A Case Study Analysis on whether tax treaties can impose taxation in India
Background to the Case Study
The Australian High Court ruling dismissing Satyam Computers' appeal raises interesting issues that the following Case Study attempts to capture for discussion. The facts in the Case Study are merely to lay down the scene for the discussion on these issues, and one need not be unduly detained in analysing those facts.
Case Study – A Tax Treaty, a Sword or a Shield
AusBank is incorporated and tax resident of Australia. It is a wholly owned subsidiary of Canberra Holdings, an Australian company which is the holding entity of the Canberra Group in the business of banking with operations worldwide. AusBank was engaged in banking business in the Indian sub-continent with branches in the metro cities in India. It did not have any significant operations outside India. AusBank had extended credit facilities to several large Indian real estate developers against the security of their land parcels. Due to the economic downturn, some of these developers went bust leaving AusBank with significant amount of bad loans. It was then decided to shut down its operations and close all its Indian branches. AusBank has usufruct mortgages on large tracts of land in Chennai which is very valuable and amounted to more than 50% of its total assets. AusBank disposed of the land and recovered its loans in the process of closing down its Indian operations. Soon after, the Group sold its entire stake in AusBank to another Banking major in Hongkong and made handsome gains.
The Tax Head of Canberra Group is confident that the transaction of sale of AusBank shares should not have any Indian tax implications but decides to approach the BCAS to rule that out conclusively. The BCAS has constituted a Panel of eminent experts to examine the case. The posers for the Panel are as follows:
1. Whether the sale of AusBank shares taxable under the Income-tax Act, 1961? Whether indirect transfer provisions apply? The Tax Head points out that the AusBank shares are of an Australian company and before they were sold, all Indian assets (including the land on which there was a usufruct mortgage) were liquidated, and monies repatriated to Australia. According to him, the indirect transfer provisions do not apply as the shares did not derive substantial value from Indian assets when they were sold.
2. The Tax Head also is unsure of the applicability of India-Australia DTAA as he knows that in India, the Treaty or the Income-tax Act whichever is more beneficial shall apply. He requires an affirmation of this understanding from the Panel. In this connection, he points to certain provisions which could militate against his belief-
a. Art. 13(4) of the India-Australia DTAA dealing with gains from shares of real property companies does not apply since the assets of AusBank did not consist wholly or principally of real property referred to in Article 6 at the time of the sale of its shares. However, Article 9(1) of the Multilateral Instrument that imposes a 365-day prior holding test applies as both India and Australia have not reserved its application. The Tax Head fears that the usufruct mortgages which formed at least 50% of the value of AusBank were disposed of only immediately prior to repatriation of all funds from India and India could be said to have a taxing right under Art. 13(4) of the DTAA.
b. Under Article 23 of the DTAA, any income, profits or gains derived by an Australian resident which, under any of the distributive rules may be taxed in India, shall for the purpose of Indian tax law, be deemed to be income from sources in India. As any income arising from a source of income in India is deemed to accrue or arise in India under section 9(1)(i), the gain from sale of shares of AusBank could be held to be taxable in India.
c. Section 90(2) provides for applying the provisions of the Act to the extent they are more beneficial which implies that there must be a comparison between the provisions of the Treaty and the Act. However, in this case, the provisions of the tax law is mandated by the DTAA itself which possibly cannot be avoided taking recourse to section 90(2).
3. The Tax Head raises the following Posers
a. Can Canberra Group contend that it would apply the DTAA, at its option, only if it is beneficial to it? If the DTAA does not apply, the impact of Art. 23 is avoided.
b. Can it be contended that, in Australia, International Tax Agreements Act, 1953 imports treaty provisions into the Australian Income-tax Act and similar provision in the tax law in India is absent. As a counter, can it be said the import of a notification under section 90(1) that implements a DTAA is like the position in Australia?
c. Is there a priority of application between sub-sections (1) and (2) of section 90 of the Act? Can s. 90(2) prevent the deeming provision in Art. 23 from being imported into the ITA and thus override s. 90(1)?
d. Article 23 of the India-Australia tax treaty only deems the source of an item of income is in India in certain circumstances. Can it be, thus, contended that the deeming provision in Art. 23 is not relevant for applying the provisions of the Act since the scope of total income is based upon its accrual, arising or receipt irrespective of its source?
1. Position under the Income-tax Act, 1961 (the "Act")
1.1 In the case study, the gains on the sale of shares of AusBank (an Australian company) do not accrue or arise or are received in India.
