all rights reserved review of tax treaty policy | 1 a review of indian tax treaty policy: comparing...

All rights reserved | 1Review of Tax Treaty Policy

A REVIEW OF INDIAN TAX TREATY POLICY: COMPARING INDIAN TAX TREATIES WITH OECD AND UN MODELS

January 24, 2008

Mukesh Butani, BMR & Associates

Jacques Sasseville, OECD


CONTENTS

Introduction

Comparative view

Jurisprudence

Recent trends

Recent treaties/protocols

Summary and Outlook


INTRODUCTION


INTRODUCTION

Tax treaty: an inter – nation agreement based on consensus ad idem

Dominant objective – avoidance of double taxation (juridical and economic)

Other objectives Promotion of international trade Exchange of information to counter tax avoidance

Multiple factors determine treaty policy Historical – tilt towards UN / OECD model National interests - economic and political Taxation systems Jurisprudence

Treaty - end result of negotiation between countries guided by multifarious considerations


TREATY FRAMEWORK IN INDIA

1947 – first limited tax treaty with Pakistan1967 – first comprehensive treaty with GreeceCurrently 67 comprehensive treaties and 24 limited treaties in forceLast ten years - 28 treaties and 10 protocols signedTreaties generally conform to UN model with some exceptions Article 5(1) – service PE in 14 treaties Article 7(1) – ‘force of attraction’ rule in a third of treaties Article 7(3) – limited deductibility of expenses only in a third of

treatiesSubstantial adaptation of Indian treaties to UN/OECD model in last 20 yearsTreaties with Greece, Egypt, Libya remain exceptions with significant departures from OECD/UN model conventions


PATTERN IN TAX TREATY POLICY

Treaties based on UN and OECD model conventionsOvertime - broad trends discernible in treaty policy

60’s to mid 70’s Limited right of taxation in country of source Closer to OECD model

Mid 70’s onwards Amendments to Income Tax Act, 1976 – strengthening taxing power with respect

to payments to non residents 1980 – UN model introduced Source rule given prominence in tax treaties

Recent treaties Limitation on benefits clause Will we see policy shift?


50 YEARS OF TAX TREATY WORK AT THE OECD

Work on model tax treaties started in the League of Nations in the 1920s; first models were adopted in 1928

Tax treaty work of the Fiscal Committee of the League of Nations ended after the Mexico Model (1943) and London Model (1946)

OECD started working on tax treaties in 1956

A first draft of a few model articles was produced in 1958; other partial drafts were produced in 1959, 1960 and 1961

The first comprehensive OECD Draft Convention was published in 1963

It was revised in 1977 and has been periodically updated since 1992


WHAT IS THE OECD?

Organization of Economic Co-operation and Development

Replaced OEEC set up to implement Marshall plan

30 industrialized countries 19 from European Union Switzerland, Norway, Iceland, Turkey Japan, Korea, Australia, New Zealand Canada, United States, Mexico


OECD Member CountriesCountries/Economies Engaged in Working Relationships with the OECD

LIMITED MEMBERSHIP BUT GLOBAL REACH


WHAT IS THE COMMITTEE ON FISCAL AFFAIRS?

Committee on Fiscal Affairs

Replaced the Fiscal Committee of the OEEC (1956-1971)

Delegates are senior officials (assistant-secretary, commissioner, general-director of international division etc.)


Committee On Fiscal Affairs

Working Party No 1 On TaxConventions and Related Questions

Working Party No 2 On Tax Policy Analysis And Tax Statistics

Working Party No 6 onTaxation of Multinationals

Working Party No 8 On TaxAvoidance And Evasion

Forum on HarmfulTax Practices

Working Party No 9 on Consumption Taxes

Forum on tax administration

COMMITTEE ON FISCAL AFFAIRS - STRUCTURE


COMPARATIVE VIEW


INSTITUTIONAL DIFFERENCES

OECD Model is a governmental model formally approved by the 30 OECD member countries

