Double taxation can be understood in two ways. Depending on the venue of taxation double taxation can be a term utilised for the domestic or the international sphere. It can refer to taxation of dividend income without relief or credit for taxes paid by the company paying the dividend on the income from which the dividend is paid. [1] Or
It can refer to taxation by two or more countries of the same income, asset or transaction, for example income paid by an entity of one country to a resident of a different country. [2]
In the present project we will only be dealing with the international perspective of double taxation.
The Fiscal Committee of OECD in the Model Double Taxation Convention on Income and Capital, 1977, defines 'the phenomenon of international juridical double taxation' as 'the imposition of comparable taxes in two or more states on the same tax payer in respect of the same subject matter and for identical periods'. [3] Therefore, the basic cause of international multiple taxation is the exercise by sovereign states of their inherent right to levy tax extra-territorially. [4] Most of the countries subject their residents to tax, on the basis of 'personal jurisdiction', on their global income including income arising or having its source in foreign countries. [5]
Double taxation is generally to provide relief to individuals who reside in one nation while earning income in another. This leads to a situation whereby the same person is taxed on the same income twice. To avoid this situation and provide relief to genuine commercial activities and also to promote international trade and commerce, countries enter into bilateral agreements which seek to provide exemptions or reliefs to the above mentioned individual.
Thus under such an agreement it might be required that tax be paid in the country of residence and be exempt in the country in which it arises, in the remaining cases, the country where the gain arises deducts taxation at source ("withholding tax") and the taxpayer receives a compensating foreign tax credit in the country of residence to reflect the fact that tax has already been paid. [6] The second aspect of the agreement is that the two taxation authorities exchange information about such declarations, and so may investigate any anomalies that might indicate tax evasion. [7]
The Indian law with regard to double taxation is encapsulated in the Income Tax Act of 1961. Section 90, 90A and 91 deal with double taxation and the extent of executive power in this regard. India's agreements with foreign countries are of two types. Firstly, Comprehensive Agreements which relate to avoidance of double taxation and prevention of fiscal evasion with respect to taxes on income and capital gain and secondly, Limited Agreements relating to income arising of enterprises from aircrafts or ships. [8]
Overview of Section 90 of the Income Tax Act.
The exclusive power of the parliament to enter into treaties with foreign nations is protected and provided through entry 14 of the union list. This power has been utilised by the parliament by enacting section 90 of the income tax act. Under section 90 of the this act the parliament has delegated to the central government the power to enter into an agreement with the government of any country and by notification on the official gazette make such provisions as may be necessary for the implementing of the agreement. [9] This power is to be exercised only for the purpose of avoidance of double taxation or for granting relief where double taxation has already taken place. [10] The Supreme Court has considered this section in UOI v Azadi Bachao Andolon and made the following observations:
A delegate in this case the central government of the legislature can exercise the power of exemption in a fiscal statue. [11]
The validity of an agreement made under this section is to be determined by ascertaining whether it is within the parameters of the legislative provision. [12]
The principles governing the interpretation of treaties are not the same as those governing the interpretation of statutory language. [13]
The effect of an "agreement" entered into by virtue of section 90 of the Income Tax Act, 1961 would be:
If no liability is imposed under the Act, the question of resorting to the Agreement would not arise. No provision of the Agreement can possibly fasten a tax liability not imposed by this Act. [14]
if a tax liability is imposed by this Act, the Agreement may be resorted to for negativing or reducing it; [15]
in case of difference between the provisions of the Act and of the agreement, the provisions of the agreement prevail over the provisions of the Act. [16]
Provisions of section 90 prevail over those of sections 4, 5 and 9 and therefore, even where a business connection is established, profit of a company would be free from tax if they are covered by a Double Taxation Agreement;
Section 90 has two ingredients, namely, a tax has first to be paid, and then only arises the right to apply for a refund of the excess payment, and provision has been made for avoiding double taxation. [17]
The Supreme Court in CIT v. Carew & Co. Ltd [18] observed that one important feature distinguishing the two concepts- avoidance of double taxation and relief against double taxation, lies in the matter that in the case of avoidance of double taxation, the assesse does not have to pay the tax first and then apply for relief in the form of refund, as he would be obliged to do under a provision for relief against double taxation. [19] The respective schemes embodying the two concepts differ in some degree from each other, and that needs to be borne in mind when statutory provisions are referred to and cases are cited on a point involving double taxation. [20]
History of Indo Mauritius Tax Treaty.
