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Concept of Non Discrimination in tax treaties

Concept of Non Discrimination in tax treaties. Pramod Kumar June 2013. Disclaimer.

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Concept of Non Discrimination in tax treaties

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  1. Concept of Non Discriminationin tax treaties Pramod Kumar June 2013

  2. Disclaimer This presentation seeks to present the academic aspects relating to, and various points of view about, the concept of non discrimination in tax treaties. This is not a statement of legal position, expression of any opinion and it does support any particular point of view. The views expressed herein do not reflect the views or the understanding of the author or author’s employer i.e. the Government of India, or the Income Tax Appellate Tribunal.

  3. A quick relook at some basic issues • What is a tax treaty, what are objectives of tax treaties and whether these objectives travel beyond avoidance of double taxation as well ? • What is impact of 2004 amendment in Section 90(1) on the treaties provisions travelling beyond the avoidance of double taxation ? • How is a tax treaty to be interpreted ; is it to be interpreted the same way a legal provision is interpreted or in any different manner ?

  4. A quick relook at some basic issues • What is conflict between source rule of taxation and residence rule of taxation and how tax treaties resolve this conflict ? • Do tax treaties allocate the taxing rights between source jurisdiction and residence jurisdiction or do they simply restrict the taxing right of source jurisdiction ?

  5. Non discrimination clauses in tax treaties • Ensure that residents of one of the treaty partner jurisdiction are not discriminated against in the other treaty partner jurisdiction • Restrict the application of domestic tax law in the treaty partner jurisdiction to the extent it is discriminatory • Does it mean both the residents are to be treated as par or is a reasonable differentiation permissible ?

  6. Impact of NDC clause on taxation in treaty partner country • Limits the application of domestic tax law provisions, vis-à-vis the residents of treaty partner country, in the host country • Extends the scope of beneficial domestic tax law provisions, vis-à-vis the residents of treaty partner country, in the host country • This also extends to a domestic enterprisewhich is owned or controlled by the residents of the treaty partner country.

  7. Who is affected by NDC • Residents (individual or corporate ) of one jurisdiction while being taxed in the treaty partner jurisdiction • Enterprise with fiscal domicile in the host country, but having capital or control by residents in the treaty partner country, while being taxed in the domicile jurisdiction

  8. ‘Discrimination’ – meaning • Its origin from Latin words ‘discriminare’ and ‘discernere’ ( to separate) and ‘cerenere’ (to shift) • Differentiation, as classical meaning of the expression would imply, could be negative, positive or neutral • Original meaning of the verb ‘to discriminate’ is thus value neutral • Its contemporary usage, however, generally refers to ‘less’ rather than ‘more’ favour, and unreasonable, arbitrary or irrelevant differentiation

  9. Non Discrimination Article 14 – Constitution of India “The State shall not deny to any person equality before the law or the equal protection of the laws within the territory of India Prohibition of discrimination on grounds of religion, race, caste, sex or place of birth .”

  10. Non Discrimination Article 14 – Constitution of India • "[t]he equal protection of laws: guaranteed by Article 14 of the Constitution of India does not mean that all laws will have to be general in character and universal in application and that the State is no longer to have the power of distinguishing and classifying persons or things for the purposes of classification". • In Kedar Nath Bajoria Vs State of West Bengal • (AIR 1953 SC 404,406)

  11. Non Discrimination Article 14 – Constitution of India • In order to pass the test of permissible classification, two conditions must be fulfilled, namely (i) the classification must be founded on an intelligible differentia which distinguishes persons or things that are grouped together from others left out of the group, and (ii) the differentia must have a rational relation to the object ought to be achieved by the legislation in question. • State of West Bengal Vs Anwar Ali Sarkar • (AIR 1952 SC 75)

  12. Non Discrimination – connotations in tax treaties • One school of thought is that differentiation, except when permitted by the relevant bilateral treaty itself, which subjects persons or capital belonging to the partner contracting states, to any taxation or connected requirements, per se amounts to discrimination • The other school of thought is that it is only when such differentiation is not on valid grounds, it does not amount to discrimination

  13. Reverse discrimination • Reverse discrimination is a situation in which persons or capital belonging to the host contracting state are subjected to more burdensome taxation or any connected requirement, vis-à-vis the persons or capital belonging to a treaty partner country. • There are no specific reverse discrimination situations dealt with by the tax treaties, though this aspect is dealt with in some Indian and foreign judicial precedents and guidelines issued by revenue authorities abroad.

  14. Impact of non discrimination provisions in tax treaties- manner • In view of the provisions of Section 90(2), treaty provisions override the provisions of Income Tax Act, 1961, except to the extent these are beneficial to the assessee. The only rider, as on now, is , with regard to tax rate. In the proposed Direct Tax Code, additional exceptions are (a) GAAR, (b) Branch Profit Tax, and (c) CFC regulations. • When domestic law comes in conflict with the provisions of the treaty, it ceases to be enforceable in to that extent. Therefore, if any provision of the domestic law is seen in conflict with NDC in tax treaties, to that extent, domestic law is ineffective.

