Double

taxation
avoidance
agreement
(DTAA)
Nature, Purpose,
Abuse and
Remedies

Aditya Mudgal (A030)

Fourth Year B.A. LL.B.

ABSTRACT
Income tax, the world over is to be charged
in the hands of the person at the place where
he or she derives the income or where he or
she resides. However, with the growth of
global trade and commerce we are faced
with the problem of double taxation. Double
taxation occurs when the resident of one
state derives his income in another state
(called the source state) then unless there
exists a double taxation treaty between the
two countries the individual may have to
pay taxes in both the resident and the source
states. This will increase his cost and deter
international trade.
Developed countries enter into double
taxation treaties because they want their
citizens to take part in international trade
and commerce whereas developing countries
enter into double taxation treaties so that
they attract more investment in their
countries. Thus these treaties are all double
taxation avoidance treaties.
The phenomenon of ‘tax treaty abuse’ or
‘treaty shopping’ has recently gained
momentum in India, especially in the
context of the India-Mauritius Treaty in
which the practice remains largely
unfettered.
In order to effectively curtail treaty abuse,
there should be a coherent and uniform
regime of international taxation, which may
eventually lead to a multilateral tax
agreement.
INTRODUCTION
A tax treaty is an agreement between two
countries to modify their generally
applicable rules of taxation for transactions
and relationships between persons resident
in the two countries.
They provide an indispensable mechanism
for alleviating double taxation of
international transactions. In bilateral
treaties, each country is assigned two
different roles - that of the investor's country
of residence and that of a host country
(where the investment, or the economic
activity, takes place). The countries have
reciprocal rights and duties, since each
country is both a residence country to its
resident investors and a host to the other
country's residents. But one could also
conceive of a treaty as an agreement
between a residence country and a host
country in which the former provides some
alleviation from double taxation in return for
some reduction by the host country in its tax
rates for investors who are residents of the
residence country.
The importance of double taxation treaties
has grown tremendously in this century and
after the Second World War, a number of
Asian and African countries gained
independence and the need to promote
greater inflow of foreign investment on
politically acceptable conditions arose. This
has been affirmed time and again in
resolutions of the General Assembly, the
UN Economic and Social Council and the
UN Conference on Trade and Development.
In 1968, the Secretary-General of the UN set
up the ad hoc group of experts on tax
treaties between developed and developing
countries. This groups of experts drafted the
final Model Convention which was
published by the United Nations in 1980
along with commentaries1.
The emergence and growth of transnational
enterprises have altered the legal and
economic relations amongst nations.
Increased foreign direct investment and
parallel opening up of new economies to
foreign investors have made international
legal and fiscal arrangements between
nations more complex. One of the
immediate outcomes has been the enhanced
concern for coordination in taxation among
nations.2
Apart from the unilateral measures, bilateral
double taxation agreements have been one
of the prominent tools that nations have
been using to counter this problem. These
bilateral tax treaties aim to lessen the burden
of juridical double taxation. Both developed
and developing nations adopt these treaties
to serve their respective needs. This often
gives rise to conflict of interests.
NATURE OF DOUBLE TAXATION
AVOIDANCE AGREEMENT
Double taxation agreements (DTAs) are
sometimes referred to as double taxation
conventions or treaties. Some States refer to
them as double taxation avoidance
agreements (DTAAs). They are all the same
thing having more or less the same object
1
K. Srinivasan, Guide to Double Taxation Avoidance
Agreements, 1.8-1.10 (1994).
2
Peggy B. Musgrave, “The OECD Model Tax Treaty:
Problems and Prospects”, Colum J World Bus,
Summer 75
and purposes, the primary among them
being the avoidance of double taxation.
These agreements are predominantly
bilateral in nature. There have been some
multilateral agreements negotiated to deal
with fiscal arrangements between nation
States, such as the Nordic convention and
the multilateral agreements among
Caribbean States, but they are not common.
Under international law, tax treaties impose
obligations on the States to guarantee that
they become a part of the domestic law and
usually require ratification by each State3.
There are two ways by which the States
incorporate such treaties into domestic law.
They are categorised as follows:
(1) Direct effect approach: Treaties are
automatically incorporated in the domestic
law of the State concerned without need for
special legislation. Examples — France,
Luxembourg, Switzerland. Sometimes a
formal executive or legislative Act may be
required as in case of the United States and
Austria.
(2) Indirect effect approach: Treaties require
enactment of special domestic legislation to
incorporate them into domestic law.
Examples — India, the United Kingdom.
Hence, we see that these tax treaties have a
dual role. They are agreements between
sovereign States under public international
law to deal with tax coordination and related
matter. At the same time they also become a
part of the domestic law of the contracting
States after they have been incorporated by
any of the two methods stated above.
