
are enlarged beyond the parameters fixed by RBI or if the Department lays its
hands on any concrete materials which substantially impact on the veracity of
the applicant’s version of facts, it is open to the Department to take
appropriate steps under law. But, at this stage, we proceed to give ruling on
the basis of facts stated by the applicant which cannot be treated as ex
facie untrue.’

 

Similarly,
the Delhi High Court in the case of Nortel Networks India International
Inc. vs. DIT [2016] 69 taxmann.com 47 held that where the Indian
subsidiary of the MNC negotiated and entered into contracts with the customers
of the MNC, the LO of the same MNC could not be held to be a PE of the MNC in
India, especially when the tax authorities had not brought on record any
evidence that the LO had participated in the negotiation of the contracts.

 

The ITAT,
Mumbai in the case of Nagase & Co. Ltd. vs. DDIT [2018] 96
taxmann.com 504 (Mum.-Trib.) held that in the absence of any material
or evidence brought on record by the Revenue authorities to the effect that the
LO was executing business or contracts independently with the customers in
India, the plea of the assessee that it was engaged in carrying out only
preparatory or auxiliary activities needs to be accepted and, accordingly, the
taxpayer’s LO in India did not constitute its PE in India.

 

(D)
Marketing activities

Where the LO
undertakes the preliminary activities of advertising, identification of customers,
attending to queries of customers, such activities would fall within the ambit
of preparatory / auxiliary activities and, accordingly, the LO would not
qualify as a PE of the MNC in India.

 

However,
where such activities cross the ‘thin-line’ of preparatory / auxiliary
activities and venture into performing income-generating activities, such
activities would require the LO to be treated as the PE of the MNC in India.

 

The
Karnataka High Court in the case of Jabon Corporation India vs. CIT (IT)
[2012] 19 taxmann.com 119 (Karnataka), while upholding the decision of
ITAT, Bangalore in the case of DDIT (IT) vs. Jebon Corpn. India [2010]
125 ITD 340 (Bang.-Trib.) that the LO has to be treated as the PE of
the Korean parent, held as follows:

 

‘10. It is on the basis of the aforesaid material, the Tribunal held that
the activities carried on by the liaison office are not confined only to the
liaison work. They are actually carrying on the commercial activities of
procuring purchase orders, identifying the buyers, negotiating with the buyers,
agreeing to the price, thereafter, requesting them to place a purchase order
and then the said purchase order is forwarded to the Head Office and then the
material is dispatched to the customers and they follow up regarding the
payments from the customers and also offer after-sales support. Therefore,
it is clear that merely because the buyers place orders directly with the Head
Office and make payment directly to the Head Office and it is the Head Office
which directly sends goods to the buyers, would not be sufficient to hold that
the work done by the liaison office is only liaison and it does not constitute
a permanent establishment as defined in Article 5 of DTAA. In fact, the
Assessing Officer has clearly set out that what was discovered during the
investigation and the same has been properly appreciated by the Tribunal and it
came to the conclusion that though the liaison office was set up in Bangalore
with the permission of the RBI and in spite of the conditions being
stipulated in the said permission preventing the liaison office from carrying
on commercial activities, they have been carrying on commercial activities.

 

11. It was further contended that the RBI has not taken any action and
therefore such interference is not justified. Once the material on record
clearly establishes that the liaison office is undertaking an activity of
trading and therefore entering into business contracts, fixing price for sale
of goods and merely because, the officials of the liaison office are not
signing any written contract would not absolve them from liability. Now that
the investigation has revealed the facts, we are sure that the same will be
forwarded to the RBI for appropriate action in the matter in accordance with
law. But merely because no action is initiated by RBI till today would not
render the findings recorded by the authorities under the Income-tax Act as
erroneous or illegal.

 

12. We are satisfied from the material on record that the finding recorded by
the Tribunal is based on legal evidence and that the finding that the liaison
office is a permanent establishment as defined under Article 5 of the DTAA and
therefore, the business profits earned in India through this liaison office is
liable for tax is established.’

 

The
Allahabad High Court in the case of Brown & Sharpe Inc. vs. CIT
[2014] 51 taxmann.com 327 (All.) held that the activities such as:

(i)
Explaining the products to the buyers in India;

(ii)
Furnishing information in accordance with the requirements of the buyers;

(iii)
Discussions on the commercial issues pertaining to the contract through the
technical representative, after which an order was placed by the Indian buyer directly to the Korean HO,
would be something more than ‘preparatory’ or ‘auxiliary’ activities and, accordingly, the LO was a PE
of the MNC in India. Further, the incentive plan designed for remuneration of the employees of the LO indicated
that the LO was undertaking not just the ‘advertising’ activities, rather such activities traversed the actual
marketing of products of the MNC in India as it was only on the basis of the
orders generated that an incentive was envisaged / organised for the employees.

 

In GE
Energy Parts Inc. vs. CIT (IT) [2019] 101 taxmann.com 142 (Delhi), the
Delhi High Court held that the LO of GE Energy Parts Inc. (GE US), established
to act as a communication channel, was carrying out core activity of marketing
and selling highly-sophisticated equipments of the US company, and hence the LO
was a fixed place PE of the assessee company in India. The GE LO was a fixed
place PE of GE due to the fact that (a) There was a fixed place of business;
(b) The fixed place of business was at the disposal of the employees of the LO,
more so when GE had not contested that activities of ‘some form’ were not
carried out from such premises and thus it was reasonable to assume that the
activities were carried through such premises; (c) Though the final word with
respect to the pricing of the products was with the HO, however, that won’t mean
that the LO was for mute data collection / information dissemination. The LO
discharged the vital responsibilities or at least had a prominent role in
contract finalisation, viz., extensive negotiations with its customers,
customisation of the products with respect to the requirements of the
customers, negotiating the financial parameters of the products and not
allowing the overseas entity to alter such terms without the consent of GE
India, etc. Accordingly, the LO was not performing merely liaising activities.
Defining the terms preparatory or auxiliary activities as ‘something remote
from the actual realisation of the profits’, the Court held that the
activities performed by the LO would not fall within the exception provided
under Article 5(3)(e) of the India-USA DTAA.

 

The Court
also held that GE’s overseas entity had agency PE for the following reasons:
(a) Where the expatriates / employees performed activities for different
entities of the same group, then it could not be construed that activities had
been performed for a single enterprise. Accordingly, the GE India (through the
employees of the LO and Indian subsidiary), constituted a dependent agent of GE
overseas MNC; (b) Relying on the decision of the Italian Court it held that the
active and major participation / involvement of the employees / representatives
in the negotiations / meetings with the customers indicated that the agents had
‘authority to conclude contracts’, even if final contracts were concluded by
the GE HO.

 

7. FUND REMITTANCE SERVICES – Decision of the Supreme Court in the case of
Union of India vs. U.A.E. Exchange Centre

In respect
of fund remittance services, the Supreme Court in Union of India vs.
U.A.E. Exchange Centre [2020] 116 taxmann.com 379 (SC) held that an
Indian LO of a United Arab Emirates (UAE) company did not constitute a PE in
India.

 

U.A.E.
Exchange Centre (the assessee), a company incorporated in the UAE, is engaged, inter
alia, in providing to non-resident Indians in UAE the service of remitting
funds to India. For its India-centric business, the assessee had set up four
LOs in Chennai, New Delhi, Mumbai and Jalandhar after obtaining prior approval
from the RBI u/s 29(1)(a) of the erstwhile Foreign Exchange Regulation Act,
1973.

 

As per the
business practice followed by the assessee, the funds collected from the NRI
remitters are remitted to India by either of the following two modes:

(i)
Telegraphic transfer: Under this mode the amount is remitted telegraphically by
transferring directly from the UAE through normal banking channels to the
beneficiaries in India and the LOs have no role to play except attending to
complaints regarding fraud, etc.

(ii)
Physical dispatch of instruments: Under this mode, on a request from the NRI
remitter, the assessee sends instruments such as cheques / drafts through its
LOs to beneficiaries in India. For this purpose, the LOs download the
particulars of the remittance (while staying connected to the server in the
UAE), and print and courier the instruments to beneficiaries in India.

 

In this
case, the contract pursuant to which the funds are remitted to India is entered
into between the assessee and the NRI remitter in the UAE. Moreover, the funds
for remittance as well as the commission are collected in the UAE.

 

From A.Y.
1998-99 to 2003-04, the assessee was filing Nil returns in India on the basis
that no income had accrued or deemed to have been accrued in India under the
ITA or the India-UAE DTAA. However, owing to some doubt expressed by the
Revenue, the assessee filed an application for advance ruling before the
Authority for Advance Rulings (AAR) in 2003 seeking a ruling on ‘whether any
income is accrued / deemed to be accrued in India from the activities carried
out by the company in India’.

 

AAR decision

The AAR
ruled that the income of the assessee was deemed to have accrued in India on
the basis that it had a ‘business connection’ in terms of section 9(1) of the
ITA insofar as activities concerning physical dispatch of instruments was
concerned. The AAR observed that without the activities of the Indian LOs, the
transaction of remittance would not be complete. Further, the commission earned
by the assessee covers not only the activities carried out in the UAE, but also
the activities carried out by the LOs in India.

 

The AAR also
held that the ‘preparatory or auxiliary’ exception to formation of a PE under
the India-UAE DTAA would not be applicable in respect of physical dispatch of
instruments. This was on the basis that a transaction for remittance would not
be completed without the activities of the Indian LOs. Specifically, the AAR
noted that the role of the LOs’ physical dispatch of instruments is ‘nothing
short of performing the contract of remitting the amounts at least in part.’

 

Delhi High
Court decision

The assessee
challenged the AAR ruling by way of a writ petition in the Delhi High Court.
The High Court noted that the AAR’s discussions and findings on the ‘business
connection’ test under domestic law were unnecessary, considering the scope of
section 90 of the ITA which allows for tax treaties to override domestic law
provisions. Accordingly, the High Court restricted its analysis to the
applicable provisions of the India-UAE DTAA, i.e., Articles 5 and 7.

 

The Court
held that although an LO comes within the inclusive list of fixed places of
business under Article 5(2)(c), it is subject to exclusions under Article 5(3),
including fixed places of business maintained solely for carrying out
activities which are ‘preparatory or auxiliary’ in nature. While relying on the
common meaning of the terms ‘preparatory or auxiliary’ under Black’s law
dictionary (i.e., activities which aid / support the main activity), the Court
concluded that the activities performed in respect of physical dispatch of
instruments were merely ‘preparatory or auxiliary’ in nature. It observed that
the error committed by the AAR was to read the test of ‘preparatory or
auxiliary’ which permits making a value judgment on whether the transaction
would or would not have been completed without the activities of the LOs and
were, therefore, significant activities. The Court indicated that the test of ‘preparatory
or auxiliary’ is not a function only of whether the activities under
consideration led to completion of the transaction.

 

In arriving
at its conclusion, the High Court applied the judgment of the SC in DIT
(IT) vs. Morgan Stanley & Co. [2007] 162 Taxman 165 (SC) and
accorded a liberal and wide interpretation to the exclusionary clause of PE.
The reason for this was that by invoking clauses of PE, income which otherwise
neither accrues / arises in India becomes taxable in India by virtue of a ‘deeming
fiction.’

 

Supreme
Court judgment

An SLP was
filed by the Revenue against the High Court decision. The core issue before the
Apex Court was whether the activities carried out by the LOs in India would
qualify the expression ‘of preparatory or auxiliary character’ as mentioned in
Article 5(3)(e) of the India-UAE DTAA.

 

In
confirming the finding of the High Court that the activities conducted by the
LOs were ‘preparatory or auxiliary’ and hence excludable from the purview of
PE, the Supreme Court also referred to the limited permission granted by the
RBI under FERA to the assessee regarding the activities to be conducted by the
LOs.

 

The Supreme
Court noted that as per the nature of activities allowed for under the RBI
permission, the LOs were only allowed to provide incidental service of delivery
of cheques / drafts drawn on a bank in India. They were not allowed to perform
business activities such as (i) entering into a contract with any party in
India; (ii) rendering consultancy or any other service directly or indirectly
with or without consideration to anyone in India; (iii) borrowing or lending
any money from or to any person in India without RBI’s permission. Thus, it was
amply clear that the LOs in India were not to undertake any other activity of
trading (commercial or industrial) or enter into any business contracts in its
own name in India. On this basis, the Supreme Court concluded that the nature
of activities conducted by the LOs as circumscribed by the RBI constituted
‘preparatory or auxiliary’ in character, and hence outside the purview of PE.

 

The Court
noted further that through the LOs the assessee was not carrying on any
business activity in India, but only dispensing with the remittances by
downloading the information from the UAE server and printing the cheques /
drafts. The LOs could not even charge commission / fee for their services.
Therefore, no income actually accrued to the LOs u/s 2(24) of the ITA.

 

The Supreme
Court further held that the activities of the LO of the taxpayer in India are
limited activities which are circumscribed by the permission given by the RBI
and are of preparatory or auxiliary character and, therefore, covered by
Article 5(3)(e). As a result, the ?xed place used by the respondent as LO in
India would not qualify the de?nition of PE in terms of Articles 5(1) and 5(2)
of the DTAA on account of non-obstante and deeming clause in Article
5(3) of the DTAA. Hence, no tax can be levied or collected from the LO of the
taxpayer in India in respect of the primary business activities concluded by
the taxpayer in the UAE.

 

The Supreme
Court also observed that after the enactment of the Finance Act, 2003,
Explanation 2 to section 9(1)(i) of the Act was inserted which de?ned business
connection as business activity carried out by a person on behalf of a
non-resident. In this regard, the Court held that even if the stated activities
of the LO of the taxpayer in India are regarded as business activity, the same
being ‘of preparatory or auxiliary character’, by virtue of Article 5(3)(e) of
the DTAA, the LO of the taxpayer in India which would otherwise be a PE, is
deemed to be expressly excluded from being so. Since, by a legal ?ction, it is
deemed not to be a PE of the taxpayer in India, it is not amenable to tax
liability in terms of Article 7 of the DTAA.

 

At present,
there are few precedents which provide guidelines for the ‘preparatory or
auxiliary’ test such as (i) to check whether the activities performed in the
fixed place of business form an essential and significant part of the
enterprise as a whole as held in Western Union Financial Services Inc.
vs. ADIT [2007] 104 ITD 40 (Delhi); (ii) whether the activities
performed in the fixed place of business form part of the core business
activities of the enterprise, as held in Angel Garments Ltd. [2006] 287
ITR 341 (AAR).

 

After
analysing the facts, the Supreme Court held the activities of the LOs to be of
‘preparatory or auxiliary’ nature without setting out guidelines for the
application of the ‘preparatory or auxiliary’ test. It would have been
extremely helpful if the Supreme Court would have laid down detailed guidelines
for the application of the ‘preparatory or auxiliary’ test.

 

The above
ruling is quite relevant for money remittance companies and potentially other businesses
which are primarily operated from outside India with some preparatory or
auxiliary activities in India.

 

It is to be
noted though that India has introduced an equalisation levy of 2% on certain
non-resident service providers providing services to customers in India, and
its application with respect to the specific facts may need evaluation.

 

Further, the
above decision is a welcome decision, wherein along with providing comments on
the meaning of ‘preparatory or auxiliary character’, the Court has re-affirmed
the guiding principle of ‘treaty override’ which forms the pillar of the
international tax law in India.

 

The Supreme
Court has laid emphasis on bringing out the characteristics of what can be
termed as ‘of preparatory or auxiliary character’ which shall be relevant for
future cases. Further, the Court has de?ned the rationale of taxability due to
which the judgment shall hold persuasive value for similar cases.

 

The decision
seems to lay down a broad guideline that where the activities of an LO are
restricted to the approvals granted by the RBI, such activities should qualify
as preparatory or auxiliary in nature and should not constitute a PE in India.

 

8. PRECAUTIONS REGARDING LOs FOR NOT BEING
CONSIDERED AS PEs

The
important point here would be to restrict the activities of the LO to
preparatory or auxiliary work only. Further, the LO should not venture into or
towards activities which could be viewed as commercial or core activities
undertaken on behalf of the foreign entity or its group entity. If it does so,
not only could the LO trigger a PE risk in India, but it could also be seen as
going beyond the domain of the activity permissions granted by the RBI.
Further, appropriate documentation should be maintained to prove that the
activities of the LO are preparatory or auxiliary in nature such as, for
instance, the RBI approval letter in the case of the U.A.E. Exchange Centre,
which reflected that the activities of the LO were mere support services to the
foreign parent entity.

 

In our view,
one should not presume that an LO or place of business will not constitute a PE
merely because the RBI or a government body has given permission for its
establishment in India. To determine the Indian tax implications, it is
critical to examine whether the LO is carrying out an important part of the
business activity of the foreign company (i.e., a commercial activity which is
core income-generating), or whether it is merely aiding or supporting
activities of the main business.

 

9. BEPS ACTION 7 AND MULTI-LATERAL INSTRUMENT (MLI)

While
analysing the ‘preparatory or auxiliary’ activities, one may additionally need
to be mindful of the BEPS Action Plan 7 and Article 13 of the MLI which deal
with the issue of artificial fragmentation of activities between various group
companies to avail the benefit of ‘preparatory or auxiliary’ activities.

 

Specific
activity exemption

In relation
to tax treaties to which the provisions of MLI regarding specific
activity-based exemption apply, it will become important to demonstrate that
the stated activity in the exclusion clause (advertising, storage, delivery,
etc.) is indeed ‘preparatory or auxiliary’ in nature. As the world moves
towards complex and innovative business models which rely on limited physical
presence in the country where the customers reside, foreign players must
assess, based on the facts, whether their Indian presence can still be said to
be merely aiding the core business in order to avail exemption under the
respective tax treaty.

 

Anti-fragmentation
rules

Article 13
is incorporated in the MLI with a view to address the issue of artificial
avoidance of the PE status through fragmentation of activities between
closely-related enterprises. Thus, businesses carrying out more than one
activity in a country which earlier individually were getting covered under the
term ‘preparatory or auxiliary character’ and hence were not forming a PE in
India, could be subject to the provision of Article 13 of the MLI. Accordingly,
such activities may thus form a PE in India if the activities performed when
seen cumulatively exceed what can be considered as of ‘preparatory or auxiliary
character’.

 

However, one
would have to first check whether Article 13 of the MLI applies to the relevant
DTAA in question.

 

With MLI
coming into force and India being a signatory thereto, going forward the
business models would need to be independently examined under the provisions of
the MLI for ascertaining whether or not a PE is established. Now, with
implementation of BEPS and signing of MLIs, litigation on this issue may
further intensify as the Indian tax authorities would now have additional
ammunition to target the LOs.

 

India has
opted for Option A and anti-fragmentation rules. Accordingly, in India no
specific exemption would be available unless the activities are preparatory or
auxiliary in nature and also there should not be artificial fragmentation of
activities within the group.

 

10. CONCLUSION

Whether or
not the activities of LOs constitute a PE of the non-resident entity is a very fact-speci?c
and vexed issue. In the past, where an LO has exceeded its scope of permitted
activities, courts have held that such an LO can constitute the PE of the
foreign entity in India. Therefore, it is important to ensure at all times that
an LO in India operates within the limits set out by RBI.

 

The
determination of the question as to whether any activities of an LO qualify as
preparatory or auxiliary in nature would depend upon the facts of each case and
the nature of business of the taxpayer. In order to decide the status of the
LO, a functional and factual analysis of the activities performed by it needs
to be undertaken.

 

It is very important to
keep in mind that all the aforementioned judicial precedents should be
critically analysed in the light of BEPS Action Plan 7, MLI and changes in the
OECD Commentary, before applying the same on the factual matrix of a particular
case.

 

Whether in sorrow or in happiness,
a friend is always a friend’s support.

— (Valmiki Raamaayan 4.8.40)

OECD’S ‘GloBE’ PROPOSAL – PILLAR TWO (Tax Challenges of the Digitalisation of the Economy – Part II)

The current international tax
architecture is being exploited with the help of digitalised business models by
the Multinational Enterprises (MNEs) to save / avoid tax through BEPS. To
counter this, the existing tax rules require reconsideration and updation on
the lines of the digitalised economy. Many countries have introduced unilateral
measures to tackle the challenges in taxation arising from digitalisation which
restricted global trade and economy.

 

Now, OECD has set the deadline of
end-2020 to come out with a consensus-based solution to taxation of
cross-border transactions driven by digitalisation. For this, OECD has
published two public consultation documents, namely (i) ‘Unified Approach under
Pillar One’ dealing with Re-allocation of profit and revised nexus rules, and
(ii) ‘Global Anti-Base Erosion Proposal (GloBE) – Pillar Two’. It is important
to understand these documents because once modified, accepted and implemented
by various jurisdictions, they will change the global landscape of international
taxation in respect of the digitalised economy.

 

Part I of this article on ‘Pillar
One’ appeared in the January, 2020 issue of the BCAJ. This, the second
article, offers a discussion on the document dealing with GloBE under ‘Pillar
Two’.

 

1.0 BACKGROUND

Thanks to advances in technology,
the way businesses were hitherto conducted is being transformed rapidly. In
this era of E-commerce, revenue authorities are facing a lot of challenges to
tax Multinational Enterprises (MNEs) who are part of the digital economy. To
address various tax challenges of the digitalisation of the economy, OECD in
its BEPS Action Plan 1 in 2015 had identified many such challenges as one of
the important areas to focus upon. Since there could not be any consensus on
the methodology for taxation, the Action Plan recommended a consensus-based
solution to counter these challenges. OECD has targeted to develop such a
solution by the end of 2020 after taking into account suggestions from the
various stakeholders. Meanwhile, on the premise of the options as examined by
the Task Force on the Digital Economy (TFDE), the BEPS Action Plan 1 suggested
three options to counter the challenges of taxation of the digitalised economy
which could be incorporated in the domestic laws of the countries. It is
provided that the measures to tackle the challenges of taxing digitalised
economy shall not be incompatible with any obligation under any tax treaty or
any bilateral treaty. They shall be complementary to the current international
legal commitments.

 

OECD issued an interim report in
March, 2018 which examines the new business framework as per the current
digitalised economy and its impact on the international tax system. In January,
2019 the Inclusive Framework group came up with a policy note to address the
issues of taxation of digitalised economy into two complementary ‘pillars’ as
mentioned below:

 

Pillar 1 – Re-allocation of
Profits and the Revised Nexus Rules

Pillar 2 – Global Anti-Base
Erosion Mechanism

 

The three proposals suggested under
Pillar 1 are as follows:

(i) New Nexus Rules – Allocation based on sales rather than physical
presence in market / user jurisdiction;

(ii) New Profit Allocation Rules – Attribution of profits based on
sales even in case of unrelated distributors (in other words, allocation of
profits beyond arm’s length pricing, which may continue concurrently between
two associated enterprises);

(iii) Tax certainty via a three-tier mechanism for profit allocation:

(a) Amount A: Profit allocated to market jurisdiction in absence of
physical presence.

(b) Amount B: Fixed returns varying by industry or region for certain
‘baseline’ or ‘routine’ marketing and distributing activities taking place (by
a PE or a subsidiary) in a market jurisdiction.

(c) Amount C: Profit in excess of fixed return contemplated under
Amount B, which is attributable to marketing and distribution activities taking
place in marketing jurisdiction or any other activities. Example: Expenses on
brand building or advertising, marketing and promotions (beyond routine in
nature).

 

Thus, it highlights potential
solutions to determine where the tax should be paid and the basis on which it
should be paid.

 

Let us look at the proposals
under Pillar Two in more detail.

 

2.0 PILLAR TWO – GLOBAL
ANTI-BASE EROSION PROPOSAL (‘GloBE’)

The public consultation document
has recognised the need to evolve new taxing rules to stop base erosion and
profit shifting into low / no tax jurisdictions through virtual business
structures in a digitalised economy. According to the document, ‘This Pillar
seeks to comprehensively address remaining BEPS challenges by ensuring that the
profits of internationally operating businesses are subject to a minimum rate
of tax. A minimum tax rate on all income reduces the incentive for taxpayers to
engage in profit shifting and establishes a floor for tax competition among
jurisdictions.’

 

The harmful race to the bottom on
corporate taxes and uncoordinated and unilateral efforts to protect the tax
base has led to the increased risk of BEPS, leading to a lose-lose situation
for all jurisdictions in totality. Therefore, the GloBE proposal is an attempt
to shield the tax base of jurisdictions and lessen the risk of BEPS.

 

Broadly, the GloBE proposal aims
to have a solution based on the following key features:

 

(i) Anti-Base Erosion and Profit Shifting

It not only aims to eliminate
BEPS, but also addresses peripheral issues relating to design simplicity,
minimise compliance and administration costs and avoiding the risk of double
taxation. Taxing the entities subject to a minimum tax rate globally will seek
to comprehensively address the issue of BEPS. Such a proposal under Pillar Two
will cover the downside risk of the tax revenue of the MNEs globally by
charging a minimum tax rate, which otherwise would lead to a lose-lose
situation for various jurisdictions.

(ii) New taxing rules through four component parts of the GloBE proposal

The four component parts of the
GloBE proposal, proposed to be incorporated by way of changes into the domestic
laws and tax treaties, are as follows:

 

(a) Income inclusion rule

Under this rule, the income of a
foreign branch or a controlled entity if that income was subject to tax at an
effective rate that is below a minimum rate, will be included and taxed in the
group’s total income.

 

For example, the profits of the
overseas branch in UAE of a Hong Kong1  (HK) company will be included in the taxable
income in HK, as the UAE branch is not subjected to tax at the minimum rate,
say 15%. But for this rule, profits of the overseas branch of an HK company
would not have been taxed in HK. Of course, HK may have to amend its domestic
law to provide for such taxability.

 

Example 1 – Accelerated taxable
income (as given in the public consultation document). In our
opinion, this example throws light on the income inclusion rule.

 

Application of income inclusion
rule

Example 1

Year 1

Year 2

Inclusion rule (Book)

Inclusion rule (Book)

Country B (Tax)

Inclusion rule (Book)

Country

B (Tax)

Income

50

100

50

0

Expenses

(10)

(20)

(10)

(0)

Net income

40

80

40

(0)

Tax paid

(16)

(16)

0

0

Minimum tax (15% x net income)

(6)

 

(6)

 

Excess tax (= Tax paid – Minimum tax)

10

 

0

 

Tentative inclusion rule tax

–

 

6

 

Excess tax carry-forward
used

–

 

(6)

 

Inclusion rule tax

–

 

0

 

Remaining excess tax
carry-forward

10

 

4

 

 

(b) Undertaxed payments rule

It would operate by way of denial
of a deduction or imposition of source-based taxation (including withholding tax)
for a payment to a related party, if that payment was not subject to tax at or
above a minimum rate.

(c) Switch-over rule

It is to be introduced into tax
treaties such that it would permit a residence jurisdiction to switch from an
exemption to a credit method where the profits attributable to a Permanent
Establishment (PE) or derived from immovable property (which is not part of a
PE) are subject to an effective rate below the minimum rate.

(d) Subject to tax rule

It would complement the
under-taxed payment rule by subjecting a payment to withholding or other taxes
at source and adjusting eligibility for treaty benefits on certain items of
income where the payment is not subject to tax at a minimum rate.

 

The GloBE proposal recognises the
need for amendment of the domestic tax laws and tax treaties to implement the
above four rules. However, it also cautions for coordinated efforts amongst
countries to avoid double taxation.

 

3.0  DETERMINATION OF TAX
BASE

The first step towards applying a
minimum tax rate on MNEs is to determine the tax base on which it can be
applied. It emphasises the use of financial accounts as a starting point for
the tax base determination, as well as different mechanisms to address timing
differences.

 

3.1 Importance of consistent tax base

One of the simple methods to
start determining the tax base is to start with the financial accounting rules
of the MNE subject to certain agreed adjustments as necessary. The choice of
accounting standards to be applied will be subject to the GloBe proposal. The
first choice to be made is between the accounting standards applicable to the
parent entity or the subsidiary’s local GAAP. The next choice is which of the
accounting standards will be acceptable for the purposes of the GloBE proposal.

 

As per the public document, it is
suggested to determine the tax base as per the CFC Rules or, in absence of CFC
rules, as per the Corporate Income Tax Rules of the MNE’s jurisdiction. Such an
approach will overcome the limitation of the inclusion of only certain narrow
types of passive income. However, it would mean that all entities of an MNE
will need to recalculate their income and tax base each year in accordance with
the rules and regulations of the ultimate parent entity’s jurisdiction. There
can be differences in accounting standards between the subsidiary’s
jurisdiction and the ultimate parent entity’s jurisdiction, and to address the
same the public document recommends that the MNE groups shall prepare the
consolidated financial statements and compute the income of their subsidiaries
using the financial accounting standards applicable to the ultimate parent
entity of the group as part of the consolidation process.

 

Accounting standards which are
accepted globally can serve as a starting point for determining the GloBE tax
base.

 

3.2 Adjustments

Financial accounting takes into
account all the income and expenses of an enterprise, whereas accounting for
tax purposes can be different. Relying on the unadjusted figures in accounts
could mean that an entity’s net profits may be overstated or understated when
compared to the amount reported for tax purposes. Most of the differences among
the accounting standards will be timing differences and some of the differences
may be permanent differences or temporary differences that require further
consideration, and some of the timing differences may be so significant that
they warrant the same consideration as permanent differences.

 

3.2.1  Permanent differences

Permanent differences are
differences in the annual income computation under financial accounting and tax
rules that will not reverse in the future. Permanent differences arise for a
variety of reasons. The need to adjust the tax base may depend upon the level
of blending ultimately adopted in the GloBE proposal. Inclusions and exclusions
of certain types of income and expenses in domestic tax policy may lead to
permanent differences. Thus, consideration for such differences is of utmost
importance while determining the tax base.

 

Examples of permanent differences

Dividends received from foreign
corporations and gains on sale of corporate stocks may be excluded from income
to eliminate potential double taxation. Under the worldwide blending approach,
the consolidated financial statements should eliminate dividends and stock
gains in respect of entities of the consolidated group. However, under a
jurisdictional or entity blending approach, the financial accounts of the group
entities in different jurisdictions would be prepared on a separate company
basis and dividends received from a ‘separate’ corporation would be included in
the shareholder’s financial accounting income.

Permanent difference also arises
due to disallowance of certain deductions under the domestic tax laws of a
particular jurisdiction, such as entertainment expenses, payment of bribes and
fines, etc.

 

3.2.2  Temporary differences

Temporary differences are
differences in the time for taking into account income and expenses that are
expected to reverse in the future. It can lead to a low cash effective tax rate
at the beginning of a period and high cash effective tax rate at the end of a
period, or vice versa. A separate blending approach may lead to
difference volatility in the ETR from one period to another. Temporary
differences are very important in determination of the tax base and also affect
the choice of blending.

 

Approaches to addressing
temporary differences

The public consultation document
on Pillar Two lists three basic approaches to addressing the problem of
temporary differences, namely,

(i) carry-forward of excess taxes and tax attributes,

(ii) deferred tax accounting, and

(iii) a multi-year average effective tax rate.

 

It also provides that these basic
approaches could be tailored and elements of the different approaches could be
combined to better or more efficiently address specific problems.

 

4.0 BLENDING OF HIGH-TAX
AND LOW-TAX INCOME FROM ALL SOURCES

According to the public
consultation document, ‘Because the GloBE proposal is based on an effective
tax rate (“ETR”) test it must include rules that stipulate the extent to which
the taxpayer can mix low-tax and high-tax income within the same entity or
across different entities within the same group. The Programme of Work refers
to this mixing of income from different sources as “blending.”’

 

Blending means the process of mixing
of the high-tax and low-tax income of an MNE from all the sources of all the
entities in the group. Blending will help to calculate the ETR on which the
GloBE proposal is based. It can be done on a limited basis or a comprehensive
basis, from a complete prohibition on blending to all-inclusive blending.
Limited basis will lead to no or less blending (mixing) of income and taxes of
all different entities and jurisdictions. This would restrict the ability of an
MNE to reduce charge of tax applied on all entities across all jurisdictions
through mixing the high-tax and low-tax income.

 

It is suggested to apply the
GloBE proposal (minimum tax rate rule) in the following manner:

First Step: Determine
the tax base of an MNE and then calculate the Effective (blended) Tax Rate
[ETR] of the MNE on the basis of tax paid.

Second Step: Compare
the ETR with the Minimum Tax Rate prescribed according to the relevant blending
approach.

Third and the final Step: Use any
of the four components as specified in the GloBE proposal to the income which
is taxed below the minimum tax rate prescribed. [The four components as
discussed above are: (i) Income inclusion rule, (ii) Under-taxed payments rule,
(iii) Switch-over rule and (iv) Subject to tax rule].

 

Determining the Effective
(blended) Tax Rate [ETR] of the MNEs forms the second step in applying a
minimum tax rate rule. It throws light on the level of blending under the GloBE
proposal, i.e., the extent to which an MNE can combine high-tax and low-tax
income from different sources taking into account the relevant taxes on such
income in determining the ETR on such income.

 

There are three approaches to
blending:

4.1   Worldwide blending approach

4.2   Jurisdictional blending approach

4.3   Entity blending approach.

 

The above three different
blending approaches are explained in brief below:

4.1 Worldwide blending approach

In this case, total foreign
income from all jurisdictions and tax charged on it are mixed. An MNE will be
taxed under such an approach if the total tax charged on such foreign income of
an MNE is below a prescribed minimum rate. The additional tax charged on such
income will be the liability of an MNE to bring the total tax charged to the
prescribed minimum rate of tax.

4.2 Jurisdictional blending approach

In this case, blending of foreign
income and tax charged on such income will be done jurisdiction-wise. The
liability of additional tax would arise when the income earned from all the
entities in a particular jurisdiction is below the minimum rate, i.e., if an
MNE has been charged lower tax on the income from a particular jurisdiction
than the minimum rate of tax. The sum of the additional taxes of all the
jurisdictions will be the tax liability of an MNE.

4.3 Entity blending approach

Under this approach blending is
done of income from all sources and tax charged on such income in respect of
each entity in the group. Additional tax will be levied on an MNE whenever any
foreign entity in a group is charged with tax below the minimum tax rate
prescribed for that foreign entity.

 

All three approaches have the
goal congruence of charging MNEs a minimum rate of tax globally with different
policy choices.

 

In addition, in respect of
blending, the public consultation document on Pillar Two also explains in
detail the following:

(1)   Effect of blending on volatility

(2)   Use of consolidated financial accounting information

(3)   Allocating income between branch and head office

(4)   Allocating income of a tax-transparent entity

(5)   Crediting taxes that arise in another jurisdiction

(6)   Treatment of dividends and other distributions.

 

5.0 CARVE-OUTS

Implementation of the GloBE
proposal is fraught with many challenges and therefore, to reduce the
complexity and restrict the application, the Programme of Work2,
through its public consultation document, calls for the exploration of possible
carve-outs as well as thresholds and exclusions. These carve-outs / thresholds
/ exclusions will ensure that small MNEs are not burdened with global
compliances. They would also provide relief to specific sectors / industries.

 

The Programme of Work calls for
the exploration of carve-outs, including for:

(a) Regimes compliant with the standards of BEPS Action 5 on harmful tax
practices and other substance-based carve-outs, noting, however, that such
carve-outs would undermine the policy intent and effectiveness of the proposal.

(b) A return on tangible assets.

(c) Controlled corporations with related party transactions below a
certain threshold.

 

The Programme of Work also calls
for the exploration of options and issues in connection with the design of
thresholds and carve-outs to restrict application of the rules under the GloBE
proposal, including:

(i)   Thresholds based on the turnover or other indications of the size
of the group.

(ii) De minimis thresholds to exclude transactions or entities
with small amounts of profit or related party transactions.

(iii) The appropriateness of carve-outs for specific sectors or industries.

 

6.0 OPEN ISSUES

There are several open issues in
the proposed document, some of which are listed below:

 

6.1 Appropriate Accounting Standards

Determination of tax base is the
starting point to apply measures given in the GloBE proposal. Thus, the use of
financial accounting is the basis to determine the tax base. Hence, the issue
could be, which of the accounting standards would be appropriate and
recommended for determining the tax base across various jurisdictions?

 

6.2 Non-preparation of consolidated accounts by smaller MNEs

There can be some instances when
smaller MNEs are not required to prepare consolidated accounts by the statute
for any purpose. In such a case where the information is not consolidated, how
will the tax base be determined?

 

6.3 Compliance cost and economic effects

The blending process,
irrespective of the policy approach, will have a lot of compliance costs which
may even exceed the economic benefit out of the process. How does the GloBE
proposal deal with this?

 

6.4 Changes in ETR due to tax assessments in subsequent years

MNEs operate in different
jurisdictions and each jurisdiction may have different tax years, assessment
procedures and so on. It is very likely that tax determined for a particular
year based on self-assessment may undergo significant change post-assessment or
audit by tax authorities. This may change the very basis for benchmarking of
ETR with a minimum tax rate. There should be a mechanism to make adjustments
beyond a tolerable limit of variance.

 

7.0 CONCLUSION

OECD had asked for public
comments on its document on GloBE not later than 2nd December, 2020.
However, there are several areas yet to be addressed which are ambiguous and to
find solutions to them within a short span of time till December, 2020 is
indeed a daunting task. However, it is also a fact that in the absence of
consensus and delay in a universally acceptable solution, more and more
countries are resorting to unilateral measures to tax MNEs sourcing income from
their jurisdictions.

 

In this context, it is important
to note that vide Finance Act, 2016 India introduced a unilateral
measure of taxing certain specified digitalised transactions by way of
Equalisation Levy (EL) @ 6%. The scope of EL is expanded significantly by the
Finance Act, 2020 by providing that E-commerce operators, including
facilitators, shall be liable to pay EL @ 2% on the consideration received
towards supply of goods and services.

 

Determination
of a tax base globally on the basis of consolidated profits is a very complex
process. To give effect to all the permanent and temporary differences while
determining the tax base along with blending of income from different sources
from all jurisdictions will be a challenging task for the MNEs. It is to be seen
how effectively the four components of the GloBE proposal, individually and in
totality, will be practically implemented. The success of the GloBE proposal
also depends upon the required changes in the domestic tax laws by the
countries concerned. The cost of compliance and uncertainty may also need to be
addressed. A higher threshold of revenue could take care of affordability of
cost of compliance by MNEs, whereas clear and objective rules may take care of
uncertainty.

 

All
in all, we are heading for a very complex global tax scenario.

RESIDENTIAL STATUS OF NRIs AS AMENDED BY THE FINANCE ACT, 2020

1.0  BACKGROUND

The
government presented the Union Budget 2020 in the month of February this year
in the midst of an economic slowdown. The Budget was based on the twin pillars
of social and economic reforms to boost the Indian economy. The Finance Bill,
2020 got the President’s assent on 27th March, 2020, getting
converted into the Finance Act, 2020 which has brought in a lot of structural
changes such as (a) giving an option to the taxpayers to shift to the new slabs
of income-tax; (b) introducing the Vivad se Vishvas scheme; (c) reducing
the corporate tax rate; and (d) changes in taxation of dividends and many other
proposals.

 

Apart from
the above, one of the significant amendments made by the Finance Act, 2020
pertains to a change in the rules for determining the residential status of an
individual.

 

Let us study
these amendments in detail. It may be noted that the amendments to section 6 of
the Income-tax Act, 1961 (the Act) are applicable with effect from 1st
April, 2020 corresponding to the A.Y. 2020-21 onwards.

 

2.0  SIGNIFICANCE OF RESIDENTIAL STATUS

A person is
taxed in a jurisdiction based on ‘residence’ link or a ‘source’ link. However,
the comprehensive tax liability is invariably linked to the residential status,
barring a few exceptions such as taxation based on citizenship (e.g., USA) or
in case of territorial tax regimes (such as Hong Kong).

 

In India,
section 6 of the Act determines the residential status of a person. Section 5
defines the scope of total income and section 9 expands the scope of total
income in case of non-residents by certain deeming provisions.

 

Along with
the incidence of tax, residential status is also important to claim relief
under a particular tax treaty, as being a resident of either of the contracting
states is a prerequisite for the same. Therefore, Article 4 on ‘Residence’ is
considered to be the gateway to the tax treaty. Once a person is a resident of
a contracting state, he gets a Tax Residency Certificate which enables him to
claim treaty benefits.

 

3.0  PROVISIONS OF SECTION 6 OF THE ACT POST
AMENDMENT

The highlighted
portion is the insertion by the Finance Act, 2020. The provisions relating
to residential status under the Act are as follows:

 

Residence in
India

‘6.
For the purposes of this Act,

(1)
An individual is said to be resident in India in any previous year, if he

(a)
is in India in that year for a period or periods amounting in all to one
hundred and eighty-two days or more; or

(b)
[***]

(c)
having within the four years preceding that year been in India for a period or
periods amounting in all to three hundred and sixty-five days or more, is in
India for a period or periods amounting in all to sixty days or more in that
year.

 

Explanation
1 – In the case of an individual,

(a)
being a citizen of India, who leaves India in any previous year as a member of
the crew of an Indian ship as defined in clause (18) of section 3 of the
Merchant Shipping Act, 1958 (44 of 1958), or 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)
being a citizen of India, or a person of Indian origin within the meaning of Explanation
to clause (e) of section 115C who, being outside India, comes on a visit
to India in any previous year, 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
and in case of the citizen or person of Indian origin having total income,
other than the income from foreign sources, exceeding fifteen lakh rupees
during the previous year, for the words ‘sixty days’, occurring therein, the
words ‘one hundred and twenty days’.

     

Clause (1A)
of Section 6

(1A)
Notwithstanding anything contained in clause (1), an individual, being a
citizen of India, having total income, other than the income from foreign
sources, exceeding fifteen lakh rupees during the previous year, shall be
deemed to be resident in India in that previous year, if he is not liable to
tax in any other country or territory by reason of his domicile or residence or
any other criteria of similar nature.

 

Explanation
2 – For the purposes of this clause, in the case of an individual,
being a citizen of India and a member of the crew of a foreign-bound ship
leaving India, the period or periods of stay in India shall, in respect of such
voyage, be determined in the manner and subject to such conditions as may be
prescribed.

 

(2) A
Hindu undivided family, firm or other association of persons is said to be
resident in India in any previous year in every case except where during that
year the control and management of its affairs is situated wholly outside
India.

 

(3) A
company is said to be a resident in India in any previous year if—

(i)
it is an Indian company; or

(ii)
its place of effective management, in that year, is in India.

 

Explanation
– For the purposes of this clause ‘place of effective management’ means a place
where key management and commercial decisions that are necessary for the
conduct of business of an entity as a whole are in substance made.

 

(4)
Every other person is said to be resident in India in any previous year in
every case, except where during that year the control and management of his
affairs is situated wholly outside India.

 

(5)
If a person is resident in India in a previous year relevant to an assessment
year in respect of any source of income, he shall be deemed to be resident in
India in the previous year relevant to the assessment year in respect of each
of his other sources of income.

 

(6) A
person is said to be ‘not ordinarily resident’ in India in any previous year if
such person is,

(a)
an individual who has been a non-resident in India in nine out of the ten
previous years preceding that year, or has during the seven previous years
preceding that year been in India for a period of, or periods amounting in all
to, seven hundred and twenty-nine days or less; or

(b) a
Hindu undivided family whose manager has been a non-resident in India in nine
out of the ten previous years preceding that year, or has during the seven
previous years preceding that year been in India for a period of, or periods
amounting in all to, seven hundred and twenty-nine days or less, or

(c)
a citizen of India, or a person of Indian origin, having total income, other
than the income from foreign sources, exceeding fifteen lakh rupees during the
previous year, as referred to in clause (b) of Explanation 1 to clause (1), who
has been in India for a period or periods amounting in all to one hundred and
twenty days or more but less than one hundred and eighty-two days; or

(d)
a citizen of India who is deemed to be resident in India under clause (1A).

Explanation
– For the purposes of this section, the expression ‘income from foreign
sources’ means income which accrues or arises outside India (except income
derived from a business controlled in or a profession set up in India).

 

4.0  DETERMINING THE SCOPE OF TAXABILITY (SECTION
5)

All over the world an individual is categorised as either a Resident or
a Non-resident. However, India has an intermediary status known as ‘Resident
but Not Ordinarily Resident’ (RNOR). This status provides breathing space to a
person from being taxed on a worldwide income, in that such a person is not
subjected to Indian tax on passive foreign income, i.e. foreign-sourced income
earned without business controlled from or a profession set up in India.

 

Thus, an
individual is subjected to worldwide taxation in India only if he is ‘Resident
and Ordinarily Resident’ (ROR).

 

Therefore,
an individual who is a resident of India is further classified into (a) ROR and
(b) RNOR (Refer paragraph 3 herein above).

The scope of
total income, based on the residential status, is defined in section 5 of the
Act which can be summarised as follows:

 

 

Sources of Income

ROR

RNOR

NR

i

Income received or is deemed to be received
in India

Taxable

Taxable

Taxable

ii

Income accrues or arises or is deemed to accrue
or arise in India

Taxable

Taxable

Taxable

iii

Income accrues or arises outside India, but it is
derived from a business controlled in or a profession set up in India

Taxable

Taxable

Not Taxable

iv

Income accrues or arises outside India other than
derived from a business controlled in or a profession set up in India

Taxable

Not Taxable

Not Taxable

 

 

5.0  NON-RESIDENT

According to
section 2(30) of the Act, ‘non-resident means a person who is not a
“resident”, and for the purposes of sections 92, 93 and 168 includes
a person who is not ordinarily resident within the meaning of clause (6)
of section 6.’

 

Section 92
deals with transfer pricing, section 93 deals with avoidance of income tax by
transactions resulting in transfer of income to non-residents and section 168
deals with residency of executors of the estate of a deceased person.
‘Executor’ for the purposes of section 168 includes an administrator or other
person administering the estate of a deceased person.

 

Thus, in
view of the amendments in section 6, a change in the classification of
residential status from that of a non-resident to an RNOR may lead to change in
the scope of taxability in respect of the above sections, viz., 92, 93 and 168.

 

6.0  RATIONALE FOR CHANGE IN THE DEFINITION OF
RESIDENTIAL STATUS

Clause (c)
of section 6(1) provides that an individual who is in India in any previous
year for a period of 60 days or more, coupled with 365 days or more in the
immediately preceding four years to that previous year, then he would be
considered a resident of India. The period of 60 days is very short, therefore
Indians staying abroad demanded some relaxations. The government also
acknowledged the fact that Indian citizens or Persons of Indian Origin (PIO)
who stay outside India often maintain strong ties with India and visit India to
take care of their assets, families or for a variety of other reasons.
Therefore, relaxation has been provided to Indian citizens / PIOs, allowing
them to visit India for longer a duration of 182 days since 1995, without losing
their non-resident status.

 

However, it
was found that this relaxation was misused by many visiting Indian citizens or
PIOs, by carrying on substantial economic activities in India and yet not
paying any tax in India. They managed to stay in India almost for a year by
splitting their stay in two financial years and yet escape from taxation in
India, even if their global affairs / businesses were controlled from India. In
order to prevent such misuse, the Finance Act, 2020 has reduced the period of stay
in India from 182 days to 120 days in case of those individuals whose
Indian-sourced income1 
exceeds Rs. 15 lakhs.

 

There is no
change in case of a person whose Indian-sourced income is less than Rs. 15
lakhs.

 

7.0 IMPACT OF THE AMENDMENTS

7.1  Residential status of Indian citizens / PIOs
on a visit to India

The amended
provision of section 6(1)(c) read with clause (b) of Explanation 1 now
provides as follows:

 

An Indian
citizen or a Person of Indian Origin, having total income other than income from
foreign sources exceeding Rs. 15 lakhs, who being outside India comes on a
visit to India, shall be deemed to be resident in India in a financial year if…

(i)    he is in India for 182 days or more during
the year; or

(ii)   he has been in India for 365 days or more
during the four immediately preceding previous years and for 120 days or more
during that previous year.

 

7.2  Amendment to the definition of
R but NOR u/s 6(6)

As mentioned
earlier, section 6(6) provides an intermediary status to an individual (even
HUF through its manager) returning to India, namely, RNOR.

 

Clause (d)
is inserted in section 6(6) to provide that an Indian citizen / PIO who becomes
a resident of India by virtue of clause (c) to section 6(1) with the 120 days’
rule (as mentioned above) will always be treated as an RNOR. The impact is that
their foreign passive income would not be taxed in India.

_______________________________________________________________

1   The amendment uses the term ‘Income from
foreign sources’ which means income which accrues or arises outside India
(except income derived from a business controlled in or a profession set up in
India). In this Article, the term ‘Indian-sourced income’ is used as a synonym
for the term ‘income other than income from foreign sources’.

 

 

Let us
understand the conditions of residential status with the help of a flowchart (as
depicted below).

 

Assuming
that an Indian citizen has satisfied one of the two conditions of clause (c) to
section 6(1), namely, stay of 365 days in India during the preceding four
financial years, the following are the possible outcomes:

 

It may be noted that a person becoming a resident by virtue of the 120
days’ criterion would automatically be regarded as an RNOR, whereas a person
becoming resident by virtue of the 182 days’ criterion would become an RNOR
only if he further satisfies one of the additional conditions prescribed in
clause (a) of section 6(6) of the Act, namely, that he has been a non-resident
in nine out of the ten years preceding the relevant previous year, or he was in
India for a period or periods in aggregate of 729 days or less in seven years
preceding the relevant previous year.

 

The impact
of the amendment is that an individual who is on a visit to India may become a
resident by virtue of the reduced number of days criterion, but would still be
regarded as an RNOR, which gives much-needed relief as he would not be taxed on
foreign income, unless it is earned from a business or profession controlled /
set up in India.

 

8.0  DEEMED RESIDENTIAL STATUS FOR INDIAN CITIZENS

Traditionally,
in India income tax is levied based on the residential status of the
individual. It was felt that in the residence-based scheme of taxation there
was scope for abuse of the provisions. It was possible for a high net-worth
individual to arrange his affairs in a manner whereby he is not considered as a
resident of any country of the world for tax purposes. In order to prevent such
abuse a new Clause 1A has been inserted to section 6 of the Act vide the
Finance Act, 2020 whereby an individual being a citizen of India having total
income, other than the income from foreign sources, exceeding fifteen lakh
rupees during the previous year, shall be deemed to be resident in India in
that previous year, if he is not liable to tax in any other country or
territory by reason of his domicile or residence, or any other criterion of
similar nature. However, this provision is not applicable to Overseas Citizens
of India (OCI) card-holders as they are not the citizens of India.

 

In other
words, an individual is deemed to be a resident of India only if all the
following conditions are satisfied:

(i)    He is a citizen of India;

(ii)   His Indian-sourced total income exceeds Rs. 15
lakhs; and

(iii) He is not liable to tax in any other country or
territory by reason of his domicile or residence or any other criterion of
similar nature.

 

By virtue of the above deemed residential status, many NRIs living
abroad and possessing Indian citizenship could have been taxed in India on their
worldwide income. In order to provide relief, clause (d) has been inserted in
section 6(6) to provide that a citizen who is deemed a resident of India by
virtue of clause 1A to section 6 of the Act, would be regarded as an RNOR. The
advantage of this provision is that his foreign passive income would not be
taxed in India.

 

The above
amendment can be presented in the form of a flow chart (Refer Flow Chart 2,
on the next page):

 

 9.0 ISSUES

9.1  What is the meaning of the term ‘liable to
tax’ in the context of determination of ‘deemed residential status’?

 

 

As per the
amended provision of section 6(1A) of the Act, an Indian citizen who is not
liable to tax in any country or territory by reason of his domicile or
residence or any other criterion of similar nature would be regarded as deemed
resident of India. However, the term ‘liable to tax’ is not defined in the Act.
This term has been a matter of debate for many years. Contrary decisions are in
place in respect of residents of the UAE where there is no income tax for
individuals.

 

Whether liability to tax includes ‘potential liability to tax’, in that
the individuals are today exempt from tax in the UAE by way of a decree2
, but they can be brought to tax any time. For that matter, any sovereign
country which is not levying tax on individuals at present always has an
inherent right to tax its citizens. Therefore,
can one say that residents of any country are always potentially liable to tax
by reason of their residence or domicile, etc.?

 

In the M.A.
Rafik case, In re [1995] 213 ITR 317, the AAR held that ‘liability to
tax’ includes potential liability to tax and, therefore, benefit of the
India-UAE Tax Treaty was available to a UAE resident. However, in the case of Cyril
Pereira the AAR held otherwise and refused to grant the benefit of the
India-UAE DTAA as there was no tax in the UAE. The Hon’ble Supreme Court, in
the case of Azadi Bachao Andolan [2003] 263 ITR 706, after
referring to the ruling of Cyril Pereira and after elaborate
discussions on the various aspects of this issue, concluded that ‘it is… not
possible for us to accept the contentions so strenuously urged by the
respondents that the avoidance of double taxation can arise only when tax is
actually paid in one of the contracting states.’

 

_______________________________________________________________

2   The UAE federal government has exclusive
jurisdiction to legislate in relation to UAE taxes. However, no federal tax
laws have been established to date. Instead, most of the Emirates enacted their
own general income ‘tax decrees’ in the late 1960s. In practice, however, the
tax decrees have not been enforced to date for personal taxation. [Source:
https://oxfordbusinessgroup.com/overview/full-disclosure-summary-general-and-new-tax-regulations]

 

 

The Hon’ble
Supreme Court in this case (Azadi Bachao Andolan, Supra), further
quoted excerpts from Prof. Klaus Vogel’s commentary on ‘Double Taxation’, where
it is clearly mentioned that ‘Thus, it is said that the treaty prevents not
only “current” but also merely “potential” double taxation.’

 

In Green
Emirate Shipping & Travels [2006] 100 ITD 203 (Mum.), the Mumbai
Tribunal after refusing to be persuaded by the decision of the AAR in the case
of Abdul Razak A. Menon, In re [2005] 276 ITR 306 held that
‘being “liable to tax” in the contracting state does not necessarily imply that
the person should actually be liable to tax in that contracting state by virtue
of an existing legal provision but would also cover the cases where that other
contracting state has the right to tax such persons – irrespective of whether
or not such a right is exercised by the contracting state. In our humble
understanding, this is the legal position emerging out of Hon’ble Supreme
Court’s judgment in Azadi Bachao Andolan case.’

 

In ITO (IT) vs. Rameshkumar Goenka, 39 SOT 132, the Mumbai
Tribunal, following the decision in Green Emirates (Supra), held
that the ‘expression “liable to tax” in that contracting state as used in
Article 4(1) of the Indo-UAE DTAA does not necessarily imply that the person
should actually be liable to tax in that contracting state and that it is
enough if the other contracting state has the right to tax such person, whether
or not such a right is exercised.’

 

In the case
of DDIT vs. Mushtaq Ahmad Vakil, the Delhi Tribunal, relying on the
decisions of Green Emirates (Supra), Meera Bhatia, Mumbai ITAT, 38 SOT 95,
and Ramesh Kumar Goenka (Supra) ruled in favour of the assessee
to give the benefit of the India-UAE Tax Treaty.

 

Thus, we
find that various judicial precedents in India are in favour of granting tax
treaty benefits to the residents of even those contracting states where there
is no actual liability to tax at present. Therefore, one may take a view that
in the context of Indian tax treaties ‘liability to tax’ includes ‘potential liability
to tax’, except where there is an express provision to the contrary in the tax
treaty concerned.

 

9.2  Can a deemed resident person avail treaty
benefit?

The benefit
of a tax treaty is available to a person who is a resident of either of the
contracting states which are party to the said treaty. Article 3 of the tax
treaties defines ‘person’ to include the individual who is treated as a taxable
entity in the respective contracting state (e.g. India’s tax treaties with the
USA and the UK). However, Article 4 of the India-UK Tax Treaty dealing with
‘Fiscal Domicile’ provides that the term ‘resident of a contracting state’
means any person who, under the law of that state, is liable to taxation
therein by reason of his domicile, residence, place of management or any other
criterion of a similar nature. This provision is similar in both the
UN and the OECD Model Conventions as well as most of the Indian tax treaties.
Here the question arises as to whether a person who is a deemed resident of
India (by virtue of clause 1A to section 6 of the Act), will be able to access
a treaty based on the wordings of Article 4? Article 4 requires him to be a
resident of a contracting state based on the criteria of domicile, residence or
any other criterion of similar nature, which does not include citizenship.
Although citizenship is one of the decisive criteria while applying
tie-breaking tests mentioned in paragraph 2 of Article 4, but first one must
enter the treaty by virtue of paragraph 1.

 

When we look
at the provisions of the India-US Tax Treaty, we find that citizenship is one
of the criteria mentioned in paragraph 1 of Article 4 on residence as mentioned
below:

 

‘ARTICLE 4 –
Residence – 1. 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.’

 

Therefore,
in case of the India-US Tax Treaty there is no doubt about the availability of
tax benefits to an individual who is deemed to be a resident of India because
of his citizenship.

 

9.3  What is the status of Indian workers working
in UAE who are invariably citizens of India?

Article 4 of
the India-UAE Tax Treaty reads as follows:

 

ARTICLE 4 RESIDENT

1.    For the purposes of this Agreement the
term ‘resident of a Contracting State’ means:

(a) ?in the case of India: any person who, under
the laws of India, is liable to tax therein by reason of his domicile,
residence, place of management or any other criterion of a similar nature. This
term, however, does not include any person who is liable to tax in India in
respect only of income from sources in India; and

(b) in the case of the United Arab Emirates: an
individual who is present in the UAE for a period or periods totalling in the
aggregate at least 183 days in the calendar year concerned, and a company which
is incorporated in the UAE and which is managed and controlled wholly in UAE.’

 

As per the
above provision, a person who stays in the UAE for 183 days or more in a
calendar year would be regarded as a resident of the UAE and therefore eligible
to get the treaty benefit.

 

The CBDT
issued a Press Release on 2nd February, 2020 clarifying that ‘the
new provision is not intended to include in tax net those Indian citizens who
are bona fide workers in other countries. In some sections of the media
the new provision is being interpreted to create an impression that those
Indians who are bona fide workers in other countries, including in
Middle East, and who are not liable to tax in these countries,
will be taxed in India on the income that they have earned there. This
interpretation is not correct.

 

In order to
avoid any misinterpretation, it is clarified that in case of an Indian citizen
who becomes deemed resident of India under this proposed provision, income
earned outside India by him shall not be taxed in India unless it is derived
from an Indian business or profession.’ (Emphasis supplied.)

 

The above
clarification is significant as it clearly provides that even though Indian
citizens in the UAE or in other countries are not liable to tax therein, their
foreign-sourced income will not be taxed in India unless it is derived from an
Indian business or profession.

 

However,
this clarification does not change the position for determination of deemed
residential status of such workers. In other words, all workers in the UAE or
other countries who are citizens of India may be still be regarded as deemed
residents of India if their Indian-sourced income exceeds Rs. 15 lakhs in a year.
The Press Release only says that their foreign income may not be taxed in
India, if the conditions are satisfied.

 

9.4  What is the impact of Covid-19 on
determination of residential status?

The CBDT
Circular No. 11 of 2020 dated 8th May, 2020 grants relief to
taxpayers by excluding the period of their forced stay in India from the 22nd
to the 31st of March, 2020 in computation of their residential
status in India for Financial Year 2019-20. The relevant extract of the said
Circular is reproduced below:

 

‘3. In
order to avoid genuine hardship in such cases, the Board, in exercise of powers
conferred under section 119 of the Act, has decided that for the purpose of
determining the residential status under section 6 of the Act during the
previous year 2019-20 in respect of an individual who has come to India on a
visit before 22nd March, 2020 and:

(a) has been
unable to leave India on or before 31st March, 2020, his period of
stay in India from 22nd March, 2020 to 31st March, 2020
shall not be taken into account; or

(b) has been quarantined in India on account of Novel Corona Virus
(Covid-19) on or after 1st March, 2020 and has departed on an
evacuation flight on or before 31st March, 2020 or has been unable
to leave India on or before 31st March, 2020, his period of stay
from the beginning of his quarantine to his date of departure or 31st
March, 2020, as the case may be, shall not be taken into account; or

(c) has departed on an evacuation flight on or before 31st
March, 2020, his period of stay in India from 22nd March, 2020 to
his date of departure shall not be taken into account.’

The above
Circular deals with the period up to 31st March, 2020. The Finance
Minister has assured similar relief for the Financial Year 2020-21. As the
operations on international flights have not resumed fully, a suitable
relaxation may be announced in future when the situation normalises.

 

10.0 EPILOGUE

The
amendments to section 6 are in the nature of anti-abuse provisions. However, in
view of the pandemic Covid-19, it is desirable that these amendments are
deferred for at least two to three years. More than half of the world is under
lockdown. India is also under lockdown for over two months now. International
flights are still not operative. Only Air India is operating international
flights under the ‘Vande Bharat’ mission to bring back or take out the
stranded passengers. This is an unprecedented situation which calls for
unprecedented measures. Today, India is considered safer than many other
countries in the world and therefore many NRIs may like to spend more time with
their families in their motherland. Under the circumstances, the amendment
relating to reduction of the number of days’ stay from 182 to 120 should be
reconsidered.

 

 

TAX CHALLENGES OF THE DIGITALISATION OF ECONOMY

With the advent of computers and internet,
the modes of business transactions have undergone significant changes. The
distinction between doing business ‘with’ a country and ‘in’ a country is
increasingly becoming blurred. Virtual presence has overtaken physical
presence. Naturally, under the changed circumstances, traditional concepts of
PE and taxing rules are just not sufficient to tax cross-border transactions.
OECD identified these challenges arising out of the digitalisation of the
economy as one of the main areas of focus in its 2015 BEPS Action Plan 1.

 

However, taxing transactions in the
digitised economy is fraught with many challenges, as traditional source vs.
residence principles and globally accepted and settled transfer pricing
regulations (especially, the principle of ‘arm’s length price’) are being
challenged and need to be tweaked or revisited. At the same time, not
addressing these issues is leaving gaps in taxation to the advantage of
Multi-National Enterprises (MNEs), who are able to save / avoid considerable
tax through Base Erosion and Profit Shifting (BEPS). Not merely that, many
countries have introduced unilateral measures (for example, India introduced
Equalisation Levy to tax online advertisements) which are resulting in double
taxation and hampering global trade and economy. Therefore, OECD has set the
deadline of end-2020 to come out with a consensus-based solution to taxation of
cross-border transactions driven by digitalisation.

 

OECD has published two public consultation
documents, namely, (i) a ‘Unified Approach under Pillar One’ dealing with reallocation
of profit and revised nexus rules, and (ii) ‘Global Anti-Base Erosion
Proposal (GloBE) – Pillar Two’. It is important to understand these documents,
because once accepted, they will change the global landscape of international
taxation.

 

This article discusses the first document
dealing with ‘Unified Approach under Pillar One’.

1.0    Background

Tax challenges of the digitalisation of
economy was identified as one of the main areas of focus in the BEPS Action
Plan 1 in 2015; however, no consensus could be reached on a methodology for
taxation. The Action Plan 1 suggested the development of a consensus-based
solution to the taxation of digitalised economy by the end of 2020 after due
consultation with all stakeholders and undertaking further work on this dynamic
subject. In the meanwhile, however, based on the options analysed by the Task
Force on the Digital Economy (TFDE), the BEPS Action Plan 1 recommended three
options for countries to incorporate in their domestic tax laws to address the
challenges of BEPS. However, countries were well advised to ensure that any of
the measures adopted did not in any way vitiate their obligation under a tax
treaty or any bilateral treaty obligation. It also provided that these options
may be calibrated or adapted in such a way as to ensure existing international
legal commitments.

 

Three options to
tax digitised transactions, as mentioned in BEPS Action Plan 1, are as follows:

(i)     New nexus in the form of Significant
Economic Presence;

(ii)    A withholding tax on certain types of digital
transactions; and

(iii)    Equalisation Levy.

 

Pending implementation of the BEPS Action
Plan till the end of 2020, India chose to introduce unilateral measures as recommended
above. Accordingly, section 9 of the Income-tax Act, 1961 was amended to expand
the scope of deemed income to include income based on Significant Presence of a
non-resident in India.

 

The new Explanation 2A was added to
section 9(1) vide the Finance Act, 2018 and provides as follows:

Significant Economic Presence shall
mean

(a) Any transaction in respect of any
goods, services or property carried out by a non-resident in India including
provision of download of data or software in India if the aggregate of payments
arising from such transaction or transactions during the previous year exceeds
the amount as may be prescribed; or

(b)
Systematic and continuous soliciting of its business activities or engaging in
interaction with such number of users as may be prescribed, in India through
digital means.

 

Provided that the transactions or activities shall constitute Significant
Economic Presence in India, whether or not

(i)    the agreement for such transactions or
activities is entered in India; or

(ii)   the non-resident has a residence or place of
business in India; or

(iii) the non-resident renders services in India.

 

Provided, further, that only so much of income as is attributable to the
transactions or activities referred to in clause (a) or clause (b) shall be
deemed to accrue or arise in India.

 

However, it may be noted that in the absence
of rules and prescription of transaction threshold, the provision has remained
infructuous.

 

Equalisation Levy (EL) was introduced in
India vide the Finance Act, 2016 whereby certain specified transactions
or payments in respect of online advertisements are subject to a levy of 6% on
a gross basis. However, EL was introduced as a separate levy and not as part of
the Income-tax Act, and hence there are issues in claiming its credit in
overseas jurisdictions.

 

OECD continued further work on this aspect
and that led to an interim report in March, 2018 analysing the impact of
digitalisation of various business models and the relevance of the same to the
international income tax system. In January, 2019, the Inclusive Framework (it
refers to the expanded group of 137 countries involved in the BEPS project
which was originally started by G20 nations) issued a short Policy Note which
grouped the proposals for addressing the challenges of digitised economy into
two pillars as mentioned below.

 

Pillar 1 Reallocation of profit and revised nexus rules

It was felt that the traditional nexus of
physical presence is not sufficient to tax the profits arising in market
jurisdiction (source state) and therefore new nexus rules are essential. This
pillar will explore potential solutions for determining new nexus-based profits
taxation and attribution based on clients or user base or both. In other words,
this Pillar deals with two significant aspects of the taxation of the
digitalised transactions, namely, nexus rules and profit allocation. Thus,
Pillar One comprises ‘User Participation’, ‘Marketing Intangibles’ and
‘Significant Economic Presence’ proposals.

 

Pillar 2 Global Anti-base Erosion Mechanism

Proposals under this Pillar go beyond
digitised economy, as it proposes to tax MNEs at a minimum level of tax. Thus,
it in its true sense addresses the BEPS challenge. It has proposed four broad
rules to ensure minimum level of taxation by MNEs. These are discussed at
length subsequently.

 

Let us look at proposals under Pillar One in
more detail.

 

2.0    Pillar One – Unified Approach towards
reallocation of profit and revised nexus rules

The public consultation document has
recognised the need to evolve new nexus rules to allocate profits arising in
digitalised economy. According to the document ‘the need to revise the rules
on profit allocation (arises) as the traditional income allocation rules would
today allocate zero profit to any nexus not based on physical presence, thus
rendering changes to nexus pointless and invalidating the policy intent. That
in turn requires a change to the nexus and profit allocation rules not just for
situations where there is no physical presence, but also for those where there
is’.

 

Thus, we can see that the new nexus approach
would recognise the contribution of the market jurisdiction or a consumer base
without a physical presence. Broadly, the Unified Approach aims to have a
solution based on the following key features:

 

(a)  Wider Scope: It not only aims to cover highly digitalised
businesses, but also to cover other businesses that are more consumer focussed.
Consumer-facing businesses are broadly defined as businesses that generate
revenue from supplying consumer products or providing digital services that
have a consumer facing element.

 

The following carve-outs are expected from
the scope of new nexus:

(i)     Extractive industries

(ii)    Commodities

(iii)   Financial services

(iv)   Sales below specified revenue threshold [e.g.,
Euro 750 million threshold for Country by Country Reporting (CbCR)].

(b) New Nexus: The new nexus of taxation would be largely based on sales, rather
than physical presence. The thresholds of sales may even be country-specific
such that even the smaller economies benefit (for example, it could be a lower
sales threshold for small and developing countries, a higher threshold for
developed countries).

 

(c) New Profit Allocation Rules: For the first time, profit allocation rules contemplate attribution
of profits even in a scenario of sales via unrelated distributors. To this
extent these rules will go beyond the arm’s length principle (ALP). ALP will
continue to apply for in-country marketing or distribution presence (through a
Permanent Establishment or a separate subsidiary), but for attribution of
profits in another scenario, a formula-based solution may be developed.

 

(d) Tax certainty via a three-tier
mechanism for profit allocation

The Unified Approach aims at tax certainty
for both taxpayers and tax administrations and proposes a three-tier profit
allocation mechanism as follows:

 

Amount A:
Profit allocated to market jurisdiction in absence of physical presence.

Amount B:
Fixed returns varying by industry or region for certain ‘baseline’ or ‘routine’
marketing and distributing activities taking place (by a PE or a subsidiary) in
a market jurisdiction.

Amount C:   Profit in excess of fixed return
contemplated under Amount B, which is attributable to marketing and
distribution activities taking place in marketing jurisdiction or any other
activities. Example: Expenses on brand building or advertising, marketing and
promotions (beyond routine in nature).

           

It is suggested to divide the total profit
of an MNE group into the above mentioned three amounts A, B, and C.

 

2.1    Amount
A:

New taxing right – Under this method, a share of deemed residual profit will be
allocated to market jurisdictions using a formula-based approach. The ‘Deemed
Residual Profit’ for an MNE group would be the profit that remains after
allocating what would be regarded as ‘Deemed Routine Profit’ for activities, to
the countries where activities are performed. Deemed residual profit thus
calculated will be allocated to the market jurisdiction under the new nexus
rules based on sales.

 

The document on Unified Approach provides
that ‘the simplest way of operating the new rule would be to define a
revenue threshold in the market (the amount of which could be adapted to the
size of the market) as the primary indicator of a sustained and significant
involvement in that jurisdiction. The revenue threshold would also take into
account certain activities, such as online advertising services, which are
directed at non-paying users in locations that are different from those in
which the relevant revenues are booked. This new nexus would be introduced
through a standalone rule – on top of the permanent establishment rule – to
limit any unintended spill-over effect on other existing rules. The intention
is that a revenue threshold would not only create nexus for business models
involving remote selling to consumers, but would also apply to groups that sell
in a market through a distributor (whether a related or non-related local
entity). This would be important to ensure neutrality between different
business models and capture all forms of remote involvement in the economy of a
market jurisdiction’.

 

The steps involved in computing profits
allocation to market jurisdictions under the New Nexus Approach are as follows:

Step 1: Determine
the MNE group’s profits from the consolidated financials from CbCR prepared as
per Generally Accepted Accounting Principles (GAAP) or International Financial
Reporting Standards (IFRS).

Step 2: Approximate
the profits attributable to routine activities based on an agreed level of
profitability. The level of profitability deemed to represent such ‘routine’
profits could be determined by way of a predetermined fixed percentage(s) which
may vary by industry. Thus, as the name suggests, routine profits are computed
based on some deeming percentage.

Step 3:
Arrive at the deemed non-routine profits (reducing deemed routine profits from
total profits of the MNE group).

Split these deemed non-routine profits into
two parts: (a) Profits attributable to the market jurisdiction, and (b) Profits
attributable to other factors such as trade intangibles, capital and risk, etc.

The rationale of attributing deemed
non-routine profits to other factors is that many activities that may be
conducted in non-market jurisdiction may give rise to non-routine profits. For
example, a social media business may generate excess profits (non-routine) not
only from the database of its customers, but also from powerful algorithms and
software.

Step 4: Allocate
the deemed non-routine profits to the eligible market jurisdictions based on
the internationally-agreed allocation key using variables such as sales (a
fixed percentage of allocation key may vary as per industry or a business
line).

 

Let us consider an example:

 

Net Profit to Revenue    –           10%

Deemed Routine Profit  –             8%

                                            ————   

Non-Routine Profit         –            2%

                                            =======

 

 

 

2.2    Amount
B:

This type of profit would seek to allocate
profits for certain baseline or routine marketing and distribution functions in
a market jurisdiction, usually undertaken by a PE or a subsidiary of the MNE
group / parent. Traditional methods of transfer pricing rules may not be
sufficient or may result in disputes, therefore in order to simplify the
allocation, a fixed return varying by industry or region is proposed.

 

2.3    Amount
C:

Under this part profit is attributed to
activities in the market jurisdiction which are beyond baseline function. There
could also be some activities which are unrelated to market and distribution.
However, the Unified Approach does not prescribe any formulae or fixed
percentage-based allocation here but leaves the allocation based on the
traditional arm’s length principle. It only suggests a robust dispute
prevention and resolution mechanism to ensure avoidance of litigation and
double taxation.

 

Summary
of Amount C

  •     Allocation of additional
    profits to market jurisdiction for activities beyond baseline level marketing
    and distribution activities (e.g., brand-building).
  •     Other business activities
    unrelated to marketing and distribution.
  •     Amount to be determined by
    applying existing arm’s length principles.

 

Let us understand
this with the help of an illustration given in the document on Unified
Approach.

 

Illustration

The facts are as follows:

  •     Group X is an MNE group
    that provides streaming services. It has no other business lines. The group is
    highly profitable, earning non-routine profits, significantly above both the
    market average and those of its competitors.
  •     P Co (resident in Country
    1) is the parent company of Group X. P Co owns all the intangible assets
    exploited in the group’s streaming services business. Hence, P Co is entitled
    to all the non-routine profit earned by Group X.
  •     Q Co, a subsidiary of P Co,
    resident in Country 2, is responsible for marketing and distributing Group X’s
    streaming services.
  •     Q Co sells streaming
    services directly to customers in Country 2. Q Co has also recently started
    selling streaming services remotely to customers in Country 3, where it does
    not have any form of taxable presence under current rules.

 

 

Proposed Taxability

Taxability
in Country 2

  •    Group X already has taxable
    presence in Country 2 in the form of Q Co. This subsidiary is already
    contracting with and making sales to local customers.
  •    Assuming that Q Co makes
    sufficient sale in Country 2 to trigger the application of new nexus, this
    would give Country 2 the right to tax on a portion of deemed non-routine
    profits of Group X (Amount A).

 

  •    The deemed non-routine profits
    of Group X in Country 2 will be attributable to P Co as it is owning the
    intangibles. P Co would be taxed on a portion of deemed non-routine profits,
    along with Q Co (as its PE to facilitate administration – similar to
    representative assessee under the Income-tax Act, 1961). P Co can claim relief
    under a tax treaty by claiming exemption or foreign tax credit of taxes
    withheld / paid in Country 2.

 

  •    Q Co would be taxed on the
    fixed return for baseline marketing and distribution (Amount B) which may be
    arrived at by applying transfer pricing adjustments to the transactions between
    P Co and Q Co to eliminate double taxation.

 

  •    Q Co may also be taxed on Amount C if Country
    2 considers that its activities go beyond the baseline activities. However, for
    this Country 2 must place a robust measure to resolve disputes and prevent double
    taxation.

 

Taxability in Country 3

  •    In Country 3, Group X does
    not have any direct presence under the existing rules. However, Q Co is making
    remote sales in Country 3.

 

  •    Assuming that Group X makes
    sufficient sales in Country 3 to meet the revenue threshold to trigger new
    nexus, Country 3 will get the right to tax a portion of the deemed non-routine
    profits of Group X of Amount A. Country 3 may tax that income directly from the
    entity that is treated as owning the non-routine profit (i.e. P Co), with P Co
    being held to have a taxable presence in Country 3 under the new nexus rules.

 

  •    Since Group X does not have
    an in-country presence in Country 3 by way of a branch or subsidiary, under
    current rules, Amount B will not be allocated.

 

3.0    Open
issues

There are several open issues in the
proposed document, some of which are listed below:

3.1
Determination of routine profit

The first step in
Amount A is to determine routine profit based on a fixed percentage. As
different industries have different profitability, business cycles, regional
disparities and so on, it is going to be a huge challenge in arriving at a
globally-accepted fixed percentage.

3.2  Determination of residual (non-routine) profit

What percentages
will be attributed to which market jurisdiction and what allocation keys are to
be used for this purpose? These will be difficult to arrive at and make the
entire exercise very complex.

3.3 Other pending issues

The document on
Unified Approach has identified several areas in which further work would be
required, such as regional segmentation, issues and options in connection with
the treatment of losses and challenges associated with the determination of the
location of sales, compliance and administrative burden, enforcement and
collection of taxes where the tax liability is fastened on the non-resident of
a jurisdiction and so on.

 

CONCLUSION

While OECD had
asked for public comments on its document on Unified Approach for New Nexus,
there are several grey areas; reaching a consensus within the stipulated time
of December, 2020 appears to be quite optimistic. However, it is also a fact
that more and more countries are resorting to unilateral measures to tax MNEs
operating in their jurisdictions through digitised means. In fact, introduction
of SEP in Indian tax laws is also perceived as a measure to convey to the world
the urgency of consensus on new nexus favouring marketing jurisdiction or a
source state taxation.

 

Bifurcation of MNEs’ profits in three parts and within three parts,
routine and non-routine profits would create huge complications. Again, both
routine and non-routine parts are determined on an approximation basis.
Consensus on a fixed percentage or allocation keys could be a huge challenge.
India has already expressed its dissent on bifurcation of routine and
non-routine profits. Such a bifurcation has the potential of shifting more
revenue in favour of developed countries. It remains to be seen how the world
reacts to the proposed new nexus rules. 


 

ATTRIBUTION OF PROFITS TO A PERMANENT ESTABLISHMENT IN A SOURCE STATE

The determination of income of a
Multi-National Enterprise (MNE) having operations in various jurisdictions
faces many challenges. It is not easy to attribute profits to various
constituents of an MNE spread over multiple jurisdictions. OECD has so far adopted
a separate entity approach and recommended determination of profits on the
Arm’s Length Principle (ALP) based on a FAR (Functions, Assets and Risks)
analysis. However, of late ALP based on FAR has been challenged by many
developing nations (including India) on the ground that it is more skewed
towards residence-based taxation and does not take into account the place of
value creation, i.e., the market. In a traditional approach, profits are taxed
in a source country only if there is a Permanent Establishment (PE). It is
easier for MNEs to plan their affairs in a manner so as to avoid the presence
of a PE in a source country. Further, in a digitalised economy, it is extremely
difficult to attribute profits to various jurisdictions based on the traditional
approach. Therefore, many countries worldwide have moved away from ALP and
resorted to either the Formulary Apportionment Method (FAM) or a Presumptive
Basis of Taxation. This article compares and contrasts the different methods of
profit attribution and provides a contextual study to understand the proposed
amendments in Rule 10 of the Income-tax Rules, 1962 (the Rules) in respect of
attribution of profits to the operations of an MNE in India.

 

PRESENT
SYSTEM OF PROFIT ATTRIBUTION

Article 5 of a tax treaty lays down norms
for determination of a PE in the state of source. Article 7 of a tax treaty
stipulates principles of determination of profits attributable to a PE. The
existence of a PE in a source state gives a right to that state to tax profits
which are attributable to its operations. As we know, a treaty only provides
for distributive rules for taxing jurisdictions, leaving detailed computation
of profits to the respective domestic tax laws. For example, once it is
established that there is a PE in India, computation of profits attributable to
that PE will be subject to provisions of the Income-tax Act, 1961 (the Act).
However, Article 7 does provide certain restrictions or guidelines thereof for
computation of profits. A moot issue is to determine how much profits are
attributable to a PE in the source state.

 

Provisions under the Income-tax Act, 1961

Section 9 of the Act deals with income
deemed to accrue or arise in India. It does provide certain source rules for
determination of such income. However, as far as business income is concerned,
section 9(1)(i) provides that all income accruing or arising whether directly
or indirectly through or from any business connection in India… shall be deemed
to accrue or arise in India. Clause (a) of Explanation 1 to section 9(1)(i)
further provides that in the case of a business of which all the operations are
not carried on in India, the income of the business under this clause deemed to
accrue or arise in India, shall be only such part of income as is reasonably
attributable to the operations carried on in India.

 

The provision in tax treaties is similar, in
that it provides that if the enterprise carries on business as aforesaid, the
profits of the enterprise may be taxed in the other state; but only to the extent
as are attributable to that PE. There is one exception, i.e., a tax treaty
which follows the UN Model Convention providing for the force of attraction
rule. According to this rule, when an enterprise has a PE in a source state,
then the entire revenue from the source state may get taxed in the hands of
that enterprise, whether or not it is attributable to that PE. Many Indian tax
treaties do have this Rule. However, the force of attraction is restricted to
the revenue derived from the same or similar activities as that of the PE.

 

Thus, determination of profits attributable
to a PE is crucial for its taxability in the source state. Ideally, the PE
should maintain books of accounts and financial statements in India (for that
matter, any source state) for determination of profit or loss from its business
operations, for it is so mandated in India. However, where such books of
accounts are not maintained (may be due to the head office’s view of
non-existence of PE or for any other reason) or where it is not possible to
ascertain the actual profits from such books of accounts, then the assessing
officer (AO) can invoke the provisions of Rule 10 which provide for
determination of profits as a percentage of the turnover, proportionate profits
or in any other manner as he may be deem appropriate. Thus, Rule 10 gives wide
discretionary powers to the AO in determination of profits attributable to a
PE.

 

Clauses (b) to (e) of Explanation 1 to
section 9(1)(i) of the Act provide various instances where income of a non-resident
from certain activities will not be deemed to accrue or arise in India.
However, Explanation 2 explicitly includes dependent agent within the scope of
business connection. Again, a question arises as to the role played by the
dependent agent and profits attributable to his activities in the dual
capacity: one, as an agent, and two, as a representative of the foreign
enterprise (as a PE).

 

Authorised OECD Approach (AOA)

At present, there are three versions of
Article 7 that feature in tax treaties worldwide, namely, (i) article 7 in the
OECD Model Convention (OECD MC) prior to 2010, (ii) article 7 in the revised
OECD Model Convention post-2010, and (iii) article 7 of the UN Model Convention
(UN MC). The distinguishing features of the above versions are given below.

 

Versions (i) and (iii) are similar in that
the pre-2010 OECD MC and the UN MC contain the provision of considering PE as a
separate and distinct enterprise. The PE, in this case, is considered as being
a separate and independent entity from its head office, such that it would
maximise its own profits. The PE, therefore, would be maintaining separate
books of accounts based on principles of accounting as applicable to a separate
and distinct entity. Klaus Vogel has referred to such a method as ‘separate
accounting’ or ‘direct method’. India supports this view and most of its tax
treaties are based on this principle.

 

However, in 2010, OECD changed its stance
and amended article 7 based on its report on the ‘Attribution of Profits to
Permanent Establishments’. In the said report and the new article 7 in its
model tax convention, OECD pronounced AOA as a preferred approach for
attribution of profits to a PE. AOA is also based on the ‘separate entity
approach’, though profits are to be determined based on Functions performed,
Assets employed and Risks assumed (FAR).

 

AOA provides
options for application of the new article 7 introduced in the OECD Model Tax
Convention in 2010 which requires that profits attributable to PE are in
accordance with the principles developed in the OECD Transfer Pricing
Guidelines wherein the PE is first hypothesised as a functionally separate
entity from the rest of the enterprise of which it is a part, and then profits
are determined by applying the comparability analysis and FAR approach.

 

The AOA recommends a two-step approach for
determination of profits attributable to a PE:

 

Step 1: A
functional and factual analysis of the PE, aligned with FAR analysis, as
recommended in transfer pricing guidelines;

Step 2: A
comparability analysis to determine the appropriate arm’s length return (price)
for the PE’s transactions on the basis of FAR analysis.

 

AOA is based on ALP, which in turn is
determined based on FAR analysis under transfer pricing, which essentially considers
the supply side of the transaction and ignores the demand side, i.e., the
market or sales; and, therefore, India has rejected the same.

 

There is one
more issue in the revised article 7 of the OECD MC. Its pre-2010 version
recognised and acknowledged that apportionment of profits based on one of the
criteria, namely, receipts (or sales revenue), expenses and working capital,
was a reasonable way of apportioning profits to the PE. This was based on
paragraph 4 of the pre-2010 version of the OECD MC which gave an option to
attribute profits by way of an apportionment if it was customary to do so in
the state of PE. However, the revised OECD MC dropped this paragraph. The
impact of this change is that even where accounts are not available or
reliable, one needs to attribute profits to a PE based on FAR without
considering the market or sales. India’s position is very clear in that it
would also take the demand side or sales into consideration for attribution of
profits to a PE.

 

Shortcomings of ALP

Section 92F(ii) defines the ‘Arm’s Length
Price’ as a price which is applied or proposed to be applied to a transaction
between persons other than associated enterprises, in uncontrolled conditions.

Thus, a transaction between two or more AEs
needs to be compared with a similar transaction between two unrelated parties,
for the same or similar product or service, in the same or similar
circumstances. These two unrelated parties, whose transactions are compared
with that of AEs, must have similar functions, assets or risks as that of the
AEs. It is practically impossible to find such comparable companies or
transactions.

 

Section 92C prescribes six methods to
determine the ALP. Pricing depends upon many factors other than FAR. ALP fails
to take into account all aspects of a business. One cannot easily find
comparables for many businesses that are engaged in specialised services or
businesses, especially specialised product-lines involving complex intangibles.

 

Moreover, availability of data in the public
domain at the time of entering into the transaction for comparison purposes is
a big challenge. Public data is available only in cases of commodity trading
through exchanges. Maintenance of contemporaneous documentation and valuation
thereof are another big challenge.

 

Profit Split Method

The Profit Split Method (PSM) is applicable
when transactions are so interrelated that it might not be logical or practical
to evaluate the same individually. Independent entities in such scenarios may
agree to pool their total profits and distribute them to each of the
participating entities based on an agreed ratio. Thus, PSM uses a logical basis
and divides profits among participating entities to a transaction similar to
what independent entities would have apportioned for arriving at such an
arrangement.

 

The PSM method first identifies the outcome
of the transaction (i.e., the net profit of the transaction) of the group. The
profit then is to be divided among the entities of the group on an economically
rational basis such that profits would have been distributed in an arm’s length
arrangement. The total profit may be the profit from the transactions or a
residual profit that cannot readily be assigned to any of the entities of the
group, e.g., profits arising from unique intangibles. The contribution of each
entity is based upon a functional analysis of each entity. Reliable external
market data, if available, is always given preference.

 

The PSM method, although a method under the
arm’s length approach, is in reality based on the principles which are used for
the purpose of ‘Formulary Apportionment’.

 

The positive aspect of every PSM approach is
that it examines the controlled transactions under review in a prudent manner
as it is a two-sided method where every MNE concerned is evaluated. Thus, the
PSM method will be beneficial if the underlying contribution involves
intangibles owned by two or more MNEs, as no transfer pricing method other than
PSM would be applicable. PSM offers flexibility because it considers the
specific facts and circumstances of MNEs which cannot be found in comparable
independent enterprises. Moreover, a real actual profit is being split which
generally does not leave any of the MNEs concerned with an unreasonably high
profit since each MNE is appraised. It also removes the possibility of double
taxation as the total profit is split and distributed to the various
constituent entities across jurisdictions.

 

Challenges of PSM – lack of availability
of data and functions

There are two fundamental disadvantages with
the PSM. First, the application of PSM usually includes a weak and sometimes
doubtful connection of external market data with the controlled transactions
under consideration, resulting in a comparison with a certain amount of
subjectivity. Moreover, there is the lack of availability of data; both
taxpayers and tax administrations might find it hard to obtain reliable
information from MNEs in foreign countries. This inconvenience might materially
affect the reliability of the method since the profit should be an economical
assessment based on each and every function undertaken by the MNE, preferably
using external comparables which can support the valuation. (Source: Markham,
Michelle – Transfer Pricing of Intangible Assets in the US, the OECD and Australia:
Are Profit Split Methodologies the Way Forward?)

 

FORMULARY APPORTIONMENT METHOD (FA)

The Meaning of FA

As the name suggests, it is the
apportionment of the profits / losses of a corporation based on some
predetermined formula, over its different units or group of companies operating
under common control, across different jurisdictions based on significant
economic presence.

 

Formulary Apportionment, popularly known as
unitary taxation, allocates profit earned (or loss incurred) by an MNE wherein
its entity has a taxable presence. It is an alternative to the separate entity
approach under which a branch or PE within a jurisdiction is reckoned as a
separate entity, requiring prices for transactions with other parts of a
corporation or a group thereof, according to ALP.

 

As opposed to this, FA assigns the group’s
total global profit (or loss) to each jurisdiction based on certain variables
such as the proportion of assets, sales or payroll in that particular
jurisdiction. It is thus akin to PSM in a sense.

 

Under this method, all entities of the group
are viewed as a single entity (unitary combination) and therefore the method is
also known as unitary taxation worldwide. This method requires combined
reporting of the group’s results.

 

Advantages of FA

A unitary approach would replace the
following major elements which create fundamental problems for taxation of MNEs
under the ALP:

 

(i)   The need for analysing arm’s length price,
that is, an analysis of internal accounts and transactions for determining the
appropriate arm’s length price;

(ii)   The need to deal with complex anti-avoidance
rules, such as thin capitalisation, controlled foreign corporations, limitation
of benefits et al to prevent base erosion and profit shifting;

(iii) Quantification of contribution of intangibles
in income generation;

(iv) Freedom from
litigation arising from source and residence attribution rules;

(v) Lesser compliance burden on MNEs.

 

The above would enable simplification of the
international tax system, which shall benefit both taxpayers and tax
administrations.

 

At present, a majority of the transfer
pricing disputes undergoing several rounds of litigation are generally decided
in favour of the taxpayer. This is so in the U.S., India and other countries.
This is bound to happen in the absence of clear guidance on transfer pricing
issues. Matters pertaining to selection of appropriate comparable(s), usage of
the most appropriate method for benchmarking the transaction, management fees,
cost allocation arrangements, royalty pay-outs, etc., have been and continue to
be under litigation.

 

On the other hand, the unitary taxation
method, if not totally, would at least reduce and significantly contribute in
settling disputes. Further, in many cases in countries where significant
economic activities are carried out, there may not be any significant
difference in corporate tax rates. Hence, in the absence of wide differences in
corporate tax rates, there may be no significant compulsion or reason to
minimise a firm’s global tax liability by relocating production activities.

 

Limitations of FA

There are two primary questions that need to
be addressed for successful implementation of FA.

 

Q1) How and what shall be the basis for
the apportionment formula?

 

Generally, an overwhelming consensus on the
determination of weights for the factors would be decided by negotiations and
trade-offs. Historical data provides that the factors have been generally given
equal weight, that is, one-third each (sales, labour and assets employed).

 

Approach of the United States of America

The water’s edge approach of the States in
the US has tilted the balance towards sales. This approach apportions income to
production and sale equally, i.e., 50% of income is apportioned based on sales
and 50% on production (assets and labour quantify production).

 

[Water’s edge election basically says that
you (as a business or entity) agree to be taxed within the jurisdiction for the
sales that occur within that state, but only within the parameters laid down by
that state.]

 

Approach of the European Union

On the other hand, in 2012 the EU amended
the proposal drafted by the EU Commission, from equal weights to the three
factors, to 10% for sales, 45% for assets and 45% for labour.

 

Differences in preferences

Countries where wage rates are higher would
favour payroll rather than headcount in respect of the labour factor. This
would tend to benefit from the inclusion of the assets factor with an equal
weight. Therefore, such countries can concede that the labour factor be based
on the number of employees.

 

Conversely, although countries which have
attracted large-scale manufacturing activities would benefit in terms of tax
revenues on account of the labour factor, they should also be willing to accept
a significant weightage for other factors. If the same has not been accepted,
there may be MNEs who would relocate their investments because of formula
over-weight tilt towards the labour factor. Therefore, it is essential that a
fine balance between factors of production and sales is achieved. This is
because some part of the income can be said to be attributable to (a) assets
employed for production, (b) number of employees on the payroll, and (c) the
sales function, of course.

 

Therefore, one may propose a ratio of 1
(assets employed): 1 (number of employees): and 2 (sales function). This is
because it gives equal importance to all factors of production as well as the
sales function. Further, equal importance is also given to the internal two (2)
factors of production as well, namely, capital and entrepreneurship.

 

Q2) 
Would it be appropriate to apply a general formula for all industries?

 

Evidently not. This issue has been debated
since the unitary approach was first mooted in the 1930s. The cause for concern
is that some types of industries do have special characteristics in need of a
special formula.

 

Examples

Transportation industries such as shipping,
aviation, etc., pose an issue because the assets which they are dependent upon
are mobile. In order to address the special nuance of this business, these
could be taxed based on the value of traffic between two contact (entry / exit)
points.

 

In the case of other nuanced industries,
such as extractive industries, the modern approach of ‘resource rent taxation’
is a more effective mode of taxation. Therefore, the interaction between
resource rent taxation and general corporate taxation would require a special
consideration.

 

However, for the purpose of achieving
neutrality, a general apportionment formula applied to most types of businesses
would be appropriate for allocating a general tax on income or profits.

 

Presumptive Taxation (PT)

As stated above, determination or
computation of profits in the source state is not an easy task and therefore there
is always an uncertainty about attribution of income and allowability of
expenses. Moreover, compliance burden is also high. In order to address these
issues, many countries give the option of presumptive taxation to
non-residents. Under this, irrespective of actual profit or loss, a certain
percentage of the gross receipts from the state of source is deemed to be
income and taxed therein. Once a taxpayer is covered by the presumptive tax
scheme, he would be relieved from the rigours of compliances.

 

The Income-tax Act, 1961 contains provisions
for taxing income of non-residents on presumptive basis. Some illustrative
provisions are given below:

 

Section

Types of assessees

Particulars of income

Tax rate

44BB

Any non-resident

Profits and gains in connection with or supplying
P&M on hire used, or to be used, in the prospecting for, or extraction or
production of mineral oils and natural gas in case of NR

10% of the gross receipts is deemed to be profits
and gains.

(Surcharge, health & education cess would be
extra)

44DA

Any non-resident

Royalties / FTS arising through a PE or fixed
place of profession in India

Taxable on net basis.

Basic rate 40%.

(Surcharge, health & education cess would be
extra)

44AE

Any assessee

Business of plying, leasing or hiring of goods
carriages owned by the assessee (not owning more than 10 goods carriages at
any time during the previous year)

Deemed profits @ Rs. 7,500 per vehicle, for every
month (or part thereof) or actual profits, whichever is higher.

In case of a heavy goods vehicle, profits are
deemed to be Rs. 1,000 per ton of gross vehicle weight or unladen weight as
the case may be, per vehicle for every month (or part thereof) or actual
earnings, whichever is higher

115A

Any non-residents and foreign company

Taxation in respect of income by way of dividend,
interest, royalty and technical service fee to non-residents and foreign
companies

(i) Interest income received by non- residents
(not being a company) or a foreign company – 20% plus applicable surcharge
and cess

(ii) Infra debt funds as specified u/s 10(47) –
5% plus applicable surcharge and cess

(iii) Dividend received by a non-resident or a
foreign company – 20% plus applicable surcharge and cess

(iv) Royalty or fees for technical services
income received by non-resident or foreign company – 10% plus applicable
surcharge and cess

115VA to V-O

Any company that owns at least one qualifying
ship and the main object of the company is to carry on the business of
operating ships

Computation of profits and gains from the
business of operating qualifying ships

(i) Qualifying ship having net tonnage up to
1,000 – Rs. 70 for each 100 tons

(ii) Qualifying ship having net tonnage up to
1,000 but not more than 10,000 – Rs. 700 plus Rs. 53 for each 100 tons
exceeding 1,000 tons

(iii) Qualifying ship having net tonnage up to
10,000 but not more than 25,000 – Rs. 5,470 plus Rs. 42 for each 100 tons
exceeding 10,000 tons

(iv) Qualifying ship having ship tonnage
exceeding 25,000 – Rs. 11,770 plus Rs. 29 for each 100 tons exceeding 25,000
tons

172

Any non-resident

Shipping business of non-residents

For the purpose of the levy and recovery of tax
in the case of any ship, belonging to or chartered by a non-resident, which
carries passengers, livestock, mail or goods shipped at a port in India –
7.5% of the amount paid or payable on account of such carriage to the owner
or charterer

Equalisation levy

Any non-resident

Charge of equalisation levy

Equalisation levy shall be charged @ 6% of the amount
of consideration payable, for any specified service received or receivable
from a non-resident, by –

i. A person resident in India carrying on any
business or profession; or

ii. A non-resident having permanent establishment
in India

 

 

Distinction between PSM / FA / PT

The stark difference between the Profit
Split Method (PSM), the Formulary Apportionment Method (FA) and the Presumptive
Taxation Method (PT) is the manner of calculation of profits.

 

Profit Spilt Method: In this method, total profits earned by related entities in
different jurisdictions is determined and then the same are attributed to each
one of them on a separate entity approach (following the arm’s length
principle), based on FAR analysis. In this case, usually the market or demand
side is overlooked or given less importance. This method is criticised in that
it is more skewed towards the country of residence of the enterprise.

Formulary Apportionment Method: Here, the actual profits of the MNE at the global level are
distributed to the participating entities. However, the distribution is based
on a predetermined formula with or without weightage. This method does take
care of demand side arising from ‘sales’, which is usually one of the factors
of profit allocation in the FA. This method considers all entities across the
globe under a single MNE as a single unit and consequently it is known as
‘Unitary Method’ as well.

 

Presumptive Taxation: This method rests on an altogether different footing. It does not
take into account the actual profit or loss of the business undertaking.
Instead, it presupposes a certain element of profit in the source state and
levies taxes based on a notional estimation. Normally, presumptive taxation is
given as an option to the taxpayer to have a tax certainty and reduce
litigation. If the actual profits are lower or there are losses, then the
taxpayer may opt for regular computational provisions along with related
compliances. Safe-harbour provisions under the TP Regulations are akin to
presumptive taxation.

 

PROPOSED PROFIT ATTRIBUTION RULE (COMBINATION
OF FA AND PT)

The CBDT Committee has recommended amendment
of Rule 10 of the Income-tax Rules to provide for detailed profit attribution
rules. It rejected the AOA for profit distribution, which is based on ALP
taking into account FAR analysis. It may be noted that AOA does not take into
account the demand side of a transaction.

 

The committee
suggested distribution of profits based on three factors carrying equal
weightage, namely, (a) sales (b) manpower and (c) assets. It is claimed that
the combination of these three factors would take into consideration both the
demand and the supply side of a transaction.

 

The draft report on Profit Attribution
outlines the formula for calculating ‘profits attributable to operations in
India’, giving due weightage to sales revenue, wages paid to employees and
assets deployed.

 

(Please refer to the July, 2019 issue of
the BCAJ for a detailed discussion on the proposed Profit Attribution Rules.)

 

CONCLUSION

Attribution of profits is a complex
exercise, more so when such attribution is related to complex intangibles or a
PE. The Arm’s Length Principle looks good in theory, but impracticable in real
ground situations. Therefore, even after decades of its existence, there are
litigations galore. Further, FAR analysis takes into account only the supply
side, giving less or no weightage to the demand side. On the other hand,
presumptive taxation, which uses estimation, may result in double taxation as
the residence country may deny the credit of taxes paid on presumptive basis.
The plausible solution seems to be a distribution of profits based on a
predetermined formula, i.e., the Formulary Apportionment Method.

 

However, unless there is a universal
consensus this method also is not practicable. Moreover, availability of data
at a global level or the willingness of a Multi-National Enterprise to share
such data could be a challenge. Difference in accounting treatment, difference
in taxable year, fluctuating exchange rates, changes in domestic tax laws, tax
incentives in different jurisdictions, etc., are all issues for which there are
no answers. This only proves that we are living in an imperfect world and that
we need to accept the imperfect tax system as the hard reality of life in an
era of cross-border transactions and the continuing emergence of giant
multinationals that rule the roost, with law-makers lagging far behind.

 

 

TAXATION OF GIFTS MADE TO NON-RESIDENTS

The Finance (No. 2) Act, 2019 has inserted
section 9(1)(viii) in the Income-tax Act, 1961 (the Act) regarding deemed
accrual in India of gift of money by a person resident in India to a
non-resident. In this article we discuss and explain the said provision in
detail.

 

INTRODUCTION

Taxation of gifts in India has a very long
and chequered history. Ideally, taxes are levied on income, either on its
accrual or receipt. However, with the object of expanding the tax base, the
Indian tax laws have evolved the concept of ‘deemed income’. Deemed income is a
taxable income where the law deems certain kinds of incomes to have accrued to
an assessee in India.

 

Similarly, the legislation in India uses the
concept of deemed income to tax gifts. The Gift Tax Act, 1958 was introduced
with effect from 1st April, 1958 and subsequently amended in the
year 1987. It was repealed w.e.f. 1st October, 1998. Till that date
(1st October, 1998), all gifts (including gifts to relatives)
barring a few exceptions were chargeable to gift tax in the hands of the donor.
The gifts were taxed at a flat rate of about 30% then, with a basic exemption limit
of Rs. 30,000.

 

With the
abolition of the Gift Tax Act, 1958 w.e.f. 1st October, 1998, gifts
were not only used for wealth and income distribution amongst family members /
HUFs, but also for conversion of money. With no gift tax and exemption from chargeability
under the Income-tax Act, gifts virtually remained untaxed until a donee-based
tax was introduced by inserting a deeming provision in clause (v) of section
56(2) by the Finance Act, 2004 w.e.f. 1st April, 2005 to provide
that any sum of money received by an assessee, being an individual or HUF,
exceeding Rs. 25,000 would be deemed to be income under the head ‘Income from
other sources’. Certain exceptions, like receipt of a gift from a relative or
on the occasion of marriage, etc., were provided.

 

The Act was amended w.e.f. 1st
April, 2007 and a new clause (vi) was inserted with an enhanced limit of Rs.
50,000. Another new clause (vii) was inserted by the Finance (No. 2) Act, 2009
w.e.f. 1st October, 2009 to further include under the deeming provision
regarding receipt of immovable property without consideration.

 

When the Act was amended vide Finance Act,
2010 w.e.f. 1st June, 2010, a new clause (viia) was inserted to also
tax (under the deeming provision) a receipt by a firm or company (not being a
company in which public are substantially interested) of shares of a company
(not being a company in which public are substantially interested) without
consideration or at less than fair market value.

 

Via the Finance Act, 2013, and w.e.f. 1st
April, 2013, another new clause (viib) was inserted for taxing premium on the
issue of shares in excess of the fair market value of such shares.

 

Yet another important amendment was made
vide the Finance Act, 2017 w.e.f. 1st April, 2017 suppressing all the
deeming provisions except clause (viib) and a new clause (x) was inserted.

 

At present, clause (viib) and clause (x) of
section 56(2) are in force and deem certain issue of shares or receipt of money
or property as income.

 

SECTION 56(2)(X) AND OTHER RELATED PROVISIONS

Section 56(2) provides that the incomes
specified therein shall be chargeable to income tax under the head ‘Income from
other sources’.

 

Section 56(2)(x) provides that w.e.f. 1st
April, 2017, subject to certain exemptions mentioned in the proviso thereto,
the following receipts by any person are taxable:

(a) any sum of money without consideration,
the aggregate value of which exceeds Rs. 50,000;

(b) any immovable property received without
consideration or for inadequate consideration as specified therein; and

(c) any specified property other than
immovable property (i.e., shares and securities, jewellery, archaeological
collections, drawings, paintings, sculptures, any work of art or bullion)
without consideration or for inadequate consideration, as specified therein.

 

It is important to note that the term
‘consideration’ is not defined under the Act and therefore it must have the
meaning assigned to it in section 2(d) of the Indian Contract Act, 1872.

 

The proviso to
section 56(2)(x) provides for exemption in certain genuine circumstances such
as receipt of any sum of money or any property from any relative, or on the
occasion of a marriage, or under a Will or inheritance, or in contemplation of
death, or between a holding company and its wholly-owned Indian subsidiary, or
between a subsidiary and its 100% Indian holding company, etc.

 

Section
2(24)(xviia) provides that any sum of money or value of property referred to in
section 56(2)(x) is regarded as income.

 

Section 5(2) provides that non-residents are
taxable in India in respect of income which accrues or arises in India, or is
deemed to accrue or arise in India, or is received in India, or is deemed to be
received in India.

 

SECTION 9(1)(VIII)

The Finance (No. 2) Act, 2019 inserted
section 9(1)(viii) w.e.f. A.Y. 2020-21 to provide that any sum of money
referred to in section 2(24)(xviia) arising outside India [which in turn refers
to section 56(2)(x)], paid on or after 5th July, 2019 by a person
resident in India to a non-resident, not being a company, or to a foreign
company, shall be deemed to accrue or arise in India.

 

Section 9(1)(viii) creates a deeming fiction
whereby ‘income arising outside India’ is deemed to ‘accrue or arise in India’.

 

Prior to the insertion of section
9(1)(viii), there was no provision in the Act which covered the gift of a sum
of money given to a non-resident outside India by a person resident in India if
it did not accrue or arise in India. Such gifts therefore escaped tax in India.
In order to avoid such non-taxation, section 9(1)(viii) was inserted.

 

Section 9
provides that certain incomes shall be deemed to accrue or arise in India. The
fiction embodied in the section operates only to shift the locale of accrual of
income.

The Hon’ble Supreme Court in GVK
Industries vs. Income Tax Officer (2015) 231 Taxman 18 (SC) while
adjudicating the issue pertaining to section 9(1)(vii) explored the ‘Source
Rule’ principle and laid down in the context of the situs of taxation,
that the Source State Taxation (SST) confers primacy and precedence to tax a
particular income on the foothold that the source of such receipt / income is
located therein and such principle is widely accepted in international tax
laws. The guiding principle emanating therefrom is that the country where the
source of income is situated possesses legitimate right to tax such source, as
inherently wealth is physically or economically generated from the country
possessing such an attribute.

 

Section 9(1)(viii) deems income arising
outside India to accrue or arise in India on fulfilment of certain conditions
embedded therein, i.e. (a) there is a sum of money (not any property) which is
paid on or after 5th July, 2019; (b) by a person resident in India
to a non-resident, not being a company or to a foreign company; and (c) such
payment of sum of money is referred to as income in section 2(24)(xviia) [which
in turn refers to section 56(2)(x)].

 

Section 9(1)(viii) being a deeming
provision, it has to be construed strictly and its scope cannot be expanded by
giving purposive interpretation beyond its language. The section will not
apply to payment by a non-resident to another non-resident.

 

It is to be noted that any sum of money paid
as gift by a person resident in India to a non-resident during the period 1st
April, 2019 to 4th July, 2019 shall not be treated as income deemed
to accrue or arise in India.

 

Exclusion of gift of property situated
in India:

Section 9(1)(viii) as proposed in the
Finance (No. 2) Bill, 2019 had covered income ‘…arising any sum of money
paid, or any property situate in India transferred…’

 

However, section 9(1)(viii) as enacted reads
as ‘income arising outside India, being any sum of money referred to in
sub-clause (xviia) of clause (24) of section 2, paid…’

 

For example, if a non-resident receives a
gift of a work of art situated outside India from a person resident in India,
then such gift is not covered within the ambit of section 9(1)(viii).

 

Thus, as compared to the proposed
section, the finally enacted section refers to only ‘sum of money’ and
therefore gift of property situated in India is not covered by section
9(1)(viii). It appears that the exclusion of the
property situated in India from the finally enacted section 9(1)(viii) could be
for the reason that such gift of property could be subjected to tax in India
under the existing provisions of section 5(2) where any income received or
deemed to be received in India by a non-resident or on his behalf is subject to
tax in India.

 

Non-application to receipts of gifts
by relatives and other items mentioned in proviso to section 56(2)(x):

As mentioned above, section 9(1)(viii) deems
any sum of money referred to in section 2(24)(xviia) to be income accruing or
arising in India, subject to fulfilment of conditions mentioned therein.

 

Section 2(24)(xviia) in turn refers to sum
of money referred in section 56(2)(x) and regards as income only final
computation u/s 56(2)(x) after considering exclusion of certain transactions
like gifts given to relatives or gift given on the occasion of marriage of the
individual, etc., as mentioned in the proviso to section 56(2)(x).

 

Thus, for example, if there is a gift of US$
10,000 from A who is a person resident in India, to his son S who is a resident
of USA, as per the provision of section 56(2)(x) read with Explanation
(e)(i)(E) of section 56(2)(vii), the same will not be treated as income u/s
9(1)(viii).

 

Therefore,
the insertion of section 9(1)(viii) does not change the position of non-taxability
of receipt of gift from relatives or on the occasion of the marriage of the
individual, etc. Similarly, the threshold limit of Rs. 50,000 mentioned in
section 56(2)(x) would continue to apply and such gift of money up to Rs.
50,000 in a financial year cannot be treated as income u/s 9(1)(viii).

 

It is important
to keep in mind that section 5 broadly narrates the scope of total income.
Section 9 provides that certain incomes mentioned therein shall be deemed to
accrue or arise in India. However, total income under the provisions of the Act
has to be computed as per the other provisions of the Act, and while doing so
benefits of the exemptions / deduction would have to be taken into account.

 

In this connection, the relevant portion of
the Explanatory Memorandum provides that ‘However, the existing provisions
for exempting gifts as provided in proviso to clause (x) of sub-section (2) of
section 56 will continue to apply for such gifts deemed to accrue or arise in
India.’

The Explanatory Memorandum, thus, clearly
provides for application of exemptions provided in proviso to section 56(2)(x).

 

Income arising outside India:

Section
9(1)(viii) uses the expression ‘income arising outside India’ and, keeping in
mind the judicial interpretation of the meaning of the term ‘arise’ or
‘arising’ (which generally means to come into existence), the income has to
come into existence outside India, i.e. the gift of money from a person
resident in India to a non-resident has to be received outside India by the
non-resident.

 

PERSON RESIDENT IN INDIA AND NON-RESIDENT

Person resident in India:

The expression ‘person resident in India’
has been used in section 9(1)(viii). The term ‘person’ has been defined in
section 2(31) of the Act and it includes individuals, HUFs, companies, firms,
LLPs, Association of Persons, etc.

 

The term ‘resident in India’ is used in
section 6 which contains the rules regarding determination of residence of
individuals, companies, etc.

 

It would be very important to minutely
examine the residential status as per the provisions of section 6 to determine
whether a person is resident in India as per the various criteria mentioned
therein, particularly in case of NRIs, expats, foreign companies, overseas
branches of Indian entities, for proper application of section 9(1)(viii).

 

Non-resident:

Section 2(30) of the Act defines the term
‘non-resident’ and provides that ‘non-resident’ means a person who is not a
‘resident’ and for the purposes of sections 92, 93 and 268 includes a person
who is not ordinarily resident within the meaning of clause (6) of section 6.

 

Therefore, for the purposes of section
9(1)(viii), a not ordinarily resident is not a ‘non-resident’.

 

It is to be noted that residential status
has to be determined as per provisions of the Income-tax Act, 1961 and not as
per FEMA.

 

Obligation to deduct tax at source:

Section 195 of the Act provides that any
person responsible for paying to a non-resident any sum chargeable to tax under
the provisions of the Act is obliged to deduct tax at source at the rates in
force. Accordingly, provisions of section 195 would be applicable in respect of
gift of any sum of money by a person resident in India to a non-resident, which
is chargeable to tax u/s 9(1)(viii) and the resident Indian gifting money to a
non-resident shall be responsible to withhold tax at source and deposit the
same in the government treasury within seven days from the end of the month in
which the tax is withheld.

 

The person resident in India shall be
required to obtain tax deduction account number (TAN) from the Indian tax
department, file withholding tax e-statements and issue the tax withholding
certificate to the non-resident. In case of a delay in deposit of withholding
tax / file e-statement / issue certificate, the resident would be subject to
interest / penalties / fines as prescribed under the Act.

 

Applicability of the provisions of
Double Taxation Avoidance Agreement (DTAA):

Section 90(2) of the Act provides that where
the Central Government has entered into a DTAA for granting relief of tax or,
as the case may be, avoidance of double taxation, then, in relation to the
assessee to whom such DTAA applies, the provisions of the Act shall apply to
the extent they are more beneficial to that assessee.

 

Therefore, the relief, if any, under a DTAA
would be available with respect to income chargeable to tax u/s 56(2)(viii).

 

The Explanatory Memorandum clarifies that
‘in a treaty situation, the relevant article of applicable DTAA shall continue
to apply for such gifts as well.’

 

A DTAA distributes taxing rights between the
two contracting states in respect of various specific categories of income
dealt therein. ‘Article 21, Other Income’, of both the OECD Model Convention
and the UN Model Convention, deals with those items of income the taxing rights
in respect of which are not distributed by the other Articles of a DTAA.

 

Therefore, if the recipient of the gift
is a resident of a country with which India has entered into a DTAA, then the
beneficial provisions of the relevant DTAA will govern the taxability of the
income referred to in section 9(1)(viii).

 

Article 21 of the OECD Model Convention,
2017 reads as follows:

Article 21, Other Income:

(i)   Items of income of a resident of a contracting
state, wherever arising, not dealt with in the foregoing Articles of this
Convention, shall be taxable only in that state;

(ii)   The provisions of paragraph 1 shall not apply
to income, other than income from immovable property as defined in paragraph 2
of Article 6, if the recipient of such income, being a resident of a
contracting state, carries on business in the other contracting state through a
permanent establishment situated therein and the right or property in
respect of which the income is paid is effectively connected with such permanent
establishment. In such case, the provisions of Article 7 shall apply.

 

Similarly, Article
21 of the UN Model Convention, 2017 reads as follows:

Article 21,
Other Income:

(1) Items of income
of a resident of a contracting state, wherever arising, not dealt with in the
foregoing Articles of this Convention shall be taxable only in that State;

(2) The provisions
of paragraph 1 shall not apply to income, other than income from immovable
property as defined in paragraph 2 of Article 6, if the recipient of such
income, being a resident of a contracting state, carries on business in the
other contracting state through a permanent establishment situated therein, or
performs in that other state independent personal services from a fixed base
situated therein, and the right or property in respect of which the income is
paid is effectively connected with such permanent establishment or fixed base.
In such a case the provisions of Article 7 or Article 14, as the case may be,
shall apply;

(3) Notwithstanding
the provisions of paragraphs 1 and 2, items of income of a resident of a
contracting state not dealt with in the foregoing Articles of this Convention
and arising in the other contracting
state may also be taxed in that other state.

 

On a comparison of the abovementioned Article 21 of the OECD and UN
Model Conventions, it is observed that Article 21(1) of the OECD Model
Convention provides taxing rights of other income to only a country of
residence.

 

However, Article 21
of the UN Model contains an additional para 3 which gives taxing rights of
other income to the source country also, if the relevant income ‘arises’ in a
contracting state.

 

DTAAs do not define
the term ‘arise’ or ‘arising’ and therefore in view of Article 3(2) of the
Model Conventions, the term not defined in a DTAA shall have the meaning that
it has at that time under the law of the state applying the DTAA.

 

India has currently
signed DTAAs with 94 countries. India’s DTAAs are based on both the OECD as
well as the UN Models. The distribution of taxation rights of other income /
income not expressly mentioned under Articles, corresponding to Article 21 of
the Model Conventions, in the Indian DTAAs can be categorised as under:

 

Sr. No.

Category

No. of countries

Remarks

1.

Exclusive right of taxation to residence state

5

Republic of Korea, Kuwait, Philippines,
Saudi Arabia, United Arab Emirates

2.

Exclusive right of taxation to residence state with limited
right to source state to tax income from lotteries, horse races, etc.

36

Albania, Croatia, Cyprus, Czech Republic,
Estonia, Ethiopia, Georgia, Germany, Jordan, Hungary, Iceland, Ireland,
Israel, Kazakhstan, Kyrgyz Republic, Latvia, Macedonia, Malta, Montenegro,
Morocco, Mozambique, Myanmar, Nepal, Portuguese Republic, Romania, Russia,
Serbia, Slovenia, Sudan, Sweden, Switzerland, Syria, Taipei, Tajikistan,
Tanzania, Uganda

3.

Source state permitted to tax other income

45

Armenia, Australia, Austria, Belarus,
Belgium, Bhutan, Botswana, Brazil, Bulgaria, Canada, China, Columbia, Slovak
Republic, Denmark, Fiji, Finland, France, Indonesia, Japan, Kenya, Lithuania,
Luxembourg, Malaysia, Mauritius, Mongolia, New Zealand, Norway, Oman,
Oriental Republic of Uruguay, Poland, Qatar, Spain, Sri Lanka, South Africa,
Thailand, Trinidad and Tobago, Turkey, Turkmenistan, Ukraine, United Kingdom,
United Mexican States, United States of America, Uzbekistan, Vietnam, Zambia

4.

In both the states, as per laws in force in each state

4

Bangladesh, Italy, Singapore, United Arab Republic (Egypt)

5.

Exclusive right to source state

1

Namibia

6.

No other income article

3

Greece, Libyan Arab Jamahiriya, Netherlands

 

Interestingly, in some of the DTAAs that
India has signed with countries where a large Indian diaspora is present, like
the US, Canada, UK, Australia, Singapore, New Zealand, etc., the taxation right
vests with India (as a source country). It is important that provisions of the
article relating to other income is analysed in detail to evaluate if any tax
is to be paid in the context of such gifts under the applicable DTAA.

 

In cases of countries covered in Sr. Nos.
1 and 2, due to exemption under the respective DTAAs, India would still not be
able to tax income u/s 9(1)(viii) arising to the residents of those countries.

 

IMPLICATIONS UNDER FEMA

Besides tax
laws, one should also evaluate the implications, if any, under the FEMA
regulations for gifts from a person resident in India to a non-resident. Thus,
one must act with caution to ensure compliance with law and mitigate
unnecessary disputes and litigation at a later date.

 

CONCLUDING REMARKS

The stated objective of section 9(1)(viii)
has been to plug the loophole for taxation of gifts of money from a person
resident in India to a non-resident. As the taxability is in the hands of the
non-resident donee, there would be a need for the donee / recipient to obtain
PAN and file an income tax return in India where there is a taxable income
(along with the gift amount that exceeds Rs. 2,50,000 in case of an
individual).

 

In conclusion, this is a welcome provision
providing certainty in the taxability of gifts to non-residents by a person
resident in India.  

 

 

RECENT IMPORTANT DEVELOPMENTS – PART II

In Part I of the article published in July,
we covered some of the important developments in India relating to
International Tax. In this Part II of the article, we cover recent major
developments in the area of International Taxation and the work being done at
OECD and UN in various other related fields. It is in continuation of our
endeavour to update readers on major International Tax developments at regular
intervals. The news items included here come from various sources and the OECD
and UN websites.

 

(A) DEVELOPMENTS IN INDIA RELATING TO
INTERNATIONAL TAX

 

Ratification by India of the Multilateral
Convention to implement tax treaty-related measures to prevent Base Erosion and
Profit Shifting (Press release dated 2nd July, 2019 issued by CBDT,
Ministry of Finance)

 

India has ratified the Multilateral
Convention to implement tax treaty-related measures to prevent Base Erosion and
Profit Shifting (MLI), which was signed by the Hon’ble Finance Minister in
Paris on 7th June, 2017 along with representatives of more than 65
countries. On 25th June, 2019 India deposited the Instrument of
Ratification to OECD, Paris, along with its final position in terms of Covered
Tax Agreements (CTAs), reservations, options and notifications under the MLI,
as a result of which MLI will come into force for India on 1st
October, 2019 and its provisions will have effect on India’s DTAAs from FY
2020-21 onwards.

 

(B) OECD DEVELOPMENTS

 

(I) OECD
announces progress made in addressing harmful tax practices (BEPS Action 5)
(Source: OECD News Report dated 29th January, 2019)

 

The OECD has
released a new publication, Harmful Tax Practices – 2018 Progress Report on
Preferential Regimes, which contains results demonstrating that
jurisdictions have delivered on their commitment to comply with the standard on
harmful tax practices, including ensuring that preferential regimes align
taxation with substance.

 

The assessment of
preferential tax regimes is part of ongoing implementation of Action 5 under
the OECD/G20 BEPS Project. The assessments are conducted by the Forum on
Harmful Tax Practices (FHTP), comprising of the more than 120 member
jurisdictions of the Inclusive Framework. The latest assessment by the FHTP has
yielded new conclusions on 57 regimes, including:

 

  •    44 regimes where
    jurisdictions have delivered on their commitment to make legislative changes to
    abolish or amend the regime (Antigua and Barbuda, Barbados, Belize, Botswana, Costa
    Rica, Curaçao, France, Jordan, Macau (China), Malaysia, Panama, Saint Lucia,
    Saint Vincent and the Grenadines, the Seychelles, Spain, Thailand and Uruguay).
  •    As a result, all IP regimes
    that were identified in the 2015 BEPS Action 5 report are now ‘not harmful’ and
    consistent with the nexus approach, following the recent legislative amendments
    passed by France and Spain.
  •    Three new or replacement
    regimes were found ‘not harmful’ as they have been specifically designed to
    meet Action 5 standard (Barbados, Curaçao and Panama).
  •    Four other regimes have been
    found to be out of scope or not operational (Malaysia, the Seychelles and the
    two regimes of Thailand), and two further commitments were given to make
    legislative changes to abolish or amend a regime (Malaysia and Trinidad &
    Tobago).
  •    One regime has been found
    potentially harmful but not actually harmful (Montserrat).
  •    Three regimes have been
    found potentially harmful (Thailand).

 

The FHTP has
reviewed 255 regimes to date since the start of the BEPS Project, and the
cumulative picture of the Action 5 regime review process is as follows:

 

The report also
delivers on the Action 5 mandate for considering revisions or additions to the
FHTP framework, including updating the criteria and guidance used in assessing
preferential regimes and the resumption of application of the substantial
activities factor to no, or only nominal, tax jurisdictions. The report
concludes in setting out the next key steps for the FHTP in continuing to
address harmful tax practices.

 

(II) New
Beneficial Ownership Toolkit will help tax administrations tackle tax evasion
more effectively (Source: OECD News Report dated 20th March, 2019)

 

The first ever beneficial
ownership toolkit was released today in the context of the OECD’s
Global Integrity and Anti-Corruption Forum. The toolkit, prepared by the
Secretariat of the OECD’s Global Forum on Transparency and Exchange of
Information for Tax Purposes in partnership with the Inter-American
Development Bank, is intended to help governments implement the Global Forum’s
standards on ensuring that law enforcement officials have access to reliable
information on who the ultimate beneficial owners are behind a company or other
legal entity so that criminals can no longer hide their illicit activities
behind opaque legal structures.

 

The toolkit was
developed to support Global Forum members and in particular developing
countries because the current beneficial ownership standard does not provide a
specific method for implementing it. To assist policy makers in assessing
different implementation options, the toolkit contains policy considerations
that Global Forum members can use in implementing the legal and supervisory
frameworks to identify, collect and maintain the necessary beneficial ownership
information.

 

‘Transparency of
beneficial ownership information is essential to deterring, detecting and
disrupting tax evasion and other financial crimes. The Global Forum’s standard
on beneficial ownership offers jurisdictions flexibility in how they implement
the standard to take account of different legal systems and cultures. However,
that flexibility can pose challenges particularly to developing countries,’
said Pascal Saint-Amans, Head of the OECD’s Centre for Tax Policy and
Administration. ‘This new toolkit is an invaluable new resource to help
them find the best approach.’

 

The toolkit covers
a variety of important issues regarding beneficial ownership, including:

  •    the concepts of beneficial
    owners and ownership, the criteria used to identify them, the importance of the
    matter for transparency in the financial and non-financial sectors;
  •    technical aspects of
    beneficial ownership requirements, distinguishing between legal persons and
    legal arrangements (such as trusts) and measures being taken internationally to
    ensure the availability of information on beneficial ownership, (such as)
    a series of checklists that may be useful in pursuing a specific beneficial
    ownership framework;
  •    ways in which the principles
    on beneficial ownership can play out in practice in Global Forum EOIR peer
    reviews;
  •    why beneficial ownership
    information is also a crucial component of the automatic exchange of
    information regimes being adopted by jurisdictions around the world.

 

With 154 members, a
majority of whom are developing countries, the Global Forum has been heavily
engaged in providing technical assistance on the new beneficial ownership
requirements, often with the support of partner organisations including the
IDB. The Toolkit offers another means to further equip members to comply with
the international tax transparency standards.

 

The Toolkit is the
first practical guide freely available for countries implementing the
international tax transparency standards. It will be frequently updated to
incorporate new lessons learned from the second-round EOIR peer reviews
conducted by the Global Forum, as well as best practices seen and developed by
supporting organisations.

 

(III)
International community agrees on a road-map for resolving the tax challenges
arising from digitalisation of the economy (Source: OECD News Report dated 31st
May, 2019)

 

The international
community has agreed on a road-map for resolving the tax challenges arising
from the digitalisation of the economy, and committed to continue working
towards a consensus-based long-term solution by the end of 2020, the OECD
announced on 31st May, 2019

 

The 129 members of
the OECD/G20 Inclusive Framework on Base Erosion and Profit Shifting (BEPS)
adopted a Programme of Work laying out a process for reaching a new global
agreement for taxing multinational enterprises.

 

The document, which
calls for intensifying international discussions around two main pillars, was
approved during the 28-29 May plenary meeting of the Inclusive Framework, which
brought together 289 delegates from 99 member countries and jurisdictions and
ten observer organisations. It was presented by OECD Secretary-General Angel
Gurría to G20 Finance Ministers for endorsement during their 8-9 June
ministerial meeting in Fukuoka, Japan.

 

Drawing on analysis
from a Policy Note published in January, 2019 and informed by a public
consultation held in March, 2019, the Programme of Work will explore the
technical issues to be resolved through the two main pillars. The first pillar
will explore potential solutions for determining where tax should be paid and
on what basis (‘nexus’), as well as what portion of profits could or should be
taxed in the jurisdictions where clients or users are located (‘profit
allocation’).

 

The second pillar
will explore the design of a system to ensure that multinational enterprises –
in the digital economy and beyond – pay a minimum level of tax. This pillar
would provide countries with a new tool to protect their tax base from profit
shifting to low / no-tax jurisdictions and is intended to address remaining
issues identified by the OECD/G20 BEPS initiative.

 

In 2015, the OECD
estimated revenue losses from BEPS of up to USD 240 billion, equivalent to 10% of
global corporate tax revenues, and created the Inclusive Forum to co-ordinate
international measures to fight BEPS and improve the international tax rules.

 

‘Important progress
has been made through the adoption of this new Programme of Work, but there is
still a tremendous amount of work to do as we seek to reach, by the end of
2020, a unified long-term solution to the tax challenges posed by
digitalisation of the economy,’ Mr Gurría said. ‘Today’s broad agreement on the
technical roadmap must be followed by strong political support towards a
solution that maintains, reinforces and improves the international tax system.
The health of all our economies depends on it.’

 

The Inclusive
Framework agreed that the technical work must be complemented by an impact
assessment of how the proposals will affect government revenue, growth and
investment. While countries have organised a series of working groups to
address the technical issues, they also recognise that political agreement on a
comprehensive and unified solution should be reached as soon as possible,
ideally before the year-end, to ensure adequate time for completion of the work
during 2020.

 

(IV)
Implementation of tax transparency initiative delivering concrete and
impressive results (Source: OECD News Report dated 7th June, 2019)

International
efforts to improve transparency via automatic exchange of information on
financial accounts are improving tax compliance and delivering concrete results
for governments worldwide, according to new data released on 7th
June, 2019 by the OECD.

 

More than 90
jurisdictions participating in a global transparency initiative under the
OECD’s Common Reporting Standard (CRS) since 2018 have now exchanged
information on 47 million offshore accounts, with a total value of around EUR
4.9 trillion. The Automatic Exchange of Information (AEOI) initiative –
activated through 4,500 bilateral relationships – marks the largest exchange of
tax information in history, as well as the culmination of more than two decades
of international efforts to counter tax evasion.

 

‘The international
community has brought about an unprecedented level of transparency in tax
matters which will bring concrete results for government revenues and services
in the years to come,’ according to OECD Secretary-General Angel Gurria,
unveiling the new data prior to a meeting of G20 finance ministers in Fukuoka,
Japan. ‘The transparency initiatives we have designed and implemented through
the G20 have uncovered a deep pool of offshore funds that can now be effectively
taxed by authorities worldwide. Continuing analysis of cross-border financial
activity is already demonstrating the extent that international standards on
automatic exchange of information have strengthened tax compliance and we
expect to see even stronger results moving forward,’ Mr Gurria said.

 

Voluntary
disclosure of offshore accounts, financial assets and income in the run-up to
full implementation of the AEOI initiative resulted in more than EUR 95 billion
in additional revenue (tax, interest and penalties) for OECD and G20 countries
over the 2009-2019 period. This cumulative amount is up by EUR 2 billion since
the last reporting by OECD in November, 2018.

 

Preliminary OECD
analysis drawing on a methodology used in previous studies shows the very substantial
impact AEOI is having on bank deposits in international financial centres
(IFCs). Deposits held by companies or individuals in more than 40 key IFCs
increased substantially over the 2000 to 2008 period, reaching a peak of USD
1.6 trillion by mid-2008.

 

These deposits have
fallen by 34% over the past ten years, representing a decline of USD 551
billion, as countries adhered to tighter transparency standards. A large part
of that decline is due to the onset of the AEOI initiative, which accounts for
about two-thirds of the decrease. Specifically, AEOI has led to a decline of 20
to 25% in the bank deposits in IFCs, according to preliminary data. The
complete study is expected to be published later this year.

 

‘These impressive
results are only the first stock-taking of our collective efforts,’ Mr Gurria
said. ‘Even more tax revenue is expected as countries continue to process the
information received through data-matching and other investigation tools. We
really are moving closer to a world where there is nowhere left to hide.’

 

(V) Money
Laundering and Terrorist Financing Awareness Handbook for Tax Examiners and Tax
Auditors

The OECD in June,
2019 released an update of its 2009 Money Laundering Awareness Handbook for
Tax Examiners and Tax Auditors. This update enhances the 2009 publication
with additional chapters such as ‘Indicators on Charities and Foreign Legal
Entities’ and ‘Indicators on Cryptocurrencies’ relating to money laundering. In
a separate chapter, the increasing threat
of terrorism is addressed by including indicators of terrorist financing.

 

The purpose of the Money
Laundering and Terrorist Financing Awareness Handbook for Tax Examiners and Tax
Auditors is to raise the awareness level of tax examiners and tax auditors
regarding money laundering and terrorist financing. As such, the primary
audience for this Handbook are tax examiners and tax auditors who may come
across indicators of unusual or suspicious transactions or activities in the
normal course of tax reviews or audits and report to an appropriate authority.
While this Handbook is not intended to detail criminal investigation methods,
it does describe the nature and context of money laundering and terrorist
financing activities, so that tax examiners and tax auditors, and by extension
tax administrations, are able to better understand how their contributions can
assist in the fight against serious crimes.

 

While the aim of
this Handbook is to raise the awareness of the tax examiners and tax auditors
about the possible implications of transactions or activities related to money
laundering and terrorist financing, the Handbook is not meant to replace
domestic policies or procedures. Tax examiners and tax auditors will need to
carry out their duties in accordance with the policies and procedures in force
in their country.

 

(VI)  G20 Osaka Leaders’ Declaration

The leaders of the
G20 met in Osaka, Japan on 28-29 June, 2019 to make united efforts to address
major global economic challenges. They stated in their declaration that they
will work together to foster global economic growth while harnessing the power
of technological innovation, in particular digitalisation, and its application
for the benefit of all.

 

In the declaration,
para 16, relating to tax, stated as follows:

 

‘16. We will
continue our co-operation for a globally fair, sustainable, and modern
international tax system, and welcome international co-operation to advance
pro-growth tax policies. We reaffirm the importance of the worldwide
implementation of the G20/OECD Base Erosion and Profit Shifting (BEPS) package
and enhanced tax certainty. We welcome the recent progress on addressing the
tax challenges arising from digitalisation and endorse the ambitious work
programme that consists of a two-pillar approach, developed by the Inclusive
Framework on BEPS. We will redouble our efforts for a consensus-based
solution with a final report by 2020. We welcome the recent achievements on tax
transparency, including the progress on automatic exchange of information for
tax purposes. We also welcome an updated list of jurisdictions that have not
satisfactorily implemented the internationally agreed tax transparency
standards. We look forward to a further update by the OECD of the list that
takes into account all of the strengthened criteria. Defensive measures will be
considered against listed jurisdictions. The 2015 OECD report inventories
available measures in this regard. We call on all jurisdictions to sign and
ratify the Multilateral Convention on Mutual Administrative Assistance in Tax
Matters. We reiterate our support for tax capacity building in developing
countries.’

 

(VII)  OECD expands transfer pricing country
profiles to cover 55 countries

 

The OECD has just
released new transfer pricing country profiles for Chile, Finland and Italy,
bringing the total number of countries covered to 55. In addition, the OECD has
updated the information contained in the country profiles for Colombia and
Israel.

 

These country
profiles reflect the current state of legislation and practice in each country
regarding the application of the arm’s-length principle and other key transfer
pricing aspects. They include information on the arm’s-length principle,
transfer pricing methods, comparability analysis, intangible property,
intra-group services, cost contribution agreements, transfer pricing
documentation, administrative approaches to avoiding and resolving disputes,
safe harbours and other implementation measures as well as to what extent the
specific national rules follow the OECD Transfer Pricing Guidelines.

 

The transfer
pricing country profiles are published to increase transparency in this area
and reflect the revisions to the Transfer Pricing Guidelines resulting from the
2015 Reports on Actions 8-10 Aligning Transfer Pricing Outcomes with Value
Creation and Action 13 Transfer Pricing Documentation and Country-by-Country
Reporting of the OECD/G20 Project on Base Erosion and Profit Shifting
(BEPS), in addition to changes incorporating the revised guidance on safe
harbours approved in 2013 and consistency changes made to the rest of the
OECD Transfer Pricing Guidelines.

 

A.    UN
DEVELOPMENTS

 

(VIII)     Manual
for the Negotiation of Bilateral Tax Treaties between Developed and Developing
Countries, 2019

 

The United Nations Manual for the Negotiation of Bilateral Tax Treaties
between Developed and Developing Countries (2019) is a compact training tool
for beginners with limited experience in tax-treaty negotiations. It seeks to
provide practical guidance to tax-treaty negotiators in developing countries,
in particular those who negotiate based on the United Nations Model Double
Taxation Convention between Developed and Developing Countries. It deals with
all the basic aspects of tax-treaty negotiations and it is focused on the
realities and stages of capacity development of developing countries.

 

The core of the Manual is contained in Section III which
introduces the different Articles of the United Nations Model Double Taxation
Convention between Developed and Developing Countries (United Nations Model
Convention). This section is not intended to replace the Commentaries thereon,
which remain the final authority on issues of interpretation, but rather to
provide a simple tool for familiarising less experienced negotiators with the
provisions of each Article.

 

We sincerely hope that the reader would find the above developments to
be interesting and useful.

 

 

THE FUGITIVE ECONOMIC OFFENDERS ACT, 2018 – AN OVERVIEW – PART 1

In the recent
past, there have been quite a few instances of big time offenders including
economic offenders (For example, Vijay Mallya, Lalit Modi, Nirav Modi, Mehul
Choksi, Deepak Talwar, Sanjay Bhandari, Jatin Mehta, Prateek Jindal etc.),
fleeing the country to escape the clutches of law. The Parliament has therefore
enacted a new law, to deal with such offenders by confiscating the assets of
such persons located in India until they submit to the jurisdiction of the
appropriate legal forum.

 

In this Part 1
of the article, we have attempted to give an overview of some of important
aspects of The Fugitive Economic Offenders Act, 2018 [the FEO Act or the Act].

 

1.  INTRODUCTION


The FEO Bill, 2018
was introduced in the Lok Sabha on 12th March, 2018 but the same
could not be passed both the houses of parliament were prorogued on 6th
April, 2018.  Hence, the FEO Ordinance,
2018 was promulgated on 21st April, 2018 which came into force
immediately. The FEO Bill, 2018 was passed by Parliament on 25th
July, 2018 and received the assent of the President on 31st July,
2018. Section 1(3) of the FEO Act provides that it is deemed to have come in to
force w.e.f. 21st April, 2018 and section 26(1) repeals the FEO
Ordinance, 2018.

 

2. 
NEED AND RATIONALE FOR FEO ACT


2.1  After approval of the proposal of the Ministry
of Finance to introduce the Fugitive Economic Offenders Bill, 2018 in
Parliament, the Press Release dated 1st March, 2018, issued by the
Ministry of Finance, Government of India, explained the background of the FEO
Bill, 2018, as follows:

 

“Background

There have been
several instances of economic offenders fleeing the jurisdiction of Indian
courts, anticipating the commencement, or during the pendency, of criminal
proceedings. The absence of such offenders from Indian courts has several
deleterious consequences – first, it hampers investigation in criminal cases;
second, it wastes precious time of courts of law, third, it undermines the rule
of law in India. Further, most such cases of economic offences involve
non-repayment of bank loans thereby worsening the financial health of the
banking sector in India. The existing civil and criminal provisions in law are
not entirely adequate to deal with the severity of the problem. It is,
therefore, felt necessary to provide an effective, expeditious and
constitutionally permissible deterrent to ensure that such actions are curbed.
It may be mentioned that the non-conviction-based asset confiscation for
corruption-related cases is enabled under provisions of United Nations
Convention against Corruption (ratified by India in 2011). The Bill adopts this
principle. In view of the above context, a Budget announcement was made by
the Government in the Budget 2017-18 that the Government was considering to introduce
legislative changes or even a new law to confiscate the assets of such
absconders till they submit to the jurisdiction of the appropriate legal
forum.”

 

2.2  The Statement of Objects and Reasons of the
FEO Bill, provides as follows:

 

“Statement of objects and reasons


There have been several instances of economic
offenders fleeing the jurisdiction of Indian courts anticipating the
commencement of criminal proceedings or sometimes during the pendency of such
proceedings. The absence of such offenders from Indian courts has several
deleterious consequences, such as, it obstructs investigation in criminal
cases, it wastes precious time of courts and it undermines the rule of law in
India. Further, most of such cases of economic offences involve non-repayment
of bank loans thereby worsening the financial health of the banking sector in
India. The existing civil and criminal provisions in law are inadequate to deal
with the severity of the problem.


2.    In order to address the said problem and
lay down measures to deter economic offenders from evading the process of
Indian law by remaining outside the jurisdiction of Indian courts, it is
proposed to enact a legislation, namely, the Fugitive Economic Offenders Bill,
2018 to ensure that fugitive economic offenders return to India to face the
action in accordance with law.


3.    The said Bill, inter alia, provides for:
(i) the definition of the fugitive economic offender as an individual who has
committed a scheduled offence or offences involving an amount of one hundred
crore rupees or more and has absconded from India or refused to come back to
India to avoid or face criminal prosecution in India; (ii) attachment of the
property of a fugitive economic offender and proceeds of crime; (iii) the
powers of Director relating to survey, search and seizure and search of
persons; (iv) confiscation of the property of a fugitive economic offender and
proceeds of crime; (v) disentitlement of the fugitive economic offender from
putting forward or defending any civil claim; (vi) appointment of an
Administrator for the purposes of the proposed legislation; (vii) appeal to the
High Court against the orders issued by the Special Court; and (viii) placing
the burden of proof for establishing that an individual is a fugitive economic
offender on the Director or the person authorised by the Director.

4.    The Bill seeks to achieve the above
objectives.”

 

2.3  Shri Piyush Goyal, then holding charge as
Finance Minister explained the rationale for the FEOA in the Rajya Sabha debate
on 25th July, 2018, as under:

 

“Sir, there have been many instances of economic
offenders in last several decades, fleeing from the jurisdiction of the Indian
Courts, sometimes in anticipation of commencement of proceedings or sometimes
during the pendency of proceedings. Sir, you are not able to impound of those
leaving the country, except through due process of law. The current laws as
they stand today, have its own limitations in stopping people who flee the
country in anticipation or during the pendency of the proceedings. The absence
of such offenders from the Indian courts has very deleterious consequences. The
existing civil and criminal laws do not allow us to adequately deal with the
severity of the problem, since they are not available or present.

 

Criminal law
does not allow us to push in for punishment, impound their properties and deal
with their properties. Therefore, it was felt necessary to provide an
effective, expeditious and constitutionally permissible deterrent to ensure
that such people do not runaway or, if they runaway, confiscate their
properties. In this context, in the Budget for
2017-18, the hon’ble Finance Minister had announced the intention of the
Government to introduce legislative changes or even a new law to confiscate
assets of such absconders till they submit themselves before the jurisdiction
of the appropriate legal forum. We are not only confiscating their assets but
we are also providing how the confiscated property will be managed and disposed
of, so that dues of Government of India, State Governments and banks, etc., can
be recovered from them.”

 

2.4  The Preamble to the FEO Act
provides as follows:

 

“An Act to
provide for measures to deter fugitive economic offenders from evading the
process of law in India by staying outside the jurisdiction of Indian courts,
to preserve the sanctity of the rule of law in India and for matters connected
therewith or incidental thereto.”

 

2.5  On 30th November, 2018 in the
meeting at Buenos Aires, India suggested following Nine Point Agenda to G-20
for action against Fugitive Economic Offences and Asset Recovery:

 

1.    “Strong and active cooperation across
G-20 countries to deal comprehensively and efficiently with the menace fugitive
economic offenders.

2.    Cooperation in the legal processes such
as effective freezing of the proceeds of crime; early return of the offenders
and efficient repatriation of the proceeds of crime should be enhanced and
streamlined.

3.    Joint effort by G-20 countries to form a
mechanism that denies entry and safe havens to all fugitive economic offenders.

4.    Principles of United Nations Convention
Against Corruption (UNCAC), United Nations Convention Against Transnational
Organized Crime (UNOTC), especially related to “International Cooperation”
should be fully and effectively implemented.

5.    FATF should be called upon to assign
priority and focus to establishing international co-operation that leads to
timely and comprehensive exchange of information between the competent
authorities and FIUs.

6.    FATF should be tasked to formulate a
standard definition of fugitive economic offenders.

7.    FATF should also develop a
set of commonly agreed and standardized procedures related to identification,
extradition and judicial proceedings for dealing with fugitive economic
offenders to provide guidance and assistance to G-20 countries, subject to
their domestic law.

8.    Common platform should be set up for
sharing experiences and best practices including successful cases of
extradition, gaps in existing systems of extradition and legal assistance, etc.

9.    G-20 Forum should consider initiating
work on locating properties of economic offenders who have a tax debt in the
country of their residence for its recovery.”

 

2.6  From the above, it is apparent that the
government is making all possible efforts to compel the FEOs to submit
themselves before the jurisdiction of the appropriate legal forum.

 

3.  OVERVIEW OF THE ACT AND THE RULES


3.1  The FEO Act is divided in three Chapters
containing 26 sections and one Schedule listing the sections and description of
various offences.

 

3.2  Various rules have been made by the Central
Government for various matters for carrying out the provisions of the FEO Act.
The present list of rules is as follows:

 

Sr. No.

Particulars of the Rules

Effective Date

1.

Fugitive Economic Offenders (Manner of Attachment of Property) Rules,
2018

(Issued in suppression of the Fugitive
Economic Offenders (Issuance of Attachment Order) Rules, 2018 dated 24th
April, 2018 and Fugitive Economic Offenders (Issuance of Provisional
Attachment Order) Rules, 2018 dated 24th April, 2018.)

24th August, 2018

2.

Declaration of Fugitive Economic Offenders (Forms and Manner of Filing
Application) Rules, 2018

(Issued in suppression of the Fugitive
Economic Offenders (Application for Declaration of Fugitive Economic
Offenders) Rules, 2018 dated 24th April, 2018.)

24th August, 2018

3.

Fugitive Economic Offenders (Procedure for sending Letter of Request
to Contracting State) Rules, 2018.

(Issued in suppression of the Fugitive
Economic Offenders (Procedure for sending Letter of Request to Contracting
State for Service of Notice and Execution of Order of the Special Court)
Rules, 2018 dated 24th April, 2018.)

24th August, 2018

4.

Fugitive Economic Offenders (Procedure for Conducting Search and
Seizure) Rules, 2018

(Issued in suppression of the Fugitive
Economic Offenders (Forms, Search and Seizure and the Manner of Forwarding
the Reasons and Material to the Special Court) Rules, 2018 dated 24th
April, 2018.)

24th August, 2018

5.

Fugitive Economic Offenders (Manner and Conditions for Receipt and
Management of Confiscated Properties) Rules, 2018.

(Issued in suppression of the Fugitive
Economic Offenders (Receipt and Management of Confiscated Properties) Rules,
2018 dated 24th April, 2018.)

24th August, 2018

 

 

3.3  Some
Salient Features of the FEO Act

a.  
The FEO Act is deemed to have come into force on 21st April
2018 i.e. the date of issuance of the FEO Ordinance, 2018.

b.  
The FEO Act extends to whole of India including Jammu and Kashmir.

c.  
The Act provides for measures to deter fugitive economic offenders from
evading the process of law in India by staying outside the jurisdiction of
Indian courts, to preserve the sanctity of the rule of law in India and for
matters connected therewith or incidental thereto.

d.   
Section 3 of the FEO Act provides that the provisions of the Act apply
to any individual who is, or becomes a Fugitive Economic Offender [FEO] on or
after the date of coming into force of the Act i.e. 21st April,
2018.

e.  
Section 4(3) provides that the authorities appointed for the purposes of
the Prevention of Money-laundering Act, 2002 shall be the Authorities for the
purposes of the Act.

f.  
Section 18 provides that no civil court shall have jurisdiction to
entertain any suit or proceeding in respect of any matter which the Special
Court is empowered by or under the Act to determine and no injunction shall be
granted by any court or other authority in respect of any action taken or to be
taken in pursuance of any power conferred by or under the Act.

 

4.    FUGITIVE ECONOMIC OFFENDER [FEO]


4.1  The term ‘Fugitive Economic Offender’ or FEO
is the main stay of the FEO Act, as the Act provides for action against FEOs
and the significance of the definition of FEO cannot be undermined. Section
2(1)(f) of the Act defines the term FEO, as follows:

“(f) “fugitive
economic offender” means any individual against whom a warrant for arrest in
relation to a Scheduled Offence has been issued by any Court in India, who –

(i)    has left India so as to avoid criminal prosecution;
or

(ii)   being abroad, refuses to return to India to
face criminal prosecution;”

 

Thus, a person is
considered to be a FEO, if he satisfies the following conditions:

a)    He is an individual;

b)    a warrant for arrest in relation to a
Scheduled Offence has been issued by any Court in India against him;

c)    he is a fugitive i.e. he (i) has left India
so as to avoid criminal prosecution; or (ii) being abroad, refuses to return to
India to face criminal prosecution.

 

4.2  Only
an Individual to be declared as FEO

From the definition
in section 2(1)(f) and provisions of section 3 (Application of Act), section
4(1) (Application for declaration of FEO and procedure therefore), section
10(1) (Notice), section 11 (Procedure for hearing application) and section 12(1)
(Declaration of FEO), makes it abundantly clear that only an individual can be
declared as a FEO.

 

Thus, prima
facie, the provisions of the FEO Act should not have application to a
company or Limited Liability Partnership [LLP] or partnership firm or other
association of persons.

 

However, as an
exception, section 14 dealing with ‘Power to disallow civil claims’ provides
that on declaration of an individual as a FEO, any Court or Tribunal in India
in any civil proceeding before it may, disallow any company or LLP (as defined
in section 2(1)(n) of the LLP Act, 2008) from putting forward or defending any
civil claim, if such an individual is (a) filing the claim on behalf of the
company or the LLP, or (b) promoter or key managerial personnel (as defined in
section 2(51) of the Companies Act, 2013) or majority shareholder of the
company or (c) having a controlling interest in the LLP.

 

Section 12(2) of
the FEO Act provides that on declaration of an individual as a FEO, the Special
court may order that any of the following properties stand confiscated to the
Central Government (a) the proceeds of crime in India or abroad, whether or not
such property is owned by the fugitive economic offender; and (b) any other
property or benami property in India or abroad, owned by the fugitive economic
offender. The assets owned by LLPs in which the FEO having controlling interest
or Companies in which the FEO is promoter or key managerial personnel or
majority shareholder, can be confiscated only if it is established that such
LLP or Company is benamidar of the FEO or the property held by the company or
LLP represents proceeds of crime. Further, it appears that the courts can lift
the corporate veil in appropriate cases and rule that the property standing in
the name of the company or LLP is actually the property of the Individual FEO
and the same is liable for confiscation.

 

4.3  Warrant
of Arrest

For an individual
to be declared as a FEO, it is necessary that (a) a warrant of arrest has been
issued against him by a Court in India; (b) such warrant is in relation to a
Scheduled Offence, whether committed before or after the date of coming in to
force of the FEO Act i.e. 21-04-18; (c) it is immaterial whether the warrant
was issued before, on or after 21-04-18 as long as the same is pending on the
date of declaration as FEO; and (d) if the warrant of arrest stands withdrawn
or quashed as of the date of declaration as FEO, then the individual cannot be
declared a FEO.

 

4.4 
Fugitive

The term ‘fugitive’
has not been defined in the FEO Act. Concise Oxford Dictionary defines a
‘fugitive’ as
a person who has escaped from the captivity or is in hiding. To be considered a
FEO the individual should
have (a) has left India so as to avoid criminal prosecution; or (b) being
abroad, refuses to return to India to face criminal prosecution.

 

Section 11(1) of
the Act provides that where any individual to whom notice has been issued under
sub-section (1) of section 10 appears in person at the place and time specified
in the notice, the Special Court may terminate the proceedings under the Act.
Thus, if the alleged FEO returns to India at any time during the course of
proceedings relating to the declaration as a FEO (prior to declaration) and
submits to the appropriate jurisdictional court, the proceedings under the FEO
Act cease by law.

 

4.5  Procedure
to declare an individual as FEO

The FEO Act, inter
alia, provides for the procedure to declare an individual as FEO, which is
as follows:

 

(i)    Application of mind by the Director or other
authorised office to the material in his possession as to whether he has reason
to believe that an individual is a FEO.

(ii)   Documentation of reason for belief in
writing.

(iii)   Provisional attachment (without Special
Court’s permission) by a written order of an individual’s property (a) for
which there is reason to believe that the property is proceeds of crime, or is
a property or benami property owned by an individual who is a FEO; and (b)
which is being or is likely to be dealt within a manner which may result in the
property being unavailable for confiscation. In cases of provisional
attachment, the Director or any other officer who provisionally attaches any
property under this section 5(2) is required to file an application u/s. 4
before the Special Court, within a period of thirty days from the date of such
attachment.

(iv)  Making an application before the special court
for declaration that an individual is a FEO (Section 4);

(v)   Attachment of the property of a FEO and
proceeds of crime (Section 5);

(vi)  Issue of a notice by the special court to the
individual alleged to be a FEO (Section 10);

(vii)  Where any individual to whom notice has been
issued appears in person at the place and time specified in the notice, the
special court may terminate the proceedings under the FEO Act. (Section 11(1))

(viii) Hearing of the application for declaration as
FEO by the Special Court (Section 11);

(ix)  Declaration as FEO by Special Court by a
speaking order (Section 12);

(x)   Confiscation of the property of an individual
declared as a FEO or even the proceeds of crime (Section 12);

(xi)  Supplementary application in the Special Court
seeking confiscation of any other property discovered or identified which
constitutes proceeds of crime or is property or benami property owned by
the individual in India or abroad who is a FEO, liable to be confiscated under
the FEO Act (Section 13)

(xii)  Disentitlement of a FEO from defending any
civil claim (Section 14); and

(xiii) Appointment of an Administrator to manage and
dispose of the confiscated property under the Act
(Section 15).

 

4.6  Manner
of Service of notice

Section 10 dealing
with Notice, provides for two alternative prescribed mode of service of notice
on the alleged FEO: (a) through the contracting state (s/s. (4) and (5); and
(b) e-service.

 

Notice through Contract State

Section 2(1)(c) of
the Act defines Contracting State as follows:

“Contracting
State” means any country or place outside India in respect of which
arrangements have been made by the Central Government with the Government of
such country through a treaty or otherwise;”

 

Section 10(4)
provides that a notice under s/s. (1) shall be forwarded to such authority, as
the Central Government may notify, for effecting service in a contracting
State.

 

Section 10(5)
provides that such authority shall make efforts to serve the notice within a
period of two weeks in such manner as may be prescribed.

 

Service of notice
through the contracting state is possible only when alleged FEO is suspected or
known to be in a contracting state with which India has necessary arrangements
through a treaty or otherwise.

 

E-service of Notice

Section 10(6)
provides that a notice under s/s. (1) may also be served to the
individual alleged to be a FEO by electronic means to:

 

(a)   his electronic mail address submitted in
connection with an application for allotment of Permanent Account Number u/s.
139A of the Income-tax Act, 1961;

(b)   his electronic mail address submitted in
connection with an application for enrolment u/s. 3 of the Aadhaar (Targeted
Delivery of Financial and Other Subsidies, Benefits and Services) Act, 2016; or

(c)   any other electronic account as may be
prescribed, belonging to the individual which is accessed by him over the
internet, subject to the satisfaction of the Special Court that such account
has been recently accessed by the individual and constitutes a reasonable
method for communication of the notice to the individual.

 

4.7  India’s
First Declared FEO

As per the news
report appearing in the New Indian Express dated 19th January, 2019,
Mr. Vijay Mallya is the first businessman to be declared an FEO under the FEO
Act. In absence of the copy of the court’s order being available in public
domain as yet, the key points of the special court’s order, as appearing in the
text of the new report, is given for reference.

 

“Businessman
Vijay Mallya’s claim that the Indian government’s efforts to extradite him were
a result of “political vendetta” was “mere fiction of his
imagination”, a special PMLA court observed in its order.

Mallya, accused
of defaulting on loans of over Rs 9,000 crore, was on January 5 declared a
fugitive economic offender (FEO) by special Judge M S Azmi of the Prevention of
Money Laundering Act (PMLA) court.

 

The judge, in
his order that was made available to media Saturday, said, “Mere statement
that the government of India had pursued a political vendetta against him and
initiated criminal investigations and proceeding against him cannot be ground
for his stay in UK.”

 

Besides these
bare statements, there is nothing to support as to how the government of India
initiated investigation and proceedings to pursue political vendetta, the judge
said in his order.

 

“Hence the
arguments in these regards are mere fiction of his imagination to pose himself
as law-abiding citizen,” he added.

 

The court said
the date of Mallya leaving India was March 2, 2016, and on that day admittedly
there was offence registered by the Central Bureau of Investigation (CBI) and
the Enforcement Directorate (ED).

 

Mallya laid much stress on the fact that he went
to attend a motorsports council meeting in Geneva on March 4, 2016.

 

“Had it
been the case that he went to attend a pre-schedule meeting and is a
law-abiding citizen, he would have immediately informed the authorities about
his schedule to return to India after attending his meeting and
commitment,” Azmi observed.

 

Therefore, in
spite of repeated summons and issuance of warrant of arrest, he had not given
any fix date of return, therefore it would be unsafe to accept his argument
that he departed India only to attend a pre-schedule meeting, he said.

 

The judge stated
that the ED application cannot be read in “piece meal” and must be
read as whole.

 

The satisfaction
or the reasons to believe by ED that Mallya was required to be declared as an
FEO appears to be based upon the foundation that despite repeated efforts, he
failed to join investigation and criminal prosecution.

 

Even the efforts
taken by way of declaring him as a proclaimed offender have not served the
desired purpose, he added.

 

Azmi said the
intention of the FEO Act is to preserve the sanctity of the rule of law and the
expression “reason to believe” has to be read in that context.

 

The reasons
supplied by the ED were the amount involved – Rs 9,990 crore, which is more
than Rs 100 crore which is the requirement of the Act.

 

As pointed out,
the summons issued were deliberately avoided, the passport was revoked,
non-bailable warrants were issued and he was also declared a proclaimed
offender, the judge said.

 

These appear to
be sufficient reasons to declare him an FEO, the judge observed.

 

Mallya is the first businessman to be declared an
FEO under the FEO Act which came into existence in August 2018.

 

The ED, which
had moved the special court for this purpose, requested the court that Mallya,
currently in the United Kingdom, be declared a fugitive and his properties be
confiscated and brought under the control of the Union government as provided
under the act.”

 

The various factors
considered by the court, as mentioned in the news report above, are important
for consideration. The special court has rejected the arguments of (a) that the
Indian government’s efforts to extradite him were a result of “political
vendetta”; (b) that he departed India only to attend a pre-schedule
meeting; (c) satisfaction or the reasons to believe by ED that Mallya was
required to be declared as an FEO appears to be based upon the foundation that
despite repeated efforts, he failed to join investigation and criminal
prosecution; and (d) since the proceedings of his extradition had begun in UK
and with those underway, Mallya cannot be declared a Fugitive.

 

In this connection,
it would be pertinent to mention that the Westminster’s Magistrates’ Court,
London, UK in the case of The Govt of India vs. Vijay Mallya, dated 10th
December, 2018 after detailed examination of various issues raised in
respect of Govt of India’s Extradition Request in its 74 page Judgement
available in public domain, found a prima facie case in relation to three
possible charges and has sent Dr. Vijay Mallya’s case to the Home Secretary of
State for a decision to be taken on whether to order his extradition.

 

4.8  Applications
in Other Cases

In a recent new
report in Hindustan Times, it is mentioned 
that the Enforcement Directorate [ED] has also submitted applications to
have Jewellers Nirav Modi and Mehul Choksi declared fugitives under the FEO Act
after they left India, where they are accused in a Rs. 14,000 scam at Punjab
National bank. These applications are likely to be heard by the same special
court.

 

4.9  Appeals

Section 17 of the Act provides that an appeal shall lie from any
judgment or order, not being an interlocutory order, of a Special Court to the
High Court both on facts and on law.

Every appeal u/s.
17 shall be preferred within a period of 30 days from the date of the judgment
or order appealed from. The High Court may entertain an appeal after the expiry
of the said period of 30 days, if it is satisfied that the appellant had sufficient
cause for not preferring the appeal within the period of 30 days. However, no
appeal shall be entertained after the expiry of period of 90 days. The Bombay
High Court in the case Vijay Vittal Mallya vs. State of Maharashtra
(Criminal Appeal No. 1407 of 2018) vide order dated 22nd
November, 2018, while dismissing the Mallya’s appeal for stay of the
proceedings u/s. 4 of the FEO Act, held that for an appeal to lie against an
order of the special court, the said order would have to determine some right
or issue.

 

5.     CONCLUDING REMARKS


The FEO Act is a
huge step towards creating a deterrent effect for economic offenders and would
certainly help the government bring alleged fraudsters such as Vijay Mallya,
Nirav Modi, Mehul Choksi and such other offenders  to justice.

 

In Part 2 of the
Article we will deal with remaining other important aspects of the FEO Act and
the Rules.

THE FUGITIVE ECONOMIC OFFENDERS ACT, 2018 – AN OVERVIEW – PART 2

In Part 1 of the
article published in the April, 2019 issue of the Journal, we have covered the
need and rationale for the FEO Act, an overview of the Act and the Rules framed
thereunder, and various aspects relating to a Fugitive Economic Offender.

 

In this
concluding Part 2 of the article, we have attempted to give an overview of some
of the remaining important aspects of The Fugitive Economic Offenders Act, 2018
[the FEO Act or the Act].

 

1.  SCHEDULED OFFENCES


Section
2(1)(m) of the Act defines the Scheduled Offences as follows:

 

(m) “Scheduled Offence” means an offence specified
in the Schedule, if the total value involved in such offence or offences is
one hundred crore rupees or more;”

 

The Schedule
to the Act lists out offences under 15 different enactments and 56 different
sections/sub-sections. The Schedule of the FEO Act is given in the Annexure to
this article for ready reference.

 

The Schedule covers offences under the Indian
Penal Code, 1860; Negotiable Instruments Act, 1881; Reserve Bank of India  Act, 1934; Central Excise Act, 1944; Customs
Act, 1962; Prohibition of Benami Property Transactions Act, 1988; Prevention of
Corruption Act, 1988; Securities and Exchange Board of India Act, 1992;
Prevention of Money-Laundering Act, 2002; Limited Liability Partnership Act,
2008; Foreign Contribution (Regulation) Act, 2010; Companies Act, 2013; Black
Money (Undisclosed Foreign Income and Assets) and Imposition of Tax Act, 2015;
Insolvency and Bankruptcy Code, 2016; and Central Goods and Services Tax Act,
2017.

 

It is
pertinent to note that the aforesaid list of 15 enactments does not include the
offences under the Income-tax Act, 1961, though it includes offences under the
Black Money Act, PMLA and the Benami Act.

 

In order to
ensure that courts are not overburdened with such cases, only those cases
where the total value involved in such offences is Rs. 100 crore or more
are covered within the purview of the FEO Act.

