The liberalization process that was started in the early 90’s and the resultant opening up of the Indian economy has been a great learning process for one and all during the last fifteen years. Countries across the globe, Governments, professionals, economists and the captains of the industries with the usual assorted soothsayers and doomsday prophets on the subject have all been proved both right and wrong in their assumptions and forced not only to change their views more than once but also to become students all over again.

One of the four principal agreements signed by the member countries is the Agreement on Trade Related Investment Measures, popularly referred to as the TRIMS. TRIMS are basically agreed upon measures by the member countries of WTO to enable international firms to access foreign markets easily by phasing out domestic rules, which discourage or limit foreign investors in their countries. These limitations and restrictions were primarily in the nature of giving excessive protection to domestic firms and/or imposing certain stiff and often unreasonable conditions on those foreign players who ventured to invest in domestic markets. Admittedly, the OECD and the developed countries of the west rooted for this agreement for their own selfish ends on the assumption that the opening up of the economies in countries like India and China would enable them to expand their business exponentially and thereby they can gain control over the resources in these countries. Those opposing this in India were also equally convinced that the Multi-national companies would devour the domestic industries and there would be misery and unemployment all over. Both sides had visions of cola flowing down the streets and people addicted to burgers and potato chips in the developing countries. Fifteen years down the line, both have been proved wrong. While the foreign companies have definitely obtained access to Indian markets, there has also been a significant amount of flight of capital and manufacturing bases out of the developed countries and the emergence of the Indian MNCs.

An enterprise traditionally grew in size by investing more and more with a view to expanding its operations. However in the present scenario mergers and acquisitions is the most popular way to grow. When these are resorted to with a view to capture foreign markets, the terminology used is Cross Border Investments. The main reasons for Cross Border investments are:

Ø Quickest way of going global

Ø Access to raw materials, qualified labour, IP rights, new technologies and other resources in bulk

Ø Gaining entry into foreign market by riding on established brand names and business groups

Ø Expanding range of products and services through backward and forward integration

Once a cross border investment decision is taken, the investment advisors/ managers are faced with the problem of formulating the most effective model for the same. This would involve selecting the most appropriate mode of investment, the method of controlling the investment, the ease with which the investment can be liquidated and last but most importantly to ensure that the entire process involves the least tax impact. In this process, the study and application of the various tax treaties or conventions between countries have assumed great importance and interest. This article gives a very brief overview of the manner in which the tax treaties are being applied in cross border investments. The study is done in three parts viz,

• Meaning and Necessity for tax treaties
• The use of tax treaties as tools for minimizing tax impact
• Current trends.

A tax treaty is essentially an agreement between two sovereign countries for governing the collection and levy of taxes arising out of transactions between the residents of the two countries. The treaty is not a law although the instrument signed by the respective countries is governed by international law. The power to enter into treaties is normally derived from the constitutional powers of the respective countries.

The usual rules of the tax laws of countries across the globe have necessitated the concept of tax treaties. One of the common rules of taxation is that a resident of country is taxed on his global income while a non resident is taxed only to the extent of the income earned by him in that country. Accordingly if X is a resident of India, then he would be liable to pay tax in India on the entire income earned by him from anywhere in the world. On the other hand if he were to be a resident of say UK, with some interest and rental income in India, then he would be taxable in India only on the income that is deemed to arise and accrue in India. In the UK however, he would be liable to pay tax on not only the income earned in UK but also in India. Thus the problem is summarized as below:

India as the Country of source for the rental and interest income would levy tax on those items as per its domestic laws on the logic that they have accrued to him within the territorial jurisdiction of India.

UK as the country of his residence would also seek to levy a tax on the same rental and interest income on the basis of his being a resident of that country.

Thus it can be seen that the same item of income has been sought to be taxed by two different countries and would act as a deterrent for the efficient use of capital. A tax treaty (generally called Double Taxation Avoidance Agreement or DTAA) is therefore drawn as an instrument to avoid double taxation of the same income in both countries and also to grant relief in one country to a taxpayer in respect of the taxes paid in the other country.

