The Double Tax Avoidance Agreement (DTAA)

Relevance: GS-III: Effects of liberalization on the economy, changes in industrial policy, and their effects on industrial growth.

A Double Taxation Avoidance Agreement (DTAA) is a treaty signed between two countries, which incentivizes and promotes the exchange of goods, services, and investment of capital between the two countries by eliminating international double taxation. It is not a regulation to impose or determine tax rates but a comprehensive treaty between two sovereign states enumerating the detailed procedure and manner of taxation, with well-defined written terms and conditions to be strictly adhered to.

Objective: Its key objective is that taxpayers in these countries can avoid being taxed twice for the same income.

DTAAs with India

• India has a vast network of DTAAs with other countries under Section 90 of the Income Tax Act, 1961. Currently, India has established 94 comprehensive DTAAs and eight limited DTAAs While comprehensive agreements address all sources of income, the scope of limited agreements is, as indicated, limited to specific sources.
• A DTAA between India and other countries is drafted on a reciprocal basis and covers only residents of India and the residents of the negotiating country.
• Any person or company that is not resident, either in India or in the other country that has entered into an agreement with India, cannot claim benefits under the signed DTAA.

Purpose of DTAAs

Globalization has resulted in the rapid growth of multinational companies operating across multiple jurisdictions, which have led to certain loopholes in the manner of taxing global income – creating an incidence of double taxation. Each country has its own international taxation laws, which are divided into two broad dimensions:

• Taxation of foreign income: Taxation of resident individuals and corporations on income arising in foreign countries.
• Taxation of non-residents: Taxation of non-residents on income arising domestically.

The implication is obvious that the taxation of foreign income for one country (resident country) is the same as the taxation of a non-resident for another country (source country). This leads to dual taxation, the resident country taxing the income and the source country levying taxes on the same income.

To avoid this scenario, and to promote foreign investment to ease the flow of capital, governments enter such treaties with other countries. The need for DTAAs can be summed up as follows:

1. Avoidance of double taxation of income
2. Income tax recovery in both the countries
3. Equitable, rational, and fair allocation of taxing rights over a taxpayer’s income between two countries
4. Promotion and encouragement of free flow of international trade, investment, and technology
5. Increased transparency

Significance of DTAA

• DTAAs are intended to make a country an attractive investment destination by providing relief on dual taxation. Such relief is provided by exempting income earned abroad from tax in the resident country or providing credit to the extent taxes have already been paid abroad.
• DTAAs also provide for concessional rates of tax in some cases.
• DTAA can become an incentive for even legitimate investors to route investments through low-tax regimes to sidestep taxation. This leads to a loss of tax revenue for the country.
• DTAA also provides tax certainty to the various investors and businesses of both the countries through the clear allocation of taxing rights between the contracting states by Agreement.

Withholding tax rates under DTAAs

• Foreign or non-resident companies operating in India are subject to tax on their income – dividend, interest, royalty, or fees for technical services, as prescribed under the Income Tax Act.
• Under the Finance Act 2020, the Indian federal government scrapped the problematic dividend distribution tax (DDT) regime and introduced withholding tax on the payment of dividends. Consequently, the dividend is now taxed only in the hands of the recipient.
• According to the new regime, an Indian company paying dividends is no longer liable to DDT but should instead withhold tax at the source at the time of payment of the dividend since the recipient of the dividend is now subject to tax.

Misuse of DTAA

• India has signed DTAA with the tax havens such as Mauritius, Singapore, Cayman Islands, etc. These DTAAs have been misused by the MNCs in order to reduce their tax liability in India.
• For example, If the company (Shell Company) is registered in a tax haven and carries out the operations through its subsidiary based in India.
• Under the provisions of DTAA, the company would be liable to pay tax only in the tax haven country, even for the profits which it makes in India. This causes significant revenue loss for India.

Note: There is no universally accepted definition of a tax haven country. However, a Tax Haven Country has certain peculiar features such as:

1. Nil or Nominal Tax rates.
2. Does not share Tax-related Information with other Countries.
3. Presence of a large number of Shell Firms. These Firms are legally registered in tax haven countries but do not have a substantial presence there. Most of its activities are carried out through its subsidiaries based in other countries.

This is mainly done because, under the Terms of DTAA, the Firm would be required to pay tax only in a tax haven country and not in other countries. Since the tax rates are either Nil or Nominal in a tax haven country, the shell firm significantly reduces its tax liability.