A REVIEW OF INDIAN TAX TREATY POLICY: COMPARING INDIAN TAX TREATIES WITH OECD AND UN MODELS

1. A REVIEW OF INDIAN TAX TREATY POLICY: COMPARING INDIAN TAX TREATIES WITH OECD AND UN MODELS January 24, 2008 Mukesh Butani, BMR & Associates Jacques Sasseville, OECD

2. CONTENTS Introduction Comparative view Jurisprudence Recent trends Recent treaties/protocols Summary and Outlook

3. INTRODUCTION

4. INTRODUCTION • Tax treaty: an inter – nation agreement based on consensus ad idem • Dominant objective – avoidance of double taxation (juridical and economic) • Other objectives • Promotion of international trade • Exchange of information to counter tax avoidance • Multiple factors determine treaty policy • Historical – tilt towards UN / OECD model • National interests - economic and political • Taxation systems • Jurisprudence • Treaty - end result of negotiation between countries guided by multifarious considerations

5. TREATY FRAMEWORK IN INDIA • 1947 – first limited tax treaty with Pakistan • 1967 – first comprehensive treaty with Greece • Currently 67 comprehensive treaties and 24 limited treaties in force • Last ten years - 28 treaties and 10 protocols signed • Treaties generally conform to UN model with some exceptions • Article 5(1) – service PE in 14 treaties • Article 7(1) – ‘force of attraction’ rule in a third of treaties • Article 7(3) – limited deductibility of expenses only in a third of treaties • Substantial adaptation of Indian treaties to UN/OECD model in last 20 years • Treaties with Greece, Egypt, Libya remain exceptions with significant departures from OECD/UN model conventions

6. PATTERN IN TAX TREATY POLICY • Treaties based on UN and OECD model conventions • Overtime - broad trends discernible in treaty policy • 60’s to mid 70’s • Limited right of taxation in country of source • Closer to OECD model • Mid 70’s onwards • Amendments to Income Tax Act, 1976 – strengthening taxing power with respect to payments to non residents • 1980 – UN model introduced • Source rule given prominence in tax treaties • Recent treaties • Limitation on benefits clause • Will we see policy shift?

7. 50 YEARS OF TAX TREATY WORK AT THE OECD • Work on model tax treaties started in the League of Nations in the 1920s; first models were adopted in 1928 • Tax treaty work of the Fiscal Committee of the League of Nations ended after the Mexico Model (1943) and London Model (1946) • OECD started working on tax treaties in 1956 • A first draft of a few model articles was produced in 1958; other partial drafts were produced in 1959, 1960 and 1961 • The first comprehensive OECD Draft Convention was published in 1963 • It was revised in 1977 and has been periodically updated since 1992

8. WHAT IS THE OECD? • Organization of Economic Co-operation and Development • Replaced OEEC set up to implement Marshall plan • 30 industrialized countries • 19 from European Union • Switzerland, Norway, Iceland, Turkey • Japan, Korea, Australia, New Zealand • Canada, United States, Mexico

9. LIMITED MEMBERSHIP BUT GLOBAL REACH OECD Member Countries Countries/Economies Engaged in Working Relationships with the OECD

10. WHAT IS THE COMMITTEE ON FISCAL AFFAIRS? • Committee on Fiscal Affairs • Replaced the Fiscal Committee of the OEEC (1956-1971) • Delegates are senior officials (assistant-secretary, commissioner, general-director of international division etc.)

11. COMMITTEE ON FISCAL AFFAIRS - STRUCTURE Committee On Fiscal Affairs Forum on Harmful Tax Practices Working Party No 1 On Tax Conventions and Related Questions Working Party No 2 On Tax Policy Analysis And Tax Statistics Forum on tax administration Working Party No 6 on Taxation of Multinationals Working Party No 8 On Tax Avoidance And Evasion Working Party No 9 on Consumption Taxes

12. COMPARATIVE VIEW

13. INSTITUTIONAL DIFFERENCES • OECD Model is a governmental model formally approved by the 30 OECD member countries • Member and non-member countries are allowed to formally express disagreements (reservations, observations and positions) on the Articles and Commentary of the OECD Model • The UN Model was drafted by a small group of experts acting in their personal capacity • The UN Model is not formally approved by the member states of the UN • The UN Model was designed from the perspective of negotiations between developed and developing countries