 

2.  DECLARATION OF AN INDIVIDUAL AS AN FEO


Section 12(1)
of the Act provides that after hearing the application u/s. 4, if the Special
Court is satisfied that an individual is a fugitive economic offender (FEO), it
may, by an order, declare the individual as an FEO for reasons to be recorded
in writing. The order declaring an individual as an FEO has to be a speaking
order.

 

Section 16
deals with rules of evidence. Section 16(3) of the Act provides that the
standard of proof applicable to the determination of facts by the Special Court
under the Act shall be preponderance of probabilities. Preponderance of
probabilities means such proof that satisfies the Special Court that a certain
fact is true rather than the reverse. The proof of beyond reasonable doubt
applicable to criminal law is not applicable in case of the FEO Act.

 

3.  CONSEQUENCES OF AN INDIVIDUAL BEING DECLARED AS AN FEO

3.1  Confiscation
of Property

3.1.1  Section 12(2) of the Act provides that on a
declaration u/s. 12(1) as an FEO, the Special Court may order that any of the
following properties stand confiscated by the Central government:

 

(a)  the proceeds of crime in India or abroad,
whether or not such property is owned by the FEO; and

(b)  any other property or benami property in
India or abroad owned by the FEO.

Article 2(g)
of the UNCAC defines confiscation as follows: “Confiscation”, which includes
forfeiture where applicable, shall mean the permanent deprivation of property
by order of a court or other competent authority. It results in the change of
ownership and property vesting in the government, which is irreversible unless
the individual declared as an FEO succeeds in appeal.

 

Section
2(1)(k) defines proceeds of crime as follows:

 

“proceeds
of crime” means any property derived or obtained, directly or indirectly,
by any person as a result of criminal activity relating to a Scheduled Offence,
or the value of any such property, or where such property is taken or
held outside the country, then the property equivalent in value held within the
country or abroad.

 

The fact that
the benami property of an FEO can be confiscated shows that section 12(2)
emphasises de facto ownership rather than de jure ownership.

 

3.1.2  Section 21 of the FEO Act provides that the
provisions of the Act shall have effect, notwithstanding anything inconsistent
therewith contained in any other law for the time being in force. Section 22
provides that the provisions of the Act shall be in addition to and not in
derogation of any other law for the time being in force.

 

A question
arises for consideration as to whether adjudication under Prohibition of the
Benami Property Transactions Act, 1988 [Benami Act] is necessary for
confiscation of the benami property of the FEO. From the aforesaid provisions,
it appears that if the alleged FEO does not return to India and submit himself
to the Indian legal system, the Special Court can order confiscation of benami
properties of the FEO after adjudicating whether property is benami property
owned by the FEO or not.

 

It is
important to note that adjudication and confiscation of benami property under
the Benami Act will apply when the individual returns to India and submits
himself to the Indian legal process.

 

The
confiscation of benami property under the FEO Act will apply when an individual
evades Indian law and is declared an FEO and consequently confiscation is
ordered by the Special Court.

 

It is
important to note that the adjudication and confiscation under the Benami Act
would cover only benami property in India, whereas under the FEO Act benami
property abroad of the FEO can also be confiscated.

 

3.1.3  Section 12(3) of the Act provides that the
confiscation order of the Special Court shall, to the extent possible, identify
the properties in India or abroad that constitute proceeds of crime which
are to be confiscated and in case such properties cannot be identified,
quantify the value of the proceeds of crime.

 

Section 12(4)
of the Act provides that the confiscation order of the Special Court shall separately
list any other property owned by the FEO in India which is to be
confiscated.

 

3.1.4  As pointed out in para 2.1 of Part 1 of the
article, the non-conviction-based asset confiscation for corruption-related
cases is enabled under provisions of the UNCAC. The FEO Act adopts the said
principle and accordingly it is not necessary that the FEO should be
convicted for any of the scheduled offences for which an arrest warrant was
issued by any court in India.

 

3.1.5  A further question arises as to whether
confiscation can be reversed if the FEO returns to India and submits himself to
the court to face proceedings covered by his arrest warrant. The answer appears
to be “No”, as once an individual is declared an FEO and his assets are
confiscated, his return to India will not reverse the declaration or the
confiscation.

 

3.2  Disentitlement
of the FEO as well as his Companies, LLPs and Firms to defend civil claims

Section 14 of the Act provides that
notwithstanding anything contained in any other law for the time being in
force,

 

(a)  on a declaration of an individual as an FEO,
any court or tribunal in India, in any civil proceeding before it, may disallow
such individual from putting forward or defending any civil claim; and

(b)  any court or tribunal in India in any civil
proceeding before it, may disallow any company or LLP from putting forward or
defending any civil claim, if an individual filing the claim on behalf of the
company or the LLP, or any promoter or key managerial personnel or majority
shareholder of the company or an individual having a controlling interest in
the LLP, has been declared an FEO.

 

3.3 Individual found to be not an FEO

Section 12(9)
of the Act provides that where, on the conclusion of the proceedings, the
Special Court finds that the individual is not an FEO, the Special Court shall
order release of property or records attached or seized under the Act to the
person entitled to receive it.

 

4.  POWERS OF AUTHORITIES

4.1  Power
of Survey

Section 7 of
the FEO Act contains the provisions relating to power of survey. It appears
that power of survey may be exercised at any time before or after filing an
application u/s. 4 for declaration as an FEO.

 

Section 7(1)
provides that —

 

  •     notwithstanding anything
    contained in any other provisions of the FEO Act,
  •     where a director or any
    other officer authorised by the director,
  •     on the basis of material in
    his possession,
  •     has reason to believe (the
    reasons for such belief to be recorded in writing),
  •     that an individual may be
    an FEO,
  •     he may enter any place –

(i)   within the limits of the area assigned to
him; or

(ii)   in respect of which he is authorised for the
purposes of section 7, by such other authority who is assigned the area within
which such place is situated.

 

Section 7(2)
provides that if it is necessary to enter any place as mentioned in s/s. (1),
the director or any other officer authorised by him may request any proprietor,
employee or any other person who may be present at that time, to – (a) afford
him the necessary facility to inspect such records as he may require and which
may be available at such place; (b) afford him the necessary facility to check
or verify the proceeds of crime or any transaction related to proceeds of crime
which may be found therein; and (c) furnish such information as he may require
as to any matter which may be useful for, or relevant to, any proceedings under
the Act.

 

Section 7(3)
provides that the director, or any other officer acting u/s. 7 may (i) place
marks of identification on the records inspected by him and make or cause to be
made extracts or copies therefrom; (ii) make an inventory of any property
checked or verified by him; and (iii) record the statement of any person
present at the property which may be useful for, or relevant to, any proceeding
under the Act.

 

4.2  Power
of Search and Seizure

Section 8 of
the Act and Fugitive Economic Offenders (Procedure for Conducting Search and
Seizure) Rules, 2018 contain the relevant provisions and procedure to be
followed in respect of search and seizure.

 

Section 8(1)
of the Act provides that:

 

Notwithstanding
anything contained in any other law for the time being in force, where the
director or any other officer not below the rank of deputy director authorised
by him for the purposes of this section, on the basis of information in his
possession, has reason to believe (the reason for such belief to be recorded in
writing) that any person –

 

(i)   may be declared as an FEO;

(ii)   is in possession of any proceeds of crime;

(iii)  is in possession of any records which may
relate to proceeds of crime; or

(iv)  is in possession of any property related to
proceeds of crime,

then, subject
to any rules made in this behalf, he may authorise any officer subordinate to
him to —

 

(a)  enter and search any building, place, vessel,
vehicle or aircraft where he has reason to suspect that such records or
proceeds of crime are kept;

(b)  break open the lock of any door, box, locker,
safe, almirah or other receptacle for exercising the powers conferred by
clause (a) where the keys thereof are not available;

(c)  seize any record or property found as a result
of such search;

(d)  place marks of identification on such record
or property, if required, or make or cause to be made extracts or copies
therefrom;

(e)  make a note or an inventory of such record or
property; and

(f)   examine on oath any person who is found to be
in possession or control of any record or property, in respect of all matters
relevant for the purposes of any investigation under the FEO Act.

 

Section 8(2)
of the Act provides that where an authority, upon information obtained during
survey u/s. 7, is satisfied that any evidence shall be or is likely to be
concealed or tampered with, he may, for reasons to be recorded in writing,
enter and search the building or place where such evidence is located and seize
that evidence.

 

4.3  Power
of Search of Persons

Section 9 of
the Act contains provisions relating to power of search of persons and it
provides as follows:

(a)  if an
authority, authorised in this behalf by the Central government by general or
special order, has reason to believe (the reason for such belief to be recorded
in writing) that any person has secreted about his person or anything under his
possession, ownership or control, any record or proceeds of crime which may be
useful for or relevant to any proceedings under the Act, he may search that
person and seize such record or property which may be useful for or relevant to
any proceedings under the Act;

(b)  where an authority is about to search any
person, he shall, if such person so requires, take such person within
twenty-four hours to the nearest Gazetted Officer, superior in rank to him, or
a Magistrate. The period of twenty-four hours shall exclude the time necessary
for the journey undertaken to take such person to the nearest Gazetted Officer,
superior in rank to him, or the Magistrate’s Court;

(c)  if the requisition under clause (b) is
made, the authority shall not detain the person for more than twenty-four hours
prior to taking him before the Gazetted Officer, superior in rank to him, or
the Magistrate referred to in that clause. The period of twenty-four hours
shall exclude the time necessary for the journey from the place of detention to
the office of the Gazetted Officer, superior in rank to him, or the
Magistrate’s Court;

(d)  the Gazetted Officer or the Magistrate before
whom any such person is brought shall, if he sees no reasonable ground for
search, forthwith discharge such person but otherwise shall direct that search
be made;

(e)  before making the search under clause (a)
or clause (d), the authority shall call upon two or more persons to
attend and witness the search and the search shall be made in the presence of such
persons;

(f)   the authority shall prepare a list of records
or property seized in the course of the search and obtain the signatures of the
witnesses on the list;

(g)  no female shall be searched by anyone except a
female; and

(h)  the authority shall record the statement of
the person searched under clause (a) or clause (d) in respect of
the records or proceeds of crime found or seized in the course of the search.

 

5. CONCLUDING REMARKS

In response
to unstarred question No. 3198, the Minister of State in the Ministry of
External Affairs on 14-03-18 answered in the Parliament that as per the list
provided by the Directorate of Enforcement, New Delhi, 12 persons involved in
cases under investigation by the Directorate of Enforcement are reported to
have absconded from India who include Vijay Mallya, Nirav Modi, Mehul Choksi
and others. In addition, as per the list provided by the CBI, New Delhi, 31
businessmen, including the aforementioned Vijay Mallya, Nirav Modi and Mehul
Choksi are absconding abroad in CBI cases.

 

It is hoped
that the stringent provisions of the FEO Act creating a deterrent effect would
certainly help the government in compelling FEOs to come back to India and
submit themselves to the jurisdiction of courts in India.

Annexure

THE SCHEDULE

[See section 2(l) and (m)]

Section

Description of offence

I.

Offences under the Indian Penal Code, 1860 (45 of 1860)

 

120B read with any offence in this Schedule

Punishment of criminal conspiracy.

 

255

Counterfeiting Government stamp.

 

257

Making or selling instrument for counterfeiting Government
stamp.

 

258

Sale of counterfeit Government stamp.

 

259

Having possession of counterfeit Government stamp.

 

260

Using as genuine a Government stamp known to be counterfeit.

 

417

Punishment for cheating.

 

418

Cheating with knowledge that wrongful loss may ensue to
person whose interest offender is bound to protect.

 

420

Cheating and dishonestly inducing delivery of property.

 

421

Dishonest or fraudulent removal or concealment of property to
prevent distribution among creditors.

 

422

Dishonestly or fraudulently preventing debt being available
for creditors.

 

423

Dishonest or fraudulent execution of deed of transfer
containing false statement of consideration.

 

424

Dishonest or fraudulent removal or concealment of property.

 

467

Forgery of valuable security, will, etc.

 

471

Using as genuine a forged [document or electronic record].

 

472

Making or possessing counterfeit seal, etc., with intent to
commit forgery punishable u/s. 467.

 

473

Making or possessing counterfeit seal, etc., with intent to
commit forgery punishable otherwise.

 

475

Counterfeiting device or mark used for authenticating
documents described in section 467, or possessing counterfeit marked
material.

 

476

Counterfeiting device or mark used for authenticating
documents other than those described in section 467, or possessing
counterfeit marked material.

 

481

Using a false property mark.

 

482

Punishment for using a false property mark.

 

483

Counterfeiting a property mark used by another.

 

484

Counterfeiting a mark used by a public servant.

 

485

Making or possession of any instrument for counterfeiting a
property mark.

 

486

Selling goods marked with a counterfeit property mark.

 

487

Making a false mark upon any receptacle containing goods.

 

488

Punishment for making use of any such false mark.

 

489A

Counterfeiting currency notes or bank notes.

 

489B

Using as genuine, forged or counterfeit currency notes or
bank notes.

II.

Offences under the Negotiable Instruments Act, 1881 (26 of
1881)

 

138

Dishonour of cheque for insufficiency, etc., of funds in the
account.

III.

Offences under the Reserve Bank of India Act, 1934 (2 of
1934)

 

58B

Penalties.

IV.

Offences under the Central Excise Act, 1944 (1 of 1944)

 

9

Offences and Penalties.

V.

Offences under the Customs Act, 1962 (52 of 1962)

 

135

Evasion of duty or prohibitions.

VI.

Offences under the Prohibition of Benami Property
Transactions Act, 1988 (45 of 1988)

 

3

Prohibition of benami transactions.

VII.

Offences under the Prevention of Corruption Act, 1988 (49 of
1988)

 

7

Public servant taking gratification other than legal
remuneration in respect of an official act.

 

8

Taking gratification in order, by corrupt or illegal means,
to influence public servant.

 

9

Taking gratification for exercise of personal influence with
public servant.

 

10

Punishment for abetment by public servant of offences defined
in section 8 or section 9 of the Prevention of Corruption Act, 1988.

 

13

Criminal misconduct by a public servant.

VIII.

Offences under the Securities and Exchange Board of India
Act, 1992 (15 of 1992)

 

12A read with section 24

Prohibition of manipulative and deceptive devices, insider
trading and substantial acquisition of securities or control.

 

24

Offences for contravention of the provisions of the Act.

IX.

Offences under the Prevention of Money-Laundering Act, 2002
(15 of 2003)

 

3

Offence of money-laundering.

 

4

Punishment for money-laundering.

X.

Offences under the Limited Liability Partnership Act, 2008 (6
of 2009)

 

Sub-section (2) of section 30

Carrying on business with intent or purpose to defraud
creditors of the Limited Liability Partnership or any other person or for any
other fraudulent purpose.

XI.

Offences under the Foreign Contribution (Regulation) Act,
2010 (42 of 2010)

 

34

Penalty for article or currency or security obtained in
contravention of section 10.

 

35

Punishment for contravention of any provision of the Act.

XII.

Offences under the Companies Act, 2013 (18 of 2013)

 

Sub-section (4) of section 42 of the Companies Act, 2013 read
with section 24 of the Securities and Exchange Board of India Act, 1992 (15
of 1992)

Offer or invitation for subscription of securities on private
placement.

 

74

Repayment of deposits, etc., accepted before commencement of
the Companies Act, 2013.

 

76A

Punishment for contravention of section 73 or section 76 of
the Companies Act, 2013.

 

Second proviso to sub-section (4) of section 206

Carrying on business of a company for a fraudulent or
unlawful purpose.

 

Clause (b) of section 213

Conducting the business of a company with intent to defraud
its creditors, members or any other persons or otherwise for a fraudulent or
unlawful purpose, or in a manner oppressive to any of its members or that the
company was formed for any fraudulent or unlawful purpose.

 

447

Punishment for fraud.

 

452

Punishment for wrongful withholding of property.

XIII.

Offences under the Black Money (Undisclosed Foreign Income
and Assets) and Imposition of Tax Act, 2015 (22 of 2015)

 

51

Punishment for wilful attempt to evade tax.

XIV.

Offences under the Insolvency and Bankruptcy Code, 2016 (31
of 2016)

 

69

Punishment for transactions defrauding creditors.

XV.

Offences under the Central Goods and Services Tax Act, 2017
(12 of 2017)

 

Sub-section (5) of section 132

Punishment for certain offences.  

 

 

RECENT IMPORTANT DEVELOPMENTS – PART I

In this issue we are covering recent major developments in the field of
International Taxation and the work being done at OECD in various other related
fields. It is in continuation of our endeavour to update readers on major
International Tax developments at regular intervals. The items included here
are sourced from press releases of the Ministry of Finance and CBDT
communications.

 

DEVELOPMENTS IN INDIA
RELATING TO INTERNATIONAL TAX

 

(I) CBDT’s proposal for amendment of Rules
for Profit Attribution to Permanent Establishment

 

The CBDT vide its communication dated 18th
April, 2019 released a detailed, 86-page document containing a proposal for
amendment of the Rules for Profit Attribution to Permanent Establishment, for
public comments within 30 days of its publication. The CBDT Committee suggested
a ‘three-factor’ method to attribute profits, with equal weight to (a) sales,
(b) manpower, and (c) assets. The Committee justifies the three-factor approach
as a mix of both demand and supply side that allocates profits between the
jurisdictions where sales takes place and the jurisdictions where supply is
undertaken. The CBDT Committee has recommended far-reaching changes to the
current scheme of attribution of profits to permanent establishments.

 

The report outlines the formula for
calculating “profits attributable to operations in India”, giving weightage to
sales revenue, employees, wages paid and assets deployed.

 

The relevant portion of the ‘Report on
Profit Attribution to Permanent Establishments’ containing the
Committee’s conclusions and recommendations in paragraphs 179 to 200 is given
below for ready reference:

 

“Conclusions and
recommendations of the Committee

179.   After detailed analysis of the issues related to attribution of
profits, existing rules, their legal history, the economic and public policy
principles relevant to it, the international practices, views of academicians
and experts, relevant case laws and the methodology adopted by tax authorities
dealing with these issues, Committee concluded its observations, which are
summarised in following paragraphs.

 

11.1 Summary of Committee’s
observations and conclusions

 

180.   The business profits of a non-resident enterprise is subjected to
the income-tax in India only if it satisfies the threshold condition of having
a business connection in India, in which case, profits that are derived from
India from its various operations including production and sales are taxable in
India, either on the basis of the accounts of its business in India or where
they cannot be accurately derived from its accounts, by application of Rule 10,
which provides a wide discretion to the Assessing Officer. Where a tax treaty
entered by the Central government is applicable, its provisions also need to be
satisfied for such taxation. As per Article 7 of UN model tax convention (which
is usually followed in most Indian tax treaties, sometimes with variations),
only those profits of an enterprise can be subjected to tax in India which are
attributed to its PE in India, and would include profits that the PE would be
expected to make as a separate and independent entity. Under the force of
attraction rules, when applicable, it would include profits from sales of same
goods as those sold by the PE that are derived from India without participation
of PE. Profits attributable to PE can be computed either by a direct accounting
method provided in paragraph 2 or by an indirect apportionment method provided
in paragraph 4 of Article 7.

 

181.   An analysis of Article 7 and its legal history shows that there
are three standard versions. The Article 7 which exists in UN model tax
convention is similar to the Article 7 as it existed in the OECD model
convention prior to 2010, except that the UN model tax convention allows the
application of force of attraction rules and restricts deduction of certain
expenses payable to the head office by the PE. This Article in the OECD model
convention was revised in 2010. Under the revised article the profits
attributable to the PE are required to be determined taking into account the
functions, assets and risk, and the option of determining them by way of
apportionment has been excluded.

 

182.   One of the primary implications of the 2010 revision of Article 7
by OECD was that in cases where business profits could not be readily
determined on the basis of accounts, the same were required to be determined by
taking into account function, assets and risk, completely ignoring the sales
receipts derived from that tax jurisdiction. This amounts to a major deviation,
not only from the rules universally accepted till then, but also from the
generally applicable accounting standards for determining business profits,
where business profits cannot be determined without taking sales into account.

 

183.   Economic analysis of factors that affect and contribute to
business profits makes it apparent that profits are contributed by both demand
and supply of the goods. Accordingly, a jurisdiction that contributes to the
profits of an enterprise either by facilitating the demand for goods or
facilitating their supply would be reasonably justified in taxing such profits.
The dangers of double taxation of such profits can be eliminated by tax
treaties. If taxes collected facilitate economic growth in that jurisdiction,
the demand for goods rises, which in turn also benefits the tax-paying
enterprise, resulting in a virtuous cycle that benefits all stakeholders. On
the contrary, if the jurisdiction is unable to collect tax from the
non-resident suppliers, it would be forced to collect all the taxes required
from the domestic tax-payers, which in turn would reduce the ability of
consumers to pay, reduce their competitiveness, hurt economic growth and the
aggregate demand, resulting in a vicious cycle, which will adversely affect all
stakeholders, including the foreign enterprises doing business therein.

 

184.   Broadly, possible approaches for profit attribution can be summed
in three categories – (i) supply approach allocates profits exclusively to the
jurisdiction where supply chain and activities are located; (ii) demand
approach allocates profits exclusively to the market jurisdiction where sales
take place; (iii) mixed approach allocates profits partly to the jurisdiction
where the consumers are located and partly to the jurisdiction where supply
activities are undertaken.

185.   The mixed approach appears to have been most commonly adopted in
international practices, though in some cases demand approach has also been
favoured. In contrast, supply side does not appear to have been adopted
anywhere, except in the 2010 revision of Article 7 of the OECD model
convention, which requires determination of profits without taking sales into
account. As a consequence, the contribution of demand to profits is completely
ignored.

 

186.   A purview (sic) of academic literature and views suggests a
wide acceptance in theory that demand, as represented by sales, can be a valid
ground for attribution of profits. There also exists a diversity of views among
academicians and experts on the validity of the revised OECD approach for
profit attribution contained in the AOA. A number of international authors
disagree with it and many have been critical of this approach.

 

187.   The AOA approach can have significant adverse consequences for
developing economies like India, which are primarily importers of capital and
technology. It restricts the taxing rights of the jurisdiction that contributes
to business profits by facilitating demand, and thereby has the potential to
break the virtuous cycle of taxation that benefits all stakeholders. Instead,
it can set a vicious cycle in place that can harm all stakeholders.

 

188.   The lack of sufficient justification or rationale and its
potential adverse consequences fully justify India’s strongly-worded position
on revised Article 7 of OECD model convention, wherein India has not only found
it unacceptable for adoption in Indian tax treaties, but also rejected the
approach taken therein. This view of India, that since business profits are
dependent on sale revenues and costs, and since sale revenues depend on both
demand and supply, it is not appropriate to attribute profits exclusively on
the basis of function, assets and risks (FAR) alone, has been communicated and
shared with other countries consistently and on a regular basis.

 

189.   Since, the revised Article 7 of OECD model tax convention has not
been incorporated in any of the Indian tax treaties, the question of AOA being
applicable on Indian treaties or profit attributed therein cannot arise. For
the same reason, additional guidance issued by OECD with reference to AOA in
respect of the changes in Article 5 introduced by the Action 7 of the BEPS
project on Artificial Avoidance of PE Status, also does not have any relevance
to Indian tax treaties. This, however, means that India cannot depend on OECD
guidance and gives rise to a need for India to consider ways and means for
bringing greater clarity and objectivity in profit attribution under its tax
treaties and domestic laws, especially in consequence to the changes introduced
as a result of Action 7.

 

190.   An analysis of case laws indicates that the courts have upheld the
application of Rule 10 for attribution of profits under Indian tax treaties. In
several such cases, the right of India to attribute profits by apportionment,
as permissible under Indian tax treaties, has also been upheld by the courts.
The judicial authorities do not appear to have insisted on a universal and
consistent method. They have also upheld the wide discretion in the hands of
the Assessing Officer under Rule 10 of the Rules, but corrected or modified his
approach for the purpose of ensuring justice in particular cases. Thus, diverse
methods of attributing profits by apportionment under Rule 10 of the Rules are
in existence. In the view of the Committee, the lack of a universal rule can
give rise to tax uncertainty and unpredictability, as well as tax disputes.
Thus, there seems to be a case for providing a uniform rule for apportionment
of profits to bring in greater certainty and predictability among taxpayers and
avoid resultant tax litigation.

 

191.   A detailed analysis of methods adopted by tax authorities for
attributing profits in recent years also highlights similar diversity in the
methods adopted by assessing officers for attribution of profits, which
reaffirms the need to consider possible options that can be consistently
adopted as an objective method of profits attribution under Rule 10 of the
Rules, and bring greater clarity, predictability and objectivity in this
exercise. Any options considered for this purpose must be in accordance with
India’s official position and views and must address its concerns.

 

192.   Accordingly, the Committee considered some
options based on the mixed or balanced approach that allocates profits between
the jurisdiction where sales take place and the jurisdiction where supply is
undertaken. The Committee did not find the option of formulary apportionment
method apportioning consolidated global profits feasible, in view of the
practical constraints in obtaining information related to jurisdictions outside
India. Thus, the Committee considers that it may be preferable to adopt a
method that focuses on Indian operations primarily and derives profits applying
the global profitability, with necessary safeguards to prevent excessive
attribution on the one hand and protect the interests of Indian revenue on the
other.

 

193.   The Committee found the option of Fractional
Apportionment based on apportionment of profits derived from India permissible
under Indian tax treaties as well as Rule 10, and relatively feasible as it is
based largely on information related to Indian operations. Out of various
possible options of apportioning profits by a mixed approach, the Committee
found considerable merit in the three-factor method based on equal weight
accorded to sales (representing demand) and manpower and assets (representing
supply, including marketing activities).

 

194.   After taking into account the principle laid down by the Hon’ble
Supreme Court in the case of DIT vs. Morgan Stanley, and the need to avoid
double taxation of profits from Indian operations in the hands of a PE, which
is primarily brought into existence either by the presence of an Indian
subsidiary carrying on parts of an integrated business, whose profits are
separately taxed in its hands in India, the Committee found it justifiable that
the profits derived from Indian operations that have already been subjected to
tax in India in the hands of a subsidiary should be deducted from the
apportioned profits. The Committee observed that in a case where no sales takes
place in India, and the profits that can be apportioned to the supply
activities are already taxed in the hands of an Indian subsidiary, there may be
no further taxes payable by the enterprise.

 

195.   In this option, in order to ensure objectivity and certainty,
profits derived from India need to be defined objectively. The Committee considers
that the same can be arrived at by multiplying the revenue derived from India
with global operational profit margin [in order to avoid any doubt the global
operational profit margin is the EBITDA margin (earnings before interest,
taxes, depreciation and amortization) of a company]. However, the Committee
also noted the need to protect India’s revenue interests in cases where an
enterprise having global losses or a global profit margin of less than 2%,
continues with the Indian operations, which could be more profitable than its
operations elsewhere. In the view of the Committee, the continuation of Indian
operations justifies the presumption of higher profitability of Indian
operations, and in such cases a deeming provision that deems profits of Indian
operations at 2% of revenue or turnover derived from India should be
introduced.

 

196.   After taking into account the developments in taxation of digital
economy and the new Explanation 2A, inserted by the Finance Act, 2018,
explicitly including significant economic presence within the definition of
business connection, the Committee considered it necessary to take into account
the role and relevance of users in contributing to the business profits of
multi-dimensional business enterprises. Users can be a substitute to either
assets or employees and supplement their role in contributing to profits of the
enterprise.

 

197.   After considering various aspects of users’ contribution, the
Committee came to the conclusion that user data and activities contribute to
the profits of the multi-dimensional enterprises and there is a strong case of
taking them into account, per se, as a factor in apportionment of profits
derived from India by enterprises conducting business through multi-dimensional
business models where users are considered crucial to the business. The
Committee concluded that for such enterprises, users should also be taken into
account for the purpose of attribution of profits, as the fourth factor for
apportionment, in addition to the other three factors of sales, manpower and
assets.

 

198.   Although a recent amendment of the 2016 proposal for CCCTB has
proposed assigning a weight to the users that is equal to the other three
factors of sales, manpower and assets, the Committee found it preferable to assign
a relatively lower weight of 10% to users in low and medium user intensity
models and 20% in high user intensity models at this stage, with the
corresponding reduction in the weightage of employees and assets except for
sales being assigned 30% weight in apportionment in both the fact patterns.
Given the rapid expansion of digital economy and the ongoing developments
related to rules governing its taxation, it may be necessary to monitor the
role of users and their contribution to profits in future and accordingly
assess the need for considering a review of the weight assigned to users in
subsequent years.

 

11.2 Recommendations

 

199.   In view of the above, the Committee makes the following
recommendations:

 

(i)   Rule 10 may be amended to provide that in the case of an assessee
who is not a resident of India, has a business connection in India and derives
sales revenue from India by a business all the operations of which are not
carried out in India, the income from such business that is attributable to the
operations carried out in India and deemed to accrue or arise in India under
clause (i) of sub-section(1) of section 9 of the Act, shall be determined by
apportioning the profits derived from India by three equally weighted factors
of sales, employees (manpower and wages) and assets, as under:

 

Profits attributable to
operations in India =

‘Profits derived from
India’ (“Profits derived from India” = Revenue derived from India x Global
operational profit margin as referred in paragraph 159.) x [SI/3xST + (NI/6xNT)
+(WI/6xWT) + (AI/3xAT)]

 

Where,

SI = sales revenue derived
by Indian operations from sales in India

ST = total sales revenue
derived by Indian operations from sales in India and outside India

NI =number of employees
employed with respect to Indian operations and located in India

NT = total number of
employees employed with respect to Indian operations and located in India and
outside India

WI = wages paid to
employees employed with respect to Indian operations and located in India

WT = total wages paid to
employees employed with respect to Indian operations and located in India and
outside India

AI = assets deployed for
Indian operations and located in India

AT = total assets deployed
for Indian operations and located in India and outside India

 

(ii)  The amended rules should provide that ‘profits derived from Indian
operations’ will be the higher of the following amounts:

a. The amount arrived at by
multiplying the revenue derived from India x Global operational profit margin,
or

b. Two percent of the
revenue derived from India

 

(iii) The amended rules should provide an exception
for enterprises in case of which the business connection is primarily
constituted by the existence of users beyond the prescribed threshold, or in
case of which users in excess of such prescribed threshold exist in India. In
such cases, the income from such business that is attributable to the
operations carried out in India and deemed to accrue or arise in India under
clause (i) of sub-section (1) of section 9 of the Act, shall be determined by
apportioning the profits derived from India on the basis of four factors of
sales, employees (manpower and wages), assets and users. The users should be
assigned a weight of 10% in cases of low and medium user intensity, while each
of the other three factors should be assigned a weight of 30%, as under:

 

Profits attributable to
operations in India in cases of low and medium user intensity business models =

‘Profits derived from
India’ x [0.3 x SI/ST + (0.15 x NI/NT) + (0.15 x WI/WT) + (0.3 x AI/3xAT)] +
0.1]

In case of digital models
with high user intensity, the users should be assigned a weight of 20%, while
the share of assets and employees be reduced to 25% each after keeping the
weight of sales as 30% as under:

 

Profits attributable to
operations in India in cases of high user intensity business models =

‘Profits derived from
India’ x [0.3 x SI/ST + (0.125 x NI/NT) + (0.125 x WI/WT) + (0.25 AI/3xAT)] +
0.2]

 

(iv) The amended rules should also provide that where the business
connection of the enterprise in India is constituted by the activities of an
associate enterprise that is resident in India and the enterprise does not
receive any payments on accounts of sales or services from any person who is
resident in India (or such payments do not exceed an amount of Rs. 10,00,000)
and the activities of that associated enterprise have been fully remunerated by
the enterprise by an arm’s length price, no further profits will be
attributable to the operation of that enterprise in India.

 

(v) However, where the
business connection of the enterprise in India is constituted by the activities
of an associate enterprise that is resident in India and the payments received
by that enterprise on account of sales or services from persons resident in
India exceeds the amount of Rs. 10,00,000 then profits attributable to the
operation of that enterprise in India will be derived by apportionment using
the three factors or four factors as may be applicable in his case and
deducting from the same the profits that have already been subjected to tax in
the hands of the associated enterprise. For this purpose, the employees and
assets of the associated enterprise will be deemed to be employed or deployed
in the Indian operations and located in India.

 

200.   The Committee recommends the amendment of Rule
10 accordingly. The Committee also recommended that an alternative can be
amendment of the IT Act itself to incorporate a provision for profit
attribution to a PE.”


The Bombay Chartered Accountants’ Society has also given its comments and
suggestions in this regard. The final rules based on the public comments
received are awaited.

 

(II)    Finance Minister N. Sitharaman bats for
‘SEP’-based solution to vexed digitalisation issue at G-20 meet (Source:
Press Release of Ministry of Finance dated 9th June, 2019)

The Union Minister for Finance and Corporate
Affairs, Mrs. Nirmala Sitharaman, attended the G-20 Finance Ministers’ and
Central Bank Governors’ meeting and associated events and programmes on 8th
and 9th June, 2019 at Fukuoka, Japan. She was accompanied by Mr. Subhash C. Garg, Finance Secretary and Secretary,
Economic Affairs, Dr. Viral Acharya, Deputy Governor of the RBI, and other
officers.

 

Mrs. Sitharaman flagged serious issues
related to taxation and digital economy companies and to curb tax avoidance and
evasion. She highlighted the issue of economic offenders fleeing legal
jurisdictions and called for cohesive action against them.

 

The Finance Minister noted the urgency to fix
the issue of determining the right nexus and profit allocation solution for
taxing the profits made by digital economy companies. Appreciating the
significant progress made under the taxation agenda, including the Base Erosion
and Profit Shifting (BEPS), tax challenges from digital economy and exchange of
information under the aegis of G-20, she congratulated the Japanese Presidency
for successfully carrying these tasks forward.

 

She noted that the work on tax challenges
arising from the digitalisation of economy is entering a critical phase with an
update to the G-20 due next year. In this respect, Mrs. Sitharaman strongly
supported the potential solution based on the concept of ‘significant economic
presence’ of businesses taking into account the evidence of their purposeful
and sustained interaction with the economy of a country. This concept has
been piloted by India and supported by a large number of countries, including
the G-24. She expressed confidence that a consensus-based global solution,
which should also be equitable and simple, would be reached by 2020.

 

Welcoming the commencement of automatic
exchange of financial account information (AEOI) on a global basis with almost
90 jurisdictions successfully exchanging information in 2018, the Finance
Minister said this would ensure that tax evaders could no longer hide their
offshore financial accounts from the tax administration. She urged the G-20 /
Global Forum to further expand the network of automatic exchanges by
identifying jurisdictions, including developing countries and financial centres
that are relevant but have not yet committed to any timeline. Appropriate
action needs to be taken against non-compliant jurisdictions. In this respect,
she called upon the international community to agree on a toolkit of defensive
measures which can be taken against such non-compliant jurisdictions.

 

Earlier, she participated in the Ministerial
Symposium on International Taxation and spoke in the session on the ongoing
global efforts to counter tax avoidance and evasion. During the session, she
also dwelt on the tax challenges for addressing digitalisation of the economy
and emphasised that nexus was important. Mrs. Sitharaman also raised the need
for international co-operation on dealing with fugitive economic offenders who
flee their countries to escape from the consequences of law. She also
highlighted the fugitive economic offenders’ law passed by India which provides
for denial of access to courts until the fugitive returns to the country. This
law also provides for confiscation of their properties and selling them off.

 

She drew attention to the practice permitted
by many jurisdictions which allow economic offenders to use investment-based
schemes to obtain residence or citizenship to escape from legal consequences
and underlined the need to deal with such practices. She urged that closer
collaboration and coordinated action were required to bring such economic
offenders to face the law.

 

India’s Finance Minister highlighted the need
for the G-20 to keep a close watch on global current account imbalances to
ensure that they do not result in excessive global volatility and tensions. The
global imbalances had a detrimental effect on the growth of emerging markets.
Unilateral actions taken by some advanced economies adversely affect the
exports and the inward flow of investments in these economies. She wondered if
the accumulation of cash reserves by large companies indicated the reluctance
of these companies to increase investments. This reluctance could have adverse
implications on growth and investments and possibly leading to concentration of
market power. She also urged the G-20 to remain cognizant of fluctuations in
the international oil market and study measures that can bring benefits to both
the oil-exporting and importing countries.

In a session on infrastructure investment,
Mrs. Sitharaman emphasised on the importance of making investments in
cost-effective and disaster resilient infrastructure for growth and
development. She suggested the G-20 focus on identifying constraints to flow of
resources into the infrastructure sector in the developing world and solutions
for overcoming them. She also took note of the close collaboration of India,
Japan and other like-minded countries, aligned with the Sendai Framework, in
developing a roadmap to create a global Coalition on Disaster Resilient
Infrastructure.

 

The Japanese Presidency’s priority issue of
ageing was also discussed. Mrs. Sitharaman highlighted that closer
collaboration between countries with a high old-age dependency ratio and those
with a low old-age dependency ratio was necessary for dealing with the policy
challenges posed by ageing. She suggested that if ageing countries with
shrinking labour force allow calibrated mobility of labour with portable social
security benefits, the recipient countries can not only take care of the aged
but also have a positive effect on global growth. She said that India’s
demography presented a dual policy challenge since India’s old-age dependency
ratio is less than that of Japan, while at the same time India’s aged
population in absolute numbers exceeds that of Japan. She detailed the policy
measures that the Government of India is taking to address these challenges.

 

While speaking on the priority of Japanese
Presidency on financing of universal health coverage (UHC), she emphasised the
importance of a holistic approach which encompasses the plurality of pathways
to achieve UHC, including through traditional and complementary systems of
medicine.

 

(III) Ratification of the
Multilateral Convention to Implement Tax Treaty-Related Measures to Prevent
Base Erosion and Profit Sharing (Source: Press Release of the Ministry of
Finance dated 12th June, 2019)

 

Text of the Press Release
of the Ministry of Finance dated 12th June, 2019:

 

“Ratification of the
Multilateral Convention to Implement Tax Treaty-Related Measures to Prevent
Base Erosion and Profit Shifting.

 

The Union Cabinet, chaired
by the Prime Minister, Mr. Narendra Modi, has approved the ratification of
the Multilateral Convention to Implement Tax Treaty-Related Measures to
Prevent Base Erosion and Profit Shifting (MLI).

 

IMPACT

The Convention will modify India’s treaties
in order to curb revenue loss through treaty abuse and base erosion and profit
shifting strategies by ensuring that profits are taxed where substantive
economic activities generating the profits are carried out and where value is
created.

 

DETAILS

i. India has ratified the
Multilateral Convention to Implement Tax Treaty-Related Measures to Prevent
Base Erosion and Profit Shifting, which was signed by the Hon’ble Finance
Minister, Mr. Arun Jaitley, at Paris on 7th June, 2017 on behalf of
India;

ii.   The Multilateral Convention is an outcome of the OECD / G-20
Project to tackle Base Erosion and Profit Shifting (the “BEPS
Project”) i.e., tax planning strategies that exploit gaps and mismatches
in tax rules to artificially shift profits to low or no-tax locations where
there is little or no economic activity, resulting in little or no tax being
paid. The BEPS Project identified 15 actions to address base erosion and profit
shifting (BEPS) in a comprehensive manner;

iii.  India was part of the ad hoc group of more than 100 countries
and jurisdictions from G-20, OECD, BEPS associates and other interested
countries which worked on an equal footing on the finalisation of the text of
the Multilateral Convention, starting May, 2015. The text of the Convention and
the accompanying Explanatory Statement was adopted by the ad hoc Group on 24th
November, 2016;

iv.  The Convention enables all
signatories, inter alia, to meet treaty-related minimum
standards that were agreed as part of the final BEPS package, including the
minimum standard for the prevention of treaty abuse under Action 6;

v. The Convention will
operate to modify tax treaties between two or more parties to the Convention. It
will not function in the same way as an amending protocol to a single existing
treaty, which would directly amend the text of the Covered Tax Agreement. Instead,
it will be applied alongside existing tax treaties, modifying their application
in order to implement the BEPS measures;

vi.  The Convention will modify India’s treaties in order to curb
revenue loss through treaty abuse and base erosion and profit shifting
strategies by ensuring that profits are taxed where substantive economic
activities generating the profits are carried out and where value is created.

BACKGROUND

The Convention is one of
the outcomes of the OECD / G-20 project, of which India is a member, to tackle
base erosion and profit shifting. The Convention enables countries to implement
the tax treaty-related changes to achieve anti-abuse BEPS outcomes through the
multilateral route without the need to bilaterally re-negotiate each such
agreement which is burdensome and time-consuming. It ensures consistency and
certainty in the implementation of the BEPS Project in a multilateral context.
Ratification of the multilateral Convention will enable application of BEPS
outcomes through modification of existing tax treaties of India in a swift
manner.

 

The Cabinet Note seeking
ratification of the MLI was sent to the Cabinet on 16th April, 2019
for consideration. Since the said Note for Cabinet could not be taken up in the
Cabinet due to urgency, the Hon’ble Prime Minister, vide Cabinet Secretariat
I.D. No. 216/1/2/2019-Cab dated 27.05.2019 has approved ratification of MLI and
India’s final position under Rule 12 of the Government of India (Transaction of
Business) Rules, 1961 with a direction that ex-post facto approval
of the Cabinet be obtained within a month. Consequent to approval under Rule
12, a separate request has already been sent to the L&T Division, MEA, for
obtaining the instrument of ratification from the Hon’ble President of India
vide this office OM F.No. 500/71/2015-FTD-I/150 dated 31/05/2019.”

 

In Part II of the Article, we will cover
various developments at the OECD relating to International Taxation. We sincerely
hope that the reader would find the above developments to be interesting and
useful. 

 


 

Decoding The Consequences of POEM in India

The Finance Act, 2016 substituted section
6(3) of the Income-tax Act, 1961 (the Act), w.e.f. 1st April 2017.
The “Place of Effective Management” (POEM) was introduced as one of the tests
for determination of the residential status of a company. Various stakeholders
raised concerns that a foreign company which is treated as a “POEM resident” in
India may not be able to comply with the provisions of the Act applicable to a
resident as the determination of POEM transpires during the assessment
proceedings that are usually years after the relevant tax year for which the
foreign company is treated as “POEM resident” in India. To mitigate such
concerns, the Finance Act, 2016 introduced section 115JH which gave the Central
Government power to notify exceptions, modifications and adaptations.
Therefore, laws and regulations applicable to an Indian company for computing the
tax liability would apply to a foreign company, which is a “POEM resident” in
India subject to such exceptions, modifications and adaptations notified by the
Central Government. On 15th June 2017, the CBDT issued a draft
notification for implementing the provisions of the section 115JH of the Act.
The Central Government has now published the final notification u/s. 115JH of
the Act on 22nd June 2018, specifying the consequences in respect of
a foreign company treated as “POEM resident” in India for the first time. This
write-up dissects and decodes the transitory consequences for a foreign
company.

 

1. 
Backdrop:

Prior to the
introduction of Place of Effective Management (POEM), a company was considered
as a resident of India only if its control and management were “wholly
situated in India”. An absolute threshold meant that companies could avoid
being classified as a resident by merely holding one key board meeting outside
India.

 

Therefore, to
protect India’s tax base and to align provisions of the Income-tax Act, 1961
(‘the Act’) with the Double Taxation Avoidance Agreements (DTAAs) entered into
by India with other countries1, India introduced the concept of POEM2
vide amendment3 to section 6(3)(ii) of the Act:

 

“Section
6(3): For the purpose of the Act, a company is said to be a resident
in India in any previous year, if—

 

(i)  it is an Indian company; or

 

(ii)  its place of effective management, in that
year, is in India.

 

Explanation.—For
the purposes of this clause “place of effective management” means a
place where key management and commercial decisions that are necessary for the
conduct of business of an entity as a whole are, in substance made.”

 

However, the use of
POEM as a test for residency was made applicable from assessment year 2017-18 onwards4.

 

As noted in the
Explanation to section 6(3), POEM is defined as the place where the “key
management and commercial decisions that are necessary for the conduct of
business of an entity as a whole are, in substance made.”

Therefore, the
definition of POEM has four limbs:-

___________________________________________________________

1   However, as per the 2017 update to the
OECD Model Tax Convention, the OECD has moved away from “POEM” to a
case-by-case resolution using Mutual Agreement Procedure (MAP) for determining
conflicts of dual residency.

2   According to the Explanatory Notes to the
provisions of the Finance Act, 2015. Circular No.- 19 /2015 dated 27th
November 2015. F. No. 142/14/2015-TPL.

3.  Refer section 4 of Finance Act 2015.

4.    Refer section 4 of
Finance Act 2016.

 

i.    Key Managerial and Commercial decisions

ii.    Necessary for the Conduct of Business

iii.   Of an entity as a whole

iv.   In substance made.

 

Since the
introduction of POEM in India, the CBDT has issued three circulars providing guidelines
with respect to POEM. The three circulars can be broadly classified as follows:

 

Circular No.

Date of Circular

Description

6

24th January 2017

Guidelines on determination of POEM.

8

23rd February 2017

Clarification on the turnover threshold for
applicability of POEM.

25

23rd October 2017

Clarification on applicability of POEM
for regional headquarters and applicability of General Anti-Avoidance Rule
(GAAR) for abuse of this Circular.

 

 

The first circular
(i.e. Circular No. 6) issued by the CBDT introduced following:

 

i.   An objective test –To determine whether a
foreign company has active operations outside India (formally known as “active
business outside India” test)5

 

ii.  Subjective Guidelines – To provide important
factors that may be considered while determining POEM.

 

A company is
considered to have an “active business outside India” when (a) its passive
income (An aggregate of sale and purchase transactions between related parties,
dividend, interest, royalty and capital gains) is less than 50 per cent of its
total income, and (b) the number of employees in India, value of assets in
India and payroll expenses relating to Indian employees is less than 50 per
cent of the company’s total employees, assets and payroll expenses,
respectively. The determination of these factors is based on an average of the
data pertaining to the relevant financial year and two previous years.

______________________________________________________

5   The “active business outside India” test and
‘passive income’ clause are akin to provisions or objectives of a Controlled
Foreign Corporation (CFC) Rule. It is pertinent to note that no country in the
world has such conditions for determination of POEM that tries to achieve dual
purposes.

 

A company having an
active business outside India is presumed to be non-resident as long as
majority of its board meetings are held outside India.

 

For companies that
fail the active business outside India test, the determination of residence
would involve identification of (a) persons who are responsible for management
decisions, and (b) place where decisions are actually made.

 

If a foreign
company gets hit by the POEM provisions, it becomes a resident and all
provisions of a resident company would apply to it. However, various
stakeholders raised concerns that a foreign company which is treated as a “POEM
resident” in India may not be able to comply with the provisions of the Act
applicable to a resident as the determination of POEM transpires during the
assessment proceedings that are usually years after the relevant tax year for
which the foreign company is treated as “POEM resident” in India. To mitigate
such concerns, the Finance Act, 2016, amongst other things, introduced special
provisions in respect of a foreign company said to be “POEM resident”6  in India by way of insertion of a new Chapter
XII-BC consisting of section 115JH in the Act with effect from 1st
April 2017. Section 115JH of the Act, inter alia, provides that the
Central Government may notify exception, modification and adaptation subject to
which, provisions of the Act relating to computation of total income, treatment
of unabsorbed depreciation, set off or carry forward and set off of losses,
etc., shall apply.

 

On 15th
June 2017, the CBDT issued a draft Notification for implementing provisions of
the section 115JH of the Act. The draft Notification invited comments from
stakeholders and the public. The Central Government, vide Notification dated 22nd
June 2018, released the final Notification7 under section 115JH(1)
of the Act. The final guidelines take forward the concept laid down in the
draft guidelines. It further provides clarification on other areas which were
not mentioned in the draft guidelines such as deemed computation of Written
Down Value (WDV) when WDV is not available in tax records, allowing carry
forward of unabsorbed depreciation on a proportionate basis when the accounting
year followed by the foreign company is different, explicitly defining “foreign
jurisdiction” etc. The consequences of a foreign company attracting POEM
provisions for the first time have been summarised below.

___________________________________________________–

6   “POEM resident” is a term coined by the
authors for companies that become “resident” as per the Income Tax Act, 1961
due to the attraction of the “POEM” provisions.

7     Notification No. S.O. 3039(E) dated 22nd
June 2018. The Notification is applicable from 1st April 2017.

 

2.  Key
takeaways from the Final Notification

The key takeaways
of the Notification are summarised below and a hypothetical case study of Ace
Ltd., is used to elucidate the takeaways in a more comprehensive manner.

 

2.1 Determination of WDV, brought forward
losses and unabsorbed depreciation for the relevant year

 

When the
foreign company is assessed to tax in the foreign jurisdiction

a)  The WDV of the depreciable asset shall be
determined as per the company’s tax records in the foreign jurisdiction.

 

b)  When WDV of the depreciable asset is not
available in tax records, the WDV is to be calculated as per the provisions of
the laws of that foreign jurisdiction.

 

c)  The brought forward loss and unabsorbed
depreciation shall be determined (year wise) on the basis of the foreign tax
records of the company.

 

When the
foreign company is NOT assessed to tax in the foreign jurisdiction

a)  The WDV of the depreciable asset, the brought
forward loss and unabsorbed depreciation (year wise) is to be determined on the
basis of the books of account maintained in accordance with the laws of the
foreign jurisdiction.

 

Other
miscellaneous provisions

a)  The brought forward losses and unabsorbed
depreciation determined above shall be allowed to be set-off and carry forward
in accordance with the provision of the Act for the remaining period,
calculated from the year in which brought forward loss and unabsorbed
depreciation occurred for the first time.

 

b)  The brought forward losses and unabsorbed
depreciation will be allowed to set off only against such income that has
become chargeable to tax in India on account of the foreign company becoming a
“POEM resident” in India.

 

c)  If there is a revision or modification in the
amount of brought forward loss and unabsorbed depreciation in the foreign
jurisdiction, then such revisions will also be made in India for set-off and
carry forward.

 

Case Study:

Ace Ltd., a foreign
company, was incorporated on 1st April 2016. It follows the same
financial year as India i.e. 1st April-31st March. It
acquired a fixed asset worth Rs 10 crores on 1st April 2016 itself.
The company attracts POEM provisions in India for financial year 2017-18. The
facts of the company are summarised below:

 

Depreciation as per
tax law – 10%.

WDV as per tax law
– 9 crores

 

Depreciation as per
company law – 20%.

WDV as per company
law – 8 crores

 

Business Loss as
per tax law – Rs 1,00,000/-

Business Loss as
per company law – Rs 1,50,000/-

 

Q1) What would be
the WDV of Ace Ltd.’s fixed assets as on 1st April 2017?

 

Scenario 1: Ace
Ltd. is incorporated in Singapore and the Singapore tax laws provide 10 rate of
depreciation.

 

Scenario 2: Ace
Ltd. is a Singapore company; however, the Singapore’s tax laws don’t provide
any specific rates for depreciation.

 

Scenario 3: Ace
Ltd. is incorporated in UAE.

 

Q2) What loss Ace
Ltd. can set off in the previous year 2017-18 in India?

 

Scenario 1: Ace
Ltd. is incorporated in Singapore.

 

Scenario 2: Ace
Ltd. is incorporated in UAE.

 

Solutions:

Answer 1:

Scenario 1: Since
Ace Ltd. is assessed to tax in Singapore and the Singapore tax laws specify the
rate of depreciation for the fixed asset, the WDV of such asset as on 1st
April 2017 will be Rs 9 crores (computed as per Singapore’s tax law).

Scenario 2: Since
Ace Ltd. is assessed to tax in Singapore and the Singapore tax laws do not
specify the rate of depreciation for the fixed asset, the WDV of such asset as
on 1st April 2017 will be Rs 8 crores (computed as per
Singapore’s company law).

 

Scenario 3: Since
Ace Ltd. is not assessed to tax in UAE, the WDV of such asset as on 1st
April 2017 will be Rs. 8 crores (determined on the basis of the books of
account maintained in accordance with UAE’s company law).

 

Answer 2:

Scenario 1: Since
Ace Ltd. is assessed to tax in Singapore, the loss in accordance with
Singapore’s tax law will be considered. Therefore, the brought forward loss
of Rs. 1,00,000/- will be allowed to be set off for eight consecutive years.

 

Scenario 2: Since
Ace Ltd. is not assessed to tax in UAE, the loss as determined in the books
of account maintained in accordance with the company law will be considered. Therefore,
the brought forward loss of Rs. 1,50,000/- will be allowed to be set off for
eight consecutive years.

 

Note: The loss calculated in both scenarios was from the year in which
brought forward loss occurred for the first time (i.e. previous year 2016-17).
It is important to always calculate the remaining period of set off from the
year the loss first occurred and not from the year in which the foreign company
becomes “POEM resident” in India.

    

2.2   Preparation of Profit and Loss and Balance
Sheet

a)  The foreign company will have to prepare
financial statements8
for the period immediately following its accounting year to the period in which
the foreign company becomes “POEM resident” in India.

 

b)  The foreign company shall also be required to
prepare financial statements for succeeding periods of twelve months till the
year the foreign company remains resident in India on account of POEM.

 

In other words, the
foreign company needs to prepare its financial statements for India on a
financial year basis consistently till it remains a “POEM resident” in India.

c)  For carry forward of loss and unabsorbed
depreciation, the following provision will apply:

 

–   If the “split period” is
less than six months, then such loss and unabsorbed depreciation will be
included in the year in which the foreign company becomes “POEM resident” in
India. Additionally, the financial statements will be extended to include the
split period.

____________________________

8   Profit and Loss Account & Balance Sheet.

 

For example:
Assuming Ace Ltd. is following a calendar year, then with a “split period” of
three months it does not have to prepare a “split” financial statement of three
months and financial year 2017-18 financial statement of twelve months
INDIVIDUALLY. It can combine both the financial statements and prepare a
fifteen month statement from 1st January 2017 to 31st
March 2018.

 

Furthermore, the
loss of previous year 2016-17 (Rs 1,00,000/- or Rs 1,50,000/- as the case may
be) will be now considered as current year business loss for the previous year
2017-18 in India.

 

–    If the “split period” is
equal to or greater than six months, then the split period would be classified
as a separate accounting year and consequently, the financial statements for
such split period need to be prepared.

 

For example: If Ace
Ltd. was incorporated in Australia where the previous year is from 1st
July – 30th June, then the split period for Ace Ltd would be nine
months  (1st July 2016 to 31st
March 2017).

 

Therefore, in such
a case, Ace Ltd. would have to file two separate financial statements i.e. (a)
split financial statement of nine months, and (b) previous year 2017-18
financial statement of twelve months.

 

It is pertinent to
note that the loss of previous year 2016-17 (Rs 1,00,000/- or Rs 1,50,000/- as
the case may be) will be allowed as a carry forward of business loss for eight
years in the previous year 2017-18 in India.

 

d)  Further, the Notification provides that in
case when separate split period accounts are prepared, the loss and unabsorbed
depreciation as per tax records or books of account, as the case may be, shall
be allocated on a proportionate basis.

 

2.3 Applicability of TDS Provisions (Chapter
XVII-B)

a)  Prior to becoming “POEM resident” in India, if
the foreign company has complied with the relevant provisions of Chapter XVII-B
of the Act, then it is considered to be compliant with the provisions of the
said Chapter.

 

b)  If more than one provision of Chapter XVII-B
of the Act applies to such foreign company as a:

–   resident, and

–    foreign company

 

then the provisions
applicable to a foreign company shall apply.

 

c)  Any payment to a foreign company who is “POEM
resident” in India – section 195(2) will still be applicable.

 

For example: If Ace
Ltd., a foreign company who is “POEM resident” in India, entered into a
management consultancy contract with an Indian entity, Soham Pvt. Ltd., then,
Soham Pvt. Ltd. (the payer) can make an application to the AO to determine an
appropriate sum chargeable to tax and to determine the liability for
withholding tax.

 

Since section
195(2) explicitly mentions that the payee i.e. Ace Ltd must be a
“non-resident”, (in the instant case Ace Ltd., being a “resident” due to the
POEM in India), the Notification specifically clarifies that the beneficial
provisions of section 195(2) will be applicable to the foreign company which is
resident in India due to its POEM in India.

 

Interestingly, it
is pertinent to note that the provisions of section 195 specifically mention
applicability to a foreign company. Therefore, any person making payment to Ace
Ltd. would be covered by the provisions of section 195 notwithstanding the fact
that Ace Ltd. has become resident of India by virtue of its POEM in India.

 

 

2.4  
Rate of Tax

a)  The rate of tax in case of the foreign company
shall remain the same even though the residential status of the foreign company
changes from non-resident to resident on the basis of POEM.9  

 

Therefore, Ace Ltd.
would be taxed at 40 per cent plus surcharge and cess. POEM, being in the
nature of
anti-avoidance to prevent base erosion, the high tax rates acts as a deterrent.

 

_____________________________________________

9   This is a derivation of key takeaways
explained in paragraphs 2.7 and 2.8.

 

 

2.5  
Foreign Tax Credit

a)  A foreign company will be eligible to avail
the benefits of India’s DTAA after it becomes “POEM resident” in India.

 

b)  In a case where income on which foreign tax
has been paid or deducted, is offered to tax in more than one year, credit of
foreign tax shall be allowed across those years in the same proportion in which
the income is offered to tax or assessed to tax in India in respect of the
income to which it relates and shall be in accordance with the provisions of
Rule 128 of the Rules.

 

2.6  
Limitation on setting off against India sourced Income

a)  The exceptions, modifications and adaptions
referred to in Para A of the Notification shall not apply to India sourced
income of a foreign company. Therefore, brought forward loss, unabsorbed
depreciation and foreign tax credit will not will available for India sourced
Income of a foreign company.

 

For example: Ace
Ltd, a Singapore entity, follows calendar year (1st January – 31st
December), and the income earned and tax paid by Ace Ltd. in Singapore and in
India is summarised below:

 

Singapore

Source

Financial Year 2017-18

(January-December)

Financial Year 2018-19

(January-December)

Amount
(Rs  in crores)

Tax (Rs 
in crores)

Amount
(Rs  in crores)

Tax (Rs 
in crores)

Business

1,200

240

2400

480

 

 

India

Source

Financial Year 2017-18 (April-March)

Amount (Rs in crores)

Tax (Rs in crores)

Business

10,000

3,000

 

 

How much foreign
tax credit can Ace Ltd. claim, assuming that Ace Ltd. gets hit by POEM
provisions in financial year 2017-18?

 

Solution:

Sine Ace Ltd. is
struck by POEM provisions in financial year 2017-18, it will be considered as a
resident in India and consequently, its global income will be taxed in India.

Furthermore, it
will be taxed at the rate applicable for foreign companies.

 

Computation of Income and tax paid for

financial year 2017-18 in India

Particulars

Amount (Rs in crores)

India sourced Income (A)

10,000

Singapore Income:

 

9 months Income of financial year
2017-18
(1 March 2017 to 31 December 2017) (B)

 

900

3 months income of financial year
2018-19

(1 January 2018 to 31 March 2018) (C)

 

600

Total Global Income (A+B+C) = (D)

11,500

Taxed at the Rate – 43.26 per cent  (E)

4974.9

Less: Proportionate Foreign Tax
Credit: 

 

9 months tax of financial year 2017-18

(1 March 2017 to 31 December 2017) (F)

 

(180)

3 months tax of financial year 2018-19

(1 January 2018 to 31 March 2018) (G)

 

(120)

Net Tax Liability (E-F-G) = (H)

4674.9

 

 

Note for determining Source wise
Foreign Tax Credit

 

 

2.7  
Transacting with a foreign company who is “POEM resident” in India

Any transaction of the foreign company with any other person or entity
under the Act shall not be altered only on the ground that the foreign company
has become Indian resident.

 

For Example: Ace Ltd. has an associated enterprise Beta Private Limited
in India. Will transfer pricing provisions apply to “international
transactions” between Ace Ltd. and Beta Ltd.?

 

As per section 92B,
an “international transaction” means a transaction between two or more
associated enterprises, either or both of whom are non-residents. Therefore, it
is important for one of the associated enterprises to be a non-resident.

 

In the instant
case, since Ace Ltd. has become a “resident” in India due to the applicability
of POEM provisions, ideally, transfer pricing provisions should not be
applicable. However, the language of the Notification creates confusion and
needs clarity.

 

2.8   
Conflict between Provisions

a)  Subject to the paragraph 2.7 above, a foreign
company shall continue to be treated as a foreign company even if it is said to
be “POEM resident” in India and all provisions of the Act shall apply
accordingly.

 

b)  It is pertinent to note that the provisions of
the Act which are specifically applicable to either a foreign company or a
resident assessee will apply to such companies. The provisions relating to
non-resident assessees will not apply to such companies. It has been further
clarified that any conflict between provisions of the Act applicable to it as a
foreign company and provisions of the Act applicable to it as a resident
assessee, the former shall prevail.

 

For example: Act
Ltd., a foreign company, who is “POEM resident” in India, is taxed on:

 

Particulars

Ace Ltd.

Reason

Scope of 
Tax

Global Income

Provisions specifically applicable to
resident shall apply to Ace. Ltd.

Rate of Tax10

40%

Conflict between Foreign company as
Resident (30%) and Foreign Company (40%) – provision applicable to foreign
company will apply.

 

 

3. 
Issues

The final
Notification has provided much-needed clarity regarding the consequences of
POEM for foreign companies who are “POEM resident” in India for the first time.
However, there remains ambiguity in the applicability of POEM for cases where
POEM is applied for the second or more time. Determination of POEM is an annual
exercise which needs to be conducted for every assessment year. Therefore, it
is always possible that the facts of the case may reveal that a foreign company
might attract POEM provisions in Year 1, not attract POEM provisions in Year 2
and again attract POEM provisions in Year 3. In such a case, there are no
guidelines about the consequences of POEM for foreign companies who are “POEM
resident” in India for multiple times.

 

Furthermore, there are some issues which have not been addressed by the
final Notification such as the applicability of advance tax, transfer pricing,
etc. For example, according to Para D of the Final Notification, transactions
of a foreign company with any other person or entity under the Act shall not be
altered only on the ground that such foreign company has become a “POEM
resident” in India. This Para implies that transfer pricing provisions will
continue to apply even if a foreign associated enterprise has become “POEM
resident” in India. Therefore, such a foreign company will have to comply with
transfer pricing provisions while transacting with its Indian associated enterprise.
This concept is irrational because transfer pricing provisions were introduced
in India to prevent shifting of profits from India to another tax jurisdiction.
Transfer pricing should not apply when both the entities are taxed in India, as
there is no opportunity for tax arbitrage.

 

4. 
Conclusion

Section 4 of the Act empowers the Central Government, to specify the
rate of tax. As per the Act, a company is differentiated either as a “domestic
company”11 or a “foreign company”12.  A higher rate of tax is provided for the
foreign company as its scope of tax is limited to Indian sourced income only. A
domestic company, however, is liable to tax on its worldwide (global) income
and therefore subject to a reduced tax rate. Thus, the principle seems to be
that as the scope of tax widens, the rate of tax reduces.13  However, in the case of a foreign company who
is “POEM resident” in India, not only is its scope of tax broader but also its
rate of tax.

Particulars

Domestic Company

Foreign

Company

Foreign Company

being “POEM resident”

Scope of 
Tax

Global Income

India sourced

Income

Global Income

Rate of Tax14

30%15

40%

40%

 

 

The consequences of
POEM of a foreign company in India are harsh and punitive. Since the
Explanatory Memorandum to the Finance Bill 2015 provides that the POEM rule is
targeted towards shell companies which are incorporated outside but controlled
from India, POEM should be used as an anti-avoidance tool and be resorted only
in exceptional cases. It is hoped that this provision will be used in the
spirit of the Explanatory Memorandum.  

________________________________________________________

10  Excluding surcharge and cess

11  Read section 2(22A).

12  Read section 2(23A).

13  This principle might be based on the principle
of equity.

14  Excluding surcharge and cess.

15   A domestic company is taxable at 30 per cent.
However, the tax rate is 25 per cent if turnover or gross receipt of the
company does not exceed Rs. 50 crore.

 

PROVISIONS OF TDS UNDER SECTION 195 – AN UPDATE – PART III

In Part I of the Article we dealt with overview of the
statutory provisions relating to TDS u/s. 195 and other related sections,
various aspects and issues relating to section 195(1), section 94A and section
195A.

 

In Part II of the Article, we dealt with provisions section
195(2), 195 (3), 195(4), section 197, refund u/s. 195, consequences of non-deduction
or short deduction, section 195A, section 206AA and Rule 37BC.

 

In this part of the Article we are dealing with various other
aspects and applicable relevant sections and issues.

 

1.     Furnishing of
Information relating to payments to non-residents

1.1    Section 195(6)

 

Section 195(6) substituted by the
Finance Act, 2015 wef 1-6-2015 reads as follows:

 

“(6)
The person responsible for paying to a non-resident, not being a company, or to
a foreign company, any sum, whether or not chargeable under the
provisions of this Act, shall furnish the information relating to payment of
such sum, in such form and manner, as may be prescribed.”

 

In respect of section 195(6) it is
important to keep in mind that the substituted s/s. mandates furnishing
information for all payments to (a) a non-resident, not being a company, or (b)
to a foreign company, irrespective of chargeability of such sum under the
provisions of the Act.

 

Section
271-I inserted w.e.f 1-6-2015 provides that if a person, who is required to
furnish information u/s. 195(6), fails to furnish such information, or
furnishes inaccurate information, the AO may direct that such person
shall pay, by way of penalty, a sum of Rs. 1 lakh.

 

It is to be noted that though
section 195(6) was substituted w.e.f 1-6-2015, there was no simultaneous
amendment in rules. Rule 37BB was substituted by Notification No 93/2015 dated
16th December 2015 effective from 1.4.2016.

 

1.2    Rule 37BB –
Furnishing of information for payment to a non-resident, not being a company, or
to a foreign company

 

a)  It is worth noting that while section
195(6) provides that information is to be submitted in respect of any sum,
whether or not chargeable under the provisions of Act, Rule 37BB(1)
provides that the person responsible for paying to a non-resident, not being a
company, or to a foreign company, any sum chargeable under the
provisions of the Act, shall furnish the prescribed information. Thus, on a
plain reading it is apparent that the Rule 37BB restricts the scope of
submission of the information as compared with the provisions of section
195(6).

b) Thus,
a question arises as to whether the rules can restrict the scope of the
section. Based on the various judicial precedents it is well settled that the
rules cannot restrict the scope of what is provided in the section.
Accordingly, the information should be furnished for all payments, irrespective
of chargeability under the provisions of Act except in cases given in Rule
37BB(3).

c) Rule
37BB in substance provides for submission of prescribed information in Form
15CA as follows:

 

i. If payments are chargeable to tax and not exceeding Rs. 5,00,000
in a financial year, information in Part A of Form 15CA.

ii. Payments chargeable to tax other than above:

 

Part B of Form 15CA
after obtaining 197 certificate from AO or Order u/s. 195(2) or 195(3) from AO

or Part C of Form 15CA
after obtaining Certificate in Form 15CB from an accountant.

iii.   Payments not chargeable to tax, information in Part D of Form
15CA.

 

d) Further,
Rule 37BB(3) provides that no information is required to be furnished for
any sum which is not chargeable under the provisions of the Act, if,-

(i) the
remittance is made by an individual and it does not require prior approval
of Reserve Bank of India as per the provisions of section 5 of the Foreign
Exchange Management Act, 1999 read with Schedule III to the Foreign Exchange
(Current Account Transaction) Rules, 2000; or

(ii) the
remittance is of the nature specified in the specified list of 33 nature of
payments given in the rule.

 

e) Form
15CA to be furnished electronically by the assessee on e-filing portal, to be
signed by person competent to sign tax return.

Furnishing of information for
payment to non-resident is summarised as follows:

 

 

2. Certificate by a CA for remittance

The CA Certificate has to be
obtained in Form 15CB and has to be furnished electronically by the CA as
against earlier practice of issuing physically and signing of the 15CB with
digital signature of the CA is mandatory.

 

As mentioned above, there is no
requirement to furnish CA certificate in Form 15CB if (a) the payments are not
chargeable to tax and (b) the same are either included in the list of 33
payments specified in Rule 37BB(3) which does not require any information to be
furnished or (c) they are by individuals and are current account
transactions  mentioned in Schedule III
of the FEM Current Account Transaction Rules not requiring RBI approval (LRS
transactions).

 

However, in practice, it is observed
that in some ultra conservative and cautious payers insist upon a CA
certificate in Form 15CB in respect of all remittances.

 

Revised Remittance Procedures –
Flow Chart

 


 

 

3. Form 15CB –
Analysis re Documents that should be Reviewed and Maintained

Before issuing a Certificate in Form
15CB, it is strongly advisable that an accountant obtains and minutely reads
and analyses, inter alia, the following documents and information before
issuing a Certificate:

 

a. Agreement
between parties evidencing important terms of the Agreement, nature of payment,
consideration, withholding tax borne by whom, etc.;

b. Taxability
of the concerned remittance under the provisions of the Act as well as
applicable Double Taxation Avoidance Agreement [DTAA] particularly keeping in
mind the various issues relating to the taxability of the nature of payment in
India, controversies, latest judicial pronouncements, reconciliation of
conflicting judicial pronouncements in the context of the remittance, latest
thinking and developments in the area of international taxation etc.

 

In this connection, inter alia,
provisions of section 206AA, Rule 37BC, latest circulars / notifications, Most
Favoured Nation [MFN] clauses and various protocols of the DTAAs entered in to
by India should also be kept in mind.

 

It would be advisable to keep a
proper note in the file recording proper reasons for taxability /
non-taxability of the remittance as it is very difficult to recall at a later
date as to why a remittance was considered as taxable or non-taxable and
applicable rate of tax.

 

c. Obtain
Tax Residency Certificate [TRC] in order to claim Treaty benefits as required
by section 90(4);

d. Opinion
/ advice, if any, obtained from consultants while taking position on
withholding tax implications in respect of the given transaction;

e. Exchange
rate Certificate / letter from the bank in respect of SBI TT buying and selling
rate, as applicable;

f. Invoice(s),
Debit Notes, Credit Notes etc;

g. Ledger
account(s) of the Party and other relevant accounts;

h. Correspondence
on which reliance is placed including emails;

i. Declarations
regarding (a) No Permanent Establishment [PE] in India (including print out of
website details of payee, if relevant and required to ascertain PE in India
etc.); (b) Associated Enterprise relationship between the payer and payee
including under the DTAA; (c) beneficial owner of
royalty/FTS/interest/dividends; (d) Fulfilment of the conditions of Limitation
of Benefits [LoB] Clause, if present, in the DTAA.

 

j. In
cases of certificates for reimbursement of expenses to the non-residents,
obtaining supporting vouchers, invoices and other documents and information, is
a must.

 

k. It
is imperative that proper record/copies of the documents / information received
and reviewed should be kept so that the same would be very handy and helpful in
responding / substantiating to the letters / communications / notices / show
cause notices, which may be received from the revenue authorities at a later
date alleging non-deduction of tax or short deduction of tax.

 

4.     Issues relating to
the Certificate by a CA for Remittance

4.1    Whether CA
Certificate is an alternate to section 195(2)?

 

In the context of this important
issue, in the case of Mahindra & Mahindra Ltd vs. ADIT [2007] 106 ITD
521 (Mum ITAT), the ITAT held as follows:

 

  •     CA Certificate is not in substitution
    of the scheme u/s. 195(2) but merely to supplement the same.

 

  •     CA Certificate has no role to play for
    determination of TDS liability.

 

  •     It is merely to support assessee’s
    contention while making remittance to a non-resident.

 

  •     Payer at his own risk can approach a CA and
    make remittance to a non-resident on the basis of CA’s Certificate.

 

4.2  Appeal to a
CIT(A) u/s. 248

In
the Mahindra & Mahindra’s case (supra), on the facts, it was held
that no appeal to a CIT(A) u/s. 248 is maintainable, against the CA
Certificate. In this case, in which the assessee filed an appeal directly
against the Chartered Accountant Certificate and had not taken the matter for
the consideration by the Assessing Officer (TDS) at all, the CIT(Appeals)
clearly erred in entertaining the appeal.

 

However, in this connection, in the
case of Kotak Mahindra Bank Ltd. vs ITO (IT) ITA No. 345/Mum/2008 ITAT
Mumbai vide its Order dated 30th June 2010 (unreported)
where the assessee had deducted the TDS and paid and later on filed the appeal
before CIT(A) denying its liability to TDS, which was rejected by the CIT(A) on
the ground that no order u/s. 195 was passed by the AO, held that the assessee acted
u/s. 195(1) which does not contemplate any order being passed and therefore the
appeal to CIT(A) u/s. 248 was maintainable.

 

In the case of Jet Air (P.)
Ltd. vs. CIT (A) [2011] 12 taxmann.com 385 (Mumbai) the matter was
remanded back to CIT(A) as the question whether section 248, as amended with
effect from 1-6-2007, was applicable or not, had not been adjudicated by
Commissioner (Appeals) and facts had not been verified.

 

4.3 Penalty in case
of non-deduction and short deduction based on CA Certificate

In the case of CIT vs. Filtrex
Technologies (P.) Ltd. [2015] 59 taxmann.com 371 (Kar), the Karnataka
High Court held that in this case the Chartered Accountant has given a
certificate to the effect that the assessee is not required to deduct tax at
source while making the payment to Filtrex Holding Pte. Ltd., Singapore. Thus,
the assessee acted on the basis of the certificate issued by the expert and
hence the CIT (Appeals) and the ITAT have rightly concluded that this is not a
fit case to conclude that the assessee has deliberately concealed the income or
furnished inaccurate particulars of the income. The assessee has filed Form 3CD
along with the return of income in which the Chartered Accountant has not
reported any violation by the assessee under Chapter XVII B which would attract
disallowance u/s. 40(a)(ia) of the Act.

 

4.4   Non deduction
based on CA certificate – section 237B and section 276C

A question arises as to
non-deduction or short deduction based on a CA Certificate would constitute
reasonable cause u/s. 273B for non-levy of penalty u/s. 271C.

 

In
the case of ADIT vs. Leighton Welspun Contractors (P.) Ltd 65 taxmann.com
68 (Mum), the ITAT held as that “The decision with regard to the
obligation of the assessee for deduction of TDS on the aforesaid payments was
highly debatable, in the given facts of the case and legal scenario and the
view adopted by the assessee based upon the certificate of the CA, was one of
the possible views and can be said to be based upon bona fide belief of the
assessee. Therefore, under these circumstances, it can be held there was
reasonable cause as envisaged under section 273B for not deducting tax at
source by the assessee on the aforesaid payments, and therefore, the assessee
was not liable for levy of penalty under section 271C.”



Similarly, in the case of Aishwarya
Rai Bachchan vs. ADCIT 158 ITD 987 (Mum) the ITAT held as follows:

 

“On a perusal of the relevant
facts on record, it is observed, the payment of U.S. $ 77,500 was made to a
non–resident for development of website and other allied works. Therefore,
question is whether such payment attracts deduction of tax under section 195.
As is evident, assessee’s C.A., had issued a certificate opining that tax is
not required to be deducted at source on the remittances to Ms. Simone
Sheffield, as the payment is made to a non–resident having no P.E. in India
that too, for services rendered outside India. It is a well accepted fact
that every citizen of the country is neither fully aware of nor is expected to
know the technicalities of the Income Tax Act. Therefore, for discharging their
statutory duties and obligations, they take assistance and advise of
professionals who are well acquainted with the statutory provisions. In the
present case also, assessee has engaged a chartered accountant to guide her in
complying to statutory requirements. Therefore, when the C.A. issued a
certificate opining that there is no requirement for deduction of tax at
source, assessee under a bona fide belief that withholding of tax is not
required did not deduct tax at source on the remittances made. …

 

While imposing penalty, the
authority concerned is duty bound to examine assessee’s explanation to find out
whether there was reasonable cause for failure to deduct tax at source. As
is evident, the assessee being advised by a professional well acquainted with
provisions of the Act had not deducted tax at source. Therefore, no mala fide
intention can be imputed to the assessee for failure to deduct tax. More so,
when the issue whether tax was required to be deducted at source, on payments
to a non–resident for services rendered is a complex and debatable issue requiring
interpretation of statutory provisions vis-a-vis relevant DTAA between the
countries. Therefore, in our considered opinion, failure on the part of the
assessee to deduct tax at source was due to a reasonable cause. The
decisions relied upon by the learned Authorised Representative also support
this view. Accordingly, we delete the penalty imposed under section 271C.”

 

4.5  When should one
approach the AO for Certificate u/s.195(2) or (3) / 197

Many a time, when the facts of a
case where certificate is required in Form 15CB, are very complex and there is
divergence of judicial decisions, lack of clarity about the taxability /
non-taxability under the provisions of the Act as well as DTAAs and the stakes
are very high, it would be advisable for the assessees to approach the tax
office for a certificate for no deduction and or lower deduction u/s. 195(2) /
(3) or section 197. After obtaining the certificate from the AO, the
certificate of CA in Form 15CB should be obtained.

 

In view of severe consequences of
disallowance u/s. 40(a)(ia), levy of interest and penalties under various
provisions of the Act for the assessee and to avoid multiplicity of proceedings
under the Act, it is imperative that a very cautious and judicious approach is
taken while issuing certificate in Form 15CB.

 

4.6 Validity period
of TRC / undertaking / declaration from the payee – for a quarter, a year or
for each single payment?

A question often arises while
issuing certificate in Form 15CB, is about the validity period of each TRC.
Revenue officials of various countries have different formats for issue of
TRCs. Some of them state the Tax Residency position as on particular date and
some of them state the same for a particular period. Obtaining TRC in the
respective countries is also time consuming and costly affair.

 

In such circumstances, should a CA
insist upon a fresh TRC each time a certificate u/s. 15CB is to be issued where
the TRC is silent about the validity period of TRC. Alternatively, for what
period the TRC should be reasonably be considered to be valid.

 

Similarly, whether a new no PE
declaration / undertaking, LoB certificate, beneficial ownership declaration
etc. should be insisted upon at the time of each remittance or can the same be
considered valid for a certain reasonable period, is not clear. Should the
reasonable period be a month or a quarter or half year or year, is not clear.

There is need for clarity from the
CBDT in this regard.

 

4.7  Responsibility of
CA

a. Whether
a Certificate under 15CB be issued in absence of a valid TRC, particularly in
cases where TDS has been deducted under the provisions of the DTAA.

 

As per the provisions of section
90(4), TRC is a pre-requisite for obtaining benefit under any treaty. However,
attention is invited to the decision of the ITAT Ahmedabad in the case of Skaps
Industries India (P.) Ltd. vs. ITO [2018] 94 taxmann.com 448 (Ahmedabad –
Trib.), which has been dealt with in Part 2 of our article. 

 

b. Similarly,
whether it is necessary for a CA to insist upon the payment of TDS and verify
the TDS Challan before issuing the Form 15CB.

 

Form 15CB does not cast a duty on a
CA to verify or mention the details of TDS Challan. It only requires a CA to
mention the amount of TDS. However, out of abundant caution, it would be
advisable for the CA to obtain the receipted challan from the remitter.

 

4.8  Manner of
certification where issue debatable

Presently, there is not enough space
or provision in the 15CA / 15CB utility to elaborately explain the debateable
issues and the stand taken by the assessee / CA for TDS. Therefore, it would be
imperative for the assessee / CA to keep proper details / reasons for any stand
taken so that the same could be substantiated at a later date in case the
revenue authorities commence any proceedings for non/short deduction of TDS.

 

4.9 Section 271 J –
Penalty for furnishing incorrect information in reports or certificate – Rs.
10,000 for each report or certificate

Section 271-J provides that “Without
prejudice to the provisions of this Act, where the Assessing Officer or the
Commissioner (Appeals), in the course of any proceedings under this Act, finds
that an accountant or a merchant banker or a registered valuer has furnished
incorrect information in any report or certificate furnished under any
provision of this Act or the rules made thereunder, the Assessing Officer or
the Commissioner (Appeals) may direct that such accountant or merchant
banker or registered valuer, as the case may be, shall pay, by way of penalty, a
sum of ten thousand rupees for each such report or certificate.”

 

It is important to note that both
the AO as well as the CIT(A) has power to levy penalty u/s. 271 J.

 

5.  Section 195(7)

“(7) Notwithstanding anything
contained in sub-section (1) and sub-section (2), the Board may, by
notification in the Official Gazette, specify a class of persons or cases,
where the person responsible for paying to a non-resident, not being a company,
or to a foreign company, any sum, whether or not chargeable under the
provisions of this Act, shall make an application to the Assessing Officer
to determine, by general or special order, the appropriate proportion of
sum chargeable, and upon such determination, tax shall be deducted under
sub-section (1) on that proportion of the sum which is so chargeable.”

 

Section 195(7) contains enabling
powers where under the CBDT may specify class of persons or cases where person
responsible for making payment to NR/Foreign company of any sum chargeable to
tax shall make application to AO to determine appropriate portion of sum
chargeable to tax. Thus, in prescribed cases Compulsory Application to AO would
have to be made and the AO may determine by general or special order the TDS to
be deducted on appropriate portion of sum chargeable.

 

Presently, no
notification has been issued u/s. 195(7).

CA
Certification and Remittance – Process to be followed

 


 

 

6.  Certain Cross Border Payments – TDS Issues

A large number of issues arises in
the context of payment of Fees for Technical Services [FTS], Royalties and
reimbursement of expenses the non-residents. There has been huge amount of
litigation in these areas.

 

It is not possible to cover various
legal issues arising in respect of the taxability of these payments in this
article.

 

It is strongly advisable that both
the assessees and the CAs issuing the Certificate in 15CB are aware of the
issues / developments in all the areas, to avoid severe consequences of
non-deduction or short deduction of TDS.

 

It is therefore advisable for a
remitter to obtain such a certificate from a CA who is well versed with the
subject and in case of any doubts about the taxability of a particular
remittance, to seek appropriate professional guidance.

 

7.  Key Takeaways in a
nutshell

a. Payments
to non-residents should be thoroughly examined from a withholding tax
perspective – under the beneficial provisions of the Act or DTAA.

 

b. Payments
can be remitted under alternative mechanism (CA certificate route) if assessee
is fairly certain about TDS obligation.

 

c. In case of a doubt or a substantial amount, it
is advisable to obtain tax withholding order section 195(2) / 197.

 

d. Mitigate
against severe consequences of non-compliance with exacting requirements of
section 195.

 

e. Ignorance
of relevant sections, rules and judicial developments may lead to avoidable
huge cost and consequences of long drawn litigation.

 

f.  Alternative
remedy of application before AO is conservative, but time consuming.

 

g. Enhanced
onerous provisions for issue of CA certificate.

 

h. Cumbersome
compliance provisions for the non-resident taxpayers.

 

i. Very
important to stay updated or take help of competent professionals for a
comprehensive evaluation of taxability of a particular remittance.

 

j. One
should have patience and trust in Indian tax judiciary and proper, balance and
judicious interpretation would enable success in these matters.

 

In view of reputational risks and
other professional consequences, more so in recent times, it would be advisable
for a professional who is not well versed with the intricacies of the entire
gamut of international taxation, to refrain from issuing the remittance
certificate without appropriate professional guidance.

 

8.  Conclusion

In these three parts of the Article
relating to ‘Provisions of TDS under section 195 – An Update’ we have covered
the developments in regard. TDS u/s. 195 is a very complex and an evergreen
subject with a large number of controversies and issues. There is no substitute
for remaining updated on the subject on a day to day basis, for proper
compliance and avoiding harsh consequences of non-compliance.  

GLOBAL TAX DEVELOPMENTS – AN UPDATE

In recent years,
there has been a flurry of developments in the International Taxation field in
the arena of taxation of Digital Economy, Preventing Base Erosion & Profit
Shifting (BEPS), particularly after publication of BEPS Reports in October 2015
and signature of Multilateral Instruments by various Tax Jurisdictions.
Investigations are being conducted by various affected Tax Jurisdictions
particularly into tax evasion and tax avoidance through the use of Offshore UK
Jurisdictions and other Tax Havens. In this issue, we have attempted to capture
such major developments of particular interest to Indian Tax payers and their
tax Advisors.

 

1.  GOOGLE, APPLE, FACEBOOK AND AMAZON (GAFA) TAX- FRANCE’S NEW DIGITAL TAX ON TECH GIANTS

The French
government’s GAFA tax is being introduced to combat attempts by the firms to
avoid paying what is considered a “fair share” of taxes in the
country, by taking advantage of European tax laws.

 

With efforts to
reform a European Union (EU) tax law not bringing the desired results, France
is going to introduce from 1st January 2019 a digital tax on
technology giants such as Google, Facebook, Apple and Amazon. The new tax
regime is expected to bring in an estimated 500 million euro ($570 million) to
the country’s coffers for 2019. Major technology companies have come under the
scrutiny of lawmakers in countries like France and Britain for allegedly
routing profits through operations in countries with extremely low tax rates or
other arrangements. Earlier this year, the European Commission published
proposals for a three per cent tax on the revenues of major tech companies with
global revenues above 750 million euro a year and taxable EU revenue above 50
million euro.


But to become law, EU tax reforms need the support of all member states. And
some countries, including Ireland, the Czech Republic, Sweden and Finland are
yet to come on board to bring the reforms.

 

2.  EU’S EXPANDED TAX HAVEN BLACKLIST COULD APPLY TO US.

2.1  Black List

The European Union
plans to update its year-old blacklist of tax havens to include new criteria
and an expanded geographic reach—possibly all the way to the U.S. The bloc has
previously threatened that the U.S. could end up on the blacklist, along with
the likes of Guam and Trinidad and Tobago, unless it adopts stricter financial
reporting standards and agrees to share that information with other tax
authorities.

 

The 2019 blacklist
of tax havens will include those that haven’t adopted the Organisation for
Economic Cooperation and Development’s Common Reporting Standard, like the U.S.
The standard calls on countries to obtain information from their financial
institutions and automatically exchange it with other countries every year.

The EU’s goal is to
flag jurisdictions that have failed to make sufficient commitments to
increasing tax transparency and reducing preferential tax measures. Its overall
goal is to eliminate tax avoidance and fraud. Countries on the blacklist could
face sanctions—measures the EU has discussed include imposing withholding taxes
on any funds moved from the EU to a country on the list.

 

What started out as
a list of 17 countries in December 2017 is down to six. Besides the U.S. Virgin
Islands, the others, including Samoa, American Samoa, Guam and Trinidad and
Tobago have insignificant financial centers.

The new criteria
for the blacklist adopted for 2019 will require countries to apply the OECD’s
base erosion and profit shifting minimum standard—requiring companies with a
$750 million global turnover to report country-by-country tax and profits to
national tax authorities. The EU is also negotiating new rules to require
countries or independent territories to apply transparency standards to publish
the beneficial owners of companies. Most EU officials, tax experts and advocacy
groups expect 2019 to be crucial because the bloc must decide how to deal with
the U.S. There were several other tension points between the EU and the U.S. in
2018. The bloc accused the U.S. of violating trade rules through some of its
international tax reform provisions, and the U.S. opposed the bloc’s proposal
to tax digital companies.

 

Some EU politicians
and tax advocacy groups insist that the EU gets either a failing grade or an
“I” for incomplete in its tax haven blacklisting process. For others, the first
year of the EU tax haven process has made a mark as part of an overall trend
away from the use of offshore financing centers in places like the Channel
Islands or the Caribbean. There is a general pressure on companies using
offshore financial centers, driven by politics, popular media and multinational
organisations such as the OECD.

So far, the process
has been an overall failure because the process has been unfair or
inconsistent. When there are tax havens within the EU and they are not on the
list it makes, it hard to go after others outside the EU.

 

The EU Code of
Conduct Group for Business Taxation, made up of officials from EU member
nations, has the final say on which countries end up on the EU list. It
excludes members of the European Parliament. There is a situation where the
United States does not meet the transparency criteria but the EU member states
have decided to ignore that. This goes to show that the process is political.

 

2.2  Grey list

Although the
current EU tax haven blacklist only contains six countries and jurisdictions,
the EU member states agreed a year ago to establish a grey list. This is a
roster of countries, which include more than 50 countries, that currently don’t
comply with EU transparency and fair corporation criteria but made commitments
to do so by the end of 2018. EU member nations are due to decide by March 2019
whether the gray list countries have either met their commitments or should be
placed on the blacklist.

 

The gray list has
been positive in pushing countries to reform harmful tax practices and has for
the first time addressed the issue of zero tax regimes. Indeed one of the most
critical issues the EU must decide in the coming months is whether countries or
jurisdictions with zero corporate tax rates have substantial “economic
substance” on the ground to justify the multinational corporations using their
territory as a headquarters. The goal is to clamp down on letterbox companies.

 

2.3 Economic
Substance Requirements

The EU is
succeeding in the Channel Islands and in other territories as of 1st January
2019. Guernsey and Jersey are introducing substance requirements for tax
resident companies carrying out relevant activities.

 

The Cayman Islands,
one of the world’s largest offshore centers for fund management, is another
territory on the EU gray list. It has also recently adopted “economic substance”
requirements for any company that uses its territory for its headquarters.

 

2.4   The Isle of Man (IOM)

The IOM Parliament
has approved tax legislation that will allow the jurisdiction to avoid being
put on the European Union’s blacklist. This means that from January 2019,
companies engaging in “relevant activities” will have to demonstrate
that they meet specific substance requirements, to avoid sanctions.

Its focus will be
on business sectors identified by the EU including banking, insurance, shipping,
fund management, finance and leasing, headquartering, holding companies,
distribution and service centres and intangible property.

 

This Order follows
a comprehensive review that was carried out by the EU Code of Conduct Group on
Business Taxation (COCG) in order to assess over 90 jurisdictions, including
the IOM against standards of tax transparency, fair taxation and compliance
with anti-BEPS Reports.

 

The review process
took place in 2017 and although the COCG were satisfied that the IOM met the standards
for tax transparency and compliance with anti-BEPS measures, the COCG raised
concerns that the IOM, and other Crown Dependencies did not have “a legal
substance requirement for entities doing business in or through the
jurisdiction.”

 

The IOM is currently
on the EU’s greylist of jurisdictions that have committed to undertake specific
reforms to their tax practices before the end of the year. Without this Order
it would have been placed on a blacklist and faced sanctions as well as
reputational damage.

 

The legislation
will require companies that are tax resident in the IOM and which operate in
these business sectors to demonstrate a minimum level of substance here.
Substance requirements are set out in the legislation and some of the
requirements vary according to the business sector.

 

2.5  Economic Substance Legislation in Jersey

Jersey has tabled
new laws to address the EU’s concerns over ‘economic substance’, the degree of
real business activity carried out by companies registered in the Island.

The new proposed requirements for an economic substance test for Jersey
tax-resident entities have been published and are set to come into force on 1st
January 2019 subject to States approval. The reforms include establish
new tests for certain tax resident companies carrying on “relevant activities”
in respect of demonstrating that they are “directed and managed” in Jersey, and
that their “core income generating activities” are undertaken here.

 

Last year the
Island avoided being placed on a new ‘blacklist’ of non-cooperative
jurisdictions drawn up by the EU Code of Conduct Group on business taxation,
but was among more than 40 regimes asked to reform their tax structures to
ensure compliance with standards, which was dubbed a ‘grey-list’ by some
commentators.

 

The EU wants Jersey
to show it has economic substance by ensuring the taxes it collects within the
financial services sector were generated through real economic activity in the
territory. In other words, proof that an offshore company is paying taxes in
Jersey because it largely does its work and earns its profits in/from Jersey.

The EU list, first
published in December 2017, was divided into three sections: i) cooperative
jurisdictions ii) non-cooperative jurisdictions and iii) jurisdictions that had
undertaken to modify their tax regimes to comply with the rules set by COCG.

 

Many of these ‘grey-listed’ jurisdictions operate tax transparency
regimes that are at least as good as the white-listed ‘cooperative’
jurisdictions, but fell foul of the COCG’s additional criterion that businesses
should only be granted tax residence in a jurisdiction once they demonstrate
they have adequate economic substance there.

 

The blacklist is to
be revised at the end of this year, and grey-listed jurisdictions such as Jersey
are at risk of being moved onto it if they do not act soon. Jurisdictions which
are blacklisted could face sanctions and risk reputational damage.

The other Crown
Dependencies, Guernsey and the Isle of Man, were also consulted and are due to
table similar draft laws soon. Affected companies should review outsourcing
arrangements (where relevant) in respect of Jersey tax-resident companies that
fall within the scope of the new law and whether the third-party service
provider agreements in place meet the tests set out therein.

 

3.  OFFSHORE UK JURISDICTIONS REACT TO LATEST TAX AVOIDANCE INQUIRY

Officials from
Britain’s overseas territories and Crown Dependencies said they were prepared
to cooperate with the latest UK government investigation into tax evasion and
avoidance, but some expressed surprise that it was felt necessary. They pointed
to a raft of new regulations, including the Common Reporting Standard – an
automatic information exchange regime currently coming into force globally –
new and pending additional rules on beneficial ownership registers, and the
UK’s Retail Distribution Review, which they argue have transformed the
so-called offshore financial services industry over the last few years.

 

The UK Parliament’s
Treasury Sub-Committee has announced a “Tax Avoidance and Evasion inquiry” into
“what progress has been made in reducing the amount of tax lost to avoidance
and offshore evasion”, and whether HM Revenue & Customs (HMRC) currently
“has the resources, skills and powers needed to bring about real change in the
behaviour of tax dodgers, and those who profit by helping them”.

 

In his piece for The Guardian, John Mann, a Labour Party MP who
is Chairman of the Sub Committee overseeing it, noted that the British Virgin
Islands, Jersey, Guernsey, the Isle of Man, Bermuda and the Cayman “are on the
EU greylist of uncooperative tax jurisdictions”, and added: “We should regard
it as a matter of national shame that the crown dependencies and overseas
territories that fly our flag give shelter to the wealth of the world’s
financial elite.”

 

In a document
posted on Parliament’s website, the Sub-Committee investigating the tax haven
matters invites comment on six questions as follows:

 

i)     To what extent has there been a shift in
tax avoidance and offshore evasion since 2010? Have HMRC efforts to reduce
avoidance and evasion been successful?

ii)    Is HMRC adequately resourced and
sufficiently skilled to identify, challenge and counteract existing and new
avoidance schemes and ways of evading tax? What progress has it made since 2010
in promoting compliance in this area and preventing and responding to
non-compliance?

iii)    What types of avoidance and evasion have
been stopped, and where do threats to the UK tax base remain?

iv)   What part do the UK’s Crown Dependencies and
Overseas Territories play in the avoidance or evasion of tax? What more needs
to be done to address their use in tax avoidance or tax evasion?

v)    How has the tax profession responded to
concerns about its role in aiding tax avoidance and evasion?

vi)   Where does it [the tax profession] see the
boundary between acceptable and unacceptable practice lie?

 

3.1 Guernsey

The States of Guernsey’s
Policy & Resources Committee, noted in a statement that the EU Council of
Finance Ministers (ECOFIN) had reaffirmed that Guernsey “was a cooperative
jurisdiction in respect of taxation, following a screening against principles
of tax transparency, fair taxation and anti-base erosion and profit shifting”
and that it had also formally “committed to the OECD anti-BEPS initiative, and
in 2017 signed the multilateral convention”.

Guernsey had
committed to address certain outstanding ECOFIN concerns relating to “economic
substance requirements in respect of the analysis of fair taxation” this year,
but the OECD’s Global Forum had assessed the jurisdiction’s tax transparency
standards generally, and found them to “exceed the required standard”, the statement
added.

 

It is also claimed
that Guernsey also meets international standards in respect of the sharing of
beneficial ownership information…and in 2017 went further by establishing a
register of beneficial ownership and putting in place arrangements to share
this information with UK law enforcement authorities.

 

3.2 Jersey – No safe harbour for rogue operators

A spokesperson for
the States of Jersey said: “Jersey is not a safe harbour for rogue operators.
We run a professional, well-regulated international finance centre that expects
companies using our services to pay the tax that is due in the jurisdictions
where it is owed. Jersey does not want abusive tax avoidance schemes operating
in the island. Jersey is not on the EU Code Group’s blacklist, and was
confirmed as a cooperative jurisdiction. The Code Group is now working with the
island, to ensure that this position is maintained.

The government of
Jersey regularly engages with parliamentarians from across the House [of
Commons], including the Treasury Sub-Committee. We are happy to provide
information to the Sub-Committee on the island’s robust financial regulation
and cooperation with HMRC and the European Union.

 

3.3 British Virgin Islands (BVI) sets out measures
to counter EU tax ‘greylist’ concerns

BVI has outlined
its action plan detailing key steps the jurisdiction pledges to undertake in
order to allay EU concerns of harmful tax competition with the bloc. In the
EU’s assessment, a range of factors were taken into account including tax
transparency, fair taxation and a commitment to combat BEPS.

 

Any jurisdiction
judged by EU to be deficient within one or more of these areas is placed on
either a blacklist or an intermediary “greylist”. The EU classifies the
greylist as being for those countries where there is one area where concerns
remain but a commitment to address it has clearly been set out.

 

The BVI said that
it now meets its requirements relating to tax transparency and those in
relation to BEPS. However, the area which the EU has highlighted for the BVI is
referred to as “economic substance”, in other words the existence of a tax
regime without any real economic activity underpinning it.

 

The UK Overseas
Territories with financial centres, as well as Crown Dependencies, have all
been advised that they need to address this issue. The Premier is leading a
team to chart a way forward, and has committed to pass appropriate legislation
ahead of the December 2018 deadline set by the EU.

 

4.  UNITED STATES – NEW BASE EROSION ANTI-ABUSE TAX (BEAT) REGULATIONS

US IRS and Treasury
officials on 14th December 2018 discussed the proposed Base Erosion
Anti-Abuse Tax (BEAT) regulations at a Washington DC tax conference, explaining
the reasoning behind many positions taken by the government in the regulations.

 

A literal reading of the statutory language of the BEAT would result in
many payments that Congress intended to be base erosion payments to fall
outside the statute. To make the statute work as intended, the government
decided that, for purposes of defining applicable taxpayers, the regulations
should provide that the aggregate group is limited to domestic corporations
plus all foreign related parties that are subject to US net
basis tax.

 

4.1 Effectively Connected Income (eci) exception

Consistent with
this new aggregate group concept, the regulations add an exception to the
definition of a base erosion payment for amounts paid or accrued to a foreign
related party that are treated as ECI.

 

Kevin Nichols, Senior Counsel, (ITC) at the US Department of Treasury
said that, “When we define the aggregate group, we sort of draw a box around
all the US corporations as well as the foreign entities to the extent they are
subject to net US taxation. So, those transactions are all disregarded for
purposes of determining the base erosion percentage and determining if you are
an applicable taxpayer. And, once you are an applicable taxpayer, then that
same payment would technically meet the definition of a base erosion payment.
In order to create symmetry between the aggregate group concept and what a base
erosion payment is we linked those two so that there is this exception . . .
which says that payments subject to net taxation are an exception from the base
erosion payment definition”.

 

4.2   Non-cash payments, reorganisations, cost
sharing

The regulations make it clear that base erosion payments
do not need to be made in cash and can occur in the context of a tax-favoured
transaction. There is no logical basis to exclude non-cash consideration,
including payments of stock, from the defintion of base erosion payments or to
exclude a situation where the delivery of the noncash consideration is in
connection with a transaction that has special status under the code, such as a
reorganisation or a section 351 transaction. This rule, coupled with the Global
Intangible Low Taxed Income (GILTI) regulations, will make it more difficult
for taxpayers to move intellectual property from lower tax structures to the US
or to other jurisdictions. Base eroding payments from US participants to a
foreign related party can also be made in the context of a cost-sharing
arrangement.

 

4.3  Services Cost Method Mark-Up Exception

The proposed
regulations take the position that if you meet all the requirements of the
services cost method exclusion from the definition of base erosion payments,
the exclusion is available to the extent of the cost but not the to extent of
any markup.

 

While it has been
clear the exclusion would apply to US corporations that reimburse a foreign
related taxpayer for costs of services provided by the foreign party, there had
been controversy regarding whether and how the exclusion would apply if a
markup is added to the payment.

The regulations
clarification is welcome as companies have wondered if they need to forgo the
markup component to take advantage of services cost method exception and, if
they did forgo the markup, how the foreign jurisdiction would react.

 

4.4 Cost of Goods
Sold  (cogs)
exception

Companies have been
spending significant resources trying to determine what costs can be properly
capitalised and thus considered reductions to gross receipts for purposes of
Cost Of Goods Sold (COGS) rather than as deductible payments subject to BEAT.
Companies that realise they have been deducting items that should have been
included in COGS now want to apply for a change in accounting method but are
concerned that the government may disregard a method change even if it is from
an improper method. Unlike the section 965 transition tax, the BEAT provisions
do not include a special anti-abuse rule aimed at changes in accounting
methods.

 

4.5  Banks, securities dealers, section 989 losses

 

The regulations add
taxpayer-favorable de minimis rules providing that if a small percentage
of a group’s activities include banking and securities dealer activities the
lower, 2 percent base erosion threshold applicable to banks will not apply.

 

Instead, the
general 3 percent threshold applies making it less likely that the group will
be subject to BEAT. The de minimus rule applies when the group’s gross receipts
from banking or securities dealer activities are 2 percent or less of total
receipts.

 

The regulations
clarify that that term “securities dealers” does not include brokers, as some
taxpayers had feared. The government decided to define the term by looking to
securities law.

 

The government,
after a lot of thought, decided to apply a neutral rule for section 988 losses,
noting that such payments can be very common. These losses are not treated as
base erosion payments and are also excluded from the denominator when computing
the base erosion percentage.

 

Note: The reader may visit the websites of the Revenue Authorities of
the concerned Tax Jurisdictions and download various draft reports / Tax
Legislations etc. referred to in this article for his study before rendering
any tax advice or undertaking any further action. If required, the taxpayers
and their tax advisors may consult tax specialists in the aforesaid tax
jurisdictions.  

 

 

PROVISIONS OF TDS UNDER SECTION 195 – AN UPDATE – PART II

In Part I of the Article we have
dealt with overview of the relevant provisions relating to TDS u/s. 195 and
other related sections, various aspects and issues relating to section 195(1),
section 94A and section 195A.

 

In this part of the Article we are
dealing with various other aspects and applicable sections.

 

1.     Section
195(2) Application by the Payer

 

Section 195(2) of the Act reads as
under:

 

“195(2) Where
the person responsible for paying any such sum chargeable under this Act (other
than salary) to a non-resident considers
that the whole of such sum would not be income chargeable in the case of the
recipient, he may make an application to the Assessing Officer to
determine, by general or special order, the appropriate proportion of such sum so chargeable, and upon
such determination, tax shall be deducted under sub-Sec (1) only on that proportion
of the sum which is so chargeable.”

 

1.1     It is important to note that no specific
rule or form has been prescribed under the Income-tax Rules, 1962. The
application has to be made on a plain paper / letter head.

 

1.2     An issue often arises as to whether an
application can be made u/s. 195(2) for ‘nil’ withholding order.

 

The judicial opinion is divided on
the issue. In the following cases it has been held that an application can be
made u/s. 195(2) for ‘nil’ withholding order:

–   Mangalore Refinery and Petrochemicals Ltd.
vs. DDIT 113 ITD 85 (Mum)

 

–   Van Oord ACZ India (P.) Ltd. [2010] 323
ITR 130 (Del.)

 

However, a
contrary view has been taken in the following cases:

–   GE India Technology Centre (P.) ltd.
[2010] 327 ITR 456 (SC)

–   Czechoslovak Ocean Shipping International
Joint Stock Company vs. ITO 81 ITR 162 (Cal)

–   Graphite Vicarb India Ltd. vs. ITO 28 TTJ
425 (Cal) (SB)

–   Biocon Biopharmaceuticals (P.) Ltd. vs.
ITO IT 36 taxmann.com 291 (Bang).

 

It appears that in practice,
application u/s. 195(2) is used for both ‘nil’ as well as ‘lower’ TDS rate
order.

 

1.3     Another question arises as to in case a
work involves multiple phases, in such scenario, is it sufficient if order u/s.
195 is obtained for phase I of the work or whether order is to be obtained for
all the phases of the work. In Mangalore Refinery and Petrochemicals Ltd.
vs. DDIT 113 ITD 85 (Mum) it has been held that the payer should apply
fresh and obtain order for all phases of the work.

 

1.4     Whether order u/s. 195(2) of the Act is
subject to revision u/s. 263 by the PCIT or CIT. It has been in the case of BCCI
vs. DIT (Exemption) [2005] 96 ITD 263 (Mum) that order u/s. 195(2) of the
Act is subject to revision
u/s. 263.

 

1.5     An important point to be kept in mind is,
order u/s. 195(2) are not conclusive and the Assessing Officer (AO) can take a
contrary view in the assessment proceedings. This has been held by the Bombay
High Court in the case of CIT vs. Elbee Services Pvt. Ltd. 247 ITR 109 (Bom).

 

1.6     Section 195(2) does not
prescribe any time limit for passing order u/s. 195(2). The Citizens Charter
2014 prescribed that decision on application for no deduction of tax or
deduction of tax at lower rate should be taken in 1 month. However, in
practice, such orders take longer time.

 

1.7     It has to be noted that application u/s.
195(2) cannot be made for Salary payment.

 

1.8     Appeal under section 248

 

a)  It is important to note that an order
u/s.195(2)/(3) is appealable, under a separate and specific section under the
Act.

 

b) Section 248 of the Act reads as follows:

 

“Appeal by a person denying
liability to deduct tax in certain cases.

 

248.   Where under an agreement or other
arrangement, the tax deductible on any income, other than interest,
under section 195 is to be borne by the person by whom the income is payable,
and such person having paid such tax to the credit of the Central
Government, claims that no tax was required to be deducted on such income,
he may appeal to the Commissioner (Appeals) for a declaration that no
tax was deductible on such income.”

 

c)  Section 248, as amended by the Finance Act,
2007 read with section 249(2)(a) provides for an appeal
u/s. 195, subject to fulfillment of following conditions:

 

i.   The tax is deductible on any income other
than interest;

 

ii.  Only if the tax is to be borne by the payer
under the agreement or arrangement. If tax is borne by the payee, a payer
cannot file an appeal u/s. 248 of the Act.

 

iii. The payer has to first pay the tax to the
credit of the Central Government;

iv. The appeal has to be filed within 30 days of
payment of tax [section 249(2)(a)].

 

d) It has been held that liability of TDS can be
appealed before CIT(A) u/s. 248 even without order from AO. CMS (India)
Operations & Maintenance Co. 38 taxmann.com 92 (Chennai).

 

2.     Section
195(3), (4) and Section 197 – Application by Payee

 

2.1     Section 195(3), (4) and section 197 of the
Act apply in respect of application for lower or nil deduction of tax under
specific circumstances and on fulfillment of certain prescribed conditions. The
distinctive features of the aforementioned provisions are discussed below.

 

2.2     The text of the section 195(3), (4) and
section 197 is given for ready reference and better appreciation of the
distinct language and purposes of the said sections, which relates to
application by the payees for lower or nil deduction of tax at source.

 

Section 195(3) –
“Subject to rules made under sub-section (5), any person entitled to receive any interest or other sum
on which income-tax has to be deducted under
sub-section (1) may make an application in the prescribed form to the Assessing
Officer for the grant of a certificate authorising him to receive such interest
or other sum without deduction of tax under that sub-section, and where any
such certificate is granted, every person responsible for paying such interest
or other sum to the person to whom such certificate is granted shall, so long
as the certificate is in force, make payment of such interest or other sum
without deducting tax thereon under sub-section (1).”

 

Section 195(4) – “A
certificate granted under sub-section (3) shall remain in force till the
expiry of the period specified therein or, if it is cancelled by the
Assessing Officer before the expiry of such period, till such cancellation.”

 

Section 197(1) – “Subject
to rules made under sub-section (2A), where, in the case of any income of
any person or sum payable to any person, income-tax is required to
be deducted at the time of credit or, as the case may be, at the time of
payment at the rates in force under the provisions of sections 192, 193, 194,
194A, 194C, 194D, 194G, 194H, 194-I, 194J, 194K, 194LA, 194LBB, 194LBC and 195,
the Assessing Officer is satisfied that the total income of the recipient
justifies the deduction of income-tax at any lower rates or no deduction of
income tax, as the case may be, the Assessing Officer shall, on an
application made by the assessee in this behalf, give to him such certificate
as may be appropriate.”

 

2.3     Section 195(3) read with rule 29B and Forms
15C and 15D, in short, provides as follows:

 

Section 195(3) provides that a
payee entitled to receive interest or other sums liable to TDS and satisfying
certain conditions prescribed in rule 29B can make an application (Form 15C for
banking companies or Form 15D for non-banking companies) i.e.

 

a.  Has been regularly filing tax returns and
assessed to Income-tax;

b.  Not in default in respect of tax, interest,
penalty etc.

c.  Additional conditions for non-banking
companies:

 

i.   has been carrying on business or profession
in India through a branch for at least 5 years

 

ii.  value of fixed assets in India exceeds Rs. 50
lakh.

 

d.  Certificate issued by the AO valid for the
financial year mentioned therein unless cancelled before.

e.  Application
for fresh certificate can be made after expiry of earlier certificate, or
within 3 months before expiry.

 

2.4     Section 197 read with rule 28AA and Form
13, in short, provides as follows:

a.  Any payee can apply for no deduction or lower
rate of deduction

b.  Prescribed form – Form 13

c.  Prescribed conditions (Rule 28AA):

 

–   Total income / existing
and estimated tax liability justifies lower deduction;

–   Considerations for
existing and estimated tax liability justifying lower or nil TDS;

–   Tax payable on estimated
income of previous year;

–   Tax payable on assessed /
returned of last 3 previous years;

–   Existing liability under
the Act;

–   Details of advance tax,
TDS & TCS.

 

d. 
AO to issue certificate indicating rate / rates of tax, whichever is
higher, of the following:

 

–    Average rate determined
on the basis of advance tax; or

–   Average of average rates
of tax paid by the taxpayer in last 3 years.

 

e.  
Certificate issued by AO can be prospective only

 

f.     Payment / credit made prior to the date of
the certificate is not covered. Circular No. 774 dated 17th March
1999.



3.     Lower
withholding – A Comparative Chart

 

The above discussion and the
comparative features of the aforesaid provisions are summarised in the table
given below.

 

Particulars

Section 195(2)

Section 195(3)

Section 197

Overview

Payer having a belief that portion (not the whole amount) of any
sums payable by him to non-resident is not liable to tax in India, may make
an application to AO to determine taxable portion.

Payee may make an application to AO for granting him a
certificate to receive income without TDS.

Payee may make an application to AO for granting him certificate
of ‘Nil’ or ‘lower’ withholding.

Application by

Payer

Non-resident Payee

Payee

Purpose

Determination of portion of such sum chargeable to tax.

No withholding

Lower / Nil withholding

Form

No Specific Format

Rule 29B – Form 15C and 15D

Rule 28 -Form 13

Outcome

AO to determine the appropriate proportion chargeable to tax and
issue order accordingly.

Certificate issued by the AO subject to conditions specified in
Rule 29B.

Certificate to be issued by AO subject to conditions specified
in Rule 28AA.

Remedy

 

Order can be appealed
u/s. 248.

uThere is no provision under Chapter XX of the
Act, to appeal against the certificate issued.

 

u Possible to pursue application u/s. 264.

 

u Possible to explore writ jurisdiction – Diamond
Services International (P.) Ltd. [2008] 169 Taxman 201 (Bom).

 

In which cases and circumstances
one should make and application for lower or nil TDS u/s. 195(2) or 197, should
be determined keeping in view the above discussion.

 

4.     Section
195 – Various situations

 

The various situations could be
faced by a payer as well as a payee has been very lucidly and succinctly
explained in the case of ITO IT vs. Prasad Production Ltd. [2010] 125 ITD
263 (Chennai)(SB), which is summarised as follows:

 

a)  If the bona fide belief of the payer is
that no part of the payment has any portion chargeable to tax, he will submit
necessary information u/s. 195. However, if the department is of the view that
the payer ought to have deducted tax at source, it will have recourse u/s. 201.

 

b)  If the payer believes that whole of the
payment is chargeable to tax and if he deducts and pays the tax, no problem
arises.

 

c)  If the payer believes that only a part
of the payment is chargeable to tax, he can apply u/s. 195(2) for deduction at
appropriate rates and act accordingly.

 

d)  If the payer believes that a part of
the payment is income chargeable to tax, and does not make an application u/s.
195(2), he will have to deduct tax from the entire payment.

 

e)  If the payer believes that the entire
payment or a part of it is income chargeable to tax and fails to deduct tax at
source, he will face all the consequences under the Act. The consequences can
be the raising of demand u/s.201, disallowance u/s. 40(a)(i), penalty,
prosecution, etc.

 

f)   If the payee wants to receive the
payment without deduction of tax, he can apply for a certificate to that effect
u/s. 195(3) and if he gets the certificate, no one is adversely affected.

g)  If the payee fails to get the
certificate, he will have to receive payment net of tax.

 

5.     Refund
of Tax withheld under section 195

 

A very important and practical
issue arises as to whether it is possible to obtain refund of tax withheld and
paid u/s. 195.

 

5.1     Circular No. 7/2007 dated 23-10-07 and
Circular No. 7/2011 dated 27-9-2011 prescribe various situations and conditions
under which refund can be obtained.

 

Conditions to be satisfied for
refund:

 

–   Contract is cancelled and no
remittance is made to the NR

 

–   Remittance is duly made to the NR, but the
contract is cancelled and the remitted amount has been returned to the
payee

 

–   Contract is cancelled after partial
execution and no remittance is made to the NR for the non-executed part;

 

–   Contract is cancelled after partial execution
and remittance related to non-executed part made to the NR has been returned
to the payee or no remittance is made but tax was deducted and deposited
when the amount was credited to the account of the NR;

 

–   Remitted amount gets exempted from tax
either by amendment in law or by notification

 

–   An order is passed u/s. 154 or 248 or 264
reducing the TDS liability of the payee;

 

–   Deduction of tax twice by mistake from
the same income;

 

–   Payment of tax on account of grossing up
which was not required

 

–   Payment of tax at a higher rate under
the domestic law while a lower rate is prescribed in DTAA.

 

5.2     In the
following cases it has been held that pursuant to favorable appellate order
whether u/s. 248 or otherwise, refund of TDS has to be granted:

 

– Telco vs.
DCIT [2005] 92 ITD 111 (Mum);

– Samcor Glass
Ltd. vs. ACIT [2005] 94 ITD 202 (Del);

– Kotak
Mahindra Primus Ltd. vs. DDIT TDS [2007] 105 TTJ 578 (Mum).

 

5.3     In
the case of Tata Chemicals Ltd. [2014] 363 ITR 658 (SC), the apex
court has held that an assessee is entitled to interest on refund of excess
deduction or erroneous deduction of tax at source u/s. 195.

 

Pursuant to the aforementioned
decision of the SC, CBDT has issued Circular 11/2016 dated 26-4-16 and mentioned
that, ‘In view of the above judgment of the Apex Court it is settled that if a
resident deductor is entitled for the refund of tax deposited under section 195
of the Act, then it has to be refunded with interest under section 244A of the
Act, from the date of payment of such tax.’

 



6.     Consequences
of non/short deduction/ reporting failures

 

6.1     The consequences of non-deduction, short
deduction as well as failure to report transactions have been summarised in the
Chart 1.


 

6.2     Disallowance
u/s. 40(a)(i) or section 58(1)(a)(ii)

 

A question often arises as to if
tax is deducted u/s. 195 though at incorrect rate, whether the disallowance
u/s. 40(a)(i) or section 58(1)(a)(ii) can be made.

 

In the following cases a favorable
view has been taken and it has been held that there should be no disallowance
if tax is deducted though at incorrect rate:

 

–   Apollo Tyres
Ltd. vs. DCIT 35 taxmann.com 593 (Cochin)

–   UE Trade
Corpn. (India) Ltd. vs. DCIT 28 taxmann.com 77 (Del)

–  ITO vs.
Premier Medical Supplies & Stores 25 taxmann.com 171 (Kol)

–  DCIT vs.
Chandabhoy & Jassobhoy 17 taxmann.com 158 (Mum)

–   CIT vs. S.
K. Tekriwal [2014] 46 taxmann.com 444 (Calcutta).

However, in the case of CIT vs.
Beekaylon Synthetics Ltd. ITA No. 6506/M/08 (Mum) it has been held that in
such case there would be proportionate disallowance.

 

6.3     An issue arises for consideration is that
if the Indian company has not deducted tax at source u/s. 195, can the
Department proceed to recover the tax from both the Indian party as well as
foreign party?

 

In this regard, explanation to
section 191 provides as follows:

 

“Explanation.—For the removal of
doubts, it is hereby declared that if any person including the principal
officer of a company,—

 

(a)     who
is required to deduct any sum in accordance with the provisions of this Act; or

 

(b)     referred
to in sub-section (1A) of section 192, being an employer,

 

does not deduct, or after so
deducting fails to pay, or does not pay, the whole or any part of the tax, as
required by or under this Act, and where the assessee has also failed to pay
such tax directly, then, such person shall, without prejudice to any other
consequences which he may incur, be deemed to be an assessee in default within
the meaning of sub-section (1) of section 201, in respect of such tax.

 

Section 205 provides as follows:

 

“Bar against direct demand on
assessee.

205. Where tax is deductible
at the source under the foregoing provisions of this Chapter, the assessee
shall not be called upon to pay the tax himself to the extent to which tax
has been deducted from that income.”

A conjoint reading of the
Explanation to section 191 read with section 205 suggest that the department
cannot proceed to recover the tax from both the Indian party as well as foreign
party.

 

7.     Tax
Residency Certificate and Implications of 206AA

 

7.1    Tax Residency
Certificate – Section 90(4)

 

–  Finance Act,
2012 has introduced sub-section (4) to section 90 w.e.f. 1-4-2013 to provide
that a non-resident will not be entitled to claim benefits under the Treaty
unless he obtains a tax residency certificate from the Government of his
residence country/territory certifying that he is a tax resident of that
country.

 

–  The
requirement applies to all Non-residents, whether Individuals, Companies, LLPs
etc., irrespective of the quantum of relief to be obtained.

 

–   Furnishing
TRC is a mandatory requirement.

 

–  Rule 21AB(1) mandates submission of following information
in Form 10F:

 

i.   Status (individual, company, etc) of the
assessee;

 

ii.   Nationality or country or specified territory
of incorporation or registration;

 

iii.  Assessee’s tax identification number in the
country or specified territory of residence and in case there is no such
number, then, a unique number on the basis of which the person is identified by
the Government of the country or the specified territory of which the assessee
claims to be a resident;

 

iv.  Period for which the residential status, as
mentioned in the certificate referred to in sub-section (4) of section 90 or
sub-section (4) of section 90A, is applicable; and

 

v.  Address of the assessee in the country or
specified territory outside India, during the period for which the certificate,
as mentioned in (iv) above, is applicable.

 

–   Declaration
not required, if TRC contains above particulars.

 

7.2    Skaps Industries India
(P.) Ltd. vs. ITO [2018] 94 taxmann.com 448 (Ahmedabad – Trib.)

 

This is an important decision in
the context of mandatory requirement of TRC u/s. 90(4). The ITAT after very
extensive discussion, held and observed as follows:

 

(i)      The
ITAT states that as per the provisions of section 90(2) of the Act, the
provisions of the Act shall apply only to the extent they are more beneficial
to that the assessee and the same was often referred to as “treaty override”

.

(ii)      The ITAT also observed that the provisions of section 90(4) do
not start with a non-obstante clause vis-à-vis section 90(2) of the Act. In the
absence of such non-obstante clause, the ITAT has held that section 90(4)
cannot be construed as limitation to the tax treaty superiority as stipulated
in section 90(2) of the Act. Accordingly, the Tribunal has held that even in
absence of a valid TRC, provisions of section 90(4) could not be invoked to
deny tax treaty benefits.

 

(iii)     The Tribunal has, nevertheless, emphasised that though the
requirement to furnish TRC is not mandatory, the US Co. had to establish that
it was a USA tax resident. The onus was on the assessee to give sufficient
and reasonable evidence to satisfy the requirements of Article 4(1) of the tax
treaty, particularly when the same was called into question.

 

(iv)     This decision lays down a very important proposition that that
the tax treaty benefits cannot be denied merely on the basis of
non-availability of TRC. Further it also lays down that, when a non-resident
assessee has substantiated its residential status by way of sufficient and
reasonable documentary evidence, the requirement of furnishing TRC would be
persuasive and not mandatory.

 

 

8.     Section
206AA Requirement to furnish PAN

 

8.1     Section 206AA provides as follows:

 

“206AA (1) Notwithstanding
anything contained in any other provisions of this Act, any person
entitled to receive any sum or income or amount, on which tax is deductible
under Chapter XVIIB (hereafter referred to as deductee) shall furnish his
Permanent Account Number to the person responsible for deducting such tax
(hereafter referred to as deductor), failing which tax shall be deducted at the
higher of the following rates, namely:-

 

i.   at the rate specified in the relevant provision
of this Act; or

 

ii.  at the rate or rates in force; or

 

iii.  at the rate of twenty per cent. ……….”

8.2     Section 206AA is very significant in the
context of TDS from payments to non-residents. It is pertinent to note that if
no tax deductible at source in view of the applicable provisions of the Act or
DTAA, provisions of section 206AA would not apply. There are various issues and
aspect relating to section 206AA are dealt with below.

 

8.3    Whether DTAA prevails over section 206AA

 

A very important question arises as
to whether section 206AA override provisions of section 90(2) and in cases of
payments made to non-residents, assessee can correctly apply rate of tax
prescribed under DTAAs and not as per section 206AA because provisions of DTAAs
are more beneficial.

 

Various benches of ITAT and Delhi
High Court have held that section 206AA does not override section 90(2) of the
Act and accordingly held that lower TDS as per favourable DTAA provisions is
applicable and not higher rate
u/s. 206AA. Some of the favourable decisions are as follows:

 

–   DDIT vs. Serum
Institute of India Ltd. [2015] 68 SOT 254 (Pune)

–   DCIT vs. Infosys BPO
Ltd. [2015] 154 ITD 816 (Bang.)

–   Emmsons International
Ltd. vs. DCIT [2018] 93 taxmann.com 487 (Delhi – Trib.)

–   Danisco India (P.) Ltd.
vs. UoI [2018] 90 taxmann.com 295 (Delhi)

–   Nagarjuna Fertilizers
& Chemicals Ltd. vs.  ACIT [2017] 78
taxmann.com 264 (Hyderabad-Trib.) (SB)

It is
pertinent to note that Article 51(c) of the Constitution states as follows:
“State shall endeavor to foster respect for international law and treaty
obligations in the dealings of organised peoples with one another; and
encourage settlement of international disputes by arbitration.”

 

The above decisions are in line
with the aforementioned constitutional mandate and spirit. Thus, in case
provisions of a DTAA is applicable, TDS would be at a lower rate as per the
DTAA even if non-resident deductee fails to furnish PAN.

 

8.4    Applicability of
surcharge or education cess on maximum rate of 20% as per section 206AA

 

It is pertinent to note that the
relevant clauses of the Finance Acts do not include section 206AA in their
ambit for the purpose of levy of surcharge or education cess.

 

The ITAT in the case of Computer
Sciences Corporation India (P.) Ltd. vs. ITO (IT) [2017] 77 taxmann.com 306
(Delhi-Trib.) after considering various aspects, held that there no
surcharge and education cess would be leviable on the rate of 20% prescribed
u/s. 206(1)(iii).

 

8.5    Whether it is
applicable to those who are exempt from obtaining PAN?

 

a)  Section 139A(8)(d) provides
that the Board may make rules providing for class or classes of persons to whom
the provisions of section 139A shall not apply. Rule 114C (1) (c) (prior to its
substitution wef 1-1-2016) provided that the provisions of section 139A regarding
allotment PAN shall not apply to the non-residents referred to in section
2(30). Section 272B provides for a penalty for failure to comply with the
provisions of section 139A of Rs. 10,000/-.

 

b)  In the case of Smt. A. Kowsalya Bai vs UoI
22 Taxmann.com 157 (Kar), the Karnataka High Court held that the assessees
having income below the taxable limit were not required to obtain Permanent
Account Numbers as per section 139A of the Act and still the provisions of
section 206AA were invoked to deduct tax at higher rate from the amount of
interest income paid to them as a result of their failure to furnish the
Permanent Account Numbers to the payers/deductors. Taking note of this
contradiction between the provisions of sections 139A and 206AA, Hon’ble
Karnataka High Court read down the overriding provisions of section 206AA and
made them inapplicable to the persons, who were not even required to obtain the
Permanent Account Numbers by virtue of section 139A.

 

c)  In this regard, the Special bench of the
ITAT in the case of Nagarjuna Fertilizers & Chemicals Ltd. vs ACIT
[2017] 78 taxmann.com 264 (Hyderabad-Trib.) (SB) held that

 

“26. Although
the facts involved in the present case are slightly different, inasmuch as, the
non-resident payees in the present case were having taxable income in India,
the facts remain to be seen is that they were not obliged to obtain the
Permanent Account Numbers in view of section 139A(8) read with Rule 114C. There
is thus a clear contradiction between section 206AA and section 139A(8) read
with Rule 114C, as was prevailed in the case of Smt. A. Kowsalya Bai (supra)
and by applying the analogy of the said decision, we find merit in the
contention raised on behalf of the assessee that the provisions of section
206AA are required to be read down so as to make it inapplicable in the cases
of concerned non-residents payees who were not under an obligation to obtain
the Permanent Account Numbers.”

 

d)    It is pertinent to note that Rule 114B and
114C have been substituted wef 1-1-16 and the rule relating to non-application
of provisions of section 139A regarding allotment PAN to the non-residents
referred to in section 2(30), is no more there except as provided in clause
(ii) of 3rd proviso to substituted rule 114B(1).

 

8.6     Whether TDS deducted at higher rate on
account of section 206AA can be claimed as a refund by filing a return u/s. 139
by the non-resident?

 

Yes. A non-resident can claim
refund of TDS deducted at higher rate on account of section 206AA by filing
appropriate return of income after obtaining PAN.

 

8.7    Section 195A vis-à-vis
Section 206AA

 

a)  
A very significant question arises in the context of application of
section 195A read with section 206AA, whether section 195A will apply in cases
where section 206AA is made applicable

 

There are different views possible
in this regard which are as follows:

 

i.   View 1 – No grossing up required.

Neither
section 195A makes reference to section 206AA, nor section 206AA provides for
grossing up.



ii.   View 2 – Grossing up required only
vis-à-vis clause (ii) of section 206AA(1), since section 195A refers to
grossing up is required where TDS is at the rates in force.

 

iii.  View 3 – Grossing up is required in all
the three clauses (i) to (iii) of section 206AA(1).

 

In our view,
View 2 seems to be a better view.

 

b)  Manner of grossing up

In cases
where rate in force is 10%* – Whether grossing up should be on 10% being rate
in force or on 20%?

The
different possible scenarios could be as under:

 

Particulars

Option 1

Option 2

Option 3

Option 4

Net of Tax Payment to non- resident

100

100

100

100

(+) Grossing up

11.11

11.11

21.11

25

Total

111.11

111.11

121.11

125

(-) TDS

11.11

22.22

21.11

25

Payment to be made to the non-resident

100

88.89

100

100

 

* Assuming a treaty rate of 10%

 

In Bosch Ltd. vs. ITO IT
[2012] 28 taxmann.com 228 (Bang) it was held that higher rate of
deduction at 20% under section 206AA is not applicable for tax grossing-up u/s.
195A, if TDS is borne by the Indian payer.

 

Higher TDS rate u/s. 206AA is
applicable only where non-resident recipient has income chargeable to
tax in India and does not furnish PAN.

 

In this regard, the ITAT observed
as follows:

 

“22. As regards
the grossing up u/s 195A of the Income-tax Act is concerned, we find that the
provision reads
as under:

 

“In a case other than that
referred to in subsection (1A) of sec. 192, where under an agreement] or other
arrangement, the tax chargeable on any income referred to in the foregoing
provisions of this Chapter is to be borne by the person by whom the income is
payable, then, for the purposes of deduction of tax under those provisions such
income shall be increased to such amount as would, after deduction of tax
thereon at the rates in force for the financial year in which such income is
payable, be equal to the net amount payable under such agreement or
arrangement.

 

23. Thus, it
can be seen that the income shall be increased to such amount as would after
deduction of tax thereto at the rate in force for the financial year in which
such income is payable, be equal to the net amount payable under such agreement
or arrangement. A literal reading of sec. implies that the income should be
increased at the rates in force for the financial years and not the rates at
which the tax is to be withheld by the assessee. The Hon’ble Apex Court in the
case of GE India Technology Center (P.) Ltd. (cited Supra) has held that
the meaning and effect has to be given to the expression used in the section
and while interpreting a section, one has to give weightage to every word used
in that section. In view of the same, we are of the opinion that the
grossing up of the amount is to be done at the rates in force for the financial
year in which such income is payable and not at 20% as specified u/s 206AA of
the Act.”

 

8.8    Section 206AA and Rule
37BC

 

a)   As per section 206AA(7), the section shall
not apply to a non-resident/foreign company, in respect of:

 

–  payment of
interest on long-term bonds referred to in section 194LC

 

–  any other
payment subject to such conditions as may be prescribed.

 

b)  Rule 37BC inserted wef 24-6-2016

 

Rule 37BC provides that section
206AA shall not apply on the following payments to non-resident deductees who
do not have PAN in India, subject to deductee furnishing the specified details
and documents to the deductor:

–       Interest;

–       Royalty;

–       Fees
for Technical Services; and

–       Payment
on transfer of any capital asset.

 

c)   In respect of the above, the deductee shall
be required to furnish the following to the deductor:

 

–  Name, e-mail
id, contact number

 

–  Address in
the country outside India of which the deductee is a resident

 

–   A certificate of his being resident from the Government of that country
if the law provides for issuance of such certificate

 

–  Tax
Identification Number of the deductee/ a unique number on the basis of which
the deductee is identified by the Government.

 

d)  
The interplay between provisions of a DTAA, section 206AA and section
90(4), in connection with TDS under section 195, is explained in the diagram
below.

 

9.     Conclusion

In this part we have dealt with
some of the important procedural and other aspects relating to the TDS from
payments to non-residents. In the third and concluding part, we will deal with
some remaining aspects relating to TDS from payments to non-residents.

Transfer Pricing Documentation – Country by Country Reporting – An Overview

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To
address the problems of Base
Erosion and Profit Shifting [BEPS] in the context of international taxation of
MNE Groups, the OECD had in response to the G20 countries adoption of a
15-point Action Plan, released its 15 final reports on the Action Plans in
October 2015.

One
of the most important report is Action 13 – Transfer Pricing Documentation and
Country-by-Country Reporting, which in the process of implementation requires
suitable legislative changes in the domestic law of various countries. In
addition, final report on Action 8-10
Aligning Transfer pricing Outcomes with Value Creation, is equally important in
this regard.

India
has been one of the active members of BEPS initiative and part of international
consensus and accordingly has acted very swiftly in this matter by inserting
section 286 and 271GB and making suitable amendments in section 92D, 271AA
& 273B of the Income-tax Act, 1961 [the Act] by the Finance Act, 2016 which
are effective from 1-4-2017 i.e. AY 2017-18.

The
purpose of this article is to bring awareness amongst the tax payers and their
consultants about the changes which are taking place in this regard in the global
and domestic front.

The
reader would be well advised to study final report on ‘Action 13 –
Transfer Pricing Documentation and Country-by-Country Reporting’ and ‘Guidance on the
Implementation of Country-by-Country Reporting’ issued by OECD in August,
2016, for an in depth study of understanding of the subject.

Synopsis
1. Introduction
2. Objectives of transfer pricing documentation requirements
3. A three-tiered approach to transfer pricing documentation
4. Country-by-Country Reporting Implementation Package
5. Recent Developments in India
6. Conclusion

1.       Introduction

1.1 International tax issues have never been as high on the political agenda as they are today. The integration of national economies and markets has increased substantially in recent years, putting a strain on the international tax rules, which were designed more than a century ago. Weaknesses in the current international taxation rules create opportunities for BEPS, requiring bold moves by policy makers to restore confidence in the system and ensure that profits are taxed where economic activities take place and value is created.

Following the release of the report Addressing Base Erosion and Profit Shifting in February 2013, OECD and G20 countries adopted a 15-point Action Plan to address BEPS in September 2013. The Action Plan identified 15 actions along three key pillars:

a) introducing coherence in the domestic rules that affect cross-border activities,

b) reinforcing substance requirements in the existing international standards, and

c) improving transparency as well as certainty.

1.2 So far, prior to the release of reports on Action 8-10 Aligning Transfer pricing Outcomes with Value Creation and Action 13 – TP Documentation and Country-by-Country, the OECD TP Guidelines for MNEs and Tax Administrations issued in July 2010, has been a major source of guidance on the TP issues to the MNEs and Tax Administrations.

1.3 Significant changes are proposed in OECD TP Guidelines, 2010, by Action 8-10 Aligning Transfer pricing Outcomes with Value Creation and Action 13 – TP Documentation and Country-by-Country Reporting, the summarised details of which are as follows:

Chapter of OECD TP

Description

I

Deletion of Section D of Chapter I in entirety and
replacement by new para 1.33 to 1.173 respect of Guidance for Applying Arm’s
Length Principle

II

Additions to Chapter II of the TP Guidelines by addition
of new para 2.16A to 2.16E in respect of Commodity Transactions

Elaboration of Scope of revisions of the guidance on the
transactional profit split method

Additional Guidance in Chapter II of the TP Guidelines
resulting from the Revisions of Chapter VI by insertion of para 2.9A

V

Deletion of text of Chapter V of the TP Guidelines in entirety
and replacement by new para 1 to 62 and Annexes I to IV in respect of TP
Documentation and Country-by-Country Reporting

VI

Deletion of current provisions of Chapter VI in entirety
and replacement by new para 6.1 to 6.212 in respect of intangibles

Deletion of current provisions of Annex to Chapter VI in
entirety and replacement by new Examples 1 to 29 in para 1 to 111 in respect
of intangibles

VII

Deletion of current provisions of Chapter VII in entirety
and replacement by new para 7.1 to 7.65 in respect of Low value-adding
Intra-Group Services

VIII

Deletion of current provisions of Chapter VIII in entirety
and replacement by new para 8.1 to 8.53 in respect of Cost Contribution
Arrangements

Insertion of Annex to Chapter VIII – Examples 1 to 5, to
illustrate the guidance on cost contribution arrangements

 

It is expected that a new version of OECD TP Guidelines for MNEs and Tax Administrations would be issued by
OED before the end of the year 2016, incorporating the changes suggested in the
BEPS Reports on Action 8-10 Aligning Transfer pricing Outcomes with Value
Creation and Action 13 – TP Documentation and Country-by-Country Reporting.

1.4  
Implementation
therefore becomes key at this stage. The BEPS package is designed to be implemented
via changes in domestic law and practices, and via treaty provisions, with negotiations
for a multilateral instrument are under way and expected to be finalised in 2016.
OECD and G20 countries have also agreed to continue to work together to ensure a
consistent and co-ordinated implementation of the BEPS recommendations. Globalisation
requires that global solutions and a global dialogue be established which go beyond
OECD and G20 countries. To further this objective, in 2016 OECD and G20 countries
are preparing an inclusive framework for monitoring, with all interested countries
participating on an equal footing.

A better understanding
of how the BEPS recommendations are implemented in practice could reduce misunderstandings
and disputes between governments. Greater focus on implementation and tax administration
should therefore be mutually beneficial to governments and business. Proposed improvements
to data and analysis will help support ongoing evaluation of the quantitative impact
of BEPS, as well as evaluating the impact of the countermeasures developed under
the BEPS Project.

BEPS Action 13 report
contains revised standards for TP documentation and a template for Country-by-Country
[CbC] Reporting of income, taxes paid and certain measures of economic activity.

1.5 Action
13 of the Action Plan on Base Erosion and Profit Shifting requires the development of “rules
regarding TP documentation to enhance transparency for tax administration, taking
into consideration the compliance costs for business. The rules to be developed
will include a requirement that MNEs provide all relevant governments with needed
information on their global allocation of the income, economic activity and taxes
paid among countries according to a common template”. In
response to this requirement, a three-tiered standardised approach to TP
documentation has been developed.

First, the
guidance on TP documentation requires MNEs to provide tax administrations with high-level
information regarding their global business operations and TP policies in a “master file” that is to be available to
all relevant tax administrations.

Second, it
requires that detailed transactional TP documentation be provided in a “local file” specific to each country, identifying
material related party transactions, the amounts involved in those transactions,
and the company’s analysis of the transfer pricing determinations they have made
with regard to those transactions.

Third,
large MNEs are required to file a CbC Report
that will provide annually and for each tax jurisdiction in which they do business
the amount of revenue, profit before income tax and income tax paid and accrued.
It also requires MNEs to report their number of employees, stated capital, retained
earnings and tangible assets in each tax jurisdiction. Finally, it requires MNEs
to identify each entity within the group doing business in a particular tax jurisdiction
and to provide an indication of the business activities each entity engages in.

Taken together, these
three documents (master file, local file and CbC Report) will require taxpayers
to articulate consistent transfer pricing positions and will provide tax administrations
with useful information to assess TP risks, make determinations about where audit
resources can most effectively be deployed, and, in the event audits are called
for, provide information to commence and target audit enquiries.

1.6  This
information should make it easier for tax administrations to identify whether companies
have engaged in transfer pricing and other practices that have the effect of artificially
shifting substantial amounts of income into tax-advantaged environments. The countries
participating in the BEPS project agree that these new reporting provisions, and
the transparency they will encourage, will contribute to the objective of understanding,
controlling, and tackling BEPS behaviours.

The specific content
of the various documents reflects an effort to balance tax administration information
needs, concerns about inappropriate use of the information, and the compliance costs
and burdens imposed on business. Some countries would strike that balance in a different
way by requiring reporting in the CbC Report of additional transactional data (beyond
that available in the master file and local file for transactions of entities operating
in their jurisdictions) regarding related party interest payments, royalty payments
and especially related party service fees. Countries expressing this view are primarily
those from emerging markets (Argentina, Brazil, People’s Republic of China, Colombia,
India, Mexico, South Africa, and Turkey) who state they need such information to
perform risk assessment and who find it challenging to obtain information on the
global operations of an MNE group headquartered elsewhere. Other countries expressed
support for the way in which the balance has been struck in BEPS Action 13
report. Taking all these views into account, it is mandated that countries participating
in the BEPS project will carefully review the implementation of these new standards
and will reassess no later than the end of 2020 whether modifications to the content
of these reports should be made to require reporting of additional or different
data.

1.7  
Consistent and effective implementation of the TP documentation standards
and in particular of the CbC Report is essential. Therefore, countries participating
in the OECD/G20 BEPS Project agreed on the core elements of the implementation of
TP documentation and CbC Reporting. This agreement calls for the master file and
the local file to be delivered by MNEs directly to local tax administrations. CbC
Reports should be filed in the jurisdiction of tax residence of the ultimate parent
entity and shared between jurisdictions through automatic exchange of information,
pursuant to government-to-government mechanisms such as the multilateral Convention
on Mutual Administrative Assistance in Tax Matters, bilateral tax treaties or tax
information exchange agreements (TIEAs). In limited circumstances, secondary mechanisms,
including local filing can be used as a backup.

These new CbC Reporting
requirements are to be implemented for fiscal years beginning on or after 1 January
2016 and apply, subject to the 2020 review, to MNEs with annual consolidated group
revenue equal to or exceeding EUR 750 million. It is acknowledged that some jurisdictions
may need time to follow their particular domestic legislative process in order to
make necessary adjustments to their local law.

1.8 In
order to facilitate the implementation of the new reporting standards, an implementation
package has been developed consisting of model legislation which could be used by
countries to require MNE groups to file the CbC Report and competent authority agreements
that are to be used to facilitate implementation of the exchange of those reports
among tax administrations. As a next step, it is intended that an XML Schema and
a related User Guide will be developed with a view to accommodating the electronic
exchange of CbC Reports.

It is recognised that
the need for more effective dispute resolution may increase as a result of the enhanced
risk assessment capability following the adoption and implementation of a CbC Reporting
requirement. This need has been addressed when designing government-to-government
mechanisms to be used to facilitate the automatic exchange of CbC Reports.

Jurisdictions endeavour
to introduce, as necessary, domestic legislation in a timely manner. They are also
encouraged to expand the coverage of their international agreements for exchange
of information. Mechanisms will be developed to monitor jurisdictions’ compliance
with their commitments and to monitor the effectiveness of the filing and dissemination
mechanisms. The outcomes of this monitoring will be taken into consideration in
the 2020 review.

2.       Objectives
of transfer pricing documentation requirements

2.1 Three objectives of TP documentation are:
1. to ensure that taxpayers give appropriate consideration to TP requirements in establishing prices and other conditions for transactions between associated enterprises and in reporting the income derived from such transactions in their tax returns;

2. to provide tax administrations with the information necessary to conduct an informed TP risk assessment; and

3. to provide tax administrations with useful information to employ in conducting an appropriately thorough audit of the TP practices of entities subject to tax in their jurisdiction, although it may be necessary to supplement the documentation with additional information as the audit progresses.

2.2 Each of these objectives should be considered in designing appropriate domestic TP documentation requirements. It is important that taxpayers be required to carefully evaluate, at or before the time of filing a tax return, their own compliance with the applicable TP rules. It is also important that tax administrations be able to access the information they need to conduct a TP risk assessment to make an informed decision about whether to perform an audit. In addition, it is important that tax administrations be able to access or demand, on a timely basis, all additional information necessary to conduct a comprehensive audit once the decision to conduct such an audit is made.

3.       A
three-tiered approach to transfer pricing documentation

3.1   This approach to TP
documentation will provide tax administrations with relevant and reliable information
to perform an efficient and robust TP risk assessment analysis. It will also provide
a platform on which the information necessary for an audit can be developed and
provide taxpayers with a means and an incentive to meaningfully consider and describe
their compliance with the arm’s length principle in material transactions.

    
(i)           
Master file

The master file should
provide an overview of the MNE group business, including the nature of its global
business operations, its overall TP policies, and its global allocation of income
and economic activity in order to assist tax administrations in evaluating the presence
of significant TP risk. In general, the master file is intended to provide a high-level
overview in order to place the MNE group’s TP practices in their global economic,
legal, financial and tax context. It is not intended to require exhaustive listings
of minutiae (e.g. a listing of every patent owned by members of the MNE group) as
this would be both unnecessarily burdensome and inconsistent with the objectives
of the master file. In producing the master file, including lists of important agreements,
intangibles and transactions, taxpayers should use prudent business judgment in
determining the appropriate level of detail for the information supplied, keeping
in mind the objective of the master file to provide tax administrations a high-level
overview of the MNE’s global operations and policies. When the requirements of the
master file can be fully satisfied by specific cross-references to other existing
documents, such cross references, together with copies of the relevant documents,
should be deemed to satisfy the relevant requirement. For purposes of producing
the master file, information is considered important if its omission would affect
the reliability of the TP outcomes.

The information required
in the master file provides a “blueprint” of the MNE group and contains relevant
information that can be grouped in five categories:

            a)   The
MNE group’s organisational structure;

            b)  A
description of the MNE’s business or businesses;

            c)  The
MNE’s intangibles;

            d)  The
MNE’s intercompany financial activities; and

            e)  The
MNE’s financial and tax positions.

Taxpayers should present
the information in the master file for the MNE as a whole. However, organisation
of the information presented by line of business is permitted where well justified
by the facts, e.g. where the structure of the MNE group is such that some significant
business lines operate largely independently or are recently acquired. Where line
of business presentation is used, care should be taken to assure that centralised
group functions and transactions between business lines are properly described in
the master file. Even where line of business presentation is selected, the entire
master file consisting of all business lines should be available to each country
in order to assure that an appropriate overview of the MNE group’s global business
is provided.

  
(ii)           
Local file

In contrast to the master
file, which provides a high-level overview, the local file provides more detailed
information relating to specific intercompany transactions. The information required
in the local file supplements the master file and helps to meet the objective of
assuring that the taxpayer has complied with the arm’s length principle in its material
TP positions affecting a specific jurisdiction. The local file focuses on information
relevant to the TP analysis related to transactions taking place between a local
country affiliate and associated enterprises in different countries and which are
material in the context of the local country’s tax system. Such information would
include relevant financial information regarding those specific transactions, a
comparability analysis, and the selection and application of the most appropriate
TP method. Where a requirement of the local file can be fully satisfied by a specific
cross-reference to information contained in the master file, such a cross-reference
should suffice.

 (iii)           
Country-by-Country Report

The CbC Report requires
aggregate tax jurisdiction-wide information relating to the global allocation of
the income, the taxes paid, and certain indicators of the location of economic activity
among tax jurisdictions in which the MNE group operates. The report also requires
a listing of all the Constituent Entities for which financial information is reported,
including the tax jurisdiction of incorporation, where different from the tax jurisdiction
of residence, as well as the nature of the main business activities carried out
by that Constituent Entity.

3.2  
The
CbC Report will be helpful for high-level TP risk assessment purposes. It may also
be used by tax administrations in evaluating other BEPS related risks and where
appropriate for economic and statistical analysis. However, the information in the
CbC Report should not be used as a substitute for a detailed TP analysis of individual
transactions and prices based on a full functional analysis and a full comparability
analysis. The information in the Country-by- Country Report on its own does not
constitute conclusive evidence that transfer prices are or are not appropriate.
It should not be used by tax administrations
to propose TP adjustments based on a global formulary apportionment of income.

4.       Country-by-Country
Reporting Implementation Package

4.1   Countries participating in the
OECD/G20 BEPS Project have therefore developed an implementation package for
government-to-government exchange of CbC Reports.

More specifically:

Model legislation requiring the ultimate parent entity of an MNE group to file the CbC Report in its jurisdiction of residence has been developed. Jurisdictions will be able to adapt this model legislation to their own legal systems, where changes to current legislation are required. Key elements of secondary mechanisms have also been developed.

Implementing arrangements for the automatic exchange of the CbC Reports under international agreements have been developed, incorporating the suggested conditions. Such implementing arrangements include competent authority agreements (“CAAs”) based on existing international agreements (the Multilateral Convention on Mutual Administrative Assistance in Tax Matters, bilateral tax treaties and TIEAs) and inspired by the existing models developed by the OECD working with G20 countries for the automatic exchange of financial account information.

4.2  
Participating
jurisdictions endeavour to introduce as necessary domestic legislation in a
timely manner. They are also encouraged to expand the coverage of their
international agreements for exchange of information. The implementation of the
package will be monitored on an ongoing basis. The outcomes of this monitoring
will be taken into consideration in the 2020 review.

5.       Recent Developments in India –
Amendments by the Finance Act, 2016

5.1   The Finance
Act, 2016 has inserted section 286 relating to furnishing of report in respect
of international group by every parent entity or the alternate reporting entity
resident in India, on or before the due date specified u/s 139(1) of the
income-tax act, 1961, in the Form and manner, yet to be prescribed. This
section is effective from 1-4-17 i.e. assessment year 2017-18 and subsequent
years.

Further, new section 271GB has
been inserted wef 1-4-17 i.e. assessment year 2017-18 and subsequent years
relating to penalty for failure to furnish report or for furnishing inaccurate
report u/s 286.

In addition, section 271AA of the
Act relating to penalty for failure to keep and maintain information and document
etc. has been amended to provide that if any
person being constituent entity of an international group referred to in
section 286 fails to furnish the information and document in accordance with
provisions of section 92D, then, the prescribed authority may direct that such
person shall be liable to pay a penalty of Rs. 5,00,000/-.

5.2   Background as
explained in Explanatory memorandum explaining provisions of the Finance Bill,
2016, is as follows:

“BEPS action plan –
Country-By-Country Report and Master file

Sections
92 to 92F of the Act contain provisions relating to transfer pricing regime.
Under provision of section 92D, there is requirement for maintenance of
prescribed information and document relating to the international transaction
and specified domestic transaction.

The OECD report on Action 13 of
BEPS Action plan provides for revised standards for transfer pricing
documentation and
a template for country-by-country reporting of income, earnings, taxes paid and
certain measure of economic activity. India
has been one of the active members of BEPS initiative and part of international
consensus. It is recommended in the BEPS report that the countries should
adopt a standardised approach to transfer pricing documentation. A three-tiered
structure has been mandated consisting of:-

(i)     a master file containing
standardised information relevant for all multinational enterprises (MNE) group
members;

(ii)    a local file referring
specifically to material transactions of the local taxpayer; and

(iii)   a country-by-country report
containing certain information relating to the global allocation of the MNE’s
income and taxes paid together with certain indicators of the location of
economic activity within the MNE group.

The
report mentions that taken together, these three documents (country-by-country
report, master file and local file) will require taxpayers to articulate
consistent transfer pricing positions and will provide tax administrations with
useful information to assess transfer pricing risks. It will facilitate tax administrations
to make determinations about where their resources can most effectively be
deployed, and, in the event audits are called for, provide information to
commence and target audit enquiries.

The
country-by-country report requires multinational enterprises (MNEs) to report
annually and for each tax jurisdiction in which they do business; the amount of
revenue, profit before income tax and income tax paid and accrued. It also
requires MNEs to report their total employment, capital, accumulated earnings
and tangible assets in each tax jurisdiction. Finally, it requires MNEs to
identify each entity within the group doing business in a particular tax
jurisdiction and to provide an indication of the business activities each
entity engages in. The Country-by-Country (CbC) report has to be submitted by
parent entity of an international group to the prescribed authority in its
country of residence. This report is to be based on consolidated financial
statement of the group.

The
master file is intended to provide an overview of the MNE groups business,
including the nature of its global business operations, its overall transfer
pricing policies, and its global allocation of income and economic activity in
order to assist tax administrations in evaluating the presence of significant
transfer pricing risk. In general, the master file is intended to provide a
high-level overview in order to place the MNE group’s transfer pricing
practices in their global economic, legal, financial and tax context. The
master file shall contain information which may not be restricted to
transaction undertaken by a particular entity situated in particular country.
In that aspect, information in master file would be more comprehensive than the
existing regular transfer pricing documentation. The master file shall be
furnished by each entity to the tax authority of the country in which it
operates.

In order to implement the
international consensus, it is proposed to provide a specific reporting regime
in respect of CbC reporting and also the master file. It is proposed to include
essential elements in the Act while remaining aspects can be detailed in rules.
The elements relating to CbC
reporting requirement and matters related to it proposed to be included through
amendment of the Act are:

          (i) the
reporting provision shall apply in respect of an international group havingconsolidated revenue above a threshold to be prescribed.

            (ii) the
parent entity of an international group, if it is resident in India shall berequired to furnish the report in respect of the group to the prescribed
authority on or before the due date of furnishing of return of income for the
Assessment Year relevant to the Financial Year (previous year) for which the
report is being furnished;

               (iii)  the
parent entity shall be an entity which is required to prepare consolidated
financial statement under the applicable laws or would have been required to
prepare such a statement, had equity share of any entity of the group been
listed on a recognized stock exchange in India;

              
(iv) 
every
constituent entity in India, of an international group having parent entity
that is not resident in India, shall provide information regarding the country
or territory of residence of the parent of the international group to which it
belongs. This information shall be furnished to the prescribed authority on or
before the prescribed date;

               
(v) the
report shall be furnished in prescribed manner and in the prescribed form and
would contain aggregate information in respect of revenue, profit & loss
before Income-tax, amount of Income-tax paid and accrued, details of capital,
accumulated earnings, number of employees, tangible assets other than cash or
cash equivalent in respect of each country or territory along with details of
each constituent’s residential status, nature and detail of main business
activity and any other information as may be prescribed. This shall be based on the template provided in the OECD BEPS report on
Action Plan 13;

             
(vi)  an
entity in India belonging to an international group shall be required to furnish
CbC report to the prescribed authority if the parent entity of the group is
resident;-

(a)   in a country with which India does
not have an arrangement for exchange of the CbC report; or

(b)   such country is not exchanging
information with India even though there is an agreement; and

(c)    this fact has been intimated to
the entity by the prescribed authority;

            
(vii)  If
there are more than one entities of the same group in India, then the group can
nominate (under intimation in writing to the prescribed authority) the entity
that shall furnish the report on behalf of the group. This entity would then
furnish the report;

          
(viii) If
an international group, having parent entity which is not resident in India,
had designated an alternate entity for filing its report with the tax jurisdiction
in which the alternate entity is resident, then the entities of such group
operating in India would not be obliged to furnish report if the report can be
obtained under the agreement of exchange of such reports by Indian tax
authorities;

             
(ix) 
The
prescribed authority may call for such document and information from the entity
furnishing the report for the purpose of verifying the accuracy as it may
specify in notice. The entity shall be required to make submission within
thirty days of receipt of notice or further period if extended by the
prescribed authority, but extension shall not be beyond 30 days;

               
(x)  For non-furnishing of the report
by an entity which is obligated to furnish it, a graded penalty structure would
apply:-

(a)   if default is not more than a
month, penalty of Rs. 5000/- per day
applies;

(b)   if default is beyond one month, penalty of Rs. 15000/- per day for the
period exceeding one month applies;

(c)    for any default that continues
even after service of order levying penalty either under (a) or under (b), then
the penalty for any continuing default beyond
the date of service of order shall be @ Rs.
50,000/- per day;

             
(xi)
In case of timely non-submission
of information before prescribed authority when called for, a penalty of Rs.
5,000/- per day applies. Similar to the above, if default continues even
after service of penalty order, then penalty of Rs. 50,000/- per day applies for default beyond date of service of
penalty order;

             
(xii)
If
the entity has provided any inaccurate information in the report and,-

(a)   the entity knows of the inaccuracy
at the time of furnishing the report but does not inform the prescribed
authority; or

(b)   the entity discovers the
inaccuracy after the report is furnished and fails to inform the prescribed
authority and furnish correct report within a period of fifteen days of such
discovery; or

(c)    the entity furnishes inaccurate information or document in response to notice
of the prescribed authority, then penalty
of Rs. 500,000/- applies;

         (xiii)The
entity can offer reasonable cause defence for non-levy of penalties mentioned
above.

The proposed amendment in the Act
in respect of maintenance of master file and furnishing it are: –

(i)   
the
entities being constituent of an international group shall, in addition to the
information related to the international transactions, also maintain such
information and document as is prescribed in the rules. The rules shall
thereafter prescribe the information and document as mandated for master file
under OECD BEPS Action 13 report;

(ii)  
the
information and document shall also be furnished to the prescribed authority
within such period as may be prescribed and the manner of furnishing may also
be provided for in the rules;

(iii)  for non-furnishing of the
information and document to the prescribed authority, a penalty of Rs. 5 lakh
shall be leviable. However, reasonable cause defence against levy of penalty
shall be available to the entity.

As indicated above, the CbC
reporting requirement for a reporting year does not apply unless the
consolidated revenues of the preceding year of the group, based on consolidated
financial statement, exceeds a threshold to be prescribed. The current international
consensus is for a threshold of € 750 million equivalent in local currency.
This threshold in Indian currency would be equivalent to Rs. 5395 crores (at
current rates). Therefore, CbC reporting for an international group having
Indian parent, for the previous year 2016-17, shall apply only if the
consolidated revenue of the international group in previous year 2015-16
exceeds Rs. 5395 crore (the equivalent would be determinable based on exchange
rate as on the last day of previous year 2015-16). …..”

5.3   Section
286 of the Act relating to furnishing of report in respect of international
group provides for furnishing of a report in respect of an international group,
if the parent entity of the group is resident in India.

Sub-section (1)
provides that constituent entity in India of an international group, not
having a parent entity resident in India shall notify the prescribed authority
regarding the parent entity of the group to which it belongs or an alternate
reporting entity which shall furnish the report on behalf of the group in the
prescribed manner.

Sub-section (2)
provides that the parent entity of an international group, which is
resident in India, shall furnish a report in respect of the international group
on or before due date specified under sub-section (1) of section 139 for
furnishing of return of income of the relevant accounting year.

Sub-section (3)
provides for the details to be contained in the report to be furnished. It,
inter alia, provides that the report shall contain aggregate information
in respect of amount of revenues, profit and loss, taxes accrued and paid,
number of employees, details of constituent entities and the country or
territory in which such entities are resident or located.

Sub-section (4) provides
for furnishing report by entities resident in India and belonging to an
international group not headed by Indian resident entity.

Sub-section (5) provides
for circumstances under which the constituent entities referred to in
sub-section (4) shall not be required to furnish the report.

Sub-section (6) provides that the prescribed
authority may, by issuance of notice for the purpose of verifying the accuracy
of the report furnished by any entity, require submission of information and
document as specified in the notice.

Sub-section (7) provides
that the reporting requirement under this section shall not apply to an
accounting year, if the total consolidated group revenue for the accounting
year preceding it, does not exceed the prescribed threshold.

Sub-section (8) provides
for application of the section in accordance with such guidelines and subject
to such conditions as may be prescribed.

Sub-section (9) of the
proposed new section, inter alia, defines various terms for the purposes
of the new section.

5.4  
The new section at 5 places makes
reference to ‘as may be prescribed’ in respect of form, manner and date of
notification, form and manner of report to be submitted, other information to
be included in the report, threshold limit of total consolidated group revenue
for application of section and other guidelines and conditions for application
of section. However, so far no rules have been prescribed in respect of section
286.

5.5   However, as
mentioned in the Explanatory Memorandum, CbC reporting for an international group having Indian parent, for the
previous year 2016-17, shall apply only if the consolidated revenue of the
international group in previous year 2015-16 exceeds Rs. 5,395 crore (the
equivalent would be determinable based on exchange rate as on the last day of
previous year 2015-16).

6.       Conclusion

6.1  
So
far 44 countries have signed the Multilateral Competent Authority Agreement (MCAA) on CbC
reporting including India.

In addition, on
16 August 2016 OECD has issued further Guidance on the Implementation of
Country-by-Country reporting. This guidance covers the following issues:

               (i)  Transitional
filing options for MNEs (“parent surrogate filing”).

             
(ii) The
application of CbC reporting to investment funds.

              (iii)The
application of CbC reporting to partnerships.

             
(iv) The
impact of currency fluctuations on the agreed EUR 750 million filing threshold.

6.2  
Countries have agreed that implementing CbC
reporting is a key priority in addressing BEPS risks, and the Action 13 Report
recommended that reporting take place with respect to fiscal periods commencing
from 1 January 2016. Swift progress is being made in order to meet this
timeline, including the introduction of domestic legal frameworks and the entry
into competent authority agreements for the international exchange of CbC reports.
MNE Groups are likewise making preparations for CbC reporting, and dialogue
between governments and business is a critical aspect of ensuring that CbC
reporting is implemented consistently across the globe. Consistent
implementation will not only ensure a level playing field, but also provide
certainty for taxpayers and improve the ability of tax administrations to use
CbC reports in their risk assessment work.

[We have extensively relied upon final
report on ‘Action 13 – Transfer Pricing Documentation and
Country-by-Country Reporting’ and ‘Guidance on the Implementation of Country-by-Country
Reporting’ issued by OECD in August, 2016, and the Memorandum
Explaining the Finance Bill, 2016, in preparing the above article giving an
overview of the subject.]

***

Equalization Levy – A step into uncharted territory

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The Finance Act 2016 has levied a new tax called “Equalisation Levy” (EL) Which is levied on the nonresident online service providers who earn from Indian customers but do not pay any taxes in India in absence of Permanent Establishment (PE). The nature of specified services is such that it does not fall within the ambit of royalties of fees for technical services. Compared to them, any Indian company engaged in similar activities would be subject to regular income-tax in India. Therefore, in order to provide a level playing field so as to equalize the incidence of tax, a new levy is imposed on specified online services. This levy is an offshoot of the G-20 Nations’ initiative of the project on Base Erosion and Profits Shifting (BEPS) Action Plan 1, Addressing Tax Challenges of Digital Economy, led by OECD. This article highlights the salient features of the EL and related issues arising therefrom. For succinct understanding the subject, the EL is explained in question-answer format.

1.0 Background
Telecommunication and Information Technology has impacted our lives significantly, commerce being no exception. The ways of doing business and business models have undergone vast and significant changes in the last two decades. E-commerce (the new term used is “Digital Economy”) is indeed an off-shoot of this technological development. 1Digital economy has obviated the necessity of physical presence in the source State for doing business. This has resulted in billions of dollars worth trade in the source States without paying any taxes. Unfortunately tax laws have not kept pace with the technological developments and hence there are gaps or opportunities for tax planning or avoidance. Therefore, the G20 Nations considered the issues arising out of “digital economy” (a term wide enough to cover all sorts of e-commerce transactions) in Action Plan 1 of the BEPS project which was released in October, 2015. However, no consensus emerged on the methodology to tax such digital transactions. The report considered the following three options to address the broader tax challenges of the digital economy:

(i) New Nexus based on Significant Economic Presence
(ii) Withholding tax on digital transactions and
(iii) Equalisation Levy

1.1 Committee on Taxation of E-Commerce
Post BEPS report, the Indian Government set up a Committee on Taxation of E-Commerce with terms of reference to detail the business models for e-commerce, the direct tax issues in regard to e-commerce transactions and a suggested approach to deal with these issues under different business models. The Committee submitted its report in February 2016 and recommended to impose Equalisation Levy (EL) on specified online transactions. The Committee suggested enacting a separate law by introducing a chapter in the Finance Act, 2016 such that it becomes a distinct tax by itself and not in the nature of income- tax. If the EL partakes the character of income-tax, then it would not serve any purpose whatsoever, as tax treaty provisions would override the provisions of the Indian Income-tax Act and unless all the treaties are renegotiated and amended, the levy would be ineffectual. Although the Committee recommended thirteen specified transactions for the levying EL, at present only online advertisement/facility for online advertisement and digital advertising space are brought within the purview of EL.

