Economies are coming closer & closer due to globalization. Number of cross-border transactions has increased. Cross border transactions have led to a dynamic change in the system of taxation. New issues have aroused due to different styles of business arrangements. In the circumstances, it is important for an aspiring Chartered Accountant to become verse with the basic understanding of different terminologies used in International Taxation.
I am a qualified Chartered Accountant and presently working with the reputed International Taxation firm and had the pleasure of attending the conference on International Taxation organized by Foundation for International taxation. I have made an attempt to explain the basic terminologies used in International Taxation parlance in a simplified manner (because of limitation of space, not much is elaborated on each of the terminologies):
Important sections in the Indian Income-tax Act: Sec. 2 (31) - Definition of a Person.
Sec. 2 (7) - Definition of an Assessee.
Sec. 6 - Conditions of Residence.
Sec. 5 - Scope of Total Income.
Sec. 9 - Income deemed to accrue or arise in India.
Sec. 4 - Charge of Income-tax.
Sec. 90 - Agreement with Foreign Countries.
Sec. 91 - Countries with which no agreement exists.
Sec. 92 - Computation of income from international transaction having regard to arms length price.
Sec. 92A - Meaning of Associated Enterprise.
Sec. 92 B - Meaning of International Transaction.
Sec. 92C - Computation of Arms Length Price.
Sec. 92D - Reference to Transfer Pricing Officer.
Sec. 93 - Avoidance of income-tax by transactions resulting in transfer of income tonon-residents.
Secs. 115 A-F - Provisions relating to non-residents.
Apart from these important sections, students must not forget to study the other relevant sections also.
1. Country of Residence:
Country where the person is tax resident under the relevant tax laws of any country is called the country of residence. Tax laws of all countries are different. At times, a taxpayer may be a resident of two countries. In such situations, he has to apply the tiebreaker test to become tax resident of only one country for the purposes of the double tax avoidance agreement (meaning of DTAA is explained in point no.11 & tie breaker tests can be seen in Article 4 Resident
of any DTAA ).
2. Country of Source:
Country where the person earns income or where the income accrues or arises is the country of source. In International Taxation parlance, it is the country where that person has done the value addition. Where the value addition is done is a big controversy in itself!
3. Country of Payment:
Country from which the person makes the payment is called the country of payment. Country of Source may not be the same as country of payment. Also, country of market / consumption may or may not be the same as country of payment.
4. Country of Market / Consumption:
Country where the actual consumption takes place is called the country of market consumption. Here also, country of source & country of payment may not be same as country of market / consumption.
5. Tax Base:
There has to be a tax base for Government of different countries to charge tax. There can only 2 bases for levy of income-tax:
1. Residence.
2. Income.
For the levy of income-tax, Indian Government can tax the global income of Indian tax residents or the Indian accrued income of tax non-residents of India. Governments cannot tax foreign sourced income of non-residents. Prima facie they have no right to levy income-tax on foreign sourced income of non-residents. There has to be a nexus between the country & its residents or the country & income sourced in that country. Unless & until, there is a nexus between any one of the two, Governments do not have a base/ jurisdiction for taxation.
6. Permanent Establishment (PE):
Sec. 92 F provides an inclusive definition of Permanent Establishment. The section says, "It includes fixed place of business through which the business of the enterprise is wholly or partly carried out." Article 5 of OECD & UN model conventions also provide for an inclusive definition of the term permanent establishment i.e. "it includes a place of management, a branch, an
office, a factory, a workshop and
.."
Attribution of profits to PE:
This is a major controversy in International Taxation i.e. How to attribute the profits to a permanent establishment? The international consensus has been that the profits should be attributed to a PE on the basis of the "separate enterprise" concept, and the application of the arm's length principle. This is currently encapsulated in Article 7(1) and (2) of the OECD Model Tax Convention as follows:
"(1) The profits of an enterprise of a Contracting State shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. If the enterprise carries on business as aforesaid, the profits of the enterprise may be taxed in the other State, but only so much of them as is attributable to that permanent establishment.
(2) Subject to the provisions of paragraph (3), where an enterprise of a Contracting State carries on business in the other Contracting State through a permanent establishment situated therein, there shall in each Contracting State be attributed to that permanent establishment the profits which it might be expected to make if it were a distinct and separate enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly independently with the enterprise of which it is a permanent establishment."
This means that PE should be hypothesized as separate unit. Accordingly, functions, risks, assets, capital employed, etc. should also be attributed to the Permanent Establishment for attributing profits to PE. Governments cannot tax the business income of a non-resident in absence of a Permanent Establishment.
