aspects of international taxation — a study (revised 2016) of... · · 2016-11-11aspects of...

Aspects of International Taxation A study

(Revised 2016)

(Case laws are updated till July, 2016)

Committee on International Taxation

The Institute of Chartered Accountants of India (Set up by an Act of Parliament)

New Delhi

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THE INSTITUTE OF CHARTERED ACCOUNTANTS OF INDIA, NEW DELHI All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form, or by any means, electronic, mechanical, photocopying, recording otherwise, without the prior permission, in writing, from the publisher. First Edition : February, 2006 Second Edition : January, 2012 Third Edition : October, 2016 Committee / Department : Committee on International Taxation E-mail : [email protected] Website : www.icai.org Price : ` 600/- ISBN No : 978-81-87080-72-5 Published by : The Publication Department on behalf of The Institute of Chartered Accountants of India, ICAI Bhawan, Post Box No. 7100, Indraprastha Marg, New Delhi-110002 Printed by : Sahitya Bhawan Publications, Hospital Road, Agra-282003 November/2016/P2022 (Revised)

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Foreword to the Third Edition

Taxation is highly complex and intriguing subject. The complexities and dynamic nature of taxation pose a number of challenges to all stakeholders general public, business organisations, taxpayer and the tax consultant. Every stakeholder has his share of issues that needs a solution. Unfortunately there is no panacea to resolve the issues overnight. All concerned need to continually learn and relearn with the emerging changes in the subject. In recent times area of International taxation has gained in importance. ICAI is all geared up to strengthen its members with the required learning in the area of International Taxation. Various activities are being undertaken by the Committee on International taxation to ensure that our members do not miss the plethora of opportunities available in respect of International taxation. I am happy to note that yet another effort has been made by the Committee for updating the members by revising the publication Aspects of International Taxation A Study I appreciate the initiative taken by CA. Nihar Niranjan Jambusaria, Chairman, Committee on International taxation. I also compliment CA. Sanjiv K. Chaudhary, Vice-Chairman and other members of the Committee for their contribution in shaping up the contents and revising the publication. I am sure that the revised edition of the publication will be immensely useful to the members in discharging their responsibilities in an effective manner.

Place : Hyderabad Date : 19-10-2016

CA. M. Devaraja Reddy, President

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Preface to the Third Edition

International Taxation due to its dynamic and ever changing nature has always been a complex subject not only to study but to practice. Due to increase in cross border transactions, mergers and acquisitions, e-commerce, capital mobility and so on, the taxation laws have become more and more complex. This ever increasing complexity in taxation laws of the global village has been a matter of consultations, dialogues, debate, discussions at various forums. The resultant of the same is identification of the concept of Base Erosion and profit shifting (BEPS) and the action points to resolve the issues. Every practising chartered accountant understands that International Taxation is an upcoming area of practice owing to global developments in respect of BEPS action plans. Since our professionals are competent and well prepared to take up the challenges involved in working in the borderless world, ICAI too is geared up to support them in respect of the required knowledge up-dation. To help our members to build the capacities in the area of international taxation, apart from other initiatives the ICAI through dedicated Committee on International Taxation Committee has been revised the publication Aspects of International Taxation- A Study. This publication broadly covers all aspects of International Taxation including taxation of non-residents, DTAAs, Transfer Pricing, advance rulings, taxation of e-commerce, Foreign tax credit, BEPS etc. Like the earlier version, this revised version too would be of immense use to our members. My sincere thanks to CA. M. Devaraja Reddy, President and CA. Nilesh Vikamsey, Vice-President of the Institute of Chartered Accountants of India who have been the guiding force behind the revision of this publication. I have no words to effectively appreciate the untiring efforts of CA. Sanjiv Chaudhary who had not even piloted the first edition but also extended his support in revising this third edition. I also express my gratitude to him for his support as a Vice-Chairman of the Committee on International Taxation. CA. Mayur Desai, CA. Parul Mehta, CA. Karishma Phatarphekar, CA. Anuradha Rathod, CA. Mrugen Trivedi, CA. Madhavi Mandovra, CA. Mugdha Desai, CA. Hetal Mehta, CA. Shailendra Dhole, CA. Vidhya Ganapathiraman, CA. Nidhi Khanna, CA. Ajay Agrawal, CA. Vinaya Phanse, CA. Alpesh Shete, CA. Ashish Choudhari, CA. Karnik Kansara and CA. Bhavesh Hodar have provided their dedicated and active support to CA. Sanjiv Chaudhary in

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revising this publication. I whole heartedly appreciate the contribution made by each of them towards the profession. I am also thankful to the other Committee Council members CA. Tarun Jamnadas Ghia, CA. Hegde Nandkishore, CA. Dhinal Ashvinbhai Shah, CA. Madhukar Narayan Hiregange, CA. G. Sekar, CA. Goyal Sushil Kumar, CA. Agrawal Manu, CA. SoniKemisha, CA. Sanjay Agarwal, CA. Atul Kumar Gupta, Shri Sunil Kanoria, Ms. Indu Malhotra and Co-opted members CA. Arpan Kiran Mehta, CA. T G Suresh, Ms. Parul Jolly, CA. P V S S Prasad and CA.M V Purushottama Rao who have contributed by giving valuable inputs in revising this Guidance Note. I appreciate the efforts made by CA. Mukta Kathuria Verma, Secretary Committee on International Taxation and her team CA. Mohd. Waseem Qureshi for co-ordinating this project. I am sure that this edition like the earlier one will be useful to the members.

Place : New Delhi Date : 19.10.2016

CA. Nihar N. Jambusaria Chairman

Committee on International taxation of ICAI

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Foreword to the Second Edition

International Taxation is evolving in response to globalization, capital mobility and the increased trade in services. The progressive development that has taken place in recent years have allured the multi-national corporations to enter into all types of business and trade formats in India and be at its own or engaging through domestic partners and channels. This introduces international tax practitioners, students and researchers to the theory, practice and international examples of the changing landscapes. This has brought the Indian tax system to the attention of Multi-national Corporation on one hand and their professional consultants on the other hand requiring them to gain better understanding and familiarity of the Double Tax Avoidance Agreements (DTAAs) which play key role in the international taxation arena. I am delighted to know that the Committee on International Taxation of ICAI has done a splendid work and have come out with the revised second edition of Aspects of International Taxation- A Study. I express my gratitude and appreciation to CA. Mahesh P. Sarda, Chairman, Committee on International Taxation of ICAI for the initiative taken to revise the publication. I thank CA. Sanjiv Chaudhary for his contribution in giving a concrete shape to this publication. I am sure this book will be immensely useful and benefit all its readers by providing an insight into the complex aspects of International taxation with due clarity on the subject matter and in a simplified manner.


CA. G. Ramaswamy President

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Preface to the Second Edition

The globalization of the Indian economy has resulted in manifold increase in volume of international transactions. Apart from the quantum increase, the international transactions have become very complex. Consequently, tax implications of international transactions have assumed greater significance. The international tax is no longer restricted to corporates or to large cities. It is therefore imperative for the ICAI to empower the Membership in general on aspects of international tax.

The first edition of the Aspects of International Taxation was brought out in 2002. The law both enacted law as well as judge made law had undergone substantial changes. Therefore, urgent need to update the publication was widely felt.

I am happy to state that CA. Sanjiv Chaudhary who piloted the project of the first edition readily accepted our request to revise the edition. The revised edition would not have seen light of the day without his untiring efforts. I do not think his efforts can be effectively appreciated through the medium of words.

CA. Sanjiv Chaudhary has been actively supported by CA. Sunil Lala, CA. Manoj Pardasani, CA. Mrugen Trivedi, CA. Naveen Kumar Gupta, CA. Maulik Mehta, CA. (Ms.) Manjusha Todankar and CA. (Ms.) Natasha Buhariwala. I place on record our sincere appreciation of the contribution made by each of them.

I thank CA. (Prof.) Tarun Chaturvedi for carrying out the vetting process.

I thank members of the Committee for immense support provided by them.

I believe the efforts in bringing out this publication will get amply rewarded if it proves to be useful to members of the Institute. It will be our endeavor to revise the edition more frequently. The publication contains discussion of case laws up to March, 2011. Considering flow of judicial pronouncements, we propose to come out with supplementary periodically.

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I appreciate the efforts made by Mr. Ashish Bhansali, Secretary of the Committee on International Taxation for co-ordination and his team members CA. Govind Krishna Agarwal and Mr. Prakash for the secretarial assistance in bringing out the publication.


