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Double Taxation Avoidance Agreements

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Published: Mon, 5 Dec 2016

SYNOPSIS

Double Taxation Avoidance Agreements negotiated between the two countries are aimed at attenuation of double taxation. However in recent times it is observed that a person of third country shops into the treaty between two other countries by interposing a company in one of the contracting states derives benefits from the situation. This is referred to as ‘treaty shopping’. Some countries exploit these new opportunities by developing policies aimed primarily at diverting financial and other geographically mobile capital. These harmful tax competitions induce potential distortions in the patterns of investments and erode national tax bases of other countries. For these reasons and others, countries have looked for counter measures against treaty shopping. The United States is in the forefront of combating treaty shopping, in setting policies to prevent treaty shopping. The anti avoidance measures adopted by US are both on the level of the treaties by inserting specific anti abuse provisions and on the national law by incorporating provisions in statute. In many cases these anti avoidance doctrines have been successfully applied to transactions between a US tax payer and a related foreign company especially established in a tax haven.

The familiarity of India in dealing with treaty shopping is in embryonic phase. The economy of India was effectively opened up in early nineties which led to foreign direct investments in various sectors and also investments in Indian capital market by foreign institutional investors. Prior to that India has entered into tax treaties with several countries including developed and developing countries. But the tax agreement with Mauritius seems to be abused by corporate houses. This is evident from the fact that more than 50% of foreign direct investments to India are routed through Mauritius. It is also alleged that Mauritius-based front companies of foreign institutional investors evade paying taxes in India with the help of loopholes in the bilateral agreement on double taxation with Mauritius. Thus effective policy measures in both administrative and legislative fronts have to be embarked on to deal with new found problem of treaty shopping in India.

Introduction

Tax is an enforced contribution, extracted pursuant to sovereign authority of the state. The efforts of the subjects to escape taxation have been a feature of human society since first known system of taxation introduced in ancient Egypt. Over a period of time the society has witnessed abuse of intellectual ingenuity and sophisticated financial wizardry in evading taxes.

The tax policy was conceived and introduced in any country in a clearly separated national market having restricted international trade. Accordingly, taxation systems were introduced and developed over a period of time to deal with economic and social concerns of the country. At that time the international dimension of tax structure of a country was limited to the amount of tax imposed on foreign source income (income generated outside) of residents of the country and the domestic income of non-residents. The process of globalization of economy led to greater economic integration across the national borders and generated opportunities for economic growth, technology transfers, flow of capital and free trade. One of the conspicuous consequences of globalization as well as deregulation and liberalization is the mobility of capital (Daniel Yergin, 1998). Concurrently, the ‘mobility of capital’ has changed the basic relationship amongst domestic tax structure. The cross border financial flows have outpaced states capacities to control it. As a result the Government has less control over the economic outcome (Jeffery, 1997) (J.C.Sharman, 2006). The ability of Multi National Enterprises (MNEs in short) to adjust their scale of operation, character and location of their worldwide operations, had opened up new avenues by which companies can evade or avoid taxes. The recent studies indicate that taxes exert a strong influence on location decision of MNEs (Rosanne Altshuler, 2001). Some countries exploit these new opportunities by developing policies and acted as conduit of capital diversion (Viherkenttä, 1991). These unhealthy competitions induce potential distortions in the patterns of investments and erode national tax bases of other countries (OECD, 1998). We have noticed proliferations of tax havens, indulgence of multi nationals in transfer mispricing, cases of capital flight, mispriced financial transfers, round tripping and massive tax frauds.

The pattern of Foreign Direct Investments (FDI) in India subsequent to the adaptation of policy of economic liberalization may be examined to ascertain the activities of Multi National Corporations. In early nineties Foreign Direct Investments (FDI) are allowed in various sectors and also Overseas Corporate Bodies (OCBs) and Foreign Institutional Investors (FIIs) were allowed to participate in the capital market. According to figures available with the Department of Industrial Policy and Promotion, of the total $98 billion foreign direct investment (FDI) that has come into India since April 2000 (till August 2009), $43.14 billion was routed through the Mauritius[1].