3
Angharad Miller and Lynne Oats, Principles of
International Taxation (Tottel Publishing, 2006) 92
There has been considerable debate over the
point whether tax treaties can impose
additional tax liabilities under domestic law.
The general consensus has been that they
lessen or eliminate tax liabilities but do not
impose additional tax burden under
domestic law.
As far as the relationship between double
taxation agreements and domestic law is
concerned, it is the international agreements
that enjoy a superior status. It is the
constitutional provisions in respective States
that will finally decide the answer as to the
choice of giving priority to international
agreements over domestic laws. Unilateral
acts by the States leading to treaty override
may lead to a chaotic situation under
international law. It will in effect, defeat the
very purpose for which the treaty was
negotiated and may be regarded as a breach
of international law4.
PURPOSE OF DOUBLE TAXATION
AVOIDANCE AGREEMENT
The central purpose of double taxation
agreements, as the name suggests, is to
lessen or eliminate double taxation. This
very objective flows from another primary
purpose of encouraging international trade.
It is believed that double taxation or
multiple taxation is one of the major
obstacles in international trade. Such
bilateral tax treaties aim at reducing the tax
burden and hence foster international trade
4 6
Roy Rohatgi, Basic International Taxation, (Vols.
1st, 2nd, Edn. 2005) 17, 18.
and movement of goods, services and capital
from one country to another.5
The States aim for improved cooperation
amongst themselves for combating fiscal
evasion. Treaties provide for mutual
assistance and exchange of information
between the contracting States. Tax treaties
also purport to restore some certainty in the
tax regime by defining common and
contentious terms such as “permanent
establishment” and “residence”. Elimination
of discriminatory tax regimes and sharing of
tax revenue are some of the other purposes
of tax treaties. The taxpayer views the treaty
from a different angle. A taxpayer is not
likely to be impressed with the provisions
against fiscal evasion and is likely to be
intimidated by the provisions for exchange
of information. The information now
provided by them to their resident State may
easily be available with the authorities of
another State with which tax treaties have
been negotiated. In my view, this might
even incite a taxpayer to adopt various
undesirable practices for withholding
important information to serve his own
purpose.6
The countries are divided into residence and
host nations which are usually developed
and developing countries respectively. The
host or a developing nation generally prefers
to administer lower rates of taxation on
foreign investment in order to face fierce
international competition. T. Dagan notes
5
Peggy B. Musgrave, “The OECD Model Tax Treaty:
Problems and Prospects”, Colum J World Bus,
Summer 75, Vol. 10
Philip Baker, Double Taxation Conventions and
International Tax Law (2nd Edn. 1994)
that minimising the “tax wedge” which the
author explains as the “efficiency loss due to
imposition of taxes” should be the goal of a
host State so as to attract foreign investment.
In deciding its fiscal scheme, the host nation
usually takes into account the corresponding
policy adopted by the resident State. This is
based on three criteria, namely, the State of
residence could either follow a scheme
providing “exemption”, “credit” or
“deduction” to its resident's foreign
investment. If the residence State “exempts”
the foreign earned income of its resident
then the host State prefers to levy no tax. In
case of “credit” given by the resident State,
the host State will tax the investments at
high rates or at the maximum rate prevalent
in the residence State and in case of
“deduction” it is advisable to forego the tax
as “deductions” do not entirely eliminate the
amount of tax that has been paid in the
foreign State. Looking from the residence
country's point of view, the most favourable
policy framework is based on the same three
mechanisms which can be enforced
unilaterally to achieve the desired goals.
This is dependent on the amount of
outbound investment the residence country
is willing to encourage and the amount of
the tax revenue it wants to share.
It is seen that in each case, unilateral action
by residence and host nations is sufficient to
prevent double taxation. The main point of
differentiation between unilateral action and
bilateral tax treaties is the allocation of the
proportion of tax revenue. Tax treaties seem
to be biased towards residence countries
helping them get a larger pie of the tax
share. This is achieved by reducing the host
country's tax rates and in some cases
restricting the jurisdiction to tax certain
kinds of income. Hence, we can say that
negotiating bilateral treaties is not a sine qua
non for alleviation of double taxation. This
can be achieved by unilateral action also.
There are other political, economic and
social factors that contribute and encourage
the conclusion of such treaties but it would
not be right to say that tax treaties are the
only means by which double taxation can be
avoided.7
ABUSE OF DOUBLE TAXATION
AVOIDANCE AGREEMENT
Individuals from countries that have
concluded no, or only unfavorable tax
treaties, often feel encouraged to take
advantage of a tax treaty between other
countries that is not normally available to
them. The term ‘treaty shopping’ or ‘treaty
abuse’ refers to the tax avoidance strategies,
which involve the use by residents of third
states of legal entities established in a tax
haven state with the principal purpose to
obtain the benefits of a tax treaty between
the tax haven state and another contracting
state.8 It represents the use of a tax treaty
provision by a person, or in a way, not
intended by the treaty drafters.
