[2006] 7 CPT 520

[2006] 7 CAT 520

CASE STUDIES /DIRECT TAX LAWS

Usefulness of non-discrimination
provision in the treaties
Delhi Tribunal in the recent case of Herbalife International India (P.) Ltd. v. Asstt. CIT [2006] 101 ITD 450
observed that the non-resident was being discriminated against, as the non-resident does not get the
deduction under section 40(a )(i). This was violation of article 26(3) of the Indo-USA DTAA (DTA) which
provided that ‘except where the provisions of paragraph 1 of article 9, paragraph 7 of article 11,
paragraph 8 of article 12 apply, interest, royalties and other disbursements paid by a resident of a
Contracting State to a resident of the other Contracting State, shall for the purposes of determining the
taxable profits of the first mentioned resident, be deductible under the same conditions if they had been
paid to a resident of the Contracting State’. In this write-up author discusses this case by referring
relevant articles of Indo-USA DTAA (DTA).

Introduction
1. In a recent ruling in the Herbalife International India (P.) Ltd. v. Asstt. CIT [2006] 101 ITD 450 case, Delhi Tribunal observed that
the non-resident was being discriminated against, as the non-resident does not get the deduction, under section 40(a)(i ). This was
violation of article 26(3) of the Indo-USA DTAA (DTA), which provided that ‘except where the provisions of paragraph 1 of article 9,
paragraph 7 of article 11, paragraph 8 of article 12 apply, interest, royalties and other disbursements paid by a resident of a Contracting
State to a resident of the other Contracting State, shall for the purposes of determining the taxable profits of the first mentioned resident,
be deductible under the same conditions as if they had been paid to a resident of the Contracting State’. ‘This ruling is important while
applying non-discrimination clause contained in DTAAs prior to assessment year 2004-05 while dealing with non-residents’, stated Mr.
Patil (Businessline 23rd Sept.).
Herbalife International India (P.) Ltd. case - Facts & decision
2. The assessee, H India, was incorporated as a company in India with 100 per cent foreign equity participation. Herbalife International,
USA (H USA), was the foreign collaborator.
2.1 Article 26(3) of DTA - The relevant para of article 26 of the DTA, applicable to the present controversy, is as under :
"Article 26(3) : Except where the provisions of paragraph 1 of article 9 (Associated Enterprises), paragraph 7 of article 11
(Interest), or paragraph 8 of article 12 (Royalties and Fees for Included Services) apply, interest, royalties, and other disbursements
paid by a resident of a Contracting State to a resident of the other Contracting State, shall, for the purposes of determining the
taxable profits of the first mentioned resident, be deductible under the same conditions as if they had been paid to a resident of the
first mentioned State."
2.2 Article 24(4) of DTA - The provision of non-discrimination as contained in the OECD model is :
"‘Article 24(4) : Except where the provisions of paragraph 1 of article 9 , paragraph 6 of article 11 or paragraph 4 of article 12 ,
apply, interest, royalties and other disbursements paid by an enterprise of a Contracting State to a resident of the other Contracting
State shall, for the purpose of determining the taxable profits of such enterprise, be deductible under the same conditions as if they
had been paid to a resident of the first mentioned State. [Other portion of article 24(4) are not repeated as they are not relevant to
the present issue].’ (p. 468)
Tribunal, for its decision, quoted from Phillip Baker, on ‘Double Taxation Conventions and International Tax Law’ A Manual on the
OECD Model Tax Convention on Income and on Capital , 1992, Second Edition at page 396 to page 397 has the following to say on
article 24(4) :
‘Article 24(4) : Deduction of interest, royalties and other disbursements 24-18-Article 24(4) is not concerned with the
discriminatory treatment of nationals, etc., of one State in the other Contracting State, but the treatment of enterprises of a
Contracting State under the tax law of that State. Subject to the position where a special relationship exists between the enterprise
 and the recipient, interest, royalties and other disbursements paid to a resident of the other Contracting State should be deductible
to the same extent that they would be deductible i f paid to a resident of the same State. Thus, this prevents the indirect
discrimination which would arise if the sums were not deductible. A similar provision is included in the article in relation to the
deduction of debts owed to residents of the other Contracting State in determining the taxable capital of the enterprise.’
