International Taxation — An Overview

S. Rajaratnam,
M.A., LLM, F.I.C.W.A.

International taxation involves study of tax effect of cross border transactions on parties of both sides of the border.

1. FIRST STEP

The tax liability for both residents and non-residents are ascertained on the basis of the domestic law. But it is possible that both may have some respite with reference to the Double Tax Avoidance Agreements.

2. LIABILITY OF NON-RESIDENT IN INDIA

Domestic law, as regards taxation of non-residents, is primarily governed by section 9 with applicability of other sections not ruled out, whether for reliefs and exemptions or even for liability.

Receipt of income as distinct from remittance is taxable under section 5 of the Income-tax Act even in respect of income, which may not otherwise be taxable as held in P.V. Raghava Reddi vs. CIT (1962) 44 ITR 720 (SC) and Standard Triumph Motor Co. Ltd. vs. CIT (1993) 201 ITR 391 (SC). But Double Tax Avoidance Agreement ignores liability solely with reference to place of receipt, so that an income subject to relief within the meaning of Double Tax Avoidance Agreement will not be taxable on receipt basis.

A non-resident is liable in India under section 9 on the basis of following classification as Indian income —

1. Business connection - Section 9(1)(i)

Any income attributable to business connection in India is taxable. Business connection has been defined by the Supreme Court in CIT vs. R.D. Aggarwal and Co. (1965) 56 ITR 20 (SC). Business connection, however, has been sought to be defined by Explanation 2 to section 9(1)(i) by the Income-tax Act, 2003 with effect from 1-4-2004 broadly on the lines of the Supreme Court decision and in a summary manner as to what is understood as permanent establishment under the Double Tax Avoidance Agreement itself. Since the expression is “attributable to” in contrast with “derived from”, the attributable income may be construed in a wider sense following Cambay Electric Supply Industrial Co. Ltd. vs. CIT (1978) 113 ITR 84 (SC) decided in a difference context of relief under Chapter VI-A.

2. Salaries — Section 9(1)(ii)

Salary income is understood as earned where service is rendered.

3. Dividend — Section 9(1)(iv)

Dividend paid by any Indian company is treated as income arising in India.

4. Interest — Section 9(1)(v)

Interest received by a non-resident from a resident or a non-resident on funds used in India is treated as taxable in India.

5. Royalties — Section 9(1)(vi)

Royalties as defined under section 9(1)(vi) payable to non-resident is taxable in India.

6. Fees for technical services — Section 9(1)(vii)

Technical service as defined under section 9(1)(vii) is treated as income taxable in India. Use of technology supplied by the non-resident would be treated as Indian income.

7. Income from property or any asset or source of income in India — Section 9(1)(i)

Income from property of any asset or source of income in India is taxable as Indian income.

8. Capital gains on transfer of a capital asset situated in India — Section 9(1)(i)

Capital gains for transfer of a capital asset situated in India is taxable in India.

3. TREATY OVERRIDE — DOUBLE NON-TAXATION

It is well-established that Double Tax Avoidance Agreement overrides the domestic law even as upheld by the Supreme Court in Union of India vs. Azadi Bachao Andolan (2003) 263 ITR 706 (SC). In the result, double non-taxation may very well occur.

Where there is liability in an international transactions under the domestic law either for the resident or non-resident in respect of any income taxable on such transaction, one has to look to the Double Tax Avoidance Agreement for any possible relief, though unilateral relief may also be possible for residents only even in absence of such Agreement under section 91 on the doubly taxed income at lower of the two rates.

4. BROAD FEATURES OF DOUBLE TAXATION AVOIDANCE AGREEMENT

Double Tax Avoidance Agreements is different from earlier Double Tax Relief Agreements. As far as possible, the Avoidance Agreement can be given effect without waiting for what happens in the other country. Only in some cases, where same income is taxed in both the countries as in the case of business, relief in the home country may well have to depend upon the outcome of the liability in the host country (country where assessee is a permanent resident). In the host country (where the assessee is a non-resident under the Agreement) itself, where income is taxed on the income attributable to permanent establishment, it is immaterial as to what is taxed in the home country of the assessee, so that pendency of assessment of income in the home country need not detain the assessment in India.

Area of taxation in case of such income by limiting jurisdiction to either country under the Agreement for certain classes of income.

Jurisdiction to tax income from immovable property is divided between the participant countries in almost all agreements with such income taxable only where the property is located. Where there is stipulated rate in the Agreement as for dividend, (when taxable), interest, royalty and technical fees, the relief can be given in the home country by giving credit for the stipulated rate, while the host country does not have to bother, whether the non-resident is taxed or not in his own country.

The other features of Double Tax Avoidance Agreement is non-discrimination clause, mutual agreement procedure for resolving disputes, exchange of information to tackle tax evasion and mutual assistance for service of notice and recovery, where there are specific provision in the agreement to that effect.