1.2 The shares of AusBank shall be deemed to have been situated in India if these shares derive their value substantially from the assets located in India, which triggers the indirect transfer provisions. As per Explanation 6 to section 9(1)(i), the shares shall be deemed to derive their value substantially from the assets located in India if the value of such Indian assets represents at least 50% of the value of all the assets owned by AusBank on the specified date. AusBank has liquidated all the assets of its India branches and repatriated the surplus to Australia before the end of its accounting year (the specified date). It may be presumed that AusBank had little or no assets located in India on the specified date. Consequently, indirect transfer provisions with respect to the gains from the sale of AusBank shares are not attracted.
1.3 None of the other limbs of section 9(1)(i) or other clauses of section 9(1) is attracted. Consequently, the gains from the sale of AusBank shares are not deemed to accrue or arise in India. Thus, the gains are not chargeable to tax under the Income-tax Act, 1961.
2 Position under the India-Australia Agreement (the "Agreement")
2.1 Under Art. 13(4), the gain from the transfer of shares of a real property company deriving their value wholly or principally from immovable property situated in India may be taxed in India.
2.2 Since on the date of transfer, AusBank does not hold any immovable property, Art. 13(4) should not have any application but for the modification through the look-back rule contained in Art. 9 of the Multilateral Instrument ("MLI"). As AusBank held immovable property (which definition includes usufruct mortgage in the Agreement) in the 365 days preceding the date of transfer, Art. 13(4) gives the taxing right to India.
2.3 Under Article 23(1) of the Agreement, if India has the taxing rights as the Source State with respect to income, profit or gain of an Australian resident under the distributive rules of the Agreement, such income profit or gain shall be deemed to be from sources in India for the purposes of its tax laws.
3 Satyam Computer's case
3.1 Satyam, an Indian company, provided IT services to Australian clients. A part of the services was performed by its employees located in India. Under the Australian Income-tax Assessment Act 1997 ("ITAA 1997"), a foreign resident is assessable in Australia only on income from Australian sources [Sec. 6-5(3)(a)]. The income derived from the services performed outside Australia is not construed as from an Australian source and is not assessable in Australia.
3.2 However, Art. 12 deems royalties (the definition includes fees for included services within its scope) paid by Australian residents as taxable in Australia.
3.3 Satyam argued that Art. 23 of the India-Australia Agreement did not create a tax liability when the Australian domestic tax law did not impose liability. The Agreement did not impose tax based on the generalised principle that tax treaties are, and can only be, exclusively relieving: that is, they are only ever "shields, not swords" and do not grant a standalone taxing power and independent imposition of taxation.
3.4 The Federal Court disagreed that these generalisations do not prevent Art. 23 from operating according to its terms. The Court referred to section 4(2) of the Australian International Tax Agreements Act, 1953 (the "Agreements Act"), which provides for the overriding effect of the agreements notwithstanding anything inconsistent in the domestic tax law, which gives paramountcy to Art. 23(1). The Court found that "there is nothing in the context, object or purpose of the Indian Agreement or the Agreements Act which permits Art. 23 to be read down to conform with a generalised assertion about the "effect" of tax treaties drawn from outside the text of the Indian Agreement.
3.5 Accordingly, the Federal Court held that Satyam was taxable in Australia on the payments received from its Australian clients even though the services were performed outside Australia.
4 Transformation of treaties into domestic law
4.1 Can it be contended that, in Australia, the Agreements Act imports treaty provisions into the Australian Income-tax Act? Since a similar provision in the tax law in India is absent, does the Satyam ruling have any application in India? As a counter, can it be said the import of a notification under section 90(1) that implements a DTAA is like the position in Australia?
4.2 In Australia, Art 50 of the Constitution provides that treaties containing provisions modifying or completing existing laws require for their validity the approval of the National Assembly, which at the time of approval may decide that the treaty should be implemented by the promulgation of laws. The Australian position is similar to what we have in India. The point of departure is whether the treaty provisions have the same or similar effect in India and Australia.
4.3 In Australia, treaty provisions are incorporated into the Australian Assessment Act by section 4 of the Agreements Act. The Preamble to the Agreements Act states that that Act is to give the force of law to certain treaties and other agreements with respect to Taxes on Income and Fringe Benefits. Sec. 4(1) of that Act provides for the incorporation of treaties into the Assessment Act and mandates that the provisions of the Assessment Act and the Agreements Act be read as one.
