The Hindu Business Line : Steer clear of neither-here-nor-there situations

A FASCINATING debate on the practice of international tax law that is coming more to the fore is whether tax treaties which are entered into for `avoidance of double taxation' can also be simultaneously interpreted to mean that they are for `avoidance of double non-taxation'.

Double non-taxation arises when an item of income is untaxed or taxed marginally, owing to the operation of a tax treaty combined with the domestic law of either or both the contracting states.

To deal with double non-taxation, perhaps one ought to take a look at the history of double taxation.

Historical perspective

The earliest recorded instance of double taxation was with respect to a problem that occurred in the 13th century on property tax levied in France and Italy.

Though the first UK tax treaties dealt with inheritance taxes, double taxation with regard to income arose as a problem when India first introduced its income-tax in 1860.

In 1861, a petition was presented to Parliament pointing out that UK residents would suffer double taxation in India. The British Parliament, however, decided that the UK income-tax (I-T) law should not be modified simply because another country had chosen to adopt a similar system of taxation.

The problem, however, was accentuated in the UK when rates of taxes rose sharply during the First World War, and, in 1916, the first tax relief was provided in the UK, whereby an assessee would be repaid an amount that would reduce the UK income-tax on his income to 17.5 per cent or the colonial income-tax on that part of his income, whichever was lower.

Thereafter, till 1945, extensive tax treaties did not find place till the treaty with the US was signed, whereby the UK policy on taxation on a `pure residence basis' was given up to recast the right of a source country to tax certain income.

Before this, in 1921, the League of Nations in response to a Resolution of the International Finance Conference held in Brussels in 1920 had appointed four independent economists to undertake the study of the subject of `International Double Taxation'. The Economist's report published in 1923, recommended four methods for double taxation relief, namely:

i) the country of residence deducts from the tax of all its residents all foreign tax paid;

ii) country of origin exempts all non-residents from tax imposed on income within its borders;

iii) tax could be divided between the country of origin and the country of residence; and

iv) specific categories of income would be assigned either to the country of origin or to the country of residence, although the latter would retain the right to tax all income but would give credit for the taxes paid.

It is interesting that though the fourth method recommended has become the generally accepted norm for double tax treaties, it was the second method which was recommended by economists.

The Organisation of Economic Co-operation and Development (OECD), published its first draft Double Tax Convention in 1963, which was followed by amendments in 1974 and the First Model Double Tax Convention with revised articles and commentaries based on experience of OECD members-states in 1977. Article 13 of the OECD Income Tax Model 1977, which relates to capital gains, is similar to the DTAA between India and Mauritius currently in force. Under this Convention, two articles dealt with `methods for elimination of double taxation' — 23A with the exemption method and 23B with the credit method.

Under the exemption method, Article 23A(1) provided that where income or capital which in accordance with the Convention "may be taxed" in the other state, the first-mentioned state (namely, the residence state) is required to `exempt such capital or income from tax' and the only provision for considering that income or capital for taxation in the residence state is for calculation of income-tax on the remaining income or capital of such resident.

Therefore, under the 1977 Model Tax Convention, especially when one considers Article 23(A), the requirement is to `exempt' income from taxation in a particular contracting state and there is no evidence or a "subject to tax" clause, which indicates that the Model Convention was for simultaneously avoidance of double taxation and double non-taxation.

When double non-taxation

Income characterisation conflicts: The possibility of double non-taxation can arise when two contracting states classify the same income under different articles of their tax treaties and issue to such classification so characterisation, the item of income remains untaxed in both the states.

For example, under the French-US 1967 tax treaty in respect of directors' fee for services rendered in the US, the IRS of the US was of the view that this income paid to a resident of France was independent personal service under Article 14 of the Treaty. And, because directors did not spend more than 183 days in the US and did not have a fixed base there, this income was not chargeable to tax in the US.

On the other hand, France held that this was "other income" taxable solely in the US under the "other income" article.

Owing to the characterisation conflict between the two states, it resulted in double non-taxation and the income remained untaxed in either state.

Both the countries removed this dichotomy in 1984 by way of a protocol which sought to prevent double non-taxation, but this led to a situation that could result in double taxation. Therefore, Article 22(1), dealing with other income, was amended thus:

"Items of income of resident of contracting state, wherever arising, not dealt with... shall be taxable only in that state." Thus, a resident from France would be taxable there of any US director's fee. This amendment removes double non-taxation, subject of course to the US not taking the view that it is independent personal services with a fixed base which may lead to double taxation.

In another case in 1974, the US did not tax foreign sourced income — salary for services rendered in the US of a German employee working for a German company, even though the employee had performed services in the US for more than 185 days, and, under the 1954 US-German tax treaty, the right to tax the same was given to US.

The German court held that pursuant to the aforesaid treaty (which was similar to Article 3(2) of the 1977 OECD Model) in interpreting German domestic law, the question simply was whether the salary was "income from sources within the US".

Under that law, the salary had a US source, because the services in respect of which it was paid were performed in the US.

However, under the Treaty there was an additional rider which provided that the exclusion from German tax under the Article was only available to income which "according to this Convention is not exempt from tax by the US".

This clause also was held not to apply to permit Germany to tax, as the exclusion from taxation was not a result of treaty operation but domestic law.

Similar situations also used to arise when residents of Germany were partners in a US resident partnership.

Interest received from that partnership was deductible in the hands of the US firm and was exempt from tax by the 1954 US Germany Tax Treaty from taxation in Germany.

(To be concluded)

(The author is a Mumbai-based advocate.)