The Concept of “Residence”
The Institute of Chartered Accountants of India
The Concept of "Residence"
in International Taxation
26th April, 2013.
CA Rashmin Sanghvi.
CA Naresh Ajwani.
CA Rutvik Sanghvi.
This paper formed the background for Webcast by the Authors on the same subject on 26th April 2013. The webcast can be viewed at https://icaitv.com/?p=2085
1. International Tax is not a complicated subject. In fact, for an Indian CA, no financial/commercial law in the world is beyond his comprehension. Still we sometimes find it difficult to practice in International Taxation. Some of the reasons may be:
(i) During our Articleship, we may not have had good exposure on International Taxation.
(ii) In our syllabus for CA Examinations, very little is covered on International Taxation.
(iii) The concepts relevant for International Taxation have not been explained to us. They are quite different from the concepts that we use in traditional taxation.
Let us consider those issues in this session.
2. International Tax is not an independent practice by itself. One has to be a master of the Indian Income-tax. Then only he can be a good practitioner on International Tax. Within Indian tax sections 4, 5, 6 and 9; 90 & 91, 195 & 201 are normally not used in our domestic tax practice. We have to again refresh our knowledge of these sections.
3. Indian Income-Tax involves only the Government of India and the assessee. If there is a difference of opinion, either party can appeal to the appropriate Indian Court of Law. International Tax involves two or more countries and their assesses. And if there is a difference of opinion between the two Governments, to which court do they appeal! Well, Governments dont appeal. The assessee suffers.
4. International Tax practice involves FEMA, Vienna Convention, Double Tax Avoidance Agreement (DTA), Transfer Pricing and E-Commerce. These issues are not relevant for domestic tax practice. (Now of course Transfer Pricing is applicable in domestic tax practice also.) Hence one needs to study these provisions for International Tax Practice.
Not a big deal. All these provisions together will be less than 10% of the syllabus that we study for final C.A. examination. We have studied more. This we can study.
5. There is a myth that International Tax is involved only in big matters like foreign collaborations. And only big firms can practise it. Far from it. Today so many individuals go abroad for employment or own business. Many NRIs return to India. So many businessmen make payments to non-residents where tax has to be deducted at source. Today residential houses are available in many countries at prices lower than the prices prevalent in Bangalore.
All students whether from Manipur, Rajkot or Trivendrum give the same CA exams. All CAs are equally competent to do International tax practice. Only issues that separate CAs from metro cities is: they have more exposure and they can attend more conferences on international taxation. This webcast is a serious attempt to reduce this difference between opportunities to study.
International Tax Practice is not reserved only for the Big CAs. Any CA/ advocate can practise it. And needs to practise.
6. In this presentation, let us discuss the concept of Residence from different angles:
Residence under Indian Income-tax Act.
Residence under the Double Tax Avoidance Treaty (DTA).
Relationship between the two concepts under domestic law and under DTA.
Tax controversies under DTA arising out of Residence.
These different aspects have been discussed at length in this paper. They are not necessarily in the same order.
Note: Participants for this presentation would not have read this paper before our presentation. However, this will serve as a reference material after the presentation is over.
Note: In this presentation we are referring to the Indian Income-tax Act. As far as International taxation principles & issues are concerned, the same are applicable to almost all countries.
7. Indian Direct Tax System Indian Tax System is one of the BEST in the world - from the assessees point of view.
7.1 It is good for the wealthy. We have no Estate Duty, no Gift tax; (except as an anti-avoidance measure - S. 56). Almost negligible wealth-tax; and Reasonable rates of Income-tax. In the U.S., individuals in the highest tax brackets want to give up U.S. citizenship to avoid estate duty that can reach 40%. They cannot give up.
7.2 With a reasonable rate structure, a large part of tax planning has become redundant on Cost Benefit analysis. This has simplified life for the businessman.
7.3 Our rate structure is good for the poor. Our average per capita income per year is more than Rs. 80,000 at current prices (Economic Survey Feb. 2013). As against this, income upto Rs. 2,00,000 per year is exempt from tax (assessment Year 2013-14). 2.5 times the average income. Many nations around the world have lowest tax brackets starting at or below the average per capita income.
7.4 It is good for the middle class people. Upto an income of Rs. 5,00,000 per year the tax payable is only Rs. 26,000 or 5.2%. This calculation is without considering Chapter VIA reliefs.
When we know that we are better than other countries, we deal international tax with confidence.
Concepts of International Taxation.
Considered in this Presentation:
9.1 Structure of Treaty.
9.2 Residence. For Individuals.
For companies. Registered Office.
9.3 Residence under Income-tax Act distinguished from Residence under the Treaty.
9.4 Nexus or Connecting Factors: Jurisdiction.
9.5 Elimination of Double Tax.
Not Considered in this Presentation:
9.6 Tax Base.
How Tax havens erode tax base.