Though India has a Double Taxation Avoidance Agreement with several developed and rich countries, it is Mauritius which is the most preferred route for FDI inflows. A closer scrutiny will reveal that tax exemptions have been a major factor for companies routing their investments into India through Mauritius. By routing the investments through Mauritius the effective tax rate comes to around 3% only against expected rate of 33%.

Further, it was also revealed that Mauritius-based foreign institutional investors (FII) are also major players in the Indian capital markets[2]. In spite of earning substantially in share transactions these FIIs neither have paid any taxes in India (due to India Mauritius tax convention) nor at Mauritius (no capital gains tax as per their domestic law). There are several such instances where it is found that the residents of the third states attempted to avail benefits of the bilateral tax treaty between India and Mauritius. There are also instances of misuse of other tax treaties in varying measures as well. As discussed earlier these schemes are designed to evade taxes which will ultimately result in erosion of tax base. This will also seriously affect the tax structure as there will be tendency to shift the tax burden from mobile to relatively immobile factors. Thus it is the time to take effective policy measures to counter such moves, as many more arrangements and agreements would be subject to atrocious misuse. This paper attempts to address the problem faced by India in the form of treaty shopping from the policy formulation perspectives.

When we think of formulation of any policy measures to contain these tax frauds we have to consider measures taken by other countries, which had faced the similar problem. Quite naturally development of policies and counter measures adopted by United States come upper most in our mind. The effects of the tax competition and abuse tax treaties otherwise known as treaty shopping may be viewed differently by two countries. Some countries viewed it differently as a policy instrument to stimulate new investment but others may view it as harmful as diversion of real investment and tax evasion (J.C.Sharman, 2006). We have chosen to study the response of United States as it is the leader in setting policies to prevent treaty shopping, not only in substantive treaty provisions, but also in domestic law. It is in the forefront of combating treaty shopping (Haug, 1996). Hence in this paper the United States experiences with abuse of tax treaties will be analyzed to explore administrative or legislative policies to contain the tax frauds associated with treaty abuse.

Background:

The independent sovereign status of each country gives it the right to tax the activities of a foreign enterprise if their business operations are relatable to its own jurisdiction. The US residents and/or citizens are subjected to US federal income tax on their world wide income, but non-resident persons[3] are subjected to US taxation on two categories of income such as

  • Certain fixed types of income originated from US e.g. interest, dividend, rents, annuities etc. collectively known as Fixed or Determinable, Annual or Periodical (FDAP) income[4]. The taxing rights on these incomes are mostly exercised by way of provisions of tax deducted at source (withholding of taxes) on payments made to foreign enterprises.
  • Income that is effectively connected to US trade or business[5]- When a foreign person engages in a trade or business in the United States, all income from sources within the United States connected with the conduct of that trade or business is considered to be Effectively Connected Income (ECI). This applies whether or not there is any connection between the income and the trade or business being carried out in the United States, during the tax year. The ECI is subjected to tax on a net basis at the applicable graduated tax rate.

But these charging provisions has resulted in double taxation of the same income with both the source country (the country e.g. in this case United States, where the income arises) and the home country (the country of residence of the enterprise) exercising their right to tax. In order to alleviate double taxation, countries have used a bilateral approach. This approach advocates implementation of tax treaties between countries that are making provisions for tax reliefs, foreign tax credits and withholding tax at a lesser rate etc. on incomes arising out of investments by residents of one contracting state in the other contracting state (Vogel, 1997). The United States has tax treaties with a number of foreign countries. Under these treaties, residents (not necessarily citizens) of foreign countries are taxed at a reduced rate, or are exempt from U.S. taxes on certain items of income they receive from sources within the United States. Consequently FDAP income which is otherwise subjected to a 30% withholding tax is entitled to reduction or elimination of withholding tax as per applicable income tax treaty[6]. Under these same treaties, residents or citizens of the United States are taxed at a reduced rate or are exempt from foreign taxes, on certain items of income they receive from sources within foreign countries. Some of these tax treaties of the US are generally in the lines of model convention of OECD.

