MLI-led changes in India’s tax treaties will significantly impact cross-border business structures and operations. Learn the changes and assess the impact on your business.
International tax rules are in an evolutionary phase and are moving towards substance-based taxation, which might be achieved with countries that are adopting greater transparency and consensus-based approach. Mr. Akhilesh Ranjan, a former member of Central Board of Direct Taxes1, at a conference, indicated “multilateralism” as an evident change in the global tax arena, where the focus of countries has shifted to multilateral discussions and consensus building2.
The development of multilateral instrument (MLI) can be considered an epitome of the global co-ordination and co-operation where over 100 jurisdictions participated on an equal footing to develop a single instrument which is expected to change more than 3,000 existing tax treaties. With 90 MLI signatories already on board, the fruitful implementation of the MLI has proven successful.
Modification of Indian treaties through MLI
India has been an active participant in BEPS project and was one of the first signatories to the convention on 7 June 2017. India also completed the ratification process and deposited the instrument of ratification along with its final positions on MLI provisions, with the Organisation for Economic Co-operation and Development (OECD) on 25 June 2019.
The MLI came into force in India on 1 October 2019 and will be effective for 20 tax treaties from 1 April 2020. These include treaties with key trade and investment jurisdictions such as Australia, France, Ireland, Netherlands, Japan, Singapore and the UK. However, key Indian tax treaties, such as those with the US, Mauritius, Germany and China currently remain outside the realm of MLI.
Impact on India’s tax treaty network
An overview of India’s position and its impact on certain key Indian treaties with respect of various MLI provisions is discussed below:
Prevention of treaty abuse
Prevention of treaty abuse was one of the key BEPS concerns and to effectively counter this concern, MLI included various provisions including minimum standards such as modification of the preamble of the existing tax treaties and insertion of principal purpose test (PPT) that all MLI signatories, including India are bound to accept.
(i) The Preamble
To comply with BEPS minimum standard, India has accepted to modify the title and preamble of its tax treaties to specifically include that the intention of the tax treaties is not only to eliminate double taxation but also to prevent non-taxation or reduced taxation through tax evasion or avoidance. Additionally, MLI contemplates an optional inclusion which provides that the treaty is also for development of economic relationship and co-operation in tax matters. Though India has not adopted this optional inclusion, it is unlikely for such non-inclusion to have an impact as it is merely a codification of an underlying objective of the treaty. Even before MLI, some of the treaties that India had signed such as those with Russia and Mauritius were also done to promote economic ties with the countries.
(ii) Principal Purpose Test (PPT) and Simplified Limitation of Benefits (SLOB)
PPT is a minimum standard and primarily comprises two parts:
(a) Reasonable purpose test: PPT seeks to deny benefit under the treaty in every case where it is reasonably possible to conclude that in the facts of the case, one of the principal purposes of an arrangement or a transaction is to obtain a tax benefit, directly or indirectly.
(b) Object and purpose test carve out: The latter part of the PPT provides for a carve-out or an exception by observing that despite the desire of obtaining tax benefit(s) under the treaty, the benefit(s) will not be denied so long as the grant of the benefit is in accordance with the objective and purpose of the relevant provisions of the treaty.
Additionally, on an optional basis, MLI contemplates inclusion of SLOB which provides for objective parameters such as listing, ownership, activity and specified entities which may need to be fulfilled by a person regarded as a qualified person entitled to benefit from the treaty.
India has opted for PPT and SLOB for testing the eligibility of the income recipient of the other country. India has also expressed its intention to adopt PPT as an interim measure with an option to modify the same in future with LOB clause to further tighten the noose around treaty shopping. This position seems to have been adopted considering that though SLOB has been opted by India, only a handful of treaties involving India will be modified to include the SLOB standard due to MLI matching principle3.
An interesting question on the applicability of PPT is on its impact on capital gains exemption under the India-Singapore treaty, according to which the shares of an Indian company acquired prior to 1 April 2017 are grandfathered while the treaty permits source-based taxation in India for the shares acquired on or after 1 April 2017. Technically, PPT, as a non-obstante provision, applies to all treaty benefits and therefore may eclipse even grandfathered benefits. However, a taxpayer may wish to contend that (i) the granting of the benefit is in accordance with the object and purpose of treaty framers who evolved such exceptional benefit to provide for a smooth transition from residence-based taxation to source-based taxation; (ii) accordingly, the benefit is protected at least by object and purpose carve out of PPT. It may be recollected that in India-Singapore treaty, PPT gets inserted from 1 April 2020 and this debate will have no applicability to gains made from transfer of shares effected prior to that2.
Another key concern of BEPS was what the OECD believed to be the “artificial avoidance of PE status” through which businesses were able to mitigate taxation in country which contributed to sales. As a measure, MLI includes various provisions which broaden the PE realm such as:
- An extended dependent agency PE (DAPE) rule which covers a person who habitually plays the principal role leading to the conclusion of contracts.
- Stricter independent agent exclusion rule denying exclusion to the agents who work exclusively for an enterprise and its closely-related enterprises (CREs).
- Availability of specific activity exemption only if such activities qualify to be of preparatory or auxiliary (PoA).
- An anti-fragmentation rule to prevent artificial disintegration of cohesive business activities done to avail specific activity exemption as POA.
- Anti-splitting rule to prevent artificial splitting of contracts between related parties such that each contract covers a period which does not exceed the time threshold provided under the relevant treaty for trigger of construction PE.
While India has accepted all the above changes to PE definition provided in the MLI, a number of India’s treaty partners have not followed the same suit. For instance, Canada, Sweden, Switzerland and the UAE have placed reservations with respect to all PE provisions of MLI. Accordingly, basis the matching principle, the PE definition in such Indian treaties will not be modified. Further, some countries have opted in only specific PE provisions of MLI and have opted out of others.
(i) Dependent agent permanent establishment (DAPE)
Basis the matching principle, it is unlikely that the extended DAPE rule would be incorporated in most of India’s tax treaties pursuant to the MLI. It may, however, be noted that as compared to OECD patterned treaties, the DAPE definition in many Indian treaties is broader even before MLI was rolled out. For instance, many treaties signed by India with Japan, Russia, Singapore, Australia and the UK contain a scope for covering persons who habitually secure orders which converges with the MLI proposal.
(ii) PoA exemption, anti-fragmentation rule and anti-splitting rule
MLI provision related to PoA exemption, anti-fragmentation and anti-splitting of contracts is currently not part of any of the existing treaties that India has signed, and these will be evaluated while analyzing PE provisions, provided India’s treaty partner has also adopted such provisions. Some of India’s tax treaties which would be modified as result of one or more of these changes include Australia, Ireland, Japan, the Netherlands, Russia and the UK.