9.7 Source of Income Concept.
9.8 Categorisation of Income.
9.9 Permanent Establishment.
9.10 Allocation of taxing rights.
9.11 Elimination of Double Tax.
9.12 Vienna Convention
9.13 OECD Model & Commentary.
9.14 UN Model & Commentary.
9.15 Indian Competent Authoritys reservations on both commentaries.
There will be different sessions in this series of webcast by the ICAI covering different concepts.
1. Structure of DTA:
To understand the real significance of the Concept of Residence, it is necessary to understand the structure of Double Tax Avoidance Treaty. Very briefly, in this paragraph, we cover the structure of the treaty.
Article 1 of the Treaty specifies: who is entitled to the treaty benefit . Any person wanting to claim the benefit of a DTA must be a resident of any one or both of the countries that have signed the treaty. Hence the concept of residence becomes important to understand right from the beginning.
Article 2 provides the list of taxes that are covered under the treaty. Only the Income-tax & wealth are covered. Municipal Taxes, Indirect taxes etc. are not covered. India does not impose Estate Duty. Many countries around the world do impose estate duty. Wherever estate duty is to be covered, a separate treaty is signed by the Governments.
Articles 3 to 5 provide for different Definitions . Article 4 provides for the Definition of Resident. Articles 6 to 22 provide for Categorisation of Income. Article 23 provides for Elimination of Double Taxation. Articles 24 to 31 cover other important issues.
Note: The article numbers given above are as per OECD Model Treaty. Different models and different treaties may have some variations in the numbers. Broadly the numbers remain the same.
How does a country get jurisdiction to levy Income-tax? When we practice the domestic law for regular clients resident in India, we never examine the issue of jurisdiction. All Indian residents are liable to tax in India on their global income. Hence when an Indian resident earns any income - whether from within India or outside India; we take it for granted that the assessee is liable to tax.
The moment there is a cross border income, the issue of jurisdiction arises. It may be interesting to note that almost 40% of the tax litigation is on the concept of jurisdiction to tax, another 40% of the litigation is on the concept of categorisation of income. Jurisdiction to tax is determined by two factors:
(i) Residence of the Assessee; and
(ii) Source of Income.
In international taxation these factors are referred to as Connecting Factors or Nexus .
It is an internationally accepted principle that when an assessee is resident of a country, the Government of that country has the jurisdiction to tax the global income of that assessee. Connecting factor of Residence is applied to the assessee.
It is also accepted that if the income is Sourced in a country, then the Government of that country has jurisdiction to tax that income. Connecting factor of Source is applied to the income.
These principles of jurisdiction may be stated in different manners: When a person is resident of India and has his income sourced in India, without any doubt the income is taxable in India. When the assessee is a non-resident of India, and the income is sourced outside India, then the income is certainly not taxable in India. India has no jurisdiction to tax such income. This issue was the bone of contention in Vodafone case.
When a non-resident of India has income sourced in India, then Indian Government has the jurisdiction to levy full tax on the income sourced in India. However, wherever India has signed a Double Tax Avoidance Agreement (DTA) with the Country of Residence (COR) of the assessee, India may levy a lower tax than the normal tax. .What rate to levy will depend upon the category of income Articles 6 to 22.
When an Indian resident earns income sourced outside India, then the Country of Source of Income (COS) may levy lower than normal tax. India as the COR will levy full tax. And from the Indian full tax, India will give credit for the taxes paid abroad. This is how the Governments try to eliminate double taxation. And this is how the two concepts of Residence and Source become important.
This may be illustrated as under: Mr. Patel is an Indian resident. He earns Rs. 10,000 as interest income from UK. We assume that the rate of Income-tax in India is 30% and in UK also it is 30%.
Mr. Patels interest income in UK:
UK will deduct tax @ source under Article 12 of the
Net receipt in India
Indian tax on total income
Less: Credit for UK tax
Balance tax payable in India
Total tax suffered by Mr. Patel remains Rs. 3,000. Double tax is avoided by the Credit mechanism .
3. Residence: Article 4 of the DTA provides that for the purposes of DTA, the assessee will be considered to be resident of a country, if he is resident of that country as per the domestic Income-tax Act. Hence let us first consider Indian domestic law. Language of Article 4 is complex. It tries to use a common language that can be applied to the tax laws of several countries. We are trying to explain the reason of complexity. Then simplify & explain the provision:
3.1 Residence under Domestic Law: How do we determine the residential status of an assessee? In India, section 6 of the Income-tax Act provides for the definition of residential status of different categories of persons. Similarly, every Government will have its own legislation providing for its own definition of residential status. There can be very wide differences amongst different definitions. For example, consider an individual. Section 6 of the Indian Income-tax Act, provides for physical stay of the individual. If the individual is physically present in India for the specified number of days, then he is an Indian resident. If he is present less than the specified number of days, then he is a non-resident of India. Very simple definition.