Member and non-member countries are allowed to formally express disagreements (reservations, observations and positions) on the Articles and Commentary of the OECD Model

The UN Model was drafted by a small group of experts acting in their personal capacity

The UN Model is not formally approved by the member states of the UN

The UN Model was designed from the perspective of negotiations between developed and developing countries


COMPARATIVE VIEW - OECD VS UN MODEL

Article UN model

(Source rule)

OECD model (Residence rule)

Indian Treaties

Article 5

Permanent Establishment

Installation PE

Service PE

Agency PE

• Includes supervisory activities

• Threshold: 6 months

Rendering of services by employees for over 6 months within 12 month period

• Resulting from habitual maintenance of stock of goods or merchandise for delivery

• Deemed PE in case of insurance enterprise

• Supervisory activities excluded

• Threshold: 12 months

No such provision

No such provision

No such provision

•Most include supervisory

activities

•Most follow UN time

threshold

Service PE found in one

third of treaties

Insurance PE occurs in

20 treaties



Article UN model

(Source rule)


Indian Treaties

Exploratory PE No such provision No such provision Enterprise deemed to have PE if:

• It provides services or facilities;

• for more than specified time frame; and

• such services and facilities are in connection with exploration, exploitation or extraction of mineral oils

Examples - treaties with

Singapore, UK and Germany

• Domestic law provides beneficial tax treatment for such enterprises



Article UN model

(Source rule)


Indian Treaties

Article 7

Attribution of Profits

Force of attraction rule – attribute to PE profits from sale of same / similar goods or

same / similar business activity or associated enterprises

No ‘force of attraction rule’

• UN - 15 treaties

• OECD - 25 treaties

• OECD or UN with variants - 27 treaties

Article 8

Shipping, Inland, Waterways Transport and Air transport

In certain circumstances, profits from operation of ships may be taxed in the source State

Profits taxable only in the state where the place of effective management is situated

Two-third of treaties make

departure from OECD rule

Article 11

Taxation of Interest

Tax rate in source country to be established through bilateral negotiations

Tax rate in the source country not to exceed 10 percent of gross amount

• OECD - 36 treaties

• UN - 27 treaties

• Libya, Mauritius, Greece and Egypt -no cap on tax withholding



Article UN model

(Source rule)


Indian Treaties

Article 12

Royalties• Includes income from use of

equipment

• Source state may also tax royalty

• Does not include rental income

• Taxing right exclusively with state of residence

UN convention followed

Exceptions - Belgium, Greece, Israel, Namibia, Netherlands and Sweden

Article 13

Capital GainsCapital gains from sale of stock

in certain circumstances may be taxed in the state where the company issuing shares is resident

Capital gains from sale of stock shall be taxed only in the state where alienator is resident

Diverse approaches – no

pattern discernible

Singapore, Cyprus,

Mauritius and

Thailand – OECD

approach

More treaties follow UN compared to OECD model


USA

• Installation PE – Threshold of 120 days (less than UN threshold)

• Service PE – Threshold of 90 days (less than UN threshold)

• Articles 7, 8, 11, 12, 13 in line with UN convention

• Installation PE – Threshold of 120 days (less than UN threshold)


• Article 7, 11, 12, 13 in line with UN convention

CANADA

FRANCE

• Installation PE – Threshold of 183 days (close to UN threshold)

• No PE resulting from supervisory activities in relation to installation project (in line with OECD convention)


COMPARATIVE VIEW – G-8 COUNTRIES

UK


• Article 7 : Business profits – No force of attraction rule (in line with OECD convention)

Source rule favored but OECD model followed in some respects


ZAMBIAINDONESIA

• Threshold for Service PE and Installation PE close to or less than UN threshold

• Supervisory activities covered by installation PE (UN)

• Contains force of attraction rule (UN)

• Article 11 – tax on interest not to exceed 10 percent (OECD)

• Article 12, 13 in line with the UN convention

COMPARATIVE VIEW – EMERGING COUNTRIES

• Installation PE has threshold of 6 months (UN)

• No service PE (OECD)

