Royalties and Fees for Technical Services in International Trade

3. DOUBLE TAXATION AVOIDANCE AGREEMENTS

When investments or business transactions transcend the frontiers of a country, the problem of double taxation of income derived from such dealings arises because both the country of domicile of the income earner and the country where the income was earned claim the right to tax on the residence basis and source principle respectively.38 Since the cumulative taxation of the same income by two countries can be prohibitive and could act as a deterrent to foreign investment, intercontinental trade and commerce, the tax system of some countries had provided for unilateral relief measures. But when these measures were not found to be sufficient, countries arrived at satisfactory accommodation of the conflicting claims through bilateral arrangements, whereby each country undertakes to give up or at least relaxes its tax claims on the residents of the other contracting state.

The influence of organisations like OECD and UNO has been substantial in making an impressive network of tax avoidance agreements. Today, India has Double Tax Avoidance Agreements [DTAA] with more than 60 countries.39

3.1 General Considerations

3.1.1 Authority to enter into Agreements

§ 90 of the IT Act authorises the Central Government to enter into DTAAs with other countries. The power to enter into international agreements is vested with the Central Government by virtue of Articles 73 and 253 of the Constitution read together. Such agreements have the force of law, not merely due to § 90 of the IT Act, but also because Article 51 of the Constitution mandates the State to endeavour to ‘foster respect for international law and treaty obligations in the dealing of organised peoples with one another.’ An Agreement reached by the Government can contain provisions for the granting of relief in respect of income on which tax has been paid under laws of both contracting states or income chargeable under the IT Act. Moreover, the purposes can also include avoidance of double taxation and exchange of information.40

3.1.2 Constitutional Validity of DTAAs

The question of the Constitutional validity of the DTAAs, especially the one entered with Mauritius came up before the Supreme Court in Union of India v. Azadi Bachao Andolan.41 The facts were that the petitioners were aggrieved by a circular issued by the CBDT directing the Income Tax authorities to accept a certificate of residence issued by the authorities at Mauritius as sufficient evidence as regards the status of resident and beneficial ownership, and filed a petition in the Delhi High Court challenging, inter alia, the powers of CBDT to issue such circulars which were allegedly ultra vires of the IT Act, the practice of ‘treaty shopping,’42 and the bar upon the Assessing Officer from lifting the corporate veil to ascertain if there is avoidance of tax by treaty shopping. The High Court allowed the petition, which led to an appeal being filed in the Supreme Court. With reference to treaty shopping, the Supreme Court held that in the absence of a limitation clause, the motives with which the residents have been incorporated in Mauritius are wholly irrelevant and cannot in anyway affect the legality of the transaction. Therefore, the Assessing Officer would not have the authority to lift the corporate veil. Next it dismissed the contention of the respondents that since there was nil or low tax in Mauritius, taking advantage of the DTAA, companies were marauding the resources of the country by shifting their tax liability to Mauritius. The Court sought to make a distinction between ‘liability to taxation’ and ‘payment of tax,’ and held that for the purposes of the DTAA only the liability to taxation was relevant.

3.1.3 Nature of DTAA and relation to IT Act

A DTAA supplements and does not oust the IT Act in India. There can be no treaty which is repugnant or inconsistent with the law in India. In fact, there is no scope for inconsistency as such in the DTAAs, since they do not purport to abrogate any provision of the IT Act, but only avoid hardship to the taxpayer. Moreover, the benefits conferred on a taxpayer by a treaty are not in lieu or in derogation of the various tax incentives, deductions and exemptions available at law, but in addition to them. Therefore, the taxpayer has an option to choose from the IT Act and the DTAA, whichever is more beneficial to him.43 Lastly, since the subject matter of DTAAs is only income, the treaties do not contain any provision covering the expenditure incurred in earning the income.44 As to the relation between DTAAs and IT Act, the law is well settled that the treaty will override the law. In CIT v. Davy Ashmore India Ltd., 45 the Court pointed out: “The conclusion is inescapable that, in case of inconsistency between the terms of the agreement and the taxation statute, the agreement alone would prevail.” The CBDT too in circular No.33, dated 2nd April, 1982 instructed ITOs that the correct legal position is that the provisions in DTAAs will prevail over the provisions contained in the IT Act.

3.2 Anchors of Treaty Entitlement

Though it is agreed that DTAAs provide for relief to the non-resident, the question arises whether the treaty would apply automatically or whether there are some conditions precedent. Most of the agreements provide that certain conditions have to be satisfied before the treaty can be applied. Here we will discuss some such general conditions.

