Utility Of Double Tax Avoidance Agreement

Introduction

A Double Tax Avoidance Agreement (DTAA) is a tax treaty or agreement between two or more countries that prevents income received in both countries from being taxed twice.

If a company in country A (origin country) invests in country B (source country) for building, the question is whether it is liable to pay tax in both countries.

No, the main goal of the Double Tax Avoidance Agreement (DTAA) is to ensure that there is no tax evasion, that information is exchanged between countries, and that there is no double taxation. Such an arrangement means that the corporation will only have to pay tax in one of the countries.

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Double Tax

A Double Tax Avoidance Agreement (DTAA) can either be a broad agreement that includes all sources of income or a restricted agreement that only taxes income from air transportation services, shipping, and other particular fields.

India has signed double taxation treaties with over 80 nations, including extensive agreements with Australia, Canada, Germany, Mauritius, Singapore, the United Arab Emirates, the United Kingdom, and the United States.[1]

Advantages OF DTAA

Aside from not having to pay double tax on earned income, there are other advantages such as-

  1. Tax Exemption- Let’s pretend that country A (the source country) levies a 10% capital gains tax. This is regarded as tax exemption when the government of country A (source country) announces that it will not collect tax on investment from country B (origin country) and will exempt country B from tax on capital gains on investment.
  2. Lower Tax Rate- Lower Tax Rate- Using the example above, if country A (source country) imposes a 10% tax on capital gains, it notifies country B (origin country) that it will collect tax on capital gains at a rate of 5% on investments made in country B. This is known as tax reduction.
  3. Refund- Assume that company X from country A (origin country) invests in country B (source country) and pays tax on income earned in country B of $100 (hypothetical) (source country). Business X may receive a refund of $100 or a portion of the tax from Country A (origin country). In the definition of a Double Tax Avoidance Agreement, this is referred to as a refund (DTAA)[2]

Misuse of DTAA

Treaty Shopping- It is when a national or a citizen of a third country impersonates a business or other individual in one of the countries in order to benefit from a double tax avoidance arrangement (DTAA) between two or more countries. Treaty shopping, as a result of this principle, is one of the misuses of double taxation avoidance agreements (DTAA).

Let’s say an investor from country A (the origin country) invests in country B (the source country) and earns a certain amount of money. Now, preferably, country B will pay a 10% (hypothetical) tax rate on this specific income.

Let’s pretend that country C and country B have signed another double tax avoidance agreement (DTAA) in which country C is excluded from paying tax on income received from country C’s investment. As a result, country C would not have to pay any taxes.

Now, when company of country A routes his investment into country B via country C, he will pay tax at 0% on the income earned, because country C is exempted from tax by the agreement between country B and country C.

Thus, when an investor from a third country routes his investment from a country which has got the agreement with the source country, where investor ends up paying very less tax or no tax at all, this concept is known as treaty shopping.

To prevent this abuse, the countries have a provision in their agreement known as the Limitation of Benefits (LOB clause) that determines which investments are made solely to benefit from the double taxation avoidance agreement (DTAA) and which are genuine investments.[3]

For example, in the case of a double taxation avoidance agreement (DTAA) between India and Singapore, the Limitation of Benefits (LOB clause) stipulates that the investor making an investment in India must have spent at least $2 million in Singapore dollars in the 12 months prior to making the investment in India.

Multilateral Instrument (MLI)

The Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting is one of the outcomes of the OECD/G20 Project to tackle Base Erosion and Profit Shifting (‘BEPS Project’) i.e. tax planning strategies that exploit gaps and mis-matches in tax rules to artificially shift profits to low or no-tax locations where there is little or no economic activity, resulting in little or no overall corporate tax being paid. The Action Plan 15 of Base Erosion Profit Shifting (‘BEPS’) Report, “Developing a Multilateral Instrument to Modify Bilateral Tax Treaties”, concluded that a multilateral instrument, providing an innovative approach to enable countries to swiftly modify their bilateral tax treaties.[4]

The functionality of MLI is given below:

  1. MLI does not replace existing tax treaties
  2. MLI modifies bilateral tax treaties in a synchronised, fast and consistent manner
  3. One negotiation, one signature, one ratification – Avoids renegotiation of each tax treaty
  4. MLI will not function in the same way as a protocol

Abuse of tax treaties is an important source of BEPS. The MLI helps the fight against BEPS by implementing the tax treaty-related measures developed through the BEPS Project alongside existing bilateral tax treaties in a synchronised and efficient manner. These measures help combat (a) treaty abuse, (b) improve dispute resolution, (c) prevent the artificial avoidance of permanent establishment status and (d) neutralise the effects of hybrid mismatch arrangements. Under OECD / G20 BEPS project, Action 15 was formulated for “Developing a MI to modify bilateral tax treaties.”

Conclusion

The intent behind a Double Tax Avoidance Agreement is to make a country appear as an attractive investment destination by providing relief on dual taxation. This form of relief is provided by exempting income earned in a foreign country from tax in the resident nation or offering credit to the extent taxes have been paid abroad.

Double Tax Avoidance Agreement is a treaty which indeed helps in removing ambiguity of paying tax twice and at same time ensures that there is no tax evasion by exchange of information among both the countries. But the most important thing to be kept in mind is to prevent misuse of the agreement, by not adopting methods such as treaty shopping.

India presently has DTAA with 80+ countries, with plans to sign such treaties with more countries in the years to come.

Author: Rishab Pillai, A Student At Dharmashastra National Law University, Jabalpur, in case of any queries please contact/write back to us via email to chhavi@khuranaandkhurana.com or at  Khurana & Khurana, Advocates and IP Attorney.

[1] Organization of Economic Co-operation and Development (OECD)-http://www.oecd.org

[2] United Nations Model Double Taxation Convention between Developed and Developing Countries, 1980-http://unpan1.un.org/intradoc/groups/public/documents/un/unpan004554.pdf

[3] Double Taxation Avoidance System,

blog.ipleaders.in/double-taxation-avoidance-agreement/

[4] Rationale behind Introduction to MLI,

wirc-icai.org/images/publication/Multilateral-Instrument-Beginners.pdf

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