[Submitted by Mr. Kartik P. Badiani,
B.Com., CA Final Student,
Mumbai, Maharashtra]

June 26, 2008

Double dip is the word very often used in international taxation. It means a situation when the system of taxation is used for receiving benefits more than once which is in a way regarded as unethical. With some recent court decisions, this will be 'the topic' to discuss in years to come. As it is very easy to understand a topic using illustrations, we will discuss 'Double Dip' with the help of a recent decision of Honorable Pune Tribunal in the case 'Patni Computers Corp. Ltd' (109 TTJ 742). There are many situations in which 'Double Dip' is possible. We will discuss one of them, i.e. Double Dip of Foreign Losses, with the help of Patni Computer's case.

To understand 'Double Dip', it is very essential to understand some important concepts of international taxation. These concepts are explained in the following points.

I) Scheme of Double Tax Avoidance Agreements :

The scheme of double tax avoidance treaties can be explained as follows :

(i) Articles 1 - 4 explain the scope, applicability, definitions and residence of the assessee.

(ii) Article 5 talks about - what would constitute a Permanent Establishment (PE)

(iii) Article 6 - 22 talk about different categories of incomes and the method of elimination of double taxation by Country of Source (COS). For eg, COS will not tax business income unless it is earned through a PE in COS (Article 7). Similarly, COS will not tax income from Immovable Property unless the immovable property is situated in COS.

(iv) Article 23 explains the method for elimination of double taxation adopted by the Country of Residence (COR). This is discussed in detail in the paragraphs to follow. Generally, Indian Double Tax Avoidance Treaties follow Credit Method of elimination of double taxation.

II) Methods for 'Elimination of Double Taxation' :

As per OECD and UN Model Conventions there are two methods for 'Elimination of Double Taxation' by COR viz. 'Exemption Method' (Article 23A of Model Convention) and 'Credit Method' (Article 23B of Model Convention). Countries can negotiate between themselves and select any one of the above two methods if they want to adopt the model conventions. We will now understand both these methods.

Facts assumed :

Japan branch (Permanent Establishment) of Indian company has reported a loss of Rs. 54 lakhs in year 1 in Japan. Indian Head Office has earned a profit (before deducting loss of branch) of Rs. 300 lakhs. In year 2, Japan branch has earned a profit of Rs. 100 lakhs while Indian HO has earned a profit (before adding profit of branch) of Rs. 300 lakhs. Tax rate in India = 34% and tax rate in Japan = 30%.

1. Credit Method :

Table 1 :

  India Japan
Year 1    
Indian Income 300.00  
Japanese Loss (54.00)
(54.00)
Total Income 246.00 (54.00)
Tax on above 83.64 -

Loss to be c/f

  (54.00)
     
Year 2    

Indian Income

300.00  
Japanese Income 100.00 100.00
Year 1 loss set/off  
(54.00)
Total Income 400.00 46.00
Tax on above 136.00 13.80
Credit of tax paid in Japan (13.80)
 
Tax payable 122.20  
     
Total tax paid in both countries 219.64  

1.1 Indian Company is a resident of India. Therefore, its global income is taxable in India. Similarly, losses incurred abroad will also be allowed for set off in India. In the present case, Indian HO has earned a profit of Rs. 300 lakhs in India in year 1. However, its Japan branch has incurred losses of Rs. 54 lakhs. These losses will be allowed to be set off against the Indian income. Therefore, net income taxable in India will be Rs. 246 lakhs.

1.2 Also, the Japan branch will be treated as a PE in Japan (Article 5 of India - Japan DTAA). Therefore, Japan will also have the right to tax the Profits attributable to PE i.e. Japan branch (Article 7 of India - Japan DTAA). Since, in the present case Japan branch has incurred a loss of Rs. 54 lakhs, there will be no tax payable in Japan and the loss will be allowed to be carried forward to be set off against income of following years.