In 1982 a Double-tax avoidance treaty entered into between India and Mauritius grants Mauritius-based companies exemption from capital-gains tax and offers concessional rate of dividend tax. [21]
In 1992 with the progressive economic liberalisation programme introduced by the central government Foreign Institutional Investors were allowed to invest in Indian stock markets. Mauritius at the same time passes Offshore Business Activities Act to enable investors to register in Mauritius and get certificate of residence. [22]
In 1994 CBDT restates that Mauritius-based companies are not liable to pay capital-gains tax in India. [23]
In 1997 CBDT's Authority on Advance Rulings clarifies that the double-tax treaty isn't just a tax-avoidance tool, but serves to promote investment in India. [24]
In 2000 some Mauritius-based FIIs get CBDT notices doubting the proof of residence. In April, the CBDT withdraws the notices and clarifies that a letter from Mauritius Government is adequate proof of residence in that country. [25]
Use of the Indo-Mauritius Tax Avoidance Treaty.
The treaty's rationale was to promote the investment in India as forming a company in Mauritius reduces hassles of Indian regulatory & exchange control approvals; further Mauritius is a low-cost offshore centre where a firm takes just two weeks to be set up and secrecy is assured. This treaty also ties in with India's strategic needs in the Indian Ocean Region (IOR).
Due to the unique nature of the bilateral treaties between India and Mauritius in congruence with the domestic laws of the individual states Mauritius has set itself up as the first India focused tax haven.
A Tax haven can be defined as a place where generally tax payers receive income or own assets without paying taxes at all or by paying taxes at extremely low rates. [26] In other words, tax haven is a foreign country with tax legislation specially designed to attract the formation of branches and subsidiaries of the parent companies based in heavily taxed territorial nations. [27]
There may be one or several reasons or ways of tax saving, namely,
Absence of income-tax, wealth-tax, gift-tax and other direct taxes. [28]
Because of the special tax structure and system, it results in very low effective rate of tax. [29]
Because of the tax treaty between the two countries there may be much lighter burden of tax. [30]
Provision exists for maintaining secrecy of funds and activities of persons operating. [31]
Some special benefits available to Mauritius companies are as under-
(i) According to Double Taxation Avoidance Agreement entered into between Government of India and Government of Mauritius, the income of Mauritian companies earned from operations in India is given preferential treatment. In other words, there is free repatriation of profits and capital from Mauritius. [32]
(ii) The income earned by Mauritian companies by way of royalty is taxed at the rate of 15 per cent in comparison with the normal rate of tax which is 20 per cent at present. [33]
(iii) The income earned by way of fees for technical services is not taxed in India unless the Mauritian company has a permanent place of business established in India. [34]
(iv) The dividend income earned by Mauritian companies is being taxed at the rate of 5 per cent if the Mauritian company holds at least 10 per cent of total share capital of an Indian company. The Mauritian company will also be provided credit regarding the income-tax payable by the Indian company on the profits out of which the dividend is so paid by the Indian company. [35]
(v) The credit of tax paid in India will also be allowed to the Mauritian companies against the tax payable in Mauritius on that income, apart from it, the tax credit in Mauritius will also include the amount of tax which would have been paid in India but for several incentive provisions regarding economic development of India, thus allowing a substantial amount of tax credit to be availed of in Mauritius even if there is no income-tax payable in India at all. [36] However, in case, if such investments are made by the foreign investors directly in India, his income will be subjected to tax at higher rate.
These benefits would have been normally available only to the citizens of Mauritius. The national government of Mauritius however made it possible for companies from anywhere in the world to become resident by simply registering themselves. [37] Thus a Mauritian lawyer could go to the registrar of companies, register any foreign company, and that company could then trade in shares in India and send profits home without incurring any tax in India. [38] This is the basis of the huge capital flows through Mauritius. Thus Mauritius has become like the legendary Trojan horse which allows for the exploitation of a bilateral treaty by a third unrelated party. In the instant case this third party is a MNC financial institution who seeks to invest and reap the benefits of the Indian stock markets while escaping the tax liability imposed on such transaction domestically.