CA. Mahesh P. Sarda Chairman

Committee on International Taxation

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Foreword to the First Edition

The process of globalisation of the Indian economy initiated in the nineties has acquired momentum and the economy is growing at a rapid rate. India has become the hub of manufacturing, servicing and outsourcing activities for the multinational corporations. There has been an enormous increase in the inflow of funds from international financial institutions. India has taken great strides in information technology. All the above developments have a great impact on taxation of the transactions arising out of such activities. Thus, international taxation is gradually becoming a major area of professional interest. However, the concepts and issues concerning international taxation are of a complex nature. Realising the importance of the subject, the Fiscal Laws Committee has taken the initiative to come out with a detailed study of the issues connected with international taxation. I congratulate the Fiscal Laws Committee and its Chairman, Mr. Ved Jain for bringing this study. I am sure that this study will be very useful for our members.


K. S. Vikamsey President

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Preface to the First Edition

The advent of economic reforms in our country has resulted in the rapid growth of the Indian economy. The process of globalisation is set to gain further impetus with the good performance of the economy in the last two years. There has been tremendous increase in the activities of multinational corporations and other non-residents in the manufacturing and servicing sectors of the economy. Outsourcing, which was confined only to non-core activities has been expanding its scope to cover even core and strategic activities of the foreign corporates. The inflow of funds from international financial institutions has been extremely impressive. India has emerged as a major player in the arena of information technology.

These developments in the frontiers of business has naturally resulted in the emergence of taxation issues which have cross-border implications. The Indian Income-tax law has been responding to the developments in this regard. Double Taxation Avoidance Agreements and Transfer Pricing Regulations are some of the examples in this regard. The Authority for Advance Rulings has also made significant pronouncements on various issues of international taxation.

The Fiscal Laws Committee decided to come out with a study covering all the relevant issues relating to international taxation. Accordingly, Shri Sanjiv Chaudhary, FCA, New Delhi was asked to prepare the basic draft. I am extremely thankful to him for his valuable contributions. I also thank the members of the Fiscal Laws Committee for their valuable suggestions in bringing out this study. I am particularly thankful to Shri K. S. Vikamsey, President and Shri T. N. Manoharan, Vice-President who have been the guiding force behind this publication.

I also thank Shri R. Devarajan, Secretary, Fiscal Laws Committee and Ms. Mukta Kathuria, Executive Officer for coordinating this project and Shri Y. S. Rawat, Sr. Steno-Typist who rendered the secretarial assistance.

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I am sure that this study will help the members in understanding the issues involved in international taxation in a methodical manner.


Ved Jain Chairman

Fiscal Laws Committee

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Contents

Chapters Page no.

1. Economic analysis of international taxation 110 1.1 A Glimpse of International Trade 1 1.2 Avoidance of double taxation - History and economic Justification history and economic justification 5 1.3 What is a treaty? 6 1.4 How does a treaty become law? 7 1.5 Source rule v. Residence rule of taxation 8

2. Broad features of the Income-tax Act, 1961 1129 2.1 Charge of tax and persons 11 2.2 Scope of total income 16 2.3 Source 18 2.4 Concept of deemed accrual- section 9 19 2.5 Business connection 20 2.6 Residential status and control and management 24 2.6.1 Individuals 24 2.6.2 Firms, AOPs and HUFs 26 2.6.3 Company 26 2.7 Jurisdictional test in India 27 2.8 Heads of income 28

3. Taxation of Non-residents 3059 3.1 Foreign income and foreign tax payers Categories of income 30 3.1.1 Royalties and FTS 30 3.1.2 Shipping income 33 3.1.3 Income from exploration of minerals 34

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3.1.4 Income from operation of aircrafts 34 3.1.5 Income from turnkey power projects 35 3.1.6 Dividend and interest 36 3.1.7 Income from Bonds or Global Depository Receipts purchased in foreign currency 36 3.1.8 Tax on non-resident sportsmen or sports association or entertainer 37 3.2 Withholding tax 38 3.2.1 A look into Section 195 40 3.2.2 Meaning of the term chargeable to tax 44 3.2.3 Rate at which tax is to be deducted 48 3.2.4 Tax Residency Certificate 49 3.2.5 Withholding at a higher rate - Section 206AA 49 3.2.6 Withholding tax provisions in respect of Specified payments 51 3.2.7 Credit for tax deducted at source 52 3.2.8 Consequences of Non-deduction of Tax at Source from Payments to non-resident 52 3.3 Treaty shopping 53 3.3.1 Treaty overrides the Act 53 3.3.2 Treaty shopping and tax havens 53 3.3.3 Tackling treaty shopping 56 3.4 Other relevant provisions for taxation non-residents/ Foreign Companies 58 3.4.1 MAT on Foreign Companies 58 3.4.2 Equalisation Levy 58 3.4.3 Return Filing Obligations 59

4 Double Taxation 60-66 4.1 Concept of double taxation 60 4.2 Circumstances that give rise to Double Taxation 60 4.3 The Concept of Tax Neutrality 61

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4.3.1 Capital export neutrality 61 4.3.2 Capital import neutrality 62 4.3.3 National neutrality 62 4.4 Methods of avoiding double taxation 63 4.4.1 Tax Treaties (Bilateral relief) 63 4.4.2 Unilateral Relief 63

5 Double Taxation Avoidance Agreements 67230 5.1 Interpretation of tax treaties 67 5.2 Scope of tax treaties 71 5.3 Chapter I Article 1: Persons Covered 74 5.4 Chapter I Article 2: Taxes covered 77 5.5 Chapter II Article 3: Definitions 81 5.6 Chapter II Article 4: Residence under tax treaties 87 5.7 Chapter II Article 5: Permanent Establishment 98 5.8 Chapter III 121 5.9 Chapter III Article 7: Business Profits (Attribution Rule and Force of Attraction Rule) 122 5.10 Chapter III Article 9: Associated Enterprises (AE) 135 5.11 Chapter III - Article 10: Dividend 139 5.12 Chapter III Article 11: Interest 149 5.13 Chapter III Article 12: Royalties and Fees for Technical Services (FTS) 160 5.14 Chapter III Article 14: Independent personnel services (IPS) 184 5.15 Chapter III Article 15: Dependent personal services 190 5.16 Chapter III Article 21: Other Income 193 5.17 Chapter V Article 23: Elimination of double taxation 201 5.18 Limitation of benefits (LOB) 208 5.19 Chapter VI Article 24 : Non-discrimination 214 5.20 Chapter VI Article 25 : Mutual Agreement Procedure 223 5.21 Protocol to DTAAs 229

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6. Transfer Pricing 231269 6.1 Introduction 231 6.2 International transaction 232 6.3 Associated Enterprises 235 6.4 Specified domestic transaction 237 6.5 Arms-length price 238 6.6 Computation of arms-length price 238 6.7 Safe harbour rules (SHRs) 248 6.7.1 Safe Harbour 248 6.7.2 International Transactions 248 6.8 Advance Pricing Agreement 252 6.9 Documentation 256 6.10 Other provisions 262 6.11 Penalties 262 6.12 Controversial issues/ Recent Developments in transfer pricing 263 6.12.1 Introduction 263 6.12.2 Risk Adjustments 263 6.12.3 Marketing Intangible 264 6.12.4 Management Services/ Intra-group service charges 264 6.12.5 Documentation requirements 265 6.12.6 Application of prescribed method for computation of arms length price 266 6.12.7 Dispute Resolution Mechanism 268 6.12.8 Customs law v. Transfer pricing legislation 268 6.13 Conclusion 269

7. Advance Rulings - Law and Procedure 270290 7.1 Introduction 270 7.2 Constitution of Authority for Advance Rulings 270 7.3 Purpose and advantage of the scheme of Advance Ruling 271

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7.4 Definition of advance ruling and eligibility 272 7.5 Procedure in detail for making an application seeking an advance ruling 275 7.6 Procedure in detail to be followed by the AAR after the filing of the application by the Applicant 278 7.7 Opportunity of hearing & right to appoint authorized representative to appear before the Authority 279 7.8 Proceedings before the AAR are not open to general public 279 7.9 Time limit within which the AAR is required to pronounce its rulings 280 7.10 Withdrawal of an application 280 7.11 Rejection of an application 280 7.12 Ex-parte Ruling 280 7.13 Situations in which the AAR can declare a ruling pronounced by it as void 281 7.14 Powers of AAR 281 7.15 Binding force of a ruling 282 7.16 Binding nature of CBDT Circulars on AAR 282 7.17 Extension of time for completing the assessment by Assessing Officers in case matter is referred for advance ruling 283 7.18 Draft specimen application to be filed before AAR 283

8. Contentious Issues 291412 8.1 Payment for software 291 8.2 E-Commerce transactions 339 8.3 Indirect transfer of assets 370 8.4 Retrospective amendment 381 8.5 Foreign Tax Credit 390 8.6 Base Erosion and Profit Shifting 395

