Double Taxation Avoidance Agreements (DTAAs) and Your India Investment Strategy

India has double taxation avoidance agreements (DTAAs) in place with over 90 countries, with certain tax treaties offering lower withholding tax (WHT) rates on certain types of income. This article examines how DTAAs can impact foreign firms and their India investment strategy.

Double taxation avoidance agreements (DTAs or DTAAs) are designed to prevent the same income from being taxed by multiple states, promoting tax compliance and facilitating efficient cross-border trade.

Primarily bilateral in nature, DTAAs draw inspiration from model conventions developed by the Organisation for Economic Cooperation and Development (OECD) or, less commonly, the United Nations. While the wording of DTAAs may share significant similarities, the specific provisions and applicability can vary substantially from one tax treaty to another.

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For investors, navigating international taxation can be confusing due to the potential clash of different tax systems. Hong Kong and Singapore, for instance, operate under a “territorial source” principle, taxing only locally sourced profits. In contrast, countries like India and the United States follow a worldwide tax system, where resident enterprises may face taxation on income earned both domestically and abroad.

DTAAs not only offer clarity on potential tax obligations for investors but also serve to structure international investments for tax efficiency.

DTAAs apply to individuals and companies from the countries or jurisdictions involved in the agreement. Their primary objective is to prevent double taxation by enabling the tax paid in one of the two countries to offset taxes owed in the other country. Additionally, they may offer exemptions or reduced tax rates for certain types of income, including royalties, interest, and dividends.

Withholding tax and profit repatriation under double taxation avoidance agreements

DTAAs also affect the repatriation of profits and earnings, allowing for strategic location of profit taking and distribution. Under legally permitted favorable circumstances, profits can be taken in a lower-cost jurisdiction and distributed from there to the overseas headquarters. This makes complete sense when developing a business in Asia, as capital injections and investments can then be made from the lower tax jurisdiction.

The distribution of dividends back to the home domicile can also be arranged in a beneficial and less tax burdensome manner than would otherwise be possible. Many preferred holding company jurisdictions maintain DTAAs that limit or eliminate withholding taxes on dividends transferred from subsidiaries to parent companies. For example, Singapore has a DTAA in place with India that lowers dividend distribution (withholding) taxes for foreign companies to 10 percent (provided the beneficial owner is a company that owns at least 25 percent of the shares of the company paying the dividends). The agreement also includes a rate of 15 percent of the gross amount of the dividends in all other cases.

What this means for foreign businesses is that they have the option to create a corporate structure so that profits from an India subsidiary may be remitted to a Singaporean holding company at a 10 percent withholding tax rate on dividends, before then being passed on to the overseas parent company with no additional tax obligations. Such reductions can result in significant tax savings over time, effectively increasing profits.

Permanent establishments and holding companies

DTAAs also serve to define scenarios where companies may not be considered to be generating taxable income in a particular country. A crucial concept within these agreements is the idea of permanent establishment (PE) status.

Globally, three general types of PEs are recognized:

• Fixed Place PEs: These are physical locations such as offices, branches, or factories where business activities are carried out.
• Agency PEs: This type includes situations where a person or entity, acting on behalf of the company, has the authority to conclude contracts or habitually exercises such authority.
• Service PEs: These are created through the provision of services, such as consulting or technical services, within a country for a specified duration.

Understanding and appropriately managing PE status is essential for businesses to navigate international tax liabilities effectively.

What happens when an enterprise triggers PE status

Triggering PE status is a significant issue as it determines the taxable status of specific legal structures and trade activities. A typical DTAA includes clauses related to the PE concept, which can favorably impact the total investment needed to enter a target market. It can also influence the type of legal vehicle required to be incorporated and, in some cases, eliminate the need for one altogether.

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The concept of PE is primarily used to determine a specific state’s right to impose tax on the business activities of foreign companies operating within its borders. Under a DTAA, the profits of a resident company doing business in another country will not be subject to tax in the other country unless the business is conducted through a PE. Once a PE is triggered, the enterprise will be subject to the host country’s business taxes, and any qualifying staff will be subject to individual income tax in that country. Therefore, it is critical for foreign businesses operating in Asia to stay informed about their PE status and the relevant tax rates in the region.

The OECD Model Income Tax Treaty defines a PE as a “fixed place of business through which the business of an enterprise is wholly or partly carried on.” Although most DTAAs use the OECD definition, countries can independently define what constitutes a PE.

This flexibility can have highly beneficial results. For example, a well-structured incorporation can provide effective services for its parent company—sometimes even billing local companies on their behalf—without triggering tax exposure in the secondary country. The specifics depend on how the PE issue is addressed within the DTAA.

Choosing a favorable holding company channel for investing in India is challenging due to the need to consider both the tax treaty network and Indian domestic tax law. However, certain reforms in India’s tax regulation seek to ease the burden on enterprises.