1.2 Statutory Basis
EL has been imposed vide Chapter VII of the Finance Act, 2016 containing section 163 to section 180. It is a self-contained code which extends to the whole of India except the State of Jammu and Kashmir. It has come into effect from 1st June 2016. Though it is levied under a separate chapter in the Finance Act, and not supposed to be in the nature of income tax, it would be administered by the Income-tax authorities. Many administrative provisions under the Income-tax Act, 1961 (such as appeals, survey, collection and recovery of taxes etc.) are made applicable to EL as well. I n the backdrop of the above information, let us proceed to understand the implications of EL in depth by way of questions and answers.

2.0 What is Equalization Levy (EL) and how it is levied?
Ans: In simple words EL is a tax on gross revenue of non-resident providing specified services to Indian residents subject to certain conditions.

EL is a tax levied at the rate of six per cent on the amount of consideration for any specified services received or receivable by any non-resident person from –

(i) A person resident in India and carrying on business or profession; or
(ii) A non-resident having a PE in India.

Exemptions from EL
(i) A non-resident providing the specified services has a PE in India and such services are effectively connected with such PE;

(In the above case, the profits of the Indian PE of a non-resident will be taxed in India and therefore, there is no loss of revenue and consequently no need to levy EL)

(ii) The aggregate amount of consideration for any specified services received or receivable in a previous year by any non-resident person from a person resident in India and carrying on business or profession; or a non-resident having a PE in India does not exceed Rupees One Lakh;

(It means that a payer can make payment to a number of service providers below Rupees one lakh in a previous year without deducting tax at source; similarly a non-resident service provider can receive revenue from a number of resident payers without attracting EL as long as it is less than Rupees one lakh per payer)

(iii) Where the payment for specified service by the person resident in India, or the PE in India is not for purposes of carrying on business or profession.

(The above provision would provide relief to many small service recipients from the burden of tax deduction and tax compliance. As such they would not be claiming such payment as expenditure and therefore there will not be any base erosion in India on such payments)

Section 166 of the EL Chapter provides that a resident payer has to deduct the EL from the amount paid or payable to a non-resident and it is to be paid to the credit of the Government within seventh day of the month immediately following the said calendar month.

It is also provided that even if the payer fails to deduct the amount of the levy, he has to pay nonetheless the levy to the Government.

3.0 Which specified services are covered under EL?

Ans. Section 164 (i) defines “specified service” means online advertisement, any provision for digital advertising space or any other facility or services for the purpose of online advertisement and includes any other services as may be notified by the Central Government of India in this behalf.

Section 164 (f) defines “Online” means a facility or services or right or benefit or access that is obtained through internet or any other form of digital or telecommunications network.

It may be noted that the Committee on Taxation of E-commerce has recommended the following definition for ‘specified services’:-

(i) online advertising or any services, rights or use of software for online advertising, including advertising on radio & television;
(ii) digital advertising space;
(iii) designing, creating, hosting or maintenance of website;
(iv) digital space for website, advertising, e-mails, online computing, blogs, online content, online data or any other online facility;
(v) any provision, facility or service for uploading, storing or distribution of digital content;
(vi) online collection or processing of data related to online users in India;
(vii) any facility or service for online sale of goods or services or collecting online payments;
(viii) development or maintenance of participative online networks;
(ix) use or right to use or download online music, online movies, online games, online books or online software, without a right to make and distribute any copies thereof;
(x) online news, online search, online maps or global positioning system applications;
(xi) online software applications accessed or downloaded through internet or telecommunication networks;
(xii) online software computing facility of any kind for any purpose; and
(xiii) reimbursement of expenses of a nature that are included in any of the above.

At present only online advertisement/facility and digital advertising space are brought under the purview of EL. It is believed that the coverage of the EL may expand in future.

4.0 What are the implications of EL for the non-resident service provider?
Ans: The newly inserted section 10(50) of the Incometax Act, 1961 (the Act) provides that any income arising from any specified service provided and chargeable to EL shall not form part of total income i.e. be exempt from tax. It means that where the non-resident service provider is subject to EL, it would not be required to comply with any other provisions of the Act. EL is levied at 6 per cent on gross revenue, whereas royalties and fees for technical services are taxed at the rate of 10 per cent on gross basis. It may be possible that going forward (when more services are notified for EL) some of the services may overlap and at that time it would be advantageous for the non-resident service provider to opt for EL as there would not be any litigation as to the characterization of income.

Another positive implication for the non-resident service provider is that if its income is covered under EL, then provisions of Transfer Pricing and General Anti Avoidance Rules (GAAR) will not be applicable.

5.0 What are the implications of EL for the resident tax payer?
Ans: The Levy imposes various obligations on the resident tax payer, and prescribes various penal consequences for failure to comply with them, as follows:

5.1 Deduction of EL @ 6 per cent on gross payment exceeding one lakh rupees to a non-resident for specified services; [section 165]

5.2 Deposit to the credit of Government (meaning cheque should be cleared or online payment should be within the working hours) by the seventh day of the month immediately following the calendar month in which EL is so deducted or was deductible. The EL must be credited as aforesaid even if the assessee (resident payer) fails to deduct it from the payment to non-resident; [section 166]

There is no clarity as to whether the payer needs to gross up the EL if the non-resident service provider refuses to pay the same. Section 166(3) casts the obligation on the Indian resident payer to deposit the levy irrespective of the fact whether the same has been deducted or not. So if a deductor has to remit Rs. 100/- whether he is required to pay Rs.6/- as EL or Rs. 6.38 after grossing it up, as everywhere the terminology is used “deducted”.

5.3 Disallowance of expenditure u/s. 40(a)(ib) for failure to deduct or after deduction failure to pay, EL as aforesaid; [section 40(a)(ib)]

5.4 Furnishing of annual statement of specified services to be submitted electronically in Form No. 1 on or before 30th June immediately following the relevant previous year; [section 167 read with Rules 5 and 6]

5.5 Payer is exposed to following penalties:

-Delayed payment of EL->simple interest at the rate of one per cent of EL for every month or part of a month by which such credit of the EL or any part thereof is delayed [section 170]

-Failure to deduct EL->Penalty amount equal to EL [section 171]

-Deducted EL but failure to pay to the Government->Penalty of Rs. 1000/- for every day during which failure continues maximum up to the amount of EL [section 171]

-Failure to furnish annual statement in form 1->Penalty of Rs. 100 per day for each day during which the failure continues [section 172]

Section 173 provides that no penalties shall be imposed for offences listed in section 171 and 172 if the assessee proves to the satisfaction of the Assessing Officer that there was reasonable cause for such failure.

5.6 Section 174 and 175 respectively provide right of appeal (to the assessee) to CIT (appeals) and the Appellate Tribunal in respect of grievances on account of penalties.

6.0 W hat is the nature of EL – Direct tax or Indirect tax?

Ans: 6.1 Whether EL is Direct tax?
The report of the Committee on Transactions of E-Commerce has clarified that “the EL will be outside the income-tax Act. It is not a tax on income, as it is levied on payments. It is therefore also payable by enterprises not making any net profits”. EL is in the nature of turnover tax. It is not a tax or levy on income but on gross revenue. Under the Income-tax act certain income are taxed in the hands of the non-resident on presumptive basis e.g. profits and gains of shipping business or exploration of mineral oil and natural gas etc. However in all such cases, a certain percentage of the gross revenue is estimated to be income on which the tax is levied at the applicable rate, whereas EL is levied on gross consideration itself.

However, two arguments in favour of those who feel that the EL is in the nature of income-tax or a tax substantially similar to income tax (so as to qualify for treaty relief by invoking provisions of Article 2) are as follows:

(i) EL would be governed by the Income tax authorities and many provisions of the Act are made applicable to it. In short EL is not a complete code by itself;

(ii) The Revenue secretary in an interview to Business Today magazine dated 5th June, 2016 opined that EL in essence is income tax.

Appendix 2 of the report of the Committee on Taxation of E-Commerce has listed the objectives of EL where in it is mentioned as “to reduce the unfair tax advantage enjoyed by a multinational digital enterprise over its Indian competitors, and thereby ensure fair market competition. The unfair tax advantage arises when domestic enterprises are taxed but multinational enterprises are not taxed on their income arising from India.”

From the above objective it is clear that EL may be called by whatever name or levied in whatever manner it being understood that, the objective is to tax income arising to non-resident service providers who earn from Indian resident payers.

6.2 EL and tax Treaties

The characterization of EL is indeed significant from the treaty perspective as well. If EL is held to be income-tax or a tax substantially similar to income tax, then as per 2Article 2 of a tax treaty, EL would be covered and as per section 90(2) of the Act, treaty provisions would override the provisions of EL. The only saving grace is that section 90 (2) makes a reference to provisions of the incometax act and EL is outside the purview of the Act. However, it would be interesting to see if any nonresident or a treaty partner country invokes Mutual Agreement Procedure for seeking clarity on this issue.

It may be possible that a non-resident providing service in India and who is subject to EL may invoke the Article on non-discrimination on the ground that the non-residents who supply goods to India are not subjected to EL even though their business model is the same.

Appendix 2 paragraph 13, of the report of the Committee on Taxation of E-Commerce has stated that “as the Equalization Levy is not charged on income, it is not covered by Double Taxation Avoidance Agreements or tax treaties. Thus, no tax credits under the tax treaties will become available to the beneficial owner in the country of its residence, in respect of Equalization Levy charged in India”.

Considering the limitation or possibility of nonavailability of credit in respect of EL, the Committee recommended levy of six per cent as against normal tax of 10 per cent in case of royalties and FTS.

6.3 Whether EL is indirect tax?

Indirect tax like service tax and VAT are charged on gross turnover and in that sense EL is closer to them. However, one fundamental difference is that service tax is a destination based consumption tax and is supposed to be collected from the ultimate consumer of services. Thus actually, the non-resident service providers are supposed to get themselves registered under the Indian Service tax Provisions and Rules collect service tax on all taxable services and deposit it with the Indian Government. Australia has implemented this method of indirect tax collection. In India specified services for EL are also taxed under the provisions of relating to Service tax but under the reverse charge mechanism whereby the service recipient pays service tax and the non-resident is spared from all hassles. CENVAT credit is allowed in respect of service tax so paid by the service recipient in India and therefore, the incidence of tax is reduced.

EL, on the other hand, is a levy on the non-resident service provider and not on the service recipient. EL is over and above the service tax.

Thus, EL cannot be considered as an indirect tax.

7.0 Whether EL is constitutionally valid?

Ans: Entry 92C of List-I – Union List of the Seventh Schedule of the Indian Constitution empowers Central Government to levy taxes on services. Entry 97 of the List-I of the same Seventh Schedule empowers to levy tax on “any other matter not enumerated in List II or List III including any tax not mentioned in either of those Lists.

List II of the Seventh Schedule contains the entries reserved for States. Entry 55 of the said list provides that “taxes on advertisements other than advertisement published in the newspapers and advertisements broadcast by radio or television.”

Thus, there seems to be some overlapping. It would be interesting to see the developments in this regard if the EL is challenged for its constitutional validity.

8.0 Summation
India is perhaps the first country to introduce EL soon after the BEPS report. It has been introduced as per the recommendations of the expert Committee who have evaluated various options and deliberated on the issues threadbare from various angles. The law is in its nascent stage and would evolve in times to come. The entire world is watching India closely. In the initial stage, the burden of EL will be on Indian tax payers only, as it would be difficult for a small users of such services to bargain with giants like Google, Yahoo or Face book etc.

In our view in order to reduce the burden of EL on the Indian residents, wherever it is borne by them, it should be allowed as a deductible expenditure (express clarification is desired). Also penalty and other provisions should be made more liberal as the payer is rendering service to the Government by collecting (in many cases bearing the additional burden himself) taxes and paying it to the Government.

There is no provision of Appeal in respect of disputes pertaining to EL (appeals are prescribed only for penalties). It appears that in case of disputes pertaining to EL, the aggrieved person will have to file writ petition to the High Court which may further increase the cost of litigation.

There can be no two views on the necessity to get a fair share of revenue in respect of income generated in a country. The present rules of taxation of digital economy are in favour of country of residence (C of R) and there is apparent unwillingness of the C of R (who are usually developed nations) to share their revenue with the Country of Source (usually developing nations like India). This necessitated introduction of EL in the domestic tax laws. The best part is that it is one of the recommended options in the BEPS report and thus has a wider acceptability. The success of EL can be greater if the Government is able to introduce a mechanism whereby the non-resident service providers are forced to pay their taxes directly to the kitty of the Government and thereby absolving resident tax payers from all the hassles of tax compliance.

It would be interesting to watch further developments in this regard.

GROWING SIGNIFICANCE OF PREVENTION OF MONEY LAUNDERING ACT, 2002

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The Prevention of Money Laundering Act, 2002 [PMLA], which extends to whole of India including Jammu and Kashmir, came into force with effect from 1st July, 2005. Major amendments to the Law were made in the year 2009 and 2012. However, PMLA has been in news in recent past as in many cases PMLA is being regularly invoked and concrete action is visible and in some cases the same has been invoked against professionals closely associated with such persons, as well.

It is therefore, of utmost importance to understand PMLA and its growing significance not only for the professionals in practice but for those in industry as well.

In this article, we have attempted to provide a brief overview of the Law and recent developments relating to PMLA.

SYNOPSIS
1. Background
2. Object of pmla
3. Meaning of money laundering
a) proceeds of crime
b) meaning of the terms ‘property’, ‘person’ ‘offence of cross border implications’
c) scheduled offences
d) major acts covered in the schedule
4. Process of money laundering
5. Impact of money laundering
6. Steps taken by govt. Of india to prevent the menace of money laundering
7. Some recent cases where pmla is invoked
8. Flow of events under pmla
9. Obligations of the reporting entities
10. Possible actions which can be taken against persons / properties involved in money laundering
11. Invocation of pmla against professionals
12. Reciprocal arrangement for assistance in certain matters and procedure for attachment and confiscation of property
13. Conclusion

1. Background
Money-laundering has been a huge challenge for the international community for quite some time. Moneylaundering poses a serious threat not only to the financial and banking systems of countries, but also to their integrity and sovereignty. To obviate such threats, international community has taken various initiatives.

Some of the major initiatives taken by the international community, from time to time, to obviate such threats have been as follows:—

a) the United Nations [UN] Convention Against Illicit Traffic in Narcotic Drugs and Psychotropic Substances, to which India is a party, called for prevention of laundering of proceeds of drug crimes and other connected activities and confiscation of proceeds derived from such offence.

b) the Basle Statement of Principles, enunciated in 1989, outlined basic policies and procedures that banks should follow in order to assist the law enforcement agencies in tackling the problem of money laundering.

c) the Financial Action Task Force [FATF] established at the summit of seven major industrial nations, held in Paris from 14th to 16th July, 1989, to examine the problem of money-laundering had made forty recommendations, which provided the foundation material for comprehensive legislation to combat the problem of money laundering. The recommendations were classified under various heads. Some of the important heads are –

i. declaration of laundering of monies carried through serious crimes a criminal offence;

ii. to work out modalities of disclosure by financial institutions regarding reportable transactions;

iii. confiscation of the proceeds of crime;

iv. declaring money-laundering to be an extraditable offence; and

v. promoting international co-operation in investigation of money laundering.

d) the Political Declaration and Global Programme of Action adopted by UN General Assembly by its Resolution No. S-17/2 of 23rd February, 1990, inter alia, called upon the member States to develop mechanism to prevent financial institutions from being used for laundering of drug related money and enactment of legislation to prevent such laundering.

e) the UN in the Special Session on Countering World Drug Problem Together concluded on the 8th to the 10th June, 1998 had made another Declaration regarding the need to combat money laundering. India is a signatory to this Declaration.

2. Object of pmla
As stated in the Preamble to the Act, it is an Act to prevent money-laundering and to provide for confiscation of property derived from, or involved in, money-laundering and to punish those who commit the offence of money laundering.

3. Meaning of money laundering
The goal of a large number of criminal activities is to generate profit for an individual or a group. Money laundering is the processing of these criminal proceeds to disguise their illegal origin.

Illegal arms sales, smuggling and other organized crimes, including illicit gambling and betting drug trafficking and prostitution rings, can generate huge amounts of money. Embezzlement, insider trading, bribery and computer fraud schemes can also produce large profits and create the incentive to “legitimize” the ill-gotten gains through money laundering. The money so generated is tainted and is in the nature of ‘dirty money’. Money Laundering is the process of conversion of such proceeds of crime, the ‘dirty money’, to make it appear as ‘legitimate’ money. Section 2(p) of the PMLA provides that ‘“moneylaundering” has the meaning assigned to it in section 3.’

Section 3 of the PMLA provides for Offence of Moneylaundering as follows:

‘Whosoever directly or indirectly attempts to indulge or knowingly assists or knowingly is a party or is actually involved in any process or activity connected with the proceeds of crime including its concealment, possession, acquisition or use and projecting or claiming it as untainted property shall be guilty of offence of money laundering.”

a) PROCEEDS OF CRIME – Section 2(1)(u) “
“Proceeds of crime” means any property derived or obtained, directly or indirectly, by any person as a result of criminal activity relating to a scheduled offence or the value of any such property.”

b) MEANING OF THE TERMS ‘PROPERTY’, ‘PERSON’ ‘OFFENCE OF CROSS BORDER IMPLICATIONS’
“(v) “property” means any property or assets of every description, whether corporeal or incorporeal, movable or immovable, tangible or intangible and includes deeds and instruments evidencing title to, or interest in, such property or assets, wherever located;”

Explanation.—For the removal of doubts, it is hereby clarified that the term “property” includes property of any kind used in the commission of an offence under this Act or any of the scheduled offences;”

“(s) “person” includes;—

(i) an individual,
(ii) a Hindu undivided family,
(iii) a company,
(iv) a firm,
(v) an association of persons or a body of individuals, whether incorporated or not,
(vi) every artificial juridical person, not falling within any of the preceding sub-clauses, and
(vii) any agency, office or branch owned or controlled by any of the above persons mentioned in the preceding sub-clauses;”

“(ra) “offence of cross border implications”, means –

(i) any conduct by a person at a place outside India which constitutes an offence at that place and which would have constituted an offence specified in Part A, Part B or Part C of the Schedule, had it been committed in India and if such person 2[transfers in any manner] the proceeds of such conduct or part thereof to India; or

(ii) any offence specified in Part A, Part B or Part C of the Schedule which has been committed in India and the proceeds of crime, or part thereof have been transferred to a place outside India or any attempt has been made to transfer the proceeds of crime, or part thereof from India to a place outside India.

Explanation.—Nothing contained in this clause shall adversely affect any investigation, enquiry, trial or proceeding before any authority in respect of the offences specified in Part A or Part B of the Schedule to the Act before the commencement of the Prevention of Money-laundering (Amendment) Act, 2009.”

c) SCHEDULED OFFENCES

The offences listed in the Schedule to the PMLA are scheduled offences in terms of section 2(1)(y) of the Act. The scheduled offences are divided into three parts – Part A, B & C.

In Part A, offences to the Schedule have been listed in 28 paragraphs and it comprises of offences under Indian Penal Code, Narcotic Drugs and Psychotropic Substances Act, Explosive Substances Act, Unlawful Activities (Prevention) Act, Arms Act, Wild Life (Protection) Act, the Immoral Traffic (Prevention) Act, the Prevention of Corruption Act, the Explosives Act, Antiquities & Arts Treasures Act etc.

Prior to 15th February, 2013, i.e. the date of notification of the amendments carried out in PMLA, the Schedule also had Part B for scheduled offences where the monetary threshold of rupees thirty lakhs was relevant for initiating investigations for the offence of money laundering. However, all these scheduled offences, hitherto in Part B of the Schedule, have now been included in Part A of Schedule w.e.f 15.02.2013. Consequently, there is no monetary threshold to initiate investigations under PMLA.

The Finance Act, 2015, w.e.f. 14-5-2015 has again inserted section 132 of the Customs Act, 1962 relating to false Declaration, false documents etc. in Part B.

Part ‘C’ deals with trans-border crimes, and is a vital step in tackling Money Laundering across International Boundaries.

Every Scheduled Offence is a Predicate Offence. The Scheduled Offence is called Predicate Offence and the occurrence of the same is a pre requisite for initiating investigation into the offence of money laundering.

d) MAJOR ACTS COVERED IN THE SCHEDULE
(i) Indian Penal Code, 1860;
(ii) N arcotic Drugs and Psychotropic Substances
Act, 1985;
(iii) Unlawful Activities (Prevention ) Act, 1967;
(iv) Prevention of Corruption Act, 1988;
(v) Customs Act, 1962;
(vi) SEBI Act, 1992;
(vii) Copyright Act, 1957;
(viii) Trade Marks Act, 1999;
(ix) Information Technology Act, 2000;
(x) Explosive Substances Act, 1908;
(xi) Wild Life (Protection) Act, 1972;
(xii) Passport Act, 1967;
(xiii) Environment Protection Act, 1986;
(xiv) Arms Act, 1959.
(xv) The offence of wilful attempt to evade any tax, penalty or interest referred to in section 51 of the Black Money (Undisclosed Foreign Income and Assets) and Imposition of Tax Act, 2015.

4. Process of money laundering

Money laundering is a single process. However, its cycle can be broken down into three distinct stages namely, placement stage, layering stage and integration stage.

a) Placement Stage: It is the stage at which criminally derived funds are introduced in the financial system. At this stage, the launderer inserts the “dirty” money into a legitimate financial institution often in the form of cash deposits in banks. This is the riskiest stage of the laundering process because large amounts of cash are pretty conspicuous, and banks are required to report high-value transactions. To curb the risks, large amounts of cash is broken up into less conspicuous smaller sums that are then deposited directly into a bank account, or by purchasing a series of monetary instruments (cheques, money orders, etc.) that are then collected and deposited into accounts at another location.

b) Layering Stage: It is the stage at which complex financial transactions are carried out in order to camouflage the illegal source. At this stage, the launderer engages in a series of conversions or movements of the money in order to distant them from their source. In other words, the money is sent through various financial transactions so as to change its form and make it difficult to follow. Layering may consist of several bankto- bank transfers, wire transfers between different accounts in different names in different countries, making deposits and withdrawals to continually vary the amount of money in the accounts, changing the money’s currency, and purchasing high-value items such as houses, boats, diamonds and cars to change the form of the money. This is the most complex step in any laundering scheme, and it’s all about making the origin of the money as hard to trace as possible. In some instances, the launderer might disguise the transfers as payments for goods or services, thus giving them a legitimate appearance.

c) Integration stage: It is the final stage at which the ‘laundered’ property is re-introduced into the legitimate economy. At this stage, the launderer might choose to invest the funds into real estate, luxury assets, or business ventures. At this point, the launderer can use the money without getting caught. It’s very difficult to catch a launderer during the integration stage if there is no documentation during the previous stages.

The above three steps may not always follow each other. At times, illegal money may be mixed with legitimate money, even prior to placement in the financial system. In certain cash rich businesses, like Casinos (Gambling) and Real Estate, the proceeds of crime may be invested without entering the mainstream financial system at all.

The Process of money laundering may be explained simply by way of diagram as follows:



Various techniques or methods used: At each of the three stages of money laundering various techniques can be utilized. Following are the various measures adopted all over the world for money laundering, even though it is not exhaustive but it encompasses some of the most widely used methods:

1. Structuring Deposits: This is also known as smurfing. This is a method of placement whereby cash is broken into smaller deposits of money, used to defeat suspicion of money laundering and avoid antimoney laundering reporting requirements.

Smurfs – A popular method used to launder cash in the placement stage. This technique involves the use of many individuals (the “smurfs”) who exchange illicit funds (in smaller, less conspicuous amounts) for highly liquid items such as traveller cheques, bank drafts, or deposited directly into savings accounts. These instruments are then given to the launderer who then begins the layering stage. For example, ten smurfs could “place” $1 million into financial institutions using this technique in less than two weeks.

2. Shell companies: These are fake companies that exist for no other reason than to launder money. They take in dirty money as “payment” for supposed goods or services but actually provide no goods or services; they simply create the appearance of legitimate transactions through fake invoices and balance sheets.

3. Third-Party Cheques: Counter cheques or banker’s drafts drawn on different institutions are utilized and cleared via various third-party accounts. Third party cheques and travellers’ cheques are often purchased using proceeds of crime. Since these are negotiable in many countries, the nexus with the source money is difficult to establish.

4. Bulk cash smuggling: This involves physically smuggling cash to another jurisdiction and depositing it in a financial institution, such as an offshore bank, with greater bank secrecy or less rigorous money laundering enforcement.

5. Impact of Money laundering
Launderers are continuously looking for new routes for laundering their funds. Economies with growing or developing financial centres, but inadequate controls are particularly vulnerable as established financial centre countries implement comprehensive anti-money laundering regimes. Differences between national anti-money laundering systems are being exploited by launderers, who tend to move their networks to countries and financial systems with weak or ineffective counter measures.

The possible social and political costs of money laundering, if left unchecked or dealt with ineffectively, are serious. Organised crime can infiltrate financial institutions, acquire control of large sectors of the economy through investment, or offer bribes to public officials and indeed governments. The economic and political influence of criminal organisations can weaken the social fabric, collective ethical standards, and ultimately the democratic institutions of the society as is evident in many countries in Latin America. In countries transitioning to democratic systems, this criminal influence can undermine the transition.

If left unchecked, money laundering can erode a nation’s economy by changing the demand for cash, making interest and exchange rates more volatile, and by causing high inflation in countries where criminal elements are doing business. The draining of huge amounts of money a year from normal economic growth poses a real danger for the financial health of every country which in turn adversely affects the global market. Most fundamentally, money laundering is inextricably linked to the underlying criminal activity that generated it. Laundering enables criminal activity to continue and flourish.

Thus, the impact of money laundering can be summed up into the following points:

Potential damage to reputation of financial institutions and market

Weakens the “democratic institutions” of the society

Destabilises economy of the country causing financial crisis

Give impetus to criminal activities

Policy distortion occurs because of measurement error and misallocation of resources

Discourages foreign investors

Encourages tax evasion culture

Results in exchange and interest rates volatility

Provides opportunity to criminals to hijack the process of privatization

Contaminates legal transaction.

Results in provision of financial support toTerrorists activities

6. Steps taken by govt. of india to prevent the menace of money laundering

Government of India is committed to tackle the menace of Money Laundering and has always been part of the global efforts in this direction. India is signatory to the following UN Conventions, which deal with Anti Money Laundering / Countering the Financing of Terrorism:

1. International Convention for the Suppression of the Financing of Terrorism (1999);

2. UN Convention against Transnational Organized Crime (2000); and

3. UN Convention against Corruption (2003).

In pursuance to the political Declaration adopted at the special session of the United Nations General Assembly (UNGASS) held on 8th to 10th June 1998 (of which India is one of the signatories) calling upon member States to adopt Anti Money Laundering Legislation & Programme, the Parliament has enacted PMLA. This Act has been substantially amended, by way of enlarging its scope, in 2009 (w.e.f. 01.06.2009), by enactment of PML (Amendment) Act, 2009. The Act was further amended by PML (Amendment) Act, 2012 w.e.f. 15-02-2013.

7. Some recent high profile cases where PMLA is invoked

A. As per the media reports

a. Chhagan Bhujbal’s case:
Former Deputy Chief Minister of Maharashtra Mr. Chhagan Bhujbal and his family members and various real estate developer firms and other associated with them.

b. Himachal Pradesh’s Chief minister Virbhadra singh and family’s case

c. Former King Fisher Chairman Vijay Mallya’s case

d. FTIL promoter Jignesh Shah in the NSEL’s case

e. Gujarat Cadre IAS Officer Pradeep Sharma’s case

f. Zoom Developers Pvt. Ltd.’s promoters Vijay Choudhary and his co-director Sharad Kabra’s case

g. Lalit Modi’s case

h. Bank of Baroda Money laundering case

i. As per the Law reports

j. B. Rama Raju v. Union of India [2011] 12 taxmann .com 181 (AP)

k. Union of India v. Hassan Ali Khan [2011] 14 taxmann.com 127 (SC)

The number of cases filed under the Prevention of Money Laundering Act, 2002 from the year 2008 to mid-2015 in various High Courts and the Supreme Court are:

The number of cases filed in the Appellate Tribunal under the Prevention of Money Laundering Act, 2002 from the year 2009 till 2014 are:

8. Flow of events under PMLA

The flow of events under PMLA is graphically depicted as follows:


9. Obligations of the reporting entities

Section 2(1)(wa) – “Reporting Entity” means a banking company, financial institution, intermediary or a person carrying on a designated business or profession. Section 2(1)(sa) – Persons carrying on Designated Business or Profession means:-

(i) a person carrying on activities for playing games of chance for cash or kind, and includes such activities associated with casino;

(ii) a Registrar or Sub-Registrar appointed u/s. 6 of the Registration Act, 1908, as may be notified by the Central Government.

(iii) real estate agent, as may be notified by the Central Government.

(iv) dealer in precious metals, precious stones and other high value goods, as may be notified by the Central Government.

(v) person engaged in safekeeping and administration of cash and liquid securities on behalf of other persons, as may be notified by the Central Government; or

(vi) person carrying on such other activities as the Central Government may, by notification, so designate, from time to time.

Obligations [Section 12]

(i) Every reporting entity have to maintain a record of all transactions covered as per the nature and value of which may be prescribed, in such manner as to enable it to reconstruct individual transactions;

(ii) They shall furnish to the Director (FIU) within such time as may be prescribed information relating to such transactions, whether attempted or executed, the nature and value of which may be prescribed;

(iii) They shall verify the identity of its clients in such manner and subject to such conditions as may be prescribed;

(iv) They shall identify the beneficial owner, if any, of such of its clients, as may be prescribed;

(v) They shall maintain record of documents evidencing identity of their clients and beneficial owners as well as account files and business correspondence relating to their clients for a period of five years in case of record and information relating to transactions; and

(vi) They shall maintain the same for a period of five years after the business relationship between a client and the reporting entity has ended or the account has been closed, whichever is later.

10. Possible actions which can be taken against persons / properties involved in money laundering

Following actions can be taken against the persons involved in Money Laundering:-

(a) Attachment of property u/s. 5, seizure/ freezing of property and records u/s. 17 or Section 18. Property also includes property of any kind used in the commission of an offence under PMLA, 2002 or any of the scheduled offences.

(b) Persons found guilty of an offence of Money Laundering are punishable with imprisonment for a term which shall not be less than three years but may extend up to seven years and shall also be liable to fine [Section 4].

(c) When the scheduled offence committed is under the Narcotics and Psychotropic Substances Act, 1985 the punishment shall be imprisonment for a term which shall not be less than three years but which may extend up to ten years and shall also be liable to fine.

(d) The prosecution or conviction of any legal juridical person is not contingent on the prosecution or conviction of any individual.

11. Risk of invocation of pmla against professionals

a. As pointed out above, section 3 of the PMLA dealing with the Offence of Money-laundering provides that ‘Whosoever directly or indirectly attempts to indulge or knowingly assists or knowingly is a party or is actually involved in any process or activity connected with the proceeds of crime including its concealment, possession, acquisition or use and projecting or claiming it as untainted property shall be guilty of offence of money laundering.” Thus, the language of Section 3 of PMLA has widest possible amplitude.

b. As per the media reports, PMLA has been invoked against the Chartered Accountant involved in the Chhagan Bhujbal case.

c. In CBI vs V. Vijay Sai Reddy Criminal Appeal No. 729 of 2013, a case relating to offence under Prevention of Corruption Act, the Supreme Court in its order dated 9th May, 2013, after analysing the facts while cancelling the bail of the respondent Chartered Accountant, observed as follows:

“26) Finally, though it is claimed that respondent herein (A-2) being only a C.A. had rendered his professional advise, in the light of the various serious allegations against him, his nexus with the main accused A-1, contacts with many investors all over India prima facie it cannot be claimed that he acted only as a C.A. and nothing more. It is the assertion of the CBI that the respondent herein (A-2) is the brain behind the alleged economic offence of huge magnitude. The said assertion, in the light of the materials relied on before the Special Court and the High Court and placed in the course of argument before this Court, cannot be ignored lightly.”

d. In order to ensure that a professional is not caught into the quagmire of PMLA it would be advisable to do a proper due diligence and KYC of the prospective clients and to ensure that one does not fall within very broad scope and contours of section 3 of PMLA. In other words, a Professional should ensure that he does not deal with clients who are engaged in various criminal activities included in the Schedule PMLA.

12. Reciprocal arrangement for assistance in certain matters and procedure for attachment and confiscation of property

a. Meaning of “Contracting State”
“Contracting State” means any country or place outside India in respect of which arrangements have been made by the Central Government with the Government of such country through a treaty or otherwise [Section 55].

b. Mechanism to obtain evidence required in connection with investigation into an offence or proceedings under PMLA if such evidence may be available in any place in a contracting State

An application is to be made to a Special Court by the Investigating Officer or any officer superior in rank to the Investigating Officer and the Special Court, on being satisfied, may issue a Letter of Request to a court or an authority in the contracting State competent to deal with such request to—

(i) examine facts and circumstances of the case,
(ii) take such steps as the Special Court may specify in such letter of request, and
(iii) forward all the evidence so taken or collected to the Special Court issuing such letter of request.

Every statement recorded or document or thing received from a Contracting State shall be deemed to be the evidence collected during the course of investigation [Section 57].

c. Mechanism to provide assistance to a Contracting State

Where a Letter of Request is received by the Central Government from a court or authority in a contracting State requesting for investigation into an offence or proceedings under PMLA, 2002 and forwarding to such court or authority any evidence connected therewith, the Central Government may forward such Letter of Request to the Special Court or to any authority under the Act for execution of such request [Section 58].

d. Confiscation of the properties involved in money laundering located in India, where the offence of money laundering has been committed outside India

The properties involved in money laundering located in India, where the offence of money laundering has been committed outside India, can be ordered to be confiscated by the Special Court/Adjudicating Authority on an application moved to the Special Court/ Adjudicating Authority [Sections 58B & 62A].

e. Reciprocal arrangements for processes and assistance for transfer of accused persons

(1) A Special Court, in relation to an offence punishable under section 4 for the service or execution of a summons, a warrant or a search warrant in a Contracting State shall send such summons or warrant, in duplicate, in prescribed form to the Court, Judge or Magistrate through specified Authorities.

(2) Similarly, a summons, a warrant or a search warrant in relation to an offence punishable under section 4, received for service or execution from a Contracting State, shall be served or executed as if it were a summons or warrant received by it from another Court in the said territories for service or execution.

After execution of summon or search warrant received from a Contracting State, the documents or other things produced or things found during search shall be forwarded to the Court issuing the summons or search-warrant through the specified Authority [Section 59].

f. Attachment or seizure of the property involved in money laundering and located in the Contracting State

In such cases, after issue of an order for attachment of any property made u/s. 5 or freezing u/s. 17(1A) or confirmation of attachment by Adjudicating Authority under Section 8 or confiscation by Special Court under Section 8, the Special Court, on an application by the Director or the Administrator may issue a Letter of Request to a court or an authority in the Contracting State for execution of such order as per the provisions of corresponding law of that country [Section 60(1)].

13. Conclusion

India has taken up various Anti-Money Laundering measures to deal with this issue but these measures somewhere or the other have some loopholes or lacunas and thus are not fulfilling their intended purpose. Some of such problems are pointed out below:

a) Growth of Technology: With the advent of technology at such a greater speed, it has been possible for the money launderers to act on obscuring the origin of proceeds of crime by cyber finance techniques. The enforcement agencies are not able to catch up with the speed of growing technologies.

b) Lack of awareness about the problem: The issue of money laundering is growing at a very high pace. Its unawareness among the common public is an impediment for implementation of proper anti-money laundering measures. The poor and illiterate people, instead of going through lengthy paper work transactions in Banks, prefer the Hawala system where there are fewer complexities and formalities, little or no documentation, lower rates and they also provide security and anonymity. Thus, they become unwitting accessories. This is mainly because such people don’t know the seriousness of this crime and are not aware of its harmful after effects.

c) Non-fulfilment of the purpose of KYC Norms: RBI has issued the policy of KYC norms with the objective to prevent banks from being used by criminals for money laundering or terrorist financing activities. However, it does not cease or abstain from the problem of Hawala transactions as RBI cannot regulate them. Further, such norms are only a mockery as the implementing agencies are indifferent to it. Also, the increasing competition in the market is forcing the Banks to lower their guards and thus facilitating the money launderers to make illicit use of the banking system in furtherance of their crime.

d) The widespread act of smuggling: There are a number of black market channels in India for the purpose of selling goods offering many imported consumers goods such as food items, electronics etc. which are routinely sold. The black market merchants deal in cash transactions and avoid custom duties thus offering better prices than the regular merchants. After liberalization of the economy, though this problem has been lessened but it has not been done away with completely and still poses a threat to a nation’s economy.

e) Lack of comprehensive enforcement agencies: The offence of money laundering is no more stuck to one area of operation but has expanded its scope include many different areas of operation. In India, there are separate wings of law enforcement agencies dealing with money laundering, cybercrimes, terrorist crimes, economic offences etc. Such agencies lack convergence among themselves. The issue of money laundering, as we have seen, is a borderless world but these agencies are still stuck with the laws and procedures of the states.

Combating the offence of money laundering is a dynamic process since the criminals involved in it are continuously looking for new ways to do it and achieve their illicit motives.

Apart from that, many a people are of the opinion that money laundering seem to be a victimless crime. They are unaware of the harmful effects of such a crime on the Nation’s economy and Democratic Institutions. So there is a need to educate such people and create awareness among them and therefore infuse a sense of watchfulness towards the instances of money laundering. This would also help in better law enforcement as it would be subject to public examination.

Foreign Tax Credit Rules 2016 – An Analysis

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1 Background
Most of the countries follow a mix of source and residence based concept of taxation i.e. a country seeks to tax the global income of a person who is a resident in that country as well as tax all the income which arises to a person (whether resident or nonresident) in its territory.

This leads to dual taxation of the same income, firstly in the country of source of income and secondly in the country of residence of the person earning income. Countries enter into Double Taxation Avoidance Agreements (‘DTAA ’), inter-alia, to eliminate this double taxation of the same income. Further, the tax which is paid in the source country by the person receiving income is either allowed as a credit by the country of residence while computing the tax payable therein or exempts such income from taxation. Additionally, most countries also provide for unilateral relief under their domestic law, which would aid in eliminating tax cascading where no DTAA exists.

Sections 90 and 90A of the Income-tax Act, 1961 (“the Act” or “ITA ”) provides for relief from double taxation of income in India if there exists a DTAA between India and a foreign country/specified territory. Typically, DTAA s entered into by India provide for availability of credits of foreign taxes with a view to afford relief from double taxation.

Similarly, section 91(1) of the Act provides for unilateral relief in respect of taxes paid on the income arising in a country with which India has not concluded a DTAA . This section provides for a credit on doubly taxed income, at the Indian rate of tax or the rate of tax of the other country, whichever is lower.

However, the Act did not specify any guidelines or rules outlining the manner and mechanism for computing the eligible tax credit as in line with Countries like USA, UK etc., resulting in avoidable litigation on various issues connected with claim for Foreign Tax Credit (FTC). In August 2013, Indian Government constituted Tax Administration Reform Commission (‘TAR C’) headed by Dr. Parthasarathi Shome, where one of the key recommendation by TAR C in its report was that Central Board of Direct Taxes (‘CBDT’) should come out with clear FTC (i.e., credit for the income tax paid by the taxpayer in another Country) guidelines in order to simplify the tax administration in India. This lead to the insertion of section 295(2)(ha) by the Finance Act, 2015 which empowered the CBDT to prescribe rules for granting relief under the Act in respect of foreign taxes paid.

Apart from the above, there are no provisions in the Act or the Rules that deal with the detailed aspects of the availability and claims for foreign tax credits. The First Report of the TAR C had recommended that the CBDT come out with clear guidelines in respect of availing FTC. Accordingly, the CBDT issued the draft FTC rules on 18 April 2016 and comments from stakeholders and general public were invited by 2nd May 2016.

2 Foreign Tax Credit Rules, 2016

After considering the comments received from the public, the CBDT has issued a Notification dated June 27th 2016 which amend the Income tax Rules 1962 to provide for a separate segment on Foreign Tax Credit Rules, 2016 (“Rules”). These rules clarify the nature and conditions for the availability of the FTC to the tax payers and provide guidance to claim FTC in India. The Rule 128(10) specifies reporting of carry backward of losses of the Current Year whereby it results in a refund of Foreign Tax for which credit had been claimed in any earlier previous year or years. The rules also provide guidelines for granting tax credit if and when the tax dispute in the foreign country is settled against the tax payer. The rules also provide that where income on which foreign taxes are paid is reflected in multiple years, the credit for FTC shall be allowed proportionately. The rules also provide for relaxation in documentation requirements and self certification supported by proof of payment of foreign taxes.

2.2 Analysis of the Rule

Salient features of Rule 128 are as follows:

2.2.1 Grant of FTC to residents:
FTC shall be allowed to a resident of India for the amount of any foreign tax paid by him, by way of deduction or otherwise.

2.2.2 Grant of FTC in the year of assessment of income:

i) FTC shall be allowed in the year in which the income (corresponding to the foreign tax paid) is offered to tax or assessed to tax in India.

ii) However, if the income (corresponding to the foreign tax paid) has been offered to tax in India in more than one year, FTC shall be allowed proportionate to the income offered in each of the years.

2.2.3 Meaning of foreign tax:
Foreign tax would mean the taxes covered under the applicable DTAA and, in other cases, the taxes covered under the double tax relief provisions of the ITA . As per Explanation (iv) to section 91 of the ITA (which grants unilateral FTC), income tax includes any excess profits tax or business profits tax charged on the profits.

2.2.4 Indian taxes for providing FTC:

i) FTC would be allowed against the amount of Indian income tax, as well as surcharge and cess payable under the ITA .

ii) No credit shall be allowed against any sum payable by way of interest, fee or penalty.

iii) In a case where minimum alternate tax (MAT ) or alternate minimum tax (AMT) is payable under the ITA , FTC shall be allowed against such MAT /AMT in the same manner as is allowable against normal tax payable under the ITA . However, where the amount of FTC available against MAT / AMT is in excess of FTC credit available against normal tax, MAT /AMT credit would be reduced to the extent of such excess [Refer Rule 128(7)].

2.2.5 Disputed foreign tax:

i) Where the foreign tax paid or any part thereof has been disputed in any manner by the taxpayer, such foreign tax would not qualify for FTC.

ii) However, FTC of such disputed foreign tax shall be allowed for the year in which such income is offered or assessed to tax in India if the taxpayer submits the following details within a period of six months from the end of the month in which the dispute is finally settled:

• Proof of settlement of dispute
• Proof of discharge of liability of such foreign tax
• Undertaking that no refund has been/shall be claimed by the taxpayer, directly or indirectly

2.2.6 Mechanism to compute FTC

i) Currency conversion rate: Foreign tax paid in foreign currency shall be converted into Indian currency by applying “telegraphic transfer buying rate” on the last day of the month immediately preceding the month in which such foreign tax was paid or deducted.

ii) Maximum credit: FTC shall be restricted to the lower of tax payable under the ITA on such income or the foreign tax paid on such income. Further, if the foreign tax paid exceeds the amount of tax payable under the DTAA , such excess shall be ignored.

iii) Source-by-source approach: FTC shall be computed separately for each source of income arising from a particular jurisdiction.

2.2.7 Documents to be furnished to claim FTC:

Mandatory documents to be furnished by a taxpayer to be eligible to claim FTC are as follows:

i) S tatement providing details of the foreign income, offered for tax for the tax year, and foreign tax paid or deducted thereon in prescribed form and

ii) Certificate or statement specifying the nature of income and the amount of tax deducted or paid thereon:

• From the tax authority of the concerned foreign jurisdiction or

• From the person responsible for with holding tax or

• Self-declaration from taxpayer, along with:

a) acknowledgement of online payment or bank counter foil or challan where for eign tax has been paid by the taxpayer

b) proof of deduction where tax been de ducted

Documents as prescribed need to be furnished on or before the due date of filing of return of income in India.

2.2.8 Details to be provided in the prescribed statement in Form No. 67 :
i) Name of the taxpayer
ii) PAN
iii) Address
iv) Assessment Year
v) Details of foreign income and FTC claimed which includes:
• Name of the country
• Source of income
• Foreign income and tax paid outside India
• Tax payable on such income in India
• Credit claimed under DTAA
• Credit claimed under double tax relief provisions of the ITA

vi) Refund of foreign tax claimed, if any, as a result of carry backward of losses providing details of the accounting year to which such loss pertains and the year in which the set off of such loss has been undertaken.
vii) If any foreign tax is in dispute, the nature and the amount of income in respect of which the tax is disputed and the amount of such disputed tax.

2.2.9. Carry backward of losses: Further, prescribed statement should also be furnished in case where there is carry backward of loss resulting in refund of foreign tax for which FTC was claimed in any of the earlier previous year(s) [Refer Rule 128(10)].

3 Open Issues :

Some of the issues which have not been dealt with in the FTC Rules are as under:

3.1 Underlying Tax Credit
The rule is silent on underlying tax credit on dividend income received by the Indian Companies from their overseas subsidiary/ associate company. It is to be noted that India have such beneficial clause in DTAA with USA, UK, Cyprus, Australia, Japan, Mauritius and Singapore subject to conditions. However, the Indian taxpayer may still claim such underlying tax credit based on Section 90(2) of the Act which allows the taxpayer to take benefit of provisions made in the DTAA to the extent such provision is beneficial to the tax payer.

3.2 Tax Sparing
Tax Sparing is a credit mechanism by which resident country allows credit for such taxes which would have been payable by the taxpayer in the source country but for such tax exemptions. In other words, credit for taxes spared by the country of source is given by the country of residence on deemed basis. DTAA s with many countries such as Mauritius, Israel, Bangladesh, Singapore, Spain etc., provides for tax sparing benefit in respect of tax holidays covered under the respective tax treaties. However, the FTC Rules are silent in respect of Tax Sparing Credit.

ecently Delhi ITAT bench in the case of Krishak Bharati Cooperative Ltd. [TS-117-ITAT-2016(DEL)] allowed FTC to the taxpayer (a co-operative society registered in India) under section 90 of the Act read with Article 25(4) of India-Oman DTAA in respect of dividend received from its Joint Venture company in Oman which was specifally tax exempt in Oman.

3.3 Carry Forward of FTC

Countries such as USA, Canada, Singapore, UK, Japan etc., allows carry forward of excess FTC for a limited period. Excess FTC can arise mainly on account of following two reasons:

• Effective tax rate in the foreign country on such income is higher than effective tax rate in the home country; or

• Ratio of high-tax income or the ratio of income earned from a high-tax rate country during a financial year is high.

However, Indian FTC Rules do not contain any provision for carry forward of such excess FTC. In absence of any mechanism to carry forward the FTC, it may lead to litigation between taxpayer and revenue.

3.4 Branch Profit Tax
Many Countries such as USA, Canada, France, Philippines, Indonesia etc., have additional branch profit tax where branches of foreign companies are taxed on profit after tax on repatriation of earning from the branch at the time of closure or termination of such branch in the foreign country. In some of the Countries, branch profit tax is as high as 30%.

As per the Act, any business profit of the branch of Indian Company is taxed under the head business income in the year of accrual, and no further tax is payable on receipt of such income from branch. Hence, in most cases where branch profit tax is paid by the taxpayer in the foreign country upon repatriation. is not eligible for FTC.

4 Concluding Remarks:

In the wake of significantly increased cross border transactions by Indian Companies, the FTC Rules were much awaited in India. The FTC Rules are expected to provide a uniform mechanism to grant FTC in India. It is also the intention of the present Government to provide certainty in taxation and reduce litigation. The FTC Rules aim to provide clear guidance in respect of some of the persisting issues in the computation of FTC Credit viz. Credit qua each source of Income, year of credit, availability of FTC against MAT etc.

The easing of documentation requirements for claiming FTC, allowance of FTC in respect of disputed tax settled subsequently and to some extent taking care of timing mismatches, is welcome and reflects an open-minded approach of the Government.

Though the claim of FTC in respect of disputed tax subsequently settled has been allowed, further clarity is required on the procedural aspects for claiming such credit, especially when the dispute is settled after the expiry of time limit for filing revised return of income under the Act.

The FTC rules as finalized also need to provide further clarity on certain other aspects e.g. calculation of underlying tax credits and tax sparing credits as envisaged by certain Indian DTAA s, eligibility to claim FTC in case of hybrid entities and in cases of mismatch in characterization of income.

Further, the FTC rules fall short of industry expectation that consistent with global practice, the taxpayer may be provided an option to claim credit on an aggregate basis by pooling all overseas tax payments, rather than adopt the source-by-source approach which typically results in increased compliance burden and leads to sub-optimal availability of credit. There are also expectations that the taxpayers are permitted grant of underlying tax credit, an option to carry forward or carry back excess FTC, ability or an option to claim deduction as an expenditure in respect of foreign tax which is not creditable against Indian tax etc.

Further, clarity has been provided on the availability of tax credit for State taxes paid in a foreign jurisdiction. It would also be interesting to see whether the restriction on MAT/AMT credit will come in conflict with the provisions of the Act or application of the relevant Tax Treaty.

The notified Rules require statement in Form 67 to be filed on or before the due date of filing return of income prescribed u/s. 139(1) of the Act, as a condition precedent for claiming FTC. The prima facie implication is that FTC will not be available if Form 67 is filed later at any stage, including with a revised return. This is likely to lead to disputes and litigation. Not only this appears to be unreasonable but also may be ultra vires the Act and the tax treaties which have no such condition envisaged for grant of FTC. The notified Rules will come into effect from April 1, 2017. Given that the notified Rules contain not only the procedure for claiming FTC, but also impacts the amount of credit, they may not apply to years prior to AY 2017-18.

Thus while some aspects have not been dealt with by the notified Rules, some clarity has been achieved and may lead to reduction in disputes and litigation surrounding FTC.

Practical Issues Relating To Foreign Tax Credit

In September, 2017 we dealt with various
methods of elimination of double taxation and salient feature of the Foreign
Tax Credit Rules in this column. This article covers some of the practical
issues that may arise in claiming FTC1.

 Q.1    Rule 128(1) provides
that “An assessee, being a resident shall be allowed a credit for the amount
of any foreign tax paid by him in a country or specified territory outside
India, by way of deduction or otherwise, in the year in which the income
corresponding to such tax has been offered to tax or assessed to tax in India,
in the manner and to the extent as specified in this rule:

 Issue for consideration

         What do you mean by
the words “deduction or otherwise”? What proof one needs to submit for claiming
the credit?

 A.1 An assessee can pay
taxes either by way of withholding tax (WHT) (i.e. Tax Deducted at Source, TDS,
e.g. in case of salaries, professional fees etc.) or by way of an advance tax
or self assessment tax. WHT/TDS would be regarded as payment by deduction
whereas any other method of payment would be regarded as payment of taxes
“otherwise”.

        The  assessee 
needs to submit an acknowledgement of online payment or bank counter
foil or challan for payment of tax or proof of tax deducted at source, as the
case may be, along with his FTC claim in form 67 before the due date of filing
Income-tax return.

_____________________________________________________________

1    Recently
BCAS had organised a workshop on FTC which was addressed by CA. P. V.
Srinivasan and CA. Himanshu Parekh. Several issues were discussed at that
workshop. This article covers some of the important issues discussed therein as
well as some other issues that may arise in claiming FTC. Views expressed in
this article are of authors of this column only and have not been endorsed by
the workshop speakers.

             Readers
are also advised to read the Article published in the August 2015 issue of the
BCAJ on “Issues in claiming Foreign Tax Credit in India”.

Q.2   Sub-rule (4) of Rule 128
of FTC provides that no credit under sub-rule (1) shall be available in respect
of any amount of foreign tax or part thereof which is disputed in any manner by
the assessee.

Issue for consideration

       Whether credit shall
be available if the dispute is initiated by the revenue authorities in source
country? Whether issuance of Show Cause Notice (SCN) by revenue authorities to
challenge the rate of withholding in source country be said to be the
initiation of dispute by the revenue authority?

A.2   Once the tax is in
dispute (whether the dispute is initiated by the assessee or the tax official),
the credit may be denied and/or postponed to the year of settlement of such
dispute. Issuance of SCN is a matter prone to dispute and therefore credit may
be denied. However, in genuine cases one can approach CBDT to provide relief
u/s. 119 of the Income-tax Act, 1961 (the Act).

Q.3   Rule 128(1) provides
that FTC is allowable in the year in which the income corresponding to such tax
has been offered to tax or assessed to tax in India.

 Issue for consideration

       At what point in time
the income needs to be offered – Whether method of accounting is relevant or
provisions of DTAA are relevant?

A.3  DTAA provisions do not
provide for computation of income. Computation of income is always left to the
provisions of domestic tax laws. Assessee is subject to computational
provisions as per the local laws. Also the method of accounting should be as
per the provisions of the domestic tax laws. For instance, in India, the
assessee is supposed to compute his income as per the method of accounting
prescribed in section 145 of the Act read with the Income Computation and
Disclosure Standards2 .

        The provision for
claiming FTC is very clear and that is FTC will be available in the year in
which the corresponding income is offered for taxation in India.

Q.4    Sub-rule 7 of Rule 128 provides that “if
foreign tax credit available against the tax payable under the
provisions of section 115JB or 115JC exceeds the amount of tax credit available
against the normal provisions, then while computing the amount of credit u/s.
115JAA or section 115JD in respect of the taxes paid u/s. 115JB or section
115JC, as the case may be, such excess shall be ignored.”

          There are three limbs
in this sub-rule

 i)   foreign tax credit
available

ii)  tax payable under the
provisions of section 115JB or 115JC

iii)  The amount of tax credit
available against the normal provisions.

        From the provisions,
it can be seen that one has to work out whether there is an excess of (i) over
(iii). If yes, then such an excess has to be ignored while computing credit
u/s. 115JAA or section 115JD in respect of the taxes paid u/s. 115JB or section
115JC. However, sections 115JAA and 115JD nowhere suggest that foreign tax
credit is not the tax paid under MAT.

    Issue for consideration

         Can Rule 128 override
provisions of section 115JAA/JD?

 A.4  Before we proceed to
answer the question, let us understand with the help of an example, the provisions
of denial of carry forward of the excess FTC in case of MAT or AMT provisions.

________________________________________________________-

 2   Some
of the ICDSs have been struck down by the Delhi High Court in
Chamber of Tax Consultants vs. Union of India [2017] 87 taxmann.com 92.

 

Particulars

Amount in Rupees

Tax as per normal provisions of the Act

1000

MAT payable as per section 115JB

1500

Foreign Tax Credit

1200

Excess credit against MAT due to FTC Not allowed to be
carried forward

200

 

       FTC Rules are framed
under delegated powers and hence cannot override provisions of Act.

        The Delhi High Court
in case of National Stock Exchange Member vs. Union of India (UOI) and Ors.
on 7th November, 2005 (Delhi HC) listed following order of hierarchy
in India:

          “In our country this
hierarchy is as follows:-

 (1) The Constitution of India.

 (2)Statutory Law, which may be either Parliamentary Law or law made
by the State Legislature.

(3) Delegated legislation which may be in the form of rules,
regulations etc. made under the Act.

(4) Administrative instructions which may be in the form of GOs,
Circulars etc.”

       In case of Ispat
Industries Ltd. vs. Commissioner of Customs, Mumbai (29th September
2006) the Supreme Court held that “if there is any conflict between the
provisions of the Act and the provisions of the Rules, the former will prevail.”

Q.5   Some countries follow
financial year which is different from the Indian financial year (i.e. April to
March). For example, USA follows calendar year. Therefore, though the income
will accrue and be chargeable to tax in India the effective rate at which tax
is payable in source country is not determinable at the time of filing of
return in India.

         To illustrate, the
effective rate of tax in respect of income accruing to Mr. B from USA in
calendar year 2017 will be determined only post 31st December 2017
and therefore for there will be problem is applying effective rate of tax for
claiming FTC in India, in respect of income from 1st Jan. 2017 to 31st
March 2017, the return for which will be due on 31st July 2017.

 Issue for consideration

        How would the
statement in Form 67 be filed in such case and how credit for tax payable in
source country be availed?

 A.5   In the above case, the
credit of taxes on the income earned during Jan – Mar 2017 would be calculated
considering the taxes paid before the filing of return. The calculation of
effective tax rate would take into account the taxes deducted at source and
advance taxes paid up to date of filing income-tax return in India. However, in
most of cases the effective tax rate would change especially where there is
other income or income where the tax is not deducted at source. In such
scenario, revised Form No. 67 and revised Income tax return has to be filed by
the assessee calculating the final effective tax rate.

Q.6    It is a settled
position that where there is a DTAA the taxes covered under the said DTAA would
be allowed as a credit. And where there is no DTAA, unilateral credit of
income-tax paid in the foreign country will be allowed as credit u/s. 91 of the
Act. Clause (iv) of Explanation to section 91 of the Act defines the term
“income-tax” as follows: – “the expression income tax in relation to any
country includes any excess profit tax or business profit tax charged on the
profits by the government of any part of that country or a local authority
in that country”.(emphasis supplied). What do we mean by the term “any
part of that country or a local authority”? Does that mean income tax levied by
the state government or prefecture would be allowed as a credit u/s. 91 of the
Act?

A.6   In the USA, income-tax
is levied by both, the central government (Federal income-tax) and state
government (state-tax). However, the India-US tax treaty covers only Federal
tax. Therefore a question arises whether an assessee can claim credit of state
taxes in India? In the case of Tata Sons [2011] 43 SOT 27, the Mumbai
Tribunal held that as per provisions of section 90(2) of the Act, the assessee
is entitled to opt for the beneficial provisions between a tax treaty and the
domestic tax law. Since section 91 is more beneficial, assessee can claim
credit of state income tax. Relevant excerpt from the Ruling is reproduced here
in below:

          “Accordingly, even
though the assessee is covered by the scope of India-US and India-Canada tax
treaties, so far as tax credits in respect of taxes paid in these countries are
concerned, the provisions of section 91, being beneficial to the assessee, hold
the field. As section 91 does not discriminate between state and federal taxes,
and in effect provides for both these types of income taxes to be taken into
account for the purpose of tax credits against Indian income tax liability, the
assessee is, in principle, entitled to tax credits in respect of the same.”

        The ratio of the
above decision will apply in relation to any other country where besides
central or federal income-tax, states also have power to levy income-tax.

         However, section 91
covers only income-tax and therefore any other indirect tax such as VAT,
Turnover Tax etc. will not be available for credit. However, Bombay High Court
in the case of K.E.C International Ltd (2000) 256 ITR 354 held that such
indirect taxes are allowed to be deducted as business expenditure without
attracting provisions of section 40(a)(ii) of the Act for disallowance.

 Q.7    Co. “A” incorporated in
Singapore is considered to be a tax resident of India u/s. 6 of the Act as its
Place Of Effective Management (POEM) is situated in India. Company “A” has
royalty income from the USA on which tax has been withheld in USA. Can Company
“A” claim credit of withholding tax in USA in India? Which treaty would be
applicable – India-USA, India-Singapore or Singapore-USA?

A.7     Since Co. “A” is
considered to be a tax resident of India, it would be taxed on its world-wide
income, including royalty income from USA. Therefore, Co. “A” can claim credit
of withholding tax in USA under provisions of the India-USA tax treaty. Even
Article 4 of a tax treaty considers residence based on POEM.

Q.8  As per the FTC Rules,
the credit shall be available against the amount of tax, surcharge and cess
payable under the Act but not in respect of any sum payable by way of interest,
fee or penalty. However, it is not clear that whether interest or penalty paid
in foreign jurisdiction will be allowed as credit. Can one argue that interest
and penalty is at par with tax paid, especially the interest element?

A.8   It seems difficult to
consider interest or penalty at par with income-tax and claim credit. At best
one may try to claim them as business deduction. However, such a claim is
fraught with possibility of litigation.

Q.9    Certain income which may
be exempt in a foreign country may be taxable in India. However, if the DTAA
provides for tax sparing clause, then credit for foreign taxes spared will be
available on deemed payment basis. However, the FTC Rules provide only for the
ordinary credit. How can one reconcile this dichotomy?

A.9     Income-tax Rules cannot
override provisions of the Act (Please refer to answer to Q.4 supra). FTC
Rules restricts the credit of foreign taxes by providing only one mode of
credit and i.e. Ordinary Credit; whereas many tax treaties provide for full
credit or tax sparing method. In case, where tax treaty is applicable, the
assessee will be eligible to opt for treaty provisions (being more beneficial) and
claim credit of foreign taxes on deemed basis. The practical difficulty would
be putting up claim in Form 67 which does not contain any details regarding tax
sparing. The assessee can lodge claim by filing a manual request.

Q.10   How does one compare the
tax rate applicable in India on a foreign sourced income as in India income
from all sources is grouped together and taxed based on applicable slab (for
individuals and HUFs)? Also there may be a situation that there is a loss from
one source or country and profit from another source or a country? Whether one
needs to aggregate income from all sources and different countries or is to be
computed separately vis-à-vis each source and each country?

         In the above
situation what would be the correct method to avail the credit – on the basis
of a) lower/lowest slab rate; b) higher/highest slab rate; and c) average rate?

A.10   In this case, two views
are possible. According to one view, one may compare the foreign source income
with the highest slab rate on the premise that it is open to assessee to take a
beneficial tax provision while claiming a foreign tax credit. As per the other
view, one may aggregate income from all sources, arrive at an average rate of
tax, then compare the same with the foreign tax rate and claim credit of lower
of the two.

          As far as source by
source computation of income is concerned, it is interesting to note the
observation of the Supreme Court in case of K. V. A. L. M. Ramanathan
Chettiar vs. CIT [1973] 88 ITR 169. In this case, assessee had earned
business profits from rubber plantation in Malaysia amounting to Rs. 2,22,532/-
and had a business loss in India of Rs. 68,568/- and other income of Rs.
39,142/-. The AO allowed double taxation relief on a sum of Rs. 1,92,816/-
(2,22,532+39,142-68,568). However, Commissioner allowed relief only on Rs.
1,53,674/- (i.e. 2,22,532-68,568) stating that only net business profits
suffered double taxation. Even ITAT and High Court concurred with this view.

        However, the Supreme
Court ruled in favour of the assessee and held that such source by source
computation is not envisaged in the Income-tax Act, 1922.

         Relevant extract of
the decision which is very relevant, is reproduced herein below for ready
reference:

        “The income from
each head u/s. 6 (the reference is to Income-tax Act, 1922) is not under the
Act subjected to tax separately, unless the legislature has used words to
indicate a comparison of similar incomes but it is the total income which is
computed and assessed as such, in respect of which tax relief is given for the
inclusion of the foreign income on which tax had been paid according to the law
in force in that country. The scheme of the Act is that although income is
classified under different heads and the income under each head is separately
computed in accordance with the provisions dealing with that particular head of
income, the income which is the subject matter of tax under the Act is one
income which is the total income. The income tax is only one tax levied on the
aggregate of the income classified and chargeable under the different heads; it
is not a collection of distinct taxes levied separately on each head of income.
In other words, assessment to income-tax is one whole and not group of assessments
for different heads or items of income. In order, therefore, to decide whether
the assessee is entitled to double taxation relief in respect of any income,
the consideration that the income has been derived under a particular head
would not have much relevance.”

         From the above
discussion, it appears that one need to aggregate income from all sources and
find out effective rate of tax in India which then needs to be compared with
the rate at which income is taxed in the foreign jurisdiction and the lower of
the two shall be allowed as foreign tax credit.

       However, specific
language of section 90(2) which gives an assessee right to choose the
beneficial provisions between a tax treaty and the Act, may lead us to a
different result.

      As far as aggregation
of income from different countries is concerned, it is interesting to consider
the observations of the Bombay High Court in the case of Bombay Burmah Trading
– 259 ITR 423. In this case the assessee had business income from the Tanzania
branch and loss from Malaysia branch. The AO wanted to consider FTC based on
net foreign income (i.e. setting off of loss from Malaysia against income from
Tanzania). However, the High Court ruled in favour of the assessee stating that
income from each country needs to be considered separately and that they cannot
be aggregated for claiming FTC in India.

         The Honourable High
Court in this case in the context of section 91 held that “If one analyses
section 91(1) with the Explanation, it is clear that the scheme of the said
section deals with granting of relief calculated on the income country wise
and not on the basis of aggregation or amalgamation of income from all foreign
countries” (Emphasis supplied).

         Though the above
decision is in the context of section 91 (i.e. unilateral tax credit), one can
apply this analogy to a bilateral treaty situation also, as the method of
granting tax credit is within the purview of the domestic tax laws. In this
context, it is interesting to go through the provisions of section 90 of the
Act. Relevant extract of the said section is as follows:

          “90. Agreement with foreign countries

          (1) ] The Central
Government may enter into an agreement with the Govsernment of any country
outside India-

        (a) for the granting
of relief in respect of income on which have been paid both income- tax under
this Act and income- tax in that country, or

        (b) for the avoidance
of double taxation of income under this Act and under the corresponding law
in force in that country,…… (Emphasis supplied)

          From the above
provisions, it is clear that the foreign tax credit is to be granted vis-à-vis
each country as per the specific agreement with that country.

Q.11 Whether credit for the
income tax paid in source country on the basis of presumptive basis (i.e. in
the nature of fixed amount irrespective of income) be available against the
income tax payable in India?

A.11   In case of a country
where no tax treaty exists, the credit will be available u/s. 91, as long as
income has suffered taxation in the source country. However, in case where
India has signed a tax treaty, the FTC will be subject to the provisions of the
concerned tax treaty. Almost all treaties invariably provide that relief from
double taxation will be available only in respect of those incomes which have
been taxed in accordance of the provisions of that agreement. Even though
treaties provide only distributive rights of taxation, maximum rate of tax in
the source state is prescribed in respect of some types of income, e.g.
dividends, interest, royalties and fees for technical services. As long as
presumptive taxation does not increase the respective threshold, the credit
should be available. For example, if the treaty provides that rate of tax on
royalty should not exceed 10% in the state of source, but the assessee has
suffered 15% withholding tax under the domestic tax law of the source state,
then the credit in the residence state may be either denied or restricted to
10%.

Q.12   How does one compute FTC
in case where in a source country (e.g. USA) joint returns are filed by the
taxpayer, whereas in India concept of joint return in not applicable?

A.12   In such as case, the
taxpayer need to find out the effective or average rate in the country wherein
the joint return is filed, and then compare the same with an effective rate in
India, after including the respective share of income. FTC will be allowed for,
at the lower of the two rates.

Q.13   FTC rules are silent on
the methodology of allowing credit due to the difference in characterization of
income between India and other country. How does one classify income for FTC
purposes – As per provisions of the Act or DTAA or source country?

A.13   A situation may arise
where an Indian company deriving Fees for Technical Service (FTS) income from
UK pays 10 per cent withholding tax as per India-UK DTAA. However, as per the
AO, the said income is in the nature of business profits and in absence of PE,
the said income ought not to have been taxed in UK as FTS and therefore deny
FTC in respect of the said income. One of the solutions in such a case may be
invocation of provisions of Mutual Agreement Procedure by the assessee.

         Similarly foreign
country may also deny credit of taxes paid in India which are in accordance
with the treaty provisions. Consider following examples:

 (i)  An Indian company may
withhold tax on payment of export commission u/s. 195 of the Act considering it
as Fees for Technical Services. However, the foreign country may consider that
payment as business income/profits in the hands of the recipient and thereby
deny the credit of taxes withheld by an Indian company. Even if the Indian
company has wrongly applied article on FTS under a tax treaty for withholding
of tax, the other government can deny the credit.

 (ii) Payment for software,
which is considered as a royalty in India is most prone to litigation as most
countries consider software as goods and therefore apply the PE test.

 Q.14   What are the
consequences if a tax payer forgets to upload Form 67? Whether consequence will
change if the same is furnished in the course of assessment before the AO?

 A.14   Rule 128 (8) make it
mandatory to submit a statement of income from a country or specified territory
outside India offered for tax for the previous year and of foreign tax deducted
or paid on such income in Form No.67 and verified in the manner specified
therein.

       CBDT issued a
Notification No. 9 dated 19th September, 2017 containing the
procedure for filing a Statement of income from country or specified territory
outside India and foreign tax credit. The said Notification has made it clear
that “all assesses who are required to file return of income electronically
u/s. 139(1) as per rule 12(3) of the Income tax rules 1962, are required to
prepare and submit form 67online along with the return of income if credit for
the amount of any foreign tax paid by the assessee in a country or specified
territory outside India, by way of deduction or otherwise, is claimed in the
year in which the income corresponding to such tax has been offered to tax or
assessed to tax in India.”

          From the above it is
clear that as of now an assessee has no choice but to file form 67 online.
Failure to file form 67 may result into litigation. However, this requirement
being procedural in nature, Courts may take a lenient view of the matter.

Q.15   Under what circumstances
FTC can be denied?

 A.15   In following
circumstances FTC may be denied:   

 (i)    Non-compliance of any
documentation, procedure or condition of FTC rules;

 (ii)  Non payment of taxes
as per provisions of a tax treaty (Income characterisation issues – Refer
answer to Q.14)

 (iii)  Excess tax paid under
FATCA. The USA is levying 30% withholding tax on US sourced income, in case of
those entities who have failed to comply with provisions of FATCA. Such an
excess amount will not be eligible for FTC in India.

(iv)  Excess taxes paid over
and above treaty rates, for example 20% tax paid u/s. 206AA of the Act for
non-compliance of PAN or other requirements.

(iv)   Local body taxes, city
or church taxes, state level taxes or any other taxes not in the nature of
direct tax and taxes not covered by the bilateral tax treaty. For example,
Equalisation Levy by India. At best, they may be allowed as business
deductions. (Refer answer to Q.6)

Conclusion

Rule 128 (1) provides that FTC shall be
allowed to an assessee in the manner and to the extent as specified in this
rule. It is perfectly alright for rules to lay down the procedure or
method of claiming FTC. However, can they unilaterally limit the extent of
foreign tax credit dehors provisions of the bilateral tax treaty. Will such a
provision not make rules ultra-vires the Act?

The stringent requirement of online
submission of form 67 should be relaxed and the assessee should be allowed to submit
the same offline and/or even during the course of assessment proceedings. In
any case, the finality of the FTC is determined much later after submission of
the tax return in India.

FTCR have addressed several issues, yet many
have remained unaddressed. It would be desirable if government revisits
provisions of FTCR to make them more robust and comprehensive to reduce
litigations in days to come.

Transfer Pricing – Secondary Adjustments Under Section 92CE

1.0   Introduction

      As the name suggests,
a Secondary Adjustment [SA] follows and is directly consequent upon a primary
transfer pricing adjustment to the taxpayer’s income. The purpose of a SA, as
articulated in the OECD Guidelines is “to make the actual allocation of
profits consistent with the primary transfer pricing adjustment.” SAs are imposed
by the same country imposing the primary adjustment and are based upon the
domestic tax law provisions of that country. Most often, a SA is expressed as a
constructive or deemed transaction (dividend, equity contribution or loan) and
is premised on the view that not only an underpayment or overpayment which must
be corrected and adjusted (primary adjustment), but also the benefit or use of
those funds must be recognized for tax purposes (the SA).

 

     OECD’s Transfer
Pricing Guidelines for Multinational Enterprises and Tax Administrations (‘OECD
TP Guidelines’) defines the term ‘Secondary Adjustment’ as “a constructive
transaction that some countries will assert under their domestic legislation
after having proposed a primary adjustment in order to make the actual
allocation of profits consistent with the primary adjustment.” SA legislation
is already prevalent in many tax jurisdictions like Canada, United States,
South Africa, Korea, France etc. Whilst the approaches to SAs by
individual countries vary, they represent an internationally recognised method
to realign the economic benefit of the transaction with the arm’s length
position. It restores the financial situation of the relevant related parties
to that which would have existed, if the transactions had been conducted on an
arm’s length basis.

 

       The underlying
economic premise for the SA is perhaps best expressed in the OECD TP
Guidelines, which state: “… secondary adjustments attempt to account for
the difference between the re-determined taxable profits and the originally
booked profits.”

 

         OCED Model Convention
only deals with corresponding adjustment. It neither forbids nor requires tax
administrator to make SA. Relevant extract of commentary in OCED model
convention provides that “…nothing in paragraph 9(2) prevents such secondary
adjustments from being made where they are permitted under domestic law of the
contacting state.”

 

1.1   International
Approaches to SAs

         Globally, the OECD
prescribes SA to take any form including constructive equity contribution, loan
or dividend.

A.     Deemed Capital
Contribution Approach

 

B.     Deemed Dividend Approach

C.     Deemed Loan Approach.

 

1.2   Secondary Adjustment
– Global Scenario

 

Jurisdiction

Approach
adopted for SA

Member State of European Union:

 

France, Austria, Bulgaria, Denmark, Germany, Luxembourg,
Netherlands, Slovenia, Spain

Deemed profit distribution /Constructive dividend

USA

Deemed distributed income /Deemed capital contribution, as
the case may be.

South Africa

Deemed dividend approach for Companies; Deemed donation
approach for persons other than Companies.

UK

Deemed loan (Proposed)

Canada

Deemed
dividend

South Korea

Deemed dividend / Deemed capital contribution, as the case
may be.

 

 

1.3   Secondary Adjustment
under the income-tax Act [the Act] – Section 92CE

 

        India is considered as
one of the most aggressive Transfer Pricing (TP) jurisdictions in the world.
The scope of TP provisions in India is very wide compared to many countries and
the provisions are vigorously implemented resulting in huge adjustments,
demands and lot of litigations. A new provision called “Secondary Adjustment”
is introduced in the Indian TP regulations with insertion of section 92CE by
the Finance Act, 2017.

 

1.4   Meaning of the term
“Secondary Adjustment”

 

        Secondary adjustment,
as defined u/s. 92CE(3)(v), means “an adjustment in the books of accounts of
the assessee and its associated enterprise to reflect that the actual
allocation of profits between the assessee and its associated enterprise are
consistent with the transfer price determined as a result of primary
adjustment, thereby removing the imbalance between cash account and actual
profit of the assessee.”

 

         SA has been recognised
by the OECD and many other jurisdictions. As explained above, normally it may
take the form of characterisation of the excess money as constructive
dividends, constructive equity contributions or constructive loans. However,
section 92CE(2) considers such an adjustment as “deemed advance”.

 

1.5   Applicability of the
Provisions

 

         Section 92CE (1)
provides that in the following cases, the tax payer shall make a SA:

 

        where a primary
adjustment to transfer price (i) has been made suo motu by the assessee
in his return of income; (ii) made by the Assessing Officer has been accepted
by the assessee; (iii) is determined by an advance pricing agreement entered
into by the assessee u/s. 92CC; (iv) is made as per the safe harbour rules
framed u/s. 92CB; or (v) is arising as a result of resolution of an assessment
by way of the mutual agreement procedure under an agreement entered into u/s.
90 or section 90A for avoidance of double taxation.

 

         It is provided that
the SA provisions will take effect from 1st April, 2018 and will,
accordingly, apply in relation to the assessment year 2018-19 and subsequent
years.

 

         Proviso to section
92CE(1) further provides that provisions of SA would not apply in following
situations:

 

         If, the amount of
primary adjustment made in the case of an assessee in any previous year does
not exceed one crore rupees and the
primary adjustment is made in respect of an assessment year commencing on or
before 1st April, 2016 i.e. up to AY 2016-17.

 

1.6   Impact of the
Secondary Adjustment

 

         Section 92CE(2)
provides that “Where, as a result of primary adjustment to the transfer
price, there is an increase in the total income or reduction in the loss, as
the case may be, of the assessee, the excess money which is available
with its associated enterprise, if not repatriated to India within the time as
may be prescribed, shall be deemed to be an advance made by the assessee
to such associated enterprise and the interest on such advance, shall be
computed in such manner as may be prescribed.” (Emphasis supplied)

 

         Primary adjustment to
a transfer price has been defined u/s. 92CE(3)(iv) to mean the determination of
transfer price in accordance with the arm’s length principle resulting
in an increase in the total income or reduction in the loss, as the case may
be, of the assessee; (Emphasis supplied)

 

         “Excess Money” has
been defined u/s. 92CE(3)(iii) to mean the difference between the arm’s length
price determined in primary adjustment and the price at which the international
transaction has actually been undertaken.

 

 

1.7   Example

 

(i)   An Indian company “A” has
sold goods worth Rs. 10 crore to its overseas subsidiary “B”. The arm’s length
price is say Rs.15 crore.

(ii)  The primary adjustment is
made by the AO by applying arm’s length principle amounting to Rs. 5 crore
(15-10).

(iii)  Excess Money Rs. 5 crore.

(iv) “A” will have to debit the
account of “B” by Rs. 5 crore in its books of accounts.

(v)  “A” will have to receive
Rs. 5 crore from “B” within the prescribed time provided in Rule 10CB(1).

(vi) If “A” fails to receive
the sum, then Rs. 5 crore will be deemed advance from “A” to “B” and the
interest on such advance shall be computed in the manner to be prescribed in
Rule 10CB(2).

 

1.8   Time Limit for
repatriation of excess money [Rule 10CB(1)]

 

CBDT vide Notification No. 52 /2017 dated 15
June 2017 inserted Rule 10CB providing for Computation of interest income
pursuant to secondary adjustments.

 

Transfer pricing Adjustments-Situations

Time Limit of 90 days for repatriation of excess money

If assessee makes suo moto primary adjustment in ROI.

From the due date of filing ROI u/s. 139(1) of the Act i.e.
30th November.

If assessee enters in to an APA u/s. 92CD of the Act.

If assessee exercises option as Safe Harbour rules u/s 92CB
of the Act.

If agreement is made under MAP under DTAA u/s. 90 or 90A of
the Act.

If assessee accepts the primary adjustment made as per the
order of Assessing Officer (AO) / Appellate Authority.

From the date of order of AO/ Appellate Authority.

 

 

1.9   Rate of Interest for
computation of interest on excess money not repatriated within time limit [Rule
10CB(2)]

 

Denomination of International Transaction

Rate of Interest

INR

1 year Marginal Cost of Fund Lending Rate (MCLR) of SBI as on
1st April of relevant previous year + 325 basis point

Foreign currency

6-month London Inter-Bank Offered Rate (LIBOR) as on 30th
September of relevant previous year + 300 basis point

 

 

The rate of interest is applicable on annual basis.

 

1.10 Analysis of section
92CE and Rule 10CB

 

a)   Extra territorial
application – The foreign AE cannot be compelled to accept SA. Even if they pay
up interest, the home jurisdiction may not allow deduction of such interest.
The taxpayer in India will pay tax on such interest but corresponding deduction
may not be available to AE in its home jurisdiction. To that extent there could
be economic double taxation.

b)   Taxpayer would be in a
precarious position if repatriation is not possible due to exchange control
regulation or some other difficulties in AE’s country.

c)   It appears that there may
not be any additional tax consequences in case interest on deemed advance is
not repatriated to India.

 

1.11 Non-Discrimination –
Domestic Law and Tax Treaty

 

      Whether the SA in
India may be challenged citing non-discrimination article in DTAA?

 

         Article 24(5) of UN
Model:

 

         “5. Enterprises of
a Contracting State, the capital of which is wholly or partly owned or
controlled, directly or indirectly, by one or more residents of the other
Contracting State, shall not be subjected in the first-mentioned State to any
taxation or any requirement connected therewith which is other or more
burdensome than the taxation and connected requirements to which other similar
enterprises of the first-mentioned State are or may be subjected.”

 

         In the light of
Article 24(5), it may be observed that this paragraph forbids a Contracting
State to give less favorable treatment in terms of taxation or any requirement
connected therewith to an enterprise owned or controlled by residents of the
other Contracting State.

         In India, there is no
provision for SA if an Indian company transacts with another Indian AE whereas
SA rule is applicable when an Indian company transacts with non-resident AE.

 

         This may tantamount to
discrimination as per non-discrimination provisions in DTAA.

 

         In this regard useful
reference could be made of the decision in case of Daimler Chrysler India
(P.) Ltd. vs. DCIT [2009] 29 SOT 202 (Pune).

 

1.12 Probable Issues

 

         Several issues could
arise from the enactment of the above provisions. Some of them could be as
follows:

 

(i)    SA in respect of
Transfer Price determined under a Mutual Agreement Procedure (MAP)

 

       Combined reading of the
section 92CE(1) and the definition of the “primary adjustment” suggest that SA
can be made only when the primary adjustment has been made in accordance
with the arm’s length principle. However, in case of a MAP the price may
not be strictly determined based on arm’s length principles and may be a result
of negotiated price. In such a case, whether SA would sustain?

 

(ii)   Adjustment by AO

 

       Section 92CE(1)(ii)
provides for the SA where the assessee has accepted the primary adjustment made
by the AO. Thus, from the plain reading of the provision, it appears that if
the said adjustment is made by CIT(A), then provisions of SA may not be
applicable even if the assessee accepts the same. However, Rule 10CB(1)(ii)
provides that for the purposes of section 92CE(2), the time limit for
repatriation of excess money shall be on or before 90 days from the date of the
order of the AO or the appellate authority, as the case may be, if the primary
adjustments to the transfer price as determined in the aforesaid order has been
accepted by the assessee.

 

       Further, if the order is
passed by the Dispute Resolution Panel (DRP) and accepted by the assessee, then
the SA would be applicable as in case of reference to DRP u/s. 144C, the
assessment is ultimately made by the AO only.

 

(iii)  Increased Litigation

 

       Section 92CE(1) lists
situations wherein the primary adjustment is accepted by the assessee. Thus,
acceptance of primary adjustment is a precondition for invoking provisions of
SA. Accordingly, till the time assessee has not exhausted his appellate
options, he cannot be compelled to accept primary adjustment and consequently
SA cannot be made.

 

       Another related issue
will be whether SA would apply with prospective effect i.e. from the date of
final judicial determination or will it apply with reference to the date of the
original assessment order.

 

       Hitherto, an assessee
could accept the primary adjustment by AO to buy the mental peace and avoid
long drawn litigation, but hence forth he will have to continue his fight to
avoid SA.

 

(iv)  Computation of threshold
of Rs. 1 Crore

 

       Proviso to section
92CE(1) provides that SA would not be applicable if, the amount of primary
adjustment made in the case of an assessee in any previous year does
not exceed one crore rupees.

 

       It is not clear as to whether
this limit would be applicable to the aggregate of adjustments during a
previous year (qua previous year) or qua each transaction or
adjustment. To illustrate, if two adjustments are made each amounting to Rs. 65
lakh, then whether cumulative limit is to be considered or limit on a
standalone basis has to be considered. Also, it is not clear as to where the
primary adjustment in respect of one transaction is exceeding Rs. 1 crore and
the other is only for Rs. 10 lakh, whether the SA would be required for both
the transactions.

 

(v)   Exceptions to the SA

       Proviso to section 92CE
(1) reads as follows:

“      Provided that nothing
contained in this section shall apply, if,– (i) the amount of primary
adjustment made in any previous year does not exceed one crore rupees; and
(ii) the primary adjustment is made in respect of an assessment year commencing
on or before the 1st day of April, 2016.”

 

       Use of the conjunction
“and” results in lot of confusion. The literal interpretation of the above
provision suggests that both the conditions need to be fulfilled to claim
exemption from SA. If that interpretation is adopted, then it would lead to
absurd results, such as SA would be required for each and every transaction
from AY 2016-17 (even for Re. 1 of the primary adjustment) and if the amount of
adjustment exceeds Rs. 1 crore then the SA would be required in respect of all
past transactions, may be from the start of the TP regulations.

 

       The logical
interpretation should be to read both the conditions/situations separately. One
should read “or” as a conjunction in place of “and”. This interpretation draws
strength from the Notes on Clauses to the Finance Bill, 2017 where both the
conditions are mentioned separately.

 

(vi)  Adjustment in the Books
of Accounts

 

       The definition of the SA
provides for an adjustment in the books of the assessee and it’s AE.

 

       The above provision
raises several issues:

 

       How can an Indian TP
regulation provide for adjustments in the books of an AE which is situated in
some other sovereign jurisdiction? Any such adjustment would render the books
and audit procedure of the AE questionable.

 

       It is also not provided
in which year’s books of accounts of the assessee such adjustments are to be
made, as by the time TP assessment is made the relevant year’s books must be
closed, audited and finalised. Thus, logically the adjustment has to be made in
the year of finalisation (acceptance) of the primary adjustment. Once assessee
makes SA, it may go against him as it will prove that the accounts of the year
in which the original transaction was effected was not recorded correctly and
therefore true and fair view of the accounts was impacted, (assuming the impact
of primary adjustment and SA are material). Transfer pricing is an art and not
an exact science and therefore to avoid such a situation it must be provided
that any such adjustment shall not affect the true and fair view of audited
accounts.

 

(vii) Transfer Pricing
Regulations in respect of SA

 

       A question may arise as
to whether the SA could be regarded as a fresh “international transaction” as
it would be deemed to be an advance. However, it would be too farfetched; the
SA is result of international transaction and cannot be cause in itself. If we
interpret it otherwise, then we go into a loop. Accordingly, other requirements
pertaining to reporting, documentation etc. should not apply. However, a
clarification to this effect is highly desirable.

 

(viii)          Computation of
Interest

 

       It is provided that the
excess money would be regarded as deemed advance and interest on such advance
shall be computed in the manner prescribed in Rule 10CB(2). However, from the
computation mechanism provided in Rule 10CB(2), it is not clear as to from
which date one needs to compute the interest. Ideally, it should not be from
the date of individual transaction, to avoid complexity in case of multiple
transactions. Logically, it should be from the expiry of the time limit within
which the excess money is required to be repatriated to India.

 

(ix)  Secondary Adjustment –
Double taxation

 

       The provision of SA is a
unilateral one. The other country may or may not agree to it. Even primary
adjustment results in double taxation, the SA would only compound the problem
and put assessee to undue hardships. Whereas each country has a sovereign right
to protect its tax base, bilateral or multilateral treaties could help reduce
the rigours of double taxation.

(x)   Repatriation of amount of
SA

 

       Section 92CE(2) provides
that the excess money owing to SA must be repatriated to India within the
prescribed time period provided in Rule 10CB(1). However, where the SA is made
between an Indian PE of a foreign company and its subsidiary in India, then the
conditions of repatriation would be difficult to comply, unless the Head Office
of the PE remits the amount of SA on behalf of its Indian PE.

 

(xi)  Implications of SA under
FEMA

 

       Section 92CE(2) provides
that the excess money to be considered as deemed advance by an Indian
entity/company to its foreign AE. As per FEMA, an Indian entity can lend money
to its foreign AE only upon fulfilling certain conditions and subject to limits
and compliance procedure. Passing an entry in the books of account without
proper compliances could result in FEMA violations.

 

(xii) Deemed dividends u/s
2(22)(e) of the Act

       Section 2(22)(e) of the
Act provides that payment by way of loan or advance by a company to a specified
shareholder (where the company is holding more than 10% of the voting power) or
to any concern in which he has a substantial interest shall be regarded as
deemed dividend.

 

       A question arises as to
whether deemed advance due to SAs u/s. 92CE would be regarded as deemed
dividend u/s. 2(22)(e) in the event AE satisfies the conditions of requisite
shareholding or is considered as an interested concern?

 

       Two views are possible
in this case:

 

       According to one view,
once a sum is considered as an “advance” all logical consequences under the Act
would follow and accordingly it ought be regarded as advance for the purposes
of section 2(22)(e).

 

       The other and more
plausible view is that section 2(22)(e) should not apply in such a situation
for various reasons. One of the important reason could be that the section
2(22)(e) refers to “any payment by a company….., of any sum… made.. by way of
advance…” and hence the emphasis on actual payment and not
deemed/constructive payment. Since advance arising out of SA are on deemed
basis, such deemed advance cannot be regarded as deemed dividends u/s. 2(22)(e)
of the Act.

 

(xiii)   Other issues

 

a)   Presently, there is no
specific provision to levy any penalty for non-compliances of SA.

b)   Multiple transactions with
multiple AEs – How does an Indian entity allocate the amount of overall / lump
sum primary adjustment arising out of various transactions with many AEs in
order to comply the provisions of SA ?

c)   Whether revised book
profit as a result of recording of SA will be subject to MAT, and if so, in
which year?

d)   The AE may not be in a
position to repatriate the amount of SA because (a) it is incurring losses; or
(b) the country where it is located prohibits such remittance under its
exchange control regulations; or (c) the AE ceases to be AE before the SA is
made; or (d) the AE is not financially sound to repatriate the excess money.
Thus, if repatriation is not possible due to any of the foregoing reasons, will
the impact of SA be perpetual, is not clear.

e)   Whether taxpayer can write
off this advance if it is not recoverable and claim deduction of write off as
there is no express provision to disallow such write off?

f)    It is not clear whether taxpayer will be allowed to set off the amount
of deemed advance against the amount of loan to be repaid to its AE.

g)   Foreign Tax Credit [FTC]:
Issues regarding FTC may arise as to (a) will FTC be available in India if
foreign withholding tax applies on repatriation of deemed advance to India; (b)
If yes, at what rate will such FTC be given; or (c) What would be the nature of
such receipts i.e. if the jurisdiction of the foreign AE treats the payment as
a dividend and accordingly applies withholding tax and will India still grant
FTC, in such cases?

h)   Whether interest on deemed
advance chargeable to tax even if AE declines to accept this as its liability?

i)    Whether SA needs to be
made in relation to deemed international transaction u/s. 92B(2)?

j)    A further question may
arise as to whether SA of interest as recorded in the books of taxpayer will be
considered for the purpose of disallowance u/s. 94B.

 

         For a satisfactory
resolution of the above issues, one hopes that the CBDT would issue the
necessary clarifications at the earliest to avoid cumbersome/repetitive / time
consuming and costly litigation which is already clogging the overburdened
judiciary.

 

1.13 Conclusion

 

         It is true that the
concept of SA is prevalent in many developed jurisdictions. In that sense,
introduction of SAs rules in Indian transfer pricing regime is in conformity
with international practice. However, considering the level of maturity of
transfer pricing regime in India, it is debatable whether this is right time to
introduce SA rules in India. Indian revenue authorities are still striving to
cope up with many contentious issues arising out of transfer pricing disputes.
In the midst of such melee, introducing another dimension of transfer pricing
appears to be a pre-mature act. Debate may arise over whether SAs are
appropriate in the current global arena, where they are not consistently
applied and where various countries take different views on corresponding or
correlative relief. Provisions of SA are complex in nature and would result in
lot of hardships and increased litigation.

 

         Further, in view of
various issues and complications, as discussed above, we wonder whether it
would not have been better if India also had adopted the deemed dividend
approach as adopted by many advanced tax jurisdictions rather than the deemed
loan approach, to obviate most of the probable issues arising due to the deemed
‘advance’ approach. _

Provisions Of TDS Under Section 195 – An Update – Part I

In
view of increasing cross border transactions which Indian enterprises have with
the non-residents, section 195 of the Income-tax Act, 1961 [the Act] dealing
with deduction of tax at source from payments to non-residents has assumed huge
importance over the years. Many amendments have taken place in the section(s),
relevant rules and forms relating to deduction of tax at source from payments
to non-residents. In addition, due huge litigation in this regard, there have
been plethora of judicial pronouncements and cleavage of judicial opinions on
various contentious issues. In this series of articles, we are dealing with the
amended provisions as well as various important judicial pronouncements and
practical issues relating to TDS u/s. 195.

 

In
view of the vastness of the subject, plethora of issues, judicial
pronouncements and space limitations, at various places we have only referred
to relevant statutory provisions, CBDT Circulars and Instructions and judicial
pronouncements. For a better understanding of the issues, reader is advised to
study the same in detail.

 

1.
Overview of Relevant Provisions

 

1.1     Relevant sections

 

Section

Particulars

195(1)

Scope
and conditions of applicability

195(2)

Application
by the ‘payer’ to the Assessing Officer [AO]

195(3),
(4) & (5)

Application
by the ‘payee’ to the AO, validity of certificate issued by the AO, Powers of
CBDT to make rules by issuing Notifications re s/s. (3)

195(6)

Furnish
the information relating to the payment of any sum under s/s. (1)

195(7)

Power
of CBDT to specify class of persons or cases where application to AO u/s.
195(2) compulsory

195A

Grossing
up of tax

197

Certificate
for deduction at lower rate

206AA

Requirement
to furnish Permanent Account Number

90(2)

Application
of Act or Treaty, whichever more beneficial

90(4)

Tax
Residency Certificate

94A(5)

Special
Measures in respect of transactions with persons located in notified
jurisdictional area

 

 

1.2     Other TDS provisions for payments to
non-residents

Section

Applicable to

Rate

192

Payment
of Salary

Average
Rate

194B

Winnings
from lottery or crossword puzzle or card game and other game of any sort

Rate
in force

194BB

Winnings
from horse races

Rate
in force

194E

Payment
to non-resident sportsmen or sports associations

20%

194LB

Interest
to non-resident by an Infrastructure Debt fund

5%

194LBA
(2) & (3)

Income
[referred in section 115UA of the nature referred in section 10(23FC) and
10(23FCA)] from units of a business trust to its unit holders

5%
/rate in force

194LBB

Income
[other than referred in section 10(23FBB)]in respect of units of investment
fund

Rate
in force

194LC

Interest
to non-resident by an Indian company or a business trust under approved loan
agreements or on long term Infra Bonds approved by Central Govt.

5%

194LD

Interest
to FIIs or QFIs on rupees denominated bonds or Government security

5%

196B

Income
from units u/s. 115AB purchased in foreign currency or Long-term capital
gains [LTCG] arising from transfer of such units

10%

196C

Interest,
Dividends or LTCG from Foreign Currency bonds or shares referred in section
115AC

10%

196D

Interest,
Dividends or Capital Gains of FIIs from securities (Other than interest
covered by section 194LD) referred in section 115AD (1)(a)

20%

 

 

1.3     Relevant Rules and Forms

 

Rule

Particulars

26

Rate
of exchange for the purpose of deduction of tax at Source on income payable
in foreign currency

115

Rate
of exchange for conversion into rupees of income expressed in foreign
currency

21AB

Certificate
(Form 10F) for claiming relief under an agreement referred to in section 90
and 90A

28(1),
28AA, 28AB & 29

Application
and Certificate for deduction of tax at lower rates

29B

Application
for Certificate u/s.195(3) authorising receipt of interest and other sums
without deduction of tax

37BB

Furnishing
of Information for payment to a non-resident, not being a company, or to a
Foreign Company

37BC

Relaxation
from deduction of tax at higher rate u/s 206AA

Form

Particulars

15CA

Information
to be furnished for payment to a non-resident, not being a company, or to a
Foreign Company

15CB

Certificate
of an Accountant

13

Application
for a Certificate u/s. 197

15C
& 15D

Application
u/rule 29B by a Banking Company and by any other person

10F

Information
to be provided u/s. 90(5) or 90A(5)

27Q

Quarterly
statement of deduction of tax u/s. 200(3) in respect of payments (other than
salary) made to non-residents

 

 

2.
Section 195 (1)

 

Other
sums.

 

195. (1) Any person responsible for paying to a non-resident, not being a
company, or to a foreign company, any interest (not being interest referred to
in section 194LB or section 194LC or section 194LD) or any other sum
chargeable under the provisions of this Act (not being income chargeable
under the head “Salaries”) shall, at
the time of credit of such income to the account of the payee or at the time of payment thereof in cash
or by the issue of a cheque or draft or by any other mode, whichever is earlier, deduct income-tax
thereon at the rates in force:

 

Provided that ….

 

Provided
further
that no such deduction shall be made in respect of any dividends referred to in
section 115-O.

 

Explanation
1.—For
the purposes of this section, where any interest or other sum as aforesaid is
credited to any account, whether called “Interest payable account”
or “Suspense account” or by any other name, in the books of
account of the person liable to pay such income, such crediting shall be
deemed to be credit of such income to the account of the payee and the
provisions of this section shall apply accordingly.

 

Explanation
2.—For
the removal of doubts, it is hereby clarified that the obligation to
comply with s/s. (1) and to make deduction thereunder applies and shall be
deemed to have always applied and extends and shall be deemed to have always
extended to all persons, resident or non-resident, whether or not the
non-resident person has—

 

(i) a
residence or place of business or business connection in India; or

 

(ii)        any
other presence in any manner whatsoever in India.”

2.1     Section 195(1) – Exclusions

 

The following are excluded from the scope
of section 195(1):

 

(i)  Interest
referred to in section 194LB or section 194LC or section 194LD.

(ii) Income
chargeable under the head “Salaries”.

(iii)       Dividends
referred to in section 115-O.

(iv)       Sum
not chargeable to tax in India.

 

a.  Non-chargeability
either due to Act or Double Taxation Avoidance Agreement [DTAA]. DTAA benefit
subject to obtaining TRC/Form 10F from the non-resident payee.

 

b.  Due
to scope of total income u/s. 5 or exemption u/s. 10.

 

c.  No
TDS on amounts exempt u/s. 10 – Hyderabad Industries Ltd. vs. ITO 188 ITR
749 (Kar).

 

d.  Income
from specified services such as online advertisement, digital advertising space
subject to Equalisation Levy (Chapter VIII of Finance Act 2016) – Exempt
u/s. 10(50).

 

(v) Section
172 – Profits of non-residents from Occasional Shipping Business

 

a.  CBDT
Cir. No. 723 dated 19.09.1995 – Payments to shipping agents of non-resident
ship owners – Provisions of section 172 apply and section 194C/195 will not
apply.

 

b.  CBDT
Cir. No. 732 dated 20.12.1995 – Annual No Objection Certificate u/s. 172 to be
issued by AO where Article 8 of DTAA applies – declaration that only
international traffic during period of validity of certificate.

 

c.  CIT
vs. V. S. Dempo & Co (P) Ltd. 381 ITR 303 (Bom) – Section 195 not
applicable to shipping profits governed by section 172 and section 44B.

 

(vi)       Where
certificate is obtained by the payee u/s 197 for non-deduction of TDS and such
certificate is in force (not cancelled), then the payer cannot be treated as
assessee in default for non-deduction of TDS – CIT vs. Bovis Lend Lease
(I) Ltd. 241 Taxman 312 (SC).

2.2     Scope of section 195 (1) – Inclusions

 

(i)  Any
person responsible for paying to a non-resident, not being a company or a
Foreign Company is covered in the scope of section 195(1). It includes all
taxable entities and there is no exclusion for individual/HUF.

 

(ii) The
term person includes a local authority. In CIT vs. Warner Hindustan
Limited 158 ITR 51 (AP), the court while holding that the expression
“person” includes a Department of a foreign government like USAID held that “As
observed by us already the expression “person” is of wide connotation and it
includes, in our opinion, the Department of a foreign Government like USAID.
Learned counsel for the assessee invited our attention to a decision in Madras
Electric Supply Corporation Ltd. vs. Boar land (Inspector of Taxes) [1935] 27
ITR 612 (HL), to support the proposition that the expression “person” includes
Crown. We find that the above-referred decision supports the view that a
Government falls within the meaning of the expression “person”.”

 

(iii)       Section
195 includes residents as well as non-residents. Following the decision of the
Supreme Court in the case of Vodafone International Holdings BV vs. Union
of India 341 ITR 1 (SC), Explanation 2 has been inserted by the
Finance Act, 2012 with retrospective effect from 1.4.1962, which clearly
provides that ‘For the removal of doubts, it is hereby clarified that
the obligation to comply with sub-section (1) and to make deduction thereunder
applies and shall be deemed to have always applied and extends and shall be
deemed to have always extended to all persons, resident or non-resident,
whether or not the non-resident person has (i) a residence or place of business
or business connection in India; or (ii) any other presence in any manner
whatsoever in India.

 

(iv)       If
a person is treated as agent of a non-resident u/s.163, the same person cannot
be proceeded u/s. 201 at the same time for non-deduction of TDS on payment to
non-resident. CIT vs. Premier Tyres Ltd. 134 ITR 17 (Bom).

 

(v) The
term Non-Resident includes a Non-resident Indian. However, it does not include
a person who is Resident but Not Ordinarily Resident [RNOR]. It is important to
note that the term non-resident includes RNOR for the purposes of sections 92,
93 and 168 but  not for the purposes of
section 195.

 

(vi)       Residential
status of a person i.e. whether he is resident or non-resident based on the
physical presence test in India of more 182 days in the current year may not be
known till year end. A question arises as to in the initial months of a
financial year, how it has to be determined as to a person is non-resident or
not.

 

Whether earlier year’s residential status
can be adopted in such cases? The Authority for Advance Ruling [AAR] in the
case of Robert W. Smith vs. CIT 212 ITR 275 (AAR) and Monte Harris vs.
CIT 218 ITR 413 (AAR), for purposes of determining the residential
status of an applicant u/s. 245Q, held that it appears more practical and
reasonable for purposes of determining the residential status of an applicant
u/s. 245Q to look at the position in the earlier previous year, i.e., the
financial year immediately preceding the financial year in which the
application is made. In the Monte Harris’s case, the AAR observed as follows:

 

“An application may be presented soon
after the commencement of the financial year. It may also have to be disposed
of before the end of that financial year. In that event, both on the date of
the application as well as on the date on which the application is heard and
disposed of, it may not be possible in all cases to predict with reasonable
accuracy whether the stay of the applicant in India during that financial year
will exceed 182 days or not. In other words, it will be difficult to determine
the residential status of the applicant with reference to the previous year of
the date of application. The expression ‘previous year’ should be so construed
as to be applicable uniformly to all cases. It cannot be said that a previous
year should be taken as the financial year in which the application is made
provided the stay of the applicant up to the date of the application or the
estimated stay of the applicant in India in that financial year exceeds 182
days and that it should be the previous year preceding that financial year in
case it is not possible to determine the duration of the stay of the applicant
in India in the financial year in which the application is made. It appears
more practical and reasonable for purposes of determining the residential status
of an applicant under section 245Q to look at the position in the earlier
previous year, i.e., the financial year immediately preceding the financial
year in which the application is made. This is a period with reference to which
the residential status of the applicant in every case can be determined without
any ambiguity whatsoever. In the instant case, though the applicant was
resident in India in the financial year 1994-95 during which the application
had been made, he was non-resident in India during the immediately preceding
financial year, i.e., 1993-94. The applicant must, therefore, be treated as a
non-resident for the purposes of the instant application. The application was,
therefore, maintainable.”

 

It remains to be judicially tested as to
whether a similar stand can be taken for the purposes of section 195(1).

 

(vii) In respect of TDS from the payment
to an agent of a non-resident in the following cases it was held that the payer
is required to deduct tax at source:

–   Narsee
Nagsee & Co. vs. CIT 35 ITR 134 (Bom).

–   R.
Prakash [2014] 64 SOT 10 (Bang.)

 

However, in the case of Tecumseh Products
(I) Ltd. [2007] 13 SOT 489 (Hyd.), the ITAT, on the facts of the case, held
that the assessee was not liable to TDS as the primary responsibility for payment
of interest was of the Bank and not of the assessee, though later on the bank
may recover the amount of interest paid by it from the assessee. In this
regard, the ITAT held as follows:

 

“In the instant case, the question for
consideration was as to who was responsible for making payment of interest to
the non-resident bank. Admittedly, the interest was paid by Andhra Bank and not
by the assessee. The case of the department was that since the bank had paid
interest on behalf of the assessee as an agent, the assessee was responsible
for making deduction of tax before payment. It was not in dispute that in terms
of letter of credit, non-resident bank negotiated with the Andhra Bank for
payment of interest on late payment. When the supplier presented the letter of
credit and negotiated the same through non-resident bank in terms of letter of
credit, Andhra Bank was bound to pay interest in case of any late payment. The
Andhra Bank might recover the payment from the assessee, but the immediate
responsibility was that of Andhra Bank and not the assessee. The Legislature
has used the words “any person responsible for paying”. In instant
case, the responsibility was of Andhra Bank and not of the assessee. The
payment might have been made on behalf of the assessee but that did not take
away the responsibility of Andhra Bank from paying interest to the foreign
bank. Therefore, it might not be proper to say that the assessee failed to
deduct tax while paying interest to the foreign banker.”

(viii) The term ‘any person’ includes a
foreign company, whether it is resident in India or not. It also includes
Indian branch of foreign company.

a)  Section
195(3) and Rule 29B contains relevant provisions regarding grant of a
certificate by the AO authorising such a branch to receive interest or other
sum without TDS as long as the certificate is force.

 

b)  A
foreign company having a branch or office in India is also covered. ITO vs.
Intel Tech India P. Ltd. 32 SOT 227 (Bang).

 

However, it is to be noted that payments
to foreign branch of an Indian company is not covered under the provisions of
section 195.

 

c)  Payment
by a branch to HO/Other foreign branch.

 

There is a cleavage of judicial
pronouncements on the subject. However, in respect of payment of interest by
the PE of a foreign bank, the law has been amended by insertion of Explanation
to section 9(1)(v), which has been explained below.

 

i. TDS Required: CBDT
Circular 740 dtd 17.4.1996 – Branch of a foreign company is a separate entity
and hence payment of interest by branch to HO is taxable u/s. 115A subject to
provisions of applicable DTAA.

 

Dresdner Bank [2007] 108 ITD 375 (Mum.).

 

CBDT Circular No. 649 dated 31st
March 1993 providing for treatment of technical expenses when being remitted to
Head Office of a non-resident enterprise by its branch office in India requires
that the branch – permanent establishment – should ensure tax deduction at
source in such cases in accordance with the provisions of section 195 of the
Act.

 

ii.  TDS
Not Required: In the following cases it was held that TDS u/s 195 is
not applicable.

 

ABN Amro Bank NV vs. CIT [2012] 343 ITR
81(Cal),

Bank of Tokyo Mitsubishi Ltd vs. DIT 53
taxmann.com 105 (Cal),

 

Deutsche Bank AG vs. ADIT 65 SOT 175
(Mum), and

Sumitomo Mitsui Bank Corpn vs. DDIT [2012]
136 ITD 66 (Mum)(SB).

 

iii. Amendment
vide Finance Act 2015 w.e.f 1.4.2016

 

Interest deemed to accrue or arise in
India u/s. 9(1)(v). Explanation inserted to section 9(1)(v) reads as follows:

 

“Explanation: for the purposes of this
clause,-

(a) it
is hereby declared that in the case of a non-resident, being a person
engaged in the business of banking, any interest payable by the
permanent establishment in India of such non-resident to the head office or any
permanent establishment or any other part of such non-resident outside India
shall be deemed to accrue or arise in India and shall be chargeable to tax in
addition to any income attributable to the permanent establishment in India and
the permanent establishment in India shall be deemed to be a person
separate and independent of the non-resident person of which it is a
permanent establishment and the provisions of the Act relating to computation
of total income, determination of tax and collection and recovery
shall apply accordingly;”

 

Thus,

–  The
aforesaid Explanation is applicable to non-resident engaged in business of
banking.

 

–  Interest
payable by Indian PE to HO, any PE or any other part of such NON-RESIDENT
outside India deemed to accrue or arise in India.

 

–  Chargeable
to tax in addition to any income attributable to PE in India.

 

–  PE
in India deemed to be separate and independent of the NON-RESIDENT of which it
is a PE.

 

–  Provisions
relating to computation of total income, determination of tax and collection
and recovery to apply accordingly.

 

2.3     Scope of section 195 (1) – Sum Chargeable
to Tax

 

(i)  Transmission
Corpn of AP Ltd. vs. CIT 239 ITR 587 (SC)

 

a)  Payment
to non-resident towards purchase of machinery and erection and commissioning
thereof.

 

b)  Assessee’s
contention – Section 195 applies only in respect of sums comprising of pure
income or profit.

c)  Held
that:                                                  

 

• TDS applicable not only to amount which
wholly bears income character but also to sums partially comprising of income.

• Obligation to deduct tax limited to
portion of the income chargeable to tax.

• Section 195 is for tentative deduction
of tax and by deducting tax, rights of the parties are not adversely affected.

• 
Rights of parties safeguarded by sections 195(2), 195(3) and 197.

• 
File application to AO – If no application filed, tax to be deducted.

 

(ii) GE
India Technology Centre (P.) Ltd. vs. CIT [2010] 193 Taxman 234 (SC)

 

The interpretation of the decision of SC
in the Transmission Corporation’s case (supra) was subject matter of litigation
in many cases and the issue once again came up for resolution before the
Supreme Court in this case. The SC held as under:

 

a)  The
moment there is a remittance out of India, it does not trigger section 195. The
payer is bound to deduct tax only if the sum is chargeable to tax in India read
with section 4, 5 and 9.

 

b)  Section
195 not only covers amounts which represents pure income payments, but also
covers composite payments which has an element of income embedded in them.

 

c)  However,
obligation to deduct TDS on such composite payments would be limited to the
appropriate proportion of income forming part of the gross sum.

 

d)  If
payer is fairly certain, then he can make his own determination as to whether
the tax is deductible at source and if so, what should be the amount thereof,
without approaching the AO.

 

(iii)       Instruction
No. 2 of 2014 dated 26-2-2014 directing that in a case where the assessee fails
to deduct tax u/s. 195 of the Act, the AO shall determine the appropriate proportion of the
sum chargeable to tax as mentioned in sub-section (1) of section 195 to
ascertain the tax liability on which the deductor shall be deemed to be an
assessee in default u/s. 201 of the Act, and the appropriate proportion of the
sum will depend on the facts and circumstances of each case taking into account
nature of remittances, income component therein or any other fact relevant to
determine such appropriate proportion.

 

(iv)       Tax
withholding from payment in kind / Exchange etc.

 

TDS u/s. 195 is required to be deducted.

 

a)  Kanchanganga
Sea Foods Ltd. vs. CIT 325 ITR 540 (SC).

 

b)  Biocon
Biopharmaceuticals (P) Ltd. vs. ITO 144 ITD 615 (Bang).

 

However, in the context of distribution of
prizes to customers wholly in kind (section 194B) and receipt of Certificate of
Development Rights against voluntarily surrender of the land by the landowner,
it has been held in the following cases that TDS provisions are not applicable:

 

c)  CIT
vs. Hindustan Lever Ltd. (2014) 264 CTR 93 (Kar)

 

d)  CIT(TDS)
vs. Bruhat Bangalore Mahanagar Palike (ITA No. 94 and 466 of 2015)(Kar).

 

(v) Payments
by one non-resident to another non-resident inside / outside India

 

a)  Asia
Satellite Telecommunications Co. Ltd. vs. DCIT 85 ITD 478 (Del) – Source of
Income in India, are covered by section 195.

 

b)  Vodafone
International Holding B.V. vs. UoI [2012] 17 taxmann.com 202 (SC).

 

(vi)       For
non-compliance by a non-resident of TDS provisions, section 201 not applicable
if recipient pays advance tax.

 

a)  AP
Power generation Corporation Ltd. vs. ACIT 105 ITD 423.

2.4     Sum Chargeable to Tax – TDS Guidelines

 

Situation

Consequences

Entire payment not chargeable to tax

Not
required to withhold tax.

 Entire payment subject to tax

Tax
should be withheld.

Part of payment subject to tax

Tax
should be withheld on the appropriate proportion of sum chargeable to tax

[CBDT Instruction No. 2/2014 dated 26 February 2014].

Part of payment subject to tax in India – Payer unable to
determine appropriate portion of the sum chargeable to tax

Apply
to AO for determination of TDS.

Payer believes that tax should be withheld but payee does not
agree

Approach
the AO for determination of TDS.

 

 

2.5     Chargeability to tax governed by provisions
of Act/DTAA

 

Nature of Income

Act (Apart from section 5, wherever applicable)

Treaty

Business/Profession

Section
9(1)(i) – Taxable if business connection in India

Article
5, 7 and 14 – Taxable if income is attributable to a Permanent Establishment
in India

Salary
Income

Section
9(1)(ii) – Taxable if services are rendered in India

Article
15 – Taxable if the employment is exercised in India (subject to short stay
exemption)

Dividend
Income

Section
9(1)(iv), section 115A – Taxable if paid by an Indian Company (At present
exempt)

Article
10 – Taxable if paid by an Indian Company

Interest
Income

Section
9(1)(v), section 115A – Taxable if deemed to arise in India

Article
11- Taxable if interest income arises in India

Royalties
/ FTS

Section
9(1)(vi), section 115A – Taxable if deemed to arise in India

Article
12 – Taxable if royalty/ FTS arises in India

Capital
Gains

Section
9(1)(i), section 45 – Taxable if situs of shares / property in India

Article
13 – Generally taxable if the situs of shares/ property in India.

 

 

 

As
per the provisions of section 90(2), provisions of the Act or DTAA, whichever
is beneficial, prevails.

 

2.6     Scope of section 195 (1) – Time of
deduction

 

(i)  Twin
conditions for attracting section 195

– For
payer – credit or payment of income

–  For
payee – Sum chargeable to tax in India

 

(ii) On
credit or payment, whichever is earlier

–  CIT
vs. Toshoku Ltd. [1980] 125 ITR 525 (SC);

–  United
Breweries Ltd. vs. ACIT [1995] 211 ITR 256 (Kar);

–  Flakt
(India) Ltd. [2004] 139 Taxman 238 (AAR).

–  Broadcom
India Research (P) Ltd. vs. DCIT [2015] 55 taxmann.com 456 (Bang.).

 

(iii)       Merely
on the basis of a book entry passed by the payer no income accrues to the
non-resident recipient

–  ITO
vs. Pipavav Shipyard Ltd. Mumbai ITAT – [2014] 42 taxmann.com 159 (Mum-Trib).

 

(iv)       1st
Proviso to section 195(1) provides exception for interest payment by Government
or public sector bank or a public financial institution i.e. deduction shall be
made only at the time of payment thereof.

 

(v) TDS
from Royalties and FTS at the time of payment:

–  DCIT
vs. Uhde Gmbh 54 TTJ 355 (Bom) [India-Germany DTAA]

–  National
Organic Chemical Industries Ltd. vs. DCIT 96 TTJ 765 (Mum) [India-Switzerland
and India-USA DTAA]

(vi)       When
FEMA/RBI approval awaited,

–  United
Breweries Ltd. vs. ACIT 211 ITR 256 – Liability at the time of credit in
the books even if approval received later on.

–  ACIT
vs. Motor Industries Ltd. 249 ITR 141 – It was held that the assessee was
not liable to interest u/s. 201(1A) since it was not obliged to deduct tax at source in respect of
amounts credited in its books for period when agreement was not in force as
foreign collaborator would have got a right to enforce its right to receive
payment only on conclusion of said agreement, (which was pending for approval).

 

(vii) TDS liability u/s. 195 when
adjustment of amount payable to a non-resident against dues i.e. when no
payment no credit.

–  J.
B. Boda & Co. (P.) Ltd. vs. CBDT 223 ITR 271

–  An
adjustment of the amount payable to the non-resident or deduction thereof by
the non-resident from the amounts due to the resident-payer (of the income)
would fall to be considered under “any other mode”. Such adjustment
or deduction also is equivalent to actual payment. Commercial transactions very
often take place in the aforesaid manner and the provisions of section 195
cannot be sought to be defeated by contending that an adjustment or deduction
of the amounts payable to the non-resident cannot be considered as actual
payment. Raymond Ltd. [2003] 86 ITD 791 (Mum).

 

(viii)
Dividend is declared but not paid pending RBI approval, then the same accrues
in the year of payment Pfizer Corporation vs. CIT (2003) 259 ITR 391 (Bom).

 

(ix) If no income accrues to non-resident
although accounting entry incorporating a liability is passed,
no liability for TDS. United Breweries Ltd. vs. ACIT 211 ITR 256.

 

(x) Payee should be ascertainable. IDBI
vs. ITO 107 ITD 45 (Mum).

 

(xi) Time of Deduction from the point of
view of the payer and not payee. Relevant in cases where one of them maintain
the books on cash basis and the other on accrual basis – C. J. International
Hotels Ltd. vs ITO TDS 91 TTJ (Del) 318.

 

2.7     Section 195(1) – Rates in force

 

(i)   Section
2(37A)(iii) provides in respect of Rates in Force for the purposes of section
195.

 

(ii)  Circular
728 dtd. 30-10-1995 – Rate in force for remittance to countries with DTAA.

 

(iii) Circular
740 dtd. 17-04-1996 – Taxability of interest remitted by branches of banks to
HO situated abroad.

 

(iv) No
surcharge and education cess to be added to Treaty rates.

–  DIC
Asia Pacific Pte Ltd. vs. ADIT IT 22 taxmann.com 310.

–   Sunil
V. Motiani vs. ITO IT 33 taxmann.com 252;

–  DDIT
vs. Serum Institute of India Ltd. [2015] 56 taxmann.com 1 (Pune Trib.).

 

(v)  Section
44DA read with 115A – Special provision for computing income by way of
royalties etc. in case of non-residents.

 

(vi) Section
44B – Non-resident in shipping business (7.5% Deemed Profit Rate [DPR])

 

(vii)      Section
44BB – Non-resident’s business of prospecting etc. of mineral oil (10% DPR)

 

(viii)     Section
44BBB – Non-resident civil construction business in certain turnkey power
projects (10% DPR)

 

(ix) Presumptive
provisions (44B, 44BB, 44BBB etc) – Section 195 applicable. Frontier
Offshore Exploration (India) Ltd vs. DCIT 13 ITR (T) 168 (Chennai).

 

(x)  Section
294 of the Act provides that if on the 1st day of April in any
assessment year provision has not yet been made by a Central Act for the
charging of income-tax for that assessment year, the provision of the
Income-tax Act shall nevertheless have effect until such provision is so made
as if the provision in force in the preceding assessment year or the provision
proposed in the Bill then before Parliament, whichever is more favourable to
the assessee, were actually in force.

 

2.8     Section 195(1) – Sum Chargeable to
tax-Exchange Rate Applicable

 

(i)   Rule
26 provides for rate of exchange for the purpose of TDS on Income payable in
foreign currency

 

(ii)  TDS
to be deducted on income payable in foreign currency.

–   Value
of rupee shall be SBI TT buying rate.

–   on
the date on which tax is required to be deducted.

 

(iii) Where
rate of exchange on date of remittance differs from exchange rate on date of
credit, no TDS to be deducted on exchange rate difference. Sandvik Asia Ltd
vs. JCIT 49 SOT 554 (Pune).

 

3.  Section 94A
– Notified Jurisdictional Areas

 

(i)   Section
94A(5) – Special measures in respect of transactions with persons located in
notified jurisdictional area

 

‘(5) Notwithstanding
anything contained in any other provisions of this Act, where any person
located in a notified jurisdictional area is entitled to receive any sum or
income or amount on which tax is deductible under Chapter XVII-B, the tax
shall be deducted at the highest of the following rates, namely:-

 

(a) at the rate or rates in force;

(b) at the rate specified in the relevant
provisions of this Act;

(c) at the rate of thirty
per cent.’

 

(ii)  Notification
No. 86/2013 [F. NO. 504/05/2003-FTD-I]/SO 3307(E), Dated 1-11-2013 – Cyprus
Notified.

 

(iii) Validity
of the notification upheld by the High Court of Madras in T. Rajkumar vs.
Union of India [2016] 68 taxmann.com 182 (Madras).

 

(iv) The
notification of Cyprus u/s 94A as a notified jurisdictional area for lack of
effective exchange of information, has been rescinded with effect from
1.11.2013 [Notification No. 114/2016 dated 14.12.2016].

 

4.
Grossing up of tax (195A)

 

(i)
Section 195A – Income payable “net of tax”

 

“In
a case other than that referred to in sub-section (1A) of section 192, where
under an agreement or other arrangement, the tax chargeable on any income
referred to in the foregoing provisions of this Chapter is to be borne by
the person by whom the income is payable, then, for the purposes of deduction
of tax under those provisions such income shall be increased to such
amount as would, after deduction of tax thereon at the rates
in force for the financial year in which such income is payable, be
equal to the net amount payable under such agreement or arrangement.”

 

(ii)  TDS Certificate to be issued even in case of
Grossing up – Circular 785 dt. 24.11.1999.

 

(iii) Absence of the words “tax to
be borne by the payer” in case of net of tax payment contracts by conduct –
Grossing up required. CIT vs. Barium Chemicals Ltd. [1989] 175 ITR 243 (AP).



(iv)
Section 195A envisages multiple grossing-up. For eg. amount payable to
non-resident is 100 and TDS rate is 10%; Gross amount for TDS purpose would be
111.11 (100*100/90)

 

(v)
No multiple grossing-up in case of presumptive tax u/s. 44BB. CIT vs. ONGC
[2003] 264 ITR 340 (Uttaranchal).

 

(vi)
Exemption from grossing-up u/s.10(6BB) – Aircraft and aircraft engine lease
rentals.

 

(vii)
Section 192(1A) – Tax on non-monetary perquisite – Not covered by section 195A.

 

Conclusion

In
this part of the Article, we have attempted to highlight various issues
relating to section 195(1), 195A and section 90(4) relating to TDS from
payments to non-residents.

 

In
the subsequent parts of the Article, we will deal with the other parts of
section 195 and other aspects thereof.  

OECD – Recent Developments – an update

In this
issue, we have covered major developments in the field of International
Taxation so far in the year 2017 and work being done at OECD in various other
related fields. It is in continuation of our endeavour to update the readers on
major developments at OECD at regular intervals. Various news items included
here are sourced from various OECD Newsletters as available on its website.

 In this write-up, we have
classified the developments into 4 major categories viz.:

1)  Transfer
Pricing 

2)  Tax Treaties

3)  BEPS
Action Plans

4)  Exchange
of Information

 

1) Transfer Pricing

 

(i)  OECD releases latest updates to the Transfer Pricing Guidelines for
Multinational Enterprises and Tax Administrations

 

     The OECD released the 2017 edition of the OECD
Transfer Pricing Guidelines for Multinational Enterprises and Tax
Administrations on 10.07.2017.

 

    The OECD Transfer Pricing Guidelines
provide guidance on the application of the “arm’s length principle”, which
represents the international consensus on the valuation, for income tax
purposes, of cross-border transactions between associated enterprises. In
today’s economy where multinational enterprises play an increasingly prominent
role, transfer pricing continues to be high on the agenda of tax administrations
and taxpayers alike. Governments need to ensure that the taxable profits of
MNEs are not artificially shifted out of their jurisdiction and that the tax
base reported by MNEs in their country reflects the economic activity
undertaken therein and taxpayers need clear guidance on the proper application
of the arm’s length principle.

    

   The
2017 edition of the Transfer Pricing Guidelines mainly reflects a consolidation
of the changes resulting from the OECD/G20 Base Erosion and Profit Shifting
(BEPS) Project. It incorporates the following revisions of the 2010 edition
into a single publication:

 

–   The substantial revisions introduced by the
2015 BEPS Reports on Actions 8-10 “Aligning Transfer Pricing Outcomes with
Value Creation” and Action 13 “Transfer Pricing Documentation and
Country-by-Country Reporting”. These amendments, which revised the guidance in
Chapters I, II, V, VI, VII and VIII, were approved by the OECD Council and
incorporated into the Transfer Pricing Guidelines in May 2016;

 

–   The revisions to Chapter IX to conform the
guidance on business restructurings to the revisions introduced by the 2015
BEPS Reports on Actions 8-10 and 13. These conforming changes were approved by
the OECD Council in April 2017;

 

–  The revised guidance on safe harbours in
Chapter IV. These changes were approved by the OECD Council in May 2013; and

 

–  Consistency changes that were needed in the
rest of the OECD Transfer Pricing Guidelines to produce this consolidated
version of the Guidelines. These consistency changes were approved by the
OECD’s Committee on Fiscal Affairs on 19 May 2017.

 

    In
addition, this edition of the Transfer Pricing Guidelines include the revised
Recommendation of the OECD Council on the Determination of Transfer Pricing
between Associated Enterprises. The revised Recommendation reflects the
relevance to tackle BEPS and the establishments of the Inclusive Framework on
BEPS. It also strengthens the impact and relevance of the Guidelines beyond the
OECD by inviting non-OECD members to adhere to the Recommendation. Finally, it
includes a delegation by the OECD Council to the Committee on Fiscal Affairs of
the authority to approve by consensus future amendments to the Guidelines which
are essentially of a technical nature.

 

   To
read the full version online: www.oecd.org/tax/transfer-pricing/oecd-transfer-pricing-guidelines-for-multinational-enterprises-and-tax-administrations-20769717.htm

 

(ii) Release of a discussion draft containing Additional Guidance on
Attribution of Profits to Permanent Establishments

 

   The
Report on Action 7 of the BEPS Action Plan (Preventing the Artificial Avoidance
of Permanent Establishment Status) mandated the development of additional
guidance on how the rules of Article 7 of the OECD Model Tax Convention would
apply to PEs resulting from the changes in the Report, in particular for PEs
outside the financial sector. The Report indicated that there is also a need to
take account of the results of the work on other parts of the BEPS Action Plan
dealing with transfer pricing, in particular the work related to intangibles,
risk and capital. Importantly, the Report explicitly stated that the changes to
Article 5 of the Model Tax Convention do not require substantive modifications
to the existing rules and guidance on the attribution of profits to permanent
establishments under Article 7 (see paragraph 19-20 of the Report).

 

   Under
this mandate, this new discussion draft has been developed which replaces the
discussion draft published for comments in July 2016. This new discussion draft
sets out high-level general principles outlined in paragraph 1-21 and 36-42 for
the attribution of profits to permanent establishments in the circumstances
addressed by the Report on BEPS Action 7. Importantly, countries agree that
these principles are relevant and applicable in attributing profits to
permanent establishments. This discussion draft also includes examples
illustrating the attribution of profits to permanent establishments arising
under Article 5(5) and from the anti-fragmentation rules in Article 5(4.1) of
the OECD Model Tax Convention.

 

(iii)   Discussion Draft on the Revised Guidance on Profit Splits

 

    Action
10 of the BEPS Action Plan invited clarification of the application of transfer
pricing methods, in particular the transactional profit split method, in the
context of global value chains.

 

    Under
this mandate, this revised discussion draft replaces the draft released for
public comment in July 2016. Building on the existing guidance in the OECD
Transfer Pricing Guidelines, as well as comments received on the July 2016
draft, this revised draft is intended to clarify the application of the
transactional profit split method, in particular, by identifying indicators for
its use as the most appropriate transfer pricing method, and providing
additional guidance on determining the profits to be split. The revised draft
also includes a number of examples illustrating these principles. 

 

   Public Consultation:  The OECD intends to hold a public
consultation on the additional guidance on the attribution of profits to
permanent establishments and on the revised guidance on the transactional
profit split method in November 2017 at the OECD Conference Centre in Paris,
France. Registration details for the public consultation will be published on
the OECD website in September. Speakers and other participants at the public
consultation will be selected from among those providing timely written
comments on the respective discussion drafts.

 

(iv) Toolkit to provide practical guidance to developing countries to
better protect their tax bases

 

    The
Platform for Collaboration on Tax (PCT) – a joint initiative of the
International Monetary Fund (IMF), Organisation for Economic Co-operation and
Development (OECD), United Nations (UN) and World Bank Group – has published a
toolkit to provide practical guidance to developing countries to better protect
their tax bases on  22/06/2017.

 

   The
toolkit responds to a request by the Development Working Group of the G20,
and addresses an area of tax called “transfer pricing,” which refers
to the prices corporations use when they make transactions between members of
the same group. How these prices are set has significant relevance for the
amount of tax an individual government can collect from a multinational
enterprise.


   The toolkit, “Addressing
Difficulties in Accessing Comparables Data for Transfer Pricing
Analyses”, specifically addresses the ways developing countries can
overcome a lack of data needed to implement transfer pricing rules. This data
is needed to determine whether the prices the enterprise uses accord with those
which would be expected between independent parties. The guidance will also
help countries set rules and practices that are more predictable for business.

 

    The toolkit is part of a series of reports
by the Platform to help developing countries design or administer strong tax
systems. Previous reports have covered tax incentives and external support for
building tax capacity in developing countries.

 

     The delivery of the toolkit coincides with
the third meeting of the Inclusive Framework on Base Erosion and Profit
Shifting (BEPS), held in the Netherlands on 21-22 June 2017, and demonstrates
the commitment of the Platform partners to work together to tackle a wide range
of pressing tax issues.

 

    The
toolkit has been updated following comments on a consultation draft which was
made public in January 2017.

 

     For
more information on the PCT, visit: www.worldbank.org/en/programs/platform-for-tax-collaboration

 

(v)  OECD releases a discussion draft on the implementation guidance on
hard-to-value intangibles

 

     In
May 2017, OECD invited public comments on a discussion draft which provides
guidance on the implementation of the approach to pricing transfers of
hard-to-value intangibles described in Chapter VI of the Transfer Pricing
Guidelines.

 

    The
Final Report on Actions 8-10 of the BEPS Action Plan (“Aligning Transfer
Pricing Outcomes with Value Creation”) mandated the development of guidance on
the implementation of the approach to pricing hard-to-value intangibles
(“HTVI”) contained in section D.4 of Chapter VI of the Transfer
Pricing Guidelines.

 

     This
discussion draft, which does not yet represent a consensus position of the
Committee on Fiscal Affairs or its subsidiary bodies, presents the principles
that should underline the implementation of the approach to HTVI, provides
examples illustrating the application of this approach, and addresses the
interaction between the approach to HTVI and the mutual agreement procedure
under an applicable treaty.

 

2) Tax Treaties

 

(i)  The Platform for Collaboration on Tax invites comments on a draft
toolkit on the taxation of offshore indirect transfers of assets

 

     In
August, 2017, the Platform for Collaboration on Tax – a joint initiative of the
IMF, OECD, UN and World Bank Group – sought public feedback on a draft toolkit
designed to help developing countries tackle the complexities of taxing
offshore indirect transfers of assets, a practice by which some multinational
corporations try to minimise their tax liability.

 

    The tax treatment of ‘offshore indirect
transfers’ (OITs) — the sale of an entity located in one country that owns an
“immovable” asset located in another country, by a non-resident of
the country where the asset is located — has emerged as a significant concern
in many developing countries. It has become a relatively common practice for
some multinational corporations trying to minimise their tax burden, and is an
increasingly critical tax issue in a globalised world. But there is no unifying
principle on how to treat these transactions, and the issue was not addressed
in the OECD/G20 Base Erosion and Profit Shifting (BEPS) Project. This draft
toolkit, “The Taxation of Offshore Indirect Transfers – A
Toolkit,” examines the principles that should guide the taxation of
these transactions in the countries where the underlying assets are located. It
emphasises extractive (and other) industries in developing countries, and
considers the current standards in the OECD and the U.N. model tax conventions,
and the new Multilateral Convention. The toolkit discusses economic
considerations that may guide policy in this area, the types of assets that
could appropriately attract tax when transferred indirectly offshore,
implementation challenges that countries face, and options which could be used to enforce such a tax.

 

     The toolkit responds to a request by the
Development Working Group of the G20, and is part of a series the Platform is
preparing to help developing countries design their tax policies, keeping in
mind that those countries may have limitations in their capacity to administer
their tax systems. Previous reports have included discussions of tax incentives,
and external support for building tax capacity in developing countries. This
series complements the work that the Platform and the organisations it brings
together are undertaking to increase the capacity of developing countries to
apply the OECD/G20 BEPS Project.

 

     The
Platform aims to release the final toolkit by the end of 2017.

 

Questions to consider

1.  Does
this draft toolkit effectively address the rationale(s) for taxing offshore
indirect transfers of assets?

2.  Does
it lay out a clear principle for taxing offshore indirect transfers of assets?

3.  Is
the definition of an offshore indirect transfer of assets satisfactory?

4.  Is
the discussion regarding source and residence taxation in this context balanced
and robustly argued?

5.  Is
the suggested possible expansion of the definition of immovable property for
the purposes of the taxation of offshore indirect transfers reasonable?

6.  Is
the concept of location-specific rents helpful in addressing these issues? If
so, how is it best formulated in practical terms?

7.  Are
there other implementation approaches that should be considered?

8.  Is
the draft toolkit’s preference for the ‘deemed disposal’ method appropriate?

9.  Are
the complexities in the taxation of these international transactions adequately
represented?

 

(ii) OECD releases the draft contents of the 2017 update to the OECD
Model Tax Convention

 

    In
July 2017, the OECD Committee on Fiscal Affairs released the draft contents of
the 2017 update to the OECD Model Tax Convention prepared by the Committee’s
Working Party 1. The update has not yet been approved by the Committee on
Fiscal Affairs or by the OECD Council, although, as noted below, significant
parts of the 2017 update were previously approved as part of the BEPS Package.
It will be submitted for the approval of the Committee on Fiscal Affairs and of
the OECD Council later in 2017. This draft therefore does not necessarily
reflect the final views of the OECD and its member countries.

 

     Comments
are requested at this time only with respect to certain parts of the 2017
update that have not previously been released for comments.

 

    As part of the 2017 update, a number of
changes and additions will also be made to the observations, reservations and
positions of OECD member countries and non-member economies. These changes and
additions are in the process of being formulated and will be included in the
final version of the 2017 update. 

 

(iii) OECD releases BEPS discussion drafts on attribution of profits to
permanent establishments and transactional profit splits

 

     In
June 2017, OECD invited Public comments on the following discussion drafts:

 

–     Attribution of Profits to Permanent
Establishments, which deals with work in relation to Action 7
(“Preventing the Artificial Avoidance of Permanent Establishment
Status”) of the BEPS Action Plan;

–  Revised Guidance on Profit Splits,
which deals with work in relation to Actions 8-10 (“Assure that transfer
pricing outcomes are in line with value creation”) of the BEPS Action
Plan.

 

3) Base Erosion and Profit Shifting (BEPS) Action
Plans

 

(i)   OECD releases further guidance on Country-by-Country reporting
(BEPS Action 13)

 

     On
06/09/2017, the OECD’s Inclusive Framework on BEPS has released two sets of
guidance to give greater certainty to tax administrations and MNE Groups alike
on the implementation and operation of Country-by-Country (CbC) Reporting (BEPS
Action 13).

 

     Existing guidance on the implementation of
CbC Reporting has been updated and now addresses the following issues: 1) the
definition of revenues; 2) the treatment of MNE groups with a short accounting
period; and 3) the treatment of the amount of income tax accrued and income tax
paid. The complete set of interpretative guidance related to CbC Reporting
issued so far is presented in the document released today.

 

     Guidance has also been released on the
appropriate use of the information contained in CbC Reports. This includes
guidance on the meaning of “appropriate use”, the consequences of
non-compliance with the appropriate use condition and approaches that may be
used by tax administrations to ensure the appropriate use of CbCR information.

 

(ii)  Neutralising the tax effects of branch mismatch arrangements

 

     On
27/07/2017, the OECD released a report on Neutralising the Effects of
Branch Mismatch Arrangements (BEPS Action 2).

 

     In October 2015, as part of the final BEPS
package, the OECD/G20 published a report on Neutralising the Effects of
Hybrid Mismatch Arrangements (OECD, 2015). This report set out
recommendations for domestic rules that put an end to the use of hybrid
entities to generate multiple deductions for a single expense or deductions
without corresponding taxation of the same payment. While the 2015 Report
addresses mismatches that are a result of differences in the tax treatment or
characterisation of hybrid entities, it did not directly consider similar
issues that can arise through the use of branch structures. These branch
mismatches occur where two jurisdictions take a different view as to the
existence of, or the allocation of income or expenditure between, the branch
and head office of the same taxpayer. These differences can produce the same
kind of mismatches that are targeted by the 2015 Report thereby raising the
same issues in terms of competition, transparency, efficiency and fairness.
Accordingly, this new report sets out recommendations for changes to domestic
law that would bring the treatment of these branch mismatch structures into
line with outcomes described in the 2015 Report.

 

(iii) Major progress reported towards a fairer and more effective
international tax system

 

     The
latest Report from OECD Secretary-General Angel Gurría to G20 Leaders  describes the continuing fight against tax
avoidance and tax evasion as one of the major success stories of the G20,
founded on enhanced international co-operation. 
The report updates progress in key areas of OECD-G20 tax work, including
movement towards automatic exchange of information between tax authorities and
implementation of key measures to address tax avoidance by multinationals.

 

     The report to G20 Leaders highlights
progress in each of the areas where OECD has been mandated to boost
international co-operation on tax issues. 
This includes ongoing movement towards greater transparency, principally
through the work of the OECD-hosted Global Forum on Transparency and Exchange
of Information for Tax Purposes, which now includes 142 members and is managing
worldwide implementation of the Common Reporting Standard and the first
automatic exchanges of financial account information (AEOI), to take place in
September 2017.

 

    Global Forum members have established close
to 2,000 bilateral exchange relationships for AEOI. “These efforts are already
paying off, with 500000 people having disclosed offshore assets and around EUR
85 billion in additional tax revenue identified as a result of voluntary
compliance mechanisms and offshore investigations.” Mr Gurría said.

 

   Implementation also continues on measures to
reduce tax avoidance by multinational enterprises under the G20/OECD BEPS
Project. 101 countries and jurisdictions are now working on an equal footing
to set standards and monitor implementation via the OECD/G20 Inclusive Framework
on BEPS. The OECD has established a peer review process to assess
implementation of the BEPS minimum standards and work continues on pending
issues including transfer pricing.

 

     At the same time, countries are considering
measures to enhance tax certainty based on the joint OECD-IMF report to G20
Finance Ministers, as well as progressing discussions on the complex issues
around taxation of the digital economy. An interim report on taxation of the
digital economy will be delivered by the OECD/G20 Inclusive Framework on BEPS
in early 2018, followed by a final report in 2020.

 

4) Exchange of Information

 

     CFA
Approves New Manual on Information Exchange

 

     In 2006, the Committee on Fiscal Affairs
approved a Manual on Information Exchange. The Manual provides practical
assistance to officials dealing with exchange of information for tax purposes
and may also be useful in designing or revising national manuals.

 

   The Manual follows a modular approach. It
first discusses general and legal aspects of exchange of information and then
covers the following specific subject matters:

(1) Exchange of Information on Request,

(2) Spontaneous Information Exchange,

(3) Automatic (or Routine) Exchange of
Information,

(4) Industry-wide Exchange of Information,

(5) Simultaneous Tax Examinations,

(6) Tax Examinations Abroad,

(7) Country Profiles Regarding Information
Exchange, and

(8) Information Exchange Instruments and
Models.

(9) Module
on joint audits: the Forum on Tax Administration joint Audits Participants Guide

 

     Joint
Audits (JA) are an innovative form of cooperation between countries. Bilateral
or multilateral JA have great potential for transfer pricing audits etc.
A JA is defined as an arrangement whereby Participating Countries agree to
conduct a coordinated audit of one or more related taxable persons (both legal
entities and individuals) where the audit focus has a common or complementary
interest and/or transaction. This new module reproduces the FTA (Forum on Tax
Administration) joint Audits Participants Guide issued by the FTA at its 6th
meeting on 15-16 September 2010 in Istanbul where tax commissioners met to
co-ordinate actions to address international compliance and taxpayer service.
They agreed that major improvements in compliance can be obtained through in
particular a Report on Joint Audits to support coordinated action through joint
audits and this  practical Guide intended
to inform tax auditors and their strategy team http://www.oecd.org/dataoecd/10/13/45988932.pdf.

 

     The modular approach allows countries to
tailor the design of their own manuals by incorporating only the modules that
are relevant to their specific exchange of information programmes.

 

     Note: The reader may visit
the OECD website and download various reports referred to in this article for
his further studies.

Royalty–The Digital Taxation Debate

1.  Background

Characterisation
of payments for digital goods and services has been a contentious issue,
especially in Indian context. Taxation of payments in the digital economy
segment has been a subject matter of considerable litigation for quite some
time now in India and even globally. In digital economy, delivery of services
can be easily done from overseas without necessitating any part of the activity
being performed or any employees being hired in the country where customers are
located, thereby avoiding taxable presence.

 

The BEPS
Action 1 Report ‘Addressing the Tax Challenges of the Digital Economy’ states
that because the digital economy is increasingly becoming the economy itself,
it would be difficult, if not impossible, to ring-fence the digital economy
from the rest of the economy for tax purposes. The digital economy and its
business models present however some key features which are potentially
relevant from a tax perspective.

 

In India, with respect to online advertising, we have following ITAT
decisions:

 

a) Yahoo India (P.) Ltd. vs. DCIT
[2011] 11 taxmann.com 431 (Mumbai-Trib)

b) Pinstorm Technologies (P.) Ltd.
vs. ITO [2012] 24 taxmann.com 345 (Mumbai-Trib)

c) ITO vs. Right Florists (P.)
Ltd. [2013] 32 taxmann.com 99 (Kolkata-Trib.)

In
these decisions, the ITAT has held that payments made for online advertising
would not constitute “royalty” and in absence of any Permanent Establishment
[PE] in India of the foreign companies, the same would not be taxable in India.

In
the earlier decision of Yahoo India, the ITAT had held that services rendered
by Yahoo Holdings (Hong Kong) Ltd. for uploading and display of the banner
advertisement of the Department of Tourism of India on its portal would not
amount to ‘royalty’. In that decision, the ITAT had observed that advertisement
hosting services did not involve use or right to use by the Indian company of
industrial, commercial or scientific equipment. Further, the Indian company had
no right to access the portal of Yahoo Hong Kong. Based on these facts, the
ITAT concluded that the payment made to Yahoo Hong Kong would be in the nature of business income and not royalty income.

Similar findings have been arrived at in the case of Pinstorm and Right
Florists.


In para 21 of the decision in Right Florist (supra), it
was held as under:


“21. That takes us to the
question whether second limb of Section 5(2) (b), i.e. income ‘deemed to accrue
or arise in India’, can be invoked in this case. So far as this deeming fiction
is concerned, it is set out, as a complete code of this deeming fiction, in
Section 9 of the Income Tax Act, 1961, and Section 9(1) specifies the incomes
which shall be deemed to accrue or arise in India. In the Pinstorm
Technologies (P.) Ltd.’s case (supra) and in Yahoo India (P.)
Ltd’s case (supra), the coordinate benches have dealt with only one
segment of this provision i.e. Section 9(1) (vi), but there is certainly much
more to this deeming fiction. Clause (i) of section 9(1) of the Act provides
that all income accruing or arising whether directly or indirectly through or
from any ‘business connection’ in India, or through or from any property in
India or through or from any asset or source of income in India, etc. shall be
deemed to accrue or arise in India. However, as far as the impugned receipts
are concerned, neither it is the case of the Assessing Officer nor has it been
pointed out to us as to how these receipts have arisen on account of any
business connection in India. There is nothing on record do demonstrate or
suggest that the online advertising revenues generated in India were supported
by, serviced by or connected with any entity based in India. On these
facts, Section 9(1)(i) cannot have any application in the matter. Section
9(1)(ii), (iii), (iv) and (v) deal with the incomes in the nature of salaries,
dividend and interest etc, and therefore, these deeming fictions are not
applicable on the facts of the case before us. As far as applicability of
Section 9(1)(vi) is concerned, coordinate benches, in the cases of Pinstorm
Technologies (P.) Ltd. (supra) and Yahoo India (P.) Ltd. (supra),
have dealt with the same and, for the detailed reasons set out in these erudite
orders – extracts from which have been reproduced earlier in this order,
concluded that the provisions of Section 9(1)(vi) cannot be invoked. We are in
considered and respectful agreement with the views so expressed by our
distinguished colleagues.”

 

2.  Recent Decision in case of Google India- ITAT
Bangalore


Recently,
ITAT Bangalore in the case of Google India Pvt. Ltd. [Google India] vs.
ADCIT [2017] 86 taxmann.com 237 (Bengaluru-Trib) dealt with the issue as to
whether payment by Google India to Google Ireland Ltd. [Google Ireland] under
‘Adwords Program’ Distribution Agreement is royalty. The ITAT held that the
said payment is taxable as royalty under the provisions of the Income-tax Act,
1961 [the Act] as well as under the India-Ireland tax treaty [DTAA] and treated
the Indian company as an assessee in default for not complying with the
withholding tax provisions.


A. Google AdWords


Google
AdWords is an online advertising service developed by Google, where advertisers
pay to display brief advertising copy, product listings, and video content
within the Google ad network to web users. The program uses the keywords to
place advertisements on pages where Google thinks they might be most relevant.
Advertisers pay when users divert their browsing to click on an advertisement.
AdWords enables an advertiser to change and monitor the performance of an
advertisement and to adjust the content of the advertisement.

The
advertisers get their advertisement uploaded into Adword program and log on the
Adword program website owned by Google. It follows the various steps to create
the Adword account for itself. The advertisers select the key words, content
and presentation related to its ads and place a bid on the online system for
the price it is willing to pay every time its user clicks on its advertisement.
Once the advertiser creates the account and uploads advertisement, the same
automatically gets stored on Adword platform owned by Google on the servers
outside India and the ads are displayed in the manner determined by the
programs running on automated platform. Google India periodically raises the
bill on advertisers for advertising spend incurred by the advertiser on clicks
through the users.


B. Brief Facts


a. Google India is a wholly owned subsidiary
of Google International LLC, USA. Google India was providing following services
to its overseas associate Google Ireland, under 2 separate agreements:

i.    Information technology (IT)
and IT enabled services (ITES) [Service Agreement]

ii.   Marketing and
distributorship services under a non-exclusive distributor agreement for resale
of online advertising space under the Adwords program to advertisers in India [Distribution
Agreement]. In addition to marketing and distribution services provided to
Google Ireland, under the Distribution Agreement, Google was also required to
provide pre-sale and post-sale / customer support services to the advertisers.

b. For the purpose of sales and marketing the
space, work wise flow of activities of the Google India and advertiser were as
under:

 i. Enter into resale agreement with Google Ireland and resale on
advertising space under the Adword program under the Indian advertisers.

 ii.   Perform marketing related
activities in order to promote the sales of advertising space to Indian
Advertisers. After training to its own sale force about the features/tools available
as part of Adword program, to enable them to effectively market the same to
advertisers.

 iii.   Enter into a contract with
Indian advertisers in relation to sale of space under the Adword program.

 iv.  Provide assistance/training
to Indian advertisers if needed in order to familiarize that with the
features/tools available as part of Adword product.

 v.   Resale invoice to the above
advertisers.

 vi.  Collect payments from the
aforesaid advertisers.

 vii.  Remit payment to Google
Ireland for purchase of advertising space from it under the resale agreement.

c. Under the distribution agreement, Google
India made a payment aggregating to Rs. 1,457 crore for the period from F.Y.
2005-06 to F.Y. 2011-12. On the premise that it is merely a reseller of advertisement
space, Google India had categorised this payment as Google Ireland’s business
income and in the absence of a PE of Google Ireland in India, the payment was
made without withholding any tax at source. Neither Google India nor Google
Ireland had obtained any order from the tax department for Nil tax withholding.

d.  As
Google India had not complied with the provisions of section 195, the tax
authorities started the proceedings u/s. 201 of the Act. Before the Assessing Officer [AO], Google India
filed the detailed reply for all the years. However, not convinced with the
reasoning of Google India, the AO, on a conjoint reading of Adword program
distribution agreement and service agreement, treated the payment as ‘royalty’
under Explanation 2 to section 9(1)(vi) of the Act as well as DTAA between
India and Ireland and determined the withholding tax liability.

e. The findings of the AO were as under:

i.    The `distribution rights`
were `Intellectual Property’ [IP] rights covered by `similar property` under
the definition of royalty and the distribution fee payable was in relation to
transfer of distribution rights.

ii.   Google Ireland had granted
Google India the right access to confidential information and intellectual property rights.

iii.   Google India had been
allowed the use or the right to use of a variety of specified IP rights and
other IP rights covered by “similar property”.

iv.  Grant of distribution right
also involved transfer of right in copyright.

v.   By exercising its right as
the owner of copyright in the software, Google Ireland had authorized Google
India to sell or offer for sale, i.e., marketing and distribution of Adwords
Software to various advertisers in India.

vi.  The consideration paid by
Google India was for granting license/authorization to use the copyright in the
AdWords program and not for purchase of such software.

vii.  Google India had been given
right to use Google Trademarks and other Brand Features in order to market and
distribute of Adwords program.

viii. Grant of distribution right
also involved transfer of know-how.

ix.  Google Ireland was obliged to
train the distributor so that Appellant could market and distribute AdWords
program.

x.   Referring to Non-Disclosure
Agreement [NDA] clauses forming part of Distribution Agreement, it was held
that Google Ireland, being the copyright holder of the AdWords program, was in
a position to share confidential information whenever required with Google
India.

xi.  Grant of distribution right
also involved transfer of process.

xii.  Without access to the
back-end, Google India could not perform its marketing and distribution
activities. Google India had access to the processes running on the data
centres, based on the distribution rights granted to it by Google Ireland.

xiii. Google India was granted the
use or the right to use the process in the Adwords platform for the purpose of
marketing and distribution.

xiv. Grant of distribution right
also involved use of Industrial, commercial and scientific equipment.

xv. Adwords program, in one way,
was also commercial cum scientific equipment and without having access to
servers running the AdWords platform, Google India could not perform its
functions as per the Distribution Agreement.

f. 
Aggrieved by the order of the AO, Google India preferred an appeal
before CIT(A). However, even the CIT(A) concurred with the view of the AO and
treated the payment to be in the nature of ‘royalty’. Aggrieved by the CIT(A)’s
order, Google India preferred an appeal before ITAT.


C. Main Issue for
consideration before ITAT


The
main issue before ITAT was whether the amounts credited in Google India’s books
to Google Ireland’s account constituted business income or royalties for use of
software, trademarks and other intellectual property rights.


D. Google’s Arguments


Before
the ITAT, Google India extensively argued that the said payment merely
represented purchase of advertisement space and it does not amount to ‘royalty’
and is in the nature of ‘business income’. Google India’s main arguments were
as under:

a)   It
was merely a reseller of advertising space. It only performed market related
activities to promote the sales of advertising space. No right or intellectual
properties were transferred by Google Ireland to Google India or to the
advertiser.

b)   The
brand features were predominantly commercial rights and were incidental to the
distribution activity and did not involve transfer of any separate right.

c)   Google
India had no control or access to the software, Algorithm and data centre. The
server on which the Adword program runs were located outside India over which
it was not having control. Google India or the advertisers did not have any
right of any use or exploitation or the underlying IP and software. None of
these parties were concerned with the back end functioning of the Adwords
program which was solely carried out by Google Ireland. Their objective was to
benefit from the services of Google and they were not interested in the use of
search service.

d)   Reliance
was also placed on the reports of High Powered Committee of the CBDT as well as
Technical Advisory Group of the OECD which had concluded that the payments in
relation to advertisement fees were not in the nature of royalty. Accordingly,
when the payments made directly by advertisers to Google Ireland could not be
regarded as royalty, the payments made by the distributor for the same ad space
also could not be characterised as royalty.

e)   Clauses
containing protection of confidential information and non-disclosure were
generic and these clauses per se could not establish that there was grant of
right to use any IP.

f)    Also,
what was envisaged in the exhibits of the agreement pertaining to after sales
services were that Google India responded to all routine queries of customers
and Google Ireland was to respond to the advertisers issues or technical
issues. Thus, no right to use any IP was granted to Google India.

g)   The
Google brand features are predominantly commercial rights and are incidental/
consequential to the distribution activity and does not involve transfer of any
separate right. In this regard, reliance was placed by Google India on the
decisions in the case of Sheraton International Inc vs. DDIT [2009) 313 ITR
267 (Delhi HC) and Formula One World Championship Ltd. vs. CIT [2016]
176 taxmann.com 6 (Delhi HC).

h)   Google
India relied upon the decisions of the coordinate bench in Right Florist
(P.) Ltd. (supra), Pinstorm Technologies (P.) Ltd. vs. ITO (supra) and Yahoo
India (P.) Ltd. vs. DCIT (supra) to prove that the issue of online
advertisement had been considered in all the decisions and it was held that the
payment made by the advertiser to the website owner was business profit and in
the absence of any business connection and PE in India and not the Royalty.


E. Tax Authorities’ Arguments


The
tax authorities argued that the payments to Google Ireland constituted
royalties on the following grounds:

a)  Google India’s marketing and
distribution functions involved the sale of certain rights in the AdWords
Program, for which Google India required a license to use the AdWords Program.
The distribution rights granted to Google India under the Distribution Agreement
were therefore in effect a license to use Google Ireland’s IP i.e., inter
alia the copyright in the underlying software code of the AdWords Program.

b)  The tax authorities concluded
that the license of Google Ireland’s IP to Google India under the Services
Agreement was actually for the purpose of providing the post-sale services
under the Distribution Agreement, and therefore the payments made to Google
Ireland constituted royalties.

c)  The Non-Disclosure Agreement
which is Exhibit-B of the distribution agreement clearly demonstrated that by
virtue of the disclosure of the confidential information and access provided to
the confidential information to the Google India by Google Ireland, the sums
payable by Google India to Google Ireland is for information, know-how and
skill imparted to Google India.

d)  Google India has been
permitted to use Google Ireland’s trademarks and brand features in order to
market and distribute the AdWords Program.

e)  The grant of distribution
rights involves transfer of rights in ‘similar property’ (Explanation 2 to
section 9(1)(vi)). The grant of distribution rights also involves the transfer
of right to use Google Ireland’s industrial, commercial and scientific
equipment i.e., the servers on which on which the Ad Words Program runs.

f)   The grant of distribution
rights also involves transfer of right in processes, including Google Ireland’s
databases software tools etc., without which it would not be able to perform
its marketing and distribution functions.


 F. ITAT Decision


The
ITAT, to get an understanding as to how Google AdWord program works, relied on
the information obtained through the written submission of Google India, the
books available in public domain on Google AdWord and Google analytics and also
through the website of the Google and the AdWords links therein. Based on its
understanding, the ITAT observed that:

a)  The entire agreement was not
merely to provide the advertisement space but was an agreement for facilitating
the display and publishing of an advertisement to the targeted customer.

b)  The arrangement was not
confined to use of space but also for the use of patented tools and software of
Google Ireland.

c)  Google India got an access to
various information and data pertaining to the user of the website in the form
of their name, age, gender, location, phone number, IP address, habits,
preferences, online behavior, search history etc. and it used this information
for the purpose of selecting the ad campaign and for maximising the impression
and conversion of the customers to the ads of the advertisers.

d)  By using the patented
algorithm, Google India decided which advertisement was to be shown to which
consumer visiting millions of website/search engine.

e)  The ITAT held that there is no
sale of space, as concluded hereinabove rather it is a continuous targeted
advertisement campaign to the targeted and focused consumer in a particular
language to a particular region with the help of digital data and other
information with respect to the person browsing the search engine or visiting the
website.

 f)   The ITAT did not agree that
advertisement distribution agreement and the service agreement were two
independent arrangements. According to the ITAT, both the agreements were
connected with the naval chord with each other.

 g)  The ITAT further held that the
payments made by the assessee under the agreement was not only for marking and
promoting the Ad Word programmes but was also for the use of Google brand
features. Needless to add that the said Google brand features were used by the
appellant as marketing tool for promoting and advertising the advertisement
space, which is main activity of Assessee and is not incidental activities.

The
use of trademark for advertising marketing and booking in the case of Hotel
Sheraton (Supra) as well as in the case of Formula 1 were
incidental activities of the assessee therein as the main activities in the
cases were providing Hotel Rooms and organizing Car Racing respectively whereas
in the present case the main activity of the assessee is to do marketing of
advertisement space for Google Adwords Programme. Therefore, these two
judgments are not applicable to the facts of the present case. Hence, for this
reason also the payment made by Google India to Google Ireland also falls
within the four corners of royalty as defined under the provisions of Act as
well as under the DTAA.

h)  The ITAT has held that the
findings of the High Powered Committee would not be applicable here as this was
not case of placement of the advertisement simpliciter but there was a module
for targeted advertisement/focus marketing campaigns using the Google software
and algorithm, patented technology, secret process, use of trade mark etc.

i)   The reliance placed by Google
India on the decisions of Pinstorm, Yahoo India, Right Florists have been
brushed aside since the ITAT felt that the facts relating to the working of the
AdWords program stood on a different footing.

j)   The ITAT held that IP of
Google vested in the search engine technology, associated software and other
features, and hence, use of these tools by Google India, clearly fell within
the ambit of ‘Royalty’. The ITAT held that as no tax was withheld by Google
India on payments to Google Ireland, Google India was an assessee in default.

k)  The ITAT was of the view that
the Ad Words Program gives an advertiser a variety of tools to enable it to
maximize attention, engagement, delivery and conversion of its advertisements.
The tools are provided using Google’s IP, software and database with Google
India acting as a gateway.

l)   The ITAT was of the view that
the use of customer data for providing services under the Service Agreement was
also utilized for marketing and distribution functions under the Distribution
Agreement. It concluded that the use of customer data and confidential
information should be regarded as the use of Google Ireland’s intellectual
property by Google India.

m) The ITAT concluded that it is
through use of Google’s intellectual property that the AdWords tools for
performing various activities are made available to Google India and the
advertisers. Therefore, payments made to Google Ireland for use of its intellectual
property would therefore clearly fall within the ambit of “Royalty”.


3.  Observations


a)     The ITAT appears to have
undertaken an intensive fact-finding mission to unearth the technological
workings of the Google AdWords Program on the basis of which it has concluded
that the distribution rights involved a grant of license to IP and
advertisements fees were in the nature of royalties.

b)    The ITAT’s ruling is clear
break with earlier positions taken on the characterization of advertisement
revenue, and payments made under distribution arrangements. Where it ruled the
payments to be in the nature of business income. In these cases, the question
is usually whether the foreign entity has a PE in India for income to be
taxable in India. In fact, the issue in such cases has been on the
determination of a PE on account of a fixed place or dependent agent rather
than whether such an arrangement will result in royalty income.

c)     In fact, it was for this
very reason that the equalization levy was introduced to capture advertising
fees within the Indian tax net, in cases where the non-resident does not have a
PE in India.

d)    The ITAT has taken an
aggressive approach where it has read two independent agreements in relation to
services provided by two different units of Google India together to show that
there was utilization of IP by the Indian entity and re-characterized the
nature of income. The decision does not provide for reasons of tax avoidance
for clubbing the two agreements.

e)     The ITAT’s decision could
have far reaching implications from businesses across the board. Utilization of
IP such as customer data, confidential information for performing services is a
fairly common industry practice and the decision raises concerns on these type
of arrangements.

f)     The above decision is very
crucial and is going to impact many cases which have the similar structure and
in such cases issue would arise as to whether such payment is in the nature of
‘royalty’.

However, one could still examine and contend that ultimately the
objective was to place the advertisement and Google India or the advertisers
were not interested in the back end process of Google Ireland and hence such
payment should constitute business income.

g)    It appears that ITAT in
Google’s case has tried to distinguish the earlier decisions by holding that
Google was not only a simpliciter provider of advertisement space but it also
provided access to software, patented tools, information, etc. which helped
Google India in targeting the customers. The ITAT has also gone into
considerable depth to understand as to how these advertisements are placed on
the website of Google, how it was ensured that large number of customers visit
those advertisements, how the bidding by the advertisers take place etc. and
based on this it came to conclusion that Google India plays a pivotal role in
all these and it was not merely placing the advertisement simpliciter.


4.     Equalisation Levy [EL]


a)     The Finance Act, 2016 has
introduced an ‘Equalisation Levy’ (Chapter VIII) in line with the
recommendation of the OECD’s Base Erosion and Profit Shifting [BEPS] project to
tax e-commerce transactions. It provides that the equalisation levy is to be
charged on specified services (online advertising, any provision for digital
advertising space or facilities/service for the purpose of online
advertisement, etc.) at 6% of the amount of consideration for specified
services received or receivable by a non-resident payee not having a PE in
India. The Equalisation Levy Rules, 2016 have also been issued by CBDT to lay
down the compliance procedure to be followed for such levy. The Rules came into
effect from 1st June 2016.

b)    Further income from such
specified services shall be exempt u/s. 10(50) of the Act. Accordingly, with
effect from 1st June, 2016, such income will not be taxed as royalty
or business income but it would be subject to equalisation levy.

An
interesting issue would arise as to whether payments made after 1st June
2016 would be liable to EL or would it still attract withholding tax treating
it as royalty based on Google India’s decision. It is notable that withholding
tax may be creditable in the country of residence of the payee but no credit is
available for EL.