The process of globalization of economy led to greater economic integration across national borders and generated opportunities for investment across the border. Further, only few countries have prohibited the formation of companies and legal entities by persons who are not residents of the same, for the purpose of carrying business. Considering the factors such as

  • the freedom to invest in a foreign country,
  • the absence of restrictions to the formations of companies by foreign investors,
  • taxes paid being one of the important cost factor and
  • the ability of Multi National Enterprises (MNEs in short) to adjust their scale of operation, character and location of their worldwide operations;

skillful tax dodgers designed ways to evade tax. Since there are no uniform tax treaties which every country have adopted vis-à-vis its peers, the experts have investigated into how the investor might evade tax by deriving benefits from the differences in approach and contents of several tax conventions which countries have concluded. The tax evasion pattern emanated from abuse of tax treaties can be categorized into four different studies as was classified by OECD. These are

  • tax havens and related issues,
  • double taxation conventions and the use of base companies
  • double taxation conventions and the use of conduit companies and
  • taxation and the abuse of secrecy clause (OECD, 1987).

In the present paper we will limit our discussion to use of conduit companies and double taxation conventions, which is popularly referred as ‘treaty shopping’.

Treaty Shopping

In the present day market economy everything has turned into merchandise. Shockingly it covers a bilateral tax treaty, which is otherwise a good faith arrangement for mutual benefit. Some contracting states by announcing their readiness to sell the benefits of a tax treaty under a well contrived opaque system have promoted a corrupt system. It is a dishonest sale of benefits to dishonest purchasers (MNCs) in a dishonest market at the cost of society. This is known as “Treaty Shopping”. The expression ‘treaty shopping’ refers to an arrangement where a resident of a third country seeks to obtain the benefit of a double tax agreement between two other countries by interposing a company or other entity in one of them. The term is of American origin. It is similar to the term ‘forum shopping’ that is used in US civil procedure, which describes a behaviour by which a party in a court case tries to ‘shop’ into jurisdiction where he expects a more favourable decision to be rendered (Wurm H. B., 1997).

Treaty Shopping Structure

There are several references where the modus operandi adopted in treaty shoppings are explained. In the report on ‘Tax Treaty Legislation in the 110th Congress: Explanation and Economic Analysis'[7], treaty shopping is described as situation where a firm gets around the absence of a treaty by routing its U.S. income through intermediate subsidiary corporations located in third countries where lower or non-existent withholding taxes apply. As a prelude to explore anti avoidance policy measures it is necessary to analyse treaty shopping structures for better understanding.

Even though the rate of withholding on US source payments of FDAP income to a foreign person is 30 percent, most of the treaties concluded with US reduce or eliminate such withholding tax on payments. Even though many treaties eliminate the 30% withholding tax, all investors are not residents of the abovementioned treaty jurisdiction. A simple strategy to eliminate the tax is available by having the non-treaty resident invest in the US through a company floated in jurisdiction whose treaty with US provides for a non deduction of tax.

A resident of Country A intends to invest in United States (country C) and to derive income as interest or dividend etc. But Country A has not concluded any treaty with US (e.g. Bermuda) or alternatively its treaty provides less benefits (e.g. Philipines). But Country B (for example Hungary) has concluded a tax treaty with United States. The treaty entitles residents of B including companies incorporated under the laws of state B (Hungary) to treaty benefits with regard to income derived from United States[8]. The dividend paid from US to Hungarian corporation is subjected to 5% withholding tax. Further, Country A (Bermuda) has a treaty with country B which provides for benefits on income derived from country B or grants relief on such income under domestic law. The dividend received in Hungary is completely exempted from Hungarian corporate tax. Under these circumstances a resident of country A sets up a company in B. This company is granted treaty benefits with respect to income derived from US and distributes its profit to the resident of country A. A dividend paid out of Hungary is exempted from withholding tax. Thus the resident of Bermuda (A) is able to reduce the overall tax burden levied on dividend income from US by interposing a Hungarian corporation ( B ) (Rubinger, May 2007).

There are several complex treaty shopping structures with insertion of stepping stone conduit companies (OECD, 1987). The layering of companies interposed to make the investigations difficult and to conceal the original beneficiaries. However from policy perspective we can simplify the structure by grouping the stakeholders into three groups.