3.2.1 Treaty Residence

Identifying an entity as a residence is essential before that person can take benefit of the DTAA. The OECD model convention specifies that resident means any person who, under the laws of that state, is liable to tax therein by reason of his domicile, residence, place of management or any other criterion of similar nature. This is a very broad definition that allows a wide category of person reliefs under the DTAAs, and is usually adopted by tax haven countries like Mauritius. However, some countries whose investors are mostly bona fide residents adopt such conditions as shown below: USA: In the case of income derived or paid by a partnership, estate, or trust, this term applies only to the extent that the income derived by such partnership, estate, or trust is subject to tax in that State as the income of a resident, either in its hands or in the hands of its partners or beneficiaries. UAE: An individual to be considered as an UAE resident should have stayed there for at least 183 days in a calendar year, and a company incorporated therein should be one managed and controlled wholly in UAE.

To avail the benefits of DTAA, a non-resident must satisfy that he is a resident of the other contracting state, where he is liable to pay tax. In Cyril Eugene Pereira,46 the benefit of DTAA with UAE was denied to the assessee on the ground that his income by way of salary which arose in India could not have been liable to tax in UAE because in UAE there is no tax on individual’s income. This decision has been severely criticised as being misdirected,47and though not expressly overruled, the distinction between ‘liability to pay tax’ and ‘payment of tax’ as expounded by the Supreme Court in Azadi Bachao Andolan’s case surely has reduced greatly the relevance of this case.

3.2.2 Beneficial Ownership

Beneficial owner may be identified as the entity exercising full control over the income component. Most of the DTAAs have a beneficial ownership clause, whereby the country of source is obliged to relax its tax treatment of the non-resident only if the beneficial owner of such income is a resident of the other contracting state. Thus, if the assessee is only a front for persons who are not bona fide residents of the other contracting state, then relief through DTAA will not be available. In Nat West Securities B.V. v. Dy. CIT,48 the tribunal observed that if there is a conduit which has been introduced in a particular country without there being any substance available with that particular conduit, a conduit which is working on a back to back basis as a post office or a courier, it may not be regarded as beneficial owner though it might be incorporated in that country.

3.2.3 Limitation of Benefits Clauses

A Limitation of Benefits (LOB) provision is an anti-abuse provision that sets out which residents of the Contracting States are entitled to the treaty’s benefits. The purpose of an LOB provision is to limit the ability of third country residents to obtain benefits under the said treaty. When third country residents establish companies in a Contracting State with the principal purpose to obtain the benefits of the treaty between the Contracting States, it is known as ‘treaty shopping.’

It was the United States which started the trend of adding a LOB clause in its income tax treaties in the early 1980s, and the reason could be that if most of the investment flowing in from a contracting state belongs to third party states, then the contracting state might lose interest in the treaty. Also, by denying DTAA benefits to entities of countries that do not have agreement with us, we compel them to make an agreement, and therefore promote transparency in trade. By now, India too is in the process of renegotiating its tax treaties to provide for a LOB clause.49

Article 24 of the Indo-US DTAA ensures that only ‘qualified residents’ of either treaty country obtain treaty benefits. In this regard, Article 24, paragraph 1, provides an Ownership/Base-erosion Test that is a two-pronged test, both of which must be satisfied. Under the first prong of the test, more than 50% of each class of an Indian company’s shares must be owned by individual residents who are subject to tax in either India or the United States, or by the government or government bodies of either Contracting State. Under the second prong of the test, the Indian company’s gross income must not be used in ‘substantial’ part, to meet liabilities (such as interest or royalties liabilities) in the form of deductible payments to persons, other than persons who are residents, US citizens or the government or government bodies of either Contracting State. Secondly, paragraph 2 of Article 24 provides that an Indian company will qualify for treaty benefits, regardless of its ownership, if it is engaged in an active trade or business in India and the item of income for which treaty benefit is being claimed is connected with or incidental to such trade or business. Thirdly, a company incorporated in a contracting state in whose principal class of shares there is substantial trading on a recognised stock exchange would not be eligible under the treaty. However, paragraph 4 of Article 24 provides that even a person that is not entitled to the benefits of this Convention pursuant to the provisions of the preceding paragraphs of this Article may, nevertheless, be granted the benefits of the Convention if the competent authority of the State in which the income in question arises so determines. Similarly, Article 29 of the Indo-UAE DTAA provides that an entity which is a resident of a Contracting State shall not be entitled to the benefits of the Agreement if the main purpose or one of the main purposes of the creation of such entity was to obtain the benefits of the Agreement that would not be otherwise available.

