Introduction
Double Tax Avoidance Agreements (“DTAAs”) are signed between governments of two countries in order to relieve individuals and businesses residing in one jurisdiction of the burden of paying taxes twice for the same income earned in another jurisdiction. Say X residing in India earns a particular sum through his business in the US. In the absence of a DTAA, X will be liable to pay tax on this earned income both in the US as well as India. Therefore, apart from giving relaxation in tax, DTAAs also help in the ease of doing business by providing incentives to individuals and body corporates to engage in cross border commercial activities without the fear of getting taxed multiple times and at multiple places for the same income earned.
This article aims at understanding fundamental features of a DTAA through statutory framework and treaties and its role in international taxation which includes but is not limited to eliminating double taxation, encouraging foreign investment in a given country, smoothening the dispute resolution process in the matter of double taxation and also addressing transfer pricing issues to some extent.
Fundamental Features of a DTAA
The first feature of a DTAA is that it allocates taxing rights between the two signatory countries. It determines which country has the right to tax a particular category of income, such as business profits, dividends, royalties and capital gains. The principle that could be followed here is the principle of source and income, where either the government in the source country or that in the country of residence exercises the right to tax the said income. Mostly the source country taxes the income earned there, and the residence country gives the relaxation against taxing the same sum second time.
Secondly, a DTAA also underscores the method through which double tax exemption has to be granted. The two most practised ways are the exemption method and the tax credit method. In the former, income earned by person X in the source country shall not be included while taxing the income in his residence country. In credit method on the other hand, income tax paid by X in the source country shall be offset against domestic tax liability. In India, these methods can be traced to section 90(1) of the Income Tax Act of 1961 (“Income Tax Act”). Whereas exemption can be given only for the countries with which India has signed a DTAA with, tax credit can be given even without such an agreement under section 91. Therefore, whereas section 90 stipulates for the bilateral agreement to give protection against double taxation, section 91 provides for unilateral relief for Indian residents.
Another feature of a DTAA is that it also sometimes establishes a Permanent Establishment (“PE”) which has the responsibility of determining when a foreign enterprise can be subjected to taxation in another country. A DTAA may also provide for anti-avoidance provisions known as General Anti-Avoidance Rules (“GAAR”) and Limitation of Benefits (“LOB”) clauses to prevent the abuse of such agreement by entities to exploit tax benefits through illegal avoidance or tax evasion through shell companies or other means. For instance, LOB clauses were introduced in India-Mauritius DTAA to prevent its misuse for tax avoidance.
In India, there exist 90+ DTAAs with countries across the globe. However, a DTAA between India and other countries would only advance benefit to the tax residents of India and those of the signatory country. Foreign or non-resident entities which operate in India are not entitled to take benefits of such agreements. Additionally, to avail DTAA benefits in India, one needs to file Form 10F with the Indian tax authorities that includes details about residency and tax status. The said form has to be filed electronically. Other requirements include a tax residency certificate (TRC) from the residence country’s tax authorities for proving tax residency and income statements and proof of tax payments in order to substantiate one’s claims on the income on which DTAA benefits are sought.
Moreover, mere existence of a treaty/agreement does not necessarily confer rights on the residents unless the same has been notified by the central government. The Indian Supreme Court clarified in the case of Assessing Officer Circle (International Taxation) New Delhi v Nestle SA (2023) that DTAAs cannot be enforced unless they are notified by the centre under section 90 of the Income Tax Act. The court in this case interpreted article 253 of the Constitution of India to hold that the treaty making power vests exclusively with the Union government.
Role in International Taxation
As highlighted earlier, DTAAs protect entities against paying tax unnecessarily in both the source and residence countries. One such example is that of India-US DTAA, which follows the tax credit method to avoid double taxation. Therefore, if an entity earns income in the US, it will be taxed in the US first, and then India would provide tax credit for taxes paid in the US. The said agreement was entered into in 1989, which came into effect in 1990, followed by multiple amendments to the same. This DTAA not only protects against double taxation (article 25), but also defines what ‘residence’ refers to (article 4) and also distributes the rights between the countries to tax different kinds of income: income from immovable property (article 6), from dividends (article 10), from interests (article 11), from royal and fees for included services (article 12), from capital gains (article 13), and from independent personal services (article 15) among other things.
DTAAs also create a suitable tax environment for Foreign Direct Investment (“FDI”) by making the procedure less uncertain and significantly reducing tax liability, thus also promoting economic growth in the process. For example, a treaty like India-Mauritius DTAA played an important role in enabling good investments to come to India. However, later revisions were made to the treaty to protect against treaty shopping practices to avoid tax. The treaty was also challenged in the case of Union of India v. Azadi Bachao Andolan (2003), in which the Supreme Court upheld the validity of the India-Mauritius DTAA and ruled that tax benefits from such treaties are not illegal and must not be denied unless it can be shown that there has been an abuse or evasion of law by the means of such treaty.
Another aspect of DTAAs is that they provide for Mutual Agreement Procedures (“MAP”) to resolve potential disputes that may arise from differences in tax treatment between the signatory countries. They also help in addressing transfer pricing issues[1] through proper allocation of income and profits across borders and thus also help in preventing tax base erosion and profit shifting.[2] In India, an amendment to the Income Tax Act was enforced in 2017 to clamp down on tax avoidance through DTAAs by the introduction of GAAR. Scholars have however argued that extension of the same to DTAAs which already have LOB clauses (such as India-Mauritius DTAA) was unnecessary as it leads to harassment of assesses even in cases of genuine transactions. Therefore, there are arguments made in favour of excluding such DTAAs from the scope of GAAR.
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[1] Transfer pricing refers to the pricing of goods, services, or intangible assets transferred between related entities within a multinational enterprise (MNE). For instance, if a parent company sells products to its subsidiary in another country, the price at which these products are exchanged is called the “transfer price.” Transfer pricing is often scrutinized by tax authorities because MNEs may manipulate prices to shift profits from high-tax jurisdictions to low-tax jurisdictions, reducing their overall tax burden.
[2] Base Erosion and Profit Shifting (BEPS) refers to strategies used by multinational enterprises (MNEs) to exploit gaps and mismatches in international tax rules to artificially shift profits to low or no-tax jurisdictions, where they may have little or no economic activity. This practice results in significant erosion of the tax base of higher-tax countries, reducing their tax revenues.