  15. Impact of non discrimination provisions in tax treaties- areas • Taxability of an income, or admissibility of deduction, in the hands of a resident of the other contracting state. • Deductibility of an expenditure in respect of payment made to other contracting state. • Treatment to an enterprise in which resident of other contracting state holds capital or control

  16. Type of discriminations which treaties protect • Discrimination on the ground of nationality ( whether resident in the treaty partner country or not ; not really relevant in India as Indian tax system does not differentiate on the basis of nationality -234 ITR 371) • Discrimination against Stateless persons ( living in the treaty partner country – not relevant again) • Discrimination against treatment to payments made to treaty partner resident - Herbalife case (except in cases of payments to associated enterprises)

  17. Type of discriminations which treaties protect ……continues • Discrimination against Taxability of Permanent Establishment ( except for personal allowances, reliefs and reductions for taxation purposes on account of civil status or family responsibilities which it grants to its own residents) – Metchem case, Automated Securities case, Rajeev Gajwani SB 129 ITD 145 • Ownership discrimination – Daimler Chrysler case ( discriminating against a business owned or controlled by the resident of other contracting state – even an Indian resident, owned or controlled by a resident of treaty partner, can be aggrieved party)

  18. Examples of PE tax equality • Same right for deduction of expenses • Same facilities for depreciation and reserves • Same option for carry forward of losses • Same rules for computation of capital gains

  19. NDC in contemporary tax treaties • UN /OECD Model Conventions • US Model Convention (i.e. with clarifications on areas to which NDC will not extend) • No ND clause at all ( e.g. India Australia tax treaty) • Restricted ND clause (such as deduction related NDC missing in several tax treaties)

  20. Terms used in NDCs • Taxation or any requirements connected therewith • which is more burdensome • less favorably levied • requirements to which nationals of the state concerned are … or may be subjected to ..

  21. Article 24 (1) UN Model Convention Nationals of a Contracting State shall not be subjected in the other Contracting State to any taxation or any requirement connected therewith which is other or more burdensome than the taxation and connected requirements to which nationals of that other State in the same circumstances, in particular with respect to residence, are or may be subjected. This provision shall, notwithstanding the provisions of article 1, also apply to persons who are not residents of one or both of the Contracting States.

  22. Article 24 (2) UN Model Convention • Stateless persons who are residents of a Contracting State shall not be subjected in either Contracting State to any taxation or any requirement connected therewith which is other or more burdensome than the taxation and connected requirements to which nationals of the State concerned in the same circumstances, in particular with respect to residence, are or may be subjected.

  23. Article 24 (3) UN Model Convention The taxation on a permanent establishment which an enterprise of a Contracting State has in the other Contracting State shall not be less favourably levied in that other State than the taxation levied on enterprises of that other State carrying on the same activities. This provision shall not be construed as obliging a Contracting State to grant to residents of the other Contracting State any personal allowances, reliefs and reductions for taxation purposes on account of civil status or family responsibilities which it grants to its own residents.

  24. Article 24 (4) UN Model Conventions • Except where the provisions of paragraph 1 of article 9, paragraph 6 of article 11, or paragraph 6 (paragraph 4 in OECD Model Convention) of article 12 apply, interest, royalties and other disbursements paid by an enterprise of a Contracting State to a resident of the other Contracting State shall, for the purpose of determining the taxable profits of such enterprise, be deductible under the same conditions as if they had been paid to a resident of the first-mentioned State. Similarly, any debts of an enterprise of a Contracting State to a resident of the other Contracting State shall, for the purpose of determining the taxable capital of such enterprise, be deductible under the same conditions as if they had been contracted to a resident of the first-mentioned State.

  25. Article 24 (5) UN Model Convention Enterprises of a Contracting State, the capital of which is wholly or partly owned or controlled, directly or indirectly, by one or more residents of the other Contracting State, shall not be subjected in the first-mentioned State to any taxation or any requirement connected therewith which is other or more burdensome than the taxation and connected requirements to which other similar enterprises of the first-mentioned State are or may be subjected.

  26. Article 24 (6) UN Model Convention The provisions of this article shall, notwithstanding the provisions of article 2, apply to taxes of every kind and description.

  27. Article 26 (1)India US tax treaty Nationals of a Contracting State shall not be subjected in the other Contracting State to any taxation or any requirement connected therewith which is other or more burdensome than the taxation and connected requirements to which nationals that other State in the same circumstances are or may be subjected. This provision shall apply to persons who are not residents of one or both of the Contracting States.