14. COMPARATIVE VIEW - OECD VS UN MODEL

15. COMPARATIVE VIEW - OECD VS UN MODEL

16. COMPARATIVE VIEW - OECD VS UN MODEL

17. COMPARATIVE VIEW - OECD VS UN MODEL More treaties follow UN compared to OECD model

18. COMPARATIVE VIEW – G-8 COUNTRIES • Installation PE – Threshold of 120 days (less than UN threshold) • Service PE – Threshold of 90 days (less than UN threshold) • Articles 7, 8, 11, 12, 13 in line with UN convention USA • Installation PE – Threshold of 120 days (less than UN threshold) • Service PE – Threshold of 90 days (less than UN threshold) • Article 7, 11, 12, 13 in line with UN convention CANADA • Installation PE – Threshold of 183 days (close to UN threshold) • No PE resulting from supervisory activities in relation to installation project (in line with OECD convention) • Service PE – Threshold of 90 days (less than UN threshold) FRANCE • Service PE – Threshold of 90 days (less than UN threshold) • Article 7 : Business profits – No force of attraction rule (in line with OECD convention) UK Source rule favored but OECD model followed in some respects

19. COMPARATIVE VIEW – EMERGING COUNTRIES • Threshold for Service PE and Installation PE close to or less than UN threshold • Supervisory activities covered by installation PE (UN) • Contains force of attraction rule (UN) • Article 11 – tax on interest not to exceed 10 percent (OECD) • Article 12, 13 in line with the UN convention ZAMBIA INDONESIA • Installation PE has threshold of 6 months (UN) • No service PE (OECD) • Article 7 : Business profits – no force of attraction rule (OECD) • Article 11 : Tax on interest not to exceed 10 percent (OECD) • Article 12 in line with the UN convention MALAYSIA Source rule favored but OECD model followed in some respects

20. COMPARATIVE VIEW – EMERGING COUNTRIES • Installation PE – Threshold of 9 months (closer to OECD) • No Service PE (OECD) • Contains force of attraction rule (UN) • 11, 12, 13 in line with the UN convention ZAMBIA • Article 7, 11, 12, 13 in line with UN convention • Time threshold for installation and service PE closer to UN convention • Contains force of attraction rule (UN) • Article 11 : interest not to exceed 10 percent (OECD) • Article 12, 13 in line with UN SRI LANKA INDONESIA • Preference for source based taxation • OECD convention followed in some respects • No significant difference in treaty policy towards developed and developing nations PAKISTAN

21. INDIAN JURISPRUDENCE

22. RELIANCE ON UN/OECD CONVENTIONS Courts have often referred to UN and OECD model conventions/ commentaries • Constitute “international tax language” & “contemporanea exposito” • Meanings assigned by OECD / UN Model or commentary should be given “due weightage” CIT v Vishakapatnam Port Trust - 144 ITR 146 (Andhra Pradesh HC) Graphite India Ltd. v. DCIT - 78 TTJ 418 (Calcutta ITAT) DCIT v ITC - 85 ITD 162 (Calcutta ITAT) • Referred to ‘reinforce’ / ’confirm’ Court’s conclusion Union of India v Azadi Bachao Andolan – 263 ITR 707 SC CIT v Vijay Ship Breaking Corpn - 261 ITR 113 (Gujarat HC)

23. RELIANCE ON UN/OECD CONVENTIONS “Favoring” reference to Commentary British Airways Plc. vs DCIT – 73 TTJ 519 (Delhi ITAT ) • Tribunal observed that Article 8 of India – UK treaty is in line with OECD convention • OECD commentary referred to for determining scope of Article 8 of India – UK treaty Graphite India Ltd. vs DCIT – 78 TTJ 418 (Calcutta ITAT) • Article 15 of India-US treaty almost same as Article 14 of OECD Model Convention • Tribunal ruled that OECD commentary was very important and relevant