Using tax treaties as tools for tax planning

While the tax treaties are entered into by the contracting states within the ambit of their domestic tax laws, it is also an established rule that the provisions of the treaty shall override the domestic law if they are more beneficial to the tax payer. Again countries enter into these treaties keeping in mind very many considerations involving political, economic and other considerations. In this process, the contracting countries may agree to exempt income earned by the resident of one country in the other or one country may even exempt or give up its right to collect tax on certain items of income in favour of the other country for the purpose of attracting investments from the entrepreneurs of that country.

Considering that different countries have different rates of taxes on income, it is but natural that an enterprise seeking to expand globally would try to route its investments through a country that would give it a tax advantage vis-à-vis the home country’s rate or at least minimize its tax burden. While investments through certain countries which are known tax havens are generally viewed with suspicion by the tax authorities, the more popular method is to take advantage of the treaty provisions that exist between countries and route the cross border investments through a country affording the maximum tax advantage. A typical example is illustrated below:

Parent Company company in USA---> Intermediary Holding Company in Mauritius --> Subsidiary in India

In the above example, assume a company in USA wants to acquire controlling interest in a company in India. It registers a holding company in Mauritius and routes its funds through that company into the Indian company’s shares. This is because the DTAA between India and Mauritius provides that capital gains arising from the sale of assets other than immovable properties would be taxable only in the country where the taxpayer is resident. Now Mauritius does not have any capital gains tax on sale of shares and India exempts dividends declared by listed companies from tax. Thus the Intermediary Company in Mauritius gets tax exempted dividends. At a future date, should the parent company in USA decide to divest its holding in the Indian company, it would ask its subsidiary in Mauritius to sell the shares of the Indian company or it will sell the shares of the Mauritius subsidiary itself to the intending buyer and thus get tax free capital gains.

The example given above is a very simple one and in practice the cross border investments are done through a much more complex network of holding and subsidiary companies across many countries.

Current Trends

Thus using DTAAs for global investments have become the norm of the day and as can be expected the tax authorities too are not far behind in coming up with their own methods to counter this. While Courts in general have ruled that taking advantage of treaty provisions as legitimate, (Refer the decision of the Supreme Court in the Azadi Bachao Andolan case, a landmark case worldwide), they have also sought to discourage the practice of tax evasion by investing through shell companies or conduits registered in tax havens. Governments too have sought to give themselves extra-territorial jurisdiction and bring to tax the income that has potentially arisen within their jurisdiction. Recently the House of Lords ruled that a payment made by Nike,a well known footwear company to a one man company owned by Andre Agassi, for endorsing its products during the Wimbledon championship was taxable in UK even though both the payer and payee were non residents of UK and the payment itself was made outside UK. Another classic example at home in India is that of the raging battle in the case of the takeover of Hutch by Vodafone. Here, Vodafone acquired from Hutchinson Telecom, registered in Hongkong, a 2 dollar company registerd in Cayman Islands, which held all the shares of an investment company in Mauritius , which in turn held the majority stake in Hutchinson Essar of India. The Income tax department issued a notice to Vodafone seeking to treat it as a defaulter inasmuch as it had paid a sum to a non-resident in respect of an interest attributable to a property in India, without deduction of tax at source. The writ petition against this notice has been dismissed by the Mumbai HC. Although the case is far from decided, the Mumbai high court has recognized in principle, the right of the Indian tax authorities to demand tax on transactions entered outside India involving property situated inside India.

Thus while the battle for going one up continues between the tax advisor and the tax gatherer, newer and smarter measures and counter-measures keep coming up. Whatever may be the outcome; the study of tax treaties has assumed a great role and offers exciting scope for both the student and the practising professional.

CA. R.E BALASUBRAMANYAM