India Tax Treaty Overrides To Be More Limited

by Mary Swire, Tax-News.com, Hong Kong

21 June 2010

The Indian Central Board of Direct Taxes (CBDT) has softened its stance on tax treaty overrides in the latest draft of the Direct Tax Code, which is published for consultation until the end of the month. Overrides would apply when General Anti Avoidance Rule (GAAR) or Controlled Foreign Corporation provisions are invoked. Such provisions were also overhauled in the latest draft.

During consultations on the first draft of the new Direct Tax Code (DTC), the proposal that in the case of conflict between a double taxation treaty and the provisions of the DTC, the one that is later in time should prevail, caused fears to be expressed that this would lead to treaty override and the existing treaties being rendered otiose.

This would result in higher rates of taxation on royalties, fees for technical services and interest income etc, which are taxed in the source country at a concessionary rate as per the provisions of some treaties. Uncertainty regarding the cost of doing business in India would also affect foreign direct investment and such overrides would be against the spirit of the Vienna Convention.

Accordingly the latest draft DTC proposes to provide that between the domestic law and relevant tax treaty, the one which is more beneficial to the taxpayer should apply. However, a tax treaty would not have preferential status over the domestic law in the following circumstances:-

• When the General Anti Avoidance Rule is invoked (see below); or
• When Controlled Foreign Corporation provisions are invoked (see below); or
• When Branch Profits Tax is levied.

The CBDT say this limited treaty override is in accordance with internationally accepted principles. Since anti-avoidance rules are part of the domestic legislation and they are not addressed in tax treaties, such limited treaty overrides should not be in conflict with the treaties and would not deprive any taxpayer of any intended tax benefit.

The CBDT states that most of India's tax treaties recognize the concept of "place of effective management‟ for determination of residence of a company as a tie-breaker rule for avoidance of double taxation. It is an internationally accepted principle that the place of effective management is the place where key management and commercial decisions that are necessary for the conduct of the entity's business as a whole, are, in substance, made. The new draft DTC proposes that a company incorporated outside India will be treated as resident in India if its "place of effective management‟ is situated in India.

The CBDT claims that General Anti Avoidance Rule (GAAR) legislation exists in a number of countries, while jurisdictions which do not have GAAR legislation impose significant additional information and disclosure requirements on tax practitioners regarding the advance intimation and registration of tax shelters with the tax administration. These can be investigated and potentially abusive arrangements can be declared impermissible.

According to the CBDT, a statutory GAAR can act as an effective deterrent and compliance tool against tax avoidance in an environment of moderate tax rates. The CBDT suggests that arrangements for tax mitigation need not be classified as impermissible avoidance arrangements under the GAAR.

Only in a case where the arrangement, besides obtaining a tax benefit for the assessee, is also covered by one of the following four conditions would GAAR provisions apply, namely when:

• It is not at arms length; or
• It represents misuse or abuse of the provisions of the Code; or
• It lacks commercial substance; or
• It is entered or carried on in a manner not normally employed for bona-fide business purposes.

The following safeguards for invoking GAAR provisions would also apply:-

• The Central Board of Direct Taxes would issue guidelines to provide for the circumstances under which GAAR may be invoked;
• GAAR provisions would be invoked only in respect of an arrangement where tax avoidance is beyond a specified threshold limit; and
• The forum of a Dispute Resolution Panel (DRP) would be available where GAAR provisions are invoked.

As an anti-avoidance measure, in line with internationally accepted practices, it is also proposed to introduce Controlled Foreign Corporation provisions so as to provide that passive income earned by a foreign company which is controlled directly or indirectly by a resident in India, and where such income is not distributed to shareholders, resulting in deferral of taxes, shall be deemed to have been distributed. Consequently, it would be taxable in India in the hands of resident shareholders as a dividend received from the foreign company.

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