Tax Treaties In International Law

Double taxation is charging tax on the same income or subject twice for the same objective, term, and tax jurisdiction. When such income is taxed in two nations, the total tax burden will be high. In 1920, the League of Nations commissioned four renowned economists, Prof. Gijsbert, Prof. Luigi Einaudi, Prof. Edwin Seligman, and Prof. Josiah Stamp, to suggest international taxation principles for distributing taxing rights under Double Taxation Avoidance to prevent multiple taxes on the same subject. The Group advocated separating taxing rights between the country of residence and the country of origin. These recommendations led to the current Rules.

In essence, the Double Tax Avoidance Agreement (DTAA) is a bilateral contract signed by two nations. By preventing double taxation, the main goal is to encourage economic trade and transactions between two countries.

AIM OF TAX TREATIES

International double taxation has a negative impact on trade, services, capital flows, and human mobility. The burden on the taxpayer would be exorbitant if the same income were taxed by two or more nations. Most nations’ domestic laws, including those of India, lessen this challenge by providing unilateral relief with regard to such double-taxed income (Section 91 of the Income Tax Act). The tax treaties attempt to remove the tax barriers that impede trade, the provision of services, and the movement of capital and people between the concerned countries because this is not a satisfactory solution given the disparity in the rules for determining sources of income in different countries. It aids in enhancing the general environment for investment. The Vienna Convention on the Law of Treaties’ guiding principles applies to the negotiations of double tax treaties, sometimes known as “DTAAs” or “Double Taxation Avoidance Agreements.”

NEED FOR DTAA

Conflicting laws in two distinct nations governing chargeability of income based on receipt and accrual, residential status, etc. give rise to the requirement for an Agreement for Double Tax Avoidance. Due to the lack of a universally agreed-upon concept of income and its taxability, an income may be subject to taxation in two different countries.

If the two nations have a double tax avoidance agreement, the following outcomes are possible:

1. The income taxes are paid only once.
2. Both nations exclude the income.
3. The income is subject to tax in both countries, but taxes paid in one nation are credited against taxes owed in the other.

In India, the Central Government has the authority to sign double tax avoidance agreements (also known as tax treaties) with other nations under Section 90 of the Income Tax Act.

TYPES OF DTAA

There are two types of DTAA- Comprehensive and Limited.

DTAAs that cover nearly all forms of incomes allowed by any model convention are referred to as comprehensive. Numerous times, a treaty also addresses wealth tax, gift tax, surtax, etc.

Limited DTAAs are those that only apply to specific types of revenue. For instance, the DTAA between India and Pakistan only applies to revenues from shipping and aircraft.

FUNCTIONS OF TAX TREATIES ON THE INTERNATIONAL LEVEL 

In order to avoid double taxation of income by dividing the taxing rights between the country where income is generated and the recipient’s country of residence, the following benefits are achieved:

• encourages investment and trade flow, avoiding discrimination between taxpayers;
• brings fiscal assurance to cross-border operations;
• restrains international tax evasion and avoidance;
• encourages the collection of international tax;
• contributes to the achievement of international development goals; and
• avoids double taxation of income by dividing up the taxing rights between the place where the money is generated and the recipient’s country of residency.

This encourages cooperation between or among States in fulfilling their commitments and ensures the stability of the tax burden.

DETERMINING THE BEST PROVISIONS UNDER DTAA/TAX LAWS

The DTAA provisions take precedence over a country’s general tax law regulations. The DTAA’s provisions supersede domestic legislation provisions in India, as is now widely accepted. Additionally, it is evident that the assessee has the choice of choosing to be controlled by the rules of a specific DTAA or the requirements of the Income Tax Act, whichever are more advantageous, with the addition of Sec 90 (2) to the Indian Income Tax Act.

For instance, tax on interest is set in the DTAA between India and Germany at 10%, although it is 20% under the Income Tax Act. As a result, one can adhere to DTAA and pay tax at 10%. Furthermore, a tax treaty has no authority to charge taxes on income if the Income Tax Act itself does not do so. The Income Tax Act recognizes this idea in Section 90(2).

MODELS OF DTAA

Applications of DTAA on how treaties are formed and negotiated between two countries, various models have been created over time. These models help to retain consistency in the structure of tax treaties. They also act as a checklist to make sure the two negotiating parties’ proposals are comprehensive.

Among these are the OECD Model, UN Model, US Model, and Andean Model. The first three of them are the most well-known and frequently applied models. A final agreement, however, can combine several alternative models.

OECD Model

The Model Double Taxation Convention on Income and on Capital, published by the Organization for Economic Co-operation and Development (hereinafter referred to as OECD) in 1977, 1992, and 1995, is primarily a model agreement between two developed countries. This model supports the “residence principle,” emphasizing the state’s legal authority to impose taxes.

UN Model

Model Double Taxation Convention between Developed and Developing Countries Adopted by the United Nations in 1980 Compared to the OECD model’s resident concept, the UN model places more emphasis on the source principle.

The Model Convention’s articles are based on the assumption that the source country recognizes that:

(a) income tax from foreign capital would take into consideration expenses allocable to the earnings of the income so that such earnings would be taxable on a net basis,

(b) taxation would not be so high as to discourage investment, and

(c) it would consider the relevance of the shareability of the income.

Additionally, the OECD Model Convention and the UN Model Convention both express the notion that it would be desirable for the residence country to grant some relief from double taxation through a foreign tax credit or waiver. India bases the majority of its treaties on the UN Model.

GENERAL FEATURES

STANDARDISED LANGUAGE

Tax treaties use common terminology and standardized international language. This is done to ensure that revenue and the assessee both comprehend and interpret the same word in the same way. The language used is archaic and technical.