5. Proposed
amendments in Section 9(1)(i) by the Finance Bill, 2018 – ‘Business Connection’
to include ‘Significant Economic Presence’


Currently,
section 9(1)(i) provides for physical presence based nexus for establishing
business connection of the non-resident in India. A new Explanation 2A to
section 9(1)(i) is proposed to inserted to provide a nexus rule for emerging
business models such as digitised businesses which do not require physical
presence of the non-resident or his agent in India.

This
amendment provides that a non-resident shall establish a business connection on
account of his significant economic presence in India irrespective of whether
the non-resident has a residence or place of business in India or renders
services in India. The following shall be regarded as significant economic
presence of the non-resident in India.

–    Any transaction in respect of
any goods, services or property carried out by non-resident in India including
provision of download of data or software in India, provided the transaction
value exceeds the threshold as may be prescribed; or

–    Systematic and continuous
soliciting of business activities or engaging in interaction with number of
users in India through digital means, provided such number of users exceeds the
threshold as may be prescribed.

In such cases, only so much of income as is attributable to above
transactions or activities shall be deemed to accrue or arise in India.


 6. Conclusion


The
Google India’s decision will have a significant impact on how other digital
economy related payments are characterised for tax purposes in India. It would
also influence other pre 1st June 2016 cases that relate to online
advertising.

In
view of the ITAT’s observation that both the Associated Enterprises are trying
to misuse the provision of tax treaty by structuring the transaction with the
intention to avoid payment of taxes, and in view of General Anti Avoidance
Rules provision under the Income-tax Act and India’s commitment to implement
Multilateral Instrument under the BEPS initiative, the taxpayers should take
appropriate caution before entering into any arrangement/structure especially
if it is to avail any tax benefit.

It
appears that the law on this issue will continue to remain somewhat unsettled
until resolved by the higher judiciary.

The
understanding of modern day developments around digital space, the complexities
surrounding it and tax implications on such transactions need a holistic
review. It is time for India to develop a framework for digital transactions.
This would be one important aspect in India’s attempts in its endeavour of ease
of doing business. 

 

Foreign Tax Credit Rules

One of the pillars of the Double Tax Avoidance Agreement
(DTAA) is Article on “Methods for Elimination of Double Taxation”. Various
methods are prescribed for elimination of double taxation. However, elimination
of double taxation through a foreign tax credit route was fraught with several
issues such as at what rate of exchange credit for taxes are to be computed,
what documents are required to prove payment of overseas taxes, what about
mismatch of taxable years in the country of source and country of residence,
what about increase or decrease in taxes due to assessment in the foreign
country and so on. In order to address all these issues and some more, last
year CBDT had issued a Notification No. S.O.2213(E) dated 27th June
2016 providing Foreign Tax Credit Rules (FTCR), which came into effect from 1st
April 2017.
This article besides explaining various methods for elimination of double
taxation, deals with salient features of the FTCR.

1.0    Introduction

          The objective of a DTAA (also known as
“tax treaty”) is to distribute tax revenue between the two Contracting States
(CS). Articles 6 to 22 in a typical tax treaty contain distributive rules to
this effect. The methods for elimination of double taxation have been dealt
with by Article 23 of the UN Model Tax Convention (UNMC) and the OECD MC.
Article 24 provides for provisions of Mutual Agreement Procedure which can be
invoked by the tax payer, if the CS fails to eliminate double taxation or
apply/interpret the treaty provisions not in accordance with its intent and
purpose. 

          Usually, State of Residence (SR) taxes
global income of a tax payer including income from the State of Source (SS).
Therefore, SR will give credit for taxes paid in the SS.

          Double taxation is eliminated in two
ways, namely, Exemption of Income or Credit of taxes paid. Various methods for
elimination of double taxation can be summarised as follows:

 

          Before we dwell into foreign tax
credit rules, let us glance through the above methods for appreciating
applicability of FTCR in an Indian scenario.

2.0    Exemption Method

2.1     Full Exemption

          In this case, the income taxed in the
SS is fully exempt in the SR.

2.2     Exemption with Progression

          Under this method, SR considers the
income taxed in the SS only for the purpose of determining the effective tax
rate.

          Let us understand the above two
methods with the help of an example.

          Tax slabs and tax incidence in the SR
are as follows:

Income

Tax Rate

Tax on

Rs. 1500

Tax on

Rs. 1000

First Rs. 200 Exempt

 0

0

0

From Rs. 201 to Rs. 500

10%

30

30

From Rs. 501 to Rs. 1000

20%

100

100

Above Rs. 1000

30%

150

—-

Total Rs.

 

280

130

 

Sr. No.

Particulars

Amount INR

1

Income in the SR

1000

2

Income in the SS

500

3

Total income taxable in SR (1+2)

1500

4

Tax
liability in the SR without 
considering Exemption (Tax on a slab basis)

280

5

Total
Income considering full exemption in the SR (income of SS is ignored totally)

1000

6

Tax
liability based in the SR considering full exemption (On a slab basis only on
income from SR i.e. Rs.1000)

 

130

7

Effective
Tax Rate in SR considering income from SS (4/3)

18.6%

8

Tax
in SR considering Exemption

with
Progression (Tax on Rs.1000 @ 18.6%)

 

186

 

 

 

              

3.0    Credit Methods

          Under the credit method, SR will tax
income of its resident on a global basis and then grant credit of taxes paid in
the SS.

          In simple words, when any income of
the person is taxed on source basis in one country and on the basis of his
residence in other country, the country of residence shall compute tax on
overall global income of such person and while doing so, it shall grant to such
a person a credit of the taxes already paid by it on the income taxable at
source in such other country.

          There are two types of credit methods,
namely, Unilateral and Bilateral.

3.1
   Unilateral Tax Credit

          Section 91 of the Income tax Act deals
with the unilateral tax credit. Sub-section (1) of the section 91 provides that
“If any person who is resident in India in any previous year proves that, in
respect of his income which accrued or arose during that previous year outside
India (and which is not deemed to accrue or arise in India), he has paid in any
country with which there is no agreement under section 90 for the relief or
avoidance of double taxation, income-tax, by deduction or otherwise,
under the law in force in that country, he shall be entitled to the deduction
from the Indian income-tax payable by him of a sum calculated on such
doubly taxed income at the Indian rate of tax or the rate of tax of the said
country, whichever is the lower, or at the Indian rate of tax if both the rates
are equal”. (Emphasis supplied)

          From the above, it is clear that the
amount of credit in India will be restricted to the lower of the proportionate
tax in India on the foreign sourced income or taxes paid in the source country.

3.1.1 Issues

          A
question arose as to whether a tax payer can avail unilateral credit in respect
of income from a country with which India has signed a limited tax treaty?
India had a limited tax treaty with Kuwait till 2008 which covered only income
from International Air Transport. (With effect from 1st April 2008,
a new and comprehensive tax treaty with Kuwait has become operative in India).
In case of JCIT vs. Petroleum India International (26 SOT 105), the
Mumbai Tribunal granted benefit of the unilateral tax credit u/s. 91(1) when
only limited DTAA was in operation. Thus, one may conclude that unilateral tax
relief may be available to a tax payer in respect of income which is not
covered by the limited tax treaty.

3.1.2 Some other issues u/s. 91 addressed by the
Judiciary  are tabulated herein below:

Sr. No.

Issue

Decision

Case Law

1

What
if part of foreign income is taxable in India?

Proportionate
credit is available only in respect of income doubly taxed.

CIT
v. O.VR.SV.VR. Arunachalam Chettiar (49 ITR 574) and Manpreet Singh Gambhir
v. DCIT

(26
SOT 208)

 

2

Whether
relief u/s 91 is available against MAT liability u/s 115JB or 115JC of the
Act in India?

If
the foreign sourced income is included in computation of book profits in
India, then relief u/s. 91 is available against MAT liability.

Hindustan
Construction Co. Ltd. v. DCIT

(25
SOT 359)

Proviso
to section 115JAA and 115JD read with Rule 128(7)

 

3

Whether
the relief u/s. 91 is available qua each country of source or one needs to
aggregate income from all foreign sources, which may have an impact of
setting off loss from one country against income from the other.

Expl.
(iii) to Section 91 defines “rate of tax of the said country” to mean
income-tax paid in the other country as per its tax laws. Therefore, relief
u/s. 91 has to be granted in respect of each source country separately.

Bombay
Burmah Trading Corporation Ltd. (126 Taxman 403)

3.2    Bilateral Tax Credit Methods

          There are four bilateral tax credit
methods, namely, (i) Full Credit Method, (ii) Ordinary Credit Method, (iii)
Underlying Tax Credit Method and (iv) Tax Sparing. Let us understand each of
them with illustrations.

3.2.1 Full Credit Method

          Under this method, total tax paid by
the person on his income in the country of source is allowed as a credit
against his total tax liability in the country of residence. The credit is
irrespective of his tax liability in the country of residence. Thus, a person
may be able to get proportionately more credit than the incidence of tax on his
foreign sourced income in the country of residence. This is known as full
credit method. India does not allow full credit of foreign tax to its residents
except under India-Namibia DTAA, which grants full credit in India of taxes paid
in Namibia.

3.2.2 Ordinary Credit Method

          The credit available under this method
shall be lower of the proportionate tax payable on the foreign sourced income
in the country of residence or the actual tax paid in country of source. As a
result, in this case, if the tax on the foreign sourced income is higher in the
country of residence than in the country of source, the taxpayer shall be
liable to pay the balance amount. However, if it is the other way round, i.e.
if tax paid in the source country is higher than the residence country, then
excess shall not be refunded. As stated earlier, tax treaties are distribution
of taxing rights and sharing of revenue between two contracting states and
therefore, any excess tax paid in one country is usually not refunded by the
other country. However, some countries do provide for carry forward of such
excess credit. As far as India is concerned, such excess amount is ignored.

          Majority of Indian tax treaties follow
Ordinary Tax Credit Method, which is not detrimental to the interest of the
country of residence of the tax payer and at the same time, it eliminates
double taxation of income.

          Let
us understand both these methods with the help of a Case Study. Facts of the
case are same as described in paragraph 2.2 herein above with the only change
of assumption of 20% rate of tax in the SS. SR is assumed to be India and SS as
Canada.

Sr.

No.

Particulars

Without DTAA Relief
Rs.

Full Credit Method
Rs.

Ordinary Credit Method Rs.

A.

Taxable
Income in India (1000+500)

1500

1500

1500

B.

Taxable
Income in Canada

500

500

500

C.

Tax
payable in India (on a slab basis)

280

280

280

D.

Tax
Payable in Canada (B*20%)

100

100

100

E.

Effective
Tax Rate in India (C/A)

18.67%

18.67%

18.67%

F

Foreign Tax Credit

NIL

100

(Full Credit)

93

(18.67% of 500)

G

Tax Paid in India net of FTC (C-F)

280

180

187

H

Total
Tax Liability (G+D)

380

280

287

3.2.3 Underlying Tax Credit Method (UTC)

          Under this method, SR gives credit for
taxes paid on profits out of which dividend is declared by the company located
in the SS. This method attempts to eliminate/reduce economic double taxation as
dividend income is taxed twice, once by way of profits in the hands of the
company and secondly by way of dividends in the hands of the shareholders.

          A few Indian tax treaties which
contain UTC provisions are treaties with Australia, China, Ireland, Japan,
Malaysia, Mauritius, Mexico, Singapore, Spain, the UK, and the USA.

          However, it is interesting to note
that most of UTC provisions in Indian tax treaties are with respect to the
residents of treaty partner country and not Indian residents. Only treaties
with Mauritius and Singapore give benefit of UTC to Indian residents.
India-Singapore DTAA provides for minimum shareholding of 25 per cent in order
to avail UTC benefit. India-Mauritius DTAA provides for minimum shareholding of
10 per cent in order to avail UTC benefit.

          An UTC clause of India-Mauritius DTAA
reads as follows:

          “In the case of a dividend paid by
a company which is a resident of Mauritius to a company which is a resident of
India and which owns at least 10 per cent of the shares of the company paying
the dividend, the credit shall take into account [in addition to any Mauritius
tax for which credit may be allowed under the provisions of sub-paragraph (a)
of this paragraph] the Mauritius tax payable by the company in respect of the
profits out of which such dividend is paid.”

          Illustration of the Underlying Tax
Credit

–   Indian company holds 100% shareholding of a
Singapore Company

–   Profits before tax of the Singapore Company
is Rs. 1,00,000/-

–   Tax rates in Singapore:

     Business Income @ 20%

     Withholding Tax on Dividends 5%

–   Tax rate on foreign dividends in India 30%

–   Assume that 100 per cent of profits are
distributed as dividends

Sr.No.

Particulars

Amount in Rs.

A

PBT
in Singapore

1,00,000

B

Tax
on Business Profits @ 20%

20,000

C

Balance
Profits declared as Dividends

80,000

D

Withholding
tax on Dividends @5%

4,000

In the hands of the Indian Company

E

Dividend
Income

80,000

F

Tax
on Dividends @ 30%

24,000

G

Underlying
Tax Credit (@ 100% of B)

20,000

H

Foreign
Tax Credit for Dividends

(Full
credit available as tax rate

in
India is higher than Singapore)

4,000

I

Total
Tax incidence in India

NIL

3.2.4 Tax Sparing

          Under this method, credit is given by
the state of residence in respect of deemed tax paid in the state of source.
Many a times, developing countries give many tax based incentives to attract
capital and technology from the developed nations. (For e.g. section 10
exemptions in India). However, income which may be exempt in India if taxed in
the other country, then the tax spared by the Indian government would go to the
other government rather than the company/entity concerned. Therefore, the
concept of tax sparing has come into being. Usually, provisions concerning tax
sparing cover specific sections of the domestic tax laws.

          However, sometimes, a general
reference is made to apply tax sparing provisions in respect of incentives
offered by a country for the promotion of economic development. [E.g.
India-Japan DTAA]  

          To illustrate, section 10(15)(iv)(fa)
of the Act provides that interest payable by a scheduled bank to a non-resident
depositor on a deposit placed in foreign currency is exempt from tax in India.
If an NRI depositor from Japan earns interest income from India, which is
exempt under this section but taxable in Japan, then the Japanese Government
will give a credit of tax which he would have otherwise paid in India, but for
this exemption.

Illustration

Sr. No.

Particulars

Amount in Rs.

A

Interest
Income received by an

NRI
in Japan on deposit placed

with
SBI in Yen.

1,00,000

B

Tax
paid in Japan @ 30%

30,000

C

Tax
Payable as per India-Japan Tax Treaty @ 10% {Actual tax

paid
is NIL either under DTAA

 or under the Act –

[exempt
u/s. 10(15)(iv)(fa)]}

10,000

D

Tax
Sparing Credit in Japan

10,000

E

Actual
Tax payable in Japan (B-D)

20,000

4.0    Foreign Tax Credit
Rules

          India by and large, follows ordinary
credit method and therefore, a lot of issues were arising for claiming credit.
There was no guidance as to at what rate taxes paid in the foreign country has
to be converted for claiming credit in India, what documents to be submitted,
what about timing mismatch and so on. In order to address these and other
issues, CBDT notified FTCR on 27th June 2016 and were made
applicable w.e.f. 1st April 2017. Let us study these provisions in
detail.

          Income Tax Rule 128 deals with the
provisions of FTC which are summarised as follows:

Sub Rule No.

Particulars

1

Credit of foreign tax to be allowed in
India in the year in

which the corresponding income is
offered to tax or

assessed in India. If income is offered
in more than one

year, then the credit for foreign tax
shall be allowed

in the same proportion in which such
income is offered

to tax or assessed in India.

(This provision takes care of timing
mismatch. If an

Indian resident receives income from
USA, where it was

taxed on a calendar year basis, then he
can offer the

proportionate income in India on
financial year basis. The

rule now clearly provides proportionate
credit of taxes if the income is offered for tax in two financial years)

 2

Meaning of foreign tax

Tax
referred to in a DTAA or as referred to in clause (iv)

of
the Explanation to section 91.

(It
means credit for state taxes or any other tax other

than
specifically covered by a bilateral tax treaty will

not
be available)

3

It
is clarified that FTC will be available against the tax,

surcharge
and cess payable under the Act but not

against
interest, fee or penalty.

4

FTC
will not be available in respect of disputed amount

of
foreign tax. (See Note 1)

5

This sub rule provides certain important
provisions:

(i)
FTC shall be computed vis-a-vis each source of

income
arising in a particular country;

(ii)
The credit shall be lower of the tax payable under

the
Act on such income and the foreign tax paid on

such
income; (See Note 2)

(iii)
As the tax in foreign country would be paid or deducted in the currency of the
respective country, the same needs to be converted into equivalent Indian
rupees. The rule provides that foreign tax should be converted at the
Telegraphic Transfer (TT) Buying Rate of the State Bank of India (SBI) on the
last day of the month

immediately
preceding the month in which such tax has

been
paid or deducted. (See Note 3)

6

Provision
allowing credit of FTC against MAT liability

u/s
115JB or 115JC

7

Excess
of FTC compared to MAT liability u/s 115JB or 115JC to be ignored

8

Documents to be submitted for claiming
FTC

(i)  Form
No. 67 containing details of foreign income and

     Tax
paid/deducted thereon.

(ii) Certificate or statement specifying
the nature of income and the amount of
tax deducted there from or paid by the assessee,—

(a)  from
the tax authority of the country or the specified territory outside India; or

(b)  from
the person responsible for deduction of such tax; or

(c)   signed
by the assessee along with an acknowledgement of online payment or bank
counter foil or challan for payment of tax or proof of tax deducted at
source, as the case may be.

9

The
above form and documents referred to in rule 8

have
to be filed on or before the due date of furnishing

income
tax return u/s. 139 of the Act.

10

Requirement
for submission of Form No. 67 in a case where The carry backward of loss of
the current year results in refund of foreign tax for which credit has been
claimed in any earlier year or years.

 

(Many
countries allow losses to be carried backward and

set
off against profits of the earlier year/s. In such a

situation,
the taxes paid earlier may be refunded to the

tax
payer. In order to avoid unjust enrichment, the

rules
provide for reversal of the FTC in India in respect

of
taxes which are subsequently refunded in the

foreign
jurisdiction)

Note1:Proviso
to sub rule 4 provides that foreign tax credit shall be allowed for the year in
which such income is offered to tax or assessed to tax in India if the assessee
within six months from the end of the month in which the dispute is finally
settled, furnishes evidence of settlement of dispute and an evidence to the
effect that the liability for payment of such foreign tax has been discharged
by him and furnishes an undertaking that no refund in respect of such amount
has directly or indirectly been claimed or shall be claimed.

Note 2:Proviso to sub rule 5 (i) provides that
where the foreign tax paid exceeds the amount of tax payable in accordance with
the provisions of the agreement for relief or avoidance of double taxation,
such excess shall be ignored for the purposes of this clause.

Illustration:

          An Indian company is taxed @ 20% on
royalty income in a foreign country X as per its domestic tax laws. However,
the DTAA between India and country X provides for the tax rate of 10% on such
royalty income, then notwithstanding, actual payment of 20%, the FTC in India
will be restricted to 10% only.

Note 3:Illustration
on conversion of FTC in Indian currency

          Mr. Patel, a resident in India has
received professional fees of USD 10,000/- on 1st February 2017 from
his UK client. His UK client deducted tax @ 20% (i.e. GBP 2000) under the UK
tax laws and paid the same to the UK government on 7th February
2017. India-UK DTAA provides the rate on FTS as 10%.

          He also earned capital gains on sale
of shares on London Stock exchange on 15th March 2017 amounting to
GBP 5000/- on which he paid tax of GBP 500 in UK on 31st March 2017.

          Consider
following rate of exchange of UK Pound vis-a-vis Indian Rupee:

Sr. No.

Date

Rate of Exchange

1 GBP = INR

1

31st
January 2017

84

2

1st
February 2017

85

3

7th
February 2017

83

4

28th
February 2017

82

5

15th
March 2017

80

6

31st
March 2017

81

 

          Rule 115 of the Act provides for the
mechanism to apply the exchange rate for conversion of foreign income to Indian
rupees.

          In the above case, applying provisions
of Rule 115 and sub-rule 5 of Rule 128, foreign income and FTC in India would
be computed as follows:

          FTC for Fees For Technical Services

          Income 10,000 @ Rs. 81/- = Rs.
8,10,000/-

          [Exchange rate as on the last date of
the previous year i.e. as on 31st March 2017 as per Rule 115(2)(c)
of the Act]

          Indian income tax @ 30% = Rs. 2,43,000/-

          FTC on 1000 @ Rs. 84/- = Rs. 84,000/-

          [Exchange rate as on the last date of
the previous month i.e. as on 31st January 2017 as per Rule 128(5)]

[Notes:

(i)       FTC restricted to the tax rate prescribed
in the India-UK DTAA and not the actual payment of GBP 2000;

(ii)      FTC is given at the exchange rate prevalent
on the last date of the preceding month in which the tax has been paid]

          FTC for Capital Gains

          Capital gains of 5000 @ Rs. 82/-    = Rs. 4,10,000/-

          [Exchange rate as on the last date of
the previous month i.e. as on 28th February 2017 as per Rule 115(f)]

          Indian Income tax @ 20%              (assumed)                                =
Rs. 88,000/-

          FTC on 500 @ Rs. 82/-                                                     =
Rs. 41,000/-

          [Exchange rate as on the last date of
the previous month i.e. as on 28th February 2017 as per Rule 128(5)]

5.0    Summation

FTCR has resolved many issues such as the rate
of exchange of FTC, the timing mismatch of two jurisdictions, credit in respect
of disputed foreign tax, loss situation etc. This will help in better
administration, clarity in claiming FTC and reduction in litigation.

Payments To non-residents law and procedure (Withholding Tax provisions under section 195 of the act)

The
subject of “withholding tax provisions (TDS) from payments made to
non-residents” is always mired in controversies.  Being 
part  of  the 
International  Tax Law, the
subject is dynamic. It is a complex subject as it involves computation of
income in the hands of non- residents. Provisions are very harsh and fraught
with severe penalties. Therefore, an attempt has been made in this write-up to
explain the law and procedure of various aspects of withholding taxes from the
payments made to non-residents, in brief, in the simple format of questions and
answers.

1.0  Introduction

Section
195 of the income-tax act, 1961 (the “act”) contains the provisions to deduct
tax at source (worldwide it is popularly known as “Withholding  tax”) from any payment made to a
non-resident.

Section
195(1) provides that, “any person responsible for paying to a non-resident not
being a company, or to a foreign company, any interest (not being interest
referred to in section 194LB  or section
194LC) or section 194LD or any other sum chargeable under the provisions of the
act (not being income chargeable under the head “salaries”) shall, at the time
of credit of such income to the account of the payee or at the time of payment
thereof in cash or by the issue of a cheque or draft or by any other mode,
whichever is earlier, deduct income-tax thereon at the rates in force. ….”

The
dissection of the above provision reveals that—

(i)  The obligation to deduct tax at source is
cast on every person making payment, be it individual, company, partnership
firm, government or a public sector bank etc. The term ’person’ as defined in
section 2(31) of the act is relevant here.

 (ii)  
The payee may be any type of entity (i.e. individual, company etc.).

(iii)  The payee must be a non-resident under the
act.

(iv)  The payment may be for interest other than
following types of interest:

(a)
Section 194LB – interest from infrastructure debt fund; or

(b)
Section  194LC   – 
interest  income  from 
Indian company before 1st July 2017;

(c)
Section 194LD – interest on certain bonds and government securities.

[In
all above types of interest payments the rate of TDS is 5 %.]

(v)   Payment of salaries is not covered by
section 195 of the act.

(vi)  Tax deduction has to be made at the time of
credit or payment of the sum to the non-resident, whichever is earlier.

(vii)
There is no threshold for deduction of tax at source. It therefore means
payment of even one rupee to a non-resident would attract TDS provisions.

In
the backdrop of above basic provisions, let us proceed to understand in detail
the law and procedure to comply with the provisions of withholding tax at
source u/s 195 of the act.

2.0   Questions and
answers

2.1     What kind of
payments to non-residents would attract withholding tax provisions under the
act? Is there any threshold exemption for deduction of tax at source?

Ans:  Section 195 casts an obligation on the person
who is making any payment to a non-resident to deduct tax at source. The
sweeping language of the section brings almost every payment, made to a
non-resident, which is chargeable to tax, within its ambit. The exclusions here
are in respect of payment of certain types of interest on borrowings (refer
para 1 herein above) and salaries. Section 192 of the act deals with TDS
provisions relating to salary paid to a non-resident, which is chargeable to
tax in India.

There
is no threshold exemption from obligation to deduct tax u/s 195. However, tax
is deductible only if income is chargeable to tax in the hands of  a non-resident and not otherwise.

The
crux of the provisions of section 195 is that the income in the hands of the
recipient must be chargeable to tax. Thus, 
if any income is exempt in the hands of the non-resident, the resident
making payment to such a non-resident need not deduct tax at source u/s 195.
(CBDT Circular no.  786 dated 7th
February, 2000 has clarified this issue).

The  hon’ble Supreme Court in the case of
Transmission Corporation of A.P. Ltd and Another vs. CIT (1999) 239 ITR 587
(SC) has held that the scheme of sub-sections (1), (2) and (3) of section 195
and section 197 leaves no doubt that the expression “any other sum chargeable
under the provisions of this act” would mean “sum” on which income-tax is
leviable. In other words, the said sum is chargeable to tax and could be
assessed to tax under the act. The consideration would be whether payment of
the sum to the non-resident is chargeable to tax under the provisions of the
act or not. That sum may be income or income hidden or otherwise embedded
therein. the  scheme of tax deduction at
source applies not only to the amount paid which wholly bears “income”
character such as salaries, dividend, interest on securities, etc., but also to
gross sums, the whole of which may not be income or profits of the recipient.”

in
this regard, it is important to note that in the subsequent decision in the
case of Ge India technology  (P) ltd (327
itr 456)(SC), the SC has dealt with the above aspect and other aspects relating
to section 195 in detail and has made important observations as follows:

 “7. ……. The most important expression in
section 195(1) consists of the words “chargeable under the provisions of the
act”. A person paying interest or any other sum to a non-resident is not liable
to deduct tax if such sum is not chargeable to tax under the income-tax act.
For instance, where there is no obligation on the part of the payer and no
right to receive the sum by the recipient and that the payment does not arise
out of any contract or obligation between the payer and the recipient but is
made voluntarily, such payments cannot be regarded  as 
income  under  the  income-tax
act. It may be noted that section 195 contemplates not  merely 
amounts,  the  whole 
of  which  are pure income payments, it also covers
composite payments which has an element of income embedded or incorporated in
them. Thus,  where an amount is payable
to a non-resident, the payer is under an obligation to deduct TAS  in respect of such composite payments. The
obligation to deduct TAS is, however, limited to the appropriate proportion of
income chargeable under the act forming part of the gross sum of money payable
to the non-resident. This obligation being limited to the appropriate
proportion of income flows from the words used in section 195(1), namely,
“chargeable under the provisions of the act”. It is for this reason that  vide 
Circular  no.   728 
dated  30-10-1995 that the CBDT
has clarified that the tax deductor can take into consideration the effect of
DTAA in respect of payment of royalties and technical fees while deducting
TAS….

….
While deciding the scope of section 195(2) it is important to note that the tax
which is required to be deducted at source is deductible only out of the
chargeable sum. this  is the underlying
principle of section 195. hence, apart from section 9(1), sections 4, 5, 9, 90
and 91 as well as the provisions of DTAA are also relevant, while applying tax
deduction at source provisions. reference to ito(tdS) u/s. 195(2) or 195(3)
either by the non­ resident or by the resident payer is to avoid any future
hassles for both resident as well as non­ resident. in our view, section 195(2)
and 195(3) are safeguards. the  said
provisions are of practical importance. this 
reasoning of ours is based on the decision of this Court in transmission
Corpn. of A.P. ltd.’s  case (supra) in
which this Court has observed that the provision of section 195(2) is a
Safeguard. from  this it follows that
where a person responsible for deduction is fairly certain then he can make his
own determination as to whether the tax was deductible at source and, if so,
what should be the amount thereof.”

8.
If the contention of the department that the moment there is remittance the
obligation to deduct TAS arises is to be accepted then we are obliterating the
words “chargeable under the provisions of the act” in section 195(1). The said expression
in section 195(1) shows that the remittance has got to be of a trading receipt,
the whole or part of which is liable to tax in India. The payer is bound to
deduct TAS only if the tax is assessable in India. If tax is not so assessable,
there is no question of TAS being deducted. [See : Vijay Ship Breaking Corpn.
vs. CIT [2009] 314 ITR 309 (SC)].

Applicability  
of   the   judgment  
in   the   case  
of Transmission Corporation (supra)

10.
In transmission Corpn. of A.P. ltd.’s case (supra) ‘a non-resident had entered
into a composite contract with the resident party making the payments. The said
composite contract not only comprised supply of plant, machinery and equipment
in India, but also comprised the installation and commissioning of the same in
India. It was admitted that the erection and 
commissioning  of  plant 
and  machinery  in India gave rise to income-taxable in
India. it was, therefore, clear even to the payer that payments required to be
made by him to the non-resident included an element of income which was
exigible to tax in India. The only issue raised in that case was whetherTDS was
applicable only to pure income payments and not to composite payments which had
an element of income embedded or incorporated in them. The controversy before
us in this batch of cases is, therefore, quite different. In transmission
Corpn. of A.P. ltd.’s  case (supra) it
was held that TAS was liable to be deducted by the payer on the gross amount if
such payment included in it an amount which was exigible to tax in India. it
was held that if the payer wanted to deduct TAS 
not on the gross amount but on the lesser amount, on the footing that
only a portion of the payment made represented “income chargeable to tax in
India”, then it was necessary for him to make an application u/s. 195(2) of the
act to the ito(tdS) and obtain his permission for deducting TAS at lesser
amount. Thus,  it was held by this Court
that if the payer had a doubt as to the amount to be deducted as TAS he could
approach the ito(tdS) to compute the amount which was liable to be deducted at
source. In our view, section 195(2) is based on the “principle of
proportionality”. The said sub-section gets attracted only in cases where the
payment made is a composite payment in which a certain proportion of payment
has an element of “income” chargeable to tax in India. it is in this context
that the Supreme Court stated, “if no such application is filed, income-tax on
such sum is to be deducted and it is the statutory obligation of the person responsible
for paying such ‘sum’ to deduct tax thereon before making payment. He has to
discharge the obligation to tdS”. if one reads the observation of the Supreme
Court, the words “such sum” clearly indicate that the observation refers to a
case of composite payment where the payer has a doubt regarding the inclusion
of an amount in such payment which is exigible to tax in India. in our view,
the above observations of this Court in transmission  Corpn. of A.P. ltd.’s  case (supra) which is put in italics has been
completely, with  respect,  misunderstood 
by  the  Karnataka high  Court to mean that it is not open for the
payer to contend that if the amount paid by him to the non-resident is not at
all “chargeable to tax in India”, then no TAS is required to be deducted from
such payment. This interpretation of the high Court completely loses sight of
the plain words of section 195(1) which in clear terms lays down that tax at
source is deductible only from “sums chargeable” under the provisions of the income-
tax act, i.e., chargeable under sections 4, 5 and 9 of the income-tax act.”

Thus,  there is no need to deduct tax at source in
respect of all incomes, which are exempt and/or not taxable under the act.

An
illustrative list of income under the act, which is exempt in the hands of
non-residents, is as follows:

(i)   Section 10(4) – interest on NRE account and
notified securities;

(ii)  Section 
10(6BB)  tax  paid 
on  behalf  of  the
non-resident by an Indian Company which is engaged in the business of operation
of aircraft;

(iii)
Section 10(6C) – income by way of royalty or fees arising to a foreign company
in respect of projects connected with security of India;

(iv)
Section  10(8a)  and 
(8B)  —  income 
of  a consultant/individual         out   
of   funds   made available to an international
organization under a technical assistance grant between the agency and the
government of a foreign State/ Government of India;

(v)
Section 10(15)(iv) etc. – income by way of interest and

(vi)
Section 10(15a) – any payment made by an Indian company engaged in the business
of operation of aircraft, to acquire aircraft or an aircraft engine on lease
from the Government of a foreign State or a foreign enterprise.

(vii)
amounts not liable to tax as per the provisions of the respective DTAAs.

Besides
the above income, if any other income of a non-resident is exempt from tax in
India, then there is no necessity to deduct tax at source by the payer.

2.2     Who has to
deduct tax at source u/s. 195 of the act?

Ans:  Section 195 casts an obligation on the person
who is making any payment to a non-resident to deduct tax at source. The only
condition is that the sum payable must be chargeable to tax in the hands of the
non-resident. The only exception is payment of salaries and specified interest
income.

2.3   Can a payer
obtain a “lower” or “nil” deduction certificate from the income tax
authorities? if yes, what is the procedure for the same?

Ans: yes, the
payer can make an application to the Assessing Officer to obtain a certificate
for “lower” or “nil” deduction of tax u/s. 195 (2) of the act. No particular
form has been prescribed for making an application and therefore, the payer can
apply on a plain paper or a letterhead giving all facts and supporting
documents justifying its claim for lower deduction or nil deduction of tax.

Alternatively,  the payer or the payee can make an
application for an advance ruling u/s. 245n of the act. The decision given by
the AAR would be binding on the applicant for the transaction for which the
ruling is sought and on the Commissioner and other income tax authorities
subordinate to him in respect of the applicant and the said transaction.

2.4   Can a payee
obtain a “lower” or “nil” deduction certificate from the income tax
authorities? if yes, what is the procedure for the same?

Ans:  a payee can apply to the AO for lower
deduction or NIL deduction certificates if the income received by him is either
not chargeable to tax or chargeable at the lower rate than what is prescribed
for withholding. Such an application can be made either u/s. 195 (3) or 197 of
the act.

Section
195(3) read with rule 29B provides for application by payee only in a case
where the income in the hands of the non-resident is not chargeable to tax in
Indian and therefore the payment is to be made without deduction of tax at
source i.e. nil tax. Whereas, the application is to be made u/s. 197 r.w. rule
28AA where the deduction is to be made at a lower rate or nil rate. Section197
covers provisions for application of certificate for lower or nil deduction for
host of other sections (e.g. from section 192 to 194 lBC)  along with section 195 of the Act.

Rule
28AA and rule 29B prescribes various conditions that a payee must fulfill in
order to be eligible to get a certificate.

2.5 At what rate tax is required to be deducted u/s. 195 of
the act?

2.5.1
income-tax act vs. double taxation avoidance agreement (DTAA)

Clause
(iii) of the section 2 (37A) of the Act specifies the rates in force for the
purposes of deduction of tax at source u/s. 195. Accordingly,  one has to apply the rate/s prescribed in the
finance  act of the relevant year or the
rates specified in a DTAA entered into by the Central Government, whichever  is 
applicable  by  virtue 
of  provisions of section 90 of
the act. In view of provisions of section 90(2) of the act, in case of a
remittance to a country with which a DTAA is in force, the tax should be
deducted at the rate provided in the finance 
act of the relevant year or at the rate provided in the DTAA, whichever
is more beneficial to the assessee. This position has been clarified by the
CBDT vide Circular no.  728, dated 30th
October, 1995. However, the provisions of section 90(4) provide that the relief
or benefit from any agreements or DTAA shall be available to a non resident  assessee 
only  on  obtaining 
from  him, a certificate of his
being a resident in a country outside India (TRC), issued by the government of
that country or specified territory.

2.5.2
CBDT Circular no. 333 dated 2-4-1982

Even
before insertion of section 90(2) reproduced above by the finance  (no. 2) act, 1991, with retrospective effect
from 1-4-1972, the CBDT had clarified vide Circular No. 333 dated 2- 4-1982
that where a specific provision is made in the DTAA, the provisions of the DTAA
will prevail over the general provisions contained in the income-tax act and
where there is no specific provision in the DTAA, it is the basic law i.e. the
provisions of the income-tax act, that will govern the taxation of such income.

The
said circular has been accepted and explained by various judicial authorities.
Hence, if a particular payment to non-resident is subject to deduction of tax
at source under the act, but under the relevant DTAA the same is not chargeable
to tax or taxable at a lower rate in India, then such lower/nil rate shall be
applicable.

2.5.3
Levy of Surcharge and the education Cess

The
rates prescribed under the act are to be increased by the Surcharge @ 2 or 5
per cent for foreign companies (as the case may be) and @ 15 per cent for non-residents
other than a company [12% in case of a co-operative society or firm]. Also,
there will be a further levy of the education Cess (@ 3 per cent on the tax and
surcharge amount.

However,  wherever theTDS rate is applied as prescribed
under a DTAA, then the same would be final and the Surcharge and the Education
Cess would not be applicable. Since DTAAs are agreements between the two
sovereign States, the rate prescribed therein is the maximum rate (i.e. the
upper ceiling), regardless of subsequent imposition of surcharge or cess, etc.

In
CIT vs. Srinivasan (K.) [1972] 83 ITR 346 the Supreme Court held that
income-tax includes surcharge. Therefore, 
the term “income tax” as included in tax treaties include surcharge as
well.

In
the following decisions it has been held that in cases where DTAA benefit
applies,TDS cannot be made at a higher rate in terms of section 206AA of the
act:

—
[2015] Serum Institute of India Ltd (68 Sot 254) (ITAT  Pune)

—
[2015] Infosys BPO ltd (154 itd 816)(ITAT 
Bang)

—
[2016]  Wipro  ltd 
(ITA  Nos.   1544 to 1547/ Bang/2013)(ITAT  Bang)

—
[2016] Bharti Airtel Ltd (67 taxmann.com 223) (ITAT  del)

A
contrary decision was earlier rendered in the case of  [2012] 
Bosch  ltd.   (141 
ITD 38)(ITAT  Bang).

2.5.4    Specific Rates prescribed in certain
Sections of the act

2.5.4.1
Section 115A of the act

The
CBDT has, in the context of section 115A [which prescribes special rates of tax
on dividends, interest, income from mutual funds, royalty and fees for
technical services payable to a non-resident (not being a company) or a foreign
company] clarified vide Circular no. 740 dated 17th  April, 1996 that if the DTAA provides for a
lower rate of taxation, the same would be applicable.

2.5.4.2
Presumptive rates of taxes

The  ratio of the above Circular would equally
apply to other special provisions applicable to non-resident such as provisions
contained in sections 44B (Special provisions for computing profits and gains
of shipping business in case of non-residents), 44BBA (Special provisions for
computing profits and gains in connection with the business of operation of
aircraft in case of non-residents), 44BBB (Special provisions for computing
profits and gains of foreign companies engaged 
in  the  business 
of  civil  construction, etc., in certain turnkey power
projects), etc.

Section
44BB prescribes a presumptive rate of 10% in respect of profits and gains in
connection with the business of exploration etc., of mineral oils.
However,  such presumptive rate would not
be applicable, if such income is otherwise covered by section 44D (i.e. Payment
of royalty and FTS  prior to 1-04-2003)
or section 115A (Payment of interest, dividends, royalties or FTS ). [ABC, in
re 234 ITR 37 (AAR)].

Following
the ratio of SC decision in the case of GE India Technology Centre (P.)
Ltd.  (supra), the ITAT  in the case of Frontier Offshore Exploration
(India)  Ltd.  vs. 
DCIT  [2011]  10 
taxmann.com 250 (Chennai) relating to payment to a non­ resident engaged
in the business of prospecting / exploration etc. of mineral oil, covered u/s
44BB of the act, held that obligation to deductTDS is limited to the
appropriate portion of income chargeable to tax.

2.5.4.3 Section 206AA of the act

This
section provides for furnishing of Permanent account number (Pan)  by any person who is entitled to receive any
sum/ income/amount on which tax is to be deducted under Chapter XVII-B  of the income tax act (includes section 195)
to the person responsible for deducting such tax, failing which tax shall be
deducted at higher of any of the following rates;

a)  The rate specified in the relevant provision
of the act,

b)  The rate or rates in force,

c)  The rate of twenty Five Percent.

However,
CBDT has notified a new Rule 37BC in the Income Tax Rules, 1962 vide
Notification no. 53/2016 dated 24th June, 
2016 providing a relaxation from deduction of tax at a higher rate u/s.
206AA in respect of certain payments. The provisions of section 206AA shall not
apply in cases where the deductee does not have a Pan and the payment made to him
is in the nature of interest, royalty, fees for technical services or payments
on transfer of any capital asset and the deductee furnishes the following
details and documents to the deductor:

(i)  Name, E-mail id, contact number;

(ii)
Address  in  the  country  or 
specified  territory outside India
of which the deductee is a resident;

(iii)
A certificate of his being resident in any country or specified territory
outside India from the Government of that country or specified territory if the
law of that country or specified territory provides for issuance of such
certificate;

(iv)
Tax Identification Number of the deductee in the country or specified territory
of his residence and in case no such number is available, then a unique number
on the basis of which the deductee is identified by the Government of that
country or the specified territory of which he claims to be a resident.

2.5.5   No TDS from
payments to foreign shipping companies or agents

The  CBDT, vide Circular no. 723 dated 19th September,
1995 had clarified that there would be no overlapping of section 172 which
provides for recovery of tax from foreign shipping companies and section 194C
& section 195, where payments are made to shipping agents of non-resident
ship owners or charterers of carriage of passengers, etc. shipped at a port in
India. The agent acts on behalf of the non­ resident ship owner or charterers
and therefore he steps into shoes of the principal and accordingly, the
provisions of section 172 shall apply and those of section 194C & 195 will
not apply. Therefore,  a resident making
payment of freight to the foreign shipping companies or their agents will not
be required to deduct TDS u/s. 195 or 194C.

2.6 What is the procedure of claiming tax treaty
benefit  while  remitting 
sum  u/s.  195  of
the act?

Ans:   Sections 90(4) and 90(5) were inserted by
the Finance Act  2012  and 
2013  respectively  to provide that any non-resident assessee who
seeks to obtain the benefit of the relevant DTAA applicable, shall avail so
only if he presents a Tax Residency Certificate (TRC) of the country of which
he is a resident for tax purposes as well 
as  any  other 
prescribed  particulars  as may be notified. Further, by Notification
No. 39/ f.no.142 /13/2012, rule 21AB was inserted which prescribes the
necessary particulars to be submitted along with the TRC u/s. 90(5) for  claiming 
treaty  benefits.  This 
includes  a self declaration by
the assessee in form 10F and it shall contain the Status, nationality, tax
Identification Number of the assessee in the country of which he claims to be a
resident, address of the assessee in that country and the period of residential
status of the assessee as mentioned in the TRC. however,  the Non­ resident shall not be required to
submit form 10F   if  the 
TRC already  contains  all 
such information as specified in form 10F.

2.7 What is the procedure to comply with the provisions of
WHT u/s. 195 of the act?

Section
195(6) of the income-tax act, 1961 provides that a person responsible for paying
any sum to a non-resident shall furnish such information as may be prescribed
under rule 37BB. The said rule 37BB provides that form no. 15CA and/or
form  no. 15CB shall be furnished for the
purpose of payment to a non-resident. Form No. 15CA is to be filed and
submitted online by  the  deductor 
i.e.  payer  and 
form 15CB is to be issued by the practicing Chartered accountant (C.A).
However, form 15CA is required to be filed only when the transaction falls
under reportable category irrespective of chargeability of tax. Form 15CA
contains four parts, A, B, C and D. When a transaction does fall into
reportable category and amount chargeable to tax does not exceed Rs. five lakh,
then part A of the form needs to be filed. But if it is taxable, one needs to
check the amount of the transaction.

If
the  transaction  value 
(payment  to  non­ resident) exceeds Rs. 5 lakh,

(a)
Part B of Form No.15CA needs to be filed after obtaining,­

(i)  A 
certificate  from  the 
Assessing  Officer u/s. 197; or

(ii)
An order from the Assessing Officer under sub-section (2) or sub-section (3) of
section 195;

Or

(b)
Part  C 
of  form   no.15CA 
after  obtaining  a certificate in Form No. 15CB from a
Chartered accountant.

Whereas,
if the transaction is below Rs. 5 lakh, only Part A of form 15CA needs to be
filed. The limit of Rs. 5 lakh is, however, not a threshold limit for
chargeability of tax or deduction of tax at source. In other words, even if
there is an exemption from submission of form 
15CB, the payer needs to deduct tax at source and deposit it with the
Government.

2.8 What are the consequences of failure to deduct tax at
source u/s. 195 of the act?

Ans:  There  
are severe consequences  for  failure 
to deduct tax at source while making payment to a non-resident. Besides
attracting levy of interest and penalty, such payments will not be allowed as
deduction in the hands of the payer while computing the profits and gains from
business and profession under the act [refer provisions of section 40(a)(i)].
Moreover, the payer may be regarded as an ‘agent’ of the non-resident u/s.163
of the act and the tax may be recovered from him. Thus,  one needs to be extremely careful in applying
provisions of the act for deduction of tax at source, from payments made to
non-residents.

Looking
at the serious repercussions of non- deduction of tax at source as a payer one
must always take a conservative view and deduct tax at source.

3.0 Some typical payments to non-residents which attracts
TDS provisions

In
following table some typical payments which are of practical importance are
covered. The idea is to give a bird’s eye view only and not a detailed or
reasoned analysis of provisions or taxability.

Some
Typical Payments to Non-Residents

Relevant
sections under the IT act

Relevant
Articles of a DTAA

Taxability
under the Act (TDS)

Withholding
Tax rate under a DTAA

 

Remarks

Interest from government or an
Indian concern on moneys borrowed or debt incurred by them in foreign
currency.

 

Sec. 115A

 

Article 11

 

20%

 

10%/15%

 

WTH rate differs from treaty to treaty.

Interest on bonds of an Indian
company issued in accordance with such scheme as the Central
Government notifies

 

Sec. 115AC

 

Article 11

 

10%

 

10%/15&

Interest on Infrastructure Debt Fund

Sec. 115A & 194LB

Article 11

5%

10%/15%

It is better to take shelter under the
domestic tax laws rather than DTAAs.

Certain income from units of a business
trust to non-resident 

Sec. 194LBA

Article 11

5%

10%/15%

Interest by an Indian Company or a
business trust in respect of money borrowed in foreign currency under a loan
agreement or by way of issue of long-term bonds

 

Sec. 115A & 194LC

 

Article 11

 

5%

 

10%/15%

Interest on rupee denominated bond of
an Indian Company or Government securities to a FII or a QFI

 

Sec. 115A & 194LD

 

Article 11

 

5%

 

10%/15%

Dividend u/s 115-O

Sec. 9(1)(iv) & 115A

Article 10

NIL

10%/15%

 

Dividend (other than u/s 115-O)

 

Sec. 9(1)(iv) & 115A

 

Article 10

 

20%

 

10%/15%

WTH rate differs from treaty-to-treaty

Purchase Consideration for immovable property (LTCG)

 

Sec. 45 & 195

 

Article 13

 

20%

No rates are prescribed as normally
taxed as per the domestic tax laws of both the countries.

Taxed per the domestic tax laws of both
countries.

 

Rent

 

Sec. 22 to

Sec. 27

 

Article 6

 

30%

 

Taxed in the country of source. No rate
is prescribed.

Taxed per the domestic tax laws of
country of source.

Commission on Imports

Sec. 9(1)(i)

Article 12

30%

10%/15%

WTH rate differs from treaty-to-treaty

Commission on exports

Sec. 9(1)(i)

N.A

Not taxable as Indian Income

N.A

Income does not accrue or arise in
India

4.0 Conclusion

The
subject of withholding tax from payments to non­ resident is faced with many challenges.
The Government’s intention is to protect the tax base of India and collect
revenue from the non-residents at source as it is difficult to catch them once
they are gone or money is transferred to them. As a payer one has to take
conservative view and deduct tax at source as far as possible. Failure to do so
may not only make him an assessee in default, but could also make him a
representative assessee u/s. 164 of the act and the tax may be recovered from
him. Other penal provisions may also follow. Therefore,  it is always advisable to obtain a lower
deduction certificate from the Assessing Officer or go for an advance ruling.

New India-Cyprus DTAA, 2016 – An Overview

A)  Background

(i)  India and Cyprus have recently signed a new Double Taxation Avoidance Agreement (New DTAA). The New DTAA replaces the earlier India-Cyprus DTAA signed in 1994 (Old DTAA), which has been a subject matter of renegotiation between the Government of India (GoI) and the Government of the Republic of Cyprus (GoC) for some time now. The New DTAA was signed on 18th November 2016 and both the Governments had previously issued press releases announcing the same. The text of the New DTAA was recently published in the Gazette of the GoC. However, the GoI is yet to make an official publication of the New DTAA. The New DTAA is the outcome of prolonged and extensive negotiations between both the countries.

(ii)  Significant provisions of the New DTAA include source country taxation rights on capital gains from shares, subject to grandfathering of shares acquired before 1st April 2017, insertion of Service Permanent Establishment (PE), expanded scope of Dependent Agent PE, revised Article on Fees for Technical Services (FTS) etc. The New DTAA limits source country taxation of Other Income. It also reduces taxation of royalty/FTS at the rate of 10% (as compared to the earlier rate of 15%). Furthermore, a modified version of the exchange of information (EOI) provision has been incorporated, which is in line with existing international standards. An additional Article on “assistance in collection of taxes” has also been introduced in the New DTAA.

(iii) The New DTAA will enter into force once the requisite procedures are completed in both the countries. The old DTAA shall stand terminated upon the New DTAA coming into force.

(iv) The GoI has rescinded the classification of Cyprus as a “Notified Jurisdictional Area” (NJA), retrospectively as from 1st November 2013.

B)  Highlights / Salient Features of the New DTAA

1.  Expanded scope of PE (Article 5)

The New DTAA expands the scope of ‘permanent establishment’, introducing the concept of a ‘service’ permanent establishment. The New DTAA has also specifically includes (i) sales outlets, (ii) warehouses (in relation to a person providing storage facilities for others) and (iii) farms, plantations or other places where agricultural, forestry, plantation or related activities are carried on, within the inclusive definition of ‘permanent establishment’. Further, the New DTAA provides for the creation of a construction permanent establishment if activities carry on for more than 6 months, instead of the earlier requirement that the activities be carried on for more than 12 months.

Insertion of a Service PE: A new Service PE clause has been introduced whereby furnishing of services, including consultancy services, by an enterprise through employees or other personnel engaged by the enterprise for such purpose, but only where activities of that nature continue (for the same or connected project) within the country for a period or periods aggregating more than 90 days within any 12 month period shall constitute a PE. The above service PE rule is in line with the UN Model Convention 2011 (2011 UN MC), except that the time threshold is lower at 90 days as compared to 183 days in the 2011 UN MC.

The criteria for the constitution of an agency PE has been amended. Accordingly, the person other than an agent of independent status shall constitute an agency PE if:

–   He is acting on behalf of an enterprise and has, and habitually exercises, in a contracting state an authority to conclude contracts in the name of the enterprise;

–   Has no such authority, but habitually maintains in the first-mentioned state a stock of goods or merchandise from which he regularly delivers goods or merchandise on behalf of the enterprise;

–   Habitually secures orders in the first mentioned state, wholly or almost wholly for the enterprise itself.

The above provisions are consistent with most of the Indian DTAAs.

There are a number of other changes in the PE definition which include, inter alia:

a) Lowered threshold for triggering construction/installation/supervisory PE to 6 months from the existing limit of 12 months.

b)  Inclusion of sales outlet, warehouse as fixed PE.

c)  Removal of “delivery” function from the scope of exempted activities.

2.   Profit Attribution / Business Profits (Article 7)

The New DTAA has removed the ‘force of attraction’ rule. Accordingly, the business profits of an enterprise may be taxed in the other state but only so much of them as is attributable to that PE.

No deduction shall be allowed in respect of amounts paid by way of royalties, fees or other similar payments in return for the use of patents, know-how or other rights, or by way of commission or other charges for specific services performed or for management, or, except in the case of banking enterprises, if any, paid (other than reimbursement of actual expenses) by the PE to the head office or any of its other offices, by way of interest on money lent to the PE.

Similarly, no account shall be taken, in the determination of the profits of a PE, of amounts charged by way of royalties, fees or other similar payments in return for the use of patents, know-how or other rights, or by way of commission or other charges for specific services performed or for management, or, except in the case of banking enterprises (other than reimbursement of actual expenses) by the PE to the head office or any of its other offices, by way of interest on moneys lent to the head office of the enterprise or any of its other offices.

This provision is comparable to Article 7(3) of the 2011 UN MC and has been adopted lately by India in most of its DTAAs.

3.   Shipping and Air Transport (Article 8)

The criteria of ‘registration’ and ‘headquarters’ have been removed. Accordingly, profits derived by an enterprise of a contracting state from the operation of ships or aircraft in international traffic shall be taxable only in that state

The term profits for the purpose of shipping and air transport has been amended. Accordingly, profits from the operation of ships or aircraft in international traffic shall include profits derived from the rental of ships or aircraft on a full time (time or voyage basis) or bareboat basis.

Exception is provided for the taxability of profits from the use, maintenance, or rental of containers for the transport of goods or merchandise solely between places within the other contracting state.

The New DTAA provides that interest on funds connected directly with the operation of ships or aircraft in international traffic, shall be regarded as profits derived from the operation of such ships or aircraft, and the provisions of Article 11 (interest) shall not apply in relation to such interest.

    by the enterprise are covered under ‘capital gains’. It shall be taxable only in the contracting state in which the alienator is a resident.

4.   Associated Enterprises (AEs) (Article 9)

The New DTAA aligns with the OECD Model Convention (OECD MC) in relation to the provisions related to AEs. Article 9(2) of the old DTAA has been removed, which provided powers to the competent authority to apply domestic laws which allow to use discretion/estimates for computing liability under Article 9(1) in cases where it is not possible, from the available information, to determine profits attributable to the concerned enterprise.

5.   Dividends (Article 10)

The rate of dividend in source state shall not exceed 10%. The rate of 15% has been removed.

6.   Interest (Article 11)

Tax rate of interest in source state shall not exceed 10% if the beneficial owner of the interest is a resident of the other contracting state.

Following entities are additionally exempt from tax:

– Export-Import Bank of India

–  National Housing Bank

– Any other institution as may be agreed upon from time to time between the competent authorities of the contracting states through the exchange of letters.

7.   Royalties and FTS (Article 12)

Under the New DTAA, royalties and FTS will attract tax withholding at the rate of 10%, as against the rate of 15% provided in existing DTAA. However, the scope of source taxation has been modified as follows:

–  The term FIS has been replaced by the term FTS.

–   The tax rate of royalties and FTS in the source state is reduced to 10% from 15 %.

–  The term royalty has been amended to include payment only.

–  The definition of the term ‘royalty’ has been amended as follows:

‘The term ‘royalties’ means payment of any kind received as a consideration for the use of, or the right to use, any copyright of literary, artistic or scientific work including cinematograph films or films or tapes used for television or radio broadcasting, any patent, trade mark, design or model, plan, secret formula or process, or for the use of, or the right to use, industrial, commercial or scientific equipment, or for information concerning industrial, commercial or scientific experience. The term ‘royalties’ will not include income for the use of, or the right to use aircrafts and ships.’

–   The term ‘FTS’ has been amended as follows:
‘FTS’ means payments of any kind as consideration for managerial or technical or consultancy services, including the provision of services of technical or other personnel.

Further, the ‘make available’ clause has been removed from the term FTS.

Additionally, Article 12(5) provides that where royalties or FTS do not arise in one of the contracting states, and the royalties relate to the use of, or the right to use, the right or property, or the FTS relate to services performed in one of the contracting states, the royalties or FTS shall be deemed to arise in that contracting state.

8.   Source based taxation of capital gains from shares (Article 13)

Capital gains arising from the transfer of shares are taxable solely in the Resident State of the alienator under the old DTAA. The New DTAA provides taxation rights to the State of residence of the company whose shares are alienated (i.e., Source State).

Additionally, taxation of indirect transfer whereby capital gains from sale of shares of a company, the assets of which consist, directly or indirectly, principally of immovable property in a Contracting State (Source State), would be taxable in the Source State.

However, shares acquired up to 31st March 2017 have been grandfathered from both the above rules on source taxation. The exemption will apply irrespective of the date of subsequent transfer of such shares.

Therefore, the source based taxation under the New DTAA shall only be applicable to capital gains arising from the transfer of investments made on or after 1st April, 2017, and capital gains arising from the transfer of investments made prior to 1st April, 2017 should continue to be taxed only in the jurisdiction in which the taxpayer is a resident.

The aforesaid provisions on direct transfer of shares are similar to the recent amendment under the India-Mauritius DTAA. The India-Mauritius DTAA additionally provides for a transitional relief of 50%, subject to fulfilment of Limitation of Benefit (LOB). Such a provision does not feature in the New DTAA with Cyprus.

The clause relating to alienation of ship and aircraft amended to provide that gains from the alienation of ships or aircraft operated in international traffic or movable property pertaining to the operation of such ships or aircraft shall be taxable only in the contracting state of which the alienator is a resident.

A new clause has been inserted to provide that gains from the alienation of shares of the capital stock of a company, the property of which consists directly or indirectly principally of immovable property situated in a contracting state, may be taxed in that state.

9.   Independent Personal Services (Article 14)

The New DTAA has introduced the rolling period concept i.e. for a period or periods amounting to or exceeding in the aggregate 183 days in any 12 month period commencing or ending in the fiscal year concerned.

10. Dependent Personal Services (Article 15)

The New DTAA has introduced the rolling period concept i.e. the remuneration derived in respect of an employment exercised in the other contracting state shall be taxable in source state only if the recipient is present in the other state for a period or periods not exceeding in the aggregate 183 days in any twelve month period commencing or ending in the fiscal year concerned.

In case the remuneration derived in respect of an employment exercised aboard a ship or aircraft operated in international traffic by an enterprise, the New DTAA has removed the place of effective management criteria. Therefore, the remuneration derived in respect of an employment exercised aboard a ship or aircraft operated in international traffic by an enterprise of a contracting state, shall be taxed in that state.

11. Limited source taxation of “Other Income” (Article 22)

Under the old DTAA, any income not expressly covered by other Articles of the DTAA and arising in a Source State could be taxed in that Source State also. The said provision has been removed in the New DTAA.

The New DTAA listed certain specified income for taxability in source state. Accordingly, if a resident of a contracting state derives income from sources within the other contracting state in the form of lotteries, crossword puzzles, races including horse races, card games and other games of any sort or gambling or betting of any nature whatsoever, such income may be taxed in the other contracting state.

12. Methods for elimination of double taxation (Article 23)

Benefits relating to tax sparing and deemed foreign tax credit (FTC) in respect of dividend, interest, royalty and FTS under the old DTAA have been removed.

13. Non Discrimination (Article 24)

The New DTAA has amended the non-discrimination clause. It provides that nationals of a contracting state shall not be subjected in the other contracting state to any taxation or any requirement connected therewith, which is other or more burdensome than the taxation and connected requirements to which nationals of that other state in the same circumstances, in particular with respect to residence, are or may be subjected. This provision shall also apply to persons who are not residents of one or both of the contracting states.

Interest, royalties and other disbursements paid by an enterprise of a contracting state to a resident of the other contracting state shall, for the purpose of determining the taxable profits of such enterprise, be deductible under the same conditions as if they had been paid to a resident of the first-mentioned state. Similarly, any debts of an enterprise of a contracting state to a resident of the other contracting State shall, for the purpose of determining the taxable capital of such enterprise, be deductible under the same conditions as if they had been contracted to a resident of the first-mentioned State.

14. Tie-breaker rule for determining residency of non-individuals through Mutual Agreement Procedure (MAP) (Article 25)

In cases of persons other than individuals who are residents of both India and Cyprus, place of effective management (POEM) rule is applied to determine residency. The New DTAA additionally provides that if POEM cannot be determined then the competent authorities of the Contracting States shall settle the question by mutual agreement within 2 years from the date of invocation of MAP under Article 25.

15. Exchange of Information (Article 26)

The scope of the EOI Article in the New DTAA has been enhanced to align with international standards on transparency and the provision in the OECD MC. The EOI Article extends to information relating to taxes of every kind and description imposed by a State or its political subdivisions or local authorities, to the extent that the same is not contrary to the taxation as per the New DTAA. Furthermore, the information can be used for purposes other than tax, with the prior approval of the authority providing such information.

EOI would also be possible in respect of persons who are not residents of the Contracting State, as long as the information requested is in possession of the concerned State. Specifically, information held by banks or financial institutions can be exchanged under the EOI Article.

16. Assistance in Collection of Taxes (Article 27)

The New DTAA includes an Article on “assistance in collection of taxes” largely in line with the OECD MC. Broadly, this Article enables the revenue claims of one State to be collected through the assistance of the other Contracting State, subject to fulfilment of certain conditions and requirements. Assistance would also involve undertaking measures of conservancy by freezing assets located in the requested State, subject to the laws therein.

Clause 4 of the Protocol clarifies that for the purpose of this Article, a State is not obliged to take measures inconsistent with its laws and policies in respect of collection of its own taxes.

C)  India rescinds notification treating Cyprus as “Notified Jurisdictional Area”

The Government of India (GoI) vide Notification No. 114 of 2016 dated 14th December 2016 (Recent Notification) has rescinded its earlier Notification No. 86 of 2013 dated 1st November 2013 which had notified Cyprus as a Notified Jurisdictional Area (NJA) u/s. 94A of the Income-tax Act, 1961 (Act).

On 1st November 2013, the Central Board of Direct Taxes (CBDT) invoked the provisions of Section 94A of the Act and notified Cyprus as an NJA owing to inadequate exchange of information by Cyprus tax authorities. On 1st July 2016, GoI issued a press release that negotiation on the revision of India-Cyprus tax treaty (Cyprus Treaty) between both the countries has been completed with –

–   Rights to source based taxation of capital gains and grandfathering of investments made prior to 1st April 2017.

–   India considering the removal of Cyprus from the list of NJAs under the Act retrospectively and initiating necessary procedures.

On 18th November, 2016, GoI issued a press release announcing the signing of the New Cyprus Treaty. Subsequent to this notification, Government of Cyprus released the text of the New Cyrus Treaty. GoI vide its recent notification has rescinded the earlier notification resulting in Cyprus not being a NJA under the Act. The recent notification also states that things done or omitted to be done before such rescission shall be an exception. On 16th December 2016, GoI has issued another press release confirming completion of internal procedures to amend the Cyprus Treaty. In this press release, GoI has also stated that Cyprus’s status as an NJA u/s. 94A of the Act has been rescinded with effect from 1st November 2013.

Impact of the Recent Notification

–   Deeming fiction provided in section 94A to deem Cyprus tax residents or a person located in Cyprus as an associated enterprise and any transactions with them as an international transaction will no longer be applicable.

–   Claim for deduction of any expenditure / allowance arising on account of transactions with Cypriot tax resident or a person located in Cyprus would now be allowable under general provisions of the Act without documentation requirements as per Rule 21AB of the Income-tax Rules, 1962 read with Form 10FC prescribed u/s. 94A of the Act.

–   Consequent to the Recent Notification, any taxable income accruing / arising to a Cypriot tax resident or a person located in Cyprus would now be subject to the withholding tax rates prescribed under the Act or the New DTAA (as and when India notifies the same), whichever is beneficial to the tax payer.

To illustrate, payments made to Cyprus tax residents or persons located in Cyprus would be subject to withholding tax as follows:

–   Royalties / Fees for Technical Services, earlier liable to withholding u/s. 94A at the rate of 30%, would now be liable to withholding at 10% under the Act.

–   Interest income, earlier liable to withholding u/s. 94A at the rate of 30%, would now be liable to withholding at 10% under the Cyprus Treaty or at an applicable lower rate under the Act, whichever is beneficial.

This is a long awaited and significant development between India and Cyprus and resets the tax position for various transactions on par with other jurisdictions.

D)  Impact and Analysis of New India-Cyprus DTAA

1.  Shift towards source based taxation.

By and large, India’s network of 94 tax treaties provide for source and residence based taxation of capital gains arising from the transfer of shares of a company. However some exceptions exist, for example, India’s tax treaties with Singapore, Jordan (provided the transferor is subject to tax in the state of residence), Philippines, Portugal, and Zambia provide for taxation of gains arising from the transfer of shares of a company only in the state of residence of the transferor.

Over the last few years, India has undertaken a concerted effort to revise its tax treaties and has successfully revised its treaties with Indonesia, Thailand, Mauritius and most recently Korea, to provide for source based taxation of capital gains arising from the transfer of shares of a company. The revision of the treaty with Mauritius (one of India’s largest sources of foreign investment) showed the determination of the Indian government to move towards a source based taxation of capital gains regime. The Indian Government is reportedly also in the process of amending its treaty with Singapore along similar lines. The New DTAA with Cyprus marks yet another milestone in this process.

For the time being, residence based taxation of gains arising from the transfer of investments in instruments other than shares e.g., debentures continues. Under India’s tax treaties, with the exception of gains arising from the transfer of (i) immoveable property, (ii) movable property forming part of a permanent establishment and, (iii) ships and aircraft, gains arising from the transfer of any other property are usually taxable only in the state of residence of the transferor. India’s tax treaties with China, USA, UK, Canada and Australia are some notable exceptions, with gains from any transfer of other property being taxable in both the state of source and the state of residence. Conversely, India’s tax treaties with Fiji, Greece and Egypt, provide for taxation of gains from the transfer any other property only in the country of source. The recently amended tax treaties with Mauritius, Korea and Thailand continue to provide for residence based taxation of gains arising from the transfer of “other property”.

Further, in the absence of an enabling treaty provision along the lines of that in the tax treaty with South Africa (Article 13(5) of the India-South Africa tax treaty provides that “Gains derived by a resident of a Contracting State from the sale, exchange or other disposition, directly or indirectly, of shares or similar rights in a company, other than those mentioned in paragraph 4, which is a resident of the other Contracting State, may be taxed in that other State.” ) gains arising from the indirect transfer of Indian shares should continue to be taxable only in the state of residence of the transferor (Article 13(6) of the New DTAA provides that “Gains from the alienation of any property other than that referred to in paragraphs 1, 2, 3, 4 and 5, shall be taxable only in the Contracting State of which the alienator is a resident). Based on the ruling of the Andhra Pradesh HC in Sanofi Pasteur Holding SA vs. Dept. of Revenue [2013] 30 taxmann.com 222 (AP) gains arising from the transfer of shares of a Cypriot company whose value is derived substantially from shares of an Indian company should fall within the scope of Article 13(6) and therefore be taxable only in Cyprus.). However, other view is also possible in this regard.

2.  Cyprus as a tax efficient jurisdiction for investing into India

While Mauritius negotiated a better interest withholding rate (7.5%) than the New DTAA currently contains (10%), and, unlike the India-Mauritius tax treaty, the New DTAA does not provide for a transition period [Under the recently notified Protocol amending the India-Mauritius Tax Treaty (set to come into effect from April 1, 2017), gains from the sale of investments made after April 1, 2017 but before March 31, 2019 are subject to taxation in the source country at only 50% of the applicable domestic tax rate. Gains from the sale of investments made prior to March 31, 2017 remain taxable only in Mauritius, but gains from investments made after March 31, 2019 will be taxable in Mauritius and India.] of taxation at reduced rates, the continuation of residence based taxation for gains arising on transfer of instruments other than shares, and Cyprus’ membership of the European Union should serve to return some of the country’s lustre as an efficient jurisdiction for investment into India. De-notification of Cyprus as an NJA may even encourage fresh investments through Cyprus prior to April 1, 2017.

3.  Limitation of Benefits Clause

Interestingly, the New DTAA does not contain a Limitation of Benefits clause (“LOB”). This is contrary to the trend that has arisen in recent years, with India amending / revising many of its tax treaties to include an LOB clause. India has incorporated variations of a LOB clause in its tax treaties with the USA (1990), Singapore (1994 / 2005), Namibia (1999), Armenia (2004), UAE (2007), Iceland (2008), Kuwait (2008), Syria (2009), Luxembourg (2010), Myanmar (2010), Tajikistan (2010), Finland (2011), Mexico (2011), Mozambique (2011), Georgia (2012), Lithuania (2012), Norway (2012), Tanzania (2012), Taiwan (2012), Uzbekistan (2012), Ethiopia (2013), Jordan (2013), Malaysia (2013), Nepal (2013), Romania (2013), UK (2013), Albania (2014), Bhutan (2014), Columbia (2014), Fiji (2014), Latvia (2014), Sri Lanka (2014), Uruguay (2014), Macedonia (2015), Malta (2015), Thailand (2015), Poland (2015), Indonesia (2016), Korea (2016) and Mauritius (2016). In the times to come, it will be exciting to see the interplay between the General Anti-Avoidance Rules (“GAAR”) which are slated to come into effect from April 1, 2017 and the re-negotiated tax treaties (especially the LOB clauses) and the impact on structures and investments. Notably, the Shome Committee report had recommended that where anti-avoidance rules are provided for in a treaty, the GAAR provisions should not apply to override the provisions of the treaty. Interestingly, the LOB clause in the amended Mauritius tax treaty requires a company desirous of claiming benefits to either (i) be listed on a stock exchange in Mauritius or (ii) incur expenditure on operations in its state of residence to a tune of Rs. 2.7 million in the 12 months immediately preceding the date on which the gains arise. This is similar to the language of the LOB clause in the Singapore tax treaty. However, the Singapore LOB clause will cease to be in effect on April 1, 2017, unless the Singapore treaty is amended prior to that date.

E)  Concluding Remarks

The New Cyprus DTAA is similar to the recently amended India-Mauritius DTAA in terms of inclusion of Service PE and source taxation of capital gains, as well as grandfathering relief. However, as compared to the amended India-Mauritius DTAA, there is no transitory concessional relief available (subject to LOB) in respect of gains made on shares acquired post 1st April 2017 but transferred before 31st March 2019.

Some other provisions on PE, FTS, EOI are also consistent with the recent trends in Indian DTAAs. Interestingly, the New DTAA does not contain an LOB provision, contrary to the trend in Indian DTAAs being signed/amended lately.

After Mauritius and Cyprus, renegotiation of the India-Singapore DTAA and the India-Netherlands DTAA is expected to be completed.

Taxpayers will need to evaluate the impact of the New DTAA based on the facts of their specific cases. One may also need to watch how the New DTAA will get impacted by the Multilateral Instrument released by the OECD recently.
The above article provides only an overview of the salient features of the New India-Cyprus DTAA. The reader is advised to go through the detailed provisions of the Treaty minutely.

Guiding Principles for Determination of Place of Effective Management (POEM)

Readers may be aware that the
Finance Act, 2015 had inserted the concept of Place of Effective Management
(POEM) for determining the residential status of a company by amending section
6(3) w.e.f. 1-4-2016. The said section 6(3) was substituted by the Finance Act,
2016  with effect from 1st April
2016 (i.e. the current Financial Year) and accordingly shall apply from the
Assessment Year 2017-18 onwards. Although the term “POEM” was defined in the
Income-tax Act, 1961 (“Act”), the definition was short and crisp. Subsequently,
the Government issued draft guidelines for determination of POEM. After
considering comments and suggestions from various stakeholders and general
public, these guidelines have been finalised in the form of “Guiding
Principles” for determination of POEM. This write-up covers detailed analysis
of these guiding principles and issues arising out of them and/or unresolved
grey areas which may lead to litigation. 

1.0    Introduction

Section 6(3) of the Act, prior to
its amendment vide Finance Act, 2015, provided that a company would be
considered as resident of India under two circumstances, namely, (i) if it is
incorporated in India or (ii) control and management of its affairs is situated
wholly in India. This definition was prone to misuse. A foreign company
owned and controlled by Indian residents could shift its insignificant part of
control or management outside India to claim its status as non-resident. There
have been cases where foreign companies, though controlled and managed by Indian
residents, were held to be non-resident as their one or two board meetings were
held outside India. In order to address these concerns, the requirement of POEM
was introduced in the Act.

The concept of POEM is not new to
the constituents of international taxation. Essentially it refers to a place
where head and brain of an organisation is located or operates from.

Section 6 (3) as amended with
effect from 1st April 2016, reads as follows:

A company is said to be a
resident in India in any previous year, if—

(i)  it is an Indian company; or

(ii)  its place of effective
management, in that year, is in India.

Explanation.— For the purposes
of this clause “place of effective management” means a place where
key management and commercial decisions that are necessary for the conduct of
business of an entity as a whole are, in substance made.

In the backdrop of the above
amendment, CBDT issued the draft guidelines for determination of POEM on 23rd
December 2015 inviting suggestions and feedback from public at large.
After a year of issuance of the draft guidelines the CBDT has now issued
Circular No. 6 of 2017 dated 24th January 2017 containing the
“guiding principles” for determination of POEM. (Hereinafter referred to as
“Circular”)

2.0 Determining
Criteria

The Circular prescribes various
tests to determine the POEM. They can be broadly classified into:

(i)  Active Business Test having sub
sets of

(a) Passive Income/Total Income Test

(b) Assets Test

(c) Employees Test

(d) Payroll Test

(ii) Control and Management Test

(iii) Location of Head Office and Senior Management Test

(iv) Location of Board of Directors’ Meeting Test and

(v) Secondary Factors Test.

Any foreign company has to be
evaluated based on these tests to determine whether it has a place of effective
management in India or not. Though the objective seems to be to apply these
tests to foreign companies owned or controlled by Indian residents, technically
it applies to any foreign company. 

Let us go through them in detail.

2.1    Active Business
Test

The Circular requires determining
an “active business outside India” with the help of various tests. The POEM of
a foreign company having an “active business outside India” shall be presumed
to be outside India if its majority of Board meetings are held outside India.
(It may be held at a place other than the country of incorporation).

It may be noted here that for the
purpose of determining whether the company is engaged in active business
outside India, the average of the data of the previous year and two years prior
to that shall be taken into account. In case the company has been in existence
for a shorter period, then data of such period shall be considered.

Where the accounting year for tax
purposes, in accordance with laws of country of incorporation of the company,
is different from the previous year, then, data of the accounting year that
ends during the relevant previous year and two accounting years preceding it
shall be considered. For example, for a foreign company following calendar year
(CY) for the previous year 2016-17 (April-March) the data of the foreign
company to be examined are CY 2016, CY 2015 and CY 2014. 

The Circular provides that for the
purposes of these guidelines, –

(a) A company shall be said to be
engaged in “active business outside India”

(i)  if the passive income
is not more than 50% of its total income and,

(ii) less than 50% of its total
assets are situated in India; and

(iii) less than 50% of total
number of employees are situated in India or are resident in India; and

(iv) the payroll expenses incurred on such employees is less
than 50% of its total payroll expenditure;

All the above tests are cumulative
in nature, meaning in order for a company to qualify as doing an active
business outside India, all the above tests need to be satisfied. However, as
reiterated by the Circular the determination of the POEM is a fact based
exercise with the underlying principle of substance over form and therefore,
failure to satisfy any single test by the foreign company per se, should
not be held against it. Much would depend upon the actual conduct of the
business and exercise of the control and management of its affairs.

2.1.1  Income Test

The income test to be fulfilled by
a foreign company for being considered as engaged in  active business outside India is:

“the passive income is
not more than 50% of its total income”.

The Circular defines both total
income as well as passive income.

Total Income

The income for this purpose is
explained to be (a) as computed for tax purpose in accordance with the laws of
the country of incorporation; or (b) as per books of account, where the laws of
the country of incorporation does not require such a computation.

It is not clear as to whether such
books of account need to be audited or not. However, looking at the spirit of
the Circular, one would be guided by the laws of the host country. If audit is
not mandatory in the host country then even self-certified accounts should be
good enough.

Passive Income

“Passive income” of a company
shall be aggregate of, – (i) income from the transactions where both the
purchase and sale of goods is from/to its associated enterprises; and (ii)
income by way of royalty, dividend, capital gains, interest or rental income.

However, any income by way of
interest shall not be considered to be passive income in case of a company
which is engaged in the business of banking or is a public financial
institution, and its activities are regulated as such under the applicable laws
of the country of incorporation.

Inclusion of trading transactions
between two associated enterprises may cause genuine hardships to some foreign
companies owned by Indian residents which may be dealing within its global AEs
without any t  ransaction with any AE
situated in India.

2.1.2  Assets Test

The assets test to be fulfilled by
a foreign company for an active business outside India is:

“less than 50% of its total
assets are situated in India”.

The value of assets : 

(a) In case of an individually
depreciable asset, shall be the average of its value for tax purposes in the
country of incorporation of the company at the beginning and at end of the
previous year; and

(b) In case of pool of a fixed
assets being treated as a block for depreciation, shall be the average of its
value for tax purposes in the country of incorporation of the company at the
beginning and at end of the year;

(c) In case of any other asset,
shall be its value as per books of account;

With world accounting converging
to International Financial Reporting Standards (IFRS), valuation of assets
should not be an issue unless the foreign company is situated in a jurisdiction
which does not follow IFRS or no audit requirements are prescribed.

2.1.3   Employees Test  

The employees test to be fulfilled
by a foreign company for an active business outside India is:

“less than 50% of total number
of employees are situated in India or are resident in India”.

The Circular provides that the
number of employees shall be the average of the number of employees as at the
beginning and at the end of the year and shall include persons, who though not
employed directly by the company, perform tasks similar to those performed by
the employees;

A question may arise as to
payments made to a retainer be included in the list of employees. Here, one may
be guided by the terms of the engagement, the nature of job profile and actual
conduct of the person etc.

2.1.4  Payroll Test

The test to be fulfilled by a
foreign company for an active business outside India is:

“the payroll expenses
incurred on such employees is less than 50% of its total payroll expenditure”.

The Circular provides that “the
term “payroll” shall include the cost of salaries, wages, bonus and all other
employee compensation including related pension and social costs borne by the
employer.

2.2  Control and Management Test

This test is useful in determining
where exactly head and brain of the company resides.

The Circular provides that in
cases of companies other than those that are engaged in active business outside
India, the determination of POEM would be a two stage process, namely:

(i)  First stage would be
identification or ascertaining the person or persons who actually make the key
management and commercial decision for conduct of the company’s business as
a whole.

(ii) Second stage would be
determination of place where these decisions are in fact being made.

It is also provided that the place
where the management decisions are taken would be more important than the place
where they are executed. Day to day routine operational decisions taken by the
junior and middle level management shall not be relevant for the purposes of
determination of POEM. It is also provided that where by operation of law certain
key decisions are left to the shareholders such as dissolution, liquidation or
deregistration of the company etc. which may typically affect the
existence of company rather than the conduct of the company from management and
commercial perspective etc. would generally be not relevant in
determination of the POEM. 

2.3  Location
of Head Office and Senior Management Test

The Circular provides that
location of Head Office (HO) will be an important factor in determining the
POEM as often key decisions are taken there.

The term HO is defined to mean the
place where the company’s senior management and their direct support staff are
located or, if they are located at more than one location, the place where they
are primarily or predominantly located. A company’s head office is not
necessarily the same as the place where the majority of its employees work or
where its board typically meets.

Location of senior management and
their support staff may play a key role in determination of the place of HO.

According to the Circular the
“Senior Management” in respect of a company means the person or persons who are
generally responsible for developing and formulating key strategies and
policies for the company and for ensuring or overseeing the execution and
implementation of those strategies on a regular and on-going basis. While
designation may vary, these persons may include: (i) Managing Director or Chief
Executive Officer; (ii) Financial Director or Chief Financial Officer; (iii)
Chief Operating Officer; and (iv) The heads of various divisions or departments
(for example, Chief Information or Technology Officer, Director for Sales or
Marketing).

Generally the locale of senior
management or the highest level of management personnel (such as the Managing Director
or the Finance Director) shall determine the location of HO. However, if the
company’s senior management is so highly decentralized that it is difficult to
determine its HO, then HO will not be of much relevance in determining the
POEM.

In case of decisions by video
conferencing, telecommunication etc. the location of maximum number of persons
taking such decision would be relevant in determination of the POEM. In case of
circular resolution or round robin voting etc. the location of the
person who has the authority and who exercises the authority to take decisions
would be a relevant factor in determination of the POEM.  

2.4 Location of Board of Directors’ Meeting
Test        

The Circular provides that the
location where a company’s Board regularly meets and makes decisions may be the
company’s place of effective management provided, the Board- (i) retains and
exercises its authority to govern the company; and (ii) does, in substance,
make the key management and commercial decisions necessary for the conduct of
the company’s business as a whole.

In deciding the place of board
meetings as the POEM, one must look at the actual conduct of business at the
board meetings, whether key decisions are taken or not. Therefore, merely a
formal board meeting at a particular place by itself would not result in the
POEM.

If the board has delegated its
power or authority to take key decisions to senior management, executive
committee or any other person including a shareholder, promoter, a strategic,
legal or financial advisor etc. then the POEM would at the place of
location of such decision maker/s.

2.5  Secondary Factors for determination of
the POEM

The Circular provides that if the
primary factors (as mentioned above) do not lead to clear identification of POEM
then the following secondary factors can be considered:

(i)  Place where main and
substantial activity of the company is carried out; or

(ii) Place where the accounting
records of the company are kept.

2.6   Summary of the POEM Tests

Based on the various tests
prescribed by the Circular, the POEM of a company can be determined based on
following criteria:

It may be noted that there is no
fixed hierarchy of the above tests.         

3.0  Exceptions and Assurances

After elaborately prescribing
various guidelines to determine the POEM in paragraphs 1 to 8, the Circular in
paragraphs 9 and 10 provides certain exceptions, clarifications and assurances
in determining the POEM. The Circular reiterates that the guiding principles
are only for the purpose of guidance and that no single principle in itself
will be decisive. One needs to take a holistic view of the matter. The
principles need to be applied over a period of time in a given previous year
and not at a particular moment. “Snapshot” approach is not to be adopted.

Following clarifications are
provided in the Circular with regard to determination of the POEM in India:

Following isolated facts in
themselves will not be conclusive evidences that the conditions for establishing
a POEM in India have been satisfied:        

     (i)  Foreign company is a wholly
owned subsidiary of an Indian company;

(ii) Foreign company has a Permanent
Establishment in India;

(iii) One or more directors of a
foreign company reside in India;

(iv) Local management of a foreign
company being situated in India in respect of activities carried out by a
foreign company in India;

(v) The existence in India of
support functions those are preparatory and auxiliary in character.

4.0  Summary
of various tests in determination of POEM as listed above

4.1         Determination of POEM
is a fact based exercise.

4.2          No single factor can be
considered as final. One needs to take a holistic view of the matter.
Determination of the POEM cannot be based on isolated facts.

4.3        In determination of
POEM, one needs to look at substance over form; only substance will prevail in
the end.

4.4        There can be more than
one place of management but there can be only one POEM at a given point of
time.

4.5        If during the previous
year a company is found to be having POEM, both in India and abroad then it
would be deemed to be at a place where it is mainly or predominantly located.

4.6         POEM is to be
considered over a period of time during the previous year and not at a
particular point in time. One should not take a “snapshot view” of the matter.

4.7         POEM should be
determined on a yearly basis. The existence or otherwise of the POEM should be
examined on year to year basis by applying various tests enumerated in the
Circular.

4.8       Just because an
intermediary holding company (say a first level subsidiary abroad of an Indian
Company) has a POEM in India, its downstream subsidiary/Joint venture companies
per se would not be regarded as having their POEMs in India. In other words,
the tests of determination of the POEM shall be applied to every overseas
entity separately and independently.

4.9        Actual conduct of the
Board of Directors or Senior Management Team or an Executive Council is
important rather than formal delegation of powers.

5.0   Threshold Limit

The Press Release issued by the
Ministry of Finance on 24th January 2017 citing issuance of the CBDT
Circular mentioned and discussed above, provides that the POEM guidelines shall
not apply to companies having turnover or gross receipts of Rs. Fifty (50) Crore or less in a financial year.

It appears that the threshold has
been prescribed for the applicability of the guiding principles only and not of
the POEM of a company itself u/s. 6 (3) of the Act. However, this does not seem
to be the intent of the CBDT. A clarification to this effect should be
issued. 

6.0  Invocation of POEM

The Circular contains certain
administrative safe guards by mandating that the Assessing Officer (AO) will
have to obtain a prior approval of the Principal CIT/CIT for initiating an
inquiry of the POEM. The AO also need to obtain an approval from the Collegium
of 3 Principal CITs/CITs before holding that POEM of a non-resident company is
in India.

One hopes that provisions of the
POEM are invoked in rare cases and used as a deterrent than as a revenue raiser
tool. In this context, highest amount of restraint is called for on the part of
the tax administration so as to strike a balance between genuine cases of
overseas ventures and shell companies.

7.0 Summation/Conclusion

The Circular at paragraph 12
contains certain illustrations as to which situations would constitute a POEM
and which would not. Readers are well advised to go through the same.

The sum and substance of these
guiding principles for determination of the POEM is that the facts are supreme.
No one particular criteria can determine the existence or otherwise of a POEM.
One needs to take a holistic view of the matter and that too over a period of
time and not in isolation. In the ultimate, one needs to look at the substance
over form in establishment of the POEM.

The way these guidelines are
drafted, a question arises as to whether the era of Special Purpose Vehicle
(SPV) at an overseas location, for various commercial reasons, is over? All
SPVs by design will have passive income only and may not have substantial or
any business activities except for holding investments in downstream companies.
It appears that only holding cum operating companies which would fulfill the
conditions of active business outside India will be able to establish their
POEMs outside India.

With the release of the final
guidelines for POEM determination, one has to wait and watch the position with
respect to introduction of Controlled Foreign Corporation [CFC] rules as stated
in the BEPS action reports. However, taking a cue from the CFC regulations
worldwide and in the interest of the Indian entrepreneurship it would be better
if the overseas listed companies are kept outside the scrutiny of the POEM.

The Finance Act, 2016 had also
introduced section 115JH in the Act to enable the Government to notify rules in
relation to computation of income, carry forward and set-off of losses,
treatment of unabsorbed depreciation and applicability of transfer pricing in
relation to foreign companies which are treated as being resident in India.
Rules in this regard are still awaited.

The compliance with these final guidelines which
are issued only now especially since POEM is effective from 1-4-2016 (AY
2017-18) and we are already 10 months down the line. This certainly merits
deferment of the provisions of POEM by a year to 1-4-2017 (AY 2018-19).
Otherwise, this retrospective application of Final guidelines for AY 2017-18
could lead to confusion and unwarranted problems for assessees.

INTERNATIONAL WORKERS AND SOCIAL SECURITY AGREEMENTS – GROWING SIGNIFICANCE – AN OVERVIEW

In view of significant increase in
the mobility of cross border workers / employees in the recent years, issues
relating to social security benefits to such International Workers [IWs] have
acquired immense importance. Consequently, Social Security Agreements [SSAs],
being bilateral instruments, entered into by various countries to protect the
social security interests of such international workers has assumed lot of
significance. India is not remaining far behind in this respect. In this
article, we have attempted to give an overview of SSAs and social security
issues of International Workers.


 1.  Background

     Foreign nationals coming
for employment in India were earlier excluded from the provisions of the
Employees’ Provident Fund and Miscellaneous Provisions Act, 1952 [EPF Act] as
their remunerations in most cases far exceeded above the statutory threshold
limit.

    On the other hand,
Indian citizens working overseas (other than countries having operational SSA
with India and fulfilling relevant conditions prescribed therein) are subjected
to all contributions to the social security fund of the country where they
work, irrespective of the time spent in another country. Often, the amount so
contributed would stand forfeited, since like the Indian Provident Fund, all
social security schemes are subject to long-term rules of withdrawal, causing
the Indian expatriate or his employer heavy losses.

    In order to create level
playing field and to pressurise other countries to enter into SSAs with India,
‘International Worker’ is introduced as a concept and they are bound to comply
with PF provisions, regardless of their remuneration break-up.

    In October 2008,
Government of India made fundamental changes in the Employees’ Provident Funds
Scheme, 1952 [EPFS] and Employees’ Pension Scheme, 1995 [EPS] by bringing
International Workers [IWs] under the purview of the Indian social security
regime. The Government of India had vide its notifications dated 1st
October, 2008 introduced Para 83 to the Employees’ Provident Fund Scheme, 1952
and Para 43-A to the Employees’ Pension Scheme, 1995 creating Special
provisions in respect of the International workers [Special provisions].

    In September 2010, the
Ministry of Labour and Employment [MoLE)] issued a notification further
amending the EPFS and EPS vis-à-vis the IWs. However, the notification raised a
lot of issues which required clarifications. In May 2012, the MoLE vide its
notification dated 24th May, 2012 made further amendments in the
Employees’ Provident Scheme to clarify various issues.

    An important
clarification is that IWs who are covered under an SSA that India has signed
with other countries and that are in force can withdraw their PF accumulations
immediately on cessation of employment in establishments covered under EPF Act
in India and will not have to wait till 58 years of age to get access to their
PF accumulations. Further, the definition of excluded employee (who need not
contribute to Provident Fund in India) has been expanded to cover exemption
granted under bilateral economic agreements.


 2.  Social Security

     The term ‘Social
Security’ has been explained by the International Labour Organisation as the
protection which society provides for its members, through a series of public
measures, against economic and social distress that otherwise would be caused
by the stoppage or substantial reduction of earnings resulting from sickness,
maternity, employment injury, unemployment, invalidity, old-age and death; the
provision of medical care; and the provision of subsidies for families with
children.

     The key social security
legislations in India with respect to employees are:

 (i)  The Employees’ Provident
Fund and Miscellaneous Provisions Act, 1952; (ii) The Employees’ State
Insurance Act, 1948; (iii) The Employees’ Compensation Act, 1923; (iv) The
Maternity Benefit Act, 1961; and (v) The Payment of Gratuity Act, 1972.

    The Social Security
contributions have significant importance while structuring international
assignments for employees. Any social security benefit payable in the host
country may become an added cost to the employer, especially in situations
where there are restrictions for withdrawal. It is in this context that SSAs
executed between countries come into perspective and they need to be carefully
evaluated to help reduce the financial implications. At times, secondment
arrangements are structured to ensure that the expatriate employee continues to
derive social security benefits in the home country during the period of
assignment.


 3.  Social Security Agreement

a.  Social Security Agreement

    A Social Security
Agreement is a bilateral instrument to protect the social security interests of
workers posted in another country. Being a reciprocal arrangement, it generally
provides for equality of treatment and avoidance of double
coverage/contribution.

 b.  Main provisions covered
in a SSA

     Generally a Social
Security Agreement covers 3 provisions. They are:

 a) Detachment:
Applies to employees sent on posting in another country, provided they are complying
under the social security system of the home country.

b)  Exportability of
Pension: Provision for payment of pension benefits directly without any
reduction to the beneficiary choosing to reside in the territory of the home
country as also to a beneficiary choosing to reside in the territory of a third
country.

c)  Totalisation of
Benefits: The period of service rendered by an employee in a foreign
country is counted for determining the “eligibility” for benefits,
but the quantum of payment is restricted to the length of service, on pro-rata
basis.

 c.  Articles forming part of
a typical SSA

    The brief description of
the Articles contained in the latest India-Australia SSA signed on 18-11-2014,
are as follows:

Sr. No.

Part / Article No.

Description of Part / Article

 

Part I

General Provisions

1.

Article 1

Definitions

2.

Article 2

Legislative Scope

3.

Article 3

Personal Scope

4.

Article 4

Equality of Treatment

5.

Article 5

Export of Benefits

 

Part II

Provisions and Coverage

6.

Article 6

Purpose and Application

7.

Article 7

Diplomats and Government Employees

8.

Article 8

Avoidance of Double Coverage

9.

Article 9

Secondment from Third States

10.

Article 10

Exceptions

11.

Article 11

Certificate of Coverage

 

Part III

Provisions relating to Australian Benefits

12.

Article 12

Residence or presence in India

13.

Article 13

Totalisation

14.

Article 14

Calculation of Australian Benefits

 

Part IV

Provisions relating to Benefits of India

15.

Article 15

Totalisation of Insurance period

16.

Article 16

Calculation of Indian Benefits

 

Part V

Miscellaneous and Administrative Provisions

17.

Article 17

Lodgement of Documents

18.

Article 18

Payment of Benefits

19.

Article 19

Exchange of information and Mutual Assistance

20.

Article 20

Administrative Arrangement

21.

Article 21

Exchange of Statistics

22.

Article 22

Resolution of Disputes

23.

Article 23

Review of Agreement

 

Part VI

Transitional and Final Provisions

24.

Article 24

Transitional Provisions

25.

Article 25

Entry into Force

26.

Article 26

Termination

 


4.  Status of various Operating Indian SSAs

 India presently has 17 operating
SSAs, the brief details of which are given below:

Sr. No.

Country

Date of Signing

Date of entry into Force

Duration of Detachment

Exportability of Pension

Totalisation 
Benefits

1 .

Belgium

03-11-06

01-09-09

60

A

A

2.

Germany

08-10-08

01-10-09

48

N/A

N/A

3.

Switzerland

03-09-09

29-01-11

72

A

N/A

4.

Denmark

17-02-10

01-05-11

60

A

A

5.

Luxembourg

30-09-09

01-06-11

60

A

A

6.

France

30-09-08

01-07-11

60

A

A

7.

Korea

19-10-10

01-11-11

60

A

A

8.

Netherlands

22-10-09

01-12-11

60

A

N/A

9.

Hungary

02-02-10

01-04-13

60

A

A

10.

Finland

12-06-12

01-08-14

60

A

A

11

Sweden

26-11-12

01-08-14

24

[Extendable for additional 24 months]

A

A

 

 

 

 

 

 

12.

Czech

09-06-10

01-09-14

60

A

A

13.

Norway

29-10-10

01-01-15

60

A

A

14.

Austria

04-02-13

01-07-15

60

A

A

15.

Canada

06-11-12

01-08-15

60

A

A

16.

Australia

18-11-14

01-01-16

60

A

A

17.

Japan

16-11-12

01-10-16

60

A

A

 (Abbreviations used:- A:
Available  NA: Not Available.)

 4.1     Administrative
Agreements

          In all cases where
India has signed SSAs except in case of SSA with Switzerland, Canada and
Hungary, Administrative arrangements have been entered into or Administrative
Agreements have also been signed, concerning the implementation of the
agreement on social security.

 4.2     SSAs with Portugal
& Quebec

        In addition to above mentioned 17 operating SSAs,
SSA with Portugal has been signed on 04-03-13 and SSA with Quebec has been
signed on 26-11-13. However, both these SSA have not been notified so far and
have, therefore, not entered into force.

4.3     SSA with Germany

          The SSA with
Germany was executed on 8th October, 2008 and came into effect on 1st October,
2009. This agreement however covered only the detachment provisions, as per
which, individuals on short term contract up to 48 months (extendable to 60
months with the prior consent of the appropriate authority) can avail
detachment from host country social security. Since this agreement did not
address exportability of pension and totalisation of contribution periods, the
Governments of India and Germany have negotiated and signed a comprehensive
social security agreement on 12th October, 2011. This agreement is
to subsume the SSA signed on 8th October 2008. However, a
notification bringing into effect the new agreement is still awaited. The new
comprehensive agreement with Germany envisages the following benefits to Indian
nationals working in Germany:

  (i)   The employees of the home country
deputed by their employers, on short-term assignments for a pre-determined
period of less than 5 years, need not remit social security contribution in the
host country. For example, in case of deputation of an Indian employee to
Germany vide a short term contract of up to five years, no social security
contribution would need to be paid under the German law by the employee
provided he continued to make social security payment in India.

 (ii)  The benefits under the
SSA shall be available even when the Indian company sends its employees to
Germany from a third country.

 (iii)  Indian workers shall
be entitled to the export the social security benefit if they relocate to India
after the completion of their service in Germany.

 (iv)  Self-employed Indians
in Germany would also be entitled to export of social security benefit on their
relocation to India.

 (v)   The period of
contribution in one contracting state will be added to the period of
contribution in the second contracting state for determining the eligibility
for social security benefits (totalisation).

4.4   Negotiations with USA
and UK

USA: USA has
entered into Totalisation Agreements i.e. SSAs with 25 countries including the
UK, South Korea, Australia, Japan and Chile etc. For almost a decade,
India and USA have had talks on the totalisation agreement, however, without
much success. India sends the highest numbers of temporary workers to the USA,
who mostly work for the tech companies.

The current social security laws in
the US, including the Employee Retirement Income Security Act of 1974, allow an
employee to withdraw pension on only after a minimum qualifying period i.e. 10
years while the visa regime does not ordinarily permit the employee to stay
beyond 10 years. Therefore, Indian employees who travel to USA for a period
less than 10 years forego their social security contributions when they return.
This has ended up being a significant issue on account of the large number of
Indian employees in USA.

It however seems that the due to
lack of political will, US is holding back the signing of the agreement since
it believes that India is likely to gain disproportionately from such an
agreement. However, whenever the long pending agreement between India and US is
executed and comes into force, it will benefit a large number of Indians
working in the US, with regard to social security contributions.

UK: The recent maiden visit of the
UK Prime Minister in November, 2016 gave a ray of hope to the supporters of
proposed SSA between India and UK. As the UK is one of the prime destinations
for outbound employees from India, a SSA will favourably impact the cost of
employment for employers in both countries.

 

5.    Some relevant Questions and Answers in respect of IWs and SSAs

 4.1   Who is an International
Worker?

       An IW may be an Indian worker or a foreign
national. IW means any Indian employee having worked or going to work in a foreign
country with which India has entered into a social security agreement and being
eligible to avail the benefits under social security programme of that country,
by virtue of the eligibility gained or going to gain, under the said agreement.

       An employee other
than an Indian employee, holding other than an Indian Passport, working for an
establishment in India to which the EPF Act applies, is also an IW.

 4.2   Is an Indian worker
holding Certificate of Coverage [COC], an International Worker?

      Merely holding the
COC does not make an employee an International Worker. He/she becomes IW only
after being eligible to avail the benefits under social security programme of
any country. After obtaining COC, the employee is exempted from contributing to
the social security systems of the foreign country with whom India has SSA,
hence he/she is not eligible to avail the benefits under the social security
programme of that country.

 4.3   Who is an ‘excluded
employee’ under these provisions?

 a) A detached IW contributing
to the social security programme of the home country and certified as such by a
Detachment Certificate for a specified period in terms of the bilateral SSA
signed between that country and India is an ‘excluded employee’, under relevant
provisions; or

 b) An IW, who is contributing
to a social security programme of his country of origin, either as a citizen or
resident, with whom India has entered in to a bilateral comprehensive economic
agreement containing a clause on social security prior to 1st
October, 2008, which specifically exempts natural persons of either country to
contribute to the social security fund of the host country (e.g. para 4 of
Article 9.3 of CECA between India and Singapore provides that “Natural
persons of either Party who are granted temporary entry into the territory of
the other Party shall not be required to make contributions to social security
funds in the host country).

 4.4   Who all shall become
the members of the EPFS?

 a)  Every IW, other than an
‘excluded employee’- from 1st October, 2008.

 b)  Every excluded employee,
on ceasing the status – from the date he ceases to be excluded employee.

 4.5   Which category of establishments shall take cognizance of provisions
relating to IWs?

       All such
establishments covered/coverable under the EPF Act (including those exempted
under section 17 of the Act) that employ any person falling under the category
of ‘International Worker’ shall take cognisance of relevant provisions.

 4.6   Whether PF rules will
apply to an employee if his salary is paid outside India?

       Yes, the provisions
will apply irrespective of where the salary is paid. The PF contributions are
liable to be paid on wages, DA, and Retaining Allowance, if any, payable to the
employee. Hence, if salary is payable by establishment in India contribution
shall be payable in India and other rules will also apply accordingly.

 4.7   Whether PF will be
payable only on the part of salary paid in India in case of split payroll?

      In case of split payroll
the contribution shall be paid on the total salary earned by the employee in
the establishment covered in India.

 4.8   ‘Monthly Pay’ for
calculating contributions to be paid under the EPF Act?

      The contribution
shall be calculated on the basis of monthly pay containing the following
components actually drawn during the whole month whether paid on daily, weekly,
fortnightly or monthly basis: • Basic wages • Dearness allowance (all cash
payments by whatever name called paid to an employee on account of a rise in
the cost of living) • Retaining allowance • Cash value of any food concession.

 4.9   What portion of salary
on which PF would be payable in case an individual has multiple country
responsibilities and spends part of his time outside India?

      Contribution is
payable on the total salary payable on account of the employment of the
employee employed for wages by an establishment covered in India even for
responsibility outside India.

 4.10 Is there a minimum
period of days of stay in India which the employee can work in India without
triggering PF compliance?

        No minimum period is
prescribed. Every eligible International Worker has to be enrolled from the
first date of his employment in India.

 4.11 Is there a cap on the
salary up to which the contribution has to be made by both the employer as well
as the employee?

        No, there is no cap
on the salary on which contributions are payable by the employer as well as
employee.

 4.12 Is there a cap on the
salary up to which the employer’s share of contribution has to be diverted to
EPS?

        No, there is no cap
on the salary up to which the employer’s share of contribution has to be
diverted to EPS, 1995 and the same is payable on total salary of the employee.

 4.13 Should the eligible
employees from any country other than the countries with whom India has entered
a social security agreement contribute as International Workers?

         Yes, International
Workers from any country can be enrolled as members of EPF.

4.14 Regarding Indian
employees working abroad and contributing to the Social Security Scheme of that
country with whom India has a Social Security Agreement, are they coverable for
PF in India or treated as excluded employees?

        No, only employees
working in establishments situated and covered in India may be covered in
India.

4.15 Regarding Indian
employees working abroad and contributing to the social security scheme of a
country with which India DOES NOT have a Social Security Agreement, are they
coverable for PF in India?

       If an Indian employee
is employed in any covered establishment in India and sent abroad on posting,
he is liable to be a member in India as a domestic Indian employee, if
otherwise eligible. He is not an International Worker.

4.16 Whether foreign
nationals employed in India and being paid in foreign currency are coverable?

       Yes, foreign
nationals drawing salary in any currency and in any manner are to be covered as
IWs.

4.17 Whether foreigners
employed directly by an Indian establishment are coverable?

        Foreigners employed
directly by an Indian establishment would be coverable under the EPF Act as
IWs.

 

4.18 What is the criterion
for receiving the withdrawal benefit for services less than 10 years under EPS,
1995?

       Only those employees
covered by a SSA will be eligible for withdrawal benefit under the EPS, 1995,
who have not rendered the eligible service (i.e. 10 years) even after including
the totalisation benefit, if any, as may be provided in the said agreement. In
all other cases of IWs not covered under SSA, withdrawal benefit under the EPS,
1995 will not be available.

4.19 How long can an Indian
employee retain the status of “International Worker”?

      An Indian employee
attains the status of “International Worker” only when he becomes
eligible to avail benefits under the social security programme of other country
by virtue of the eligibility gained or going to gain, under the said agreement on
account of employment in a country with which India has signed SSA. He/she
shall remain in that status till the time he/she avails the benefits under EPF
Scheme. In other words, once an IW, always an IW.

4.20 Whether the
International Worker will earn interest even after cessation of service after
three years also in view of provisions of inoperative accounts?

      Since the provisions
of inoperative accounts are not applicable in case of international workers,
the restriction of earning interest will not apply. The international worker
shall continue to earn interest upto the age of 58 years or otherwise becomes
eligible for withdrawal.

4.21 Under what circumstances
accumulations in the Fund are payable to an International Worker?

        On retirement from
service in the establishment at any time after the attainment of 58 years. On
retirement on accounts of permanent and total incapacity for work due to bodily
or mental infirmity. A member suffering from tuberculosis or leprosy or cancer.

        In respect of a
member covered under a social security agreement entered into between the
Government of India and any other county on such grounds as may be specified in
that agreement till the time he/she avails the benefits under a social security
programme covered under that SSA.

4.22 Under what condition the
contributions received in the PF account are payable along with interest to
International Worker?

      The full amount
standing to the credit of a member’s account is payable if anyone of the
circumstances mentioned under amended Para 69 of the EPF Scheme, 1952 is
fulfilled, namely: i) on retirement from service in the establishment at any
time after 58 years of age; ii) on retirement on account of permanent and total
incapacity for work due to bodily or mental infirmity, duly certified by the
authorised medical officer; and iii) in accordance with the terms and
conditions provided in an SSA.

 4.23 Is there a cap on the
salary up to which the contribution has to be made under the EDLI Scheme, 1976
by the employer?

       Yes, the amended cap
on the salary up to which contribution has to be made under the EDLI Scheme,
1976 is Rs. 15,000.

 5.    SSA Provisions Explained – Based on India-Belgium SSA

 5.1   How it is that double
coverage is avoided after an agreement?

      When you are employed
either in India or Belgium and sent on a posting to the other contracting
Country, you and your employer would normally have to pay Social Security
Contributions/taxes to both countries for the same work. With the agreement in
place, this double coverage is eliminated and you are required to pay
Contributions/taxes to only one country, provided your posting in the other
country is for no more than 60 months.

 5.2  How does it help
employees who work or have worked in both countries to augment their
eligibility for monthly retirement, disability or survivors benefits?

 a. When you have Social
Security insurance periods in both India and Belgium, you may be eligible for
benefits from one or both countries.

b. Should you have enough
insurance periods under one country’s system, you will get a regular benefit
from that country.

c. If
you do not have enough insurance periods, the agreement may help you augment
your eligibility for a benefit by letting you add together your Social Security
insurance periods in both countries, only for the purpose of deciding your
eligibility.

d. However, each country will
pay a benefit based solely on your periods of insurance under its pension
system.

e. Although each country may
count your insurance periods in the other country, they are not actually
transferred from one country to the other.

f.  Since your insurance
periods remain on your record in the country where you earned them, they can
also be used to qualify for benefits there.

 5.3   What is a detachment
certificate?

      A detachment certificate is otherwise a
“Certificate of coverage” issued by one country (indicating the details of
coverage/membership under its social security system) that serves as proof of
exemption from Social Security contributions/taxes on the same earnings in the
other country.

 5.4   How to obtain a
Certificate of coverage?

      To seek an exemption
from coverage under the Belgian system, the employee must be working in an
establishment covered or coverable under Employees’ Provident Fund Organisation
(EPFO), the Indian Liaison agency. Both the employer as well as the employee
must jointly request a certificate of coverage, in the prescribed format, from
the jurisdictional Regional Provident Fund Commissioner of EPFO.

5.5   I am holding a
Certificate of coverage. When does the date of exemption from the other
country’s social security system start?

      The certificate of
coverage carries a provision for indicating the effective date of your
exemption (based on the information provided in your joint application) from
paying Social Security contributions/taxes in the other country. Normally, this
date shall be on or after the date you started working in the other country but
cannot be a date earlier than the date of effect of the Agreement.

 5.6 Who are all eligible
for applying for a certificate of coverage?

         There are 2
categories of employees eligible for applying for a Certificate of coverage.

a.Those already deputed on a
pre-determined short-term assignment and working in Belgium should apply for a Certificate
of coverage for the period from 1st Sept. 2009 to the date of
completion of the deputation.

b.Those to be deputed on or
after 1st Sept. 2009 should apply for a certificate of coverage for
the entire period of deputation in Belgium.

 5.7   How to ascertain
whether an employee is coverable under the Indian or Belgian Social Security
system?

 a.    
An Indian national working in Belgium

Nature of employment

Coverage under

1.  Sent on
short-term posting by an Indian employer for a period of less than 5 years

Indian system

2.  Sent on
Long-term posting by an Indian employer for a period of more than 5 years

Belgian system

3.  On local
employment by an Indian employer directly in Belgium

Belgian system

4.  On local
employment by a Non-Indian employer directly in Belgium

Belgian system

 

b.    A Belgium
national working in India

Nature of employment

Coverage under

1.   Sent
on short-term posting by a Belgian employer 
for a period of less than 5 years

Belgian system

2.  Sent on
Long-term posting by a Belgian employer for a period of more than 5 years

Indian system

3.  On local
employment by a Belgian employer directly in India

Indian system

4.  On local
employment by a Non- Belgian employer directly in India

Indian system

 

5.8   What benefits are due
to an employee covered under the Indian system administered by EPFO?

S. No.

Benefit

Nature

To whom payable

1.

Provident fund benefit (EPF

A lump sum cash benefit that gets
accrued in a member’s account by way of the contributions remitted and the
interest earned thereon.

1.  Member: on leaving
employment on superannuation or disability.

Or

2.  Survivors, if the
member is not alive.

2. 

Pension benefit (EPS)

A Monthly cash benefit paid into the
credit of the beneficiary’s bank account.

1.  Member: on leaving
employment on superannuation or disability. Or

2.  Widow/widower and
the eligible children: if the member is not alive. Or

3.  Nominee/Parents: if
the member dies without leaving any family.

 

3.

Insurance benefit (EDLI)

A lump sum cash benefit.

1.  To the survivors on
death of the member.

2.  The death should
have occurred during employment.

 


5.9   Whom does the agreement
help?

       The agreement helps the employee,
her/his family and the employer.

5.10 How does the agreement help
the employee?

 The
agreement helps at 3 stages.

a) During the period while the employee is
working;

b) At the time of claiming the benefits and

c) At the time of receiving the benefits.

        While working

a. If both the Indian and Belgian Social Security
systems cover an employee’s work, the employer along with the employee would
normally have to pay Social Security contributions to both countries for the
same work. The agreement eliminates this double coverage so that contributions
are paid to only one system.

 b.Under the agreement, an eligible Belgium
national employed in India will be covered by India, and that employee and the
employer will pay Social Security contributions only to India. If an Indian
national is employed in Belgium, she/he will be covered by Belgium, and that
employee and the employer shall pay Social Security contributions only to
Belgium.

 c.On the other hand, if an employer sends an
employee from one country to work for that employer in the other country for
five years or less, that employee will continue to be covered by her/his home
country and that she/he will be exempt from coverage in the host country. For
example, if an Indian employer sends an employee to work for that employer in
Belgium for no more than five years, the employer and the employee will
continue to pay only Indian Social Security contributions and will not have to
pay in Belgium.

When claiming the benefits

a. An employee may have contributed to the Social
Security systems in both India and Belgium but not have enough insurance
periods to be eligible for benefits in one country or the other. The agreement
makes it easier to qualify for benefits by allowing totalisation of such Social
Security contributory periods in both countries.

b. If an employee has Social Security insurance
periods in both India and Belgium, she/he may be eligible for benefits from one
or both countries. If she/he meets all the basic requirements under one
country’s system, she/he will get a regular benefit from that country. If she/he
does not meet the basic requirements, the agreement may help her/him qualify
for a benefit by allowing totalisation of insurance periods in both the
countries.

c. If she/he does not qualify for regular
benefits, she/he may be able to qualify for a partial benefit from India,
against the contributions made to India, based on totalisation of both Indian
and Belgian insurance periods.

d. Similarly, she/he may be entitled for a partial
Belgian benefit against the contributions made to Belgium, based on totalisation
of both Belgian and Indian insurance periods.

At the time of receiving the benefits

        The benefits under Indian social
security system is not payable outside India. An employee from Belgium was at a
loss being not able to get the due benefits on her/his relocation outside
India. Now, the agreement provides for making payment of benefits to the member
irrespective of whether she/he lives in India or Belgium or a third country.

5.11 Can you tell me an example how the employees
are benefited under the Agreement?

        A member who worked in India and
contributed to EPS, 1995 for 7 years is now living in Belgium after
contributing under the Belgian system for 20 years. He is more than 58 years
old.

 Entitlement

a. Without the Agreement:

        The member has less than the 10 years of
pensionable service required to qualify for member’s pension under EPS, 1995
and hence is not entitled to receive any pension benefit.

 b. With the Agreement

–  Eligibility to Pension under EPS 1995 can be
claimed by totalizing the insurance periods spent under the Indian system (7
years) with the Belgian system (20 years).

–  Since the total insurance period will work out
to 27 years (7+20), which is more than the required minimum eligible service of
10 years, the member becomes eligible to get pension under EPS, 1995.

–  However, this totalised period shall be
considered for deciding the eligibility only and hence, the actual pension will
be sanctioned taking into account the period spent under the EPS, 1995 (7
years) as the pensionable service.

–  Such a pension is payable to the member’s bank
account either in Belgium or in India.

7.    Conclusion

       India’s move to require IWs to
contribute to the Indian social security system has encouraged many countries
to negotiate and execute SSAs with India. The SSAs significantly benefit Indian
workers employed abroad, especially those on short-term contracts.

        In cases where employees are suspended
but their employment is not terminated, in the home country, it is difficult to
ascertain whether the same would trigger provisions of EPF Act and the SSAs. In
some cases, it is difficult to ascertain whether the relationship is in the
nature of employment or assignment and hence whether provisions of EPF Act and
the SSAs would be applicable.

      Application and interpretation of SSAs
and the social security law in India with respect to expatriates is still
evolving. There are open questions when it comes to secondment and deputation
arrangements, especially in light of possible tax implications.

      It is advisable that readers should
carefully examine the provisions of the SSAs before providing any structuring
and other guidance relating to mobility of IWs. _

Decoding Residence Rule through not so rhyming POEM – How Melodious is the Indian POEM – an Analysis

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“Residence” is one of the primary factors to fasten the tax liability
on any tax payer in a country, be it an individual, a company or any
other entity. Determination of a residential status of an assessee
assumes significant importance in international taxation. Elaborate
rules are prescribed in tax laws of every country and/ or in tax
treaties prevalent worldwide. One of such rules for residence of
companies accepted and followed worldwide is that of Place of Effective
Management. Finance Act, 2015 amended Section 6(3)(ii) of the Income-tax
Act, 1961 dealing with Residence of companies from the “Control and
Management Principle” to the “Place of Effective Management” (POEM).
POEM is dealt with by both, the OECD and UN in their Model Commentaries.
In December 2015, CBDT came out with Draft Guidelines on determination
of POEM for a Company. This write-up highlights crucial aspects
regarding determination of residential status of a company taking into
account the concept of POEM.

Backdrop
Corporate
Residency has been one of the most important issues across the world.
With businesses moving across countries and with digital economy being
the flavour of the 21st century, countries are in a tiff to make sure
that they don’t lose their pie of taxes. The steps taken by the G20
Nations to prevent Base Erosion and Profit Shifting (BEPS) are in this
direction. In case of multinational companies, the structures adopted
are such that it becomes difficult to ascertain where its control and
management are situated. Countries worldwide have introduced various
concepts like POEM, Place of Management (POM), Control and Management (C
& M), Central Control & Management etc. to ascertain the
residency based on overall control and management of the company.

Concept of Corporate Residency before the Amendment

As
per Section 6(3) of the Act before the Amendment, the Income-tax law
was as under – “A company is said to be resident in India in any
previous year, if –

(i) It is an Indian company; or
(ii) During that year, the control and management of its affairs is situated wholly in India.” (Emphasis Supplied)

Hence,
a foreign company was treated as resident only if the control and
management of its affairs were situated wholly in India during that
year. It meant, even if a part of control was outside India, the company
was not regarded as resident and hence, it was subjected to tax only on
income sourced in India.

In the erstwhile definition it was
easy for a foreign company (which was controlled and managed from India)
to avoid Indian taxes on global income by artificially shifting/
retaining part of its C & M outside India. Typically, resident
Indians who have set up overseas companies could use the erstwhile
definition to their advantage.

It may be noted that the term
“Control and Management” was not defined in the Act. However, in general
parlance, it was understood that control and management did not mean
conducting day to day management of the company, but it referred to the
head and brain of the company that take major decisions for effective
functioning and managing of the company.

C & M being not
defined in the Act was a major bone of contention between the taxpayers
and revenue authorities. Let us look at some of the judicial rulings on
the interpretation of C & M:

C & M as per Indian Courts
In
Subbayya Chettiar (HUF) vs. CIT (19 ITR 168) (SC) Honourable Supreme
Court observed that C&M signifies the controlling and directive
power, the head and brain; and “situated” implies the functioning of
such power at a particular place with some degree of permanence.

In Narottam & Pereira Ltd. (23 ITR 454),
the Bombay High Court held that Control of a business does not
necessarily mean the carrying on of the business, and therefore, the
place where trading activities or physical operations are carried on is
not necessarily the place of control and Management. The High Court
disregarded the presence of strong manager overseas in favour of
controlling directors being situated in India. It was held that the
direction, management and control, ‘the head, seat and directing power’
of a company’s affair is situated at the place where the directors’
meetings are held and consequently, a company would be resident in India
if the meetings of directors who manage and control the business are
held in India.

In the case of Radha Rani Holdings (P) Ltd. [2007] 16 SOT 495 (Del),
it is provided that the situs of the Board of Directors of the company
and the place where the Board actually meets for the purpose of
determination of the key issues relating to the company, would be
relevant in determining the place of control and management of a
company1.

The meaning of the expression ‘control and management’
as used in section 6(3) (ii) of the Act was the subject matter of
judicial interpretation in the past. The legal position is well-settled
that the expression “control and management” means the place where the
‘head and brain’ of the company is situated and not the place where the
day-today business is conducted.

Professor Klaus Vogel, in his treatise, has observed that what is decisive is not the place where the management directives
take effect, but rather the place where they are given (Klaus Vogel on
Double Taxation Conventions, 3rd Edition, Para 105 on page 262). Thus,
it is “planning” and not “execution” which is decisive.

Finance Act – 2015 and Explanatory Memorandum on POEM

In
order to protect its tax base and to align provisions of the Act with
the Double Taxation Avoidance Agreements (DTAA s) entered into by India
with other countries, the concept of POEM was introduced vide amendment
to Section 6(3)(ii) of the Income-tax Act, 1961 (‘Act’).

According
to the amended definition, a company would be resident in India if it
is incorporated in India or its ‘place of effective management’ (POEM),
in that year, is situated in India.

POEM has been defined to
mean a place where key management and commercial decisions that are
necessary for the conduct of the business of an entity as a whole are,
in substance made.

The said amendment has significant impact
on various foreign companies incorporated by Indian MNC’s for Outbound
Investments and business operations outside India.

POEM and its Implications

Some
questions which may come to readers’ mind are (i) whether POEM is
different from the concept of C & M and if yes, how? (ii) What is
the impact of such difference? Before answering these questions, let us
analyse the definition of POEM in detail. We may compare and contrast
the concept of C & M while dissecting the definition of POEM.

POEM as defined by the Finance Act, 2015 has four limbs as follows:-

  • Key Managerial and Commercial decisions
  • Necessary for the Conduct of Business
  • Of an entity as a whole
  • in substance made.

Important
Factors relevant to POEM in India 1) Place where Board Meetings are
held O ne of the primary factors which may lead to effective management
rests with the place where the board meetings are held. Key Managerial
and Commercial Decisions are always meant to be understood as strategic
ones taken by the highest authority of the company. The Board of every
company is considered to be the head and brain of the company. However,
mere holding of board meetings might not hold ground if decisions are
made/taken at some other place. C & M Many courts have ruled that
one of the most important factors to determine C & M of a company is
where its head and brain i.e. Board of Directors is situated. Thus
location of board and decisions taken by them was crucial even for
determination of C & M as it is in the case of POEM.

2) Key Managerial and Commercial Decisions:-

The
intention of the legislation becomes clear from the word “key” inserted
in the definition of POEM. It implies that the decisions should be more
of strategic and should be above the day to day operational decisions.
It tries to distinguish the secretarial decisions taken at the board
meetings.

Similar was the stand in determination of C & M.

3) Operational management vs. broader top level management

The
decisions taken by the Chief Executive Officer and Chief Operating
Officer might be managerial and commercial in nature but may not always
“key” in nature. For example, procurement of goods from vendors,
inventory management, offers and discounts for increase in sales etc.
would be classified as managerial and commercial decisions but not
strategic in nature. Such decisions might not be relevant for the
determination of POEM.

However, the decisions of opening a
new branch or launching of a new product, pricing policies, expansion of
the current facilities etc. which would have significant impact on the
business and on the company as a whole might be taken by the Board or
the Top Management of the Company. Such decisions would be more relevant
in establishing POEM.

All these factors are/were relevant in the determination of C & M as well.

4) Other relevant factors

There
are other relevant factors in the determination of POEM. They are the
place where the accounting records are maintained; the Place of
incorporation of the company; the primary residence of the directors of
the company, the details of the stewardship functions by the parent
company etc. The parent company should restrict itself from actual
running of the subsidiary. The guidance or influence of the parent
company should be limited.

All these factors are/were relevant in the determination of C & M as well.

From
the above discussion, one may conclude that POEM is a fact and
circumstance specific concept and hence, all relevant facts and
circumstances must be examined on case by case basis. POEM refers to
comprehensive control over the entity as a whole during the year and is
not the same thing as a part of the control of the entity residing in
India for the whole of the year. It may be possible that a MNC has a
flat structure and shared powers or large scale autonomy in the
organisation where there could be more than one place where C & M
are situated. However, when one looks at the Company as a whole (which
is the requirement under POEM) then, one would be able to narrow down
POEM to one place/country.

OECD/UN perspective on POEM

The
OECD Model Commentary2 states that “The place of effective management
is the place where key management and commercial decisions that are
necessary for the conduct of the entity’s business are in substance
made. The place of effective management will ordinarily be the place
where the most senior person or group or persons (for example Board of
Directors) make its decisions, the place where the actions to be taken
by the entity as a whole are determined”.

According to the UN Model Commentary in determining the POEM, the relevant factors are as follows:–

(i) the place where a company is actually managed and controlled;

(ii)
the place where the decision-making at the highest level on the
important policies essential for the management of the company takes
place;

(iii) the place that plays a leading part in the management of a company from an economic and functional point of view; and

(iv) the place where the most important accounting books are kept.

To summarise, the criteria generally adopted to identify POEM are:

– Where the head and the brain is situated.
– Where defacto control is exercised and not where the formal power of control exists.
– Where top level management is situated.
– Where business operations are carried out.
– Where directors reside.
– Where the entity is incorporated
– Where shareholders make key management & commercial decisions.

Different Shades of POEM, POM and PCMC

POEM
is interpreted differently by different countries. Countries like
China, Italy, South Africa, Russia etc. have adopted the concept of POEM
in their Domestic tax laws. However, countries like The U.K.,
Australia, Germany etc. although do not have the concept of POEM but
they have adopted the concept of ‘Central Management’ and ‘Control or Place of Management’
and control as residence test for companies in their Statutes. Further,
POEM has been interpreted by countries in their own ways. This
interpretation can be observed from the reservations and observations of
various countries to the OECD Commentary.

BEPS and POEM
Final
Report of OECD on Base Erosion and Profit Shifting (BEPS), [Action
Point 6 on “preventing the granting on treaty benefits in inappropriate
circumstances”] prefers that in case of Tie-breaker for the
determination of treaty residence of a person other than individual, be
done by the Competent Authorities of respective states.

Draft Guidelines by CBDT on POEM

The
CBDT released draft guidelines for determination of POEM of a Company
on 23rd December 2015. A brief summary of the principles enumerated in
the draft guidelines is as follows –

POEM adopts the concept of substance over form.

The Company may have more than one place of management but it can have only one POEM at any point of time.

Residential
status of a person under the Act is determined every year. Accordingly,
for the purpose of the Act, POEM must be determined on year to year
basis. The determination would be based on facts and circumstances of
each case.

The
process of determining the POEM would primarily be based on whether a
company is engaged in ‘active business’ outside India or otherwise.

For
this purpose, a company shall be said to be engaged in ‘active
business’ outside India if all of the above conditions are satisfied –

For this purpose, an average of the data of the current financial year and two years prior shall be taken into account.

POEM guidelines for companies engaged in active business outside India:

The
POEM of a company engaged in active business outside India shall be
presumed to be outside India if the majority of meetings of the
company’s Board of Directors (BOD) are held outside India.

However,
in case the Board of Directors are standing aside and not exercising
its powers of management and such powers are being exercised by the
holding company or by any other persons resident in India, the POEM
would be considered to be in India.

Issues: Indian
Guidelines provide both objective and subjective criteria. On the one
hand it provides to look at the objective criteria for operations of
business such as earnings, assets, employee base, etc. (see the diagram)
while on the other hand, it also looks at actual control &
Management by BOD. Worldwide only control & management criteria
(decision making by BOD) are used. Indian Provisions for POEM are a
departure from International practice in that sense. POEM guidelines for
companies other than those engaged in active business outside India For
companies other than those engaged in active business outside India
(i.e. passive business), determining the POEM would be a two-stage
process:

First stage would be identifying/ascertaining person or
persons who are making the key management and commercial decisions for
conducting the company’s business as a whole.

Second stage would be the place where these decisions are being made.

Thus,
the place where management decisions are taken would be more important
than the place where the decisions are implemented. Some guiding
principles for determining the POEM are as follows:

Location where the company’s Board regularly meets and makes decisions can be the POEM of the company, provided the Board:

• retains and exercises its authority to govern the company; and

• in substance, makes key management and commercial decisions necessary for the conduct of the company’s business as a whole.

•
However, mere holding of a formal Board meeting would not be
conclusive. If key decisions by the directors are taken at a place which
is different from the location of the Board meetings, then such place
would be relevant for POEM.

A company may delegate (either
through board resolution or by conduct) some or all authority to
executive committee consisting of key senior management. In these
situations, location of the key senior managers and the place where such
people develop policies and make decisions will be considered as POEM.

The location of the head office
will be very important in considering the POEM because it often
reflects the place where key decisions are made. The following points
need to be considered for determining the location of the head office:

•
The place where the company’s senior management (which may include the
Managing Director, Whole Time Director, CEO, CFO, COO, etc.) and support
staff are located and that which is considered as the company’s
principal place of business or headquarters would be considered as the
head office.

• If the company is decentralised, then the
company’s head office would be the location where senior managers are
predominantly based or normally return to, following travel to other
locations, or meet when formulating or deciding key strategies and
polices for the company as a whole.

• In cases where the senior
management participates in meetings via telephone or video conferencing,
the head office would be the location where the highest management and
their direct support staff are located.

• In cases where the
company is so decentralised that it is not possible to determine its
head office, then the same may not be considered for determining the
POEM.

• Day-to-day routine operational decisions undertaken by
junior/middle management would not be relevant for determining the POEM.

• In the present age, where physical presence is no longer
required for taking key management decisions, the place where the
majority of the directors/ persons taking the decisions usually reside
would be considered for the POEM.

• If the above guidelines do
not lead to clear identification of the POEM, then the place where the
main and substantial activity of the company is carried out or place
where accounting records of the company are kept would be considered.

POEM to be a fact-based exercise: Examples of isolated instances would not necessarily lead to POEM

Issues:
If
a MNC holds its one of the Global Board Meetings in India, where
significant decisions are taken for its worldwide operations say group
policies are framed – can it lead to POEM? Perhaps not, being isolated
or one of its kind of meetings.

Place where accounting records
are kept may be considered for determination of POEM. This may lead to a
practical problem. What if mirror accounts are kept at two places?

Merely keeping accounting records should not lead to establishment of POEM.

Passive
Income: – Trading with a group company is considered as passive income.
When Transfer Pricing Regulations are in place this kind of provision
is uncalled for.

Objective and Subjective Criteria: – Ultimately
nothing seems to be clear. Each provision is with a caveat leaving to
lot of subjectivity and powers to Assessing Officers.

Local
Management: – It is provided that place of local management may not lead
to POEM but what is ‘local management’ is not defined.

As POEM
is sought to be clarified by way of guidelines, a moot question arises
whether guidelines be binding or override the provisions of law? In
fact, it is provided in the guidelines that they are neither binding on
the Income-tax department nor on the taxpayers. In such an event, what
is the sanctity of such guidelines?

Some Silver Linings

A
foreign company being completely owned by an Indian company would not
necessarily lead to POEM in India (Example – TATA Motors owning Jaguar
PLC).

One or some of the directors of a foreign company residing in India would not necessarily lead to POEM in India.

Local management of the foreign company situated in India would not be conclusive evidence for establishing the POEM in India.

Mere
existence in India of support functions that are preparatory or
auxiliary in nature would not be conclusive evidence for establishing
the POEM in India.

Other key points of the Guidelines

Guidelines
provide that the principles enumerated in the guidelines are only for
the purpose of guidance. In such cases, no single principle will be
decisive in itself.

POEM to be a fact-based exercise – a
‘snapshot’ approach cannot be adopted and activities are to be seen over
a period of time and not at a particular time.

In case the POEM is in India as well as outside India, POEM shall be presumed to be in India if it is mainly/ predominantly in India.

Prior
approval of higher tax authorities would be required by the tax officer
in case he proposes to hold a foreign company as resident in India
based on its POEM. The taxpayer must be given the opportunity to be
heard.

Does Guidelines on POEM sound similar to CFC Rules?

POEM, a step closer to CFC rules
Various
efforts have been undertaken by the Government of India to simplify the
Income-tax law in India5. The Finance Minister Shri Arun Jaitley at the
time of scrapping the Direct Tax Code (DTC) had mentioned that there is
no need of introducing DTC. Suitable amendments to the Income-tax law
would be made for the purpose of simplification.

The erstwhile
DTC contained the ‘Controlled Foreign Corporation’ Rules (CFC rules).
CFC rules, in principle, targets the offshore entities which are used to
park income in low or NIL tax jurisdictions. Similarly, POEM too tries
to achieve a similar objective. The guidelines defining ‘active business
outside India’ and ‘passive income’ are akin to provisions or
objectives of CFC Rules. No country in the world has such conditions for
determination of POEM which tries to achieve dual purposes.

Comments on the draft POEM Guidelines

Arbitrary use of powers
–
POEM, as a provision in the law specifically targets the unacceptable
tax avoidance structure(s). The use of shell/conduit companies is
discouraged. Considering subjectivity involved while determining POEM,
the draft guidelines are issued to narrow down its wide scope. However,
it has been specified that the guidelines are not binding on tax
authorities nor it is binding on the taxpayers. In such a case
guidelines are infructuous. Tax payers may fear that the provisions of
POEM may be applied harshly and interpreted in the widest possible sense
in favour of revenue.

Residency assumed, unless proved otherwise?
– The draft guidelines in current form seem to suggest that it’s assumed that you are resident barring a few exceptions.
– The wide subjectivity of guidelines can hamper Indian Entrepreneurship in the long run.
– Subsidiaries of Indian MNC’s particularly wholly owned subsidiaries
outside India would be facing an uphill task of establishing that the
POEM is not in India.
– The definition of passive income seems to be very wide and hamper genuine business transactions.

Whether the guidelines would have a retrospect effect??
–
Considering the wide scope of POEM, it was mentioned in the Explanatory
Memorandum of the Finance Act 2015 that the guiding principles would be
followed soon. However, it is unfortunate that the guiding principles
(in a draft format) have been issued at the fag end of the Financial
Year. In such cases, a question arises that whether these principles
would be applicable with retrospective effect from 1st April, 2015? The
answer seems to be “yes” as these are merely guidelines and not the law.
There is no question of retrospective effect. In fact what guidelines
say is supposed to be followed by companies in the normal course.

Summation
For
the purpose of determining POEM, it is the de facto control and
management and not merely power to control which must be checked. In the
redefined corporate tax residency regime of the domestic tax law (in
line with international principles), place of effective management has
become one of the relevant factors for the purpose of determining
residential status of a company. In such a scenario, the company would
be deemed to be resident of the Contracting State from where it is
effectively controlled and managed. The draft guidelines leave much to
the discretion of the Income-tax Authorities. We hope that the tax au
thorities are made accountable for their actions and certain fundamental
binding principles are laid down so that unnecessary litigation is
avoided. It is expected that the final guidelines will be modified and
litigation prone issues would be addressed. It would be interesting to
see how the Government and Income-tax authorities would view or evaluate
structures of various companies going forward. Prudence suggests that
applicability must be postponed for at least one year so that
unnecessary hardships to tax payers can be avoided. Further, this would
give an opportunity for hygienic check to taxpayers for their outbound
structures.

Revised Procedure for making Remittances to Non Residents – New Rule 37BB u/s. 195(6) of the Income – tax Act, 1961

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Every resident payer has a question as to “what is the procedure for making payments to a non-resident?” This question is relevant even for non-resident payer as the obligation for withholding tax1 is cast on every payer (whether resident of India or not) if the income in the hands of the recipient is taxable in India. Recently, CBDT has amended the procedure w.e.f. 1st April, 2016 for issuance and submission of Form 15CA and 15CB which facilitates remittance of money to a non-resident person. This article highlights the salient features of the new procedure for making payment to a non-resident.

1. Purpose of section 195
Section 195 of the Act is a mechanism to deduct tax from any payment (which is chargeable to tax) made to a nonresident. The underlying philosophy behind any withholding tax provisions is “pay as you earn”. The ease and certainty of collection of taxes make such provisions attractive for any tax legislature.

2. Person responsible to deduct tax at source u/s. 195 of the Act
Section 195 casts an obligation on the person who is making any payment to a non-resident to deduct tax at source. The sweeping language of the section brings almost every payment, made to a non-resident, which is chargeable to tax, within its ambit. The only exclusion here is that of a payment of salaries. Section 192 of the Act deals with TDS provisions relating to salary paid to a non-resident, which is chargeable to tax in India.

Section 195 provides that, “Any person responsible for paying to a non-resident not being a company, or to a foreign company, any interest or any other sum chargeable under the provisions of the Act (not being income chargeable under the head “salaries”) shall, at the time of credit of such income to the account of the payee or at the time of payment thereof in cash or by the issue of a cheque or draft or by any other mode, whichever is earlier, deduct income-tax thereon at the rates in force.”

The dissection of the above provision reveals that—

(i) The obligation to deduct tax at source is cast on every person making payment, be it individual, company, partnership firm, Government or a public sector bank etc. The term ’person’ as defined in section 2(31) of the Act is relevant here.

(ii) The payee may be any type of entity (i.e. individual, company etc.).

(iii) The payee must be a non-resident under the Act.

(iv) The payment may be for interest or any other sum chargeable to tax except salaries.

(v) Tax has to be deducted at source at the time of credit or payment of the sum to the non-resident, whichever is earlier.

(vi) There is no threshold for deduction of tax at source. It therefore means payment of even one rupee to a nonresident would attract TDS provisions.

3. TDS by a non-resident from payments to another non-resident
This issue had come up for examination in some landmark cases; notable amongst them is the Apex Court’s decision in case of Vodafone International Holdings B.V. vs. Union of India, wherein the Supreme Court held in favour of Vodafone and held that indirect transfer of shares2 by one non-resident to the another non-resident did not result in taxable income in the hands of the transferor and hence, there was no obligation for the payer to withheld tax at source. The Supreme Court followed the “look at” approach, i.e. form rather than substance, and refused to lift the corporate veil to bring the capital gains arising to HTIL to tax in India. In order to discourage such kind of indirect transfers and bring them to tax (especially where such transfers derives its value from assets situated in India) section 9 of the Act was amended retrospectively to bring to tax in India the capital gains arising on transfer of any assets outside India, between two non-residents, if such transfer derives substantial value in respect of any asset situated in India.

Section 195 was also amended, to clarify that the nonresident payer is liable to deduct tax at source, if the income in the hands of payee is taxable in India.

Explanation 2 was inserted to section 195 (1) of the Act vide Finance Act, 2012 with retrospective effect from 1st April 1962, clarifying that the obligation to deduct tax at source u/s. 195 has always been there for any nonresident, whether such person has any place of business or business connection or presence in any other manner. Whether it results in an extra-territorial jurisdiction is a matter of debate. For the sake of understanding, the relevant provision is reproduced herein below:

Explanation 2.—For the removal of doubts, it is hereby clarified that the obligation to comply with sub-section (1) and to make deduction there under applies and shall be deemed to have always applied and extends and shall be deemed to have always extended to all persons, resident or non-resident, whether or not the non-resident person has—
(i) a residence or place of business or business connection in India; or
(ii) any other presence in any manner whatsoever in India.

4. Procedure for furnishing of information of deduction of tax at source u/s 195(6)
Section 195(6) of the Act provides that a person responsible for paying to a non-resident (hereafter referred to as ‘payer’) shall furnish such information as may be prescribed under Rule 37BB. The said Rule 37BB provides that Form No. 15CA and/or Form No. 15CB4 shall be furnished for the purpose of paying to a non-resident. Form No. 15CA is to be filled and submitted online by the deductor i.e. payer. Form 15CB is to be issued by the practicing Chartered Accountant (C.A) certifying (actually expressing his opinion) the taxability (chargeability) of the income in the hands of the payee and the amount of tax required to be deducted by the payer. In order to arrive at the amount of tax to be deducted the CA is required to take into account various applicable provisions of the Act (to compute the income of the non-resident payee) as well as provisions of the applicable Double Tax Avoidance Agreement (DTAA ) and other relevant supporting documents and agreement, if any.

5. Steps while making a Remittance
Form 15CA is required to be furnished by the taxpayers for the purpose of remittance to a non-resident. It may be noted that Form 15CA should be filed in every case whether the remittance amount is chargeable to Incometax or not. However, exemption from filing of Form 15CA is provided in case of certain types of remittances.

Let us first deal with cases where the income is chargeable to tax. 15CA has four parts, namely, A,B,C and D. Following flow chart will be useful in understanding which part is to be filled in and under what circumstances.

6. Procedure where a remittance is not chargeable to tax:

6.1 Such remittances are classified in the following two categories as follows:
i. Non-reportable Transaction
ii. Reportable transaction

Let us first deal with transactions which are not required to be reported, meaning there is no need to file any form with the tax authorities.

6.2 Non-reportable Transactions
In following two cases there is no requirement to furnish Form 15CA or Form 15CB.

(i) Individuals making remittances under the Liberalised Remittance Scheme of FEMA and

(ii) Certain specified remittances as listed herein below.

Specified List of payments for which Form 15CA or Form 15CB are not required to be filed:

The earlier Rule 37BB contained 28 items which did not require submission of Form 15CA or 15CB at the time of the remittance. However, the new Notification No. 93/ 2015 now expands the list to 33 items.–

6.3 Reportable Transactions

Any transaction other than the non-reportable category is considered as reportable transaction. In other words, even if the remittance is not chargeable to tax, information in respect of such remittance is required to be provided in Part D of Form 15CA.

7. What is the difference between earlier Rule 37BB and the new Rule 37BB which is effective from 1st April, 2016?
Amendments in the new Rule 37BB as compared with earlier Rule 37BB are as follows:

Form 15CA and Form 15CB will not be required if an individual is making a remittance, which does not require RBI’s approval under FEMA or under the Liberalised Remittance Scheme (LRS).

The list of items which do not require submission of Forms 15CA and Form 15CB has been expanded from 28 to 33. The newly introduced items are as under –

i. Advance Payments against imports
ii. Payment towards import settlement of invoice
iii. Imports by diplomatic missions
iv. Intermediary trade
v. Imports below Rs. 5 Lakh (For use by Exchange Control Department offices)

Only the payments which are chargeable to tax under the provisions of Act in excess of Rs. 5 Lakh would require Certificate from a Chartered Accountant in Form 15CB.

A new reporting obligation is introduced for the authorised dealers (ADs) (i.e. the Banks). ADs will have to file Form 15CC (quarterly) in respect of the foreign remittances made by them.

8. Some Practical Issues

8.1 Cases where Tax Residency Certificate (TRC ) is required

Under the provisions of section 90(2), it has been provided that provisions of the Act or the DTAA , whichever are more beneficial to the assessee, shall be applicable. This benefit is, however, subject to satisfaction of conditions provided u/s. 90(4) of the Act. In order to claim the benefit of a DTAA , it has been provided that the non-resident payee must furnish a TRC which confirms that the payee is a Tax Resident of the other State. This becomes important from the perspective of the Act as well as DTAA since Article 4 (dealing with “Residence”) of almost all the DTAA s signed by India provides that benefits of the DTAA can be claimed only by such persons who are residents of either of the contracting states. In this connection, the reader may also refer to the Rule 21AB prescribing declaration in Form 10F to be obtained from the Non-resident payee.

8.2 Is there any other alternative other than a TRC since obtaining a TRC may not be feasible sometimes?

Section 90(4) provides for mandatory submission of TRC, issued by the foreign Government or a specified territory, in order to claim benefit of the DTAA. Thus, there is no alternative to submission of TRC.

However, if any foreign Government does not have a format or provision to issue TRC, then the taxpayer at best can get the information prescribed in Form 10F certified by the revenue authorities of the concerned foreign country or territory in order to avail the DTAA benefit.

It may be possible that the format in which TRC is issued by the foreign tax authority does not contain all the details required under Form 10F. For example, US IRS issues TRC in the Form 6166 which does not contain all details required in Form 10F. Therefore, the remitter needs to keep both the documents on record and submit to the Income tax Authorities in India, if and when required.

8.3 What are the details required to be provided in Form 10F?

Form 10F requires the following details –

(i) Name, Father’s name and designation of the person signing the form

(ii) Status (individual, company, firm etc.) of the assessee;

(iii) Nationality (in case of an individual) or country or specified territory of incorporation or registration (in case of others);

(iv) Assessee’s tax identification number in the country or specified territory of residence and in case there is no such number, then, a unique number on the basis of which the person is identified by the Government of the country or the specified territory of which the assessee claims to be a resident;

(v) Period for which the residential status, as mentioned in the certificate referred to in sub-section (4) of section 90 or sub-section (4) of section 90A, is applicable; and

(vi) Address of the assessee in the country or specified territory outside India, during the period for which the certificate, as mentioned in (iv) above, is applicable.

9. How to file Form No. 15 CA electronically

Form 15CA is required to be filed by the tax payer in every case of remittance except where remittance falls within the category of non-reportable transactions. (Refer paragraphs 5 and 6 supra).

In the subsequent paragraphs step by step procedure is given for filling up Form No. 15 CA and filing it electronically:

Note: Before proceeding to e-file Part D of Form No. 15CA, keep the hardcopy duly filled in ready with you to expedite the process.

Step 1. Go to the website of incometaxindiaefiling.gov. in.

Step 2. Login using:
a. User Id- PAN
b. Password- as is used for e-filing the income tax return
c. D ate of Birth/Incorporation- as is already registered with the income tax for e- filing of return of income etc.

Step 3. Next screen will appear:
– Click on ‘e-file’
– Select “prepare and submit online Form other than ITR”.

Step 4. Next screen will appear
– Select Form Name- “15CA”
– Click on “Click here to download the DSC Utility”
– O pen the “DSC Utility” and double click on the utility
– General Instruction Page will appear on the screen
– Click on “Register DSC” tab next to the Instruction tab
– Enter e-filing User- Id- which is PAN of the assessee
– Enter PAN of the DSC- Registered in e-filing which is the PAN of the person authorized to sign Form No. 15 CA
– Go to “Select type of digital signature certificate- Click on “USB token”
– Go to “Select USB token Certificate” and
select the name of the person authorized
to sign Form No. 15CA
– Click on “Generate Signature File”
– E nter the PIN of DSC and click ok.
– Save the “DSC Signature file”
– Come back to e-filing website- Attach “DSC
Signature File”. For this, click on “Browse” and attach the signature file saved and press “continue”.
– Select Relevant Part of Form No. 15CA from the drop down- PART D
– Click on continue and Form No. 15CA will be displayed on the screen.

Step 5. Fill up the details of the Remitter from the Hardcopy of PAR T D- Form No. 15CA.
– Following details are to be selected from the drop down
– State
– Country
– Status of the Remitter
– R esidential status of the remitter

Step 6. Fill up the details of the “Remittee”
– Following details are to be selected from the drop down
– State- Select “State outside India”
– Country- Select the Country of Residence of the remmittee
– Country to which remittance is to be made- Select the country of remittee
– Currency- Select the currency of remittance
– Country to which recipient of remittance is resident if available – Select the country of residence

Step 7. Fill up the details of “Remittance”
– Following details are to be selected from the drop down
– Name of the bank through which the remittance shall be made

Step 8. Fill up the “Nature of Remittance”
– Nature of Remittance as per the agreement / document is to be selected from the list of 65 categories of remittance mentioned in the Drop Down

Step 9. Fill up the “Relevant purpose code as per RBI”
– 1st Drop Down- Select the category of remittance from the list of 24(Twenty Four) categories mentioned
– 2nd Drop Down- Select the purpose code and description of remittance as mentioned in the hardcopy of Part D of Form No. 15CA

Step 10. Click on PAR T D- Verification tab next to Form 15CA on the top of the page.
– Fill up the details of the person authorized to sign “Form No. 15CA”
– Click on “Submit” button on the top of the page.
– Part D – Form No. 15 CA will be uploaded successfully.

Step 11. A fter filing Part D. Click on “My Account” tab nd Click on “View Form No. 15CA”

Step 12. Click on the Acknowledgement No link on the screen and then click on “ITR/FORM”.

Step 13. To open the PDF file enter the password. The password for the same is PAN in small letter with Date of birth/incorporation in continuation without using any special character.

Step 14. After downloading the PDF file, Save and print the same.

10. How to file Form No. 15 CB electronically

Step by step procedure for E-filing of Form Nos. 15 CA and 15 CB is as follows:

PRE-REQUISITES

In order to file Form 15CB, Tax payer must add CA. To add CA, Please follow the steps given below:

Step 1 – Login to e-filing portal, Navigate to: My Account? Add CA”.

Step 2 – E nter the Membership Number of the CA

Step 3 – Select 15 CB as Form Name and click submit.

Once the taxpayer adds the CA, the CA can file Form 15 CB in behalf of taxpayer.

In order to file Form 15CB, Chartered Accountant must follow the below steps.

Step 1 – U ser should be registered as “Chartered Accountant” in e-Filing. If not ready registered, user should click the link Register Yourself in the homepage.

Step 2 – Select “Chartered Accountants” under Tax Professional and click continue.

Step 3 – E nter the mandatory details and complete the registration process.

FILING PROCESS
Note:

Before proceeding to e-file Form No. 15CB keep the hardcopy duly filled in ready with you to expedite the process.

Kindly note that all the amounts to be entered in INR unless and until specifically required to be filled in Foreign Currency.

Step 1 – Go to the website of incometaxindiaefiling.gov.in.

Step 2 – on “Forms Other than ITR” on the Right Hand Side of the Website.

Step 3 – Download “Form No. 15CB”

Step 4 – on “ITD_EFILING_FORM15CB_PR1.jar”

Step 5 – General instruction page will appear on the screen

Step 6 – Click on “Form 15CB” tab on the Top left hand side
– F ill up Form 15CB from the hard copy of the Form 15CB prepared. Step 7 – Point No. 6 of Form 15CB
-1st Drop Down- Select “Nature of remittance” from 65 categories stated in drop down.

Step 8 – Point No. 7 of Form 15 CB
– 1st Drop Down- Select “Relevant Purpose Group Name” of remittance from 24 categories from the drop down.
– 2nd Drop Down- Select “Relevant Purpose Code and Description” of remittance.
– 3rd Drop Down- Select Yes or No for “In case the remittance is net of taxes, whether tax payable has been grossed up”

Step 9 – After filling up the details- Click on “Save Draft”
Step 10 – Click on “Validate”
Step 11 – Click on “Generate XML” and save the XML file.
Step 12– Go to “incometaxindiaefiling.gov.in” website and Login using:

a. User Id- PAN
b. Password- as is used for e-filing the income tax return
c. D ate of Birth/Incorporation- as is already registered with the income tax for e-filing of return of income etc.

Step 12 – Click on “e-file” – “Upload Form”

Step 13 – Fill up the following details
– PAN/TAN of the Assessee (Remitter)
– PAN of CA (for example: Name of CA – PAN of the CA)
– Select Form Name- 15CB
– Select filing type- Original
– A ttach the “XML” file saved
– A ttach “DSC of CA”
– Click on submit- Form No. 15CB will be submitted successfully

Step 14 – After filing Form 15CB Click on “My Account” tab and Click on “e-filed returns/forms”
– Click on PAN/TAN of assessee (Remitter)
– Click on relevant Acknowledgement Number link
– Click on ITR/FORM
– To open the PDF file, enter the password.
The password for the same is PAN in small letter with Date of birth/incorporation in continuation without using any special character.-
– After downloading the PDF file, Save and print the same.
– Click on “Receipt”
– Save and print the same.

11. Summation
Amendments to Rule 37BB though appearing complicated will reduce the compliance burden of the tax payer. It also provides the much needed certainty by specifying various transactions for which reporting is not required. Small value transactions not exceeding Rs. Five lakh per year are exempted from the cumbersome procedure of reporting by e-filing. However, a word of caution here is that the transactions not exceeding Rs. Five lakh per year are exempted only from reporting and not from the obligation of withholding tax wherever applicable. Therefore, the tax payer may have to deduct tax at source in an appropriate case even if the transaction value is less than Rs. Five lakh. Similarly, robust documentation would be required to justify the non-reporting or non-deduction transactions as hitherto. In order to determine whether the tax is deductible or not, the remitter would be required to ascertain the taxability of payment in the hands of the non-resident and that will require knowledge of the legal provisions governing Taxation of Cross Border Transactions. The remitter would be faced with a number of issues such as (i) Classification/ Characteriation of the payment (e.g. Business Income vs. Capital Gains or FTS or Royalty); (ii) Existence or otherwise of a PE (iii) Quantum of Income to be attributed to the PE (iv) Eligibility to access a Tax Treaty, (v) Application of the provisions of a DTAA vs. the Income-tax Act, (iv) issues relating to Interpretation and application of a DTAA , etc. In many cases although prima facie the remitter is not required to deduct tax at source and the new procedure also does not require him to obtain a CA Certificate in Form 15 CB, it would be advisable that he obtains CA Certificate in the Form 15 CB for NIL TDS because the CA would be able to substantiate the non-deduction of tax at source with valid documentation, judicial support and detailed and sound reasoning. In such a case, the remitter may fill up Part C of the Form 15 CA along with Form 15 CB.(However, in view of the language of Part D of Form 15CA, there is ambiguity as to whether Part C has to be filled up or Part D. In our view, once Form 15CB is obtained and uploaded electronically and acknowledgment number of such Form 15CB is filled in by the remitter in Form 15CA, Part C of Form 15CA will be automatically filled in). The issue needs to be clarified by the CBDT about the procedure to be followed by the remitter in case he desires, out of abundant caution, to obtain a CA Certificate in Form 15CB to be absolutely certain about taxability or otherwise of a particular remittance under the provisions of the Income-tax Act and/or the applicable Tax Treaty. Presently, the consequences of non-deduction of tax at source are very serious as it would not only lead to disallowance of the payment u/s. 40(a)(i) but also penalty u/s. 271C and levy of Interest u/s 201 of the Act. Many a time, the Assessing Officers are prone to summarily disallow all remittances from which tax has not been deducted at source and hence it may land the tax payer into a long drawn litigation. However, if the remitter has obtained a CA certificate for non-deduction of tax, it would help him in the Assessment and Penalty Proceedings, if any.

Taxation of Artistes and Sportsmen

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1. Overview
In recent years, it has been observed that various
International sporting events like Formula 1 Race, Indian Premier
League (IPL), Indian Super League (ISL) and I-League etc. are being
successfully held in India year after year. It is worth noting that
India has largest number of very keen cricket fans in the world viewing
various cricket matches. Similarly, there are various Indian films &
advertisements where international artistes are featuring. Many foreign
filmmakers have been shooting films in India such as Life of Pi, The
Bourne Supremacy, Slum Dog Millionaire etc. On various occasions,
concerts by non-resident entertainers are regularly held in India e.g.
concerts/performances by Metallica, Lady Gaga, Katy Perry etc. In
addition, performances by International Artistes & entertainers are
increasingly becoming a part of big Indian theme parties, wedding
extravaganzas and Reality shows etc.

Taxation of such
non-resident Artistes and Sportsmen, corporates and sports
associations/bodies involved in organising, managing and regulating such
events, concerts or performances is gaining increasing importance in
view of huge sums by way of fees and other contract amounts involved. In
this Article, we have attempted to give an overview of the taxation
provisions under the Income-tax Act and various model Tax Treaties.

2. Taxability under the Domestic Law

The relevant provisions and circulars under the Income-tax Act, 1961 [the Act] are as follows:
Section 5 r.w.s. 9 will determine taxability of income of Artistes etc. in India
Section 115BBA – Tax on non-resident sportsman or sports association
Withholding tax provisions u/s. 194E
CBDT Circular No. 787 dated 10.02.2000

2.1 Section 115BBA of the Act reads as follows:
“Tax on non-resident sportsmen or sports associations. 115BBA. (1) Where the total income of an assessee, –

a) being a sportsman (including an athlete), who is not a citizen of India and is a non-resident, includes any income received or receivable by way of –
i. participation in India in any game (other than a game the winnings wherefrom are taxable under section 115BB) or sport; or
ii. advertisement; or
iii. contribution of articles relating to any game or sport in India in newspapers, magazines or journals; or

b) being a non-resident sports association or institution, includes any amount guaranteed to be paid or payable to such association or institution in relation to any game (other than a game the winnings wherefrom are taxable u/s. 115BB) or sport played in India; or

c) being an entertainer, who is not a citizen of India and is a non-resident,
includes any income received or receivable from his performance in
India, the income-tax payable by the assessee shall be the aggregate of —

i. the amount of income-tax calculated on income referred to in
clause (a) or clause (b) or clause (c) at the rate of twenty per cent;
and
ii. the amount of income-tax with which the assessee would have
been chargeable had the total income of the assessee been reduced by the
amount of income referred to in clause (a) or clause (b) or clause (c):

Provided that no deduction in respect of any expenditure or allowance shall be allowed under any provision of this Act in computing the income referred to in clause (a) or clause (b) or clause (c).

2) It shall not be necessary for the assessee to furnish under sub-section (1) of section 139 a return of his income if—
(a)
his total income in respect of which he is assessable under this Act
during the previous year consisted only of income referred to in clause
(a) or clause (b) or clause (c) of sub-section (1); and

(b) the tax deductible at source under the provisions of Chapter XVII-B has been deducted from such income.”

(Emphasis supplied)
2.2 Analysis of Section 115BBA
It applies only to a non-resident and a person who is not a citizen of India

Who is a sportsman (including athlete) and

Earns income from
• Participation in India in any game or sports
• Advertisement
• Contribution of article in newspaper, magazine or journals relating to any game or sport in India

Applies to a non-resident sports association or institution

Who earns income from
• Guarantee money in relation to any game or sport played in India
• Except games referred to in section 115BB

Applies only to a non-resident and a person who is not a citizen of India
• Who is an entertainer and
• Earns income from his performance in India
• Applicable tax rate is 20% on gross income
• Deduction of any expenditure incurred for earning such income is not allowed
• No need to file return if tax deductible at source has been deducted from such income.

3. CBDT Circular No. 787 dated 10-02- 2000 – Income of artists, entertainers, sportsmen etc.

The salient features of the said circular are as under:

Income derived from event or show for entertainment or sports includes:
• Sponsorship money;
• Gate money;
• Advertisement revenue;
• Sale of broadcasting or telecasting rights;
• Rents from hiring out of space, etc.
• Rent from caterers.

Article on “Artistes and Sportsman” will apply to
• Income from personal activities of sportsman or artist in India
• Advertising income and Sponsorship income, if it is related directly or indirectly to performance or appearance in India.

Article on “Royalty” will apply to
• Royalty payment for recorded performance

Article on “Other income” will apply to
• Guarantee money earned by Sports association
• E.g. Tax treaty with U.S, U.K., Japan, Australia, New Zealand, Sri Lanka, France etc.

Illustrations given in the Circular
Income not taxable in India
• Artist performing in India gratuitously without consideration.
• Artist performing in India to promote sale of his records without consideration.
• Consideration paid to acquire the copyrights of performance in India for subsequent sale or broadcast or telecast abroad.

Income taxable in India
• Consideration for the live performance or simultaneous live telecast or broadcast in India.
• Consideration paid to acquire the copyrights of performance in India for subsequent sale or broadcast or telecast in India.
• Endorsement fees (for launch or promotion of products, etc.) which relates to the artist’s performance.

4. Relevant Case Laws – Section 115BBA and 194E
Some of the important case laws are as under:

4.1 International Merchandising Corporation vs ADIT [2015] 57 Taxmann.com 179 (Delhi-Trib)

Issues:
i. Payment made to Association of Tennis Professionals (ATP), whether liable to Tax u/s. 115BBA?
ii. Whether section 194E does not apply as AT P is just a governing body of sport and not a sports association?

Held:
a) 194E read with section 115BBA apply to payments made to a non-resident sports association or an institution.
b)
ATP is undisputedly a governing body of the world wide men’s
professional Tennis Circuit responsible for ranking of its players and
co-ordinating the Tennis tournament in the world.
c) ATP is a
non-resident sports institution and therefore section 194E applies to
the payments made by the assessee to the AT P.

4.2 PILCOM vs. CIT [2011] 198 Taxman 555 (Cal.)
In this case, it was held as follows:
a)
Section 115BBA is completely independent from other sections such as
section 5(2) or section 9 and it has got nothing to do with the accrual
or assessment of income in India as mentioned in section 9.
b) Non-resident individual has to pay the tax, the moment he participates in India in any game or sport.
c)
Once the payment is made to non-resident sports association or
institution or it becomes payable in relation to any game or sports
played in India, there is accrual of income in India.
d) Section 115BBA is to be applied irrespective of place of making payment.
e)
Payment received by any sports association or personalities for the
matches not played in India is not taxable or liable for withholding
tax.
f) Department’s contention that source of payment is from India irrespective of place of game is overruled.

4.3 Indcom vs. CIT (TDS) [2011] 11 taxmann.com 109 (Cal.)

Issues:
Whether
tax will be deductible on amounts paid to foreign teams for
participation as prize money or administrative expenses, is deemed to
accrue in India u/s. 115BBA?

Whether the match referees and umpires will be considered as sportsmen?

Held:
The
amount paid to the foreign team for participation in the match in India
in any shape, either as prize money or as the administrative expenses,
was the income deemed to have accrued in India and was taxable u/s.
115BBA and, thus, section 194E was attracted.

The payments made
to the umpires or match referees do not come within the purview of
section 115BBA because the umpires and match referee are neither
sportsmen (including an athlete) nor are they non-resident sports
association or institution so as to attract the provisions contained in
section 115BBA. Therefore, although the payments made to them were
‘income’ which had accrued in India, yet, those were not taxable under
the aforesaid provision and thus, the liability to deduct u/s. 194E
never accrued.

The umpires and the match referee can, at the
most, be described as professionals or technical persons who render
their professional or technical services as umpire or match referee. But
there is no scope of deducting any amount u/s. 194E for such payment.

The
reader may also refer to the decision in the case of Board of Control
for Cricket in India vs. DIT (Exemption) [2005] 096 ITD 263 (Mum), on
the subject.

5. Scope of the Article 17 of OECD Model Tax Convention

Salient features of Article 17 are as under:
• Primary taxing rights is with the State of Source / State of performance
• It overrides Article 7, 14 and 15.
• It applies to entertainer, sportsperson or any other person

6. Article 17 (1)

6.1 Model Conventions – A Comparison

6.2 Scope of Article 17(1)
a. A pplies to Individual resident of one of the contracting state.
b. I ndividual is either an entertainer or a sportsperson.
c. He derives income from personal activities.
d. Word “personal activities” suggests “public appearance” is necessary.
e. Personal activities/performance are exercised in the source State i.e. country of performance.
f. Performance should be in public or recorded and later produced for an audience.
g. Performance must be artistic and entertaining.
h. Entertainer or sportsperson must be present in the state of source during the performance.
i. It is not necessary to remain present in the Source State for any minimum period.
j. Person performing even for a single event is covered.
k. Person involved in a political, social, religious or charitable nature is covered, if the entertaining character is present.
l. It covers both professional activities and occasional activities.
m. Source State gets right to tax income earned in that state.

6.3 Meaning of ‘Entertainer’
a. There is no precise definition of the term in Model convention or in treaty.
b. Dictionary meaning of “Entertainer”
i.
“A person whose job is amusing or interesting people, for example, by
singing, telling jokes or dancing” – Oxford Advanced Learner’s
Dictionary
ii. “A person, such as a singer, dancer, or comedian, whose job is to entertain others” – Oxford Dictionary of English
iii. “A person who entertains; a professional provider of amusement or entertainment” – Shorter Oxford Dictionary
c.
Term ‘Entertainer’ includes the stage performer, film actor or actor
(including for instance a former sportsperson) in a television
commercial.
d. Entertainer or sportsperson includes anyone who acts as such even for a single event.

6.4 Meaning of “artiste” and “artist”
a. There is no precise definition in Model convention or in treaty.
b. Dictionary meaning of “Artiste” is:
i. “An artist, especially an actor, singer, dancer, or other public performer” Random House Webster’s Dictionary
ii.
“A public performer who appeals to the aesthetic faculties, as a
professional singer, dancer, etc. also one who makes a ‘fine art’ of his
employment, as an artistic cook, hair dresser, etc. Oxford English
Dictionary
iii. “A professional entertainer such as singer, a dancer or an actor” Oxford Advanced Learner’s Dictionary

c. Difference between the word “artiste” and “artist”:
i. “Artist” has a broader meaning compared to “artiste”
ii. Artist includes those who create work of art, such as painter, sculptors etc.
iii. Artist is a person whose creative work shows sensitivity and imagination
iv. A rtiste is restricted to performing arts.
v. Artiste is a person who is a public performer or skilled performer.
vi. A rtiste is the one who has an entertaining character
vii. The word “entertainer” seems to cover the lighter versions of the performing arts.