24. RELIANCE ON UN/OECD CONVENTIONS Favoring reference to Commentary – Recent Decisions Morgan Stanley – 201 Taxation 160 (Supreme Court) • Reference made to UN model convention by Supreme court while interpreting Service PE under India - US treaty • No reference made to OECD model Aztec Software – 294 ITR 32 (Bangalore ITAT) • “India is not a member of OECD. However the organization has been supporting efforts of tax administration in India to properly and effectively administer and implement Transfer Pricing policy. A useful reference can always be made to OECD guidelines, for the purpose of resolving dispute of transfer pricing in India, however subject to statutory regulations.” Mentor Graphics - 112 TTJ 408 (Delhi ITAT) • TPO erred in neither applying the transfer pricing regulations nor the OECD Guidelines Set Satellite (Singapore) PTE Ltd – 106 ITD 175 (Mumbai ITAT) • Reliance on OECD’s 2006 report on attribution of profits while determining that income of the foreign company in India may be taxed even where it pays an arm’s length remuneration to its dependent agent in India Galileo International Inc and Maruthi Info and Tech Centre ITA No. 1733/Del/2001 • Tribunal has referred to OECD commentary for construing the meaning of a fixed place of business in India- US treaty

25. RELIANCE ON UN/OECD CONVENTIONS Indian Perspective – “Disapproving” reference to Commentary CIT vs VR SRM firm and others – 208 ITR 400 (Chennai HC) • “The articles in the OECD model convention and those in the treaty with Malaysia under consideration show wide range of difference and per se render the commentaries on the model convention wholly inapplicable and expose the unreasonableness and futility in seeking to apply the same” (Chennai HC) • Reliance sought to be placed by Revenue on OECD commentary considered inappropriate and unjustified P. No. 28 of 1999 - 242 ITR 208(AAR) • On Article 5(1) and 5(2) of India – US treaty - AAR applied the principle of statutory interpretation observed for interpreting domestic law – “the inclusive definition is intended to add to the primary meaning” • Ruled that reference to OECD commentary was not appropriate as it ran contrary to well established principle of statutory interpretation TVM Ltd - 237 ITR 230 (AAR) • “Several observations in the Commentary on the UN Model will be equally apposite even for the interpretation of the India-Mauritius Treaty” AAR applied the UN Commentary while interpreting the meaning of permanent establishment under India – Mauritius treaty

26. RELIANCE ON OECD MODEL IN OECD COUNTRIES • Recommendation of the OECD Council “… that their tax administrations follow the Commentaries on the Articles of the Model Tax Convention, as modified from time to time, when applying and interpreting the provisions of their bilateral tax conventions…” • Paragraphs 29, 33-36.1 of the Introduction to the Model Tax Convention • The courts of most OECD countries use the OECD Model Convention as a tool for interpreting tax treaties • US Court of Appeals in National Westminster Bank, PLC (15 January 2008) “The “entire context” of the 1975 Treaty is informed by, and is based on, the Organisation of Economic Cooperation and Development’s (“OECD”) 1963 Draft Double Taxation Convention on Income and Capital (“1963 Draft Convention”)”

27. RECENT TRENDS

28. CHANGING ECONOMIC SCENARIO • Manifold increase in foreign direct investment • India continues to be favourite investment destination • Increase in outbound investment – will it trigger review of treaty policy “The finance ministry is in favour of reviewing such treaties that India has with over 100 countries, in view of the country’s changing economic scenario. The treaties should be such that they are more suitable for Indian investments abroad as much as it is for incoming capital” Source: Economic Times December 6, 2007

29. ‘NORTH BLOCK SPEAK’ • Indian companies have invested over $ 20 billion abroad in the past one year • Government keen to encourage firms investing abroad to send profits back home through market mechanism • Protection of revenue required at the time of export of capital by domestic companies “ We are working very hard on a model tax treaty as we have realised today that India not only imports capital but also invests abroad. So the very nature of the DTAAs has to change” Ministry of Finance

30. IMPLICATIONS FOR TREATY POLICY • Indian economy still in transition mode • 2007 - outbound in excess of inbound • 2006 – inbound greater than outbound • Relaxation of source rule – to what extent can it be diluted? • Heading towards a hybrid model – mix of source and residence based taxation

31. OECD INFLUENCE • OECD keen on greater Indian participation • June, 2006 - India becomes observer at Committee of Fiscal Affairs • May, 2007 – OECD Council offered enhanced engagement with a view to possible membership to Brazil, China, India, Indonesia and South Africa • Will observer status impact? • Treaty interpretation • Courts and judiciary taking views – Aztec decision takes note of OECD support role while relying on OECD commentary • Treaty negotiation and government policy? • Policy review triggered primarily by change in economic circumstances

