Pramod Kumar June 2013 This presentation seeks to present the academic aspects relating to, and...

Concept of

Non Discriminationin tax treaties

Pramod KumarJune 2013

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.

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 ?

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 ?

A quick relook at some basic issues

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 ?

Non discrimination clauses in tax treaties

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 enterprise which is owned or controlled by the residents of the treaty partner country.

Impact of NDC clause on taxation in treaty partner country

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

Who is affected by NDC

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

‘Discrimination’ – meaning

“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 .”

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)


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)


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

Non Discrimination – connotations in tax treaties

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.

Reverse discrimination

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.

Impact of non discrimination provisions in tax treaties- manner

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

Impact of non discrimination provisions in tax treaties- areas

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)

Type of discriminations which treaties protect

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)

Type of discriminations which treaties protect ……continues

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

Examples of PE tax equality

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)

NDC in contemporary tax treaties

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 ..

Terms used in NDCs

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.

Article 24 (1) 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.


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.


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.

Article 24 (4) UN Model Conventions

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.


The provisions of this article shall,

notwithstanding the provisions of article 2, apply to taxes of every kind and description.


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.

Article 26 (1)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.

Article 26(2) 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.

Article 26(3) 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.


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).


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.

Are there any differences between UN and US approach – Models

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..........

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)).

Examples of differentiation not amounting to discrimination - US

Herbalife Metchem Canada Automated Securities, Rajeev Gajwani (SB) Daimler Chrysler Mashreque Bank , State Bank of Mauritius Credit Lyonnais

Some ITAT decisions on NDC

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.

Herbalife case 101 ITD 450

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.

Herbalife case …..continues

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 ?

Metchem 100 ITD 251

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.

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

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."

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

Metchem

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.

Mashreqbank 14 SOT 1

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. “

Mashreqbank

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.

State Bank of Mauritius 2012 TII

150 ITAT MUM

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.

Daimler Chrysler 29 SOT 202

Daimler Chrysler India Pvt Ltd– change in holding ownership

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.

Daimler Chrysler

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 ?

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 ?


Canadian Pacific Ltd. Vs. The Queen – (for the proposition that different countries should not construe the terms differently)Delaware case – (for the important proposition that while comparing a foreign enterprise for ND, comparison should be with a similar domestic enterprise)SA Andriz case – (for knocking down the thin capitalization rule since in a similar situation, there was leeway for a french enterprise)


PE of a foreign company exporting software80 HHE declined as PE not “resident of India”Discrimination was felt by appellant ND invoked unsuccessfully since ITAT held, this benefit appears to be linked to getting FE in IndiaPE could not satisfy this expectationITAT also held that for US treaty at least differentiation simplictor not enough – US practices referred to ; reciprocity element examined

Automated Securities 118 TTJ 619

Despite bar in s. 80HHE, Non-Residents eligible for deduction in view of non-discrimination clause in DTAA

The assessee, a US citizen and resident, exported software from his PE in India and claimed incentive deduction u/s 80HHE

Section 80 HHE provides that only resident taxpayers eligible for this incentive deduction

Rajeev S Gajwani 129 ITD SB 145

Invoked Article 26(2), and claimed that he was treated less favourably than a taxpayer resident in India

The provisions of Section 80 HHE read down to include non residents as well and held to be discriminatory vis-à-vis non residents

Automated Securities thus overruled

Rajeev S Gajwani …..continues

Reasoning adopted

If the provisions contained in the DTAA are capable of clear and unambiguous interpretation, it is not necessary to refer to the commentary on the OECD Model Convention, the US Technical Explanation or decisions of any foreign jurisdiction

In Automate Securities, bench unnecessarily considered the commentary and the technical explanation. The plain meaning of the provisions was not considered. Greater stress was placed on on the heading "non-discrimination" rather than on the contents of paragraph (2) of article 26, which are clear and unambiguous.

Reference to Article 14 of Constitution of India was irrelevant.

Plain literal meaning is always preferable

Rajeev S Gajwani …..continues

A foreign company operating in India, intended to claim 80M deduction80M available to domestic companiesForeign bank invoked ND articleITAT held against, on the reasoning that the limitation of 80M (for domestic companies) is not nationality basedIn a given case, even a foreign company can become a domestic company … hence no discrimination ….

Credit Lyonnais 94 ITD 401

UnionBanCal Corp v Comr of Internal Revenue (2002) 5 ITLR 912 US

Delaware case (Case No IR 699) Federal Tax Gazette (2004) Part II 1043 German

NEC Semi-Conductors Ltd v Revenue and Customs Comrs (2007) 9

ITLR 995

S A Andritz (French Supreme Administrative Court - 2003)

FCE Bank plc Vs Commissione (2012) EWCA Civ 1290

Some foreign rulings on NDC

Law on non discrimination in tax treaties in India is still in early stages; not many decisions from the Hon’ble High Courts as yet.

Take recourse to NDC only when you find genuine discrimination vis-à-vis a resident , your are sure that it is not express or intended, and you find that FE has no measures to assume a level playing field.

If you hit the wall, then NDC provides a way out. After all, equality before law does matter ….

General observations

Thank you !

Pramod Kumar June 2013 This presentation seeks to present the academic aspects relating to, and...

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