  • Company B incorporated in country B, is the intermediary company interposed and country B has tax treaty with country C.
  • Country C – where the income is originated
  • Company A resident of country A is the beneficiary

Policy Initiatives

As mentioned earlier the United States is in the forefront of combating treaty shopping, in setting policies to prevent treaty shopping. Periodically it is extensively discussed in US congress and provisions are incorporated and also amended, not only in substantive treaty provisions, but also in domestic law. The anti avoidance measures adopted by US are both on the level of the treaties by inserting specific anti abuse provisions and on the national law by incorporating provisions in statute.

The existence of “conduit companies” is perceived as cause of the problem. Thus attacking conduit companies and invoking judicial doctrines to establish the fraud is one of the approaches promoted. The other approach advocated in US is to apply some of those treaty provisions which in some way or other produce the side effect of preventing certain treaty shopping provisions or to renegotiate tax conventions with those countries where interposed companies are often established. The third approach implemented to combat treaty shopping is at the level of national tax. They incorporate provisions which are aimed at setting aside those transactions which are considered as abusive or contrary to the purposes and intentions of tax laws (Infanti., 2006).

Anti-avoidance measures basing upon judicial doctrines –

One of the approaches adopted in US to contain treaty shopping, is to treat the conduit company (intermediary company B) as sham or the transactions involving company B as fictitious. While interpreting tax treaties various judicial doctrines e.g. business purpose, substance over form and step transaction are relied upon. Such anti avoidance approach routed from the Anglo-Saxon judicial pronouncements where the court favor substance over form i.e. they view the overall effect rather than the individual transactions or legal arrangements through colorable devices that are designed only for tax avoidance purposes (Wurm F. J., 1988). The transactions are ignored if the transaction is fictitious and lacking any business purpose or if it entered into solely for the purpose of evading taxes or if the interposed company in substance merely serves as conduit for the person or company holding its shares.

The development of the doctrine of fiscal nullity and piercing of corporate veil in UK by the courts are the key factors of this approach. It is often said that the taxpayers are free to arrange their business affairs which are more beneficial to them, that a particular action has been taken for lower incidence of tax cannot deprive the tax payers the tax benefits to which they are otherwise entitled under the law[9]. This principle is famous as Westminster doctrine. In significant departure to its earlier observation (Westminster doctrine) in one of the landmark judgements[10] which subsequently became famous as Ramsay Doctrine, the UK courts have indicated that, where a series of transactions exist and which, when viewed collectively, constitute a scheme that has no purpose apart from the avoidance of tax, then the arrangement is regarded as nullity for tax purposes.

A classic pattern of treaty shopping is illustrated in Aiken Industries, Inc. v. Commissioner[11]. An US corporation MPI through its holding company Aiken borrowed funds amounting to $2.25 million from a related corporation ECL, a Bahamian corporation. The interest paid by Aiken to ECL is subjected to withholding tax of 30 percent. But a back-to-back loan arrangement was designed with ECL giving the MPI notes of $2.25 m worth to Industries, its Honduran subsidiary. The Honduran Corporation then claimed an exemption from US federal income tax under US-Honduras treaty with respect to the interest payments received from the US Corporation (Article IX of US-Honduran did exempt US source interest received by the Honduran Corporation from US withholding tax).

In this case US court had decided whether interest paid as a part of back to back arrangement between related entities was eligible for tax treaty benefits. The Tax Court emphasized upon the term “received by” in the interest payment article of treaty and held that the company has to have complete dominion and control over the interest receipt to eligible for treaty benefits. The court ruled that the related entity did not retain the necessary dominion and control over the funds to qualify for treaty benefits as it paid matching interest payments to another entity resident in a non-treaty country. On these facts the Court inferred that the transaction is lacking any business purpose.

Thus it can be held that the transactions can be ignored if the transaction is lacking any business purpose or if it entered into solely for the purpose of evading taxes or if the interposed company in substance merely serves as conduit for the person or company holding its shares.