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9. Base Erosion Profit Shifting 413452 9.1 Introduction 413 9.2 Summary of Action Points 415

ANNEXURES 453812 A Withholding tax rates for various kinds of income viz. royalty / FTS, dividend and Interest with select countries 453 B Synopsis of Some Important Judgements and Advance Rulings 468

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Chapter 1 Economic Analysis of International Taxation

1.1 A Glimpse of International Trade "The hardest thing in the world to understand is the income tax."- Albert Einstein With all the nuances that the taxation system in the world is grappling with, the above quote from one of the greatest minds, is clearly standing the test of time in its widest sense. Before proceeding with the subject on international tax, it will be useful to have a glimpse of the current international trade environment. The current decade has witnessed some of the unprecedented changes in the worlds economy. The traditional real business is giving way to the internet led e-commerce, competition changing from product enhancement model to innovative disruption model, the traditional boundaries of the countries are getting dimmer with the seamless opportunities provided by internet and e-marketplaces. On one hand, the world is going through the sea change in the way the businesses are run, we have also witnessed the financial recession in 2008 and economic slowdown after that. The global slowdown has had a natural impact on the global trade. Declines in both imports and exports were recorded in all G20 economies in 2015. The trends of international trade in G20 nations can be pictorially depicted as under.

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Aspects on International Taxation A Study

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Source: oecdobserver.org The impact of the global slowdown can also be seen in the GDP1s. The quarterly GDP movement from 2010 to 2014 can be seen as under.

Source: data.oecd.org

The kaleidoscope of International trade over the past decade has made it imperative for the States to reassess their international and domestic tax 1 Gross Domestic Product (GDP) is the standard measure of the value of final goods and services produced by a country during a period minus the value of imports

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Economic Analysis of International Taxation

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policies. With increased pressure on profitability impacted by the slowdown, the Multinational organisations are now seeking innovative ways to structure their operations and maximize their post-tax returns. The ability and willingness of taxpayers to create diverse and complex global value chains, shift taxable income between jurisdictions, and respond to incentives created by the interaction of domestic and foreign tax rules, necessitates mindful formulation of tax policies. Global Tax rate trends: At this stage, it may also be useful to see the trends in the tax rates over last decade. The changes are sometimes a result of medium to long term economic policy of a country, but at times, a nervous reaction to the state of businesses. Tax rate differences over time and between countries can be very large, and are capable of significantly affecting the post-tax returns to FDI in a particular jurisdiction. The global trends in corporate tax levies for the previous decade shows a continuing decline in the rates. The same can be seen from the Table A below. However, in India the rate of corporate tax raised from 33.66% in 2006 to 34.61% in 2016 except for the years 2011 and 2012 where there was a slight decline.

TABLE A: corporate Tax rates Location 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Africa average

30.82 30.56 28.65 28.75 28.38 28.55 29.02 28.29 27.85 27.92 27.46

Americas average

29.97 29.27 28.84 28.82 28.28 29.28 28.67 28.35 27.96 27.35 27.86

Asia average

28.99 28.46 27.99 25.73 23.96 23.1 22.89 22.05 21.91 22.59 21.97

Europe average

23.7 22.99 21.95 21.64 21.46 20.81 20.42 20.6 19.68 20.12 20.48

Oceania average

30.6 30.2 29.6 29.2 29 28.6 28.6 27 27 27 26

North America average

38.05 38.05 36.75 36.5 35.5 34 33 33 33.25 33.25 33.25

Latin America average

29.07 28.3 27.96 27.96 27.52 28.83 28.3 27.96 27.52 26.85 27.29

EU average

24.83 23.97 23.17 23.11 22.93 22.7 22.51 22.75 21.34 22.25 22.09

OECD average

27.67 27 25.99 25.64 25.7 25.4 25.15 25.32 24.11 24.86 24.85

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Location 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 BRICS Average

32.31 32.38 30.31 29.51 29.51 29.20 29.20 28.20 28.20 28.32 28.32

Global average

27.5 26.95 26.1 25.38 24.69 24.5 24.4 23.71 23.64 23.87 23.63

Source: kpmg.com The global trends in individual tax rates can be seen in the below Table B. Though the OECD country average seems to remain more or less flat effect, the BRICS country average rate seem to have fallen from 31.1% in 2006 to 24.31% in 2016.

TABLE B: Personal Tax rates Location 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 Africa average

29.73 28.95 27.81 26.92 27.09 26.85 28.53 31.41 32.09 31.13 31.43

Americas average

31.63 30.85 31.38 31.3 31.86 31.3 31.76 31.48 31.34 31.91 31.67

Asia average

29.04 28.2 28.64 27.96 27.96 27.56 28 27.07 27.64 26.88 27.29

Europe average

35.62 35.04 33.49 33.15 33.62 33.4 33.66 32.83 32.7 32.28 37.46

Oceania average

40.5 39.25 39.25 39 38.38 37.75 37.75 33.4 33.4 35 39

North America average

32 32 32 32 32 32 32 34.3 34.3 34.3 36.3

Latin America average

31.58 30.7 31.3 31.22 31.84 31.22 31.73 31.25 31.08 31.7 30.96

EU average

39.9 39.32 37.56 37.03 37.3 37.09 37.46 38.51 38.38 38.08 39.74

OECD average

41.88 41.44 40.39 40.26 40.76 40.4 40.88 41.89 41.78 41.8 41.88

Brics Average

31.10 31.10 31.10 31.10 31.10 31.28 31.28 31.90 31.90 32.02 24.31

Global average

32.68 31.96 31.44 30.96 31.25 30.86 31.35 31.02 31.2 30.79 32.83

Source: kpmg.com Various jurisdictions have attempted to incentivize investment through favourable rates, domestic investment policies, favorable Treaty clauses, speedy and simpler dispute resolution mechanisms, tax credit mechanisms etc. Weaknesses in the existing international taxation rules have created opportunities for profit shifting, requiring bold moves by policy makers to

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restore confidence in the system and ensure that profits are taxed where economic activities take place and value is created. To counter the problems emanating from the new global environment, the G20 leaders and the OECD proposed to counter Base Erosion and Profit Shifting (BEPS) in September 2013. After two years of relentless efforts the OECD with contributions of G20 and other organisations2, the OECD delivered a package of 15 Action points putting in place commonly-agreed international tax standards aimed to better align the location of taxable profits with the location of economic activities and value creation, and improve the information available to tax authorities to apply their tax laws effectively. To minimize the incidence of double taxation, improving dispute resolution as well as establishing mechanisms to support and monitor the implementation of the measures are also a key part of the BEPS reforms. To appreciate the current global environment and conduct business in a tax efficient manner, it is important to understand the key aspects of international tax which are enshrined in the following chapters of this book and the subtle nuances imbibed therein. The following contents of this book will introduce you to some of the key aspects of international taxation in the backdrop of the domestic regime prevailing in India. To begin with it would be interesting to look at the brief history of how double taxation was sought to be avoided.

1.2 Avoidance of double taxation - History and economic justification

International Law has evolved out of needs of trade (like shipping) which necessitated certain accepted codes of conduct being recognized even in domestic law though the transaction may be between the two different countries. It is really in the field of tax agreements that the first major steps for an international society have been taken. Double taxation occurs when two or more jurisdiction seeks to tax the income arising out of the same transaction. It is more than essential that such double taxation be eliminated for smooth conduct of international trade. The genesis of Double Taxation Avoidance Agreements (DTAAs) can be 2 organisations such as the African Tax Administration Forum (ATAF), Centre de rencontre des administrations fiscales (CREDAF) and the Centro Interamericano de Administraciones Tributarias (CIAT) joined international organisations like the International Monetary Fund (IMF), the World Bank (WB) and the United Nations (UN) contributed to the work

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traced back to the process initiated by the League of Nations in its attempts to form an international community. It prepared a first formal draft of a Treaty in 1927. After World War II, Conventions in Mexico and London in 1943 and 1946, respectively, proposed variations. This work was taken over by the predecessor of the OECD and led to the draft in 1963, which is called the Model Convention. It was following the publication of this draft that rapid development took place in development of an international treaty network. This resulted in the publication in 1977 of a new Model Convention and Commentaries, 1977 by which time there was already a well-advanced treaty network among the members. A need was felt to update and adapt the Model Convention of 1977 considering the fundamental changes taking place in the ways in which cross-borders transactions were undertaken. This lead to publication of the 1992 Model Convention in a loose-leaf format. Unlike the 1963 Draft Convention and the 1977 Model Convention, the revised Model was not the culmination of a comprehensive revision, but rather the first step of an ongoing revision process intended to produce periodic updates and thereby ensure that the Model Convention continues to reflect accurately the views of Member countries at any point in time. In the later updates, produced in 1997, the positions of a number of non-Member countries on the Model Convention were also added. The OECD now periodically updates the Model Commentary. It has also published separate publication e.g. Attribution of profits to Permanent Establishment (PE), Transfer Pricing Guidelines for Multinational Enterprises and Tax Administrations (Existing TPG).