• Article 7 : Business profits – no force of attraction rule (OECD)

• Article 11 : Tax on interest not to exceed 10 percent (OECD)

• Article 12 in line with the UN convention

MALAYSIA

Source rule favored but OECD model followed in some respects


ZAMBIA

• Installation PE – Threshold of 9 months (closer to OECD)

• No Service PE (OECD)


• 11, 12, 13 in line with the UN convention

• Article 7, 11, 12, 13 in line with UN convention

• Time threshold for installation and service PE closer to UN convention


• Article 11 : interest not to exceed 10 percent (OECD)

• Article 12, 13 in line with UN

SRI LANKA

INDONESIA

COMPARATIVE VIEW – EMERGING COUNTRIES

PAKISTAN

• Preference for source based taxation

• OECD convention followed in some respects

• No significant difference in treaty policy towards developed and developing

nations


INDIAN JURISPRUDENCE


RELIANCE ON UN/OECD CONVENTIONS

Courts have often referred to UN and OECD model conventions/ commentaries

Constitute “international tax language” & “contemporanea exposito”

Meanings assigned by OECD / UN Model or commentary should be given “due weightage”

CIT v Vishakapatnam Port Trust - 144 ITR 146 (Andhra Pradesh HC)

Graphite India Ltd. v. DCIT - 78 TTJ 418 (Calcutta ITAT)

DCIT v ITC - 85 ITD 162 (Calcutta ITAT)

Referred to ‘reinforce’ / ’confirm’ Court’s conclusion

Union of India v Azadi Bachao Andolan – 263 ITR 707 SC

CIT v Vijay Ship Breaking Corpn - 261 ITR 113 (Gujarat HC)



“Favoring” reference to Commentary

British Airways Plc. vs DCIT – 73 TTJ 519 (Delhi ITAT )

Tribunal observed that Article 8 of India – UK treaty is in line with OECD convention

OECD commentary referred to for determining scope of Article 8 of India – UK treaty

Graphite India Ltd. vs DCIT – 78 TTJ 418 (Calcutta ITAT)

Article 15 of India-US treaty almost same as Article 14 of OECD Model Convention

Tribunal ruled that OECD commentary was very important and relevant



Favoring reference to Commentary – Recent Decisions

Morgan Stanley – 201 Taxation 160 (Supreme Court)Reference made to UN model convention by Supreme court while interpreting Service PE under India - US treatyNo reference made to OECD model

Aztec Software – 294 ITR 32 (Bangalore ITAT) “India is not a member of OECD. However the organization has been supporting efforts of tax administration in India to properly and effectively administer and implement Transfer Pricing policy. A useful reference can always be made to OECD guidelines, for the purpose of resolving dispute of transfer pricing in India, however subject to statutory regulations.”

Mentor Graphics - 112 TTJ 408 (Delhi ITAT)TPO erred in neither applying the transfer pricing regulations nor the OECD Guidelines

Set Satellite (Singapore) PTE Ltd – 106 ITD 175 (Mumbai ITAT)Reliance on OECD’s 2006 report on attribution of profits while determining that income of the foreign company in India may be taxed even where it pays an arm’s length remuneration to its dependent agent in India

Galileo International Inc and Maruthi Info and Tech Centre ITA No. 1733/Del/2001Tribunal has referred to OECD commentary for construing the meaning of a fixed place of business in India- US treaty



Indian Perspective – “Disapproving” reference to Commentary

CIT vs VR SRM firm and others – 208 ITR 400 (Chennai HC)

“The articles in the OECD model convention and those in the treaty with Malaysia under consideration show wide range of difference and per se render the commentaries on the model convention wholly inapplicable and expose the unreasonableness and futility in seeking to apply the same” (Chennai HC)

Reliance sought to be placed by Revenue on OECD commentary considered inappropriate and unjustified

P. No. 28 of 1999 - 242 ITR 208 (AAR)

On Article 5(1) and 5(2) of India – US treaty - AAR applied the principle of statutory interpretation observed for interpreting domestic law – “the inclusive definition is intended to add to the primary meaning”

