Salient features of the US Convention

1. Citizenship-based taxation
   
   The domestic income-tax law of India treats tax conventions as special rules and provides that where the Government of India has entered into a tax convention with the Government of any other country the provisions of the domestic tax law shall apply to the extent they are more beneficial to the tax-payer1. Tax conventions normally apply to persons who are residents of one or both states. If the person is a resident of both states, then, applying the “tie-breaker rule”, his residence under the convention, and consequent taxation of income, is determined.
   
   In addition to the residence-based taxation generally adopted by tax treaties, the US Convention provides for citizenship-based taxation2. For instance, if a resident of India performs independent personal services in the United States and the income is not attributable to a fixed base in the United States, Article 15 of the US Convention would normally prevent United States from levying a tax on such income. However, if the service performer is also a citizen of the United States, then, Article 1(3) permits the United States to include such remuneration in his worldwide income and bring it to tax in the United States. Thus, the provisions of the Act are overridden to an extent by Article 1(3) of the US Convention.
   
   In a significant Indian ruling3, a pension trust established in the USA, which enjoys tax exemption in the US, was held not to be entitled to the benefits of the US Convention. The authority noted that Article 4(1) of the US Convention was subject to para (a) and (b) thereof. Para (a) states that the term ‘resident’ does not include any person who is liable to tax in that State in respect only of income from sources in that State. Para (b) states that in the case of income derived or paid by a trust, the term resident of a contracting state (USA) applies only to the extent that the income derived by such trust is subject to tax in USA as the income of the trust, either in its hands or in the hands of its beneficiaries. The authority noted that while para (a) uses the expression “liable to tax”, para (b) uses the expression “subject to tax”. According to the authority, the two expressions were not synonymous. While “liable to tax” would mean bringing into the tax net, “subject to tax” would mean actual taxation. The authority noted that the Trust was exempt from tax under the domestic US tax law. The authority also noted that nothing was brought on record to show that its beneficiaries were taxed in the US. Therefore, applying the provisions of para (b), the authority took the view that the Trust was not resident of the USA and hence not entitled to claim benefits of the US Convention. It may be mentioned that the subsequent application for rectification of the ruling, wherein certain additional materials were sought to be relied on by the applicant, has been rejected by the authority4. The ruling raises a question whether the framers of the US Convention indeed intended to give a different meaning by using the expression “liable to tax” and “subject to tax” in paras 4(1)(a) and 4(1)(b).
    

2. Taxation of Dividends and Interests
   
   The DTAA provides source based taxation of dividends and interest. Dividends from a subsidiary to a parent corporation (i.e., which holds at least 10% shares in the subsidiary) are taxable at 15%, whereas other dividends are taxable at 25%. Interest is taxable at 15%, although interest received by a bank carrying on a bona fide banking business, etc. is taxable at 10%. Interest received by either of the two Governments, by certain governmental financial institutions, and by residents of a Contracting State on certain government approved loans, is exempt from tax.
   
   Rates for taxation of income in the source country apply if the recipient is the ‘beneficial owner’ of the income. An issue arises whether an intermediate subsidiary company, which receives income from its subsidiary and passes it on to its holding company can be regarded as ‘beneficial owner’ of the income. This issue is largely untested in India.
    

3. Royalties
   
   In general, industrial and copyright royalties are taxable at 20% for the first five years from the US Convention coming into effect,
   dropping to 15 per cent thereafter. Where the payer of the royalty is one of the Governments, a political sub-division or a public sector corporation, tax is imposed from the date of entry into force of the US Convention at 15%. Payments for the use of, or the right to use, industrial, commercial or scientific equipment are treated as royalties and are subject to tax at 10%.
   
   The definition of the term royalties in the US Convention5 is narrower than the definition of that term in the Act6. Insofar as industrial royalty is concerned, the Act regards as royalty consideration for (i) the transfer of all or any rights in respect of the specified intellectual property such as patent, invention, etc. (ii) imparting of any information concerning the working of, or the use of, such intellectual property and (iii) use of such property. On the other hand, the US Convention defines royalties as payments received as a consideration for (i) the use of, or the right to use, any intellectual property and (ii) gains derived from the alienation of intellectual property which are contingent on the productivity, use, or disposition thereof. Similarly, the definition of equipment and other royalties in the Act appears to wider than the definition in the US Convention.
   
   In an Indian ruling7, the provisions of Article 12(7)(b) of the US Convention have been given a somewhat unusual meaning. Article 12(7)(a) provides that royalties shall be deemed to arise in the contracting state where the payer is resident. Article 12(7)(b) provides that where royalties under Article 12(7)(a) do not arise in one of the Contracting States, and they relate to the use of, or the right to use, the right or property in one of the Contracting States, they shall be deemed to arise in that Contracting State. The facts of the case were that royalty was paid by a US company to another US company in respect of certain trademarks used by an Indian company (i.e., the royalties arose in the USA as the payer was a US resident and, therefore, one would have ordinarily thought that article 12(7)(b) should not apply). However, the authority ruled that sub-paragraph (b) was applicable because the royalties did not arise in “one of the contracting states”, i.e., they did not arise in India. What the authority has effectively held is that article 12(7)(b) would not apply only in a case where royalty arises in both India as well as the US, which seems absurd. The view taken by the authority has rendered Article 12(7)(b) almost unworkable.
   
