The Hindu Business Line : The application of tax treaties

How are foreign companies taxed in India? The Double Taxation Avoidance Agreement (DTAA) with a country has to be interpreted along with the Indian income-tax law. No DTAA provision can fasten a tax liability where such liability is not imposed by the Income-Tax Act. The Agreement may be resorted to for nullifying or reducing a tax imposed by the I-T Act. In case of difference between the provisions of the Act and an Agreement, the latter will prevail.

Knowhow fees vs royalty

In this case (CIT vs Reiter Ingolsteadt Spinnervimaschinenbau Ag 285 ITR 199), a German company, Reiter Ingolsteadt Spinnervimaschinenbau Ag, entered into a collaboration agreement with Lakshmi Machine Works Ltd for manufacture of, among other things, high speed draw frames. The Indian company made down-payments in three instalments and the German company claimed that such payments were in the nature of technical knowhow fees and should be taxed at 20 per cent. The assessing officer (AO), however, held that the payments were in the nature of lumpsum attracting Section 9(1)(vi) of the I-T Act, 1961 and amounted to royalty which should be taxed at 30 per cent.

Para 5 of the exchange of notes between Germany and India laid down that royalty income consisting of lumpsum consideration shall be taxed in India at a rate not exceeding 20 per cent of the gross amount of such payment. The Tribunal held that, as per the DTAA provisions, the gross receipts received by the German company, whether termed as royalties or fees for technical services, should be taxed at 20 per cent. The Madras High Court upheld this view and decided the matter against the Revenue.

Treaty override

If the DTAA provides for a lower rate of tax, such rate will prevail over what the domestic law levies. This is because of the concept of treaty override. The Department, in the aforementioned case, did not dispute this concept. Instead, it chose to rely on the fact that the company's case rested on exchange of notes. Naturally, the court was not impressed. The practice of applying DTAA vis-à-vis domestic law varies from country to country.

The US and Japan prefer to apply the domestic law if it is more advantageous. Section 90(2) of the I-T Act makes it clear that where an agreement for granting tax relief for avoidance of double taxation has been entered into, then, in relation to the assessee to whom such agreement applies, the I-T Act will apply to the extent it is more beneficial than the DTAA provisions.

This principle has been recognised by the Supreme Court in the Azadi Bachao Andolan (263 ITR 706) case. But then one has to contend with the Explanation to Section 90, which declares that taxing a foreign company at a rate higher than at which a domestic company is shall not be regarded as a less favourable charge or levy of tax in respect of such foreign company.

In other words, application of differential rates of taxation to foreign and domestic companies would not amount to discrimination. Justification for the Explanation is given on the ground that dividends declared by domestic companies are taxed in India. The foreign companies do not declare dividends in India and the question of taxing the same will not arise.

Section 10(33) exempts dividends, but then Section 115-O levies tax on distribution of dividends. In several cases, the non-discrimination clause was invoked in appellate fora. One may refer to the Supreme Court Ruling in the Societe Generale case and the decision of the Authority for Advance Ruling (AAR) in the same case (236 ITR 103).

The Income-Tax Appellate Tribunal (ITAT) had decided the matter against the Revenue while interpreting the DTAA between India and the Netherlands in the ABN Amro Bank (33 BCAJ 667) case. In none of these cases did the Revenue highlight the retrospective amendment brought about by the insertion of the Explanation to Section 90. The Explanation itself goes against the sprit of the Vienna Convention of 1969 prohibiting discriminatory taxation of two sets of income earners who are otherwise considered as being in the same circumstance.

The Explanation is yet to be tested before any High Court. It was brought into the statute book by Finance Act, 2001 with retrospective effect from April 1, 1962. It can be argued that domestic law can override an international treaty. As far as possible, statutes are to be interpreted so as not to be inconsistent with established principles of international law.

The Supreme Court had recognised in the Gramaphone Company (1984 (1) SCALE 50) case that rules of international law are incorporated into national law and considered to be part of the national law, unless they are in conflict with an Act of Parliament. Indian courts will endorse international law only when it is not in conflict with an Indian law. If the intention is made expressly clear, the domestic law will prevail.

Would the decision in the Reiter Ingolsteadt case have been different if the retrospective amendment brought about by Explanation to Section 90 had been cited?

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