However, the US Internal Revenue Code (IRC) provides as under: Every citizen of USA is tax resident of USA. Even a Green Card holder is a tax resident of USA. This would be true even if the assessee has left USA for a job/ business abroad for many years.
In United Kingdom (UK), the concept of residential status is highly complex. Consider Mr. U, a resident & citizen of UK. He goes abroad for job and stays abroad for five years. On vacation he visits his parents in UK. He continues to own a home, bank account and investments in UK. These may be considered adequate connections to decide that he continues to be a Resident of UK.
Note: When we discuss tax laws of other countries, we would like to clarify that we do not have expert knowledge of any country other than India. These issues are raised only to highlight an issue.
The issue relevant here is that different countries have different definitions of residential status. This has several consequences.
When India signs a treaty with say, UK; how would the treaty define the residential status? And India has signed treaties with almost 80 countries. If all the countries have different definitions, how would OECD or United Nations (U.N.) make a draft definition in their model treaties?
The best solution adopted in the treaties is: not to define residential status in the treaty. The treaties refer to the domestic legislation. In other words, the residential status will be determined by the domestic Income-tax Act.
There is a further complication. Some laws may not even refer to the term Resident . The law may simply say that the citizen of the country will be liable to tax in the country. Now, if the treaty refers to the resident and the domestic law does not even talk of resident, then the reference will be incomplete.
To resolve these difficulties, article 4 of the treaty simply provides as under: If a person is liable to tax in the country, then he is resident of that country. In trying to use a common language under DTA which can cover different legislative systems of different countries; the DTA language has become complex.
So far we have seen three issues under Article 4: if the person is liable to tax qua the connecting factor of residence, as per the domestic legislation, then he will be considered resident for the purposes of the treaty. We have three concepts: (i) Liability to tax, (ii) A liability to tax arising out of residential status and (iii) This liability should be as per the domestic legislation.
As we have seen above in the classical system of taxation, countries also assume jurisdiction to tax when the income is sourced in their countries. Even if the assessee may be a non-resident of India. For example, Mr. NR may be citizen and resident of USA. However, he earns interest income from India. This interest income is taxable in India qua the nexus of source of income and not qua the residential status. Mr. NR will not be held to be a resident of India just because he is liable to tax on income sourced in India.
In other words, if a person is liable to tax in a country because he is a resident, or a citizen or a domicile of that country - then only for the purposes of the treaty he will be considered to be a resident of that country. If his liability to tax arises only because his income is sourced in that country, he will not be considered resident of that country for the purposes of treaty.
This clarification may appear to be simple and evident. However, many people have been confused. Consider two illustrations:
(i) In M. A. Rafiks case, (213 ITR 317 AAR) Honourable Authority for Advance Ruling held that: Mr. Rafik had income sourced in India. He was liable to tax in India. Hence he was Resident of India. With respect, we submit that this decision is incorrect. Issue was, whether Mr. Rafik is a resident of UAE or not. Just because he was liable to tax in India on Indian sourced income, he cannot be held to be Resident of India.
(ii) Honourable Supreme Court held in the Chettiar case (CIT V. P.V.A.L. Kulandagan Chettiar 267 ITR 654) that since the assessee had income taxable in Malaysia, he became resident of Malaysia. With respect, this conclusion by the Honourable Supreme Court is incorrect. We have given a detailed analysis of the decision on our website under the title Jurisdiction to Tax .
For ready reference the text is provided below. OECD model treaty Article 4(1):
1. For the purposes of this Convention, the term "resident of a Contracting State" means any person who, under the laws of that State, is liable to tax therein by reason of his domicile, residence, place of management or any other criterion of a similar nature, and also includes that State and any political subdivision or local authority thereof. This term, however, does not include any person who is liable to tax in that State in respect only of income from sources in that State or capital situated therein.
Analysis: For a better understanding, the definition is broken up into several clauses below.
1. For the purposes of this Convention, the term "resident of a Contracting State" means
2. any person who,
3. under the laws of that State,
4. is liable to tax therein 5. by reason of his domicile, residence, place of management or any other criterion of a similar nature,
6. and also includes that State and any political subdivision or local authority thereof.
7. This term, however, does not include any person who is liable to tax in that State in respect only of income from sources in that State or capital situated therein.
Rules of Good writing: Now the issue is: For defining a Resident (phrase 1 above), the treaty uses the word Residence (phrase 5 above). This raises the question: Is this something like a circular calculation in an excel sheet! Such circular calculations are not workable. It is a rule of good English writing that: When you are defining a word, you cannot use the same word in the definition .
Real fact is, the definition is not using the same word twice. The word Resident in the first phrase refers to Resident as per the DTA. And the word Residence in the fifth phrase refers to the residence under ITA. Both are different. For defining DTA residence, OECD says, one has to be resident under the domestic legislation. Then only he can claim DTA benefits.