Ruled that reference to OECD commentary was not appropriate as it ran contrary to well established principle of statutory interpretation

TVM Ltd - 237 ITR 230 (AAR)

“Several observations in the Commentary on the UN Model will be equally apposite even for the interpretation of the India-Mauritius Treaty” AAR applied the UN Commentary while interpreting the meaning of permanent establishment under India – Mauritius treaty


RELIANCE ON OECD MODEL IN OECD COUNTRIES

Recommendation of the OECD Council “… that their tax administrations follow the Commentaries on the Articles of the Model Tax Convention, as modified from time to time, when applying and interpreting the provisions of their bilateral tax conventions…”

Paragraphs 29, 33-36.1 of the Introduction to the Model Tax Convention

The courts of most OECD countries use the OECD Model Convention as a tool for interpreting tax treaties

US Court of Appeals in National Westminster Bank, PLC (15 January 2008)“The “entire context” of the 1975 Treaty is informed by, and is based on, the Organisation of Economic Cooperation and Development’s (“OECD”) 1963 Draft Double Taxation Convention on Income and Capital (“1963 Draft Convention”)”


RECENT TRENDS


CHANGING ECONOMIC SCENARIO

Manifold increase in foreign direct investment

India continues to be favourite investment destination

Increase in outbound investment – will it trigger review of treaty policy

“The finance ministry is in favour of reviewing such treaties that India has with over 100

countries, in view of the country’s changing economic scenario. The treaties should be such

that they are more suitable for Indian investments abroad as much as it is for incoming

capital”

Source: Economic Times December 6, 2007


‘NORTH BLOCK SPEAK’

“ We are working very hard on a model tax treaty as we have realised today that India not only imports capital but also invests abroad. So the very nature of the DTAAs has to change”

Ministry of Finance

Indian companies have invested over $ 20 billion abroad in the past one year

Government keen to encourage firms investing abroad to send profits back home through market mechanism

Protection of revenue required at the time of export of capital by domestic companies


IMPLICATIONS FOR TREATY POLICY

Indian economy still in transition mode 2007 - outbound in excess of inbound 2006 – inbound greater than outbound

Relaxation of source rule – to what extent can it be diluted?

Heading towards a hybrid model – mix of source and residence based taxation

Type 2007 (Jan to Aug)

Mil US$

2007 (Jan to Aug)

No of deals

2006Mil US$

2006 No of deals

Outbound 30,794 164 9,914 190

Inbound 15,152 73 5,400 76

Domestic 2,451 223 4,990 214

Total M&A deals 48,397 460 20,304 480

Cross border deals 45,946 237 15,313 266

PE deals 10,821 267 7,859 302


OECD INFLUENCE

OECD keen on greater Indian participation

June, 2006 - India becomes observer at Committee of Fiscal Affairs

May, 2007 – OECD Council offered enhanced engagement with a view to possible membership to Brazil, China, India, Indonesia and South Africa

Will observer status impact? Treaty interpretation Courts and judiciary taking views – Aztec decision takes note of OECD support

role while relying on OECD commentary Treaty negotiation and government policy? Policy review triggered primarily by change in economic circumstances


LIMITATION OF BENEFITS CLAUSE

Background and reasons for growing importance Azadi Bachao Andolan

Absence of limitation of benefits (LOB) clause in India-Mauritius tax treaty Cited treaty with US as example of treaty with LOB clause No disabling provisions in India-Mauritius treaty to prevent resident of third nation

from availing treaty benefit Form of transaction to be respected

Indian Revenue concerned about tax base erosion, round tripping and money laundering

Worldwide concern on harmful tax practices 1998 - OECD Report On Harmful Tax Competition Existing and potential treaty partners insisting on LOB clause

Recent treaties containing LOB clause Singapore UAE

Mauritius and Cyprus treaty – LOB clause under negotiation


RECENT TRENDS IN INDIA’S TREATY POLICY NEGOTIATION

Continuing emphasis on source based taxation

Increase in cross-border transactions – thrust on information exchange (Article 26 of UN/OECD convention) and collection assistance articles (Article 27 of OECD convention)