4.4 In the Indian context, the Supreme Court described the treaty-making powers of the Central Government and the Parliament in the following words:
"17. The power of entering into a treaty is an inherent part of the sovereign power of the State. By article 73, subject to the provisions of the Constitution, the executive power of the Union extends to the matters with respect to which the Parliament has power to make laws. Our Constitution makes no provision making legislation a condition for the entry into an international treaty in time either of war or peace. The executive power of the Union is vested in the President and is exercisable in accordance with the Constitution. The Executive is qua the State competent to represent the State in all matters international and may by Agreement, convention or treaty incur obligations which in international law are binding upon the State. But the obligations arising under the Agreement or treaties are not by their own force binding upon Indian nationals. The power to legislate in respect of treaties lies with the Parliament under entries 10 and 14 of List I of the Seventh Schedule. But making of law under that authority is necessary when the treaty or Agreement operates to restrict the rights of citizens or others or modifies the law of the State. If the rights of the citizens or others which are justiciable are not affected, no legislative measure is needed to give effect to the Agreement or treaty." [underlining supplied]
4.5 Under section 90(1), the Central Government may make such provisions as may be necessary for implementing double tax agreements entered into by it. Though there are several rulings of the courts that State that section 90(1) is an enabling provision that empowers the Central Government to enter into tax avoidance agreement, it is respectfully submitted that role of section 90(1) is not to delegate the power to the Central Government to enter into such agreements, which power is anyway vested with it under Article 73 of the Constitution, but its role is to implement the tax agreements into the domestic law. In other words, section 90(1) gives legal force to the agreements.
4.6 The Central Government issues notification as envisaged under section 90(1) to make the necessary provisions to implement treaties. For example, the notification of the India- Australia Agreement states as follows:
Whereas the annexed Agreement between the Government of the Republic of India and the Government of Australia for the avoidance of double taxation and the prevention of fiscal evasion with respect to taxes on income has entered into force on the 30th day of December, 1991, on the exchange of notes notifying each other that the last of such things has been done as is necessary to give the said Agreement the force of law in India and in Australia, in accordance with paragraph (1) of Article 28 of the said Agreement ;
Now, therefore, in exercise of the powers conferred by section 90 of the Income-tax Act, 1961 (43 of 1961), and section 24A of the Companies (Profits) Sur Tax Act, 1964 (7 of 1964), the Central Government hereby directs that all the provisions of the said Agreement shall be given effect to in the Union of India. [underlining supplied]
4.7 The notification of the India-Australia Agreement indicates that, on entering into force, the said Agreement is given "the force of law", and all the treaty provisions have legal effect in India. In Davy Ashmore Ltd, the Calcutta High Court found the notification of the India – United Kingdom Treaty with similar wordings expressing a clear intention that all provisions of the said Convention shall be given effect notwithstanding the provisions contained in the relevant Act.
4.8 The legal effect of the treaty provisions cannot be differentiated from the provisions of the Act (or any other law). There is also no evidence to suggest that the treaty provisions stand on a lower footing than the laws legislated by the Parliament. Any such discrimination would be without basis.
5 Are treaties optional?
5.1 In the case study context, the question is whether the non-resident can seek to apply the treaty at its option, that is, only if it is beneficial to it.
5.2 It may be contended that the non-resident assessee is not chargeable to tax on the gains on the sale of shares of AusBank under the Act. Hence, there is no occasion to examine the position under the India – Australia Treaty. By adopting this procedure, any possible application of Art. 23 of the treaty is avoided.
5.3 Generally, the tax is imposed by domestic law, not by the treaty. As held by the Supreme Court, once an agreement is notified under section 90, the provisions of such an agreement would operate even if inconsistent with the provisions of the Income-tax Act. Similarly, section 4(2) of the Australian Agreements Act provides for the overriding effect of the agreements, notwithstanding anything inconsistent with those provisions contained in the Assessment Act or an Act imposing Australian tax.
5.4 The illustration by Klaus Vogel also suggests that a treaty cannot cover any additional area not covered by domestic law. On the question of whether the treaty law or the domestic law should be first examined, Vogel suggests that both procedures are equivalent since the treaty acts like a stencil that is placed over a pattern of domestic law and covers over certain parts [Klaus Vogel on Double Tax Conventions, Introduction, m no. 56].
5.5 However, in the same paragraph, he states that where one level refers to the other (as it is in the case of Art. 23 of the India-Australia Treaty), a particular order of examination is exceptionally required. Thus, it may be logical to examine the treaty first and then the domestic law. If one is required to adopt this different procedure, Art. 23 cannot be avoided.
