In the current world of continually advancing globalization and liberalization, international transactions and businesses growing on a global scale are routine scenarios. Many of the developed and developing countries already have a complex tax structure for residents and multiple forms of entities, such as companies, firms, LLPs, LLCs, etc., and the growing global businesses have increased this complexity in terms of accounting and taxation. A situation of double taxation (where both countries want to tax the income in their respective zones) arises when a person (an individual or an artificial Person) is a resident in one country and earns income from another country, or when a business incorporated and registered in one country earns income in another country.
To avoid the issue of double taxation, a double taxation avoidance agreement (DTAA) is signed by both nations. DTAA are of two kinds, i.e., Comprehensive agreements and Limited agreements. Comprehensive agreements take into consideration all sources of income while considering the double taxation, whereas, the Limited agreements take into account Income from Operations of Aircrafts & Ships, Estate, Inheritance & Gifts. As of now, India has signed 96 Comprehensive agreements & 14 Limited agreements.[i]
India-U.S. Double Taxation Avoidance Treaty
The treaty applies to persons who are residents in one or both countries. The treaty allows the persons to claim the benefit of exemptions, deductions, exclusions, allowance, or any other credit applicable in their respective countries. The word “persons” used in the treaty includes an Individual, an estate, a trust, a partnership, a company, a body of individuals, or any other taxable entity (the word person would be used for all the mentioned entities in this report from now on). There are varied factors that affect your business when one expands its reach in the international market.
The factors such as tax law of both the countries, determination of tax residency, and Permanent establishment of the business are the key factors that decide the overall tax calculation under DTAA.[ii]
Amongst multiple taxes levied, the following taxes are covered by the DTAA[iii],
- Federal income tax levied by the Internal Revenue Code (IRC)
- Varied excise taxes are collected on the insurance premiums, which are mainly paid to foreign insurers, to the extent of risk coverage provided by them. Such risk coverage shall not be reinsured with a person, who is not entitled to exemptions from such taxes.
The Income taxes levied by the Income Tax department of India and surcharge, which is an additional income tax charged over and above standard income taxes, when the total income exceeds a predefined sum.
The residency of a person is a key factor in determining the tax liability of a person. The term “Resident of a Contracting State” signifies a person, who is liable to pay the taxes as per the laws of the state, on account of his citizenship, domicile, place of management of the business, place of incorporation of the entity, residence, or other similar criteria. The term residence excludes the following scenarios:
- For income earned by a partnership firm, trust, or an estate, the term residence shall apply only to the extent of income earned by such entity in those respective states, as income of a resident; and
- The term is not applicable to a person who is liable to pay taxes in a state, only in respect to income sources in the state.
Based on the definition of “Resident of a Contracting State” provided above, there may be scenarios where an individual is resident of both the Contracting states (i.e., India and USA). In such cases, a Tie-breaker rule is required to be applied as per Article 4 of the Double Taxation Avoidance Agreement. Following are the guidelines, as per the DTAA treaty, to decide residency in such cases:
- The individual shall be considered to be a resident of the state where he has a permanent home. If he has permanent homes in both the states, then he shall be considered a resident of the state, where he has a majority of his personal and economic relations (vital interests).
- In cases, where the individual doesn’t have a vital interest in any of the states or the same cannot be identified, the residency shall be decided based on the place where he has habitual abode.
- Also, if he has a habitual abode in both India and the USA, he shall deem to be a resident of the country to that nation he belongs.
- At last, if he is a national of both the countries, then the residency shall be decided by both the countries via a mutual discussion and agreement.
Based on the definition of the “Resident of a Contracting State”, if a company is considered to be a resident of both the contracting states, then such corporations shall be treated as if they are not covered under the said convention. However, there are certain exceptions to the rule, such as Dividends (Article 10), Non-discrimination (Article 26), Mutual agreement procedure (Article 27), and other such scenarios.
As per the definition of the “Resident of a Contracting State”, if an entity other than an individual or a company is considered to be a resident of both the contracting countries, the competent authorities of both the nations shall mutually discuss and agree on the residential status of such entity.
