In this article, Varsha Balasubramanian pursuing Diploma in Entrepreneurship Administration and Business Laws from NUJS, Kolkata, elaborates on Double Taxation Avoidance Agreements and its impact on your decision to do business in a country.
When two or more sovereigns seek to impose, under their domestic laws, comparable taxes on the same person regarding the same taxable event and for an identical period, what arises is international double taxation. Double taxation occurs because the tax codes of most jurisdictions provide for both residence-based and source-based levy of tax. Typically, this arises when one jurisdiction seeks to tax a person on his worldwide income, based on his residence, and another jurisdiction taxes the person regarding his income sourced in that other jurisdiction. To avoid double taxation, most jurisdictions have entered into bilateral international income tax treaties primarily for the allocation of fiscal jurisdiction as between the treaty partners. These are treaties as defined by the Vienna Convention on the Law of Treaties and are binding on the countries.
Position in India
As of now, India has DTAA with 84 nations, to establish a strong tax bond with other nations as such agreements work towards promoting trade and investments among contracted nations. Regarding the double taxation issue, Section 90 of the Income Tax Act, 1961 conferred power on the central government to enter into income tax treaties with other countries. According to section 90(2), the taxpayer can either choose the provisions of the Income Tax Act, 1961 or the DTAA whichever is ‘‘more beneficial’’ to the taxpayer.
- In its application to a taxpayer, a section 90 treaty is accorded a preferential status over the Income Tax Act, 1961; and
- In case of a conflict between the treaty and the Income Tax Act, 1961, it is the more beneficial of the two that prevails.
Though structurally similar, treaties often differ in terms of their exact texts, making some treaties more favorable than others and attracting businesses to take advantage of the most favorable treaty, leading to what is sometimes referred to as treaty shopping.
What is Treaty Shopping
Treaty shopping can be defined as a process of setting up an entity by the investors in a country having a favourable tax treaty, through which the investment is routed into the source country, being the country to which the investment is destined to and wherefrom the income is expected to be earned.
Effective treaty shopping tend to have the following components,
- A beneficial tax treaty between the intermediate country (wherein the investor proposes to set up an enitty to route his investment) amd the destination country wherein the investment is propsoed to be made and income earned from.
- Favourable tax laws internally in such intermediate country.
Treaty shopping is arguably, a tool for international tax planning. If it is just a planning device, then why should it evoke so much debate on an objectionable measure? International tax community has put forth lots of reasoning for the use of treaty shopping as a tool of tax planning. In a leading case, the Supreme Court upheld the legality of treaty shopping.
Treaty shopping being valid every businessman’s mentality will be to choose the country that gives maximum tax benefits and exemptions. Hence there are certain pros and cons of treaty shopping.
Advantages of Treaty shopping
In Union of India v. Azadi Bachao Andolan, the Supreme Court emphasized that in developing countries treaty shopping was often regarded as a tax incentive to attract scarce foreign capital or technology. Developing countries are keenly looking for foreign investments. Treaty shopping opportunities can be strong incentives to attract such investments. The developing countries may permit the use of treaty shopping, in order to accommodate inflow of capital and technology from developed countries. Such developing economy may consider the tax losses on account of treaty shopping as a small cost as compared to the significant gains it will obtain by way of economic activity and related benefits flowing to the country from such investments. Most often, such source countries keep a “shut eye” policy towards treaty shopping unless and until the revenue losses lead to significant erosion of overall revenues/benefits to the state or such measures are leading to other abuses of the law. Developing economies may bear “Treaty Shopping” as a part of the cost of long-term development; in its consideration, the increased economic activity from treaty shopping could more than offset the country’s tax losses.
Disadvantages of Treaty shopping
Treaty shopping is perceived as harmful by both, the OECD and the UN. The revenue loss due to treaty shopping is massive if the statistics are looked at. India’s tax treaty with Mauritius was reviewed because the tax department had estimated a revenue loss of over Rs.5,000 crore caused by treaty shopping.