3.3 Royalties and fees for technical services in DTAAs

In order to promote international free movement of intellectual property and technology, DTAAs may provide for clauses which drastically narrow the scope of services which are liable to tax in the source state. We already know that in case of variance between the domestic law and treaty law, the domestic law has to acquiesce. In such situations, the assessee is free to choose whichever law which gives him more benefits. There are two popular models of DTAAs—one by OECD and the other by UNO. Most the treaties India has signed are modelled on the UNO Treaty.

3.3.1 Royalties in Indian DTAAs

The UNO model on which most of Indian DTAAs are modelled defines royalty as ‘payments of any kind received as a consideration for the use of, or the right to use, any copyright of literary, artistic or scientific work including cinematograph films, or films or tapes used for radio or television broadcasting, any patent, trademark, design or model, plan, secret formula or process, or for the use of, or the right to use, industrial, commercial, or scientific equipment, or for information concerning industrial, commercial or scientific experience.’50 It can be observed that DTAAs narrow the scope of items which otherwise would have been liable for tax on royalty. Thus, if a transfer of an intellectual property is not mentioned in the DTAA, then the non-resident assessee can claim that profits to be taxed under the head of business income since they have been exempted in the DTAA.

Relief is possible to the non-resident through the narrowing of the term royalty in the DTAA. An instance of relief gained through such narrow terminology would be Dy. CIT v. Panamsat International Systems Inc. 51 The issue in this case was whether the payments received from various TV channels by PanAmSat International Systems, a US-based satellite transmission service provider, do not constituted royalty and thus not liable to tax in India. There was a precedent in Asia Satellite Telecommunications Co. Ltd. v. Dy. CIT, wherein the tribunal had held that payments received by the assessee for lease of transponder capacity on satellites with an India footprint were royalty according to § 9(1)(vii) of the IT Act because, according to the tribunal a “process” was provided by the satellite operator to its Indian customers. However, in Panamsat, the assessee sought to distinguish itself from Asia Satellite on the ground that under the Indo-USA DTAA which was applicable to the assessee, royalty applied to only those processes which were secret in nature, because in the DTAA a comma had been placed after the words “secret formula or process” a deliberate departure from § 9(1)(vi) of the Income Tax Act, 1961, implying that the process should be secret to qualify the payment as Royalty. Since transponder technology was also available off the shelf, it could not be categorised as secret process, thus it was held that the assessee was not liable for tax on royalties. So, even when business models are similar, if a different wording is given in the DTAA, relief can be availed.

3.3.2 Technical Services in India DTAAs

A study of DTAAs entered by India will show that India has been very liberal in allowing technical services rendered by non-residents to take advantage of tax benefits by the methods of absence of article relating to such services, override of independent personal services article and the concept of fees for included services.

Analysis of the DTAAs entered by India with Mauritius, Philippines, and Saudi Arabia will show that there is a deliberate absence of an article relating to technical services. Similarly, the DTAA signed with USA does not provide recognition for managerial services, in contrast with § 9(1)(vii) of the IT Act. The consequence of this is that assessees from such countries can claim profits arising by way of technical services to be business income, which is taxed at very low or nil rates by virtue of the DTAAs.52

The second method of liberalisation is through override of the article on independent personal services. A study of DTAAs entered by India with USA, UK, UAE and Mauritius shows independent personal service has been defined broadly to include the independent scientific, literary, artistic, educational or teaching activities as well as the independent activities of physicians, surgeons, lawyers, engineers, architects, dentists and accountants. The DTAAs provide that income earned from independent personal service can be taxed only by the country of residence, except in some cases. These activities of skilled persons which could have come within the definition of technical service have thus been exempted this way. The third method is the concept of Fees for Included Services, a term peculiar to the DTAA entered with USA. The term Fees for Included Services deals with technical services, but its coverage is much narrower than fees for technical services. The MoU entered between India and USA shows that for a service to be considered as an included service it should be not only a technical or consultancy service but it should also be ancillary and subsidiary to the application or enjoyment of a right, property or information for which a royalty payment is made; or if it makes available technical knowledge, experience, skill, know-how, or processes, or consists of the development and transfer of a technical plan or technical design. The following hypothetical example will demonstrate the meaning of included services. An Indian manufacturing company produces a product that must be manufactured under sterile conditions. A US company has developed a special cleaning process for removing such deposits from that type of machinery. The US company enters into a contract with the Indian company under which the former will clean the latter’s machinery on a regular basis. As part of the arrangement, the US company leases to the Indian company a piece of equipment which allows the Indian company to measure the level of bacterial deposits on its machinery in order for it to known when cleaning is required. Here, the provision of cleaning services by the US company and the rental of the monitoring equipment are related to each other. However, the clearly predominant purpose of the arrangement is the provision of cleaning services. Thus, although the cleaning services might be considered technical services, they are not “ancillary and subsidiary” to the rental of the monitoring equipment, and accordingly will not be classified as included service.