6.5 Relevant decisions regarding meaning of ‘Artist’ given in the context of Section 80-RR of the Act

a. Sachin Tendulkar vs. CIT [2011] 11 taxmann. com 121 (Mum).
The
Mumbai Tribunal in case of Sachin Tendulkar held that Sachin should be
regarded as an artiste while appearing in advertisements and
commercials, modeling etc. and hence is entitled to deduction u/s. 80RR.

b. Amitabh Bachchan vs. CIT [2007] 12 SOT 95 (Mum)
The
Mumbai Tribunal held that both Amitabh Bach chan receiving income for
acting as an anchor for a TV programme and Shahrukh Khan receiving in
come from endorsement of performance where he has to give photographs,
attend photo sessions, video shoots, etc. are entitled to deduction u/s.
80RR.

The reader may also refer to the following decisions on the subject:

Tarun Tahiliani-[2010] 192 Taxman 231(Bom)
Harsha Ahyut Bhogale vs. ACIT – [2008] 171 Taxman 108 (Mum) (Mag)
David Dhawan vs. DCIT – [2005] 2 SOT 311 (Mum)
Anup Jalota – [2003] 1 SOT 525 (Mum)

6.6 Meaning of ‘Sportsperson’
a. There is no precise definition is given of the term “sportspersons”.
b.
N ot restricted to participants in traditional athletic events (e.g.
runners, jumpers, swimmers). Also covers e.g. golfers, jockeys,
footballers, cricketers and tennis players, as well as racing drivers.
c.
A lso includes activities usually regarded as of an entertainment
character such as billiards, snooker, chess and bridge tournaments
d.
Since sportsperson is grouped with entertainer, Article 17 will apply
only to those who perform in public. Therefore, mountaineers or scuba
divers are not covered.
e. Sportsperson also covers the one whose
activities includes advertising or interviews that are directly or
indirectly related to such an appearance.
f. Sportsperson does not include managers or coaches of the sports team.
g.
Merely reporting or commenting on a sports event in which the reporter
does not participate is not an activity as a sportsperson.
h. Owner
of a horse or a race car is not covered under Article 17 unless the
payment is received on behalf of the jockey or car driver.

6.7 Meaning of “Athlete”
A person who is trained or skilled in exercises, sports, or games requiring physical strength, agility or stamina

Dictionary meaning is one who is engaged in sport more specifically in the field and track events

6.8 Persons covered under Article 17 and regarded as performing entertainers or artistes

6.9 Persons not covered under Article 17 and not regarded as performing entertainers or artistes

6.10 Article 17(1) – Illustrative types of Income covered:

a. Income derived from performance.

b. Income connected with performance such as awards
i. Payment received by a professional golfer for an interview given during a tournament in which he participates.
ii. Payment made to a star tennis player for the use of his picture on posters advertising a tournament in which he will participate.

c. Advertising and sponsorship fee directly or indirectly related to performance in source country

i. Payments made to a tennis player for wearing a sponsor’s logo, trade mark or trade name on his tennis shirt during a match.

d. Income generated from promotional activities of the entertainer during his presence in source country.

e. Payments for the simultaneous broadcasting of a performance by an entertainer or sportsperson made directly to the performer or for his or her benefit (e.g. a payment made to the star-company of the performer).

f. Income from combined activities (for e.g. Steven Spielberg directing and acting in a movie – Predominantly performing nature – Article 17 would apply – Performing element negligible – entire income out of Article 17).

g. Performance based fees/remuneration such as participation fees, share in gate receipts.

h. Income from writing a column in daily newspaper or journals related to performance.

i. Salary income of a member of an orchestra or troupe for his performance.

j. Entertainer earning salary as an employee is liable to pay tax in source country in proportion to his salary which corresponds to his performance.

k. Income of one person company belonging to entertainer if domestic law of Source State permits “look through” approach.

l. Illustration:
• Film actor is performing in India where a film is shot. Article 17 will apply to the income of the film actor.
• If the film is released worldwide except India, Article 17 will apply to the income of Film actor irrespective of where the film is released.

6.11 Article 17(1) – Illustrative types of Income not covered

a. Payments received upon cancellation of a performance are not taxable under Article 17(1).

b. Royalties for intellectual property rights will normally be covered under Article 12 i.e. Income to third party holding IPR for broadcasting rights.

c. Income received by impresarios etc. for arranging the appearance of an entertainer or sportsperson is outside the scope of the Article, but any income they receive on behalf of the entertainer or sportsperson is of course covered by it.

d. Income received by administrative or support staff (e.g. cameramen for a film, producers, film directors, choreographers, technical staff, road crew for a pop group, etc.

e. Income from speaking engagement in conferences.

f. Income as reporter or commentator h. Promoters involved in production of event i. Guest judge in singing competition

j. Income not attributed to performance in source state.

6.12 Items of Income Covered by Other Articles

Taxation of the following types of income is governed by other Articles of a Tax Treaty:

a. Income for Image rights not closely connected with performance

b. Sponsorship and advertising fees not related to performance

c. Merchandising income from sale which is not related to performance

d. Income against the cancellation of performance, since it is compensation for income lost due to cancellation of performance and not associated with performance.

e. Income from restrictive covenants

f. Income earned by a former sportsperson providing commentary during the broadcast of a sport event or reporting on sport event in which he is not participating.

g. Income from repeat telecast

h. Fees for interview with music channel not closely connected with performance.

6.13 Aspects which are not relevant while applying Article 17

a. Location or residence of Payer

b. Number of days stay in the source country

c. Having PE or fixed base of the entertainer in the source country

d. Entertainer or sportsperson performing as an employee or independently on contract

e. Entertainers present directly on the stage or through radio or TV.

f. One time performance or regular performance

g. Indian Treaty examples
i. India-Egypt tax treaty provides time threshold of 15 days during the relevant fiscal year.

ii. India-USA tax treaty – Exception provided where net income derived does not exceed USD 1,500.

6.14 Foreign Judicial Precedents

a) Agassi vs. Robinson – UK Judicial Precedent
• Mr. Andre Agassi, a US-tax resident visited UK for short duration to play in various tournaments and in particular at Wimbledon.

• He controlled a US corporation (Andre Agassi Enterprises Inc) through which he negotiated endorsement contracts with manufacturers of sporting equipment including Nike and Head, neither of which had a tax presence in UK.

• Revenue authorities assessed Andre Agassi for tax in connection with the sponsorship income received by the non-resident corporation.

• UK House of Lords upheld the extra-territorial applicability of the UK domestic tax law provisions and held that endorsement income paid by non-resident UK sponsors to non-resident corporation is liable to tax in UK.

b) Canadian decision in Cheek vs. The Queen (2002 DTC 1283 (Tax Court of Canada))

• Issue: Whether a “radio broadcaster” of baseball games would fall under Article XVI (Artistes and Athletes) of the 1980 Canada–United States Income Tax Convention?

• The radio broadcaster Thomas Cheek, had been the commentator of the Toronto Blue Jays together with a partner-commentator.

• Thomas Cheek was resident in the United States, was not an employee and did not have a fixed base in Canada that would have made him taxable under Article XIV (Independent Personal Services).

• In a baseball game of three hours, only 16-18 minutes are actual “motion”, the rest is “down time”. The challenge facing the broadcaster is to hold the attention of the radio audience, even when there is no activity on the field.

• The court stated that professional sports in itself is entertaining, but doubted whether the broadcaster could be seen as an entertainer, that is, as a “radio artiste”, such as for example the late Bing Crosby. The baseball fan who turns on the radio to hear a particular baseball game wants to know how the players are performing on the field.

• The broadcaster may be able to hold the attention of the fan with his “down time” commentary but he is not the reason why the fan turns on the radio. Therefore the court decided that Thomas Cheek was not a radio artiste, although he was a very skilful and experienced radio journalist.

c) NL: HR, 7 May 2010, 08/02054 (Tax Treaty Case Law IBFD)

• A football player who was resident in Sweden was transferred by a Swedish club to a team resident in the Netherlands.

• He took up residence in the Netherlands after the transfer.

• Pursuant to the terms of his contract with the Swedish club, he received a share of the transfer price paid by the Dutch club;

• He received this payment when he had already become a resident of the Netherlands.

• The taxpayer claimed that this payment related to his past employment activity with the Swedish club and was covered by Article 15 (Income from employment) of the treaty.

• Conversely, the Dutch tax authorities maintained that the payment was within the scope of Article 17 (allowing Sweden the primary right to tax and double taxation should in that case be relieved in the Netherlands via a credit under Article 24(4).

• Held – The payment was clearly related to the past activities of the taxpayer as football player for the Swedish team and that, therefore, Article 17 doubtlessly applied. As a consequence, the taxpayer had to include this payment in his income for Dutch tax purposes and then ask a credit for the taxes paid to Sweden upon that same income.

7.2 India’s DTAA s – Article 17 (2)

• India’s treaties with Egypt, Libya, Syria and Zambia provide that income accrued to another person is not taxable in source country.

• India’s treaty with Zambia provides for deemed PE if the enterprise carries on business of providing the services of public entertainer

• India’s treaty with USA provides that income accrued to another person is not taxable if entertainer establishes that neither the entertainer or athlete nor persons related thereto participate directly or indirectly in the profits of that other person in any manner, including the receipt of deferred remuneration, bonuses, fees, dividends, partnership distributions, or other distributions.

• Paragraph applies when income from personal activities exercised by an entertainer or a sportsperson accrues to another person and not to an entertainer or sportsperson.

• Another person could be a corporate or non-corporate entity

• Such entity may be owned by the performer himself

• Even if another person and entertainer are tax resident of different countries, paragraph applies

• Source state may tax such income.

• It overrides the provisions of Article 7 (Business profit) and 15 (Income from employment).

7.3 Article 17 (2) – Anti Avoidance Rule
• Another person i.e. entity could be a Management Company, team, troupe, orchestra or “renta- star” company.

• “Rent a star” company is controlled by the performer or artist and performer would be the beneficiary of maximum profit of the company

• Income for the performance of entertainer in the source state is received by such entity and not by the entertainer.

• An entertainer or sportsperson is either hired or employed by such entity for the entertainment program to be held in Source State.

• Such entity may pay nominal amount or modest salary to the performer.

• Such entity, in the absence of Permanent Establishment or business connection, may avoid tax in the Source State.

• Income does not accrue to the performer, hence paragraph 1 of Article 17 will not apply.

• Individual performer/entertainer may avoid tax for non-application of Article 15 or may pay tax on modest salary.

• Paragraph 2 deal with such an arrangement and gives taxing rights to the Source State.

7.4 Article 17(2) – Important Points

a. Para 2 does not apply to Prize money that the owner of a horse or the team to which a race car belongs, derives from the results of the horse or car during a race or during races, taking place during a certain period.

b. Does not cover the income of all enterprises that are involved in the production of entertainment or sports events, e.g.:

i. income derived by the independent promoter of a concert from the sale of tickets; and

ii. allocation of advertising space is not covered by paragraph 2.

c. Computation Mechanism – as per the domestic laws of the Source country.

7.5 Computation and rate of tax
Approach for computing income
• Treaty does not provide for method of computing income

• Income is to be computed as per domestic law of the source state (e.g. section 115 BBA of the Act)

• Domestic law may tax only company or the entertainer or both on their respective income

• Non-resident may choose to be governed by the treaty law or the domestic law.

Rate of tax
• Rates are generally not provided in the treaty

• Domestic law may provide for tax on gross income or give an option to be taxed on net income (@20% u/s. 115 BBA of the Act).

7.6 Taxation of Team Performance

A team performance is defined as the exercise of personal activities by more than one entertainer or sportsperson who come together as a group ? Group entity may or may not be a resident or have a permanent establishment in the state of source ? Each team member is classified as entertainer or sportsperson or support staff based on the nature of services rendered

Entertainer or sportsperson of the team are taxed in the state of performance

Support staff, technical personnel and all employees other than artistes or sportsmen are governed by Article 15.

Tax treatment in the state of source is as under:

Payments attributable to entertainer and sportsperson is taxed under Article 17(1)

• Profit earned by the team is apportioned between profit attributable to the performance of entertainer or sportsperson and profits attributable to activities of non-performing members

• Profit attributable to the performance of entertainer or sportsperson is taxed under Article 17(2)

7.7 Relevant Case Law re Article 17(2)

Wizcraft International Entertainment Private Limited vs. ADIT [2014] 45 taxmann.com 24 (Bombay)

• Commission paid to the UK agent was not for services of entertainers/artists.

– The UK agent had not taken any part in the events, nor performed any activities in India. Hence, it was not covered by Article 18 of India- UK DTAA .

• The UK agent did not have any PE in India [Carborandum Co. vs. CIT, (1977) 108 ITR 335 (SC) and CBDT Circular Nos. 17 dated 17.07.1953 and 786 dated 07.02.2000], commission paid to the UK agent was not taxable in India and no obligation on Indian Co to deduct tax at source.

• Reimbursement of expenses – The law is well settled that reimbursement of expense not chargeable to tax and hence, no obligation to deduct tax at source [DIT (IT) vs. Krupp UDHE Gmbh (2010) 38 DTR (Bom) 251 following own decision in CIT vs. Siemens Aktiongesellschaft 220 CTR (Bom) 425].

• Reliance was placed on Circular No. 786 dated 7 February 2000 in respect of non-taxability in India of export commission payable to non-resident agents rendering services abroad.

Note: The aforementioned Circular No. 786 dated 7 February 2000, is withdrawn by Circular No. 7/2009 dated 22nd October, 2009. However, the ITAT and the courts in various cases have held that even after the withdrawal of said circular, export commission payable to non-resident agents rendering services abroad, is not taxable in India.

8. Additional Consideration relating to paragraph 1 & 2 of Article inserted as Article 17(3) in many India’s DTAAs

Article 17 ordinarily applies when the entertainer or sportsperson is employed by a Government and derives income from that Government. However, certain conventions contain provisions excluding entertainers or sportspersons employed in organisations which are subsidised out of public funds from the application of Article 17.

Some countries may consider it appropriate to exclude from the scope of the Article events supported from public funds.

This has been provided as additional consideration in Commentary to Model Convention July 2014 with modifications.

8.1 Such provisions are existing in most of India’s DTAA s and are inserted as paragraph (3) or (4) of Article 17.

8.2 A rticle 17(3) in some of the India’s DTAA s
India – Armenia and India – Japan tax treaty Income taxable only in the resident state, if the event is for approved cultural or sports exchange program.

India – Australia, India – Belgium, India – Indonesia, and India – Mauritius tax treaty Income taxable only in the resident state, if the event is supported by public funds of resident state.

India-Brazil and India – Bangladesh Tax Treaties

Paragraph 1 and 2 will not apply if the activity is wholly or mainly or substantially supported from the public funds of the other contracting state.

9. Conflicts

It is important to note that all the income of the Artistes and Sportsmen may not in all cases be covered by Article 17. It is nature of income which will determine whether the same would fall within the scope of Article 17 or the same would be covered by Article 18 relating to Pensions or Article 19 relating to remuneration in respect of government service.

Conflicts between Article 17 and 18
• Remuneration derived from the entertainment show is governed by Article 17.

• Pension received after termination of performance activity will fall under Article 18.

• Golden handshakes are payment linked to employment and not to the performance, hence does not fall under Article 17.

Conflicts between Article 17 and 19

In case Artists or Sportsperson renders service to Government and receives remuneration then normally Article 17 applies if the activity of the Government is in the nature of business, otherwise Article 19 will apply.

The above article provides just a bird’s eye view of the subject. To gain an in-depth understanding of the subject, the reader would be well advised to study the commentaries on Article 17 of various model conventions and the relevant judicial pronouncements.

Framework of Sources of Exchange of Information in Tax Matters – An Overview

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Introduction and Need for Exchange of Information [EoI]

Tackling
offshore tax evasion and tax avoidance and unearthing of unaccounted
money stashed abroad have become a pressing concern for governments all
around the world. The information and/or evidence of such tax
avoidance/evasion and the underlying criminal activity is often located
outside the territorial jurisdiction and thus this menace can be
addressed only through bilateral and multilateral cooperation amongst
tax and other authorities. India has played an important role in
international forums in developing international consensus for such
cooperation as per globally accepted norms and continuous monitoring of
their adoption by every jurisdiction including offshore financial
centres.

Initially, the international norms were to provide
assistance to other countries only on satisfaction of the norms of “dual
criminality”, i.e., in cases of drug trafficking, corruption, terrorist
financing etc. which are criminal activities in both countries.
However, at present the cooperation has extended to cases of tax evasion
and avoidance and countries are obliged to exchange information
requested as per provisions of tax treaties/agreements. The third stage
of cooperation would be automatic exchange of financial account
information without countries having to make requests for the same,
thereby enabling the receiving country to verify whether such accounts
indicate tax evaded money and to take necessary action. Despite a global
consensus on coordinated action to tackle the problem of tax evasion
and tax avoidance, foreign governments, particularly offshore financial
centres, are most unlikely to provide information on the basis of just
letters or on a plea regarding their moral obligations to prevent tax
evasion. Among other factors, parting with information without a legal
basis may be challenged in their own Courts and may be against their own
public policy or public opinion of their citizens. Such information
about money and assets hidden abroad and about undisclosed transactions
entered into overseas, can be obtained only through “legal instruments”
or treaties entered into between India and those countries.

Tax
Treaties, which include, Double Taxation Avoidance Agreements (DTAA s),
Tax Information Exchange Agreements (TIEAs), Multilateral Convention on
Mutual Administrative Assistance in Tax Matters (Multilateral
Convention) and SAARC Limited Multilateral Agreement (SAARC Agreement),
are the legal instruments which provide a legal obligation on a
reciprocal basis for providing various forms of administrative
assistance, including Exchange of Information, Assistance in Collection
of Taxes, Tax Examination Abroad, Joint Audit, Service of Documents etc.
Through one or more of these tax treaties, India has exchange of
information relationships with more than 130 countries/jurisdictions
including well known offshore financial centres and these jurisdictions
are legally committed to provide administrative assistance and are
actually providing the same in cases where requests are made.
Information and other forms of assistance can also be requested through
Mutual Legal Assistance Treaties (MLAT s) through Ministry of Home
Affairs, particularly with countries/jurisdictions with which there is
no tax treaty. Information/evidence obtained through MLAT s can also
supplement the information received under tax treaties when a criminal
complaint is made for tax evasion on the basis of information received
under tax treaties. Information can also be obtained through Egmont
Group of Financial Intelligence Units (FIUs) which may be further
supplemented by making further requests under tax treaties/ MLAT s.

Despite
the existence of legal instruments for administrative assistance and
the willingness of India’s treaty partners to provide information, these
provisions are still underutilised, largely because tax officials are
not fully aware of the provisions and need guidance for framing
effective requests for information under appropriate legal instruments.
The taxpayers, their advisers and the tax officers may also not be fully
aware of the recent international developments in transparency
including the global adoption of the new standards on automatic exchange
of information, which will bring about a sea-change in India’s ability
to receive and utilize information regarding Indians having financial
accounts in offshore financial centres.

Thus there are nine major sources of EoI of various kinds relating to tax matters, which are summarised below:

1. EoI Article under the Model Conventions on Income and on Capital

2. Tax information Exchange Agreements [TIEAs]

3.
Automatic Exchange of Information [AEoI] under The Multilateral
Convention on Mutual Administrative Assistance in Tax Matters [CoMAA]
alongwith Multilateral Competent Authority Agreement on Automatic
Exchange of Financial Account Information [MCAA]

4. EoI under
Inter-Governmental Agreement [IGA] and Memorandum of Understanding (MoU)
between India and USA to improve International Tax Compliance and to
implement Foreign Account Tax Compliance Act [FAT CA] of the USA

5. SAARC Limited Multilateral Agreement [SAARC Agreement]

6. Mutual Legal Assistance Treaties [MLAT s]

7. The Egmont Group Financial Intelligence Units (FIUs)

8. Joint International Tax Shelter Information & Collaboration – JITSIC

9. EoI under Base Erosion and Profit Shifting [BEPS] Project.

Brief
outline of nine major sources of EoI of various kinds, is as under: In
this article, we aim to introduce to the readers various sources of EoI
amongst various authorities and various countries. Each one of the above
are discussed below in brief:

Sr. No. Source of EOI
Type of EoI and Purpose
1 Article 26 -OECD
Model Convention 		EoI under bilateral DTAA framework covering
EoI on request, Spontaneous and Automatic
EoI
2 TIEA TIEA facilitates EoI with countries where comprehensive
DTAA is non-existent to promote
international co-operation in tax matters
3 CoMAA EoI including AEoI in tax matters under the
most comprehensive Multilateral Convention.
AEoI is facilitated by MCAA.
4 IGA-FATCA AEoI on a reciprocal basis under the IGA
signed with USA
5 SAARC Agreement Limited Multilateral Agreement incorporating
EoI amongst 7 SAARC member Countries
6 MLATs EoI and mutual assistance in criminal matters,
inter alia, involving tax evasion
7 Egmont group of
FIUs		 International co-operation including EoI against
money laundering and financing of terrorism –
8 JITSIC To enhance collaboration amongst tax administrators
enabling EoI to combat multinational tax
evasion and to counter abusive tax schemes
and tax avoidance structures
9 Action plan 5,12
& 13 – BEPS project		 EoI including automatic exchange of countryby-
country reports, spontaneous exchange of
rulings and exchange of mandatory disclosure
regimes
1. Exchange of Information [EoI] Article under the Model Conventions on Income and on Capital

(a)
1928 Model developed by the League of Nations provided for provision of
Information on request and for Automatic EoI relating to Specific
Categories such as Immovable properties etc. In the London and Mexico
draft models of 1946, a Draft Agreement on Administrative Co-operation
was included. Both the Obligation and Form of Information Exchange were
narrowed during the formalisation of OECD Model after World War-II by
removing the obligation for Automatic Exchange of Information. The Draft
OECD Model was first developed in 1963 which contained Article on EoI.
Until 8th Edition released in 2010, Article 26 of the OECD Model
Convention contained the pre-updated version of Article 26. On 17th
July, 2012 Update to Article 26 and its commentary was approved by OECD
Council which extensively revised the commentary on Article 26. There
are three forms of EoI (On Request, Automatic and Spontaneous). Para 9
of the Commentary on Article 26 provides that all three forms of EoI are
covered by the Article.

In the update, in para 2 of Article 26
the following sentence was added: “Notwithstanding the foregoing,
information received by a Contracting State may be used for other
purposes when such information may be used for such other purposes under
the laws of both States and the competent authority of the supplying
State authorises such use.” Many of India’s DTAA s signed before July
2012 have been amended in recent past by way of Protocols to incorporate
the updated EoI Article. Most of the India’s DTAA s signed before July
2012 contain pre-updated Article 26 and DTAA s signed after July 2012
contain updated Article 26. (b) OE CD Model Convention – Text of Article
26 – Exchange of Information Text of the updated Article 26 of the OECD
Model Convention is reproduced below for ready reference: 1. The
competent authorities of the Contracting States shall exchange such
information as is foreseeably relevant for carrying out the provisions
of this Convention or to the administration or enforcement of the
domestic laws concerning taxes of every kind and description imposed on
behalf of the Contracting States, or of their political subdivisions or
local authorities, insofar as the taxation thereunder is not contrary to
the Convention. The exchange of information is not restricted by
Articles 1 and 2. 2. Any information received under paragraph 1 by a
Contracting State shall be treated as secret in the same manner as
information obtained under the domestic laws of that State and shall be
disclosed only to persons or authorities (including courts and
administrative bodies) concerned with the assessment or collection of,
the enforcement or prosecution in respect of, the determination of
appeals in relation to the taxes referred to in paragraph 1, or the
oversight of the above. Such persons or authorities shall use the
information only for such purposes. They may disclose the information in
public court proceedings or in judicial decisions. Notwithstanding the
foregoing, information received by a Contracting State may be used for
other purposes when such information may be used for such other purposes
under the laws of both States and the competent authority of the
supplying State authorises such use. 3. In no case shall the provisions
of paragraphs 1 and 2 be construed so as to impose on a Contracting
State the obligation: a) to carry out administrative measures at
variance with the laws and administrative practice of that or of the
other Contracting State; b) to supply information which is not
obtainable under the laws or in the normal course of the administration
of that or of the other Contracting State; c) to supply information
which would disclose any trade, business, industrial, commercial or
professional secret or trade process, or information the disclosure of
which would be contrary to public policy (ordre public). 4. If
information is requested by a Contracting State in accordance with this
Article, the other Contracting State shall use its information gathering
measures to obtain the requested information, even though that other
State may not need such information for its own tax purposes. The
obligation contained in the preceding sentence is subject to the
limitations of paragraph 3 but in no case shall such limitations be
construed to permit a Contracting State to decline to supply information
solely because it has no domestic interest in such information. 5. In
no case shall the provisions of paragraph 3 be construed to permit a
Contracting State to decline to supply information solely because the
information is held by a bank, other financial institution, nominee or
person acting in an agency or a fiduciary capacity or because it relates
to ownership interests in a person.” 2. Tax information Exchange
Agreements [TIEAs] The Model TIEA was released in April 2002, containing
Two Models of Bilateral Agreements. The Model TIEA covered only EoI on
Request. A large No. of bilateral agreements have been based on Model
TIEA. In June 2015, OECD approved a Model Protocol to the TIEA for the
purpose of allowing Automatic and Spontaneous exchange of information
under a TIEA. India has so far signed 16 TIEAs with countries with whom
India has not signed a Comprehensive DTAA , namely: Argentine, Bahrain,
Belize, Gibralter, Principality of Liechtenstein, Liberia, Macao SAR,
Monaco, Bahamas,

Bermuda, British Virgin Islands, Cayman Islands, Guernsey, Isle of Man, Jersey and Maldives.

The Model TIEA contains the following Articles:

Article Article heading
1 Object and Scope of the Agreement
2 Jurisdiction.
3 Taxes Covered
4 Definitions
5 Exchange of Information upon Request
6 Tax Examinations Abroad
7 Possibility of Declining a request
8 Confidentiality
9 Costs
10 Implementation Legislation
11 Language [This article may not be required in Bilateral TIEA.]
12 Implementation Legislation
13 Other international agreements or arrangements [This article may
not be required in Bilateral TIEA.]
14 Mutual Agreement Procedure
15 Depositary’s functions [This article may not be required in Bilateral
TIEA.]
16 Entry into Force
17 Termination

3. The Multilateral Convention on Mutual Administrative Assistance in Tax Matters [Co- MAA]

The
CoMAA was developed jointly by the OECD and the Council of Europe in
1988 and amended by Protocol in 2010. The CoMAA was amended to align it
to the international standard on exchange of information on request and
to open it to all countries. The amended Convention was opened for
signature on 1st June 2011.

The CoMAA has now taken an
increasing importance with the G20’s recent call for automatic exchange
of information to become the new international tax standard of exchange
of information.

As of 27-11-2015, 77 countries, including India
have signed the CoMAA and it has been extended to 15 jurisdictions
pursuant to Article 29 of The CoMAA. This represents a wide range of
countries including all G20 countries, all BRICS, almost all OECD
countries, major financial centres and a growing number of developing
countries.

India signed the CoMAA on 26-1-2012 which was notified on 28-8-2012 and which entered into force wef 1-6-2012.

a. Relevance of the CoMAA

  •  Designed
    to facilitate international co-operation among tax authorities to
    improve their ability to tackle tax evasion and avoidance and ensure
    full implementation of their national tax laws, while respecting the
    fundamental rights of taxpayers.
  •  Most comprehensive multilateral instrument available for tax cooperation and exchange of information.
  • Provides for all possible forms of administrative cooperation between states in the assessment and collection of taxes.
  • Co-operation
    includes automatic exchange of information, simultaneous tax
    examinations and international assistance in the collection of tax
    debts.

b.Benefits of the CoMAA

Scope of the Convention is broad: it covers a wide range of taxes and goes beyond exchange of information on request.

  •  Provides
    for other forms of assistance such as: spontaneous exchanges of
    information, simultaneous examinations, performance of tax examinations
    abroad, service of documents, assistance in recovery of tax claims and
    measures of conservancy and automatic exchange of information.
  • Facilitates joint audits.
  • Includes extensive safeguards to protect the confidentiality of the information exchanged.

c. Chapter III Section I – Article 4 to 5 relevant for EoI

The text of the same are given below for ready reference. Article 4 – General Provision

 “1.
The Parties shall exchange any information, in particular as provided
in this section, that is foreseeably relevant for the administration or
enforcement of their domestic laws concerning the taxes covered by this
Convention.

2. Deleted.

3. Any Party may, by a
declaration addressed to one of the Depositaries, indicate that,
according to its internal legislation, its authorities may inform its
resident or national before transmitting information concerning him, in
conformity with Articles 5 and 7.

Article 5 – Exchange of Information on Request

“1.
At the request of the applicant State, the requested State shall
provide the applicant State with any information referred to in Article 4
which concerns particular persons or transactions.

2. If the
information available in the tax files of the requested State is not
sufficient to enable it to comply with the request for information, that
State shall take all relevant measures to provide the applicant State
with the information requested.”

d. The CoMAA and Automatic Exchange of Information

Article
6 of the CoMAA provides for AEoI. It is an ideal instrument to
implement AEoI swiftly and multilaterally. To implement Article 6, an
administrative agreement between the competent authorities of two or
more interested Parties to the Convention is required. It would address
issues such as the procedure to be adopted and the information that will
be exchanged automatically.

Sharing of information with other
law enforcement authorities to counteract corruption, money laundering
and terrorism financing is permissible subject to certain conditions;
information received by a Party may be used for other purposes when

(i) such information may be used for such other purposes under the laws of the supplying Party and
(ii) the competent authority of that Party authorises such use.

e. Main benefits of Automatic Exchange

  • AE
    oI can provide timely information on non-compliance where tax has been
    evaded either on an investment return or the underlying capital sum.
  • Help detect cases of non-compliance even where tax administrations have had no previous indications of non-compliance.
  • Has deterrent effects, increasing voluntary compliance and encouraging taxpayers to report all relevant information.
  • Help
    in educating taxpayers in their reporting obligations, increase tax
    revenues and thus lead to fairness – ensuring that all taxpayers pay
    their fair share of tax in the right place at the right time.
  • Possibility
    to integrate the information received automatically with their own
    systems such that income tax returns can be prefilled.

f. Chapter III Section I – Article 6 to 10 relevant for AEoI

The text of the same are given below for ready reference. Article 6 – Automatic Exchange of Information

“With
respect to categories of cases and in accordance with procedures which
they shall determine by mutual agreement, two or more Parties shall
automatically exchange the information referred to in Article 4.”

Article 7 – Spontaneous Exchange of Information

“1.
A Party shall, without prior request, forward to another Party
information of which it has knowledge in the following circumstances:

a. the first-mentioned Party has grounds for supposing that there may be a loss of tax in the other Party;
b.
a person liable to tax obtains a reduction in or an exemption from tax
in the first mentioned Party which would give rise to an increase in tax
or to liability to tax in the other Party;
c. business dealings
between a person liable to tax in a Party and a person liable to tax in
another Party are conducted through one or more countries in such a way
that a saving in tax may result in one or the other Party or in both;
d.
a Party has grounds for supposing that a saving of tax may result from
artificial transfers of profits within groups of enterprises;
e.
information forwarded to the first-mentioned Party by the other Party
has enabled information to be obtained which may be relevant in
assessing liability to tax in the latter Party.

2. Each Party
shall take such measures and implement such procedures as are necessary
to ensure that information described in paragraph 1 will be made
available for transmission to another Party.”

Article 8 – Simultaneous Tax Examinations

“1.
At the request of one of them, two or more Parties shall consult
together for the purposes of determining cases and procedures for
simultaneous tax examinations. Each Party involved shall decide whether
or not it wishes to participate in a particular simultaneous tax
examination. 2. For the purposes of this Convention, a simultaneous tax
examination means an arrangement between two or more Parties to examine
simultaneously, each in its own territory, the tax affairs of a person
or persons in which they have a common or related interest, with a view
to exchanging any relevant information which they so obtain.”

Article 9 – Tax Examinations Abroad

“1.
At the request of the competent authority of the applicant State, the
competent authority of the requested State may allow representatives of
the competent authority of the applicant State to be present at the
appropriate part of a tax examination in the requested State.

2.
If the request is acceded to, the competent authority of the requested
State shall, as soon as possible, notify the competent authority of the
applicant State about the time and place of the examination, the
authority or official designated to carry out the examination and the
procedures and conditions required by the requested State for the
conduct of the examination. All decisions with respect to the conduct of
the tax examination shall be made by the requested State.

3. A
Party may inform one of the Depositaries of its intention not to accept,
as a general rule, such requests as are referred to in paragraph 1.
Such a declaration may be made or withdrawn at any time.”

Article 10 – Conflicting Information

“If
a Party receives from another Party information about a person’s tax
affairs which appears to it to conflict with information in its
possession, it shall so advise the Party which has provided the
information.”

g. Confidentiality of Information Exchanged under Co- MAA and Protection of taxpayers’ rights

  • The CoMAA has strict rules to protect the confidentiality of the information exchanged.
  • Provides
    that information shall be treated as secret and protected in the
    receiving State in the same manner as information obtained under its
    domestic laws.
  • If personal data are provided, the Party
    receiving them shall treat them in compliance not only with its own
    domestic law, but also with the safeguards that may be required to
    ensure data protection under the domestic law of the supplying Party.

h. Articles of Model CoMAA

The outline of the contents of the Model CoMAA is as under:

i. Standard for Automatic Exchange of Financial Account information in Tax Matters [Standard]

For facilitating the AEoI amongst various countries, OECD has developed a Standard. The Standard sets out

Chapter/Section/
Article		 Chapter / Section/ Article heading
Chapter I Scope of the convention
1 Object of the convention and persons covered
2 Taxes Covered
Chapter II General Definitions
3 Definitions
Chapter III Forms of Assistance
Section I Exchange of Information
4 General Provision
5 Exchange of Information on Request
6 Automatic Exchange of Information
7 Spontaneous Exchange of Information
8 Simultaneous Tax Examinations
9 Tax Examinations Abroad
10 Conflicting Information
Section II Assistance in Recovery
11 Recovery of Tax Claims
12 Measures of Conservancy
13 Documents accompanying the Request
14 Time Limits
15 Priority
16 Deferral of Payment
Section III Service of Documents
17 Service of Documents
Chapter IV Provisions relating to all forms of assistance
18 Information to be provided by the Applicant State
19 Deleted
20 Response to the Request for Assistance
21 Protection of Persons and Limits to the Obligation to provide
Assistance
22 Secrecy
23 Proceedings
Chapter V Special Provisions
24 Implementation of the convention
25 Language
26 Costs
Chapter VI Final Provisions
27 Other international agreements or arrangements
28 Signature and entry into force of the convention
29 Territorial application of the convention
30 Reservations
31 Denunciation
32 Depositaries and their functions
the financial account information to be exchanged, the financial
institutions & intermediaries that need to report, the different
types of accounts and taxpayers covered, as well as common due diligence
procedures to be followed by the financial institutions &
intermediaries. It consists of two components: (I) the CRS, which
contains the reporting and due diligence rules to be imposed on
financial institutions; and(II) the Model Competent Authority Agreement
[Model CAA], which contains the detailed rules on the exchange of
information.

The full version of the Standard, as approved by
the Council of the OECD on 15 July 2014, also includes the Commentaries
on the Model CAA and the CRS, and following seven annexes to the
Standard:

1. M ultilateral Model CAA;
2. N onreciprocal Model CAA;
3. CRS schema and user guide;
4. Example questionnaire with respect to confidentiality and data safeguards;
5. Wider Approach to the CRS;
6. Declaration on Automatic Exchange of Information in Tax Matters; and
7. Recommendation on the Standard.

j. Confidentiality of the Information Exchanged

The
Standard contains specific rules on the confidentiality of the
information exchanged and the underlying international legal exchange
instruments already contain safeguards in this regard.

  • Where the Standard is not met (whether in law or in practice), countries will not exchange information automatically.
  • To
    facilitate the decision making by Global Forum members as to which
    jurisdictions they will automatically exchange information with, the
    Global Forum AEOI Group is undertaking high level assessments of the
    confidentiality and data safeguards of jurisdictions committed to AEOI.
    Centralising this work in the Global Forum will further assist
    jurisdictions in speedily implementing AEOI, by reducing the need for
    each jurisdiction to conduct its own assessment of the information
    security practices of each of the many jurisdictions committed to
    implementing AEOI. The process is now underway with the first batch of
    around 50 assessments due to be finalised by the end of 2015 and the
    assessments with respect to the remaining committed jurisdictions due to
    be finalised by mid-2016.

k. Implementation of Standard at domestic level

  • No particular timelines in the Standard.
  • Implementation at co-ordinated timelines would bring benefits for both business and governments.
  • Over
    95 jurisdictions have already publicly committed to implement the
    Standard, either through the signing of the Multilateral Competent
    Authority Agreement, the G20 or the Global Forum commitment process,
    with first exchanges of information to occur in 2017 or 2018.

 l. Multilateral Competent Authority Agreement on Automatic Exchange of Financial Account Information [MCAA]

The Agreement contains 8 sections and 6 Annexes as follows:

Section Section heading
1 Definitions
2 Exchange of Information with respect to Reportable Accounts
3 Time and Manner of Exchange of Information
4 Collaboration on Compliance and Enforcement
5 Confidentiality and Data Safeguards
6 Consultations and Amendments
7 Term of Agreement
7 Co-ordinating Body Secretariat
Annex Annex heading
A List of Non-reciprocal Jurisdictions
B Transmission Methods
C Specified Data Safeguards
D Confidentiality Questionnaire
E Competent Authorities for which this is an Agreement in effect
F Intended Exchange Dates

4. EoI under IGA re FATCA

FATCA is a USA law which seeks
to facilitate flow of financial information. FAT CA requires Indian
banks to reveal account information of persons connected to the USA.
Indian financial institutions in India, i.e. an insurance company, bank,
or mutual fund, would be required to report all FAT CA-related
information to Indian governmental agencies, which would then report
these information to Internal Revenue Service (IRS). Indian Financial
Institutions must report account numbers, balances, names, addresses,
and U.S. identification numbers. There is punitive 30% withholding tax
on any financial institution that fails to report.

India signed a
Model 1 (reciprocal) IGA with the U.S which is notified vide
Notification No. 77/2015 dated 30- 9-2015. For effective implementation
of FAT CA, Rules 115G to 115H has been notified vide Notification no.
62/2015 dated 7-8-2015. The IGA would require Indian financial
institutions to report information on U.S. account holders to India’s
CBDT, which would then share the information with the U.S. IRS. The
agreement would provide the IRS, access to details of all offshore
accounts and assets beyond a threshold limit held by American citizens
in India, while a reciprocal arrangement would be offered for Indian tax
authorities as well.

a. Articles of India-USA IGA
The contents of the Agreement are as follows:

Article Article heading
1 Definitions
2 Obligations to obtain and Exchange Information with respect
to Reportable Accounts
3 Time and Manner of Exchange of Information
4 Application of FATCA to Indian Financial Institutions
5 Collaboration on Compliance and Enforcement
6 Mutual commitment to continue to enhance the effectiveness
of Information Exchange and Transparency
7 Consistency in the application of FATCA to Partner Jurisdictions
8 Consultations and Amendments
9 Annexes
10 Term of Agreement
Annex Annex heading
I Due Diligence obligations for identifying and reporting on U.S.
Reportable Accounts and on payments to certain nonparticipating
financial institutions
II List of Entities treated as exempt beneficial owners or
deemed-compliant FFIs and accounts excluded from the
definition of Financial Accounts

Memorandum of Understanding [MoU]
b. Main differences between the Standard and FATCA

  • The Standard consists of a fully reciprocal automatic exchange system from which US specificities have been removed.
  • It is based on residence and unlike FAT CA does not refer to citizenship.
  • Terms,
    concepts and approaches have been standardised allowing countries to
    use the system without having to negotiate individual annexes.
  • Unlike
    FAT CA, the Standard does not provide for thresholds for pre-existing
    individual accounts, but it includes a residence address test building
    on the EU Savings Directive.
  • It also provides for a simplified indicia search for such accounts.
  • It
    has special rules dealing with certain investment entities where they
    are based in jurisdictions that do not participate in automatic exchange
    under the Standard. 5. SAARC Limited Multilateral Agreement SAARC
    Limited Multilateral Agreement (SAARC Agreement) is a multilateral
    agreement amongst SAARC countries and has been in force since 1st April,
    2011. It has provisions for a wide range of administrative assistance
    including EoI on a reciprocal basis. SAARC comprises of 7 countries i.e.
    Bangladesh, Bhutan, India, Maldives, Nepal, Pakistan and Sri Lanka. The
    text of Article 5 of the SAARC Agreement, relating to EoI is given
    below for ready reference.

“Article 5 – Exchange of Information

1.
The Competent Authorities of the Member States shall exchange such
information, including documents and public documents or certified
copies thereof, as is necessary for carrying out the provisions of this
Agreement or of the domestic laws of the Member States concerning taxes
covered by this agreement insofar as the taxation thereunder is not
contrary to the Agreement. Any information received by a Member State
shall be treated as secret in the same manner as information obtained
under the domestic laws of that Member State and shall be disclosed only
to persons or authorities (including courts and administrative bodies)
concerned with the assessment or collection of, the enforcement or
prosecution in respect of, or the determination of appeals in relation
to the taxes covered by the agreement. Such persons or authorities shall
use the information only for such purposes. They may disclose the
information in public court proceedings or in judicial decisions.

2. In no case shall the provisions of paragraph 1 be construed so as to impose on a Member State the obligation:
(a)
to carry out administrative measures at variance with the laws and
administrative practices of that or of the other Member State;
(b)
to supply information, including documents and public documents or
certified copies thereof, which are not obtainable under the laws or in
the normal course of the administration of that or of the other Member
State;
(c) to supply information which would disclose any trade,
business, industrial, commercial or professional secret or trade
process, or information, the disclosure of which would be contrary to
public policy (ordre public).”

6. Mutual Legal Assistance Treaties [MLATs]

The MLAT s are legal instruments through which the Contracting States agree to provide each other with the

widest measures of mutual legal assistance in criminal
matters emanating out of proceedings under direct taxes
and not for other tax enquiries. India has a MLAT with 39
countries enabling assistance from countries with which
there is no tax treaty such as Hong Kong.

The scope of cooperation is different in various MLAT s
but is normally quite wide and may include the following:

  • Provision of information, documents and other records
  • Taking of evidence and obtaining of statements of
    persons
  • Location and identification of persons and objects Execution of requests for search and seizure
  • Measures to locate, restrain and forfeit the proceeds
    and instruments of crime
  • Facilitating the personal appearance of the persons
    giving evidence
  • Service of documents including judicial documents
  • Delivery of property, including lending of exhibits
  • Other assistance consistent with the objects of the
    MLAT which is not inconsistent with the law of the requested
    State (catch all provision).

7. The Egmont Group Financial Intelligence
Units (FIUs)

The Egmont Group is an informal network of FIUs established
with a view to have international cooperation
including information exchange in the fight against
money laundering and financing of terrorism. As on 1st
May, 2015, FIUs of 147 countries are part of the Egmont
Group. The FIUs of the Group exchange information in
accordance with Egmont Principles for Information Exchange
and Operational Guidance for FIUs, which is
available on the Internet.

The tax authorities may request information available
with FIUs of other countries through FIU-IND (the Indian
FIU) using the information exchange mechanism of the
Egmont Group.

MoU between FIU and CBDT

On 20th September, 2013, a Memorandum of Understanding
(MoU) was entered into between FIU and CBDT
in which it has been provided that if CBDT requires information
from a foreign FIU, a request will be made to
FIU-IND in Egmont prescribed proforma in electronic
format and CBDT shall abide by the conditions that may
be imposed by the foreign FIU on the use of information
provided by the foreign FIU.

Clause Clause heading
1 General
2 Exchange of Information
3 Data Protection and Confidentiality

8. Joint International Tax Shelter Information & Collaboration – JITSIC

The
original Joint International Tax Shelter Information Centre was created
in 2004 as a joint revenue authority initiative of Australia, Canada,
the United Kingdom and the United States to counter abusive tax schemes
and tax avoidance structures. Later on, Japan, Germany, South Korea,
France and China joined the JITSIC. The Competent Authorities of these
countries exchange information through the legal instrument of DTAA s
including sharing expertise relating to the identification and
understanding of abusive tax arrangements. Under the JITSIC framework,
the Competent Authorities are able to put the various international
pieces together to examine complex cross border transactions, such as
non-commercial capital and finance arrangements, aggressive transfer
pricing strategies and foreign tax credit generation schemes. Similarly,
structures involving tax havens and trust structures in connection with
high net wealth individuals also came under JITSIC scrutiny.

Recognising
that the information exchanges should not be limited to the original
JITSIC member countries, on a call from G20, the Forum on Tax
Administration A) of the OECD in its 9th Meeting in Dublin on 24th
October, 2014, determined that the composition of JITSIC would be
expanded and remodeled with a greater focus on collaboration. Reflecting
this change, the taskforce was renamed as the Joint International Tax
Shelter Information & Collaboration (still called JITSIC) with an
emphasis on collaboration on information exchange and a de-emphasis on
the need for exchange to occur through central hubs. The JITSIC Network
is open to all FTA members on a voluntary basis and integrates existing
JITSIC cooperation procedures among tax administrators within the larger
FTA network. India has joined the JITSIC Network and Joint Secretary
(FT&TR-I) has been appointed as the Single Point of Contact for
India.

9. EoI under BEPS Project

Base Erosion and
Profit Shifting refers to strategies adopted by taxpayers having
cross-border operations to exploit gaps and mismatches in tax rules of
different jurisdictions which enable them to shift profits outside the
jurisdiction where the economic activities giving rise to profits
areperformed and where value is created. At the request of G20 Finance
Ministers, in July 2013 the OECD, working with G20 countries, launched
an Action Plan on BEPS, identifying 15 specific actions needed in order
to equip governments with the domestic and international instruments to
address this challenge.

A number of recommendations for
combating BEPS envisage enhanced cooperation amongst the tax
administrations and exchange of information as per the provisions of the
existing network of tax treaties, including the following:

a. Automatic Exchange of Country by Country [CbC] Reports – Action 13

Action 13 of the BEPS Action Plan relates to a three-tiered standardised approach to transfer-pricing documentation comprising:

  • a master file of information relating to the global operations of the MNE Group, which will be filed by all MNE group members,
  • a local file referring specifically to material transactions of the local taxpayer, and
  • a
    CbC report of information relating to the global allocation of the MNE
    group’s income and taxes paid, alongwith certain indicators of economic
    activity. While the master file and local file will be filed by the
    taxpayer in the local jurisdiction, the CbC report will be filed in the
    country where the MNE is resident and will be transmitted on an
    automatic basis to the jurisdictions in which the MNE operates through a
    multilateral instrument modelled on the basis of MCAA, maintaining
    confidentiality and data safeguarding standards.

b. Spontaneous Exchange of Rulings – Action 5

Action
5 of the BEPS Project relates to countering harmful tax practices more
effectively taking into account transparency and substance. To address
this, the taxpayer specific rulings related to tax regimes resulting in
BEPS need to be mandatorily exchanged on a spontaneous basis.
Taxpayer-specific rulings for this purpose would include both
pre-transaction, including advance tax rulings or clearances and advance
pricing agreements, and post transaction.

c. Exchange of Mandatory Disclosure Regimes – Action 12 Under

Action
12, modular rules for mandatory disclosure of aggressive or abusive
transactions, arrangements, or structures would be recommended to enable
tax administrators to receive information about tax planning strategies
at an early stage so as to respond quickly to tax risks either through
timely and informed changes to legislation and regulations or through
improved risk assessment and compliance programmes (targeted audits).
Under these rules, the “international tax schemes” would also be
disclosed and the same may be shared by tax administrators using the
mechanism of EoI

This Article gives only a brief overview of the
framework of the Exchange of Information in Tax matters. The subject is
receiving increasing attention of the Governments and Tax
Administrations of various countries. It is very important for the
taxpayers & their advisors to gain an in-depth understanding of the
evolving subject. Therefore, the reader needs to study the relevant
Agreements / MOUs / Protocols / Standards in greater detail.

Digest of recent important foreign Supreme Court decisions on cross border taxation

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In this article, some of the recent important foreign Supreme Court decisions on cross border taxation are covered. In view of increasing globalisation, movement of Capital, Technology and Personnel, various issues arising in taxation of Cross Border Transactions are increasingly becoming similar. The various issues discussed in these Foreign Supreme Courts’ decisions have a global resonance due to common terminology used in Model Tax Conventions and various Double Tax Avoidance Agreements. These decisions represent useful accretion to the jurisprudence on the respective topics/issues. The compilers hope that these decisions would be useful in guiding taxpayers, tax advisors, Revenue Officials and the Judiciary when similar issues come up for consideration in the Indian context.

1. France – Treaty between France and India – French Administrative Supreme Court rules on tax sparing/ matching credit provisions

In a decision (No. 366680, SA Natixis) given on 25th February 2015, the French Administrative Supreme Court (Conseil d’Etat) ruled on the tax sparing/matching credit provisions of the France – India Income and Capital Tax Treaty (1992) (the Treaty). The Court ruled that, for a French resident receiving interest from India to benefit from a tax sparing/matching credit, such interest must either have been subject to taxation in India or exempted by virtue of the laws of India referred to in article 25(3)(c)(i) or article 25(3)(c)(ii) of the Treaty.

(a) Facts. The French-resident bank SA Natixis (formerly SA Natexis Banques Populaires) received interest income from residents of India in 1998 and 1999. This interest income was exempt from tax in India. The tax authorities granted a tax credit for this income. However, considering that the tax credit was not calculated in accordance with the Treaty provisions, the French bank filed a claim. The first-instance Tribunal (Tribunal administratif) rejected its claim.

Confirming the judgment from the first-instance Tribunal, the administrative court of appeal (Cour administrative d’appel) ruled that the tax sparing/matching credit provided for by the Treaty regarding interest shall be granted only where such interest income was subject to tax in India. Where the interest income was not subject to any tax in India, it shall not entitle the French resident to a tax sparing/ matching credit, except where an Indian tax might have been payable but was not levied on the basis of one of the laws of India referred to in article 25(3)(c)(i) or article 25(3) (c)(ii) of the Treaty.

Thus, the administrative court of appeal found that the French bank was not entitled to any tax sparing/matching credit as the French bank:
– neither proved that the Indian-source interest income was subject to Indian tax;
– nor proved that the Indian-source interest income was exempt from Indian tax by virtue of one of the laws of India referred to in the Treaty.

Thus, the court first applied the interpretation given by the French Administrative Supreme Court regarding matching credit provisions contained in the Brazil-France Tax Treaty and then took into account the exception provided for in the Treaty.

(b) Issue. Whether interest income that was fully exempt from tax in India entitle its French recipient to a tax sparing/ matching credit under article 25 of the Treaty?

(c) Decision. The French Administrative Supreme Court ruled that:
– in general, a French resident receiving interest from India may benefit from a tax credit only where such interest was subject to taxation in India; and
– as an exception, a French resident receiving interest from India that was exempt from Indian tax may still benefit from a tax credit where a Indian tax would have been payable but for a full exemption granted under one of the laws of India referred to in article 25 of the Treaty.

The French Administrative Supreme Court then noted that the French bank:
– neither proved that the Indian-source interest income was subject to Indian tax;
– nor proved that the Indian-source interest income was exempt from Indian tax under one of the laws of India referred to in article 25 of the Treaty, and specify the law in question.

The French Administrative Supreme Court therefore concluded that the bank, which bore the burden of proof, was not entitled to any tax sparing/matching credit, and dismissed its claim.

2. Japanese Supreme Court decision – Bermuda LPS is not a corporation

On 17th July 2015, the Japanese Supreme Court disallowed an application by the tax authorities to appeal a Tokyo High Court decision, in which a limited partnership (LPS) registered in Bermuda was held not to be a corporation for Japanese tax law purposes.

(a) Facts. The taxpayer (Tokyo Star Holdings LP) is an LPS based on Bermuda law (Partnership Act 1902 and Limited Partnership Act 1883). The taxpayer is also an exempted partnership (EPS) based on Bermuda law (Exempted Partnerships Act 1992), which is not subject to tax on income in Bermuda.

A Delaware LLC and two Cayman corporations entered into several silent/sleeping partnership agreements with the former as silent/sleeping partners (tokumei kumiaiin) and the latter as business operators (eigyousha). The Cayman corporations as eigyousha had branches in Japan and were in the business of collecting claims.

The Delaware LLC then sold the interests in the silent/ sleeping partnerships to an Irish corporation. The taxpayer and the Irish corporation (as tokumei kumiaiin) subsequently entered into a swap contract under which the business profits of the eigyousha were distributed to the tokumei kumiaiin and, in turn, to the taxpayer.

The Japanese tax authorities argued that the distribution received by the taxpayer from the tokumei kumiai constituted domestic source income under article 138(11) of the Japanese Corporate Tax Act (CTA ). The taxpayer argued that since, as a Bermuda LPS, it was not a corporation within the meaning of the CTA , it was not a taxable entity.

(b) Issue. The first issue was whether the taxpayer was a corporation for Japanese tax law purposes. If not, the second issue was whether the taxpayer was a “non-judicial association, etc.” (jinkaku no nai shadan tou) within the meaning of article 3 of the CTA , which provides that such an association is treated as a corporation.

(c) Decision. The Tokyo District Court, in its decision of 30th August 2012, case number Heisei 23 (2011) gyou-u No. 123, reported in Kinyû Shôji Hanrei 1405-30, ruled that the taxpayer was neither a corporation nor a “non-judicial association, etc.”, and that taxation of the taxpayer was not void but illegal.

The tax authorities appealed, but the Tokyo High Court, in its decision of 5th February 2014, case number Heisei 24 (2012) gyou-ko No. 345, reported in Kinyû Shôji Hanrei 1450-10, upheld the Tokyo District Court’s decision.

The Supreme Court did not allow the tax authorities’ further appeal of the respondent, whereupon the matter was finalised.

With respect to the first issue, article 36(1) of the Japanese Civil Code provides that “…, no establishment of a foreign juridical person shall be approved; provided, however, that, this shall not apply to any foreign juridical person which is approved pursuant to the provisions of a law or treaty.” The courts held that whether a business entity is considered a “foreign corporation” (a foreign judicial person under the Civil Code) is determined with reference to the relevant foreign law governing the corporate legal personality of the business entity in question. In this case, the courts held that Bermuda law did not provide the taxpayer with a corporate legal personality, so that the taxpayer was not a “foreign judicial person” under civil law; therefore, the taxpayer was also not a “foreign corporation” under the CTA.

For the second issue, the courts held that a “non-judicial association, etc.” (jinkaku no nai shadan tou) under the CTA was equivalent to an “association without capacity to hold rights” (kenri nouryoku naki shadan) under civil law, which had been defined by the Supreme Court decision of 15th October 1964, case number Shouwa 35 (1960) o No. 1029, reported in Minshû 18-8-1671. In the 1964 Supreme Court case, it was stated that an “association without capacity to hold rights” must have (1) an organisation as a body, (2) a decision by majority, (3) continuation of the body despite the change of the members, and (4) a defined rule concerning representation, operation of a general meeting, management of properties, etc. In this case, the courts held that the requirements of (1), (2) and (4) were not satisfied; therefore, the taxpayer was not a “non-judicial association, etc.” and was not subject to Japanese corporate tax.

In conclusion, the tax authorities erred in taxing the Bermuda LPS; instead, the partners of the LPS (being corporate entities) should have been subject to tax.

Note: The Supreme Court, in its decision of 17th July 2015 ruled that a Delaware LPS was a corporation. In that case, the Supreme Court applied a “second stage of determination” where the attribution of rights and duties was concerned. Although the attribution of rights and duties was argued by the tax authorities in this Bermuda LPS case, the Tokyo District Court and High Court explicitly rejected this in arriving at their decisions on 30th August 2012 and 5th February 2014, respectively. Since the Supreme Court, in disallowing the appeal, did not mention the second stage of determination, it is reasonable to assume that the Supreme Court would have found that the Bermuda LPS was not a corporation, even if the second stage of determination in the Delaware LPS case had been applied.

3.    Argentina – Supreme Court decision on application of substance-over-form principle and CFC rules

On 24th February 2015, the Supreme Court gave its decision in the case Malteria Pampa S.A. concerning the application of the substance-over-form principle (realidad económica) and controlled foreign company (CFC) rules. Specifically, the Court dealt with the difference between a foreign subsidiary and foreign permanent establishment (PE) of a resident company, and the timing of income taxation. Details of the case are summarised below:

(a)    Facts. Malteria Pampa, a resident company, had a wholly-owned subsidiary based in Uruguay. The tax authority reassessed the company’s tax returns for 2000 and 2001 to include the profits derived by the non-resident subsidiary. The subsidiary had not paid any dividend; however, the tax administration applied the substance-over-form principle in order to disregard its legal form and to treat it as a foreign PE of the resident company. The tax authority based its position on the resident company’s control of the non-resident subsidiary in the form of capital ownership, voting power and company board appointment power.

(b)    Legal Background. The CFC regime generally applies when a foreign subsidiary is a resident of a blacklisted jurisdiction and the passive income derived by that subsidiary is more than 50% of its total income.

The Income Tax Law (Ley de Impuesto a las Ganancias, LIG) contains detailed provisions distinguishing between a subsidiary and a PE by providing for a different tax treatment, i.e. article 69 of the LIG lists different taxable entities, explicitly stating PEs as taxable entities different from the subsidiaries. Articles 18, 128, 133, 148 of the LIG set out the timing for taxation of income accrued by PEs and subsidiaries, regulating situations where CFC rules apply.

(c)    Decision. The Court upheld the taxpayer’s position based on the application of the provisions of the LIG, rejecting the application of the substance-over-form principle. In particular, it underlined the relevance of the legal form and confirmed that income derived by a foreign subsidiary may be taxed in the hands of a resident only when dividends are paid, unless CFC rules are applicable.

4    Finland Supreme Administrative Court – Profits of foreign PEs included when calculating FTC although no tax was actually paid abroad

The Supreme Administrative Court of Finland (Korkein hallinto-oikeus, KHO) gave its decision on 31st October 2014 in the case of KHO:2014:159.

(a)    Facts. A company resident in Finland (FI Co) exercised its business activities in Finland and through permanent establishments (PEs) abroad, including PEs in Estonia (EE

PE) and the United Kingdom (UK PE). The PE profits, in general, were included in the taxable income of FI Co.
In addition, the PE profits were taxed in the country where they were located. However, UK PE did not have any taxable profits due to the losses from previous tax years which were set off against the profits. EE PE, on the other hand, did not pay any tax due to the Estonian tax system which does not tax undistributed profits.

(b)    Legal Background. Under Law on Elimination of International Double Taxation (Laki kansainvälisen kaksinkertaisen verotuksen poistamisesta), double taxation is eliminated by crediting the tax paid on the foreign income in the source country. The foreign tax credit (FTC) is limited to the amount of Finnish tax payable on the foreign-source income.

(c)    Issue. The issue was whether or not the PE profits from

EE PE and UK PE should be taken into account when calculating the maximum credit for the tax paid abroad.
(d)    Decision. The Supreme Administrative Court held that the PE profits of EE PE and UK PE are to be included in the profits of FI Co when calculating the maximum credit for the taxes paid abroad. The Court pointed out that, when calculating the base for the FTC, it is not required that tax has actually been paid for such income. What is essential is that the income is taxable in Finland and in its source country. The fact that the moment of taxation has been deferred, as in the case of EE PE, has no relevance.

5.    Norway – Supreme Court allows use of “secret comparables” in TP assessment

The Supreme Court of Norway (Norges Høyesterett) gave its decision on 27 March 2015 in the case of Total E&P Norge AS vs. Petroleum Tax Office (case 2014/498, reference number HR-2015-00699-A)

(a)    Facts. Between 2002 and 2007, the taxpayer Total E&P Norge AS (NO Parent) sold gas to 3 foreign related companies. The tax authorities regarded that the sales prices were not at arm’s length based on a comparison between the sales by NO Parent and similar transactions executed by third-party taxpayers (the Third-party Sales). The tax authorities refused to disclose details of the

Third-party Sales due to confidentiality rules. NO Parent appealed on the assessment.

(b)    Issue. The issue was whether the tax authorities could base their assessment on comparables which are not fully disclosed to the taxpayer.

(c)    Decision. The Court rejected the appeal and ruled that the tax assessment could be based on “secret comparables”. The use of secret comparables was deemed necessary to ensure an effective control of the transactions. Even though NO Parent was not given access to all the Third-party Sales used as comparables, NO Parent obtained enough information to have an adequate opportunity to defend its own position and to safeguard effective judicial control by the courts, as stated in the OECD Transfer Pricing Guidelines.

6.    France – Administrative Supreme Court rules that individual with French income only is resident of France

In a decision given on 17th June 2015 (No. 371412), the Administrative Supreme Court (Conseil d’Etat) ruled that an individual living outside France, but whose only income is a French-source pension has the centre of his economic interests in France. Such an individual is thus a resident of France under domestic law.

(a)    Facts. Mr. Georges B. is a French pensioner who lived in Cambodia from 1996 to 2007, working there as a volunteer for non-governmental organisations. His only income during these years was a French pension paid to a French bank account.

The pension was subject to withholding tax applicable to pensions paid to non-resident individuals. As the withholding tax was higher than the income tax that he would have paid as a resident, Mr. Georges B. claimed a tax refund. The tax authorities, however, considered that Mr. Georges B. could not be regarded as a resident of France and that the withholding tax was applicable to his case. The Court of First Instance (tribunal administratif) as well as the Administrative Court of Appeals (cour administrative d’appel) confirmed the tax authorities’ position. The Administrative Court of Appeals considered that the mere payment of a French pension to Mr Georges B. was not sufficient to retain the centre of his economic interests in France insofar as:

– the payment of the pension to a French bank account was merely a technical method chosen by the taxpayer himself;

– parts of the pension were transferred to Cambodia to cover the needs of Mr. Georges B. and his new family there;

– Mr. Georges B. administered his French bank account from Cambodia; and
– the pension was not a remuneration derived from an economic activity carried out in France.

(b)    Issue. Under article 4 B(1) of the General Tax Code (Code général des impôts, CGI), resident individuals are persons who:

– have their home or principal abode in France; or

– perform employment or independent services in France (unless such activity is only ancillary); or
– have the centre of their economic interests in France.

In this case, the issue was whether an individual living and working outside France but whose only income is a French-source pension has the centre of his economic interests in France.

(c)    Decision. The Administrative Supreme Court ruled that the elements on which the lower courts based their judgments did not prove that the centre of the economic interests of Mr. Georges B. shifted out of France. As his only income was French-sourced, Mr. Georges B. still had the centre of his economic interests in France between 1996 and 2007. Thus, Mr. Georges B. was a resident of France under domestic law.

The French Administrative Supreme Court thus confirmed that the centre of the economic interests of an individual must be assessed mainly with regard to his income, irrespective of the exercise of an economic activity.

Note: Cambodia and France did not conclude a tax treaty.

Consequently, only domestic law was applicable.

7.    Netherlands Supreme Court – business motive test also applies to external acquisitions

On 5th June 2015, the Netherlands Supreme Court (Hoge Raad der Nederlanden) (the Court) gave its decision in the case of X1 BV and X2 BV v. the tax administration.

(a)    Facts. Two Dutch resident companies (X1 BV and X2 BV) were part of a South African Media group. In 2007, the listed parent company of the group issued shares. Thereafter, the parent company lent part of the proceeds from the share issue to its subsidiary, which was a South African resident holding company. This holding company subsequently contributed the funds to a holding company located in Mauritius. The Mauritius-based holding company then lent the funds to the financing company of the group, which was also resident in Mauritius.

In 2007, the two Dutch resident companies acquired several participations. Those acquisitions were partially financed by funds received from the Mauritian finance company. Those funds originated from the issue of shares by the parent company of the group.

Due to the financing structure, the Dutch resident companies took on a related party debt for financing the acquisition of the participations.

Reasoning that both the acquisitions and the loans were based on commercial reasons, the companies claimed a deduction of interest paid to the Mauritius finance company.

(b)    Issue. The issue was whether the interest on the related party debt was deductible.

(c)    Decision. The Court began by observing that article 10a of the Corporate Income Tax Act (CITA) limits the deduction of interest on funds borrowed from another group company. This restriction, inter alia, applies in the case of funds borrowed for the acquisition of shares in a company. Thereafter, the Court emphasised that it is for the taxpayer to prove that a decision to borrow funds from a related party to finance acquisitions of participations is predominantly motivated by commercial reasons.

However, in this context the Court decided that not only the taxpayer’s motives are decisive, but that the reasons of all parties involved in a transaction must be taken into account for the determination of whether the business purpose test is met.

Consequently, an interest deduction cannot be justified with the argument that there was no alternative than to accept a loan offer from a related party.

Thereafter, the Court repeated its consistent case law that a parent company can freely decide to fund its subsidiaries with debt or equity. This rule implies that the Dutch legislator has to accept a direct funding through a low-taxed group finance company.

The Court rejected the taxpayer’s argument that both the loan and the acquisitions were predominantly based on commercial reasons. In this context, the Court held that a reference to case law based on the abuse of law doctrine was irrelevant in the case at hand, because this case law is not relevant for the application of the Dutch base erosion rules.

The Court also rejected the reasoning of the taxpayers which was based on legislative history. The taxpayers indicated that the obtaining of a related party debt was based on commercial reasons because debt arose from the issuance of shares. Furthermore, the proceeds from the share issue were not received from the finance company to obtain a specific acquisition but only to obtain acquisitions in general. The Court judged that the moment when a taxpayer decides to purchase a specific acquisition is not decisive for the determination of whether a borrowed loan from a third party is based on commercial reasons.

Due to the fact that it was not shown that all transactions involved in the transaction were based on commercial reasons, the Court denied the interest deduction. In addition, the case was referred to another lower court to determine if funds provided by the Mauritius company to the financing company of the group determined whether the construction was based on commercial reasons.

Note: The importance of the case is that the Court has clarified that a re-routing outside the Netherlands must be based on business motives to claim an interest deduction. In addition, the Court, however, decided that the interest deduction restriction of article 10a CITA does not always apply when an acquisition is financed with an intra-group loan based on tax motives, if the taxpayer shows that business motives exist.

8.    Japanese Supreme Court decision – Delaware LPS is a corporation

The Japanese Supreme Court held in its decision dated 17th July 2015, case number Heisei 25 (2013) gyou-hi No.166, that a Delaware limited partnership (LPS) is, for Japanese tax purposes, a corporation.

(a)    Facts. The plaintiffs (Japanese resident individuals) participated in a LPS pursuant to the Delaware Revised Uniform Limited Partnership Act (hereafter, DRULPA). The LPS invested in the leasing of used collective housing in the US states of California and Florida, which incurred losses. The plaintiffs filed their individual income tax returns treating the LPS as transparent and taking the losses arising into account when reporting their taxable income as per article 26 of the Income-tax Act (ITA).

The Japanese tax authorities, however, argued that the LPS was in fact a corporation (and opaque) and therefore the losses did not belong to partners, but to the corporation.

(b)    Issue. The issue was whether the Delaware LPS was a corporation.

(c)    Decision. The Supreme Court overturned the Nagoya High Court’s decision on 24th January 2013 (case number Heisei 24 (2012) No. 8) which had ruled in favour of the taxpayers.

Instead, the Supreme Court held that article 2(1)(7) of the ITA defines a “foreign corporation” as “a corporation that is not a domestic corporation”, but does not go on to define a “corporation”. Therefore, whether or not a foreign entity is a “corporation” (houjin) is based on whether it would be considered a “corporation” in Japanese law.

There are two stages to this. Firstly, it is scrutinised whether the wordings or mechanics of the incorporating law explicitly (meihakuni) gives, without question, legal status to the entity as a corporation or explicitly does not give it. If it is neither, then, at the second stage, it is scrutinised whether the entity is a subject to which rights and duties attribute.

In this case, at the first stage, DRULPA uses the wordings of “separate legal entity”, but it is not clear whether a “legal entity” in Delaware constitutes a “corporation” in Japan.
 

Additionally, the General Corporation Law of the State of Delaware uses “a body corporate” to mean a “corporation” in Delaware. Therefore it is not explicitly clear whether a “separate legal entity” in Delaware has the same legal status as a “corporation” in Japan.

At the second stage of determination, it is clear that the LPS is a subject to which rights and duties attribute. The partners of the LPS only have abstract rights on whole assets of the LPS, they do not have concrete interests on the respective goods or rights belonging to the LPS.

Therefore, the losses in the leasing business did not belong to Japanese partners. Stating that an LPS in the USA was generally treated as transparent, it remains to be seen by the Nagoya High Court if the taxpayers had “justifiable grounds” in understating their income. Article 65(4) of the Act on General Rules for National Taxes provides that additional tax for understatement will not be charged if a taxpayer has justifiably understated his taxable income.

9.    Italy – Supreme Court rules on application of transfer pricing rules to interest-free loans between related companies

The Italian Supreme Court (Corte di Cassazione) gave its Decision No. 27087 of 19 December 2014 (recently published) on the application of transfer pricing rules to interest-free loans between related companies.

An Italian company granted an interest-free loan to its Luxembourg and US subsidiaries in order to optimise the available resources and maintain the market share. The Italian Tax Authorities (ITA) reassessed and included in the corporate income tax basis of the Italian company interest income calculated at the normal value, on the basis of article 110(7) of Presidential Decree No. 917 of 22nd December 1986. Precisely, the ITA defined the Italian company’s choice to grant an interest-free loan as “abnormal” and claimed that, by obtaining the interest–free loan, the non-resident subsidiaries were in a more favourable position compared to other companies operating in the open market.

The Supreme Court noted that the Italian company’s choice to grant an interest-free loan to its non-resident subsidiaries was aimed at addressing their temporary economic needs and, therefore, it did not constitute an unlawful or elusive conduct. Furthermore, the Supreme Court held that article 110(7) of Presidential Decree No. 917 of 22nd December 1986 does not provide for the absolute presumption that any cross-border transaction with related parties must be onerous, but only provides for the valuation of components of income deriving from onerous cross-border transactions, on the basis of the normal value (article 9(3) of Presidential Decree No. 917 of 22nd December 1986) of the goods transferred, services rendered, and services and goods received.

10.    Brazil Supreme Federal Court confirms income tax on accumulated income calculated on accrual basis

On 23rd October 2014, the Supreme Federal Court (Supremo Tribunal Federal, STF) confirmed that the income tax levied on accumulated income received at a later stage as a lump-sum payment (rendimento recebidos acumuladamente) must be calculated on an accrual basis (regime de competência) and not on a cash basis (regime de caixa). The STF gave its position in Appeal 614406 (Recurso Extraordinário 614406), lodged by the tax authorities against a decision given by the lower court in favour of the taxpayer.

Since the STF recognised the “general repercussion” (repercussão geral) of the case (see Note), the decision will have an impact on more than 9,000 similar cases currently examined in lower courts.

(a)    Background. The National Institute of Social Security (Instituto Nacional de Seguridade Social, INSS) paid a debt it owed to a taxpayer as a lump-sum payment. Tax authorities calculated the income tax due on a cash basis, i.e. on the basis of the accumulated income (i.e. the lump-sum payment) and according to tax brackets and rates applicable at the moment of the payment. The taxpayer requested the calculation he would have been entitled to if the amounts had been correctly paid by the INSS, that is, on an accrual basis. Accordingly, the income tax due would be calculated on the basis of monthly instalments and according to the tax brackets and rates applicable at each month.

(b)    Decision. The STF stated that the income tax must be calculated according to the rules existing at the time the income should have been paid. As a result, income tax must be levied on the amount that was due per month and according to the tax brackets and rates applicable at each respective month. The Court stated that the levy of the income tax on the accumulated income would be contrary to the ability to pay and proportionality principles.

Note: The STF may recognise the “general repercussion” (repercussão geral) in cases of high legal, political, social or economic relevance. Once “general repercussion” is recognized in a case, the decision given by the STF on the matter must be subsequently applied by lower courts in similar cases. The purpose of the “general repercussion” procedure is to reduce the number of appeals lodged at the STF.

11.    Belgium – Supreme Court – Principles of good governance and fair trial govern admissibility in court of illegally obtained evidence


On 22nd May 2015, the Supreme Court (Hof van Cassatie/ Cour de Cassation) rendered a decision (No. F.13.0077N)    in respect of the Issue whether and under which circumstances illegally obtained evidence in matters of taxation is admissible in court.

(a)    Facts. The Special Tax Inspectorate requested from the Portuguese VAT authorities information concerning certain intra-Community supplies of goods to Portugal and Luxembourg. The information was used to levy VAT, penalties and late interest payments because the information revealed that the goods were not transported to and thus delivered in Portugal and Luxembourg.

The tax payers challenged the levies and argued that the information was obtained illegally.

(b)    Legal Background. The information request was based on article 81bis of the Belgian VAT Code and the Mutual Assistance Directive [for the exchange of information] (77/799) (now Mutual Assistance Directive

[on administrative cooperation in the field of taxation]

(2011/16)). Both Directives deal with the mutual assistance by the competent authorities of the Member States in the field of direct taxation and taxation of insurance premiums.

In Belgium, however, the expression “competent authority” means the Minister of Finance or an authorised representative, which is the Central Unit for international administrative cooperation, and not the Special Tax Inspectorate, merely acting in this case on the basis of an internal circular concerning the Netherlands.

Before the Court of Appeal, the taxpayers repeated their argument that illegally obtained information cannot be used. Any unlawful action by the tax authorities should be considered a breach of the principles of good governance and fair trial, leading to the nullification of the assessment.

(c)    Decision. The Supreme Court confirmed the decision of the Court of Appeal. Belgian tax legislation does not contain any specific provision prohibiting the use of illegally obtained evidence in determining a tax debt, a tax increase or a penalty.

The principles of good governance and the right to a fair trial indeed govern the question whether illegally obtained evidence should be disallowed or is admissible in court. Unless the legislator has provided for specific sanctions, illegally obtained evidence in tax matters can, however, only be disallowed if the evidence is obtained in a manner contrary to what may be expected from a properly acting government. As a result, the use of such evidence is in all circumstances deemed unacceptable, particularly if it jeopardises a taxpayer’s right to fair trial.

While assessing this issue, the Court may take into account one or more of the following circumstances: the purely formal nature of the irregularity, its impact on the right or freedom protected by the norm, whether the committed irregularity was intentional by nature and whether the gravity of the infringement by the taxpayer far exceeds the illegality committed by the tax authorities.

Note: This decision, which has received some strong criticism from tax lawyers and advisers, is fully in line with the “prosecution-friendly” Antigoon case law in criminal matters since the decision of the Supreme Court of 14th October 2003, as converted into law on 24th October 2013. Since then, the inadmissibility of illegally obtained evidence has no longer been an automatic sanction in criminal matters. Neither the Belgian Constitutional Court nor the European Court on Human Rights (ECHR) has considered the case law of the Supreme Court in criminal matters to be in conflict with the European Convention on Human Rights.

Some commentators state that, notwithstanding the fact that there are certain limits the tax authorities must respect, it is clear that this judgment will give them less incentive to follow the rules and procedures, thereby decreasing legal certainty. Others, however, feel that, on the contrary, pursuant to this decision, lower courts must determine whether the principles of good governance and the right to fair trial were respected by the tax authorities while collecting the evidence, providing the taxpayer with additional defences.

12.    Canada – United Kingdom Treaty – Supreme Court of Canada denies Conrad Black’s leave to appeal

Conrad Black made an application for leave to appeal the decision of the Federal Court of Appeal upholding an earlier decision of the Tax Court of Canada. No reasons were given. The earlier Tax Court decision held that Black was deemed to be a resident of the United Kingdom under the Canada-United Kingdom Income Tax Treaty (1978) but was also a Canadian resident subject to tax.

Treaty between Canada and UK – Tax Court of Canada decides that individual resident in Canada and the United Kingdom, but not liable to UK tax, is subject to tax in Canada

The Applicant, Conrad Black, made an application for the determination of a question of law u/s. 58 of the Tax Court of Canada Rules (General Procedure) prior to the hearing of his case.

(a) Issue. The issue was:

– whether or not article 4(2) of the Canada – United Kingdom Income Tax Treaty (1978) (the Treaty), which deemed Black (according to the tie-breaker rule) to be a resident of the United Kingdom for the purposes of the Treaty overrides the provisions of the Canadian Income-tax Act so as to prevent the applicant from being assessed under the Canadian Income-tax Act on certain amounts as a resident of Canada; and

– whether or not article 27(2) of the Treaty allows for the assessment of such tax as a resident of Canada on any assessed items.

(b)    Facts. Black was assessed tax, as a resident of Canada, on certain items of income received by virtue of an office or employment. From 1992 onwards, he was also a resident of the United Kingdom. By virtue of article 4(2) of the Treaty, he was a deemed resident of the United Kingdom, however, he was not domiciled in the United Kingdom and, therefore, was only subject to tax in the United Kingdom on a remittance basis. The amounts at issue were never remitted and, therefore, not subject to tax in the United Kingdom. If Canada were not able to tax him on the income at issue, a situation of double non-taxation would arise.

(c)    Decision. The Tax Court adopted a liberal and purposive approach to interpreting the Treaty. Based on this approach, it found that there is no inconsistency between finding that a taxpayer is a resident of the United Kingdom for the purpose of the Treaty and a resident of Canada for the purpose of the Canadian Income Tax Act. Whether someone is a resident of Canada for the purposes of the Income-tax Act is a question of fact. Further, the Commentaries on the OECD Model provide that treaties do not normally concern themselves with the domestic laws of the contracting states that determine residency. Where a treaty gives preference to one state, deeming the taxpayer to be a non-resident of the second state, it is only for the purpose of the distributive rules in the treaty and thus the taxpayer continues to be generally subject to the taxation and procedural provisions of his state of secondary residence that apply to all other taxpayers who are residents thereof. The Court noted that there is no objective provision of the Treaty that being a resident of Canada would contravene, as the assessment of tax in Canada would not give rise to double taxation, which the purpose of treaties is to prevent, given that the amounts were never remitted to the United Kingdom or taxed therein. Therefore, the Court found that Black could be taxed as a resident of Canada on the income at issue.

Further, under article 27(2) of the Treaty, when a person is relieved from tax in Canada on income and, under UK law, that person is subject to tax on a remittance basis only, Canada will relieve that person from tax only in respect of income that is remitted to or received in the United Kingdom. The tax authorities argued that since no income was remitted to the United Kingdom, Canada is not required to relieve the Applicant from taxation in Canada. The Applicant, however, argued, inter alia, that this provision only relates to income that is sourced in Canada. Some of the income was sourced in third countries. The Court found that there was no basis to read words such as “arising in Canada” into the provision and, therefore, even if the Court was incorrect on the first issue, Black would still be taxable on the income at issue under article 27(2) of the Treaty.

[Acknowledgment/Source: We have compiled the above summary of decisions from the Tax News Service of the IBFD for the period August, 2014 to September, 2015]

Automatic Exchange of Information

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Every country in the world is concerned about its tax base. The Organization of Economic Development (OECD) has drawn comprehensive action plan to address the issue of the Base Erosion and Profit Shifting (BEPS) which has been endorsed by G20 leaders and their finance ministers at their summit held in St. Petersburg in September 2013. Exchange of Information is the key to prevent erosion of the tax base.

The Foreign Account Tax Compliance Act (FATCA) was enacted by the Government of the United States in 2010, to combat offshore tax evasion and for detecting tax noncompliance by US individuals and US owned entities having foreign financial accounts and offshore assets. On July 9, 2015, India signed an Inter-Governmental Agreement (IGA) with the US to implement FATCA and improve tax compliance. This IGA obliges qualifying financial institutions (QFIs) in India to report about the financial accounts held by US persons in India to the Indian competent authority who in turn shall share the information with the US IRS. The agreement is reciprocal in nature i.e. US IRS is also obliged to provide India with information regarding accounts/assets held by Indian persons in the US.

On the other hand, OECD along with G-20 countries, on similar lines as FATCA, has developed a Standard for automatic exchange of Financial Account Information, Common Reporting Standard (CRS).

An attempt is made in this article to highlight the need, manner and impact of exchange of information under various types of agreements/frameworks.
1. Introduction

1.1 Article on Exchange of Information under a Tax Treaty

Exchange of Information between two jurisdictions can be made in several ways. Article 26 of the United Nations Model Convention (UNMC) and the OECD MC deal with provisions relating to the Exchange of Information (EOI). Almost all comprehensive tax treaties signed by India contain Article on Exchange of Information whereby Tax Authorities in India can obtain information about specific query from its counterpart in the other contracting State.

1.2 Tax Information Exchange Agreement (TI EA)

Countries (especially Tax Havens) with which India does not have a full-fledged tax treaty, an agreement to share information known as “Tax Information Exchange Agreement” (TIEA) has been entered into by India with 15 countries including Saint Kitts and Nevis, Bahamas, Bermuda, Liechtenstein, Gibraltar, British Virgin Islands, Isle of Man, Cayman Islands, Jersey, Macau, Liberia, Argentina, Guernsey and Monaco, San Marino.

The nature and type of information that can be requested under the TIEA include identity and ownership information, accounting information and banking information among other things.

Under a TIEA, the Contracting States are not required to provide administrative assistance and exchange information in cases of “fishing expedition”, i.e. speculative requests that have no apparent nexus to the inquiry or investigation in the requesting State. Thus, the information about all Indians having bank accounts in a particular country cannot be requested as it would amount to a fishing expedition.

1.3 Limitations of EOI under a Treaty and TIEA

Exchange of Information, both under a Tax Treaty or a TIEA has a major limitation and i.e. these instruments cannot be used for fishing expedition. In other words, information in respect of a specific person or case/ matter can only be obtained under these agreements. Therefore, perhaps a need was felt by India for more comprehensive and a broad framework whereby information flows continuously on an automated basis and that too in respect of all overseas transactions by residents/tax payers in India to unearth illicit deals or black money stashed abroad. In the above background, automatic exchange of information under FAT CA and Multilateral Agreement under the framework of CRS by OECD would prove to be crucial sources of information to Indian Revenue Authorities.

Let us deal with both these frameworks in some more detail.

2.0 Foreign Account Tax Compliance Act (FATCA)

2.1 Manner of Reporting under FATCA

The FATCA guidelines specify two types of Inter Governmental Agreements (IGA) that countries are expected to enter into with the US – Model 1 and Model 2. Under the Model 1 IGA, all foreign financial institutions (FFI) in the participant country (for instance, an insurance company or a bank operating in India) would be obliged to report all FAT CA related information to its specified competent authority (which, in India is the Central Board of Direct Taxes), who would then report this information to the US authorities. Under the Model 2 IGA, all foreign financial institutions are required to report information directly to IRS.

In each of such models, the foreign financial institutions will need to get itself registered with the IRS. However, in case of Model 2 IGA, these financial institutions will also need to sign an FFI agreement with the IRS. Switzerland is one such country that has adopted Model 2 IGA. India has executed the Model 1 IGA. As a result, qualifying Indian institutions need not sign an FFI agreement, but will have to register on the FAT CA Registration Portal or file Form 8957 of the IRS and obtain a Global Intermediary Identification Number.

Basic framework of IGA signed by India

(For further information on FATCA, you may refer to an article by CA. Sunil Kothare published in March 2015 issue of BCAJ) 2.2 I nformation reporting and disclosure under the IGA by Qualifying Financial Institutions (QFIs) in India As per the IGA, all financial accounts with QFIs in India such as banks accounts, investment in mutual funds or hedge funds, insurance policies etc. come under the purview of reporting under FAT CA. However, there are certain accounts which are not required to be reported by the QFIs to the Indian Competent Authority and in turn to the US IRS under FAT CA. They are as follows: ? List of Accounts exempt from reporting under FATCA A. C ertain Savings Accounts i. N on-Retirement Savings Accounts established in India under the Senior Citizens Saving Scheme of 2004 to provide Indian senior citizens savings and deposit accounts. ii. Retirement and Pension Account maintained in India that satisfies the following conditions: – T he account is subject to regulation as a personal retirement account or is part of a registered or regulated retirement or pension plan for the provision of retirement or pension benefits (including disability or death benefits); or is subject to regulation as a savings vehicle for purposes other than for retirement as the case may be;
– The account is tax-favored (i.e. contributions to the account that would otherwise be subject to tax under the laws of India are deductible or excluded from the gross income of the account holder or taxed at a reduced rate, or taxation of investment income from the account is deferred or taxed at a reduced rate);
– Annual information reporting is required to the tax authorities in India with respect to the account;
– Withdrawals are permitted only on reaching a specified retirement age, disability, or death, or on specific criteria related to the purpose of the savings account or penalties apply to withdrawals made before such specified events; and
– Either Annual contributions are limited to $50,000 or less or there is a maximum lifetime contribution limit to the account of $1,000,000 or less.

iii. Non-Retirement Savings Account that is maintained in India (other than an insurance or Annuity Contract) and satisfies following conditions:

– The account is subject to regulation as a savings vehicle for purposes other than for retirement;
–    The account is tax-favored (i.e., contributions to the account that would otherwise be subject to tax under the laws of India are deductible or excluded from the gross income of the account holder or taxed at a reduced rate, or taxation of investment income from the account is deferred or taxed at a reduced rate);

–    Withdrawals are permitted on meeting specific criteria related to the purpose of the savings account (for example, the provision of educational or medical benefits), or penalties apply to withdrawals made before such criteria are met; and

–    Annual contributions are limited to $50,000 or less and subject to certain rules laid down.

B.    Term Life Insurance Contracts satisfying the following conditions:

–    Maintained in India with a coverage period that will end before the insured individual attains age 90;
–    On which periodic premiums are paid which do not decrease over time and are payable at least annually during the period the contract is in existence or until the insured attains age 90, whichever is shorter;
 

–    The contract has no contract value that any person can access (by withdrawal, loan, or otherwise) without terminating the contract and is not held by a transferee for value.

C.    Account maintained in India, and is held solely by an estate if the documentation for such account includes a copy of the deceased’s will or death certificate.

D.    Escrow Accounts maintained in India established in connection with any of the following:

–    A court order or judgment;

–    For a sale, exchange, or lease of real or personal property subject to fulfillment of certain conditions;
–    An obligation of a Financial Institution servicing a loan secured by real property to set aside a portion of a payment solely to facilitate the payment of taxes or insurance related to the real property at a later time;

–    An obligation of a Financial Institution solely to facilitate the payment of taxes at a later time.

E.    Partner Jurisdiction Accounts

It refers to an account maintained in India and which is excluded from the definition of Financial Account under an agreement between the United States and another Partner Jurisdiction1 to facilitate the implementation of FATCA. However, such account should be subject to the same requirements and oversight under the laws of such other Partner Jurisdiction as if such account were established in that Partner Jurisdiction and maintained by a Partner Jurisdiction Financial Institution in that Partner Jurisdiction.

2.3 Due Diligence thresholds in case of new and pre existing accounts

FATCA requires full compliance by QFIs in India for “new accounts” (i.e. accounts opened after 30th June, 2014) as well as “pre-existing accounts” (i.e. accounts existing as on 30th June, 2014). This involves review, identification and reporting of relevant financial accounts. However, certain exemption thresholds are laid down by virtue of which no review or reporting of such accounts is required.

Account
balance

FATCA
compliance

USD 50,000 or less as at the end

Out of scope for FATCA, only in

of the
calendar year date

case of
Cash Value Insurance

 

contract

PRE-EXISTING
ACCOUNTS

 

Account
balance

FATCA
compliance

(as
of 30th June, 2014)

 

 

USD 50,000 or less

Out of scope for FATCA

USD 250,000 or less

Out of scope for FATCA, only in

 

case of
Cash Value Insurance

 

contract or an Annuity Contract

> USD
50,000 (USD 250,000 for

–   Referred as ‘Lower value

a Cash
Value Insurance Contract

 

account’

or
Annuity Contract) up to USD

–

Review of
electronically

1,000,000

 

searchable
data required by

 

 

the
reporting Indian financial

 

 

institution for US Indicia2

> USD 1,000,000

–

Review of electronically

 

 

searchable
data required by

 

 

the
reporting Indian financial

 

 

institution
for US Indicia,

 

–   If the electronic databases

 

 

do not
capture all of the

 

 

requisite
information, then

 

 

paper
record search

 

–   findings of the relationship

 

 

manager (if applicable).

2.4    Impact of the IGA signed by India

2.4.1 Impact on US Citizens and Green card Holders living in India

Starting calendar year 2011, FATCA has subjected all US persons to report on Form 8938 their Bank, investment and brokerage accounts as well as other specified financial assets including but not limited to cash value of life insurance contracts and accumulation in certain retirement plans. Reporting of global income on US income tax return, including income earned in India, has undoubtedly been an important legal obligation of all US persons living in India. This is in addition to the long-standing requirement for US persons in India to report their bank accounts on Form TD 90.22-1 i.e. “Report of Foreign Bank and Financial Accounts (FBAR)”.

(For further information on FBAR, the reader may refer to Q.14 of our Article published in this column in April 2015 issue of BCAJ)

FATCA will have a direct impact on the US Citizens and green card holders who qualify to be US persons. Such persons may be holding accounts with QFIs in India which shall now be reported to the Indian Competent Authority and in turn to the US IRS. It may happen that they have not reported/ disclosed such accounts to the IRS and as a consequence of such reporting, they are exposed to heavy financial penalties and even criminal prosecution under the US tax laws. Such individuals may however opt to disclose the said accounts under the 2014 Offshore Voluntary Disclosure Program (OVDP) to avoid prosecution and limit their exposure to civil penalties.

2.4.2 Impact on Indian residents

With the Black Money Law now in force, the IGA signed by Government of India can further have adverse implications for the Indian resident taxpayers who are holding undisclosed assets in the US. The reciprocal nature of the IGA will oblige US to provide India with information regarding accounts/assets held by Indian persons in the US and which may happen to be undisclosed to the authorities in India.

Such information will provide more teeth not only to the Indian tax authorities but also to the RBI for detecting assets held by Indian residents/ taxpayers in the US.

2.4.3 Impact on Financial Institutions in India

The Inter-Governmental Agreement between India and US is based on Model-1 of FATCA guideline. Hence, the QFIs in India need not report directly to the IRS.

The IGA would result into following implications for FIs in India:

  •     QFIs in India need to upgrade and expand their existing ‘Know Your Customer’ (KYC) procedures to identify US persons and impose additional reporting requirements on them;

  •    Banks and other financial bodies may also need to get waivers from account holders to report information collected from them to the Indian competent authority;

  •   Section 285BA of the Income-tax Act 1961 has been amended so as to serve as a broad enabling provision for reporting by QFIs in India for the purposes of tax information regimes such as FATCA. However, due to confidentiality clauses under different laws in India, appropriate regulations may need to be introduced which will enable and empower qualifying Indian institutions to comply with FATCA requirements and to mandate the US account holders to provide the requisite information.

  •   Both FATCA and CRS require Indian financial institutions to make changes to their systems, processes and documentation to capture information for identification of account-holders and for reporting to the Indian government. This is an uphill task involving manpower training, system changes, changes to new client on-boarding, remediation of pre-existing account-holders, classification of entity accounts as per FATCA taxonomy, etc., which have an attached cost.

  •     Non-compliant FIs would be liable to a penal withholding tax of 30 per cent of their US sourced income.

3.0    Multilateral Automatic Exchange Of Financial Account Information

The Organization of Economic Development (OECD) along with G-20 countries, on similar lines as FATCA model 1 IGA, has developed a framework for multilateral automatic exchange of financial account information, known as Common Reporting Standard (CRS). CRS sets out a standard basis for automatic financial account information exchange between member countries.

As of 4th June 2015, 61 countries are signatories to the Multilateral Competent Authority Agreement (MCAA) committed to reciprocal tax information exchange. India is an early adopter and agreed for the implementation of CRS by January 1, 2016. India signed the MCAA AEOI CRS on 3rd June 2015. Compliance with CRS becomes mandatory from 1st January 2016.

More than 50 countries of the world have committed to exchange tax information on an automatic basis with effect from 2017 which includes notable tax havens and many developed nations as well. Some of the notable jurisdictions include Barbados, British Virgin Islands, Cayman Islands, Cyprus, Gibraltar, Guernsey, Isle of Man, Jersey, Liechtenstein, Luxembourg, Malta, Bahamas, UAE, Andorra, Bahrain, Panama, Cook Islands, Mauritius, UK, France, Germany and host of other countries including India.

4.0    Summation

Automatic Exchange of Information between US and India would hopefully start flowing from 1st October 2015 under FATCA. Information from more than 50 countries including notable tax haven would start flowing to India from 1st January 2016. Under the scenario, Indian tax officials will be better equipped to tackle the menace of Black Money and illicit/unreported transactions. Unprecedented powers are given to the Tax Administration under the Black Money (Undisclosed Foreign Income & Assets) and Imposition of Tax Act, 2015. There is a fear amongst citizens about misuse of powers without corresponding accountability on the part of the tax officials. It is high time that Government bring about Tax Administration Reforms as per the recommendations by the Parthasarthi Shome Committee’s Report.

Issues in Claiming Foreign Tax Credit in India

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Getting credit in respect of tax deducted or paid in a Source Country
(Foreign Tax Credit) is one of the significant objectives of any tax
treaty as it relieves incidence of double taxation. Normally, tax credit
is given by the State of Residence which enjoys the comprehensive right
of taxation. Such credit is given in respect of taxes paid by the tax
payer in the State of Source. However, several issues arise while
claiming tax credits in the State of Residence as to timing difference,
evidence of payment, rate of conversion of foreign currency etc. This
article besides discussing some basic concepts of Tax Credits focuses on
such issues relating to claiming foreign tax credits in India.

1. Background on BEPS

Two
methods of granting foreign tax credits are in vogue, namely, (i) Full
Credit and (ii) Ordinary Credit. Indian tax treaties generally follow
the Ordinary Credit Method. Similarly, section 91 of the Income-tax Act,
1961 (“Act”) also prescribes ordinary tax credit method. Two methods of
tax credit are explained in brief herein below:

(i) Full Credit Method

Under
this method, total tax paid in the country of source is allowed as
credit against the tax payable in the country of residence.

(ii) Ordinary Credit Method

Taxes
paid in the country of source are allowed as credit by the country of
residence only to the extent of the incremental tax liability due to
inclusion of such income. If taxes paid in country of source are higher,
the tax payer would not get the refund of such taxes. However, if the
taxes paid in the country of source are lower than the incremental tax
liability in the country of residence then the tax payer need to pay the
balance amount of taxes.

Example:
A Ltd (Indian company)
has the following income:- Income from India – Rs. 200,000/- [Tax rate –
30%] Income from foreign country – Rs. 50,000/- [Tax rate – 40%]

Total Income Taxable (India) – Rs. 2,50,000/-

Besides
the above two methods, Indian tax treaties provide two more types of
tax credit methods, namely, (i) Tax Sparing and (ii) Underlying Tax
Credit. The same are explained as follows:

(i) Tax Sparing

State of residence allows credit for deemed tax paid on income which is otherwise exempt from tax in the state of source.

(ii) Underlying Tax Credit

This
is a method which helps in eliminating economic double taxation
(example: – Dividend income). Under this method, the country of
residence grants credit not only for taxes paid which are withheld from
dividend income but also for the taxes paid on the profits out of which
such dividend has been paid. The examples of Indian tax treaties which
allow underlying tax credit are: Australia, Mauritius, Singapore, USA
and UK. Now let us discuss some practical issues that may arise in
claiming foreign tax credit in India. For the sake of simplicity and
understanding, let us examine issues of claiming foreign tax credit
faced in various situations by an Indian Resident, namely, Mr. Darshan
Dholakia (an imaginary name for understanding various illustrations).

2. Timing issues on account of different tax years

2.1 It is a known fact that different countries follow different tax years and rules for
(i) Levy
(ii) Computation and
(iii) Collection of Tax

Therefore,
it becomes a challenging task for the taxpayer to claim the credit of
foreign taxes paid in his country of residence at the time of
discharging his tax liability in a cross border transaction where the
incidence of tax is in two States i.e. Country of Source and Country of
Residence.

2.1.1 Illustrations

a. India follows Financial Year (FY) from 1st April – 31st March as the tax year;
b. USA follows Calendar Year (i.e. 1st January – 31st December) as the tax year;

2.1. 2 Income from Salaries

Let
us consider a situation where Mr. Darshan Dholakia, an Indian resident
goes to US for employment on 31st December 2014. This is his first visit
abroad in his lifetime. Therefore, for the FY 2014-15 he remains
Resident and Ordinary Resident in India. He is required to pay taxes in
India on his worldwide income for the FY 2014-15 i.e. including his
salaries in US for the period from 1st January 2015 to 31st March 2015.
In US he would be taxed on a Calendar Year basis, i.e. CY 2015. Under
the circumstances, how does he compute his tax liability in India and US
and claim credit in India in respect of taxes paid in US, especially
for the overlapping period (from 1st January 2015 to 31st March 2015)
which falls in two different tax years in two jurisdictions?

2.1.3
In the above illustration, Mr. Darshan needs to include his income from
US for the period from 1st January 2015 to 31st March 2015 in his
Indian tax return for the FY 2014-15. He can claim the credit of
proportionate taxes paid to US Govt. (by way of deduction or otherwise)
on such income by producing necessary evidences to this effect.

2.1.4
At a later date, if there is any voluntary upward / downward revision
in computation of the taxable income of Mr. Darshan in US, then he shall
revise his Income-tax return in India u/s. 139(5). His claim for credit
of US taxes shall alter accordingly.

Further, if the assessment
of his income in India has been completed, then Mr. Darshan may not be
able to file the revised return of income in India and in such cases, he
shall inform the Income-tax department in writing and the AO shall
modify his tax liability.

2.1.5 Business Income

What
if Mr. Darshan is earning business income from his proprietary concern
in US which is taxable in India as he is a Resident and Ordinary
Resident of India? In such a situation how his US income which is
ascertained on a Calendar Year basis, will be considered for tax in
India where income is assessed based on the Financial Year?

a.
Whether Mr. Darshan needs to compute profits of his US business for the
period from January 2015 to March 2015 while filing his return for the
FY 2014-15? OR

b. Can he include US profits for the CY 2015 in FY 2015 -16?

In
situation (a) above, it is assumed that profits of the business accrue
on a day to day basis and therefore there is a need to compute US
Profits separately for the overlapping period. Even if it is assumed
that profits of the business accrue only at the year end, upon drawing
of profit and loss account, one is confronted with provisions of section
44AB which requires one to get one’s accounts audited if the turnover
or gross receipts from all businesses put together exceeds Rs. one crore
in a previous year. The Previous year is defined u/s. 3 of the Act as
the Financial Year i.e. from April to March. So applying this
interpretation Mr. Darshan has no choice but to maintain accounts of his
US business from April to March for the purpose of complying with
Indian tax regulations.

In the above scenario, many practical
difficulties could arise as to claiming of tax credit. It may so happen
that tax may be paid for the US business post 31st March 2015. If it is
so, how can Mr. Darshan claim credit as the provisions of India-US DTAA
provides for credit of “taxes paid” and not “payable”. Even assuming
taxes are paid whether Mr. Darshan needs to apportion the same based on
profits ascertained for the period from 15th January to 15th March? What
if he has incurred losses in the period from 15th April to 15th
December? There are no clear answers to these issues. Therefore, one may
consider following alternative interpretation (which covers situation
(b) above).

In the above scenario, many practical difficulties could arise as to claiming of tax credit. It may so happen that tax may be paid for the US business post 31st March 2015. If it is so, how can Mr. Darshan claim credit as the provisions of India-US DTAA provides for credit of “taxes paid” and not “payable”. Even assuming taxes are paid whether Mr. Darshan needs to apportion the same based on profits ascertained for the period from 15th January to 15th March? What if he has incurred losses in the period from 15th April to 15th December? There are no clear answers to these issues. Therefore, one may consider following alternative interpretation (which covers situation (b) above).

Profits or losses are determined only at the year-end or when accounts are made up as per statutory requirements. There is no doubt that profit or loss is embedded in every transaction, but its actual determination is done only when accounts are drawn up for a particular period as business exigencies depends on so many factors, such as season, demand and supply etc. and these factors are best captured over a period of time. This view has been supported by the Apex Court in case of Ashokbhai Chimanbhai [(1965) AIR 1343] wherein it was held as follows:

“In the gross receipts of a business day after day or from transaction to transaction lie embedded or dormant profit or loss. On such dormant profits or loss, undoubtedly, taxable profits, if any, of the business will be computed. But dormant profits cannot be equated with accrued profits charged to tax u/s. 3 and 4 of the Income-tax Act, 1922. The concept of accrual of profits of a business involves the determination by the method of accounting at the end of the accounting year or any shorter period determined by law; and unless a right to the profits comes into existence, there is no accrual of profits.”

One more principle propounded by the above ruling is “right to receive” profits, which gets crystallised only on determination of profits or losses in accordance with provisions of law. All though the above ruling is in the context of 1922 Act, principles laid down can be applied to the provisions of the Income-tax Act, 1961 as well.

Applying the above ruling Mr. Darshan may offer in India the profits/losses earned in US business for the CY 2015 along with profits/losses of FY 2015-16 as the CY 2015 falls within FY 2015-16. This has to be done on a consistent basis. Similarly, he has to club the turnover of the US Business for CY 2015 with the turnover of Indian Business for 2015-16. Here he can argue that for the purpose section 44AB the previous year for the US Business is Calendar Year and therefore, he has considered the turnover of CY 2015 for the AY 2016-17.

It is pertinent to note that the above discussion would also be applicable in case of an Indian enterprise having a branch office in USA.

3.    Tax credit in case of deductions under special provisions

Consider a situation where Mr. Darshan Dholakia, an Indian Tax Resident, has earned foreign sourced income which in India is entitled to deductions say 50% or enjoying tax holidays on account of some provisions of the Act, (for example Exemptions u/s. 10AA to a Unit in SEZs from Exports Profits). A question may arise in relation to the admissibility of foreign taxes paid outside India on the whole of such income as credit against the income-tax liability in India?

In such cases, it has been held by the undernoted Courts that proportionate credit must be granted:-

a. The Rajasthan High Court [1994] 209 ITR 394 (RAJ.) at the time of reversing the decision of the Tribunal in the case of Dr. K. L. Parikh vs. ITO, 1982 (14 TTJ 117), held that the Tribunal was not justified in holding that the assessee was entitled to credit for the entire amount of tax deducted at source in Iran u/s. 91(1) of the Act and not in proportion to the income included in the total income of the assessee after considering the provisions of section 80RRA of the Act and relief was granted proportionately up to 50% of FTC.

b.    A similar view was upheld by the Andhra Pradesh

High Court in the case of CIT vs.. M.A. Mois (1994) 210 ITR 284.

4.    Exchange rate implications while determining income and the tax liability thereon
4.1  Rule 115 of the Income-tax Rules, 1962 provides that “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.”

4.2 Clause 2 of Explanation to Rule 115(1) provides that specified date means-

a. In respect of
salaries

Last day of the month immediately

 

preceding
the month in which

 

the
salary is due, or is paid in

 

advance or in arrears

b. Interest on securities

Last day of the month immediately

 

preceding
the month in which the

 

income is due

c. House  property, 
business

Last day of the previous year

income, other sources
other

 

income by way of
dividends

 

and income on
securities

 

d. Income  from  business 
in

Last day of the month immediately

relation to shipping
business

preceding the month in which

 

such
income is deemed to accrue

 

or arise in India

e. Dividends

Last day of the month immediately

 

preceding
the month in which

 

dividend
is declared, distributed or

 

paid by company

f.  Capital gains

Last day of the month immediately

 

preceding
the month in which the

 

capital asset is transferred

Since the foreign income is to be converted into INR for the purpose of computation, it appears to be a fair proposition that the conversion rate provided on the specified date under rule 115 shall also apply to convert the tax paid in foreign country into its rupee equivalent for the purpose of computing the available foreign tax credit. However, some tax treaties provide for foreign tax credit only on payment basis. In such cases, credit may be availed only on payment of taxes, but the taxes paid in foreign currency should be converted at the same rate at which the underlying income is converted in Indian Rupees. This is necessary for avoiding any artificial tax benefit (or tax loss) on account of currency conversion.

5    Computation of relief where there is income from more than one foreign country (Income from one Country and loss in the other Country)
Under provisions of the Act, tax is levied on a resident on his global income and therefore, income from all sources whether in India or outside shall be taxable in India subject to DTAA provisions which may/may not tax the income in the country of source.

5.2 In a case where Mr. Darshan Dholakia is carrying on business in more than one country and he has suffered loss from a business outside India say in UK and has profit in Hong Kong, a question may arise as to how shall the relief be granted in order to discharge his tax liability in India.

5.3 In the context of section 91 of the Act (which deals with Unilateral Tax relief where India has no tax treaty), in the case of Bombay Burmah Trading – 259 ITR 423, the Bombay High Court has held as under:

“If one analyses S. 91(1) with the Explanation, it is clear that the scheme of the said section deals with granting of relief calculated on the income country wise and not on the basis of aggregation or amalgamation of income from all foreign countries. Basically u/s. 91(1), the expression ‘such doubly taxed income’ indicates that the phrase has reference to the tax which the foreign income bears when it is again subjected to tax by its inclusion in the computation of income under the Income-tax Act. Further S. 91(1) shows that in the case of double income-tax relief to the resident, the relief is allowed at the Indian rate of tax or at the rate of tax of the other country whichever is less. Therefore, the relief u/s.91 (1) is by way of reduction of tax by deducting the tax paid abroad on such doubly taxed income from tax payable in India. Under the circumstances, the scheme is clear. The relief can be worked out only if it is implemented country wise. If incomes from foreign countries were to be aggregated, it would be impossible to compare the rate of tax of the foreign country with the rate under the Indian Income-tax Act.”

5.4 Similarly, in cases where DTAA exists between India and the country of source, the said DTAAs being bilateral in nature, one may infer that tax relief shall be computed country wise and not after aggregating the foreign sourced income.
Thus, in the given example, Mr. Darshan will be able to claim relief of taxes paid in Hong Kong u/s. 91 of the Act, whereas the loss from UK will be available for set-off in India, provided his income from UK is otherwise taxable in India. In any case for his income/ loss from UK, provisions of the India-UK DTAA shall apply.

6    Claiming credit for tax paid in a country outside India with whom DTAA exists but the type of taxes paid are not covered

6.1 In this context, we have a direct decision in the case of TATA Sons Ltd. – 43 SOT 27, wherein, the assessee had paid State Income Taxes in USA and Canada. However, the India-USA and India-Canada DTAA covers only the Federal taxes paid and the assessee had sought to claim relief u/s. 91 of the Act in respect of the State Income taxes paid outside India.

6.1 The issue before the Tribunal was whether the assessee would be eligible for claiming credit u/s. 91 in light of provisions of section 90(2) of the Act?

6.2 It was held by the Hon. Tribunal that “State Income Taxes cannot be allowed as a deduction and also cannot be taken into account for giving credit is absurd and results in a contradiction. A tax payment which is not treated as admissible expenditure on the ground that it is payment of Income-tax has to be treated as eligible for tax credit. While section 91 of Act allows credit for Federal and State taxes, the DTAA allows credit only for Federal taxes. The result is that section 91 is more beneficial to the assessee and by virtue of section 90(2) of Act, provisions of section 91 must prevail over the DTAA even though this is a case where India has entered into a DTAA. Accordingly, even an assessee covered by the scope of the DTAA will be eligible for credit of State taxes u/s. 91 of Act despite the DTAA not providing for the same.”

6.3 It may be noted that the above case refers to the payment of State Income tax in the US and Canada. Assessee first claimed these taxes as expenditure u/s. 37(1) of the Act on the ground that the respective DTAA covers only Federal (Central) Taxes. This claim of the Assessee was rejected by the Tribunal vide its order dated 24th November 2010. However, the Assessee sought further clarifications and in a fresh order dated 23rd February 2011, the Hon. Tribunal held that the Assessee was eligible to claim credit for State Income tax paid in US and Canada u/s. 91 of the Act read with section 90(2), notwithstanding existence of DTAA with both these countries.


7    Claim for refund of tax in a case where more tax is paid in a foreign country compared to the tax payable in India on the same income

7.1 The answer to the above issue can be better explained with the help of an example.

A Ltd. (Domestic Company) – Foreign taxes paid:- INR 150/– Income-tax payable:- INR 100/– Credit allowed:- INR 100/-

–    Excess credit:- INR 50/- (150-100)

7.2 A question may arise as to whether the tax payer is eligible for a refund (if available) or he would be allowed to claim the excess tax paid as credit which may be carried forward and may be set off against the liability of the subsequent year?

No refund is allowed in respect of excess foreign taxes paid to any tax payer in India for the obvious reason that such tax is paid to the foreign government. In absence of any rules or provision allowing carry forward of unavailed/excess tax credit, the same cannot be carry forward to the next year. However, some countries do allow carry forward of excess tax credits. Canada, Japan, Singapore, UK and USA do allow carry forward of excess foreign tax credit for the period ranging from three years to an indefinite time period.

8    How shall tax relief be computed and granted in the case of a person being

i.    A Company whose tax liability is determined under the Minimum Alternate Tax (MAT) provisions?

ii.    A person other than a company whose tax liability is determined under the Alternate Minimum Tax (AMT) provisions?
Under the provisions of the Act, a company is subjected to tax either as per normal provisions of the Act or MAT whichever is higher. Similarly tax payers other than the company, are taxed as per normal provisions of the Act or AMT whichever is higher.

8.2 Therefore a question arises whether a tax payer who is subjected to tax in India either under MAT or AMT would be eligible to claim credit of foreign taxes paid on the same income?

8.3  Bombay High Court in the case of Bombay

Burmah Trading Corporation Limited (2003) 259 ITR 423 held that “basically u/s. 91(1), the expression ‘such doubly taxed income’ indicates that the phrase has reference to the tax which foreign income bears when it is again subjected to tax by its inclusion in the computation of income under the Indian Income-tax Act, 1961”.

8.4 In the light of the above decision, it would appear that wherever MAT or AMT is applicable to foreign income, it would amount to double taxation and the tax payer would be eligible to claim applicable tax credits in respect of foreign taxes paid abroad on the same income.

9    Can the taxes (based on turnover) paid to foreign government be allowed as deduction computing the total income of the assessee?

In this matter, there is a direct decision of the Bombay High Court in the case of K.E.C International Ltd (2000) 256 ITR 354 wherein the tax payer paid turnover tax in Thailand. Income-tax ideally should mean a tax which is levied on income, something which is directly linked to income of the tax payers and not indirect taxes such as Service tax, VAT or Sales Tax or Turnover Tax etc. Since the tax paid was indirect in nature and not Income-tax, it was held to be allowable as a business deduction. The Court held that in such a case, provisions of section 40(a)(ii) of the Act cannot be invoked for disallowance.

10    What if there is additional tax required to be paid on assessment in Foreign Countries? Will the same automatically increase income in India?

If the tax payer challenges various additions to his returned income in the foreign country at some higher forum, then there will not be any tax implications in India. However, if the tax payer does not challenge the additions made in the foreign country, then he is under obligation to revise his return of income in India. If the return is time barred, then necessary recourse provided under the Act will be applicable.

11    Difference in Characterisation of Income

It may be possible that business profits are offered for tax as fees for technical services (FTS) in India (say Country of Source) whereas, the Country of Residence (say, Singapore) thinks that the tax is wrongly paid as FTS and in absence of PE there was no tax liability in India. In such a scenario, Singapore may deny the tax credit and the tax payer may have to resort to Mutual Agreement Procedure.

12    Conclusion

Section 91 of the Act provides for unilateral tax relief. India has signed more than 80 comprehensive Double Tax Avoidance Agreements which also provide for tax credits. By and large Indian tax treaties provide for Ordinary Tax Credits. Prominent issues in claiming foreign tax credits are timing difference, evidences of payment and the rate of exchange for conversion of income and taxes in Indian currency.

Tax payers must remember that any income received from a foreign jurisdiction has to be computed under the Indian tax laws, by applying provisions of the Act. Rules of computation may differ in two different jurisdictions. Therefore, the credit of foreign taxes paid is always restricted to the additional tax liability in India on account of inclusion of foreign income.

The Finance Act, 2015 has amended section 295 and inserted clause (ha) to empower the CBDT to make Rules for the procedure for the granting of relief or deductions of foreign taxes against the income-tax payable in India. Many issues may get resolved once these Rules are notified by the CBDT.

OECD – Base Erosion and Profit Shifting Project [BEPS] – Part I

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There is a growing perception that governments lose substantial corporate tax revenue because of planning aimed at shifting profits in ways that erode the taxable base to locations where they are subject to a more favourable tax treatment. Recent news stories show increased attention mainstream media has been paying to corporate tax affairs. Civil society and non-governmental organisations (NGOs) have also been vocal in this respect, sometimes addressing very complex tax issues in a simplistic manner and pointing fingers at transfer pricing rules based on the arm’s length principle as the cause of these problems. In this article, an attempt has been made to explain the background of a very ambitious and important BEPS Project undertaken by OECD. In addition, brief description of the task and issues of all the 15 Action Plans alongwith the time line and present status has been given for an understanding of the same.

1. Background on BEPS
Base erosion and profit shifting (BEPS) is a global problem which requires global solution. BEPS refers to tax planning strategies that exploit gaps and mismatches in tax rules to artificially shift profits to low or no-tax locations where there is little or no economic activity, resulting in little or no overall corporate tax being paid. BEPS is of major significance for developing countries due to their heavy reliance on corporate income tax, particularly from multinational enterprises (MNEs).

In an increasingly interconnected world, national tax laws have not always kept pace with tax planning by global corporations, fluid movement of capital, and the rise of the digital economy, leaving gaps that can be exploited to generate double non-taxation. This undermines the fairness and integrity of tax systems.

This increased attention and the inherent challenge of dealing comprehensively with such a complex subject has encouraged a perception that the domestic and international rules on the taxation of cross-border profits are now broken and that taxes are only paid by the naive. Multinational enterprises (MNEs) are being accused of dodging taxes worldwide, and in particular in developing countries, where tax revenue is critical to foster long term development.

Business leaders often argue that they have a responsibility towards their shareholders to legally reduce the taxes their companies pay. Some of them might consider most of the accusations unjustified, in some cases deeming governments responsible for incoherent tax policies and for designing tax systems that provide incentives for Base Erosion and Profit Shifting (BEPS). They also point out that MNEs are still sometimes faced with double taxation on their profits from cross-border activities, with mutual agreement procedures sometimes unable to resolve disputes among governments in a timely manner or at all.

The debate over BEPS has also reached the political level and has become an issue on the agenda of several OECD and non-OECD countries. The G20 leaders meeting in Mexico on 18-19 June 2012 explicitly referred to “the need to prevent base erosion and profit shifting” in their final Declaration. This message was reiterated at the G20 finance ministers meeting of 5-6 November 2012, in the final communiqué.

The European Commission presented an Action Plan on 17-06-2015 to fundamentally reform corporate taxation in the EU. The Action Plan sets out a series of initiatives to tackle tax avoidance, secure sustainable revenues and strengthen the Single Market for businesses. The measures to be developed complement the work carried out in the OECD/G20 BEPS Project, whose outputs are expected to be presented to the G20 in October 2015.

1.1 Legality and issues relating to BEPS
Corporate tax is levied at a domestic level. When MNEs undertake activities across borders, the interaction of domestic tax systems means that an item of income can be taxed by more than one jurisdiction, thus resulting in double taxation. The interaction can also leave gaps, which result in income not being taxed anywhere. BEPS strategies take advantage of these gaps between tax systems in order to achieve double non-taxation or very low taxation.

Although some schemes used are illegal, most are not. Largely they just take advantage of current rules that are still grounded in a bricks and mortar economic environment rather than today’s environment of global players which is characterised by the increasing importance of digital economy, e-commerce, intangibles and risk management.

A question arises for consideration: if the BEPS strategies/ schemes are considered to be legal, then why should anyone worry about BEPS. There are three important factors in this regard. First, because it distorts competition: businesses that operate cross-border may profit from BEPS opportunities, giving them a competitive advantage over enterprises that operate at the domestic level. Second, it may lead to inefficient allocation of resources by distorting investment decisions towards activities that have lower pre-tax rates of return, but higher after-tax returns. Finally, it is an issue of fairness: when taxpayers (including ordinary individuals) see multinational corporations legally avoiding income tax, it undermines voluntary compliance by all taxpayers.

1.2 Importance of BEPS Project now and OECD’s role in addressing BEPS
The OECD has been providing solutions to tackle aggressive tax planning over the years. The debate and concern over BEPS has now reached the highest political levels in many OECD and non-OECD countries. The OECD does not see BEPS as a problem created by one or more specific companies. Apart from some cases of very bad and easily noticed abuses, the issue lies with the tax rules themselves. Business cannot be faulted for making use of the rules that governments have put in place. It is therefore governments’ responsibility to revise the rules or introduce new rules.

Many BEPS strategies take advantage of the interaction between the tax rules of different countries, which means that unilateral action by individual countries will not fully address the problem. In addition, unilateral and uncoordinated actions by governments responding in isolation could result in double – and possibly multiple – taxation for business. This would have a negative impact on flow of capital and technology, investment, growth and employment globally. There is therefore a need to provide an internationally coordinated approach which will facilitate and reinforce domestic actions to protect tax bases and provide comprehensive international solutions to respond to the issue. The BEPS Action Plan provides a consensus-based plan to address these issues and is part of the OECD’s ongoing efforts to ensure that the global tax architecture is equitable and fair.

1.3 BEPS Action Plans
It sets forth 15 actions to address BEPS in a comprehensive and coordinated way. These actions will result in fundamental changes to the international tax standards and are based on three core principles: coherence, substance, and transparency. The Action Plan also calls for further work to address the challenges posed by the digital economy. Looking toward innovative approaches to deliver change quickly, the Action Plan calls for a multilateral instrument that countries can use to implement the measures developed in the course of the work. While the OECD steps up its efforts to address double nontaxation, it will also continue work to eliminate double taxation, including through increased efficiency of mutual agreement procedures and arbitration provisions.

In July 2013, the Action Plan on Base Erosion and Profit Shifting directed the OECD to commence work on 15 actions designed to ensure the coherence of corporate income taxation at the international level. The first seven of these actions were presented to G20 Leaders at the Brisbane Summit in November 2014.

1.4    Actions plans being carried out in the context of BEPS
Domestic tax systems are coherent – tax deductible payments by one person results in income inclusions by the recipient. We need international coherence in corporate income taxation to complement the standards that prevent double taxation with a new set of standards designed to avoid double non-taxation. Four actions in the BEPS Action Plan (Actions 2, 3, 4, and 5) focus on establishing this coherence.

Current rules work well in many cases, but must be modified to prevent instances of BEPS. The involvement of third countries in the bilateral framework established by treaty partners puts a strain on the existing rules, in particular when done via shell companies that have little or no economic substance: e.g. office space, tangible assets, business operations and employees. In the area of transfer pricing, rather than replacing the current system,  the best course is to fix the flaws in it, in particular with respect to returns related to over-capitalisation, risk and intangible assets. Nevertheless, special rules, either within or beyond the arm’s length principle, may be required with respect to these flaws. Five actions in the BEPS Action Plan focus on aligning taxing rights with substance (Actions 6, 7, 8, 9, and 10).

Because preventing BEPS requires greater transparency at many levels, the Action Plan calls for: improved data collection and analysis regarding the impact of BEPS; taxpayers’ disclosure about their tax planning strategies; and less burdensome and more targeted transfer pricing documentation. Four actions in the BEPS Action Plan focus on improving transparency (actions 11, 12, 13, and 14).

The brief description, timeline and present status of the Action plans are given in para 2 below.

1.5    Implementation of the BEPS actions
The BEPS Action Plan calls for the development of tools that countries can use to shape fair, effective and efficient tax systems. Because BEPS strategies often rely on the interaction of countries’ different systems, these tools will have to address the gaps and frictions that arise from the interaction of these systems. Some actions, for example, work on the OECD Transfer Pricing Guidelines and the Commentary to the OECD Model Tax Convention, will result in changes that are directly effective.  Others will be implemented by countries through their domestic law, bilateral treaties, or a multilateral instrument.

1.6    Time frame for action plans
Addressing BEPS is critical for most countries and must be done in a timely manner so that concrete actions can be delivered quickly before the existing consensus-based framework unravels. At the same time, governments need time to complete the necessary technical work and achieve widespread consensus. Against this background, it is expected that the Action Plan will largely be completed within 2 years of its adoption. Indeed, the first set of measures and reports was released in September 2014, just 12 months after the launch of the BEPS project. Work on the reports to be delivered in 2015 has already started, and this work will continue at a fast pace to ensure the rapid development of concrete measures that countries can use to end double non-taxation and base erosion due to artificial shifting of profits.

1.7    Role of the G20 in BEPS project
Since its launch by the OECD, the work on BEPS received strong and consistent support by the G20 and it is a key item on the Finance Ministers’ and Leaders’ agendas.

Furthermore, all G20 countries have participated as equal partners in the development of the work. Their continued participation and endorsement at the highest levels of government have been critical to guarantee a level playing field and prevent inconsistent standards.

The delivery of the 2014 BEPS outputs is concrete evidence of how OECD and G20 members working together can achieve consensus on important tax reforms with a worldwide impact. Non-OECD G20 countries are Associates in the BEPS Project and participate on an equal footing in the decision making process, at the level of both the OECD Committee on Fiscal Affairs and of its subsidiary bodies carrying out the technical work. In addition, other countries and stakeholders have engaged in regular and fruitful dialogues throughout this process.

1.8    BEPS action plan and Tax competition Taxation is at the core of countries’ sovereignty, and each country is free to set up its corporate tax system as it chooses, including by charging the rate it chooses. The work is not aimed at restricting the sovereignty of countries over their own taxes; instead, it is aimed at restoring  and strengthening sovereign taxing rights by ensuring that countries can protect their tax bases. It does so by addressing regimes that apply to mobile activities and that unfairly erode the tax bases of other countries, potentially distorting the location of capital and services.

1.9    Risk of not addressing harmful Tax Practices
The dangers of not addressing harmful tax practices can be felt both by governments and business. Firstly, harmful tax competition can introduce distortions and an unlevel playing field between businesses operating at domestic level and those that operate globally and have access to preferential tax regimes. Secondly, countries have long recognised that a “race to the bottom” would ultimately drive applicable tax rates on certain sources of income to zero for all countries, whether or not this is the tax policy a country wishes to pursue.

1.10    BEPS action plan & “Tax Havens”
The BEPS Action Plan aims to end the use of shell companies used to stash profits offshore or unduly claim tax treaty protection and neutralise all schemes that artificially shift profits offshore. Though the BEPS Action Plan is not about dictating whether countries should have a specific corporate income tax rate, it will have an impact on regimes that seek to attract foreign investors without requiring any economic substance.

1.11    Is BEPS effectively a tax increase on multinationals?
The BEPS project is not about increasing corporate taxes. Non- or low-taxation is not itself the concern, but  it becomes so when it is achieved through practices that artificially separate taxable income from the activities that generate it. These strategies may increase tax disputes as countries fight against tax strategies that defy common sense. Implementation of the recommendations coming out of the BEPS project will reduce those disputes, giving business greater certainty, and reinforcing the fairness and consistency of international tax system.

1.12    Involvement of businesses and civil society in BEPS project
During the course of the work so far, stakeholders have been consulted at length. Discussion drafts released during the course of the work so far have generated more than 3,500 pages of comments, and have attracted a large number of participants at various public consultations. The OECD’s public webcasts of these consultations and updates on the project have attracted more than 10,000 viewers. This transparent and inclusive consultation process will continue throughout the course of the work.

1.13    BEPS action plan and offshore Tax Evasion
The work on BEPS focusses largely on legal tax planning techniques rather than offshore tax evasion, which is illegal. However, other work being carried out by the OECD and the OECD Global Forum on Transparency and the Exchange of Information is focused on combatting offshore tax evasion. More information about this work can be found on line at www.oecd.org/tax/exchange-of-tax¬information.

2.    Brief description, timeline and present status of the BEPS action plans

2.1    Action 1 – Address the tax challenge of the digital economy

a)    Anticipated result: Report identifying issues raised by the digital economy and possible actions to address them
b)    initial deadline: September 2014
c)    Present status: Final Report Issued.
d)    Description of tasks and issues:
Identify the main difficulties that the digital economy poses for the application of existing international tax rules and develop detailed options to address these difficulties, taking a holistic approach and considering both direct and indirect taxation.

Issues to be examined include, but are not limited to, the ability of a company to have a significant digital presence in the economy of another country without being liable to taxation due to the lack of nexus under current international rules, the attribution of value created from the generation of marketable location relevant data through the use of digital products and services, the characterisation of income derived from new business models, the application of related source rules, and how to ensure the effective collection of VAT/GST with respect to the cross- border supply of digital goods and services. Such work will require a thorough analysis of the various business models in this sector.

2.2    Action 2 – Neutralise the effects of hybrid mismatch arrangements
a)    Anticipated result: Changes to the Model Tax Convention Recommendations regarding the design of domestic rules.
b)    initial deadline: September 2014
c)    Present status: Comments on discussion draft received and published.
d)    Description of tasks and issues:
Develop model treaty provisions and recommendations regarding the design of domestic rules to neutralise the effect (e.g. double non-taxation, double deduction, long- term deferral) of hybrid instruments and entities.

This may include: (i) changes to the OECD Model Tax Convention to ensure that hybrid instruments and entities (as well as dual resident entities) are not used to obtain the benefits of treaties unduly; (ii) domestic law provisions that prevent exemption or non-recognition for payments that are deductible by the payer; (iii) domestic law provisions that deny a deduction for a payment that is not includible in income by the recipient (and is not subject to taxation under controlled foreign company (CFC) or similar rules); (iv) domestic law provisions that deny a deduction for a payment that is also deductible in another jurisdiction; and (v) where necessary, guidance on coordination or tie-breaker rules if more than one country seeks to apply such rules to a transaction or structure. Special attention should be given to the interaction between possible changes to domestic law and the provisions of the OECD Model Tax Convention. This work will be co-ordinated with the work on interest expense deduction limitations, the work on CFC rules, and the work on treaty shopping.

2.3    Action 3 –Strengthen CFC rules

a)    Anticipated result: Recommendations regarding the design of domestic rules.
b)    initial deadline: September 2015
c)    Present status: Comments on discussion draft received and published.
d)    Description of tasks and issues:
Develop recommendations regarding the design of controlled foreign company rules. This work will be coordinated with other work as necessary.

2.4    Action 4 – Limit base erosion via interest deductions and other financial payments

a)    Anticipated result: (i) Recommendations regarding the design of domestic rules.
(ii)    Changes to the Transfer Pricing Guidelines
b)    initial deadline: (i) September 2015 and (ii) December 2015, respectively.
c)    Present status: Comments on discussion draft received and published.
d)    Description of tasks and issues:
Develop recommendations regarding best practices in the design of rules to prevent base erosion through the use of interest expense, for example through the use of related- party and third-party debt to achieve excessive interest deductions or to finance the production of exempt or deferred income, and other financial payments that are economically equivalent to interest payments.

The work will evaluate the effectiveness of different types of limitations. In connection with and in support of the foregoing work, transfer pricing guidance will also be developed regarding the pricing of related party financial transactions, including financial and performance guarantees, derivatives (including  internal  derivatives  used in intra-bank dealings), and captive and other insurance arrangements. The work will be coordinated with the work on hybrids and CFC rules.

2.5    Action 5 – Counter harmful tax practices more effectively, taking into account transparency and substance

a)    Anticipated result: (i) Finalise review of member country regimes; (ii) Strategy to expand participation to non OECD members; and (iii) Revision of existing criteria.
b)    initial deadline: (i) September 2014; (ii) September 2015; and (iii) December 2015, respectively.
c)    Present status: Interim report issued; deadline for second output September 2015 (engaging with other non-OECD member countries on the basis of the existing framework).
d)    Description of tasks and issues:
Revamp the work on harmful tax practices with a priority on improving transparency, including compulsory spontaneous exchange on rulings related to preferential regimes, and on requiring substantial activity for any preferential regime. It will take a holistic approach to evaluate preferential tax regimes in the BEPS context.  It will engage with non-OECD members on the basis of the existing framework and consider revisions or additions to the existing framework.

2.6    Action 6 – Prevent treaty abuse
a)    Anticipated result: (i) Changes to the Model Tax Convention; and (ii) Recommendations regarding the design of domestic rules.
b)    initial deadline: For both (i) & (ii) September 2014.
a) Present status: First Discussion draft released on 21-11-2014. Based on the Comments received, a new discussion draft released on 22- 5-2015, for Public Comments by 17-06- 2015. Comments on the revised discussion draft have been received and published on 18-06-2015.
c)    Description of tasks and issues:
Develop model treaty provisions and recommendations regarding the design of domestic rules to prevent the granting of treaty benefits in inappropriate circumstances. Work will also be done to clarify that tax treaties are not intended to be used to generate double non-taxation and to identify the tax policy considerations that, in general, countries should consider before deciding to enter into a tax treaty with another country. The work will be coordinated with the work on hybrids.

2.7    Action 7 – Prevent the artificial avoidance of PE status
b)    Anticipated result: Changes to the Model Tax Convention.
c)    initial deadline: September 2015
d)    Present status: First Discussion draft released on 31-10-2014. Based on the Comments received, a new discussion draft released on 15- 05-2015, for Public Comments by 12-06- 2015. Comments have been received and published on 15-06-2015.
e)    Description of tasks and issues:
Develop changes to the definition of PE to prevent the artificial avoidance of PE status in relation to BEPS, including through the use of commissionaire arrangements and the specific activity exemptions.
Work on these issues will also address related profit attribution issues.

2.8    Action 8 – Assure that transfer pricing outcomes are in line with value creation: intangibles

a)    Anticipated result: (i) Changes to the Transfer Pricing Guidelines and possibly to the Model Tax Convention; and (ii) Changes to the Transfer Pricing Guidelines and possibly to the Model Tax Convention.
b)    initial deadline: (i) September 2014; and (ii) September 2015, respectively.
c)    Present status: Discussion draft released. Comments received and published on discussion draft on Actions 8, 9 and 10. Detailed discussion draft on Cost Contribution Arrangements also released. Comments on discussion draft on Cost Contribution Arrangements have been received and published on 01-06-2015. Comments on discussion draft on Action 8 (Hard-to-value intangibles) have been received and published. Public consultation on discussion draft will be held on 6-7 July 2015.

d)    Description of tasks and issues:
Develop rules to prevent BEPS by moving intangibles among group members. Phase:
I.    (i) adopting a broad and clearly delineated definition of intangibles;
(ii) ensuring that profits associated with the transfer and use of intangibles are appropriately allocated in accordance with (rather than divorced from) value creation;

II.    (iii) developing transfer pricing rules or special measures for transfers of hard-to-value intangibles; and
(iv) updating the guidance on cost contribution arrangements.

2.9    Action 9 – Assure that transfer pricing outcomes are in line with value creation: risks and capital
a)    Anticipated result: Changes to the Transfer Pricing Guideline and possibly to the Model Tax Convention.
b)    initial deadline: September 2015.
c)    Present status: Discussion draft released. Comments received and published on discussion draft on Actions 8, 9 and 10.
d)    Description of tasks and issues: Develop rules to prevent BEPS by transferring risks among, or allocating excessive capital to, group members. This will involve adopting transfer pricing rules or special measures to ensure that inappropriate returns will not accrue to an entity solely because it has contractually assumed risks or has provided capital. The rules to be developed will also require alignment of returns with value creation. This work will be coordinated with the work on interest expense deductions and other financial payments.

2.10    Action 10 – Assure that transfer pricing outcomes are in line with value creation: other high-risk transactions
a)    Anticipated result: Changes to the Transfer Pricing Guideline and possibly to the Model Tax Convention.
b)    initial deadline: September 2015.
c)    Present status: Discussion drafts released. Comments received and published on discussion draft on Actions 8, 9 and 10. Comments also received and published on Action 10: low-value adding services, Cross-border commodity transactions and Use of profit Splits in the context of the global value chains.
d)    Description of tasks and issues:
Develop rules to prevent BEPS by engaging   in transactions which would not, or would only very rarely, occur between third parties. This will involve adopting transfer pricing rules or special measures to:
(i)    clarify the circumstances in which transactions can be recharacterised;
(ii)    clarify the application of transfer pricing methods, in particular profit splits, in the context of global value chains; and
(iii)    provide protection against common types of base eroding payments, such as management fees and head office expenses.

2.11    Action 11 – Establish methodologies to collect and analyse data on bEPS and the actions to address it
a)    Anticipated result: Recommendations regarding data to be collected and methodologies to analyse them.
b)    initial deadline: September 2015.
c)    Present status: Discussion draft released. Comments on discussion draft received and published.
d)    Description of tasks and issues:
Develop recommendations regarding indicators of the scale and economic impact of BEPS  and ensure that tools are available to monitor and evaluate the effectiveness and economic impact of the actions taken to address BEPS on an ongoing basis. This will involve developing an economic analysis of the scale and impact of BEPS (including spillover effects across countries) and actions to address it.
The work will also involve assessing a range of existing data sources, identifying new types of data that should be collected, and developing methodologies based on both aggregate (e.g. FDI and balance of payments data) and micro- level data (e.g. from financial statements and tax returns), taking into consideration the need to respect taxpayer confidentiality and the administrative costs for tax administrations and businesses.

2.12    Action 12 – require taxpayers to disclose their aggressive tax planning arrangements
a)    Anticipated result: Recommendations regarding the design of domestic rules
b)    initial deadline: September 2015
c)    Present status: Discussion draft released. Comments on discussion draft received and published.
d)    Description of tasks and issues:
Develop recommendations regarding the design of mandatory disclosure rules for aggressive  or abusive transactions, arrangements, or structures, taking into consideration the administrative costs for tax administrations and businesses and drawing on experiences  of  the increasing number of countries that have such rules. The work will use a modular design allowing for maximum consistency but allowing for country specific needs and risks. One focus will be international tax schemes, where the work will explore using a wide definition of “tax benefit” in order to capture such transactions. The work will be coordinated with the work on co-operative compliance. It will also involve designing and putting in place enhanced models of information sharing for international tax schemes between tax administrations.

2.13    Action 13 – Re-Examine transfer pricing documentation

a)    Anticipated result: Changes to Transfer Pricing Guidelines and recommendations regarding the design of domestic rules.
b)    initial deadline: September 2014
c)    Present status: Discussion draft released. Comments on discussion draft received and published. A Country-by-Country Reporting Implementation package developed under the OECD/G20 BEPS Project has been released on 08-06-2015.
d)    Description of tasks and issues:
Develop rules regarding transfer pricing documentation to enhance transparency for tax administration, taking into consideration the compliance costs for business. The rules to be developed will include a requirement that MNE’s provide all relevant governments with needed information on their global allocation of the income, economic activity and taxes paid among countries according to a common template.

2.14    Action 14 – Make Dispute resolution mechanisms more effective

a)    Anticipated Result: Changes to the Model Tax Convention
b)    Initial Deadline: September 2015
c)    Present Status: Discussion draft released. Comments on discussion draft received and published.
d)    Description of tasks and issues:
Develop solutions to address obstacles that prevent countries from solving treaty-related disputes under MAP, including the absence of arbitration provisions in most treaties and the fact that access to MAP and arbitration may be denied in certain cases.

2.15    Action 15 – Develop a multilateral instrument

a)    Anticipated Result: (i) Report identifying relevant public international law and tax issues; and (ii) Develop a multilateral instrument.
b)    Initial Deadline: (i) September 2014; and (ii) December 2015, respectively.
c)    Present Status: (i) Final Report issued.
d)    Description of tasks and issues:

Analyse the tax and public international law issues related to the development of a multilateral instrument to enable jurisdictions that wish to do so to implement measures developed in the course of the work on BEPS and amend bilateral tax treaties.

On the basis of this analysis, interested Parties will develop a multilateral instrument designed to provide an innovative approach to international tax matters, reflecting the rapidly evolving nature of the global economy and the need to adapt quickly to this evolution.

In the next part(s), we would discuss the various other aspects relating to BEPS Project including engagement with developing countries and impact on Non-G 20 or Non- OECD countries.

India’s Double taxation Avoidance Ag reements [DTAAs] & Ag reements for Exchange of information [AEIs] – Recent Developments

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In the last 3 years since our last Article on the subject published in
the December, 2012 issue of BCAJ, India has signed DTAAs with 8
countries and has entered into revised DTAAs with 4 countries. India has
also amended few DTAAs by signing Protocols amending the existing
DTAAs. In this Article, our intention is to highlight the salient
features of such DTAAs or Protocols amending the DTAAs. The purpose is
not to deal with such DTAAs or Protocols extensively or exhaustively. It
will be seen that the recent treaties/protocols follow more or less a
similar pattern.

Further, the DTAAs with certain countries have
been modified primarily to include ‘Limitation of Benefits (LOB)
Clause’. Further, Articles on ‘Exchange of Information’ and ‘Assistance
in Collection of Taxes’ have been included or the scope of such existing
Articles has been extended.

The reader is advised to refer the text of the relevant DTAA or the Protocol while dealing with facts of a particular case.

Digest of recent important foreign decisions on cross border taxation

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In this Article, some of the recent important foreign decisions on cross border taxation are covered.

1. France Participation exemption – Administrative Supreme Court clarifies 5% participation threshold criteria

In a decision (No. 370650) given on 5th November 2014, the Administrative Supreme Court (Conseil d’Etat) ruled that the 5% participation threshold provided for by the French participation exemption regime does not relate to both capital and voting rights of a subsidiary, but only to capital. A parent company which holds at least 5% of the capital, but less than 5% of the voting rights of its subsidiary may therefore benefit from the participation exemption on dividends derived from shares carrying a voting right.

a) Facts: In 2008 and 2009, Sofina, a company resident in Belgium, received dividends from the French company Eurazeo, which were subject to a 15% withholding tax. Sofina held shares representing 5% of the capital of Eurazeo, all of which carried a voting right. However, the shares held by Sofina represented only 3.63% of the voting rights of Eurazeo in 2008 and 4.29% of the voting rights of Eurazeo in 2009. Sofina claimed the repayment of the withholding tax on the basis of the French tax authorities’ guidelines which, following the European Court of Justice decision in Denkavit II (Case C-170/05), provide that where a EU non-resident parent company which fulfils the domestic 5% participation requirement finds it impossible to set off the French withholding tax on dividends derived from its French subsidiary, such dividends shall not be subject to a withholding tax.

b) Issue: Under article 145(1)(b) of the General Tax Code, a company must hold at least 5% of the capital of its subsidiary at the date of payment of the dividends to benefit from the participation exemption. Article 145(6) (b)(ter) provides that the participation exemption shall not apply to dividends derived from shares which do not carry a voting right, unless the parent company holds shares representing at least 5% of both capital and voting rights of its subsidiary. The tax authorities took the view that these provisions imply that, in order to benefit from the participation exemption, a parent company shall hold shares representing at least 5% of the capital and at least 5% of the voting rights of its subsidiary. The firstinstance tribunal (tribunal administratif) dismissed the claim of Sofina, but the Administrative Court of Appeals (cour administrative d’appel) later ruled in favour of the Belgian company. The Conseil d’Etat confirmed the decision of the Administrative Court of Appeals.

c) Decision. The Conseil d’Etat ruled that:

– article 145 of the General Tax Code does not require, for the 5% participation in capital condition to be met, that a voting right be attached to every share held by the parent company, nor that voting rights attached to the shares, if any, be strictly proportionate to the portion of capital such shares represent;

– the fact that, under article 145(6)(b)(ter) of the General Tax Code, dividends derived from shares which do not carry a voting right may not be exempted, unless the parent company holds shares representing at least 5% of both capital and voting rights of its subsidiary, does neither mean nor imply that the application of the participation exemption is limited to parent companies which hold shares representing at least 5% of the capital and 5% of the voting rights of a subsidiary.

Dividends derived from shares carrying a voting right received by a parent company which holds at least 5% of the capital of its subsidiary may therefore be exempted under the French participation exemption, notwithstanding the fact that the shares held by the parent company do not represent 5% of the voting rights of the subsidiary.

2) Canada
Tax Court of Canada holds foreign exchange gains not realised on conversions of convertible debentures

The Tax Court of Canada gave its decision, on 4th November 2014, in the case of Agnico-Eagle Mines Limited vs. The Queen (2014 TCC 324). The taxpayer, Agnico-Eagle Mines Limited (Agnico), a taxable Canadian corporation, issued US-denominated convertible debentures in 2002 at an aggregate price of $ 143,750,000. The issue in the appeal was whether or not Agnico realised foreign exchange gains when the convertible debentures were converted and redeemed for Agnico’s common shares. The tax authorities argued that foreign exchange gains were realised because the conversions and redemption resulted in a repayment of the debt equal to its US dollar principal amount, which had decreased when translated to Canadian dollars. Agnico argued instead that the principal amount of the debt became irrelevant once holders exercised their rights of conversion, as most of them did. It submits that a gain could not have been realised because it borrowed far less than it paid out in Canadian dollar terms (i.e., CAD 228,289,375 borrowed and CAD 280,987,312 paid out, measured by the value of common shares issued to holders).

a) Background: Agnico produces gold. Its shares (Common Shares) were listed on the New York Stock Exchange (NYSE) and the Toronto Stock Exchange (TSX). In 2002, it issued convertible subordinated debentures (Convertible Debentures) at a price of $ 1,000 each, which traded on the TSX. Under the terms of an indenture, interest was payable at 4.5%, the principal amount was $ 1,000 and they were redeemable on or after 15th February 2006 for a redemption price (Redemption Price) equal to the principal amount plus accrued and unpaid interest. Agnico had the option of delivering Common Shares on redemption instead of cash. The holder had the option to convert the debentures for 71.429 Common Shares at any time prior to redemption or maturity. Most of the debentures were converted into Common Shares during 2005 and 2006. Most of the conversions took place after Agnico issued a notice of redemption late in 2005. Most investors availed themselves of the option to convert rather than being subject to the redemption because this yielded a higher number of Common Shares.

The tax authorities determined that Agnico realised deemed capital gains on the conversions and the redemption pursuant to section 39(2) of the Incometax Act. The amounts assessed are the same as if the principal amount had been repaid in cash. This resulted in assessments of deemed capital gains in the amounts of CAD 4,499,360 and CAD 57,676,430 for the 2005 and 2006 taxation years, respectively.

b) Court’s decision: The Court concluded that the consideration received for the issuance of the Common Shares was $ 14 per Common Share or US CAD 1,000 per Convertible Debenture. The Court then determined that the relevant amounts should be translated into Canadian dollars at the spot rates when the amounts “arose”. The date of translation relating to the issuance of the debentures was not in dispute, but the translation date for the amount paid out by Agnico on the conversions. The Court determined that the appropriate date was the date the debentures were issued, in which case there could be no gain. With respect to the redemption, however, the Court held that the terms of the indenture made it clear that the Common Shares issued on redemption are in satisfaction of the redemption price, which became due and payable on the date of redemption. As such, there was a foreign exchange gain on the date of redemption. In conclusion, no foreign exchange gains were realized on the conversions and the tax authorities’ determination of foreign exchange gain on the redemption was upheld.

3) European Union; United Kingdom

ECJ Advocate General’s opinion: Commission vs. United Kingdom (Case C-172/13) – Cross-border loss relief – details

Advocate General Kokott of the Court of Justice of the European Union (ECJ) gave her opinion in the case

Commission vs. United Kingdom of Great Britain and Northern Ireland (Case C-172/13). Details of the opinion are summarized below.

    Facts: Following the ECJ judgment in Marks & Spencer (Case C-446/03) on cross-border loss relief, the United Kingdom had introduced group relief in regard to foreign group members by amending the Corporate Tax Act with effect from 1st April 2006. In 2007, the Commission raised concern that the United Kingdom breaches freedom of establishment by imposing conditions on cross-border group relief that make it virtually impossible in practice to obtain such relief. After the United Kingdom had failed to comply with the Commission’s request to amend its legislation, the Commission brought an action before the Court.

    Advocate General’s Opinion: The AG opened her assessment by stating that it is necessary to examine whether legislation at hand breaches the freedom of establishment (article 49 of the Treaty on the Functioning of the EU (TFEU) and article 31 of the EEA Agreement). The AG continued by stating that contested legislation restrict the freedom of establishment because it imposes stricter requirements on claiming the advantages of group relief if a parent company establishes a subsidiary abroad than if it does so in its state of residence. According to the settled ECJ case law, such restriction is justified only if it relates to situations which are not objectively comparable or where there is an overriding reason in the public interest.

Regarding the objective comparability, the AG notes that although the objective comparability test should not be rejected, there is a significant and, to some extent, crucial difference in the situation of a parent company with a resident or a non-resident subsidiary. The AG concluded that difference must therefore be examined as a possible justification for unequal treatment, including a test of the proportionality of the national rules.

Going further, on overriding reason in the public interest, the AG refers to the ECJ decision in the Marks & Spencer case (C-446/03) by stating that this decision created the so-called “Marks & Spencer exception”. Based on that exemption, losses incurred by a non-resident subsidiary can be transferred to the parent company if those losses cannot be taken into account elsewhere, either for present, past or future accounting periods, in which connection the burden of proof lies with the taxpayer and the Member States are entitled to prevent abuse of that exception. The AG continued by noting that the regime created under this exception has proved to be impracticable and as such does not protect the interest of the internal market. According to the AG, its application also constitutes source of legal disputes because of four reasons:

– the possibility of loss relief elsewhere is in terms of fact really precluded only if the subsidiary has ceased to exist in law;

– the case in which the loss cannot by law be taken into account in the state in which the subsidiary is established, the “Marks & Spencer exception” comes into conflict with another line of case law;

the impossibility of loss relief elsewhere can be created arbitrarily by the taxpayer; and

– the parent company’s Member State is obliged, on the basis of the freedom of establishment, only to accord equal treatment which means that it is possible that a notional tax situation over a period of decades has to be investigated retrospectively.

In conclusion of the analysis of the “Marks & Spencer exception”, the AG stated that this exception should be abandoned because of numerous reasons. By abandoning the exception, the contradictions in the ECJ case law would be resolved and clear borders of the fiscal powers of the Member States would be established. As a second argument, the AG stated that this solution is in line with the requirement of legal certainty which provides for law to be clear and its application foreseeable. Finally, the AG concluded that the abandonment of the “Marks & Spencer exception” does not infringe the ability-to-pay principle as the Commission has claimed.

The AG finalised her assessment by stating that even the complete refusal of loss relief for a non-resident subsidiary satisfies the principle of proportionality. Any restriction on cross-border relief in respect of a subsidiary is thus justified by ensuring the cohesion of a tax system or the allocation of the power to impose taxes between Member States.

In the light of the above, the AG proposed that the ECJ should:

–  dismiss the action;

–  order the European Commission to pay the costs; and

– order the Federal Republic of Germany, the Kingdom of Spain, the Kingdom of the Netherlands and the Republic of Finland to bear their own respective costs.

4) France; United States

Treaty between France and United States – French Administrative Supreme Court rules that participation exemption does not apply to dividends received through a US partnership

In a decision given on 24th November 2014 (No. 363556), the French Administrative Supreme Court (Conseil d’Etat) ruled that dividends received by a French corporation from a US corporation held through a general partnership registered in Delaware may not benefit from the participation exemption, even though such a partnership is transparent for tax purposes under Delaware law. Details of the decision are summarised below.

    Facts: The French corporation Artémis SA held 98.82% of the capital of the general partnership Artemis America, registered in the state of Delaware. This partnership, which did not elect to be treated as a corporation, held more than 10% of the capital of the US corporation Roland. The French corporation Artémis SA received from the partnership Artemis America a EUR 4.7 million share of the dividends distributed by the US corporation Roland to the partnership. Considering that such dividends could benefit from the participation exemption, the French corporation Artémis SA deducted them from its taxable result for year 2002. The French tax authorities, however, contested the deduction of the dividends.

    Issue: Does domestic law, combined with the provision of the France – United States Income and Capital Tax Treaty (1994) (the Treaty) and in particular of article 7(4) of the Treaty, allow the application of the participation exemption on dividends received by a parent company where such dividends are derived from shares held through a transparent US partnership?

Article 7(4) of the Treaty provides that “a partner shall be considered to have realised income or incurred deductions to the extent of his share of the profits or losses of a partnership, as provided in the partnership agreement (…). For this purpose, the character (including source and attribution to a permanent establishment) of any item of income or deduction accruing to a partner shall be determined as if it were realised or incurred by the partner in the same manner as realised or incurred by the partnership.”

    Decision: In accordance with the well-established principle of subsidiarity of tax treaties, the French

Administrative Supreme Court first applied domestic law and then considered whether the Treaty provisions might have an impact on domestic rules.

Domestic law

The Court explained that where the tax treatment of a transaction involves a foreign legal person, one should first determine the type of French legal person to which such foreign legal person is the closest in regard of all the characteristics and of the law ruling the formation and functioning of the foreign legal person. The tax regime which is to be applied to the transaction shall then be determined according to French law.
 

The Court noted that the partnership Artemis America was not treated as a corporation in the US and that, under the law of Delaware, it had a legal personality which was distinct from the one of its partners. Therefore, such a partnership should be viewed as a French partnership (société de personnes) ruled by article 8 of the General Tax Code, even though the partnership Artemis America is transparent for tax purposes under the law of Delaware (while French partnerships are semi-transparent).

Article 145 of the General Tax Code provides that the participation exemption may only apply to companies subject to corporate income tax which hold shares fulfilling certain conditions. The Court ruled that these provisions mean that a French partnership (société de personnes) may not benefit from the participation exemption insofar as it is not subject to corporate income tax, even in the case where its partners are subject to corporate income tax. In addition, the Court ruled that a parent company must have a direct participation in the capital of its subsidiary to benefit from the participation exemption. Therefore, a parent company may not benefit from the participation exemption on dividends derived from shares held through a French partnership.

Insofar as the US partnership Artemis America, which is comparable to a French partnership, stands between the French corporation Artémis SA and the US corporation Roland, the parent corporation Artémis SA is not allowed under domestic law to benefit from the participation exemption on the dividends distributed by the US corporation Roland.

The Treaty

The Court ruled that the purpose of article 7 of the Treaty is to allocate the taxing rights over profits realised by enterprises resident in one of the two contracting states. The only purpose of article 7(4) is to allocate such taxing rights when profits are realised by a US partnership. Pursuant to articles 7 and 10 of the Treaty, dividends distributed by a US corporation to a US partnership, a partner of which is a French corporation, must therefore be seen as dividends distributed to the French partner, thus being taxable in France. However, it does not result from article 7 of the Treaty that such dividends should be seen as dividends directly distributed to the partner for the application of French tax law.

Hence, the Court concluded that the Treaty does not include any provision allowing the French corporation Artémis SA to deduct from its taxable result its share of the dividends distributed by the US corporation Roland to the US partnership Artemis America, and dismissed the taxpayer’s appeal.

5) Finland; Hungary

Supreme Administrative Court: Private pension based on work exercised abroad not income from Finnish sources The Supreme Administrative Court (Korkein hallinto-oikeus, KHO) gave its decision on 6th October 2014 in the case of KHO:2014:146. Details of the decision are summarised below.

    Facts: The taxpayer, A, has moved permanently to Hungary on 23 October 2005 and has been treated as a non-resident of Finland since 1st January 2009. In 2009, A received pension payments from a Finnish pension fund. The pension was based on work done for eight private employers between the years 1972 and 2002.

The first four employments were mainly exercised in Finland, whereas the four latter ones between 1988 and 2002 were exercised abroad.

The tax authorities taxed the pension payments fully whereas the Tax Appeal Board investigated the tax treatment based on each employment and ruled that the part which related to employment exercised abroad was not taxable in Finland. The tax authorities appealed against the ruling which was also upheld by the District Administrative Court of Helsinki.

    Legal background: Section 10 of the Income-tax Law (Tuloverolaki) includes a non-exhaustive list of items of income which are treated as derived from Finland. The list includes pension which is received from a pension insurance taken from Finland.

    Issue: The issue was whether or not the pension paid to the non-resident taxpayer is regarded as income from Finnish sources.

    Decision: The Court upheld the decisions of the Tax Appeal Board and the District Administrative Court and held that the pension income was not income from Finnish sources and not taxable in Finland as it related to work exercised abroad.

The Court acknowledged that it would be in accordance with the wording of the law to treat pension from a Finnish pension fund as income from Finnish sources. The Court, however, looked into the law proposal (HE 62/1991) (the Proposal) which added the pension insurance taken from Finland to the list of items of income which are treated as derived from Finland. The Proposal was explicitly referring only to pensions based on private pension insurances, whereas the tax practice about pensions based on obligatory pension insurances was that such pensions are taxable in Finland only if they were based on work exercised in Finland. This was also established in the unpublished decision of the Supreme Administrative Court (decision No. 3922 from 1990).

The Court emphasised that if the legislator wanted to change the existing practice, the Proposal should have explicitly stated this. Considering the Proposal and the tax practice, there were no grounds to change the interpretation so that pension insurance from Finland would cover obligatory pension insurance. The Court acknowledged that such interpretation may lead to double non-taxation of such pension due to the functioning of a tax treaty, which is likely not the intended effect of tax treaties. Despite this, there were no grounds to change the previous interpretation.

6) Finland; Switzerland

Treaty between Finland and Switzerland – Administrative Court of Helsinki: Licence fee for using group name and logo paid to a Swiss related party not deductible for Finnish company

The Administrative Court of Helsinki (Helsingin hallinto-oikeus) (the Court) gave its decision on 10th October 2014 in the case of 14/1103/4. Details of the decision are summarised below.

    Facts: A Finnish company (FI Co) has belonged to an international group since 1981. FI Co has been using the group’s logo since 1989 and the group’s name has been included in its name since 1995. In 2004, FI Co concluded a contract with a Swiss company (CH Co), which belongs to the same group and holds the rights to the group’s name and logo. Under the contract terms FI Co received the right to use the group’s name and logo in Finland and in return was charged a licence fee for the those rights. During the court proceedings, FI Co emphasised that the licence fee covered also other features of the brand, such as the mission and values of the group.

    Issue: The issue was whether or not the licence fee (royalty) FI Co paid to CH Co was a tax deductible business expense for FI Co.

    Decision: The Court held that the licence fee was not tax deductible for FI Co. The Court referred to section 31 of the Law on Tax Procedure which stipulates on transfer pricing adjustments between related parties and section 7 of the Business Income Tax Law under which all costs and expenses incurred for the purpose of earning, securing, or maintaining the taxpayer’s income are deductible for tax purposes. The Court emphasised that it is crucial whether an independent entity in similar circumstances would be willing to pay for such rights or were they simply benefits which FI Co accrued by belonging to a group.

As a starting point, the Court pointed out that the name and logo as well as the mission and values of the group are common for all entities belonging to the same group and indicate that the entity in question is part of a bigger entity. As such, those are benefits which accrue based on the group relationship without a fee. A fee can, however, be charged provided that the entity paying the fee can show that it has obtained commercial benefits from the contract.

The Court pointed out that FI Co has belonged to the group since 1981, used its logo since 1989 and attached the group name to its own name since 1995, whereas the licence fee was introduced only in 2004. Although these facts on their own are not decisive to deem the licence fee non-deductible, such facts have specific significance when no significant changes in the market position and circumstances have taken place. FI Co has not indicated that there has been a significant change in its market circumstances since 2000.

The Court held that FI Co had failed to show that the increase in its profits resulted from the contract. The benefits FI Co had accrued are benefits obtained based on the group relationship. As such, there were no grounds for CH Co to charge for such benefits and no business reasons for FI Co to pay for them.

Article 9 (associated enterprises) of the 1991 Finland-Switzerland tax treaty was mentioned as an additional legal basis for the decision although the Court did not elaborate more on the treaty aspects.

7) France; Germany

Treaty between France and Germany – French Administrative Supreme Court qualifies income derived from “jouissance” rights as dividend

In a decision (No. 356878) given on 10th October 2014, the French Administrative Supreme Court (Conseil d’Etat) ruled that the income derived from German “jouissance” rights (Genussscheine) within the meaning of German law is to be treated as dividend pursuant to paragraphs 6 and 9 of article 9 of the France – Germany Income and Capital Tax Treaty (1959) (as amended through 2001) (the Treaty).

    Facts: From 2004 to 2006, the French bank Caisse régionale du crédit agricole mutuel du Finistère received an income from securities issued by the German entity Landesbank Sachsen. These securities were denominated as “Genussscheine” in the issuance contract.

Under the contract, the annual income to be received by the French bank amounted to 6.6% of the nominal value of the securities, except:

– where and insofar as the payment of this amount would create or worsen a loss in the debtor’s accounts; or
– where, after a capital reduction resulting from debtor’s losses, the capital has not been built up to its former total nominal value.

The contract also provided that the amounts paid in relation to the “jouissance” rights (Genussscheine) were deductible from the profits of the securities’ issuer.

The income received by the French bank was subject to a 26.375% withholding tax corresponding to the corporate income tax and the solidarity tax due under the German tax legislation.

    Legal background: Article 9 (6) of the Treaty provides that the term “dividends” as used in this article means income from shares, “jouissance” shares or “jouissance” rights, mining shares, founders’ shares or other rights, not being debt claims, participating in profits.

In turn, article 9(9) of the Treaty provides that income referred to in paragraph 6 arising from rights or shares participating in profits (including “jouissance” rights or “jouissance” shares) and, in the case of Germany, income from a sleeping partner (stiller Gesellschafter) from his participation as such, and income from loans participating in profits (partiarisches Darlehen), and income from profit-sharing loans (Gewinnobligationen)) that is deductible in determining the profits of the debtor may be taxed in the contracting state in which it arises, according to the laws of that state.

    Issue: The French bank considered that it was entitled to a French tax credit amounting to the German withholding tax, pursuant to article 20(2)(a)(bb) of the treaty referring to    income    arising    from    rights    participating    in    profits,    that is     deductible     in     determining     the     profits     of     the     debtor    (article 9(9) of the treaty).

However, the french tax authorities took the view that the income derived from “jouissance” rights constituted interest, which is taxable only in the state of which the recipient is a resident (article 10 of the treaty), and refused to grant the tax credit.  The french bank made a claim against this decision. On 5th december 2011, the french administrative Court of appeals (Cour administrative d’appel),    confirming the judgment given by the administrative tribunal (tribunal administratif) on 28th  january 2010, ruled that, in regard to the terms of the issuance contract and especially of its provision    which    defines    “jouissance” rights as debt claims, the income derived from these “jouissance” rights cannot be     qualified     as     dividend     under     article     9(6)     of     the     Treaty.    Consequently, the German withholding tax cannot give rise to a tax credit in france.

In the course of the subsequent proceedings, however, the Conseil d’Etat ruled in favour of the french bank.

d)  Decision: The Conseil d’Etat noted that the following facts were not disputed:
–   the income received by the french bank was derived from “Genussscheine” within the meaning of the German legislation;    and

–   the income derived from “Genussscheine” is expressly mentioned as a dividend in paragraphs 6 and 9 of article 9 of the treaty in its German-language version, which is equally authentic pursuant to the treaty.

The Conseil d’Etat, therefore, concluded that the income received    by    the    French    bank    qualified    as    a    dividend    under    article 9(6) of the treaty.

Note. The case has been referred back to the administrative Court of appeals.

Authority for Advance Rulings – Important aspects and issues

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In this article, the authors, besides giving a brief overview of the
advance ruling process, have also discussed various important technical
issues which confront an applicant seeking an advance ruling from the
AAR, such as meaning of words/phrases ‘proposed transaction’, ‘pending
before any income tax authority’, AAR’s discretionary powers to reject
an application and grounds for judicial review etc.

A. Introduction & Objective

The
scheme of advance ruling was introduced from 1st June 1993 in Chapter
XIX-B of the Income-tax Act, 1961, for the benefit of non-residents to
enable them to obtain an advance ruling from the Authority for Advance
Ruling [AAR] so that they are relieved of uncertainty with regard to
taxability of income arising out of their business /investment,
activities or transaction undertaken or proposed to be undertaken in
India.

This provisions has now been extended to residents with
regard to taxability of income arising out of one or more transactions
valuing Rs. 100 crore or more.

The most striking feature of the
Indian system is that the proceeding is adversarial (in most countries,
proceedings are negotiated), which makes the decision binding on the
applicant and the revenue authorities. In most countries, the advance
rulings are delivered by the revenue authorities and not by a judicial
or quasi-judicial body. Therefore, these rulings are largely considered
to be nonbinding. However, in India the AAR has been set up as a
high-level quasi-judicial authority, which has been granted statutory
recognition. Owing to the binding nature of rulings on the applicant as
well as the revenue, this scheme is intended to significantly faster
dispute resolution process as compared to normal litigation process.

