The Hindu Business Line : A second look at double tax

MAURITIUS continues to hog the limelight and accounts for over 20 per cent of investments in the equity markets by foreign institutional investors (FIIs) in India.

The total market value of FII investment in the country is around Rs 3,50,000 crore, of which, Mauritius accounts for Rs 17,700 crore. Leading FIIs have set up equity funds in Mauritius because the government there does not levy any tax on capital gains.

India's Double Taxation Avoidance Agreements (DTAAs) are drafted in such a way that these FIIs do not have to pay tax on profits in share market transactions. In addition to Mauritius, Luxembourg and Hong Kong have emerged as important tax havens.

The hue and cry raised about the favoured tax treatment to investments through Mauritius led to a landmark judgment by the Supreme Court, which ruled that whether the country should have recourse to questionable foreign funds at the expense of tax revenues was a matter to be decided by Parliament and the Government and it was not for the courts to interfere in such policy matters (UOI vs Azadi Bachao Andolan — 263 ITR 706).

The Government has not responded to the criticism about abuse of treaty provisions. Instead, it showed acute awareness of the problem when it incorporated the `Limitation of Benefits' clause in the agreement entered into with Singapore last year. This is similar to Article 24 of our agreement with the US.

The same rule should be incorporated in all our treaties with countries which are seen as tax havens. If necessary, the Income-Tax Act, 1961 should be amended to incorporate this clause so that all DTAAs are subject to this provision and the need to amend each of the agreements country by country avoided.

In a recent report, the Comptroller and Auditor General of India (C&AG) considered some aspects of non-resident taxation with reference to DTAAs. It emphasised that there should be an effective mechanism to ensure that the benefits of residency are available only to bona fide residents of the countries with whom we have entered into a treaty.

The C&AG recommended that the Finance Ministry undertake a cost-benefit analysis of the extension of benefits based on residency through treaty shopping even in respect of the existing DTAAs. If there is revenue leakage, it should be clear whether the Government was aware of it and chose to forego the revenue for other fiscal considerations. It may be that the Government wants to encourage inbound investments at the cost of revenues to give a boost to the economy.

Cross-border flows are in hundreds of billions of dollars. Our tax law has become dated, framed as it was with the manufacturing economy as the core. Today, the economy is dominated by services. Recently, the Supreme Court, in the TCS (271 ITR 401) case, held that the branded shrink-wrapped software is in the nature of goods and this has led to a plethora of rulings to the effect that the sale of software is for a copyrighted article and payments thereon cannot be treated as royalty.

The result is that the foreign supplier cannot be subjected to Indian taxes. Our own idea of royalty differs from country to country. The agreements with Russia, Morocco and Malaysia treat payments for transfer of software programs as royalty.

The OECD convention takes into account the local copyright law prevailing in the country where the software is acquired and advocates that the use of de minimis right be ignored in determining whether a payment can be characterised as royalty. Our ideas regarding software use and acquisition, telecom bandwidth, media and broadcasting transactions will all have to crystallise into a model legislation.

Indian companies have started acquiring overseas entities. Many of the countries, such as the UK and the US, have already structured the tax code to take care of entities run in the form of limited liability partnership (LLP) and limited liability company (LLC).

The Department of Company Affairs (DCA) has floated a concept paper on the subject. Issues concerning taxation of LLP/LLC and the partners thereon and capital gains on conversion of partnership into an LLP will have to be addressed in the near term.

The Government will have to clarify whether it accepts the ruling — in the Fidelity Advisor Series VIII (271 ITR 1) case — about not taxing FIIs from the US if they are doing business in the Indian stock exchanges.

Again, the issue of withholding taxes on remittances abroad needs a fresh look. Probably, one can do with less number of TDS rates than at present. The approach to taxation of foreign companies and their subsidiaries/branches will also require elucidation and clarification.

Is the branch of a foreign bank a separate entity as specified in Sections 92A, 92B, 92F, or is it part of a single corporate body (ABN AMRO BANK and Bank of Tokyo 280 — ITR 117 Kolkata SB)? Litigation cannot be allowed to proliferate on these issues.

(The author is a former Chief Commissioner of Income-Tax.)