Transfer Pricing Adjustment Vs Article 11(6)/12(6)

Transfer Pricing Adjustment Vs DTAA’s Article 11(6)/12(6)

Brief on relevant Articles of DTAA

Article 11 – UN Model

1.       Article 11 deals with allocation of Taxability right of Interest income in source state (Payer State) between source state and Resident state

2.       Article 11(1) gives resident state right to tax Interest Income in Source state.

3.       Article 11(2) gives source state right to tax interest income at prescribed rate (ranging from 10-15% on GROSS Interest amount)

4.       Article 11(6) provides as under:-

a)      There is special relationship between payer and beneficial owner of Interest

b)      As a result of special relationship, the amount of Interest paid exceeds the amount, having regard to debt claim, which would have been agreed upon by the payer and the beneficial owner in the absence of such relationship.

c)       In such case, the provision of Article 11 will apply to Normal Interest (Interest which would have agreed between Payer and beneficial owner in the absence of special relationship)

d)      The excess Interest will be taxable according to laws of respective state, due regard has to other provisions of DTAA

5.       Thus Article 11(6) provides that Source state is not restricted to tax EXCESS AMOUNT at the rates prescribed under Article 11(2) and it can tax the said amount according its own domestic laws, with due regard to other provisions of DTAA.

Article 12- UN Model/OECD Model

1.       Article 12 deals with Royalty and Fees for Technical Service (FTS)

2.       Article 12 also contains provision similar to article 11(6) i.e Source state is not constrained to tax EXCESS AMOUNT at a beneficial rate provided in Article 12. (For our analysis, the corresponding Article is christened as 12(6))

Example

1.       Suppose an Indian Company paid Rs. 50 lacs as FTS to Foreign Company (Associated Enterprise (AE) of Indian Company and deducts withholding tax @ 15% as per DTTA.

2.       Later on in Transfer Pricing assessment of Indian Company, Rs. 20 lacs was disallowed, being not at ALP.

Issue

1.       Whether can AO invoke Article 12(6) and tax Rs. 20 lacs in the hands of foreign AE @ 40%, being rate applicable to foreign Company.

2.       Whether can AO make Indian Company as an agent of foreign AE u/s 163 and ask it to pay differential tax of 25% (40% -15%) on Rs. 20 lacs.

 

 

Analysis

1.       We need to evaluate about the satisfaction of conditions of 12(6) on two counts:-

a)      Special Relationship

b)      Excess Royalty.

i)                    The Words special relationship has not been defined in Article but OECD commentary provides that said term is wide enough to cover not only relationship envisaged in Article 9 but also cover relationship by blood or marriage and, in general, any community of interests

ii)                   Excess royalty – Article has adopted imaginative criteria, rather comparative criteria to determine EXCESS Amount. Under Comparative mode, an amount is compared with certain benchmark to arrive at excess amount i.e Actual Amount –ALP. In imaginative method, the excess amount is determined by evaluating what could have Normal amount in the absence of special relationship. It seems that imaginative way to determine excess amount is wide enough to embrace comparative approach.

Thus based on afore-said a conclusion can be drawn that excess royalty disallowed under TP assessment of Indian Company also satisfy the conditions for invoking provisions of Article 12(6)

2.       Taxability of Excess Amount under Income Tax Act, 1961.

Article 12(6) confers the right to tax excess amount to source state according to its own domestic law but also obligating to simultaneously respect other provisions of DTAA.

The taxability of Excess amount is analyzed as under:-

a)      Nature of Excess Amount – In Transfer pricing assessment, AO held that having regard to service involved, the Arm’s Length Price is Rs. 30 lacs. Thus 20 lacs paid by Indian Company to foreign company are not for services but due to some extraneous factors. In view of stated reasoning,  a vibrant conclusion can be drawn that Excess Amount does not retain the nature of income, to which it was originally made part i.e Rs. 20 lacs  cannot be  treated as  fees for technical services in the hands of foreign Company to be taxed at the rates provided in the domestic legislation.

b)      Determining taxability under Income Tax Act

·         For Taxability of any amount, following requirement is must:-

i)                    Amount meeting the criterion of Income.

ii)                   Classification of said Income to particular Category.

iii)                 Determination of Source rule applicable to said category.

iv)                 Computation methodology for said income to arrive at net taxable income.

·         Income Tax Act, 1961 does not presently contains explicit provisions treating such excess amount as deemed income in the hands of foreign company and providing other essentials, as narrated above, to draw taxability. Express categorization of amount to particular Income category is must to enable the Foreign Company at least to claim benefit of concessional tax under relevant Article of DTAA relating to said categorized income. For Example, had the Excess amount is to be treated as Dividend under Income Tax Act; the foreign company can claim the beneficial tax rate under Article 10(2) relating to Dividend.

