FAQ

What is double taxation?
Double taxation can be defined as the levy of taxes on income / capital in the hands of the same tax payer in more than one country, in respect of the same income or capital for the same period. Double taxation may arise when the jurisdictional connections, used by different countries, overlap or the taxpayer may have connections with more than one country.

What are the different jurisdictional connections used by countries?
Broadly, there are three groups of countries:
Status Jurisdiction- Anglo-Saxon System: Status of the taxpayer is the jurisdictional test. E.g. Citizenship in USA. An American citizen pays US tax on his global income. In the case of India, residence in the country is the jurisdictional test. I.e., if a taxpayer is a resident of India, he will pay tax in India on his world income. In the case of estate duty, the jurisdictional test is domicile.
Features of Status jurisdiction:

• Jurisdictional connection is the personal status of the taxpayer--rather than the source of his income;

• In the case of companies, fiscal domicile (location of the seat of management) and not legal domicile (place of incorporation) is the jurisdictional test;

• Tax is paid on global income, i.e., income from domestic and foreign sources are taxed (global in character);

• Tax rates are applied on the total global income (canon of equity);

• Economically advanced countries like US, UK, Germany, Sweden, and Netherlands follow this system.

Source Jurisdiction: European countries follow source jurisdiction. Income, arising or accruing from a source within the country, is subject to taxation.
Features of Source Jurisdiction:

• The jurisdictional connection is the source of income;

• Only income from domestic sources is taxed (territorial rule of jurisdiction);

• A scheduler system is followed i.e., income from each source in the country is computed and taxed, separately;

• France, Latin American countries and some Middle East countries follow this system.

Both Status and Source Jurisdiction: India follows both the methods. However, unlike source jurisdiction countries, income from each source is not taxed separately, though it is computed under each source. The aggregate income from all sources is taxed, applying the principle of progressive taxation, thus satisfying the canon of equity. However, it results in double taxation in many ways. E.g. ‘A’, an American citizen gets income from his investment in India and pays tax in India since his source of income is in India. He also has to pay tax on this income in the US, since he is an American citizen and, thus, is liable to pay tax on his global income.

What is the need for Double Taxation Avoidance Agreements?
Due to the phenomenal growth in international trade and commerce and increasing interaction among nations, citizens, residents and businesses of one country extend their sphere of activity and business operations to other countries, where income is earned. It is in the interest of all countries to ensure that an undue tax burden is not cast on persons who earn an income, by taxing them twice; once in the country of residence and again, in the country where the income is derived. At the same time, sufficient precautions are also needed to guard against tax evasion and to facilitate tax recoveries.
To avoid hardship to individuals and also with a view to seeing that national economic growth does not suffer, the Central Government, under Section 90 of the Income Tax Act, has entered into double tax avoidance agreements with other countries.

These Tax Treaties serve the following purposes:
1. Provide protection to tax-payers against double taxation and thus, prevent any discouragement which the double taxation may otherwise create in the free flow of international trade, international investment and international transfer of technology;
2. Prevent discrimination between the tax-payers in the international field;.
3. Provide a reasonable element of legal and fiscal certainty within a legal framework;
4. They also contain provisions for mutual exchange of information and for reducing litigation by providing for mutual assistance procedure.
The Government of India has entered into Double Tax Avoidance Agreement agreements with several countries, including Australia, Austria, Bangladesh, Belgium, Brazil, Bulgaria, Canada, China, Cyprus, (erstwhile) Czechoslovakia, Denmark, Egypt, Finland, France, Germany, Greece, Hungary, Indonesia, Israel, Italy, Japan, Kenya, Korea (South), New Zealand, Norway, Philippines, Poland, Romania, Singapore, Sri Lanka, Sweden, Switzerland, Syria, Tanzania, Thailand, Turkey, U.A.E., United Kingdom, United States of America, U.S.S.R. (Russian Federation) Vietnam and Zambia.