Constitution
The AAR is an independent quasi-judicial body. An AAR Bench, generally, comprises of three members:

The Chairman, who is a retired judge of the Supreme Court or the Vice-Chairman who has been a Judge of a High Court;

One
Revenue member from the Indian Revenue Service who is a Principal Chief
Commissioner, Principal Director General, Chief Commissioner or
Director General of Income-tax; and

One Law member from the Indian Legal Service who is an Additional Secretary to the Government of India.

Scope of Advance Ruling
Generally, applicants may raise any question which relates to tax liability –

Both ‘questions of law’ as well as ‘questions of fact’ can be raised before the AAR.

Questions can pertain to both concluded transactions as well as anticipated transactions.

Hypothetical questions cannot be raised before AAR.

Applicant can raise more than one question in one application.

The
questions may relate to any aspect of the applicant’s liability
including international aspects and aspects governed by the Double Tax
Avoidance Agreements (‘DTAA ’).

Advantages of AAR
Assurance to non-resident investors to obtain the ruling without undue delay and with certainty regarding its tax implications.

Best suited to sort out complex issues of taxation including those concerning interpretation of the applicable DTAA .

Rulings
binding on the applicant as well as the revenue, not only for one year
but for all the years unless there is a change in facts/ law.

Facility to modify or reframe the questions, agreements or projects till the time of hearing.

Confidentiality of proceedings is maintained.

Protracted hearing of the application is avoided.

Significantly faster dispute resolution process as compared to the normal litigation process.

The
AAR is by law mandated to pronounce its ruling within 6 months as
compared to more time involved even at the second level appellate
tribunal level.

B. Some Important Issues

1. Meaning of Advance Ruling – Section 245N

U/s. 245N(a)(i), a non-resident applicant can seek a ruling in relation to
a transaction undertaken or proposed to be undertaken by a non-resident
applicant. U/s. 245N(a) (ii), a resident applicant can seek a ruling in
relation to determination of the tax liability of a non-resident
arising out of a transaction undertaken or proposed to be undertaken
with such non-resident.

The words ‘tax liability’ has not
been a part of subclause (i) as compared to sub-clause (ii) & (iia)
of section 245N. While deciding on maintainability of application u/s
245N, a doubt had arisen as regards admissibility of application in case
of Umicore Finance [2009] 184 Taxman 99, since, on facts, it
appeared prima facie that the determination sought by the non-resident
applicant was in relation to the tax liability of an Indian Company. The
AAR held in favour of the assessee, as follows:

“6. It seems to us that the application is maintainable having
regard to the wider language of sub-clause (i) of section 245N(a) in
contrast with the language employed in sub-clause (ii). There is no
specific requirement in sub-clause (i) that determination should relate
to the tax liability of a non-resident. Going by the averments of
the applicant, it is clear that the capital gain tax issue arising in
the case of the acquired Indian company has a direct and substantial
impact on the applicant’s business in view of the stipulations in share
purchase agreement. Subclause (i) has to be construed in a wider sense and moreover a remedial provision shall be liberally construed.
We are, therefore, of the view that the question raised by the
applicant falls within the definition of ‘advance ruling’ under section
245N(a) of the Act. Accordingly, the application is allowed under
section 245R(2) and posted for hearing on merits on 11-8-2009.”

Previously, in case of Connecteurs Cinch, S.A. [2004] 138 Taxman 120, the application was rejected u/s. 245N(a), since the applicant sought ruling on tax liability of its Indian subsidiary,
which was considered as not a consequence of the transaction undertaken
or proposed to be undertaken by the non-resident applicant.

However, while interpreting the words ‘proposed transaction’
in case of Trade Circle Enterprises LLC [2014] 42 taxmann.com 287
(AAR), it has been held that the ruling of Umicore Finance is not
applicable. The AAR while rejecting the application as incompetent, held
as follows:

“…. In order to bring in the question within the
scope of section 245N of the Act, there has to be either a transaction
undertaken or proposed transaction to be undertaken by the non-resident
applicant. This is not the case in the present application. “Transaction” or “proposed transaction” are not the same as mere intention.
In this case the applicant intends to invest in a 100 per cent
subsidiary company in India which in turn intends to set up a consortium
by way of partnership firm with the Indian company and the partnership
firm propose to acquire the undertaking of the Indian company which is
stated to be eligible for deduction u/s 80IA of the Income-tax Act,
1961. We are of the view that the 100 per cent subsidiary company has to
exist in reality and the partnership firm has to be set up in order to
make transaction or proposed transaction of the applicant with the
Indian company/subsidiary. The question relates to proposed setting
up of the subsidiary and the partnership firm with the Indian company
and as to whether the subsidiary or the partnership firm will be
eligible to 100 per cent deduction u/s 80IA of the Income-tax Act. The
ruling of this Authority in the case of Umicore Finance, In re [2009]

Issues Concerning Indian Expatriates Working in the US

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The US tax laws and Indian Tax Law are unique in their own ways and hence it is advantageous to have some basic knowledge before one plans to move from one country to the other. With this intention, we published a series of articles on US Taxation in this column.

In the earlier parts of this series on US Taxation, we covered tax implications on passive income such as capital gains, dividends, interest and rental income pertaining to NRIs, US Citizens residing outside US and Indian expatriates working in US etc. This part covers tax implications on active income such as salaries and income from trade and business1 especially for Indian Expatriates working in US. In order to elucidate issues clearly, they are discussed in a Questions – Answers format based on a Case Study.

The intention of this article is to highlight some of the important issues for the Indian Expatriates who intend to serve in the US or engage in some trade or commerce. One more aspect that such expatriates need to bear in mind is applicability of the Social Security Laws, which is not a subject matter of this article. Readers are well advised to consult US Tax Expert before taking a final call on any issues. This article should be referred as a piece of information and not as professional advice.

Introduction
India has experienced massive brain drain for a long period of time. However, of late, the trend seems to be reversing with more and more Indians returning home for better prospect. Even those who are taking up assignments in the US, ranging from three months to five years, are planning for eventual settlement in India. Those who go to the US for a short stint either on deputation, secondment or a job are addressed as “Indian Expatriates” (IE) in this Article for the purpose of better understanding.

These assignments for a specified/short duration may make IE tax resident of the US (resident alien) and in the year of their return to India they may land up having dual residency of both India and the US.

Under the US Tax law, it is possible to have a dual status i.e. non-resident alien and a resident alien, for the same tax year. This usually occurs in the year the IE arrives in or departs from the US. We shall discuss such eventualities as well.

Let us examine the tax implications for an Indian Expatriate in respect of his active income such as salaries and income from trade and business taking into account dual status and transitory issues, with the help of a case study.

Case Study:
Mr. Shah, a Citizen and resident of India, is offered a job with Google in the US. He was unmarried in the year 2013. He had relocated to California, USA in October 2013 for work and starts his new job from November 1st 2013. He stays in the US for the rest of 2013 and the whole of 2014. His Green card was applied by the company and was received by him in February 2014. Mr. Shah got another fabulous opportunity in March 2015 with Flipkart and decides to move back to India and would like to surrender his green card. He moves to India on 1st May 2015 after surrendering his Green Card in April 2015 and resumes his new job on 1st June 2015. In the meantime, he gets married in India in May 2015.

Mr. Shah had earned the following income in Calendar Years (C.Y.) 2013, 2014 and 2015:-

He also earns income in India which if converted to US$ would be as follows:-

(It is assumed that Dividends and Interest Income are accrued to Mr. Shah evenly during the year. This assumption will help us in apportionment of income for the part of the year. However, in actual practice, one must consider the actual accrual during the period of computation of income)

As explained in Part I of the current series of Articles, in the US, the residential status is decided under two tests i.e. Green Card and Substantial Presence Test. Mr. Shah would not be a US resident in 2013 as he was neither holding a green card nor he had resident under substantial presence in the US. Therefore, Mr. Shah’s tax status in the US for the C.Y. 2013 would be ‘Non – resident Alien’. His tax status for the Calendar Year 2014 & 2015 would be that of a ‘Resident Alien’ as he possessed Green Card. In the backdrop of above facts, let us understand the applicable US tax provisions.

1. For a non resident alien, what are the factors determining the taxability of US sourced income?

A non-resident alien (meaning a foreign citizen nonresident of US) in the US is usually subject to tax only on U.S. source income. Under limited circumstances, certain foreign source income is also subject to the US tax.

The general rules for determining liability of the US source income that apply to most non-resident aliens are shown in the Table below:

Not all items of US source income are taxable in the hands of non residents. Certain Interest and dividend income, services performed for foreign employer etc. earned in US may not be taxable in the US. In general, a resident alien is subject to the same taxes as a US Citizen, while a non – resident alien pays tax on income that is generated within the US but not including Capital Gains.

Mr. Shah was a “Non – resident Alien” in the US for the C.Y. 2013. Therefore, salaries earned by him for the month of November & December 2013 would be taxed in the US.

The provision for taxation of salaries in the US for “non – resident aliens” is similar to section 9 (1) (ii) of the Indian Income-tax Act, 1961 which also provides that the salaries are deemed to be earned and taxed where services are rendered.

2. What are the various categories (tax status) available to a “resident alien” in US for filing Return of income? What difference does it make while selecting a particular tax status? What are the various threshold exemption limits under different tax status categories?

Various filing categories (Tax Statuses) that a “Resident alien” in the US can choose are:
Single Individual
Married Filing Jointly
Married Filing Separately
Head of Household
Qualifying Widow(er) with Dependent Child

[Tax rates in all above categories ranges from 10% to 39.6% with different slabs for different categories. Higher tax is levied to a person with fewer responsibilities. e.g. Single Individual would get 10% slab for an annual income upto US$ 9,075, whereas a Married man filing jointly return would be taxed @ 10% on an annual income up to US$ 18,150/-]

Computation of tax depends upon the filing status of the tax payer. Various items which varies as per filing status of the tax payer are: the amount of standard deduction available to a resident alien, Itemised2 deductions, exemptions and certain credits (They are all covered in the later part of this article); as well as the tax rate schedule which dictates the marginal tax bracket.

Marginal Tax Rates for 2014 for all the above statuses are:-

For 2015 Tax Slabs and US Federal Income Tax Rates are as follows:-

In the case study under consideration, since Mr. Shah was unmarried in 2014, he has to file Return in the status/category of single individual.

3. How is the Gross Income computed in the US and what are the various deductions and exemptions available from the Gross Income in the US?

For the US income tax purposes, “gross income” means all income from whatever source received, except for those items specifically excluded by law.

Gross income includes wages, salaries and other compensation, interest and dividends, State income tax refund (if claimed as an itemised deduction in prior years), income from a business or profession, alimony received, rents and royalties, gains on sales of property, income from small business corporation, trust, or partnership.

In this case study, Gross Income of Mr. Shah would be calculated as follows:-

Mr. Shah would be “non resident alien” in 2013, as he neither fulfills the Substantial Presence Test nor holds Green Card. hence, only the uS sourced income would be considered while calculating Gross Income for filing return for the Calendar year 2013:-

 

Salaries (for november & december 2013) interest in uS

2013

uS$ 20,000

uS$ 75

total

uS$ 20,075

 

2014

Salaries

uS$ 1,20,000

dividends3

uS$ 750

interest
(1,000+1,500)4

uS$ 2,500

total

uS$
1,23,250


Deductions from gross income are used to arrive at Adjusted Gross Income (AGI). Non-resident alien can claim deductions only to the extent they are effectively connected with the uS business activity.

? Deductions and exemptions from Gross income:-

Besides deductions for business expenditure following two types of deductions/exemptions are available to a resident alien in uS:-

(i)    Standard Deduction or Itemised Deduction

Taxpayers  have  the  choice  of  either  taking  a  standard deduction or itemising their deductions i.e. actual deductions, whichever will result in a larger deduction. The amount of the standard deduction varies depending on the filing status. Non-resident aliens cannot claim the standard deduction.

If the allowable sum of actual deductions is greater than the standard deduction allowed based on the filing status, one should opt for actual deductions. the following are examples of amounts that can qualify as itemised or actual deductions: medical and dental expenses, Greater of state and local income taxes or general sales taxes, foreign  taxes  (if  one  elect  to  deduct  rather  than  take a  credit),  real  estate  taxes,  Personal  property  taxes, Qualified home mortgage interest and points, Mortgage insurance premiums, Charitable contributions to  qualified U.S. charities, Investment interest, if applicable, unreimbursed employee expenses, miscellaneous expenses, gambling losses etc. non-resident aliens can deduct certain itemized deductions if he receives income effectively connected with uS trade or business.

Standard deductions: – The standard deduction for 2014 is $6,200 for single taxpayers and married taxpayers filing separately. the standard deduction is $12,400 for married couples filing jointly and $9,100 for heads of households.

In 2013, Mr. Shah would be taxed as Non – resident Alien and would be taxed on his entire salary earned in the US without Standard Deduction.

In 2014, Mr. Shah has an option: either to claim Standard deduction of US$ 6,200 or actual deduction of US$ 8,000 in respect of State income tax. Since, the actual deduction is more than the standard deduction, it’s advisable for him to opt for itemise deduction.

(ii)    Exemptions

Exemption in US tax law context, are akin to personal allowance. a resident alien can claim certain amount as exemption from its taxable income. This is over and above Standard deduction or itemised deduction mentioned above.

Resident aliens can deduct $3,950 for year 2014 for each exemption  allowed.  resident  aliens  are  allowed  one exemption for themselves, and if one is married and files a joint return, then he can claim one exemption  for the spouse and one exemption for each dependent person. Certain dependency tests needs to be met in order to qualify for exemption i.e. he/she either has to be a qualifying child or a qualifying relative.

“non-resident aliens” can claim only one personal exemption for themselves.
 
As Mr. Shah has no dependent, he would be eligible for one exemption i.e. US$ 3,950 for himself.

Computation of Taxable Income of Mr. Shah would be as follows:-

Gross income

uS$
1,23,250

Minus

deductions
from Gross income5

 

nil

Equals

adjusted
Gross income (aGi)

 

uS$
1,23,250

Minus

itemised or
Standard deduction

 

uS$ 8,000

Equals

taxable
income before exemptions

 

uS$
1,15,250

Minus

exemptions

 

uS$ 3,950

Equals

taxable income

 

uS$
1,11,300

Application of tax rates as above

tentative tax liability

uS$ 24,340


4.    What are the various credits available to a resident alien and a non-resident alien? What are the provisions in US tax laws for granting foreign tax credit?

Tax planning in the uS consists of two equally important parts, namely, (i) using deductions to reduce taxable income  and  (ii)  using  credits  to  reduce  tax. tax  credits reduce a person’s tax liability. Various tax credits available are foreign tax credit, credit for child care and dependent care expenses, credit for elderly and disabled, education credit, retirement savings contribution credit, child tax credit, adoption tax credit, earned income credit and other credits.

Resident and Non – resident aliens have different filing advantages and disadvantages for example, a “resident alien” can use foreign tax credits whereas a “non – resident alien” cannot.

Foreign taxes paid are allowed as credit against the US tax, on income which is taxed in both jurisdictions. This is referred to as the foreign tax credit. To qualify for this credit, the foreign tax incurred must be imposed on a person and levied on his income.

The  foreign  tax  credit  is  limited  to  the  lesser  of  the actual foreign tax paid or accrued or the uS tax liability associated with the income that attracts the foreign tax (foreign source taxable income).

Two levels of computation for calculation of Foreign Tax Credit:

In the first level, one needs to compute foreign source taxable income. While calculating foreign source income, it is necessary to allocate a portion of the deductions used to arrive at taxable income (before the deduction for personal exemptions). this can be done based on the following formula:-

Foreign Source income   X Certain itemized deduction Gross income    = amount of deduction allocated to foreign Source income

Gross  foreign  Source  income  –  amount  of  deduction allocated  to  foreign  Source  income  =  foreign  Source taxable income

In our case study, dividends (uS$ 750) earned by mr. Shah are not taxable in india as they are exempt under 10(34)  of  the  income  tax  act.  however,  interest  (uS$ 1,500) is taxable and US$ 200 was paid by him in india.

Let’s first find foreign source income less deductions. i.e. US$ 2,250/ US$ 1,23,2506 = 0.018. applying the said ratio to deduction i.e. 0.018*US$ 8,0007 = 144.

Hence foreign source taxable income = US$ 2,106 (US$ 2,250 – US$ 144)

The second level is where foreign tax Credit limitation is calculated by applying the following formula:

Foreign Source taxable income
X U.S.tax Liability = foreign tax Credit
Since Mr. Shah’s foreign tax credit US$ 200 is less than the eligible tax credit of US$ 445, US$ 200 would be allowed as foreign tax credit on foreign sourced income.

5.    What are the various activities that fall under Trade and business income in the US?

Whether a resident or a non resident alien is considered as engaged in trade and business activities in the uS depends upon the nature of business activities carried on by such a person. It also depends upon any income received in that year as effectively connected with that trade or business. activities like performing Personal Services (even that of babysitting), business operation of selling services/products/merchandise, membership of a Partnership firm in the US, beneficiary of an estate or trust in the US, trading in stocks, securities and commodities through a fixed place of business in the US, may result in a person to be engaged in trade and business in the uS.

However, if a non resident’s only US business activity is trading in stocks, securities, or commodities (including hedging transactions) through a US resident broker or other agent, then he will not be regarded as engaged in a trade or business in the uS.

6.    What is the meaning of “dual status”? What types of income are taxed in the US in a dual status year? What are the restrictions on the dual status tax payers as per the US Laws?

“dual Status” arises when a person has been both a “resident alien” and a “non-resident alien” in the same year. dual status does not refer to citizenship; it refers only to a residential status under the uS tax laws. the most common dual-status tax years are the years of arrival and departure.
An Indian Expatriate is taxed on his worldwide income in US for the part of the year when he is a “Resident alien”.
 
Total taxable income Before exemptions
 
Limitation
 
for that part of the year when a person is a non-resident alien, he is taxed on (i) income from uS sources and (ii) on certain foreign source income which are treated as
 
Applying the above formula, the foreign  tax  credit  would be:-

US$ 2,106/ US$ 1,15,250 (US$ 1,23,250 – US$ 8,000) X US$ 24,340 = US$ 445
effectively connected with a US trade or business.

When determining what income is taxed in the US, one must consider exemptions under the US tax law as well as the reduced tax rates and exemptions provided by the tax treaty between the US and india.

The following restrictions apply if a person is filing a tax return for a dual-status tax year.

?    Standard deduction: Standard deduction will not be available. however, one can itemise any allowable deductions.
?    Exemptions:   the   total   reduction   on   account   of exemptions for a person’s spouse and allowable dependents cannot be more than his taxable income [computed (figured) without deducting personal exemptions] for the period he is a resident alien.
?    Head of household: one cannot use the head of household  tax  table  column  or  tax  Computation Worksheet. In other words, one cannot file return in the status of “head of household” in a dual status year.
?    Joint  return:  One  can  file  a  joint  return,  subject  to fulfillment of certain conditions.
?    Tax credits. one cannot claim the education credits, the earned income credit, or the credit for the elderly or the disabled unless one is married, and chooses to be treated as a resident for the whole year by filing a joint return with the spouse who is a u.S. citizen or resident.

In our case study, Mr. Shah would be a dual – status taxpayer for Calendar Year 2015. his residency in US ends on 30th April 2015. he would be taxable from 1st January 2015 to 30th April 2015 on his worldwide income as a resident alien. As discussed above Mr. Shah would be faced with some restrictions with respect to deductions and exemptions while filing his return as dual tax payer.

However, for the period of “non – resident alien” (i.e. from 1st may 2015 to 31st december 2015) Mr. Shah would be taxed only on uS sourced income or an income effectively connected with US trade or business.

Bank interest earned by US non – residents on bank deposits in US are exempt from uS income tax if not connected to US trade or Business.

Computation of income of mr. Shah for the year 2015 would be as follows:-

Gross total income from 1st jan 2015 to 30th April 2015

Particulars

uSd

Salary
Income

US$ 30,000

Interest
Income in the US (500*4/12)

US$    42

Interest
income in India (3000*4/12)

US$ 1,000

Dividend
Income in India (800*4/12)

US$ 267

Gross Income during period of residence

US$ 31,309

Gross
income

uS$ 31,309

Minus

deductions
from Gross income

 

nil

Equals

adjusted
Gross income (aGi)

 

uS$ 31,309

Minus

itemised or
Standard deduction *

 

uS$ 1,500

Equals

taxable
income before exemptions

 

uS$ 29,809

Minus

exemptions
2015

 

uS$ 4,000

Equals

taxable income

 

uS$ 25,809

Application of tax rates as proposed for
2015

tentative tax liability

uS$ 3,410

Minus

tax credits**

 

uS$     138

Equals

net tax liability

 

uS$ 3,272


As  mentioned  above,  dual  tax  payers  can’t  claim standard  deduction.  therefore,  mr.  Shah  will  have  to claim itemised deduction in place of Standard deduction. one of the itemised deduction is State income tax which in mr. Shah’s case is uS$ 1,500/-

**in our case study, dividend (uS$ 800) earned by mr. Shah is not taxable in india as it is exempt under 10(34) of the income-tax act. however, interest (uS$ 3,000) is taxable and US$ 150 was paid by him in India. Let’s first find foreign source income (US$ 3800*4/12 = US$ 1267) less deductions. i.e. US$ 1,267/ US$ 29,809 = 0.043. applying the said ratio to deduction i.e. 0.043*US$ 1,500
= 65. hence foreign source taxable income = US$ 1,202 (US$ 1,267 – US$ 65)

Applying the formula, the foreign tax credit would be:- US$ 1,202/ US$ 29,809 X US$ 3,410 = US$ 138
Since Mr. Shah foreign tax credit of uS$ 150 is more than the eligible tax credit of US$ 138, US$ 138 would be allowed as foreign tax credit on foreign source income.

Net Tax Liability
for 2015 Minus Tax Withheld

Net Tax
refund due to Mr. Shah

US$ 3,272

US$ 4,000

(US$ 728)


for the non – residence period (i.e. 1st may 2015 to 31st december 2015), the only uS sourced income of mr. Shah is interest on bank deposits which is exempt for non residents aliens.
 
7.    For how long the records for the US earned income and expenses are to be kept?

The length of time for which a person is required to keep record of income and expenses depends upon the action, expense, or event which the document records. Generally, one must keep the records that support an item of income, deduction or credit shown on his tax return till the period of limitations for that tax return runs out.

the  period  of  limitations  is  the  period  of  time  in  which a person can amend his tax return to claim a credit or refund, or the irS can assess additional tax. in normal cases i.e. if returns are filed in time and correctly, one needs to keep records for at least three years.

Period of Limitations that apply to Income tax returns

a)    Keep records for 3 years if situations (d), (e), and (f) below do not apply to a person.
b)    Keep records for 3 years from the date in which a person has filed original return or 2 years from the date in which he paid the tax, whichever is later, if he filed a claim for credit or refund after he filed his return.
c)    Keep records for 7 years if a person filed a claim for a loss from worthless securities or bad debt deduction.
d)    Keep records for 6 years if a person did not report income that should be reported, and it is more than 25% of the gross income shown on his return.
e)    Keep records indefinitely if one does not file a return.
f)    Keep records indefinitely if one files a fraudulent return.
g)    Keep employment tax records for at least 4 years after the date that the tax becomes due or is paid, whichever is later.

8.    What precaution a resident alien has to take before leaving the US?

Before leaving the US, all aliens (except those which are not required to obtain Sailing or departure Permits) must obtain a certificate of compliance. This document, also popularly known as the sailing permit or departure permit, is part of the income tax form one must file before leaving. A person will get the permit from an IRS office in the area of his employment, or he may obtain one from an IRS office in the area of his departure. A person will receive a sailing or departure permit after filing Form 1040-C or form 2063.

A person gets his sailing or departure permit at least 2 weeks before he plans to leave. he cannot apply earlier than 30 days before his planned departure date.

Also the person has to comply with the provision of expatriation tax provisions. (refer the  answer to the next question)

9.    What is an Expatriate Tax (Exit Tax) and what are the provisions related to it?

The expatriation tax provisions apply to uS citizens who have renounced their citizenship and long-term residents who have ended their residency. Long term resident are persons who were a lawful permanent resident of the uS in at least 8 of the last 15 tax years ending with the year his residency ends.

If   a   person   expatriated   after   June   16,   2008,   the expatriation rules apply to him if he meets any of the following conditions.

?    Income Tax Test: the expatriate’s average annual u.S. income tax liability over the 5 years prior to expiration was over uS$ 160,000/- for 2015 ($1,57,000/- for 2014).
?    Net worth test:  the expatriate’s net worth is at least uS$ 2 million.
?    Compliance Test: the expatriate does not certify that he met all US tax obligations for the five years before expatriation.

If a person is subject to exit tax, then he is known as “covered expatriate” and he is treated as if he has sold all  his  property  at  its  fair  market  Value  (FMV)  on  the day before his date of expatriation. Any resulting gains in excess of exclusion amount (US$ 6,68,000/- for 2013, US$ 6,80,000 for 2014 & US$ 690,000/- for 2015) are subject to income tax (called as “mark-to-market tax”). For  the  purposes  of  calculating  this  “deemed  gain”  on property that he owned when he first became a US resident, he is treated as if he acquired that property for its FMV on the date that he became a US resident, if that amount is higher than the actual cost of acquisition.

A person who expatriated or terminated his US residency, must file Form 8854, attach it to Form 1040 or Form 1040NR (whichever is applicable). a person can also make an irrevocable selection to defer payment of the mark-to-market tax imposed on the deemed sale of property subject to certain conditions.

Summation:
US tax laws are unique in many ways. To understand US tax system, we need to unlearn many indian tax concepts. in US, tax rates are prescribed from US$ 1 and there is no threshold exemption. However, Standard deductions and exemptions are available before arriving net taxable income. Tax payers have the option to file joint tax returns. Tax  relief  is  given  based  on  family  responsibilities  one bears. foreign tax credit is allowed in proportion to US tax liability on the same income. exit tax is levied on uS Citizens and long-term residents on fulfillment of certain tests. Finally, the dual tax status allows one to compute tax liability for the part of the year, such that double taxation can be avoided in the year of migration, in or out of USA.

Some US Tax Issues concerning NRIs/US Citizens

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Non-resident Indians1 (NRIs) residing in the US, constitute the second largest Asian population in the USA next only to China. Many NRIs have dual sources of income i.e. from US and India. Many questions arise as to the taxability of Indian income in the USA not only in case of NRIs but also in respect of the US Citizens/Green Card holders who may be tax residents in India. 2This article attempts to answer some basic issues pertaining to the the US tax laws which will help not only NRIs, but Indian expatriates working in the US or those who are US Citizens or Green Card holders who are not tax residents of the USA. In order to elucidate issues clearly, they are discussed in a Questions
– Answers format.

Introduction
The USA is a unique county which levies taxes on the basis of both Citizenship and Residential status of a person. A US Citizen is taxed on his worldwide income, irrespective of his residential status. The term used for foreign citizen in the US tax law is “alien”. The first seven questions deal with determination of residential status of a person in the US and scope of taxability based on such status. Thereafter, some questions deal with taxability in the USA of certain Indian incomes which are exempt from taxation in India. Many NRIs holding US Citizenship or Green Card holders prefer to settle in India post retirement or may simply return to India for good during their active life. In any event, any US Citizen or Green Card holder who may be a tax resident of India, needs to disclose his Indian income and assets in his US Tax Return and file regular tax return and disclosure returns in the USA.

Many returning Indians are simply unaware about these requirements and expose themselves to unintended penalties and prosecution. They need to be properly advised to comply with the US Regulations, especially in view of the recent stringent enforcement of Foreign Account Tax Compliance Act (FAT CA). When an Indian tax resident, (Resident and Ordinary Resident), who is also a US Citizen or a Green Card holder is subjected to double taxation, (as both India and US taxes on worldwide basis), he can resort to provisions of India-USA Double Tax Avoidance Agreement (DTAA ) for relieving double taxation.

FATCA and India
The Government of India has concluded an ‘In Substance’ agreement with the Government of USA for entering into an Inter-Governmental Agreement (IGA) for implementation of FAT CA. In view of this, all banks and other financial institutions in India will be required to identify, establish and report information on financial accounts held directly or indirectly by US persons.

The last three questions in this Article deal with two reporting requirements, namely, (i) Report of Foreign Bank and Financial Accounts (FBAR) and (ii) Form 8938. It is interesting to read the comments by Robert W. Wood on the stringent penalty and prosecution provisions of FAT CA in his article in Forbes Magazine, reproduced herein below:

“FATCA—the Foreign Account Tax Compliance Act— is America’s global disclosure law. It penalizes foreign banks if they don’t hand over Americans. Most foreign countries and their banks are getting in line to comply, so don’t count on bank secrecy anywhere.

Besides, on top of FATCA, the U.S. has a treasure trove of data from 40,000 voluntary disclosures, whistleblowers, banks under investigation and cooperative witnesses. So the smart money suggests resolving your issues. You can have money and investments anywhere in the world as long as you disclose them.

You must report worldwide income on your U.S. tax return. If you have a foreign bank account, you must check “yes” on Schedule B. You may also need to file an IRS Form 8938 with your Form 1040 to report foreign accounts and assets. Yet tax return filing alone isn’t enough.

U.S. persons with foreign bank accounts exceeding $10,000 in the aggregate at any time during the year must file an FBAR—now rebranded as a FinCEN Form 114—by each June 30. Tax return and FBAR violations are dealt with harshly. Tax evasion can mean five years in prison and a $250,000 fine. Filing a false return? Three years and a $250,000 fine.

Failing to file FBARs can be criminal too. Fines can be up to $500,000 and prison can be up to ten years. Even civil FBAR cases are scary, with non-wilful violations drawing a $10,000 fine. For willful FBAR violations, the penalty is the greater of $100,000 or 50% of the amount in the account for each violation. Each year you didn’t file is a separate violation.”

In light of the severity of penalties under FAT CA, as mentioned above, it is all the more important for NRIs and other US citizens/Green Card holders residing outside US, to understand their tax liability and/or to comply with US tax regulations.

1. When will a person be considered as a resident alien or a non resident alien in the US?

As per US tax law, a foreign citizen4 is considered either as a non resident alien or a resident alien for levy of US taxes. Though in some instances, he/she might be considered as both i.e. Dual Residential Status.

Non Resident Alien:
A foreign citizen is considered as a non resident alien, unless he meets one of the two tests described herein below for Resident Aliens.

Resident Alien:
A foreign citizen is resident alien of the United States for tax purposes if he meets either the green card test or the substantial presence test during a calendar year (January 1–December 31).

2. What is meant by the “Green Card Test”?

A person will be considered as a “resident” for tax purposes if he/she is a lawful permanent resident of the United States at any time during a calendar year. This is known as the “Green Card” test.

A person will be a lawful permanent resident of the United States at any time if he/she has been given the privilege, according to the immigration laws, of residing permanently in the United States as an immigrant. This status is generally received if the U.S. Citizenship and Immigration Services (USCIS) (or its predecessor organisation) has issued to a person an alien registration card, which is also known as a “green card.” Resident status under this test continues unless the status is taken away from or is administratively or judicially determined to have been abandoned.

3. What is meant by the “Substantial Presence Test”?

A person will be considered as a U.S. tax resident if he/ she meets the substantial presence test for the relevant calendar year. To meet this test, one must be physically present in the United States on at least:

1. 31 days during a relevant calendar year, and
2. 183 days during the 3-year period that includes the current year and the 2 years immediately before that, counting:
– All the days he was present in the current year, and
– 1/3 of the days he was present in the first year before the current year, and
– 1/6 of the days he was present in the second year before the current year. (For illustration, please refer answer to the question number 4 below)

4. Mr. A was physically present in the United States on 120 days in each of the years 2012, 2013, and 2014. Will Mr. A be considered as a resident under the substantial presence test for 2014?

To determine whether Mr. A meets the substantial presence test for 2014, full 120 days of presence in 2014, 40 days in 2013 (1/3 of 120), and 20 days in 2012 (1/6 of 120) will be counted. Because the total for the 3-year period is 180 days, Mr. A is not considered as a resident under the substantial presence test for 2014.

Dual Residential Status

5. Who is considered as a dual status alien?

One is considered as a dual status alien when one has been both a uS resident alien and a non-resident alien  in the same tax year. dual status does not refer to one’s citizenship, but it refers only to one’s residential status for tax purposes in the united States. In determining one’s US tax liability for a dual-status tax year, different rules apply for the part of the year when a person is a uS tax resident and the part of the year when he/she is a non- resident. The most common dual-status tax years are the years of arrival and departure.

Residential Status can be presented diagrammatically as shown at the bottom of this page:

6.    What is meant by days of presence in the US? Are there any exemptions to days of presence in the US?

Days of presence of a person is counted on the basis of his physical presence in the united States of america at any time during the day.

The exemption to days of presence is as follows:

?    days on which a resident of Canada or mexico is commuting to the uSa for work on daily basis.
?    days a person is in the united States for less than 24 hours when he is in transit between two places outside the united States.
?    days a person is present in the united States as a crew member of a foreign vessel.
?    days a person is unable to leave the united States because of a medical condition that arose while he was in the united States.
?    days spent by certain exempt individuals (students, teachers/trainees).

7.    What are the specific rules that apply for the days that are exempt from “days of presence”?

Days in transit: – The days on which a person is in the united States for less than 24 hours and he is in transit between two places outside the united States. Suppose, Mr. A travels between airports in the united States to change planes en route to his foreign destination, he will be considered as being in transit.

?    Crew members: – days when a person is temporarily present in the united States as a regular crew member of a foreign vessel (boat or ship) engaged  in transportation between the united States and a foreign country or a u.S. possession, should not be counted as days of presence in the uS. however,   this exception does not apply if a person is otherwise engaged in any trade or business in the united States on those days.

?    Medical Condition
do not count the days where a person intended to leave, but could not leave the united States because of a medical condition or problem that arose while he/ she was in the united States.

?    Taxation of income source from US

8.    how does one compute the income of a person who has worked partly in the uS and partly outside the US for a uS source income?
    US sourced compensation in respect of a job which is partly performed in the uS and partly outside the US, is computed in the proportion of the time spent on such job in the USA.

for example:
Mr. A, resident of india, worked for 240 days for a uS company during the tax year and receives $ 80,000 in compensation (excluding fringe benefits). Mr. A performed services in united States for 60 days and performed services in india for 180  days.  Using  the  time  basis  for determining the source of compensation, $ 20,000 (80000*60/240) is his US income.

Public Provident Fund (PPF)
9.    Whether amount received on maturity of PPF, by a NRI who is US resident Alien, is taxable in US?

amount received on maturity of ppf is not taxable in india but the resident alien will have to pay tax in the US. As per the US tax laws, the interest earned on the amount in PPF account is taxable and the person can choose to pay tax each year or defer it till withdrawal on maturity.

10.    Tax regulations in the uS regarding maturity of life insurance policy for resident aliens?

In India, benefits from a life insurance policy, including earnings, whether on death or maturity are treated as tax-free subject to fulfillment of prescribed conditions, as may be applicable. in the US, for instance, taxation of life insurance proceeds is quite complicated. Death benefits are tax-free to the extent of the sum assured or life cover. Any amount over and above the sum assured, such as bonuses, will be taxed. Similarly, there are certain rules regarding  withdrawals  from  a  policy. The  cash  value  of life insurance is allowed to grow on a tax deferred basis, that is, earnings are taxed only on withdrawal. In certain cases, withdrawals maybe tax free to the extent of premiums paid till the date of withdrawal.

Gifts
11.    Whether gifts received from india by a NRI who is a us resident alien are taxable in us?

as per the indian law, any gift received in cash or kind from a non-resident exceeding Rs. 50,000/- would attract tax except in case of gift from specified close relatives5 which is exempt. however gifts received on the occasion of marriage, and under Will are exempt from taxation.

As per the US law, tax on gifts is levied in the hands of the donor or person making the gift and not the receiver. moreover, this only applies where the person making the gift is a uS taxpayer, that is, a US resident, green card holder or citizen. Where a gift is made by a person resident in india to a uS person, no gift tax is payable as the donor (indian resident) is not a US taxpayer. However, the person receiving the gift, being a uS taxpayer, must report it in form 3520 – ‘annual return to report transactions with foreign trusts and receipt of foreign gifts’.

12.    Types of the uS Source income or income received in the uS by non-resident aliens that may be exempt under income tax treaties?

6 Following types of income or receipts in uSA may be exempt under the us Tax Treaties:

?    Remuneration of professors and teachers who teach in the united States for a limited period of time.
?    Amounts received from abroad for the maintenance, education and training of foreign students and business apprentice who are in the united States for study experience.
?    Wages and salaries and pension received by an alien from employment with a foreign government while in the united States.
?    Certain capital gains from the sale or exchange of certain capital assets by non-resident aliens under certain conditions.
?    Depending upon the facts of each case, the tax payer must study applicability of relevant tax treaty.

13.    What are the exclusion of Foreign Earned income in the hands of a us Citizen or a resident alien?

7 If certain requirements are met, a US citizen or a resident alien may qualify for the exclusions of foreign earned income and foreign housing exclusions and the foreign housing deduction.

If a person is a uS citizen or a resident alien of uS and   is living abroad, he is taxed on his worldwide income. however, he may qualify to exclude from income up to an amount of his foreign earnings that is adjusted annually for inflation ($ 92,900 for 2011, $ 95,100 for 2012, $ 97,600 for 2013, $ 99,200 for 2014 and $ 100,800 for 2015). in addition, he can exclude or deduct certain foreign housing amounts. he may also be entitled to exclude from income the value of meals and lodging provided to him by his employer.

Certain requirements for exclusion of foreign earned income are as follows:

?    A US citizen who is a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year.
?    A US resident alien who is a citizen or national of a country with which the united States has an income tax treaty in effect and who is a bona fide resident of a foreign country or countries for an uninterrupted period that includes an entire tax year.
?    A US citizen or a US resident alien who is physically present in a foreign country or countries for at least 330 full days during any period of 12 consecutive months.

14.    What is FBAR and who is required to file it?

fBar8   refers  to  report  of  foreign  Bank  and  financial accounts.

“United States persons” are required to file an FBAR if:
1.    The United States person had a financial interest in or signature authority over at least one financial account located outside of the united States; and

2.    The aggregate value of all foreign financial accounts exceeded $10,000 at any time during the calendar year reported.

“united States person” includes u.S. citizens; u.S. residents; entities, including but not limited to, corporations, partnerships, or limited liability companies, created or organized in the united States or under the laws of the united States; and trusts or estates formed under the laws of the united States.

?    Exceptions To The Reporting Requirement
Exceptions  to  the  fBar  reporting  requirements  can be  found  in  the  FBAR  instructions9.  There  are  filing exceptions for the following united States persons or foreign financial accounts:

?    Certain foreign financial accounts jointly owned by spouses
?    united States persons included in a consolidated fBar
?    Correspondent/nostro accounts
?    Foreign financial accounts owned by a governmental entity
?    Foreign financial accounts owned by an international financial institution
?    Owners and beneficiaries of U.S. IRAs
?    Participants in and beneficiaries of tax-qualified retirement plans
?    Certain individuals with signature authority over, but no financial interest in, a foreign financial account
?    Trust beneficiaries (but only if a U.S. person reports the account on an FBAR filed on behalf of the trust)
?    Foreign financial accounts maintained on a United States military banking facility.
?    the taxpayer must consult his uS tax Consultant in this regard about the current reporting requirements.

15.    What is Form 8938 and who is required to submit it?

Certain U.S. taxpayers holding financial assets outside the united States must report those assets to the IRS, generally using Form 8938, Statement of Specified foreign   financial  assets.   The   form   8938   must   be attached to the taxpayer’s annual tax return.

16.    What are the specified foreign financial assets that one needs to report on Form 8938?

The person, who is required to file Form 8938, must report his financial accounts maintained by a foreign financial institution. Examples of financial accounts include:

?    Savings, deposit, checking, and brokerage accounts held with a bank or broker-dealer. and, to the extent held for investment and not held in a financial account, he must report stock or securities issued by someone who is not a U.S. person, any other interest in a foreign entity, and any financial instrument or contract held for investment with an issuer or counterparty that is not   a US person. Examples of these assets that must be reported if not held in an account include:
?    Stock or securities issued by a foreign corporation;
?    A note, bond or debenture issued by a foreign person;
?    An interest rate swap, currency swap, basis swap, interest rate cap, interest rate floor, commodity swap, equity swap, equity index swap, credit default swap or similar agreement with a foreign counterparty;
?    An option or other derivative instrument with respect to any of these examples or with respect to any currency or commodity that is entered into with a foreign counterparty or issuer;
?    A partnership interest in a foreign partnership;
?    An interest in a foreign retirement plan or deferred compensation plan;
?    An interest in a foreign estate;
?    Any interest in a foreign-issued insurance contract or annuity with a cash-surrender value.

17.    What is the difference between Form 8938 and FinCEN Form 114 (FBAR) i.e. report of Foreign bank and Financial Accounts (FBAR) 10?

a)    Who needs to file
i)    Form 8938 has to be filed by Specified individuals, which include U.S citizens, resident aliens, and certain non-resident aliens that have an interest in specified foreign financial assets and  meet  the  reporting  threshold  (total  value  of assets) i.e. $ 50,000 on the last day of the tax year or $ 75,000 at any time during the tax year (higher threshold amounts apply to married individuals filing jointly and individuals living abroad).

ii)    FBAR has to be filed by U.S. persons, which include U.S. citizens, resident aliens, trusts, estates, and domestic entities that have an interest in foreign financial accounts and meet the reporting threshold i.e. $ 10,000 at any time during the calendar year.

b)    What needs to be reported
i)    Under  form  8938,  an  individual  has  to  report about Maximum value of specified foreign financial assets, which include financial accounts with foreign financial institutions and certain other foreign non-account investment assets i.e. interest in foreign partnership firms, foreign stock or securities not held in a financial account, foreign hedge funds and private equity funds etc.
ii)    Under  fBar,  a  person  has  to  report  maximum value of financial accounts maintained by a financial institution physically located in a foreign country which also includes indirect interest in foreign financial assets through an entity. One also has to report the foreign financial account for which one is designated as authorised signatory.

c)    Form 8938 has to be filed along with one’s income tax return, whereas FBAR is to be filed separately and the due date for filing is 30th June.

Epilogue
The US tax law is a complex subject. one cannot possibly cover all aspects in a short write-up. the intention of few FAQs mentioned herein above is to draw one’s attention to the onerous compliances required by US Citizens/ Green Card holders living outside US and also about disclosure requirements under FATCA.

Secondment of Employees – Taxability of Reimbursement of Remuneration in the hands of Overseas Entity

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1. Introduction
In the current global
scenario, the international business entities have extended their
business worldwide and they have made their presence by establishing
their own subsidiaries or group entities with whom they have business
arrangement. These overseas entities depute their technical staff and
human resources in other countries, to support their global business
functions and to ensure quality and consistency in their operations.
Under a classic Secondment agreement, the seconded employees who are
under employment of non-resident overseas entity are deputed or
transferred to subsidiary company in the overseas countries to work for
special assignment which are more technical and managerial in nature.
These seconded employees usually work under direct control and
supervision of the subsidiary entities in their country. Since these
seconded employees belong to the main parent entity, therefore, they
continue to receive their remuneration and salaries with all social
security benefits from the parent entity. Such costs and remuneration
are reimbursed by the subsidiary company to the parent entity. Strictly
speaking on paper they remain the employees of the parent entities but
they are under direct supervision and control of subsidiary entity,
where their day to day activities are managed and governed by them and
so much so they can be removed by them. Once the terms of secondment is
over, they revert back to their overseas entity. In a way, subsidiary
entity is the economic employer of the seconded employee who ultimately
bears the salary cost and exercise control over their work.

Generally,
it is contended that reimbursement of cost cannot be treated as payment
for Fees for Technical Services [FTS] or Fees for Included Services
[FIS], unless there is an explicit agreement between the parties that
technical services would be provided through these employees. The
deputation of employees is mainly for the benefit of the subsidiary
company to smoothly and efficiently conduct the business. However, such a
reimbursement of salary cost by the subsidiary entity has been matter
of huge controversy, as to what is the nature of such payment, whether
it is ‘fee for included services’ or not. Other related controversy is
that, on the basis of duration of the stay of seconded/deputed employees
in the host countries, whether the non-resident parent entity
constitute the service PE in the host country or not. Let us know
discuss the meaning the words ‘Secondment’ or ‘Deputation’.

2. Meaning of the words ‘Deputation’ or ‘Secondment’

Deputation
as per Concise Oxford Dictionary is “a group of people who undertake a
mission on behalf of a larger group”. Whereas Secondment as per Concise
Oxford Dictionary is “temporarily transfer (a worker) to another
position.”

Dictionary meanings of ‘deputation’ and ‘secondment’
are different. However, in common practice, both these terms are used
interchangeably.

The term secondment in common parlance means
that the employee remains an employee of his existing employer but by
virtue of some agreement between the employer and the third person, the
employee has to perform the duties for the benefit of such third person.

With globalisation, mobility of employees has become an
integral part of business enterprise. For various commercial reasons,
employment contracts are often concluded by the legal entity
incorporated in the country where the employee is domiciled at the time
of his appointment. However, this formal contract with the employee is
not intended to restrict the employee from seeking global opportunities.
If the employment is required to be exercised in another country, the
employee makes available his capacity to work to the entity or
establishment in the other country (“host country”). While doing so, the
employee retains a lien on the formal employment contract. This
arrangement of facilitating the global mobility of employees is called
“secondment”.

The entity or establishment in host country
becomes the economic employer, since it bears the responsibility or risk
for the result produced by the employee rendering the service. The
remuneration in relation to services of the employee in the host country
may be disbursed and borne by the entity in the host country.
Alternatively, the remuneration may be disbursed to the employee by the
formal employer and claimed as a reimbursement from the entity in the
host country. In some cases, an overriding fee is also charged from the
entity in the host country to cover the administrative efforts involved
in disbursing salary.

3. Decisions in the case of Centrica India Offshore (P.) Ltd.

3.1
In the case of Centrica India Offshore (P.) Ltd. [CIOPL], [2012] 19
taxmann.com 214 (AAR), the following questions were raised before the
AAR: (a) Whether, on the facts and in the circumstances, of the case
the amount paid or payable by the applicant to the overseas entities
under the terms of Secondment Agreement is in the nature of income
accrued to the overseas entities? (b) If the answer to question no. 1
above is in the affirmative, whether the tax is liable to be deducted at
source by the applicant under the provision of section 195 of the
Income-tax Act, 1961 [the Act]?

The AAR held that the payment by the applicant under the agreement is not FTS but would be income accruing to overseas entities in view of the existence of a service PE in India and on question No. 2, held that tax is liable to be deducted at source u/s. 195 of the Act.

3.2 Against the ruling of the AAR, CIOPL filed a writ petition and the Delhi High Court in its judgment Centrica India Offshore (P.) Ltd. vs CIT, [2014] 44 taxmann.com 300 (Delhi) held that the reimbursement of salaries to the oversea entity is liable to tax as FTS/FIS and also Service PE exists in India.

3.3
A gainst the decision of the Delhi High Court, CIOPL filed a Special
Leave Petition [SPL] in the Supreme Court, which has been dismissed by
the SC. Centrica India Offshore (P.) Ltd. vs CIT [2014] 51 taxmann.com 386 (SC).

3.4 Effect of Rejection of SLP in Limine (at the threshold) by Supreme Court:

a)    in Indian Oil Corporation Ltd. vs. State of Bihar [1987] 167 ITR 897; [1986] 4 SCC 146; AIR 1986 SC 1780, the Supreme Court held that “the dismissal of a special leave petition in limine by a non-speaking order does not jus- tify any inference that, by necessary implication, the contentions raised in the special leave petition on the merits of the case have been rejected by the Supreme Court. it has been further held that the effect of a non-speaking order of dismissal of a special leave petition without anything more indicating the grounds or reasons of its dismissal must, by necessary implication, be taken to be that the Supreme Court had decided only that it was not a fit case where special leave should be granted”.
b)    the above case has also been referred by the Supreme Court in case of Employees’ Wel- fare Association vs. Union of India, AIR 1990 SC 334; [1989] 4 SCC 187.
c)    in V. M. Salgaocar and Brothers Pvt. Ltd. vs. CIT [2000] 243 ITR 383, the Supreme Court held that “when a special leave petition is dismissed this court does not comment on the correctness or otherwise of the order from which leave to appeal is sought. But what the court means is that it does not consider it to be a fit case for exercise of its jurisdiction under article 136 of the Constitution.”
d)    thus, the fact that SLP is rejected by the apex Court, especially in limine without assigning any reasons, does not signify that it has ap- proved the judgment of the delhi high Court.
e)    therefore, the decision of delhi high Court in the case of Centrica cannot be held as final on the issue of “Secondment”.

4.    Concept of ‘Economic or real employer vs Legal employer’

In the context of determination of taxability of reimbursement of such remuneration i the hands of the parent entity, determination of the real employer is very important. In case of Secondment payments, it is very crucial to understand the concept of ‘Economic or real employer vs Legal employer’.

A legal employer appoints someone and, therefore, has the  right  to  terminate  the  employment.  the  economic employer, on the other hand, enjoys the fruits of the labour, possesses the authority to inspect and control and bears the risks and results of the work performed by the employee.  The  place  of  employment  or  work  would also be that directed by the economic employer. The  economic employer may not have the legal right to terminate the employment altogether, it would possess the right to terminate the contractual arrangement, i.e. the secondment  agreement.  The  payment  of  salary  of  the seconded employee is charged to/reimbursed by the economic employer.

In this respect, the following points need to be borne in mind:
a)    the  concept  of  deputation  or  secondment  proceeds on the presumption that the seconded employees will continue to retain employment only with the parent entity.  if they ought to join the indian establishment,  it becomes a regular employment and the concept of deputation and a corresponding relationship with an economic employer would not arise.
b)    the principle ‘legal employer vs. economic employer’ has gained acceptance and recognition. the legal employer would continue to possess the right to terminate the employment, whereas the economic employer will be possessed only with the right to terminate the services.
c)    an entity becomes an economic employer if it has  the right to supervise and control over the seconded employees and the employees in turn discharge their duties and responsibilities under the instruction of the economic employer.
d)    the decisive test appears to be ‘ control and supervision’ and not ‘ right of termination’.

Thus, if on the facts of a case and considering the tests laid down above, the entity in the host country is held to be the ‘economic or real employer’, then the question of existence of Service PE or characterisation of payment as ftS, may not arise.

5.    Relevant commentary of the OECD Model Convention, 2014 on Article 15

The following paragraphs of the oeCd commentary on article 15 are pertinent for determination of the issues relating to secondment of employees:

“8.1 It may be difficult, in certain cases, to determine whether the services rendered in a State by an individual resident of another State, and provided to an enterprise of the first State (or that has a permanent establishment in that State), constitute employment services, to which article 15 applies, or services rendered by a separate enterprise, to which article 7 applies or, more generally, whether the exception applies. While the Commentary previously dealt with cases where arrangements were structured for the main purpose of obtaining the benefits of the exception of paragraph 2 of article 15, it was found that similar issues could arise in many other cases that did not involve tax- motivated transactions and the Commentary was amended to provide a more comprehensive discussion of these questions.

8.4 In many States, however, various legislative or jurisprudential rules and criteria (e.g. substance over form rules) have been developed for the purpose of distinguishing cases where services rendered by an individual to an enterprise should be considered to be rendered in an employment relationship (contract of service) from cases where such services should be considered to be rendered under a contract for the provision of services between two separate enterprises (contract for  services).  That  distinction  keeps  its  importance when applying the provisions of article 15, in particular those of subparagraphs 2 b) and c). Subject to the limit described in paragraph 8.11 and unless the context of a particular convention requires otherwise, it is a matter of domestic law of the State of source to determine whether services rendered by an individual in that State are provided in an employment relationship and that determination will govern how that State applies the Convention.

8.11    The conclusion that, under domestic law, a formal contractual relationship should be disregarded must, however, be arrived at on the basis of objective criteria. For instance, a State could not argue that services are deemed, under its domestic law, to constitute employment services where, under the relevant facts and circumstances, it clearly appears that these services are rendered under a contract for the provision of services concluded between two separate enterprises. The relief provided under paragraph 2 of article 15 would be rendered meaningless if States were allowed to deem services to constitute employment services in cases where there is clearly no employment relationship or to deny the quality of employer to an enterprise carried on by a non-resident where it is clear that that enterprise provides services, through its own personnel, to an enterprise car- ried on by a resident. Conversely, where services rendered by an individual may properly be regarded by a State as rendered in an employment relationship rather than as under a contract for services concluded between two enterprises, that State should logically also consider that the individual is not carrying on the business of the enterprise that constitutes that individual’s formal employer; this could be relevant, for example, for purposes of determining whether that enterprise has a permanent establishment at the place where the individual performs his activities.

8.13    The nature of the services rendered by the individual will be an important factor since it is logical to assume that an employee provides services which are an integral part of the business activities carried on by his employer. It will therefore be important to determine whether the services rendered by the individual constitute an integral part of the business of the enterprise to which these services  are  provided.  For  that  purpose,  a  key consideration will be which enterprise bears the responsibility or risk for the results produced by the individual’s work.

8.14    Where a comparison of the nature of the services rendered by the individual with the business activities carried on by his formal employer and by the enterprise to which the services are provided points to an employment relationship that is different from the formal contractual relationship, the following additional factors may be relevant to determine whether this is really the case:
•    who has the authority to instruct the individ- ual regarding the manner in which the work has to be performed;
•    who controls and has responsibility for the place at which the work is performed;
•    the remuneration of the individual is directly charged by the formal employer to the enterprise to which the services are provided (see para- graph 8.15 below);
•    who puts the tools and materials necessary for the work at the individual’s disposal;
•    who determines the number and qualifications of the individuals performing the work;
•    who has the right to select the individual who will perform the work and to terminate the contractual arrangements entered into with that individual for that purpose;
•    who has the right to impose disciplinary sanctions related to the work of that individual;
•    who determines the holidays and work schedule of that individual.”

8.15    Where an individual who is formally an employee of one enterprise provides services  to another enterprise, the financial arrangements made between the two enterprises will clearly be relevant, although not necessarily conclusive, for the purposes of determining whether the remuneration of the individual is directly charged by the formal employer to the enterprise to which the services are provided.

For  instance,  if  the  fees  charged  by  the  enterprise that formally employs the individual represent the remuneration, employment benefits and other employment costs of that individual for the services that he provided to the other enterprise, with no profit element or with a profit element that is computed as a percentage of that remuneration, benefits and other employment costs, this would be indicative that the remuneration of the individual is directly charged by the formal employer to the enterprise to which the services  are provided. That should not be considered to be the case, however, if the fee charged for the services bears no relationship to the remuneration of the individual or if that remuneration is only one of many factors taken into account in the fee charged for what  is really a contract for services (e.g. where     a consulting firm charges a client on the basis   of an hourly fee for the time spent by one of its employee to perform a particular contract and that fee takes account of the various costs of the enterprise), provided that this is in conformity with the arm’s length principle if the two enter- prises are associated. it is important to note, however, that the question of whether the remuneration of the individual is directly charged by the formal employer to the enterprise to which the services are provided  is only one of the subsidiary factors that are relevant in determining whether services rendered by that individual may properly be regarded by a State as rendered in an employment relationship rather than as under a contract for services concluded between two enterprises.”

In our view, the above tests/criteria laid down by the OECD, though in the context of article 15, are very relevant for determination of the issues relating to taxability of the reimbursement of remuneration of seconded employees  in  the  hands  of  the  overseas  entity  as  FTS  or whether such seconded employees constitute PE of the overseas entity in india. The above commentary has not been considered by various judicial authorities in india as would appear from various reported decision on the topic.

6.    Whether such payment constitute mere ‘reimbursement of Expenses’ and not FTS/FIS

Reimbursement of salaries to overseas entities in respect of secondment, is normally without mark up and hence claimed to be not liable to tax as the same does not involve any element of income. What constitutes ‘reimbursement’ is a very ticklish issue and there are a number of cases, where based on the facts and circumstances, payments have been held to be ‘reimbursement’.

For the proposition that such a reimbursement of salary of the seconded employees is not taxable as fiS, there is a catena of decisions, which are as under:

a)    Temasek Holdings vs. DCIT, (2013) 27 itr (trib) 125 (mum) = 2013-tii-163-itat-mum-intL
b)    ITO vs. AON Specialist Services Private Limited 2014-tii-78-itat-BanG-intL
c)    DIT vs. HCL Infosystems Ltd (2005) 274 ITR 261 (delhi) upheld itat decision in the case of HCL Info- systems Ltd. vs. DCIT -2002 76 ttj 505).
d)    CIT vs. Karlstorz Endoscopy India Pvt. Ltd. 2010-tii- 135-itat-deL-intL
e)    Abbey Business Services India Pvt. Limited vs. DCIT (2012)  53  Sot  401  (Bang)  =  2012-tii-145-itat-BanG-intL
f)    ACIT vs. CMS (India) Operations and Maintenance Co. Pvt. Ltd (2012) 135 itd 386 (Chennai)
g)    ITO vs. Ariba Technologies (India) Pvt. Ltd. 2012-tii-68-itat-BanG-intL
h)    idS Software Solutions (india) Pvt. Ltd (2009) 122 ttj 410;  2009-tii-22-itat-BanG-intL
i)    Cholamandalam mS General insurance Co. Ltd (2009) 309 itr 356 (aar); 2009-tii-02-ara-intL
j)    DDIT vs. Tekmark Global Solutions LLC (2010) 38 Sot 7 (mum) = 2010-tii-50-itat-mum-intL.
k)    Fertilisers and Chemicals Travancore Ltd. vs. CIT – (2002) 255 itr 449 (Ker), (2002) 174 Ctr 257 (Ker)
l)    Dolphin Drilling Ltd. vs. ACIT – (2009) 29 Sot 612 (del), (2009) 121 ttj 433 (del)
m)    United Hotels Ltd. vs. ITO – (2005) 2 Sot 267 (del), (2005) 93 ttj 822 (del)
n)    ADIT vs. Mark & Spencer Reliance India (P.) Ltd. – [2013] 38 taxmann.com 190 (mum)
o)   XYZ – (2000) 242 itr 208 (aar), (1999) 156 Ctr 583 (aar)
p)   Centrica india offshore Pvt. Ltd. – (2012) 206 taxman 545 (aar) (2012) 249 Ctr 11 (aar)

In the following cases the reimbursement of salaries of seconded employees have been held to be FTS/ FIS:
a.    at&S  india  Pvt.  Ltd.  –  (2006)  287  itr  421  (aar), (2006) 206 Ctr 315 (aar)
b.    Verizon data Services india Pvt. Ltd. (2011) 337 itr 192 (aar), (2011) 241 Ctr 393 (aar)
c.    flores  Gunther  vs  ito  –  (1987)  22  itd  504  (hyd), (1987) 29 ttj 392 (hyd)
d.    Tekniskil (Sendirian) Berhad vs. CIT – (1996) 222 itr 551 (aar), (1996) 135 Ctr 292 (aar)
e.    XYZ Ltd. – 2012-TII-14-ARA-INTL
f.    JC Bamford investments rochester vs. ddit – [2014] 47 taxmann.com 283 (delhi – trib.)
g.    Centrica india offshore (P.) Ltd. vs Cit, [2014] 44 tax- mann.com 300 (delhi)

7.    Whether the such payment claimed to be not-tax- able on the doctrine ‘Diversion of income by Overriding Title’

At times, it is also argued that payment is not the income of the overseas entities on account of the doctrine of ‘diversion of income by overriding title’.

In this regard, in the case of Centrica India Offshore (P.) Ltd. vs. CIT (supra), [2014], the Delhi High Court, rejecting the argument of the assessee held as under:

40. The final issue concerns the ‘diversion of income by overriding title’. here, CioP argues that the payment made to the overseas entity is not income that accrues to the overseas entity, but rather, money that it is obligated to pass on to the secondees. in other words, this money is overridden by the obligation to pay the secondees, and thus, is not ‘income’. This is insubstantial for two reasons. One, in view of the above findings that:
(a) the payment is not in the nature of reimbursement, but rather, payment for services rendered, (b) the employment relationship between the overseas entities and CiOP-from which the former’s independent obligation to pay the secondees arises – continues to hold, no obligation to use money arising from the payment by CIOP to pay the secondees arises. the  overseas  entities’  obligation  to  pay  the  secondees arises under a separate agreement, based on independent conditions, in relation to CIOP’s obligation to pay the overseas entity. assuming the agreement between CIOP and the overseas entity envisaged a certain payment for provision of services (and not styled as reimbursement). Surely, no argument could be made that such payment is affected by the doctrine of diversion of income by overriding title. if that be the case, then, as held above, the fact that the payment under the secondment agreement is styled as reimbursement, and limited on facts to that, without any additional charge for the service, cannot be hit by that doctrine either. The money paid by CIOP to the overseas entity accrues to the overseas entity, which may or may not apply it for payment to the secondees, based on its contractual relationship with them. This, at the very least, is independent of the relationship and payment between CiOP and the overseas entity.”

8.    Whether such ‘Secondment’ constitutes ‘Service PE’ in india

The  moot  question  which  arises  for  consideration  is whether such secondment of the employees could lead to establishment of the Service Pe in india.

Such an establishment of Service Pe under these circum- stances have been dealt by the hon’ble Supreme Court in the case of Morgan Stanley & Co. (2007) 292 ITR 416 (SC).  the SC held that the employees of overseas entities to the indian entity constitutes service Pe in india. The relevant finding of the Hon’ble Supreme Court in this regard is as under:

“15. As regards the question of deputation, we are of the view that an employee of MSCo when deputed to MSAS does not become an employee of MSAS. A deputationist has a lien on his employment with MSCo. As long as the lien remains with the MSCo the said company retains control over the deputationist’s terms and employment. The concept of a service PE finds place in the U. N. Convention. It is constituted if the multinational enterprise renders services through its employees in India provided the services are rendered for a specified period. In this case, it extends to two years on the request of MSAS. It is important to note that where the activities of the multinational enterprise entails it being responsible for the work of deputationists and the employees continue to be on the payroll of “the multinational enterprise or they continue to have their lien on their jobs with the multinational enterprise, a service PE can emerge. Applying the above tests to the facts of this case we find that on request/requisition from MSAS the applicant deputes its staff. The request comes from MSAS depending upon its requirement. Generally, occasions do arise when MSAS needs the expertise of the staff of MSCo. In such circumstances, generally, MSAS makes a request to MSCo. A deputationist under such circumstances is expected to be experienced in bank- ing and finance.  On completion of his tenure he  is repatriated to his parent job. He retains his lien when he comes to India. He lends his experience to MSAS in India as an employee of MSCo as he re- tains his lien and in that sense there is a service PE (MSAS) under Article 5(2}(1). We find no infirmity in the ruling of the ARR on this aspect. In the above situation, MSCo is rendering services through its employees to MSAS. Therefore, the Department is right in its contention that under the above situation there exists a Service PE in India (MSAS). Accordingly, the civil appeal filed by the Department stands partly allowed. “

In Centrica india Offshore (P.) Ltd. [CIOPL], [2012] 19 taxmann.com 214 (AAR), the AAR held as follows:

“29. …. We have found in this case that the employees continue to be the employees of the overseas entities and their employer continues to be the overseas entity concerned.  the  employees  are  rendering  services  for their employer in india by working for a specified pe- riod for a subsidiary or associate enterprise of their employer. We are of the view that this will give rise to a service Pe within the meaning of art.5 of the india-uK treaty, falling under article 5.2(k) thereof.”

In Morgan Stanley International Incorporated vs. DDIT, 2014-TII-186-ITAT-Mum-Intl, [mSii] the mumbai itat after considering the decision of SC in morgan Stanley’s case and the decision of the delhi high Court in CioPL’s case, held as follows:

“Thus, from the aforesaid decision it is amply clear that such deputed employees if continued to be on pay rolls of overseas entities or they continue to have their lien with jobs with overseas entities and are rendering their services in india, Service Pe will emerge.  This concept and the ratio has been strongly upheld by the hon’ble delhi high Court also. We therefore, hold that the seconded employees or deputationist working in india for the indian entity will constitute a Service PE in india.”

In addition, in the following cases of secondment also, it has been held that Service PE is constituted in India:

1.    [2014] 47 taxmann.com 283 (delhi – trib.) – JC Bam- ford Investments Rochester vs. DDIT IT

2.    [2014] 43 taxmann.com 343 (delhi – trib.) – DDIT IT vs. .C Bamford Excavators Ltd.

9.    implications of Service PE – Application of Article 12 vs Article 7

The mumbai itat in the case of Morgan Stanley inter- national incorporated (supra), in this regard after proper consideration of provisions of the article 12(6) of the India-USA DTAA, held as under:

“14. If we accept this concept that, by virtue of deputing seconded employees in india, the assessee has established a Service PE, then whether such a payment made by indian entity to the assessee, (even though it is reimbursement of salary cost), would be taxable under article 12(6) of india –US DTAA.
…….
Para 6 of article 12 makes it amply clear that tax- ability of ‘royalty’ and ‘fees for included services’ shall not apply, if the resident of the contracting state (uSa) carries on the business in other con- tracting states (india) in which FIS arises through Pe situated therein, then in such case the provisions of article 7 i. e., “Business Profits” shall apply.  In other words, if there is a PE, then royalty or FIS cannot be taxed under article 12, albeit only under article 7 of the dtaa. It is an undisputed fact in this case, that DTAA benefit has been availed by the assessee and therefore, treaty benefit has to be given to the assessee for granting relief. Now, if the taxability of such payment has to be examined and determined on the basis of computation of business profit under Article 7, then the salary paid by the assessee would amount to cost to the assessee, which is to be allowed as deduction while computing the business profit of the Pe in india. in our opinion, if logical conclusion of the decision of the hon’ble Supreme Court in the case of morgan Stanley & Co (supra) and the decision of the hon’ble delhi high Court in the case of Centrica india offshore (P.) Ltd. (supra) is to be arrived at, then the seconded employees will constitute Service Pe of the assessee in india and in that case any payment received on account of rendering of service of such employees will have to be governed under article 7 as per unequivocal terms of para 6 of article 12. Thus, the ratio laid down in the decision of hon’ble delhi high Court, will not help the case of the revenue, in any manner because under the concept of PE, FIS cannot be taxed under article 12, but only as a business profit under Article 7. It is very interesting to note that, similar provision is also embodied in the india-Canada DTAA in para 6 of Article 12, but this issue was neither raised or brought to the notice before the Hon’ble Delhi High Court nor it was contested by either parties. There is inherent contradiction in this concept, as in most of the treaties, exclusionary clause like Article 12(6) has been embodied, which makes the issue of taxability of FTS of FIS in such cases as non applicable and have to be viewed from the angle of Article 7. Thus, the decision of the hon’ble delhi high Court and all other decisions relied upon by the revenue will not apply in the case of the assessee, as nowhere the concept of para 6 of article 12 have been taken into account for determining the taxability of such a payment under the provisions of treaty. Thus, in our conclusion, the payment made by the indian entity to the assessee on account of reimbursement of salary cost of the seconded employees will have to be seen and examined under Article 7 only, that is, while computing the profits under Article 7, payment received by the assessee is to be treated as revenue receipt and any cost incurred has to be allowed as deduction because salary is a cost to the assessee which is to be allowed. Accordingly, the AO is directed to compute the payment strictly under terms of Article 7 and not under Article 12 of the DTAA. in view of the aforesaid finding, the grounds raised by the assessee is treated as allowed.”

Thus, as per mumbai itat in MSII’s case, on application of article 7 in cases of Service Pe, the salaries of the seconded employees reimbursed to the overseas entity, would not be taxable in india as taxation of the Service Pe under article 7 would be on ‘net’ basis and the amount of salaries reimbursed by the indian entity would be allowable as deduction, leading to nil income of overseas entity in india.

Assuming some adjustment or addition of mark up on account of transfer pricing, the net impact would be restricted to taxation of the mark up amount.

Even if it is held that the nature of payment is that of fees for technical services, still the taxability thereof would be on net basis under section 44DA of the act, as the same would be effectively connected to a Service PE in india.

10.    Implications of the absence of ‘Service PE’ clause in a Treaty

It is pertinent to note that the conclusion reached by the mumbai itat in mSii’s case, is in the context of india-uSa dtaa, which has a ‘Service PE’ clause in article 5 relating to Permanent establishment. Similarly, in case of 37 more dtaas signed by india, there is Service PE clause in article 5.

A question arises for consideration is, whether in case of countries with which india has a dtaa but not hav- ing a ‘Service Pe Clause’ in the article 5 of the DTAA, whether such secondment payment, would still be not taxable either as ‘reimbursement of expenses’ or as not falling within definition of the ‘FTS’ [due to absence of the words ‘managerial’ or the phrase ‘including through the provision of services of technical or other personnel’] of given in the respective DTAA.

It is interesting to note that so far such no such case has come up for consideration before any judicial authority and therefore, no judicial guidance is available on this issue.

11.    Implications in case of payment to entity in case of non-treaty country

In case of non-treaty countries, the provisions of the income-tax act, 1961 would be applicable and the taxability of such reimbursement of salaries of the seconded employees, would be decided accordingly. No judicial guidance is available on this issue also.

12.    Summation
However, the fundamental issue  which  requires  proper consideration is where services rendered by seconded employee to an indian entity should be considered to be rendered in an employment relationship (contract of service) or such services should be considered to be rendered under a contract for the provision of services between two separate enterprises (contract for services). In our view, on proper appreciation and application of the oeCd Commentary on article 15 quoted above, in deciding the taxability of reimbursement of remuneration and costs of the seconded employees in the hands of the overseas entity, the entire controversy on the issue can be amicably settled in favour of the tax- payer as the entire remuneration has already borne taxation in india in the hands of the employee and such an interpretation would avoid double taxation of the same payment.

Some US Tax Issues concerning NRIS/US Citizens Part II

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In our previous article, an attempt was made to answer some basic issues pertaining to the US tax laws related to Non-resident Indians1 (NRIs) including Indian expatriates working in the US or those who are the US Citizens or Green Card holders who are not tax residents of the USA and brief discussion on enactment of FATCA and its impact, Residential Status in the US, Exempt Income in the US, FBAR (FinCEN Reporting) and Form 8938 reporting. To take a step further, this article2 attempts to throw light on taxation of passive income (such as Capital Gains, Dividend and rental income). In order to elucidate issues clearly, they are discussed in a Questions- Answers format.

Introduction
In the USA, complying with the tax laws can be very challenging as the same is fraught with complications. Indian Citizens who have moved to the US for employment or for better prospects and in the process have become residents of the US or Green Card Holders should understand the nuances of local tax laws very carefully and start strictly complying with the same from day one. Non compliance or non awareness of taxability of certain income in US can be a very costly affair, as the US has one of most stringent laws with respect to interest and penalty provisions for non compliance.

If you are a tax resident (even if a non citizen i.e. resident alien) in the US, then you are taxed on your worldwide income, just as in case of a Citizen of the USA. In other words, you are taxed on your worldwide income in US2 during the period u you are tax resident of the USA. In the US, the income is basically categorized in two types of Income i.e.,

Trade or business income or
Passive Income (Capital Gains, Dividends, Rental Income etc.) In this article, we would discuss the nuances regarding the taxability of passive income of the US tax residents from outside the USA (i.e., from India) both in the US and India. We would also touch upon the taxability (in both jurisdictions) of passive income arising to Indian Residents from the US.

Capital Gains from Sale of Immovable Property situated in India

1. How capital assets are defined for “Resident Alien”3 in the US and how their cost is determined? Whether a “Resident alien” in US is required to declare his capital assets located in India?

Capital Assets in the US are defined to mean almost everything one owns and uses, for personal or investment purposes. Examples include a home, personal-use items like household furnishings, car and stocks or bonds held as investments.

The US IRS (Internal Revenue Service) uses the term “Basis of Assets” for the cost. Basis is the amount of investment in asset for tax purposes. The basis is the amount one pays for it in cash, debt obligations, and other property or services. It includes sales tax and other expenses connected with the purchase. For stocks or bonds, basis is the purchase price plus any additional costs such as commissions and recording or transfer fees. Basis is increased to incorporate cost of improvements and decreased to consider depreciation, non dividend distribution on stock/stock splits etc.

“Resident Alien” in the US is required to report capital assets wherever located while filing his tax return in Form 8938 or FBAR as may be applicable. Thus, it can be seen that the definition of “Capital Asset” under the US tax law is quite similar to the Indian tax laws.

2. What are the provisions pertaining to Long term capital gains on sale of Immovable properties located in India and pertaining to the US resident alien?

In India, sale of Immovable property is considered as long term, if it is sold 3 years after its date of acquisition. Long Term Capital Gains from immovable property situated in India is taxed @ 20% plus 3% Education Cess + Surcharge, as may be applicable. However, as per the US Tax law, the time period for computing “Long term asset” is one year. In US, the tax rate on Long term Capital Gains depends upon the ordinary income tax bracket of an individual.

3. Can a NRI (Who is Resident Alien in the USA) claim exemption in India of Capital gains earned from sale of Immovable Property situated in India?

Section 54 to 54F of the Income-tax Act, 1961 contains provisions regarding exemptions/relief from Long Term Capital Gains in India. These exemptions/reliefs are subject to fulfillment of certain conditions. Exemptions are available if capital gain earned is invested in a residential house situated in India or some specified bonds in India. These sections restrict the exemption to an individual and HUF. The exemption is not dependent on the residential status or citizenship of the seller/assessee. Thus a NRI residing outside India can claim exemption [as per provisions of section 54 to section 54F] in respect of the sale proceeds/capital gains arising from transfer of a long term capital asset.

Further as per section 54 and 54F, capital gains are exempted if NRI invests in a new house property. As per the recent Amendment in the Income Tax Law4, the location of the new house property should be in India.

4. H ow Capital Gains earned in India by a NRI (who is a “Resident Alien” of US) are taxed in USA? Can he claim tax exemption in the US for the property sold in India?

Capital Gains arising in India in the hands of a NRI, who is a Resident tax Alien in the US, will be computed in the US as per the US tax laws, irrespective of the tax treatment that gains suffered in India. As per the US tax laws, Long term Capital Gains on sale of a main home, is exempted up to $ 2,50,000/5- subject to certain conditions. Exemption of $ 250,000/6 – for sale of a property depends on the ownership requirement and use requirement.

However, when the US resident alien files his tax return in the US, he/she has to take into account the difference in the time period for calculating long term capital gain, the exemption available as per the tax laws of US and treat his Indian capital gains as per the time period specified in the US law.

NRI can claim a foreign tax credit in his/her US tax return as per India – USA DTAA .

To elucidate the matters more clearly, let us consider an example (it will be not possible to cover and analyse all types of situations that may arise in real life situations) which is given below in Q 5.

5. Mr. Rich, a NRI and “US Resident Alien” owns a house in New York, USA (being his Main Home) and a Flat in Mumbai. He sells the Flat in Mumbai for Rs. 75 lakh and earns Rs. 55 lakh as Long term Capital Gains. Can he invest Rs. 50 lakh in REC/NHAI Bonds u/s. 54EC? What would be implications under the US Tax Law? What are the Implications under India – US DTAA?

As per the India US DTAA , Capital Gains are taxed in India as well as USA in accordance with the provisions of the respective domestic tax laws. Therefore, the capital gains arising from the sale of flat in Mumbai would be taxable in India.

As explained above a NRI residing outside India can claim exemption under section 54 to section 54F of the Incometax Act, 1961. Thus, out of the capital gains arising from transfer of a flat i.e. long term capital asset the investment under 54EC is permissible.

Mr. Rich being a US resident will pay taxes on Capital Gains of Rs. 55 lakh as per the US Law. As his house in New York is the “main home” (satisfies the ownership and the user requirement of the main home), he will be not able to take the benefit of the exclusion provided as per the US Laws for the Mumbai Flat7 . Though, as per India – US DTAA he would be allowed credit for the taxes paid in India against the taxes payable in US.

6.    What are the provisions relating to Capital gains arising from shares, debentures and Bonds in India? Can a NRI claim exemption from Capital gains u/s. 10(38) of the Income-tax Act earned from sale of equity shares of Indian Companies?

Taxability in india
Profits and gains earned on sale of any shares, debentures, mutual funds and other securities are taxed under the head of “Capital Gains” under the income-tax act, 1961.

Gains on shares, debt or balanced schemes of mutual funds, are defined as Long term capital Gain if the same are held for more than 12 months.

Short  term  Capital  Gains  on  sale  of  shares  or  mutual funds which are debt oriented are taxed at normal rate of tax along with other taxable income. However, Short term Capital Gains on sale of equity shares or units of an equity oriented fund on which STT is paid, is taxed at the rate of 15% plus 3% education cess plus curcharge as may be applicable.

Long term Capital Gains (LTCG) from sale of equity shares or unit of equity oriented mutual fund listed in india on which Stt is paid, is exempt u/s. 10(38) for both residents and non-residents.  However,  LTCG  from  unlisted  securities shall  be  taxed  at  10%.  LTCG  on  Listed  Securities  on which Stt is not paid is taxed @ 10% without indexation, whereas taxed @ 20% with indexation plus 3% education cess plus curcharge as may be applicable.

7.    How Capital gains earned in India by a NRI, who is a US Resident Alien, are taxed in USA?

Taxability in the USA
In  the  US,  the  tax  rates  on  Long  term  and  Short  term Capital Gain will depend on tax brackets of the ordinary income of an individual. Given below is the table of various

Tax rates applicable8 to an individual depending upon his/ her tax bracket:-

tax Brackets
for a Single individual

ordinary
income tax rate

long term capital Gain rate

Short term capital
Gain rate

$0 – $9075

10%

0%

10%

$9076 – $36900

15%

0%

15%

$36901 – $89350

25%

15%

25%

$89351 – $186350

28%

15%

28%

$186351 – $405100

33%

15%

33%

$405101 – $406750

35%

15%

35%

$406751 & Above

39.6%

20%

39.6%

Let us consider one more example to understand the impact under both tax laws:-

Mr. Rich, a NRI and US Resident Alien, owns Rs. 10 crore worth of shares of listed Indian Companies. he sells all the shares and earns long term Capital gains of Rs. 5 crore and Short Term Capital gains of Rs. 1 crore. What are the implications under India and US Tax law? Whether such Capital gains would be taxable in the US? Can Mr. Rich claim tax credit in US of taxes paid in india?

Implications as per Income-Tax Act, 1961
As per section 5 of the income-tax act, any income arising in india will be taxable in india. however, Long term Capital Gains on sale of equity Shares is exempt u/s. 10(38) of the act. Though, Short term Capital Gains arising from sale of equity shares would be taxable at the rate of 15% (plus 3% education Cess and applicable surcharge) u/s. 111a of the act. Hence in the given example, Mr. rich would be exempt from tax on Long term Capital Gains but would be taxed at 15% (plus 3% education Cess and applicable Surcharge) on Short term Capital Gains.

    Implications under US Tax Laws:-
Mr. rich would be taxed on his worldwide income in the uS and hence, he would be taxed on the Capital Gains arising in india. however, as per article 25 of india – US DTAA, he can avail foreign tax credit of the taxes paid in india against the uS taxes.

Long term  Capital  Gains  and  Short term  Capital  Gains arising on sale of shares will be taxable as per the tax brackets  of  Mr.  Rich.  even  though  Long  term  Capital Gains from sale of equity are exempt from tax in india, such gains will be taxable in the US. Short term Capital Gains are taxed in the US as per the ordinary income tax rates, whereas the Long term capital gains are taxed at a concessional rate depending upon the ordinary income tax bracket. The table of tax rates for both short term and long term capital gains is given above for reference.

Taxation of Dividend Income
8.    What are the implications under Indian and US Tax laws for a US Resident receiving Dividends from indian Companies?

In india, the recipient of dividends is not liable to pay any tax on dividend received/accrued as the company distributing the dividend is liable to pay dividend distribution tax at the rate of 15% plus surcharge and education Cess. Thus, a US tax resident receiving dividends from the indian company which has paid dividend distribution tax is not subjected to tax in india. However, such dividend would be taxed in US as per the normal income tax rates.

 Taxation of Rental Income
9.    Mr. Rich, a NRI, residing in the US. he has given his residential house in India on rent. What will be the implications of the rental income received by Mr. Rich under the US tax law?

Rental income received by mr. rich will be taxed both in india and uS. article 6 of the india – uS dtaa provides that rent from immovable property (real property) may be taxed in the country where it is situated. thus, mr. rich has to pay tax on rental income in india as the property is situated in india and he has to pay tax in the uS also, being taxed on worldwide income. the major difference in india and uS is that in india mr. rich would get a standard deduction of 30% whereas in uS taxation only actual expenses incurred would  be  deducted  from  such  rental  income.  following deductions will be allowed against such income:

–    mortgage Property taxes
–    insurance
–    utilities
–    depreciation – allowed for building; any furnishings; appliances (except land).
However, the taxes paid in india would be available as foreign tax Credit under indian – US DTAA.

    Taxation of Interest
10.    how is interest income of a NRI (who is resident alien in USA) taxed in India and US?

As per the india – US dtaa, the right of taxing interest primarily lies with the Country of residence of the person earning it. However, article 11 does give right of taxation to the source country but the maximum rate at which it can get taxed is capped at 15%. 9

Taxation of Income of Non-resident Aliens (i.e. Indian residents) in US

So far we have discussed taxability of nris settled in USA who (mostly regarded as resident alien or uS Citizen) have sources of income in india. Let us now turn to a situation where indian tax residents have sources of income in USA.

11.    A resident Indian sells an immovable property in US (acquired 2 years ago) and earns a capital gain of $15,000/-. What would be implications under the US Tax law and the Indian IT Act? What is the India – US Tax Treaty implications on the same?

In the given case, since the property was held for two years, the capital gains would be treated as Long term Capital Gains in the US. The net capital gain is normally taxed at the appropriate10  graduated tax rates. however, if withholding tax is applicable, then tax is deducted by the purchaser at the rate of 10% of the gross sale proceeds. Resident Indian would therefore be required to file income tax return in the US and pay appropriate capital gains tax, subject to exemption of $ 2,50,000/-, if gains arise on sale of main home. In certain cases, subject to certain filings and fulfillment of conditions withholding of tax can be avoided.

Resident Indian while filing his income tax return in India would have to treat such capital gains as short term capital gains as the period of holding is less than three years. however, as per the india – US DTAA, resident indian will be able to claim the foreign tax credit for the taxes paid in the US while filing his tax return in India.

12.    A resident Indian has earned Capital gains on sale of a foreign property (long term capital asset) which was held for more than three years, Will he be able to claim capital gains exemption as per the IT Act by investing in a residential house in india or NHAI bonds in india?

A resident indian can avail exemption u/s. 54eC and 54f upon fulfillment of certain conditions if the investment made from transfer of a long term capital asset. The exemption is available irrespective of the fact that the capital asset is situated outside india.

13.    What are the implications under Indian and US Tax laws for an Indian Resident receiving Dividends from US Companies?

In the US, dividends are considered as part of passive income. Generally, tax at the rate of 30% or lower treaty rate (i.e. 25% as per india – US DTAA) is withheld by a uS Corporation on the dividends distributed to a non-resident.

In india, such dividends would be taxed in the following manner

(i)    If dividend is received by an indian Company from its Wholly owned subsidiary in uS, then it is taxed @15%; and
(ii)    In all other cases, at the applicable tax rate.

The tax withheld by the US Corporation would be available as foreign tax credit against the tax payable in india.

14.    What will be the implications under the US tax law for the rental income received by Indian resident from renting of property in US?

As per the US Laws, tax rates depends on whether a non- resident alien is able to choose to treat all income from real property as effectively/not effectively connected with a trade or business.

If the rental income is in connection with any trade or business in USA, then the tax would be levied on a graduated applicable tax rates, otherwise tax would withheld @ 30% on gross rental. The taxpayer i.e. an indian resident has to make appropriate declaration by exercising choice at the time of filing his tax return.

Epilogue
The US tax law is a complex subject. one cannot possibly cover all aspects in a short write-up. The intention of few FAQs mentioned herein above is to highlight some of the nuances of US & indian tax laws on passive income in india pertaining to nris in the USA (resident alien or uS Citizen) & passive income in the uSa of indian tax residents.


Transfer Pricing – Issue of Shares at a Premium to Non-resident AEs – Whether alleged shortfall in Share premium can be taxed u/s. 92 of the Act

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Synopsis
In the past, we have seen lots of twists & turns in Transfer Pricing litigation One such interesting issue has been whether any such alleged shortfall in share premium can be taxed u/s. 92 of the Act under the pretext that the assessee has forgone the so called notional income on the funds that it would have received. In the case of Vodafone a pro-assessee judgment was pronounced by the Honorable Mumbai High Court where it was held that the transaction did not give rise to any ‘income’ from International Transactions and therefore TP provisions are not applicable.

Tele-Services (India) Holdings Limited, wherein total TP adjustment of Rs. 1,397.26 crore was made for the Assessment Year [AY] 2009-10. The assessment order of the AO was challenged in a Writ Petition before the Bombay HC and the Court, after comprehensively dealing with various contentions, vide its order dated 10th October, 2014 decided the issue in favour of the petitioner.

Similarly, a writ petition in the case of Shell India relating to issue of shares by it to its non-resident AE Shell Gas BV, wherein a total TP adjustment of Rs. 15,220 crore has been made for the Assessment Year [AY ] 2009-10, is being heard by the Bombay High Court [HC].

There are about 24 other assessees facing tax demands on similar grounds.

In this Article, we discuss the salient features of the HC’s decision in the case of Vodafone.

Vodafone India Services Pvt. Ltd. vs. UOI (WP No. 871 of 2014, Bombay HC)

Brief Facts
1. The brief facts are as follows:

1. The Vodafone India Services Private Ltd. [Petitioner] issued certain equity shares to its holding company of face value of Rs. 10 each at a premium of Rs. 8,509 per share.

2. The petitioner contended that Fair Market Value [FMV] of the equity shares was Rs. 8,519 as determined in accordance with the prescribed methodology.

3. However, according to the AO and the TPO, the equity shares ought to be valued at NAV of Rs. 53,775 per share. Thus, the consequence of issue of shares by the Petitioner to its holding company at a lower premium resulted in the Petitioner subsidising the price payable by the holding company. This deficit was treated as a deemed loan extended by the petitioner to its holding company and periodical interest thereon is to be charged to tax as its interest income.

Issues involved

2. The main issues raised in the Writ Petition are as follows:

(a) Whether Chapter X of the Income-tax Act, 1961 [the Act] is a separate code by itself and the difference in valuation between ALP and the contract/ transaction price would give rise to income?

(b) Whether “Income” as defined in section 2(24) of the Act is an inclusive definition and it does not prohibit taxing capital receipts as income?

(c) Whether the forgoing of premium on the part of the Petitioner amounts to extinguishment/relinquishment of a right to receive fair market value and therefore, the issue of shares is a transfer within the meaning of section 2(47) of the Act?, and

(d) Whether the meaning of International Transaction as given in clauses (c) and (e) of the Explanation (i) to section 92B of the Act would include within its scope even a capital account transaction?

Petitioner’s Contentions
3. The petitioner contended that:
(a) Chapter X of the Act is a special provisions relating to avoidance of tax. Section 92 of the Act provides for computation of income arising from International Transaction, having regard to ALP. Section 92(1) of the Act which applies to the present facts, directs that any income arising from an International Transaction should be computed, having regard to the ALP. Thus, the sine-qua-non, for application of section 92(1) of the Act is that income should arise from an International Transaction. In this case, it is submitted that no income arises from issue of equity shares by the Petitioner to its holding company;
(b) T he impugned order dated 11th February, 2014 after correctly holding that the word ‘Income’ has not been separately defined for the purpose of Chapter X of the Act, yet proceeds to give its own meaning to the word ‘Income.’ This is clearly not permissible. The word ‘Income’ would have to be understood as defined by other provisions of the Act such as section 2(24) of the Act. A fiscal statute has to be strictly interpreted upon its own terms and the meaning of ordinary words cannot be expanded to give purposeful interpretation;
(c) Chapter X of the Act is not designed to bring to tax all sums involved in a transaction, which are otherwise not taxable. The purpose and objective is not to tax difference between the ALP and the contracted/book value of said transaction but to reach the fair price/consideration. Therefore, before any transaction could be brought to tax, a taxable income must arise. The interpretation in the impugned order to tax any amounts involved in International Transaction tantamount to imposing a penalty for entering into a transaction (no way giving rise to taxable income) at a value which the revenue determines on application of ALP;
(d) T he impugned order itself demonstrates the fact that the share premium on issue of shares is per se not taxable. This is so as the amounts received by the Petitioner on account of share premium has not been taxed and only the amount of share premium which is deemed not to have been received on application of ALP, alone has been brought to tax;
(e) I n case of issue of shares, it comes into existence for the first time only when shares are allotted. It is the creation of the property for first time. This is different from the transfer of an existing property. An issue of shares is a process of creation of shares and not a transfer of shares. Therefore, there is no transfer of shares so as to make Section 45 of the Act applicable. It was submitted that if the contention of the Revenue is correct, then every issue of shares by any Company would be subjected to tax;
(f) The issue of shares by the Petitioner to its holding company and receipt of consideration of the same is a capital receipt under the Act. Capital receipts cannot be brought to tax unless specifically/expressly brought to tax by the Act. It is well settled that capital receipts do not come within the ambit of the word ‘Income’ under the Act, save when so expressly provided as in the case of section 2(24) (vi) of the Act. This brings capital gains chargeable u/s. 45 of the Act, to tax within the meaning of the word ‘Income’;
(g) Attention was drawn to the definition of `Income’ in section 2(24) (xvi) of the Act which includes in its scope amounts received arising or accruing within the provisions of section 56(2)(viib) of the Act. However, it applies to issue of shares to a resident. Besides, it seeks to tax consideration received in excess of the fair market value of the shares and not the alleged short-fall in the issue price of equity shares. Thus, this also indicates absence of any intent to tax the issue of shares below the alleged fair market value as in this case;
(h) T he impugned order proceeds on an assumption, surmise or conjecture that in case the notional income, i.e., the amount of share premium forgone was received, the Petitioner would have invested the same, giving rise to income. It is submitted that no tax can be charged on guess work or assumption or conjecture in the absence of any such income arising; and
The impugned order itself demonstrates the fact that the share premium on issue of shares is per se not taxable. This is so as the amounts received by the Petitioner on account of share premium has not been taxed and only the amount of share premium which is deemed not to have been received on application of ALP, alone has been brought to tax;

    In case of issue of shares, it comes into existence for the first time only when shares are allotted. It is the creation of the property for first time. This is dif-ferent from the transfer of an existing property. An issue of shares is a process of creation of shares and not a transfer of shares. Therefore, there is no transfer of shares so as to make Section 45 of the Act applicable. It was submitted that if the contention of the Revenue is correct, then every issue of shares by any Company would be subjected to tax;

    The issue of shares by the Petitioner to its holding company and receipt of consideration of the same is a capital receipt under the Act. Capital receipts cannot be brought to tax unless specifically/expressly brought to tax by the Act. It is well settled that capital receipts do not come within the ambit of the word ‘Income’ under the Act, save when so expressly provided as in the case of section 2(24) (vi) of the Act. This brings capital gains chargeable u/s. 45 of the Act, to tax within the meaning of the word ‘Income’;

    Attention was drawn to the definition of `Income’ in section 2(24) (xvi) of the Act which includes in its scope amounts received arising or accruing with-in the provisions of section 56(2)(viib) of the Act. However, it applies to issue of shares to a resident. Besides, it seeks to tax consideration received in excess of the fair market value of the shares and not the alleged short-fall in the issue price of equity shares. Thus, this also indicates absence of any intent to tax the issue of shares below the alleged fair market value as in this case;

    The impugned order proceeds on an assumption, surmise or conjecture that in case the notional income, i.e., the amount of share premium forgone was received, the Petitioner would have invested the same, giving rise to income. It is submitted that no tax can be charged on guess work or assumption or conjecture in the absence of any such income arising; and

    The impugned order places reliance upon the meaning of International Transaction as provided in subsection (c) and (e) of Explanation (i) to section 92B of the Act to conclude that the income arises. It is submitted that Explanation (i)(c) to section 92B of the Act only states that capital financing transaction such as borrowing money and/or lending money to AE would be an International Transaction. However, what is brought to tax is not the quantum of amount lent and/or borrowed but the impact on income due to such lending or borrowing. This impact is found in either under reporting/ over reporting the interest paid/interest received etc. Similarly, Explanation (i)(e) to section 92B of the Act, which covers business restructuring would only have application if said restructuring/reorganising impacts income. If there is any impact of income on account of business restructuring/reorganising, then such income would be subjected to tax as and when it arises whether in present or in future. In this case, such a contingency does not arise as there is no impact on income which would be chargeable to tax due to issue of shares.

    Revenue’s Contentions

    Revenue contended that:

    Section 92(1) of the Act is to be read with section 92(2) of the Act. It is stated that a conjoint reading of two provisions would indicate that what is being brought to tax under Chapter X of the Act is not share premium but is the cost incurred by the Petitioner in passing on a benefit to its holding company by issue of shares at a premium less than ALP. This benefit is the difference between the ALP and the premium at which the shares were issued. Issue of shares by the Petitioner to its holding company, resulted in the following benefits to its holding company:

    Cost incurred by the Indian Co. for a correspond-ing benefit given to the Holding Co. After all, the Holding Co. has actually got shares worth Rs. 53,775/- each at a price of Rs. 8,159/- each.

    Benefit also accrues to the valuation of Holding Co. in the international market by taking undervalued shares of the subsidiary Co., by increasing the real net worth of the Holding Co.

Besides the above, at the hearing, following further sub-missions in support of the conclusion arrived by the impugned order were also advanced:

    The Petitioner does not challenge the constitutional validity of Chapter X of the Act or any of the Sec-tions therein. The Petitioner raises only an issue of interpretation. Moreover, the fact that the Petitioner-Company and its holding company are AEs within the meaning of Chapter X of the Act is also not disputed. Therefore, the provisions of Chapter X of the Act are fully satisfied and applicable to the facts of the present case;

    The Petitioner itself had submitted to the jurisdiction of Chapter X of the Act by filing/sub-mitting Form 3-CEB, declaring the ALP. Thus, the respondent-revenue were under an obligation to scrutinise the same and when found that the ALP determined by the Petitioner-Company is not cor-rect, the AO and the TPO were mandated to apply Chapter X of the Act and compute the correct ALP. Therefore, the Petitioner should be relegated to the alternate remedy of approaching the Authorities under the Act;

    The issue of Chapter X of the Act being applicable is no longer res integra as identical provision as found in Section 92 of the Act was available in sec-tion 42(2) of the Income-tax Act, 1922 (1922 Act). The SC in Mazagon Dock Ltd. vs. CIT [1958] 34 ITR 368 – upheld the action of revenue in seeking to tax a resident in respect of profit which he would have normally made but did not make because of his close association with a non-resident. Further, the Court observed that it is open to tax notional prof-its and also impose a charge on the resident. The aforesaid provision of section 42(2) of the 1922 Act were incorporated in its new avtar as section 92 of the said Act. It was thus emphasised that the legis-lative history supports the stand of the respondent-revenue that even in the absence of actual income, a notional income can be brought to tax;

    Section 92(1) of the Act uses the word ‘Any in-come arising from an International Transaction’. This indicates that the income of either party to the transaction could be subject matter of tax and not the income of resident only. Further, it is submitted that for the purpose of Chapter X of the Act, real income concept has no application, otherwise the words would have been ‘actual income’. Therefore, the difference between ALP and the contracted price would be added to the total Income;

    It was further submitted that under the Act what is taxable is income when it accrues or arises or when it is deemed to accrue or arise and not only when it is received. Therefore, even if an amount is not actually received, yet, in case income has aris-en or deemed to arise, then the same is charge-able to tax. Thus, the difference between ALP and contract price is an income which has arisen but not received. Thus, income forgone is also subject to tax;     Chapter X of the Act is a complete code by itself and not merely a machinery provision to compute the ALP. Chapter X of the Act applies wherever the ALP is to be determined by the A.O. It is the hidden benefit in the transaction which is being charged to tax. Therefore, the charging section is inherent in Chapter X of the Act; Even if there is no separate head of income u/s.

14 of the Act in respect of International Transaction, such passing on of benefit by the Petitioner to its holding company would fall under the head ‘Income’  from  other  sources  u/s.  56(1)  of  the Act; and Section 4 of the Act is the charging section which provides that the charge will be in respect of the total income for the Assessment Year. The scope of total income is defined in section 5 of the Act to include all income from whatever source which is received or accrues or arises or deemed to be received, accrued or arisen would be a part of the total income. Therefore, the word ‘Income’ for purposes of Chapter X of the Act is to be given widest meaning to be deemed to be income aris-ing, for the purposes of total income in section 5 of the Act.

In view of the above, it was submitted that the Petition should not be entertained.

    Findings/Decision of the HC

    Wider meaning of ‘Income’ is not permissible in absence of specific provision in the Statute

On the contention of the revenue that the definition of In-ternational Transaction in the sub-Clause (c) and (e) of Explanation (i) to section 92B of the Act should be given a broader meaning to include notional income, the HC held as under:

    While interpreting a fiscal/taxing statute, the intent or purpose is irrelevant and the words of the taxing statute have to be interpreted strictly;

    In case of taxing statutes, in the absence of the provision by itself being susceptible to two or more meanings, it is not permissible to forgo the strict rules of interpretation while construing it;

    The SC in Mathuram Agarwal vs. State of M.P. [1999] 8 SCC 667 had laid down the following test for interpreting a taxing statue as under:

 “The intention of the legislature in a taxation statute is to be gathered from the language of the provisions particu-larly where the language is plain and unambiguous. In a taxing Act it is not possible to assume any intention or governing purpose of the statute more than what is stated in the plain language. It is not the economic results sought to be obtained by making the provision which is relevant in interpreting a fiscal statute.

Equally impermissible is an interpretation which does not follow from the plain, unambiguous language of the statute. Words cannot be added to or substituted so as to give a meaning to the statute which will serve the spirit and intention of the legislature. The statute should clearly and unambiguously convey the three components of the tax law i.e. the subject of the tax, the person who is liable to pay the tax and the rate at which the tax is to be paid. If there is any ambiguity regarding any of these ingredients in a taxation statute then there is no tax in law. Then it is for the legislature to do the needful in the matter.”

    In view of the above, it was clear that it was not open to DRP to seek aid of the supposed intent of the Legislature to give a wider meaning to the word ‘Income’.

    Whether the definition of ‘Income’ u/s. 2(24) includes ‘Capital Receipt’

    Following decision of the Bombay HC in the case of Cadell Weaving Mill Company Private Limited vs. CIT [2001] 249 ITR 265 (Bombay) upheld by the Apex Court in CIT vs. D. P. Sandu Brothers Chembur Private Limited. [2005] 273 ITR 1 (SC), it could not be disputed that income would not in its normal meaning under the Act include capital receipts unless specified.

    Section 56(2)(viib) of the Act seeks to tax a Com-pany in which public are not substantially interest-ed, in respect of the consideration received from a resident on sale of shares, which is in excess of the fair market value of the shares, as Income from Other Sources. The amount received on issue of shares was admittedly a capital account transac-tion not separately brought within the definition of income, except in cases covered u/s. 56(2)(viib) of the Act. Therefore, in absence of express legisla-tion, no amount received, accrued, or arising on capital account transaction could be subjected to tax as income. Parliament had consciously not brought to tax amounts received from a non-resident for issue of shares, as it would discourage capital inflow from abroad.

    Neither the capital receipts received by the tax payer on issue of equity shares to its AE, a non-resident entity, nor the alleged shortfall between the so called fair market price of its equity shares and the issue price of the equity shares, could be considered as ‘Income’ within the meaning of the expression as defined under the Act.

    A transaction on capital account or on account of restructuring would become taxable to the extent it impacts income, i.e., under-reporting of interest received or over-reporting of interest paid or claim of depreciation, etc. It was only that income which had to be adjusted to the ALP. The issue of shares at a premium was a capital account transaction and not income.

    In tax jurisprudence, it is well settled that the fol-lowing four factors are essential ingredients to a taxing statute:

    subject of tax;

    person liable to pay the tax;

    rate at which tax is to be paid, and

    measure or value on which the rate is to be applied.

    There is difference between a charge to tax and the measure of tax (i) & (iv) above. This distinction is brought out by the SC in Bombay Tyres India Ltd. vs. Union of India reported in 1984 (1) SCC 467 wherein it was held that the charge of excise duty is on manufacture while the measure of the tax is the selling price of the manufactured goods.

    In this case also the charge is on income as under-stood in the Act, and where income arises from an International Transaction, than the measure is to be found on application of ALP so far Chapter X of the Act is concerned.

    The arriving at the transactional value/ consideration on the basis of ALP does not convert non-income into income. The tax can be charged only on income and in the absence of any income arising, the issue of applying the measure of ALP to transactional value/consideration itself does not arise.

    The ingredient (g)(i) mentioned above, relating to subject of tax is income which is chargeable to tax, is not satisfied. The issue of shares at a premium is a capital account transaction and not income.

    TP Provisions – Scope and Objective

    Section 92(1) of the Act has clearly brought out that ‘Income’ arising from an International Transaction is a condition precedent for application of

Chapter X of the Act. Transfer Pricing provisions in Chapter X of the Act are to ensure that in case of International Transaction between AEs, neither the profits are understated, nor losses overstated.

They do not replace the concept of income or expenditure as normally understood in the Act, for the purposes of Chapter X of the Act.

    Section 92(2) of the Act dealt with a situation where two or more AEs entered into an arrangement whereby, if they were to receive any benefit, ser-vice or facility, then the allocation, apportionment or contribution towards the cost or expenditure had to be determined in respect of each AE having regard to the ALP. It would have no application in Petitioner’s case where there was no occasion to allocate, apportion or contribute any cost and/ or expenses between the tax payer and the AE.

    The objective of Chapter X of the Act is not to punish Multinational Enterprises and/ or AEs for doing business inter se. Arm’s Length Price (ALP) is meant to determine the real value of the transaction entered into between AEs. It is a re-computation exercise to be carried out only when income arose in case of an International transac-tion between AEs. It does not warrant re-computation of a consideration received/given on capital account.

    Real income versus Notional income

Reliance by the Revenue upon the definition of Interna-tional Transaction in sub-Clauses (c) and (e) of Explanation (i) to section 92B of the Act to conclude that income had to be given a broader meaning to include notional income, as otherwise Chapter X of the Act would be ren-dered otiose/ meaningless, was held to be far-fetched.

It was contended by the Revenue that in view of Chapter X of the Act, the notional income is to be brought to tax and real income will have no place. The entire exercise of determining the ALP is only to arrive at the real income earned, i.e., the correct price of the transaction, shorn of the price arrived at between the parties on account of their relationship viz. AEs. In this case, the revenue seems to be confusing the measure to a charge and call-ing the measure a notional income. The HC found that there is absence of any charge in the Act to subject issue of shares at a premium to tax.

    Charging or Machinery Provisions

    Chapter X of the Act is a machinery (computation-al) provision to arrive at the ALP of a transaction between AEs. The substantive charging provisions are in sections 4, 5, 15 (Salaries), 22 (Income from house property), 28 (Profits and gains of business), 45 (Capital gain) and 56 (Income from other Sources). Even income arising from International Transactions between AEs had to satisfy the test of ‘Income’ under the Act and had to find its home in one of the above heads, i.e., charging provisions. Following the five member bench of the apex court in CIT vs. Vatika Township Private Limited [2014]

49 taxmann.com 249 (SC), in absence of a charg-ing section in Chapter X of the Act, it was not possible to read a charging provision into Chapter X of the Act.

    It was submitted that the machinery section of the Act cannot be read de-hors charging section. The Act has to be read as an integrated whole. The HC held that on the aforesaid submission also, there can be no dispute. However, as observed by the SC in CIT vs. B. C. Srinivasa Shetty 128 ITR 294, “there is a qualitative difference between the charging provisions and computation provisions and ordinarily the operation of the charging pro-visions cannot be affected by the construction of computation provisions.” In the present case, there is no charging provision to tax capital account transaction in respect of issue of shares at a pre-mium. Computation provisions cannot replace/ substitute the charging provisions. In fact, in B. C. Srinivasa Shetty (supra), there was charging provision but the computation provision failed and in such a case the Court held that the transaction cannot be brought to tax. The present facts are on a higher pedestal as there is no charging provision to tax issue of shares at premium to a non-resident, then the occasion to invoke the computation provisions does not arise. The HC therefore, found no substance in the aforesaid submission made on behalf of the Revenue.
 

    It was also contended that Chapter X of the Act is a complete code by itself and not merely a machinery provision to compute the ALP. It is a hidden benefit of the transaction which is being charged to tax and the charging section is inherent in Chapter

X of the Act. It is well settled position in law that a charge to tax must be found specifically mentioned in the Act. In the absence of there being a charging Section in Chapter X of the Act, it is not pos-sible to read a charging provision into Chapter X of the Act. There is no charge express or implied, in letter or in spirit to tax issue of shares at a premium as income. In the present case, there is no charging provision to tax capital account transaction in respect of issue of shares at a premium. Computation provisions cannot replace/substitute the charging provisions.

    The HC held that the issue of shares at a premium by the Petitioner to its nonresident holding company does not give rise to any income from an admitted International Transaction. Thus, no occa-sion to apply Chapter X of the Act can arise in such a case.

    Whether the Share premium is chargeable to tax as ‘Income from other sources’

    Share premium have been made taxable by a legal fiction u/s. 56(2)(viib) and the same is enumerated as ‘Income’ in section 2(24)(xvi) of the Act. How-ever, what is bought into the ambit of income is the premium received from a resident in excess of the fair market value of the shares.

    Whereas in this case, what is being sought to be taxed is capital not received from a non-resident i.e. premium allegedly not received on application of ALP. Therefore, in absence of express legislation, no amount received, accrued or arising on capital account transaction can be subjected to tax as income.

    Thus, neither the capital receipts received by the Petitioner on issue of equity shares to its holding company, a non-resident entity, nor the alleged short-fall between the so called fair market price of its equity shares and the issue price of the equity shares can be considered as income within the meaning of the expression as defined under the Act. Although section 56(1) of the Act would permit in-cluding within its head all income not otherwise excluded, it did not provide for taxing a capital account transaction of issue of shares as was specifically provided for in section 45 or section 56(2) (viib) of the Act and included within the definition of income in section 2(24) of the Act.

    Concluding Remarks

Thus, the HC held that the issue of shares at a premium by Petitioner to its AE did not give rise to any ‘Income’ from an International Transaction and therefore, there was no need to invoke TP provisions. The ruling surely comes as a morale booster for investors’ confidence and will also help improving the overall image of the Indian tax system. It goes without saying that the said principles should squarely apply to similar matters pending before the Bombay HC, namely Shell, Essar, etc., provided the basic facts are the same as those of Petitioner.

It seems that the tax department may take the matter to the SC and pass on the responsibility for taking a decision in this regard to the SC, instead of dropping the issue at this stage, as otherwise the dispute should not have actually traversed beyond the level of the DRP.

One can only hope that wiser counsel will prevail and the department as also the Government will accept the decision, issue a circular clarifying that except for specific charging provisions, capital receipts are not taxable and generally, use this opportunity to win/regain the faith of taxpayers and investors especially foreign investors.

International Taxation-Recent Developments in USA

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In this Article, we have given information about
the recent significant developments in USA in the sphere of
international taxation. Since many Indian Corporates have substantial
business interests in and dealings with USA, we hope the readers would
find this information useful. This will help to create awareness about
impending important changes in law and practices in USA.

1. IRS issues FATCA guidance and final FFI agreement for foreign financial institutions

The
US Internal Revenue Service (IRS) has issued Revenue Procedure 2014-13
to provide guidance to foreign financial institutions (FFIs) entering
into FFI agreements directly with the IRS to be treated as participating
FFIs under the Foreign Account Tax Compliance Act(FAT CA). Revenue
Procedure 2014-13 also provides guidance to FFIs and branches of FFIs
treated as reporting financial institutions under an applicable Model 2
inter governmental agreement (IGA) (reportingModel2FFIs) on complying
with the terms of the FFI agreement, as modified by the Model 2 IGA.

Revenue
Procedure 2014-13 includes a final FFI agreement for participating FFIs
and for reporting Model 2 FFIs. The FFI agreement finalises the draft
FFI agreement that was released on 29th October, 2013 as section V of
IRS Notice 2013-69.

Revenue Procedure 2014-13 states that the
FFI agreement generally does not apply to a reporting Model 1 FFI, or
any branch of such an FFI, unless the reporting Model 1 FFI has
registered a branch located outside of a Model 1 IGA jurisdiction so
that such branch may be treated as a participating FFI or reporting
Model 2 FFI. In such a case, the terms of the applicable FFI agreement
apply to the operations of such branch.

Revenue Procedure 2014-13 is effective on 1st January ,2014.

2. Public comments requested on source of income from sales of natural resources and other inventory

The
US IRS and the Treasury Department have issued a notice requesting
comments on the existing regulations (TD8687) that provide rules for
allocating and apportioning income from sales of natural resources or
other inventory produced in the United States and sold outside the
United States or produced outside the United States and sold in the
United States. The regulations were issued u/s. 863 of the US Internal
Revenue Code (IRC).

Under the regulations, gross receipts equal
to fair market value of natural resources at the export terminal are
allocated to the location of the farm, mine, well, deposit, or uncut
timber, with the source of gross receipt from such sales in excess of
the product’s fairmarket value at the export terminal allocated to the
country of sale.

The regulations also provide rules for
allocating and apportioning income from inventory sales other than
natural resources where the taxpayer produces property in the United
States and sells outside the United States, or produces property outside
the United States and sells in the United States. Such income is
treated in part as USsource income and in part as foreign-source income
under one of the three methods described in the regulations: the 50/50
method, the independent factory price method, and the books and records
method.

The information collected under the regulations issued
by the IRS to determine on audit whether the tax payer has properly
determined the source of its income from export sales.

3. Updated IRS Publication 80 issued–Federal Tax Guide for Employers in US possessions

The
US IRS has released the revised IRS Publication 80, Circular SS
(Federal Tax Guide for Employers in US Virgin Islands, Guam, American
Samoa, and the Commonwealth of the Northern Mariana Islands). The
publication is dated 17th December, 2013 and is intended for use in
preparing 2014 tax returns.

Publication 80 provides information
for employers whose principal place of business is US Virgin Islands,
Guam, American Samoa, and the Commonwealth of the Northern Mariana
Islands (CNMI), or who have employees subject to income tax withholding
in these US possessions. Publication 80 notes that employers and
employees in these jurisdictions are generally subject to US social
security and Medicare taxes under the US Federal Insurance Contributions
Act (FICA), and summarises employer responsibilities to collect, pay,
and report these taxes. Additionally, Publication 80 provides employers
in the US Virgin Islands with a summary of the irresponsibilities under
the US Federal Unemployment Tax Act (FUTA ).

Revised Publication 80 provides information on new rules, including:

– The social security wage base limit (ceiling) for 2014 is $117, 000

– The social security tax rate remains 6.2% for each of the employer and employee;

– The Medicare tax rate remains 1.45%for each of the employer and employee;

–
Beginning 1st January, 2014, any entity assigned an employer
identification number (EIN) must file IRS Form8 822-B (Change of Address
or Responsible Party—Business) to report the change in the identity of
its responsible party; and

– IRS Notice 2013-61 provides special
administrative procedures for claims for refund or adjustments of over
payments of social security and Medicare taxes resulting from
recognition of certain same-sex marriages

Revised Publication 80 also provides reminders, including:

–
Employers are required to withhold an Additional Medicare tax of 0.9%
from wages paid to an employee in excess of $ 200,000 in a calendar
year;
– The IRS will not assert that an employer has understated
liability for FICA taxes by reason of a failure to treat services
performed before 1st January, 2015 in the CNMI by residents of the
Philippines as “employment” u/s. 3121(b)of the USIRC; and
– CNMI government employees are subject to social security and Medicare taxes beginning in the fourth quarter of 2012.

Publication 80 includes a calendar with the due dates for the IRS filing requirements.
In addition, Publication 80 refers to other IRS publications that are relevant in this context, Including:

– P ublication 15, Circular E (Employer’s Tax Guide) for information on US federal income tax withholding;
– P ublication 509 (Tax Calendars); and
–
P ublication 570 (Tax Guide for Individuals With Income From US
Possessions) for information on the self-employed tax. Publication 80 is
available on the IRS website.

4. IRS publishes quarterly list of individuals who have expatriated: Q2/2014

The
US IRS published on 7th August, 2014 a quarterly notice with a list of
US citizens and long-term US residents (green cardholders) who have
renounced their citizenship or resident status for tax avoidance
purposes.

The notice is dated 18th July, 2 014, and is based on
information that the US Treasury Department received during the quarter
ending 30th June, 2014.

The notice is required u/s. 6039G of the
USIRC. The list contains the name of each individual losing US
citizenship or long-term resident status within the meaning of IRC
sections 877(a) or 877A, dealing with the tax treatment of individuals
who are deemed to have expatriated from the United States for tax
avoidance purposes.

5 Public comments requested on treatment of compensatory stock options under transfer pricing rules

The us irs and the us treasury department have is- sued a notice requesting comments on information collection requirements imposed by the existing final regulations (td9088) dealing with the treatment of compensatory stock options under the transfer pricing rules of section 482 of the us IRC. the notice was published in the federal register on 7th august, 2014.

The final regulations, which were issued on 26th August, 2003, provide guidance on the treatment of stock-based compensation for purposes of the transfer pricing rules governing qualified cost sharing arrangements and for purposes of the comparability factors to be considered under the comparable profits method.

The final regulations adopted with modifications the proposed regulations (reG-106359-02 ) issued on this subject on 29th july, 2002. the irs requested that comments be submitted no later than 6th october, 2014. The mailing address and other contact information are given in the notice.

6.    IRS updates FAQs on FATCA registration System

The  us  irs  has  released  updated  frequently  asked Questions  (FAQs)  on  the  FATCA under  the  heading  of FATCA registration system. the FAQs indicate a last reviewed or updated date of 1st august, 2014.

The fAQs provide guidance on the following topics:
–    FATCA registration system–overview;
–    registration system resource materials;
–    General system questions;
–    fatCa account creation and access;
–    Registration status and account notifications;
–    Expanded Affiliated Groups (EAG);
–    registration updates;
–    sponsoring entity;
–    ffi list;
–    paper registrations;
–    Global Intermediary Identification Number (GIIN)–
overview; and
–    GIIN format.
The update is made by adding:
–    Question 1 to the topic, fatCa account creation and access;
–    Questions 6 and 7 to the topic, registration status and account notifications; and
–    Question 7 to the topic, registration updates.

The IRS notes that additional fAQs are available for the FATCa–FAQs General (last reviewed or updated on 29th july, 2014) and fAtCa FFI list (last reviewed or updated on 1st august, 2014).

7.    IRS updates FAQs on FATCa FFI List

The  us  irs  has  released  updated  frequently  asked Questions  (fAQs)  on  the  fatCa under  the  heading  of irs ffi list fAQs. the fAQs indicate a last reviewed or updated date of 1st august, 2014.

The FFI list is a list that is issued by irs and that includes all financial institutions and branches that have submitted a registration and have been assigned a Global interme- diary Identification Number (GIIN).

The fAQs provide guidance on the following topics:
–    FFI list overview;
–    registration deadline;
–    FFI List fields;
–    FFI list;
–    downloading;
–    searching;
–    legal entity name; and
–    XML/CSV files.

Rhe  update  is  made  by  adding  questions  1  and  2  to the  topic,  ffi  list,  and  adding  question  2  to  the  topic, searching.

8.    IRS further updates countries with residence waiver for foreign earned income exclusion for 2013

The  us  irs  released announcement  2014-28  on  30th july, 2014 to update the list of foreign countries for which the residence requirement for the us foreign earned income exclusion u/s. 911 of the us irC can be waived for 2013 due to adverse conditions that prevented the normal conduct of business. the original list for 2013 was provided in revenue procedure 2014-25.

Announcement 2014-28 adds south sudan, effective for departure on or after 17th december, 2013.

IRC section 911 permits qualified individuals to exclude a limited amount of foreign earned income ($97, 600 for 2013, see united states-5, news 23rd october, 2012) from us taxation and to claim an exclusion or deduction for certain foreign housing costs if a foreign residence re- quirement is met.

The  residence  requirement  can  be  waived  for  an  indi- vidual who left the listed countries on or after the stated departure date if:

–    There are adverse conditions, such as war, civil un- rest, or similar conditions, that prevent the normal con- duct of business in the countries; and

–    The individual can establish a reasonable expectation of meeting the residence requirement but for the ad- verse conditions.

9.    IRS issues revised instructions  for  requesters  of withholding certificates (Forms W-8) to implement FATCA

The US IRD has released revised irs instructions for the requester of forms W-8Ben, W-8eCi, W-8eXp, and W- 8imy to implement the fatCa. the instructions are dated 16th july, 2014.

The revised instructions supplement the instructions for the following forms:

–    Form W-8BEN (Certificate of Foreign Status of Ben- eficial Owner for United States Tax Withholding (Indi- viduals));

–    Form W-8BEN-E (Certificate of Status of Beneficial owner for united states tax Withholding and reporting (entities));

–    FormW-8ECI (Certificate of Foreign Person’s Claim that income is effectively Connected With the Conduct of a trade or Business in the united states);

–    FormW-8EXP (Certificate of Foreign Government or other foreign organisation for united states tax Withholding); and

–    Form W-8IMY (Certificate of Foreign Intermediary, foreign flow-through entity, or Certain us Branches for united states tax Withholding).

A withholding agent or a foreign financial institution (FFI) may need to request, and obtain, a withholding certificate (i.e., form W-8series) in order to:

–    establish the status of a payee or an account holder under chapter 4 of the us irC (dealing with the fat- Ca provisions)or the payee’s status under irC chapter 3 (dealing with the regular withholding on us-source income paid to foreign persons); or
–    Validate a payee’s or an account holder’s claim of for- eign status when there are us indicia associated with the payee or the account.

The revised instructions provide, for each form, notes to assist withholding agents and ffis invalidating the forms for chapters 3 and 4 purposes. The revised instructions also outline the due diligence requirements applicable to withholding agents for establishing a beneficial owner’s foreign status and claim for reduced withholding under an income tax treaty.

10.    Guidance issued on FTC limitations for foreign asset acquisitions

The IRS and the us treasury department have issued notice 2014-44 to announce their intention to issue regulations addressing the limitations of foreign tax credits (FTCs) related to certain foreign asset acquisitions u/s. 901(m) of the irC. notice 2014-44 was released on 21st july, 2014.

FTCs may be limited by IRC section 901(M)if the FTCs result from certain foreign asset acquisitions, referred to as “covered asset acquisitions” (Caas), in connec- tion with which taxpayers may elect to claim a higher tax basis in the “relevant foreign assets” (RFAS) for us tax purposes than for foreign tax purposes. as a result of the difference, the amount of taxable gain from the rfas, and potentially the tax, is higher in the foreign jurisdiction than in the united states.

IRC  section  901(m)  disallows  the  portion  of  the  ftC (the”disqualifiedportion”) that is attributable to the tax basis difference in the rfas to the extent the basis dif- ference is allocated to the taxable year. The disqualified portion of any ftC is allowed as a deduction. irC section 901(m)(3)(B)(i) allocates the basis difference to taxable years using the applicable cost recovery method for us income tax purposes.

IRC section 901(m)(3)(B)(ii) provides that, if there is a dis- position of an rfa, the basis difference allocated to the taxable year of the disposition (the “dispositionamount”) is the remaining (i.e., unallocated) basis difference, and no basis difference will be allocated to any subsequent taxable years (the “statutory disposition rule”).

To prevent taxpayers from avoiding the purpose of irC section 901(m) by invoking the statutory disposition rule, notice 2014-44 provides that, for purposes of section 901(m), a disposition means an event (for example, a sale, abandonment, or mark-to-market event) that results in gain or loss being recognised with respect to an rfa for purposes ofus income tax or a foreign income tax, or both. Notice 2014-44 clarifies that a disposition does not occur from a tax-free deemed liquidation that arises when an acquired foreign target corporation makes an entity classification election to become a disregarded entity for us tax purposes under the us check-the-box regulations.

Notice 2014-44 applies two separate rules for determin- ing the disposition amount, depending on whether or not the disposition is fully taxable for both us and foreign income tax purposes. in addition, notice 2014-44 contains special rules with re- gard to a Caa that is an acquisition of an interest in a partnership that has an election in effect under irC section 754, i.e., an election that permits the inside tax basis of partnership assets to be increased under irC section 743 following the acquisition of an interest in the partnership. notice 2014-44 also provides that IRC section 901(m) continues to apply to an rfa until the entire basis difference in the rfa has been taken into account using the applicable cost recovery method or as a disposition amount (or both), regardless of a change in the ownership of an RFA.

The rules provided in notice 2014-44 will generally apply to dispositions occurring on or after 21st july, 2014, subject to exceptions described in section 5 of the notice.

11.    Joint Committee on Taxation issues report on proposal store form taxation of multinational corporations

The  joint  Committee  on  taxation  of  the  us  Congress (JCT) has released a report on recent proposal store form the us taxation of multinational corporations.

The report is entitled present law and Background re- lated to proposals to reform the taxation of income of multinational enterprises. the report is dated 21st july, 2014, and is designated jCX-90-14.

The report includes the following:
–    a description of present us tax law applicable to in- bound investment (the us activities of foreign persons) and outbound investment (the foreign activities of uspersons);
–    a description of current policy concerns related to the taxation of multinational corporations;
–    Background on recent global activity related to the taxation of cross-border income; and
–    descriptions and a comparison of recent proposal store form the us international taxs ystem.

The report was prepared in connection with a public hear- ing that the us senate Committee on finance held on 22nd july, 2014 with regard to the taxation of cross-bor- der income.

12.    Final regulations issued regarding information re- porting by US passport applicants

The us treasury department and the irs have issued final regulations (td9679) to provide guidance on information reporting rules for certain individuals that apply for us passports (including renewals) u/s. 6039e of the us IRC. The final regulations were published in the Federal register on 18th july, 2014.

IRC section 6039e requires individuals applying for permanent residence (i.e., a green card) in the united states or for a us passport to include certain tax information in their applications. the us federal agency, to which the applica- tion is made, must provide such information to the IRS.

On 24th december, 1992, proposed regulations (intl- 978-86,reG-208274-86) were issued with guidance for both passport and permanent residence applicants to comply with information reporting rules under irC section 6039e. the 1992 proposed regulations also indicated the responsibilities of the specified US Federal agencies to provide certain information to the irs.

On 26th january, 2012, new proposed regulations (reG- 208274-86, rin1545-aj93) were issued to withdraw the 1992 proposed regulations and to provide guidance on information  reporting  by  passport  applicants.  the  2012 proposed regulations did not provide rules for information reporting by applicants for permanent residence. The final regulations adopt the 2012 proposed regulations with minor revisions.

The final regulations provide that a passport applicant, other than an applicant for an official passport, diplomatic passport, or passport for use on other official US government business, must provide his or her full name (including previous name, if applicable), permanent address and, if different, mailing address, tax payer identification number (TIN), and date of birth. a penalty of $ 500 may be imposed for non-compliance.

The final regulations further provide that a passport appli- cant who fails to provide the required information has 60 days (90 days for an applicant outside the united states) from the date of the irs’s written notice of the potential penalty assessment to respond to the notice if the appli- cant wishes to avoid the penalty. the applicant must do this by establishing that the failure is due to reasonable cause and not due to willful neglect.

The final regulations are designated Treasury Regula- tion section 301-6039e-1. they are effective on 18th july, 2014, and apply to passport applications submitted after 18th july, 2014.

13.    Final regulations issued regarding source rules for allocation and apportionment of interest expenses

The us treasury department and the irs have issued final regulations (td9676) to provide guidance on the allocation and apportionment of interest expenses between us and foreign sources u/s. 861 and 864(e) of the us IRC. The final regulations were published in the Federal register on 16th july, 2014.

The final regulations provide guidance on a number of is- sues, including the allocation and apportionment of interest expenses by corporations and individuals that own a 10% or greater interest in a partnership, as well as rules for valuing debt and stock of related persons. The final regulations also update the interest allocation regulations to conform to the statutory amendments regarding the al- location and apportionment of interest expenses by us corporate groups that include certain affiliated foreign cor- porations for purposes of irC section 864(e).

IRC section 864(e) provides that interest expenses of us corporate groups are to be allocated and apportioned between us and foreign sources as if all members of the group were a single corporation, and further that such allocation and apportionment are to be made on the basis of the assets of the corporate group (i.e., us and foreign) rather than on the basis of the gross income of the group. the amended irC section 864(e)(5)(a) treats a qualifying foreign corporation as a member of a US affiliated group for interest allocation purposes, and thus all the assets and interest expenses of the foreign member are taken into account, if specified 80% stock ownership and 50% us gross income/effectively Connected income (ECI) requirements are met.

The final regulations adopt, with no substantive change, the temporary regulations (td9571) issued on 17th january, 2012, as well as the portions of the earlier temporary regulations (td8228), issued on 14th september, 1988, that were not amended by the 2012 temporary regulations.

The final regulations amend provisions within Treasury regulation sections 1.861-9, -9t, -11, and-11t.

The final regulations are effective on 16th July, 2014, and generally apply to taxable years beginning on or after 16th july, 2014.

14.    IRS issues Memorandum on withholding on pay- ments to beneficial owner that fails to file income tax returns

The Office of Chief Counsel of the IRS has issued a memorandum that discusses the us withholding consequences of a beneficial owner’s failure to file US income tax returns after claiming a withholding exemption for us effectively connected income.

In the facts of the Memorandum, a Beneficial Owner (BO) provided a Withholding agent (WA) with irs formW-8eCi (Certificate of Foreign Person’s Claim That Income Is Effectively Connected With the Conduct of a trade or Busi- ness in the united states) to claim an exemption from us withholding tax on payments of income effectively con- nected with the conduct of a us trade or business (eCi). the Wa did not withhold on the payments made to the Bo in reliance on the form W-8eCI.

The BO certified in the FormW-8ECI that the amounts re- lated to the claim of exemption were ECI and were includible in the us gross income. the formW-8eCI includes a note that “Persons submitting this form must file an an- nual us income tax return to report income claimed to be effectively connected with a us trade or business.” the BO, however, did not file a US income tax return for any of the taxable years at issue.

Sections 1441 and 1442 of the irC require a withholding agent to withhold 30% of US-source fixed or determin- able, annual, or periodical (fdap) income paid to a foreign person. irC section 1441(c)(1), however, exempts withholding for eCi that is included in the gross income of the recipient. the consequence of this procedure is that the foreign person reports the eCi on a us income tax return and computes us income tax liability on a net in- come basis (i.e., gross income less allowable deductions) using the regular progressive us income tax rates rather than computing US tax liability at a flat 30% rate (or lower treaty rate) on the gross amount of the payment.

Under treasury regulation (treas. reg.) section 1.1441- 7(b)(1), a withholding agent may rely on a claim of exemption  contained  in formW-8eCi,  but a withholding  agent that receives a valid formW-8eCi must still withhold if it has actual knowledge or reason to know that the claim of exemption is incorrect.

The memorandum concludes that, because the BO made a claim of exemption for ECI and failed to file US tax

Returns including such amounts in gross income, the irs can determine the claim to be “incorrect” and provide direct notification to the WA under Treas. Reg. section 1.1441-7(b)(1) that it cannot rely on the Bo’s claim of exemption. the memorandum further states that the Wa will not be able to rely on the Bo’s claim of exemption beginning on the date that is 30 calendar days after the Wa receives such a notification, as described in Treas. Reg. section 1.1441-7(b)(1).

The  memorandum  is  designated  ilm201428007.  the memorandum is dated 7th may, 2014, and indicates are lease date of 11th july, 2014.

15.    IRS updates FaQs on general FATCA issues

The  us  irs  has  released  updated  frequently  asked Questions  (faQs)  on  the  FATCA  under  the  heading of  FATCA–fAQs  General.  the  fAQs  indicate  a  last reviewed or updated date of 10th july, 2014.

The  updated  fAQs  provide  guidance  on  the  following topics:

–    Qualified Intermediaries (QIs)/Withholding foreign partnerships(Wps)/Withholding foreign trusts (Wts);
–    inter Governmental agreement (iGa) registration;
–    Expanded Affiliated Groups (EAGs);
–    sponsoring/sponsoredentities;
–    Responsible  Officers  (ROs)  and  Points  Of Contact
(POCS);
–    financial institutions (FIS)
–    Exempt beneficial owners;
–    non-financial foreign entities (NFFES);
–    registration updates;
–    Branches/disregarded entities;
–    FFI and AGG changes;
–    General compliance;
–    additional supports; and
–    FATCA registration system technical supports.

The  update  was  made  with  regard  to  NFFES,  FFI  and EAG changes, and registration updates.

16.    IRS issues instructions to withholding certificate for foreign entities (FormW-8BEN-E) for FATCA

The us irs has released irs instructions for irs formW- 8BEN-E (Certificate of Status of Beneficial Owner for united states tax Withholding and reporting (entities)) to implement the fatCa. the instructions are dated 20th june, 2014.
the irs previously issued the new irs form W-8Ben- E (Certificate of Status of Beneficial Owner for United states  tax  Withholding  and  reporting  (entities))  to  be used by entities.

IRS formW-8Ben-e is used by a foreign entity:

–    To certify its status as a beneficial owner or payee of a payment for purposes of chapter 3 of the us irC (dealing with the regular withholding on income paid to foreign persons);

–    To claim income tax treaty benefits, if applicable, for the purpose of IRC chapter 3;

–    to certify its status under irC chapter 4 (dealing with the fatCa provisions); and

–    to submit to a payment settlement entity (pse) re- questing the form if the entity receives payments that would trigger information reporting for the pse under irC section 6050W (i.e., payments made in settlement of payment card transactions and third-party network transactions) unless the payee is a foreign person.

A foreign entity must furnish irs form W-8Ben-e to the withholding agent or payer when:

–    the  foreign  entity  receives  a  withholdable  payment from a withholding agent;
–    the foreign entity receives a payment subject to chap- ter 3 withholding; and
–    a foreign financial institution (ffi) with which the for- eign entity maintains an account requests the form.

IRS form W-8Ben as in use for 2013 and previous years was completed by both individuals and entity beneficial owners of the income to which the form related. the re- vised 2014 IRS FormW-8BEN (Certificate of Foreign Sta- tus of Beneficial Owner or United States Tax Withholding (individuals)) is for use exclusively by and entities should use the new irs form W-8BEN-E.

17.    IRS revises instructions to Form 1042-S for reporting foreign persons’ US source income to include FATCA requirements

The  us  IRS  has  released  revised  irs  instructions  for form   1042-s   (foreign   person’s   us   source   income subject to Withholding). the instructions are dated 24th june, 2014. the irs previously issued revised irs form 1042-s. irs Form 1042-S has been modified to accommodate report- ing of payments and amounts withheld under chapter 4 of the us IRC, commonly known as the fatCa, in addition to those amounts required to be reported under irC chap- ter 3. IRC chapter 3 deals with the regular withholding on US-source income paid to foreign persons, including fixed or determinable annual or periodical (fdap) income.

When a financial institution reports a payment made to its financial account, IRS Form 1042-S also requires the reporting of additional information about a recipient of the payment, such as the recipient’s account number, date of birth, and foreign tax payer identification number, ifany. For withholding agents, intermediaries, flow-through entities, and recipients, irs form 1042-s requires that the chapter 3 status (or classification) and/or the chapter 4 status be reported on the form according to codes provided in the instructions.

In addition, IRS Form 1042-2 must be filed to report specified Federal procurement payments made to foreign persons that are subject to withholding under IRC section 5000C and to report distributions of us effectively Connected income (ECI) by a publicly traded partnership or nominee.

18.    IRS issues instructions for FATCA reporting form

The  us  IRS  has  released  IRS  instructions  for  form 8966  (fatCa report).  the  instructions  are  dated  20th june, 2014.

The irs previously issued new irs form 8966. irs form 8966 is required to be filed under chapter 4 of the US IRC, commonly referred to as the FATCA, to report information with respect to certain us accounts, substantial us owners  of  passive  non-financial  foreign  entities  (nffes), us accounts held by owner-documented foreign financial institutions (FFIS), and certain other accounts as applicable based on the filer’s chapter 4 status.

Filers of irs form 8966 include a participating FFI (PFFI), a us branch of a PFFI that is not treated as a us person, a registered deemed-Compliant (RDC) ffi (including a reporting model 1 FFI), a limited branch or limited ffi, a reporting Model 2 FFI, a Qualified Intermediary (QI), a Withholding foreign partnership (Wp), a Withhold- ing  foreign  trust  (Wt),  a  direct  reporting  nffe,  and  a sponsoring entity. for calendar years 2015 and 2016, irs form 8966 is also filed by PFFIs, RDCFFIs, and reporting Model 2 FFIs to report certain amounts paid to their account holders that are non-participating ffis.

The initial filing of IRS Form 8966 will be required to be made on or before 31st march, 2015 for the 2014 calen- dar year.

19.    IRS releases addendum to user guide for FATCA online registration

The us IRS has released publication 5118a (addendum to the fatCa online registration user Guide). the addendum is dated july, 2014.

The addendum serves as a supplement to, and should be  used  in  conjunction  with,  publication  5118  (FATCA online   registration   user   Guide,   rev.12-2013).   the user  guide  provides  instructions  for  using  the  FATCA registration system to complete the fatCa registration process online.

The  addendum  describes  new  functionality  introduced since the last revision of the use rguide. Specifically, the addendum updates 6.6 appendix e: Country look up table of the user guide (pages 116 through 121) by adding the West Bank and Gaza (numeric Code: 275).

20 IRS announces changes to its offshore voluntary compliance programmes

The us irs has announced major changes in its off shore voluntary compliance programmes that will allow a broader group of us tax payers to participate so that they can come into compliance with their us tax obligations. The announcement was made in an irs news release (IR- 2014-73) dated 18th june, 2014. the irs Commissioner has also issued a statement dated 18th june, 2014.

The  changes  include  an  expansion  of  the  streamlined filing compliance procedures announced in 2012 and modifications to the 2012 Offshore Voluntary Disclosure program(oVdp).

Expansion of streamlined filing compliance procedures the expanded streamlined procedures are intended for us tax payers whose failure to disclose their offshore assets was non-wilful.

The changes to the streamlined procedures include:

–    extending eligibility to include us taxpayers residing in the united states, in addition to us taxpayers resid- ing broad;

–    eliminating a requirement that the taxpayer have usd 1,500 or less of unpaid tax per year;

–    eliminating the required risk questionnaire; and

–    requiring the taxpayer to certify that previous failures to comply were due to non-willful conduct.

Modifications to OVDP

The modified OVDP is designed to cover US taxpayers whose failure to comply with reporting requirements is considered willful in nature, and who therefore do not qualify for the streamlined procedures.

The modifications to the 2012 OVDP include:

–    Requiring additional information from taxpayers apply- ing for the programme;

–    Eliminating the reduced 5% and 12.5% penalties for certain non-wilful taxpayers in light of the expansion of the streamlined procedures;

–    Requiring taxpayers to submit all account statements and pay the offshore penalty at the time of the oVdp application;

–    Enabling an electronic submission of records; and

–    Increasing the offshore penalty from 27.5% to 50% if, before the taxpayer’s OVDP pre-clearance request is submitted, it becomes public that a financial institution where the taxpayer holds an account or another party facilitating the taxpayer’s offshore arrangement is under investigation by the irs or the us department of justice.

Related items
The IRS has also released the following related items:

–    a factsheet (fs-2014-6) with highlights of the irs offshore voluntary programmes since 2009;

–    A factsheet (FS-2014-7)with tax filing information for us taxpayers with offshore accounts; and
–    OVDP documents and forms.

Results of offshore evoluntary programmes

The  IRS  notes  that  its  three  voluntary  programmes  in 2009, 2011, and 2012 have resulted in more than 45,000 disclosures and the collection of approximately USD6.5 billion in taxes, interest and penalties.

21.    IRS releases guidance on options for US taxpay- ers with undisclosed foreign financial assets

The us IRS has issued guidance on options for us tax- payers who have previously failed to comply with us tax and information return obligations with respect to their non-us bank accounts and other foreign investments. the guidance indicates a last reviewed or updated date of 18 june 2014.

The guidance includes the following options:

–    the 2012 offshore Voluntary disclosure program (oVdp);

–    streamlined filing compliance procedures;

–    delinquent fBar submission procedures; and

–    delinquent international information return submission procedures.

The OVDP is specifically designed for taxpayers with ex- posure to potential criminal liability and/or substantial civil penalties due to a wilful failure to report foreign financial assets and pay all tax due in respect of those assets. The OVDP is designed to provide such taxpayers with protection from criminal liability and sets out the terms for resolving their civil tax and penalty obligations.
The streamlined filing compliance procedures are available to taxpayers who certify that their failure to report foreign financial assets and pay all tax due in respect of  those  assets  did  not  result  from  wilful  conduct.  the streamlined procedures are designed to provide such tax- payers with a streamlined procedure for filing amended or delinquent returns and set out terms for resolving their tax and penalty obligations.

The   delinquent   FBAR   submission   procedures   are intended for taxpayers who:
–    have not filed a required Report of Foreign Bank and financial accounts (FBAR) (finCen form 114, previously form TD f 90-22.1);
–    are not under a civil examination or a criminal investi- gation by the irs; and
–    have not already been contacted by the irs about the delinquent fBars.

The  delinquent  international  information  return  submis- sion procedures are available to taxpayers who:

–    have not filed one or more required international infor- mation returns;
–    have reasonable cause for not timely filing the infor- mation returns;
–    are not under a civil examination or a criminal investi- gation by the irs; and
–    have not already been contacted by the irs about the delinquent information returns.

For a report on the recent announcement of changes to the 2012 oVdp and the streamlined procedures, see united states-1, news 23rd june, 2014.

22.    Final and proposed regulations issued on IRS Form 5472 reporting requirements

The us treasury department and the irs have issued final regulations (TD9667) and proposed regulations (reG–114942–14) u/s. 6038a and 6038C of the us irC to provide guidance on the requirements to file IRS Form 5472  (information  return  of  a  25%  foreign-owned  us Corporation or a foreign Corporation engaged in a us trade or Business). the form is used by the irs to collect information on transfer pricing transactions between related parties.

IRC section 6038a requires information reporting by a 25% foreignowned domestic corporation  with  respect to certain transactions between such corporation and related parties.

IRC section 6038C imposes a similar reporting requirement on a foreign corporation engaged in a trade or business within the united states.

Final  regulations  (td8353)  were  issued  on  19th  june, 1991 to provide that:
–    a reporting corporation under irC sections 6038a and 6038C is required to file Form 5472 with its US income tax return by the due date of the return with respect to each related party with which the corporation has had any reportable transaction during the taxable year;
–    Such reporting corporation is also required to file a duplicate form 5472 with the irs Centre in philadel- phia, pa (i.e.,the duplicate filing requirement); and
–    if a reporting corporation’s income tax return is not timely filed, Form 5472 nonetheless I required to be filed (with a duplicate to the IRS Centre in Philadel- phia, pa) at the irs Centre where the return is due (i.e.,the untimely filed return provision), and, when the income tax return is ultimately filed, a copy of Form 5472 must be attached to the return.

Temporary  regulations  (TD9529)  were  issued  on  10th June, 2011 to remove the duplicate filing requirement on the ground that advances in electronic processing and data collection in the irs made it no longer necessary.

The new final regulations (TD9667)adopt the 2011 temporary regulations without substantive change as final regulations. The final regulations are designated Treasury regulation (treas.reg.) section 1.6038a-1, and -2. the final regulations are effective on 6th June, 2014.

In addition, the new proposed regulations (reG–114942–14) Eliminate the untimely filed return provision to promote efficient tax administration and consistency with other similar international reporting obligations applicable to us persons. as a result, the proposed regulations require a reporting corporation to file Form 5472 only with its in- come tax return by the duedate (including extensions)of the return.

The  proposed  regulations  are  designated  treas.reg. section 1.6038a-1, -2, and-4. the proposed regulations will apply to taxable years ending on or after the date on which the proposed regulations are published as final.

23.    IRS releases its first list of FATCA compliant financial institutions

The US IRS released the first IRS Foreign Financial Institution (FFI) list. the irs has also issued a related statement dated 2nd june, 2014.

The IRS FFI list is a list of financial institutions (FIS) and other entities (e.g. direct reporting non-financial foreign entities and sponsoring entities) that have completed fatCa registration  with  the  irs  and  obtained  a  Global Intermediary Identification Number(GIIN).

The first FFI List includes FIs in approved status as of 23rd May, 2014. The FFI List is updated on the first day of each month and will only include fis that are approved five business days prior to the first day of the month.

The FFI list search and download tool can be used to look for fis and their branches to determine if they are on the FFI list. the tool can download the entire FFI list or search for a particular fi by its legal name, GIIN,or country. no login or password is required to search or download the ffi list. the results will be displayed on the screen and can be exported in CSV, Xml, or pdf formats.

The IRS previously issued the following related items:

–    publication 5147 (FFI list search and download tool: UserGuide);
–    fatCa FFI  list  resources  and  support  information Webpage; and
–    FFI list frequently asked Questions(fAQs).

24.    Regulations issued to amend FaTCa provisions and coordinate FaTCa regulations with pre-existing tax rules

The  us treasury  department  and  the  IRS  issued  temporary regulations  (TD9657) on 20th february, 2014 to make additions and clarifications to the previously issued regulations on implementation of the FATCA. the treasury department and the irs also issued additional temporary regulations (TD9658) on the same day to provide guidance to coordinate FATCA rules with pre-existing reporting and withholding requirements under other provisions of the us IRC.

The treasury department issued a related press release dated 20th february, 2014, together with a factsheet on the new regulations.

Amendments to prior FATCA regulations

The first regulations (TD9567) contain over 50 amend- ments and clarifications to the previous FATCA regulations that were issued on 17th january, 2013 (TD9610) in response to certain stakeholder comments regarding ways to further reduce compliance burdens. Key changes include those relating to:
–    the  accommodation  of  direct  reporting  to  the  irs, rather than to withholding agents, by certain entities regarding their substantial us owners;
–    the treatment of certain special-purpose debt securi- tisation vehicles;
–    the treatment of disregarded entities as branches of
foreign financial institutions (FFIs); –    The definition of an expanded affiliated group; and
–    transitional rules for collateral arrangements prior to 2017.

Coordination of FATCA with pre-existing reporting and withholding rules

irC chapter 3 contains reporting and withholding rules relating to payments of certain us-source income (e.g. dividends on stock of us corporations) to non-us per- sons. irC chapter 61 and irC section 3406 impose the reporting and withholding requirements for various types of payments made to certain us persons (us non-ex- empt recipients).

the second regulations (td9568) coordinate these pre- fatCa regime with the requirements under fatCa to in- tegrate these rules, reduce burden (including certain du- plicative information reporting obligations), and conform the due diligence, withholding, and reporting rules under these provisions to the extent appropriate. Specifically, the coordinating rules make changes that are intended:

–    to remove inconsistencies in the chapter 3 and fat- Ca documentation requirements relating to the identi- fication of payees (including inconsistencies regarding presumption rules in the absence of valid documenta- tion);
–    to ensure that payments are not subject to withhold- ing under both irC chapter 3 and ftCA, or under both IRC section 3406 and FATCA;
–    to  relieve  non-us  payors  from  chapter  61  report- ing to the extent the non-us payor reports on the account in accordance with the fatCa regulations or an applicable inter governmental agreement (iGa);
–    to provide a limited exception to reporting under irC chapter61 for both us payors and non-us payors that  are  ffis  required  to  report  under  fatCa or  an applicable iGa, with respect to payments that are not subject to withholding under irC chapter 3 or irC section 3406 and that are made to an account holder that is a presumed (but not known) us non-exempt recipient;
–    to  provide  a  limited  exception  from  reporting  under irC chapter 61 for us payors acting as stock transfer agents or paying agents of distributions from certain passive foreign investment companies (PFICS) made to us persons; and
–    to make other conforming changes.
Effective  date:  the  regulations  will  become  effective when published as final

25.    IRS releases Transfer Pricing audit roadmap

The   transfer   pricing   operations   (TPO)of   the   large Business  and  international  (lB  &  I)  division  of  the  us irs  has  released  the  transfer  pricing  audit  roadmap (roadmap)to the public. The irs also issued a statement announcing   the   release   of   the   road   map   on   14th february 2014.

TPO is a dedicated team of transfer pricing specialists that is established by the lB & i of the irs and that encompasses both the advance pricing and mutual agreement program (APMA) and the transfer pricing practice (TTP).

TPO  has  developed  the  road  map  to  provide  the  irs transfer pricing practitioner with audit techniques and tools to assist with the planning, execution, and resolution of transfer pricing examinations. the road map is organised around a notional 24-month audit timeline.
The IRS notes that the road map is not intended as a template, but rather serves as a toolkit that provides recommended audit procedures and links to useful reference material. the road map also provides the public within sight into what to expect during a transfer pricing exami- nation.

The IRS also states that TPO will review the road map and make changes over time as new techniques arise or additional reference materials become available.

[Acknowledgement/Source: We have compiled the above information from the Tax News Service of IBFD for the period 01-01-2014 to 09-08-2014]

Impact of Retrospective Amendments to Section 9 of the Income-tax Act, 1961

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Fundamental principles for retrospective amendments to tax laws (especially direct taxes) are that such amendments should be made in exceptional cases and should be constitutionally valid. India has witnessed a series of retrospective amendments in its Income-tax law in the past decade. Most or a majority of them are to subvert the decisions of Judicial Authorities in favour of the tax payers resulting into uncertainty, distrust and ambiguity in tax laws. This article throws light on retrospective amendments in Indian Tax Law, their impact and resulting issues, primarily in the arena of taxation pertaining to non-residents.

1.0 Introduction
“Government should collect taxes from citizens the way a bee collects honey from the flowers – quietly without inflicting pain.” – Chanakya.

There are three pillars of Tax System in India- namely, Legislature, Execution/Administration and the Judiciary. The Parliament has the sovereign right to legislate tax laws, which are executed or administered by the tax department and the judiciary keeps watch, vigil and resolves disputes through just and proper interpretation of the law. All the three pillars derive their powers and limitations from the Indian Constitution.

Entry 82 of the List I to the Seventh Schedule, referred to in Article 246 of the Constitution of India, gives power to the Union Government to levy “Taxes on income other than agricultural income” and Entry 85 of the same Schedule gives power to levy “Corporation tax”.

2.0 Constitutional Validity of Retrospective Amendments

A question arises whether enactment of retrospective legislation is within the powers conferred by the Constitution?

The Parliament has the sovereign power to legislate and this includes prospective as well as retrospective legislations. Where the legislature can make a valid law, it may provide not only for the prospective operation of the material provisions of the said law, but it can also provide for the retrospective operation of the said provisions1.

In the undernoted cases, the Supreme Court examined the validity of retrospective amendments to laws and accorded them Constitutional validity.

(i) Chhotabhai Jethabhai Patel and Co. vs. UOI and another 2
(ii) Rai Ramakrishna vs. State of Bihar1
(iii) I. N. Saksena vs. State of M.P.3
(iv) National Agricultural vs. UOI4

To be constitutionally valid, any retrospective amendment has to broadly satisfy the following tests:

i) T he retrospective operation of the Act should not alter the character of the tax imposed by it so as to make the state incompetent to legislate5;
ii) R estrictions imposed by the Act should not be so unreasonable that they contravene the fundamental rights of the tax payer granted by the Constitution of India under Article 19(1)(g)6;
iii) R etrospective legislation should not be violative of a constitutional provision.

In Kesavananda Bharati’s case, the Supreme Court held that any legislation which has an impact of amending the basic structure of the Constitution or denying the fundamental rights, is considered as unconstitutional.

3.0 I mpact of Retrospective Amendments

3.1 Can the payer be held in default for failure to deduct tax at source u/s. 201 of the Income-tax Act, 1961?

Deduction of tax at source is a machinery provision. Section 195 of the Act casts obligation on every payer to deduct tax at source from the payment made to a nonresident. There is no threshold for the same. In case a payer fails to deduct tax at source, he will be held as an assessee in default u/s. 201 of the Act and shall be liable to pay the amount of tax together with interest thereon.

Therefore, in case of Vodafone International Holdings’ case where it acquired the shares of a Non-Resident (NR) company from the Hutch Group, which through its step down subsidiaries ultimately held the Indian telecommunication business of the erstwhile Hutch in India; it was held to be assessee in default u/s. 201 of the Act for failure to deduct tax at source while making payment to the NR company of Hutch Group. Vodafone contended that no tax was required to be deducted as shares were located outside India and the income of the NR Company was not taxable in India u/s. 9 of the Act. Vodafone won the case in the Supreme Court of India where the Apex Court held that the present provisions do not cover a situation of indirect transfer to the Indian tax net by adopting “look at” approach.

Subsequently, section 9 of the Act was amended vide the Finance Act, 2012 with retrospective effect from 01-04- 1962 to bring indirect transfer of shares within the ambit of deemed income in India by providing for “look through” approach whereby corporate veil of intermediary companies can be lifted to determine whether the substantial value of the transfer is attributed to assets located in India.

Since the amendment is made retrospective, it has an impact of nullifying the Supreme Court decision in favour of Vodafone, subject to the outcome of the writ petitions challenging constitutional validity of such retrospective amendment

The Expert Committee in its draft report on Retrospective Amendments Relating to Indirect Transfer has recommended that “no person should be treated as an assessee in default u/s. 201 of the Act read with section 9(1)(i) of the Act as amended by the Finance Act, 2012, or as a representative assessee of a non-resident, in respect of a transaction of transfer of shares of a foreign company having underlying assets in India as this would amount to the imposition of a burden of impossibility of performance.”

The recommendation of the Expert Committee is justified in the sense that how can one deduct tax at source when the income is brought to tax by retrospective amendments. The only argument in favour of revenue could be that it claims that these amendments were only clarificatory in nature. Courts have upheld retrospective application of amendments where they were found to be in the nature of explanatory, declaratory, curative or clarificatory nature.10

3.2 Can the expenses be disallowed u/s 40(a)(i) in the hands of the payer for failure to deduct tax at source?

In the case Metro and Metro vs. Additional Commissioner of Income-tax11, the Agra bench of the ITAT held that testing fees paid by the Indian company without deduction of tax at source to the TUV Product Und Umwelt GmbH – a tax resident of Germany, cannot be disallowed u/s. 40(a)(i) of the Act on the ground that the payer failed to deduct tax at source. In the instant case such fees became taxable in India only as a result of the amendment in section 9(1), by virtue of the Finance Act, 2010. The assessee relied on the decision of the Supreme Court in the case of Ishikawajimaharima Heavy Industries Ltd. vs. DIT12 to conclude that fees paid by it were not taxable as services were rendered outside India.

The ITAT ruled in favour of the assessee and held that no disallowance can be made in view of the decision of the coordinate bench in the case of Channel Guide India Ltd vs. ACIT13 wherein, following the views expressed by the Ahmedabad bench in the case of Sterling Abrasives Ltd. vs. ITO (ITA No. 2234 and 2244/Ahd/2008; order dated 2008), it is held that law cannot cast the burden of performing the impossible task of tax withholding with retrospective effect, and, accordingly, the disallowance u/s. 40(a)(i) cannot be made in a situation in which taxability is confirmed only as a result of retrospective amendment of law.

The Cochin Bench of the income-tax appellate tribunal14 [ITAT] in case of Kerala Vision Ltd. vs. ACIT held that the payment made for pay channel charges is taxable as royalty with the introduction of retrospective amendments in the act, but the same could not be disallowed u/s. 40(a)(i)Of the act, as it was not taxable before the introduction of the amendment.

3.3    Can Assessee be asked to pay interest and penalty for shortfall in payment of Tax?

Article 20 (1) of the indian Constitution provides that (i) no person shall be convicted of any offence except for violation of a law in force at the time of the commission of the act charged as an offence and (ii) he shall not be subjected to a penalty greater than that which might have been inflicted under the law in force at the time of the commission of the  offence.  thus,  penal  laws  generally,  cannot  have retrospective operation.15

Expert Committee headed by dr. P. shome recommended that no penalty should be levied in respect of the income brought to tax on application of retrospective amendments u/s. 271(1)(c) (for concealment of income) and 271C (for failure to deduct tax at source) of the act.

Similarly, the expert  Committee  also  recommended  that in all cases where demand of tax is raised on account of the retrospective amendment relating to indirect transfer u/s. 9(1)(i) of the act, no interest u/s. 234a, 234B, 234C and 201(1a) of the act should be charged in respect of that demand, so that there is no undue hardship caused to the taxpayer.

3.4    Reopening of Assessments:

In Babu Ram vs. C. C. Jacob and others16 the supreme Court held that the retrospective amendment is not applicable to the matter which has already attained finality before  introduction  of  the  amendment.  The  apex  Court further observed that the prospective declaration of law is  a devise innovated by the apex Court to avoid reopening of settled issues and to prevent multiplicity of proceedings. It is also a device adopted to avoid uncertainty and litigation. By the very object of prospective declaration of law, it is deemed that all actions taken contrary to the declaration of law, prior to its date of declaration are validated. This is done in the larger public interest. in matters, where decisions opposed to the said principle have been taken prior to such declaration of law, cannot be interfered with on the basis of such declaration of law.17

It would be interesting to note here that where the supreme Court has expressly made its ratio prospective, the high Court cannot give it retrospective  effect.  By  implication, all contrary actions taken prior to such declaration stand validated.18

Post retrospective amendments to section 9 vide the finance act, 2012, for taxing indirect transfer to tax in india, CBdt has issued a letter to CCits and dgits19    stating that the amended laws would not be applicable to assessments that are already completed. the  letter states that “in case where assessment proceedings have been completed u/s. 143(3) of the act, before 1st april, 2012 and no notice for reassessment has been issued prior to that date; such cases shall not be re-opened u/s. 147/148 of the act on account of the above mentioned clarificatory amendments introduced by the Finance Act, 2012.” It further clarifies that “assessment or any other order which stand validated due to the said clarificatory amendments in the Finance Act, 2012 would of course be enforced.” this will have an impact on all cases which are pending at different stages of appeal.

Thus, the  letter seem to be providing relief to only those tax payers whose assessments have been completed and no appeals are pending at any level.

4.0 Retrospective Amendments and Tax Treaties

Tax  treaties,  being  bilateral  agreements,  signed  by  two sovereign states, would prevail over domestic tax laws wherever there are conflicting provisions. Section 90 (2) provides  that  between  provisions  of  the  act  and  a  tax Treaty, whichever is more beneficial to the tax payer shall apply. Various terms are defined in Article 3 of a Tax Treaty or certain articles dealing with different types of income, for example,  dividend,  interest,  royalty,  fees  for  technical services (fts) etc.

Wherever, any particular term is defined in the tax treaty, and if there is a retrospective amendment to the definition of that term in the act, then such amendment will have no impact on provisions of tax treaty. For example, in CIT vs. Siemens Aktiengesellschaft20 the Bombay high Court held that the amendment in the definition of the “Royalty” with retrospective date will have no impact on interpretation of tax treaty. Payments made by the indian Company (BHEL) were held to be in the nature of “commercial profits” under the  india-germany  tax  treaty  (old)  and  were  held  not to be taxable in india in absence of Pe. The income-tax department’s argument of applying ambulatory approach for interpretation of the term “royalty” in view of its amendment under the income-tax act, was overruled by the high Court stating that, assessee has right to opt for provisions of the tax treaty u/s. 90(2) read with CBdt Circular 333 dated 2nd April, 1982 as they are more beneficial to him.

In B4U International Holdings Ltd. vs. DCIT21, the mumbai tribunal  held  that  hire  charges  for  transponder  satellite would not constitute “royalty” applying provisions of india- usa dtaa, notwithstanding retrospective amendments in the definition of “Royalty” u/s. 9(1)(vi) of the Act by the finance act, 2012.

In Sanofi Pasteur Holding SA vs. Dept. of Revenue22 the A. P.  high Court held that “the retrospective amendment   to section 9(1) so as to supersede the verdict in Vodafone international and to tax off-shore transfers does not impact the provisions of the india-france dtaa because the dtaa overrides the act.” the Court also rejected the revenue’s contention that as the “alienation” is not defined in the dtaa, it should have the meaning of the term “transfer” in section 2(47) as retrospectively amended. The Court ruled that as per article 31 of the Vienna Convention, a treaty has to be interpreted in good faith and in accordance with the ordinary meaning. it further held that, though article 3(2) provides that a term not defined in the treaty may be given the meaning in the act, this is not applicable because the term “alienation” is not defined in the Act.

In Director of Income-tax vs. Nokia Networks OY23, it was held that the assessee had opted to be governed by the dtaa and the language of the dtaa differed from the amended  section  9  of  the  act.  The  amendment  cannot be read into the DTAA. On the wording of the dtaa, a copyrighted article does not fall within the purview of royalty.

Article 3 of the un model Convention (MC) and the OECD MC as well as almost all indian tax treaties provide that any term not defined in the tax treaty shall have the meaning that it has at that time under the laws of that state, for the purpose of taxes to which the treaty applies. In other words, the meaning of a particular term is not defined in the treaty, then tax laws of the state which applies provisions  of a  tax treaty (i.e., state of source generally for determining taxability  of  income)  would  be  applicable.  for  example, the term “FTS” is not defined in India’s tax treaties with mauritius and uae. In such a scenario amendments made to the term fts in the act with retrospective effect would be applicable to any entity earning such income from india who is resident of these countries.

Article 7 in certain tax treaties (for example,  dtaa  with usa and uK) provide that  deductibility  of  expenses  of  the Permanent establishment (Pe) shall be subject to the provisions of the domestic tax laws. In such a scenario, if there is a retrospective amendment in the act, concerning computation of business profits of a PE, then such revised provisions would be applicable.


5.0 Expert Committee on Retrospective Amendments to section 9 relating to indirect Transfer of Shares

Retrospective  amendments  are  supposed  to  cure  the unintended  defect  or  lacuna  in  the   legislations   and/  or to bring clarity in law. However, the recent trend of retrospective amendments is very disturbing, which is to overrule or nullify the effect of favourable decisions of the Courts  and  tribunals  in  favour  of  the  tax  payer,  albeit, the Government has inherent right to correct infirmities in the law which may have been surfaced in a decision of a Court or tribunal resulting in a favourable decision to the tax payer. Thus, any retrospective amendment which may have an effect of neutralizing a Court ruling, by itself, would not render it unconstitutional unless, it alters the character of the tax imposed by the state so much, that it renders  the state incompetent to legislate and/or  its  operation  is so unreasonable that it results in to contravention of the fundamental rights of tax payers guaranteed by indian Constitution. At the same time, where the retrospective legislation is introduced to overcome a judicial decision,  the power cannot be used to subvert the decision without removing the statutory basis of the decision.24  further, such amendment cannot be made retrospectively only for the purpose of nullifying a judgment where there was no lacuna or defect in the original law.25

In 2012, the then Prime minister constituted an expert Committee  on  general  anti  avoidance  rules  (gaar), to undertake stakeholder consultations and finalise the guidelines for gaar after far more widespread consultations so that there is a greater clarity on many fronts26.

In the meantime the finance act, 2012, inserted following two explanations to section 9(1)(i) of the act with retrospective effect from 01-04-1962.

“Explanation  4.—for  the  removal  of  doubts,  it  is  hereby clarified that the expression “through” shall mean and include and shall  be  deemed  to  have  always  meant and included “by means of,” “in consequence of” or “by reason of.”

Explanation  5.—for  the  removal  of  doubts,  it  is  hereby clarified that an asset or a capital asset being any share or interest in a company or entity registered or incorporated outside india shall be deemed to be and shall always be deemed to have been situated in india, if the share or interest derives, directly or indirectly, its value substantially from the assets located in india.”

The above explanations were inserted to nullify the effect of the land mark decision of the supreme Court in case of Vodafone International Holdings BV vs. Union of India27 where in the apex Court held that indirect transfer of asset (in this case it was “shares”) by one non-resident to another non-resident of a foreign company which owned an indian company through various intermediary companies, was not covered by section 9 of the act and hence not taxable in india. as the stake involved was very high (about rs. 14,200 crore), government amended section 9 of the income-tax act with retrospective effect. However, it resulted in lot of opposition, criticism and negative impact about stability  and reliability of indian tax laws in the minds of foreign investors, thus impacting flow of foreign investments. At that time the expert Committee headed by dr. Parthasarathy shome was already examining gaar provisions. So, the government expanded the scope of the expert Committee on gaar to include the examination of the applicability of the amendment on taxation of non-resident transferring assets, where the underlying asset is in india.

