In this blog post, Esha Chauhan, a student at Campus Law Center and pursuing a Diploma in Entrepreneurship Administration and Business Laws from NUJS, Kolkata, analyses the importance of DTAA.
If we had to come up with a word that captures the zeitgeist of the current century, ‘Globalization’ would surely be one of the strongest contenders. In the present day scenario, globalization is a reality which has led to an unprecedented and unique kind of interaction amongst the various nations of the world. This interface and dialogue at the global level, with the help of technological advancements which have aided communication and travel across the world, has helped fade the boundaries that exist geographically. As the world is quickly moving towards the concept of what one calls a ‘global village’, we are all slowly becoming citizens of the world rather than citizens of a single nation. While this exchange of information, ideas and cultures between people from different parts of the world has benefitted the entrepreneurs in particular, the increase in international trade has also brought up the issue of how is one supposed to tax the income of an entrepreneur carrying out business on an international scale. To understand how this problem can hinder the growth the world is witnessing today, and also to appreciate the solution that has been developed, we need to delve into the concept of international taxation and its principles.
What is Double Taxation
International taxation in itself is not a universal concept that exists objectively in the international sphere, but rather refers to the taxation laws of various nations, which deal with the international aspects of taxation within the nations.
The ever increasing transactions amongst the nations of the world has led to an immense growth in international trade and commerce, as it allows the residents of one country to conduct business activities in any other country that they may so choose. On the flipside, this has also brought up the problem of deciding which country should tax an entrepreneur who is a resident of a country that is different from the one where he is conducting business activities. This confusion may result in the entrepreneur being taxed twice, once in the country where his source of income lies and another time by the country where he resides.
If such an entrepreneur was required to pay tax as per both, the source of income (tax to be paid where the source of income lies), as well as the residence rule (tax to be paid where the taxpayer resides), the burden of being taxed twice would surely act as a deterrent to anyone wanting to conduct business internationally. The cost of operations would be much higher and the profits significantly lower, thereby removing any attraction which one could have towards conducting business at a global level. It is in this context that double taxation avoidance agreements find their importance.
The Solution – DTAA
Double taxation has adverse effects on the movement of people as well as the movement of capital as it creates an unnecessary burden on the taxpayer to pay the tax not once but twice.
The domestic laws of various countries help deal with this problem by providing unilateral relief. This solution, however, is not sufficient as the principles of what is taxable and what is not, and also the method of determining what the source of income is, differ greatly from country to country.
Tax Treaties help in making it easier for the capital and the people to move from one country to another without any added burden. They also make investing in other countries a fairly simple and positive business decision, something that would have been fraught with risks had these treaties not existed.
The double tax treaties which are commonly known as double taxation avoidance agreements are governed by the principles elucidated during the Vienna convention on the law of treaties and are negotiated as per the principles of public international law.
While it is in the interest of all the countries to ensure an investment friendly environment where the taxpayer is not being unfairly taxed twice, it is also necessary to ensure that safeguards are in place to prevent tax evasion and other such unfair practices.
The fiscal Committee of OECD defines 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.”
In India, for example, the Central Government has been authorized to enter into double taxation avoidance agreements with other countries with the help of Section 90 of the Income Tax Act, 1961.
OECD commented on what necessitated the need for tax treaties in the ‘Model Tax Convention on Income and on Capital’:
‘It is desirable to clarify, standardize, and confirm the fiscal situation of taxpayers who are engaged, industrial, financial, or any other activities in other countries through the application by all countries of common solutions to identical cases of double taxation’.
The presence of a DTAA brings more certainty to the investment market. The taxpayer has clarity with respect to his own taxation liabilities. The two countries that enter into this agreement specify the rules for dividing the revenue amongst themselves. It also allows for income tax to be recoverable to some extent in both the countries in a fair and just manner, ensuring no one is unjustly benefiting from the payment or even the lack of payment of tax. The taxing rights of both the countries on the taxpayer’s income are also fairly and equitably distributed and determined.
Further, the double taxation treaty is a trade friendly treaty which encourages international trade and investment along with the free flow of technology. Since it lays down the laws and parameters as to how taxation is supposed to work, there is also increased transparency. The DTAA clearly shows the position of a taxpayer with foreign income or one whose source of income is in another country with respect to domestic taxpayers.
Functions of DTAA
The countries that enter into these double taxation agreements agree upon certain definitions for the purposes of taxation which help bring to light what may be taxable and also elucidate the taxing rights of the taxpayer. Most important amongst all the definitions that are decided upon for the purposes of the applicability of the treaty is that of permanent establishment. In cases where any provision of the treaty is under dispute, the treaty itself provides for a solution by specifying the mutual agreement procedures. Further, the treaty itself ensures it is in line with and incorporates certain rules and regulations such as the General Anti- Avoidance Regulations (GAAR), to prevent abuse of the concessions of the treaty. These rules and regulations that are incorporated in tax treaties help in the identification of transactions which are done solely for the purpose of tax evasion.
The treaties also have provisions for easy exchange of tax information amongst the counties and this helps combat the problem of tax evasion.
DTAA and India
An archetypal DTAA between India and another country usually concerns the residents of India as well as the residents of the country that has entered into the agreement with India. A person who is neither a resident of India nor of the other contracting country does not qualify to avail any benefit under the said DTA agreement.
These agreements, which India presently has with 88 other countries out of which 85 are in effect, not only help mitigate the problem of double taxation between the two countries in question but also assign the rights relating to taxation in accordance with the consensus as per the said DTAA. While the developed nations follow the OECD model of DTAA with their emphasis on residence based taxation, the developing nations follow the UN based model of DTAA which emphasises the need for source based taxation. India in formation of its treaties with difference countries has been liberal in its acceptance of various parts of different models and also inserted new clauses and articles as per its requirement. This has been made possible because the above mentioned models are just that, models and not treaties in themselves, so they need not be adopted in their entirety.
Section 90, 90A and 91 of the Income Tax Act, 1961 deal with the two types of reliefs from double taxations. Section 91 deals with unilateral relief which is given by India (home country) in cases where no DTAA exists between India and the concerned nation. Section 90 and 90A talk of bilateral relief which is extended due to the existence of the DTAA. Bilateral reliefs are mutually decided as per the double taxation agreements entered into by both the countries.
The discussion above makes it amply clear why there is a need to avoid double taxation. It’s an unfair phenomenon which leads to thinning of profits and makes international trade a highly undesirable investment prospect, something that would be dangerously unhealthy in the present age of globalization. While we liberalize our economies with hopes of receiving investment to help our nations prosper and we cannot ignore the problem of double taxation, as this even alone could make it nearly impossible to attract foreign investment. In order to achieve the goals of prosperity with the help of an open market economy, double taxation treaties become vital to the growth and prosperity of any country.