·          The argument to treat such excess amount as Income from other sources in the hands of foreign Company in current scenario, may also fail to attract taxability on account of following:-

i)                    Foreign company may claim that excess amount represents debt repayable to Indian Counterpart.

ii)                   Further, in the absence of specific computation provision for such Excess amount, charging such amount as Income from other sources will not attract taxability. i.e charging provision fails in the absence of computation provision.

iii)                 Further  Article 21 (UN Model) provide that ‘Other Income” shall be taxable in the Resident state, unless such other income is attributable to PE of fixed place in source state, in which case source state also has right to tax such income. Thus on this count, taxability of such excess amount will fail as in the instant case foreign Company does not have PE or fixed place of business in India.

Thus in my view, the excess amount as discussed above, cannot be bought to tax again in the hands of Foreign Company by making Indian company as agent of foreign Company . On extreme side, , foreign company may claim for refund of withholding tax on Rs. 20 lacs deducted earlier, since in the absence of categorization of excess amount to the Income under domestic law and under DTAA, there is no justification for levy withholding tax and same justify refund.

Finance Bill 2015 proposal- Residential Status of Companies- Repercussions

Finance Bill 2015 proposal- Residential Status of Companies- Repercussions

Present government, which is offering red carpet welcome for foreign investors and also liberalising the tax regime for funds raising activities in India, is at the same time making terrain tough for domestic companies having foreign subsidiaries or foreign companies having operations in India through PE.

One amendment which is expected to encounter lot many challenges is change in the way Residential Status of companies in India is to be tested.

Finance Bill 2015 propose that Company will be resident in India (i.e its global income will be taxable in India) if:-

a)      It is an Indian Company

b)      Its place of effective management , at any time in that year, is in India

For the purposes of this clause “place of effective management” means a place here key management and commercial decisions that are necessary for the conduct of the business of an entity as a whole are, in substance made.

The million dollar question is whether propose amendment to tax global income of foreign company in India is in consonance with Power vested in Indian Constitution to tax income having territorial nexus with India i.e whether place of effective management of foreign company, at any in India, established sufficient territorial nexus with India to justify the taxation of global income of foreign company in India.

The expected hiccups upon operation of above-said propose amendments are as under:-

1.       Sharing Business secrets with Income tax department.

Since the concept of Place of effective management (POEM) is quite subjective, foreign company may be required to share with Indian Income tax Authority all key management and commercial decisions to substantiate that nothing of such sort has taken place in India.

2.       Referring to Mutual Agreement Procedure

a)      In case there is DTAA between foreign Country, where foreign company is incorporated, and India, there needs to attribute  the residential status of said company under DTAA to any one of the Country, which can claim to have right to tax its global business income.

b)      Under DTAA, following steps are required for arriving at the Residential status of Company:-

i)                    Determine Place of Incorporation or place of management of company.

ii)                   If place of Incorporation is in one country and place of management is in other country or place of management is in both the countries, determine the place of effective management

iii)                 Company will be the resident of Country where the place of effective management is located

iv)                 DTAA has provided any criterion to evaluate Residential Status criterion, where place of effective management is located in the both the countries.

v)                  If that be the case, company has to invoke the Mutual Agreement Procedure under DTAA  for arriving at its residential status under DTAA.

c)       Thus for any decision of foreign company taken  in India, which is claimed by IT Authorities to be key management decision, said company has to go Competent Authorities of both the countries under Mutual agreement procedure to conclude on its residential status.

d)      This aspect will further deteriorate the ranking of Indian under World Bank’s ease of doing business Index.

3.       Impediment in International taxation

a)      Considered a Case where foreign Company is located in Country X and it has cross border transaction (Say FTS) with country Y.

b)      At the time of transaction between X and Y, the foreign company was resident of country X.

c)       Under DTAA between X and Y, Y (Source country) does not have right of taxation and as such, country Y does not withhold the tax on FTS payment made to foreign Company in country X

d)      Later on due to some business exigency, certain Key management decision of foreign company is taken in India and it becomes resident of Indian under Proposed amendment and also under DTAA between Country X and India.

e)      Suppose India has DTAA with country Y and under said DTAA, Country Y has right of taxation on FTS payment.

f)       Now Foreign Company is Resident of India under DTAA between India and country X. In this case, Foreign Company claim to be resident of Country X under DTAA between X and Y seems doubtful.

g)      In this scenario, Country Y may claim that foreign company, which has now become resident of India, is also liable to pay tax in Country Y on FTS payment and will further lead to the complexities relating Triangular Treaties issues.

h)      Thus proposed amendment is likely to create obstacles in the smooth functioning of International Taxation

4.       Other Procedural Issues

Certain payments to foreign company from India (when foreign company was resident of foreign company), which is not taxable under DTAA but taxable under Income Tax Act, , may cast liability on payer for non-deduction of TDS, if foreign company becomes resident of India later on due to operation of  proposed amendment.