Now we examine individual phrases in detail. These are not in the same serial order as given in para 3.2 above.
4.1 The assessee has to be Liable to Tax to be considered a Resident under ITA. What is the meaning of a person being liable to tax ?
Does it mean he should be paying taxes in the country? What if the person is taxable, but his income is exempt?
What if the person is taxable, but due to losses, he is not paying taxes? Does it include potential tax liability?
If a non-resident of India is taxable due to source of income in India, does he become an Indian resident?
These issues have been a matter of debate in the Indian Courts and Authority for Advance Ruling. To discuss the entire issue will require another paper. Here a gist of issues and court decisions has been given.
Consider two illustrations: (i) An Indian resident (present in India for more than 182 days) has income below Rs. 2,00,000. (ii) Another Indian resident as per ITA has income of Rs. 5,00,000. However, entire income is from agricultural activities and hence exempt under section 10 of the ITA. Both are Residents under the ITA. However, under the DTA, will they be treated as Residents of India? They are not liable to pay any tax in India.
Assume that they have some foreign income, will they get the benefit of DTA between India & the COS?
This query itself is based on a misunderstanding. Both these persons are liable to tax in India- if they had taxable income. The fact that - they do not have taxable income results into their Nil liability to tax. As we have seen earlier, there are two pillars of Income-tax: Assessee and Income . Only when both factors are covered within the ITA, there will be a tax liability. If a person has no income, it does not mean that for the purposes of DTA - article 4, he is not liable to tax in India. If such a person has a foreign income, he should get the DTA benefit.
Same issue repeated in different words: If the income is below taxable limits, or if it is exempt from tax, it does not mean that the person is not resident of India. He is liable to tax if he has a taxable income. Thus, if the farmer also has other business income or investment incomes, he will be liable to pay tax in India. Hence for treaty purposes, he will be considered to be a Resident of India. A more appropriate term may be Subject to tax . However, since treaties use the term Liable to tax , we use that term only.
Such instances can be many. Consider a person who was employed abroad. He had his savings & investments abroad. He retired & returned to India leaving his investments abroad. His income in India would be small. He may not be liable to pay any tax in India. But he will get DTA benefit.
4.2.1 Technically: In Dubai, the Government collects Income tax only from foreign banks & oil companies. The Income-tax decree is not applied to all other persons. Hence other residents of Dubai are not liable to tax in Dubai. Hence they are not residents of Dubai. Hence they are not entitled to DTA relief.
On this issue, there has been considerable controversy. During the period of liberalisation from the year 1992 to 1995, Government of India signed several treaties with tax havens like UAE, Cyprus, Malta, etc. India signed treaty with UAE with a specific purpose of encouraging NRIs in UAE for investing in India. Income-tax department in some cases, refused to give the DTA benefit to UAE NRIs on the grounds that: (i) They were not liable to tax in UAE. (ii) Hence they cannot be considered to be residents of UAE. (iii) Hence they are not entitled to treaty benefits. There were conflicting decisions on this issue.
4.2.2 In Cyril Pereiras Advance Ruling (239 ITR 650), the Authority elaborated on the issue of liable to tax in the matter of India-UAE DTA. The Authority held that there was no Income-tax Act in Dubai applicable to individuals. Only certain kinds of companies were paying taxes. Therefore as there was no double tax, there was no question of application of DTA.
This principle has been followed in Abdul Razak Memans Advance Ruling (276 ITR 306)
4.2.3 Potential Liability:
In the Tribunal decision in the case of Green Emirate Shipping and Travels (286 ITR 60) it has been held that the India UAE DTA will apply.
The assessees submission was that while during the previous year the assessee was not liable to pay tax, the Dubai Government could in future impose tax liability. Since the assessee was potentially liable to tax, it was entitled to DTA benefit. Tribunal accepted the principle of Potential Liability & held that the assessee was entitled to DTA relief.
In our humble submission, with respect, this decision is incorrect. It is a settled principle of law under Income-tax Act that: Income-tax applies qua a previous year. What happened before the previous year and what may happen after the previous year will not affect the tax liability during the previous year. (Carry forward of loss is an exception, a legitimate relief provided under the law.) Today the Dubai Government does not impose taxes. Hence today the assessee is not a treaty resident of UAE. Today the assessee cannot get DTA relief. Tomorrow, if the Dubai Government imposes tax liability, the assessee may be become tax resident, DTA resident & hence may be entitled to DTA relief. That is tomorrow. Not today.
4.2.4 Municipal Tax in Dubai: Some people in Dubai have raised an issue as under. While we have no Income-tax, we pay considerable Municipal tax on rent, on motor car, etc. Why we should be denied treaty benefits?
The simple answer to this query is: Under the treaty only Income-tax is covered. Municipal taxes or other taxes are not covered for the purposes of the treaty. Municipal tax is not the correct reason to claim treaty benefit.