7. Business Connection:
Sec. 9 (i) explains business connection. It says it includes "any business activity carried out through a person who, acting on behalf of the non-resident-
(a) has and habitually exercises in India, an authority to conclude contracts on behalf of the non-resident, unless his activities are limited to the purchase of goods or merchandise or the non-resident ; or
(b) has no such authority, but habitually maintains in India a stock of goods or
merchandise from which he regularly delivers goods or merchandise on behalf of the non-resident ; or
(c) habitually secures orders in India, mainly or wholly for the non-resident or for that non-resident and other non-residents controlling, controlled by, or subject to the same common control, as that non-resident :
Provided that such business connection shall not include any business activity carried out through a broker, general commission agent or any other agent having an independent status, if such broker, general commission agent or any other agent having an independent status is acting in the ordinary course of his business :
Provided further that where such broker, general commission agent or any other agent works mainly or wholly on behalf of a non-resident (hereafter in this proviso referred to as the principal non-resident) or on behalf of such non-resident and other non-residents which are controlled by the principal non-resident or have a controlling interest in the principal non-resident or are subject to the same common control as the principal nonresident, he shall not be deemed to be a broker, general commission agent or an agent of an independent status.
Explanation 3 Where a business is carried on in India through a person referred to in clause (a) or clause (b) or clause (c) of Explanation 2, only so much of income as is attributable to the operations carried out in India shall be deemed to accrue or arise in India. " For better understanding of business connection & permanent establishment, kindly refer:
1. CIT v. R. D. Aggarwal & Co., 56 ITR 20 (1965) SC
2. Circular No. 1 of 2004 dated January 2, 2004.
3. Circular No. 23 of 1969 dated 23rd July, 1969.
4. Circular No. 5 of 2004 dated 28th September, 2004.
8. Associated Enterprises:
Sec. 92A subsection (1) provides for the meaning of Associates Enterprises. Sub-section (2) lists out the possible situations in which two enterprises will become associated enterprises. Article 9 of OECD & UN model conventions also provide for the meaning & situations in which two entities will become associated enterprises. Identification of associated enterprises is very important for applicability of transfer pricing provisions.
9. Arm's Length Price - Transfer Pricing Methods:
Sec. 92 (1) says "any income arising from an international transaction (sec. 92B) i.e. a transaction between two or more associated enterprises, either or both of whom are nonresidents shall be computed having regard to the arm's length price." Sec. 92 C (1) read with rule 10 B provides for the methods to be used for computation of arm's length price. The Board has prescribed following 5 methods for calculation of arm's length price:
(a) comparable uncontrolled method,
(b) resale price method,
(c) cost plus method,
(d) profit split method,
(e) Transactional net margin method.
Transfer pricing refers to the price at which an associated enterprise of one country enters into a financial transaction with other associated enterprise of different country. The arm's length price is determined with the use of comparables. One has to calculate the arm's length price with regard to several factors like capital employed, risk undertaken, assets used by the associated enterprise, functions undertaken, etc. Practically, it is very difficult to calculate the arm's length price. One has to use the most appropriate method out of the CBDT prescribed methods.
10. Double Tax Avoidance Agreements (DTAA):
Sec. 90 (1) gives power to the Government to enter into an agreement with the
Government of any country outside India for granting relief in respect of double taxation, promotion of mutual economic relations, trade & investment, for the avoidance of double taxation, for exchange of information & for recovery of taxes.
Sec. 90 (2) states that provisions of Indian Income-tax or DTAA whichever is more beneficial to the assessee will apply i.e. in DTAA can even override the provisions of Indian Income Tax Act. Tax treaties are signed for sharing of tax between the country of residence & country of source. Mr. Ankur Nishar, in his article on International Taxation in the May, 2007 newsletter has very rightly explained the concept of double taxation & DTAAs. So, I would not elaborate on this aspect.
11. Categorisation of Income:
Since different incomes will have different ways of determining the location of source; different categories have been listed. For e.g.: royalty, interest, dividend, fees for technical services, rental income, etc. Under the DTA, it is necessary to determine the country of source of income. Since different incomes will have different ways of determining the country of source; different categories are useful to determine the source. The house property income is sourced in
the country where the property is situated. The dividend income is sourced where the company distributing the dividend is resident. Salary income is taxable where services are performed. Thus for determining the location or the country of source, the categorisation is useful. Under the domestic law, categorisation is useful for computation. Different categories of
income may have different computation provisions.
