Why you should be aware of double tax avoidance treaties?

Why you should be aware of double tax avoidance treaties?

The agreement was conceived to protect expats and companies from being taxed twice, but its misuse is rampant

Why you should be aware of double tax avoidance treaties?

In November 2018, India and China signed a protocol on Double Taxation Avoidance Agreement (DTAA) to avoid taxing individuals and companies twice for the same earning and also to prevent tax evasion.

In a statement, the Indian government said that besides other changes, the Protocol – an international agreement that supplements or amends a treaty – “updates the existing provisions” in the original agreement with China, and “incorporates changes required to implement treaty-related minimum standards”.

China is not the only country with which India has signed the Double Taxation Avoidance Agreement (DTAA) – there are altogether 88; of this, agreements with 86 are in force, though the terms, agreed rates of tax, and the jurisdiction on specified types of income usually vary from country to country

Related: Small businesses: Taxation 101 

Explaining Double Taxation Avoidance Agreement (DTAA)

DTAA is an international tax agreement between two or more countries who want to ensure that a tax paying individual or a company from any of the signatory countries but working/operating in one of the others is not taxed twice on the same earnings. 

Such an agreement is needed as chances of double taxation of an entity or a person, for one particular income, becomes a distinct possibility when there is free flow of trade, investment, and transfer of technology between two countries.

This is because a taxpayer’s native or home country has a sovereign right to tax him or her, even for earnings from any occupation in another country. At the same time, the other country – the “host country” where the individual works – also has a right to tax any income arising on its territories. 

This is where Double Taxation Avoidance Agreement (DTAA) comes handy; without its cover, an expatriate in any country may end up paying income taxes in the country he or she makes an income, as well as to the government of the home country. This goes for Indians working abroad as well; they will be protected from double taxation if the country where they are stationed in has a DTAA with India in place.

Related: How to minimise the effect of taxation on long-term capital gains 

There are two broad types of DTAAs: first, it may be comprehensive, meaning it encompasses income from all sources, or second, it may be limited to earnings in some specific sectors, such as shipping, airlines, inheritance etc.  

India’s DTAAs with Australia, Canada, Germany, Mauritius, Singapore, UAE, the UK and the US fall in the first category. 

Among its “limited” agreements is the air transport pact it has with Afghanistan. Then again, there are DTAA on capital gains; this agreement is in place with several countries such as Cyprus, Singapore and Egypt, among others.

Double Taxation Avoidance Agreement (DTAA) Advantages

There are numerous advantages to be had under Double Taxation Avoidance Agreement (DTAA), apart from the fundamental one of not getting subjected to double taxation on the same income and much-needed tax neutrality. Some of the other advantages are for the companies and citizens of the signatory countries are:

  • Tax deduction at source or TDS (i.e. lower withholding tax*)
  • Tax credits**
  • Tax exemption
  • Tax rate concessions

*Withholding tax, also called a retention tax, is an income tax paid to the government by the payer of the income rather than by the recipient of the income. Paying it means the TDS burden on a taxpayer gets automatically lowered, and is applicable for incomes such as interest earnings, dividend earnings or royalty. 

**(Most DTAA provide for tax credits in the country of operations or the source to avoid double taxation).

At the government level, DTAA helps in:

  • Reducing the possibility of tax evasion in both or either of the signatory countries;
  • Making each country more attractive to investors of the other.

Double Taxation Avoidance Agreement (DTAA) provisions supersede the general provisions of tax laws of a particular country, including India’s domestic statutes. Sec 90(2) in the Indian Income Tax Act, 1961 allows the assessee the choice to be governed by either the relevant DTAA or the 1961 tax Act.

How NRIs Benefit

India’s Income Tax Act spells out who qualifies to be an Indian citizen, but not who is an NRI. Thus, anyone not meeting these standards is generally known as an NRI, provided he or she is born of Indian parents outside India and permanently residing outside India.

They are also sometimes known as a person of Indian origin (PIO). A perfect and well-known example would be author Jhumpa Lahiri: born to Bengali emigrants in London and raised in Rhode Island, who still maintains close links with her parents’ families in Kolkata. 

There are also the emigrants, people who have migrated to another country for work and settled there; former Pepsi CEO Indra Nooyi would be one such; born and raised in Chennai and now an American citizen, she is known to travel to Chennai on a private visit; she too is deemed an NRI.  

