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The Convention between the Government of the United States of America and the Government of India for the

Avoidance of
Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income (“the US Convention”) was signed at
New Delhi on September 12, 1989. It entered into force with effect from December 18, 1990. In general, the US Convention
follows the pattern of the United States Model Tax Convention and is different from the conventions based on the OECD and UN
Models in many respects. In this article, some of the peculiarities of the US Convention and certain issues arising out of
interpretation of the US Convention and the decisions of the Indian Courts thereon are discussed.

Salient features of the US Convention

1. Citizenship-based taxation

In a significant Indian ruling, a pension trust established in the USA, which enjoys tax exemption in the US, was held not to be
entitled to the benefits of the US Convention. The ruling raises a question whether the framers of the US Convention indeed
intended to give a different meaning by using the expression “liable to tax” and “subject to tax” in paras 4(1)(a) and 4(1)(b).

The domestic income-tax law of India treats tax conventions as special rules and provides that where the Government of India
has entered into a tax convention with the Government of any other country the provisions of the domestic tax law shall apply to
the extent they are more beneficial to the taxpayer*1. Tax conventions normally apply to persons who are residents of one or both
states. If the person is a resident of both states, then, applying the “tie-breaker rule”, his residence under the convention, and
consequent taxation of income, is determined.

In addition to the residence-based taxation generally adopted by tax treaties, the US Convention provides for citizenship-based
taxation*2. For instance, if a resident of India performs independent personal services in the United Statesand the income is not
attributable to a fixed base in the United States, Article 15 of the US Convention would normally prevent United States from
levying a tax on such income. However, if the service performer is also a citizen of the United States, then, Article 1(3) permits
the United States to include such remuneration in his worldwide income and bring it to tax in the United States. Thus, the
provisions of the Act are overridden to an extent by Article 1(3) of the US Convention.

In a significant Indian ruling*3, a pension trust established in the USA, which enjoys tax exemption in the US, was held not to be
entitled to the benefits of the US Convention. The authority noted that Article 4(1) of the US Convention was subject to para (a)
and (b) thereof. Para (a) states that the term ‘resident’ does not include any person who is liable to tax in that State in respect only
of income from sources in that State. Para (b) states that in the case of income derived or paid by a trust, the term resident of a
contracting state (USA) applies only to the extent that the income derived by such trust is subject to tax in USA as the income of
the trust, either in its hands or in the hands of its beneficiaries. The authority noted that while para (a) uses the expression “liable
to tax”, para (b) uses the expression “subject to tax”. According to the authority, the two expressions were not synonymous.
While “liable to tax” would mean bringing into the tax net, “subject to tax” would mean actual taxation. The authority noted that
the Trust was exempt from tax under the domestic US tax law. The authority also noted that nothing was brought on record to
show that its beneficiaries were taxed in the US. Therefore, applying the provisions of para (b), the authority took the view that
the Trust was not resident of the USA and hence not entitled to claim benefits of the US Convention. It may be mentioned that
the subsequent application for rectification of the ruling, wherein certain additional materials were sought to be relied on by the
applicant, has been rejected by the authority*4. The ruling raises a question whether the framers of the US Convention indeed
intended to give a different meaning by using the expression “liable to tax” and “subject to tax” in paras 4(1)(a) and 4(1)(b).

2. Taxation of Dividends and Interests


The DTAA provides source based taxation of dividends and interest. Dividends from a subsidiary to a parent corporation (i.e.,
which holds at least 10% shares in the subsidiary) are taxable at 15%, whereas other dividends are taxable at 25%. Interest is
taxable at 15%, although interest received by a bank carrying on a bona fide banking business, etc. is taxable at 10%. Interest
received by either of the two Governments, by certain governmentalfinancial institutions, and by residents of a Contracting State
on certain government approved loans, is exempt from tax. Rates for taxation of income in the source country apply if the
recipient is the ‘beneficial owner’ of the income. An issue arises whether an intermediate subsidiary company, which receives
income from its subsidiary and passes it on to its holding company can be regarded as ‘beneficial owner’ of the income. This
issue is largely untested in India.

3. Royalties
In general, industrial and copyright royalties are taxable at 20% for the first five years from the US Convention coming into
effect, dropping to 15 per cent thereafter. Where the payer of the royalty is one of the Governments, a political sub-division or a
public sector corporation, tax is imposed from the date of entry into force of the US Convention at 15%. Payments for the use of,
or the right to use, industrial, commercial or scientific equipment are treated as royalties and are subject to tax at 10%.