Over the past few years, more money has come through the Mauritius route to India than through direct investments from almost any other country. According to the latest publically available figures prior to the current financial meltdown in April-June 2006-07, a total of Rs. 4,165 crore came in through Mauritius to India - as against Rs. 1,105 crore from the US. [39] By the end of 2006-07 financial year, the money flowing in from Mauritius to India was as high as Rs 15,000 crore. In 2005-06, a total of Rs 11,441 crore came in through this route, more than double the Rs 5,141 crore in 2004-05, which in turn was almost double the Rs 2,609 crore that had come in in 2003-04. [40] Compare that with the relatively piddly Rs 2,210 crore that came in through the US in 2005-06. [41] Investment through Mauritius is over half the total FDI coming into India.
According to the tax officials there are two methods of utilising this tax treaty that is being currently practised. One is the system of round tripping which is employed by the Indian financial institutions or companies and second is the system of "treaty shopping" employed by foreign institutional investors.
Round Tripping:
The purpose of round tripping is to convert unaccounted or black money into legitimate wealth. This is done through a three step process:
The Indian entity inflates its exports. While the importer pays Rs. 10 he shows an outflow of Rs. 50. [42]
The monies are transferred to Mauritius by setting up a global business company (GBC). It costs $ 700 to set a GBC up and $ 5000 to maintain it yearly. The real ownership pattern of the GBC is only known to the management company (MC) that helps set up the GBC. The MCs are not in a position to verify the source of the funds as the money comes through the banking system that maintains confidentiality. [43]
The GBC then buys equity in the original Indian entity and the money routed through the Hawala channel is returned to Indian company. [44]
Treaty Shopping:
The purpose is to reduce total tax incidence on capital gains made in India.
Instead of directly investing in the Indian stock market an investor based in a third country sets up a GBC in Mauritius. [45]
A management company (MC) sets up the GBC and provides all administrative support. The GBC then sets up a FII sub account and invests in the Indian stock market thought this FII sub account. This costs $ 20000 to set up and $ 70000 a year to maintain. [46] If Rs. 100 is invested which appreciates to Rs. 150 then the foreign entity makes Rs 50 gain and repatriates it to Mauritius while paying no taxes.
An FII investing in India would have normally to pay the specified rate of short term capital gains tax on gains made by investing in listed and unlisted companies. But due to the Tax treaty the FII created GBC need not pay any tax in India. The money is sent back to the parent company. [47]
Supreme Court Opinion on Treaty Shopping
To clarify the situation and create a favourable environment for investment in India the CBDT issued a circular No. 682 dated 30.3.1994. [48] This circular was issued under the powers provided in section 90 of the IT act. It was clarified that capital gains of any resident of Mauritius by alienation of shares of an Indian company shall be taxable only in Mauritius according to Mauritius taxation laws and will not be liable to tax in India. Relying on this, a large number of Foreign Institutional Investors s (hereinafter referred to as "the FIIs"), which were resident in Mauritius, invested large amounts of capital in shares of Indian companies with expectations of making profits by sale of such shares without being subjected to tax in India.
Due to the increasing flows of investment from the Mauritius route a few show cause notices were issued to FIIs asking for reasons why they should not be taxed on their earnings. The basis on which the show-cause notice was issued was that the recipients of the show-cause notice were mostly 'shell companies' incorporated in Mauritius, operating through Mauritius, whose main purpose was investment of funds in India. [49] It was alleged that these companies were controlled and managed from countries other than India or Mauritius and as such they were not "residents" of Mauritius so as to derive the benefits of the DTAC. [50]
These show cause notices created panic in and resulted in withdrawal of funds from the domestic market. To settle the law in this matter and provide comfort to FIIs and other investors, the Finance Ministry issued a press note dated 4th April 2004. [51] This circular offered clarifications on two issues. One was the continuation of treaty benefits to FIIs and second was regarding the validity of residency certificates issued by the Mauritius authorities for the purpose of determining resident status of investment companies.
This circular was challenged before the Delhi High Court in a PIL filed by the lawyer Shiv Kant Jha. This was enumerated as follows Shiva Kant Jha v. Union of India (2002) 256 ITR 563 (Del). this case resulted in the Delhi HC passing an adverse judgement against the circular. The Delhi HC among other observations held that 'Treaty Shopping' is an illegal exploitation of law and such a loophole should not be allowed to be utilised to deny the tax liability of transactions. Due to the varied ramifications of this judgement the Indian government challenged the Delhi HC judgement was in the Indian Supreme Court in the case of Union of India v. Azadi Bachao Andolan(2003) 263 ITR 706 (SC).