12. Authority for Advance Ruling:
Sec. 245 N defines an advance ruling. Authority for Advance Ruling is a quasi judicial authority that helps the non-resident to know his taxability in India relating to a financial transaction in advance. This helps in avoiding controversies & litigation at a later stage i.e. after the financial transaction is undertaken. In the past, AAR has given several rulings. Unfortunately, with due respect, these rulings have put precedents that differ from the Tribunal, High Court or the Supreme Court decisions.
13. Tax Heavens:
A tax heaven is a country which does not charge tax to its residents or charges lower rates of tax. These countries sign the DTAAs with other countries in such a way, that there may not be any tax payable by the assessee in any country. Therefore, a lot many number of companies structure their investments so that they are outside the purview of any tax jurisdiction. Countries like Isle of Man, Cayman Islands, Mauritius, Cyprus, Malta, Singapore, etc. are
examples such tax heavens.
14. Treaty Abuse or Treaty Shopping:
Treaty shopping is nothing but shopping of the DTAA. Companies may take the benefit of the most beneficial DTAA. Generally, a treaty shopping arises when a resident of a State other than Contracting States of a tax treaty attempts to capitalize on benefits of the treaty by setting up a company with no economic substance or conducting a bogus transaction. A good example of treaty shopping is that of Malaysia-Korea, India- Mauritius, etc. Treaty shopping can occur in the following two ways:
1) A taxpayer of a country that has no treaty with the a particular country say India seeks the coverage of a favorable treaty, or
2) A taxpayer of India treaty partner prefers the treaty of another country.
15. Round Tripping:
Round tripping is the act of moving your funds outside the country & then channelising them back in the country to change the actual character of funds. Funds earned through illegal sources, etc. may be sent abroad & reinvested in the same country as legal funds. Companies use round tripping for changing the character of domestic funds into foreign funds or illegal funds into legal funds.
16. Hybrid Entities:
Hybrid entities are the different forms of entities. Say, for example, India gives the status of the firm as a tax resident. It axes the firm on its income & the income of the firm is exempt in the hands of the partners. In some countries, taxation is transparent i.e. it may not tax the income of the firm in the hands of the firm but it may tax the partners individually on income earned through the firm. There are also several other entities like US LLP, UK LLP, Dutch CV, German KG * Co., trust, partnership, co-operative societies, venture capital funds & collective investment vehicles, etc.; taxation of which may be separate in separate countries. This may give rise to conflict in classification of cross border scenario. Hybrid entities may also give rise to complication in application of treaty provisions.
17. Tax Sparing:
Developing countries often attempt to attract foreign investors with incentives in the form of reduced rates of taxation or, in some cases, the exemption of certain types of income from tax. In order to preserve the resultant investment revenues to the developing country, the country of residence of the investor (that is, the
developed country) "spares" the tax that it would normally impose on the low-taxed or untaxed income earned by its resident abroad by granting foreign tax credits equal to, or possibly greater than, the tax that would otherwise have been exigible in the developing country. Tax sparing is intended to promote economic development among developing nations by ensuring that tax incentives offered to foreign investors by these countries were not eroded through the tax treatment of the income from the advantaged activities in the
investor's country of residence.
18. Underlying Tax Credit:
Credit is available in residence country for taxes paid by subsidiaries of companies in foreign countries. The above can be explained with the help of following example:
Say, for e.g.: Company A in India has a wholly owned subsidiary in a foreign country. During the year, foreign subsidiary earns a profit of $ 1,000. Assuming tax rate in foreign country is 35 %, foreign subsidiary is liable to pay $ 350 in foreign country itself & shall remit the balance $ 650 in India. Foreign subsidiary will also have to pay a dividend distribution tax on this, say 15 % i.e. $ 97.5 on $ 650.
In India, Co. A will be taxed on its overseas subsidiary's profit. Since corporate taxes in India is, say we assume 30 %, then this translates to a tax of $ 300. But since a tax greater than this has been paid in the foreign country, no taxes are paid in India. In effect, Co. A has paid a tax of 44.75 % ($ 350 + $ 97.50) & tax credits of $ 147.5 is lost. Pooling of foreign tax credits:
If however India would have permitted pooling of foreign tax credit, then even $ 147.5 would have been available as credit. Many international treaties signed provide for underlying & pooling tax credits.
19. Non-Discrimination Clause:
Article 24 of OECD & UN Model Convention provide for subjecting the residents of one country to taxation & requirement connected therewith in other country similar to that of the residents of that other country i.e. the taxation & connected requirements should not be more burdensome than subjected to residents of that other country.
