Features of Treaties - International Taxation - Income Tax

Features of Treaties Basic Features of Tax Treaties Tax Residency Allocation of taxing rights Non-aggravation principle Tax credit mechanism Exchange of Information Limitation on benefits Tax residency Determination of residential status plays a crucial role for availing benefit of tax treaty in case the person is resident of one or both of the contracting States, Country of residence may have full right to taxing the global income of its resident and would grant relief in respect of tax paid in the country of Source. Article 4 of the tax treaty governs the provision of residence. It is to be noted that Article 4 of the tax treaty deals with residential status of a person, it does not provide rules for determination of residence. Instead, it refers to the determination in accordance with the provisions of domestic tax law of the respective Contracting State. Therefore, the residency of a person is determined by reference to the residency criteria under the domestic tax law of each state. Different states provide for different criteria like based on number of days of stay in a country, citizenship, personal and economic connection, habitual abode. Allocation of taxing Rights Generally, the residence state has the primary right to tax the global income of its residents unless it exempts that income under its domestic tax law. The taxing right of the source state gets curtailed under the DTAA as it is always a secondary state and has limited connection with the taxpayer. The rights of the source state are sometimes limited (e.g. in case of royalties, interest) or are unconditional or are conditional (e.g. business profits only taxable if PE exists). In some cases, no rights are granted to the Source State and the entire income is taxable in the Residence State. The allocation or distribution of the taxing rights depends upon the negotiation which takes place between the two countries and flow of investment and trade between them. Under the Income-tax Act, 1961, income is classified under five heads for determining the income chargeable to tax in India. Similarly, under DTAA, the income is characterized under articles 6 - 22 for the purpose of allocation of taxing rights in the country of source and in the country of residence. Non-aggravation principle Meaning of Non-Aggravation Principle Avoid actions that disputes domestic tax laws. No new charge can be created under the treaty The purpose of the tax treaty is to allocate or distribute the taxing rights between the Residence State and the Source State. The treaty cannot create a new charge or liability which is not provided for under the domestic tax law. Also, the treaties do not provide for the computation mechanism, the collection and the assessment of taxes and that is left to the discretion of the domestic tax laws of the respective countries. Tax treaties only distribute or assign taxing jurisdiction. It does not impose tax. Ex If any income is not taxable under domestic tax laws, such income cannot be taxed even if taxing provision provided under the treaty of such income. Tax Credit mechanism The Residence State is obliged to grant the credit of the taxes paid in the Source State as right of the Source State is curtailed under the tax treaty, There are two methods for granting credit of tax paid in source state a) the credit method or b) the exemption method. The exemption method - the Residence State exempts the income taxed in the source state. Some states also follow exemption with progression method whereby the income taxed in the Source State is exempted in the Residence State, however, the same is included for the purpose of determining the tax rate. The credit method - the states either follow full credit method or the limited credit method. Under the full credit method, the entire credit is granted for the taxes paid in the Source State. Under the limited credit method, the credit granted in the Residence State is restricted to the lower of the tax paid in source state or the tax on that income in the residence state. In some cases, certain types of income are relieved from double taxation by using the credit method while some get relieved from double taxation by using the exemption method. Exchange of Information India follows Tax Credit Method for elimination of double taxation in most of its treaties. Exchange of Information For avoidance of any tax evasion and tax avoidance Article 26 assumes a lot of significance. According to this Article, the competent authorities of the Contracting States shall exchange such information as is foreseeably relevant for carrying out the provisions of this agreement or to the administration or enforcement of the domestic laws of the Contracting States concerning taxes of every kind and description imposed on behalf of the Contracting States. Limitation on benefits/Entitlement to benefits. Limitation on benefits No benefit of treaty in case of tax avoidance and the treaty shopping arrangements. It limits the benefits of the tax treaty to be granted only in the genuine cases. Limitation on benefits clause provide for certain objective tests like expenditure tests, active business test for the resident of a particular country to qualify for the treaty benefits. It provides for not granting the treaty benefit to the sham entities. India has included Limitation on benefits article in its treaties with the USA, Singapore, Mauritius, etc.