The said expert Committee submitted its draft report in 2012 titled “draft report on retrospective amendments relating to indirect transfer”, wherein it concluded that “retrospective application of tax law should occur in exceptional or rarest of rare cases, and with particular objectives:

(i)    to correct apparent mistakes/anomalies in the statute;
(ii)    to apply to matters that are genuinely clarificatory in nature, i.e., to remove technical defects, particularly in procedure, which have vitiated the substantive law; or,
(iii)    to “protect” the tax base from highly abusive tax planning schemes that have the main purpose of avoiding tax, without economic substance, but not to “expand” the tax base.

Moreover, retrospective application of a tax law should occur only after exhaustive and transparent consultations with stakeholders who would be affected.”

The   “Tax  Administration   Reform   Commission”   (TARC) headed by Dr. Parthasarathy shome harshly criticised “Retrospective Amendments.” TARC submitted its first report   on   30th   may,   2014.   the   report28   states   that: “retrospective amendments have further undermined the trust between taxpayers and the tax administration. Many seem to feel that it has become the order of the day. Many of the retrospective amendments  have  been  introduced to counter interpretation in favour of the taxpayer upheld earlier by the judiciary. the most famous is the introduction of provisions for taxation of ‘indirect transfer’ with effect from 1st april, 1962, to overrule a supreme Court judgment which held that indian tax authorities did not have territorial jurisdiction to tax offshore transactions, and therefore, the taxpayer was not liable to withhold the taxes29. An overnight change in the interpretation of a provision, which earlier held ground for decades, provides scope for tax officials to rake up settled positions. This approach to retrospective amendments has resulted in protracted disputes, apart from having deeply harmful effects on investment sentiment and the macro economy.

6.0 Some Typical Retrospective Amendments pertaining to Non-residents have been tabulated in the table on the following page:

Reflecting the challenges behind just and correct application of retrospective amendments there is a constitutional or statutory protection against it in several countries. Countries such as Brazil, Greece, Mexico, Mozambique, Paraguay, Peru, Venezuela, Romania, Russia, Slovenia and sweden have prohibited retrospective taxation30.

7.0 Conclusion
The Parliament has the sovereign right to amend the income-tax act and such amendments can be retrospective in nature. however, retrospective  amendments  results in uncertainty and distrust between tax payers and tax department. Imagine the plight of a tax payer who fights through various stages of appeal up to supreme Court by substantial devotion of time, efforts and money, gets  a favourable judgment and the act is amended to render the said judgment ineffectual. Retrospective amendments results in tremendous hardships to tax payers especially in a scenario where there is no accountability on the part of the tax administration.

TRAC has recommended that retrospective amendment should be avoided as a principle. it further commented that “retrospective amendments clustered during 2009- 12 may reflect this lackadaisical approach. In turn, this reflects complete lack of accountability at any level except on grounds of lagging behind in revenue collection.”

Retrospective amendments to section 9 of the act vide finance  act,  2012  to  tax  indirect  transfers  vitiated  the investment climate in india. Taking a cue from the criticism by the expert Committee and protest from tax payers, the present nda government has taken a stand to exercise the power of retrospective amendments with extreme caution and judiciousness keeping in mind the impact of each such measure on the economy and over- all  economic  climate.  The  finance  minister  in  his  Budget speech has stated that NDA government will not ordinarily bring about any change retrospectively which creates a fresh liability. Such an assurance on the floor of the Parliament will certainly boost investors’ and tax payers’ confidence.

“International Taxation – Recent Developments in USA”

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In this Article, we have given information about the recent significant developments in USA in the sphere of international taxation. Since many Indian Corporates have substantial business interests in and dealings with USA, we hope the readers would find this information useful. This will help to create awareness about impending important changes in law and practices in USA.

1. IRS releases update on FATCA registration for financial institutions

The US Internal Revenue Service (IRS) has released IRS Announcement 2014-1 to provide an update on the Foreign Account Tax Compliance Act (FATCA) registration for financial institutions (FIs).

FIs can use the IRS FATCA registration website, which was launched on 19th August 2013, to register with the IRS under FATCA and to renew their status as a qualified intermediary (QI), withholding foreign partnership (WP), and withholding foreign trust (WT).

Announcement 2014-1 states that every FI that has made an online registration prior to January 2014 must revisit its account on or after 1st January 2014 to edit, sign its FFI agreement if registering as a participating FFI, and submit its registration information as final.

Announcement 2014-1 also states that the final FFI (Foreign Financial Institutions) agreement is expected to be published prior to 1st January 2014, that the final QI, WP, and WT agreements will be published in early 2014, and that the first IRS FFI list will be posted by 2nd June 2014. Announcement 2014-1 further states that Model 1 FIs will not need to register or obtain Global Intermediary Identification Numbers (GIINs) until on or about 22nd December 2014 to ensure inclusion on the IRS FFI list by 1st January 2015.

Announcement 2014-1 notes that the guidance in Announcement 2014-1 is consistent with the previous guidance in IRS Notice 2013-43 .

2. IRS issues Memorandum on creditable foreign taxes from inter-branch dealings

The Office of the Associate Chief Counsel (International) of the US Internal Revenue Service (IRS) has issued a Memorandum that discusses the determination of creditable foreign taxes for a US corporation, or a controlled foreign corporation (CFC), that engages in transactions with its foreign branch or foreign disregarded entity (DE), or with the foreign branch or DE of its affiliated corporation.

The Memorandum states that, because a foreign branch or DE and its US owner are treated as a single entity with the result that transactions between them do not give rise to income or expense for US tax purposes, an application of the arm’s length standard of the US transfer pricing rules to such disregarded transactions would not affect the amount of taxable income that the US owner recognizes for US tax purposes, and thus generally is not meaningful.

The Memorandum further states that, if the US tax owner reports too much income to the foreign country by means of non-arm’s length transfer prices and claims a foreign tax credit (FTC) for the overpaid foreign income taxes, the FTC may be disallowed under the non-compulsory payment rule of Treasury Regulation section 1.901-2(e)(5), which provides that a foreign tax is not considered paid for FTC purposes to the extent that the amount paid exceeds the amount of liability under foreign tax law.

The Memorandum concludes that the US transfer pricing principles may be relevant in determining whether non-arm’s length transfer prices result in non-compulsory payments of foreign tax to the extent foreign tax law, as modified by tax treaties, includes similar arm’s length principles, as most do, and further that taxpayers have the burden to establish to the satisfaction of the IRS that they have properly minimised their creditable foreign tax liability by exhausting all effective and practical remedies, including resort to competent authority proceedings.

The Memorandum also states that similar issues involving non-compulsory payments of foreign tax may arise in cases involving a CFC where a foreign branch or DE that is a part of a CFC engages in transactions with the CFC, a related but separately regarded CFC, a US shareholder of the CFC, or a US shareholder of a related but separately regarded CFC.

In addition, the Memorandum states that, under US tax treaties that adopt the authorized OECD approach (AOA) and thus apply the OECD Transfer Pricing Guidelines, by analogy, in determining the profits of a permanent establishment (PE), profits of a US PE may be determined based on all of the PE’s dealings, including transactions between the US PE and the foreign corporation of which it is a part (or another branch of such foreign corporation), even though such interbranch dealings would not give rise to income, gain, profits, or loss of the foreign corporation under the US Internal Revenue Code (IRC).

3. IRS released revised user guide for FATCA registration website

The US Internal Revenue Service (IRS) has released revised Publication 5118 (Rev. 12-2013), Foreign Account Tax Compliance Act (FATCA) User Guide.

The user guide provides instructions for using the FATCA Registration System to complete the FATCA registration process online, including what information is required, how registration will vary depending on the type of financial institution (FI), and step-by-step instructions for each question.

The FATCA Registration System is a web-based system that FIs may use to register completely online as a participating foreign financial institution (PFFI), a registered deemed-compliant FFI (RDCFFI), a limited FFI (Limited FFI), or a sponsoring entity (see United States-2, News 20 August 2013).

The IRS has also released the FATCA Registration Update Summary to provide a summary of the updates made to the FATCA Registration System. The summary indicates a last reviewed or updated date of 11th December 2013.

4 IRS issues updated Publication 54 – Tax Guide for US Citizens and Resident Aliens Abroad

The US Internal Revenue Service (IRS) has released the 2013 revision of Publication 54 (Tax Guide for US Citizens and Resident Aliens Abroad). The publication is dated 3rd December 2013.

Publication 54 explains the special rules used to determine the US federal income tax for US citizens and resident aliens who work abroad or who have income earned in foreign countries.

Revised Publication 54 is intended for use in preparing 2013 tax returns. It includes the 2013 amount for the foreign earned income exclusion ( $ 97,600) and the housing expense base amount ( $ 15,616) for the housing cost exclusion u/s. 911 of the US Internal Revenue Code (IRC). The limits for the maximum amounts that can be excluded and/or deducted under IRC section 911 are also discussed.

Publication 54 discusses the following items:
– US tax return filing requirements (Chapter 1);
– Withholding of US income, social security and Medicare taxes (Chapter 2);
– US self-employment tax (Chapter 3);
– IRC section 911 foreign earned income exclusion and foreign housing exclusion or deduction (Chapter 4);
– Other applicable exemptions, deductions, and credits (Chapter 5);
– Tax treaty benefits (Chapter 6); and
– How to obtain tax information and assistance from the IRS (Chapter 7).

Publication 54 also includes a list of tax treaties, which is updated through 31st October 2013.

5.    Public comments requested on IRS Form for withholding on foreign partners

The  US  Internal  Revenue  Service  (IRS)  and the  US  Treasury  Department  have  issued  a notice  requesting  comments  on  IRS  Form 8804  (Annual  Return  for  Partnership  With- holding  Tax  (Section  1446));  IRS  Form  8804 (Schedule  A)  (Penalty  for  Underpayment  of Estimated Section 1446 Tax by Partnerships); Form  8805  (Foreign  Partner’s  Information Statement of Section 1446 Withholding Tax); and Form 8813 (Partnership Withholding Tax Payment Voucher (Section 1446)).

U/s.  1446  of  the  US  Internal  Revenue  Code (IRC),  foreign  partners  are  subject  to  US withholding  tax  on  their  allocable  share  of the US effectively connected taxable income (ECTI)  of  a  partnership  that  is  engaged  in  a trade  or  business  in  the  United  States.  The withholding  tax  is  imposed  at  the  highest income  tax  rates  applicable  to  the  foreign partner,  currently  35%  for  corporations  and 39.6%  for  individuals.  The  withholding  tax  is collected by the partnership.

IRS Forms 8804, 8805, and 8813 are used to pay and report IRC section 1446 withholding tax  based  on  ECTI  allocable  to  foreign  part- ners.

IRS Form 8804 is used to report the total liability under IRC section 1446 for the partnership’s tax year. IRS Form 8804 is also a transmittal form for IRS Form 8805. IRS Form 8804 has been modified for use in tax year 2013 to reflect the increase in the maximum tax rates for individuals to 39.6% with regard to ordinary income and to 20% with regard to capital gains.

IRS  Form  8805  is  used  to  show  the  amount of  ECTI  and  the  total  tax  credit  allocable  to the foreign partner for the partnership’s tax year. IRS Form 8813 is used to pay the with holding tax under IRC section 1446 to the United States Treasury. Form 8813 must accompany each payment of IRC section 1446 tax made during the partnership’s tax year.

The IRS requested that written comments be submitted no later than 27 January 2014. The mailing address and other contact information are listed in the notice.

6.    Public comments requested on IRS Form for claiming FTC for corporations

The US Internal Revenue Service (IRS) and the Treasury Department have issued a notice to announce the intention to submit an information collection request to the US Office of Management and Budget (OMB) for its review and clearance with regard to IRS Form 1118 (Foreign Tax Credit-Corporations). The Treasury Department has also requested public comments on the form.

IRS Form 1118 and separate Schedules I, J, K are used by US domestic and foreign cor- porations to claim a credit for taxes paid or accrued to foreign countries or US posses- sions under section 901 of the US Internal Revenue Code (IRC). The IRS uses Form 1118 and related schedules to determine whether the corporation has computed the foreign tax credit (FTC) correctly.

To claim a FTC, it is generally required to file IRS Form 1118 with the US income tax return. A separate Form 1118 is required for foreign taxes paid on each designated category of income (i.e. passive category income, general category income, IRC section 901(j) income, certain income re-sourced by treaty, and lump- sum distributions).

7.    Public comments requested on IRS Form for reporting transfer of property to foreign corporation

The US Internal Revenue Service (IRS) and the Treasury Department have issued a notice to announce the intention to submit an information collection request to the US Office of Management and Budget (OMB) for its review and  clearance  with  regard  to  IRS  Form  926 (Return by a US Transferor of Property to a Foreign  Corporation).  The  Treasury  Department has also requested public comments on the form.

IRS Form 926 is used by US persons to report exchanges or transfers of property to foreign corporations as required by section 6038B(a) (1)(A) of the US Internal Revenue Code (IRC).

Section 6038B of the IRC imposes such reporting requirements with regard to transactions involving  subsidiary  liquidations,  corporate organizations, and corporate reorganizations, as  described  in  sections  332,  351,  354,  355, 356,  and 361 of the IRC.

The US transferor must file IRS Form 926 with its  income  tax  return  for  the  tax  year  that includes the date of the transfer.

A penalty may be imposed in the amount of 10% of the fair market value of the property at  the  time  of  the  exchange  or  transfer  if the  US  transferor  fails  to  file  IRS  Form  926. The penalty is limited to USD 100,000 unless the  failure  to  file  IRS  Form  926  was  due  to intentional  disregard.  The  penalty  does  not apply if the failure is due to reasonable cause and not wilful neglect.

Moreover, under section 6501(c)(8) of the IRC, the period of limitations for assessment of tax on the exchange or transfer of the property is extended to the date that is 3 years after the  information  required  to  be  reported  is provided to the IRS.

8.    Public comments requested on tax-free merg- ers and consolidations involving foreign corporations

The US Internal Revenue Service (IRS) and the US Treasury Department have issued a notice requesting comments on final regulations (TD 9243, Revision of Income Tax Regulations u/s. 358, 367, 884, and 6038B Dealing with Statutory Mergers or Consolidations u/s. 368(a)(1)(A) Involving One or More Foreign Corporations).

TD  9243  was  issued  on  26TH  January  2006 to  provide  amendments  to  regulations  that were  affected  by  the  revised  merger  and consolidation rules of concurrently-issued final regulations (TD 9242,  Statutory Mergers and Consolidations) including amendments to the regulations  u/s.  367  of  the  US  Internal  Rev- enue Code (IRC), dealing with US-inbound and outbound reorganisations, amendments to IRC section  884,  dealing  with  the  branch  profits tax,  and  amendments  to  IRC  section  6038B, dealing with the tax reporting obligations for US outbound transfers.

The notice states that the collection of information under TD 9243 is necessary to preserve US income taxation on gain of certain stock.

9.    IRS proposes revised procedures for request- ing competent authority assistance

The  US  Internal  Revenue  Service  (IRS)  has issued  Notice  2013-78  to  propose  a  revised revenue procedure for requesting competent authority assistance under US tax treaties. The proposed  revenue  procedures  would  update and  supersede  the  current  procedures  in Revenue Procedure 2006-54.

The US competent authority procedures permit taxpayers to request IRS assistance when they believe that the actions of the United States, the treaty country, or both, have resulted or will result in taxation that is contrary to the provisions  of  the  treaty,  for  example,  economic  double  taxation  arising  from  transfer pricing adjustments u/s. 482 of the US Internal Revenue Code (IRC).

The proposed revenue procedure would pro- vide guidance on:

–    requesting assistance from the US competent authority under the provisions of the US tax treaties; and

–    determinations that the US competent author- ity may make on competent authority issues.

The  proposed  revenue  procedure  would include  provisions  that  reflect  the  IRS’s structural  changes  relating  to  the  US  com- petent  authority  since  2006,  including  the establishment of the IRS Large Business and International Division (LB&I) that includes the office  of  the  US  competent  authority,  and provisions  that  effect  a  limited  number  of significant substantive changes, as summarised in a table contained in Notice 2013-78.

10.    IRS proposes revised procedures for advance pricing agreements

The  US  Internal  Revenue  Service  (IRS)  has issued  Notice  2013-79  to  propose  a  revised revenue  procedure  with  guidance  on  filing advance  pricing  agreement  (APA)  requests and on the administration of APAs. The pro- posed revenue procedures would update and supersede the current procedures in Revenue Procedure  2006-9,  as  modified  by  Revenue Procedure 2008-31.

The proposed revenue procedure would pro- vide the following:

–    guidance and instructions on APAs; and

–    guidance and information on the IRS’s administration of APAs.

The  proposed  revenue  procedure  would  include  provisions  that  reflect  the  IRS’s  struc- tural changes relating to the APAs, including the  establishment  of  the  IRS  Large  Business and  International  Division  (LB&I)  and  the creation  of  the  Advance  Pricing  and  Mutual Agreement  Program  (APMA)  and  provisions that  effect  a  limited  number  of  significant substantive changes, as summarised in a table contained in Notice 2013-79.

11.    US Senate Finance Committee releases proposals for tax administration reform

The  US  Senate  Committee  on  Finance  has announced the issuance of a staff discussion draft on proposed reforms to the administration  of  the  US  tax  laws.  The  announcement was  made  in  a  Press  Release  dated  20TH November 2013.

The issued discussion draft is the second in a series of discussion drafts to overhaul the US tax code. The discussion draft proposes a number of reforms to modernise the tax administration, minimise compliance burdens, combat tax-related identity theft and fraud, and reduce the tax gap.

The significant proposals in the discussion draft
include, among others:

–    deadlines for filing certain information returns are accelerated to 21ST February (either on paper or electronically) so that taxpayers will receive the information needed to file their income tax returns on a more timely and orderly basis;

–    taxpayers are no longer required to file cor- rected information returns if the error is less than $ 25;

–    tax returns generated by a computer but filed on paper must contain a scannable code in order to enable the US Internal Revenue Service (IRS) to upload the return information more efficiently;

–    the number of returns that trigger an elec- tronic filing requirement reduces over 3 years from 250 returns per year to 25;

–    IRS Form W-2 (Wage and Tax Statement) no longer includes the taxpayer’s full social security number (SSN);

–    access to databases containing SSNs of re- cently deceased individuals is restricted for 3 years;

–    filing a  tax  return using  another person’s
identity is a felony subject to a fine of up to
$ 250,000 and/or up to 5 years in prison; and

–    banks must report the existence of bank accounts.

The discussion draft also includes a list of unaddressed issues on which public comments are requested.

The documents released by the Committee on Finance include the following:

–    Tax Administration Reform Staff Discussion Draft Legislative Language;

–    Tax Administration Reform Draft Summary;

–    Tax Administration Reform One-Pager;

–    JCT Technical Explanation of the Chairman’s Staff Discussion Draft of Tax Administration Reform;

–    Tax Administration Reform Technical Correc- tions Legislative Language;

–    JCT Explanation of Tax Administration Draft Technical Corrections; and

–    List of Provisions Identified by the Staff of the Joint Committee on Taxation as Potential Deadwood.

12.    US Senate Finance Committee releases pro- posals for international business tax reform

The  US  Senate  Committee  on  Finance  has announced the issuance of a staff discussion draft on international business tax reform. The announcement was made in a Press Release dated 19th November 2013.

The issued discussion draft is the first in a series of discussion drafts to overhaul the US tax code. It proposes a modern, competitive, simpler, and fairer international tax system by means of:

–    reducing incentives for US and foreign multina- tionals to invest in, or shift profits to, low-tax foreign countries rather than the United States;

–    reducing incentives for US-based businesses to move abroad, whether by re-incorporating abroad or merging with a foreign business;

–    increasing the ability of US businesses to compete against foreign businesses in foreign markets;

–    ending the lock-out effect (i.e. keeping the earnings of foreign subsidiaries offshore in- stead of repatriating such earnings to the United States); and
–    simplifying the international tax rules so that firms with the most sophisticated tax advisors are not advantaged.

The significant proposals in the discussion draft
include, among others:

–    all foreign income of US corporations is taxed immediately or permanently exempt, depend- ing on the type of the income;

–    earnings of foreign subsidiaries from periods before the effective date of the proposal that have not been subject to US tax are subject to a one-time tax at a reduced rate payable over 8 years;

–    international aspects of the “check-the-box” rules are eliminated; and

–    base erosion arrangements are addressed to prevent foreign multinationals from making such arrangements to avoid US tax.

The discussion draft also includes a list of un- addressed issues on which public comments are requested.

The documents released by the Committee on Finance include the following:

–    International Tax One Pager;
–    International Tax Summary;
–    International Tax Discussion Draft Common;
–    International Tax Discussion Draft Option Y;
–    International Tax Discussion Draft Option Z; and
–    International Tax Discussion Draft Request for Comments.

In addition, the US Joint Committee on Taxa- tion (JCT) has issued a report with a technical explanation of the provisions in the discussion draft.

13.    Joint Committee on Taxation issues report on international business tax reform proposals

The Joint Committee on Taxation of the US Congress (JCT) has released a report to provide a technical explanation of the staff discussion draft on international business tax reform issued by the US Senate Committee on Finance.

The report is entitled Technical Explanation of the Senate Committee on Finance Chairman’s Staff Discussion Draft of Provisions to Reform International Business Taxation. The report is dated 19th November 2013, and is designated JCX-15-13.

14.    US Treasury Department updates FATCA model agreements

The  US  Treasury  Department  has  released updated model Intergovernmental Agreements (IGAs) for the implementation of the Foreign Account  Tax  Compliance  Act  (FATCA).  The updated model IGAs are dated 4th November 2013.

For the purpose of defining the term “financial account” under article 1, the updated model IGAs include new provisions that explain:

–    the condition for interests to be treated as “regularly traded”;

–    the meaning of an “established securities market”; and

–    the circumstance in which an interest in a financial institution is not “regularly traded” and thus treated as a financial account.

The updated model IGAs expands the list of persons that are excluded from the definition of the term, “specified US person”. The up- dated model IGAs also modify, inter alia, the rules regarding related entities and branches that are non-participating financial institutions.

The updated model IGAs, which are available on the FATCA page of the Treasury Depart- ment website, are as follows:

–    Reciprocal Model 1A Agreement, Preexisting TIEA or DTC (Updated 11-4-2013);

–    Nonreciprocal Model 1B Agreement, Preexisting TIEA or DTC (Updated 11-4-2013);

–    Nonreciprocal Model 1B Agreement, No TIEA or DTC (Updated 11-4-2013);

–    Model 2 Agreement, Pre existing TIEA or DTC (Updated 11-4-2013);

–    Model 2 Agreement, No TIEA or DTC (Updated 11-4-2013);

–    Annex I to Model 1 Agreement (Updated 11- 4-2013);

–    Annex I to Model 2 Agreement (Updated 11- 4-2013);

–    Annex II to Model 1 Agreement (Updated 11- 4-2013); and

–    Annex II to Model 2 Agreement (Updated 11- 4-2013).

15.    Draft instructions for annual withholding form for foreign person’s US-source income issued to implement FATCA

The  US  Internal  Revenue  Service  (IRS)  has released a draft of revised Instructions for IRS Form 1042 (Annual Withholding Tax Return for US  Source  Income  of  Foreign  Persons).  The draft  instructions  are  dated  6th  November 2013.  The  IRS  previously  issued  the  revised Form 1042  in draft form.

When  adopted  as  final,  the  draft  Form  1402
and instructions will be used to report:

–    the tax withheld under chapter 3 of the US Internal Revenue Code (IRC) (dealing with the normal withholding for foreign persons) on certain US-source income of foreign persons, including non-resident aliens, foreign partnerships, foreign corporations, foreign estates, and foreign trusts;

–    the tax withheld under IRC chapter 4 (i.e. the FATCA provisions);

–    the 2% excise tax due on specified foreign procurement payments under IRC section 5000C; and

–    payments that are reported on IRS Form 1042- S under IRC chapter 3 or 4. The draft Form 1042 modifies the current Form
1042  by:

–    revising the current form for withholding agents to report payments and amounts withheld under IRC chapter 4 in addition to under IRC chapter 3;

–    requiring a reconciliation of US source fixed or determinable annual or periodical (FDAP) income payments for chapter 4 purposes;

–    including separate chapter 3 and 4 status codes for withholding agents; and

–    adding lines for reporting the tax liability under chapters 3 and 4.

The  current  Form  1042  and  the  Instructions for  the  current  Form  1042  are  available  on the IRS website (www.irs.gov).

16.    IRS issues memorandum on US tax conse- quences of payments to foreign distributors

The Office of Associate Chief Counsel (International) of the US Internal Revenue Service (IRS) has issued a memorandum that discusses the character and source of certain payments made to foreign distributors by a multi-level marketing company and the related withholding responsibilities.

The facts reviewed in the Memorandum in- volve payments made by a US corporation to reward its foreign distributor for recruit- ing, training, and supporting the distributor’s lower-tier distributors to cultivate a multi-level chain of distributors (the “sponsorship chain”) for the sale of the US corporation’s products.

The Memorandum discusses the tax conse- quences of the payments (the “earnings”) that the foreign distributor received from the US corporation based on purchases of products from the US corporation by lowertier distributors in the distributor’s sponsorship chain.

The Memorandum reaches the following conclusions:

– the earnings constitute income from performance of personal services;

–    the source of the earnings is based on where the services of the foreign distributor are performed with the result that income at- tributable to services performed in the United States is US source income and that income attributable to services performed outside the United States is foreign source income;

–    the US corporation is required to withhold tax on the earnings of a distributor who is a non- resident foreign individual for the performance of services within the United States;

–    the US corporation is not required to withhold tax on the earnings of a distributor that is a foreign corporation for the performance of services within the United States if the distributor provides the US corporation with IRS Form W-8ECI (Certificate of Foreign Person’s Claim That Income Is Effectively Connected With the Conduct of a Trade or Business in the United States); and

–    the earnings are not subject to US tax if the distributor is a resident of a foreign country that has an income tax treaty with the United States; does not have a fixed base or permanent establishment in the United States to which the earnings are attributable; and provides the US corporation with IRS Form 8233 (Exemption From Withholding on Compensation for Independent (and Certain Dependent) Personal Services of a Nonresident Alien Individual) (in the case of an individual distributor) or IRS Form W-8BEN (Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding) (in the case of a corporate distributor).

17.    Public comments requested on IRS form for extending statute of limitations on cross- border transfers of stock and securities

The US Internal Revenue Service (IRS) and the US Treasury Department have issued a notice requesting comments on IRS Form 8838 (Con- sent To Extend the Time To Assess Tax Under Section 367—Gain Recognition Agreement).

IRS form 8838 is used to extend the statute of limitations for US persons who transfer stock or securities to a foreign corporation and enter into gain recognition agreements (GRAs) with the IRS. A GRA allows the trans- feror to defer the payment of US tax on the transfer.

IRS Form 8838 must be filed by a US transferor for a GRA that is entered into under section 367(a) of the US Internal Revenue Code (IRC) with regard to transfers of stock and securities to a foreign corporation in cross-border corporate transactions, i.e. incor- porations, liquidations, mergers, acquisitions and other reorganisations, as described in IRC section 367(a).

IRS  Form  8838  must  also  be  filed  by  a 80%-owned US subsidiary and its foreign parent  corporation  for  a  GRA  that  is  entered into under IRC section 367(E)(2)  with regard to a liquidation of the US subsidiary into the foreign  parent  corporation,  as  described  in IRC section 332.

The IRS uses IRS Form 8838 so that it may assess tax against the transferor after the expiration of the original statute of limitation.

18.    Public comments requested on withholding
certificates for foreign persons

The US Internal Revenue Service (IRS) and the US Treasury Department have issued a notice requesting comments on various IRS forms that are used as withholding certificates for foreign persons (i.e. certificates to claim reduced or zero withholding on US-source payments) and on the EW-8 MOU Program.

The following IRS forms are currently used as
withholding certificates for foreign persons:

–    Form W–8BEN (Certificate of Foreign Status of Beneficial Owner for United States Tax Withholding);

–    IRS Form W–8ECI (Certificate of Foreign Per- son’s Claim for Exemption From Withholding on Income Effectively Connected With the Conduct of a Trade or Business in the United States); –    IRS Form W–8EXP (Certificate of Foreign Gov- ernment or Other Foreign Organization for United States Tax Withholding); and

–    IRS Form W–8IMY (Certificate of Foreign In- termediary, Foreign Flow-Through Entity, or Certain US Branches for United States Tax Withholding).

The IRS is revising those forms to reflect the new withholding, due diligence, and reporting requirements under the Foreign Account Tax Compliance Act (FATCA). The IRS has issued the following drafts of the revised forms:

–    a draft of IRS Form W–8BEN (for foreign individuals);

–    a draft of IRS Form W–8BEN–E (for foreign entities);

–    a draft of IRS Form W–8ECI;

–    a draft of IRS Form W–8EXP; and

–    a draft of IRS Form W–8IMY.

The EW-8 MOU (Memorandum of Understand- ing) Program is a voluntary collaborative programme between the IRS and withholding agents that have systems collecting IRS Forms W-8 electronically.

5.    IRS issues Memorandum on cross-border re-organization transactions

The Associate Chief Counsel (Corporate) of the US Internal Revenue Service (IRS) has issued a Memorandum that discusses the US tax consequences of cross-border restructuring transactions undertaken by a taxpayer’s affiliated group.

The restructuring occurred in two stages a few months apart. The first stage (the “F Reorganization”) included a series of transac- tions that the taxpayer treated as a tax-free reorganisation described in section 368(a)(1)
(F) of the US Internal Revenue Code (IRC).

The second stage (the “Transaction”) in- volved a triangular reorganisation where a foreign  subsidiary  (F  Sub  5)  acquired  stock of  its  foreign  parent  company  (F  Sub  4)  by, in  part,  issuing  notes  (i.e.  debts)  to  F  Sub 4, and used the stock of F Sub 4 to acquire another  foreign  subsidiary  (F  Sub  6)  from  a US  subsidiary.  Subsequently,  F  Sub  5  repaid the notes to F Sub 4 (the “Payment”).

The Memorandum concludes that, based on the particular facts and circumstances of this case, the F Reorganisation and the Transac- tion should not be stepped together, or with the subsequent Payment, and should each be respected as qualifying for non-recognition treatment, respectively, under IRC sections 368(a)(1)(F) (dealing with the reorganisation of a single operating company as to the form or place of incorporation) and 368(a)(1)(C) (dealing with the acquisition of a target’s assets in exchange for an acquiring corporation’s stock). The Memorandum notes that both the F Reorganisation and the Transaction were supported by business considerations that satisfied the business purpose threshold applicable to IRC section 368 reorganisations.

The  Memorandum  next  states  that  the  fact that  the  Transaction  involved  a  leveraged buyout  (i.e.  F  Sub  5  WAS  capitalised  with lesser  capital  than  the  F  Sub  4  Stock  that  it acquired)  does  not  negate  the  fact  that  the Transaction was a value-for-value exchange.

The Memorandum also concludes that F Sub 5 is not required to recognise gain on the F Sub  4  stock  when  such  stock  was  used  to acquire  F  Sub  6  because  the  F  Sub  4  stock had  not  appreciated  while  F  Sub  5  held  the stock.  Gain  would  otherwise  be  required  to be  recognised  under  IRC  section  1032  and the  regulations  thereunder  dealing  with  the use  of  the  stock  of  a  parent  corporation  in a triangular reorganisation.

The Memorandum further concludes that, because the notes should be respected as debt, the Payment should constitute repayment of debts, not dividends or other amounts that would generate subpart F income.

The Memorandum notes that the restructuring transactions  occurred  prior  to  22ND  September 2006, and thus are not governed by IRS Notice 2006-85, which announced regulations that  were  later  adopted  under  IRC  section 367  as  final  regulations  (TD  9526).  Under the regulations, in a triangular reorganisation where a subsidiary (S) or its parent company
(P) (or both) is foreign, the property trans- ferred from S to P in exchange for P stock is treated as a distribution from S to P under IRC section 301(c) with the result that an inclusion in P’s gross income as a dividend, a reduction in P’s basis in its S or T (target) stock, and the recognition of gain by P from the sale or exchange of property may occur, as appropriate.

20.    Draft instructions for form to report foreign person’s US-source income issued for FATCA

The  US  Internal  Revenue  Service  (IRS)  has released  a  draft  of  revised  Instructions  for IRS Form 1042-S (Foreign Person’s US Source Income  Subject  to  Withholding).  The  draft instructions  are  dated  1st  November  2013. The  IRS  previously  issued  the  revised  Form 1042-S  in draft form.

The current Form 1042-S and the Instructions for the current Form 1042-S are available on the  IRS  website.  The  current  Form  1042-S is  used  to  report  amounts  paid  to  foreign persons  (including  persons  presumed  to  be foreign)  that  are  subject  to  US  withholding under chapter 3 of the US Internal Revenue Code  (IRC),  including  fixed  or  determinable annual or periodical (FDAP) income from US sources  (e.g.  US-source  interest,  dividends rent, royalties, pension, annuities).

The draft Form 1042-S revises the current form to accommodate new requirements under the Foreign Account Tax Compliance Act (FATCA). The  revised form contains new  boxes to re- quest withholding agents to indicate whether the withholding is made under IRC chapter 3 (i.e. the normal withholding for non-residents and foreign corporations) or under IRC chap- ter 4 (i.e. the FATCA provisions).

In addition, the draft form includes boxes requesting, among other information, the withholding agent’s Global Intermediary I dentification Number (GIIN) and additional in- formation about the recipient of the payment, including the recipient’s account number, date of birth, and foreign tax identification number, if any. GIIN indicates the identification number that is assigned to a participating foreign financial institution (FFI) or registered deemed-compliant FFI (including a reporting Model 1 FFI).

For  withholding  agents,  intermediaries,  flow- through entities, and recipients, the draft Form 1042-S  requires that the chapter 3 status (or classification) and chapter 4 status be reported on  the  form  according  to  codes  provided  in the draft instructions.

21.    IRS issues memorandum on indirect FTC rules in connection with stock redemptions

The  Associate  Chief  Counsel  (International) of the US Internal Revenue Service (IRS) has issued  a  memorandum  that  discusses  the interconnection  of  the  indirect  foreign  tax credit  (FTC)  rules  of  section  902  of  the  US Internal  Revenue  Code  (IRC)  and  the  stock redemption rules of IRC sections 302 and 312.

IRC  section  902  allows  a  US  corporation  to claim  an  indirect  or  deemed-paid  FTC  for foreign  income  taxes  paid  by  its  foreign subsidiary  (referred  to  as  the  “section  902 corporation”)  if  the  US  corporation  receives a dividend from the section 902  Corporation and certain conditions are met.

The amount of the foreign income taxes for which  the  indirect  FTC  may  be  claimed  is equal to the same proportion of the section 902  Corporation’s  “post-1986 foreign  income taxes” (the FT pool) that the amount of the dividend  bears  to  the  section  902  Corpora- tion’s  post-1986  undistributed  earnings  (the E&P pool) (i.e. indirect FTC = FT pool × (divi- dend received/E&P pool)).

The FT pool is defined by IRC section 902(C) as the foreign income taxes paid with respect to the taxable year in which the dividend is paid, as well as with respect to prior taxable years beginning after 31st December 1986. IRC sec- tion 902 reduces the amount of the FT pool to take into account dividends distributed by the  section  902  CORPORATION  in  prior  taxable years.

In the case reviewed in the Memorandum, a section  902  Corporation  was  60%  owned  by a  US  parent  company  (USP)  and  was  40% owned by an unrelated foreign party (FP). The section 902 CORPORATIOn redeemed all of the stock owned by FP by way of a distribution of cash. IRC section 312(A) and (n)(7) reduces the  section  902  CORPOration’s  E&P  pool  to take  into  account  the  redemption.  In  the following  year,  the  section  902  Corporation paid its entire remaining E&P to the USP as a dividend.

The  issue  of  the  Memorandum  is  whether the  section  902  Corporation’s  FT  pool  must be reduced for the purpose of calculating the USP’s indirect FTC although IRC section 302(A) treats the redemption as a sale or exchange transaction, rather than a dividend.

The  Memorandum  refers  to  Treasury  Regulation  section  1.902-1(a)(8),  which  provides that  foreign  taxes  paid  or  deemed  paid  by a  foreign  corporation  on  or  with  respect  to earnings  that  were  distributed  or  otherwise removed from E&P in prior post-1986 taxable years  must  be  removed  from  the  FT  pool. The  Memorandum  states  that  the  language “otherwise  removed”  is  broad  enough  to cover  reductions  of  earnings  under  section 312(A)-Related  redemptions  that  are  treated as a sale or exchange transaction.

The Memorandum accordingly concludes that the  section  902  Corporations’  FT  pool  must be reduced as a result of the redemption of the stock held by FP.

The Memorandum is designated AM2013-006. The  Memorandum  is  dated  30th  September 2013,  and  indicates  that  it  was  released  on 25TH  October 2013.

22.    US Senate Finance Committee releases proposals for cost recovery and tax accounting rules

The US Senate Committee on Finance has  announced  the  issuance  of  a  staff discussion draft on proposed reforms to the cost recovery and tax accounting rules. These are the rules that are used to determine when a business can deduct the cost of investments and how businesses account for their income. The announcement was made in a Press Release dated 21ST  November 2013.

The issued discussion draft is the third in a series of discussion drafts to overhaul US Internal Revenue Code (IRC). The significant proposals in the discussion draft include, among others:

–    a single set of depreciation rules apply to all business taxpayers;

–    the number of major depreciation rates is reduced from more than 40 to 5;

–    the need for businesses to depreciate each of their assets separately is eliminated, except for real property;

–    real property is depreciated on a straight-line basis over 43 years;

–    research and experimental expenditures, as well as natural resource extraction expenditures, are capitalised and amortised over 5 years;

–    the cash method of accounting and immedi- ate expensing of the cost of inventory are allowed for all businesses (other than tax shelters) with annual gross receipts under $ 10 million;

–    the IRC section 179 expensing allowance (i.e. current year deduction in lieu of capitalisation and depreciation) is permanently increased to
$ 1 million with the phase-out threshold of $ 2 million, together with an expansion of the types of qualifying property; and

–    the following rules would be repealed:

–    the LIFO (last in, first out) method of account- ing for inventory;

–    the lower of cost or market (LCM) rule for inventory;

–    the like-kind exchange rules that permit tax- free roll-over transactions; and

–    the completed contract method of accounting, except for small construction contracts.

The discussion draft also includes a list of un- addressed issues on which public comments are requested.

The documents released by the Committee on Finance include the following:

–    Cost Recovery and Accounting Staff Discussion
Legislative Language;

–    Cost Recovery and Accounting Summary;

–    Cost Recovery and Accounting One Pager; and

–    JCT Technical Explanation of Cost Recovery and Accounting Draft.

23.    Regulations issued regarding withholding on payment of dividend equivalents from US sources

The US Treasury Department and the Internal Revenue Service (IRS) have issued final regu- lations (TD 9648) u/s. 871(m) of the Internal Revenue Code (IRC) to provide guidance to non-resident individuals and foreign corporations that hold specified notional principal contracts (“specified NPCs”) providing for payments that are contingent upon or determined by reference to US source dividend payments and to withholding agents.

IRC section 871(m) treats a “dividend equiva- lent” as a dividend from sources within the United States for purposes of the US gross basis income tax and subjects such dividend equivalent, if paid to a non-resident person, to the 30% withholding tax that applies to fixed or determinable annual or periodical income (FDAP income) from US sources.

The  term  dividend  equivalent  is  defined  by IRC section 871(M)(2)  as:
–    any substitute dividend made pursuant to a securities lending or a sale-repurchase transaction (repo) that is contingent upon or determined by reference to a US source dividend payment;

–    any payment made pursuant to a specified NPC that is contingent upon or determined by reference to a US source dividend payment; and

–    any payment determined by the Treasury Department to be similar to the foregoing.

IRC  section  871(m)(3)(A)  defines  a  specified NPC  as  a  NPC  that  contains  terms  or  condi- tions  that  are  specified  in  the  statute,  and applies  this  definition  with  regard  to  pay- ments  made  between  14th  September  2010 and  18th  March  2012.  IRC  section  871(m)(3)

(B)  then  provides  that,  with  respect  to  pay- ments made after 18th March 2012, any NPC will  be  a  specified  NPC  unless  the  Treasury Department determines that such contract is of  a  type  that  does  not  have  the  potential for tax avoidance.

Temporary  regulations  (RIN  1545-BK53,  TD 9572), issued on 23RD January 2012, extended the  section  871(m)(3)(A)  statutory  definition of  a  specified  NPC  through  31st  December 2012 (see United States-1, News 25TH January 2012). The final regulations, inter alia, further extend  the  applicability  of  the  definition  to payments made before 1st January 2016.

The above definitions also apply for purposes of FATCA withholding under chapter 4 of the IRC. The Treasury Department and IRS state in the preamble to the final regulations that they will closely scrutinise other transactions that are not covered by IRC section 871(m) and that may be used to avoid US taxation and US withholding taxes.

The final regulations are designated Treasury Regulation  sections  1.863-7,  1.871-15,  1.881-2, 1.892-3,  1.894-1,  1.1441-2  through  -4,  -6,  and -7, and 1.1461-1.

The  final  regulations  are  effective  on  5Th December  2013  and  generally  apply  to  payments  made  on  or  after  23rd  January  2012 with exceptions.

In  addition,  the  Treasury  Department  and the  IRS  contemporaneously  issued  proposed regulations (REG–120282–10) to provide, inter alia,  a  new  definition  of  a  specified  NPC  for payments made on or after 1st January 2016.

24.        US Treasury Department reissues list of boy- cott countries that result in restriction of US tax benefits

The US Treasury Department has reissued its list of the countries that require cooperation with or participation in an international boy- cott as a condition of doing business.

The countries listed are Iraq, Kuwait, Lebanon, Libya, Qatar, Saudi Arabia, Syria, the United Arab Emirates, and the Republic of Yemen.

The  list  is  dated  20th  November  2013  and was published in the Federal Register on 27TH September  2013.  The  new  list  is  unchanged from the list dated 26TH  August 2013.

The listed countries are identified pursuant to section 999 of the US Internal Revenue Code (IRC), which requires US taxpayers to file reports with the Treasury Department concerning operations in the boycotting countries. Such taxpayers incur adverse consequences under the IRC, including denial of US foreign tax credits for taxes paid to those countries and income inclusion under subpart F of the IRC in the case of US shareholders of controlled foreign corporations (CFCs) that conduct operations in those countries.

[Acknowledgement/ Source: We have compiled the  above  information  from  the  Tax  News Service  of  IBFD  for  the  period  01-10-2013  to 18-12-2013.]

Transfer Pricing Regulations for Financial Transactions

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Cross Border Financial Transactions such as intercompany loans and guarantees between Associated Enterprises have received prominent attention worldwide due to implications under the Transfer Pricing Regulations. Several issues arise in respect of benchmarking and documentation of such transactions. Divergent rulings by Tribunals on these issues have caused further complications. This article attempts to throw light on Indian Regulations, Judicial Rulings and some of the international practices in this arena. This Article is written in Questions and Answers format for elucidating relevant provisions/law more succinctly.

Q.1 Which types of financial transactions are covered by the Transfer Pricing Regulations?

A.1 Most common Financial Transactions (FTs) undertaken between Associated Enterprises (AEs) are in the nature of loans and guarantees, as such the scope of discussion in this Article is restricted to Transfer Pricing Regulations (TPRs) pertaining to such transactions. Other types of FTs such as “Cash Pooling” and “Factoring Arrangements” etc. are not discussed in this Article.

Transfer Pricing Regulations world over primarily seek to cover inter-company loans and/or guarantees. Focus on other types of FTs under TPRs is limited.

Q.2 What are OECD’s views on loans to AEs?

A.2 There is no specific guidance in OECD’s Transfer Pricing Guidelines regarding FTs. However, OECD implicitly guides to apply the relevant method in determining the “arm’s length rate of interest” on inter-company loans. Therefore, one needs to look at the jurisdictional transfer pricing rules, if any, in determining the arm’s length rate of interest on intercompany loans between AEs.

Q.3 What are the provisions under the UN Transfer Pricing Guidelines?

A.3 The Department of Economic & Social Affairs of the United Nations has published a “Practical Manual on Transfer Pricing for Developing Nations” (Manual) in 2013. The object of this Manual is to provide clearer guidance on the policy and administrative aspects of transfer pricing analysis by developing countries. The Manual is addressed at countries seeking to apply “arm’s length standard” to transfer pricing issues. Since India has adopted the “arm’s length” principle in its Transfer Pricing regime, the Manual would provide a useful guide.

While the Manual provides a practical guidance on issues faced by developing countries, it has its inherent limitations, in that it represents views of the authors and members of the Sub-committee entrusted with the task of preparing it. Chapter 10 of the Manual represents an outline of particular country’s administrative practices as described in detail by representatives from those countries. Commenting on the practices followed by Indian Transfer Pricing Administration (ITPA), the Manual states (Paragraph 10.4.10 on page 405) that the following practices are followed by the ITPA in determination of the arm’s length pricing of inter-company loans:

  • Examination of the loan agreement;
  • Comparison of terms and conditions of loan agreement;
  • Determination of credit rating of lender and borrower;
  • dentification of comparable third party loan agreement;
  • Suitable adjustments to enhance comparability

The ITPA prefers to apply the Prime Lending Rate (PLR) of Indian banks for outbound loans (i.e., loans advanced by an Indian Company to its overseas AEs), on the premise that loans are advanced from India in Indian currency which are subsequently converted into foreign currency. This stand is formally accepted and incorporated into the Safe Harbour Rule which provides for acceptable interest rates based on Prime Lending Rates of Indian Banks.

However, the above stand of the Tax Department has been challenged by tax payer and the Tribunal has ruled in favour of the tax payers. (Refer answer to question no. 6 infra).

Q.4 What are the provisions under the Income-tax Act, 1961?

A.4 Explanation to section 92B has been retrospectively amended vide Finance Act 2012 to bring FTs under TPRs in India. Accordingly, the following Clause has been added to the definition of the term “International Transaction”:

“Explanation—For the removal of doubts, it is hereby clarified that—

(i) the expression “international transaction” shall include—

(c) Capital financing, including any type of longterm or short-term borrowing, lending or guarantee, purchase or sale of marketable securities or any type of advance, payments or deferred payment or receivable or any other debt arising during the course of business;

From the above explanation, it is clear that loans and guarantees between AEs are covered under the TPRs of India retrospectively w.e.f. 1st April 2002.

Safe Harbor Provisions as applicable to loan transactions [Notified on 18th Sept. 2013 applicable for Five Assessment Years beginning from AY 2013-14]




Q.5 Under what circumstances interest free loan can be justified?

A.5 Interest free loans prima facie are not at arm’s length as normally a lender would not give any interest free loans to a stranger. However, the lender may justify such loan to its AE on considerations other than interest. For example, if the interest free loan is in the nature of quasi capital, then it can be justified.

In April 2002, the Central Government constituted an Expert Group to recommend transfer pricing guidelines for companies for pricing their products in connection with the transactions with related parties and transactions between different segments of the same company. The Group submitted its Report in August 2002. It generally recommended arm’s length principle except in following cases:

“Exceptions to arm’s length transfer price

In exceptional cases, the company may decide to use a non-arm’s length transfer price provided:

• the Board of Directors as well as the audit committee of the Board are satisfied for reasons to be recorded in writing that it is in the interest of the company to do so, and
• the use of a non-arm’s length transfer price, the reasons therefore, and the profit impact thereof are disclosed in the annual report

Remarks: Examples of such exceptional cases could be a company giving an interest free loan to a loss making subsidiary or a company accepting the offer of a controlling shareholder to work as the CEO on a nominal salary.”

However, the same Report identifies “Borrowing or lending on an interest-free basis or at a rate of interest significantly above or below market rates prevailing at the time of the transaction” as one of the undesirable corporate practices related to transfer pricing.

In nutshell, interest free loans may be justified in following circumstances:

• When loan has more of an equity substance than loan i.e. it is in the nature of Quasi Capital.

The Australian Taxation Office in its Discussion Paper on “Intra-group Finance Guarantees & Loans Application of Australia’s Transfer Pricing and Thin Capitalization Rules –June 2008” (paragraph 58 on page 15 of the Paper) has opined that to the extent that the debt funding performs the role of an equity contribution it would seem appropriate that portion of the debt funding be regarded as quasi equity and that it be costed on an interestfree basis, consistent with its purpose and effect. This is in line with the OECD view that the cost of funding a company’s participation is a ‘shareholder activity’ and that it would not justify a charge to the borrowing company.

On  the  peculiar  facts  of  the  case,  (where  loan was  converted  into  equity  upon  receipt  of  RBI approval)  the  Tribunal,  in  case  of  Micro  Inks  Ltd. vs.  ACIT  [2013]  36  taxmann.com  50,  held  that  the loan  provided  was  in  the  nature  of  quasi  capital. One  of  the  interesting  observations  made  by  the Tribunal  was  regarding  consideration  of  the  com- mercial  business  consideration  between  AEs.  The Tribunal  held  that  sustainability  of  business  of  the step  down  subsidiary  in  USA  was  crucial  to  the Indian company (who advanced loan to it) in view of  the  fact  that  the  Indian  company  has  substan- tial  business  transactions  with  it  and  therefore  it would  not  be  appropriate  to  equate  the  relations between  AEs  to  that  of  a  lender  and  a  borrower.

The  above  observations  are  significant  as  in  ear- lier  in  case  of  VVF  Ltd.  [2010]  TII  4  ITAT,  the Mumbai Tribunal held that commercial expediency to  be  irrelevant  as  the  impact  of  any  such  inter- relationship  should  be  neutralised  by  arm’s  length treatment.  Further,  in  the  case  of  Perot  Systems TSI India Ltd. [2010] 130 TTJ 685, the Delhi Tribunal had refused to accept the contention of the as- sessee that the outbound loan  was  quasi  capital in nature on the grounds that no lender  would  lend money to new company or the intention of  the lender company was to earn dividends  and  not interest.

  •  Loan is in the nature of a Hybrid Instrument.

The loan may be structured in the form of con- vertible debentures or bonds where there may not be any interest or very low interest for the initial period and may be converted into equity at a later date. This may be resorted by a parent company   to give sufficient time to its subsidiary to make profit without much financial burden.

Every case of thin capitalisation may not be to avoid tax. Sometimes, host countries regulations justify low equity and high debt especially when companies do not want to compromise on liquid- ity. Moreover, loans require less documentation, highly flexible in their repayment and lending in- stitutions also take them at par with equity when they are from AEs.

Q.6If interest has to be charged on inter-company loans, how does one bench mark it? Who shall be the tested party – the borrower or the lender?

Also elucidate on Separate/Standalone Entity Approach vs. Group Entity/On-lending Approach

A.6    Indian Transfer Pricing Regulations do not have special rules (except in case of Safe Harbor Rules) or guidance on benchmarking loan transactions between AEs. However, one needs to apply general provisions of transfer pricing regulations while determining arm’s length interest rate on loans between AEs.

Consider a case where an Indian Company “A” has advanced loan to its wholly owned subsidiary “B” in UAE. While undertaking the benchmarking analysis to determine arm’s length rate of interest, often a dilemma arises as to whether one should look at the rate at which “B” would have  been  able  to  borrow  in UAE market or the rate at which ‘A” would have earned interest, had it advanced loan to    a non-related party. Normally, Indian Entity is used as a tested  party and also it being the assessee under the Indian Transfer Pricing Regulations, benchmarking of in- terest charged is done from Indian Entity’s point   of view. In the given example, what company “A” would have earned had it given a loan to non AE would be relevant. For determining income of “A” in an arm’s length scenario, sources of funds  of “A” i.e., cost of funds (i.e. whether it is back to back loan or out of internal accruals), foreign ex- change risks, risk of default, availability of internal or external CUP etc. would be relevant.

As stated earlier, in such a scenario, Indian Transfer Pricing Administration would prefer to apply Prime Lending Rate of the Company  A’s  bank  in  India  as an external CUP as loan would be advanced  from India in Indian currency rather than LIBOR or EURIBOR. The idea seems to arrive at opportunity cost of earning, i.e., if Company “A” would have advanced similar loan to Company “B” in India, what would have been the rate of interest?

On  similar  facts,  in  case  of  Bharti  Airtel  Ltd.  vs. ACIT  [2014]  43  taxmann.com  150  (Del.  Trib.),  the assessee  contended  that  the  loans  were  given  in foreign  currencies  and  in  the  international  market where  the  bank  lending  rates  are  based  on  LIBOR rates. Hence, the LIBOR rate should be considered for determining the arm’s length interest rate. The Tribunal  upheld  the  contentions  of  the  assessee.

In case of M/s. Siva Industries & Holdings Ltd. vs. ACIT [(I.T.A. No. 2148/Mds/2010) paragraph 11], the Chennai Tribunal held that “Once the transaction between the assessee and the Associated Enter- prise is in foreign currency and the transaction is   an international transaction, then the transaction would have to be looked upon by applying the commercial principles in regard to international transaction. If this is so, then the domestic prime lending rate would have no applicability and the international rate fixed being LIBOR would come into play. In the circumstances, we are of the view that it LIBOR rate which has to be considered while determining the arm’s length interest rate in respect of the transaction between the assessee and the Associated Enterprises”.

Thus, one has to benchmark the Indian entity and find out what interest it would have earned, had it advanced loan to an independent entity operating in same circumstances, located in the same market and on similar terms and conditions. In the process one also needs to benchmark the borrower based on the separate entity approach taking into account the circumstances in which it operates.

General Rules of Transfer Pricing Analysis suggest that one needs to arrive at arm’s  length  inter-  est rate as if Company “B” is an independent/ standalone entity. Here one needs to examine various factors such as terms and tenor of loan, guarantee offered, nature of interest rate such as fixed vs. floating, the overall financial market in UAE, credit rating of “B”, nature of loan instru- ment i.e., whether pure loan or hybrid instrument with conversion option etc. Thus if “A” were to lend to any  other  independent  entity  operating  in UAE with similar terms and conditions, then what it would have earned or if there is any  other comparable data already available in public domain then that may be used.

In real life situations company “B” would be able  to borrow at LIBOR linked rate. Therefore, the starting point of benchmarking analysis would be LIBOR which may further be fine tuned consider- ing various factors other discussed above.

Thus, one may conclude that while arriving at the arm’s length interest rate especially in case of outbound loans from India, one may take LIBOR/ EURIBOR, as the case may be, as base rate and make adjustments to arrive at arm’s length interest rate taking into account facts  and circumstances in the country in which the borrower AE operates.

It may however be noted that the Safe Harbor Rules in India does  not  support  above  view  and it requires Indian entity to apply the interest rate based on the Base Rate of State Bank of India . (Refer answer to Q.4 supra). It may also be noted that Safe Harbor Rules prescribes “acceptable price/ range of margins and/or rate of interest” without determining arm’s length price,  margin or interest. More often than not, unilateral Safe Harbor Rule results in litigation in the opposite country as the acceptable range in one country would  lead  to loss of revenue  in the other country.

Group Entity or On-lending Approach
Another approach which is followed  is  known as Group Entity or On-lending Approach. In this case, the taxpayer has a central treasury which raises loan at the group level and then allocates funds to various subsidiaries. In this case,  there  will not be a separate evaluation of subsidiary’s borrowing capacity or credit rating as the loan is advanced at the group level and therefore implic- itly subsidiary assumes the same credit  rating  as its parent. This approach makes sense in real life commercial/financial world.

However, the standalone entity approach is widely practiced as it supports arm’s length standard. Even OECD prefers this approach.

Australian Transfer Pricing Rules
The  Australian  Transfer  Pricing  Rules  have  been comprehensively amended for the first time in past 30  years  vide  Tax  Laws  Amendment  (Countering Tax  Avoidance  and  Multinational  Profit  Shifting) Act  2013.

The  new  rules  are  applicable  for  income  year  on or  after  1st  July  2013.  The  new  rules  provide  for independent/standalone  party  approach.  Australia also has Thin Capitalisation Rules in place. The new rules provide that in order to determine the arm’s length  conditions  between  two  AEs  on  the  same footing  as  they  may  exist  between  two  indepen- dent enterprises, one may need to consider issues such as whether independent entities operating in comparable  circumstances  would  have  advanced loans  with  the  same  or  similar  characteristics, provided  various  forms  of  credit  support,  sought to  refinance  at  a  different  market  interest  rate, issued  shares  or  paid  dividends.

In short, the taxpayers need to:

•    Assess if the quantum of debt meets arm’s length conditions.

•    Consider if the capital structure (debt/equity mix) is arm’s length.

•    Re-consider the interest rate with regard to fac- tors such as the impact of the rate on profits    of the company, and whether or not the rate     is adjusted as the parent company’s cost of funds changes.

Q.7 Are there any judicial precedents in India  on  the above issue?

A.7So far decisions on the issue of inter-company loans have come from Tribunals only. Ratios laid down by various decisions are as follows:



Other Relevant Decisions:

•    Tata Autocomp Systems Ltd. vs. ACIT [2012] 21 taxmann.com 6 (Mum.)
•    Aurinpro Solutions Ltd. vs. ADCIT [2013] 33 taxa- mann.com 187 (Mum.)
•    Mascon Global Ltd. vs. DCIT ITA No. 2205/
MDS/2010
•    Four Soft Limited vs. DCIT – TS-518-ITAT-201 (Hyd)
•    DCIT vs. Tech Mahindra Ltd. [2011] 12 taxmann. com 132(MUM.)
•    Aithent Technologies (P.) Ltd. vs. ITO [2012] 17 taxmann.com 59 (Del)
•    Mahindra & Mahindra vs. DCIT – TS-408-ITAT- MUM-2012
•    Cotton Naturals (I) (P.) Ltd. vs. DCIT [2013] 32 taxmann.com 219 (Del-Trib)
•    Hinduja Global Solutions Ltd. vs. ADCIT – TS-147- ITAT-MUM-2013
•    ITO vs. Maharishi Solar Technology Pvt. Ltd. TS- 306-ITAT-2012-DEL

for outbound loans. At  times  benchmarking of inbound transactions is more crucial than outbound as it results in base erosion, interest being deductible expense.

Though  India  does  not  have  Thin  Capitalisation Regulations  in  place,  it  has  robust  Foreign  Ex- change  Laws  which  regulates  borrowing  from overseas.  Borrowing  from  overseas  shareholder requires  minimum  25  %  of  shareholding.  There  are several  restrictions  for  use  of  borrowed  money as  well  as  the  sectors  which  can  borrow.  For example  only  real  sector  (i.e.  industrial  sector), infrastructure  sector  and  certain  service  sectors such  as  software,  hospital  and  hotel  are  allowed to  borrow  from  overseas.  Borrowing  for  general corporate  purpose  or  for  working  capital  require- ment  is  practically  banned.

The biggest benchmarking or safe harbor limit (so to say) is contained in “all-in-cost borrowing limit” prescribed under the Foreign Exchange Manage- ment Act, 1999 (FEMA). Since RBI does not allow payment of interest beyond this limit, generally payment of interest at the rate  prescribed  by RBI should be considered as arm’s length. One may draw support for this contention from  the  fact that the Indian Safe Harbor Rules prescribes the acceptable limit of minimum interest to be charged for loans advanced by Indian entity  (i.e. for outbound loans) but does not prescribe limit
 
From the above case laws, it is apparent that different tribunals have taken divergent views. Transfer pricing cases being  more  facts  based,  it is difficult to arrive at standard conclusion and perhaps that is why transfer pricing analysis is regarded as an “art” and not a “science”.

However, Tribunals have upheld application of LIBOR rate for determination of arm’s length inter- est rate in contradiction of Indian Transfer Pricing Administration’s stand of applying PLR of Indian Banks. It would be interesting to see how this jurisprudence develops further at higher forums.

Inbound Loans

Q.8 What are the provisions applicable to inbound loans?

A.8    The same transfer pricing rules and regula- tions apply to inbound loans as are applicable or maximum interest that may be allowed as deduction on inbound loans.

Present limits of all-in-cost borrowing under External Commercial Borrowing (ECB)  route  are  as follows:

Average Maturity Period

All-in-cost
over 6 month LIBOR*

Three years and up to five years

350 bps

More than five years

500 bps

* for the respective currency of borrowing or applicable
benchmark

All-in-cost limit includes rate of interest, other fees and expenses in foreign currency except commit- ment fee, pre-payment fee, and fees payable in Indian Rupees.

Transfer Pricing – Inter – corporate Financial Guarantees

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In our previous Article, we studied transfer pricing implications of cross border inter-corporate loans. In this article, we shall look at transfer pricing implications of cross border corporate guarantees between two Associated Enterprises. Guarantees may be for loan, performance of contract or delivery of products etc. However, we shall restrict our discussion, primarily to loan guarantees though principles discussed herein below would be equally applicable to other types of guarantees. We have maintained the Questions and Answers format for elucidating relevant provisions/law more clearly.

Q What are the different types of Guarantees?
A    Meaning of the word Guarantee as per the Oxford Dictionary is:

“An undertaking to answer for the payment or performance of another person’s debt or obligation in the event of a default by the person primarily responsible for it.”

OECD’s Statistical Glossary defines Loan Guarantee as: “A legally binding agreement under which the guarantor agrees to pay any or all of the amount due on a loan instrument in the event of non payment by the borrower.”

Wikipedia defines Loan Guarantee as: “A loan guarantee, in finance, is a promise by one party (the guarantor) to assume the debt obligation of a borrower if that borrower defaults. A guarantee can be limited or unlimited, making the guarantor liable for only a portion or all of the debt.” A Guarantee may be implicit or explicit.

Implicit Guarantee
Implicit guarantee is one when the lender assumes that the borrower being part of a well known group or with financial backing of its parent company, its dues/debts are secured. In case of any unforeseen circumstances, the borrower will be rescued/bailed out by its parent or other group companies.

Implicit guarantees are informal and hence not enforceable in law. Implicit guarantees are not recognised by many countries and normally do not enter the transfer pricing arena.

Explicit Guarantee
Explicit guarantee is one where a formal guarantee agreement is executed whereby the guarantor undertakes to make good loss to the lender in case of default by the borrower. Guarantee commission on explicit guarantees between Associated Enterprises (AEs) needs to be benchmarked on an arm’s length basis applying provisions of the transfer pricing regulations.

Other types of guarantees are letter of comfort/letter of intent whereby the parent company assures the lender that it will safeguard the interest of its subsidiary. This type of guarantee may not have a legally binding force. At times, the parent may undertake to replenish capital in the event of continuing losses which may erode subsidiary’s net worth. Safe Harbour Rules in the Indian Transfer Pricing Regulations clearly define what types of guarantee is covered. The definition of the Corporate Guarantee as per said Rules is as follows:

“Corporate guarantee” means explicit corporate guarantee extended by a company to its wholly owned subsidiary being a non-resident in respect of any short-term or long term borrowing. (Emphasis supplied)

Explanation:– For the purposes of this clause, explicit corporate guarantee does not include letter of comfort, implicit corporate guarantee, performance guarantee or any other guarantee of a similar nature.

Provisions of the Safe Harbour Rules (SHRs) throw light on the following issues:

• SHRs are applicable for explicit corporate guarantees (Implicit Guarantees and other forms of guarantees are not covered);
• SHRs cover guarantees given by an Indian Company (i.e., only the outbound scenario);
• SHRs are applicable only when a guarantee is given to the Wholly Owned Subsidiary (WOS) and not otherwise;

Q. What are the regulations under FEMA for obtaining and issuing Guarantees by an Indian entity?
A. FEMA Regulations for issuing guarantees:
(Master Circular on Direct Investment by Residents in Joint Venture (JV)/Wholly Owned Subsidiary (WOS) Abroad Para B.1)

Indian entities can offer any form of guarantee – corporate or personal (including personal guarantee by indirect resident individual promoters of the Indian Party)/primary or collateral/guarantee by the promoter company/guarantee by group company, sister concern or associate company in India provided that:

i) All financial commitments including all forms of guarantees are within the overall ceiling prescribed for overseas investment by the Indian party i.e., currently within 100% of the net worth as on the date of the last audited balance sheet of the Indian party.
ii) No guarantee should be ‘open ended’ i.e., the amount and period of the guarantee should be specified upfront. In the case of performance guarantee, time specified for the completion of the contract shall be the validity period of the related performance guarantee.
iii) I n cases where invocation of performance guarantees breach the ceiling for the financial exposure of 100% of the net worth of the Indian Party, the Indian Party shall seek prior approval of the Reserve Bank before remitting funds from India, on account of such invocation.

[Note: In case of invocation of a performance guarantee, which had been issued before 14th August, 2013, the limit of 400% shall be applicable and remittance on account of such invocation over and above 400% of the net worth of the Indian party shall require prior approval of the Reserve Bank.]

iv) A s in the case of corporate guarantees, all guarantees (including performance guarantees and Bank Guarantees/SBLC) are required to be reported to the Reserve Bank, in Form ODI-Part II. Guarantees issued by banks in India in favour of WOS/JV outside India, and would be subject to prudential norms, issued by the Reserve Bank (DBOD) from time to time.

Note: Specific approval of the Reserve Bank will be required for creating a charge on immovable/moveable property and other financial assets (except pledge of shares of overseas JV/WOS) of the Indian party/group companies in favour of a non-resident entity within the overall limit fixed (presently 100%) for the financial commitment subject to submission of a ‘No Objection’ by the Indian party and its group companies from its Indian lenders.

FEMA Regulations for obtaining overseas guarantees: (Foreign Exchange Management (Guarantees) Regulations, 2000, Para 3A)

With prior approval of RBI:
A Corporate registered under the Companies Act, 1956 can avail of domestic rupee denominated structured obligations by obtaining credit enhancements in the form of guarantee by international banks, international financial institutions or joint venture partners.

Without prior approval of RBI:
A person resident in India may obtain without the prior approval of the Reserve Bank, credit enhancement in the form of guarantee from a person resident outside for the domestic debts raised by such companies through issue of capital market instrument like bonds and debentures subject to the following conditions:

• Eligibility:
– A person resident in India
– Other than branch or office in India owned or controlled by a person resident outside India
– I n accordance with the provisions of the

Automatic Route Scheme specified in schedule Automatic route scheme: (Foreign Exchange Management

(Borrowing or Lending in Foreign Exchange) Regulations, 2000, Schedule I, Regulation 6(1)] Borrowing (Guarantee) in Foreign Exchange up to $ 500 million or its equivalent:

Eligibility:
• Any company registered under the Companies Act, 1956, other than a financial intermediary (such as bank, financial institution, housing finance company and a nonbanking finance company)

•    The borrowing should not exceed in tranches or otherwise $ 500 million or equivalent in any one financial year (April – March)

End use purpose:
•    For investment in real sector – industrial sector including Small and medium enterprises (Sme) and infrastructure sector in india.

•    For first stage acquisition of shares in the disinvestment process and also in the mandatory second stage  offer to the public under the Governments’ disinvestment programme of PSU shares.

•    For direct investment in overseas Joint Ventures(JV)/ Wholly owned Subsidiaries (WoS) subject to the existing guidelines on Indian Direct Investment in JV/WOS abroad.

Q. Whether Guarantee is an “international transaction” under the Indian Transfer Pricing regulations?

A. In one of the earlier rulings on the subject of guarantee, delivered on 9th September, 2011, the hyderabad Tribunal in case of Four Soft limited [(hyd. ITAT) – 62 DTr 308] ruled that:

“The corporate guarantee provided by the assessee company does not fall within the definition of international transaction. The TP legislation does  not  stipulate  any  guidelines in respect to guarantee transactions. In the absence of any charging provision, the lower authorities are not correct in bringing aforesaid transaction in the TP study. In our considered view, the corporate guarantee is very much incidental to the business of the assessee and hence, the same cannot be compared to a bank guarantee transaction of the Bank or financial institution. In view of this matter, we hold that no TP adjustment is required in respect of corporate guarantee transaction done by the assessee company.”

However,  thereafter  the   Income   tax   Act, 1961 (“Act”) was amended vide Finance Act 2012 to bring guarantees and other financial transactions within the ambit of the Transfer Pricing regulations (TPrs). Explanation to section 92B was added to the definition of the term “International Transaction”, which reads as follows (only the relevant extract is reproduced):

“Explanation—For the removal of doubts, it is hereby clarified that—

(i) the expression “international transaction” shall include—

(c)    Capital financing, including any type of long-term  or  short-term  borrowing,   lending  or guarantee, purchase or sale of marketable securities or any type of advance, payments or deferred payment or receivable or any other debt arising during the course of business;”

from the above, it is clear that loans and guarantees between AEs are covered under the TPRs of India  retrospectively
w.e.f. 1st april 2002.

Post the above amendment, divergent rulings of the tribunals have come which are enumerated hereunder:

i)    Bharati Airtel Ltd. vs. ACIT [2014] 43 Taxmann.com 150 (delhi – trib.)

In  this  case,  the  tribunal  held  that  “even  after  the amendment to Section 92 B, by amending explanation to section 92 B, a corporate guarantee issued for the benefit of the aes, which does not involve any costs to the assessee, does not have any bearing on profits, income, losses or assets of the enterprise and or therefore, it is outside the ambit of ‘international transaction’ to which ALP adjustment can be made.”

ii)    The  mumbai  tribunal,  in  cases  of  (a)  Everest  Kanto Cylinder Ltd. vs DCIT (ITA No. 542/Mum/2012) and (b) Technocraft Industries (India) Ltd. vs. ACIT (ITA No.7519/ Mum/2011), Mumbai (January 2014) held that post amendment of section 92B guarantee transactions are covered by the Transfer Pricing Regulations.

Safe harbor Provisions as applicable to Guarantee transactions [Notified on 18th September 2013 applicable for Five Assessment years beginning from Ay 2013-14]

Sr.

No.

Eligible
Interna- tional Transactions

Acceptable
Circumstances

Remarks

1

Providing
corpo- rate guarantee where the amount guaranteed does not exceed Rs.100
crore.

Guarantee
com- mission or the fee charged
should be minimum

2% per annum of the amount guaranteed.

Corporate
Guar- antee is defined to mean explicit corporate guaran- tee extended by a

company to
its WOS being a non-resident in respect of any short-term or long term
borrowing.

The Australian Taxation Office in its Discussion Paper on “Intra-group Finance Guarantees & Loans Application of Australia’s Transfer Pricing and Thin Capitalization Rules
 
Between AES be given without charging any commission?

A. Post amendment of section 92B of the Act, transactions of cross border Guarantees between two aes are covered under the transfer pricing regulations. however, we have divergent decisions from tribunals on this point. (Refer Ans. 3 supra)

OECD Guidelines on Transfer Pricing (Para 7.13) provide intra-group services are said to be rendered when an AE derives benefits from an active association in the form of explicit guarantee from a group member and/or global marketing and promotion of the group whereas no services are said to be rendered where there is incidental benefits due to passive association of the ae with its group members. in the former case, issuance of guarantee would demand charging whereas, in the later case there is no need of any charge as no services are said to be rendered.

Australian Discussion Paper (2008) (paragraph 31) on “intra-group  finance  Guarantees  and  loans”  states  that “incidental benefits from association with a larger group where the market accords those benefits without an associated company actually providing an economic service that confers a benefit on the recipient would not usually be a basis for imposing a charge.”

From the above discussion, one may conclude that in the following circumstances, intra-group guarantees may not carry any charge or commission and therefore, are out of ambit of the transfer pricing regulations:

i)    When the benefit  obtained  by an AE is on  account  of a passive association (something akin to implicit guarantee);

ii)    When the corporate guarantee is issued for the benefit of the ae, which does not involve any costs to the assessee and therefore does not have any bearing June 2008” (paragraph 181 on page 42 of the Paper)  has opined that where the provision of a guarantee relates exclusively to the establishment or maintenance of a parent company’s participation as an investor, the costs of such participation should not be allocated to the subsidiary and should not affect the allocation of profit between the parent and subsidiary. in such a circumstance it could be fair and reasonable to determine that the arm’s length consideration for the provision of the guarantee is nil. On profits, income, losses or assets of the Guarantor (Based on the
decision of the delhi tribunal in case of Bharati Airtel (I.T.A. No.
5816/Del/2012));

iii)    Where the guarantee is provided for the debt which is in lieu of equity or which is in the nature of equity.

At Paragraph 105 of the Paper it is reported that: “The pricing of a guarantee is calculated as a percentage or spread on the amount of the debt being guaranteed. no chargeable percentage or spread arises on any portion of the debt that serves the purposes of equity.”

Q. What are the provisions under the OECD Transfer Pricing Guidelines regarding cross border guarantees?

A. Paragraph 7.13 of the (Chapter VII- Intra-Group Services) OECD Guidelines on Transfer Pricing (July 2010) makes a distinction between an “active  association” and a “passive association”  between  aes.  according to the Guidelines, in case of a passive association, an AE would receive incidental  benefits  just  because  it is part of the  multinational  enterprise  Group.  in such a scenario, no services are said to be rendered even though it receives higher credit rating being affiliated to a larger group. however, in case of an active association, services are said to be rendered when the ae receives higher credit rating because of guarantee offered by another group member or benefit obtained from the group’s reputation deriving from global marketing and public relation campaigns.

Benefit on account  of  “passive  association”  is  akin to “implicit guarantee”  whereas,  benefit  on  account  of “active association” is akin to “explicit guarantee”. therefore, even oeCd supports the view that there is no need of any charge in the case of implicit guarantee whereas explicit guarantee needs to be charged and benchmarked under transfer pricing regulations.

Q. how does one benchmark guarantee fee?
a.    Benchmarking of guarantee fee is a complex issue in view of unavailability of comparable data and unique nature of the transaction.

Various methods or approaches can be used to benchmark a guarantee fee depending upon the facts of the case and availability of the comparable data. Various situations and appropriate methods/approaches are discussed in the Australian Discussion Paper (2008) (paragraphs 128 to 171) on “intra-group finance Guarantees and loans” as well as arising from different case laws, as follows:

i)    CUP Method
CUP Method is the most appropriate method where sufficient data for comparison are available.

Under this method, the guarantee fee is determined by comparing the arm’s length guarantee fee charged by an independent party for providing similar guarantee on similar terms and conditions. in this approach, quantum of risk, type of guarantee, period of guarantee, borrower’s standalone credibility etc. are considered for arriving at arm’s length guarantee fee.

There may be Internal CUP or External CUP. In the case of the former, the spread between guaranteed and non-guaranteed third party loans are compared and the guarantee fee charged is equivalent or more due to difference in interest rates between these two types of loans.

In case of External CUP the fees applicable to Letter of Credit or Collateral debt Securities data are used.

The CUP method would be ideal in cases where a creditworthy subsidiary that is able to raise the debt funding it needs on a stand-alone basis obtains better terms with the benefit of a parent guarantee.

ii)    Benefit/yield Approach
This  approach  is  also  known  as  “interest  Saving approach”. in this method, arm’s length guarantee fee is determined through the interest rate saving which the subsidiary earns due to explicit guarantee by its parent. Thus, this method/approach seeks to benchmark the guarantee fee from the perspective of the borrower.

Under this approach, uncontrolled interest  rates,  risk assessments and market indicators are used as indirect benchmarks for arriving at the arm’s length fee, rather than using uncontrolled guarantee fee as a benchmark.

In other words, an arm’s length fee is estimated as the spread between the interest rate the borrower would have paid without the guarantee and the rate it pays with the guarantee, less the arm’s length discount. the remaining spread, net of the discount, would have to be sufficient to make the deal attractive to an independent guarantor for the additional risk it would assume, if it provided the guarantee. if there is no additional risk, then consideration has to be given to the economic substance of the arrangement between the parties.

In the case of General electric Capital Canada inc.’s in  december  2009  (Ge  Capital),  the tax  Court  of Canada (TCC) (2009 TCC 563 Date: 20091204)
Upheld the yield approach for determination of arm’s length fee for the explicit guarantee provided to the Canadian subsidiary (GE Canada) by the US Parent Co. (Ge uSa).

In the case of Four Soft Ltd. vs. DCIT [(Hyd. ITAT)
– 62 DTR 308], the Tribunal, while upholding non charging of guarantee fees by the indian Company in respect of overseas aes observed that “the subsidiary company has not received any benefit in the form of lower interest rate by virtue of the corporate guarantee given by the assessee company and at the same time, the assessee company significantly benefited from such transaction”. Thus the Tribunal did look at the “benefit approach” in benchmarking guarantee fees.

iii)    Profit Split Method
this  method  is  useful  where  there  are  series  of transactions owing to special relationship between the parent company and its subsidiary.

For example, the parent may supply trading stock to a subsidiary, purchase outputs from the subsidiary and also provide debt funding and a guarantee. There may be benefits flowing from the parent to the subsidiary as well as from the subsidiary to the parent. Such cases require a careful analysis of benefit flows and their impacts on the respective parties in order to appropriately determine the share of profit each party should receive for its contribution to the profit channel.

iv)    Risk/Reward Based Approach or Cost Based approach

This approach takes into account the risk the parent would take in extending guarantee to its subsidiary/ ae in the event of default and reward it in terms of increased profitability and sustainability or viability of subsidiary’s business. the reward could also be based on the quantified risk and perceptions of the probability that the risk will not materialise compared to the probability that it will materialise.

This approach seeks to value the guarantee fee from the perspective of the guarantor by focussing on the actual and potential financial and other impacts of providing guarantee. The  benchmarking  is  done  as  if  such  guarantee transaction is entered into by two independent parties taking into account the circumstances of the borrower. The borrower’s creditworthiness [to be determined based on arm’s length, i.e., as if it is an independent enterprise] is of utmost importance as it has a direct bearing on its financial strength and the default risk.

v)    The  other  two  approaches  are,  namely:  (i)  option Pricing  Model  Approach  [Using  financial  model for valuing options where the guarantee fee is ascertained as equivalent to a premium chargeable for insuring the underlying loan asset] or (ii) Credit Default Swaps [which is akin to a financial guarantee where a parent would make a periodic fixed payment to a third party should the subsidiary default on its obligation].

Both the above approaches are not much in vogue and hence not discussed at length.

In actual practice, especially in complex cases a combination of various approaches may be used.

Q. What are the Judicial Precedents for benchmarking of cross border guarantees?

A.    Indian experience and judicial precedents (in addition to cases discussed hereinabove) on charging of guarantee fees are summarised as follows:

Indian Experience
Indian Transfer Pricing Administration prefers CUP method for benchmarking guarantee commission in cases of outbound guarantees (i.e., where indian company has given guarantee to its overseas ae). in most cases, interest rate quotes and guarantee rate quotes available from banking companies are taken as the benchmark rate to arrive at the ALP. The Indian tax administration also uses the interest rate prevalent in the rupee bond markets in india for bonds of different credit ratings. the difference in the credit ratings between the parent in india and the foreign subsidiary is taken into account and the rate of interest specific to a credit rating of indian bonds is also considered for determination of the arm’s length price of such guarantees.

In the above context, it is interesting to note the observations of the hyderabad tribunal in case of four Soft limited (supra) wherein the tribunal observed that “in our considered view, the corporate guarantee is very much incidental to the business of the assessee and hence, the same cannot be compared to a bank guarantee transaction of the Bank or financial institution.”

In case of M/s. Asian Paints Ltd. vs. ACIT (ITA No. 408/ Mum/2010), the Mumbai Tribunal upheld following observations of the Cit (a) which are worth noting:

“The TPO has collected data from the Website of Allahabad Bank,  hSBC  Bank  and  robo  india  finance  and  applied the flat rate of 3%. That is to say the TPO has adopted a ‘naked quote’ without factoring in the qualitative factors which determine the fees. a quotation given by a  third party e.g. a Banker does not constitute a CUP since it is quotation and not an actual uncontrolled “transaction”. the TPO has adopted a 3% rate or guarantee fees when the Citi Bank Singapore (the bank providing the loan amount) itself has charged interest at the rate of 1.625% only on the loan granted to its ae at Singapore. this makes the stand of the TPO unsustainable as guarantee fees can in no circumstances exceed the rate at which interest is charged on loan.”

From the above, two principles emerge which are as follows:

(i)    Banks’ quotes of “Guarantee Commission” cannot be applied blindly (naked quote) without factoring into qualitative factors thereunto
(ii)    Under no circumstances, guarantee fees can exceed the rate of interest charged on the underlying loan for which guarantee is given.

In the case of Reliance Industries Ltd. [I.T.A. No.4475/ Mum/2007], the Mumbai Tribunal held as follows:

(i)    Guarantee transactions do fall within the definition of the “International Transaction” under the Transfer Pricing regulations post retrospective amendment of section 92B of the act vide the finance act 2012;

(ii)    For benchmarking of guarantee fees, one cannot apply any naked bank rate, as guarantee fee largely depends upon the terms and conditions on which loan has been given, risk undertaken, relationship between bank and the client, economic and business interest etc.

In the case of Glenmark Pharmaceuticals Limited vs. ACIT [TS-329-ITAT-2013(Mum)-TP], the Mumbai Tribunal also held as follows:

(i)    CUP is the most appropriate method for benchmarking Guarantee transactions.

(ii)    There   is   a   conceptual   difference   between   Bank Guarantee and Corporate Guarantee. Bank Guarantee is a foolproof instrument of security for the customer and failure to honour the guarantee is treated as deficiency of services of the Bank under the Banking laws. on the other hand, the CG – Corporate Guarantee is provided by the Company either to the Customer or to the Bank for giving loans to the sister concerns/AEs of the said company; but it is not foolproof. failure to honour the guarantee may attract contract laws and it is however a legally valid document and the Customer/Bank can sue the company in Court if it does not pay up.

(iii)    Unless the ‘naked quotes’ of the  bank  guarantee  rates as given in the websites for public, are adjusted to various controlling factors, these rates are no good CUP.

(iv)    Conclusion:

From  the  above  discussion,  it  can  be  concluded  that guarantee given by an Indian Parent to its overseas subsidiary needs to be benchmarked as per transfer pricing regulations in India. The CUP method is ideal subject to availability of comparable data. in complex cases one or more methods/approaches can be used. Indian Safe harbour provisions provide considerably higher rate of guarantee commission/fees and therefore, less likely
to be opted by assesses in india.

Benchmarking of guarantee is never an easy task in view of commercial  exigencies  and  other  factors  involved. The Indian Transfer Pricing Administration (ITPA) should therefore adopt a comprehensive approach in arriving at arm’s length fees rather than adopting naked rates/fees as are quoted on the website of the Banks/Financial Institutions. It would be interesting to see whether the ITPA would be willing to allow as deduction guarantee commission/fee charged by the foreign parent to its indian subsidiary based on the bank rate.

Digest of recent important foreign decisions on cross-border taxation

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Part II

In the first part of the Article published in November, 2011, we dealt with some of the recent important foreign decisions on cross-border taxation. The remaining decisions are covered in this part.

8. New Zealand — Supreme Court decision on tax avoidance
On 24 August 2011, in a significant unanimous decision by five judges, the Supreme Court in Penny and Hooper v. Commissioner of Inland Revenue, SC 62/2010 (2011) NZSC 95 held that the transfer of the taxpayers’ medical practices to companies owned by family trusts was lawful, being a business structure choice that the taxpayers were entitled to make. There was nothing artificial or unusual for companies under the taxpayers’ control to pay salaries to the taxpayers. However, fixing the salaries at an artificially low level to avoid paying tax at the highest personal tax rate did constitute tax avoidance. The commencement of paying lower salaries coincided with the increase in the top personal income tax rate to 39%, while the corporate rate was 30%. In addition, the taxpayers maintained control of all of the companies’ income and were able to, and did, transfer funds from the companies for their own, and their families’ use.
The Court acknowledged that there circumstances where the setting of a salary at a low level may be justified, e.g., where a company has a commercial need to retain funds for capital expenditure, or where a company faces, or is about to experience, financial difficulties. In these situations, tax avoidance does not arise when low salaries are paid. However, where the setting of the annual salary is influenced in more than an incidental way by the impact of taxation, the whole arrangement is considered to be tax avoidance. In this case, the tax advantage was at least one of the principal purposes and effects of the taxpayers’ arrangements, rendering them void u/s. BG 1 of the Income-tax Act, 2007.

The Court stated the basic principle as follows:

— “. . . . the policy underlying the general antiavoidance provision is to negate any structuring of a taxpayer’s affairs whether or not done as a matter of ‘ordinary business or family dealings’ . . . unless any tax advantage is just an incidental feature. That must include using a company structure to fix the taxpayer’s salary in an artificial manner”; and
— “Parliament must have contemplated and been content that people may structure their transactions for commercial reasons or for family reasons in which any tax advantage is merely incidental, but that they will not be permitted to do so when tax avoidance is more than a merely incidental purpose or effect of the steps they have taken.”
The Supreme Court decision followed Peate v. Commissioner of Taxation of Commonwealth of Australia, (1962-1964) 111 CLR 443, affirmed (1967) 1 AC 308 (PC), where a doctor similarly used a company, which paid him a low salary, to avoid taxation that would have been paid if the doctor had derived the income himself and then applied it for the benefit of his family. The doctor nevertheless retained control of all of the income.

On a separate matter, the Court also criticised the practice (which was evident in this case) of expert witnesses going beyond their role as authorities in their field of expertise and expressing their views on legal issues in the case at hand. The Court considered the practice undesirable and a wasteful duplication of time and effort, and rather pointedly directed that the practice stop and, if it did not, lower courts should require amended briefs to be filed.

There is now a call from tax practitioners seeking Inland Revenue certainty about what constitutes artificially low salaries. It is difficult to see Inland Revenue drawing a definitive line given that there are circumstances where, on a case-by-case basis, low salaries can be justified, as noted by the Supreme Court. Reference :

 TNS:2010-06-07:NZ-1; ITS:NZ; ITA:NZ; IGTT:NZ.

9. Estonia — Application of CFC and GAAR — Substance over Form Principle — Supreme Court rules Re attribution of foreign company’s profits to Estonian company
On 26 September 2011, the Supreme Court of Estonia gave its decision in the case of Technomar v. Tax Authorities, (Case No. 3-3-1-42-11) where it, among other issues, decided for the first time on the attribution of a foreign company’s income to an Estonian company.

(a) Facts

The Estonian resident individual held shares in a taxpayer, Estonian resident company, Technomar. A Manx company (Ltd.) and a US company (L.L.C.) derived their income from (i) purchasing goods from third parties and selling them for a higher price to Technomar, or from (ii) purchasing goods from Technomar and selling them for a higher price to third parties. Both of these companies were incorporated and controlled by the above-mentioned individual shareholder of Technomar.
L.L.C. transferred EEK 118 million from its Estonian bank account to its Austrian account.
The tax authorities considered that Technomar used Ltd. and L.L.C. as conduit companies to evade taxes. Therefore, the tax authorities applied the look-through approach and concluded that all the transactions, profits and assets of Ltd. and L.L.C. were Technomar’s and, correspondingly, all transfers from the bank account of L.L.C. must be treated as made directly by Technomar.
Further, as, due to the bank secrecy rules, the tax authorities did not manage to receive information from the Austrian authorities on the L.L.C.’s bank account in Austria, the EEK 118 million transferred by L.L.C. to Austria was treated as undocumented expense of Technomar. As a result, the tax authorities assessed Technomar in respect of these transfers.
Technomar appealed against the assessment to the administrative Court, which upheld the tax authorities’ position. Subsequently, the Court of appeal also decided in favour of the tax authorities. Technomar appealed to the Supreme Court.

(b) Legal background

U/s.22 of the Income-tax Law (ITL), resident individuals are taxable on the income of a controlled company established in a low-tax territory, whether or not such company has distributed any profits. As retained earnings of resident companies are tax exempt, the ITL does not contain such a provision for companies.
Section 84 of the Law on Taxation sets out the general anti-avoidance rule which provides that where, from the content of a transaction it is evident that such a transaction is performed for the purposes of tax evasion, the conditions corresponding to the actual economic substance shall apply for tax purposes (substance-over-form principle).

(c) Issue

The issue before the Court was, in essence, whether or not the transactions and bank transfers of Ltd. and L.L.C. could be attributed to the Estonian company under the general anti-avoidance rule, and whether bank transfers to accounts, of which the tax authorities have no means to receive information about, can be qualified as taxable hidden profit distributions under the ITL.

(d)    Decision

The Court agreed with the tax authorities that the substance-over-form principle allows the authorities to attribute the income of a foreign company to an Estonian company if the circumstances of the transactions demonstrate that the transactions of the foreign company have not been directly concluded for the interests of the individual who manages and controls the company, but to conceal the transactions related to the economic activities of the Estonian company.

Technomar’s argument that Ltd. and L.L.C. were separate legal persons with separate tax liabilities and, therefore, the tax authorities should have, instead of applying the general substance-over-form principle, applied specific provisions such as section 22 ITL or section 50(4) ITL (transfer pricing), was not upheld. The Court stated that in order to apply the latter provisions, the companies should have been engaged in independent economic activities. In the case at hand, the Court agreed with the tax authorities that Ltd. and L.L.C. did not engage in such activities and the transactions concluded by them were fictitious.

Also, the Court did not recognise the position of Technomar that transfers of funds from one account of the company to its other account, whether Estonian or foreign, cannot be considered as a non-business expense. The Court held that in certain circumstances it is allowed to tax as a non-business expense payments from one account of the company to another or withdrawals of cash. The pre-condition for the non-taxation of retained corporate profits is the use of these profits in business. However, such use must be proven. Any transfer or cash payment which makes it impossible to exercise control over the use of funds must be taxed as a non-business expense. If the movement of attributed funds on the bank accounts is not reflected in the company’s books and the tax authorities have no means to receive information on the use of funds on some accounts, then the transfer to such account constitutes a payment for which there is no source document certifying the transaction. In this regard, there is no difference in which country the bank account is situated or for which reason the tax authorities are not able to obtain information about the account.

The Court upheld the position of the tax authorities and the lower Courts, and dismissed the appeal of Technomar.

Reference: CTA:EE:10.

10.    Brazil — CFC — Superior Court of Justice rules on impossibility of setting off tax losses of foreign-controlled and affiliated companies against taxable profit in Brazil

The Superior Court of Justice (Superior Tribunal de Justiça — STJ) in the session held on 27 September 2011, within the case records of Special Appeal n. 1161003 filed by Marcopolo S/A against the Federal Treasury, ruled on the question of the impossibility of offsetting tax losses of foreign-controlled and affiliated companies against taxable profits of the parent company in Brazil.

(a)    Background

Law 9,249/1995 determines that profits accrued by foreign-controlled and affiliated companies of Brazilian companies are taxable in Brazil. When imposing this obligation, Law 9,249/1995 expressly provides that potential tax losses resulting from activities carried out by these foreign entities could not be offset against the taxable profits of the parent company in Brazil.

Subsequently, Provisional Measure 2,158/2001 (PM 2,158) anticipated the timing for recognition and taxation of foreign profits earned by foreign-controlled or affiliated companies to the end of the same calendar year in which they are accrued in the balance sheet of the foreign companies, regardless of their actual distribution to the Brazilian parent company.

PM 2,158 was silent vis-à-vis the impossibility of offsetting tax losses incurred by foreign-controlled and affiliated companies against the taxable profits of the parent company in Brazil. Therefore, Marcopolo S/A has argued that PM 2,158 has actually revoked the prohibition set forth by Law 9,249/1995 and, from that moment on, the offsetting would be allowed.

(b)    Decision

The Justices of the Superior Court of Justice, in a unanimous decision, ruled that tax losses of foreign-controlled and affiliated companies cannot be offset against the taxable profits of their parent company in Brazil. This reasoning was based on the argument that this would provide a double advantage to the Brazilian company, given that these tax losses could be used to offset the profits to be generated by the same foreign-controlled and affiliated companies in the following tax years.

Furthermore, the Justices understood that PM 2,158 has not revoked the prohibition set forth by Law 9,249/1995 in that regard and, therefore, the provisions brought by the latter are still applicable.

It is expected that Marcopolo S/A would file an appeal against this decision before the Brazilian Supreme Court (Supremo Tribunal Federal — STF).

Reference: CTS:BR:1.5.1., 6.1.1.; CTA:BR:1.8.1., 7.2.2.

11.    Netherlands; European Union; France; Ger-many; Portugal — Thin capitalisation rules Netherlands Supreme Court — AG opines on application of thin capitalisation provision under tax treaties with France, Germany and Portugal

On 9 September 2011, Advocate-General (AG) Wattel delivered his opinion in case No. 10/05268 on the application of the Dutch thin capitalisation rules under the France-Netherlands tax treaty on income and capital of 16 March 1973 as amended, the Germany-Netherlands tax treaty on income and capital of 16 June 1959 as amended and the Netherlands-Portugal tax treaty on income and capital of 20 September 1999 (‘the treaties’).

(a)    Facts:

The taxpayer is a company resident in the Netherlands, which in 2004 was owned for 95% by a French company. In 2004, The taxpayer had debts to companies, established in France, Germany and Portugal, belonging to the same group as the taxpayer. The taxpayer deducted the negative balance of the group interest. The tax inspector rejected the deduction based on the Dutch thin capitalisation provision of Article 10d of the Corporate Income Tax Act (CIT).

(b)    Issues and opinion:
The issues before the Supreme Court are as follows:

Issue (1)

The AG considered that the thin capitalisation provision is compatible with EU law with reference to the decision of the European Court of Justice (ECJ) of 25 February 2010 in the case C-337/08, X-holding, in which it was held that the Netherlands rules disallowing cross-border group taxation are compatible with freedom of establishment and a decision of the Supreme Court of 24 June 2011, nr. 09/05115, in which it was decided that the loss relief restriction applicable to holding companies is not incompatible with EU freedom of establishment (see TNS:2011-06-27:NL-3). In addition, the AG considered that EU law does not oblige to allow a cross-border consolidation and also not to separate from a package deal group regime, parts which in domestic situations result only from the full consolidation.

Issue (2)

The AG refers to the decision of the ECJ of 21 July 2011 in the Case C-397/09, Scheuten Solar Technology. The AG observed that the aim of the Directive is not a broadening of the tax base of the related company paying the interest, but the prevention of legal double taxation at the level of the receiving company. Therefore, the AG takes the view that the thin capitalisation provision is compatible with Article 1 of the Interest and Royalty Directive.

Issue (3)

The AG rejected the appeal based on Article 25(5) (non-discrimination) under the treaty with France because the taxpayer is not treated differently from another company which is not part of a group and is not comparable with a group company. In addition, the AG held that the non-discrimination provision does not oblige to allow a cross-border fiscal unity.

Furthermore, the AG rejected the appeal based on Article 6 of the treaty with Germany and Article 9 of the treaty with France, because the application of a thin capitalisation provision is not incompatible with those arm’s-length provisions. Based on the wording ‘may’, the AG opined that those provisions do not preclude the application of thin capitalisation provisions without the possibility of proof to the contrary.

In addition, the AG pointed out that these treaty provisions textually do not concern capital structures or the determination of the tax base, but transactions.

The AG did not take the 1992 Commentary to the OECD Model Convention into account, because the tax treaties with France and Germany were signed before, but noted that the 1992 Commentary supports the view of the taxpayer.

In addition, the AG referred to the group test, included in the thin capitalisation provision. Under this test, companies may opt that the excessive debt is determined by multiplying the difference between the average annual debts and the average annual equity using a multiplier based on the commercial debt/equity ratio of the group. The AG held that this option may be regarded as a possibility of proof to the contrary.

The AG accepted the taxpayer’s appeal based on Artilce 9 of the treaty with Portugal and Article X of the protocol to that treaty and held that this arm’s-length provision obliges the treaty states to allow the taxpayer with the possibility of providing proof to the contrary.

Consequently, the AG opined to overturn the decision of the Lower Court Haarlem and held that the case should be referred to another Court for further fact finding.

Reference:  tnS:2010-11-19:nl-2;  tnS:2011-06-27:nl-3;
CtS:nl:7.3.; Cta:nl:10.3.; hold:nl; tt:Fr-nl:02:enG:1973:tt;
tt:de-nl:02:enG:1959:tt;  tt:nl-Pt:02:enG:1999:tt;
tt:e2:82:enG:2003:tt; eCJd:C-337/08; eCJd:C-397/09.

Acknowledgment/Source:
We have compiled the above summary of decisions from the Tax News Service of IBFD for the period September to October, 2011.

Recent Global Developments in International Taxation part II

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In this Article, we have given brief information about the recent global developments in the sphere of international taxation which could be of relevance and use in day-to-day practice and which would keep the readers abreast with various happenings across the globe in the arena of international taxation. We intend to keep the readers informed about such developments from time to time in future.

(1) United Kingdom

(i) Finance (No. 1) Act, 2010 — New measures regarding DOTAS

On 19 October 2010, Her Majesty’s Revenue & Customs (HMRC) announced that it was anticipated that the package of five measures revising and extending disclosure of tax avoidance schemes (DOTAS), which were issued for consultation following the Pre-Budget Report 2010-11 and in respect of which legislation was included in Finance (No. 1) Act, 2010 will be implemented on 1st January 2011. Some of the descriptions of schemes (‘hallmarks’) requiring disclosure that were the subject of the consultation will, however, be implemented in 2011-12.

(ii) Tax avoidance clampdown — New measures announced

On 6th December 2010, the Exchequer Secretary to the Treasury announced a number of anti-avoidance measures.

The following measures take immediate effect:

— legislation to prevent groups of companies using intra-group loans or derivatives to reduce the group’s tax bill (group mismatch schemes); and
— legislation aimed at schemes involving accounting derecognition, i.e., where a company does not fully recognise in its accounts certain amounts involving loans and derivatives.

Further details will be published in respect of the following measures:

— legislation to address the practice of disguised remuneration (basically arrangements involving trusts or other vehicles);
— legislation aimed at avoidance involving changes in the functional currency of an investment company. The legislation is expected to take effect for accounting periods beginning on or after 1st April 2011; and
— legislation targetting VAT avoidance involving ‘supply splitting’. The legislation is expected to come into force with effect from the date of Royal Assent to the Finance Bill, 2011.

(iii) Disclosure of Tax Avoidance Schemes — Extension to certain inheritance tax transfers

On 6th December 2010, HMRC published a document in response to the consultation on bringing within the disclosure regime inheritance tax (IHT) on transfers of property into trust.

The Disclosure of Tax Avoidance Schemes (DOTAS) regime came into force on 1st August 2004. It introduced an obligation to report to HMRC certain tax avoidance arrangements. Broadly, where an arrangement is notifiable, the promoter must, within a specified time, provide HMRC with details of the arrangement. In certain cases, the obligation to report is shifted from the promoter to the user of the scheme.

The scheme currently covers income tax, capital gains tax, corporation tax, national insurance contributions, VAT, and stamp duty land tax.

(iv) Statement of Practice on Advance Pricing Agreements updated

On 17th December 2010, HMRC issued an updated version of Statement of Practice on Advance Pricing Agreements (APAs) SP3/99 so as to provide greater transparency regarding the processes in respect of APAs for businesses and advisors and also to cover the relevant legislative changes that have been enacted since 1999.

The updated version of SP3/99 is available on the HMRC website.

(v) GAAR — Study group established

On 14th January 2011, HM Treasury announced that it had been notified of the experts who will work on the study into a General Anti-Avoidance Rules (GAAR) and the areas that the experts will cover. This follows the announcement on 6th December 2010 that a study group would be established to explore the case for GAAR in the United Kingdom.

The topics that the study group will consider include:

— consideration of the existing experience with GAARs and other anti-avoidance principles in other jurisdictions;
— what a UK GAAR could usefully achieve; and
— what the basic approach of a GAAR should be.

The study will also consider whether or not a GAAR could deter and counter tax avoidance, whilst providing certainty, retaining a tax regime that is attractive to business, and minimising costs for businesses and HMRC.

The study group will complete its work by the 31st October 2011 and will report its conclusions to the UK Treasury.

(2) Italy

(i) Tax Authorities issue Ministerial Circular No. 51/E: new CFC regime clarified

On 6th October 2010, the Italian Tax Authorities (ITA) issued Ministerial Circular No. 51/E (the Circular) aimed at providing further clarifications in respect to the new CFC regime introduced on 1st July 2009 by Article 13 of the Anti-crisis Law Decree No. 78 converted into Law No. 102/2009.

(3) South Africa

(i) Transfer pricing and thin capitalisation rules revised

The Taxation Laws Amendment Act of 2010 has introduced new transfer pricing (TP) rules. Section 31 of the Income-tax Act of 1962 has been repealed and replaced. The main reason for introducing new TP rules is to further align the Income-tax Act with Article 9 of the OECD and UN Model Tax Conventions. This is in view of the fact that: — the current wording focusses on separate transactions, as opposed to overall arrangements driven by an overarching profit objective;

— the current wording seems to emphasise the comparable uncontrolled price method over other TP methodologies;

— the emphasis, in the current legislation on ‘price’ as opposed to ‘profits’ does not neatly align with tax treaty wording, potentially creating difficulties in the mutual agreement procedures available under tax treaties; and

— the need to directly merge thin capitalisation rules into the TP rules, as opposed to having parallel rules as is currently the case.

The revised legislation comes into effect on 1st October 2011.

(ii) Regional headquarter company regime introduced

In order to make South Africa an ideal location for multinational enterprises wishing to invest in Africa, a regional headquarter (HQ) company regime has been introduced vide the Taxation Laws Amendment Act of 2010. The regime is intended to address some tax barriers to the setting up of regional holding companies in South Africa.

(4) Thailand

Additional tax incentives package for Regional Operating Headquarters

On 27th October 2010, Royal Decree No. 508 (RD 508) was issued that added another package of tax incentives for Regional Operating Headquarters (ROH). With the advent of RD 508, a company may opt to apply for the old or new package of tax incentives. A company that wishes to apply for the new package is required to notify the Thai Revenue Department within five years from the date specified by the Director-General (to be announced later). RD 508 is effective from 28th October 2010.

(5) Mauritius

Budget for 2011 — Details

The Budget for 2011 was presented to the Parliament by the Minister of Finance on 19th November 2010. Details of the Budget, which unless otherwise indicated will apply from 1st January 2011, are summarised below.

Direct taxation

(a)    Corporate taxation
— corporate entities operating in the real estate business will be taxed as a separate taxable person at the rate of 15% instead of being taxed at the level of their individual partners;
— corporate entities holding Category 1 Global Business Licence, previously limited to carry on business offshore, will be allowed to conduct business both inside and outside Mauritius. Accordingly, foreign source income derived by such entities will continue to benefit from foreign tax credits while their domestic income will be subject to tax at the standard rate; and
— the current preferential corporate tax regime applicable to companies established in Free Trade Zones has been extended for two additional years.

(b)    Personal taxation
— interest income will be exempt from in come tax;
— individuals with total income (inclusive of exempt income) exceeding MUR 2 million will be subject to a 10% solidarity tax on their exempt income; this will apply in addition to their personal tax liability;
— new statutory deductions for individuals are introduced and include:

  •     deduction for interest expense on loans for the first acquisition/construction of a residence; and

  •     deduction for educational expenses in respect of children undertaking undergraduate studies at the university; and

— a reintroduction of tax exemption on income generated from the first 60 tonnes of sugar for small sugar-cane farmers with less than 15 hectares of land and who rely solely on income from sugar farming.

(c)    Capital gains tax
— gains from the sale of immovable property will be taxed at the rate of 15% for corpo rate entities. A reduced rate of 10% will apply for individuals after an exemption of MUR 2 million.

(d)    Other direct tax measures

— costs undertaken in the context of sugar-related business reform, such as factory closure costs, will be tax deductible;
— the threshold for the exemption from land conversion tax for small and medium planters is raised from 1 to 2 hectares;
— the 5% surcharge on land transfer tax introduced in 2008 is removed; and
— a fixed fee of MUR 350,000 per hectare is levied on the transfer of land conversion rights between unrelated parties.

Other measures

(a)    Tax management
— the deadline for e-filing of tax returns is extended for 15 days; and
— small sugarcane farmers are not required to file an income tax return.

(b)    Company laww
The Trust Act is amended to allow unlimited duration for non-charitable purpose trusts.

(6)    Japan

Transfer pricing

In accordance with the amendments to the OECD Transfer Pricing Guidelines, the proposed amendment in the transfer pricing regime include:

— priority of methods adopted in calculating arm’s-length price;
— arm’s-length price range; and
— secret comparables.

Tax haven rules (CFC)

Under the proposal, there are amendments to:

— the effective income tax rates;
— the exemption conditions (Regional Headquarters Company);
— the calculation of aggregated income; and
— the passive income aggregation rule.

Foreign tax credits

Under the proposal, there are amendments to:
— the scope of foreign taxes;
— creditable foreign taxes;
— the scope of foreign source income; and
— the creditable limit of foreign taxes.

New special incentives for Comprehensive Investment Zones/Asian Base in Japan

(a)    Special incentives for Comprehensive Investment Zones

— A 50% initial depreciation or a tax credit of 15% of the acquisition costs of assets will be available for company conducting business as stipulated in International Strategy Special District Plan. This rule will be applied to assets acquired from the day the new regime become effective until 31st March 2014; or
— reduction of 20% taxable income for each fiscal year ending prior to the day five years from the day on which the designation was obtained.

A company will not eligible for both incentives at the same time.

(b)    Special incentives for Asian base in Japan

Under the proposal, to encourage foreign companies to set up a R&D centre or regional headquarters in Japan, Japanese subsidiary of a foreign company designated by competent ministers will enjoy the following incentives:

—    reduction of 20% taxable income which relate to such designated business for each fiscal year ending prior to the day five years from the day on which designation is obtained; and

— defer tax for income from excising stock option of a foreign parent company granted to the directors and employees.

(7)    Singapore

Budget for 2011 — Details

The Budget for 2011 was presented to the Parliament by the Finance Minister on 18th February 2011. Main details of the Budget, which unless otherwise indicated will apply from the year of assessment (YA) 2012, are summarised below:

Direct taxation

(a)    Corporate taxation

— for the YA 2011, companies with a 20% corporate tax rebate capped at SGD 10,000. Small and  medium-sized  enterprises  (SMEs)  will receive the higher of the 20% rebate or a cash grant  amounting  to  5%  of  the  company’s revenue, but capped at SGD 5,000. The cash grant  is  available  only  to  SMEs  that  made Central Provident Fund (CPF) contributions in YA 2011;
— a foreign tax credit (FTC) pooling system will be introduced, under which FTC is computed on a pooled basis for each particular stream of foreign income (FI) remitted into Singapore. The amount of FTC to be granted will be based on the lower of the pooled foreign taxes paid on the FI and the pooled Singapore tax payable on such FI, subject to the resident taxpayer meeting certain conditions;
— businesses can claim pre-commencement revenue expenses incurred in the accounting year immediately preceding the accounting year in which they earn the first dollar of trade receipts;
— the tax deduction of 250% on contributions to Institutions of Public Charter (IPCs) will be extended for another five years for donations made during 1st January 2011 to 31st December 2015;
— eligible   companies   that   make   voluntary contributions to the Medisave accounts of their self-employed person (SEP) partners from 1st January 2011 can deduct up to SGD 1,500 per SEP per year. The SEPs would be exempt from tax on these contributions;
— with effect from 1st April 2011, banks and other approved or licensed financial institutions will be exempt from withholding tax on interest and other qualifying payments made to all non-resident persons (excluding permanent establishments in Singapore), if the payments are made for the purpose of their trade or business; and
— companies that set up special purpose vehicles (SPVs) to acquire shares for their equity-based remuneration schemes can deduct the cost of the shares, subject to conditions.

(b)    Personal taxation
— a one-off personal income tax rebate of 20% that is capped at SGD 2,000 will be granted to all residents for YA 2011;
— taxpayers will be exempted from tax on alimony and maintenance payments they receive under a court deed or deed of separation;
— spouse relief and handicapped spouse relief will no longer be granted to taxpayers for maintaining their former spouses; and

(c)    Tax incentives
— various enhancements were made to existing incentives, such as:

  •     Productivity and Innovation Credit (PIC);
  •    Global Trader Program (GTP);
  •     Finance Treasury Centre (FTC);
  •     Captive insurance; and
  •     Marine insurance.

(8)    OECD

(i)    OECD — Report on disclosure initiatives for tackling aggressive tax planning released

On 1st February 2011, the OECD published a report on tackling aggressive tax planning through improved transparency and disclosure, which was prepared by the Aggressive Tax Planning Steering Group of Working Party 10 of the Committee of Fiscal Affairs (CFA).

The report was adopted by the CFA on 3rd January 2011 and outlines the importance of timely, targeted information to counter aggressive tax planning and provides an overview of disclosure initiatives introduced in some OECD countries.


(ii)    OECD — Transfer pricing aspects of intangibles — Scoping document released

On 25th January 2011, the Committee on Fiscal Affairs released the scoping document regarding its new project on the transfer pricing aspects of intangibles.

The work will focus on the following aspects:

— The development of a framework for analysis of intangible-related transfer pricing issues.
— Definitional aspects.
— Specific categories of transactions involving intangibles, such as research and development activities, differentiation between intangible transfers and services, marketing intangibles, other intangibles and business attributes.
— How to identify and characterise an intangible transfer.
— Situations where an enterprise would at arm’s length have a right to share in the return from an intangible that it does not own.
— Valuation issues.

The work is expected to lead to an update of the existing guidance on intangibles which is found in Chapter VI of the OECD Transfer Pricing Guidelines (TPG). In addition, a review will be carried out of the existing guidance in Chapter VIII of the TPG on Cost Contribution Arrangements, although the extent of any further work that might be needed on that chapter remains to be decided.

(9)    Miscellaneous

(i)    Austria — Ministry of Finance publishes Transfer Pricing Guidelines

On 28th October 2010, the Austrian Ministry of Finance published the Transfer Pricing Guidelines 2010; the first domestic transfer pricing guidelines ever published by the Ministry of Finance. The Guidelines deal with selected transfer pricing issues such as the methodology to be used, group internal financing, business restructuring and documentation requirements, but also with issues that are usually not directly linked to transfer pricing, such as permanent establishments, the Authorised OECD Approach and abuse of law by interposing companies.


(ii)    Treaty  between  Denmark  and  Luxembourg — Danish Tax Tribunal rules Luxembourg intermediary beneficial owner of Danish interest; Parent-Subsidiary Directive applies

On 17th November 2010, the Danish Tax Tribunal (Landskatteretten) published a decision (SKM 2010.729 LSR) and held that a holding company resident in Luxembourg was the beneficial owner of interest distributed by a holding company resident in Denmark. Details of the decision are summarised below.

Facts
A number of private equity funds and other investors acquired a Danish holding company (DK HoldCo) through a holding company resident in Luxembourg (Lux HoldCo). DK HoldCo distributed dividends to its parent company, Lux HoldCo. On the day of distribution of the dividends, Lux HoldCo granted two loans (one convertible loan and the other an ordinary loan) to DK HoldCo equal in amount to the distributed dividends. At the end of the income year in which the loans were granted, the convertible loan including the accrued interest, was converted into shares of DK HoldCo. In the following income year the ordinary loan, including the accrued interest, was also converted into shares of DK HoldCo. The Danish tax authorities concluded that the interest payments on the loans were subject to withholding tax, and required that the DK HoldCo should pay a withholding tax on the interests distributed to the Lux HoldCo, for two reasons:

—  Lux HoldCo was not the beneficial owner of the interest since (i) it did not carry out an active business but the holding of shares in
DK HoldCo, and (ii) had no real power to act regarding the disposition of the interest.

—  the  Interest  and  Royalty  Directive  (the Directive) does not prevent Denmark from levying withholding tax on the interests as the Directive only applies if the beneficial owner of the interests is a company or a permanent establishment resident in a Member State.

Legal background
Under the Danish law, interest paid to a foreign-related entity (i.e., an entity owning or controlling, directly or indirectly, more than 50% of the share capital or voting power in the company paying the interest) is subject to a withholding tax. No withholding tax is, however, levied if the withholding tax is reduced or abolished by a tax treaty or by the Directive. Under the Denmark-Luxembourg treaty (the Treaty), interests paid to a resident in the other contracting state can only be taxed in that other state if that resident is the effective beneficial owner of the interest [Art. 11(1)].

Issue
The issue was whether the Luxembourg holding company was the beneficial owner of the interest received from a Danish company, and subsequently qualified for the Treaty protection and/or protection under the Directive.

Decision
The Tax Tribunal emphasised, by referring to their earlier case law (see TNS:2010-04-23:DK-1), that a conduit company could only be disregarded as the beneficial owner of interest if the interest was redistributed. As the interest was not redistributed but converted into shares of the DK HoldCo, Lux HoldCo could not be regarded as a conduit company in respect of the interest. Thus, Lux HoldCo was held to be the beneficial owner of the interest under the Treaty and the Directive. The Tax Tribunal ruled in favour of the taxpayer and thereby overruled the decision made by the tax authorities.

Acknowledgment
We have compiled the above information from the Tax News Service of the IBFD for the months of October, 2010 to March, 2011.

Base Erosion and Profit Shifting (BEPS)

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Synopsis

Base Erosion and Profit Shifting (BEPS), a term coined by OECD, proposes 13 action plans to address important issues which the world is facing and/or may face in the field of international taxation and transfer pricing in this decade. BEPS refers to tax planning strategies that exploit gaps and mismatches in tax rules to make profits ‘disappear’ for tax purposes or to shift profits to locations where there is little or no real activity but taxes are low resulting in little or no overall corporate tax being paid. The learned authors vide this article provide insights on BEPS, its action plans and impact on India.

“Base Erosion and Profit Shifting” (BEPS) is a buzz term or expression these days in the arena of International Taxation. What is BEPS? Why do we need to study it? How does it affect us? Why G20 Nations vigorously pursue it? What is the role of OECD in BEPS? These and many other questions naturally arise in readers’ mind. This write-up attempts to put across the concept of BEPS and recent developments in this regard.

Introduction
Developments in national tax laws have not kept pace with developments in global businesses and technology. Physical presence based taxation in traditional ways is simply not adequate to cover all situations of business where the determination of source of income and the tax residence of an entity itself is a challenge. E-commerce or digital economy has changed the ways in which we used to transact businesses. Today, we live in a virtual global village. This, coupled with skewed development of the world economy, where developed countries are worried about the erosion in their tax base, whereas developing countries are more concerned about investments, technology and job creations, compel countries to adopt different tax systems or rules. Differences in tax systems pose challenges to Multi National Enterprises (MNEs) as well as provide an opportunity for tax planning. Proliferation of tax havens and low-tax jurisdictions over the past few decades have only helped MNEs to lower their tax incidence further.

In February 2013, OECD published its report ‘Addressing Base Erosion and Profit Shifting’ which has been a subject matter of much discussion on this topic.

BEPS
Base Erosion and Profit Shifting, (BEPS) in simple words means either erosion of base by claiming dubious allowances/deductions or shifting of profits from a high tax jurisdiction to a low tax jurisdiction/ tax haven by using gaps in the tax laws of the high tax jurisdiction. The FAQ on the OECD website on BEPS gives following meaning:-

“Base erosion and profit shifting (BEPS) refers to tax planning strategies that exploit gaps and mismatches in tax rules to make profits ‘disappear’ for tax purposes or to shift profits to locations where there is little or no real activity but the taxes are low resulting in little or no overall corporate tax being paid.”

Thus, BEPS poses serious questions concerning fairness and equity as MNEs are able to reduce their tax liability through various means, whereas individuals or SMEs (Small and Medium Enterprises) bear the brunt of higher taxes. This discourages voluntary compliance on the part of both individuals and SMEs.

It is said “tax” is an obligation in the home country and a cost in the host country. MNEs try to reduce cost to increase profitability. If MNEs pay the full rate of tax in one country, then also it may not be of much concern, but in reality “some multinationals end up paying as little as 5% in corporate taxes, when smaller businesses are paying up to 30%”. Even though MNEs may be resorting to legal ways to exploit gaps in tax systems of home and host countries, resulting in BEPS, it creates wider economic risks as resources of countries are depleted which may be used for generating employment and other social projects.

BEPS and OECD

BEPS is the result of aggressive tax planning. The OECD has been providing solutions to tackle aggressive tax planning for years. According to OECD, BEPS is not a problem created by one or more specific companies (barring some cases of blatant abuse of tax laws) but is a result of inefficient tax rules. BEPS is the result of gaps arising due to interaction of domestic tax systems of different countries and therefor, unilateral action by any one country will not be able to solve the problem. Therefore, OECD has put in place “BEPS Action Plan” with a view to provide a consensusbased plan to address the issue.

BEPS Action Plan by OECD

OECD’s Action Plan on BEPS will address the issue in a comprehensive and co-ordinated way. These actions will result in fundamental changes to the international tax standards and are based on three core principles, namely, (i) coherence (ii) substance and (iii) transparency. OECD plans to work towards elimination of double non-taxation through BEPS Action Plan and also elimination of double taxation through and including increased efficiency of Mutual Agreement Procedure (MAP) and Arbitration.





BEPS and G20 Nations

OECD’s initiative and work on BEPS has been strongly supported by G20 Nations. Key member countries of G20 which are not part of OECD (i.e. Argentina, Brazil, China, India, Indonesia, Russia, Saudi Arabia and South Africa) were also involved in work related to BEPS, as they all participated in the meeting of the Committee on Fiscal Affairs where the Action Plan was adopted. In order to facilitate greater involvement of non-OECD economies in the ‘BEPS Project’, G20 countries who are not OECD Members will participate in the BEPS project on an equal footing. Other non-G20 and non-OECD members may be invited to participate on an ad hoc basis. The idea seems to be to make the BEPS Action Plan as broad-based as possible so that the Plan becomes effective and practical. India is part of G20 Nations as well as an observer country at OECD and it has actively participated in BEPS Project so far.

BEPS and Double Non-taxation

Countries enter into bilateral agreements with each other in order to avoid double taxation of income and to prevent tax evasion. However, more often than not, MNEs are able to structure their affairs in a manner that the income is not taxed either in home or in a host country and goes totally taxfree resulting into “Double Non-taxation.” Double non-taxation could be a result of aggressive tax planning, hybrid mismatches etc. The focus of BEPS Project is on avoidance of double non-taxation. Double non-taxation may be a result of interaction of domestic tax laws and international tax laws. It may be perfectly legitimate as well. For example, a Mauritius Company deriving dividend income from India or earning capital gains on sale of securities in India would not be paying any tax in India and generally not taxed Mauritius. It would be interesting to see how BEPS Action Plan tackles such issues.

BEPS and India

In India whether tax treaties can result in ‘double non-taxation’  is  an  issue  debated  over  a  number of years. As stated earlier, tax can be a powerful tool for attracting foreign investments. India being a developing country, its priority is to attract for- eign investment and technology for its economic development.  Section  90  of  the  Income-tax  Act, 1961  [the  Act]  was  amended  vide  the  Finance Act,  2003  with  effect  from  1st  April  2004  to  pro- vide that the Central Government may enter into agreement with foreign governments to promote mutual economic relations, trade and investment. These  objectives  are  also  in  line  with  objectives of  bilateral  tax  conventions  as  laid  down  by  the United  Nations.

Keeping in mind the above objectives, it appears that India’s tax treaties with UAE, Malta, Kuwait, Cyprus, Luxembourg etc. have been entered for the purpose of attracting foreign investments than avoiding double taxation. In M.A. Rafik’s case AAR No. 206 of 1994, 213 ITR 317 which related to India- UAETax  Treaty,  the  Authority  for  Advance  Ruling (AAR) observed that “India is also in the process of looking out for foreign countries interested in investing  in  India  and  must  have  considered  the DTAA as providing an opportunity to improve the economic  relations  between  the  two  countries and to encourage the flow of funds from Dubai”. In  its  subsequent  Rulings,  applicability  of  India- UAE  Tax  Treaty  to  UAE  residents  was  upheld  by AAR.  The  Supreme  Court,  in  case  of  UOI  (Union of India) vs. Azadi Bachao Andolan (2003) 263 ITR 706, held that ‘the preamble to the Indo-Mauritius Double  Tax  Avoidance  Convention  (DTAC)  recites that it is for the encouragement of mutual trade and  investment’  and  this  aspect  of  the  matter cannot  be  lost  sight  of  while  interpreting  the treaty  provisions.  These  observations  were  very significant,  whereby  the  Apex  Court  upheld  the economic considerations as one of the objectives of  a  Tax  treaty.

The dissenting judgement by AAR in case of Cyril Pereira (1999) 239 ITR 650 stated that DTAA is not a  device  for  evasion  of  the  only  tax  imposed  by a  country  on  the  income  of  the  person  resident in the another country. In other words, provisions of  DTAA  cannot  result  in  Double  Non-Taxation. However, the said argument was discarded by the Supreme Court in its subsequent ruling in case of Azadi  Bachao  Andolan.  Recently,  the  Apex  Court in  case  of  Vodafone  followed  the  approach  of ‘look  at  rather  than  look  through’  any  transaction  and  interpreted  provisions  of  the  Income Tax  Act  more  liberally  in  favour  of  the  taxpayer. In  essence,  it  gave  weightage  to  the  ‘form’  of  a transaction/entity  rather  than  ‘substance’of  it.  In India, presently, the issue under debate is ‘whether one  needs  to  look  at  the  moral  aspects  while interpreting  tax  laws’.  The  opinion  seems  to  be divided  on  the  issue.

Coming to the trends in the Indian tax treaties, we find India encouraged tax sparing/exemption method by its treaty partner countries (developed nations) in respect of income arising to their resi- dents in India. This was done keeping in mind, that India is a net capital importing country. However, there is a perceptible change in India’s recent tax and treaty policy. India has introduced Article on Limitation of Benefits (LOB) in many of its tax treaties (for e.g. UAE, Singapore, etc.) to prevent their abuses. It is gathered that India is in the process of signing LOB articles with many other countries. Recently, India notified Cyprus as a non co–operative jurisdiction denying treaty benefits to residents of Cyprus. Recent tax treaties signed by India do not carry provisions of Tax sparing.

On  the  domestic  tax  front,  India  amended  the definition  of  section  9  of  the  Act,  pertaining  to royalty  with  retrospective  effect  from  1st  June 1976  to  bring  in  ‘computer  software’  within  its ambit.  It  further  amended  the  definition  of  section 9 to tax the indirect transfer of shares where the underlying value of shares were derived from the  assets  situated  in  India(to  nullify  the  effect of Vodafone decision). India has tightened its tax policy of giving effect to tax treaties by providing mandatory  submission  oftax  residency  certificate for  claiming  treaty  benefits.  Section  206AA  has been  introduced  making  it  mandatory  to  obtain PAN  by  non-residents.  The  domestic  tax  rate  for royalty  and  FTS  is  substantially  increased  from 10  %   to  25  %.  India  proposes  to  introduce  GAAR provision with effect from 1st April 2016. From the above discussion, one can conclude that the Indian Government  has  taken  several  steps  to  prevent BEPS. However, Indian judiciary have been liberal in  giving  benefit  to  the  tax  payers  for  what  may be  called  permissible  tax  avoidance  within  four corners  of  the  law.

Conclusion
There is no doubt that BEPS is not good for any country. However, as pointed out by OECD, BEPS arises due to a variety of reasons and often, unintentional and/or due to legitimate tax planning. When developing countries resort to lower tax rates to attract foreign investment and technology, they are blamed to be supporting BEPS. On the other hand, certain low tax jurisdictions or so called tax heavens, are ruled by Developed Countries. Advocating home truths but not implementing the same in letter and spirit, is self-defeating and cannot promote a healthy order of growth and development.

Perhaps, we have to strike a balance between growth and taxation.

International Ruling — An Indian Perspective

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Dell Products (NUF) v. Tax East (12 ITLR 829) (Oslo District Court of Norway)

Facts of the case

A US multinational corporation manufactured and sold computers, etc. In the Norwegian market, its products were sold through an indirectly owned subsidiary (Norway Co.), which acted as a commissionaire for the Irish group company (Ireland Co.).

Tax audit was carried out by Norwegian Tax Authorities on Norway Co. At the time of the audit, Ireland Co. had no employees, but procured all necessary services from another group company in Ireland.

Norway Co. had a margin of about 1% of the turnover in the years that were covered by the tax audit. All agreements with customers were concluded on standard terms and conditions set out by Ireland Co. Ireland Co., as the principal, prepared marketing strategies, had access to the products, was responsible for the freight and logistics, customer followup, technical assistance, administrative tasks, etc. Ireland Co. did not regard itself as taxable in Norway and therefore did not report any income to Norwegian tax authorities. After the tax audit of Norway Co.,

Ireland Co. was considered to have a permanent establishment (PE) in Norway.

A schematic representation of arrangement is as follows:


Issues involved

  •  Whether the expression ‘authority to conclude contracts in the name of the enterprise’ in English version of tax convention between Ireland and Norway or the expression ‘authority to conclude contracts on behalf of the enterprise’ in the Norwegian version requires that the contract entered into by an agent is ‘legally binding’ on the principal or it is sufficient that the contract ‘in reality binds the agent’ to trigger Agency PE?

  •  Whether Norway Co. was a dependent agent of Ireland Co.?

  •  If there is an agency PE, what is the profit attributable to the PE? Relevant provisions in the Double Tax Avoidance Agreement (DTAA) The relevant Article of Ireland-Norway DTAA was based on OECD Model. Article 5(5) of the OECD Model reads as follows: “Notwithstanding the provisions of paragraphs 1 and 2, where a person — other than an agent of an independent status to whom paragraph 6 applies — is acting on behalf of an enterprise and has, and habitually exercises, in a Contracting State an authority to conclude contracts in the name of the enterprise, that enterprise shall be deemed to have a permanent establishment in that State in respect of any activities which that person undertakes for the enterprise, unless the activities of such person are limited to those mentioned in paragraph 4 which, if exercised through a fixed place of business, would not make this fixed place of business a permanent establishment under the provisions of that paragraph.”

The Norwegian version of DTAA uses the expression ‘authority to conclude contracts on behalf of the enterprise’ instead of ‘an authority to conclude contracts in the name of the enterprise’ as used in the English version. Main contentions of the taxpayer For the condition of Agency PE to be satisfied, the contract must be legally binding on the principal. If it is not legally binding, it cannot be regarded as concluded on behalf of or in the name of the principal. Under the civil law of the UK, an agent could legally bind the principal, regardless of the fact whether contract was entered in the name of principal or not.

To clarify that such agents were covered, a paragraph 32.1 was added in OECD Commentary to the effect that the paragraph applies equally to an agent who concludes contracts which are binding on the principal even if those contracts are not in the name of the principal. This supports the argument that the phrase ‘authority to conclude contracts in the name of the enterprise’ only means that it must be legally binding on the principal.

However, under Norwegian law, an agent cannot enter into contracts that are binding on the principal. This was also a term in the contract between Ireland Co. and Norway Co. that Ireland Co. is not bound towards Norway Co.’s customers and hence, conditions of agency PE are not satisfied. Since Ireland Co. is an empty company, it cannot instruct and control Norway Co.

Control as a result of group connection, board representation, daily management, and integrated accounting system is not relevant for determining dependency. The agency contract states that the agent is an ‘independent contractor’, neither party shall have the power to direct or control the daily activities of the other and that Norway Co. is free to involve itself in contracts with other parties. Norway Co. also sells additional products from other supplier/s.

Main contentions of tax authority

Under Vienna Convention of Law of Treaties, a purposive interpretation should be given to tax conventions.

OECD Commentary is important for interpretation since Ireland-Norway DTAA is modelled on the lines of OECD. The expression ‘on behalf of’ in Norwegian text or the expression ‘to conclude contracts in the name of enterprise’ in the English text does not indicate that contract should be legally/statutorily binding on the principal. One should interpret the phrase having regard to its functional impact. Since agent draws the principal into the national economy of Norway, it should be taxed in Norway.

OECD Commentary also supports functional interpretation when it states in para 32 that agent must involve the principal to a particular degree in the country concerned for trigger of permanent establishment. The addition of paragraph in OECD Commentary should not be looked as a consequence of difference between common law and civil law of the UK.

The phrase ‘in the name of’ should not be interpreted strictly, but one must understand it as synonymous with ‘on behalf of’. A substance over form approach must be adopted. The decisive factor is whether the agent in reality binds the principal. An internal administrative circular by the Ministry of France also asserts that one has an agency structure where the agent in reality binds the principal.

The following factors show that Norway Co. was binding Ireland Co. in reality

  •  All sales took place under the brand name of Ireland Co. without showing that Ireland Co. was not behind the sales.

  •  A large number of contracts entered into took place on standard conditions within detailed limits where Ireland Co. could not refuse to meet its obligation.

  •  Sales on conditions other than standard terms could be made only with prior approval of Ireland Co.

  •  In practice, Ireland Co. did not review the contract entered into by Norway Co.

  •  here was no instance demonstrated by Ireland Co. where sale undertaken by Norway Co. was not approved by Ireland Co. Norway Co. was a dependent agent of Ireland Co. on account of the following factors

  •  Norway Co. was subject to Ireland Co.’s instruction and control.

  •   Norway Co. could only sell allowed products on approved contract conditions and at fixed prices terms of which were fixed by Ireland Co.

  •  There was an overlap of board members and management of Norway Co. and Ireland Co.

  •  There was an integrated accounting system which gave Ireland Co. full insight into Norway Co.’s financial status.

  •  Ireland Co. had access to Norway Co. premises under the agency contract.

  •   Norway Co. acted only for one principal as an agent. Though, formally under the contract, Norway Co. was not prevented from entering into contract with outsiders, in reality it was so prevented.

  •     Sale of third-party products was marginal.


High Court Ruling

On the question of PE

The wordings of the Norwegian and English texts are reasonably open and the wordings in itself do not provide a basis for concluding the matter.

Para 32.1 of the OECD Commentary reads as fol-lows:

“32.1 Also, the phrase ‘authority to conclude contracts in the name of the enterprise’ does not confine the application of the paragraph to an agent who enters into contracts literally in the name of the enterprise; the paragraph applies equally to an agent who concludes contracts which are binding on the enterprise even if those contracts are not actually in the name of the enterprise. Lack of active involvement by an enterprise in transactions may be indicative of a grant of authority to an agent. For example, an agent may be considered to possess actual authority to conclude contracts where he solicits and receives (but does not formally finalise) orders which are sent directly to a warehouse from which goods are delivered and where the foreign enterprise routinely approves the transactions.”

While the latter part of the first sentence in the OECD Commentary reading ‘the paragraph applies equally to an agent who concludes contracts which are binding on the enterprise even if those contracts are not actually in the name of the enterprise’ in the OECD Commentary supports the appellant, the third sentence (namely, lack of active involvement of principal being indicative of agent’s authority) and the example following it reading ‘For example, an agent may be considered to possess actual authority to conclude contracts where he solicits and receives (but does not formally finalise) orders which are sent directly to a warehouse from which goods are delivered and where the foreign enterprise routinely approves the transactions’, support tax authority’s contention that it is sufficient that the contract is binding on the principal in reality. Commentaries by authors Avery Jones & Skaar also support this interpretation.

The purpose of the agency rule is to avoid eva-sion of tax obligation. The presence of a local representative within defined characteristics is at par with a business through permanent establishment. In order to realize this purpose one must look at the realities in the relationship between the agent and principal. It is sufficient that the agent effectively binds the principal.

Accordingly, the Court held that there is an agency PE and for this purpose, the Court noted as follows:

  •     Norway Co. enters into contracts directly with the Norwegian customers and sells Dell Products to them.

  •     The sales take place within clear guidelines for the activity and authority.

  •     It is absolutely unthinkable that Ireland Co. would change a signed customer contract in Norway between Norway Co. and the customer, and factually, also this has not happened.

  •     The formal organisation of the sale through an agency relationship where the agent may not be able to bind the principal formally (either according to an agency contract or according to the applicable Agency Act) cannot be the only decisive factor in evaluation of emergence of a permanent establishment.

On the question of independence

Independence is a fact-based exercise to be examined applying same criteria as applicable to unrelated parties. The fact that there is an overlap of board members and management is not in itself a decisive factor.

However, in the present facts, Norway Co. was financially and legally dependent on Ireland Co. in view of the following factors:

  •    Norway Co. could not have existed without right to sell.

  •    Norway Co. could only sell permitted products on standard terms and conditions and at fixed prices — all provided by Ireland Co. as the principal.

  •    Norway Co. did not have an independent accounting system and the principal had full access to Norway Co. accounts.
  •     In terms of the Commissionaire Agreement, Ireland Co. had access to Norway Co.’s premises.
  •     Norway Co. acted as commissionaire for only one principal, namely, Ireland Co.
  •     Third-party sale was marginal.
  •     The provisions in the agency contract that the agent shall act as an independent party and that none of the parties shall be able to control one another, were self-proclaimed paper provisions which did not reflect reality of conduct between the parties.

On apportionment
The main rule for attribution of PE profit is the direct method indicated in Article 7(2). This entails that the permanent establishment shall be viewed as an entirely independent enterprise which carries out the same activity under the same conditions. Thereafter, on principle, each individual item of income and expense has to be evaluated and view needs to be taken to decide whether it can be attributed to PE.

However, Article 7(4) also allows use of indirect method (formulary approach) where total result of the enterprise between the head office and establishment is apportioned by adopting relevant allocation key (e.g., turnover, income, expenses, number of employees and capital structure).

When separate accounts are not kept for the Norwegian activity, it will not be possible to apply the direct method. The company’s function, business equipments and risk connected to the permanent establishment need to analysed. Nor-wegian tax authorities must then undertake an estimation based on these parameters, and decide a part of the profits that shall be attributed to the permanent establishment.

This estimation lies outside the Court’s authority for judicial review as long as the estimation is not unjustifiable or extremely unreasonable. The Court has no reason to see that this is the case.

The taxpayer’s argument that a large part of the value creation takes place outside Norway as Ire-land Co. undertakes market analysis, etc. is duly considered in apportionment of 60% of the profits to Norway and 40% to Ireland.

Since the main part of the income from sales of the products in Norway is generated in this country, and since the tax authorities have attributed to Ireland Co. (which does not even have employees) with 40% of the profits, apportionment method adopted by the lower authorities is irrefutable.

The Court is in agreement with the tax authority that there is no requirement for an evaluation to be undertaken of whether income from commission is market related — and in that case no further apportionment of the profits can be made to Norway.

Indian perspective
Substance over form

The High Court observed that in deciding whether there is an agency PE or not, one must look at the realities in the relationship between the agent and principal and it is sufficient that the agent effectively binds the principal. The Court also observed that the provision in the contract that the agent shall act as an independent party and that none of the parties shall be able to control one another was a pure paper provision which did not express reality between the parties.

The aforesaid observations are in line with the Indian judicial trend, a summary of which is given below:

?    ACIT v. DHL Operations BV (2005) 142 Taxman 1 (Mum.) (Mag) — The Tribunal observed that in determining agency relationship one has to consider the substance of the agreement between the parties rather than its form.

?    The verification of participation in the conclusion of contracts must not only be conducted from the formal standpoint, but also from a substantial standpoint [ABC, In re (2005) 274 ITR 501 (AAR) citing Ministry of Finance v. Phillip Morris GmbH 4 ITLR 903 (Supreme Court of Italy)].

?    An agency-principal relationship may be con-stituted notwithstanding

(a)    Denial of agency in the agreement [Morgan Stanley & Co., In re (2006) 284 ITR 260 (AAR); Galileo International Inc. v. DCIT, (2009) 116 ITD 1 (Del.) para 17.3].

(b)    Description in the agreement as independent contractor [ABC, In re (2005) 274 ITR 501 (AAR), para 16].

(c)    Provision in the agreement that neither party has any authority to bind or to contract in the name of the other [ABC, In re (2005) 274 ITR 501 (AAR), para 16; Morgan Stanley & Co., In re (2006) 284 ITR 260 (AAR)].

(d)    Description in the agreement as independent consultant and not an employee of the com-pany [Sutron Corpn., In re (2004) 268 ITR 156 (AAR), para 13].

(e)    Specification in the agreement that services would be rendered on a principal-to-principal basis [ACIT v. DHL Operations B.V. (2005) 142 Taxman 1 (Mum.) (Mag), para 33].

  •     The question (regarding agency PE) must be decided not only with reference to private law but must also take into consideration the actual behavior of the contracting parties. An approach relying solely on aspects of private law (the law of contracts) would make it easily possible to prevent an agent from being deemed a PE even where he is engaged most intensively in the enterprise’s business [Prof. Klaus Vogel in Treatise on Double Taxation Convention cited in Motorola Inc. v. DCIT, (2005) 95 ITD 269 (Del.) (SB), para 132].

  •    There is an agency PE if despite specific terms of contract, agent habitually concludes contracts on behalf of the principal without any protest or dissent from the principal. If the agent habitually exceeds his authority and concludes contracts, such ‘illegal’ exercise should be regarded as an approval by the principal on account of its conduct and the agent should be deemed to have the authority [TVM Ltd., In re (1999) 237 ITR 230 (AAR), para 14, 16].

  •    Amadeus Global Travel Distribution S.A. v. DCIT, (2008) 113 TTJ 767 (Del.) — The Tribunal held “The phrase ‘authority to conclude con-tracts on behalf of the enterprise’ does not confine to application of para 4 to an agent who enters into contract literally in the name of the enterprise. The para applies equally to an agent who concludes contracts which are binding on the enterprise even if those contracts are not actually in the name of the enterprise. Lack of activity involved by the enterprise in the transactions may suggest of an authority being granted to the agent.”

  •    Jebon Corporation India Liaison Office v. CIT, (2010) 125 ITD 340 (Bang.) — In this case, based on peculiar facts, the Tribunal held that the activities carried on by the Liaison Office (LO) were not confined to liaison work, but LO was actually carrying on commercial activities of procuring purchase orders, identifying the buyers, negotiating with the buyers, agreeing to the price, thereafter requesting them to place a purchase order and to forward the same to HO. Material was then dispatched to cus-tomer and then LO followed up with customer regarding the payments and also offerred after sales service. Tribunal further held that “merely because the buyers place orders directly with the Head Office and make payment directly to the Head Office and it is the Head Office which directly sends goods to the buyers, would not be sufficient to hold that the work done by the liaison office is only liaison and it does not constitute a permanent establishment as defined in Article 5 of DTAA.”

The High Court, affirming the above decision of the Tribunal observed — “Once the material on record clearly established that the liaison office is undertaking an activity of trading and therefore entering into business contracts, fixing price for sale of goods and merely because the officials of the liaison office are not signing any written contract would not absolve them from liability.”

Dependent agent

One of the facts which influenced the Court in holding that Norway Co. was a dependent agent of Ireland Co. was that though, formally in terms of agency contract Norway Co. was not prevented from entering it to contract with outsiders, in reality it was so prevented and it acted as an agent for only one principal. Again, it could sell permitted products only on standard terms and conditions and at fixed prices, provided by Ireland Co.

Some of the Indian precedents which have consid-ered such features in connection with independent agent are as follows:

  •    In Dassault Systems KK, In re 2010 TIOL 02 ARA-IT, in determining economic dependence, the AAR was influenced by the fact that the number of principals were more than one.

  •     An agent could be dependent notwithstanding a resolution by the board of directors that the company can deal with third parties, when otherwise the company was legally and economically dependent only on one enterprise from whom it earned its entire revenue [Morgan Stanley & Co., In re (2006) 284 ITR 260 (AAR)].

  •     Brokers and bankers in India through whom an FII, a non-resident, carried on transactions on stock exchanges in India were agents of independent status vis-à-vis the FII [Morgan Stanley & Co. International Ltd., In re (2005) 272 ITR 416 (AAR), para 11].

  •     A custodian in India, which was providing custodial services to an FII, a non-resident and also a number of other local and international companies on a routine basis was an independent agent, both legally and economically vis-à-vis the FII [Fidelity Advisor Services VIII, In re (2004) 271 ITR 1 (AAR), para 23 ].

  •     K, an Indian company, was engaged in pro-moting professional examinations/certification programmes of foreign institutes, societies, professional bodies, etc. of international repute. K signed or was in the process of signing agreements with US non-profit-making bodies (foreign entities) for conducting certification programmes. K was to collect registration forms and fees from individuals in India, who wished to register themselves for the examinations; and pass them on to the foreign entity after deducting its administrative cost and commission. The foreign entity would conduct examinations either through K or through other entities in India. The evaluation of answer sheets and award of certificates was to be done by foreign entities who would also send certificates to K for local distribution to the successful candidates. The Authority observed that there was no financial, managerial or any other type of participation between K and foreign entities. K carried on a variety of is activities besides promoting examinations of foreign entities. It had engaged itself into business relationship with foreign entity and was in the process of forging such relationship with other foreign entities it was open for K have such relationship with other foreign entities. He was not subject to any control of foreign entity with regard to the manner in which it will carry out its activities with regard to promotion of the examinations. On these facts, the Authority held that K was enjoying an independent status [KnoWerX Education (India) (P) Ltd., In re (2008) 301 ITR 207 (AAR)].

Profit attributable to the PE

The High Court observed that direct method of apportionment cannot be applied since no separate accounts are kept by Ireland Co. in respect of Norwegian activity. Therefore, apportionment of profits should be based on an indirect method. The Court also observed that there is no requirement for an evaluation to be undertaken on whether income from commission is market related and in that case no further apportionment of profits can be made to Norway. However, unfortunately, the Court did not provide any reasoning behind this observation.

It is pertinent that the Court rejected application of direct method of apportionment since no separate accounts were maintained, and it was not possible to conduct FAR analysis (functions performed, assets used and risks assumed), which the Court held was an essential requirement for application of direct method of apportionment. Likewise, for evaluation as to whether commission is market related, it is necessary to conduct FAR analysis, which perhaps, the Court felt that was not possible. Hence, it may perhaps be on account of the feature that the aforesaid observations relevant evaluation of commission were made and not as a general proposition of law.

However, if the observations are read to mean that the Court held that payment of commission at ALP to agent would not exhaust further apportionment of profit, then it deviates to that extent from the Indian position. In DIT v. Morgan Stanley & Co., (2007) 292 ITR 416 (SC), it was observed that if a PE is remunerated on arm’s-length basis (ALP) taking into account all the risk-taking functions of the enterprise, then there is no further requirement to attribute profit. The Supreme Court further observed that if transfer pricing analysis does not adequately reflect the functions performed and risks assumed by the enterprise, then in such situation, there would be a need to attribute further profits to PE.

The Supreme Court decision was explained in eFunds Corporation v. ADIT, (2010) 42 SOT 165 (Del.) and Rolls Royce Plc v. DDIT, (2009) 34 SOT 508 (Del.). The Tribunal, after taking note of the Supreme Court observations, stated that the as-sessment of PE gets extinguished only if the following two conditions are cumulatively met:

(i)    The associate enterprise has been remunerated on arm’s-length basis and

(ii)    Having regard to FAR analysis, nothing more can be attributed to PE.

Both the decisions of Tribunal observe, if remuneration to the agent does not take into account all the risk taking functions of the non-resident enterprise, then in such case there would be a need to attribute profits to the PE for those functions/risks of principals which are not covered by the agent’s remuneration.

Recent Global Developments in International Taxation — part I

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In this Article, we have given brief information about the recent global developments in the sphere of international taxation which could be of relevance and use in day-to-day practice and which would keep the readers abreast with various happenings across the globe in the arena of international taxation. We intend to keep the readers informed about such developments from time to time in future.

(1) Australia

(i) Federal Court holds non-resident manager of portfolio of Australian shares for non-resident companies liable to tax in Australia

The Federal Court on 8th September 2010 handed down a decision in Leighton v. FCT, (2010) FCA 1086 that dealt with taxation in Australia of a non-resident manager who was managing a portfolio of Australian shares for two non-resident companies.

Briefly, Mr. Leighton was, during the relevant period, a resident of Monaco and was not a resident of Australia. He was engaged by two companies, who were not tax resident in Australia and were incorporated in the British Virgin Islands and the Bahamas, to manage a portfolio of Australian shares for them and to provide other services incidental to the management services. Mr. Leighton opened a bank account in Australia and engaged a number of Australian brokers and an Australian custodian. The trading instructions were given by Mr. Leighton, on behalf of the two companies, from Monaco. The trading activities generated taxable income during the relevant period.

Non-residents are subject to tax in Australia only on income sourced in Australia. The judgment does not discuss whether the relevant income has a source in Australia and, presumably, assumes that it does.

After considering the facts, the judgment concludes that Mr. Leighton, in acting as a manager, was, during the relevant period, a trustee of a trust for the non-resident companies as beneficiaries. As such, he is liable for tax for the taxable profits under former section 98(3) of the Income Tax Assessment Act, 1936.

(ii) Treaty between Australia and US: US LLC disregarded under treaty

The Australian Taxation Office released Interpretative Decision ATO ID 2010/188 that confirms that:

— A limited liability company (LLC) incorporated in the United States that has a single owner and is disregarded as an entity separate from the owner for the US tax purposes, is not a resident of the US under the tax treaty between Australia and the US.

However, — where the single owner is a treaty resident of the US, it may be entitled to benefits under the treaty in respect of income derived by the LLC.

(iii) ATO rules on private equity investments into Australia: revenue/capital distinction; treaty shopping; source rules; treaty protection

On 11th November 2010, the Australian Taxation Office (ATO) released two final determinations and two draft determinations that deal with taxation of private equity investments into Australia.

Two final determinations were released in draft in 2009 after an unsuccessful attempt by the ATO to collect AUD 678 million in tax and penalties from the TPG Group in respect of the listing of the Myer group in Australia. By the time the ATO issued the assessments, the funds had left Australia. It has been reported that the ATO has yet to collect the outstanding debt.

(iv) Foreign Managed Fund Exemption announced

The Assistant Treasurer announced that taxation law will be amended to implement a new foreign managed fund exemption. The exemption, called the Investment Manager Regime, is intended to apply to investment income of foreign managed funds that is attributable to a permanent establishment in Australia arising from the activities in Australia of a dependent agent of the fund.

It appears that the exemption will apply to tax treaty investors only. Fund management fees will continue to be subject to tax in Australia.

(v) Taxation of trusts clarified by Federal Court

The Federal Court handed down a decision in Colonial First State Investments Limited v. FCT, (2011) FCA 16 that deals with taxation of net income of unit trusts. Specifically, the judgment deals with the effect of a change in a trust deed on the income of beneficiaries of the trust in case of redemption of units. The changes of the deed were affecting both redeeming and remaining unit holders.

(vi) Non-resident may be required to withhold income tax, FBT

The Australian Taxation Office released Taxation Determination TD 2011/1 that expresses a view that where a non-resident entity pays an Australian resident for work performed overseas, the nonresident entity may be required to withhold income tax under the Pay-As-You-Go (PAYG) provisions and become subject to Fringe Benefits Tax (FBT) if the non-resident entity has a sufficient connection with Australia, such as, for example, a physical presence in Australia.

The Taxation Determination also states that if the foreign entity does not have PAYG obligations, it will not be subject to FBT.

(vii) Final ruling on business restructures and transfer pricing released

The Australian Taxation Office (ATO) has released Taxation Ruling TR 2011/1, which deals with the application of domestic transfer pricing provisions and Australian tax treaties to business restructuring. The ruling was previously released as Draft Taxation Ruling TR 2010/D2 and expresses a view that in applying to business restructuring arrangements, both domestic transfer pricing provisions and associated enterprises articles of Australia’s tax treaties require following the arm’s-length principle and therefore the 3-step process adopted by the ATO to transfer pricing analysis should equally be applied to business restructuring.

(viii) NDF execution is not trading in currency

The Australian Taxation Office (ATO) released an Interpretative Decision (ID) ATO ID 2011/27 stating that execution of non-deliverable forwards (NDF) is not trading in currency or rights in respect of currency.

In reaching this decision, the ATO noted that NDSs are very similar to wagering contracts and relied on an 19th century judgement for a definition. Further, the connection with the reference currency is too remote for an NDF to confer a right in respect of a currency.

The implication of this ID would be that income from executing NDFs with residents would not qualify for a reduced income tax rate of 10% under the Offshore Banking Unit (OBU) rules.

(ix) Final ruling on interaction of thin capitalisation and transfer pricing rules issued

The Australian Taxation Office (ATO) released final ruling TR 2010/7 on the interaction between the transfer pricing and thin capitalisation provisions. The ruling was previously released in draft as TR 2009/D6 (see TNS: 2009-12-21: AU-2), and was not substantially changed from the earlier draft ruling.

Briefly, the ATO expresses a view that the transfer pricing provisions may apply to a loan that satisfies the safe harbour test under the thin capitalisation provisions. As such, loans should be priced based on commercially realistic outcome. This may include consideration of parental affiliation, as well as other circumstances of the parties (including, for example, the ability of the borrower to borrow from unrelated third parties or prevailing market and economic conditions).

The ruling has retrospective application.

(2) United States

(i) Small Business Jobs Act of 2010 signed

President Obama signed the Small Business Jobs Act of 2010 (H.R. 5297) into law on 27th September 2010. Significant business tax measures of the Act are summarised below.

— The Act temporarily excludes 100% of the gain from the sale of qualified small business stock held at least five years.

— The Act extends the carryback period for eligible small business credits from one year to five years.

— The Act allows eligible small business credits to offset both regular and alternative minimum tax liability.

—  The Act temporarily reduces the recognition period to five years for built-in gains of Sub-chapter S corporations that convert from prior Subchapter C status.

— The Act increases the maximum amount a taxpayer may elect to deduct in connection with the cost of qualifying section 179 property placed in service in 2010 and 2011 to USD 500,000. The maximum amount is phased out by the amount by which the cost of qualifying property exceeds USD 2 million. The Act temporarily expands the definition of qualifying section 179 property to include certain real property, i.e., qualified leasehold improvement property, qualified restaurant property, and qualified retail improvement property. The maximum amount of deduction for such real property is USD 250,000.

— The Act extends the additional first-year depreciation deduction which is allowed equal to 50% of the adjusted basis of qualified property placed in service through 2010.

—  The Act increases the maximum amount that a taxpayer may deduct in connection with trade or business start-up expenditures from USD

5,000 to USD 10,000. The maximum amount is phased out by the amount by which the cost of start-up expenditures exceeds USD 60,000, increased from USD 50,000.

— The Act revises the penalties that may be imposed for failure to disclose a reportable transaction to the IRS.

— The Act allows self-employed individuals to deduct the cost of health insurance for themselves and their spouses, dependents, and any children under age 27 for purposes of the social security and Medicare taxes imposed by the Self-Employment Contribution Act (SECA).

— The Act removes cell phones and similar telecommunications equipment from the definition of listed property so that the heightened sub-stantiation requirements and special depreciation rules do not apply.

— The Act imposes the same information reporting requirements (i.e., IRS Form 990-MISC) on tax-payers who are recipients of rental income from real estate as are imposed on taxpayers engaged in a trade or business, with a few exceptions.

— The Act treats as US-source income amounts received, whether directly or indirectly, from a non-corporate US resident or a US domestic corporation for the provision of a guarantee of indebtedness of such person.

— The Act increases the amount of the required estimated tax payments otherwise due by large corporations in July, August, or September, 2015, by 36 percentage points.

A complete description of the provisions of the Act is included in the technical explanation prepared by the US Joint Committee on Taxation (JCX-47-10). The White House also issued a press release with a summary of the principal business provisions that are included in the Act.

(ii)    IRS confirms withdrawal of proposed trans-fer pricing regulations on controlled services transactions and intangibles

The US Internal Revenue Service (IRS) has issued Announcement 2010-60 confirming its withdrawal of proposed regulations issued on 10 September 2003 regarding the treatment of controlled services transactions and the allocation of income from intangibles u/s. 482 of the US Internal Revenue Code.

The proposed regulations were withdrawn due to the subsequent issuance of final regulations on these topics on 4th August 2009.

The withdrawal was previously announced on 7th September 2010 in the US Federal Register. For a report, see TNS: 2010-09-09: US-1.

(iii)    IRS announces non-acquiescence in VERITAS transfer pricing case

The US Internal Revenue Service (IRS) has issued an Action on Decision (AOD) announcing that it does not acquiesce in the result or the reasoning of the US Tax Court’s decision in VERITAS Software Corporation and Subsidiaries v. Commissioner of Internal Revenue, 133 T.C. No. 14 (Docket No. 12075-06, 10 December 2009), reported in TNS: 2009-12-21: US-1.

(iv)    Guidance issued on FTC splitting transactions

The US Treasury Department and Internal Revenue Service (IRS) have issued Notice 2010-92 (the Notice) with guidance on foreign tax credit (FTC) splitting transactions. These are transactions in which the FTC is separated (i.e., split) from the associated foreign income and claimed by a US taxpayer prior to the tax year in which such income is subject to tax in the United States.

(v)    Proposed regulations extend reporting re-quirements for US bank interest paid to all non-residents

The US Treasury Department and the Internal Revenue Service (IRS) have issued proposed regulations u/s. 6049 of the US Internal Revenue Code (returns regarding payments of interest). The proposed regulations provide guidance on the information reporting requirements for interest paid to non-resident individuals on deposits maintained at US offices of specified financial institutions.

The regulations are proposed to be effective for payments made after 31st December of the year in which the regulations are adopted as final.

The US Treasury Department and the IRS have requested comments on the regulations and a public hearing is scheduled for 28th April 2011.

(vi)    US Treasury Department reissues list of boycott countries that result in restriction of US tax benefits

The US Treasury Department has reissued its list of the countries that require cooperation with or participation in an international boycott as a condition of doing business. The countries listed are Kuwait, Lebanon, Libya, Qatar, Saudi Arabia, Syria, the United Arab Emirates and the Republic of Yemen. The Treasury Department stated that Iraq was not included in the list but that its future status remained under review. The list is dated 19th January 2011 and was published in the Federal Register on 28th January 2011. The new list is unchanged from the list issued on 23rd November 2010.

(vii)    IRS issues updated Publication 514 — Foreign Tax Credit for Individuals

The US Internal Revenue Service (IRS) has released the 2011 revision of Publication 514 (Foreign Tax Credit for Individuals). The Publication is dated 27th January 2011 and is intended for use in preparing 2010 tax returns.

(viii)    IRS announces 2011 offshore voluntary disclosure initiative

The US Internal Revenue Service (IRS) has announced a second special voluntary disclosure initiative designed to bring offshore money back into the US tax system and help people with undisclosed income from hidden offshore accounts get current with their taxes (News Release IR-2011-14). The new initiative, called the 2011 Offshore Voluntary Disclosure Initiative (OVDI), is available through 31st August 2011.

Taxpayers participating in the 2011 OVDI must file all original and amended tax returns and pay back-taxes and interest for up to eight years as well as accuracy-related and/or delinquency penalties by the deadline.

The overall penalty structure for the 2011 OVDI is higher than the 2009 Offshore Voluntary Disclosure Program. As a result, taxpayers who did not come forward through the 2009 OVDP, which ended on 15th October 2009, will not be rewarded for procrastinating.
    
The 2011 OVDI imposes a 25% penalty on the amount in the foreign bank accounts in the year with the highest aggregate account balance between 2003 and 2010. Taxpayers in limited situations may be eligible for lower penalties of 5% or 12.5%.

A taxpayer can qualify for a 5% penalty if the taxpayer meets all the following cumulative conditions:

—  the taxpayer did not open the account;

— the taxpayer has exercised minimal and infrequent contact with the account;

— the taxpayer has not withdrawn more than USD 1,000 from the account in any year covered by the 2011 OVDI; and

— the taxpayer can establish that all applicable US taxes have been paid on funds deposited to the account.

The 5% penalty also applies to taxpayers who are foreign residents and who were unaware they were US citizens.

Taxpayers whose offshore accounts or assets did not exceed USD 75,000 in any calendar year covered by the 2011 OVDI can qualify for a 12.5% penalty.

According the IRS News Release, taxpayers hiding assets offshore who do not come forward will risk far higher penalties as well as the possibility of criminal prosecution.

The IRS has also launched a new section on its website (www.IRS.gov) that contains the full terms and conditions of the 2011 OVDI, including:

— an extensive set of Q&A’s for frequently asked questions and answers;

— the procedures for a voluntary disclosure, including contact points and mailing addresses; and

— a list of documents, worksheets, and forms needed to participate in the 2011 OVDI.

The IRS website also includes information on the 2009 OVDP.

(ix)    IRS issues updated Publication 513 — Tax information for visitors to US

The US Internal Revenue Service (IRS) has released the 2011 revision of Publication 513 (Tax Information for Visitors to the United States). The publication is dated 23rd February 2011 and is intended for use in preparing 2010 tax returns.

(x)    IRS issues updated Publication 515 — Withholding of Tax on Non-resident Aliens and Foreign Entities

The US Internal Revenue Service (IRS) has released the 2011 revision of Publication 515 (Withholding of Tax on Non-resident Aliens and Foreign Entities). The publication is dated 11th March 2011 and is intended for use in 2011.

Publication 515 provides guidance for withholding agents who pay income to foreign persons, including non-resident aliens, foreign corporations, foreign partnerships, foreign trusts, foreign estates, foreign governments and international organisations.

(xi)    IRS announces availability of IRS Free File for US taxpayers abroad

The US Internal Revenue Service (IRS) has announced that US taxpayers abroad can now use IRS Free File to prepare their US tax returns and then e-file them free of charge (News Release IR-2011-30). Free File will be available until 17th October 2011 in order to accommodate overseas taxpayers who file on or before the regular deadline of 15th June 2011 as well as taxpayers who claim the six-month extension.

(xii)    IRS releases frequently asked questions on reporting uncertain tax positions

The US Internal Revenue Service (IRS) has issued seven frequently asked questions (FAQs) regarding the requirement to report uncertain tax positions (UTPs) on IRS Schedule UTP. The FAQs are intended to supplement the information contained in the 2010 instructions and in the other guidance issued on Schedule UTP.

The IRS noted that additional FAQs on Schedule UTP may be forthcoming.

(xiii)    US Treasury issues final regulations on reporting foreign financial accounts

The Financial Crimes Enforcement Network (FinCEN) of the US Department of the Treasury has issued final regulations amending the Bank Secrecy Act (BSA) regulations regarding reports of foreign financial accounts. Under the BSA regulations, a US person having a financial interest in or signature or other authority over financial accounts in a foreign country is required to report such accounts by filing Form TD-F 90-22.1, Report of Foreign Bank and Financial Accounts (FBAR), and to maintain the records of the accounts for five years. No report is required if the aggregate value of the accounts does not exceed USD 10,000.

(xiv)    US individuals sentenced for hiding assets offshore

The US Department of Justice (DOJ) and the US Internal Revenue Service (IRS) announced that US Federal District Court judges sentenced US individuals to three years probation for hiding assets in offshore bank accounts (DOJ Press Releases dated 4th March 2011 and 14th March 2011).

(3)    Indonesia

(i)    Introduction of transfer pricing regulations The Director General of Taxation (DGT) has introduced transfer pricing (TP) regulations for Indonesian taxpayers, via Regulation No. PER-43/PJ/2010 which took effect on 6th September 2010. The Regulations are based significantly on the OECD’s TP Guidelines, and its main contents are summarised below.

Scope
The Regulations apply to transactions between related parties which have an impact on the reporting of income or expenses for corporate tax purposes, including:

— the sale, transfer, purchase or acquisition of tangible goods and/or intangible goods;

— payments of rental fees, royalties, or other payments for the provision of or use of both tangible and intangible property;

— income received or costs incurred for the provi-sion of or utilisation of services;

—  cost allocations; and

— the transfer or acquisition of property in the form of a financial instrument, as well as income or costs from the transfer or acquisition of the financial instrument.

The Regulations also endorse the five OECD TP methods, and specifically state that the hierarchy is as follows:

— comparable uncontrolled price (CUP) method;

—  resale price method (RPM);

—  cost plus method (CPM);

—  profit split method (PSM); and

—  transactional net margin method (TNMM).

(ii)    Guidelines for implementing CFC rule

The Tax Office issued Regulation PER-59/PJ/2010 on 30th December 2010, which provides further guidance on the implementation of the controlled foreign corporation (CFC) rule. The CFC rule applies to all Indonesian investment in all foreign countries, except where the foreign company’s shares are listed on a recognised stock exchange.

The salient points of the Regulation are summarised below:

— qualifying shareholders are deemed to receive dividends from the CFC;

— in the fourth month after the annual corporate income tax return deadline, or

— seven months from the end of the financial year, where (i) the company is not obliged to file a tax return or (ii) where the tax filing deadline is not stipulated;

— the deemed dividends are calculated based on the shareholding percentage and the CFC’s after-tax profits;

— the dividends must be reported by the shareholders in the annual corporate income tax returns together with the CFC’s financial statements;

— the CFC rule does not apply if the CFC has distributed dividends to the qualifying shareholders consistently with the prescribed formula and before the above-mentioned deadline;

— dividends received in excess of the deemed dividends must be reported in the shareholders’ corporate income tax returns in the year the dividends are distributed; and

— a foreign tax credit is available on foreign tax paid or withheld on the dividend.

Acknowledgement
We have compiled the above information from the Tax News Service of the IBFD for the months of October, 2010 to March, 2011.

Digest of Recent Important Foreign Decisions on Cross- Border Taxation — part II

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In the first part of the Article published in May, 2011 some of the Recent Important Foreign Decisions on Cross-Border Taxation were covered. In this part, the remaining decisions are being covered.