4. CONCLUSION

The above study on the confluence of intellectual property and taxation in international trade has taken us on a journey demonstrating the struggles of the Indian taxation system in coping with taxation of intangibles. With the judgments in Azadi Bachao Andolan and Ishikawajima-Harima cases, the judiciary has restored some order into the chaos and brought the taxation in accordance with accepted principles of taxation, though there have been also some aberrations like the case of Cyril Eugene Pereira. These cases have restored hope that along with DTAAs, the Indian taxation system can create a conducive atmosphere for the investment in India of foreign intellectual property and technology. In this respect the authors humbly put the following suggestions:

• The DTAAs entered into by India should be modified to have compulsory LOB clause so that they are not abused for treaty shopping purposes by third country residents.

• S.195(2) of the IT Act which provides that when a person responsible for paying a sum chargeable to income tax to a non-resident, if he considers such sum not chargeable to income tax, should first obtain a certificate from the Assessing Officer needs to be repealed because it is not in consonance with the DTAAs signed by India, and also with S. 195(1) of the IT Act itself. 5.

REFERENCES

1 United Nations Conference on Trade and Development, Taxation and Technology Transfer: Key Issues, https://www.unctad.org/en/docs/iteipc20059ch1_en.pdf, last visited on 06.09.08.
2 This is applicable if certain conditions given in the provisions are satisfied and only to agreements reached on or after
01.05.2005; for agreements reached on or before 31.05.1997, the rate is 30 percent, and for agreements reached between
31.05.1997 and 31.04.2005, the rate is 20 percent. § 115A(1) of the Income Tax Act.
3 Sunil Agarwal, Payments to Non-Residents under Composite Agreements and Withholding Tax, [2004] 271 ITR 20 (Jour.).
4 [1964] 51 ITR 353.
5 [2000] 72 ITD 415.
6 See supra headings 2.1.1 and 2.1.2.
7 [1979] 120 ITR 444 (Pat.).
8 Cited in Samsung Electronics Company Ltd. v. ITO, [2005] 276 ITR 1(Bang).
9 PSI Data Systems Ltd v. CCE, (1997) 2 SCC 78.
10 [2007] 288 ITR 408.
11 [2003] 259 ITR 391(Bom.).
12 But intangible goods like software too are classified as goods when they are embedded in a physical thing like tape or disc. See Tata Consultancy Services v. State of AP, [2004] 271 ITR 401.
13 See Sudhir Raja Ravindran, Intellectual Property and Taxation, New Delhi: LexisNexis, 2007, p.57.
14 See infra heading 2.2.2.
15 (1995) 76 ELT 481 (SC).
16 Oxford Dictionary of Law, 5th ed., Oxford: Oxford, 2003. See also Rajaratnam and Venkataramaiah, Commentary on Double Taxation Avoidance Agreements, 3rd ed., New Delhi: Snow White, 2007, chap.25.
17 [1991] 190 ITR 626 (Cal).
18 Tata Consultancy Services v. State of AP, [2004] 271 ITR 401.
19 Sunil Agarwal, Are Computer Software License Fees Royalty under Income Tax Laws, [2005] 274 ITR 113 (Jour.).
20 Ibid.
21 [2006] 286 ITR 133 (Bang). See also Motorola Inc. v. Dy. CIT, (2005) 95 ITD 2G9 (Del)(SB), Kotak Mahindra Primus Ltd. v.
Deputy Director of Income Tax, MANU/IT/0259/2006.
22 103 ITD 3
23 [2003] 263 ITR 230(MP).
24 [2005] 278 ITR 57(AT).
25 Clause (iva) to Explanation 2 of § 9(1)(vi) of the IT Act. However, the amounts referred to in § 44BB are excluded.
26 Neeru Ahuja, Characterisation of Income—Royalty & Fees for Technical Services, https://www.ficci.com/media-room/speechespresentations/
2006/nov/tax/day%202/session3/neeru.ppt, last visited on 06.09.08.
27 PD Desai, Lecture on Royalties & Fees for Technical
28 Ibid.
29 Ibid.
30 Ibid.
31 [2000] 243 ITR 459(Mad).
32 [2004] 267 ITR 209(Kar).
33 [2001] 251 ITR 53(Mad.).
34 See supra note 24 .
35 [2003] 263 ITR 230(MP).
36 169 Taxmann 201.
37 [1997] 224 ITR 203(AAR).
38 See TN Pandey, Double Taxation Avoidance Agreements and their Implementation—Tax Treaties and Domestic Law, [2000] 243
ITR 1 (Jour.).
39 KD Raju, Intellectual Property Taxation In India: Need For A Comprehensive Policy And Law, https://ssrn.com/abstract=1166546,
last visited on 06.09.08.
40 § 90(1) of the IT Act.
41 [2003] 263 ITR 706. See V. Swaminathan, Tax Treaties—Nuances of Case Law, [2007] 295 ITR 17(Jour.).
42 When third country residents establish companies in a Contracting State with the principal purpose to obtain the benefits of the
treaty between the Contracting States, it is known as ‘treaty shopping.’
43 § 90(2) of the IT Act.
44 See supra note 38 .
45 [1991] 190 ITR 626(Cal.).
46 [1999] 239 ITR 650.
47 S. Rajaratnam, Double Tax Avoidance Agreements—Unresolved Uncertainties, [2003] 260 ITR 37 (Jour.).
48 MANU/IU/5044/2004.
49 Declan Gavin, Limitation of Benefits Provisions in Income Tax Treaties, https://www.bcasonline.org/articles/artin.asp?771, last
visited on 06.09.08.
50 See Rajiv Shah, Royalties and Fees for Technical Services—Indian treaties, https://www.bcasonline.org/articles/artin.asp?150, last
visited on 06.09.08.
51 MANU/IT/0177/2006.
52 See supra note 27.

