Double Tax Avoidance Agreement

Category: Global Economy Sub-category: Indian Economy
Document type: article

One of the most heavily guarded jurisdictions of a country is its fiscal jurisdiction. Therefore, even in the age of globalization, double taxation continues to be one of the major obstacles to the development of international economic relations. The Fiscal Committee of OECD in the Model Double Taxation Convention on Income and Capital, 1977, defines double taxation as 'the imposition of comparable taxes in two or more states on the same tax payer in respect of the same subject matter and for identical periods'. Whereas a tax payer's own country (referred to as home country) has a sovereign right to tax him, the source of income may be in some other country (referred to as host country) which also claims a right to tax the income arising in that country. Nations are often forced to discuss and settle the claims of other nations by means of double taxation avoidance agreements, in order to bring down the barriers to international trade.

Double tax treaties are settlements between two countries, which include the elimination of international double taxation, promotion of exchange of goods, persons, services and investment of capital. This is because, the interaction of two tax systems of two different countries can result in double taxation. Every country seeks to tax the income generated within its territory on the basis of one or more connecting factors such as location of the source, residence of taxable entity and so on. Double Taxation of the same income would cause severe consequences on the future of international trade.

Countries of the world therefore aim at eliminating the prevalence of double taxation. Such agreements are known as "Double Tax Avoidance Agreements" (DTAA) also termed as "Tax Treaties".

Following the footsteps of most countries of the world that levy tax on income / capital, India has also imposed Income Tax on the "total world income" i.e. income earned anywhere in the world. The result is that income arising to a resident out of India is subjected to tax in India as it is part of total world income and, also in host country which provides the source for that income.

The statutory authority to enter into such agreements is vested in the Central Government by the provisions contained in Section 90 of the Income Tax Act in terms of which India has, by the end of March 2002, entered into 64 agreements of this nature which deal with different types of income which may be subjected to double taxation. A list of such agreements and the respective years of their coming into force forms annexure to this book. In addition there are 12 agreements which deal with only profit of enterprises engaged in operation of aircraft and 5 which are limited to shipping profit.

Depending on their scope, double taxation avoidance agreements are classified as Comprehensive and Limited. While comprehensive Double Taxation Agreements provide for taxes on income, capital gains and capital, Limited Double Taxation Agreements refer only to income from shipping and air transport, or estates, inheritance and gifts. Comprehensive agreements ensure that the taxpayers in both the countries would be treated equally, in respect to problems relating to double taxation.

The object of a Double Taxation Avoidance Agreement is to provide a settlement between the tax claims of two governments, both legitimately interested in taxing a particular source of income. Firstly, they help in avoiding the burden of international double taxation, by -

  1. laying down rules for division of revenue between two countries;
  2. exempting certain incomes from tax in either country;
  3. reducing the applicable rates of tax on certain incomes taxable in either countries

Secondly, the tax treaties help a taxpayer of a country to know with greater certainty the potential limits of his tax liabilities in the other country.

Pattern of taxation
Double taxation agreements allocate jurisdiction to the concerned countries, with respect to the right to tax a particular kind of income. The principle underlying tax treaties is to share the revenues between two countries. If each country gets a reasonable share of tax revenues and the overall tax collection also increases, both countries tend to benefit. Income from business, movable and immovable property comes under the sphere of double tax avoidance agreement. The agreements provide of allocation of taxing jurisdiction to different contracting parties in respect of different heads of income. In general, the rules include that income from the business is taxed:

  • only in the resident country, if the business entity has no activity in the source state;
  • Only on the source state, if there is a fixed place of business, i.e. Permanent Establishment.
  • Income form immovable property arising to a non-resident is taxed primarily in the state of its location, i.e. the source state.
  • Income from movable property such as dividends, interest and royalties are usually taxed in the resident state, but the source state may also impose a reduced tax.

Methods of Eliminating Double Taxation:
The objective of double taxation can be obtained through tax treaties involving various methods or a combination of the following methods:

(i) Exemption Method: This method is for the residence country to exclude foreign income from its tax base and the exclusive right to tax such incomes goes to the source country. This is known as complete exemption method and is sometimes followed in respect of profits attributable to foreign permanent establishments or income from immovable property. Indian tax treaties with Denmark, Norway and Sweden are of this nature with respect to certain incomes.

(ii) Credit Method: It reflects the underline 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.

(iii) Tax Sparing: One way of directing the foreign investment flows in India from foreign developed countries, is to let the investor preserve to himself/itself benefits of tax incentives available in India for such investments. This is done through the Tax Sparing method, where the tax credit is allowed by the country of its residence, not only in respect of taxes actually paid by it in India but also in respect of those taxes India forgoes due to its fiscal incentive provisions under the Indian Income Tax Act (ITA).

The regular tax credit is a measure of preventing double taxation, but the tax sparing credit extends the relief granted by the source country to the investor in the residence country by the way of an inducement to stimulate foreign investment flows and does not seek reciprocal arrangements by the developing countries.

Applicability of Treaty benefits:
In order to get the benefit of a tax treaty, it is necessary to have an access to it. For that purpose, a person must qualify in terms of the treaty as a:

  • person
  • resident of any of the Contracting states; and
  • beneficial owner of the income by the way of dividends, interest or royalties for a lower rate of withholding tax

Residence of a Person:
The determination of the residential status of the tax payer is of great signifi