International TaxationDemystifying the cross border taxation tangle Narayan Mehta Partner, Sudit K. Parekh & Co. JB Nagar CPE Study Circle, 12th July 06
Agenda • Introduction to DTAA • Specific treaty provisions with practical case studies • Business income • Dividends / Interest • Royalties / FTS • Independent / Dependent personal services • Other incomes • Elimination of double taxation • Outbound investments • Inbound investments • International tax planning- how undertaken in practice? • Way forward…
Causes of Double Taxation • One state claims to tax on the basis of “Source of Income” & another on the basis of “Residence”; OR • Both states claim to tax incomes based on “Residence” Hence the need for elimination of Double taxation!
Double Taxation Convention - Objectives • To protect tax payers from Double Taxation • To encourage free flow of International Trade & investment • To encourage transfer of technology • To prevent discrimination between tax payers • To provide a reasonable level of legal and fiscal certainty to investors and traders • To arrive at acceptable basis to share tax revenue between the states
Treaty Override • In cross-border tax scenario: • The assessee can avail the benefit of bilateral agreements between contracting state; OR • The assessee can choose to be governed by the Indian tax laws Whichever is more beneficial to the tax-payer!
Article 1 – Scope of the Convention • To Whom Does the Treaty Apply? • Article 1 provides for application of tax treaty to persons resident of one or both the contracting states • Hence it does not apply to persons who are not residents of any of the contracting states • “Persons” defined in Article 3 of the model convention to include an individual / company / any other taxable entity
Article 2 – Taxes Covered • Applies to income and capital • Taxes assessed directly & also taxes which are withheld at source • Tax calculated as supplementary levies and surtaxes are also covered • All Non-Government taxes, dues, duties etc are not covered • Indirect taxes are not covered by DTAA
Residence under domestic law Domicile Residence Place of management Any other criterion of similar nature Tie – breaker test: individuals Permanent home Centre of vital interest Habitual abode Nationality MAP Tie – breaker test: Others Place of effective management Article 4 – Residence Residence – Steps for Determination
Fixed place PE Place of management Branch Office Factory Workshop Mine / oil / gas well / quarry / any other place of extraction of natural resources Construction/ Installation PE Building site Construction Assembly / installation / supervision in this connection Service PE Dependent Agency PE Article 5 – Permanent Establishment
Case Study: Minimizing Indian Tax • Transaction structured to legitimately avoid Y Co from having a PE in India • Location selection of Y co examined from Belgian & Indian angles X Co (Belgium) Y co (Mauritius) Indian PE 75% of work sub-contracted
Article 7 – Business Profits • Taxation of profits only by state of residence • Taxation by source country allowed only to the extent profits are attributable to a PE of the enterprise therein • Therefore, profit attribution absolutely essential • HO and PE deemed to be separate and distinct enterprises operating independently • Check if the treaty has “force of attraction” rule! • Expenses incurred for business of the PE deductible • Therefore, only net profits to be taxed • Use of customary proportionate method allowed • However, results should be at arm’s length • Consistent method to be followed every year • Not applicable if items covered under different Articles
Attribution of Profits to PO- a Case Study Sub-contract Price INR + USD X Inc. (US) Y AS (Norway) Ship lift system to be done by X Inc Ship transfer system Shiplift & Ship transfer System within 3 years of the contract signing Contract Price INR + USD Indian Navy
The Operating Model Work done: Drawings / Designing / Engineering X Inc. (US) Y AS. (Norway) US $ payments Repatriation of surplus on Completion of project Work done: Local assembly through local vendors PO PO INR payments Indian Navy US $ payments INR payments
Fiscal year – 1st April to 31st March Y AS’s Permanent establishment (PE) under India / Norway tax treaty constituted Attribution of profits to head office No prescribed methods- fact sensitive Methods to attribute profits to various business activities Resources deployed as a basis of attribution Salaries paid / costs incurred as basis of profits attribution Others based on facts Surveyor’s certification of work done Terms of contract, price list, etc Computation of profits for each contract period Method of accounting - % Completion v/s Completed contract Method? Coordinate method with accounting policy followed by head office ! General administrative and Head office expenses upto 5% of total income Corporate tax – 40% on net profits attributable to PE plus 5% surcharge for 2002-2003 Practical Considerations
Article 10 & 11 – Dividends & Interest • Taxation primarily by state of residence of recipient • Participation exemption in certain countries for dividends • Taxation by source country limited to a certain percentage (generally 5 – 15%) • If interest / dividend connected with PE in source country, Article 7 applies • Net basis of taxation in such a case • Interest paid to AE must be at ALP
Article 12 - Royalties / FTS • Exclusive right of taxation to state of residence • Country of source may retain the right to deduct withholding tax • Definition of FTS restricted to FIS in some treaties (for instance, India – US treaty) • Thus, FTS not taxable, if they do not • “make available”- Technical knowledge, Experience, Skill, Know-how, Process • Consist of development and transfer of technical plan / design • If Royalty / FTS connected with PE in source country, Article 7 applies • Royalty / FTS paid to AE must be at ALP
Check Protocols to Treaty! • Protocols / MOUs • Generally provide amendments to the existing treaties • Provide for explanations to the treaty provision • Check whether the treaty / protocol has the MFN Clause!