Dividend distribution tax

The Dividend Distribution Tax (DDT) was a tax on dividends paid by corporations to shareholders, deducted before distribution. Under section 1150 of the Income-tax Act, 1961, companies had to pay a 15 percent tax on gross dividends, while section 2(22)(e) imposed a 30 percent tax on presumed profits, exempting shareholders from further tax on these dividends.

The Finance Act 2020 abolished the DDT, shifting the tax burden from companies to shareholders. Now, shareholders pay tax on dividends according to their tax bracket. This change aims to reduce the burden on businesses, improve ease of doing business in India, and make India more attractive to international investors by eliminating double taxation of profits. Under the new system, dividends are taxed at the shareholder’s applicable rate, such as 30 percent for those in the 30 percent tax bracket.

India’s position on the BEPS MLI: Tax implications

In November 2016, over 100 jurisdictions, including India, concluded negotiations on the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (BEPS MLI). This convention swiftly updates international tax rules and reduces tax avoidance opportunities for multinational enterprises. The BEPS MLI was first signed on June 7, 2017 and entered into force on July 1, 2018. Currently, 102 jurisdictions have joined, with 85 having ratified, accepted, or approved it, covering around 1900 bilateral tax treaties.

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The MLI entered into force for India on October 1, 2019. For India’s 22 treaty partners who deposited their Instrument of Ratification by June 30, 2019, the MLI’s provisions took effect from the financial year 2020-21, starting on April 1, 2020.

The BEPS MLI provides concrete solutions to close gaps in international tax rules, implements minimum standards to counter treaty abuse, and enhances dispute resolution mechanisms, while allowing flexibility for specific tax treaty policies.

Source: Income Tax India

Key developments

In April 2024, India and Mauritius signed the protocol amending their DTAA, which now incorporates the Principal Purpose Test (PPT). This provision serves as a criterion to determine the eligibility of foreign investors to avail benefits under the India-Mauritius DTAA. Mauritius was one of the top choices as an investment destination for decades, since the country offered non-taxable capital gains. However, the tax agreement was revised in 2016, and India was able to tax capital gains on share transactions that went through Mauritius, beginning on April 1, 2017. 

On December 30, 2016, Singapore and India agreed on amending their DTAA for capital gain income. The agreement came into effect on April 1, 2017, and India aims to tackle investments coming into the country through shell companies and prevent tax avoidance. In February 2024, it was reported that the Mauritius government had decided to amend the DTAA with India in order to go with OECD’s proposal on base erosion and profit shifting. The two nations first signed the agreement in 2016. 

The India and Cyprus DTAA, first signed in November 2016, was revised next year with the inclusion of a ‘Grandfathering’ clause for investments made before April 1, 2017. The two countries had also decided to make further use of the Joint Economic Committee as a mechanism to expand mutually beneficial cooperation in all areas of common interest.

It may be worth noting that in 2023, India’s Supreme Court ruled that it is mandatory to issue a notification under Section 90 of the Income Tax Act, 1961, to implement changes in DTAA provisions. The ruling considered most-favored nation (MFN) clauses in DTAAs between India and France, the Netherlands, and Switzerland. In March 2024, the Income Tax Department aligned with this ruling, extending lower tax rates from the India-Germany DTAA to taxpayers under the India-Spain DTAA.

India has gradually adopted OECD standards to regulate residency and transfer pricing norms and became a signatory to the OECD’s Multilateral Competent Authority agreement for the automatic exchange of Country-by-Country reports (CbC MCAA) in 2016. 

Place of Effective Management (POEM) regulations in India came into effect on April 1, 2017. POEM is an internationally recognized test for determining the residence of a company incorporated in a foreign jurisdiction. The new norms came into effect in the assessment year 2017-2018. As per the October 23, 2017, CBDT circular, the PoEM provisions will not apply to a foreign company having turnover or gross receipts of INR 500 million or less in a tax year.

The General Anti-Avoidance Rules (GAAR) came into effect in India from April 1, 2017. GAAR is an anti-avoidance regulation that allows tax authorities to deny tax benefits on transactions conducted with the purpose of avoiding taxes. It has been applicable since the assessment year 2018–19.

Both POEM and GAAR tackle the perceived weaknesses in international tax rules, addressed in the OECD Country-by-Country Reporting Agreement’s BEPS measures.

Conclusion

In addition to the above-mentioned taxation implications, DTAAs lay out the ground rules for many other bilateral tax agreements. The nature of these differs significantly depending upon each individual treaty; however, each should be studied in detail to ascertain both the required legal structure and the scope of trade. International businesses intending to trade with India and/or establish a physical presence would be wise to examine the applicable treaties and seek professional advice over the legal and financial implications prior to contemplating the legal structure itself.

(This article was originally published in July 2013. It was last updated May 17, 2024.)

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