5.6 The phrase "force of law" in the notification of the India-Australia Agreement hardly indicates that any of the provisions of that Agreement is optional, either to the assessee or the Revenue. On the other hand, the notification requires all the provisions of the Agreement to be given effect in the Union of India.
5.7 What is, though, available through section 90(2) is that the provisions of the Act shall apply to the extent they are more beneficial to the assessee.
6 Contours of section 90(2)
6.1 Is there a priority of application between sub-sections (1) and (2) of section 90 of the Act? Can section 90(2) prevent the deeming provision in Art. 23 from being imported into the ITA and thus override section 90(1)?
6.2 Sub-section (2) was inserted in Section 90 by Finance Act, 1991, with retrospective effect from April 1, 1972. CBDT Circular No. 621 dated 19.12.1991 explained its purpose as follows:
" Taxation of foreign companies and other non-resident taxpayers -
43. 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. It may so happen that the tax treaty with a foreign country 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 subsequently be amended, reducing the incidence of tax to a level lower than what has been provided in the tax treaty.
43.1. Since the tax treaties are intended to grant tax relief and not put residents of a contracting country at a disadvantage vis-à-vis other taxpayers, section 90 of the Income-tax Act has been amended to clarify that any beneficial provision in the law will not be denied to a resident of a contracting country merely because the corresponding provision in the tax treaty is less beneficial." [underlining supplied]
6.3 For section 90(2) to apply, a comparison is envisaged between the provisions of the Act and the corresponding provisions of the tax treaty. The Madras High Court, in T Rajkumar, explained the contours of section 90(2) in the following words:
69. First of all, section 90(2) does not use a non obstante clause to say that the provisions of an agreement entered into by the Central Government under Section 90(1) would prevail over the other provisions of the Act. Secondly, Sub-Section (2) of Section 90, instead of ousting the application of the other provisions of the Act, simply directs attention to what is more beneficial to the assessee. If the provisions of the Income Tax Act are more beneficial to the assessee to whom an agreement of the nature specified in Section 90(1) applies, those provisions would apply to him. If an option is given to choose between two alternatives, it cannot be said that one alternative is inconsistent with the other. Section 90(2) merely speaks about two options, one of which is more beneficial than the other to the assessee. This provision does not speak about any inconsistency between the provisions of the Income Tax Act and an Agreement entered into by the Central Government under Section 90(1). [underlining supplied]
6.4 The question for consideration is at what stage the provisions of the Act and the treaty should be examined to ascertain the beneficial nature of the provisions. For a comparison, the charge, computation, and tax rate must be determined under the Act and the treaty. In Dresdner Bank, the taxpayer's attempt to compute income tax under normal provisions under the Act and treaty provisions for MAT was rejected by the Tribunal, which laid down that different treatment cannot be given for each segment for taxation of the income. On the other hand, in cases of multiple sources of income, an assessee is entitled to adopt the provisions of the Act for one source while applying the provisions of the DTA for the other.
6.5 However, where Art. 23 imposes a charge of tax for the purposes of the Act, a comparison would amount to be of the two provisions, both of which are of the Act which is not contemplated by section 90(2). Also, any comparison of a charge of tax with the provisions of the Act (minus that charge imposed in the Act by Art 23) would result in that treaty provision not having any effect. Such an outcome may fail to give legal effect to all the treaty provisions by the notification under section 90(1), which is also legislated by the Parliament.
7 Objective behind Art. 23 in India–Australia Agreement
7.1 The Explanatory Memorandum to the Amending Act in 1991 that inserted the India-Australia Agreement in the Agreements Act states as follows concerning Art. 23:
Article 23 effectively deems income, profits or gains derived by a resident of one country which, under the Agreement, may be taxed in the other country, to be income from sources in the latter country for the purposes of the domestic laws of both counties and Article 24 (Methods of Elimination of Double Taxation) of the Agreement. It thus ensures the jurisdictional (source) right of each country to exercise the taxing rights allocated to it by the Agreement over residents of the other country.
The article is also designed to ensure that where an item of income, profits or gains is taxable under the Agreement by both countries, double taxation relief will be given by the country of residence of the recipient of the income, profits or gains (pursuant to Article 24) in respect of tax levied by the other country in accordance with the taxing rights allocated to it under the Agreement. To this end, the article effectively provides for income, profits or gains derived by a resident of Australia which is taxable by India under the Agreement to be treated as foreign income for the purposes of the foreign tax credit provisions of the ITAA. [underlining supplied]
7.2 The object and purpose behind Art. 23, as understood by the Australian Parliament, is to ensure taxation by the Source State where the Agreement gives it the taxing right. There appears to be no reason why such understanding does not bind the Australian resident concerning its taxation in India as a Source State.