The two judge bench of the Supreme Court in a long 59 page judgement completely overturned the Delhi HC stand on the circular. The SC upheld the circular along with quashing the challenges to relevant sections of the Income Tax Act while upholding the power of the parliament to delegate power to executive and most importantly holding that the Indo-Mauritius DTAC is not ultra-vires.
The Supreme Courts stand on Treaty Shopping:
The Supreme Court defined Treaty Shopping as follows:
"Treaty shopping is a graphic expression used to describe the act of a resident of a third country taking advantage of a fiscal treaty between two Contracting States." [52]
They further approvingly quoted the following observations of Lord McNair:
"That any necessary implementation by municipal law has been carried out, there is nothing to prevent the nationals of 'third States', in the absence of any express or implied provision to the contrary, from claiming the rights, or becoming subject to the obligations, created by a treaty; for instance, if an Anglo-American Convention provided that professors on the staff of the universities of each country were exempt from taxation in respect of fees earned for lecturing in the other country, and any necessary changes in the tax laws were made, that privilege could be claimed by, or on behalf of, professors of those universities who were the nationals of 'third States'." [53]
Supporting the continued practice of 'Treaty Shopping' it was argued by the appellants and accepted by the court that if a national of a third state was to be precluded from accessing the benefits of the bilateral 'Double Tax Avoidance Treaty' then there would have been exclusive words which barred the same. Reliance was placed on Article 24 of the Indo-US Treaty on Avoidance of Double Taxation which specifically provides the limitations subject to which the benefits under the Treaty can be availed of. One of the limitations is that more than 50% of the beneficial interest, or in the case of a company more than 50% of the number of shares of each class of the company, be owned directly or indirectly by one or more individual residents of one of the contracting States. [54]
This is in opposition to the Indo-Mauritius treaty where no such disabling clauses were incorporated. Further it was argued and accepted by the SC that equity is not a consideration in a fiscal statute. Either the statute applies proprio vigore or it does not. There is no question of applying a fiscal statute by intendment, if the expressed words do not apply.
The court while deciding on validity of Treaty Shopping posed itself a question:
"If the residents of State C qualify for a benefit under the treaty, can they be denied the benefit on some theoretical ground that 'treaty shopping' is unethical and illegal?"
The Supreme Court reading Oppenheim's International Law and on observations of Philip Baker claimed the refuge of the maxim 'Judicis est jus dicere, non-dare". The SC held that 'It is to decide what the law is, and apply it; not to make it.' [55]
The Supreme Court after going through the rival contentions has described its stand on treaty shopping in the following words:
"Many developed countries tolerate or encourage treaty shopping, even if it is unintended, improper or unjustified, for other non-tax reasons, unless it leads to a significant loss of tax revenues…….." [56]
Quoting Roy Rohtagi from his book on 'Basic International Taxation' the supreme court observed:
"In developing countries, treaty shopping is often regarded as a tax incentive to attract scarce foreign capital or technology. They are able to grant tax concessions exclusively to foreign investors over and above the domestic tax law provisions. In this respect, it does not differ much from other similar tax incentives given by them, such as tax holidays, grants. Developing countries need foreign investments, and the treaty shopping opportunities can be an additional factor to attract them." [57]
The court then recounted the successful use of tax havens to increase the flow of investments into various regions; for example Cyprus and Portugal for investment into European Union and Singapore for South-East Asia. The court then saw Mauritius as a conduit for investment into the Indian sub-continent and Southern Africa. It was noted that the in-flow of investments would have been much lower in India in the absence of a DTAC with Mauritius.
The court finally upheld the 'Treaty Shopping' supportive nature of the Indo-Mauritius Tax Treaty in the following words:
"Overall, countries need to take, and do take, a holistic view. The developing countries allow treaty shopping to encourage capital and technology inflows, which developed countries, are keen to provide to them. There are many principles in fiscal economy which, though at first blush might appear to be evil, are tolerated in a developing economy, in the interest of long term development. Deficit financing, for example, is one; treaty shopping, in our view, is another. Whether it should continue, and, if so, for how long, is a matter which is best left to the discretion of the executive as it is dependent upon several economic and political considerations. This Court cannot judge the legality of treaty shopping."