5. RELIEF UNDER DOUBLE TAX AVOIDANCE AGREEMENT UNDER DIFFERENT HEADS

Schedular system for computation of taxable income, which has come for critical comment in Rajah Chelliah Committee is followed under the domestic law of Anglo-Saxon countries, so that its shadow has fallen on U.N., OECD and U.S. Models and in almost all agreements. Under schedular system, income is computed with reference to the heads of income under which it falls. Double Tax Avoidance Agreement also follows the same pattern for relief from taxation depending upon the Article under which the class of income falls. Reliefs under Double Tax Avoidance Agreement are classified under Articles generally following OECD pattern as under:

1. Business income attributable to permanent establishment - Article 7 (Permanent establishment is defined in Article 2 read with Article 5 defining permanent establishment). Income diverted through an associated enterprise is covered by Article 9.

2. Income from house property — Article 6.

3. Income from shipping and air transport — Article 8

4. Dividends — Article 10

5. Interest — Article 11

6. Royalties and technical fees — Article 12

7. Capital gains — Article 13

8. Independent personal service — Article 14 (income from profession) is omitted in OECD Model from 2000 on the ground, it is already included under Article 7.

9. Dependant personal service (income from employment) — Article 15.

10. Other miscellaneous incomes (director’s fees, artistes, sportsmen, pension, government servants, stipend for students and other income) — Articles 16 to 21.

6. CONCEPT OF RESIDENTIAL STATUS

India has a peculiar category of residential status viz., Resident but not Ordinarily Resident. The definition of “resident” under domestic law is different from the definition under Double Tax Avoidance Agreement, which is concerned with the country, where the assessee is a permanent resident. For a corporation, it is place of effective control, while for an individual, it is the place of permanent residence, place of vital interest, habitual abode, citizenship or by mutual agreement in that order. In the result, a person could be a non-resident under the domestic law, but still a resident under the Double Tax Avoidance Agreement, so that relief under Double Tax Avoidance Agreement is available in the country in which he is permanently a resident, While tax will be computed on the basis of his residential status under the domestic law at the first stage, such liability will be finally determined in respect of international transactions by the Agreement, if any or under section 91.

7. BROAD BASIS OF RELIEF

Business income may be taxed in both the countries in the country of which the enterprise is a resident on the entire income subject to relief, if any, under the Double Tax Avoidance Agreement. In such a case, where any part of the business income of the enterprise is also taxed in the other (host) country because of permanent establishment or otherwise as business income within the meaning of Article 7, such tax may be given set off as provided in the Agreement.

Salary income may be taxed both in the country, where service is rendered and the country in which the employee is a permanent resident. Exemption may be given in the country where service is rendered, if the number of days of employment is less than the prescribed period, ordinarily 182 days in a fiscal year. The home country does not tax such salary income, which is taxable, where the salary income is earned.

Interest, dividend, royalty and technical fees may be taxed in the home country on the entire income, but in the host country, it is taxed at a stipulated rate, which is usually lower than the domestic rate, provided under the Double Tax Avoidance Agreement in the respective Articles. In the home country, relief is given on the doubly taxed income.

Income from immovable property is taxed only in the country, where it is located and not in the other country. Capital gains on immovable property is also taxed only in the county where it is located.

8. TRANSFER PRICING RULES

Transfer pricing rules have come up for interpretation before the Supreme Court in DIT (International Taxation) vs. Morgan Stanley and Co. Inc. [2007] 292 ITR 416 (SC) in the case of a non-resident company with an office set up by the company in India to support main office functions in equity and fixed income research, account reconciliation and in providing IT enabled services such as back office operations, data processing and support centre, what can be compendiously described as stewardship activities.

Authority for Advance Rulings (AAR) had held that the assessee did not have a fixed base or permanent establishment (PE) in India, as it was not concluding any business in India, a finding that was not palatable to revenue, which argued that there was an agency PE, so that it cannot avoid liability for income attributable to the operations in India. The only further point in its view was ascertainment of an arm’s length price (ALP) for determining income attributable to its PE in India. The Supreme Court accepted this argument.

Out of the methods prescribed for the purposes, the Supreme Court found that the Transactional Net Margin Method (TNMM) would be the most suitable method, since under this method, total operating profits from the transactions in India and abroad are allocated between the non-resident’s main office and the office in India on the basis of sales, costs, assets etc. In response to the assessee’s argument, that the local office did not take any risk, it was pointed out that this factor can be taken into consideration in fixing the ratio of profits. The Supreme Court directed that the matter to be further examined by the department as to whether service charges payable fully represents the value of the service for a decision as to applicability of transfer pricing rules. As for the economic nexus, it was pointed out, that it was an important aspect of the attribution principle.