However, there are also those who are eligible for NRI status if he or she has been domiciled abroad for 181 days. Once an Indian citizen is deemed an NRI on this count, and if that individual wants to avail of concessions granted to an NRI, his or her original savings bank account will have to be converted to a Non-Resident Ordinary (NRO) account; such people cannot operate a regular savings account. 

The NRO account, which can be jointly held with a resident Indian, is also a savings account but specifically designed for NRIs, and which enables them to make transactions of funds originating in India such as rents, dividends, pensions etc. 

NRO accounts come handy for people who are temporarily stationed overseas and avail of NRI benefits. The interest they earn on deposits in such accounts is treated as income originating in India, and is taxed a hefty 30.9%.

However, if India has Double Taxation Avoidance Agreement (DTAA) with the NRI’s adopted country, TDS will be at the rate proposed in the agreement, which is usually between 7%-15%.

If any of the services mentioned below are taxable in the country of residence for an NRI, he or she can avail of benefit from DTAA to pay tax only once. Broadly, these services are:

  • Salary earned in India;
  • Fixed deposits in India;
  • Saving bank account deposits in India;
  • Capital gains earned in India;
  • Salary received in India, and
  • Real estate property in India.

How to Tap Double Taxation Avoidance Agreement (DTAA)

Whatever be the source of income, there are two basic methods by which relief is extended under DTAA: bilateral relief, and unilateral relief.

*Bilateral relief: This is the type of relief that comes into play when two countries reach an agreement to provide safeguard their respective citizens against double taxation by mutually working out the mechanism to enable it. In India, the legal go-ahead to work out such an agreement is granted under Section 90 and 90A of the Income-tax Act, 1961.

*Unilateral relief: This kind of relief is extended by the native country even if there is no DTAA signed with the resident country, and this is done as sometimes, even bilateral agreements may prove insufficient to meet all the instances of double taxation. Section 91 of the Income Tax Act, 1961 facilitates such relief. Unilateral relief is only available when doubly taxed income is included in assessee’s total income.

The assessee NRI has the right to choose the method best suited for him or her when applying for relief under DTAA. But the assessee must submit the following documents to the tax authorities:

  • A self-declaration-cum-indemnity form;
  • A self-attested copy of visa and passport;
  • A copy of PIO Proof;
  • A self-attested copy of PAN card;
  • A Tax Residency Certificate (TRC). 

What needs to be noted is that if one is working in India and is a taxpayer, it is mandatory to have a Permanent Account Number (PAN). TRC is a key credential for getting Double Taxation Avoidance Agreement (DTAA) benefits, and like the PAN card, can be got from India’s income-tax department.

Related: How advance tax can help you stay on track with tax payments 

Double Taxation Avoidance Agreement (DTAA) Misuse

The problem is, an agreement that is meant to bring relief to the taxpayer is frequently abused by some taxpayers, usually misused by individuals operating through shell companies, and even corporates from a third country. India has faced this problem, and its treaty with Mauritius is exploited for the abuse.

There are two ways by which Double Taxation Avoidance Agreement (DTAA) abuse occurs: round-tripping and treaty shopping.

*Round-tripping: This is when domestic investors of a country route investment through a shell company in a DTAA partner country to avoid paying tax at home. Indian businessmen are known to take this route, misusing India’s pact with Mauritius. Their modus operandi: they first “invest” in Mauritius to set up a shell company there; then this “invested” amount” is rerouted to India as Foreign Direct Investment (FDI) for investing in the capital markets. Point to note: Investments from tiny Mauritius account for about 35 % of India’s FDI inflows.

Related: What makes tax-saving exercise an important financial planning tool? 

*Treaty shopping: This is when investors from a third country take the shell company route.

There are two main reasons why the DTAA with Mauritius is found attractive for abuse, when India has similar agreements with some 87 other countries, though according to recent reports, the Netherlands too is fast emerging as a “competitor” to Mauritius.

The first reason is that an individual only needs to have a postal address to be deemed a resident of Mauritius, which makes it that much simpler to set up a shell company. Second, Mauritius is a tax haven and imposes no capital gains tax. This means that investing in India as a “Mauritius-based investor”, companies and individuals not capital gains exemptions in India under the DTAA, but they are also exempted in Mauritius.

This was earlier, the treaty has now been amended, and India will apply capital gains tax in a phased manner.