4.2.5 Protocol: Finally, to avoid all controversies India signed a protocol with UAE and provided for a different definition. Now, if an individual is physically present in the UAE for more than 182 days, he will be considered to be a resident of UAE irrespective of whether he is liable to any tax in the UAE or not.
By signing protocol, GOI has unequivocally declared that it wants to give DTA relief to UAE investors. Now the tax department cannot deny treaty benefit to UAE NRIs.
4.3 Mauritius: In Azadi Bachao Andolans case (263 ITR 706), the Honourable Supreme Court has held that if the Mauritian authority has issued a Tax Residency Certificate, the person is a resident of Mauritius.
Liability to tax is a legal situation. Payment to tax is a fiscal situation. Payment of tax is not relevant for determining applicability of DTA under Article 1. Payment of tax becomes relevant under Article 23 for Elimination of Double Tax.
Therefore, as per this decision, in case of countries where it is possible to obtain a Tax residency certificate, or otherwise it can be established that a person is a tax resident, DTA benefit will be available.
As per Finance Act 2012, Section 90 has been amended to the effect that a tax payer can claim a treaty benefit only if he provides a Tax Residency Certificate of that country. Till this far, it was alright. However, this situation has recently been brought under doubt. The Finance Bill 2013 has proposed an amendment stating that while a tax residency certificate will be necessary, it may not be a sufficient condition to claim treaty relief. This changes the position of the law laid down by the Supreme Court in Azadi Bachao Andolan whereby a tax residency certificate was enough to claim treaty relief. The Finance Ministry has made some clarifications. However, a final view can be taken only once the Finance Bill is passed into law.
5. Corporate Residence: How do we determine the residential status of a company? Again let us first look at the residential status defined under section 6(3) of the Indian Income-tax Act. Thereafter we consider article 4.
5.1 Residence under Domestic Law:
Section 6 (3): A company is said to be resident in India in any previous year, if
(i) it is an Indian company; or
(ii) during that year, the control and management of its affairs is situated wholly in India.
Normally, clause 3 (i) applies. This takes us further to the definition of an Indian company under section 2(26). This section provides that in short any company registered under the Indian Companies Act or similar other Registration Acts shall be considered to be an Indian company. Important issue to be noted is that once a company is incorporated in India, then no other issue is to be considered. That company is treated as an Indian company and hence Indian resident. Such a companys global income is taxable in India,
Section 6 (3) (ii). When a company is incorporated outside India, then it is treated as Indian resident only if during the whole of the previous year the control and management of its affairs is situated wholly in India.
Illustration FEMA has been liberalised. Now Indian residents can incorporate companies abroad. Let us say, ABC Ltd., an Indian company incorporates a Special Purpose Vehicle (SPV) in a Free Zone in Dubai. The Dubai company thereafter makes a further investment in an operating company in UK. Operating company means that the UK company is doing a proper business. Now the Dubai company would be owned 100% by Indian resident shareholder. All its directors would be Indian residents. It will have no office, and no staff in Dubai. Let us assume that this company is wholly controlled and managed from India.
Such a company will be considered as Indian resident u/s. 6 (3) (ii). Since it will be Indian resident, its global income would be taxable in India.
Now let us consider different legal issues that arise regarding the residential status of a company.
5.2 It is very easy to ensure that the condition provided under section 6 (3) (ii) is not fulfilled. In other words, atleast a part of control and management is situated outside India. In such a case, the company will be treated as a non-resident of India. Once it is a non-resident, that companys foreign income is not taxable in India qua the connecting factor of Residence .
Will the Dubai Company (see illustration above) be able to claim the benefit of the India-UAE DTA? As per the protocol signed by India and UAE, this company will be entitled to the treaty benefits, if it fulfills the following conditions:
(i) the company is incorporated in the UAE; &
(ii) it is managed and controlled wholly in UAE.
This is converse of section 6 (3) (ii). This company should be wholly managed & controlled from within UAE, then only it will be entitled to treaty benefits. If even a part of its control and management lies in India (or anywhere outside UAE) that company will not be entitled to treaty benefits.
As per the present tax laws prevailing in UAE, this company is not liable to any tax in UAE. Still, under the protocol, it will be entitled to treaty benefits.
5.3 Companys Residence under Article 4 (1):
Even a companys residential status is described under Article 4 (1). It refers us back to the domestic tax law. We have already seen the provisions of domestic law.
Article 4 (1) provides for Place of Management as a criterion for determining residential status. However, it should be noted that this criterion is given only as an illustration. Final criterion for determining residential status is to be provided by the domestic law.
5.4 Treaty Shopping:
Normally, most countries around the world adopt similar criteria once a company is registered / incorporated in a jurisdiction, it is considered to be resident of that county. This provision is utilised for Treaty Shopping or even Residence Shopping . Let us consider an illustration.