Treaty negotiation with developing countries is challenging Same stage of economic development – similar concerns and needs Keen to attract foreign investment Need for greater revenue

Anti-abuse provisions important in negotiations with low tax countries


ALIGNMENT IN DOMESTIC LAW

Transfer pricing regulations make express reference to ‘permanent establishment’ - Finance Act, 2001

‘Business connection' includes a concept similar to Agency PE - Finance Act, 2003

Domestic withholding tax rate for royalties and fees for technical services brought down to 10 percent

Gradual alignment of domestic law with Indian treaties


RECENT TREATIES / PROTOCOLS


RECENT TREATIES

India - Serbia and Montenegro Follows OECD convention with features of UN model

India – Mexico Interest, dividends and royalties – taxable in country of source and residence but

tax not to exceed 10 percent Capital gains from alienation of shares to be taxed in country where the company

issuing shares is resident

First time treaties with Botswana, Senegal, Iceland and Kuwait

Treaty with Thailand (to replace treaty of 1985) and Luxembourg under negotiation


PROTOCOL TO TREATY WITH SINGAPORE

Protocol effective August 1, 2005 LOB clause Test - primary purpose to take advantage of treaty benefits Shell company - legal entity with negligible business operations or with no real

and continuous business activities Deeming provision

Total annual expenditure on operations (< S$200,000 or Rs 50,00,000) in the preceding period of 24 months from the gain

Capital gains - sale of stock Taxable only in state where alienator is resident

Royalties – may be taxed in the source state but rate not to exceed 10 percent

Amendments in line with OECD convention


PROTOCOL TO TREATY WITH UAE

Protocol effective April 1, 2008

Change in definition of ‘resident’ – earlier based on liability to tax under domestic law but now also based on period of stay/management and control

Capital gains - sale of stock Taxed in country where company issuing shares is resident For real estate business, taxed in country where immovable properties are

situated

LOB clause Main purpose – creation of an entity to obtain treaty benefits Covers legal entities not having bonafide business activities

Amendments in line with strict ‘source based taxation’ principles


SUMMARY AND OUTLOOK


SUMMARY AND OUTLOOK

Source based taxation – starting point for treaty negotiation

Certain features of OECD model also adopted

Treaties reflect a mixed approach though clearly source rule finds prominence

Concern on treaty abuse mounting – likelihood of LOB clauses in treaties if misused

Mauritius, Thailand and Cyprus under the Revenue lens

Changing economic scenario could force Government to contemplate a policy shift

Treaty policy review – an ongoing process, though no specific personnel assigned

Pre-mature to comment on exact nature of change – expectation of a greater leaning towards residence based taxation


ANNEXURE


OUTBOUND ACQUISITIONS

Industry Acquirer Target Value in MUSD

% stake

Metals Tata Steel Corus 12,000 100

Metals Aditya Birla Group Novelis 6,000 100

Pharmaceuticals Dr. Reddy’s Betapharm Arzneimittel, Germany

570 100

Pharmaceuticals Ranbaxy Terapia 324 100

Renewable Energy

Suzlon RE Power 1,700 100

Communications VSNL Teleglobe 239 100

Auto Ancillary Bharat Forge Carl Dan Peddinghaus and Federal Forge

N.A. 9.1

100 100

Some Examples*

* Figures include stake acquisitions after Jan 2006

Increase in outbound investments is one of the key reasons that has triggered review of treaty policy


DOMESTIC LAW Vs MCs – PERMANENT ESTABLISHMENT

Conditions

Indian Domestic Law

(Business Connection)

UN model

(Agency PE)

OECD model

(Agency PE)

Authority to conclude contracts

Maintenance of a stock of goods / merchandise from which regular delivery takes place

Habitually secures orders for non – resident

Yes

Yes

Yes

Yes

Yes

No

Yes

No

No

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