In a decision delivered on October 5, India’s Income Tax Appellate Tribunal, New Delhi ruled that the Indian Income Tax Act cannot limit the claim of expenses of a permanent establishment in the absence of such limitation in the India-Mauritius tax treaty.
Business income (other than royalty, fee for services, interest etc.) of an entity is taxable in a foreign tax jurisdiction when the entity has a taxable presence in that foreign jurisdiction (source jurisdiction). The result is that income of the entity which is attributable to such a presence is taxable in the source jurisdiction as business profits (given the reasonable nexus with that jurisdiction).
Bilateral tax treaties generally specify the circumstances in which a taxable presence, that is, a permanent establishment could be deemed to arise and the rules around attribution of income to the permanent establishment.
The income is to be computed after reducing related business expenses to arrive at the net profits chargeable to tax in the source jurisdiction.
Some tax treaties provide that set-off of expenditure will be subject to the domestic laws of the source jurisdiction; while some do not have such an overriding restriction.
As per the tax treaty between India and Mauritius, the set-off of business-related expenses is not subject to domestic tax law. Notably, Indian tax law enables a non-resident taxpayer to be governed by the provisions of the applicable tax treaty or those of domestic tax law, whichever are beneficial to the taxpayer.
The key facts
In its decision delivered in the case relating to Unocol Bharat Limited, the Income Tax Appellate Tribunal, New Delhi dealt with the issue of claim of expenses by a Mauritian entity having a permanent establishment in India.
In the facts of that case, the Mauritian entity which had a permanent establishment in India paid salary to seconded employees and made payments to some non-residents (of India).
In either of the situations, the Mauritian entity did not withhold tax whilst making the payments.
Under the Indian tax law, certain payments attract withholding tax and in case of non-compliance by the payer, the consequences include disallowance of corresponding expenditure (in part) while computing taxable profits of the payer.
The tax authorities applied the domestic law provisions and disallowed the expenses which were claimed by the Mauritian entity while reporting the losses of its permanent establishment.
The court’s decision
The Tribunal ruled in favour of the taxpayer.
The Tribunal observed that Article 7(3) of the India-Mauritius tax treaty is unambiguous and it is not subject to any restriction or limitations of the domestic law.
According to the Tribunal, the claim of expenses cannot be denied to the Mauritian permanent establishment on the basis of the Indian Income Tax Act by importing its provisions into the tax treaty. Once the salary payment has been incurred by Mauritian permanent establishment, the expenses claimed by it towards the payment cannot be denied, the Tribunal ruled.
On the issue of payments to non-residents which are subject to withholding tax only when the same are chargeable to tax in India, the Tribunal observed that the tax authorities failed to analyze whether in the first place, such payments were taxable in India. The Tribunal held that regardless of this, if Article 7 of the tax treaty is applied, the payments to the non-resident should also be allowed as expenses.
The ruling has rightly given precedence to the treaty provisions over those of domestic law. Interestingly, the tax treaties do provide that if a term is not defined in the tax treaty, then the meaning of the term under the domestic law should be applied. However, bringing in an operative provision of the domestic law where the tax treaty is silent, is not a correct application of law and may be contrary to the underlying intention of the contracting states signing the bilateral tax treaties.
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