NW bank from UK wants to invest in the shares of a company in India. If the British company invests in the Indian company, it will get the benefit of the treaty between India and UK. In future, if NW bank sells the shares in the Indian company, it would be liable to capital gains tax under the Indian Income-tax Act.
To avoid the Indian Income-tax, the bank may plan as under. NW Bank will literally shop around for a treaty that gives it better tax advantage as compared to the India-U.K. treaty. It decides that India-Mauritius treaty is more beneficial. However, since NW Bank is not a resident of Mauritius, it cannot claim benefit of Mauritius DTA.
To resolve this problem, NW bank will incorporate an SPV in Mauritius. A consultant in Mauritius will provide registered office address. Let us call it NW SPV. This company will have no office of its own, no staff in Mauritius. The consultant will provide directors and secretaries. The office will actually have no business in Mauritius. Funds will come from the UK company to the Mauritius company and they will be invested in the Indian company. In practice, there will be absolutely no substance in Mauritius. Yet, just because, the SPV is incorporated in Mauritius, it will be considered to be a resident of Mauritius.
Mauritius Government will be glad to provide Tax Residency Certificate. Hence NW SPV will be able to claim the benefit of India Mauritius DTA. Whenever in future, NW SPV sells the shares held by it in the Indian company, it will not be liable to pay the capital gains tax in India.
In short, NW bank of UK has done a tax planning. The treaty between India and UK does not avoid Indian capital gains tax. Hence NW bank goes out shopping for the best available treaty. It finds that India- Mauritius treaty suits its purpose. Hence it incorporates a company in Mauritius. By simply spending a few thousand dollars per year, the company can save considerable taxes.
There was considerable litigation on this issue culminating into the Supreme Court decision in the case of Azadi Bachao Andolan. [(263 ITR 706 (SC)]. Honorable Supreme Court has held that neither Indian Income-tax Act, nor the India-Mauritius Treaty has an Anti-Avoidance provision covering this situation. Hence under the law, a company incorporated in Mauritius can claim the treaty benefit. Honourable SC has held Treaty Shopping to be legal. (Note: Once the Direct Taxes Code brings in General Anti-Avoidance Provisions GAAR, one may have to review this tax planning.)
The simple provision of residential status has been used for massive tax planning by Hutchison & Vodafone. This has become a very famous case. Hence we will not discuss in details. In brief, Hutchison of Hong Kong incorporated an SPV in Cayman Islands. The paid up capital of the SPV was $ 1. The SPV held shares through other companies in the Indian company Hutchison Essar. Later, the shares held in the Indian company were sought to be transferred. However, instead of selling the shares of the Indian company, Hutchison sold the share of Cayman Island SPV.
During the college studies of the Companies Act, we have studied the famous British case of Solomon Vs. Solomon. This principle is now incorporated of the Indian companies Act as well as the Companies Act of most countries. Under this principle, a company is a separate legal entity. The shareholders do not own the assets of the company. Any change in the shareholders of the company does not affect the assets owned by the company.
Hutchison used following principles to its advantage:
(i) Company is a separate legal entity.
(ii) Company is resident where it is incorporated.
(ii) Tax Havens like Mauritius make laws convenient for tax avoidance.
By using a combination of several principles, Hutchison and Vodafone together enjoyed the benefit of tax avoidance. Indian Government tried to recover the tax from Vodafone. Matter went in appeal. Honourable Supreme Court decided in Vodafone International Holdings Vs. Union of India [341 ITR 1 (SC)] that Vodafone was not liable to pay the tax.
All these very important and famous case laws revolve around articles 1 & 4 of the treaty. What look like simple provisions in law have become important tools for tax avoidance. Government of India is aware of the position. Hence the Indian Income-tax Act, Section 9 has been amended. Explanation 5 has been introduced to Section 9 (1) (i) deeming such gains to be taxable in India.
6. Non Corporate Non Individual Person:
Article 4 (1) of the treaty covers all categories of assesses companies, individuals, partnership firms, trust, etc. Hence as far as the treaty provision is concerned, article 4 (1) applies to all of them. However, under the Indian Income-tax Act (section 6), different provisions are made for different categories of persons. A person who is neither a company nor an individual like a trust, HUF, Partnership Firm, etc. is covered by section 6 (2).
A Hindu Undivided Family, firm or other association of persons is said to be resident in India in any previous year in every case except where during that year the control and management of its affairs is situated wholly outside India. This is very difficult provision. Any non-corporate non-individual entity would be considered Indian resident, if even a small part of its control and management for even a short period lies in India.
Illustration: Mr. Patel, an Indian resident joins as a partner in a British Partnership firm. Other 15 partners are UK residents. Since a part of the firms control & management is situated in India, whole firm will become Indian resident. Its global income will be taxable in India. Hence if any non-resident wants to do business in India or wants to make any investment in India, he should avoid non-corporate non-individual entities. A corporate entity would be better for avoiding the harsh provision of section 6 (2).