I think that ease and certainty in the operation of taxing statute is pressing need in current scenario, merely favourable tax frame work for fund raising activities unaccompanied by analogous treatment in corporate taxation will not serve the desire purpose.

Finance Bill 2015 Proposal- Foreign Bank- Taxability of Interest Income from Indian Branch

Finance Bill 2015- Proposal-Foreign Bank – Taxability of Interest Income from Indian Branch.

Finance Bill 2015 has proposed an explanation to section 9(1)(v) as under:-

“It is hereby declared that in the case of a non-resident, being a person engaged in the business of banking, any interest payable by the permanent establishment in India of such non-resident to the head office or any permanent establishment or any other part of such non-resident outside India shall be deemed to accrue or arise in India and shall be chargeable to tax in addition to any income attributable to the permanent establishment in India and the permanent establishment in India shall be deemed to be a person separate and independent of the non-resident person of which it is a permanent establishment and the provisions of the Act relating to computation of total income, determination of tax and collection and recovery shall apply accordingly.”

It provides that Non-resident Banking entity’s Head office or any other branch office outside India will be liable to pay tax on interest income in India, hereinafter referred to as HO Interest Income, earned from Branch in India.

My observation on said proposal is as under:-

Income Test

1.       Section 9 provides test for determination of accrual of income in India. But before this test can be applied, it is essential that amount involved is the income concerned. Unless the amount is income, there is no need to apply section 9, as the same is not chargeable to tax under the Income Tax Act

2.       Section 2(24) defines Income in inclusive manner but it is established principle that Act envisaged taxation of real income, unless there is specific provision for taxation of Notional income.

3.       A person cannot earn income from himself and there cannot be taxation of such notional income in ordinary course, unless Act specifically provides for the same.

4.       Section 45(2) is an exception to the rule stated at point no. 3  and specifically provide for chargeability of income arising from conversion of capital asset into stock in trade under the head Capital Gains i.e provide for taxability of income earned by person from himself.

5.       For Taxability of HO Interest Income, neither the Income definition nor Interest Definition u/s 2(28A) has not been extended to cover in their ambit the Interest Income of HO from Branch in India.

6.       Thus unless income or interest definition is amended, merely explanation in section 9(1)(v) will fail to test the judicial scrutiny at higher forum for taxability of HO Interest Income.

Double Taxable Avoidance Agreement

Position under DTAA for taxation of HO Interest Income

1.       Under DTAA, Permanent Establishment is treated as separate entity, distinct from its HO, only for the purpose of attribution of business profit under Article 7. In other words, for all other Articles, PE is not a separate entity.

2.       Article relating to Interest, define Interest as income from debt claim of every kind. Since PE is not treated as separate entity for said article, it cannot be said that HO earned interest income attributable to debt claim from Branch in India. Thus in instant case, HO cannot claim the benefit of concessional rate envisaged in Said Article, since income is not interest income as per said Article.

3.       Thus DTAA neither provides for taxation nor exclude taxation of HO interest Income. It is outside the scope of DTAA.

4.       Further Article relating to Elimination of Double taxation, provide that residence state (HO state) will allow credit for taxes paid in Source state (India) under laws of India and in accordance with the provision of DTAA. 

5.       In view of afore-said, whether a position can be taken  by Source state’s Income tax Authorities that Tax on HO interest Income is not in accordance with DTAA and hence may denied the benefit of elimination of Double taxation.

6.       The only exception to aforesaid is provision in India- USA, DTAA, where under Article 14, India can levy tax on Interest income paid by Indian Banking Branch to USA HO at rate not exceeding the rate specifying in Article 11, the reference of the same is also given in the memorandum explaining the finance bill 2015.

Non-Discrimination Clause

1.       DTAA generally have a Non-discrimination clause which provides that National of Contracting state shall not be subjected to 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 are or may be subjected.

2.       In India, there is no provision for taxation of Interest Income paid by Indian Branch to HO in India or Interest Income paid by Indian HO to foreign Branch.

3.       Thus for the proposed amendment, foreign Bank may take shelter under Non-discrimination clause and may avoid paying taxes on HO Interest Income.

4.       At this stage, it is worth mentioning Article 26 of India-USA DTAA dealing with Non-Discrimination, specifically exclude the levy of tax under Article 14 from purview of discrimination and permit said levy.

Thus I suppose that merely appending explanation to section 9(1)(v) will not serve the desired purpose unless consequential changes as stated above is also carve out.