At page 411, the following commentaries are found on article 24(4) :
‘This paragraph is designed to end a particular form of discrimination resulting from the fact that in certain countries the deduction
of interest, royalties and other disbursements allowed without restriction when the recipient is resident, is restricted or even
prohibited when he is a non-resident. The same situation may also be found in the sphere of capital taxation, as regards debts
contracted to a non-resident. It is however open to Contracting States to modify this provision in bilateral conventions to avoid its
use for tax avoidance purposes.’"
2.3 Articles 9(1) & 24(3) of DTA - Para 1 of article 9 is to the following effect :
Associated enterprises
"(1) Where :
( a)an enterprise of a Contracting State participates directly or indirectly in the management, control or capital of an enterprise of the
other Contracting State; or
( b)the same persons participate directly or indirectly in the management, control or capital of an enterprise of a Contracting State and
an enterprise of the other Contracting State, and in either case conditions are made or imposed between the two enterprises
in their commercial or financial relations which differ from those which would be made between independent enterprises,
then any profits which, but for those conditions would have accrued to one of the enterprises, but by reason of those
conditions, have not so accrued, may be included in the profits of that enterprise and taxed accordingly."
View of Phillip Baker is that where a special relationship exists between the enterprise and the recipient, non-discrimination article
would not apply. This does not seem the correct position. Para 1 of article 9 presupposes two conditions, one existence of special
relationship and second absence of arm’s length relationship.
From facts, discussed above, H India and H International were associated enterprises, under Indo-USA DTA. From the limited facts
available, it cannot be said that ‘arm’s length relationship was absent’. Prima facie, it cannot be said that the case was covered by article
9(1), and so article 24(3), would not apply.
We may refer to the technical explanation to the DTA, issued by US treasury, which has understanding in India also.
Paragraph 3 prohibits discrimination in the allowance of deductions. When an enterprise of a Contracting State pays interest, royalties or
other disbursements to a resident of the other Contracting State, the first-mentioned Contracting State must allow a deduction for those
payments in computing the taxable profits of the enterprise under the same conditions as if the payment had been made to a resident of
the first-mentioned Contracting State. An exception to this rule is provided for cases where the provisions of paragraph 1 of article 9
(Associated Enterprises), paragraph 7 of article 11 (Interest) or paragraph 8 of article 12 (Royalties and Fees for Included Services)
apply, because all of these provisions permit the denial of deductions in certain circumstances in respect of transactions between related
persons. The term other disbursements is understood to include a reasonable allocation of executive and general administrative expenses,
research and development expenses and other expenses incurred for the benefit of a group of related persons which includes the person
incurring the expense.
Thus, the technical explanation also supports the author’s view that non-discrimination clause does not apply between related
enterprises. However, view expressed in the technical explanation, that discrimination has to be considered by weighing the treatment
between resident and non-resident payees, under the same conditions, is not correct. The deduction has to be under the same conditions
and not that payees should be under the same conditions. This is the position under paras 1 and 2 of non-discrimination article, where
nationals of the two bilateral States should be in ‘same circumstances’ and ‘PE and the resident’ should be ‘carrying the same activities’.
2.4 Article 12(8) of DTA - Para 8 of article 12 of the DTA, about transactions between related enterprises, is as under :
"Where, by reason of special relationship between the payer and the beneficial owner or between both of them and some other
person, the amount of the royalties or fees for included services paid exceeds the amount which would have been paid in the
absence of such relationship, the provisions of this article shall apply only to the last mentioned amount. In such case, the excess
part of the payments shall remain taxable according to the laws of each Contracting State, due regard being had to the other
provisions of the Convention."
Here also, before denying non-discrimination article, two things have to be proved, one existence of special relationship and second the
non-arm’s length payment.
To judge the applicability of article 26(3), the Tribunal was to give finding whether article 9(1) or article 12(8) applied. When
applicability of article 26(3) was in dispute, the question, whether article 9(1) or article 12(8) applied, would also be in dispute. The
Tribunal was empowered to look into facts in this regard and ‘pass such orders thereon as it thinks fit’[section 254(1) of the Act]. Thus,
if this aspect was not looked into by lower authorities, the Tribunal could have itself looked into them and recorded a finding.