What are the different models for DTA Agreements?
These are essentially the UN (United Nations) and the OECD (Organisation of Economic Co-operation and Development) Models for DTA Agreements. The UN Model for a DTA Agreement takes into consideration the requirements of and the prevailing conditions in the developing countries and safeguards their interests, while the OECD Model is biased in favour of the developed countries. India’s DTA Agreements are mostly based on the UN Model. The US has its own model which issued for DTAs with United States.

How is the term ‘resident’ defined in a DTA Agreement?
A resident: The definition of the term, ‘resident,’ is central to the application of a treaty because treaties often assign the taxing authority to the state of residence. Each contracting state defines ‘residence’ for individuals and companies under its domestic law. However, the definition of residence under a DTAA may be the same as that under the regular tax laws of a contracting state, i.e. based on the number of days’ stay in that country or other such criterion, or on the basis of whether he has a permanent home in both states, or where his personal and economic relations (center of vital interest are greater.
If the center of the vital interests cannot be determined, then the ‘habitual abode’ test is applied. In the absence of habitual abode, citizenship may be the determining factor. If the person is a citizen of both/ states or neither, some DTAAs specify that it will be the phase of effective management which is determinative.
If a provision under the domestic Income-tax Act is more beneficial than a corresponding provision in the DTA Agreement, then which will apply?
A situation may arise when, originally, the tax provision in the other contracting state gave concessional treatment compared to India at a particular time. However, Indian laws were subsequently amended to bring incidence of tax to a level, lower than the tax rate, existing in the other contracting state. Since the tax treaties are meant to be beneficial and not intended to put tax payers of a contracting state to a disadvantage, it is provided in Sec. 90 (2) that beneficial provisions, under the Income Tax Act of India will not be denied to residents of a contracting state, merely because the corresponding provision in a tax treaty are less beneficial. Thus, whichever is more beneficial, between the treaty and (Indian) Income-tax Act provisions, will apply.

What is meant by withholding rate of tax?
Usually, taxation of income of an enterprise in any State is on net basis, i.e., after allowing all relatable expenses. However, in case of non-resident recipients, who have no organisation of funds in the country of source, it becomes difficult for the source country to arrive at the taxable income using normal methods. Such income usually relates to dividends, interest, royalties and fees for technical services, shipping profits and aircraft profits. In order to remove uncertainties for both sides, the usual practice now is to specify in domestic laws, the rates of tax on gross basis. This tax is to be charged on dividends, interest and royalties or fees for services, which would be deducted at source from the payments, before they are remitted out of the country. Such retention of tax is termed as ‘withholding tax’.

