Conflicts and Issues under The U.S. - India Tax Treaty

TAX TREATIES Conflicts and Issues under The U.S. - India Tax Treaty Shefali Goradia*, Carol P. Tello** When the income tax treaty between India and the United States ( Treaty ) was negotiated in the late 1980s, the economic relationship between the two countries was markedly different than today. At that time, the bulk of the capital and technology flowed from the United States to India and income flowed from India to the United States. The Treaty reflects this one-sided economic relationship in which the permanent establishment standard differs from the OECD Model Income Tax Treaty and withholding rates are higher than under U.S. treaties that reflect the OECD Model Income Tax Treaty. This one-sided economic relationship has changed, however, in over 20 years since the Treaty came into effect in 1991. As of 2011, India represented the 17th largest goods export market of the United States. The export from * Shefali Goradia is a Partner in the Mumbai office of BMR Advisors. ** Carol Tello is a Partner in the Tax Group of Sutherland Asbill & Brennan in Washington, D.C. She previously wrote Income tax treaty between India and the United States - Some observations [International Taxation 234 (Sept. 2012)] INTERNATIONAL TAXATION VOL. 10 JANUARY 2014 35 27

the United States of private commercial services to India also has grown during the period in which the Treaty has been in effect. For example, an increase of 351% over that in 2000 occurred. Moreover, India was the 13th largest supplier of goods to the United States in 2011. The imports to the United States from India totalled $36.2B in 2011, which is a 238% increase from 2000. Overall, Indian imports accounted for 1.6% of U.S. imports in 2011. 1-2 The growth in trade and investment is anticipated to continue to increase in the future. This growth raises the obvious question of when a new treaty that reflects the new economic relationship will be negotiated. Notwithstanding the increase in trade with the United States, in the last few years, the Indian tax system has undergone a number of reforms and measures have been undertaken to protect the tax base. In the current economic environment, many countries are attempting to correct the economic imbalances through unilateral domestic law changes. This has raised concerns over the sanctity of the tax treaties and, at times, prevented the contracting States from truly benefitting from the provisions of the treaties. Until such time that the Treaty is revised to reflect the current economic equation between the two countries, U.S. and Indian companies will continue to operate under the existing Treaty. This article examines some of the significant conflicts and issues under the Treaty. 1. CREDIT FOR SECONDARY TAXES PAID IN INDIA A company with distributable reserves typically has two options to offer to its shareholders. It can either pay dividends to shareholders or buyback its shares. As per the Indian Income-tax Act, 1961 ( Act ), dividend distributions by Indian Companies are liable to a distribution tax ( DDT ) at the rate of 16.995 per cent at the time dividend is declared, distributed or paid. Such distributions will not be taxable in the hands of the recipient shareholders and no further credit of such taxes can be claimed either by the company or its shareholders. DDT is not a withholding tax and the treaty withholding rates on dividends do not reduce this tax. DDT is a secondary tax on the profits distributed by the Indian Companies. Since the levy is on the Indian companies distributing dividends and not the shareholders, there remains an ambiguity on whether the shareholder would be eligible to claim credit of such DDT pursuant to the provisions of the relevant tax treaty. Treaties normally allow tax credit (subject to domestic law provisions in home country) on the tax levied on recipient of the income in the source country (e.g.: India). In the case of DDT, the tax will be levied on the Indian company and the shareholder would be fully exempt. Therefore, credit of DDT may generally not be available under the Indian treaties unless the domestic law in the country of residence of the shareholder provides for it. In the context of the Treaty, while there are no specific provisions concerning the creditability of DDT in the US, the following arguments prevail in support of such a position: (i) DDT partakes the nature of income-tax under the Act as is referred in the relevant provisions of India-US tax treaty 3 on the basis that it is referred to as additional incometax under the Act 4. (ii) Article 2(b) of the Treaty excludes from the scope of the Indian tax, any tax on undistributed profits of the companies imposed under the Act. Considering the references to the terms the tax on distributed profits so paid under the Act, DDT should not qualify as tax on undistributed profits of the companies. The US Internal Revenue Service has not issued any specific guidance on whether the dividend distribution tax will qualify as a foreign tax credit. Given that this is a tax levied at the Indian company level, the possibility of treating it as an indirect tax credit 5 for the US reporting purposes could be considered. To claim an indirect tax credit for US tax purposes, a corporate shareholder must directly own at least 10% or more of the stock entitled to vote. Article 25(1)(b) of the Treaty allows an indirect credit for Indian taxes paid by a distributing Indian corporation with respect to the profits out of which the dividends are paid. The argument certainly may be made that the DDT is described by Article 28 INTERNATIONAL TAXATION VOL. 10 JANUARY 2014 36