1.3 What is a treaty? Treaty as understood by a layman is a formally concluded and ratified agreement between independent nations. Tax treaties are generally a matter of bargain taking into consideration the economic interests of the countries involved. Some concessions may be made keeping in mind political and trade considerations. DTAAs play an important role in encouraging an inflow of investments into the country. A businessman would like to know the returns after tax on his investments. DTAAs enable a taxpayer to estimate his liabilities and duties towards compliance with the foreign countries tax laws. Keeping all interest in mind, a country may have to give up the right to tax one source of income but may want to justify taxing another source of income, which arises in its territory for e.g. a country with a busy port would push for exemption of shipping income for its residents and agree to give concessions to the partner country which would be in the interest of its residents

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Trade agreements are used by countries to serve a dual purpose of encouraging its own residents to compete in the world markets and encourage inflow of capital but even more importantly these help countries curb tax evasion. This is also the reasoning behind the Article for Exchange of Information. There has been a flight of capital to countries with lower rate of tax of tax or tax havens. Under-invoicing of exports and over-invoicing of imports, or setting- up dummy companies in tax havens as a means of directing the funds are a few common means of tax evasion. The Exchange of Information Article, if used effectively, would help in nabbing such tax evaders. Therefore, India recently has been focusing on renegotiating its Treaties to enable exchange of information to trace black money.

1.4 How does a treaty become law? The agreement entered into becomes a part of domestic law only when it has sanction of the constitution of the nations, which are a party to it. In India, Part IV of the Indian Constitution setting out the Directive principles of State Policy includes a specific provision, covering international law and treaty obligations in Article 51 as follows: The State shall endeavor to (a) promote international peace and security; (b) maintain just and equitable relations between nations; (c) foster respect for international law and treaty obligations in the

dealings of organized people with one another; and (d) encourage settlement of international disputes by arbitration. The judgment in Shah J. Meganbhai v. UOI AIR 1969 SC 783 spells out the true nature of the power of the executive under the Constitution to make a treaty or to implement a treaty with a foreign State. As it explains, the power of the Union of India is co-extensive with the legislature power of Parliament under Article 73. Accordingly, (I) Subject to the provision of this Constitution the executive power of the

Union shall extend; (a) to the matter with respect to which Parliament has powers to make

laws; and (b) to the exercise of such rights, authority and jurisdiction as are

exercisable by the Government of India by virtue of any treaty or agreement.

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The power to legislate is conferred on the Parliament by entries 10 and 14 of List I of VII Schedule. Therefore the Central Government has power to enter into DTAA. However, all Treaties are also required to be followed by local legislation. As the Legislature in India has delegated the power to the Executive, a formal approval of a Treaty by notification or such other means of ratification is required.

1.5 Source rule v. Residence rule of taxation Double taxation may happen in two ways; when the same income is taxed in two countries in the hands of a single taxpayer (jurisdictional double taxation) or taxation of the same income in the hands of two taxpayers (economic double taxation). The DTAA would, normally, decide on the distribution of the income between the two countries. Taxation of same income in more than one hand amounts to economic double taxation so that the revenue sharing between the countries gets distorted e.g. capital expenditure being disallowed while income is taxed in the hands of the recipient. Most countries adopt residential status as the basis of taxation but at times the source or territoriality principle is also adopted so as to tax the income in the country where it arises. The UN Model has a slant on source principle and it is generally believed that it is more lenient to developing countries than the OECD Model. The UN Model also tries to ensure removal of discrimination between taxpayers in the international field. However, the common objective of the Governments while negotiating treaties is to ensure that tax revenues are shared in a manner most optimal to both. The common objectives of Treaties, irrespective of which Model is used as a base, would be to remove the burden of double taxation which harms free movement of goods, capital, services, technology and persons between Countries. DTAAs of India are generally a mix of both source taxation and residence taxation. The main negotiation takes place in assigning the right to tax the income between the countries. A country would like to keep with it the right to tax its resident on his global income whereas; the country of source would also like to stake a claim to the pie. Therefore, a settlement is reached under the treaty say allowing the country of source to take a percentage of the income e.g. royalty, FTS. In certain cases, the right to tax is left with the country of residence unless there is substantive activity in the source State e.g. business profits are only taxed, as said above, if the business is carried on through a PE. The domestic law also emphasizes that income of a non-resident will be deemed to accrue or arise in India whether or not the non-

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resident has a residence or place of business or business connection in India or the non-resident has rendered services in India.

The International Fiscal Association in 38th Congress in Buenos Aires has resolved that the source system of taxation is preferable. However, this may work to the disadvantage of developing countries with lesser economic resources. Therefore, most DTAAs have a combination of both source as well as residence form of taxation. The source rule is also sometimes referred to as the classification or assignment rule as it classifies the income with reference to the source. The country where the income is generated gets the right to tax it. The logic behind it is that it is that country which has, so to say, nurtured the income e.g. in case of royalties and patents, the country may have allowed tax breaks in the development of the patents and would now want a share in the revenue earned from those royalties or patents. Therefore, while negotiating DTAAs, countries try to bargain hard in their best interests and often a compromise is reached depending on each countrys strengths and is also influenced politically by bargaining power capacity. This compromise may be reached in the form of a lower rate of tax at which the source country is allowed to tax the income e.g. royalty, FTS. This leads to another issue, i.e., whether the income should be taxed on gross basis or net basis. A balance in the scheme/right of taxation between the countries is sought to be achieved so as to make it an easy and level playing field for all. This is a challenge as even the way of doing business has changed, from the traditional to e-commerce. Therefore, establishing jurisdiction over income has become even more difficult. The earlier guiding principle in determining the source of income and the location of the gross profit was to ask the question what has been done to earn the profit? Now the more appropriate question would be what and where has the profit earning activity been carried out? In case of tangible goods profits arise when they are delivered. However, with the increased use of technology and e-commerce, it is necessary to adopt appropriate systems to determine point of taxation. This is to ensure that a country does not lose out on the right to tax an income e.g. an international book store or record company selling its books or records in India either through an exclusive agent or by setting up its brand shop in India would be taxed; however if the same company sells goods through the Internet, which are directly delivered through mail/courier it would become very difficult to capture such sales and further there would be no business connection/PE to bring that company to tax in India. (In the subsequent

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chapter dealing with taxation of e-commerce the complexities involved in establishing the State of Source will become clearer.) The digital economy and its business models present some key features which are potentially relevant from a tax perspective. These features include mobility, reliance on data, network effects, the spread of multisided business models, a tendency toward monopoly or oligopoly and volatility. The types of business models include several varieties of e-commerce, app stores, online advertising, cloud computing, participative networked platforms, high speed trading, and online payment services etc. The digital economy has also accelerated and changed the spread of global value chains in which MNEs integrate their worldwide operations. Recently OECD has vide Action point 1 of its BEPS initiative has tried to identify and tackle some key challenges posed by digital economy. The same is broadly discussed subsequently in this book in a separate chapter on BEPS.