What is the Indian government doing about such treaty shopping?
On March 31, 2000, Foreign Institutional Investors (FII), who were not considered `residents’ of Mauritius because their actual, effective management did not vest in Mauritius, were served with notices by the Income-tax Department. By issuing the notices, the tax department sought to lift the corporate veil to find the real beneficial owner. In some cases, the notices were issued to the custodians, who were held as the representative agents of the FIIs.
Investments via Mauritius are either broad-based- e.g. investors from all over the world invest in a Mauritius offshore company, which then routes the investment to India, — or ,they are two-tiered. It is the two-tiered structure which was attacked by the tax officials. In such a structure, a single investor from a country, e.g. the U.S. sets up a wholly-owned subsidiary in Mauritius. This subsidiary then invests in India. FIIs which have such a structure were hit with demand notices from Indian tax authorities.
If the Mauritius Company had more than one shareholder, the tax authorities have not sent it any notice. Notices have also not been sent in those cases where effective management was found to be in Mauritius.
Based on several court cases and rulings, given by the Authority for Advance Rulings, such as in the case of Natwest (Indo-UK treaty), the favourable provisions of the Indo-Mauritius treaty have been denied to certain FIIs. The tax authorities have also relied on the `conduit company guidelines,’ issued by the Organisation for Economic Co-operation & Development (OECD), which says that, in certain circumstances, the intermediate company can be ignored. Based on these guidelines, a Mauritius-based intermediary company was totally ignored by the tax officials. This was severely criticised on two grounds:
The concept of beneficial ownership exists in the article relating to dividend income in the Indo-Mauritius treaty. However, this tenet does not prevail for capital gains. As the two wholly-owned subsidiaries were found to be resident in Mauritius, the treaty provisions, relating to capital gains, were applicable Therefore, it was the opinion of international tax consultants that demand notices for capital gains income could not have been issued to the FIIs.
The `Limitation of Benefit clause’ does not exist in the Indo-Mauritius treaty. It only exists in the Indo-US treaty. Therefore, it was wrong of the assessing officer to look beyond and deny the benefits under the Indo-Mauritius treaty.
The market reacted very badly to the issue of the notices and the Central Board of Direct Taxes (CBDT) had to issue a circular, clarifying its position regarding taxation of income from dividends and capital gains under the Indo-Mauritius Double Tax Avoidance agreement (DTAA). Taxation of dividends/ capital Gains in the hands of investors from Mauritius, Circular No. 789 dated 13th April 2000, Issued by the Central Board of Direct Taxes.
The Delhi High Court, in an order issued in May 2002, had quashed 13th April 2002 CBDT circular that prevented income tax (I-T) officials from investigating the accounts of OCBs and FIIs. According to the quashed CBDT circular, a certificate of residence issued by the Mauritius government should be considered sufficient proof for determining their tax status.
The CBDT issued this circular after the I-T authorities in Mumbai asked some OCBs and FIIs to prove their claim of Mauritius resident ship. India and Mauritius have a double taxation treaty, under which the capital gains arising in India for a Company in Mauritius is exempt from tax.
In Mauritius, these FIIs are liable to pay only a nominal income tax, but no capital gains tax. I-T officials suspect that some OCBs and FIIs have misused this route. A SEBI investigation into the Ketan Parekh scam had also revealed the involvement of several OCBs, registered in Mauritius, in rigging up stock prices.
The Delhi High Courts decision also empowers I-T officers to send notices to the FIIs to prove their Mauritius resident ship. However, according to the Economic Times, it is learnt, that the finance ministry has informally asked the department to wait till it decides on the issue of whether to appeal or not, before taking any action. The department has started gathering information in case it needs to act against them. A prove by the I-T department will force these OCBs and FIIs to prove their residential status, some official feels.
While a company with a management presence in Mauritius may still be in a position to prove its claim of residential status the FII may still need to prove effectively that beneficial ownership and effective management is based in Mauritius.
30th August 2002 is the last date for the Government to appeal to the Supreme Court against a Delhi High Court order.
If there is no appeal income tax officials will investigate the accounts of OCBs and FIIs resident in Mauritius, in order to determine their residential status.

What is a harmful preferential tax regime?
The OECD defines a harmful preferential tax regime as one that:

1. imposes a low or zero effective tax rate on the relevant income;
2. the regime is ring-fenced (that is, it does not offer its domestic tax-payers the same incentives for the same activity as are offered to foreigners);
3. operation of the regime is non-transparent and
4. there is no effective exchange of information with other countries.

What is meant by ‘treaty shopping’?
In the present age of economic globalization, both individuals and corporates are ever anxious to find ways and means of minimizing their tax burden. One way to do so is by moving to a tax haven, i.e., a tax jurisdiction, where the tax incidence is very small, sometimes even nil. Another way of doing this is to take the benefit of the double taxation avoidance agreements, entered into by one country with one or more other countries. This amounts to treaty shopping, which is a method of using or misusing the tax treaties by taking advantage by investing in low tax countries. In effect, there may be a situation where a person, resident in a third State, seeks to obtain the benefit of a double tax treaty between two other countries. MNCs shop for DTA Agreements, signed by countries to obtain fiscal advantages. It is used by investors for the following purposes:

• to reduce the source country taxation;

• to pay a low or zero effective rate of tax in the payee treaty country; and,

• to pay a low or zero tax rate on payments from the payee treaty country to the tax-payer.