25(1)(b). Moreover, because the DDT is imposed on distributed profits, it may be argued that the DDT meets the requirements under the US foreign tax credit regulations. 6 Similar controversy may prevail in respect of the newly introduced buy-back distribution tax. As per the recently introduced provisions under the Act, Indian unlisted companies implementing a buy-back of shares are subjected to buy-back distribution tax ( BDT ) of 22.66 per cent on the difference between the consideration paid for buy-back and the amount received by the company on issue of such shares being bought back. The consideration received on buy-back will not be taxable in the hands of the shareholders and no further credit of such tax can be claimed either by the company or its shareholders in India. BDT does not apply to buy-back of shares listed on a recognised stock exchange in India. Like DDT, it becomes important to evaluate the availability of credit in the hands of the foreign shareholder of the BDT paid by an Indian company as in the absence of tax credit, BDT would be a cost for multinational enterprises. Since the provisions of BDT are akin to the DDT, the uncertainty around the creditability of such taxes as discussed above may continue. Further, as the computation of gain does not take into account the actual cost of shares in the hands of the shareholder, this may pose further challenges. Since this is a recent provision, the tax credit issue may not have yet arisen. 2. CAPITAL GAINS AND CREDIT MECHANISM Under the Treaty, each country has the right to tax capital gains in accordance with the provisions of its domestic tax law. Even though Article 25 seeks to provide relief from such double taxation by allowing credit of taxes paid in one country against the taxes to be paid in the other country, practical difficulties in claiming such credit continue to exist. Whether the taxpayer would be able to claim credit of the taxes paid in one country against the liability in another country remains uncertain due to administrative differences and may at times, result in double taxation of capital gains. Additionally, the recently introduced tax on indirect transfers may lead to a plethora of issues. Multinational enterprises typically hold shares in Indian subsidiaries through offshore special purpose vehicles ( SPV ), resulting in indirect holding in Indian companies. Until recently, such indirect transfer of stake in Indian entity by virtue of transfer of shares in a foreign SPV between two non-residents was understood to be outside the purview of the Act. After much litigation and controversies, the Act was amended retrospectively to bring within its ambit taxation of such indirect transfers. From a US perspective, Indian taxation of indirect transfers could be problematic. It is not clear whether the US would recognize the Indian tax on an indirect transfer as being consistent with Article 25(3) of the treaty. However, Article 13 clearly permits both India and the US to tax capital gain under domestic law. Therefore, Article 13 could require the US to allow a credit for Indian tax on indirect transfers. In that case, however, gain resourced under a treaty is subject to a separate foreign tax limitation. 7 That means that the Indian taxes imposed on the indirect transfer would be creditable only against the gain on which the Indian tax were imposed and could not be cross-credited against other income. Under US tax principles, the US provides a credit only for non-us taxes imposed on foreign source income as determined under US principles. When a US person sells stock, the source is determined by reference to the residence of the seller. Although a special source rule exception treats gain from the sale of certain foreign affiliates as foreign source gain, 8 that rule likely would not apply to an indirect transfer because one of the requirements is that the sale occur in the foreign country in which the affiliate is engaged in the active conduct of a trade or business. A non-indian holding company generally would not be engaged in such an active trade or business. As a result, the source of the gain from the indirect transfer would be US source under US domestic rules and the US treaty resourcing rule would apply. INTERNATIONAL TAXATION VOL. 10 JANUARY 2014 37 29