As per Article 5 of the Double Taxation Avoidance Agreement, the place which is fixed by the business for carrying on business activities wholly or partly is considered as a permanent establishment of the business. Identifying the permanent establishment of a business is again an essential part of deciding the tax liability under the DTAA between India and the USA.
The term “Permanent Establishment” would majorly include the following,
- Place of management of business
- Branch office
- Factory for production
- Various workshops
- and other such places or structures necessary for carrying out the business.
The following shall not be considered as a permanent establishment of a business,
- Place used for only storage, display of products, or infrequent deliveries
- Place used solely for the purpose of collecting information or for purchasing the goods for the person
- Place used for the purpose of research, supply of information, or advertising for the person.
Thus, if a business has a place of business in any of the states for such auxiliary purposes mentioned above, such places shall not be considered as a permanent establishment.
A business entity that carries out its business as a broker or a commission agent in one country, shall not be deemed to have a permanent establishment in that country.
Also, when a business entity, resides in one country and, is controlling or is controlled by another entity, which resides in another country (or is just carrying on its business in another country, with or without a permanent establishment), shall not deem to be the resident of another country.
Also, when a company is a resident of one nation, and controls or is controlled by the company which is resident of the other nation, or is just carrying on the business in such other nation, it shall not be deemed for either of the companies to be considered as a permanent establishment of the other.
Analysis of the income earned by businesses and their taxability
Following are varied kinds of income and their taxability guidelines[iv],
Income from Immovable property
A business or an individual, being resident of a country (For example USA), selling immovable properties situated in another country (For example India), shall be taxed in that another country (i.e., India). The taxes shall also be levied if the immovable property is directly used, let out, or used in any other form to generate income. The definition of the term “Immovable property” shall be defined by the country in which such property is situated.
Income from business profits
For the purpose of this treaty, the business profits would include earnings from any trade or business, income from the furnishing of the services, income from rent of tangible properties. The profits earned by a person for the business shall be taxable in the country in which the business activities are conducted. In a scenario, where a person operates in another country with a permanent establishment, the income earned from such permanent establishment would be taxed by such another country as per their income tax laws.
Thus, when a business entity or a person, who operates the business in a country which it is a resident of, and also operates a business in another country, with a permanent establishment, the same shall be treated as a separate or individual entity of such another country to extent of the business activities performed by such permanent establishment. Such permanent establishment, for taxation purposes, shall be treated as a local entity carrying on a business of similar goods or merchandise or providing similar service, i.e., at the arms-length price[v].
Expenses, allowances, and deductions
While determining the profits of the permanent establishment, all the expenses incurred for operating the business in the permanent establishment shall be allowed as deductions. Also, a reasonable allocation of executive and general administrative expenses, expenses incurred in scientific research, interest, and other such expenses incurred in the country where the permanent establishment is situated or elsewhere. However, no payments made to the head office such as royalty, fees, charges relating to the use of patents, know-how, commission, or other such charges shall be allowed as deduction while determining profits for the tax purposes.
Also, no profits can be allocated to the permanent establishment by the head office, for the sole reason that the permanent establishment purchased the goods or merchandise for the enterprise.
The dividend income paid by a company, to a resident person of another country, shall be taxed by such another country.
These dividends are also taxed by the country from which the dividend is paid, as per the laws of such country. However, when the beneficial owner of the dividend income is a resident of another country, such tax shall not exceed
- 15% of the gross amount of the dividend, in the case where the beneficial owner earning the dividend is holding 10% of the total voting stock of the company.
- The maximum tax shall not exceed 25% in all other cases.[vi]
In a nutshell, before expanding the business globally, i.e., from the USA to India or vice versa, the comprehensive DTAA treaty between the countries must be considered. Also, the complexity of the tax laws in both countries differs for various entities. Hence, before going global, an entity must carefully select the form of entity, i.e., Proprietorship firm, Partnership firm, Company, and so on. Also, the size of the business and the taxation laws of both countries that is applicable. The countries must be kept in mind while choosing the form of the entity. Also, the type of income must be carefully checked.
Recently, even individuals have started investing in foreign markets in order to nullify the risk on their investment. Various Asset management companies have introduced plans where they diversify the funds of their investors in various industries and various countries as well, to significantly minimize the risk. Thus, understanding the impact of taxes on such global income has become more important than ever.