The same issue has been dealt with by the Special Bench of the Tribunal (Delhi Bench) in Mentor Graphics (Noida) Ltd. vs. Dy. CIT [ITA No. 1969/D/2006 dated 2nd November, 2007] in respect of determination of arm’s length price and denial of deduction under section 10A of the Act. The appellant company is a software development support service provider for its parent company in U.S. The assessee justified its accounts by a working under TNMM method further supported by Cost Plus Method. But revenue (Transfer Pricing Officer, [TPO]) sought to apply Comparable Uncontrolled Price (CUP) method. Assessee selected ten cases as comparable cases, but ultimately 5 cases were relied upon by TPO to arrive at an addition of about 1.46 crores. The addition was confirmed in appeal. Deduction under section 10A was found inadmissible as it was an old unit, while relief under section 80HHE could not be given for lack of audit certificate.

In appeal to the Tribunal, assessee challenged selection of comparable cases. The Tribunal found three of the cases selected could be treated as comparable, since two of them having dealing with related parties could not be taken as comparable. It found that application of TNMM method did not arise because the arguments before the lower authorities were on CUP method. Taking into consideration that the parent company bore the risk except for exchange risk borne by the assessee. Intellectual Property Rights were with non-resident principal. Though the Tribunal referred to the Supreme Court decision in TNMM method, it found that even under this method in Rule 10(B)(1)(e)(ii), net profit margin arrived at would require adjustment arising out of comparable uncontrolled transactions. Cases chosen by assessee as comparable could not have been rejected, so that the addition was not justified. As for claim for deduction under section 10A, it was remitted to the Assessing Officer as was done for an earlier year. It could have been added that even if 10A is not admissible, assessee should be permitted to file tax audit certificate for relief under section 80HHE on the basis of assessee’s alternative plea and matter considered on merits.

9. TURNKEY PROJECTS

The decision of AAR in Rotem Company In rel., [2005] 279 ITR 165 (AAR) involving a composite contract as between Delhi Metro Rail Corporation and a consortium of Rotem Co., a Korean Co. and Mitsubishi Corporation, a Japanese company can now be taken as an authority for the view that a contract which is single one with no option to treat it as severable, could still be considered for income-tax purposes as severable, because of the possibility of apportioning the consideration as between different components. The application of this decision to turnkey projects case cannot be easy for lack of objective criteria for splitting up the different components and attributing the lump sum consideration to each of them. Probably, the easier inference is to understand such contracts as business agreements, so that the income attributable to such contract executed in India can be estimated both for purposes of domestic law as well as double tax avoidance agreements.

The Bombay Bench of the Tribunal in Dy. CIT vs. Roxon Oy [2007] 291 ITR (AT) 275 (Mum) has decided that, in the case of a turnkey project, where there was both supply and installation, the income attributable to permanent establishment cannot include the profit on supply of machinery. The reasoning of the Tribunal is that supply precedes the execution of the project, so that it cannot form part of the income of permanent establishment. The Tribunal invoked the “force of attraction rule” pointing out, that the mere fact that, there is a permanent establishment, does not mean that the entire income of the non-resident becomes taxable. Though the decision was rendered without the benefit of the Supreme Court decision in Ishikawajima-Harima Heavy Industries Ltd. v. Director of Income-tax, Mumbai [2007] 288 ITR 408 (SC), it accords with the principle decided therein. Even the amendment intended to nullify the decision in Explanation to section 9 by the Finance Act, 2007 would limit the application of the decision only in respect of income from interest, royalty and technical fees, which would be liable to tax, whether the non-resident has a residence or place of business or business connection in India. It would be so even under Double Tax Avoidance Agreement even without considering the explanation, which is applicable only to the domestic law. In the case before the Tribunal, supply of machinery was a disjunctive part from its business undertaken in India, so that the decision of the Supreme Court is in all fours with the assessee’s case.

10. TREATY ABUSE

Revenue would infer treaty abuse wherever a transaction is routed through a country with which India has an agreement with more favourable terms as in the case of agreements with Mauritius and UAE and to a slightly lesser degree with Singapore and Malaysia. Such treaty shopping by itself cannot be ignored as it is legitimate, unless there are specific provisions in the Agreement enabling the participant countries to disregard the same.