BIBLIOGRAPHY

BOOKS

Sudhir Raja Ravindran, Intellectual Property and Taxation, New Delhi: LexisNexis, 2007

Rajaratnam and Venkataramaiah, Commentary on Double Taxation Avoidance Agreements, 3rd ed., New Delhi: Snow White, 2007

LECTURE

PD Desai, Lecture on Royalties & Fees for Technical Services in International Trade, Bombay Chartered Accountants’ Society, Mumbai, on 07.05.08.

ARTICLES

Sunil Agarwal, Payments to Non-Residents under Composite Agreements and Withholding Tax, [2004] 271 ITR 20 (Jour.).

Sunil Agarwal, Are Computer Software License Fees Royalty under Income Tax Laws, [2005] 274 ITR 113 (Jour.).

TN Pandey, Double Taxation Avoidance Agreements and their Implementation—Tax Treaties and Domestic Law, [2000] 243 ITR 1 (Jour.).

V. Swaminathan, Tax Treaties—Nuances of Case Law, [2007] 295 ITR 17(Jour.).

S. Rajaratnam, Double Tax Avoidance Agreements—Unresolved Uncertainties, [2003] 260 ITR 37 (Jour.).

WEBSITES

United Nations Conference on Trade and Development, Taxation and Technology Transfer: Key Issues, https://www.unctad.org/en/docs/ iteipc20059ch1_en.pdf, last visited on 06.09.08.

Neeru Ahuja, Characterisation of Income— Royalty & Fees for Technical Services, https:// www.ficci.com/media-room/speeches-presentations/ 2006/nov/tax/day%202/session3/neeru.ppt, last visited on 06.09.08.

KD Raju, Intellectual Property Taxation In India: Need For A Comprehensive Policy And Law, https://ssrn.com/abstract=1166546 Declan Gavin, Limitation of Benefits Provisions in Income Tax Treaties, https://www.bcasonline.org/ articles/artin.asp?771, last visited on 06.09.08. Rajiv Shah, Royalties and Fees for Technical Services—Indian treaties, https://www.bcasonline.org/ articles/artin.asp?150, last visited on 06.09.08