7. Territorial System of Taxation:
7.1 India, UK, USA and Several other countries have adopted the classical system of taxation. Under this system, the resident of the country is liable to domestic Income-tax on his global income. Hence, when a person is Indian resident, all his income is taxable in India irrespective or the source of the income. At the same time, if any income is sourced in a country, that country has the jurisdiction to tax the sourced income irrespective of the residential status of the assessee.
Some countries however, adopt Territorial System of Taxation . Singapore, Hong Kong, France & some other countries have adopted the territorial system. Under this system only the income sourced in that country is taxable in that country. Thus for example, if a person resident in Singapore has income from India, than Singapore will not levy any income-tax on the Indian income. Singapore will tax only the income which is sourced within Singapore.
We need to consider here the second sentence in Article 4 (1). It reads as under: This term, however, does not include any person who is liable to tax in that State in respect only of income from sources in that State or capital situated therein.
Will the Singapore residents who are taxed only on their incomes sourced in Singapore be considered to be Residents of Singapore? Will they get DTA relief? Literal interpretation of the Article 4(1) suggests that they will not get relief. For a proper answer to this issue we need to refer to the OECD Commentary to its model treaty. Specific purpose for introducing this sentence in Article 4 (1) was to clarify the following position. Foreign Consular officers in a country are not liable to tax on their foreign income. However, they may be liable to tax on incomes arising within the host country. Such liability on the local income should not make them deemed to be residents of the host country. The purpose is not to disqualify all the proper residents of countries which have adopted Territorial System of taxation. Conclusion: Singapore tax residents will be considered residents for DTA purposes and will get the DTA relief.
This also raises another issue. DTA is different from domestic law. A DTA is to be interpreted as provided in the Vienna Convention according to the intent & purpose of the treaty. And interpretation has to be in Good Faith. There is no room for literal interpretation ignoring substance.
7.2 Tax Planning by adopting Singapore Residence:
Consider an illustration where Mr. NRS (a person non-resident of India and resident of Singapore) has capital gains income from India. Because of the Article 13 (4) of the India-Singapore Treaty, India will not tax this income. As per the domestic Income-tax Act in Singapore, this income will not be taxed in Singapore also. Thus there will be double non-taxation. Hence for foreign investors Singapore serves as a tax haven. Many investors from abroad form their SPVs in Singapore & then claim India Singapore DTA benefit.
8. Dual Residence - Individuals: Article 4(2):
Same individual may be treated as resident of both the countries being parties to a treaty. For example, Mr. NRU is a citizen of UK. He has a house, a bank account and other connections with UK. However, he has taken up employment in India. For last few years, as well as during the current previous year, he is residing in India. Hence, under section 6(1) he will be treated as a resident of India. However, under the UK Income-tax Act, he will be treated as a resident of UK. Hence the same person will be treated as resident of two countries. This is called dual residence.
India and UK both will want to tax the global income of Mr. NRU. Let us say, India and UK both have the highest tax rate of 30%. Then Mr. NRU will pay 60% income-tax. To avoid such situation, article 4 (2) provides for Tie-Breaking provisions. Article 4 (2) considers several probable tests which determine the country in which the tax payer is resident. Each test is to be considered in the serial order in which it is listed under article 4 (2).
8.1 Permanent Home:
Consider a situation where Mr. NRU has a permanent home available to him in any one of the countries and does not have a permanent home in the other country. He will be considered to be a resident of the country in which he has the permanent home. It may be noted that it is not necessary that the assessee owns a home. The only condition applicable is that the assessee has a home available to him. It may be a rental home. Or it may be a home owned or rented by a family member. As long as the home is available to Mr. NRU, he will be considered as resident of the country in which the home is available.
8.2 Personal & Economic Relations:
Another probable situation: Mr. NRU has permanent home available to him in both the countries or in no country. Then it will not be possible to determine his residential status by the permanent home test. Hence the treaty provides that he will be treated as resident of that country with which he has closer personal and economic relations.
Thus for example, Mr. NRU is employed by British company, his family continues to stay in Britain and he is only deputed to an Indian Group company, then Mr. NRU may claim that his personal and economic relations with Britain are closer than his personal and economic relations with India. In such a case, he will be treated as resident of Britain.
The test: Personal & Economic Relations is also referred to as Centre of Vital Interests .
8.3 Habitual Abode:
Some people may have their commercial interest as well as family spread out in both countries. For example, Mr. NRU and his wife may stay in India. However, his parents and children continue to stay in UK. Mr. NRU has substantial savings, and investments and income in both the countries. It is not very easy to determine whether the centre of his vital interests lies in India or in UK. In such a situation, one has to find out the state in which the assessee has his habitual abode. Now the term habitual abode is different from the term permanent home. There may be some people who do not have a permanent home but do have a habitual abode in one of the countries. Habitual abode refers to that country where the tax payer stays for a comparatively longer time.
