Can tax treaties be used to create a tax liability?

pramod_achuthan_in_ey_com_LThumbIn India, it is a settled principle of law that the tax treaties cannot create more onerous obligations or liabilities independent of enabling provisions under the domestic law. As such, where any income is exempt under the provisions of domestic tax law, the tax treaty cannot create a fresh tax liability.

Internationally, most of the countries also follow the same principle.

There are various international decisions supporting this principle. Also, this finds support in the international tax commentaries authored by Klaus Vogel and Philip Baker. However, Philip Baker has pointed out that ultimately the position depends on the constitutional provision and domestic legislation giving effect to the tax treaties.

Relevant to the above discussion, in October 2018, the Full Federal Court of Australia (Full Court) ruled that Satyam’s (taxpayer, now amalgamated with Tech Mahindra Limited – hereafter referred to as taxpayer) royalty receipts pertaining to software development services rendered from India, i.e., offshore services shall be deemed to be Australian sourced income by virtue of Article 23 of India-Australia tax treaty and therefore assessable as income for Australian tax purposes. Let us look at the background to this decision of the Full Court:

Taxpayer was rendering IT services to Australian customers through its branch in Australia (onsite services) as well as its India office (offshore services). Taxpayer had not offered to tax the offshore service income in Australia based on the view that the Australian domestic law does not permit taxation of income which is not Australia sourced and Article 23 of India-Australia tax treaty (the Treaty) cannot create a charge on income independent of enabling provisions of domestic law.

To appreciate the technicalities of the arguments, it is important to understand the provisions of the Australian domestic tax law and the Treaty. Australian domestic tax law does not have enabling provisions to tax India sourced income. However, Australia gives force of law to the tax treaties it enters with various countries by making them part of the domestic law and the India-Australia tax treaty thus becomes part of the Australian domestic law. Such domestic law where treaties are incorporated is called the International Tax Agreements Act. This Act also interestingly incorporates the Australian domestic tax law (called as Assessment Act) into the International Tax Agreements Act. With this background, we turn to Article 23 of the Treaty which was the key provision under consideration. Article 23 of the Treaty which is unique to Australia’s treaties provides that, royalty income (among other streams of income) which may be taxed in the other contracting state (i.e., Australia in this case), shall for the purpose of its domestic tax law, be deemed to be income from sources in that state (i.e., Australia).

Australian Tax Officer argued that in view of these specific provisions of Article 23 of the Treaty, offshore service income is deemed to be sourced in Australia for the purpose of its domestic tax law and hence, taxable in Australia.

Taxpayer argued that the Australian domestic tax law does not have provisions to levy tax on India sourced income. Further, the purpose of Article 23 may be understood as granting the right to tax where the domestic tax law levies tax on concerned income. To explain, where Australian domestic tax law levies tax on offshore income, India cannot dispute such a right to tax. The intention of tax treaties is to act as a shield and not as a sword, i.e., to eliminate double taxation but not provide standalone taxing powers. Accordingly, Article 23 cannot have the effect of extending the scope of Australian domestic tax law by deeming income to have an Australian source. Also, the taxpayer relied on Indian judicial precedents which support the principle that tax treaties cannot fasten a tax liability where the liability is not imposed by the Indian Income-tax Act.

The Full Court brushing aside the arguments of the taxpayer ruled that Indian Agreement does not warrant a different construction being given to the meaning of Article 23 which otherwise is sufficiently clear, deeming the provision to treat offshore income as Australia sourced. The statute governing the international agreements and the domestic tax law are to be interpreted and read as one. To the extent of inconsistency between the two statutes, the provision of the statute governing the International agreements will override the provisions of the domestic tax law. So, Article 23 shall have the effect of superseding, specifically, the definition of “Australian source” in the Australian domestic tax law. Therefore, the submission of the taxpayer that there is no Australian taxing law that imposes tax on the income from the Indian services was held to be not acceptable. In conclusion, the Full Court on combined reading of provisions of Article 23 of the Treaty and the domestic tax law of Australia, held the offshore income as taxable in Australia.

One needs to wait and watch if this decision is challenged before the High Court of Australia (the highest Court of Australia) and the outcome of the same. Irrespective, if the above principle laid down by the Full Court is considered as the law in Australia, then while invoking the principle that tax treaties cannot create fresh tax liability, one needs to consider the impact of the scheme of domestic statutes of the country governing the taxation and the tax treaties.

Impact on Indian IT companies and way forward:

This decision shall have an impact on taxation in Australia of Indian IT companies, especially those delivering software services from India to Australian customers. Similarly, Indian companies providing engineering services (including the subcategories of bioengineering, aeronautical, agricultural, ceramics, chemical, civil, electrical, mechanical, metallurgical and industrial engineering) and architectural and other services consisting of the development and transfer of a technical plan or design could be impacted.

Where the offshore income is taxable in Australia, the availability of foreign tax credit in India would depend on the Indian tax position of the taxpayer (tax holiday/incentives availed in India would play a role). Further, there could be challenges in availing foreign tax credit in India where the matter is under litigation in Australia.

In view of the above, it may be worthwhile to explore Alternate Dispute Resolution mechanism like Mutual Agreement Procedure to try and achieve certainty on this issue. In addition, industry level representation to the Government of India/Australia could also be sought. Ultimately, one hopes the principle that a treaty cannot create a tax liability independent of domestic law provisions is upheld.


The author of the blog is Pramod Achuthan, Partner, Business Tax Services, EY India

The blog is co-authored by Anuj Deshmukh, Senior Manager, Business Tax Services, EY India

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