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Chapter 2 Broad Features of the Income-tax

Act, 1961

2.1 Charge of tax and persons Income tax simply put is a tax on income, of a person, for a defined period. The power to levy tax is of wide import and rests with the Parliament. In terms of the power given under the Constitution, the Parliament has enacted the Income-tax Act, 1961 (the Act), and various other statutory Acts. The word income though is not defined in the Constitution. However, the same is defined in Section 2(24) of the Act. The definition of income is an inclusive definition. It includes not only those things which this clause declares that it shall include, but such things as the word signifies according to its natural import [Raghuvanshi v. CIT (1952) (22 ITR 484) (SC)]. Therefore, if a particular receipt, though not specifically included as income, is in the nature of income, it is liable to be taxed. The Supreme Court in the case of G.R. Karthikeyan [(1993) 201 ITR 866] observed that The idea behind providing an inclusive definition in section 2(24) is not to limit its meaning but to widen its net. This court has repeatedly said that the word income is of the widest amplitude and it must be given its natural and grammatical meaning. The tax is levied on the income for the year. In determining the income, the income received as well as the income accrued has to be considered. The method of payment or its measure is not important. Income includes not only money payment but also the value of any benefit or perquisite, whether convertible into money or not [K. C. Suresh v. Director of Lotteries (1993) (199 ITR 266) (Ker HC)]. Any kind of income earned by the assessee attracts income-tax at the point of earning, and tax law may not be concerned with how the income is expended. Some of the basic concepts around taxation of income are explained below. Distinction between revenue receipt and capital receipt Income as generally understood, means receipt of a revenue nature. However, in the case of certain receipts e.g. surrender of agency rights, the taxpayer would treat it as a receipt on capital account whereas the tax authorities would want to tax it as a revenue receipt. These classification

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issues for certain types of income i.e. on revenue or capital account has led to disputes between the taxpayer and the tax authorities. Fundamentally, only revenue receipts and not capital receipts are taxable except to the extent of any capital receipt expressly covered under the definition of income'. What should constitute revenue and capital is to be decided on the facts of each case. The Supreme Court in the case of Oberoi Hotel (P) Ltd. v. CIT [(1999) XI SITC 109 (SC)], has held that the question whether the receipt is the capital or the revenue has to be determined by drawing the conclusion of law ultimately from the facts of the particular case and it is not possible to lay down any single test as infallible or any single criterion as decisive. The Bombay High Court in CIT v. Mahindra And Mahindra Ltd. [(1973) 91 ITR 130] has observed that a receipt is not taxable if it is referable to fixed capital. It is taxable as a revenue item when it is referable to circulating capital or stock-in-trade. The fixed capital is what the owner turns to profit by keeping it in his own possession. Circulating capital is what he makes the profit of by parting with it and letting it change its masters. The determining factors must be the nature of the trade in which the asset is employed. Real income theory Income-tax is a tax on the real income. It is the real income which has accrued in a practical sense that is brought into account for tax purposes [CIT v. Bokaro Steel [(1999) (236 ITR 315) (SC)], Godhra Electricity Co. Ltd. v. CIT [(1997) (225 ITR 746) (SC)]. The Bombay High Court in the case of CWT v. Bombay Suburban Electric Supply Limited [(1976) 103 ITR 384] held that ..Income tax is a tax on the real income i.e., profits arrived at on commercial principles subject to the provisions of the Act. A similar view was also taken in Poona Electric Supply Co. Ltd v. CIT [(1965) (57 ITR 521) (SC)]. A noteworthy decision in this respect is the decision of the Supreme Court in the case of State Bank of Travancore v CIT [(1986) (158 ITR 102) (SC)] wherein it was held that if income which may have accrued in theory, but has been surrendered in reality, it cannot be said that any income has resulted; because the income did not really accrue. Whether income has really accrued or not has to be decided in the light of the facts of each case so as to uphold the intention of the Act. It may be worthwhile to note here that in the context of recognition of interest on non-performing assets, the Courts have held that even under the accrual system of accounting, it is illusory to take credit for interest where the principal itself is doubtful of recovery. The Courts, in various decisions, have also recognized the theory of real income and held that notwithstanding that a taxpayer may be following the mercantile system of accounting, the taxpayer could only be

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Broad Features of the Income Tax Act, 1961

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taxed on real income and not any hypothetical/illusory income. [UCO Bank v. CIT [1999] 237 ITR 889 2 (SC), CIT v. Shoorji Vallabhdas & Co. [1962] 46 ITR 144 (SC), Godhra Electricity Co. Ltd. v. CIT [1997] 225 ITR 746 1 (SC), CIT v. Bokaro Steel Ltd. [1999] 102 Taxman 94/ 236 ITR 315 (SC)]. Presumptive taxation A little off-track from the concept of real income is the concept of presumptive taxation. In certain cases, especially in the case of non-residents where it is not possible or would be cumbersome, the legislature prescribes a presumptive rate on receipts e.g. In case of Shipping Income, seven and a half percent of shipping receipts is deemed to be the income arising from shipping business on which the tax is levied at the applicable rate; in case of non-residents engaged in oil exploration activities an amount equal to ten percent of receipts is deemed to be the income on which tax is levied at the applicable rate. The important point is that the presumptive rate is applied on the receipts and not on the income. This leads to the question, whether a deduction can be allowed for the expenses incurred in the business? The tax authorities generally take a view that, where a presumptive rate is applied, all expenses have been deemed to be allowed, and nothing further is allowable. Therefore, it is the gross receipts on which tax is levied. In certain situations, in case of residents also, presumptive taxation may apply e.g. in case of residents engaged in any business (except business of plying, hiring or leasing goods carriage) whose total turnover in the previous year does not exceed specified amount, a sum equal to eight percent of the total turnover or gross receipts paid or payable is deemed to be the income from the business. Income-tax is a tax on income, but it has to be levied with reference to a person for a specified period. This is done by dividing the taxpayers into various categories of persons. As covered above, income-tax is a tax on income of a person for a particular assessment year levied at the rates specified in the Finance Act. Person The charge of tax is on a person which is defined under section 2(31) of the Act. According to section 2(31) person includes the following: (i) an individual, (ii) a Hindu undivided family, (iii) a company, (iv) a firm,

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(v) an association of persons or a body of individuals, whether incorporated or not,

(vi) a local authority, and (vii) every artificial juridical person, not falling within any of the preceding

sub-clauses. The definition of person is an inclusive definition and covers almost all categories of taxpayers. However, though their natural meanings may be the same, the term individual and persons are different under the Act. While every individual is a person every person is not an individual. The term individual refers to a natural person i.e. human being while the term person also includes artificial juridical persons like idols and deities. Hindu undivided family is a concept which is unique to Indian tax laws. This status arises from being a family, as the title suggests, and which incorporates all new members born into the family. The term company in the definition of person covers all companies within its ambit whether incorporated inside India or outside India. The term company used in this section is to be read in conjunction with the definition of company in section 2(17) of the Act. The term partnership as included in section 2(23) of the Act takes us back to the definition of firm, partner and partnership in the Indian Partnership Act, 1932. With the concept of limited liability partnerships being introduced, the definition of firm has been amended to include limited liability partnership as defined in the Limited Liability Partnership Act, 2008 and the definition of partner has been amended to include a partner of a limited liability partnership as defined therein. In the Act a firm is treated as a separate taxable entity that is distinct from its partners. In fact, till the time the Finance Act, 1992 introduced section 10(2A) to the Act w. e .f. 1 April 1993, both the partner the partnership were taxed. As this amounted to taxing the same income twice once in the hands of the firm and then again in the hands of the partners, section 10(2A) of the Act was introduced which provides that the share of profit that a partner receives from a firm will be exempt in the hands of the partner. Therefore, though the Act still recognizes that the firm and the partners are independent, double taxation of the same income is avoided. An association of persons as the name suggests is a group of persons who may or may not be individuals. In fact, in the 1922 Act, the term used was association of individuals which was changed to association of persons to remove any doubt that the term included persons other than individuals also.

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The term body of individuals is similar to association of persons and denotes a group of persons joining together to earn income. The Finance Act, 2002, w.e.f. 1 April 2002, inserted an Explanation to clarify that an association of persons, body of individuals, local authority or juridical person will be deemed to be a person irrespective of whether the association of persons, body of individuals, local authority or juridical person was formed with the object of deriving profit or not. A local authority is also a unit of assessment. The Explanation referred to above, inserted by the Finance Act, 2002, also applies to a local authority. There is also a residuary clause to include any other category not specifically mentioned. In the 1922 Act, there was no separate category for idols or deities and they were included under individuals. Under the 1922 Act the presumption was that the word individual is wide enough to wide enough to cover idols, statutory bodies like Bar Council, or a University. However, the 1961 Act has a separate category in clause (vii) viz. every artificial juridical person. Person not falling within any of the preceding sub-clauses fall within this category. The Explanation specifying that profit motive is not important is equally applicable to these entities. In order to fasten tax liability on a person, two essential elements to be considered are: i) the scope of total income, and ii) the residential status of the person. The levy of tax is contemplated in section 4 of the Act, the scope of total income in section 5 of the Act and meaning of a resident in section 6 of the Act. Rate - rate or rates in force is defined in section 2(37A) of the Act and takes one back to the rate specified in the Finance Act of the relevant financial year. The charging section 4(1) of the Act also stipulates that the tax shall be charged on the income computed as per the provisions of the Act at the rate specified in the Central Act. However, it is important to note the following words in section 4 those rates shall be charged for that year in accordance with, and subject to the provisions (including provisions for the levy of additional income-tax).of, this Act------. This is because, in respect of certain incomes, the rate of tax is already specified in the Act and is not varied by the Finance Acts. The Supreme Court in the case of CIT v. Vatika Township (P.) Ltd. [(2014) (49 taxmann.com 249)] observed that Chapter XIVB comprehensively takes care of all the aspects relating to the block assessment and undisclosed income, which includes section 158BA(2) as the charging section and even the rate at which such income is to be taxed is mentioned in section 113. It observed that when a separate charging section is introduced specifically, to assess the undisclosed income, notwithstanding a provision in the nature of section 4 already on the statute