2.5 Scope of section 40(a)(i) - Board’s circular No. 528 dated December 16, 1988, explaining the scope of section 40(a)(i ), stated, as
under:
In order to ensure effective compliance of the provision of section 195 relating to tax deduction at source in respect of payments outside
India, the scope of the above provision has been extended to cover payments in respect of royalty, fees for technical services or other
sum chargeable under the Act. The condition of there being an agent is not necessary as it provides an escape route to the persons
making these payments.
The provision in section 40(a)( i) was introduced as a tax avoidance measure. It will not constitute discrimination, under para 3 of article
24, as explained by Phillip Baker and quoted by the Tribunal.
Metchem Canada Inc. v. Dy. CIT
3. In a similar ruling in the case of Metchem Canada Inc. v. Dy. CIT [2006] 5 SOT 121, Mumbai Tribunal answered in the affirmative
and held that, ‘where section 44C is to be not applicable in matter of a non-resident company, head office expenses incurred by non-
resident company to extent same can be fairly allocated to the PE are admissible as deduction under section 37(1), in the light of the
provisions of non-discrimination article 24, of the India-Canada DTA’ .
Both section 44C and non-discrimination article are special provisions. A tax avoidance measure in domestic law could supersede the
provision in a treaty. We may analyse, whether section 44C is a tax avoidance measure. We may refer, in this regard, to the departmental
Circular No. 202 dated July 15, 1976, which is to the following effect :
"It is extremely difficult to scrutinize and verify claims in respect of such expenses, particularly in the absence of account books of
the head office which are kept outside India. Foreign companies operating through branches in India sometimes try to reduce the
incidence of tax in India by inflating their claims in respect of head office expenses. With a view to getting over these difficulties,
the Finance Act, 1976, has inserted a new section 44C in the Income-tax Act laying down certain ceiling limits for the deduction of
head office expenses in computing the taxable profits in the case of non-resident taxpayers."
Unlike USA DTA, Indo-Canada DTA has no provision restricting non-discrimination article, between arm’s length enterprises.
However, in para 1 of article 23, it provides treaty override, as under.
The laws in force in either of the Contracting State will continue to govern the taxation of income in the respective Contracting States
except where provisions to the contrary are made in this agreement.
Section 44C was introduced in 1976. Indo-Canada DTA was notified in 1998. Thus, article 24(2), of Indo-Canada DTA, would override
section 44C, irrespective of the objective of section 44C.
Indo-USA DTA has no provision, similar to article 23(1) in Indo-Canada DTA. Can one say that section 40(a)( i) would override article
26(3)? Technical explanation discusses 2 provisions in US domestic law, sections 367(e)(2) and 1446 of the code, and States that these
do not constitute non-discrimination. However, absence of specific understanding about section 40(a)( i), which ensures effective
compliance of the provision of section 195 relating to tax deduction at source in respect of payments outside India, may not mean that it
would not override non-discrimination article. This would be apparent from the objective of section 1446 of the code, discussed in the
technical explanation:
‘…the requirement to withhold on the Indian but not the U.S. partner’s share is not discriminatory taxation, but, like other
withholding on non-resident aliens, is merely a reasonable method for the collection of tax from persons who are not continually
present in the United States, and as to whom it may otherwise be difficult for the United States to enforce its tax jurisdiction. If tax
has been overwithheld, the partner can, as in other cases of over-withhold, file for a refund’.
Conclusion
4. Thus, the assessee, before the Tribunal, H India, would not have been able to take shelter, that absence of specific ‘treaty override’
means that section 40(a)( i) does not override article 26(3).
Non-consideration of applicability of articles 9(1) & 12(8) and tax avoidance objective of section 40(a)( i) were mistakes apparent from record of the
Tribunal. Tribunal is empowered to rectify its order suo motu, under section 254(2) of the Act. Tribunal may like to consider rectifying the mistake, so
that apparently incorrect ratio laid down by it, in H India’s case is not pressed into service by other Benches or Appellate Authorities or Assessing
Officers.