32. LIMITATION OF BENEFITS CLAUSE • Background and reasons for growing importance • Azadi Bachao Andolan • Absence of limitation of benefits (LOB) clause in India-Mauritius tax treaty • Cited treaty with US as example of treaty with LOB clause • No disabling provisions in India-Mauritius treaty to prevent resident of third nation from availing treaty benefit • Form of transaction to be respected • Indian Revenue concerned about tax base erosion, round tripping and money laundering • Worldwide concern on harmful tax practices • 1998 - OECD Report On Harmful Tax Competition • Existing and potential treaty partners insisting on LOB clause • Recent treaties containing LOB clause • Singapore • UAE • Mauritius and Cyprus treaty – LOB clause under negotiation

33. RECENT TRENDS IN INDIA’S TREATY POLICY NEGOTIATION • Continuing emphasis on source based taxation • Increase in cross-border transactions – thrust on information exchange (Article 26 of UN/OECD convention) and collection assistance articles (Article 27 of OECD convention) • Treaty negotiation with developing countries is challenging • Same stage of economic development – similar concerns and needs • Keen to attract foreign investment • Need for greater revenue • Anti-abuse provisions important in negotiations with low tax countries

34. ALIGNMENT IN DOMESTIC LAW • Transfer pricing regulations make express reference to ‘permanent establishment’ - Finance Act, 2001 • ‘Business connection' includes a concept similar to Agency PE - Finance Act, 2003 • Domestic withholding tax rate for royalties and fees for technical services brought down to 10 percent • Gradual alignment of domestic law with Indian treaties

35. RECENT TREATIES / PROTOCOLS

36. RECENT TREATIES • India - Serbia and Montenegro • Follows OECD convention with features of UN model • India – Mexico • Interest, dividends and royalties – taxable in country of source and residence but tax not to exceed 10 percent • Capital gains from alienation of shares to be taxed in country where the company issuing shares is resident • First time treaties with Botswana, Senegal, Iceland and Kuwait • Treaty with Thailand (to replace treaty of 1985) and Luxembourg under negotiation

37. PROTOCOL TO TREATY WITH SINGAPORE • Protocol effective August 1, 2005 • LOB clause • Test - primary purpose to take advantage of treaty benefits • Shell company - legal entity with negligible business operations or with no real and continuous business activities • Deeming provision • Total annual expenditure on operations (< S$200,000 or Rs 50,00,000) in the preceding period of 24 months from the gain • Capital gains - sale of stock • Taxable only in state where alienator is resident • Royalties – may be taxed in the source state but rate not to exceed 10 percent Amendments in line with OECD convention

38. PROTOCOL TO TREATY WITH UAE • Protocol effective April 1, 2008 • Change in definition of ‘resident’ – earlier based on liability to tax under domestic law but now also based on period of stay/management and control • Capital gains - sale of stock • Taxed in country where company issuing shares is resident • For real estate business, taxed in country where immovable properties are situated • LOB clause • Main purpose – creation of an entity to obtain treaty benefits • Covers legal entities not having bonafide business activities Amendments in line with strict ‘source based taxation’ principles

39. SUMMARY AND OUTLOOK

40. SUMMARY AND OUTLOOK • Source based taxation – starting point for treaty negotiation • Certain features of OECD model also adopted • Treaties reflect a mixed approach though clearly source rule finds prominence • Concern on treaty abuse mounting – likelihood of LOB clauses in treaties if misused • Mauritius, Thailand and Cyprus under the Revenue lens • Changing economic scenario could force Government to contemplate a policy shift • Treaty policy review – an ongoing process, though no specific personnel assigned • Pre-mature to comment on exact nature of change – expectation of a greater leaning towards residence based taxation

41. ANNEXURE

42. OUTBOUND ACQUISITIONS Increase in outbound investments is one of the key reasons that has triggered review of treaty policy Some Examples* * Figures include stake acquisitions after Jan 2006

43. DOMESTIC LAW Vs MCs – PERMANENT ESTABLISHMENT