3. CHARACTERIZATION OF SOFTWARE PAYMENTS From the perspective of the Treaty, taxability of software payments is another important issue that merits discussion. The issue of taxation of cross border software licensing transactions has been a subject matter of contention between the Indian Revenue Authorities ( IRA ) and the taxpayers for more than a decade now, with the stakes involved becoming increasingly material. The principal issue is characterization of software payments for determination of taxation rights. The crux of the matter is the determination of what really is being procured when a payment for software is made and what rights are granted to a user. If the grant is of a copyright (i.e. an intangible) then the source country can tax it as royalty on a source basis. If instead, it is a sale of a copyrighted article (i.e. a product), the source country can tax it only in the event the vendor has a permanent establishment ( PE ) in the source country. On one side of the debate are taxpayers who argue that in purchasing software, end-users merely receive a copy of the software, i.e. a copyrighted article and not a right to the copyright in the software. Payments made represent purchase price for the article and are in the nature of business income. Consequently, such payments are not liable to tax in India in the absence of a PE in India. On the other side, the IRA argues that such purchases are in effect a license granted by software companies to end-users and hence the payments made represent a royalty for such license. The issue of characterization of payment for software purchase is unsettled and litigation is bound to continue. While there are conflicting decisions on the subject, few of these matters are now pending before the Supreme Court of India. The decision of the Supreme Court on the issue will help to clarify taxation of payments for software purchases in general. The US issued its software regulations 9 in 1998 that classify transactions involving computer programs. Under those regulations, a transfer of a computer program is treated as being one of the following: (i) a transfer of a copyright right in the computer program; (ii) a transfer of a copy of the computer program (a copyrighted article); (iii) the provision of services for the development or modification of the computer program; or (iv) the provision of know-how relating to computer programming techniques. The US generally will not provide a credit for foreign taxes imposed under a treaty royalty article on the sale of a copy of a copyrighted article. Under US foreign tax credit regulations, a taxpayer must exhaust all effective and practical remedies, including competent authority assistance, before claiming credit. 10 Consequently, if a US taxpayer does not challenge the imposition of the tax, the payment is treated as a noncompulsory payment. A foreign levy is a tax only if it requires a compulsory payment. 11 With the introduction of new forms of virtual business transactions such as cloud computing, the issues raised by computer software are compounded as taxpayers and governments engage in discussions to determine how to characterize the new digital business models. Action 1 of the OECD BEPS Action Plan is to address the challenges of the digital economy. The Task Force established to study these issues and to provide a report is expected to deliver a discussion draft in March, 2014. 4. CONCLUSION The economic relationship between India and the United States has changed since 1991 and continues to change and expand. The issues highlighted in this article are important to businesses that invest in the other country and that need certainty as to how they will be taxed. Without guidance on the foreign tax issues, uncertainty exists as to whether double taxation will result. And as the digital economy grows, more issues will arise. The significance of an income tax treaty is that it provides stability and predictability for investors. The need for a robust and resolution-oriented Competent Authority relationship between the United States and India is much needed to ensure that stability and predictability exists as the economic relationship changes and matures. i 30 INTERNATIONAL TAXATION VOL. 10 JANUARY 2014 38

1-2. The statistics presented are the latest available from the Office of the United States Trade Representative website, www.ustr.gov as of Dec. 20, 2013. The U.S. Census Bureau figures show 2013 trade in goods with India as U.S. exports to India as 18,477.6 M and imports from India as $35,954.6M. Compare these figures to the 1985 figures of U.S. exports of $1,641.9M and imports of $2.294.7M. http://www.census.gov/foreign-trade/balance/ c5330.html 3. Article 2(b) of the Treaty. 4. Section 115-O of the Act. 5. Section 902 of the Internal Revenue Code of 1986, as amended (the Code ). 6. Only an income tax may be creditable. To be an income tax requires that (1) it is a tax; (2) it is imposed by a foreign taxing authority; (3) it has as its predominant character that of an income tax in the U.S. sense. 6 Additionally, an income tax must reach net gain, which requires that four tests be met: (i) taxed on realization (and not before); (ii) gross receipts at fair market value (as opposed to a formulary determination of tax not based on actual gross receipts); (iii) net income, i.e., allows for recovery of expenses; and (iv) is not a soak-up tax, i.e., only imposed if a credit is provided by another country. 7. Section 904(h)(10) of the Code. 8. Section 865(f) of the Code. 9. Treas. Reg. 1.861-18 (T.D.8785 (9/20/1998)). 10. Treas. Reg. 1.901-2(e)(5). Note that only practical and effective remedies must be pursued. Where it is clear that a challenge to the amount or imposition of a foreign tax will not be successful, such challenge will not be required as a condition for claiming a foreign tax credit against U.S. tax. 11. Treas. Reg. 1.901-2(a)(2)(i). INTERNATIONAL TAXATION VOL. 10 JANUARY 2014 39 31