What is a tax haven?
The Organization for Economic Co-operation & Development (OECD) has laid down four determinants for a tax haven. These include the following:
1. Lack of effective exchange of information;
2. Lack of transparency;
3. Attracting business with no substantial activities.

How are disputes, regarding the interpretation of a DTA Agreement, resolved?
If there are any disputes in the interpretation or implementation of the terms of DTA Agreements, normal remedies of appeal, provided in the Income-tax Act, are available to the aggrieved party. The DTA Agreements also contain mutual agreement procedures. The aggrieved party may approach the Competent Authority of the Contracting State wherein he is a resident, who, if he is unable to resolve the dispute by himself, will approach the competent Authority of the other Contracting State to arrive at a solution after mutual discussion.
The (Indian) Income-Tax Act also contains a special provision, which is offered to those Non- residents who would like to have advance ruling on a matter of law or fact, in relation to a transaction undertaken or proposed to be undertaken by them. The facilities, available in such provision, can be availed of by Non-residents in the matters regarding Double Taxation of income, also.

What is meant by the term ‘permanent establishment’?
One important term that occurs in all the Double Taxation Avoidance Agreements is the term 'Permanent Establishment' (PE), which has not been defined in the Income- tax Act.
There is a consensus that the host country can tax income of foreign companies only if it maintains a PE. Normally, a PE includes the following:

• a place of management;

• a branch;

• an office;

• a factory.

Thus, a PE takes the form of a facility, a construction site or an agency relationship, all of which require a measure of permanence.
India’s approach has been to enlarge the definition of PE, so as to get maximum tax revenue. In general terms, a business connection is deemed to exist if there is any continuous relationship between a business carried on in India and, a non-resident person who derives income through this connection. There must be a continuity of transactions so as to establish a business connection. Normally, the time period to constitute a PE in the host country is six months. Another issue is the scope of income earned by a PE in a country, i.e., what is the portion of the income of PE earned in India that can be taxed. Under the ‘Attribution Rule’, only those profits are taxable which are attributable to the PE, computed on the basis of a hypothesis that the establishment in a country is completely independent of the head office in another country. The profits, which such an independent enterprise might be expected to derive on the amount so ascertained, are taken into account in the computation of the business income of the PE. Under the "force of an attraction rule", the income, arising from all sources in a country, where a foreign enterprise maintains a PE is subject to tax in that country. This means that in addition to the profits attribution to the PE, those attributable to the sale of goods or merchandise and activities, similar to those carried on through the PE in another country are also taxable in the source country. Thus, in keeping with India’s stand that the country of source has a greater right to tax the profits of all enterprises of the country as compared to what it had in the treaties, based on the OECD model. As an alternative, all income in the source country which is not covered by the PE may be subject to the withholding tax if under the domestic law of the country, the income in question is taxable.

What is meant by the term ‘business income’?
As a general rule, each country will tax a non-resident enterprise, engaged in the active pursuit of business in its territory, with a certain degree of intensity and regularity. Historically, the treatment of business income of a taxpayer is governed by a tax convention, which is tied to the ‘permanent establishment’ concept. A business enterprise or undertaking is subject to income tax on its industrial and commercial profits on parity with local enterprises in a treaty country, but only when it is engaged in trade or business in the country through a permanent establishment.

How is income from Air and Shipping Transport, taxed under a DTA agreement?
Income, derived from the operation of Air transport in international traffic by an enterprise of one contracting state, will not normally be taxed in the other contracting state. An air transport company will be liable to tax only in the treaty country in which it is incorporated. However, this does not apply to aircraft companies, engaged in domestic traffic.
In respect of an enterprise of one contracting state, income earned in the other contracting state from the operation of ships in international traffic, will be taxed in that contracting state, wherein the place of effective management of enterprise is situated. However, some DTA agreements contains provisions to tax the income in the other contracting state also, although, at a reduced rate. These provisions do not apply to coastal traffic

How are associated enterprises taxed under DTA Agreements?
In order to plug loop holes for tax evasion, there is generally a separate article in DTA agreement, which provides for taxing the notional income, deemed to arise on account of an enterprise of one contracting state, participating directly/indirectly in the management of another enterprise in the other contracting state or, where some persons participate directly or indirectly in both the enterprises, under conditions different from those existing between the independent enterprises.