The proliferation of tax treaties with tax
havens, along with the increasing
availability of tax advice for investors in the
international arena, the large number of
investors. seeking countries with stable
7
Tsilly Dagan, “The Tax Treaties Myth”, (2000) 32
NYUL Int'l Law & Pol 939
8
Andre Fogarasi et al., Current Status of U.S Tax
Treaties, 26 Tax Mgmt. Int'l J. 139.
political and economic systems in which to
invest their funds, technological advances in
communications, and a growing
international banking network have made
treaty shopping very viable.
These third-country residents search for a
country that has (1) a favourable income tax
treaty with the source state and (2) attractive
internal tax laws. Once the third-country
resident investor has found such a country,
income from the source state may be
channeled through a corporation (or other
entity) organised under the laws of that
country. The withholding tax rate on passive
income under a tax treaty is usually less than
the rate applicable to residents of non-treaty
countries, in many cases completely
exempting the income from taxation. Thus,
by redirecting his income flow through a tax
treaty country, an investor may significantly
reduce the tax on his income. In addition,
the laws of many tax treaty countries set low
tax rates or, in some cases, a rate of zero on
dividends or interest paid to non-resident
investors. By funneling profits through the
country with the most favourable
combination of tax treaty terms and internal
tax laws, a non-resident alien investor is able
to avoid most or all tax on the source
income.9
REMEDIES TO ABUSE OF
TREAITES
Prevention of treaty shopping is usually
accomplished through clauses that restrict
treaty benefits to few individuals and entities
on the basis of their proximity to the treaty
9
P. Postlewaite and M. Collins, International
Individual Taxation, 226-27 (1982).
countries.35 These clauses are called ‘anti-
abuse’ or ‘limitation-on-benefits’ clauses.
The clauses try to exclude mere conduits
from taking advantage of the treaty benefits
by identifying a company's substantial
business nexus to one or both contracting
states. From a technical point of view, those
clauses may be seen as further limitations on
treaty use, as well as being clauses that
determine the personal scope of the treaty.
In order to limit tax treaty benefits to their
intended beneficiaries, the ‘limitation-on-
benefit’ clauses inquire as to the
appropriateness of making the benefits of a
particular treaty available to a given person.
Tax treaties generally operate for the benefit
of the ‘residents’ of the other contracting
state. The limitation-on-benefit provisions
that have been included in tax treaties
effectively embellish on the definition of the
term resident and, in general, function as a
gatekeeper to deny treaty benefits to entities
of third-country owners without adequate
linkage to the residence jurisdiction.
Residence of a person is determined in
accordance with the Double Taxation
Avoidance Agreement between the
10
contracting states.
INDIAN POLICY OF DOUBLE TAX
AVOIDANCE AGREEMENT
TAX
Section 90 of the Income Tax Act, 1961
states as follows:
(1) The Central Government may enter into
an agreement with the Government of any
country outside India —
10
Dietmar Anders, The Limitation-on-Benefits Clause
of the US-German Tax Treaty and its Compatibility
with European Union Law, 18 J
(a) For the granting of relief in respect of
income on which have been paid both
income-tax under this Act and income-tax in
that country, or
(b) For the avoidance of double taxation of
income under this Act and under the
corresponding law in force in that country,
or
(c) For exchange of information for the
prevention of evasion or avoidance of
income-tax chargeable under this Act or
under the corresponding law in force in that
country, or investigation of cases of such
evasion or avoidance, or
(d) For recovery of income-tax under this
Act and under the corresponding law in
force in that country, and may, by
notification in the Official Gazette, make
such provisions as may be necessary for
implementing the agreement.
(2) Where the Central Government has
entered into an agreement with the
Government of any country outside India
under sub-section (1) for granting relief of
tax, or as the case may be, avoidance of
double taxation, then, in relation to the
assesse to whom such agreement applies, the
provisions of this Act shall apply to the
extent they are more beneficial to that
assesse.
(3) Any term used but used but not defined
in this Act or in the agreement referred to in
sub-section (1) shall, unless it otherwise
requires, and is not inconsistent with the
provisions of this Act or the agreement, have
the same meaning as assigned to it in the
notification issued by the Central
Government in the Official Gazette in this
behalf.