  28. Article 26(2) India US tax treaty Except where the provisions of paragraph 3 of article 7 (Business Profits) apply, the taxation on a permanent establishment which an enterprise of a Contracting State has in the other Contracting State shall not be less favourably levied in that other State than the taxation levied on enterprises of that other State carrying on the same activities. This provision shall not be construed as obliging a Contracting State to grant to residents of the other Contracting State any personal allowances, reliefs and reductions for taxation purposes on account of civil status or family responsibilities which it grants to its own residents.

  29. Article 26(3) india US tax treaty Except where the provisions of paragraph 1 of article 9 (Associated Enterprises), paragraph 7 of article 11 (Interest), or paragraph 8 of article 12 (Royalties and Fees for Included Services) apply, interest, royalties, and other disbursements paid by a resident of a Contracting State to a resident of the other Contracting State shall, for the purposes of determining the taxable profits of the first-mentioned resident, be deductible under the same conditions as if they had been paid to a resident of the first-mentioned State.

  30. Article 26(4) India US tax treaty Enterprises of a Contracting State, the capital of which is wholly or partly owned or controlled, directly or indirectly, by one or more residents of the other Contracting State, shall not be subjected in the first-mentioned State to any taxation or any requirement connected therewith which is other or more burdensome than the taxation connected requirements to which other similar enterprises of the first-mentioned State are or may be subjected.

  31. Article 26(5) India US tax treaty Nothing in this article shall be construed as preventing either Contracting State from imposing the taxes described in Article 14 (Permanent Establishment Tax) or the limitations described in paragraph 3 of Article 7 (Business profits).

  32. Are there any differences between UN and US approach – Models • One school of thought – no difference at all; in substance provisions are the same, even though there may be slight variations in the wordings. • The other school of thought – as long as PE tax is protected as not covered by the NDC, the differentiation per se not enough to invoke the NDC. Technical Explanation further supports this theory when various differentiations in US laws are justified.

  33. Examples of differentiation not amounting to discrimination - US Section 1446 of the Code imposes on any partnership with income that is effectively connected with a U.S. trade or business the obligation to withhold tax on amounts allocable to a foreign partner. .... There is no similar obligation with respect to the distributive shares of U.S. resident partners. It is understood, however, that this distinction is not a form of discrimination within the meaning of paragraph 2 of the Article. No distinction is made between U.S. and non-U.S. partnerships, since the law requires that partnerships of both U.S. and non-U.S. domicile withhold tax in respect of the partnership shares of non-U.S. partners. Furthermore, in distinguishing between U.S. and non-U.S. partners, the requirement to withhold on the non-U.S. but not the U.S. partner's share is not discriminatory taxation, but, like other withholding on nonresident aliens, is merely a reasonable method for the collection of tax from persons who are not continually present in U.S., and as to whom it otherwise may be difficult for the U.S. to enforce its tax jurisdiction..........

  34. Examples of differentiation not amounting to discrimination - US There are cases, however; where the two enterprises would not be similarly situated and differences in treatment may be warranted For instance, it would not be a violation of the nondiscrimination protection of paragraph 2 to require the foreign enterprise to provide information in a reasonable manner that may be different from the information requirements imposed on a resident enterprise, because information may not be as readily available to the Internal Revenue Service from a foreign as from a domestic enterprise. Similarly, it would not be a violation of paragraph 2 to impose penalties on persons ,who fail to comply with such a requirement (see, e.g., sections 874(a) and 882(c)(2)).

  35. Some ITAT decisions on NDC • Herbalife • Metchem Canada • Automated Securities, Rajeev Gajwani (SB) • Daimler Chrysler • Mashreque Bank , State Bank of Mauritius • Credit Lyonnais

  36. Herbalife case 101 ITD 450 • The assessee, an Indian company, paid Rs.5.83 crores to US company Herbalife International Inc., as administrative fee as consideration for the various services received from H Inc. • AO held that held that income was taxable in India in the hands of H Inc, and since assessee did not deduct tax at source, it has to be disallowed under section 40(a)(i) in the hands of the assessee. • In first appeal, action of the AO was confirmed.

  37. Herbalife case …..continues • In view of Article 26(3) of India US tax treaty, which mandates that the disbursements by a resident in India “be deductible under the same conditions as if they had been paid to a resident of the first-mentioned State” • However, while section 40(a)(i), as it stood at the material point of time, did not require disallowances of payments to resident companies while the same could be invoked for payments to non resident companies. • It amounts to discrimination against the US company. Section 40(a)(i) held to be in applicable. Disallowance deleted.

  38. Metchem100 ITD 251 • Whether or not the limitation on deduction of head office expenditure, as set out in section 44C of the Indian Income-tax Act, will apply in the case of non-resident companies governed by the India-Canada tax treaty (164 1TR Stat 87), particularly in the light of non-discrimination clause in the said DTAA ?