8 Source in a Contracting State
8.1 Art. 23 of the India-Australia Agreement provides that where a distributive rule in the treaty gives the taxing right concerning the income of a resident of a Contracting State to the other State, such income is deemed to be from sources in that other State for the purposes of its tax law.
8.2 The phrase "income from sources in a Contracting State" is found in a few treaty articles. The article defining treaty residence uses the phrase [Art. 4(1) (2nd Sentence), OECD Model]. Also, the phrase is found in the article dealing with methods for eliminating double taxation of some treaties [Art. 24 of the India-UK treaty]. The India-UK Treaty provides that, for the purposes of the Elimination of Double Tax Article, profits, income, and chargeable gains owned by a resident of a Contracting State may be taxed in the other Contracting State in accordance with the provisions of the Convention shall be deemed to arise from sources in that other Contracting State.
8.3 Apart from using the phrase "income from sources in a Contracting State" in Articles 4 (Residence) and Article 24 (Method for Elimination of Double Taxation), the India-Australia Agreement provides that where a distributive rule gives the taxing rights to a Contracting State, for the purposes of the tax law of that State, the income, profits and gains shall be deemed to be income from sources in that State. Notably, the deeming provision in Art. 23 is not for the purposes of the treaty but the domestic tax law. Thus, the Article seeks to ensure the chargeability of the item of income under the domestic tax law in all cases where the distributive rule provides the taxing right.
8.4 The ITAA 1997 in Australia includes, within the scope of assessable income of a foreign resident, ordinary income derived directly or indirectly from all Australian sources during the income year [Sec. 6-5(3)(a)]. Consequent to Art. 23 read with the ITAA 1997, if the treaty provides Australia with the taxing right for an income, profit or gain, such income will be considered to be from Australian sources and be assessable under ITAA 1997. Thus, the general understanding that a treaty cannot impose a charge to tax is no longer valid. The treaty could be a sword and not a shield in certain circumstances.
8.5 The taxpayer could contend that a similar effect may not result in India. Under the Indian Income-tax Act, the scope of total income in section 5 is defined as income "from whatever sources derived, " indicating that the source itself or its location is not relevant to determining the scope of total income. As a result, though Art. 23 deems the source of certain income to be in India. That provision does not affect the inclusion of the same in the scope of total income of a non-resident under section 5 unless the income accrues or arises or is deemed to accrue or arise or received or deemed to be received in India. In other words, the source in India does not trigger inclusion in the scope of total income unless the income accrues, deemed to accrue or is received in India. Thus, the taxpayer could contend that the position in India differs from Australia, and the conclusion in Satyam Computer's case cannot be extended to a reverse situation where the income belongs to an Australian resident.
8.6 On the other hand, the deemed accrual rule in section 9(1)(i) provides that any income from a source in India is deemed to accrue or arise in India. It could be the Revenue’s stand that Article 23 is to be given effect to in India by the notification issued in section 90(1). Once Art. 23 provides for deeming the source of income to be in India, section 9(1)(i) is attracted.
8.7 Importing a deeming provision arising from Art. 23 of the DTAA (that is, the source of income is in India) into section 9(1)(i) could be accused of leading to an unreasonable degree of artificiality since section 9 itself is a deeming provision. The counter to this argument could be that section 9(1) deems the place of accrual of income to be in India and does not deem its source to be in India which is what Art. 23(1) purports to do. Thus, there is no superimposition of a deeming fiction on top of another fiction. Due to the notification issued in terms of section 90(1), the provisions of Art. 23 cannot be avoided.
9 Proposed Amendment to the International Tax Agreements Act 1953
9.1 The Australian Tax Office released an exposure draft to amend the Agreements Act to give an exemption from the application of the effect of Art. 23 to Indian tech firms. A new Schedule is proposed to be introduced, which shall provide that the India-Australia Agreement shall not have the effect of subjecting to Australian tax any payments or credits as consideration for the rendering of any included services covered by paragraph 12(3)(g) of that Agreement and that are not royalties (within the meaning of the Income Tax Assessment Act 1936) and would not be otherwise subject to tax in Australia.
9.2 Notably, the proposed amendment to the Agreements Act does not cover distributive rules relating to income other than fees for included services that are not royalties. Moreover, the said amendment is to the Australian domestic law and should not impact the true legal position in India under the Act.