In cross-border trade and commerce, whenever goods and services emerging from one country are sold in another, tax liability can arise in both countries.
Every country has the right to tax its residents or nationals on their global incomes. Thus, commerce can become unviable if a person’s income is taxed twice: in the home country (based on ‘residence’), and in the host country (based on ‘source’).
International taxation seeks to address issues such as how much tax is payable on how much income, in which country, levied by which Government and to which Government. To address the problem of double taxation, countries sign bilateral double taxation avoidance treaties (tax treaties).
These treaties usually override domestic tax laws of both signatory countries, and lay down ‘compromises’ that both sides agree to. This reduces the inconvenience to those engaging in trade and commerce, while preserving tax revenues for both countries by selectively exempting incomes in one country or giving credit for taxes paid in the other country.
Treaty shopping
However, tax officials in most countries believe that this system does not prevent multinational enterprises (MNEs) from achieving an effective lower-than-average tax rate. In part, this is because an MNE based in another country can go “treaty shopping” and can take advantage of the treaties signed between two other well-chosen countries.
In the past few years, steps have been taken to ensure that each country gets a share of tax revenues proportionate to the value added in that country. This stems the resultant fall in the country’s tax revenues. Such measures are changing the face of international taxation the world over. They are briefly explained below.
Transfer Pricing: Many countries (including India) have transfer pricing regimes that prescribe pricing norms for cross-border transactions between associated enterprises. These norms prescribe ‘arm’s length pricing’ that ensures a fair share of tax, proportionate to value added in the country, for countries involved in the transactions.
Treaty override: Most countries (including India) accord primacy to tax treaties, allowing treaty provisions to override domestic laws. Some countries, however, have passed laws that override tax treaty provisions. This undermines the sanctity of tax treaties. But most countries say they do this to restrict the abuse of tax treaties.
Controversies arise when amendments that override a treaty are inserted into domestic law after a treaty is signed. Which, then, will prevail?
The US has several provisions that override treaties. India attempted to override treaties by attempting to introduce Chapter XA of the Income-Tax Act (commonly called GAAR or General Anti-Abuse Rules). Australia, Canada, China, Germany and South Africa too have provisions to override domestic treaties.
Limitation of Benefit (LoB) clause in tax treaties : Sometimes, tax treaties limit the benefits available to taxpayers in both countries.
For example, the US Model Convention explains the circumstances in which treaty benefit may not be available.The LoB clause is present in most tax treaties that the US has signed. India, too, has negotiated LoB clauses in tax treaties with many countries including Mexico, Iceland, Kuwait, the US and Singapore.
India is now in the process of negotiating LoB clauses with many countries including, notably, Mauritius. A significant part of the foreign portfolio investment (in listed shares and securities on Indian markets) enters India through Mauritius.
‘Judicial GAAR’ and doctrine of substance over form : India (and the UK) lack legislative treaty overrides, but have several court decisions that effectively create a so-called ‘judicial GAAR’.
One result is the emergence of ‘substance over form’. This allows Indian tax authorities, in effect, to insist on evidence of ‘substance’ in commercial transactions, without which the ‘form’ of the transactions can be ignored.
This is a subtle form of Limitation of Benefit in the context of tax treaties, though the doctrine also applies in domestic transactions. It has even been applied in situations where India, or an Indian enterprise, is not directly involved at all.
For instance, in the Vodafone ‘indirect transfer’ case, Indian tax authorities claimed that Vodafone Netherlands’ payment to Hutchison Whampoa of Hong Kong for acquiring shares of a Mauritius-registered company should have been taxed in India. The reason given was that the Mauritian company owned a business in India that added significant value to the parent company’s shares.
Exchange of information: Until recently, countries had been reluctant to exchange information on tax evaders, criminals and offenders with authorities in other countries. Prosecutors across the globe found that investigations would often hit a dead-end if evidence, in cases of financial crimes and financial aspect of other cases, led to another country. But in recent times, countries have shared information with prosecutors and tax authorities in other countries.
Several Tax Information Exchange Agreements (TIEAs) have been signed and most new tax treaties also incorporate a clause enabling information exchange between law enforcers in both countries.
A US law provides for the automatic exchange of information relating to transactions in financial institutions’ books with law enforcers in the US and in countries that agree to cooperate.
India can declare a country that refuses to share information with its law enforcers to be a ‘non-cooperative jurisdiction’ and impose higher taxes on entities whose transactions are routed through that country – like a teacher punishing the whole class because no student admits to a misdemeanour.
Several other measures proposed under the OECD’s Base Erosion and Profit Shifting project aim to ‘tighten the noose’ around the necks of criminals and tax evaders. These will continue to change the face of international taxation as we know it today, and will be the subject of another article.
Rajesh Haldipur is Director, Tax & Regulatory Services, PwC India and Anuja Talukder, Assistant Manager, PwC