This section empowers the Central
Government to enter in to agreement with
foreign countries for the granting of relief in
respect of double taxation or for the
avoidance of double taxation. In exercise of
the powers conferred by the corresponding
provision in the 1922 Act and by this
section, agreements with many countries
have been entered into for relief against or
avoidance of double taxation.11
The four clauses in sub-section (1) lay down
the scope of power of the Central
Government to enter in to agreement with
another country. Clause (a) contemplates
situations where tax has already been paid
on the same income in both countries and it
empowers the Central to grant relief in
respect of such double taxation. Clause (b),
which is wider than clause (a), provides that
an agreement may be made for the
'avoidance of double taxation of income
under this Act and under the corresponding
law, in force in that country’. This clause
cannot be extended to make provisions in
agreements for situations not relating to
double taxation. However, it is not necessary
that a situation regarding 'avoidance of
double taxation' can arise when tax is
actually paid in one of the contracting
countries. Moreover, as long as the
objectives in these clauses are sought to be
effectuated by an agreement, the power of
the Central Government cannot be said to
have been used in an ultra vires manner.
11
VYAS, DINESH, KANGA PALKHIWALA VYAS THE
LAW & PRACTICE OF INCOME TAX 1512 (Lexis Nexis
2008).
Clauses (c) and (d) essentially deal with
agreements made for the exchange of
information investigation of cases and
recovery of income tax.
CASE STUDIES
Chohung Bank v. Dy. Commissioner of IT12
The assesse here was a banking company
based at Korea having a branch in India.
Appellant's claim was for the benefit of the
non-discrimination clause of the India-Korea
DTAA” and taxing the appellant's income at
the rate of 48% instead of at the rate
applicable to a domestic company i.e., 35%.
The AO rejected the claim of the assesse
arguing that: The matter reached the ITAT
was considered by it, which adjudicated as
under:
(1) The DTAA gets the trade off only with
the provisions of the IT Act and unless so
specifically provided in a particular DTAA,
the rate of tax which is prescribed in the
annual Finance Act, cannot give way to the
DTAA.
(2) It cannot be said that a Korean Bank is
working in the same circumstances as the
Indian banks, because the former has no
constraints as an Indian bank has and it is
free to operate its profit making apparatus to
the maximum possible extent.
(3) The provision of non-discrimination has
nothing to do with the rate of tax, which is
dealt with separately by other articles of the
DTAA.
12
2012 SCC OnLine ITAT 7308 : [2012] ITAT 6731
(4) The DTAA in general does not prevail
over the Finance Act and hence over tax
rates. Section 90
does not provide so. However, wherever the
DTAA has provided the taxation of a
particular category of income at certain
rates, then charging of that income at
different rates as per the Act, may come in
conflict with the DTAA and hence, the taxes
over that category of income will be levied
at that rates, so provided in the DTAA. But
where no such rates on an income or a
category of income on the status of an
assesse has been prescribed in the DTAA,
then there cannot be any conflict with the
Act.
The DTAA will therefore not prevail over
the Finance Act and hence the rates of tax
applicable to domestic companies cannot be
applied to non-domestic companies.
(5) A domestic banking company and a non-
resident banking company do not function
under the same circumstances and hence the
discrimination clause in Article 25 of the
Indo Korean DTAA is not applicable.
Rolls Royce Industrial Power Limited v.
ACIT13
The Hon'ble Delhi ITAT commented on the
scope of Article 26(2) of the Indo-UK
DTAA (which deals with the PE of a non-
resident not being treated less favourably
than a resident)/"As per the observations of
the Delhi ITAT, to attract the non-
discrimination clause, it must be shown:
Firstly, the non-resident company is taxed in
a manner that is more burdensome vis-a—
13
2017 SCC OnLine Del 8434 : (2017) 394 ITR 547
vis in Indian company; and secondly, the
resident company being compared to must
be in an identical business as the non-
resident company.
CONCLUSION
Double taxation agreements have, no doubt,
become an integral part of international
economic relations and foreign policy. Tax
treaties help in restoring certainty in fiscal
regimes, provide provisions for mutual
assistance and exchange of information.
Such arrangement helps to curb tax
avoidance and foster international trade and
foreign direct investment, especially when
the treaty is concluded between two States
with similar level of development.
In order to effectively curtail treaty abuse,
there should be a coherent and uniform
regime of international taxation, which may
eventually lead to a multilateral tax
agreement.
However till such a regime is established,
there is a need to draft a limitation-on-
benefits provision carefully to protect the
interests of the taxing authorities. At the
same time, care should be taken to ensure
that the measures adopted do not act as a
deterrent to globalisation of business.

However, this may not be the case when a

treaty is concluded between developed and
developing nations. As discussed above, tax
treaties are not the only means by which the
primary goal of alleviating double taxation
can be achieved. This can also be done by
unilateral acts of the nations. From the
developing nation's perspective, tax treaties
are a price negotiated in the form of the
amount of tax revenue foregone to achieve
the desired level of foreign investment.
Excessive rules regarding tax avoidance
may discourage foreign investors and hence
the developing countries may not be too
willing to cooperate and exchange
information. On the brighter side, a balanced
and well-negotiated tax treaty may foster
FDI in the developing countries which may
be needed to increase employment and
correct other economic irregularities. It will
help them to associate and build relations
with the developed nations.