Thus the payment would be treated as paid directly to company A by US company C and subject to higher withholding tax. But tax payers can defeat the above arguments by showing that i. Company B meets all the statutory requirements of a company ii. Company B actually performs business activity or serves a business function as holding company[12] iii. Company B maintains separate bank accounts and account records[13] etc.

Doctrine of step transactions to disregard intermediate entries was adopted in the Del Commercial Properties case[14]. In this case by disregarding the involvement of the intermediate companies, the courts re-characterized the financing arrangements as loan directly between Canadian Corporation and the US Corporation. Thus instead of complete exemption due to US Netherlands treaty withholding tax of 15% applied as per US-Canada tax treaty.

However application of judicial doctrines to prevent abuse has limitations. The tax payers can defeat the judicial observations or obiter dictum by restructuring the transactions. Further, it was judicially held that if a state law conflicts with the provisions of a tax treaty then the treaty provisions will prevail over the state law[15] (Infanti., 2006). Thus taking shelter of judicial doctrines to counter treaty provisions may not work always.

Lessons for India: Abovementioned measures are case specific and may not be applicable in Indian scenario. The Supreme Court of India had an occasion to look into ‘treaty shopping’ issue when a public interest litigation was filed before it. It was argued that the offshore companies have been incorporated under the laws of Mauritius only as shell companies and has no business activities. These are floated and incorporated only with the motive of taking undue advantage of the tax treaty between India and Mauritius. Thus the transactions are alleged to be illegal and amount to a fraud on the treaty. However Supreme Court declined to intervene in this case. The reason for non-intervention to reject the evils of Treaty Shopping is the Supreme Court’s perception of judicial role stated with reference to a Latin maxim “judicis est jus dicere, non dare” – Court is to decide what the law is, and apply it; not to make it[16].

Treaty Provisions

In this approach adapted by US, various provisions have been incorporated into tax treaties itself to combat treaty shopping. The basic guideline is that the use or application of a tax treaty that is contrary to the intentions of the treaty partners, constitute a misuse of the treaty (Weeghel, 1998). The commentary to article 1 of the OECD model convention provides that states are not required to provide the benefits under a tax treaty if the arrangements entered into by the treaty subject concerned constitute an abuse of the provisions of treaty (OECD, 1998)[17]. The OECD recommended that an important solution to problem caused by conduit companies is the insertion of specific clauses dealing with this special situation (OECD, 1987). These are 1. The Abstinence Approach -The US like many other countries responds to this challenge by abstaining from concluding treaties with the countries which they considered to be tax havens[18] (e.g. Panama, Liechtenstein, Monaco and the Channel Island). 2. The Exclusion Principle – In this approach a tax treaty will be concluded with another state however special low taxed companies resident in other state are excluded from the treaty benefits. 3. The ‘look through’ approach – to allow benefits only to the extent that it is not owned directly or through one or more companies, wherever resident by persons who are not residents of the contracting state. 4. The ‘subject to tax’ approach – treaty benefits granted only if the respective income is subject to tax in the state of residence. 5. The Channel approach – improper use of conduit arrangement and 6. Bona fide provisions.

All modern income tax treaties concluded or renegotiated by the United States contain anti-avoidance provisions in the treaty itself. These are often called anti-treaty shopping rules.

  • Beneficial ownership clauses: Tax treaties concluded by US after 1976 have been providing that the benefits of treaty relief with respect to dividends, interest and royalties incomes under the treaty are restricted to only the beneficial owners of such income[19]. Inclusion of the concept of the ‘beneficial ownership’, enables tax authorities to deny treaty relief, where a company, resident in a country, is interposed into a group or financing structure to take advantage of treaty benefits and that company merely acts as a conduit, i.e. it receives and forwards dividends without beneficially becoming the owner of them. The term beneficial owner has also recently been expressed in the Draft Contents of the 2002 Update to the Model Treaty in light of the prevention of fiscal evasion and avoidance[20].
  • Limitations of benefits clauses (LOB): The US response to modify treaties to arrest treaty shopping has evolved in different stages. The American Law institute identifies various approaches such as special measures approach, the principal purpose approach and the comprehensive approach (American Law Institute, 1991). In special measures approach the tax law of the contracting state is examined by US. This is to ascertain features of the domestic tax law of other state which creates a potential for residents of a 3rd country to float a legal entity in contracting state and using it to receive income from US. Further such income is not subject to taxation in 3rd country. A treaty provision then created which excludes that entity from benefits of the treaty. An example of this approach is art I of the 1963 protocol to US Netherland Antilles treaty.