20. Limitation of Benefits:
Many persons were using the provisions of treaties to their own benefits. Some persons have even misused the treaty provisions by forming conduit, shelf, offshore companies or SPVs i.e. Special Purpose Vehicles.
Limitations on benefits provisions generally prohibit third country residents from
misusing treaty benefits. For example, a foreign corporation may not be entitled to a reduced rate of withholding unless a minimum percentage of its owners are citizens or residents of the treaty country.
Article 23 of the UK - USA treaty provides for limitation of benefits clause.
Recently Indo- Singapore treaty was amended to insert the limited version of limitation of benefits clause. Indian tax authorities are also trying to re-negotiate tax treaties with UAE, Cyprus, Mauritius to insert this limitation of benefits clause.
21. Mutual Agreement Procedure (MAP):
Article 25 of the OECD & UN Model Convention state that where a person considers that the actions of his domestic country or the other country shall result in taxation not in accordance with the treaty provisions, irrespective of the remedies provided by the domestic law of those states, he can present his case to the competent authority in the country of his residence. The competent authority of residence country shall verify the arguments stated whether the arguments are justified & if the case of unable to arrive at a satisfactory solution as regards elimination of the double taxation or interpretation of tax treaty, competent authorities of both the countries shall resolve the difficulties by mutual agreement.
22 Advanced Pricing Arrangements (APA):
An APA is an arrangement between a taxpayer and the tax authority wherein the method of determining the transfer pricing for inter-company transactions are set out in advance. Such programmes are designed to resolve actual or potential transfer pricing disputes in a cooperative manner. The tax payer must submit a formal APA application, tax authorities shall review & evaluate the proposal & then negotiate and execute the APA. An APA:
provides your business with certainty on an appropriate transfer pricing methodology, enhancing the predictability of tax treatment of your international dealings, substantially reduces or eliminates the possibility of double taxation in the future, provides a possible solution to situations where there is no realistic alternative way of both avoiding double taxation and ensuring that all profits are correctly attributed and taxed, limits the prospect of a potentially costly and time-consuming examination of major transfer pricing issues that would arise in the event of a transfer pricing audit, and lessens the possibility of protracted and expensive litigation, places your business in a better position to predict costs and expenses, including tax liabilities, reduces the record keeping burden on your business as you know in advance what records you are required to keep to substantiate the agreed methodology, and reduces your business costs, as no fee is charged for the APA.
23. Withholding tax at source:
Withholding tax is additional tax imposed by the country of source when various types of remuneration (dividends, interest, royalties etc.) are paid in favour of non-residents of that country. The principle of a withholding tax is that it is withheld (retained) by the payer and given directly to the taxation authorities. The payee is given only the balance after the withholding tax amount. The primary motivation is to reduce tax evasion or failure to pay.
24. Force of Attraction rule:
Normally, business profits are taxed in the country of residence except when the entity functions or performs business in the other country with the help of a dependent agent or a permanent establishment. In such cases, income attributable to the permanent establishment is taxed in the country of source. The Contracting States will attribute to a permanent establishment the profits that it would have earned had it been an independent enterprise engaged in the same or similar activities under the same or similar circumstances. As the name suggests, the force of attraction approach focuses on the actual economic connection between a particular item of income and the permanent
establishment. Under the "force of attraction" approach, all domestic sourced income is attributed to the permanent establishment, irrespective of whether the relevant item of income is in fact economically connected with the activity of such a permanent establishment.
25. Controlled Foreign Corporations (CFC) rules:
Income from a foreign source is taxed usually after it is accrued or received as income in the country of residence of the taxpayer. The use of intermediary entities in a tax-free or low-tax jurisdiction enables a tax resident to defer (or avoid) the domestic tax on the income until it is repatriated to the residence state. This tax deferral could lead to an unjustifiable loss of domestic tax revenue. A CFC is a legal entity that exists in one jurisdiction but is owned or controlled primarily by taxpayers of a different jurisdiction. CFC laws can be introduced to stop tax evasion through the use of offshore companies in
low-tax or no-tax jurisdictions such as tax havens. It is rarely illegal to have a financial or controlling interest in a foreign legal entity; however, many governments require taxpayers to declare their interests and pay taxes on them, and CFC laws (combined with a no-tax jurisdiction or a double taxation agreement) sometimes mean that a company is only taxed in one jurisdiction. The CFC rules are designed to stop companies avoiding tax in residence country by diverting income to subsidiaries situated in low tax regimes.
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