MFN Clause in Dutch Treaty “ 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, interest, royalties, fee for technical services or payments for the use of equipment at a lower rate or scope provided for in this Convention on the said items of income, then, as from the date on which the relevant India 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. The Dutch treaty was signed on 30 July 1988 ”
Original Text of Dutch Treaty • 20% w/tax on royalties and fees for technical services • Broad scope of royalties and fees for technical services • Most favored nation clause (MFN) for royalties and fees for technical services, interest and dividends
Favorable Treaties since 1990 • US treaty 18 Dec 1990 • German treaty 26 Oct 1996 • Swedish treaty 25 Dec 1997
Lease Payments • Gross w/tax of 20% wipes out margins on cross border leases • Payments on cross border leases no longer taxable in India due to Swedish treaty • Fillip to Dutch leasing industry
Technical Services • Certain technical services taxable • “make available” technical knowledge • Development and transfer of a technical plan or design • Are ancillary to the royalty payments • Other services not taxable • Ancillary to rental of ships, aircraft, etc. • Independent personal services
Interior Design Projects- A Case Study • Interior design project mgt co based in HK & Singapore sets up Indian subsidiary • Lands up lucrative contracts in India • Objective : Minimize Indian taxes • Management fees/ FTS • Royalties • Commission • Payments can be made to Singapore, Malaysia or HK subs
Payment of Management Fees FIPB issue ! A Co (Singapore) 26% 15% 0% X Co (India) 10% B Co (Malaysia) 0% 20% C Co (HK) 0% Overall tax rate reduced from 26% to only 10%!
Section 195 / Section 197 Certificate • Section 195(2) • Payer can apply to determine appropriate portion of the sum chargeable to tax and liable for withholding • Section 195(3) • Non-resident can make an application to the assessing officer for grant of a certificate for Nil withholding tax rate • Section 197 • Payee can apply for NIL or lower deduction of Tax certificate
Section 195 • Time of Deduction • Credit or payment whichever is earlier • Section to not apply if sums paid are not chargeable to tax • CPA Certificate / certificate from tax office in appropriate cases
Magnesium Sinter Plant- A Case Study • Sale of magnesium sinter plant by Austrian co for Indian co • Supervision of erection also undertaken • Technical service payments made to Austrian co • Tax withheld @ 30% gross
Tax Refund relating to FTS • Tax refund was claimed • Classifying payments as reimbursement of expenses rather than payment of FTS • Detailed examination of all evidences and conferences with Austrian auditors re the evidence of reimbursement • More than 25 visits to the tax offices !
Articles 14– Independent Personal Services • IPS (Income from Independent personal services) • Primary right to tax – state of residence • Source state also has right to tax only if • If he has a fixed base regularly available to him in the other state for performing his activities • Stay >= 60 / 90 / 183 days; or • IPS deleted in OECD MC – 2000 Update
Articles 15 – Dependent Personal Services • DPS (Income from Employment) • Primary right to tax – state of residence • Source state also has right to tax only if: • Stay >= 183 days; or • Remuneration paid by or on behalf of employer resident in source state; or • Remuneration borne by PE of the employer in source state • Remuneration in respect of employment aboard ship / aircraft – place of effective management
Some Interesting Issues In Relation To Expatriate Taxation • Determination of Residential Status of the expat when different years are followed for tax purpose in home and host country? • Taxability of Living allowance paid to the expatriates in India – Whether exemption under section 10(14) of ITA? • Taxability of Social Security Contributions made abroad in India? • Taxability of Salaries for services rendered partly in India and partly for other countries – Possibility of Split Contract? • Exposure to Service PE in India- Morgan Stanley Ruling! • Exposure to FBT in India for foreign company
Article 21 – Other Income • Income not covered by other paragraphs covered here • Generally, exclusive taxation by country of residence of recipient • Some treaties do provide for source based taxation • Place where income arises – not relevant • Computation of taxable income based on domestic laws • Article applies only where there is no PE in source state
Check if the treaty is in effect! • Entry into force – check for each of the countries, • The Date of Entry into force of the convention • The Date of Effect of the convention
Ensure that the Treaty has not terminated! • Treaty remains into force till terminated • Some treaties provide for a period during which treaty cannot be terminated • Termination requires notice through diplomatic channels • Some treaties provide for period of notice and some do not • Check if the treaty is in force before applying it!
Approaches for Elimination of Double Taxation • Bilateral Agreements between Contracting states • Section 90 provides for tax relief in accordance with treaties executed by India • Unilateral Tax credit – Foreign tax credit system • Section 91 provides relief where no treaty exists
Exemption Method Credit Method Methods of Granting Tax Credits Full Exemption Exemption with Progression Full Credit Ordinary Credit State of residence allows credit of tax paid in the state of source Restricted to that part of the income-tax which is attributable to the income, taxable in the state of residence Total tax paid in the state of source is allowed as a credit against any tax payable in the state of residence Income earned in the state of source is considered in the state of residence only for rate purpose The Income earned in the state of source is fully exempt in the State of residence
Tax Credits – Full Exemption The income earned in the State of source is fully exempt in the state of residence Old Austria Treaty, Greece
Tax Credits – Exemption With Progression The income earned in the State of source is considered in the state of residence only for rate purpose Australia, Cyprus, Germany (Indian Income), UK, Malta
Tax Credits – Full Credit Total tax paid in the state of source is allowed as a credit against any tax payable in the state of residence Germany, Canada, Singapore, Sweden
Tax Credits- Ordinary Credit State of residence allows credit of tax paid in the state of source Restricted to that Part of the income-tax which is attributable to the income, taxable in the state of residence Most Indian Treaties i.e. Australia, Cyprus, Denmark, UK, USA, France, Japan, Mauritius