There are two decisions by AAR one inferring treaty abuse as unacceptable treaty shopping and the other, where treaty shopping was legitimate as is evident from the comments at p.699 and p.700 of 3rd Edition of “Commentary on Double Tax Avoidance Agreement (Part 1)” as under:

“In Advance Ruling No. P. 9 of 1995 In re (1996) 220 ITR 377 (AAR), where a British Bank, which had subsidiaries incorporated in Mauritius, sought confirmation that the dividend from investments made in India through two of its subsidiaries would be eligible for the benefit of double tax avoidance agreement as between India and Mauritius. The AAR after an analysis of the transactions that had taken place found that though the investors were Mauritius companies, the beneficial owner of the shares was UK Bank and that the ultimate shareholder was only the UK Bank and that the transaction is one intended prima facie for avoidance of tax so as to avail the benefit of Indo-Mauritius Agreement for Avoidance of Double Taxation. This decision, apart from the fact that it indicates that advance ruling need not be in advance of the transaction, is an illustration of the jurisdiction of the AAR to go behind a transaction as is even otherwise implicit in any double tax avoidance agreement, that any transaction solely intended to evade tax cannot be subject matter of relief.

The position of law as discussed herein has come up for review by AAR in Advance Ruling P. No. 10 of 1996 In re (1997) 224 ITR 473, where the issue raised was similar to the one as was seen in the case reported in P. No. 9 of 1995 In re (1996) 220 ITR 377 (AAR), except that in this case it is an American company, which sought to transact business in India, through Mauritius company with the help of an Indian financial service company. Opportunity was taken to clear many of the misgivings raised on account of the earlier decision. The Department naturally relied upon the earlier decision to deny the benefit claimed in the application for advance ruling. It claimed that it was a case similar to the earlier one and that the ruling should not be given as it would help the parties to avoid the pitfalls arising out of adverse ruling and modify the transaction. The AAR pointed out that if the applicant is prepared for “the risk of ruling”, it is not for the Authority to deny such ruling according to law. On that ground, it cannot be said that the ruling is “infructuous.” It further found that it was not a case, where the Mauritius company was proposed to be only a conduit pipe and that therefore it cannot be said that it is an instance of prima facie avoidance of tax. Merely because Mauritius is chosen as the place of investment for tax advantage, when other considerations also prompt the choice of the place, the arrangement cannot be dismissed as lacking in bona fides, as the arrangement is one which benefits the Indian company as well and not merely the applicant.”

Where a transaction is artificially put through introducing an intermediary, such intermediary could be ignored as a dummy as was done by the Tribunal where the non-resident had no activity in Mauritius notwithstanding its incorporation in Integrated Container Feeder Service vs. Jt. CIT (2005) 278 ITR (AT) 182 (Mum).

In such cases, the definition of resident for a corporate entity that it will be a place of effective control, which determines residential status, would be required to be considered. There is considerable confusion on the part of the Income-tax Department as is evident from the requirement of acceptance of incorporation certificate as a test for determining residential status in respect of investment income in Circular No.789 dated 13th April, 2000 (2000) 243 ITR (St.) 57 but this Circular was hastily withdrawn the same by another Circular No.1 of 2003 dated 10th February, 2003 (2003) 260 ITR (St.) 245 on the basis of the decision in Shiva Kant Jha vs. Union of India (2002) 256 ITR 563 (Del). But the Supreme Court had upheld the withdrawn Circular in Azadi Bachao Andolan’s case (supra) with no further reaction from the Income-tax Department.

11. SOME OUTSTANDING ISSUES

Place of a transaction was more easily inferable, before satellite transactions had come into vogue. Double Tax Avoidance Agreements have not tackled this problem, with the result that there are controversies. It is generally understood as more clearly stated in the Indo-US Agreement, that technical service can be inferred only where there is transfer of technology and not merely because the service may involve technical content as part of business arrangement. Softwares involving intellectual property rights conveyed whether on CDs, floppy, diskettes, perforated sheets or other means has been recognised as tangible assets liable to sales tax in Tata Consultancy Services vs. State of A.P. (2004) 271 ITR 401 (SC) and for customs duty in Sprint RPG India Ltd. vs. Commissioner of Customs (2000) 2 SCC 486. But in Bharat Sanchar Nigam Ltd. v. UOI (2006) 282 ITR 273 (SC) in the matter of service tax, supply of SIM Card in the context of supply of mobile communication service was treated as liable for service tax, inferring that supply of handset did not make it a sale, since electro-magnetic waves and radio frequencies are not goods. Income-tax law would require consideration of these decisions in future.

Liability for book profits tax, fringe benefits tax, service tax and obligations relating to tax deduction at source are some of the other tax-related problems, which are to be faced by the global partners of Indian enterprises with solution possible, only if the problems are addressed either by statutory amendments or clarifications or further protocols under Double Tax Avoidance Agreements to make it easier for the trade and industry in India and prospective investors from abroad.

Source : Paper Presented at programme for Orientation & Training of New Members, Income Tax Appellate Tribunal, Mumbai. held from 12th November, 2007 to 28th November, 2007.

Acknowledgement : We are thankful to Hon’ble President, Vice President, ITAT, Mumbai for granting us permission to print the article for the benefit of Tax Professionals.