- Treaty Shopping breaches the reciprocity of a tax treaty: First and foremost, it is put forth that treaty shopping is a method of tax avoidance and, accordingly contrary to the objectives of tax treaties. It is also a contention that treaty shopping breaches the reciprocity of a treaty and lead to revenue loss by violating the principle of reciprocity. The State of residence receives disproportionate benefits as compared to the source State due to treaty shopping. A person, whose country has not participated in an arrangement with the source country (which is the investment destination and source for the income) and thus may not reciprocate similar benefits (including exchange of information), by using treaty shopping, is able to derive the benefits of the treaty between the source country and a third country. In this process, expected quid pro quo of the treaty is obviated and there is the misuse of the intended benefit.
- Treaty Shopping leads to revenue gains for third countries: Secondly, considering the principle of economic allegiance, a taxable base is attributable to the jurisdiction where it is presumed to have its economic existence. Tax treaties are effected according to this principle, in terms of allocation of taxing rights between the countries. Treaty concessions are expected to be available only to residents of the treaty countries and are not expected to be extended to residents of other countries. Under treaty shopping, it is quite conceivable that a third country could gain revenue even though there is substantial absence of any claim to economic allegiance. It can also be argued that treaty shopping leads to disinterest for countries to effect tax treaties, as the benefit from such tax treaties ultimately flow to third countries with a loss to the countries which actually have a right as per the economic allegiance principle. It also could lead to putting countries which have agreed to fiscal co-operation and exchange of information at a disadvantage in the global financial market.
- Treaty Shopping leads to revenue loss: Lastly, it can be considered that treaty shopping could be linked with undesirable revenue loss. Tax treaties are effected on a balanced consideration of the capital and income flow amongst the effecting countries. When this balance is impaired due to treaty shopping, it automatically leads to distortion in the revenue amongst these countries. Treaty shopping leads to the bilateral relationship of the treaty being expanded to cover transactions and situations beyond the underlying intent leading to the bilateral nature being de facto modified to multi-lateralisation. This could result in a significant unwarranted cost to the source country.
Factors that have to be considered while treaty shopping
- Tax Benefits and Exemptions: The businessman who chooses a DTAA should primarily check on the tax benefits and exemptions offered in the country. The businessman should be aware of the fact that countries have different tax rates for various types of businesses and some of them can even avail exemptions, like in India registered charitable institutions are exempt from payment of tax.
- Other Legislations: It is extremely important to look into the other legislation in the country where the businessman decides to do his business. Sometimes a country might offer the best tax benefits through a DTAA but might place a check on such businesses through other laws. Certain types of businesses may be exempt from tax but may have to follow some Income Tax, Labour, Registration laws etc, that are extremely stringent that either it takes great efforts to set up the business or if established makes it impractical to run smoothly.
- Limitation of Benefit Clause: A Limitation of Benefits provision is an anti-abuse provision that sets out which residents of the Contracting States are entitled to the treaty’s benefits. The purpose of a Limitation of Benefits provision is to curtail benefits under the said treaty being obtained by residents of a third country. Hence certain countries in their DTAA might have a Limitation of Benefits clause which might not be visible to the naked eye of the businessman but might curb the growth and actual purpose of the business as the businessman would have planned it in such a way anticipating several tax benefits by seeing the DTAA on the face and not analysing much. It is hence pertinent to scrutinise the DTAA before structuring a business model based on it.
DTAA of different countries provide for various tax benefits but have some drawbacks like the ones mentioned above which if not noticed will lead to great risk factor and loss for a businessman setting up a business in another country solely relying on the provisions of the DTAA. Hence other legislation should be read hand in hand with the provisions of the DTAA before coming to a decision about which country to invest in.
 Can the Proposed Tax Code Override Indian Tax Treaties? by Amit M. Sachdeva
 Union of India v. Azadi Bachao Andolan, 263 ITR 707 (SC).