Below are definitions for a few terms:

• Contracting State: The nation that signs a treaty.
• State of Residence: The nation in which a person resides.
• State of Source: The nation from which money is derived.
• Enterprise of a Contracting State: Any individual or entity liable to pay taxes.
• Permanent Establishment: An entity/subsidiaries’ permanent location in the state of Source.

To grasp the treaty’s provisions in their appropriate context, one must carefully study the document. The DTAA can best be understood by contrasting it with a partnership contract between two individuals. The phrases “the party of the first part” and “the other contracting state” are used in partnerships and the DTAA, respectively. For a broader insight, one can also read the DTAA again and substitute the names of the relevant nations for the terms “Contracting States.”

FORMULATION OF A COMPREHENSIVE DTAA

For the purposes of analysis, the Articles of a convention can be broadly split into six groups:

1. Scope provisions

Such as those in Articles 1 (Personal scope), 2 (Taxes covered), 30 (Entry into effect), and 31 (Termination). These clauses specify the parties, taxes, and time frame that a treaty applies to.

2. Definition clauses

These can be found in Article 3 (General Definitions), Article 4 (Residence), and Article 5 (Permanent Establishment), as well as the definitions of terms in a few substantive clauses (such as the definition of “immovable property” in Article 6(2)).

3. Substantive provisions

These are the Articles between Articles 6 and 22, and they deal with certain types of income, capital gains, or capital, and they divide up the taxing authority between the two Contracting States.

4. Dispositions to prevent double taxation

Notably, Article 23, and Article 25 (Mutual Agreement) can potentially fall under this heading.

5. Provisions against avoidance

Such as Article 9 (Associated Enterprises) and 26 (Exchange of information). Articles like 24 (Non-Discrimination), 28 (Diplomats), and 29 (Other Provisions) fall under this sixth group (Territorial Extension).

CASE LAW

Ishikawajma Harima Heavy Industries Limited vs. Director of Income Tax

The corporation in this instance was incorporated in Japan. It established a consortium with four other companies and signed a contract with Petronet LNG Ltd, an Indian company, to build a plant in Gujarat for receiving and degasifying liquefied natural gas. The consortium’s members were each expected to get their own pay-outs. The contract included construction, erection, onshore supply, onshore services, and offshore supply. The cost of offshore supply and services was due in US dollars, whilst the cost of onshore supply, services, construction, and erection was due in a combination of US dollars and Indian rupees.

ISSUE- Whether the money that the Japanese firm received from Petronet for the offshore supply of supplies and equipment was subject to tax under the India-Japan double taxation avoidance pact and the Indian Income Tax Act?

The Japanese company was found to be obligated to pay direct tax, despite the treaty, according to the Authority for Advance Rulings (Income Tax). The company then requested the Supreme Court. It claimed that the transactions took place outside of the nation. Due to the contract’s divisional nature, there was no tax obligation with respect to offshore services and offshore supply.

On the other side, the government argued that the contract was composite. The turnkey project was responsible for both the provision of services and the supply of commodities, both domestically and abroad. In the end, the Supreme Court declared that the tribunal made a mistake and overturned its decision. Although the Japanese company was given relief in the case, the ruling is noteworthy for the guidelines it has established to be followed in similar situations. The Supreme Court established nine rules for the offshore provision of tools and materials in the light of this case, but they are applicable generally.

1. Only the portion of revenue that can be linked to activities carried out in this nation can be taxed here.
2. The transaction cannot be taxed in India if the entire transaction—including the transfer of goods and the payment—takes place elsewhere.
3. It is necessary to adhere to the apportionment principle, which states that a state’s ability to tax an event depends on its territorial jurisdiction.
4. If the offshore supply-related activities took place outside of India and cannot be said to have accrued or arisen there, it is of no material significance that the contract was signed there.
5. The court also made it clear that a permanent establishment and a business link are two different things. While the former is used to apply the Income Tax Act, the latter is used to evaluate a non-income resident under a double taxation avoidance agreement. In terms of offshore services, the court ruled that in order for the income to be taxed, there must be a substantial territorial nexus between the rendering of the services and the boundaries of India. The activities in India wouldn’t be responsible for the entire contract. The taxpayer’s residence is the criterion for determining residency, not the user of such services, according to international law.
6. The Supreme Court emphasised that the technological services must not only be used within India but must also be rendered there or have such a “live link” with India that the full income becomes taxable here in accordance with Section 9(1)(vii)(c) of the Income Tax Act.
7. Determining the taxability of multiple operations is crucial for applying the apportionment principle to composite transactions that involve some operations in one area and others in others. It would not be possible to tax income from that source due to the location of the source’s income within India.
8. There is a distinction between a business connection’s existence and the revenue that accrues or results from it.
9. The permanent establishment must be involved in the activity that generated the profits in order for the gains to be “attributable directly or indirectly.”

CONCLUSION

However, India needs to realize that international corporations are abusing the DTAA’s provisions. Treaty shopping, a method of avoiding taxes, has taken over. It seems unlikely that we will enter DTAA agreements with the rest of the world. There are indications that significant changes have recently occurred, such as the updated DTAA with Singapore, Cyprus, Mauritius, and other tax havens.

However, the Double Taxation Avoidance method urgently needs to be overhauled. Following engagement with OECD nations, the Taskforce on Direct Tax Code may provide relevant recommendations.

Author:Paridhi Agrawal (Legal Intern ) and Co-Author:  Mr. Ajay Kacher – Legal Associate, in case of any queries please contact/write back to us at support@ipandlegalfilings.com or   IP & Legal Filing.