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How Should Double Taxation Avoidance Agreements Impact Your Decision To Do Business In A Specific Country?

August 12, 2016

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In this blog post, Pritishree Dash, a student, pursuing her fourth year LLB at National University of Advanced Legal Studies, Kochi and a Diploma in Entrepreneurship Administration and Business Laws from NUJS, Kolkata, discusses how a double taxation avoidance agreement impacts a company’s decision to do business in a specific country.

Double Taxation and Double Taxation Agreements

Fiscal jurisdiction is a heavily guarded jurisdiction of any sovereign because it helps serve state functions. As a consequence, even in times of ongoing economic globalisation and frequent movement of goods, services, and capital, double taxation is still one of the major obstacles to the development of inter-country economic relations. The Fiscal Committee of OECD in the Model Double Taxation Convention on Income and Capital, 1977, defines ‘the phenomenon of international juridical double taxation’ as ‘the imposition of comparable taxes in two or more states on the same taxpayer in respect of the same subject matter and for identical periods’.

Because of globalisation and increased growth in international trade and commerce, residents of countries are concentrating on doing business not only in their own countries but also extending their sphere of business to other countries where they see a scope for benefit. Now, in such situation of globalisation one of the major impacts that are seen is the effect of one country’s domestic taxation policy on the economy of another. This has led to assessing and amending one country’s tax policies time and again according to the change in the other countries.

Double taxation occurs when an individual is required to pay two or more taxes on the same income, asset, or financial transaction in different countries more than once. The double liability is often mitigated by tax agreements, known as treaties, between countries. A Double Taxation Agreement is, therefore, a contract signed by two countries (referred to as the contracting states) to avoid or alleviate (minimise) double territorial taxation of the same income by the two countries. Double tax agreements are also known as ‘double tax treaty’ or a ‘double tax convention.’

Types

There are various types of tax treaties of which the most common are treaties for the avoidance of double taxation of income and capital. Bilateral agreements are entered between two countries. However, there are also multilateral agreements which are entered between more than two countries. There are two kinds of DTAA. Comprehensive Agreements are meant to address all source of income whereas Limited Agreements scope to cover only in income from operation of aircrafts & ships, estates, inheritance & gifts. There are two basic rules attached to DTAAs that enable the country of residence as well as the country having the source of income to impose tax, namely,

Source rule: The source rule holds that income is to be taxed in the country in which it originates irrespective of whether the income accrues to a resident or a non-resident.
Residence rule: The residence rule stipulates that the power to tax should rest with the country in which the taxpayer resides.

Now, if both rules apply simultaneously to a business entity, it suffers tax at both ends, the cost of operating on an international scale would become astronomic and deter the very objective of globalization. This is the reason that double taxation avoidance agreements (DTAA) become very significant.

Tax Reliefs Under DTAA

Tax reliefs under DTAA can be granted in the following ways:

Exemption Method: One method of avoiding double taxation is for the residence country to exclude foreign income from its tax. The country of source achieves exclusive right to tax such incomes. This method is known as a complete exemption and is sometimes followed in respect of profits which can be attributed to foreign permanent establishments or income from immovable property. Indian tax treaties with Denmark, Norway, and Sweden embody with respect to certain incomes.
Credit Method: This method reflects the underlying concept that the resident remains liable in the country of residence on its global income, however as far the quantum of tax liabilities is concerned, credit for tax paid in the source country is given by the residence country against its domestic tax as if the foreign tax were paid to the country of residence itself.
Tax Sparing: One of the aims of the Indian Double Taxation Avoidance Agreements is to stimulate foreign investment flows in India from foreign developed countries. One way to achieve this aim is to let the investor preserve benefits of tax incentives available in India to himself for such investments. This is done through “Tax Sparing”.

DTAA and Business Income

What item can be determined as business income? The answer can be decided by determining whether the activity giving rise to the income is properly characterised as a business. When there is no definition of business in income tax law, the term ‘business’ will have its ordinary meaning. In broad terms, a business is a commercial or industrial activity of an independent nature undertaken for profit. Here, business is deemed to include both trade and professional activity. Taxes generally can be attributed to employment. Sometimes, businesses can be synonymous with employment for tax purposes. Definition of business income is essential for a sound tax system, for instance, to identify a category of income for which special deductions apply. The receipts and outgoing system and the balance sheet system are the two models which determine the taxable income out arising from business activity.

In theory, all costs incurred to derive business income should be recognised for the purpose of determining net income. Statutes often prevent deductions for personal expenses. Other deduction denial expenses include capital expenses and certain expenses which are restricted from being deducted due to policy-motivated reasons, e.g., fines or bribes.

For business income, tax treaties start with the permanent establishment concept. This refers to a relatively enduring presence in a country either through location or personnel. This term’s definition can be customised according to the domestic law. The term “permanent establishment” includes especially a place of management; a branch; an office; a factory; a workshop, and a mine, an oil or gas well, a quarry or any other place of extraction of natural resources. A building site or construction or installation project constitutes a permanent establishment only if it lasts more than twelve months.

Businesses should be aimed at countries which have lucid taxing treaties. Taxpayers looking to invest in another country will be encouraged to do so when they have confidence in the tax system of that country. By providing a clear, transparent, non-discriminatory and predictable tax environment, developing countries may facilitate and encourage foreign investment. The underlying legal and economic infrastructure should effectively support such investment along with the tax treaties. Countries with a good infrastructure for investment, e.g., political and economic stability, robust regulatory framework, suitable workforce, and reliable and effective administration, should be aimed at while investing in a specific country and not just the tax treaties that it has entered into.[1]

Foreign investors welcome the certainty and stability that tax treaties provide. Tax treaties may resolve particular problem issues that have arisen between the two countries. The existence of a treaty is a good impetus to facilitate and encourage cross-border investment flows and economic activity between the two countries.

Tax treaties can facilitate cross-border trade and investment by limiting source taxation that might otherwise act as a deterrent to that trade or investment and which might be something that the resident country is not able to mitigate.

Discriminatory tax rules can be a significant deterrent to foreign investment. Tax treaties aim to remove these obstacles to cross-border activities by addressing some common forms of tax discrimination.

India taxes income from a business connection in the country. However, most treaties provided for taxing business profits only when they are earned from a permanent establishment or a fixed base in India.

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