   In another ruling8, payments made by an Indian company to a US company for accessing data from a Central Processing Unit maintained by the US company has been held to be royalty. The authority ruled that the payment was being made for use of intellectual property because the Indian company was allowed to access the software protected and maintained by the US Company. In another case, payments for acquiring a copy of the computer programme without the transferor granting a right to use the copyright in the programme to the transferee has been held9 not to be royalty.
    

4. Fees for included services
   
   Fees for included services are defined as payments for technical or consultancy services if such services (i) are ancillary and subsidiary to the licensing of an intangible or the rental of tangible personal property, both of which give rise to royalty payments, or, (ii) make available technical knowledge, experience, skill, know-how, or processes, or consist of the development and transfer of a technical plan or technical design. A detailed memorandum of understanding has been developed by the negotiators to provide guidance as to the intended scope of the concept of “included services” and the effect of the memorandum is agreed to in an exchange of notes. Fees for all other services are treated either as business profits under article 7 or as independent personal services income under Article 15.
   
   A question arises as to the meaning of the term ‘make available’ in the definition of ‘fees for included services’. That is, when can the technical services be regarded as making available technical knowledge, etc. to the recipient of the services. This issue has been examined by the Mumbai tax Tribunal10 in the context of an Indian company making commission payment to a UK-based lead manager in respect of a GDR issue managed by the latter in the UK. The issue was whether the services performed by the UK company could be regarded as making available to the Indian company any technical knowledge etc. by virtue of performing its services. The Tribunal examined the scope of the expression “make available” in the definition of ‘fees for technical services’ (which is similar to the definition of the term ‘fees for included services’ in the US Convention) and came to the conclusion that the services did not “make available” any technical knowhow etc. The Tribunal took the view that technical knowhow, etc. can be regarded as being made available only if it enables the person receiving the services to in turn be able to offer those services to another. The services wherein the service provider himself utilizes his technical knowledge, etc. to perform the services without passing on the technology contained in the services to the recipient of the services cannot be regarded as “making available” the technical knowledge, etc. to the recipient. That would be a case of making available fruits of the technical knowledge, etc. to the recipient and not the technical knowledge itself. The Tribunal held that in the case before it, the recipient of the service (i.e., the Indian company) did not acquire any expertise to manage GDR issues. Therefore, the services did not make available any technical knowledge, etc. to the recipient. In arriving at the conclusion, the Tribunal was guided, inter alia, by the protocol to the US Convention which gives various illustrations of when a service is to be regarded as making available technical knowledge, etc.
   
   Fees for included services also mean payments if services consist of the development and transfer of a technical plan development and transfer of a technical plan or technical design. The question that arises is whether the development and transfer of a technical plan or technical design, without enabling the recipient to develop such technical plan or design himself, is sufficient to regard the payments as fees for included services. For instance, a technical design for a machinery developed and transferred by the service provider may enable the recipient thereof to manufacture the machinery with the help of the technical design. However, it may not enable the recipient to make another technical design for manufacture of machine. The definition of ‘fees for included services’ appears to be wide enough to cover such consideration. Indeed, illustration 5 in the protocol to the US Convention also confirms this. It is, however, interesting to note that in the Convention entered into between India and Singapore, services which consist of development and transfer of technical plan or design are not regarded as ‘fees for technical services’ unless they enable the recipient thereof to apply the technology contained therein. Therefore, it appears that the provisions of the US Convention and Singapore Convention are at variance on this issue.
    

5. Permanent Establishment Tax11
   
   The US Convention preserves for the United States the right to impose the permanent establishment tax. It preserves for both Contracting States their statutory taxing rights with respect to capital gains. The US Convention also contains rules for the taxation of business profits which provide a broader range of circumstances (Force of Attraction clause in Article 7) under which one State may tax the business profits arising to a resident of the other State by virtue of a permanent establishment in the first state or otherwise.
    

6. Shipping and Aircraft Operating Income12
   
   The US Convention contains reciprocal exemption at source for shipping and aircraft operating income, including income from the incidental leasing of ships, aircraft or containers (i.e., where the lessor is an operator of ships and aircraft). Income from non-incidental leasing of ships, aircraft or containers (i.e., where the lessor is not an operator of ships or aircraft) is not covered by the article. Income from such non-incidental leasing is treated as a royalty, taxable at 10%.
   
    

7. Personal Service Income13
   
   The treatment under the US Convention of various classes of personal service income is similar to the other convention. It has been held14 that services would fall within the ambit of ‘independent personal services’ if the services are in the nature of professional services or activity of independent character, not being in the nature of commercial or industrial activity (the latter could be ‘included services’).
    