In an Indian ruling, the provisions of Article 12(7)(b) of the US Convention have been given a somewhat unusual meaning. What
the authority has effectively held is that article 12(7)(b) would not apply only in a case where royalty arises in both India as well
as the US, which seems absurd. The view taken by the authority has rendered Article 12(7)(b) almost unworkable. In another
ruling..

The definition of the term royalties in the US Convention*5 is narrower than the definition of that term in the Act*6. Insofar as
industrial royalty is concerned, the Act regards as royalty consideration for (i) the transfer of all or any rights in respect of the
specified intellectual property such as patent, invention, etc. (ii) imparting of any information concerning the working of, or the
use of, such intellectual property and (iii) use of such property. On the other hand, the US Convention defines royalties as
payments received as a consideration for (i) the use of, or the right to use, any intellectual property and (ii) gains derived from the
alienation of intellectual property which are contingent on the productivity, use, or disposition thereof. Similarly, the definition of
equipment and other royalties in the Act appears to wider than the definition in the US Convention.

In an Indian ruling*7, the provisions of Article 12(7)(b) of the US Convention have been given a somewhat unusual meaning.
Article 12(7)(a) provides that royalties shall be deemed to arise in the contracting state where the payer is resident. Article 12(7)
(b) provides that where royalties under Article 12(7)(a) do not arise in one of the Contracting States, and they relate to the use of,
or the right to use, the right or property in one of the Contracting States, they shall be deemed to arise in that Contracting State.
The facts of the case were that royalty was paid by a US company to another US company in respect of certain trademarks used
by an Indian company (i.e., the royalties arose in theUSA as the payer was a US resident and, therefore, one would have
ordinarily thought that article 12(7)(b) should not apply). However, the authority ruled that sub-paragraph (b) was applicable
because the royalties did not arise in “one of the contracting states”, i.e., they did not arise in India. What the authority has
effectively held is that article 12(7)(b) would not apply only in a case where royalty arises in both India as well as the US, which
seems absurd. The view taken by the authority has rendered Article 12(7)(b) almost unworkable.

In another ruling*8, payments made by an Indian company to a US company for accessing data from a Central Processing Unit
maintained by the US company has been held to be royalty. The authority ruled that the payment was being made for use of
intellectual property because the Indian company was allowed to access the software protected and maintained by the US
Company. In another case, payments for acquiring a copy of the computer programme without the transferor granting a right to
use the copyright in the programme to the transferee has been held*9 not to be royalty.

4. Fees for included services


Fees for included services are defined as payments for technical or consultancy services if such services (i) are ancillary and
subsidiary to the licensing of an intangible or the rental of tangible personal property, both of which give rise to royalty
payments, or, (ii) make available technical knowledge, experience, skill, know-how, or processes, or consist of the development
and transfer of a technical plan or technical design. A detailed memorandum of understanding has been developed by the
negotiators to provide guidance as to the intended scope of the concept of “included services” and the effect of the memorandum
is agreed to in an exchange of notes. Fees for all other services are treated either as business profits under article 7 or as
independent personal services income under Article 15.

A question arises as to the meaning of the term ‘make available’ in the definition of ‘fees for included services’. That is, when
can the technical services be regarded as making available technical knowledge, etc. to the recipient of the services. This issue
has been examined by the Mumbai tax Tribunal*10 in the context of an Indian company making commission payment to a UK-
based lead manager in respect of a GDR issue managed by the latter in the UK. The issue was whether the services performed by
the UK company could be regarded as making available to the Indian company any technical knowledge etc. by virtue of
performing its services. The Tribunalexamined the scope of the expression “make available” in the definition of ‘fees for
technical services’ (which is similar to the definition of the term ‘fees for included services’ in the US Convention) and came to
the conclusion that the services did not “make available” any technical knowhow etc. The Tribunal took the view that technical
knowhow, etc. can be regarded as being made available only if it enables the person receiving the services to in turn be able to
offer those services to another. The services wherein the service provider himself utilizes his technical knowledge, etc. to perform
the services without passing on the technology contained in the services to the recipient of the services cannot be regarded as
“making available” the technical knowledge, etc. to the recipient. That would be a case of making available fruits of the technical
knowledge, etc. to the recipient and not the technical knowledge itself. The Tribunal held that in the case before it, the recipient
of the service (i.e., the Indian company) did not acquire any expertise to manage GDR issues. Therefore, the services did not
make available any technical knowledge, etc. to the recipient. In arriving at the conclusion, the Tribunal was guided, inter alia, by
the protocol to the US Convention which gives various illustrations of when a service is to be regarded as making available
technical knowledge, etc.