Under the principal purpose approach the treaty language focuses on the motive underlying the contemplated treaty application.

Under the comprehensive approach it has become an established part of US tax treaty policy to include comprehensive LOB provisions[21] when it negotiates or renegotiates its tax treaties. These provisions prescribes disallowances of some or all of the treaty benefits to persons who do not satisfy at least one of several tests designed to establish linkage between the resident of a contracting state requesting the treaty benefits and the same contracting state. This is comparable with look through approach and also similar to channel approach also. The tests to determine the benefits are as follows.

  • 75% Ownership Test: Under this test unless more than 75% of the beneficial interest in a corporation of a contracting state receiving divide income is owned by persons who are residents of that state or residents of US or companies whose shares are regularly traded in a recognised stock exchange in the contracting state then the benefits of relief will not apply[22].
  • Pass through Test: Under this test if more than 50% of the gross income derived by intermediate company B from US company is used to make payments of interest to persons that are not are residents of that state or residents of US or companies whose shares are regularly traded in a recognised stock exchange in the contracting state then the benefits of relief will not apply.
  • Principal Purpose Test: If it can be established that the establishment, acquisition and maintenance of such person and the conduct of its operations did not have as a principal purpose the purpose of obtaining benefits under the Convention then it can still qualify for reduced withholding rates[23]. Thus in this case the Company B must show that some appreciable advantage / disadvantage flows from interposing company B apart from tax benefit.
  • Investment or Holding Company Test: It was designed to deny favourable withholding rates on income received by an investment or holding company whose income through special legislation was either exempt from tax or subject to reduced rate of tax in its country of residence[24] [Article 15 of US-Luxembourg treaty 1962]. At present most of the treaties of US contain typical ‘investment or holding Company’ provision restricting the benefits to US source payments of dividend, interest royalties and capital gains if by reason of special provisions these income are subject to tax at a lower rate that is generally imposed and 25% of sovereign company is not owned by US citizens [US-Norway treaty 1971[25], US-Trinidad and Tobago Treaty[26]].

Lessons for India: As on date India has concluded income tax treaties with 84 countries already. Most of these agreements do not have anti-avoidance articles as discussed above. The reason being that it was a closed economy and foreign direct investments were permitted only in few sectors earlier. Even the FIIs were not allowed to operate in Indian capital market previously. But at present we have to renegotiate these treaties to include anti avoidance provisions to counter treaty shopping. These anti-avoidance provisions in the treaty have also limitations. There are advanced techniques of improper use of tax treaties which could not be covered by the subject to tax and exclusion approach. It will also exclude from the benefits concerns enjoying tax privilege granted to charitable trusts. The look through approach will require bona fide amplification. This will led to rules which are difficult to administer. Some of these anti avoidance provisions will depend on standards of the contracting state which have developed judicial doctrines to counter unjustifiable tax advantages.

Legislative Measures

United States is one of the few countries to incorporate an anti abuse provision specifically directed against treaty shopping. However the US tax legal system contains a number of general anti avoidance rules (GAAR) that are potentially applicable to international transactions. These provisions include the intercompany pricing rules in section 482 of the code to prevent shifting of income among related taxpayers, the accumulated earnings tax[27], the provision with respect to foreign investment companies[28] and foreign trusts[29] and the rules regarding property transfers abroad[30].

But consequent to passage of Tax Reforms Act of 1986, specific anti avoidance provisions were incorporated in US tax law to deal with treaty shopping activities. Section 884 inserted in the code, imposes a branch profits tax and branch level interest tax on foreign corporation. The branch profits tax is levied on US branches of a corporation resident in a foreign country with which US has concluded a tax


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