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book, this move of the legislature has to be assigned some reason, otherwise, there was no necessity to make a provision in the form of section 158BA(2). It could only be that for assessing undisclosed income, charging provision is section 158BA(2) alone. Where the rate is not so specified, the rates stated in the Finance Act will apply. The Finance Act prescribes the rate of income tax for the year, the rates for deduction of tax at source and the rates for payment of advance tax. The income tax is an annual tax, not only in the sense that it is annually imposed by the Finance Act but in the sense that it is annual in its structure and organisation. Though the subject of the charge is the income of the previous year, the law to be applied is that in force in the assessment year, unless otherwise stated or implied [Reliance v. CIT (120 ITR 921) (SC)], The power and the authority to levy the income-tax are granted by the Constitution of India. Any provision introduced in the Act and the rates specified will be constitutionally valid unless otherwise held by the Courts i.e. the High Court or the Supreme Court. The burden of showing that a receipt does not constitute income taxable under the Act is upon the taxpayer. The Act is a self-contained exhaustive code subject to interpretation by the Courts. Previous year The income is to be computed with reference to a previous year. Previous year has been defined in section 3(1) of the Act to mean the financial year immediately preceding the assessment year. This takes us back to the definition of assessment year in section 2(9) of the Act which defines assessment year to mean the period of twelve months commencing on the 1st day of April every year. The only exception provided is in case where a business, profession or vocation is newly set up, or a source of income newly comes into existence, in the financial year, the previous year would be the period from the date when the business, profession or vocation is set up or the source of income comes into existence to the March 31, next following. The period to be considered under the Act is April-March and not the calendar year. The fiscal period may differ from country to country and when dealing with international tax matters it may create complications, especially if taxes paid have to be split into two different fiscal periods. Eligibility to tax is determined by the scope of section 5 of the Act.

2.2 Scope of total income The term total income has been defined in section 2(45) of the Act to mean

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the total amount of income referred to in section 5, computed in the manner laid down in the Act. The definition thus goes back to the scope provided in section 5. Therefore, while computing the total income, one has to have regard to the scope of income specified in section 5 of the Act and then compute the income in the manner laid down in the Act. Total income is the entire income of a person received or deemed to be received or which accrues or is deemed to accrue in a previous year. Section 5 defines the scope of total income. Section 5 classifies the total income based on residential status. Section 5(1) deals with residents and section 5(2) deals with non-residents. Section 5 also starts with the phrase Subject to the provisions of this Act.. Therefore, if an income is exempt under section 10 (which exempts certain income from tax), it cannot be taxed simply because a charge is put by section 5. Section 5 refers to income received and accrues. In the case of a resident, there are three situations contemplated namely, receipt and/or deemed receipt in India, accrual and/or deemed accrual in India and accrual outside India. The point to note here is that in the case of income accruing/arising outside India there are no deeming provisions, and therefore, the income needs to have actually accrued or arisen to be taxed. In the case of a non-resident, there are two situations contemplated i.e. when income is received or is deemed to be received in India and when it accrues or is deemed to accrue or arise in India irrespective of actual receipt. The receipt need not be by the resident or non-resident himself. Even if it is received by someone on his behalf, it is taxable. If a person has alienated or assigned the source of his income so that it is no longer his, he may not be taxed upon the income arising from the assignment of the source [E.D. Sassoon v. CIT (26 ITR 27) (SC)]. However, if he does not transfer the source of income and merely applies the income so that it passes through him and goes to an ultimate purpose, even though he may have entered into a legal obligation to apply it in that way, still it remains his income. The Supreme Court in the case of CIT v. Sitaldas Tirathdas [(1961) (41 ITR 367)] held that .where by the obligation income is diverted before it reaches the assessee, it is deductible; but where the income is required to be applied to discharge an obligation after such income reaches the assessee, the same consequence, in law, does not follow. Thus, where income is not applied but diverted by overriding title from the assessee who would otherwise have received it, it cannot be considered the income of the assessee at all. The words used in section 5(1) are ------ total income of any previous year of a person who is a resident includes all income from whatever source derived which --------.The words from whatever source derived are not there as a

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guide to the place where the profits accrue or arise but merely to make it clear that source is irrelevant for determining chargeability under this section in the case of a resident. Section 5(2) begins in a similar manner except it deals with non-resident.

2.3 Source Income cannot be generated from thin air. It has to be derived as a result of an activity or as a result of earning from an asset or from something which can be construed to be a source. The source can also be a combination of these i.e. a person can be carrying on a business which will generate business income and will also earn income from his personal assets e.g. shares, or letting of a house. The activity may also be in the form of work e.g. salary income. Therefore, all income must originate from a source and should be capable of being traced to a source. An agreement e.g. a loan agreement is also a source of income. This concept is important, especially at the time of determining whether a particular item or activity is a source of income for the purpose of section 9 of the Act which deems certain income to accrue or arise in India. Identification of the source of income is also essential to categorize the income into the respective heads of income. The concept of heads of income is discussed in greater detail in the subsequent chapters. When one talks about the receipt, it implies some control over the income. Without such control, the income cannot be said to have parted title in favour of the recipient. Therefore, a mere entry in the books of account is not sufficient to constitute a receipt liable to tax with respect to the persons in whose name it has been credited [CIT v. Toshuku Ltd. (1980) (125 ITR 525) (SC)]. It may be pertinent to note the decision of the Supreme Court in the case of Kanchanganga Sea Foods Ltd v. CIT, ITO, and Ors [(2010) 325 ITR 540], wherein it has been held that the remittance in kind by an Indian company to the non-resident is taxable in India if such amount has been received or accrued in India. Further, the payer in such cases is not absolved of withholding obligations, notwithstanding the fact that remittance was made in kind to the non-resident. One may keep in mind the Supreme Court decision in the case of Standard Triumph Motor Co. Ltd v. CIT [(1993) 201 ITR 391 (SC)] where it was held that the credit entry to the account of the non-resident assessee in the books of the Indian company did amount to its receipt by the non-resident assessee and was accordingly taxable, and it was immaterial when it actually received

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the same abroad. Therefore, the income would be taxable depending on the facts of the case and the congruence of the provisions of section 5 read with section 9. For the moment, the simple principle to be kept in mind is that receipt involves full receipt, with control over the usage and disposal of the income. Therefore, even a constructive receipt would be taxable if it satisfies that condition.

2.4 Concept of deemed accrual- Section 9 The Act contemplates taxation not only on actual receipt but also on accrual. Accrues, arises and received are three different situations contemplated. The term receipt implies actual receipt with full control over ownership and disbursal. The words accrues or arises denote a right to receive. While accrues may mean at a future date upon accumulation, arises is more concrete & denotes that a right to receive is more immediate and tangible. Both the terms, accrues and arises are used in different context and are not synonymous. The landmark decision of the Supreme Court in this connection is in the case of E.D. Sassoon and Co. Ltd v. CIT [(1954) (26 ITR 27) (SC)] wherein the Supreme Court has interpreted the words accruing or arising to mean a right to receive e.g. a debt created in favour of a person gives that person a right to receive. However, a mere claim is not a right because there is no reciprocal acknowledgement of the debt unless the claim is legally enforceable. The Supreme Court in the case of C.I.T. v. K.R.M.T.T. Thiagaraja Chetty and Co. [(1986) 24 ITR 525 (SC)] held that mere fact that the company was withholding payment on account of a pending dispute could not be held to mean that the amount did not accrue to the assessee. Similar view was adopted in the case of [Babulal Narottamdas v. CIT (1991) (55 Taxman 3) (SC)]. Concept of accrual is neutral to considerations like treatment by the taxpayer in the books of account, difficulty of recovery or non-receipt of income. The often cited decision in the case of Hindustan Housing and Land Development Trust Ltd[(1986) (161 ITR 524) (SC)] laid down that when the dispute is only regarding quantification of income and not the right to receive the income, the income is said to have accrued or arisen. But, where the right to receive is itself disputed, there cannot be any accrual. Therefore, as can be seen, while certain guiding principles are laid down, there is no absolute solution; every case has to be evaluated on its own facts and merits. Section 9 has to be read in conjunction with section 5. Section 9 deems certain income to accrue or arise in India in case of a non-resident. In other words, section 9 creates a deeming fiction and lays down circumstances

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where income will be deemed to accrue or arise in India. It deals with both, residents and non-residents and various categories of income. Section 9(1) inter-alia covers income accruing or arising from business connection in India or from any property in India or source of income in India or through or from any capital asset situated in India. It also covers salary income, interest, royalty and fees for technical services (FTS). As these are in connection with a non-resident, they are restricted to income which arises or is deemed to accrue or arise in India. There has been whole lot of dispute and plethora of case laws on what can be considered a business connection or a source of income or asset in India.