Again there can be some people who have a habitual abode either in both the states or in none of the states. Here one may consider the concept of permanent travelers. There are some people who have their business and or investments in several countries. They can arrange their affairs so that they are not physically present in any single country for a period of 6 months. These people either may not have house in any country; nor have habitual abode in any country; or may be having homes available to them in several countries. Since they are permanent travelers, they may not be held to be resident of any one country. In such cases, they avoid COR taxes in all the countries. Of course they will be liable to COS taxes in the countries in which they earn income. If they are actually non-residents of all the countries, they will not get treaty benefit in any country.
However, in cases like UK, Canada, USA, etc. even if a person is not present for a long period in the country, he may be held to be tax resident of that country. And he may become resident of two countries. In such cases, for the purposes of tie-breaking under Article 4(2)(c) one has to examine his nationality. He will be considered to be a resident of that country of which he is a national.
8.5 Mutual Agreement:
There may be individuals who are not nationals of any of the Treaty countries or who are nationals of both countries. India does not permit a person to be citizen of two countries. In other words, if a person wants Indian citizenship, he cannot be citizen of any other country. However, there are some countries which permit dual citizenship.
In such cases it becomes impossible to determine the residence by any criteria listed in article 4 (2). Then for the purposes of tie-breaking, he will have to apply to the competent authority. The competent authorities of both the countries will mutually discuss and decide the residence of the assessee.
9. Dual Residence Companies: Article 4 (3):
Just as an individual can be resident of two or more countries, a company or other non-individual entity can also be resident of two or more countries. In such cases, determining the residential status for the purposes of treaty becomes difficult. OECD Model provides a criterion for the purposes of tie breaking. The country in which its Place of Effective Management is situated shall be considered to be the Country of Residence.
This concept of Place of Effective Management is a complex subject requiring a full paper. In this paper, we shall discuss it only briefly. Place of Effective Management ignores incorporation, location of registered office and all formal nomenclature. The country from which the management of the Company is effectively carried out, is considered to be the Country of Residence.
10. Tax Planning through Residence:
Several cases discussed above involved tax planning by the assessee & judicial decisions on the same. Two more tax planning methods using the concept of residence are discussed in this paragraph.
10.1 Even individuals sometimes use the concept of Corporate Residence for tax planning. Consider an illustration: Mr. IR (an Indian Resident) wants to buy a house in London. If he buys the house in his own name, he will be liable to tax in India: (i) House Property Income-tax; and (ii) Wealth-tax. He will also liable to Inheritance-tax in the U.K. in addition to Income-tax.
So he may plan as under. Mr. IR will incorporate a company in a tax haven. This company (SPV) will purchase the house in London. Now, Company is a separate legal entity. It is resident where it is incorporated. Shareholder of a company is not the owner of companys assets.
Hence, Mr. IR will not be liable to Indian Income-tax & Wealth-tax on London House. Company cannot die. On death of Mr. IR, the ownership of the London house does not pass to anyone. Hence there will be no Inheritance-tax in the U.K.
This is how the concept of Residence is used for tax planning. In India, Direct Taxes Code proposes to bring Controlled Foreign Company Rules (CFC Rules) to plug this tax planning.
Companies conducting business through E-Commerce can also use the concept of Residence for tax planning. Consider the illustration of Google Corporation. It is conducting its global business through E-Commerce. If entire business is done from USA, its global income would be liable to tax in USA. Hence it has incorporated a subsidiary in the tax haven-Ireland. Iris Company receives the advertisement revenue from all advertisers outside USA. Through a complex structure of tax haven entities, Google Corporation avoids tax liability in USA.
When we break-down the complex tax planning to the underlying principle, it is: incorporate a company in a tax haven. Shift foreign income to the tax haven entity. Avoid COR taxes.
Today OECD, G 20 and several countries are vigorously trying to set right the taxation systems to plug the tax avoidance by E-Commerce companies. It is a challenging & interesting subject.
A Government gets jurisdiction to tax by any one or both of the connecting factors: (i) Residence of the Assessee and (ii) Source of Income. When the income of an assessee is taxable by two Governments, DTA tries to avoid double taxation.
An assessee can take benefit of any DTA only if he is Resident of any one or more of the countries that have signed DTA.
DTA does not define residential status. DTA refers to domestic tax law for determining residential status. If an assessee happens to be resident of two countries, Articles 4 (2) & 4 (3) provide for Tie-Breaking rules.
Companies do Treaty Shopping by setting up Special Purpose Vehicles in tax havens or in countries that have better treaties. People execute several other tax avoidance schemes. Governments keep amending law to plug tax loopholes. The cycle goes on.