  39. Metchem • Assessee, a company incorporated in Canada, claimed deduction in respect of head office overhead expenses allocated to the work it was carrying on for a project in India. • The deduction was restricted to 5% of adjusted total income under section 44C • AO rejected NDC protection on the ground that domestic Indian enterprise and the non-resident companies cannot be said to be "in the same circumstances" which is sine qua non for application of non-discrimination clause.

  40. Metchem • CIT(A) confirms the restriction on the ground that the treaty is to be read as a whole and on the basis of, what he perceived as, fairness in scheme of Section 44 C • ITAT findings ….it is clear that it is in the nature of a disabling provision which puts a ceiling on the admissibility of a deduction. It does constitute a restriction - and a restriction which is not similarly placed for a domestic enterprise. The head office expenses, to the extent the same can be fairly allocated to the permanent establishment are admissible as deduction under section 37(1) …. Fair approach argument rejected on the basis of Deutsche Bank decision by Bombay HC

  41. Metchem • What Article 24(2) seeks to remove is the discrimianton to the permanent residents of Indian and Canadian residents in the other States vis-a-vis the domestic business entities of that other State. When domestic tax laws permit such discrimination, such legal provisions have to be treated as overridden by the provisions of the Indo-Canadian DTAA • PE must be accorded the same right as resident enterprises to deduct the trading expenses that are, in general, authorised by the taxation law to be deducted from taxable profits in addition to the right to attribute to the PE a proportion of overheads of the head office of the enterprise. Such deductions should be allowed without any restriction other than those imposed on the resident enterprise."

  42. Metchem • Note the interplay between Article 7(3) and NDC – specific rider ‘subject to the provisions of’ • India’s official position in OECD commentary • India reserves the right to add a paragraph to clarify that this provision can neither be construed as………nor as being in conflict with provisions of paragraph 3 of Article 7

  43. Mashreqbank14 SOT 1 • Assessee’s case was that since ‘subject to provisions of’ words missing in Article 7 (3) of India UAE tax treaty, the expenses must be allowed without recourse to artificial disallowances such as under section 37(2A), 43 B etc. • AO rejected the claim and disallowed the expenses under provisions of the IT Act. In appeal, CIT(A) confirmed the disallowance. • ITAT confirmed the action of the AO and CIT(A) on the ground that it will amount to reverse discrimination.

  44. Mashreqbank • Canadian Federal Court in Utah Mines vs The Queen 92 DTC 6194 :“The interpretation proposed by the appellant.. would have the effect of giving US taxpayer with a PE in Canada a more favourable treatment than its Canadian competitor. Such a result would not be in accordance with the policy expressed in the Preamble to the Convention and indeed would be contrary to it” • UK Revenue’s International Tax Handbook “It would be inequitable to permit a non resident trading in a territory through a PE to deduct items which a resident would not be permitted to deduct. “

  45. State Bank of Mauritius 2012 TII 150 ITAT MUM • Disallowance under section 43 B does not come into play because there are no restrictions placed, in Article 7(3) which provides for computation of taxable profits of the PE, on deductions of expenses incurred for business • if there is no restrictive clause in the treaty, then the expenditure incurred for the purposes of the business of permanent establishment has to be allowed in full. • If a DTAA provides for a more liberal mode of computation of income, then it is this mode of computation, which needs to be followed notwithstanding any contrary provision contained in the Act. 

  46. Daimler Chrysler 29 SOT 202 • The assessee company was partly owned by a German company which 81.33% shares in the Indian company. The German company had a merger with an American company. The ownership pattern of India company also thus changed as below. • As a result of this change in ownership pattern, restrictions for carry forward of loss was invoked.

  47. Daimler Chrysler India Pvt Ltd– change in holding ownership

  48. Daimler Chrysler • Section 79 creates a bar on carry forward of losses • Any Pvt. ltd. Indian co., which could be subsidiary of a listed company, can escape the rigors if it could fall under Section 2(18) . • No such level playing field to a the appellant company though it was subsidiary of a large public company listed abroad. A foreign company cannot be covered by Section 2(18). Bar in Section 79 read down to reconcile with non discrimination clause in tax treaty.

  49. Daimler Chrysler – issues in analysis • Can an Indian company be eligible for benefits of India German tax treaty ? • Appropriate comparator – with another foreign company or with a domestic company ? • Is a tax treaty only for relieving double taxation or for more than that ?

  50. Daimler Chrysler – issues in analysis • What is the role of decisions from foreign Courts and Tribunals ( particularly when no decisions on that issue are available from domestic judicial forums) and whether decisions from treaty partner country are on a different footing vis-à-vis other foreign decisions ?

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