2.5 Business connection Earlier the term business connection was not defined in the Act. The Finance Act 2003, with effect from 1.4.2004 inserted Explanation 2 to section 9(1) of the Act. Explanation 2 to section 9(1) of the Act provides as under: .."business connection shall include any business activity carried out through a person who, acting on behalf of the non-resident,- (a) has and habitually exercises in India, an authority to conclude

contracts on behalf of the non-resident, unless his activities are limited to the purchase of goods or merchandise for the non-resident; or

(b) has no such authority, but habitually maintains in India a stock of goods or merchandise from which he regularly delivers goods or merchandise on behalf of the non-resident; or

(c) habitually secures orders in India, mainly or wholly for the non- resident or for that non-resident and other non-residents controlling, controlled by, or subject to the same common control, as that non-resident:

Provided that such business connection shall not include any business activity carried out through a broker, general commission agent or any other agent having an independent status, if such broker, general commission agent or any other agent having an independent status is acting in the ordinary course of his business: Provided further that where such broker, general commission agent or any other agent works mainly or wholly on behalf of a non-resident (hereafter in this proviso referred to as the principal non-resident) or on behalf of such non-resident and other non-residents which are controlled by the principal

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non-resident or have a controlling interest in the principle non-resident or are subject to the same common control as the principal non-resident, he shall not be deemed to be a broker, general commission agent or an agent of an independent status. The definition of business connection as provided by the explanation is more or less in line with the definition of an agency P.E. in the DTAAs, which is dealt with exhaustively later and is, therefore, not discussed in this Chapter. The landmark decision in the context of business connection is the case of R.D. Agarwal and Co. [(1965) 56 ITR 20 (SC)] wherein the Supreme Court noted that there can be said to be a business connection when there is a nexus between the business carried on by a non-resident which yields profit, and the activity carried on in India which contributes to such profits or gains. It gives some element of continuity between the business and the activity in India. The connection must be real and intimate. Therefore, mere canvassing (sales promotion) operations by a commission agent in India who had no authority to accept the orders or enter into contracts on behalf of the non-resident were held not to constitute such a real and intimate relation so as to amount to a business connection. A few illustrations of what constitutes a business connection are a branch, a factory, an exclusive agency, etc. After establishing whether or not there is a business connection or that the income is or can be deemed to accrue or arise in India, i.e., once the taxability under the Act is established, then the question to be asked is; whether any relief is available under the DTAA e.g. in the case of interest income, the DTAA may provide that it is not taxable in India or may provide that it is taxable at a reduced rate. It is now established beyond doubt that if the provisions of the DTAA are more beneficial, the income has to be taxed under the DTAA. [Circular No 333 dated 24 April 1982 issued by the Central Board of Direct Taxes, CIT v. Vishakapatnam Port Trust [(1983) (144 ITR 146)] and UOI v. Azadi Bachao Andolan [[2003] 263 ITR 706] referred to earlier]. The Explanation to section 9(1) clarifies that in the case of a business of which all the operations are not carried out in India, only such part of the income as is reasonably attributable to the operations carried out in India shall be deemed to accrue in India under this clause. Section 9 creates a fiction to bring into the tax zone, certain specified income. What is actually received in India is taxed on a stand-alone basis and not under section 9. This fiction of section 9 comes into play only when the income is not charged to tax on the basis of receipt in India, as receipt of income in India by itself attracts tax whether the recipient is a resident or

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non-resident. However, to bring the income to tax, a territorial nexus with the income and the person sought to be taxed is to be established. The territorial nexus doctrine plays an important part in the assessment of tax. Income arising out of operations in more than one jurisdiction would have territorial nexus with each of the jurisdiction on actual basis. If that be so, it would not be correct to contend that the entire income 'accrues or arises' in each of the jurisdiction [Ishikawajma-Harima Heavy Industries Ltd. v. DIT (2007) (158 Taxman 259)]. Section 9(1) clause (i) deems all income accruing or arising whether directly or indirectly, through the transfer of a capital asset situated in India. A landmark ruling of the Supreme Court in the case of Vodafone International Holdings B.V. [(2012) (17 taxmann.com 202) (SC)] held that the transfer, by a non-resident to another non-resident, of shares of a foreign company holding an Indian subsidiary Company [more often known as indirect transfer] does not amount to transfer of any capital asset situated in India. Accordingly, the gains arising from the said transaction were not liable to tax in India. Thus, the Apex Court concluded that the legal fiction has a limited scope and cannot be expanded to give purposive interpretation. This is particularly if the result of such an interpretation would seek to transform the very basis of the concept of chargeability of the section. As a result of this decision, the Finance Act, 2012 inserted Explanation 4 to section 9(1)(i) with retrospective effect from 1 April 1963 clarifying that the expression through shall mean and include and shall be deemed to have always meant and included by means of, in consequence of or by reason of. It further, clarified that an asset or a capital asset being any share or interest in a company or entity registered or incorporated outside India shall be deemed to be and shall always be deemed to have been situated in India, if the share or interest derives, directly or indirectly, its value substantially from the assets located in India. The provision was construed to be draconian considering its wide scope (applicability being retrospective) and language as well as lack of clarity on mainly on what would be considered to be deriving value substantially from Indian assets. The Finance Act, 2015 clarified that the share or interest of a foreign company or entity shall be deemed to derive value substantially from Indian assets (tangible or intangible) only if the value of Indian assets as on the specified date: exceeds the amount of Rs. 10 crores and

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Represents at least 50% of the value of all the assets owned by the foreign company or entity.

Accordingly, where the value of Indian assets is below Rs. 10 crores or represents at least 50% of the value of total assets of the foreign company or entity, transfer of shares of such company or interest in such entity should not be chargeable to tax in India. Moving on from the first clause in section 9(1) which inter-alia dealt with business income and indirect transfers to the second clause i.e. section 9(1)(ii)&(iii) which deals with taxation of salary income. Salary income is taxable in India if it is earned in India. While this clause may appear simple, it has also created a plethora of litigation as to the quantum of the salary income to be considered as earned in India. A long drawn battle was regarding taxability of off-period salary i.e. salary paid to a non-resident, otherwise rendering service in India, while he is on leave or rest period. The argument was that the salary paid abroad cannot be deemed to accrue or arise in India, however, the Finance Act 1999, w.e.f. 1 April 2000, inserted an Explanation to section 9 (1)(ii) of the Act to provide that the rest period or leave period salary will be taxable in India. Other clauses in section 9(1) deals taxation of dividend, interest, royalty and Fees for Technical Services (FTS). These are dealt with in detail in Chapter 3. The clauses which have caused a lot of disputes between the taxpayer and the tax authorities are the clauses 9(1)(vi) & 9(1)(vii) dealing with taxation of royalty and FTS. Mainly, the dispute revolves around whether the income constitutes royalty or FTS or business income and also whether the services rendered from outside and utilized in India will be taxed in India or only the services rendered in India and utilized in India shall be taxable in India. In this regard, the Supreme Court in the case of Ishikawajma Harima Heavy Industries Limited v. DIT [(2007) (288 ITR 408) (SC)] held that that for services to be taxable in india, the services not only have to be utilized within India but also be rendered in India or have such a "live link" with India that the entire income from fees becomes taxable in India. However, subsequently, the Act has been amended w.r.e.f 1 June 1976, to provide that income of a non-resident from rendering services in the nature of interest, royalty and FTS are deemed to accrue or arise in India irrespective of whether the non-resident has a place of business, residence or business connection in India or services are rendered in or outside India. The Tribunal also, in the case of Linklaters v. ITO [(2010)(132 TTJ 20)] based on the amendment has held that as long as the services are utilised in

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India, the income is deemed to arise in India irrespective of the fact that services are rendered outside India. Therefore, entire fees for professional services earned by the taxpayer in connection with the projects in India are taxable in India under the Act. The effect of clause (vi) and (vii) is merely to deem income to accrue in India when it, in fact, accrues abroad, but these clauses do not deem any capital receipt to be income. Therefore, if the royalty or FTS is on capital account, it is not within the ambit of this section. The agreement in this regard has to be studied carefully and must establish a sufficient nexus with the income and the accrual in India. In case of FTS, as long as the services are utilized in a business carried on in India, it would be taxable in the hands of the non-resident. It is the nature of the payment that is to be seen and not the nomenclature given by the parties. In the case of GVK Industries Ltd v. ITO [(2015) (371 ITR 453) (SC)], a success fee was also held to be in the nature of FTS. These clauses in section 9 are specific to deem certain income like royalty, interest or FTS to accrue or arise in India. Where income cannot be deemed to accrue or arise in India under these clauses, it cannot be deemed to accrue or arise at all by forcing it to fit within clause (i) of section 9(1). [Meteor Satellite v. ITO (1980) (121 ITR 311), CIT v. Copes Vulcan (1987) (167 ITR 884)]

2.6 Residential status and control and management

Taxation is with reference to the income of a person derived in a relevant previous year. The person is further classified as resident or non- resident. The definition of resident is under section 6. This section lays down technical and artificial tests to determine the territorial connection to justify taxability of a person. The section is divided into three parts, sub- sections 1 and 6 deals with individuals, sub-section 2 deals with HUF, firm or association of persons, sub-section 3 deals with company, sub-section 4 deals with every other person i.e. artificial juridical person e.g. statutory corporations and idols, sub-section 5 is clarificatory to state that the residential status applies to all sources of income.