13. Thailand: Royalty

Supreme Court — Marketing fee paid pursuant to international franchise agreement constitutes ‘royalty’

The Supreme Court recently issued a judgment that the marketing fee paid by a Thai franchisee would be subject to Thai withholding tax as the fee constituted royalty income.

In a typical international franchise scheme, the foreign franchisor would charge the Thai franchisee a franchise fee, which typically consists of a royalty for the intellectual property and a marketing fee. It is common practice for the franchisor to ensure that any marketing activity undertaken by the franchisee is in line with the franchise’s international standards, and for the marketing fee to be computed based on net sales.

From a tax perspective, there remains no question that the franchise fee is categorised as royalty income, which would be subject to Thai withholding tax at the rate of 15% u/s. 70 of the Revenue Code. However, the marketing fee incurred by the Thai franchisee via payments made to Thai advertising companies had largely gone unnoticed for Thai withholding tax purposes.

The Supreme Court has now held that marketing fees paid in Thailand to Thai advertising firms would be subject to 15% Thai withholding tax as royalty, as if it had been paid to the foreign franchisor. The Court based the judgment on the following:

— the fee is deemed to be the additional income of the franchisor, as it directly, or indirectly, benefits the brand as well as the trademark of the franchisor;

— the franchisor effectively has control over the advertising activities; and

— this fee is calculated in a similar manner to franchise fee, i.e., based on sales.

It appears that the Court has ruled in this manner so as to prevent tax planning by a foreign company (which was not carrying on any business in Thailand) from avoiding withholding tax u/s. 70 of the Revenue Code.

This judgment is expected to have a huge impact on audits carried out by revenue officers with revenue officers raising more assessments on the franchisee in Thailand for past payments.

14. United Kingdom: Determination of residence for individuals

Court of Appeal rules on HMRC’s interpretation of IR20
On 16th February 2010, the Court of Appeal dismissed applications for judicial review in the cases of R (oao Davies and anor) v. CRC; R (oao Gaines- Cooper) v. CRC.

The taxpayers sought judicial review of HMRC’s determination that they were resident and ordinarily resident in the United Kingdom.

(a) Facts and legal background. The issue centred on guidance published by HMRC on residence and ordinary residence of individuals, known as IR20.

Paragraph 2.2 of IR20 provided that a taxpayer would be treated as non-resident and non-ordinarily resident if:

— he left the UK for the purposes of full-time employment abroad;

— he remained abroad for at least a whole tax year, and

— his visits to the UK totalled less than 183 days in any tax year, and averaged less than 91 days per tax year.

Paragraphs 2.7 to 2.9 of IR20 dealt with ‘Leaving the UK permanently or indefinitely’. Thereunder, HMRC reiterated the 91-day rule mentioned above. That section also stated that HMRC might request evidence of permanent abode outside the UK.

The taxpayers had left the United Kingdom, but not for the purposes of employment abroad. As such, their situation fell under IR20 paras 2.7.-2.9, and not IR20 para 2.2.

HMRC issued a determination that the taxpayers were resident in the United Kingdom, on the basis that they had not made a ‘distinct break’ from ties in the United Kingdom. Thus, it was not sufficient for the taxpayers simply to meet the 91-day rule.

The taxpayers argued that the ‘distinct break’ requirement was contrary to the guidance in IR20. They argued further that even if the requirement were found to be in line with the guidance, HMRC had, in practice, previously not insisted on this requirement. The fact that HMRC only began to require such evidence in 2004-05 amounted to a change in approach, and this breached their legitimate expectations.

(b) Issue. The issues were:

— whether, in requiring evidence of a distinct break, HMRC had departed from the terms of IR20, and

— even if HMRC had not so departed, whether HMRC had changed their approach, leading to a breach of the taxpayers’ legitimate expectations.

(c) Decision. IR20 para 2.2. dealt with leaving the United Kingdom for the purposes of full-time employment abroad. Under this paragraph, there was no requirement for a ‘distinct break’. Thus, for individuals who came within the terms of that paragraph, there was no need for HMRC to look into any persisting social or family ties in the UK.

The Court rejected the taxpayers’ argument that this interpretation should also apply to IR20 paras 2.7-2.9. According to the Court, because IR20 paras 2.7-2.9 deal with leaving the United Kingdom ‘permanently or indefinitely’, these words are crucial in terms of construing those paragraphs. It is therefore important to consider the extent to which the taxpayer has retained social and family ties within the United Kingdom.

There is therefore a clear distinction between the determination of residence for individuals who have left the UK for full-time employment abroad, and those who have left the UK permanently or indefinitely.

The taxpayers fell within IR20 paras 2.7-2.9, and therefore HMRC was entitled to request from them evidence of having left the United Kingdom ‘permanently or indefinitely’, and this included evidence of a ‘distinct break’.

On the change of approach point, Moses LJ stated that there was no public law obligation of fairness that prevents HMRC from increasing, without warning, the intensity or scrutiny of claims by taxpayers to be non-resident. Indeed, the absence of warning might be a powerful tool to deploy, to ensure that taxpayers provide frank disclosure. Nevertheless, the Court held that HMRC’s rejection of the taxpayers’ claim was not as a result of a changed approach. The appeals were dismissed.

Ward LJ, while agreeing with the decision, nevertheless, expressed some sympathy for the taxpayers. He understood the taxpayers’ suspicions that HMRC had indeed changed their policy. However, he was persuaded that what has been construed to be a change in HMRC policy was actually the effect of a closer and more rigorous scrutiny and policing of a growing number of claims. This is permissible for HMRC to undertake, and is not a root-and-branch change in policy.

Note: In 2009, IR20 was withdrawn and replaced by new guidance document, HMRC6.

15. France: Administrative Supreme Court clarifies notion of domicile for individuals

On 27 January 2010, the Supreme Administrative Court gave its decision in the case of SCP Vier (No. 294784) concerning the domestic notion of fiscal domicile. Details of the decision are summarised below.

(a) Legal background. Domestic law treats individual taxpayers as residents for tax purposes when they have their fiscal domicile in France. The definition of fiscal domicile, provided by Article 4B of the Code Général des Impôts (CGI), is based on three alternative criteria:

— personal: the home or principal place of residence; or

— professional: performance of a trade, business or professional activity; or

— economic: the centre of the economic interests.

Under the economic criterion, an individual is considered to have the centre of his economic interests in France, if the individual:

—  has made major investments;

— has a main office or effective place of management; or

—  derives most of his income in France.

(b)    Facts. The taxpayer possessed immovable and movable assets situated in France, while his regular income was derived from an employment in Greece. After a tax investigation, the French tax authorities decided to assess the taxpayer as a French resident on his worldwide income. They took the position that due to the location of his assets, the taxpayer met the economic criteria provided by Article 4B1(c) of the CGI: the ‘centre of its economic interests’. The taxpayer claimed not to be a resident and, thus, only liable to French source income.
    
(c)    Issue. The issue was whether the notion of ‘centre of economic interests’ should be considered as (i) the place where the individual has made major investments, regardless of their profitable nature; or (ii) the place where the individual derives most of his actual income.

(d)    Decision. The Administrative Supreme Court ruled in favour of the taxpayer and held that the notion of ‘centre of economic interests’ refers primarily to the place where an individual derives most of his income. Thus, the location of the assets must be regarded as a secondary criterion in the definition of ‘centre of its economic interests’.


16.    United States: Transfer Pricing:

US Court of Appeals withdraws decision in Xilinx transfer pricing case

The US Court of Appeals for the Ninth Circuit has withdrawn its decision in the case of Xilinx Inc. and Consolidated Subsidiaries v. Commissioner of Internal Revenue, (Docket No. 06-74246). See TNS:2009-06-05:US-1.

The decision was issued 27th May 2009 and held that the specific rules for cost-sharing agreements (CSAs) in the US Treasury Regulations issued u/s. 482 of the US Internal Revenue Code prevailed over the general arm’s-length standard.

As a result, the value of stock options granted by Xilinx in connection with a CSA were required to be included in the pool of costs to be shared under the CSA even when the facts indicated that companies operating at arm’s length would not do so. The Court of Appeals also determined that this result did not violate the provisions of the 1997 US-Ireland income tax treaty due to the saving clause in Article 1(4).

The decision of the Court of Appeals, which was by a 2:1 majority of a three-member judicial panel, proved controversial, and the taxpayer petitioned the Court for re-hearing (see TNS:2009-08-18:US-1) . The Court’s Order withdrawing the decision is dated 13th January 2010. It does not indicate the next step to be taken in the proceeding.

17.    Spain: Substance v. Form

Treaty between Spain and US-Spanish Supreme Court takes substance over form in approach applying treaty

The Supreme Court gave its decision on 25th September 2009 in the case of the sale of shares of the Spanish company La Cruz del Campo, S.A. owned by US Stroh Brewery Company to Guinness Plc (Recurso de Casación 3545/2003). Details of the decision are summarised below.

(a)    Facts. The appellant, Stroh Company, held shares representing 28.45% of the capital of La Cruz del Campo, S.A. In January 1991, Stroh accepted the offer by Guinness Plc to buy those shares. It also told the buyer that it would exercise the transfer in several steps. At the time of the offer, the shares were deposited in the United States. In January 1991, Stroh transferred part of the shares to its US subsidiary, Victors Company, in exchange for 17 shares in the latter. Victors Company sold the shares to Guinness Plc for the same price as that for which it had acquired them. In May 1991, Stroh transferred the remaining shares in La Cruz del Campo S.A. to another US subsidiary, Hoya Ventures, in exchange of 100% in the latter’s capital. These shares represented less than 25% of the capital in La Cruz del Campo, S.A. The shares were sold by Hoya Ventures to Guinness Plc in February 1992 for the same price as that for which it had acquired them. The tax administration and the decision of the First Instance Court considered that the capital gain of the sale was obtained by Stroh, and was therefore taxable in Spain.

(b)    Issue. Spanish corporate income tax legislation at the time of transactions considered income derived from securities issued by Spanish resident companies to be taxable in Spain, but the law only expressly taxed capital gains derived from assets located in Spain. Therefore, the appellant claimed that Spain did not have taxing rights on the transaction.

Article 13(4) of the USA-Spain tax treaty states that gains derived from the alienation of stock in the capital of a company resident in a contracting state may be taxed in this state if the recipient of the gain during the 12 -month period preceding the alienation had a participation, directly or indirectly, of at least 25% of the capital. Item 10(c) of the protocol to the treaty establishes an exception to the taxation of an alienation when the alienations are contributions between companies of the same group, and the consideration thereof consists of a participation in the capital of the acquiring company.

The appellant considered that there was a breach of the tax treaty since the tax administration and the First Instance Court decision qualified as ‘sales’ the transactions that were non-monetary contributions to the capital of the subsidiaries, which were excluded from taxation by the protocol. In addition, the interpretation of an international convention could not be undertaken unilaterally by one of the parties. Moreover, the second transaction entailed less than 25% of the capital, so it could have only been taxable in the United States. Furthermore, in case the transactions were subject to tax in Spain, the taxable capital gains should be those obtained by the subsidiaries from the difference between the selling price and the acquisition cost. In this case, there was no difference between the two.

(c)    Decision. The Supreme Court held that as the company issuing the shares was resident in Spain and the shareholder’s rights should be exercised in Spain, the shares should be considered as being located in Spain independently of where the shares were deposited. Therefore, the capital gain was subject to tax in Spain.

The Court stated that the person applying the law must qualify any act or transaction in accordance with its real juridical nature, bearing in mind its content, consideration and legal effects, without following the forms or names given by the parties. Therefore, both the tax administration and the Court of First Instance were allowed to qualify the transactions when those transactions did not correspond to the true legal nature of the considerations.

At the time of acceptance of the offer, Stroh fulfilled the two requirements established in Article 13(4) of the treaty, which allow the transaction to be taxed in Spain. The purpose of the subsequent share transactions with the subsidiaries was not for restructuring reasons. When examining the transactions involved as a whole, it appeared
that the intention of the appellant was not the one that is usually assigned to these types of transactions.

Therefore, there was a relative contractual simulation that occurs when there is an (unwanted) fictitious transaction aimed at disguising the real transaction (that was made in breach of the law). The effect of the law is to reveal the legal implications that the parties had tried to avoid. Therefore, the Court concluded that the tax administration was correct in its assessment.

18.    Australia: Foreign Tax Credit

ATO Interpretative Decision ATO ID 2010/175 — FTC for foreign tax paid in respect of gain not fully assessable in Australia

On 8 October 2010, the Australian Taxation Office (ATO) issued an Interpretative Decisions (ATO ID).

ATO ID 2010/175 deals with the entitlement to a foreign income tax offset (i.e., foreign tax credit) for a foreign tax paid in respect of a gain where the gain is not fully assessable in Australia. The ATO reached a decision that based on the wording of the legislation, only a proportion of the foreign tax should be available as a credit. Interestingly, the ATO ID notes a statement in Explanatory Memorandum to the Bill implementing the new foreign tax credit rules that seems to suggest that a full credit should be available. The ATO expressed its view that the statement is inconsistent with the words and purpose of the legislation and should be disregarded.

19.    United States; France: Foreign Tax Credit

Treaty between US and France-US Tax Court: income earned in or over foreign countries; US or international airspace (saving clause, foreign earned income exclusion, FTC)

The US Tax Court has decided on the availability of the foreign -earned income exclusion and foreign tax credit with regard to a flight attendant’s income. Savary v. Commissioner of Internal Revenue, T.C. Summary Opinion 2010-150, Docket No. 6839-09S (6 October 2010).

The case involved a taxpayer who was a US citizen but resident of France. She worked as a flight attendant on flights between France and the United States:

— 38.2% of her income was earned in or over for-eign countries (the ‘foreign income’); and

— the remaining portion was earned while in the United States or in international airspace (the ‘US/international airspace income’).

US-France tax treaty

The first issue was whether the United States was precluded from taxing her income by Article 15(3) of the treaty between the United States and France signed on 31st August 1994 (the ‘Treaty’), which provides that income from employment as a crew member of a ship or aircraft operated in international traffic is taxable only by the country of which the taxpayer is a resident.

The Tax Court held that the saving clause in Article 29(2) of the Treaty, which provides that the United States may tax its citizens and residents as if the Treaty had not come into effect, took precedence and thus her income was taxable under the Internal Revenue Code (IRC).

Foreign earned income exclusion

The second issue was whether the taxpayer was entitled to claim the foreign-earned income exclusion under IRC section 911.

The Tax Court concluded that the ‘US/international airspace income’ was US source income and not foreign-earned income, noting that international airspace is not a foreign country for purposes of IRC section 911.    Accordingly, the taxpayer was not entitled to claim the foreign-earned income exclusion.

On the other hand, the taxpayer was allowed to exclude the ‘foreign income’.

FTC:

The third issue was whether the taxpayer was entitled to a foreign tax credit in the United States under Article 24 of the Treaty and IRC section 901 for the taxes paid to France.

The Tax Court denied a US credit for US tax payable on the ‘foreign income’, on the ground that the taxpayer was already allowed a US exclusion of such foreign source income under IRC section 911.

Further, the Tax Court disallowed a US credit for French tax paid on the ‘US/international airspace income’, explaining that the United States consented in Article 24 only to provide a FTC on income attributable to sources in France, as determined under the source of income rules of the IRC, and not to US source income. The Tax Court stated that a credit in France would be the only treaty relief from double taxation. The Tax Court noted that the French tax authorities had already denied the credit on the basis of Article 15(3) of the Treaty. The Tax Court was of the view, however, that the French tax authorities had erred in this regard, and that the taxpayer could seek reconsideration from the French authorities or, as a last resort, competent authority relief under Article 26 of the Treaty.

Accuracy-related penalty:

The fourth and final issue was whether the tax-payer was liable for the accuracy-related penalty under IRC section 6662.

The Tax Court declined to impose the penalty be-cause it was not demonstrated that the taxpayer’s underpayment was attributable to her negligence or disregard of rules or regulations.

20.    Italy: Beneficial Owner

Treaty between Italy and Luxembourg — Italian decision on interpretation of term ‘beneficial owner’

On 19 October 2010, the Lower Tax Court of Piemonte (Commissione tributaria provinciale del Piemonte/Torino) issued decision no. 124 regarding the interpretation of the term ‘beneficial owner’ contained in Article 12 (Royalties) of the tax treaty between Italy and Luxemburg (the Treaty). Details of the decision are summarised below.

(a)    Facts. The taxpayer is an Italian company that signed an agreement for the use of a trademark owned by a Luxemburg company (Luxco). Luxco is wholly owned by a company resident in Bermuda.

On the royalties paid by the Italian taxpayer to Luxco, the reduced withholding tax (10%) provided for by Article 12 of the Treaty was withheld instead of the domestic withholding tax of 30%.

The Italian tax authorities claimed that Luxco was not the beneficial owner of the royalty’s payment; therefore, it cannot benefit from the reduced with-holding tax provided for by the Treaty.

(c)    Decision. The taxpayer asserted that Luxco was the beneficial owner of the royalties payments based on the following grounds:

— Luxco was the owner of the trademark, which was accounted for in Luxco’s annual balance sheet;

— the trademark was properly registered in Luxemburg;

— the use of the trademark was granted by a proper licence agreement between the Italian taxpayer and Luxco;

— the income generated by the licence agree-ment was properly accounted for in Luxco’s profit and loss accounts.

The Court noted that the arguments put forward by the taxpayer only prove that Luxco was the formal owner of the trademark and that it formally received the royalty payments, but not that Luxco was the beneficial owner. Therefore, the Court rejected the arguments of the taxpayer, giving the following reasons:

— The beneficial owner must have an autonomous organisation to provide services and must bear the entrepreneurial risks of such activity. This was not the case in respect to Luxco. Indeed, Luxco acquired the trademark free of charge and it has no costs related to such trademark; moreover, Luxco had a very small operative organisation (no movable properties, low employment costs). In this respect, Luxco is acting without any entre-preneurial risks.

—  Luxco was wholly owned by a sole shareholder (resident in Bermuda).

21.    Finland: Transfer Pricing

Supreme Administrative Court rules on interest rate on intra-group loan

The Supreme Administrative Court of Finland (Korkein hallinto-oikeus, KHO) gave its decision on 3 November 2010 in the case of KHO:2010:73. Details of the decision are summarised below.

(a)    Facts. As part of restructuring the financial structure of a group, the taxpayer, Finnish company A Oy, paid back two loans taken from a third party and took a corresponding loan from a Swedish company B AB, which was acting as the group financing company. The loans taken from the third party carried interest at the rates between 3.135% and 3.25%, whereas the interest rate on the intra-group loan was set to 9.5% based on the average group interest rate. The average group interest rate was determined by interest rates applied on loans that the group had taken from third parties and loans from its shareholders.

(b)    Legal background. Affiliated companies are required to observe the arm’s-length principle. If the tax authorities conclude, based on section 31 of the Law on Tax Procedure, that the arm’s-length principle has not been observed in transactions between group companies, the taxation may be corrected and reassessment may be made to re-flect the arm’s-length conditions.

(c)    Issue. The issue was whether the interest rate set on the intra-group loan, 9.5%, was at arm’s length, considering that the loans taken from a third party had been subject to interest rates of 3.135% and 3.25%.

(d)    Decision. The Court emphasised that the interest rate on an intra-group loan cannot be based on an average group interest rate in circumstances (e.g., the company’s good creditworthiness) where financing could have been obtained from a non-related party at a substantially lower interest rate than the average group interest rate. The Court pointed out that the taxpayer’s financing needs did not substantially change in the refinancing and it had not received any financial services from B AB which may have influenced the interest rate.
The Court held that the interest rate on the intra-group loan was not at arm’s length and increased the taxpayer’s taxable income by the amount of non-deductible interest which was the difference between the interest rate on intra-group loan (9.5%) and the interest rate of 3.25%.

United States: Residency

USVI District Court denies residency for lack of intent to become USVI residents

The US District Court of the United States Virgin Islands (USVI) has determined that five family members were not bona fide residents of the USVI on the ground that they failed to demonstrate their genuine intent to become USVI residents. VI Derivatives, LLC v. United States, Case No. 3:06-CV-12 (18 February 2011).

This case involved five members of the Vento family — Richard Vento (husband), Lana Vento (wife), Nicole Mollison (daughter), Gail Vento (daughter), and Renee Vento (daughter). They filed their income tax returns with the USVI Bureau of Internal Revenue (BIR) in 2001. Both the BIR and the US Internal Revenue Service (IRS) issued Notices of Deficiency to the Vento family. Each Vento family member filed a petition to determine their income tax liability for 2001 and their petitions were con-solidated into this case.

The Vento family took the position that they were exempt from US taxation on the income reported in the USVI u/s. 932 of the US Internal Revenue Code (IRC) because they were present in the USVI on the last day of 2001 with intent to become residents. The BIR contended that the petitioners’ pattern of repeated travel to the USVI and their development of a residential property was sufficient to establish USVI residency. The IRS argued that the petitioners were not bona fide residents of the USVI, because they did not take sufficient action to demonstrate an intent to become USVI residents and did not abandon their prior residences by the end of 2001.

The District Court stated that under IRC section 932, as applied in 2001, a taxpayer who was a bona fide resident of the USVI at the end of a year generally was exempt from filing a US federal income tax return or paying income taxes to the United States for that year. The District Court further stated that IRC section 932, however, drew a distinction between a bona fide residents and mere transients or sojourners, and required the latter to file a tax return with both the IRS and the BIR for income received from the USVI.

The District Court noted that both parties agreed the standard set forth in Sochurek v. Commissioner, 300 F.2.d 34 (7th Cir. 1962) should be applied in deciding whether the Vento family members were bona fide USVI residents at the end of 2001.

The District Court further noted that while the abandonment of a prior residence is not required to claim residency elsewhere, a court may consider whether a taxpayer maintains strong ties to a location other than the claimed residence.

The District Court stated that the subjective Sochurek factors — whether the petitioners intended to be USVI residents at the end of 2001 or whether they travelled to the USVI for the purpose of avoiding US income taxes — had particular relevance, given the suspicious timing of the family’s decision to ‘move’ to the USVI. The District Court noted that in early 2001, the family realised a gain of USD 180 million from the sale of their shares in a technology business (Objective Systems Integrators, Inc.), of which Richard Vento was a founder, and that the USVI residency for 2001 would allow them tax savings of more than USD 9 million.

The District Court held that the Vento family’s testimony that they intended to become USVI residents by the end of 2001 was undermined by the objective facts:

— the house they purchased in the USVI was not liveable by the end of 2001, despite efforts to renovate it as quickly as possible;

— the house was not fully furnished by the end of 2001;
—  none of the family’s furniture or valuable personal possessions were brought to the house;

—  the family spent very little time in the USVI during 2001 and 2002 and primarily engaged in vacation-type activities when in the USVI;

— the family did not have a bank account in the USVI in 2001;

— neither of the two businesses Richard Vento was starting in the USVI was up and running by the end of 2001;

— there is no evidence that Richard and Lana Ventos were involved in community activities in the USVI or had assimilated into its culture in 2001;

—  the family’s office remained in Nevada;

— Richard and Lana Ventos purchased property in Nevada in May 2001 with a plan to construct a mansion on the property;

— Nicole Mollison’s children were enrolled in school in Nevada in 2001; and

—  in 2001, Gail Vento was attending college in Colorado, and Renee Vento had a clear goal of obtaining a master’s degree in California.

After applying the relevant Sochurek factors, the District Court concluded that no member of the Vento family was a bona fide resident of the USVI at the end of 2001.

Acknowledgment/Source

We have compiled the above summary of decisions from the Tax News Service of the IBFD for the period April, 2010 to March, 2011.

Tax Implications of Liaison Office in India

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The activities of liaisoning per se should not result in any tax implication in India. However, when such activities cross the threshold of liaisoning, they would constitute Permanent Establishment and proportionate profits attributable to its activities in India may be subjected to tax. Several cases by Tribunals, Courts and AAR have been decided and in this Article, various aspects concerning taxability of liaison offices have been dealt with.

1.0 Introduction

1.1 Meaning of the term ‘Liaison’

The dictionary (Collins Thesaurus) meanings of the term ‘liaison’ are: ‘communication, connection, contact, go-between, hook-up, interchange, intermediary’.

A ‘Liaison Office’ (LO) is a representative office set up primarily to explore and understand the business and investment climate. Such office is not permitted to undertake any commercial/trading/industrial activity, directly or indirectly, and is required to maintain itself out of inward remittances received from the parent company through normal banking channels.

1.2 Meaning of the term ‘Liaison Office’ as per FEMA

Clause 2(e) of the Notification No. FEMA 22/2000-RB, dated 3rd May 2000 pertaining to Foreign Exchange Management (Establishment in India of Branch or Office or other Place of Business) Regulations, 2000 defines ‘Liaison Office’ as under:

“ ‘Liaison Office’ means a place of business to act as a channel of communication between the Principal place of business or Head Office by whatever name called and entities in India but which does not undertake any commercial/trading/industrial activity, directly or indirectly, and maintains itself out of inward remittances received from abroad through normal banking channel.”

Schedule II of the said Notification lists activities which are permitted to a Liaison Office in India as follows:

(i) Representing in India the parent company/group companies;

(ii) Promoting export import from/to India;

(iii) Promoting technical/financial collaborations between parent/group companies and companies in India;

 (iv) Acting as a communication channel between the parent company and Indian companies.

Thus, in essence, a ‘Liaison Office’ (LO) is nothing but a representative office of the non-resident entity in India, whose activities are confined to dissemination of information, facilitate/promote trade and/or to act as a communication channel between group companies and Indian companies. A liaison office is not supposed to undertake activities which cross the threshold of doing business in India, such as raising invoice, effecting delivery of goods, conclusion of contracts, etc. But when such activities are carried on, they may result in tax incidence.

2.0 Taxability of Liaison Office under the provisions of the Income-tax Act, 1961


Section 5 read with section 9 of the Income-tax Act, 1961 (the ‘Act’) provides that income of a non-resident is taxed in India when the same is received or is deemed to be received or accrues/arises or is deemed to accrue/arise in India. Section 9(1) lists the situations under which income of a non-resident is deemed to accrue or arise in India.

The ambit of clause (i) of section 9(1) is wide enough to cover “all income accruing or arising, whether directly or indirectly, through or from any business connection in India or through or from any property in India, or through or from any asset or source of income in India, or through the transfer of a capital asset situate in India”.

Of all the different incidences of income covered by section 9(1)(i) above, the following are most relevant for our discussion:

— Income arising through “business connection in India”; and
— Income arising through any source of income in India.

Certain activities of an LO would not attract any tax liability in view of the specific exemptions provided u/s.9, which are as follows:

9(1)(i) Expl. 1. (b) : Activities which are confined to the purchase of goods in India for the purpose of export; Expl. 2 : Activities which do not qualify the test of ‘Business Connection’ (This explanation defines ‘Business Connection’ on the lines of ‘Agency PE’ under Tax Treaty Provisions).

2.1 Business Connection (BC)

The most celebrated CBDT Circular No. 23 of 1969 (since withdrawn w.e.f. 22-10-2009) had explained the concept of ‘Business Connection’ in depth. Even though the Circular stands withdrawn, the principles enunciated therein still hold good. The Circular clarifies that “the expression ‘business connection’ limits of no precise definition. The import and connotation of this expression has been explained by the Supreme Court in their judgment in CIT v. R. D. Aggarwal and Co. and Another, (56 ITR 20). The question whether a nonresident has a ‘business connection’ in India from or through which income, profits or gains can be said to accrue or arise to him within the meaning of section 9 of the Act has to be determined on the facts of each case. However, some illustrative instances of a non-resident having business connection in India, are given below:

(a) Maintaining a branch office in India for the purchase or sale of goods or transacting other business.

(b) Appointing an agent in India for the systematic and regular purchase of raw materials or other commodities, or for sale of the non-resident’s goods, or for other business purposes.

(c) Erecting a factory in India where the raw produce purchased locally is worked into a form suitable for export abroad.

(d) Forming a local subsidiary company to sell the products of the non-resident parent company.

(e) Having financial association between a resident and a non-resident company.”

The Circular further states that wherever the transactions are on a principal-to-principal basis, as well as on arm’s-length basis, between a subsidiary and a parent company, the same cannot result into BC. In other words, the concept of BC carves out an exception in respect of transactions between the principal and independent agent.

The Apex Court in the case of R. D. Aggarwal and Co. held that the expression ‘Business Connection’ means something more than a business, that it pre-supposes an element of continuity between the business of the non-resident and the activity in the taxable territory, though a sporadic or isolated transaction may not be construed as such, for the connection may take several forms, like carrying on a part of the main business or activity incidental to the non-resident through an agent or it may merely be a relation between the business of the non-resident and the activity in the taxable territory which facilitates or assists in the carrying on of that business. Applying this test in the case of Western Union Financial Services Inc., (2007) 291 ITR (A.T.) 176, wherein the assessee (Western Union) was engaged in the business of transfer of monies in India from abroad through various agents (including Department of Post, NBFCs, banks, travel agents, etc.), the Delhi Tribunal held that there exists BC in India.

The Supreme Court in the case of Anglo-French Textile Co. Ltd. v. CIT, (1953) 23 ITR 101 (SC), held that where there was a continuity of business relationship between the person in India, who helps to make the profits and the person outside India who receives the profits, BC exists.

In the case of GVK Industries Ltd. v. CIT, (1997) 228 ITR 564 (AP), the Andhra Pradesh High Court enumerated the following principles in respect of BC after examining various case laws:

(i) “Whether there is a business connection between an Indian company and a non-resident (company) is a mixed question of fact and law which has to be determined on the facts and circumstances of each case;

(ii)    the expression ‘business connection’ is too wide to admit any precise definition; however, it has some well-known attributes;

(iii)    the essence of ‘business connection’ is the existence of close, real, intimate relationship and commonness of interest between the Non-Resident Company (NRC) and the Indian person;

(iv)    where there is control of management or finances or substantial holding of equity shares or sharing of profits by the NRC with the Indian person, the requirement of principle (iii) is ful-filled;

(v)    to constitute ‘business connection’, there must be continuity of activity or operation of the NRC with the Indian party and a stray or isolated transaction is not enough to establish a business connection.”

From the above legal analysis it is clear that if the activities of an LO are such that they constitute BC, there would be incidence of tax in India. However, if the activities of the LO are confined to purchase of goods in India for the purpose of export [as per section 9(1) (i) Expl. 1(b)], then there will be no tax incidence in India. Let us examine, under what circumstances, activities of the LOs were held to be covered by the exclusion of section 9.

2.2    Activities confined to purchases from India for the purpose of exports

Cases in favour of assessee
2.2.1 In a number of decisions, viz. Angel Garments Ltd., [287 ITR 341 AAR; (2006) 157 Taxman 195 (AAR)], Gutal Trading Est., [278 ITR 63 (AAR)], Ikea Trading (Hong Kong) Ltd., [2008 TIOL 23 (AAR); (2009) 308 ITR 0422 (AAR)], and DDIT v. Nike Inc., [2009 TIOL 143 (Bang. ITAT)], ADIT (IT) v. Fabrikant & Sons Ltd., (2011 TII 46 ITAT-Mum.-Intl.), it has been held that where the activities of the Liaison Office in India are confined to purchase of goods in India for the purpose of export, the income therefrom cannot be brought to tax in India.

Cases against assessee
2.2.2 The Delhi Tribunal made interesting observations in case of Linmark International (Hong Kong) Ltd., [2011 TII 05 ITAT-Del-Intl], wherein it held that the purchase exclusion [section 9(1)(i) Expl. 1(b)] only scales down the extent of incomes that are deemed to accrue or arise in India. Such a limitation cannot be read into the provision which deals with income that accrues or arises in India. In this case it was found that the Indian LO was doing substantial business activities on behalf of a BVI company which was a non-functional entity. The Tribunal placed reliance on the Supreme Court decision in the case of Performing Rights Society Ltd. & Another v. CIT & Others wherein it was held that, where income has actually accrued in India, there is no requirement to further examine whether the income is covered by the provision that deems income to accrue or arise in India.

2.2.3 In case of Columbia Sportswear Company, (2011) 337 ITR 0407 (AAR) (applicant), on the facts of the case, the AAR held that there was a Business Connection, observing that “in the matter of manufacturing of products as per design, quality and in implementing policy, the liaison office is actually doing the work of the applicant. The activities of the liaison office are not confined to India. It also facilitates the doing of business by the applicant with entities in Egypt and Bangladesh. A person in the business of designing, manufacturing and selling cannot be taken to earn a profit only by sale of goods”.

Two interesting observations made by AAR in the case of Columbia Sportswear are:

(i)    All activities (including purchase) other than actual sale cannot be divorced from the business of manufacture; and
(ii)    If the activities of the Indian LO supports businesses in other countries as well (in the present case it was Egypt and Bangladesh), then it cannot be stated that the operations of the applicant in India are confined to the purchase of goods in India for the purpose of export.

2.2.4 Nokia Networks OY, Finland (NOY), [No. 2005 TIOL 103 ITAT Del-SB; 95 ITD 269 (SB) (Del. Tribunal)], is a tax resident of Finland. NOY had a liaison office (‘LO’) in India. Further, NOY had a 100% subsidiary in India by name Nokia India (P) Ltd. (NPL). NOY entered into an agreement with an Indian Company for supply of telecom equipment (hardware with software embedded therein). NPL, the Indian subsidiary of NOY, entered into an agreement for installation of the said equipment supplied by NOY.

It was held that NOY had a Business Connection under the Act, not because NOY had liaison office in India, but because it had its own subsidiary (NPL) in India and there was intimate business connection based on facts. There was a service agreement and a technical support agreement between NOY and NPL and other Indian Cos. which support the NOY’s activity of supplying telecom equipments. NPL having a live link with NOY, was held to be the business connection in India.

2.3    Activities in addition to or incidental to purchases
Many a time, activities of LOs extend beyond merely purchases. In such a scenario, can the assessee take shelter under the exclusion of section 9(1)(i) Expl. 1(b)? By and large, the Tribunals/AAR/Courts have held that if other activities are incidental to the activity of purchases for the purpose of exports, then there will not be any incidence of deemed income u/s.9 of the Act.

The table below shows what kind of activities were held to be incidental to purchases and which were not so:
 

Sr.

Nature of activities

Whether held as deemed income u/s.9(1) of
the

Case Law

No.

 

Act?

 

 

 

 

 

1

Training of the employees of

No

DDI
v. NIKE Inc

 

the manufacturers (to ensure

 

(Indian
Liaison Office)

 

quality) who supplied goods

 

2009 TIOL 143 ITAT-Bang.

 

to the affiliates of the LO.

 

 

 

 

 

 

2

Negotiation of prices, assort-

 

ADIT
v. Fabricant & Sons Ltd.

 

ment of diamonds.

No

(2011 TII 46 ITAT-Mum.-Intl)

 

 

 

 

3

Material management, mer-

Yes. It was held that in the matter of
manufac-

Columbia
Sportswear

 

chandising, production man-

turing of products as per design, quality
and in

Company

 

agement, quality control and

implementing policy, the liaison office is
actually

(2011) 337 ITR 0407 (AAR)

 

administration support consti-

doing the work of the applicant.

 

 

tuting teams from finance,

 

 

 

human resources and infor-

 

 

 

mation systems.

 

 

 

 

 

 

4

Facilitation by the liaison of-

Yes. As activities were not confined to India,
the

Columbia
Sportswear

 

fice in doing business with

exclusion provided in section 9(1)(i) Expl.
1(b) will

Company

 

entities in Egypt and Bangla-

not be applicable.

(2011) 337 ITR 0407 (AAR)

 

desh.

 

 

 

 

 

 

5

Indian office rendering sup-

Yes & No

Aramco
Overseas Company BV

 

port services to the non-

The AAR held that to the extent Indian
Office

(AAR No. 825 of 2009)

 

resident parent company and

engaged in purchases for its non-resident
principal

2010 TIOL 14 ARA-IT

 

its group company.

there is no income u/s.9(1). But income is
attribut-

 

 

 

able to the activities of the Indian Office
for the

 

 

 

group company as the applicant failed to
establish

 

 

 

that the Indian Office worked as an agent of
the

 

 

 

group company.

 

 

 

 

 


3.0    Taxability of Liaison Office under the provisions of DTAA

Under Article 5 of the DTAA if the activities of an LO are considered to be PE in India, then under Article 7, the income of the non-resident attributable to such PE in India would be liable to tax in India.

Article 5 of the UN and OECD Model Conventions deals with the definition of a Permanent Establishment (PE). Paragraph 4 of Article 5 contains a list of exclusions i.e., activities, which will not constitute a PE.

The following activities are not regarded as PE:

(a)    the use of facilities solely for the purpose of storage, display, of goods or merchandise belonging to the enterprise;

(b)    the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of storage, display;

(c)    the maintenance of a stock of goods or merchandise belonging to the enterprise solely for the purpose of processing by another enterprise;

(d)    the maintenance of a fixed place of business solely for the purpose of purchasing good or merchandise or of collecting information, for the enterprise;

(e)    the maintenance of a fixed place of business solely for the purpose of carrying on, for the enterprise, any other activity of a preparatory or auxiliary nature;

(f)    the maintenance of a fixed place of business solely for any combination of activities, men-tioned in sub-paragraphs (a) to (e), provided that the overall activity of the fixed place of business resulting from this combination is of a preparatory or auxiliary nature.

It may be noted that in respect of activities mentioned in paragraph (a) and (b) above, the scope of the OECD Model Convention is wider than UN MC in that “the use of facilities or the maintenance of stock of goods or merchandise for the purpose of delivery” would not constitute a PE. In the case of UN MC, delivery of goods or merchandise would constitute PE.

The OECD Model Commentary makes it clear that a fundamental feature of these activities is that they are all of a preparatory or auxiliary nature.

3.1    Meaning of preparatory or auxiliary services

Paragraph 4 of Article 5 on PE, in both the MCs, list activities which are excluded from the definition of PE. Besides specific exclusions (e.g., maintenance of stock of goods, facilities used for storage, display, fixed place of business solely for the purpose of purchasing goods or collecting information, etc.), clauses (e) and (f) of the said paragraph provide that the maintenance of a fixed place of business would not result in PE, if the activities of the enterprise are of a preparatory or auxiliary in nature. However, which of the activities would constitute of preparatory or auxiliary in nature and which would not, is difficult to determine at times for the reason that it would also depend upon the facts and circumstances of each case.

The main and indeed, the decisive criterion would be whether or not the activity of the fixed place of business by itself forms an essential and significant part of the activity of the enterprise, as a whole. If the activities of the fixed place are identical with the general purpose and object of its parent, then such activities cannot be regarded as preparatory or auxiliary in nature, e.g., the parent company is engaged in the business of supply of auto components and its fixed base, too, is the engaged in supply of auto components, then such activity of PE cannot be regarded as of auxiliary or preparatory in nature.

It would be worth noting that preparatory or auxiliary activities, which are exclusively for the enterprise by itself, would not result in PE. “If the same are rendered for a consideration and for third parties, then they may constitute the enterprise’s main object and the corresponding facilities may well be PE.” (Klaus Vogel on Double Taxation Conventions — M. No. 116 a — page 321)

The AAR in the case of UAE Exchange ascertained the nature of activities carried on by Indian liaison office by interpreting the term ‘auxiliary’ as used in common English usage, meaning, “helping, assisting or supporting the main activity.”

The Special Bench of the Delhi Tribunal in case of Motorola Inc. v. DCIT, Non-Resident Circle, 95 ITD 269 (Delhi Tribunal), held that the activities carried on by the employees of Motorola, Sweden, through the office of its Indian subsidiary were of preparatory or auxiliary in nature. These activities were carried on prior to commencement of business in India. Activities included such as market survey, industry analysis, economy evaluation, furnishing of product information, ensuring distributorship and their warranty obligations, ensuring technical presentations to potential users, development of market opportunities, providing services and support information, procurement of raw materials for Motorola, accounting and finance services, etc. for a period of one year.

If the activities of the LO are confined to preparatory or auxiliary, then it would not result in PE. Fundamentally, as per FEMA provisions LOs are not supposed to cross the threshold of preparatory or auxiliary activities as they are barred from carrying on any activities of commercial or industrial in nature. They are supposed to restrict themselves to the activities of liaisoning, dissemination of information, export promotion, etc. etc. However, in actual practice when it is found that LOs have crossed this limit, they have been held to be PE in India.

3.2  Can LO be regarded as PE?

Let us examine the various case laws on this aspect:

Cases where it was held not to be PE

3.2.1 In IAC v. Mitsui and Co. Ltd., (1991) 39 ITD 59, Special Bench, ITAT Delhi, has held that the LO cannot be regarded as a PE and a similar view was taken by the Delhi Bench in BKI/Ham V. O. F. v. Additional CIT, (2001) 70 TTJ 480.

3.2.2 In the case of Western Union Financial Services Inc. the Delhi Tribunal held that since the assessee did not have an outlet of its own in India, there was no fixed place of business and therefore there is no PE. It further held that installation of software, use of credit cards or display of names of the Principal by its agents in India does not give rise to a PE.

3.2.3 In the case of K. T. Corporation v. DIT, [23 DTR 361 (AAR) (2009) 180 Taxman 395 (Bom.)], the AAR held that as per provisions of Article 5(4)(d) [Article 5(4)(d) of the India-Korea Tax Treaty reported at 165 ITR (St). 191], collecting information for an enterprise by an LO located abroad is considered an auxiliary activity, unless the collecting of information is the primary purpose of the enterprise. Accordingly, preparation of reports dealing with India’s market scenario in mobile as well as broadband segments, etc., which were in the nature of ‘aid’ or ‘support’ of the main activities, were held to be preparatory and auxiliary activities. While holding on to the facts stated by the applicant that there is no PE, the AAR added a caveat that if the activities of the LO are enlarged beyond the parameters fixed by RBI or if the Department lays its hands on any concrete materials which substantially impact on the veracity of the applicant’s version of facts, it is open for the Department to take appropriate steps under law. Even though the last observations by the AAR were not warranted, it shows that activities of LO are always under close radar of the Income-tax Department.

Cases where it was held to be a PE

3.2.4 In the case of Nokia Networks OY (NOY) (supra) its subsidiary was held to be a PE in India because Nokia virtually projected itself in India through Nokia India Private Ltd. (NPL), as NOY was able to monitor its activities in India through NPL.

3.2.5 The AAR in the UAE Exchange Centre LLC, (2004) 268 ITR 09, held that the Indian LO is the PE of the UAE Enterprise. On the facts of the case, the AAR held that an activity of printing cheques/drafts in India and dispatching the same to the addresses of the beneficiaries by the Indian LO could not be said to be of an auxiliary nature.

3.2.6 In case of Columbia Sportswear Company, (2011) 337 ITR 0407 (AAR), the AAR held that “if an establishment satisfies provisions of Article 5.1 of a DTAA which defines a PE to mean a fixed place of business through which the business of an enterprise is wholly or partly carried on, there is no need to go into the question whether the establishment cannot be brought within the inclusive part of the definition in sub-article 2. Once the definition in Article 5.1 is satisfied, the only inquiry to be undertaken is to see whether it is one of those establishments excluded by sub-article 3”. The AAR held that the LO constituted a fixed place of business within the meaning of Article 5.1 of the India-US DTAA and considering the nature of activities of the LO, it held that the LO would constitute PE in India. The AAR observed that the LO was practically involved in all the activities connected with the business of the applicant, except the actual sale of the products outside the country.

3.2.7 The Karnataka High Court in case of Jebon Corporation India, [2011 TII 15 HC-Kar-Intl], on the facts of the case held that the LO was carrying on the commercial activities of procuring purchase orders, identifying the buyers, negotiating and agreeing on the price, ensuring material dispatch to the customers, following up payments from customers and also offering after sales support. Consequently, the High Court held that the Indian LO is a PE under Article 5 of the India-Korea tax treaty. Some of the interesting observations made by the High Court are as follows :

(i)    The mere fact that buyers placed orders and made payments directly to HO and the HO directly sent goods to the buyers is not sufficient to establish that there is no PE;

(ii)    When the facts clearly showed that the LO was engaged in trading activity and therefore entering into business transactions/contracts, the mere fact of them being not signed by the LO would not absolve it of liability;

(iii)    Just because RBI did not take any action against the LO for carrying on the alleged commercial activities, would not render the findings, recorded by the Income-tax Authorities under the Act, as erroneous or illegal.

4.0    Conclusion
The activities of LOs are under Income-tax Department’s scanner for quite some time now. Even though RBI permits restricted activities for the LO, in actual practice, it has been found that some LOs are crossing the threshold of liaisoning and carries on full-fledged business activities in India.

RBI generally, relies on the CA certificate about the nature of activities carried on by LOs in India. Thus, a CA certifying that LO’s activities are confined to what is permitted by RBI assumes colossal responsibility. In case of Jebon Corporation (where it was found that the LO was engaged in the trading activity), the Karnataka High Court observed that the facts revealed on investigation will be forwarded to the RBI for appropriate action in accordance with law. In the light of these developments, we, CAs, need to be more vigilant and careful in issuing certificates about the activities of LOs. The clients should be advised to convert their LO in to a branch/subsidiary, if so warranted, as undertaking non-permitted activities would result in penal consequences, in a addition to tax implications, in India.

Recent Global Developments in International Taxation

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In this Article, we have given brief information about the recent global developments in the sphere of international taxation which could be of relevance and use in day-to-day practice and which would keep the readers abreast with various happenings across the globe. We intend to keep the readers informed about such developments from time to time in future.

(1) United States

(i) IRS issues updated Publication 519 — US Tax Guide for Aliens

The US Internal Revenue Service (IRS) has released the 2012 revision of Publication 519 (US Tax Guide for Aliens). The publication is dated 7 February 2012 and is intended for use in preparing tax returns for 2011.

Publication 519 provides detailed guidance for resident and non-resident aliens to determine their liability for US federal income tax. Specifically, Publication 519 discusses:

  • the rules for determining US residence status (e.g., the US green card test and the US substantial presence test);

  • the rules for determining the source of income; ? exclusions from US gross income;

  • the rules for determining and computing US tax liability;

  • US tax liability for a dual-status tax year (i.e., where an individual has periods of residence and non-residence within the same tax year);

  • filing information;

  • paying tax through withholding tax or estimated tax;

  • benefits under US income tax treaties and social security agreements;

  • exemptions for employees of foreign governments and international organisations under US tax treaties and US tax law;

  • sailing and departure permits for departing aliens; and

  • how to get tax help from the IRS.

Publication 519 also includes:

  • filled-in individual income tax returns (IRS Form 1040 and Form 1040NR) as illustrations of dualstatus returns;

  • Table of US tax treaties (updated through 31 December 2011);

  • Appendix A (Tax Treaty Exemption Procedure for Students), which contains the statements non-resident alien students and trainees must file with IRS Form 8233 [Exemption From Withholding on Compensation for Independent (and Certain Dependent) Personal Services of a Non-resident Alien Individual] to claim a tax treaty exemption from withholding of tax on compensation for dependent personal services; and

  • Appendix B (Tax Treaty Exemption Procedure for Teachers and Researchers), which contains the statements non-resident alien teachers and researchers must file for the same purpose as Appendix A.

Revised Publication 519 provides information on relevant tax changes for 2011 and 2012, including:

  • the requirement to file new IRS Form 8938 (Statement of Specified Foreign Financial Assets) to report certain foreign financial assets (for 2011);

  • exclusion of interest paid on non-registered (bearer) bonds from portfolio interest (for 2012); and

  • expiration of the exemptions for certain USsourced interest-related dividends and shortterm capital gain dividends that are received from a mutual fund or other regulated investment company (for 2012).

Additionally, Publication 519 refers to the other IRS publications that are relevant in this context, including:

  • Publication 514 (Foreign Tax Credit for Individuals);

  • Publication 515 (Withholding of Tax on Nonresident Aliens and Foreign Entities);

  • Publication 597 (Information on the United States-Canada Income Tax Treaty); and

  • Publication 901 (US Tax Treaties).

(ii) IRS Notice 2010-62: Application of codified economic substance doctrine

The Internal Revenue Service (IRS) has issued Notice 2010-62 with information on implementation of the economic substance doctrine. This doctrine previously applied under US common law and has now been codified by the Health Care and Education Act of 2010, effective for transactions entered on or after 31 March 2010.

The economic substance doctrine permits the IRS to deny tax benefits from a transaction unless (i) the transaction changes in a meaningful way (apart from Federal income tax effects) the taxpayer’s economic position, and (ii) the taxpayer has a substantial purpose (apart from Federal income tax effects) for entering into the transaction.

Notice 2010-62 provides information on how the IRS intends to apply the newly codified doctrine. Particular guidance is provided with respect to:

  • the application of the two-part conjunctive test of the doctrine;

  • the calculation of net present value of reasonably expected pre-tax profit (which is a necessary requirement for meeting the test); and

  • the treatment of foreign taxes as expenses in appropriate cases.

Application of the US accuracy-related penalties is also discussed.

Notice 2010-62 provides, in general, that the IRS will apply the codified economic substance doctrine in the same manner as the doctrine was applied by the US courts under common law. The IRS states, however, that it does not intend to issue administrative guidance regarding the types of transactions to which the doctrine will or will not be applied.

(iii) Offshore Voluntary Disclosure Program reopened indefinitely

The US Internal Revenue Service (IRS) issued a News Release (IR-2012-5) on 9 January 2012 to announce reopening of the Offshore Voluntary Disclosure Program (OVDP) to allow taxpayers with undisclosed offshore accounts to report such accounts to the IRS and get current with their US taxes. The new OVDP is effective from 9 January 2012 and will remain open for an indefinite period until otherwise announced.

The new OVDP requires participants to pay a penalty of 27.5% of the highest aggregate balance in foreign bank accounts/entities or value of foreign assets during the 8 full tax years prior to the disclosure. That is increased from 25% in the 2011 program. The new OVDP maintains the reduced 5% and 12.5% penalties that applied in limited situations under the 2011 program.

Participants must file all original and amended tax returns and include payment for back-taxes and interest for up to eight years as well as paying accuracy-related and/or delinquency penalties.

The IRS stated that more details will be released within the next month.

The IRS also announced in the press release that more than USD 4.4 billion have been collected so far from the two previous disclosure programs.

(iv) Joint Committee on Taxation issues report on taxation of financial instruments

The Joint Committee on Taxation of the US Congress has released a report on US Federal tax rules relating to financial instruments.

The report is entitled Present Law and Issues Related to the Taxation of Financial Instruments and Products. The report is dated 2 December 2011 and is designated JXC-56-11.

The report is divided into four sections, as follows:

  • Section I describes economic, financial accounting, and regulatory considerations related to holding, issuing, and structuring financial instruments;

  • Section II describes the basic US income tax principles of timing, character, and source that underlie the taxation of financial instruments;

  • Section III provides an overview of the timing, character, and source rules for five types of financial instruments (i.e., equity, debt, options, forward contracts, and notional principal contracts), plus a description of the economic relationships among various financial instruments (including so-called put-call parity) and the financial accounting treatment of financial instruments; and

  • Section IV discusses selected timing, character, source, and categorisation issues in taxation of financial instruments.

The report also includes an appendix with data on holdings and issuance of financial instruments.

(v)    IRS updates annual list of international no-ruling areas

The US Internal Revenue Service (IRS) has issued Revenue Procedure 2012-7 with its updated list of international tax issues on which it will not accept applications for private letter rulings and determination letters.

Revenue Procedure 2012-7 includes two lists of international no-ruling areas, i.e., (i) areas in which rulings or determination letters will not be issued, and (ii) areas in which rulings or determination letters will ‘not ordinarily be issued’.

Inclusion of an item on the ‘not ordinarily be issued’ list means that the IRS will not issue a private letter ruling or determination letter on the issue absent unique and compelling reasons given by the taxpayer that would justify a ruling or determination letter.

The 2012 lists have not changed from the 2011 lists, and include such no-ruling and ordinarily no-ruling areas as, among others:

  •     whether a payment constitutes portfolio interest u/s.871(h) of the US Internal Revenue Code (IRC), regarding the US tax exemption on certain portfolio interest received by non-resident foreign individuals;

  •     whether a taxpayer is eligible to claim benefits under the limitation on benefits provision (LOB) of a US income tax treaty;

  •     whether a foreign individual is a non-resident of the United States;

  •     issues that are the subject of a pending request for competent authority assistance under a US tax treaty;

  •     whether a foreign taxpayer is engaged in a trade or business in the United States, and whether income is effectively connected to a US trade or business;

  •    whether a foreign taxpayer has a permanent establishment in the United States, and whether income is attributable to a US permanent establishment;

  •     whether a foreign levy meets the requirements of a creditable tax or in-lieu-of-tax in the United States; and

  •     specified issues concerning conduit financing arrangements.

Revenue Procedure 2012-7 is effective from 3 January 2012.

(vi)    Final regulations issued for CSAs in transfer pricing

The US Treasury Department and Internal Revenue Service (IRS) have issued final regulations (TD 9568) on the transfer pricing rules for cost-sharing arrangements (CSAs). The final regulations were issued u/s.482 of the US Internal Revenue Code (IRC) and are effective from 16 December 2011.

The final regulations provide guidance on the determination of and compensation for economic contributions by controlled participants in connection with a CSA in accordance with the arm’s-length standard. The final regulations adopt with modifications the 2008 temporary and proposed regulations on this topic, which was published on 5 January 2009. The final regulations provide modifications and clarifications to the 2008 regulations, including:

  •     treatment of research tools as platform contributions;

  •    clarification on updating reasonably anticipated benefit (RAB) shares;

  •     supplemental guidance on transfer pricing methods applicable to platform contribution transactions (PCTs);

  •     supplemental guidance on application of the best method analysis and the income method;

  •     clarifications with regard to the acquisition price and market capitalisation methods;

  •     clarifications with regard to the residual profit split method;

  •     clarifications regarding forms of payment; and

  •     determinations of periodic adjustments.

The Treasury Department and the IRS state in the preamble to the final regulations that they continue to consider the matters regarding the valuation of stock options and other stock-based compensation and intend to address this issue in a subsequent regulations project.

(2)    Germany: Guidance on amended Anti-Treaty Shopping rules published

On 25 January 2012, the Ministry of Finance published official guidance (IV B 3 – S 2411/07/10016) on the application of the anti-treaty-shopping rules embodied in Article 50d(3) of the Income-tax Act as amended in 2011.

Under the revised rules, treaty benefits to a non-resident (intermediate) company are denied if:

  •     as far as its shareholders would not be entitled to the treaty benefits if they would have invested directly; and

  •     as far as the functional requirements of Article 50d(3) are not fulfilled, i.e., the company derives harmful revenue.

The functional requirements are met if:

  •     as far as the company generates its gross income from its own active business activities; or

  •     in regard to the company’s gross income that is not generated from its own business activities:

– there are economic or other important reasons for the use of the intermediate company in view of the respective income; and

– the foreign company is adequately equipped for carrying out its own business activities and for participating in the general commerce.

The amendments brought by the bill on the implementation of Directive 2010/24 and other tax laws were necessary in response to the infringement procedure initiated by the European Commission in 2010. Under the old rules, treaty benefits were denied to an intermediate company, inter alia, if the company did not generate more than 10% of its gross income from its own active business activities. The European Commission considered this all-or-nothing approach as disproportionate and going beyond what is necessary to attain the objective of preventing tax evasion. The amended rules provide for a pro-rata relief, to the extent the functional requirements of Article 50d(3) of the ITA are met and there is non-harmful gross income.

Article 50d(3) of the ITA imposes the burden of proof on the non-resident company in respect of the existence of economic or other important reasons for the interposition of the intermediate company as well as for its adequate business substance. The Guidance defines ‘own business activities’ as activities that exceed the mere management of assets and require a participation in general commerce. Further, the interposition of an EU entity can only qualify if the interposed company participates in general commerce within the Member State of its jurisdiction in an active, permanent and persistent fashion. Services for group companies qualify as business activities if invoiced at arm’s length.

Regarding the notion of ‘economic or other important reasons’ for the use of the intermediate company, the Guidance stipulates that an economic reason is given, if the intermediate company is used in order to start an own business activity and the respective activities can be clearly proven.

Other business reasons, relating to the concerns of the entire group (e.g., coordination and organisation, customer relationship building, cost reduction, location preferences or overriding group business objectives) do not qualify as sufficient economic reason. The Guidance further points out that the mere securitisation of assets or shareholders’ pensions in times of economic crisis, as well as the structuring of ancestral successions, do not qualify as an economic reason in this respect.

The amended rules generally apply as from 1 January 2012. However, the rules shall apply as well to all pending cases in which the application of the amended rules lead to more beneficial results for the taxpayer.

(3)    New Zealand: Exposure draft of interpretation statement on tax avoidance

An exposure draft of an interpretation statement, released by Inland Revenue on 19 December 2011, has invited comments from the public on tax avoidance and Inland Revenue’s interpretation of sections BG1 and GA1 of the Income Tax Act, 2007 (ITA). Following a number of significant court decisions on tax avoidance in recent years, the exposure draft discusses Inland Revenue’s interpretation of tax avoidance.

In Ben Nevis Forestry Ventures Ltd. & Ors. v. Commissioner of Inland Revenue; Accent Management Ltd. & Ors. v. Commissioner of Inland Revenue (2009) 24 NZTC 23, 188, the Supreme Court examined the approach between section BG1 and the rest of the Income Tax Act. Subsequently, the approach adopted in Ben Nevis was endorsed as the correct approach to apply section BG1 in Penny and Hooper v. Commissioner of Inland Revenue (2011) NZSC

95.    The exposure draft sets out the analysis to be undertaken to determine whether an arrangement is a tax avoidance arrangement, viz.:

  •     identify the arrangement;
  •    review all information to ensure all aspects and effects of the arrangement are understood;
  •     identify the provisions of the ITA that were used or circumvented under the arrangement and its outcomes;
  •     identify the commercial reality and economic effects of the arrangement;
  •     ascertain Parliament’s purpose for the provisions of the ITA used or circumvented in the whole arrangement and its outcomes;
  •     decide whether the arrangement, viewed in a commercially and economically realistic way, falls outside Parliament’s purpose; and
  •     exclude any arrangements where the tax avoidance is ‘merely incidental’ to a non-tax purpose.

The deadline for comments on the exposure draft is 31st March, 2012.

Taxation of Royalties and FTS as Business Profits (Interplay of Sections 44BB, 44D and 44DA)

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1.0 Background

Income in the nature of Royalties and Fees for Technical Services (FTS) in the hands of nonresidents are generally taxed on gross basis as per Article 12 of the applicable Treaty or u/s.115A read with section 9(1)(vi) and (vii) of the Income-tax Act, 1961 (the ‘Act’). Essentially both kinds of income are subset of Business Income. Therefore, ideally they should be taxed on a net basis. However, even under tax treaties these incomes are taxed on gross basis in the State of Source, albeit at a concessional rate. Prior to the enactment of section 44DA on Statue, section 44D was in operation (Applicable to agreements entered into by non-residents up to 31st March 2003) which specifically disallowed deduction of any expenditure in computing Foreign Company’s Income by way of Royalties and FTS. Thus, it resulted in taxation of royalties/FTS on gross basis even in a case where there existed a Permanent Establishment in India. However, the silver lining was applicability of section 44BB which covered payments in connection with supplying of Plant and Machinery on hire which is used or to be used for prospecting for, extraction or production of mineral oils including natural gas. Section 44BB provides for presumptive basis of taxation whereby 10% of the gross amount is deemed to be taxable profits.

2.0 Royalty and FTS

— Sections 9(1)(vi) and (vii) of the Act In this Article, we shall discuss the provisions of Royalty and FTS in the context of sections 44BB, 44D and 44DA only. We shall not go into the other aspects or controversies in respect of Royalty and FTS.

2.1 Royalty

Clause (iva) of the Explanation 2 of the section 9(1)(vi) provides that “the use or right to use any industrial, commercial or scientific equipment but not including the amounts referred to in section 44BB” would constitute royalty. This exception is significant in that it substantially reduces tax liability in the hands of the recipient of royalty income. Section 115A provides that royalties referred to in section 9(1)(vi) are taxed at the rate of 10% on gross basis (other than royalty referred to in section 44DA), whereas if the income is taxed u/s.44BB, then the incidence of tax would be @ 4% on gross basis (excluding applicable Surcharge and Education Cess).

2.2 Fees for Technical services (FTS)

Explanation 2 of section 9(1)(vii) excludes consideration for any construction, assembly, mining or like project undertaken by the recipient from the purview of FTS. The CBDT has issued an Instruction No. 1862, dated October 22, 1990 based on the opinion of the then Attorney General of India Shri Soli J. Sorabjee in the context of interpretation and coverage of section 9(1)(vii) in respect of contract between ONGC and M/s. Scan Drilling Co. Ltd. Accordingly “the expressions ‘mining project’ or ‘like project’ occurring in Explanation 2 to section 9(1)(vii) of the Income-tax Act would cover rendering of services like imparting of training and carrying out drilling operations for exploration or exploitation of oil and natural gas . . . .” Based on the above CBDT Instruction in ONGC v. ACIT, (2007) 12 SOT 584 (Delhi) it was held that imparting training for carrying out of drilling for exploration of oil and natural gas was held to be covered by the exception referred to in Expl. 2 to section 9(1)(vii) and can be taxed on presumptive basis u/s.44BB of the Act. Supervisory services In Income-tax Officer v. SMS Schloemann Siemag Aktiengesellshaft Dusseldorf, (57 ITD 254) it was held that mere ‘supervisory services’ undertaken by the assessee would not amount to undertaking of the construction or assembly of the plant for exclusion from FTS under Expl. 2 to section 9(1)(vii) of the Act.

3.0 Section 44D of the Act

Section 44D of the Act dealt with computation of royalty or FTS received by a foreign company from Government or an Indian concern in pursuance of an agreement entered into before 1st April 2003. Up to 31st March 1976 it provided for a flat deduction of 20% from the gross amount of royalty or FTS. From 1st April 1976 to 31st March 2003 it did not provide for deduction of any expenditure. In other words royalty or FTS (not covered 44BB) earned by a foreign company during this period was taxed on gross basis @ 30/20% (plus applicable Surcharge and Education Cess). Thus, the incidence of taxation was quite high even though the foreign company would have a permanent establishment in India.

4.0 Section 44DA of the Act

Section 44DA was introduced vide the Finance Act, 2003 to replace section 44D of the Act. It also covers income by way of royalty and FTS. The distinguishing features of both the sections are as follows:

Abbreviations :
(i) NR = Non-resident * Plus applicable Surcharge and Education Cess
(ii) FTS = Fees For Technical Services
(iii) PE = Permanent Establishment as defined Clause (iiia) of section 92F

5.0 Interplay of sections

44BB, 44D and 44DA Royalty and FTS are essentially covered by section 9 r.w.s. 115A as well as sections 44BB and 44D and 44DA. The impact of taxation in each of the case differs depending upon the applicability of provisions and existence or otherwise of a PE. The overall implications under various provisions of the Act can be summarised as follows: If Royalty & FTS as per

  •  section 115A tax section 9(1)(vi)/(vii) @10% on gross basis and No PE If No Royalty and ? If income is covered No PE by section 44BB — Presumptive Profit @10% of gross receipts. Effective rate of tax 4% [With an option to tax on net basis u/s.44BB(3)] If Royalty & FTS as per
  • Section 44DA on net section 9(1)(vi)/(vii) basis @ 40% and PE (Rates are quoted without Surcharge and Education Cess) In Geofizyka Torun Sp. zo. o. (2010) 320 ITR 0268 — the AAR explained the relationship between section 44BB and 44DA as under: “If the business is of the specific nature envisaged under 44BB, the computation provision therein would prevail over the computation provision in section 44DA.”

Abbreviations : (i) NR = Non-resident
(ii) P&M = Plant & Machinery
(iii) FTS = Fees For Technical Services
(Rates are quoted without Surcharge and Education Cess)

6.0 Taxability under DTAA

By and large all tax treaties which contain Articles on Royalty and FTS provide for their taxation in the State of Source (SS) on gross basis, albeit, at reduced rates. However, wherever the recipient has a PE in the ‘SS’, and such incomes are effectively connected with that PE, then they are taxed as ‘Business Profits’ [DDIT v. Pipeline Engineering GMBH, (2009) 318 ITR (A.T.) 0210]. Article 7 of DTAAs provides that profits attributable to a PE in ‘SS’ are taxed therein. Article 7 further provides for computation of profits where by deduction of expenses are allowed in accordance with the provisions of and subject to limitations of the taxation laws of SS. In some treaties specific deductions are mentioned, whereas in most treaties they are left to domestic tax laws.

Business Profits, thus taxable in India would be subject to provisions of section 28 to 44C of the Act. However, section 44D contained non-obstante clause which provided that “notwithstanding anything to the contrary contained in section 28 to 44C……” income derived by a foreign company in the nature of royalty and FTS to be taxed on gross basis. This resulted in severe difficulties as despite treaty provisions, Royalty and FTS even though attributable to a PE used to be taxed on gross basis. In DDIT v. Pipeline Engineering GMBH, [(2009) 318 ITR (A.T.) 0210] the Mumbai Tribunal held that “the combined reading of the treaty and the act leads to only one conclusion that no deduction is to be allowed against the receipts by way of royalties or fees for technical services in case of non-resident company, even if the business profits in respect of such income are to be computed under Article 7 of the DTAA”.

In order to avoid this anomaly, section 44DA was introduced w.e.f. 1st April 2004, which provided for net basis of taxation where royalty and FTS are effectively connected to a PE and incurred wholly and exclusively for the business carried on by that PE.

7.0 Judicial precedence

Majority of the decisions are in respect of characterisation of income between royalty as defined u/s.9(1)(vi) and business income covered by section 44BB of the Act.

7.1  Choice to opt for presumptive taxation

In DSD INDUSTRIEANLAGEN GmbH v. DDIT, (2009 TII 67 ITAT-Del.-Intl), the Tribunal held that the option to compute the income either on a presumptive basis or under normal provisions of the Act lies with the assessee and that he may exercise this option annually. “The Assessing Officer cannot force the system, which has been followed in the earlier year as per the option by the provision of law itself.”

7.2 Cases pertaining to section 44BB

7.2.1  Mobilisation expenses

In WesternGeco International Limited (2011) 338 ITR 0161 it was held that mobilisation and demobilisation revenues whether in respect of vessels moving into India or moving outside India are taxable in aggregate u/s.44BB on presumptive basis and that “there is no scope for splitting up the amount payable to the assessee.” The assessee however can opt for net basis of taxation u/s.44BB(3).

However, in case of R&B Falcon v. ACIT, (2007) 14 SOT 281 (Delhi) it was held that mobilisation revenue attributable to activities carried out in India are only liable to be included for the purposes of section 44BB.

7.2.2 In the undernoted cases the services of seismic data acquisition and processing were held to be covered under the provisions of section 44BB of the Act:

(i)    WesternGeco International Limited. (2011) 338 ITR 0161

(ii)    Geofizyka Torun SP. ZO.O. (2010) 320 ITR 0268

(iii)    Seabird Exploration FZ LLC (2010) 320 ITR 0286

7.2.3 Time charter

In the undernoted cases the income derived by provision of time charter of seismic vessel were held to be covered by section 44BB of the Act:

(i)    Wavefield Inesis ASA, (2010) 322 ITR 0645

(ii)    Bourbon Offshore Asia Pte. Ltd., (2011) 337 ITR 0122

7.2.4 General applicability of section 44BB

In the undernoted cases section 44BB was held to be applicable:

(i)    DIT v. Jindal Drilling and Industries Ltd., (2010) 320 ITR 0104 (Delhi)

(ii)    ONGC as agent of Foramer France (1999) 70 ITD 468 (Delhi)

(iii)    Paradigm Geophysical Pvt. Ltd. (2008 TIOL 362 ITAT-Del.)

(iv)    Dresser Mineral International Inc., 50 TTJ 273 (Del.)

(v)    Scan Drilling Co. (Delhi ITAT)

(vi)    Lloyd Helicopters International (2001) 249 ITR 162 (AAR)

7.2.5 Some Specific inclusions while considering Gross Receipts u/s.44BB:

(i)    Services tax : Technip Offshore Contracting bv (2009 TIOL 54 ITAT-Del.)

(ii)    Taxes paid on behalf of NR contractor: Compagnie General (48 ITD 424)

8.0 Conclusion

The cases discussed here are not exhaustive. It is neither possible nor intended to cover all case laws on the subject in one article. The object here is to analyse the impact and interplay of sections 9(1)(vi) and (vii), 44BB, 44D and 44DA and 115A and to assess the taxability of Royalty and FTS both on gross as well as net basis.

As India is aggressively exploring its oil and gas resources, more and more foreign companies are setting up their operations in India in the field of prospecting, exploring and production of oil and natural gas and therefore study of these sections of the Act will gain importance in coming days.

India’s DTAAs – Recent Developments

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In the last two years, India has signed DTAAs with
several developing countries and revised DTAAs with several advanced
countries either by signing a Protocol amending the existing DTAA or by
signing a revised DTAA. In this Article, our intention is to highlight
the salient features of some such DTAAs or Protocols amending the DTAAs.
The purpose is not to deal with such DTAAs or Protocols extensively or
exhaustively. It will be seen that the recent treaties with developing
countries follow more or less a similar pattern. Further, the DTAAs with
Developed Countries are being modified to exclude the concept of “Make
Available”, include ‘Limitations of Benefits (LOB) Clause’ and other
Anti- Abuse Provisions. Further, Articles on ‘Exchange of Information’
and ‘Assistance in Collection of Taxes’ are being included or the scope
of such existing Articles is being extended.

The reader is advised to refer the text of the relevant DTAA or the Protocol while dealing with facts of a particular case.

A) DTAAs/Protocols Signed and Notified

1. Finland

A revised DTAA and Protocol has been signed on 15-01-2010 between India and Finland, effective from 1st April, 2011.

As
per the revised Agreement, withholding tax rates have been reduced on
dividends from 15 % to 10 % and on royalties and fees for technical
services from 15 % or 10 % to a uniform rate of 10 %.

The
revised DTAA excludes the concept of “Make Available” from Article 12
(FTS). The revised Agreement also expands the ambit of the Article
concerning Exchange of Information to provide effective exchange of
information.

The Article, inter-alia, provides that a
Contracting State shall not deny furnishing of the requested information
solely on the ground that it does not have any domestic interest in
that information or such information is held by a bank etc. An Article
for Limitation of Benefits to the residents of the contracting countries
has also been included to prevent misuse of the DTAA.

Other features of the revised Agreement are:-

a) Provisions regarding Service PE has been included in the Article concerning PE.

b)
Paragraph 2 to Article 9 has been included to increase the scope for
relieving double taxation through recourse to Mutual Agreement Procedure
(MAP).

c) A new Article on assistance in collection of taxes
has been added, to ensure assistance in collection of taxes when such
taxes are due under the domestic laws and regulations.

d) The
time test for Independent Personal Service has been extended from 90
days or more in the relevant fiscal year to 183 days or more in any
period of 12 months commencing or ending in the fiscal year concerned.

2. Switzerland

India
has signed a Protocol amending the DTAA with Switzerland, notified on
27-12-2011, effective from 01-04-2012 (and, in respect of Exchange of
Information Article 26, effective from 01-04-2011).

The 14 Articles of the Protocol deal with various matters. Some of the noteworthy changes are as follows:

i) International Traffic to include transport via ship also:

The
earlier definition under the Article 3 (i) of the DTAA referred to
means of transport as ‘aircraft’ alone. Now the ambit has been increased
and the word ‘ship’ has also been added. The business profits will not
exclude the profits from the operation of ships; the change in
definition is evident due to the change in the ambit of international
traffic, which now includes ‘ship’ also as one of the means of
transport. Further changes under Article 8 in addition to air transport
also include shipping, which is consequential. Similar changes are
incorporated under Article 11 & 13.

ii) Non-discrimination clause:

Article
24 of the India-Swiss Protocol has incorporated the changes on the
basis of agreement which is line with the USA. Therefore, the taxation
of a permanent establishment which an enterprise of a Contracting State
has in the other Contracting State, shall not be less favorably levied
in that other State than the taxation levied on enterprises of that
other State carrying on the same activities. This provision shall not be
construed as obliging a Contracting State to grant to residents of the
other Contracting State any personal allowances, reliefs and reductions
for taxation purposes on account of civil status or family
responsibilities, which it grants to its own residents.

Further,
it is clarified that the non-discrimination provision shall not be
construed as preventing a Contracting State from charging the profits of
a permanent establishment which a company of the other Contracting
State has in the first mentioned State, at a rate of tax which is higher
than that imposed on the profits of a similar company of the first
mentioned Contracting State, nor as being in conflict with the
provisions of business profits. However, the difference in tax rate will
not exceed 10 % points in any case.

iii) Exchange of Information:

The
competent authorities of the States will exchange information for the
purposes of carrying out provisions of the DTAA between India and Swiss
and the domestic laws and compliances concerning the taxation. Further,
the exchange of information is not restricted to apply only to the
residents of the Contracting State alone. Proper disclosure methods have
also been provided. On a request for information from India,
Switzerland will need to use its administration to obtain that
information regardless of whether it requires this information under its
own tax laws, as long as it does not violate its legal process. The
information may be held by a bank, financial institution, nominee or
person acting in an agency or a fiduciary capacity. But for the same,
India has to first exhaust its own laws to obtain the information. A
host of procedures are provided in the protocol which are mandatory.

The
amendment clarifies that exchange of information which is foreseeable
and relevant, the procedure has to be set out in order to safeguard the
genuine issues.

iv) Definition of the term “Resident of a Contracting State” in Article 4 (1) expanded:

A
new paragraph is added to the Protocol, which expands the scope of the
term “Resident of a Contracting State”, and includes a recognised
pension fund or pension scheme in that Contracting State. These pension
funds or pension schemes will be recognised and controlled according to
the statutory provisions of that State, which is generally exempt from
income tax in that state and which is operated principally to administer
or provide pension or retirement benefits.

v) Conduit Arrangement:

This
provision is a anti-abuse provision. It states that benefits under
Articles 10 (Dividends), Article 11 (interest), Article 12 (Royalty) and
Article 22 (Other Income) would not be available, where such sums are
received under a “conduit arrangement”.

The term “Conduit Arrangement” means a transaction or series of transactions which is structured in such a way that a resident of a Contracting State entitled to the benefits of the Agreement, receives an item of income arising in the other Contracting State but that resident pays, directly or indirectly, all or substantially all of that income (at any time or in any form) to another person who is not a resident of either Contracting State and who, if it received the item of income directly from the other Contracting State in which the income arises, or otherwise, to benefits with respect to that item of income which are equivalent to, or more favourable than those available under this agreement to a resident of a Contracting State and the main purpose of such structuring is obtaining benefits under this Agreement.

3.    Lithuania

India signed a DTAA with Lithuania on 26-07-2011 and notified on 26 -07-2012, effective from 01 -04-2013. Lithuania is the first Baltic country with which a DTAA has been signed by India.

The Agreement provides for fixed place PE, building site, construction & installation PE, service PE, Off-shore exploration/exploitation PE and agency PE.

Dividends, interest and royalties & fees for technical services income, will be taxed both in the country of residence and in the country of source. The low level of withholding rates of taxation for dividend (5% & 15%), interest (10%) and royalties & fees for technical services (10%) will promote greater investments, flow of technology and technical services between the two countries.

The Agreement further incorporates provisions for effective exchange of information including exchange of banking information and supplying of information without recourse to domestic interest. Further, the Agreement provides for sharing of information to other agencies with the consent of supplying state. The Agreement also has an article on assistance in collection of taxes. This article also includes provision for taking measures of conservancy. The Agreement incorporates anti-abuse (limitation of benefits) provisions to ensure that the benefits of the Agreement are availed of by the genuine residents of the two countries.

4.    Mozambique

India has notified the DTAA with Mozambique on 31st May, 2011, effective from 1st April, 2012.

The DTAA provides that profits of a construction, assembly or installation project will be taxed in the state of source, if the project continues in that state for more than 12 months.

The DTAA provides that profits derived by an enterprise from the operation of ships or aircraft in international traffic, shall be taxable in the country of residence of the enterprise. Dividends, interest and royalties income will be taxed both in the country of residence and in the country of source. However, the maximum rate of tax to be charged in the country of source will not exceed 7.5% in the case of dividends and 10% in the case of interest and royalties. Capital gains from the sale of shares will be taxable in the country of source.

The Agreement further incorporates provisions for effective exchange of information and assistance in collection of taxes including exchange of banking information and incorporates anti-abuse provisions to ensure that the benefits of the Agreement are availed of by the genuine residents of the two countries.

5.    Tanzania – Revised DTAA

India has signed a revised DTAA with Tanzania on 27th May, 2011, effective from 1st April, 2012.

The DTAA provides that business profits will be taxable in the source state, if the activities of an enterprise constitute a permanent establishment in the source state. Profits of a construction, assembly or installation project will be taxed in the state of source, if the project continues in that state for more than 270 days.

The DTAA provides that profits derived by an enterprise from the operation of ships or aircrafts in international traffic shall be taxable in the country of residence of the enterprise. Dividends, interest and royalties income will be taxed both in the country of residence and in the country of source. However, the maximum rate of tax to be charged in the country of source will not exceed a two-tier 5% or 10% in the case of dividends and 10% in the case of interest and royalties. Capital gains from the sale of shares will be taxable in the country of source.

The Agreement further incorporates provisions for effective exchange of information and assistance in collection of taxes including exchange of banking information and incorporates anti-abuse provisions, to ensure that the benefits of the Agreement are availed of by the genuine residents of the two countries.

6.    Georgia

India has signed a DTAA with Georgia on 24-08-2011, effective from 1st April, 2012.

The Agreement provides for fixed place PE, Building Site, Construction & Installation PE, Service PE, Insurance PE and Agency PE. The Agreement incorporates para 2 in Article concerning Associated Enterprises. This would enhance recourse to Mutual Agreement Procedure, to relieve double taxation in cases involving transfer pricing adjustments.

Dividends, interest and royalties & fees for technical services income will be taxed both in the country of residence and in the country of source. The low level of withholding rates of taxation for dividend (10%), interest (10%) and royalties & fees for technical services (10%) will promote greater investments, flow of technology and technical services between the two countries.

The Agreement incorporates provisions for effective exchange of information, including exchange of banking information and supplying of information without recourse to domestic interest. The Agreement also provides for sharing of information to other agencies with the consent of supplying state.

The Agreement has an article on assistance in collection of taxes, including provision for taking measures of conservancy. The Agreement incorporates anti-abuse (limitation of benefits) provisions to ensure that the ben-efits of the Agreement are availed of by the genuine residents of the two countries.

7.    Singapore

India has signed a Second Protocol amending DTAA with Singapore on 24th June, 2011, entered into force from 1st September, 2011, but shall be given effect to for taxable periods falling after 01-01-2008, i.e. Financial Year 2008-09 & subsequent financial years. Both India and Singapore have adopted internationally agreed standard for exchange of information in tax matters. This standard includes the principles incorporated in the new paragraphs 4 and 5 of OECD Model Article on ‘Exchange of Information’ and requires exchange of information on request in all tax matters for the administration and enforcement of domestic tax law without regard to a domestic tax interest requirement or bank secrecy for tax purposes.

8.    Norway

India signs revised DTAA with Norway on 2nd February, 2011, effective from 1st April, 2012.

The revised tax treaty provides for exchange of information between the two nations including banking data. It also provides that each state would be required to collect and provide the information, even though such information is not needed by that state.

It also provides for the Limitation of Benefit (LOB) clause, whereby the treaty benefit would be denied, if the main purpose of the transaction or creation or existence of residence is to avail the treaty benefit.

9.    Japan

India has notified on 24-05-2012, amendments to Article 11 of the India-Japan DTAA, but effective from 1st April, 2012.

As per Article 11(3), interest arising in India and derived by Central Bank or any financial institution wholly owned by Government of Japan, is not taxable in India. Earlier, Inter-national business unit of Japan Finance Corporation was one of the entities entitled to the benefit under Article 11(3). According to the amendment, Japan Bank for International Cooperation would be entitled to the benefit now, instead of the International business unit of Japan Finance Corporation.

10.    Taipei (Taiwan)

The Taipei Economic and Cultural Center in New Delhi has signed a DTAA with the India – Taipei Association in Taipei. Taiwan’s Ministry of Finance (MOF) on August 17, 2012 announced that Taiwan’s income tax agreement and protocol with India entered into force on August 12, 2012 and will apply to income derived from Taiwan on or after January 1, 2012, and to income derived from India on or after April 1, 2012. The agreement has been entered u/s. 90A of the Income-tax Act, 1961 wherein any “specified association” in India may enter into a DTAA with any “specified association” in a “specified territory” outside India. The Taipei Economic and Cultural Center in New Delhi and India – Taipei Association in Taipei have been notified as “specified associations” and “the territory in which the taxation law administered by the Ministry of Finance in Taipei is applied”, has been notified as the “specified territory” for the purpose of Section 90A.

Salient Features of the DTAA

Persons Covered – The DTAA applies to persons who are residents of India, Taipei or both.

Taxes Covered
•    In case of India, the DTAA will cover income tax (including any surcharge thereon).
•    In the case of Taipei, it would cover the following (including the supplements levied thereon):

–  the profit seeking enterprise income tax;

–  the Individual consolidated income-tax; and

–  the income basic tax.

Definition of Person

•    The term “person” to include an individual, a company, a body of persons and any other entity which is treated as a taxable unit under the taxation laws of the respective territories.

Resident

•    In order to qualify as a “resident of a territory” under the DTAA, person has to be “liable to tax” therein by reason of his domicile, residence, place of incorporation, place of management or any other criterion of a similar nature, and also includes that territory and any sub-division or local authority thereof.

•    Further, the term ‘resident’ does not include any person who is liable to tax in that territory only in respect of income from sources in that territory.

•    In case of dual residency, necessary tie breaker rules have been prescribed to determine tax residency. For individuals, the DTAA provides for criteria such as permanent home, centre of vital interests, habitual abode, etc. For persons other than individuals, the tie breaker provides for place of effective management criteria.

Permanent Establishment (‘PE’) – The DTAA contains clauses for constitution of a fixed place PE and inclusions thereon. For construction/supervisory PE, the activities at a building site, or construction, installation, or assembly project or supervisory activities should last for more than 270 days. In respect of constituting a PE by way of furnishing of services, including consultancy services, the services should be rendered for a period or periods aggregating to more than 182 days within any 12 month period for the same or connected project.

Shipping and air transport – Profits from operation of ships or aircraft in international traffic shall be taxable only in the territory of residence.

Dividends, Interest, Royalties and Fees for Technical services (‘FTS’)

•    Dividends, Interest, Royalties and FTS may be taxed in the territory of residence as well as in the source territory.

•    The rate of tax in the source territory shall not exceed the following rates (on a gross basis) in case the beneficial owner of the Dividend, Interest, Royalties and FTS is a resident of the other territory:

– Dividends: 12.5%
– Interest: 10%
– Royalties and FTS: 10%

•    FTS has been defined to mean payments of any kind, including the provision of services of technical or other personnel.

Capital gains

•    Income by way of Capital gains shall be taxed as follows:

– From alienation of Immovable property: In the territory in which the immovable property is situated.

– From alienation of ships or aircraft operated in international traffic: The territory in which the alienator is a resident.

– From alienation of shares deriving more than 50% value from immovable property: In the territory in which such immovable property is situated.

– From alienation of any other shares: The territory in which the company whose shares are alienated, is a resident.

– From alienation of any other property: The territory in which the alienator is a resident.

Methods of Elimination of Double Taxation (Tax Credit)

•    The DTAA allows for the “credit method” to eliminate taxation of income by both India and Taipei. The tax credit for taxes paid on such income in the other territory is available as a credit to a taxpayer in his territory of residence. However, the above tax credit should not exceed the tax on the doubly taxed income in the territory of his residence.

•    It has also been provided that, where any income received in accordance with the provisions of the DTAA by the resident of the other country is exempt from tax in the country of residence, then in calculating the tax on the remaining income of such resident, the resident country may nevertheless take into the exempted income.

•    Further, India would not grant credit to its residents on the Land Value Increment Tax imposed under the Land Tax Act, in Taiwan.

Limitation of Benefits (LOB)

•    This Article restricts the benefits under the DTAA if the primary purpose or one of the primary purposes was to obtain the benefits of the DTAA. Legal entities not having bonafide business activities are also covered by the LOB clause.
(Source: Taiwan’s Ministry of Finance)

11.    Nepal

India signed a revised DTAA with Nepal on 27-11-2011 and notified on 12-06-2012, effective from fiscal year beginning on or after the 1st day of April, 2013.

B)    DTAAs signed but not notified

12.    Australia – Protocol amending the DTAA

The protocol was finalised in February, 2011. The protocol amending the DTAA was signed on 16th December, 2011. However, the same is not yet notified.

In the Protocol, the threshold limit to avail the exemption for service, exploration and equipment permanent establishments and taxation thereof have been enhanced/rationalised to encourage cross border movement of capital and services between the two countries. It also removes the “Force of Attraction Rule” in Article 7.

The Exchange of Information Article is updated to internationally accepted standards for effective exchange of information on tax matters, including bank information, and also for exchange of information without domestic tax interest. It also provides that the information received from Australia in respect of a resident of India can be shared with other law enforcement agencies with authorisation of the competent authority of Australia and vice-versa. This will facilitate higher degree of mutual cooperation between the two countries.

The protocol provides that India and Australia shall lend assistance to each other in the collection of revenue claims.

According to it, the assets or money kept in one country can be recovered by the other country for the purposes of recovery of taxes by following certain conditions and procedure.

In the existing treaty, the concept of non-discrimination was not present. As per the protocol signed, nationals of one country shall not be discriminated against the nationals of the other country in the same circumstances in line with international practices.

13.    UK – Protocol to the DTAA

India has signed a protocol dated 30th October, 2012 with UK and Northern Ireland amending the DTAA. This Protocol amends the DTAA which was signed on 25th January, 1993. However, the same is not yet notified.

The Protocol streamlines the provisions relating to partnership and taxation of dividends in both the countries. Now, the benefits of the DTAA would also be available to partners of the UK partnerships to the extent income of UK partnership are taxed in their hands. Further, the withholding taxes on the dividends would be 10% or 15% and would be equally applicable in UK and in India.

The Protocol also incorporates into the DTAA anti-abuse (limitation of benefits) provisions to ensure that the benefits of the DTAA are not misused.

The Protocol incorporates in the DTAA provisions for effective exchange of information, including exchange of banking information and supplying of information irrespective of domestic interest. It now also provides for sharing of information to other agencies with the consent of the supplying state.

There would now be a new article in the DTAA on assistance in collection of taxes. This article also includes provision for taking measures of conservancy.

14.    Indonesia – Revised DTAA

India has signed a revised DTAA with Indonesia on 27th July, 2012. However, the same is not yet notified.

The revised DTAA gives taxation rights in respect of capital gains on alienation of shares of a company to the source State. The Agreement further provides for rationalisation of the tax rates on dividend income, royalties and Fees for Technical Services in the source State @ 10%.

The revised DTAA further incorporates provisions for effective exchange of information including banking information and sharing of information without domestic tax interest. The revised DTAA also provides for assistance in collection of taxes and incorporates Limitation of Benefits and anti-abuse provisions to ensure that the benefits of the Agreement are availed of by the genuine residents.

15.    Uruguay

India has signed a DTAA with Uruguay on 8th September, 2011. However, the same is not yet notified.

The DTAA provides that profits derived by an enterprise from the operation of ships or aircraft in international traffic shall be taxable in the country of residence of the enterprise. Dividends, interest and royalty income will be taxed both in the country of residence and in the country of source. However, the maximum rate of tax to be charged in the country of source will not exceed 5% in the case of dividends and 10% in the case of interest and royalties. Capital gains from the sale of shares will be taxable in the country of source and tax credit will be given in the country of residence.

The Agreement also incorporates provisions for effective exchange of information including banking information and assistance in collection of taxes including anti-abuse provisions to ensure that the benefits of the Agreement are availed of by the genuine residents of the two countries.

16.    Ethiopia

India has signed a DTAA with Ethiopia on 25th May, 2011. However, the same is not yet notified.

The DTAA provides that profits of a construction, assembly or installation projects will be taxed in the state of source if the project continues in that state for more than 183 days.

The DTAA provides that profits derived by an enterprise from the operation of ships or aircrafts in international traffic shall be taxable in the country of residence of the enterprise. Dividends, interest, royalties and fees for technical services income will be taxed both in the country of residence and in the country of source. However, the maximum rate of tax to be charged in the country of source will not exceed 7.5% in the case of dividends and 10% in the case of interest, royalties and fees for technical services. Capital gains from the sale of shares will be taxable in the country of source.

The Agreement incorporates provisions for effective exchange of information and assistance in collection of taxes including exchange of banking information and incorporates anti-abuse provisions to ensure that the benefits of the Agreement are availed of by the genuine residents of the two countries.

17.    Colombia

India has signed a DTAA with Colombia on 13-05-2011. However, the same is not yet notified.

The DTAA provides that profits of a construction, assembly or installation projects will be taxed in the State of source if the project continues in that State for more than six months.

The DTAA provides that profits derived by an enterprise from the operation of ships or aircraft in international traffic shall be taxable in the country of residence of the enterprise. Dividends, interest and royalty income will be taxed both in the country of residence and in the country of source. However, the maximum rate of tax to be charged in the country of source will not exceed 5% in the case of dividends and 10% in the case of interest and royalties. Capital gains from the sale of shares will be taxable in the country of source.

The Agreement further incorporates provisions for effective exchange of information and assistance in collection of taxes including exchange of banking information and incorporates anti-abuse provisions to ensure that the benefits of the Agreement are availed of by the genuine residents of the two countries.

18.    Netherlands

India and Netherlands have concluded a Protocol on 10th May, 2012 to amend the Article 26 of the DTAA concerning Exchange of Information. However, the same is not yet notified.

The Protocol will replace the Article concerning Exchange of Information in the existing DTAC between India and Netherlands and will allow exchange of banking information as well as information without domestic interest. It will now allow use of information for non-tax purpose if allowed under the domestic laws of both the countries, after the approval of the supplying state.

USA — Disclosure of Foreign Accounts and Offshore Voluntary Disclosure Program (OVDP)

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In
this article, we have given brief information about the Offshore
Voluntary Disclosure Program (OVDP) reopened by the U.S. Internal
Revenue Service (IRS) and its relevance to the Non-resident Indians
(NRIs) and Persons of Indian Origin (PIOs) residing in the USA as well
as to the U.S. citizens residing in India. Since a large number of NRIs
and PIOs live in the USA, the information given in this article would be
relevant to many of them as well as to the tax practitioners in India
who are often consulted on the implications and desirability of
disclosure under OVDP.

Background

According to
the provisions of the Internal Revenue Code of 1986 (IRC) as amended, of
the USA, all U.S. residents, green-card holders and citizens must file
their tax returns in the U.S. on their global income and pay taxes on
that income in the U.S. The penalties for failure to pay tax on global
income in the U.S. can be quite severe. This includes penalty for
failure to file return of income in time, failure to pay the taxes by
the due dates and levy of interest for delay in payment of taxes.

In
order to ensure that all the U.S. taxpayers comply with the provisions
of the IRC, the followings additional reporting requirements for
offshore income have been prescribed:

A. Report of Foreign Banks and
Financial Accounts (FBAR) — Form TD F 90–22.1

(a) The U.S.
Congress passed the Bank Secrecy Act (BSA) in 1970 as the first laws to
fight money laundering in the United States. The BSA requires businesses
to keep records and file reports that are determined to have a high
degree of usefulness in criminal, tax, and regulatory matters. The
documents filed by businesses under the BSA requirements are heavily
used by law enforcement agencies, both domestic and international to
identify, detect and deter money laundering whether it is in furtherance
of a criminal enterprise, terrorism, tax evasion or other unlawful
activity.

(b) Accordingly, U.S. residents or persons in and
doing business in the U.S. must file a report with the government if
they have a financial account in a foreign country with a value
exceeding INR614,567 at any time during the calendar year. Taxpayers
comply with this law by reporting the account on their income tax return
and by filing Form TD F 90–22.1, the Report of Foreign Banks and
Financial Accounts (FBAR). The FBAR must be received by the Department
of the Treasury on or before June 30th of the year immediately following
the calendar year being reported. The June 30th filing date may not be
extended. Willfully failing to file a FBAR can be subject to both
criminal sanctions (i.e., imprisonment) and civil penalties equivalent
to the greater of INR6,145,675 or 50% of the balance in an unreported
foreign account — for each year since 2004 for which an FBAR was not
filed.

B. Statement of Specified Foreign Financial Assets under the Foreign Account Tax Compliance Act (FATCA) — Form 8938

(a)
The FATCA, enacted in 2010 as part of the Hiring Incentives to Restore
Employment (HIRE) Act, is an important development in U.S. efforts to
combat tax evasion by U.S. persons holding investments in offshore
accounts.

Under FATCA, certain U.S. taxpayers holding financial
assets outside the United States must report those assets to the IRS. In
addition, FATCA will require foreign financial institutions to report
directly to the IRS certain information about financial accounts held by
U.S. taxpayers, or by foreign entities in which U.S. taxpayers hold a
substantial ownership interest.

(b) Reporting by U.S. Taxpayers Holding Foreign Financial Assets

FATCA
requires certain U.S. taxpayers holding foreign financial assets with
an aggregate value exceeding INR3,072,837 to report certain information
about those assets on a new form (Form 8938 — Statement of Specified
Foreign Financial Assets) that must be attached to the taxpayer’s annual
tax return. Reporting applies for assets held in taxable years
beginning after March 18, 2010. For most taxpayers this will be the 2011
tax return they file during the 2012 tax filing season. Failure to
report foreign financial assets on Form 8938 will result in a penalty of
INR614,567 (and a penalty up to INR3,072,837 for continued failure
after IRS notification). Further, underpayments of tax attributable to
non-disclosed foreign financial assets will be subject to an additional
substantial understatement penalty of 40 percent.

(c) Reporting by Foreign Financial Institutions

FATCA
will also require foreign financial institutions (‘FFIs’) to report
directly to the IRS certain information about financial accounts held by
U.S. taxpayers, or by foreign entities in which U.S. taxpayers hold a
substantial ownership interest. To properly comply with these new
reporting requirements, an FFI will have to enter into a special
agreement with the IRS by June 30, 2013. Under this agreement a
‘participating’ FFI will be obligated to:

(i) undertake certain identification and due diligence procedures with respect to its accountholders;

(ii)
report annually to the IRS on its accountholders who are U.S. persons
or foreign entities with substantial U.S. ownership; and

(iii)
withhold and pay over to the IRS 30% of any payments of U.S. source
income, as well as gross proceeds from the sale of securities that
generate U.S. source income, made to

(a) non-participating FFIs,

(b) individual ac-countholders failing to provide sufficient information to determine whether or not they are a U.S. person, or

(c) foreign entity accountholders failing to provide sufficient information about the identity of its substantial U.S. owners.

(d)
Form 8938 is and will be a significant tool for the IRS to identify the
scope of international tax non-compliance of a given U.S. taxpayer. The
reason why Form 8938 is so useful for the IRS is that Form 8938 now
requires a taxpayer to disclose more information, which connects various
parts of a taxpayer’s international tax compliance including the
information that escaped disclosure on other forms earlier.

(e)
Form 8938, allows the IRS to effectively identify the overall scope of a
taxpayer’s noncompliance. Form 8938 may lay the foundation (and road
map) for an IRS investigation of whether the taxpayer has been in
compliance previously. For example, Question 3a of Form 8938 indirectly
asks a problematic question: it requires the taxpayer to tick the box
‘account opened during tax year’, if the account is opened during the
tax year.

(f) For older accounts, this is a dangerous question.
Answering that the account was not opened in the tax year, implicitly
(and affirmatively by omission) states that account was opened in a
prior year. As a result, prior years FBARs should have been filed. The
answer to question 3a could provide incriminating evidence to the IRS.

(g)
The IRS is tracking foreign accounts in all countries, but thanks to
recent indictments of account-holders in countries like Switzerland and
India (several HSBC India account-holders have been indicted), there
could be increased focus on these countries.

(h) For Basic
Questions and Answers on Form 8938, the interested reader can refer to
the IRS website link at www.irs.gov/businesses/
corporations/article/0,,id=255061,00.html.

Offshore Voluntary Disclosure Program (OVDP)

For years, the IRS has been pursuing the disclosure of information regarding undeclared interests of U.S. taxpayers (or those who ought to be U.S. taxpayers) in foreign financial accounts. On January 9, 2012, the IRS announced yet another Offshore Voluntary Disclosure Program (the 2012 OVDP) following the success of the 2009 Offshore Voluntary Disclosure Program (the 2009 OVDP) and the 2011 Offshore Voluntary Disclosure Initiative (the 2011 OVDI), which were announced many years after the 2003 Offshore Voluntary Compliance Initiative (OVCI) and the 2003 Offshore Credit Card Program (OCCP).

The OVDP programs basically eliminate the risk of criminal prosecution for taxpayers that are accepted into the program, and provide for reduced civil penalties than would apply if the IRS were to discover the taxpayer’s non-compliance in this area. In part, the success of such initiatives often depends on the perception that strong government tax enforcement efforts will follow.

2012 OVDP — Salient features

(a)    The IRS on 9th January, 2012 reopened the OVDP to help people hiding offshore accounts get current with their taxes.

(b)    The program is similar to the 2011 OVDI program in many ways, but with a few key differences. Unlike 2011 OVDI, there is no set deadline for people to apply. However, the terms of the program could change at any time going forward. For example, the IRS may increase penalties in the program for all or some taxpayers or defined classes of taxpayers — or decide to end the program entirely at any point.

(c)    The overall penalty structure for the 2012 OVDP is the same as was for 2011 OVDI, except for taxpayers in the highest penalty category. For the 2012 OVDP, the penalty framework requires individuals to pay a penalty of 27.5% of the highest aggregate balance in foreign bank accounts/entities or value of foreign assets during the eight full tax years prior to the disclosure. That is up from 25% in the 2011 OVDI. Some taxpayers will be eligible for 5 or 12.5% penalties; these remain the same in the 2012 OVDP as in 2011 OVDI. Smaller offshore accounts will face a 12.5% penalty. People whose offshore accounts or assets did not surpass $75,000 in any calendar year covered by the 2012 OVDP will qualify for this lower rate. As under the prior programs, taxpayers who feel that the penalty is disproportionate may opt instead to be examined.

(d)    Participants must file all original and amended tax returns and include payment for back-taxes and interest for up to eight years as well as pay accuracy-related and/or delinquency penalties.

Who should take advantage of the OVDP?

Taxpayers who have undisclosed offshore accounts or assets are eligible to apply for the 2012 OVDP penalty regime.

Taxpayers who reported and paid tax on all their taxable income but did not file FBARs, should not participate in the 2012 OVDI but should merely file the delinquent FBARs with the Department of Treasury, Post Office Box 32621, Detroit, MI 48232-0621 and attach a statement explaining why the reports are filed late. Under the 2011 OVDI, the IRS agreed not to impose a penalty for the failure to file the delinquent FBARs if there were no underreported tax liabilities and taxpayers filed the FBARs by September 9, 2011 (FAQ 17). Presumably, the IRS will follow the same course under the 2012 OVDP since those with no underreported tax liabilities are not truly within the range of taxpayers the IRS is trying to identify.

However, those taxpayers who have failed to report their foreign income altogether, might consider taking the advantage of 2012 OVDP. The ability of a U.S. taxpayer to maintain an undisclosed, ‘secret’ foreign financial account is fast becoming impossible. Foreign account information is flowing into the IRS under tax treaties, through submissions by whistleblowers, from others who participated in the 2009 OVDP and the 2011 OVDP who have been required to identify their bankers and advisors.

It does not matter if the failure to report foreign income or tax evasion was unintentional. For many years the IRS has, as part of the tax return in Schedule B of the Form 1040 — U.S. Individual Income Tax Return, had asked for information on foreign bank accounts and hence a taxpayer is expected to be aware of this.

Additional information will become available as the FATCA and new mandatory IRS Form 8938 — Statement of Specified Foreign Financial Assets has become effective. Under such circumstances, the decision to apply for 2012 OVDP involves fair bit of risk management. Although the 2012 OVDP penalty regime may seem overly harsh for many, the decision to participate should include an economic analysis of the taxpayer’s projected future earnings that could be generated from the foreign funds. It is important to note that if a taxpayer is discovered before any voluntary disclosure submission, there could be harsh criminal (in addition to civil) penalties. The risks may outweigh the benefits.

For those taxpayers at substantial risk of being treated as willful non-filers by the IRS, the OVDP’s fixed civil penalties, generally, are substantially lower than the potential maximum willful penalties. Therefore, filing under the OVDP generally should be a good deal for such taxpayers.

For those few taxpayers, however, who have credible and strong reasonable cause arguments to avoid penalties completely, the fixed penalties of the OVDP program generally do not appear to be an attractive option.

For the vast majority of taxpayers who fall somewhere in between (i.e., clearly not a willful non-filer, but also no credible reasonable cause arguments), the decision becomes a difficult one of number-crunching and comparing all possible outcomes, followed by risk-tolerance and risk-aversion based choices from amongst those possible outcomes in deciding which course to follow. Anyone considering an OVDP submission must carefully examine all potential civil penalties and evaluate the risk of criminal prosecution.

Options available to taxpayers

Taxpayers who have not disclosed their foreign assets and wishing to come into compliance, have the following two options:

(a)    a formal disclosure through the IRS’s standard voluntary disclosure program (a ‘noisy disclosure’) or

(b)    simply trying to file prior year original or amended returns and hope they slip through the cracks and don’t get audited (a ‘silent disclosure’).

Taxpayers must be clearly aware that the IRS is getting more aggressive in auditing ‘silent disclosures’ of offshore accounts and, therefore, this option remains highly risky and is not advisable for most taxpayers. However, a silent disclosure could be a preferred option for some taxpayers, depending on their specific circumstances and that the IRS will never be able to succeed in forcing all taxpayers into a noisy disclosure, which is their stated goal. It is strongly advisable to consult one’s tax advisor for his specific situation. An individual’s situation maybe different from the facts of a generic article of this type and hence it’s better to look at getting the right advice.

Risks of non-reporting and IRS initiatives to seek Foreign Accounts Information

There are rumors regarding ongoing ‘John Doe’ summons (A John Doe summons is any summons where the name of the taxpayer under investigation is unknown and therefore not specifically identified) activity seeking to force foreign financial institutions to deliver account-holder information to the U.S. government as well as possible indictments of foreign financial institutions. Recently, several foreign institutions have advised their account-holders to consult U.S. tax advisers regarding the IRS voluntary disclosure program and their U.S. tax reporting relating to their foreign financial accounts. It is reasonable to assume that such institutions will take whatever action is necessary to avoid being indicted, beginning with the delivery of information regarding account-holders to the U.S. government.

It is likely that the U.S. will require foreign financial institutions doing business in the United States to disclose account-holders having relatively small accounts and earnings. There have been rumors of discussions regarding accounts having a high balance of the equivalent of $50,000 at any time between 2002 and 2010. U.S. persons having interests in foreign financial accounts should not find comfort in a belief that their foreign financial institution will somehow refrain from disclosing very small accounts in the current enforcement environment. Those who think too long may be sorely surprised at the high level of ultimate cooperation of their institution with the U.S. government.

The U.S. government is establishing special disclosure pacts with France, Germany, Italy, Spain and the United Kingdom. Under this approach, foreign banks would disclose data on U.S. account-holders to their own governments, which would then provide information to the IRS. The U.S. government is looking to expand these pacts to other countries as well.

It is important to keep in mind that the U.S. government has prosecuted taxpayers in many cases who did not report their foreign accounts and foreign income. The list of some of such cases is given below:

(a)    U.S. v. Mauricio Cohen Assor (Florida, 2011) got 120 months jail time — his son was also convicted and received the same jail time.

(b)    U.S. v. Diana Hojsak (San Francisco, CA, 2007) got 27 months jail time.

(c)    U.S. v. Igor Olenicoff (Orange County, CA, 2007) got 2 years probation and 120 hours community service.

(d)    U.S. v. Monty D. Hundley (New York, 2005) got 96 months jail time.

(e)    U.S. v. Brett G. Tollman (New York, 2004) got 33 months jail time — his mother and other relatives were also convicted.

Conclusion

Taxpayers having undisclosed interests in foreign financial accounts must consult competent tax professionals before deciding to participate in the 2012 OVDI. Others may decide to risk detection by the IRS and the imposition of substantial penalties, including the civil fraud penalty, numerous foreign information return penalties, and the potential risk of criminal prosecution. If discovered before any voluntary disclosure submission, the results can be devastating. Waiting may not be a viable option.

In view of the above discussion, the NRIs, PIOs and green-card holders living in the USA would be well advised to plan investments in India in a manner that they are able to obtain full credit for Indian taxes paid/withheld at source against their U.S. Tax liability on such Indian income. Further, planning to have the tax-free/low-taxed income in India may not be very prudent in many cases, in view of tax liability of such income in the USA.

The purpose of this article is to bring awareness about the 2012 OVDP of U.S. IRS and the potential risks of non-reporting of foreign financial accounts. This article is based on the information given on U.S. IRS website and views, experiences of earlier OVDPs and articles of U.S. tax experts, available in public domain. The reader is advised to consult U.S. Tax Expert(s) before taking advantage of 2012 OVDP.

Taxation of Commission Payments to Non-Residents

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Taxability of commission paid to a non-resident agent has become a contentious issue especially after withdrawal of the celebrated CBDT Circular No. 23 of 1969, dated 23rd July 1969 and Circular No. 786, dated 7th February 2000 on 22nd October 2009. Many issues arise in characterisation as well as taxability of commission income in light of provisions under the Income-tax Act, 1961 and under the provisions of a Tax Treaty. This Article discusses various such issues.

1. Provisions under the Income-tax Act, 1961 (the ‘Act’)

Indian exporters and/or businessmen avail services of foreign agents for a variety of purposes, such as securing export orders, sourcing of raw materials and plant & machinery, participation in exhibitions, buying or selling of properties and so on. When a non-resident receives commission for rendering such services outside India, from an Indian payer, whether it is taxable in India? Whether resident payer needs to deduct tax at source u/s.195 of the Act?

We will discuss various issues arising in this context such as:

  • Whether taxability of the commission income received by a non-resident depends upon the nature of the underlying transaction?

  • Whether commission income of a non-resident agent is taxable u/s.5 or u/s.9(1)(i), being source of income in India or u/s.9(1)(vii) as Fees for Technical Services (FTS)?

  • What is the impact of withdrawal of CBDT Circulars (No. 23 of 1969 and 786 of 2000) dealing with taxability of commission income of foreign agents of Indian exporters?

  • Whether the payment of commission to non-resident agent be taxed as ‘Other Income’ under Article 21 of a Tax Treaty relating to Other Income?

Let us first examine provisions of the Act in this regard.

(i) Section 5 r.w. Section 9 of the Act deals with this situation. Section 5 defines the scope of total income according to which, income of a nonresident is taxed in India if it is received, accrue or arise or deemed to be received, accrue or arise in India. Section 9 of the Act deals with Income deemed to accrue or arise in India. Inter alia it covers any income accruing or arising to a non-resident, directly or indirectly, through or from (i) any business connection (BC) in India and (ii) any asset or source of income in India.

(ii) Explanation to 2 to section 9(1)(i) defines the term ‘business connection’ (BC). The analysis of the said Explanation would show that any business activity in India carried out by a broker, general commission agent or any other agent having an independent status in his ordinary course of business will not constitute a BC in India and conversely that of a dependent agent will constitute a BC.

Thus, commission income of a foreign agent will not be taxed in India unless that agent has a BC in India. In absence of a BC, can it be construed that ‘source’ of commission income is in India as the payer is a tax resident of India?

(iii) In this connection, it is interesting to note the relevant contents of the CBDT Circular 23 of 1969 (since withdrawn), which is as follows:

“. . . . . . (4) Foreign agents of Indian exporters — A foreign agent of Indian exporter operates in his own country and no part of his income arises in India. His commission is usually remitted directly to him and is, therefore, not received by him or on his behalf in India. Such an agent is not liable to income-tax in India on the commission.” (Emphasis supplied)

The above position was reaffirmed by the CBDT vide its Circular No. 163, dated 29-5-1975.

(iv) In this connection, it is interesting to note the observations of the AAR in case of SPAHI Projects (P.) Ltd. (2009) 183 Taxman 92 (AAR), wherein it held that “irrespective of the existence or otherwise of the business connection of ‘Z’, in India, since no business operations are carried out in India by ‘Z’, the attribution in terms clause (a) of the Explanation 1 is not possible and, therefore, no income can be deemed to accrue or arise in India merely because ‘Z’ promotes the business of the applicant in South Africa.”

Here the AAR held that even if it is assumed that there exists a BC in India, only so much of income as is attributable to that BC in India would be taxable in India as provided in Explanation 1 to section 9(1) of the Act, which reads as follows:

“Explanation 1 — For the purposes of this clause

— (a) In the case of a business of which all the operations are not carried out in India, the income of the business deemed under this clause to accrue or arise in India shall be only such part of the income as is reasonably attributable to the operations carried out in India;”

Therefore, in a case where there exists a BC, but commission is paid in respect of services which are rendered outside India only, then no income can be said to accrue or arise in India.

(v) The Supreme Court in the case of Carborandum Co. v. CIT, (1977) 108 ITR 335, has held that “the carrying on of activities or operations in India is essential to make the non-resident have business connection in India in order that he may be liable to tax in respect of the income attributable to that business connection”.

(vi) In case of CIT v. Toshoku Ltd., (1980) 125 ITR 525 the Apex Court, while dealing with the issue of taxation in India of commission paid to a nonresident agent, held that “the assessees did not at all carry on any business operations in the taxable territories and as such the receipt in India of the sale proceeds of tobacco remitted or caused to be remitted by purchasers from abroad, did not amount to an operation carried by the assessees in India as contemplated by clause (a) of the Explanation to section 9(1)(i). The impugned commission could not, therefore, be deemed to be income which had either accrued or arisen in India”.

1.1 Applicability of TDS provisions u/s.195 on commission paid to non-resident

The Income-tax Department vide its Circular No. 786, dated 7-2-2000 clarified that “the deduction of tax at source u/s.195 would arise if the payment of commission to the non-resident agent is chargeable to tax in India. In this regard attention to CBDT Circular No. 23, dated 23rd July, 1969 is drawn where the taxability of ‘Foreign Agents of Indian Exporters’ was considered along with certain other specific situations. It had been clarified then that where the non-resident agent operates outside the country, no part of his income arises in India. Further, since the payment is usually remitted directly abroad it cannot be held to have been received by or on behalf of the agent in India. Such payments were therefore held to be not taxable in India. The relevant sections, namely, section 5(2) and section 9 of the Income-tax Act, 1961 not having undergone any change in this regard, the clarification in Circular No. 23 still prevails. No tax is therefore deductible u/s.195”.

Many decisions wherein taxability of Commission paid to foreign agents was examined are rendered in the context of deductibility of tax at source u/s.195 of the Act.

The Tribunals, AAR and Courts in following cases held that provisions of section 195 of the Act are not applicable in case of commission payments to foreign agents of Indian entities as the said income is not taxable in India in the hands of the recipient.

(i) CIT v. Cooper Engineering Ltd., (1968) 68 ITR 457 (Bom.)

(ii) CIT v. Toshoku Ltd., (1980) 125 ITR 525 (SC)

(iii) Ceat International S.A. v. CIT, (1999) 237 ITR 859 (Bom.)

(iv) Indopel Garments Pvt. Ltd. v. DCIT, (2001) 72 TTJ 702

(v) Ind. Telesoft (2004) 267 ITR 725 (AAR)

(vi) DCIT v. Ardeshir B. Cursetjee & Sons Ltd., (2008) 24 SOT 48 (Mum.) (URO)

(vii) Jt. CIT v. George Williamsons (Assam) Ltd., (2009) 116 ITD 328 (Gau.)

(viii)    Dr. Reddy Laboratories Ltd. v. ITO, (1996) 58 ITD 104 (Hyd.)

(ix)    SOL Pharmaceutical Ltd. v. ITO, (2002) 83 ITD 72 (Hyd.)

(x)    Eon Technology (P) Ltd. v. DCIT, (2011) 11 tax-mann.com 53 (Del.)

(xi)    ACIT v. Meru Impex, (2011) 16 Taxmann.com 219 (Mumbai ITAT)

(xii)    ITO v. Asiatic Colour Chem Ltd., (2010) 41 SOT 21 (Ahd.) (URO)

(xiii)    ACIT v. Tamil Nadu Newsprints and Papers Limited, (2011 TII 215 ITAT Mad.-Intl.)

(xiv)    DCIT v. Divi’s Laboratories Ltd., (2011 TII 182 ITAT Hyd.-Intl.)/(2011) 12 taxmann.com 103

(xv)    ADIT (IT) v. Wizcraft International Entertain-ment (P.) Ltd., (2011) 43 SOT 470 (Mum.)

(xvi)    DCIT v. Mainetti (India) (P.) Ltd., (2011) 12 tax-mann.com 60 (Chennai)

All controversies arising in respect of interpretation of section 195 regarding non-deduction of tax at source were put to rest by with decision of the Supreme Court in the case of GE India Technology Centre P. Ltd. v. CIT, (2010) 327 ITR 456 wherein the Apex Court following Vijay Ship Breaking Corporation v. CIT, (2009) 314 ITR 309 (SC) held that “The payer is bound to deduct tax at source only if the tax is assessable in India. If tax is not so assessable, there is no question of tax at source being deducted”.

The decision of GE India Technology Centre P. Ltd. (supra) assumes special significance as it explained the decision of the Supreme Court in case of Transmission Corporation of A. P. Ltd. v. CIT,(1999) 239 ITR 587 (SC) in proper perspective. The said decision is often invoked by the Income-tax Department to fasten TDS obligation on the payer on a gross basis and even when the income is not chargeable to tax in the hands of the recipient thereof. The Apex Court stated that in the case of decision of the Transmission Corporation (supra), the issue was of deciding on what amount of tax is to be deducted at source, as the payment was in respect of a composite contract. The said composite contract not only comprised supply of plant, machinery and equipment in India, but also comprised the installation and commissioning of the same in India.

With the above-mentioned correct interpretation of the decision in the case of Transmission Corporation (supra), the Apex Court set aside the decision of the Karnataka High Court in the case of CIT v. Samsung Electronics Co. Ltd. (2010) 320 ITR 209 wherein it was held that resident payer is obliged to deduct tax at source in any type of payment to a non-resident be it on account of buying/purchasing/ acquiring a packaged software product and as such a commercial transaction or even in the nature of a royalty payment. Applying the ratio of this decision the Income-tax Department used to disallow any payment to a non-resident where tax was not withheld, irrespective of the fact that the corresponding income was not chargeable to tax in the hands of a non-resident.

The CBDT vide circular 7/2009 [F. No. 500/135/2007-FTD-I], dated 22-10-2009 withdrew all three Circulars, namely, (i) 23 dated 23-7-1969 (ii) 163 dated 29-5-1975 and (iii) 786 dated 7-2-2000 which is giving rise to many controversies.

1.2    What is the impact of withdrawal of CBDT Circulars mentioned above?

Even though the above Circulars stand withdrawn, principles contained therein still hold the ground. Circular 23 of 1969 provided certain clarification regarding taxability in India in respect of certain transactions by a non-resident with an Indian resident, for example, sale of goods to India by a non-resident exporter, commission income of foreign agents of Indian exporters, purchasing of goods by a non-resident from India, sale of goods by non-resident in India either directly or through agents, etc. The Circular clarified about various situations that would not result in any business connection in India. One of the clarifications pertained to commission income earned by foreign agents of Indian exporters where the Circular clearly stated that no income shall deem to accrue or arise in India. In essence the said Circular interpreted provisions of section 9 of the Act whereby the underlying principles propounded were that the commission income of a foreign agent cannot be taxed in India if there exists no business connection in India and the income is not received in India. The subsequent amendments to section 9 of the Act, which relates to clarification of business connection in case of dependent/independent agent and taxability of Fees for Technical Services, do not alter the legal position. Therefore, even post withdrawal of impugned CBDT Circulars, commission earned by foreign agents of Indian exporters would not be taxable in India provided all services are rendered outside India (i.e., the foreign agent does not have any BC in India) and the income is not received in India.

This position has been upheld in DCIT v. Divi’s Laboratories Ltd., 2011 TII 182 ITAT Hyd.-Intl./(2011) 12 taxmann.com 103, wherein the Tribunal held as follows:

“We have considered the submissions of both the parties and perused the relevant material available on record. The moot question that arises out of these appeals is whether the payment of commission made to the overseas agents without deduction of tax is attracted disallowance u/s.40(a)(ia) of the Act or not. Whether the payment in dispute made by way of cheque or demand draft by posting the same in India would amount to payment in India and consequently whether mere payment would be said to arise or accrue in India or not? First we will take up the issue whether the payment of commission to overseas agents without deduction of tax is attracted disallowance u/s.40(a)(ia) of the Act or not. We find that the CBDT by its recent Circular No. 7, dated 22-10-2009 withdrawn its earlier Circular Nos. 23, dated 23-7-2009, 163 dated 29-5-1975 and 786, dated 7-2-2000. The earlier Circulars issued by the CBDT have clearly demonstrated the illustrations to explain that such commission payments can be paid without deduction of tax. Thus, the main thrust in such a situation is whether the commission made to overseas agents, who are non-resident entities, and who render services only at such particular place, is assessable to tax. Section 195 of the Act very clearly speaks that unless the income is liable to be taxed in India, there is no obligation to deduct tax. Now, in order to determine whether the income could be deemed to be accrued or arisen in India, section 9 of the Act is the basis. This section, in our opinion, does not provide scope for taxing such payment, because the basic criteria provided in the section is about genesis or accruing or arising in India, by virtue of connection with the property in India, control and management vested in India, which are not satisfied in the present cases. Under these circumstances, withdrawal of earlier Circulars issued by the CBDT has no assistance to the Department, in any way, in disallowing such expenditure. It appears that an overseas agent of Indian exporter operates in his own country and no part of his income arises in India and his commission is usually remitted directly to him by way of TT or posting of cheques/demand drafts in India and therefore the same is not received by him or on his behalf in India and such an overseas agent is not liable to income-tax in India on these commission payments. This view is fortified by the judgment of Apex Court in the case of Toshoku Ltd. (supra).”

Thus, in respect of payment of commission to non-resident agent by a resident in respect of services rendered outside India, it is clear that withdrawal of the aforesaid CBDT Circulars would not affect the existing settled position in law that the same would not be taxable in India.

1.3    Can the withdrawal of aforesaid CBDT Circulars have retrospective effect?

In Satellite Television Asia Region Advertising Sales BV v. ADIT, (2010 TII 58 ITAT Mum.-Intl.) the Mumbai Bench, in the context of payment for sale of advertising time, held that though the Circular No. 23, dated 23rd July, 1969 was withdrawn on 22nd October, 2009, the withdrawal is prospective in nature. Since for the year under consideration, the Circular was in force, the Circular was still applicable to the case under consideration.

The Mumbai ITAT reiterated the same view in the case of DDIT v. Siemens Aktiengesellschaft, 2010 TII 09 ITAT Mum.-Intl.

1.4    Can commission paid to an individual be classified as salaries?

Can a commission payment be classified as salaries if the same is paid to a non-resident individual who represents an Indian entity was a question examined by the Mumbai Tribunal in case of ACIT v. Meru Impex, (2011) 16 Taxmann.com 219. In this case the Assessing Officer held that the appointment as agent to represent the assessee before foreign buyer was sham and not genuine; and that even assuming said payment to be genuine, the same was in nature of salary. However, the Tribunal ruled that the said payment cannot be classified as salaries in absence of employer-employee relationship.

1.5    Can commission be classified as fees for technical services?

In the case of Wallace Pharmaceuticals P. Ltd. (2005) 278 ITR 97 (AAR), on the facts of the case the AAR held that “though Penser is a tax resident of USA, it has rendered consultancy services in India and as the consultancy fee payable in respect of services utilised is not in connection with a business or profession carried on by the applicant outside India for the purposes of making or earning any income from any source outside India, the consultancy fee would be deemed income of Penser in India. In addition to the monthly consultancy fee under the agreement, Penser is also entitled to 10% commission on the orders procured by it. The commission will also be deemed income arising to Penser in India.”

It appears that since the commission was linked to monthly consultancy fees, the AAR considered it at par with the consultancy fees, notwithstanding the fact that services, inter alia, included promotion of Wallace’s products in the USA. Ironically, provisions of India-US DTAA were not considered/applied in this case. If the provisions of India-US DTAA were considered, probably the conclusion of the AAR would have been different due to existence of ‘Make Available’ clause in Article 12(4)(b) of the DTAA. Also if Penser had no PE in India, it would also not be taxable under Article 7 of the DTAA.

The AAR in case of SPAHI Projects (P.) Ltd. (2009)183 Taxman 92 (AAR) held that there could possibly be no controversy that the non-resident will not be rendering services of a managerial, technical or consultancy nature and, therefore, the liability to tax cannot be fastened on it by invoking the provisions dealing with fee for technical services.

However, in case of DCIT v. Mainetti (India) (P.) Ltd., (2011) 12 taxmann.com 60 the Chennai Tribunal held that “No doubt technical service would definitely include managerial services. However, canvassing of orders abroad could not be regarded as managerial services, nor could it be said to be for any consultation. Thus, definitely technical services as per Explanation 2 to section 9(1)(vii) of the Act would have no application.”

2.    Taxability under a tax treaty

Under the provisions of a tax treaty, the income is taxed under different sub-heads with each having a separate set of distributive rules and definition. For example, profits from operation of ships and aircrafts, royalties and Fees for Technical Services (FTS) are dealt by separate articles though essentially they are all part and parcel of business activities. Under domestic tax law, they are all taxed under the same head of business profits. Therefore, difficulty arises about characterisation of income under a treaty scenario.

Under a tax treaty, business profits earned by an enterprise resident of one country are taxed only in its country of residence unless it has a Permanent Establishment (PE) in the source country. However, royalties and FTS can be taxed in a source country even if there is no PE.

Another difference is that whereas business profits are taxed on a net basis (that too only to the extent they are attributable to the PE in the source country), royalties and FTS are taxed on gross basis, albeit at a concessional rate.

In the treaty context the following situations arise:

2.1    Commission income treated as business income

Ideally, commission income should be classified as business income as it is neither royalty nor fees for technical services. In such a scenario, taxability in India would depend upon whether the foreign agent has a PE in India or not. If the foreign agent has a PE in India, then commission income which is attributable to it would be subject to tax in India. Usually, foreign agents of Indian exporters operate outside India and therefore there will not be a PE in India. In such a scenario, commission earned by them would not be taxed in India.

In SPAHI Projects (P.) Ltd. (supra), the AAR held that income received by the non-resident on account of commission paid by the resident is not chargeable to tax in India by virtue of Article 7 of the India-South Africa Tax Treaty and therefore the payer is not obliged to deduct tax at source u/s.195 of the Act.

2.2    Can commission paid to a non-resident be classified as Professional Fees?

In case of ACIT v. Meru Impex (supra) the assessee claimed benefit of Article 15 of the India-USA Tax Treaty which provides that income of a USA tax resident from the performance in India of professional services or other independent activities of a similar character shall be taxable only in the USA as the non-resident agent did not have a fixed base in India, nor did his stay in India exceeded 90 days. Incidentally India-USA treaty requires two conditions to be satisfied to claim exemption from tax in the State of source, which are:

(i)    non-existence of fixed base, and
(ii)    stay of 90 days or less in the relevant taxable year, in the State of Source.

The assessee relied on the term ‘other independent activities of a similar character’ to classify commission income into professional income and claimed exemption in India. However, the Mumbai Tribunal rightly observed that though the definition of ‘Professional Services’ is not exhaustive, it contemplates existence of professional skill and performance of such professional skill for which they receive payments. In absence of relevant details, the matter was remanded back to the AO for fresh determination. Interestingly, the CIT (Appeals) had granted benefit of Article 15 to the NR agent on the ground that he did not have a fixed base in India.

2.3    Can commission paid to a non-resident be classified as ‘Other Income’ falling under Article 21?

Almost every tax treaty contains a residuary clause, namely, ‘Other Income’ which gives right of taxation to both the countries (as per majority of Indian tax treaties). This Article covers income not dealt with in any other Articles of the concerned tax treaty.

In Rajiv Malhotra’s case (2006) 284 ITR 564 (AAR) the overseas agent rendered services abroad in respect of an exhibition to be organised in India. On the facts of the case, the AAR held that “though the agent rendered services abroad and pursued and solicited exhibitors there, the right of the agent to receive the commission arose in India only when the exhibitor participated in the Food and Wine Show to be held in India and made full payment to the applicant in India. The commission income would, therefore, be taxable in India, as income arising from a ‘source of income’ in India in view of the specific provisions of section 5(2)(b) read with section 9(1) of the Income-tax Act, 1961. The facts that the agent rendered services abroad in the form of pursuing and soliciting participants and that the commission was to be remitted to him abroad were wholly irrelevant for the purpose of determining the situs of the income”.

Surprisingly, AAR applied Article 23 on ‘Other Income’ to commission income instead of Article 7 on Business Profits and held that “paragraph 3 of Article 23 of the Agreement for the Avoidance of Double Taxation between India and the French Republic was at par with the provisions of section 5(2) read with section 9(1) and did not grant any further benefit”.

In our humble opinion, with due respect, this decision needs reconsideration. In any case, being advance ruling, it is case specific and therefore it does not render any binding precedent.

2.4    Taxability of commission paid to a non-resident for events held in India

CBDT Circular Nos. 23 of 1969 and 786, dated 7-2-2000 dealt with commission paid to foreign agents of Indian exporters. Therefore, a question often arises as to their applicability to payment of commission otherwise than for exports. However, in the case of ADIT(IT) v. Wizcraft International Entertainment Pvt. Ltd., (2011) 43 SOT 470 (Mum.), the Mumbai Tribunal held that “Though, the above Circular (i.e., Circular No. 786, dated 7-2-2000) is issued in the context of commission paid to foreign agent of Indian exporters, it applies with equal force to commission paid to agents for services rendered outside India”.

In this case one Mr. Colin Davie, a resident of UK earned commission from co-ordinating an entertainment event which was performed in India. The Mumbai Tribunal held that no income is deemed to accrue or arise in India in view of the fact that the services were rendered outside India. The Tribunal also rejected the argument of the Income-tax Department that the income of Mr. Davie be taxed under Article 18 of the India-UK Tax Treaty (dealing with income of ‘Artists and Athletes’) as Mr. Davie neither took part in events during the dates of engagements, nor did he exercise any personal activities in India. It further observed that the income of Mr. Davie by way of commission does not relate to the services of entertainer/artiste. The Tribunal held that the commission income was in the nature of Business Income and was not taxable in India in absence of a PE.

3.    Whether written agreement is crucial to establish commission payment and to get deduction thereof

In ACIT v. Meru Impex, (2011) 16 taxmann.com 219, the Mumbai Tribunal held that “if the services rendered are established, then the assessee would be entitled to claim deduction on account of commission paid. The existence or non-existence of written agreement would not be fatal to claim deduction on account of expenditure on account of commission. Therefore, the finding of the Assessing Officer with regard to the agreement being a sham document cannot be sustained and in any event, they are irrelevant”.

4.  Conclusion

The law on taxability of commission income of foreign agents of Indian exporters does not seem to have altered with withdrawal of the CBDT Circulars. In view of the clear provisions of the Act as well as decisions of Tribunals, Courts and AAR one can conclude that carrying on of business operation in India is crucial to result in a BC and in case of foreign agents where services are rendered outside India, commission cannot be said to be accruing or arising in India [refer the Supreme Court’s observations in case of Carborandum Co. at para 1.1 (v) (supra)]. In fact, even in a case where the event had taken place in India [refer the decision of the Mumbai Tribunal in the case of Wizcraft International Entertainment Pvt. Ltd. at para 2.4 (supra)], no income was deemed to accrue in India as long as services were rendered outside India.

The AAR has recently rendered a Ruling dated 22.02.2012, in the case of SKF Boilers and Driers Pvt. Ltd. (AAR No. 983-983 of 2010), wherein the AAR has held that such Export Commission is taxable in India u/s 5(2)(b) r/w Section 9(1)(i) of the Act. As the Applicant was not present and the Ruling was rendered in absentia, the correct position in Law as discussed above and the catena of decisions favourable to the Assessee (listed in Para 1.1 above) could not be presented and considered by the AAR, which followed its own Ruling in Rajiv Malhotra [284 ITR 564 (AAR) refer Para No. 2.3 above] but ignored its Ruling in SPAHI Projects (P.) Ltd. [2009] 183 TAXMAN 92 (AAR) discussed in Para Nos. 1(iv) and 1.5 above. In our humble opinion, if the correct position in Law and the relevant favourable case laws were presented and considered by the AAR, the Ruling could have been different.

As far as applicability of provisions of section 195 are concerned, the Supreme Court [in the case of GE India Technology, para 1.1 (supra)] has held that they are applicable only if income is chargeable to tax. The taxpayer can refrain from deducting tax at source if according to him the income is not chargeable to tax in India in the hands of the non-residents.

Taxation of Payments for Technical Plan or Technical Design

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Part V In the first part of the article published in December 2010 issue of BCAJ, we discussed broadly the issues which arise while making payments for designs and drawings acquired from foreign entities for diverse business purposes, definitions of the terms Royalty and Fees for Technical Services (FTS) under the Income-tax Act, 1961 (the ACT), under Model Conventions and under some important Indian DTAAs.

In the second, third and fourth parts of the article published in January, February and March 2011, we discussed taxability of the payments for technical plans and technical designs with reference to various judicial pronouncements with a view to understand how the case law has developed over the years and to cull out guiding principles.

In this final and concluding part, based on our earlier discussion and analysis of various judicial pronouncements and other available material, we have attempted to cull out few general guiding principles/broad propositions in respect of taxability or otherwise of the payments for technical design and technical plans, which could be applied in various practical situations, depending upon the facts and circumstances of each case. It is important to note that we have only considered and analysed the aspect relating to taxation of payments for Technical Plan or Technical Design. Other aspects relating to PE, etc. have not been discussed or analysed here.

Appropriate meaning of the word ‘design’ as appearing in Article 12 relating to Royalties and section 9(1)(vi) of the Act, in contrast with the word ‘Technical Design’ appearing in FTS/FIS Article in certain Indian treaties:

As pointed out in part I of the article, definition of the term ‘Royalty’ in the Act as well as definition of ‘Royalties’ under the Model Conventions consider payments of any kind received as a consideration for the use of, or the right to use, any ‘design’, as royalty.

Similarly, in respect of DTAAs entered into by India with various countries where the word FTS has been given a restricted meaning, the typical definition of FTS provides that the term ‘fees for technical services’ means, inter alia, payments of any kind to any person in consideration for the rendering of any technical or consultancy services which make available technical knowledge, experience, skill, know-how or processes, or consist of the development and transfer of a technical plan or technical ‘design’.

Therefore, in respect of DTAAs entered into by India with various countries where the word FTS has been given a restricted meaning and which also have relevant article regarding royalties containing the word ‘design’, a question arises as to what is meaning of the same term ‘design’ appearing in two different definitions of the term Royalty and FTS, in the same article of the same treaty.

In this connection, attention is invited to para 10.2 of the Commentary on Article 12 of the OECD Model Tax Convention (July, 2010), which reads as under:

“10.2 A payment cannot be said to be ‘for the use of, or the right to use’ a design, model or plan if the payment is for the development of a design, model or plan that does not already exist. In such a case, the payment is made in consideration for the services that will result in the development of that design, model or plan and would thus fall under Article 7. This will be the case even if the designer of the design, model or plan (e.g., an architect) retains all rights, including the copyright, in that design, model or plan. Where, however, the owner of the copyright in previously-developed plans merely grants someone the right to modify or reproduce these plans without actually performing any additional work, the payment received by that owner in consideration for granting the right to such use of the plans would constitute royalties.” (Emphasis supplied)

It is important to note that the above para 10.2 provides that in a case where the payment is made in consideration for the services that will result in the development of that design, model or plan, the same would fall under Article 7, as the OECD Model Tax Convention does not contain FTS article.

From the above, it clearly emerges that only in those cases where a design or plan already exists and any payment is made for use of or right to use the same, then only the same could be considered as ‘Royalty’ and not otherwise.

Hence, in cases where the payment is made for the development of a design or for development and transfer of a design, the same cannot be construed or characterised as royalty but the same would fall within the meaning of the term FTS.

It is important to note that, there is no FTS clause in 16 treaties signed by India i.e., in DTAAs with Greece, Bangladesh, Brazil, Indonesia, Libya, Mauritius, Myanmar, Nepal, Philippines, Saudi Arabia, Sri Lanka, Syria, Tajikistan, Thailand, United Arab Emirates, United Arab Republic (Egypt). In such cases, in respect of development and transfer of designs, the payment would fall under Article 7 relating to Business Profits and in the absence of any PE in India, the same would not be taxable in India.

It is, therefore, advisable to minutely look in various clauses of the relevant agreements and also to properly know the nature of payment in relation to designs, to determine whether the same would be taxable as royalties or not.

Payment for customised designs/designs supplied in connection with/along with the supply of plant and machinery, equipments etc. — Not to be taxable as royalties:

In many cases, payment for customised designs is made in connection with supply of plant and machinery, equipments, etc. which is necessary for proper supply, erection and commissioning of plant and machinery.

In this connection, courts have taken consistent view that in such circumstances, the payment of designs shall not be considered as royalties. In this connection, the following observations of the Madras High Court in the case of (2000) 243 ITR 459 CIT v. Neyveli Lignite Corporation Ltd. are very important:

“The term ‘royalty’ normally connotes the payment made by a person who has exclusive right over a thing for allowing another to make use of that thing which may be either physical or intellectual property or thing. The exclusivity of the right in relation to the thing for which royalty is paid should be with the grantor of that right. Mere passing of information concerning the design of a machine which is tailor-made to meet the requirement of a buyer does not by itself amount to transfer of any right of exclusive user, so as to render the payment made therefor being regarded as ‘royalty’.

In a contract for the design, manufacture, supply, erection and commissioning of machinery which does not involve licence of the patent concerning the machinery, or copyright of its design, mere supply of drawings before the manufacture is commenced to ensure that the buyer’s requirements are fully taken care of and the supply of diagram and other details to enable the buyer to operate the machines, and also to assure the buyer, that the machines will perform to the specification required by the buyer, such supply is only incidental to the performances of the total contract which includes design, manufacture and supply of the machinery.
The price paid by the assessee to the supplier is a total contract price which covers all the stages involved in the supply of machinery from the stage of design to the stage of commissioning. The design supplied is not to enable the assessee to commence the manufacture of the machinery itself with the aid of such design. The limited purpose of the design and drawings is only to secure the consent of the assessee for the manner in which the machine is to be designed and manufactured, as it was meant to meet the special design requirements of the buyer.

There is no transfer or licence of any patent, invention, model or design. The design referred to in the contract is only the design of the equipment required to be manufactured by the supplier abroad and supplied to the purchaser. The information concerning the working of the machine is only incidental to the supply as the machinery was tailor-made for the buyers. Unless the buyer knows the way in which the machinery has been put together, the machinery cannot be maintained in the best possible way and repaired when occasion arises. No licence of any patent is involved. Sub-clause (vi) and also of section 9(1) would have no application as the design was only preliminary to the manufacture and integrally connected therewith. The other three sub-clauses also in the circumstances of the case are not attracted.” (Emphasis supplied)

In this connection useful reference may also be made to the cases of ITO v. Patwa Kinariwala Electronics Ltd., (2010) 40 SOT 148 (ITAT Ahd.) and CIT v. Mitsui Engineering and Ship Building Co. Ltd., (2003) 259 ITR 248 (Delhi).

Therefore, in cases where customised designs/ drawings are supplied in connection with supply, erection and commissioning of machinery and equipments, etc., on the facts of any given case, it would be possible to argue that the same does not constitute Royalty or FTS.

Payment for designs considered as part of Cost of capital equipment:

In certain circumstances, on the facts of the given case, the ITAT has held that the payments for de-signs would constitute part and parcel of the cost of the capital equipments/machineries supplied.

In this connection, reliance could be placed on the following decisions of the ITAT:

    ACIT v. King Taudevin and Gregson Ltd. (Bang.) (2002) 80 ITD 281

    Skoda Export VO Ltd. v. DCIT, (2003) TII 18 ITAT

    ADIT v. Zimmer AG, (2008) TII 21 ITAT-Kol.

In King Taudevin’s case (supra), the ITAT held that the documentation services comprising of technical drawings, designs and data could be treated as book and constituted ‘plant’ or ‘tools of trade’. What was received by the Indian company in the instant case from the foreign company was capital asset and the remittance to the foreign company was by way of payment of purchase price for the capital goods imported from abroad.

Similarly, in Skoda Exports’ case, it was held that the receipt by the non-resident assessee for import of drawings and designs and technical documents is in the nature of plant and machinery and hence cannot be considered as FTS.

In Zimmer AG’s case, the ITAT held that the sup-ply of engineering drawings and designs together with supply of plant and equipments constituted one composite supply, which enabled ‘S’ to erect, commission, set up, operate and maintain the plant for manufacture of bottle-grade PET resins. Without the supply of engineering drawings and designs, ‘S’ could not have been able to set up, operate and maintain the plant at Haldia and, therefore, engineer-ing documentation formed an integral part of the plant and machinery supplied by the assessee.

The ITAT further held that the assessee did not supply any secret formula, processes, patents, engineering know- how developed by it which would enable ‘S’ to start business of manufacture of plant and machinery or any other product. Supply of engineering, drawing and designs was incidental to selling of plant and equipment which was tailor-made to suit specific requirement of ‘S’ for setting up a petro-chemical project at Haldia. Therefore, the supply of engineering drawings and designs was integral part of supply of plant and equipment and it could not be viewed in isolation and, therefore, payment made by ‘S’ was not for acquiring mere right to use engineering documentation, so as to constitute royalty.

In appropriate cases, based on the facts and circumstances, it could be possible to gainfully use the ratios laid down by the aforesaid decisions and contend that the payment for drawing would be part of supply of plant and equipment and would not constitute royalty or FTS and hence not taxable in India.

Payment for ‘Outright Purchase/Sale’ of designs and drawings, not taxable:

In many cases, based on the facts of the given cases, the ITAT/AAR/High Courts have held that the payments for designs and drawing are for the outright sale of designs and drawings to the Indian entity and the same would be covered by Article 7 relating to Business profits and in absence of a PE in India, would not be taxable in India.

In this connection, useful reference may be made to the following cases, which have been summarised in earlier parts of the article:

    CIT v. Davy Ashmore India Ltd., (Cal.) (1991) 190 ITR 626

    The Indian Hotels Company Ltd. v. ITO — Un-reported, ITA No. 553/Mum./2000

    Munjal Showa Ltd. v. ITO, (2001) 117 Taxman 185 (Delhi) (Mag.)

    Pro-Quip Corporation v. CIT (AAR), (2002) 255 ITR 354

    DCIT v. Finolex Pipes Ltd., (2005) TIL 25 ITAT Pune-Intl.

    Abhisek Developers v. ITO, (2008) 24 SOT 45 (Bang.) (URO)

    Parsons Brinckerhoff India Pvt. Ltd. v. ADIT, [2008]-TII-27-ITAT-(Del)-Intl

    CIT v. Maggtonic Devices Pvt. Ltd., (2009) TII 21 HC HP-Intl.

    International Tire Engineering Resources LLC (2009) TII 25 ARA-Intl.

In this regard, for considering whether a particular transaction of payment for design and drawings would constitute ‘Outright Sale’, the following important points should be kept in mind:

    a) In all cases, where the non-resident supplier of designs and drawings, does not retain any property or ownership rights in the designs and drawings, the same could constitute outright sale of designs and drawings. (CIT v. Davy Ashmore India Ltd.)

    b) Wherever the purchaser is entitled to use the designs and drawings, as he likes and he is entitled to sell or transfer the designs and drawings as per his wish, then in those cases it could constitute outright sale.

    c) If the agreement vests only a limited right and places restrictions as to the use of designs and drawings, then it cannot be said that there has been an out-and-out sale or transfer of the designs and drawings.

    d) In any alienation of right or property is made for consideration and such consideration is payable contingent upon productivity, use or disposition, then the same would not consti-tute ‘outright sale’, but the same could be considered as royalty.

    e) If the agreement has a secrecy/confidentiality clause, which prohibits the Indian party from disclosing the information received from the foreign party, the logical inference would be that there is no outright transfer of the designs/drawings/plans.

    f) Similarly, if the agreement restricts the Indian party from selling the designs, drawing and plan to the third party, the logical inference would be that there is no outright transfer in the property of the designs and drawings.

    g) Where the agreement for the supply of designs is for a limited period of the agreement and not for all times to come, the conclusion should be that there is no outright transfer of designs.

    h) Where the transfer is on ‘Non-exclusive’ basis, it conveys the idea that the designs and drawings that the seller owns and possesses are not transferred absolutely to the purchaser and that the seller is not divested of the proprietary rights and interest in the designs and drawings and hence the same cannot be considered as outright sale.

It would, therefore, be extremely important to minutely study and understand the facts and circumstances of each case and based on the relevant parameters, examine as to whether the payment is being made for outright purchase/sale of designs and drawings. If the payment is actually made for the outright purchase of designs, then based on the various judicial precedents cited above and the principle laid down by the courts, it should be possible to successfully contend that the same should not be taxable in India.

Meaning of the word ‘transfer’ in the words ‘development and transfer of a technical plan or technical design’:

A question arises for consideration as to what is the meaning of the word ‘transfer’ appearing in the words ‘development and transfer of a technical plan or technical design’. Does the word ‘transfer’ refer to absolute transfer of rights of ownership or mere use of such design by the person of other contracting state?

As pointed out above, absolute transfer of rights of ownership or transfer of all rights, title and interest, would generally make the transaction an outright sale and the same would not fall within the meaning of the term FTS.

In the context of the phrase ‘development and transfer of a technical plan or technical design’, the word transfer, in our view, would mean de-velopment of design and transfer of the same for the use of such developed design. In that event it would be FTS. Mere transfer of existing design, without any further development, would generally fall with in the definition of term royalty.

This question came up for consideration in the case of Gentex Merchants (P.) Ltd. v. DDIT (IT), (2005) 94 itd 211 (Kol.). In this regard, the ITAT held as under:

“From the agreement between the assessee and the American company it is apparent that the latter was to deliver the technical draw-ings and designs to the former for its own use and benefit in India. The term transfer as used in Article 12(4) does not refer to the absolute transfer of rights of ownership. It refers to the transfer of technical drawing or designs to be effected by the Resident of one State to the Resident of other State which is to be used by or for the benefit of Resident of other state. The said Article 12(4)(b), in our opinion, does not contemplate transfer of all rights, title and interest in such technical design or plan. Even where the technical design or plan is transferred for the purpose of mere use of such design or plan by the person of other contracting state and for which payment is to be made, Article 12(4)(b) will be attracted. The facts on record clearly indicate that under the agreement the American company was required to deliver such technical designs or plan for the sole use by the assessee-company in India. In fact, the assessee did use these technical plans and drawing for constructing and/or installing the Water Feature at 22 Aurangazeb Road, New Delhi. In the above circumstances we are of the opinion that the payments effected under the agreement with the American company squarely fell within the defini-tion of ‘fees for included services’ and therefore the assessee was liable to deduct tax @ of 15% of the amount payable, u/s.195 of the Act.”

Thus, it is very important to examine the factual position, in any given case and then determine the character of the income i.e., as to whether any such transfer would tantamount to FTS, royalty or outright sales.

Whether the concept of ‘make available’ be applied to ‘development and transfer of a technical plan or technical design’:

It is important to note that neither of the three model conventions i.e., OCED, UN and US Model Convention, contain separate Article relating to FTS. Thus, the concept of FTS appears to have originated from Indian DTAAs.

As of now, India has signed 79 DTAAs with various countries. Out of these, DTAAs with nine countries have FTS Article containing the concept of ‘make available’. These countries are: Australia, Canada, Cyprus, Malta, Netherlands, Portuguese Republic, Singapore, UK and USA.

In addition, due to existence of ‘Most Favoured Nation’ (MFN) clause in the protocols to the seven DTAAs providing for restricted scope of the FTS Article, it is possible to apply the concept of ‘Make Available’ in those cases. These countries are: Belgium, France, Hungary, Israel, Kazakstan, Spain and Sweden. In case of Swiss Confederation, the MFN clause in the protocol provides for further negotiations, but does not provide for automatic application of the restricted scope and of the concept of ‘make available’. Hence, practically as of now, the benefit of Swiss DTAA, the MFN clause is not available until the negotiations actually take effect and the same is made effective.

In case of DTAAs abovementioned 8 countries (except Singapore) having ‘make available’ concept in the FTS Article, the typical language of the Article e.g., India-USA DTAA reads as under:

“(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.”

However, in case of India-Singapore DTAA, the same article reads as under:

“(b)    make available technical knowledge, experi-ence, skill, know-how or processes, which enables the person acquiring the services to apply the technology contained therein; or

    c) consist of the development and transfer of a technical plan or technical design, but excludes any service that does not enable the person acquiring the service to apply the technology contained therein.

For the purposes of (b) and (c) above, the person acquiring the service shall be deemed to include an agent, nominee, or transferee of such person.”

A question, therefore, arises as to whether the concept of make available could be applied in the case of second limb of the clause i.e., ‘or consist of the development and transfer of a technical plan or technical design.’

This question came up for consideration in the case of SNC -Lavalin International Inc. v. DDIT, IT, Delhi (2008) 26 SOT 155 (Delhi). The ITAT in this case held as under:

“Thus, if the payment for rendering any technical or consultancy service is ‘fees for included services’, if such services either make available technical knowledge, experience, skill, know-how or process or consists of the development and transfer of a technical plan or technical design. When the payment is for development and trans-fer of a technical plan or technical design, it need not be coupled with the condition that it should also make available technical knowledge, experience, skill, know-how or process, etc. The words ‘make available’ go with technical know-how, experience, skill, know-how or process, etc. but do not go with “constraints of the development and transfer of a technical plan or a technical design”. The second limb in clause (b) of sub-article (4) of Article 12 of DTAA can be invoked when the amount is paid in consideration for rendering of any technical or consultancy services and if such services consists of the development and transfer of a technical plan or a technical design also. By the way, the condition of mak-ing available technical knowledge is not sine qua non for considering the question as to whether the amount is fees for included services or not particularly when the payment is only where the technical or consultancy services consists of development and transfer of a technical plan or technical design only. This will be considered as ‘fees for included services’ within the meaning of Article 12(4) of the Act and hence, in terms of Article 12(2) tax rate should be charged.” [Emphasis supplied]

However, it is important to note that in case of India-Singapore DTAA, the portion relating to development and transfer of design and draw-ings have been made in to a separate clause (c) instead of keeping the same in the same clause as is the case with 8 other DTAAs mentioned above. On a proper reading of the Article 12(4)(c) of India-Singapore DTAA, as mentioned above, it would appear that in the case of Singapore, due to the peculiar language of the clause (c), concept of make available would be applicable even in case of development and transfer of a technical plan or technical design. This proposition is yet to be tested before a judicial forum.

Architectural designs and drawings:

The issue of taxability of architectural designs and drawings is a contentious one. The issue which arises is whether the contracts between the parties is a contract of service and whether the payment made by the assessee constituted a purchase consideration for the transfer of title in the drawings? There is a cleavage of judicial opinion in the matter.

In Abhishek Developers’ case (BCAJ March, 2011 Sr. No. 21 page 61), the ITAT, Bangalore bench held, on the facts of the case, following the un-reported decision of the Mumbai Bench of ITAT in the case of Indian Hotels Company Ltd. v. CIT, (BCAJ, January 2011, Sr. No. 7 page 43), that the transaction in question was a transaction of sale and not a case of rendering technical services as contemplated u/s.9(1)(vii).

However, in the following cases, a contrary view had been taken and the payment has been held to be in the nature of FTS/FIS:

    a) Gentex Merchants (P.) Ltd. v. DDIT (IT), (2005) 94 ITD 211 (Kol.)

    b) HMS Real Estate Pvt Ltd., (2010) 190 Taxmann 22 (AAR)

    c) GMP International GmbH, (2010) 188 Taxmann 143 (AAR).

Fees for Technical Services:

In the following cases, the payment for designs and drawings was held to be in the nature of FTS:

    a) AEG Aktiengesellschaft v. CIT, (2004) TII 05 HC Kar.-Intl (BCAJ, February, 2011 page 53)

    b) Rotem Company v. DIT, (2005) 148 Taxmann 411 (AAR)

In this case, the AAR held that the contract comprises of elements of fees for technical services within the meaning of DTAAs with Japan and Korea and the same is not in the nature of business profits.

    c) Mangalore Refinery and Petrochemicals Ltd. DCIT, (2007) TII 49 ITAT Mum-Intl. (BCAJ, February, 2011, pages 54-55)

    d) SNC — Lavalin International Inc. v. DDIT, (2008) 26 SOT 155 (Delhi)

    e) Worley Parsons Services Pty. Ltd. (2009) 179 Taxman 347 (AAR)

It may noted that in the India-Australia DTAA, FTS are covered under Article 12(3) and described as ‘Royalty’ and the term ‘Fees for Technical Services’ has not been used.

However, in ITO v. De Beers India Minerals (P.) Ltd., (2008) 115 ITD 191 (Bang.), the payment for certain services was held not to be in the nature of ‘Fees for technical services’ as the payments were not in consideration for the development and transfer of technical plan and technical design under Article 12(5) of the India-Netherlands DTAA.

Royalties:

In the following case, the payment was held to be in the nature of royalty:

    a) Leonhardt Andra Und Partner, GmbH v. CIT, (2001) 249 ITR 418

In this case, payment was made to the German company in connection with design of the bridge to be built. In absence of definition of the term royalty under the old India-Germany DTAA, the court held it to be royalty u/s.9(1)(vi) of the Act.

    b) DCIT v. All Russia Scientific Research Institute of Cable Industry, Moscow (2006) 98 ITD 69 (Mum.) [BCAJ, January 2011, Page 44, Sr. No. 8]

    c) DCIT v. Majestic Auto Ltd., (1994) 51 ITD 313 (Chd.) (BCAJ, February 2011, Page 49-50, Sr. No. 10)

    d) International Tire Engineering Resources LLC (2009) 185 Taxmann 209 (AAR) (BCAJ, March 2011, Page 69-71, Sr. No. 10)

In this case, part of the payment i.e., payment relating to non-exclusive right to use the know-how, was held to be in the nature of royalty.

India-USA DTAA — Memorandum of Understanding (MoU):

In the context of technical plan, Example 5 of the MoU is relevant and the same reads as under:

“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 assess the company’s central computers for information on what products are 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 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 it transfers to the Indian company the technical plan (i.e., the computer program) which it has developed.” (Emphasis supplied)

It is a moot point whether ‘modification of a computer software’ results in transfer of technical plan, in all circumstances. This Example 5 of the MoU relating to article 12 of the India-USA DTAA, has not been subject matter of judicial scrutiny as yet.

The above example seems to support the ratio of the decision of the ITAT in the case of SNC-Lavalin International Inc. v. DDIT, IT, Delhi (2008) 26 SOT 155 (Delhi), wherein it was held that the words ‘make available’ go with technical know-how, experience, skill, know-how or process, etc. but do not go with the phrase ‘development and transfer of a technical plan or a technical design’.

Conclusion:
In view of the broad propositions emerging from the above discussion of various judicial pronouncements and statutory provisions, the reader would be well advised to minutely study and analyse the relevant contracts/agreements and all the relevant facts of the matter on hand and apply appropriate legal propositions discussed in the article. The law on the subject is still developing and has not attained finality on various aspects. The readers are advised to keep themselves updated with various developments on the topic.

Digest of Recent Important Global Tax Decisions

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1. United States: US taxpayers sentenced to prison for hiding assets offshore

A US District Court chief judge sentenced US taxpayers to 12 months and 1 day in prison for hiding assets in secret offshore bank accounts. The US taxpayers were also ordered to pay restitution to the US Internal Revenue Service (IRS) and to pay a civil penalty for failing to file Form TD-F 90-22.1 (Report of Foreign Bank and Financial Accounts, FBAR).

The sentencing was announced in a Press Release dated 30th July 2012, issued by the US Department of Justice.

The Press Release states that the US taxpayers failed to report their financial accounts at UBS (a Swiss bank) and several other foreign accounts in the Isle of Man, Hong Kong, New Zealand, and South Africa. The Press Release further states that the US taxpayers failed to report any income earned on the foreign accounts and that they also under-reported their income by using their Swiss bank accounts.

UBS AG entered into a deferred prosecution agreement with the US Department of Justice on 19th February 2009 on charges of conspiring to defraud the United States in the ascertainment, computation, assessment, and collection of US federal income taxes. As part of the agreement, UBS AG provided the United States with the identities of, and account information of certain US clients.

An FBAR is a form separate from an income tax return that a taxpayer is required to file with the US Internal Revenue Service (IRS) every June, to disclose information about foreign financial accounts over which the taxpayer has signature authority or other control, and which have an aggregate value exceeding $10,000 at any time during the year.

2 Netherlands : Court of Appeal ‘s-Hertogenbosch decides that sportsman is entitled to avoidance of double taxation for foreign employment income attributable to a test match

On 29th July 2012, the Court of Appeal ‘s-Hertogenbosch (Hof ‘s-Hertogenbosch) gave its decision in X. v. the Tax Administration (Case No. 12.0024, BX 0587) on the avoidance of double taxation for a sportsman, who derived foreign employment income from playing test matches in Spain and Thailand. Details of the case are summarised below.

(a) Facts:
The Taxpayer was a Dutch resident who played as a sportsman for a Dutch club. In 2002, he played test matches with his club in Spain and Thailand. He claimed avoidance of double taxation for the part of his employment income attributable to the days spent in Spain and Thailand, based on article 25 of the Netherlands – Spain Income and Capital Tax Treaty (1971) and article 23 of the Netherlands – Thailand Income and Capital Tax Treaty (1975) (the Treaties). The tax inspector refused to grant avoidance of double taxation for those days arguing that the test matches did not constitute a public performance.

(b) Legal Background:
Article 18 of the Treaty with Spain and article 17 of the Treaty with Thailand provide that income derived by sportsmen from their personal activities may be taxed in the state where those activities are exercised. Based on article 25 and 23 of those Treaties, the Netherlands applies an exemption with progression method for foreign employment income.

(c) Decision
Contrary to the Lower Court of Breda, the Court decided that avoidance of double taxation must also be granted with respect to the foreign employment income attributable to test matches played in Spain and Thailand. The Court held decisive that the test matches were open for the public, which meant that the sportsman was carrying out personal activities. Therefore, the Court decided that the sportsman was entitled to avoidance of double taxation for the days spent in Spain and Thailand.

Note: For the attribution of the employment income, reference can be made to a Decision of the Dutch Supreme Court of 7th February 2007 , in which it was held that the part of the basic salary of a sportsman, which can be classified as income from personal activities, depends on the intention of the contracting parties as expressed in the employment contract. If that contract obliges a sportsman to participate in games and races in foreign countries, the basic salary, generally, has to be allocated to his income from personal activities in the state of performance on a pro-rata basis, unless the employment contract indicates otherwise.

In addition, the Supreme Court indicated that the term “personal activities” covers the performance aimed at an audience and time spent for activities related to such performance as training, availability services, travels and a necessary stay in the country of performance. Due to the fact that the test matches were open for the public, this requirement seems to be met in the case at hand.

3 Treaty between Spain and Ireland – Spanish Administrative Tribunal considers commission agent acting in his own name as PE

Spain’s Tribunal Económico-Administrativo Central gave its resolution on 15th March 2012 (No. 00/2107/2007), published in June 2012, in a case relating to a multinational group involved in the design, development and manufacture of computer products which are commercialised through entities of the group. Details of the resolution are summarised below.

(a) Facts :
An Irish company, without human or material resources, commercialises computer products in Spain (as in other several countries) through a commission agent, a Spanish affiliate company, acting on behalf of the Irish enterprise but in its own name, with the support of foreign entities that provide after-sales services as technical assistance or repair. The commercialisation in the Spanish market was formerly realised directly by the Spanish affiliate. However, a group reorganisation took place under which the customer’s profile was transferred to the Irish company. For commercialisation purposes, the Spanish market was segmented into two areas:

– large customers who require personalised and customised attention so they were addressed to the Spanish commission agent; and

– retail customers with whom contact is made through foreign call-centres or on-line through a web page registered under a “.es” domain, hosted in server located outside Spain.

(b) Issue :
The tax authorities considered that the Irish company deemed to have a permanent establishment (PE) in Spain because the Irish company had in this country:

(i) a fixed place of business or, alternatively,
(ii) a dependent agent.

(i) Fixed place of business: Contrary to the taxpayer ´s argument that having an affiliate was insufficient to give rise to a PE, the Tribunal held that the Irish company had a PE in Spain. To support its consideration, the Tribunal held that the Irish company did not merely realise auxiliary or preparatory activities through a steady business framework in Spain.

(ii) Dependent agent: Alternatively, the Tribunal maintained that in case no fixed place of business was found to exist, the Irish company could be deemed to have a PE in Spain as a dependent agent. It based this result on the grounds that the Spanish company was sufficiently empowered to bind the Irish company, which was its sole client, and had to follow its instructions, provide reporting, request its authorisation before setting prices or delivery, allow record inspections as well as copyright control.

In addition, the tax authorities considered that income derived from all sales in Spain of the Irish company should be allocated to its Spanish affiliate, including those made through the web page, although the server was outside the Spanish territory (reference is made to the Spanish reservation included in the OECD Model (2005) and OECD Model (2003) versions in this respect). Only part of the Irish costs was directly allocated to the Spanish PE.

(c)    Decision:
The Spanish Tribunal resolution, following the Supreme Court decision of 12th January 2012, confirmed the existence of a PE based on the facts that demonstrate the substance of the activities and the operational reality of the Spanish company as well as the opinion of the tax authorities in respect of the attribution of income to the PE.

4    Treaty between Singapore and Japan : Unutilised losses of de-registered branch allowed for offset against profits of re-registered branch of a foreign company

The Income Tax Board of Review gave its decision recently in the case of AYN v. The Comptroller of Income Tax [2012] SGITBR1 on the availability of unutilised tax losses for offset against the profits of a foreign branch in Singapore. Details of the decision are summarised below.

(a)    Facts :
In 1992, a Japanese company called AYN Corporation (the Appellant) registered a branch in Singapore (the “old branch”) to carry on business there. The old branch was de-registered in 2004, at which time it had accumulated unutilised losses amounting to SGD 30 million. In 2006, the Appellant re-registered itself in Singapore and carried on business activities through a newly-registered branch (the “new branch”).

The Appellant sought to deduct the unabsorbed losses of the old branch against the business profits of the new branch for the year of assessment 2008. However, the claim was disallowed by the Comptroller of Income Tax, on the basis that pursuant to article 7 of the Japan – Singapore Income Tax Treaty (1994) (the Treaty), a branch is treated as a distinct and separate entity from the enterprise of which it is a part for income tax purposes. As such, the losses incurred by the old branch cannot be utilised against profits earned by the new branch.

The Appellant argued that a branch is from a legal perspective, an extension of the head office, and that section 37(3)(a) of the Income Tax Act (ITA) dealing with unabsorbed losses refers to the amount of loss incurred by a “person”, which refers to the legal entity, i.e. AYN Corporation and not the Singapore branch.

(b)    Issue :
The issue was whether the unabsorbed tax losses of the de -registered branch could be utilised against the profits earned by the new branch of the same company, i.e. whether they were the same “person”, as required by the ITA.

(c)    Decision:
The Board of Review held that the unutilised losses of the old branch could be used to offset the profits of the new branch, on the following grounds:

  •     Section 37(1) of the ITA provides that “the assessable income of any person…shall be the remainder of his statutory income for that year after the deductions in this Part have been made”. Section 37(3)(a) allows the deduction of “the amount of loss incurred by that person in any trade, business, profession or vocation”.

  •     The term “person” is defined in the ITA to include a company. The Appellant was a company incorporated under the laws in Japan, and was in the Board’s view, a “person” as covered by section 37 of the ITA. On the other hand, a branch is an extension or arm of the foreign company in Singapore and exists to carry on the business of the foreign company in Singapore. It has no separate legal status, and is for all intents and purposes the same legal person as the parent company formed outside Singapore.

  •     Article 7 of the Treaty deals with the allocation of profits to a permanent establishment and does not modify the provisions of section 37.

The Board concluded that the unabsorbed tax losses belonged to the Appellant and therefore were available for offset, provided that there was no substantial change (more than 50%) in the shareholders and their shareholdings of the Appellant.