Myopia over DTAAs

Confusing short-term gains with being an emerging power


Manoj Kumar | June 13, 2011

In recent weeks, one Double Taxation Avoidance Agreement (DTAA) every week (the last being with Mozambique), has been our average. However, our handling of the Vodafone tax case has left much to be desired.

The government of India has been entering into DTAAs with various countries to provide for reduced rates of tax on dividend, interest, royalties, technical service fees etc received by residents of one country from those in the other. Where total exemption is not granted in the DTAAs and the income is taxed in both countries, the country in which the person is resident and is paying taxed, the credit for the tax paid by that person in the other country is allowed.

The recent Vodafone tax case relating to capital gains issues by the government has left gaping holes in the scope and commitments under the DTAAs and the government’s willingness to implement the same in letter and spirit. Capital gain means an increase in the value of a capital asset that gives it a higher worth than the purchase price. It may be short-term (one year or less) or long-term (more than one year). Section 45 of the Income Tax Act, 1961 defines it as any profit or gain arising from the transfer of a capital asset in the previous year shall be chargeable to income tax under the head ‘capital gain’. Further, Section 2(14) gives a very wide definition of ‘capital asset’, as property of any kind subject to exceptions. ‘Property’ itself has been understood as including intangible rights as well.

Tax on the capital gains makes no difference between movable and immovable property with the result that transfer of either would attract capital gains tax. The DTAAs that the government does not seem to be getting tired of signing also provide for avoidance of double taxation, in cases of capital gains tax. Circular No. 621 – dated September 19, 1991 – issued by the income tax department provides that tax treaties generally contain a provision to the effect that the laws of the two contracting states will govern the taxation of income in the respective state except when express provision to the contrary is made in the treaty.

The treaty may contain a provision giving concessional treatment to any income as compared to the position under the Indian law existing at that point of time. However, the Indian law may be subsequently amended, reducing the incidence of tax to a level lower than what has been provided in the tax treaty. It further provides that the agreement will prevail over the general provisions contained in the Income Tax Act and that only where there is no specific provision in the Agreement, the domestic law will prevail. The circular is only a reiteration of the circular issued by the CBDT in Circular 333 dated April 2, 1982. This circular has been taken judicial notice of in a number of cases.

Taxation on capital gains purportedly arising to the ultimate parent on account of sale of global businesses including an enterprise in India is now being argued to be taxable in India as being the state of the residence of the company issuing shares, irrespective of any other provisions and factum of residence of transferor, transferee or where the sale is taking place. The government has found no reason of disagreement with the Income Tax department which has made such a claim from erstwhile ultimate parent of Vodafone.

The Dutch government’s repeated calls, initially to reassess the Vodafone tax case and recently to have an out of court settlement, have been rejected by the government of India thus leaving the scope, intent and ability of signatory countries to resolve double taxation situations in terms of the signed DTAA. This, of course, is bound to send a negative signal to most other similar companies having similar substantial investments in India.

Failure on the part of the government to deal with this critical issue has led to the issue being contested in court. Article 51 of the Constitution of India directs that the state shall endeavour to promote international peace and security, maintain just and honourable relations between nations, foster respect for international law and treaty obligations in the dealings of organised people with one another. Even the supreme court, in a 1990 case, has pointed out that parliament itself has provided for DTAA as  part of the income-tax law so that any ambiguity in interpretation of law would be resolved with reference to the treaty.

Even globally, the same principle has been applied by most jurisdictions. In a 1964 case, the United States court held that one should not deny treaty benefit, merely on the ground that the claim was motivated by tax avoidance. Again, the US tax court, in a 1971 case, held that where there are bona fide transactions, on the mere ground that multi-national company acts through a treaty, the state need not disqualify the relief. In UK also, the principle, that a person is entitled to arrange his affairs in a manner that he may pay least tax, has yet to be confirmed by law, while it is recognised that a distinction has to be made between mere tax planning and fictitious claim.

Additionally, on one hand the government of India is laying out a red carpet to increase the decreasing FDI inflows by going to the extent of scrapping press note 1 of 2005 and talking of imminent opening of retail sector. On the other hand, when it comes to actual implementation of the DTAAs, on whose strength most FDI inflows have come in, the government is not maintaining the same colour. This has left most guessing about possibly the left hand and right hand of the government working at cross-purposes. The actions of the government, either way, have impacted the sentiments of the foreign investors, existing and potential alike.

In its short-sighted view, the government ought not to forget the Indian corporate houses themselves are placed similarly as Vodafone’s erstwhile promoters with substantial foreign investment and operating businesses in various jurisdictions. The possibility of the government’s short-call on the issue being followed by other signatory countries has been a matter of concern for them as well. Many are asking if the government is indeed confused between the need to make short-term gains and the need to position India as an emerging economic power by standing to its commitments under global treaties and DTAA agreements with other countries and stand out amongst other similarly placed emerging economies of the day.



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