2.6.1 Individuals The test to determine the residential status of an individual is based on the number of days of stay in India. Therefore, even a day or two here and there

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could make a fundamental difference. The category of residents is further divided into; (i) resident and ordinarily resident; (ii) resident but not ordinarily resident; and (iii) non-resident. Section 6 of the Act only states what constitutes a resident and a not ordinarily resident. If the person does not fall into either category, he would be a non-resident, the definition of which is provided in section 2(30) of the Act. The test of residence in section 6(1) is based on the physical presence in India. This test has to be carried out each year. The tests of residence (as provided below) in section 6(1) are alternative and not cumulative. The physical presence is in connection with the territorial jurisdiction of India and therefore, even stay on a yacht within the territorial waters of India would constitute the physical presence in India. A person can be a resident of one or more countries because work may require a person to travel, however, the country of origin or domicile will always be one. This is, in fact, where DTAAs come in to decide the country of which a person can be considered as resident for the purpose of taxation. Though a source country can get a territorial right to tax the income, the country of residence will have to give credit for taxes abroad while taxing the global income. As per section 6(1) if either, a person is in India for 182 days or more during the relevant previous year; or has been in India for 365 days or more in the last 4 years; and has been in India for at least 60 days in the relevant previous year he would be a resident. As per section 6(6) an individual will be not ordinarily resident if, he has been a non-resident in 9 out of 10 previous years preceding that year; or during seven previous years preceding that year has been in India for a period amounting to 729 days or less. In the case of foreign-bound ships where the destination of the voyage is outside India, there was uncertainty with regard to the manner and basis of the determination of the period of stay in India for crew members of such ships who are Indian citizens. In view of the same, the Finance Act, 2015 amended the Act to provide that in the case of an Individual, being a citizen of India and a member of the crew of a foreign-bound ship leaving India, the period or periods of stay in India shall, in respect of such voyage, be determined in the manner and subject to such conditions as may be prescribed. CBDT notified new rules clarifying that the period of stay of seafarers outside India will be calculated from the date stamped on their continuous discharge certificate (CDC) (a seafarers identity document) at the time of joining the ship for the voyage till the date entered in the CDC at the time of signing off.

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Only an individual or an HUF can be classified as not ordinarily resident. In the case of all other persons, they can either be resident or non-resident.

2.6.2 Firms, AOPs, and HUFs In the case of HUFs, firms and AOPs the test revolves around where the head and the brain is located. An HUF, firm or AOP is resident in India if the control and management of its affairs are situated wholly or in part in India. If the control and management of these entities is situated wholly outside India, it is not a resident for the purpose of taxation. Hence, a firm, HUF or AOP can also have a residence in one or more countries. The control and management is dependent on where the head and the brain is located i.e. the persons who can be considered to be the ones making the decisions which in the case of an HUF would be a Karta, and in the case of a company would be the board of directors. [Erin Estate, Gallah, Ceylon (1958) (34 ITR 1) (SC) & Nandlal Gandalal (1960) (40 ITR 1) (SC)]]. Control does not necessarily mean where the trading activities are carried out; nor is the business managed from a place where the accounts are drawn up, or profits are distributed. Control and management implies directing the flow of resources and deciding the strategy and tactical moves with a long-term growth prospect of the entire company and not just a particular territory.

2.6.3 Company Erstwhile, two alternative tests were provided for determining the residence of the companies. A company was considered to be a resident if it was an Indian company or if the control and management of its affairs is situated wholly in India in the accounting year. Thus, every Indian company is a resident Indian. A point of distinction in the test of residence between HUF, firm, AOP and company is that, in the case of the former partial control and management in India is sufficient to constitute a resident, whereas in the case of a company the control and management must be wholly situated in India. Again, as in the case of an individual, a company can have more than one residence but the country of origin so to say is important for elimination of double taxation. Therefore, a non-Indian company whose control and management is not wholly situated in India would not be a resident. The word affairs means affairs which are relevant for the purpose of the Income-Tax Act and which have some relation to income [Erin Estate, Gallah, Ceylon (1958) (34 ITR 1) (SC) & Nandlal Gandalal (1960) (40 ITR 1) (SC)]]. The most common test for

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where the control and management is located is, where the directors board meetings are held. The place/country in which they are regularly held would be the country of residence. The place where the shareholders meetings are held is of no consequence. The Finance Act, 2015 amended section 6 sub-section 3 of the Act with respect to the test of residence in case of companies w.e.f. 1 April 2016. It was observed that due to the requirement that whole of the control and management should be situated in India and that too for the whole of the year, the condition had been rendered to be practically inapplicable. A company could easily avoid becoming a resident by simply holding a board meeting outside India. This facilitated the creation of shell companies that were incorporated outside India but controlled from India. In view of this, the Finance Act, 2015 introduced the internationally recognized concept for determination of residence of a company incorporated in foreign jurisdiction viz. Place of Effective Management (POEM). Further, POEM was defined to mean a place where key management and commercial decisions that are necessary for the conduct of the business of an entity as a whole are, in substance, made. The Explanatory Memorandum to the Finance Bill, 2015 had stated that since POEM is an internationally well-accepted concept, there are well recognised guiding principles for determination of POEM although it is a fact dependent exercise. However, it was proposed that in due course, a set of guiding principles for determination of POEM, would be issued for the benefit of the taxpayers as well as, tax administration. The draft of guiding principles was issued by the Government on 23 December 2015 for comments and suggestions from stakeholders and the general public. The same are yet to be finalized. In order to provide clarity in respect of the implementation of POEM based rule of residence and also to address concerns of the stakeholders, the Finance Act, 2016 has deferred the applicability of POEM based residence test by one year. Accordingly, it shall be applicable from 1 April 2017. The residential status of all taxpayers may change from year to year and therefore, must be examined each year afresh.

2.7 Jurisdictional test in India The power to levy and collect tax is derived from the Constitution of India. The Income-tax Act also derives authority from the Constitution. The important provisions of the Constitution are Article 265 which states that No tax shall be levied or collected except by authority of law and Article 246

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gives the authority to legislate to the Union and the States. A taxing statute can also be challenged on the ground that it contravenes any of the fundamental rights guaranteed by the Constitution. However, unless a provision is struck down by the Court as being ultra vires, there is a presumption that it is intra vires the Constitution. The Act is an exhaustive self-contained code. To establish taxability, there must be a link or a territorial connection between the person sought to be charged and the country seeking to tax him. If that connection is real and substantial even a non-resident is liable to tax in respect of his Indian income. This is where, the DTAAs come into play, to reduce or eliminate such taxation. However, as we saw it is the source rule which is predominant in most countries and therefore while double taxation may not be eliminated it will be reduced and credit for foreign taxes will be available in the country of residence. There are certain provisions, like section 9, which extend the territorial operation by way of fiction to deem certain income to accrue or arise in India. The Act extends to the whole of India. The Finance Act, 2007 amended the definition of India to mean the territory of India as referred to in Article 1 of the Constitution, its territorial waters, seabed and subsoil underlying such water, continental shelf, exclusive economic zone or any other maritime zone as referred to in the Territorial Waters, continental Shelf, Exclusive Economic Zone and other Maritime Zones Act, 1976 (80 of 1976) and air space above its territory and territorial waters. Every country has an extended zone which extends the boundary beyond the natural geographical limits. The Indian territorial waters limit is 12 nautical miles from the nearest point of the appropriate base line. This limit is important to extend the territorial scope of taxation especially in the case of oil and exploration activities. The sovereign of India extends to the territorial waters of India. Beyond the territorial waters, India has limited sovereign rights in respect of the sea-bed

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