How is dividend income taxed under a DTA Agreement?
Dividend paid out by a company in country A to a resident of country B could e taxed in both countries. Prior to 1st June 1997, a dividend, received by a shareholder from an Indian company was taxable in India. However, the DTAAs provide for a confessional rate of tax, e.g. 5% or 10%, as against the normal rate of tax of 25% under section 115A of the Income-tax Act. A resident of another contracting State, entitled to the receipts of a DTAA, was therefore entitled to opt for the lower rate of tax to be applied to him in the paying country. In India, with effect from 1st June 1997 to 31st March 2002 a tax on distribution of dividends is to be paid by the Company on distributing the dividends. No tax is levied by India on the recipient of the dividend. However, by virtue of the Finance Act 2002, dividend is again taxable in the hands of the recipient with effect from AY: 2003-2004 and therefore the taxability of dividend under the DTAA assumes significance.
How is interest income taxed under a DTA Agreement?
Taxation of Interest Income under DTA agreement: Interest, paid in a Contracting State to a resident of the other Contracting State is chargeable in both the States. Usually, the following are the common features in all DTA Agreements, regarding the taxation of income from interest:

• If the payee is the Government or the Central Bank of the Government or a Government agency, the interest would usually be exempt from tax in the country in which the payment is made.

• Penalty charges for late payment e.g. for defaults in clearance of dues for purchases will not constitute interest nor will any item be treated as dividend, though styled as dividend by the taxpayer or the person with whom he has the relevant transaction.

• There will be no deduction of tax at source if the payee has a permanent establishment in the country from which the payment is made, or if he is engaged in professional services there. In this case, the income will be covered by his assessment to tax in that country in the ordinary course.

• Interest will be deemed to arise in that State in which the payer resides

What is meant by royalties?
Royalties are defined as a share of the proceeds from a patent, book, song, etc. paid to the owner, author, composer, etc. Royalty is defined in the majority of the agreements to cover payments of any kind, received as consideration for the use of or the right to use any copyright of literary, artistic or scientific work, including motion pictures, films, tele-video tapes for use in connection with radio or television, any patent, trademark, design or model plan or secret formula or process for the use of or, the right to use industrial, commercial or scientific experience.

How is income from royalties taxed under a DTA Agreement?
Regarding Royalties, arising in a Contracting State, that are paid to a resident of the other Contracting State:-

• Some DTA agreements provide for taxation in the other Contracting State.

• Some agreements provide for taxation in the contracting State.

• Some agreements provide for taxation in both the States.

How is income from capital gains taxed under a DTA Agreement?
Capital Gains will usually be taxed in the state where the capital asset is situated at the time of sale. However, some DTAAs-- e.g. India’s agreements with Mauritius and with Cyprus provide that there will be no Capital gains tax on the sale of shares in one contracting state by a resident of the other Contracting State.
How is income from professional services taxed under a DTA Agreement?
Income will be taxed in the state where the person is resident and practicing his profession. However, if he has a fixed base in the other Contracting State, the income, attributable to the fixed base, will be taxed in the other contracting state. Some treaties also specify that a professional will be liable to tax if he stays in another country for more than a specified number of days, (183 days for most treaties but 90 for the US) and derives income in that country, even if he does not have a ‘fixed base’ there.

What is meant by the term ‘other income’?
Any income, not specifically covered in the treaties, is usually subject to tax in the State in which the income arises.
Services

• Planning of withholding taxes on various payments such as royalty, dividend, interest and fee on technical services.
• Advice on permanent establishments (PE)
• Planning for avoidance of double taxation
• Optimum utilization of double taxation treaty