Fees for included services also mean payments if services consist of the development and transfer of a technical plan or technical
design. The question that arises is whether the development and transfer of a technical plan or technical design, without enabling
the recipient to develop such technical plan or design himself, is sufficient to regard the payments as fees for included services.
For instance, a technical design for a machinery developed and transferred by the service provider may enable the recipient
thereof to manufacture the machinery with the help of the technical design. However, it may not enable the recipient to make
another technical design for manufacture of machine. The definition of ‘fees for included services’ appears to be wide enough to
cover such consideration. Indeed, illustration 5 in the protocol to the US Convention also confirms this. It is, however, interesting
to note that in the Convention entered into between India and Singapore, services which consist of development and transfer of
technical plan or design are not regarded as ‘fees for technical services’ unless they enable the recipient thereof to apply the
technology contained therein. Therefore, it appears that the provisions of the US Convention and Singapore Convention are at
variance on this issue.

5. Permanent Establishment Tax*11


The US Convention preserves for the United States the right to impose the permanent establishment tax. It preserves for both
Contracting States theirstatutory taxing rights with respect to capital gains. The US Convention also contains rules for the
taxation of business profits which provide a broader range of circumstances (Force of Attraction clause in Article 7) under which
one State may tax the business profits arising to a resident of the other State by virtue of a permanent establishment in the first
state or otherwise.

6. Shipping and Aircraft Operating Income*12


The US Convention contains reciprocal exemption at source for shipping and aircraft operating income, including income from
the incidental leasing of ships, aircraft or containers (i.e., where the lessor is an operator of ships and aircraft). Income from non-
incidental leasing of ships, aircraft or containers (i.e., where the lessor is not an operator of ships or aircraft) is not covered by the
article. Income from such non-incidental leasing is treated as a royalty, taxable at 10%.

7. Personal Service Income*13


The treatment under the US Convention of various classes of personal service income is similar to the other convention. It has
been held*14 that services would fall within the ambit of ‘independent personal services’ if the services are in the nature of
professional services or activity of independent character, not being in the nature of commercial or industrial activity (the latter
could be ‘included services’).

8. Provisions designed to prevent Treaty Shopping


The US Convention contains provisions*15 designed to prevent third-country residents from treaty shopping, i.e., from taking
unwarranted advantage of the US Convention by routing income from one Contracting State through an entity created in the
other State. These provisions identify treaty shopping in terms both of third-country ownership of an entity, and of the substantial
use of the entity’s income to meet liabilities to third-country persons. Notwithstanding the presence of these factors, however,
treaty benefits are allowed if the income is incidental to or earned in connection with the active conduct of a trade or business in
the State of residence, if the shares of the company earning the income are traded on a recognized stock exchange, or if the
competent authority of the source State so determines.

9. Other provision
The US Convention makes detailed provisions regarding taxation of Government remuneration and pension*16, private pensions,
annuities, alimony and child support*17, payments received by students and apprentices*18, payments received by professors,
teachers and research scholars*19.

10. Non-discrimination, Dispute Resolution Mechanism and Exchange of Information


The US Convention prohibits tax discrimination*20, creates a dispute resolution mechanism*21 and provides for the exchange of
tax information*22 between the tax authorities of the two countries. These provisions are in line with the provisions in the other
treaties.

The domestic tax law of India provides that charging a higher rate of tax to a foreign company as compared to a domestic
company is not to be regarded as discrimination*23. It appears that in view of this provision, the nondiscrimination provisions in
the US Convention so far as the rate of tax is concerned have been rendered otiose. The question that arises is whether this
provision also renders Article 14(2) redundant. Article 14(2) provides that a US company may be taxed in India at a rate higher
than the domestic companies but the difference in the tax rate shall not exceed 15%.

11. Tax Credit and Tax Sparing Credit


The US Convention follows credit method for providing relief from double taxation*24. Credit is allowed for taxes paid in the
source country and where the US company owns at least 10% voting stock in an Indian company from which the US company
receives dividends, underlying tax credit with respect to the profits out of which the dividends are paid is also allowed. In an
exchange of notes, the United States and India have agreed that, although the US Convention does not contain a tax sparing
credit, if United States policy changes in this regard, the US Convention will be promptly amended to incorporate a tax sparing
provision. However, no such tax sparing provision has been introduced in the US Convention so far.