8.  Provisions designed to prevent Treaty Shopping
   
   The US Convention contains provisions15 designed to prevent third-country residents from treaty shopping, i.e., from taking unwarranted advantage of the US Convention by routing income from one Contracting State through an entity created in the other State. These provisions identify treaty shopping in terms both of third-country ownership of an entity, and of the substantial use of the entity’s income to meet liabilities to third-country persons. Notwithstanding the presence of these factors, however, treaty benefits are allowed if the income is incidental to or earned in connection with the active conduct of a trade or business in the State of residence, if the shares of the company earning the income are traded on a recognized stock exchange, or if the competent authority of the source State so determines.
    

9.  Other provisions
   
   The US Convention makes detailed provisions regarding taxation of Government remuneration and pension16, private pensions, annuities, alimony and child support17, payments received by students and apprentices18, payments received by professors, teachers and research scholars19.
    

10. Non-discrimination, Dispute Resolution Mechanism and Exchange of Information
    
    The US Convention prohibits tax discrimination20, creates a dispute resolution mechanism21 and provides for the exchange of tax information22 between the tax authorities of the two countries. These provisions are in line with the provisions in the other treaties.
    
    The domestic tax law of India provides that charging a higher rate of tax to a foreign company as compared to a domestic company is not to be regarded as discrimination23. It appears that in view of this provision, the non-discrimination provisions in the US Convention so far as the rate of tax is concerned have been rendered otiose. The question that arises is whether this provision also renders Article 14(2) redundant. Article 14(2) provides that a US company may be taxed in India at a rate higher than the domestic companies but the difference in the tax rate shall not exceed 15%.
     

11. Tax Credit and Tax Sparing Credit
    
    The US Convention follows credit method for providing relief from double taxation24. Credit is allowed for taxes paid in the source country and where the US company owns at least 10% voting stock in an Indian company from which the US company receives dividends, underlying tax credit with respect to the profits out of which the dividends are paid is also allowed.In an exchange of notes, the United States and India have agreed that, although the US Convention does not contain a tax sparing credit, if United States policy changes in this regard, the US Convention will be promptly amended to incorporate a tax sparing provision. However, no such tax sparing provision has been introduced in the US Convention so far.
     

12. Technical memorandum
    
    A technical memorandum explaining in detail the provisions of the US Convention and the related Protocol has been prepared by the Department of the Treasury. The Technical Memorandum serves as a source of information as regards the view of the Government of the United States on the various provisions of the US Convention.
    
    Conclusion
    
    Interpretation of the US Convention has more often than not proved to be more difficult than interpretation of other treaties. In part, this is owing to the unique features in the US Convention, which are in form and substance different from the corresponding provisions in OECD and UN Model Conventions. Therefore, the popular commentaries cannot always effectively aid the issues arising from interpretation of the US Convention. The memorandum of understanding annexed to the US Convention as well as the Technical Explanation resolves many of such issues. It is hoped that these issues will be clarified in due course of time by judicial decisions or by clarifications issued by the respective Governments.
    
    [Source : India-USA — Business and Legal Partnership — Strategies Page No. 117.]
     

1. Section 90(2) of the Income-tax Act, 1961 ("the Act").

2. Article 1(3) of the US Convention provides that notwithstanding any provision of the US Convention, a Contracting State may tax its residents [as determined under Article 4 (Residence)], and by reason of citizenship may tax its citizens, as if the US Convention had not come into effect. For this purpose, the term citizen shall include a former citizen whose loss of citizenship had as one of its principal purposes the avoidance of tax, but only for a period of 10 years following such loss.

3. General Electric Pension Trust, In Re [2006] 280 ITR 425 (AAR).

4. General Electric Pension Trust, In Re [2007] 289 ITR 335 (AAR)

5. Contained in Article 12(3) of the US Convention.

6. Explanation 2 to section 9(1)(vi) of the Act.

7. XYZ, In Re [1999] 238 ITR 99 (AAR).

8. ABC, In re [1999] 238 ITR 296 (AAR).

9. Hewlett-Packard (I) Pvt. Ltd. vs. ITO (International Taxation) (2006) 5 SOT 660 (Bang).

10. In the case of Raymond Ltd. vs. DCIT [2003] 86 ITD 791.

11. Article 14 of the US Convention.

12. Article 8 of the US Convention.

13. Article 15 (Independent Personal Services) and Article 16 (Dependent Personal Services).

14. Graphite India Ltd. vs. DCIT [2003] 86 ITD 384 (Kol).

15. Article 24 – Limitation on Benefits.

16. Article 19 of the US Convention.

17. Article 20 of the US Convention.

18. Article 21 of the US Convention.

19. Article 22 of the US Convention.

20. Article 26 of the US Convention.

21. Article 27 of the US Convention.

22. Article 28 of the US Convention.

23. Explanation to section 90 of the Act.

24. Article 25 of the US Convention.