All rights reserved | 1 Review 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
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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
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CONTENTS
Introduction
Comparative view
Jurisprudence
Recent trends
Recent treaties/protocols
Summary and Outlook
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INTRODUCTION
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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
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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
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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?
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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
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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
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OECD Member CountriesCountries/Economies Engaged in Working Relationships with the OECD
LIMITED MEMBERSHIP BUT GLOBAL REACH
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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.)
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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
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COMPARATIVE VIEW
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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
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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
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COMPARATIVE VIEW - OECD VS UN MODEL
Article UN model
(Source rule)
OECD model (Residence 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
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COMPARATIVE VIEW - OECD VS UN MODEL
Article UN model
(Source rule)
OECD model (Residence 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
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COMPARATIVE VIEW - OECD VS UN MODEL
Article UN model
(Source rule)
OECD model (Residence 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
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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)
• Service PE – Threshold of 90 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)
• Service PE – Threshold of 90 days (less than UN threshold)
COMPARATIVE VIEW – G-8 COUNTRIES
UK
• Service PE – Threshold of 90 days (less than UN threshold)
• Article 7 : Business profits – No force of attraction rule (in line with OECD convention)
Source rule favored but OECD model followed in some respects
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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
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ZAMBIA
• Installation PE – Threshold of 9 months (closer to OECD)
• No Service PE (OECD)
• Contains force of attraction rule (UN)
• 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
• Contains force of attraction rule (UN)
• 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
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INDIAN JURISPRUDENCE
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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)
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RELIANCE ON UN/OECD CONVENTIONS
“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
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RELIANCE ON UN/OECD CONVENTIONS
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
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RELIANCE ON UN/OECD CONVENTIONS
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
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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”)”
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RECENT TRENDS
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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
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‘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
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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
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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
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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
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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
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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
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RECENT TREATIES / PROTOCOLS
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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
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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
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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
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SUMMARY AND OUTLOOK
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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
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ANNEXURE
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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
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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