12. Technical memorandum

A technical memorandum explaining in detail the provisions of the US Convention and the related Protocol has been prepared by
the Department of the Treasury. The Technical Memorandum serves as a source of information as regards the view of the
Government of the United States on the various provisions of the US Convention.
Conclusion

Interpretation of the US Convention has more often than not proved to be more difficult than interpretation of other treaties. In
part, this is owing to the unique features in the US Convention, which are in form and substance different from the corresponding
provisions in OECD and UN Model Conventions.

Therefore, the popular commentaries cannot always effectively aid the issues arising from interpretation of the US Convention.
The memorandum of understanding annexed to the US Convention as well as the Technical Explanation resolves many of such
issues. It is hoped that these issues will be clarified in due course of time by judicial decisions or by clarifications issued by the
respective Governments.

A permanent establishment may be defined as a fixed place of business through which activities of an organization are wholly or
partially carried on. The term permanent establishment includes a place of management, a branch, an office, a factory, a workshop,
and a mine, oil or gas well, quarry or other place of extraction of natural resources residing in a foreign jurisdiction.

A permanent establishment exists where an enterprise has a fixed place of business located in a foreign jurisdiction. As noted in the
Conventions Commentaries, the enterprise must carry on business in the Contracting State through a fixed place. The term fixed
implies a certain degree of permanence as opposed to temporary. Construction projects for example, which last more than twelve
months, are considered permanent. This does not imply that businesses need to have a duration of longer than twelve months to
be deemed permanent. However, if the place where business is conducted is often changed, even a long period of activity does not
lead to a permanent establishment.[1]

The concept of a permanent establishment is not limited to a fixed place of business, it may extend to include an agent who is
legally separate from an enterprise but sufficiently connected and dependent upon the enterprise so that a permanent establishment
is implied to exist, through the actions of that agent. This concept is found in paragraph 5 and 6 of the Article 5, which bridges the
gap between common law and civil law. Thus, there are two types of permanent establishments; a fixed place of business
(associated enterprise) and a dependent agent (unassociated enterprise).

The concept of a permanent establishment exists in all three Model Conventions. It is intended to be a condition necessary for the
taxation of business profits under the residence and source principles. A permanent establishment is liable to tax on its income and
assets by the State in which it is located. This liability to tax is based on the resident principle unless, the enterprise has a
permanent establishment in another State to which income is attributable. States look for the existence of a permanent
establishment as a prerequisite to attach fiscal liability. Treaties look to permanent establishments to allocate the States right to tax.

The permanent establishment concept is important because it distinguishes between enterprises that are trading with a country and
those trading within a country. This is an important distinction since enterprises trading within a country are subject to taxation on
the income and assets derived from its physical presence through a permanent establishment. This insures that business activities
will not be taxed by a State unless there is a significant economic relationship between the permanent establishment and the State.

As indicated in the OECD Commentaries, a general principle to be observed in determining whether a permanent establishment
exists is that the place of business must be "fixed" in the sense that a particular building or physical location is used by the
enterprise for the conduct of its business, and that it must be foreseeable that the enterprises use of this building or other physical
location will be more than temporary.

There are exceptions to this rule. For example, sales offices in which individuals do not have the capacity to contract and whose
primary functions are simply advertising the products will not be deemed a permanent establishment. To qualify, the sales office
may
(a) provide a fixed base to store small samples which may be displayed along with their application and models to be sent from
another country; (b) circulate literature to interested potential customers; and (c) pass on any inquiries or other information which
may affect potential sales.

When determining the existence of a permanent establishment, in it necessary to first determine if there is a fixed place of business
as put forth in the rules. These rules are put forth below in Article 5. If the conclusion is; there is a fixed place of business then,
paragraphs 5 and 6 which provide for agency relationships is of no consequence; they are inapplicable.

On the other hand, if the applications of rules 3 and 4 do not conclude a permanent establishment exists due to one of the
exceptions being met in paragraph 4 then again the dependent agency relationship in paragraph 5 cannot lead to permanent
establishment.
It is when the first and second paragraphs do not conclusively indicate a permanent establishment that paragraph 5 and 6 should be
consulted. It is the plan on which the business is established that creates permanence. A place of business should be taken as
established on a permanent basis despite premature failure due to lack of working capital or earnings power.

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