1.3 In year 2, Indian HO has earned a profit of Rs. 300 lakhs and Japan branch has also earned a profit of Rs. 100 lakhs. As explained in para 1.1 above, global income of Indian enterprise will be taxable in India. Therefore, Indian HO will have to pay tax on profit earned in India as well as in Japan i.e. on Rs. 400 lakhs.

1.4 As explained in para 1.2 above, profit of Rs. 100 lakhs will also be taxable in Japan. However, in Japan, year 1 loss which was carried forward will now be allowed to be set off against current year's income of Rs. 100 lakhs. Therefore, taxable income in Japan will be Rs. 46 lakhs.

1.5 This would lead to double taxation of the income of Rs. 46 lakhs earned in Japan. To eliminate this double taxation, India will have to give "Credit" for tax paid in Japan (Article 23 of India - Japan DTAA).

This is also the method prescribed under Article 23B of OECD & UN Model Conventions.

2. Exemption Method :

Table 2 :

  India Japan
Year 1    
Indian Income 300.00  
Japanese Loss  
(54.00)
Total Income 300.00 (54.00)
Tax on above 102.00 -
Loss to be c/f   (54.00)
     
Year 2    
Indian Income 300.00  
Japanese Income   100.00
Year 1 loss set/off  
(54.00)
Total Income 300.00 46.00
Tax on above 102.00 13.80
     
Total tax paid in both countries 217.80  

 

2.1 As explained in para 1.2 profits attributable to Japan PE will be taxable in Japan. If exemption method for elimination of double taxation is followed then the Country of Residence (COR) exempts the whole income that is taxable in Country of Source (COS). Also, the loss will not be allowed to be deducted from income in COR. In the present case the, in year 1, the loss of Rs. 54 lakhs incurred in Japan (COS) will not be allowed to be deducted in India (COR) and the income of Rs. 100 lakhs earned in Japan will not be taxable in India as the same is taxable in Japan.

This is also the method prescribed under Article 23A of OECD & UN Model Conventions.

3. Understanding Double Dip by analysis of Patni Computer's Ruling :

3.1 Summary :

(i) Income-tax Act : Global tax system is followed.

(ii) Under the DTA, the double tax can be eliminated by the Exemption System or Credit System.

(iii) With the two decisions, R .M. Muthiah (202 ITR 508) and Vr SRM Firm (208 ITR 400) - Exemption System is binding.

(iv) Assessee has an option to choose IT Act or DTAA, whichever is more beneficial to him.

(v) Choice can be changed every year.

3.2 Explanation :

Following the two High Court decisions in the cases of R .M. Muthiah (202 ITR 508) and Vr SRM Firm (208 ITR 400) the Tribunal in Patni Computer's case has ruled that India - Japan DTAA follows exemption method for elimination of double taxation. This would mean that profits earned in foreign country through a permanent establishment and attributable to that PE shall not be taxable in India. They will be only taxable in the foreign country.

The assessee has the right to choose Indian IT Act or India - Japan DTAA which ever is more beneficial to assessee. Therefore, even if India - Japan DTAA follows exemption method, if the assessee chooses Income-tax Act, then his income (which includes loss) will be added to (deducted from) his Indian income. Therefore, even losses incurred in Japan will be allowed to be set off against Indian income as per Indian IT Act.

Tribunal also ruled that the option of choosing IT Act or DTAA whichever is beneficial can be changed every year as each and every assessment year is a separate unit.

On the basis of the above decision, when assessee earns income through PE in foreign country, he will choose to be governed by DTAA and the income will not be taxable in India (exemption method) as explained in para 3.1. However, when the assessee incurs losses in foreign country, he will choose to be governed by Indian IT Act, and therefore, the losses will be allowed to be set off against Indian income.

3.3 Computation as per Patni Computer's ruling :

Table 3 :

  India Japan
Year 1    
Indian Income 300.00  
Japanese Loss (54.00)
(54.00)
Total Income 246.00 (54.00)
Tax on above 83.64 -
Loss to be c/f   (54.00)
     
Year 2    
Indian Income 300.00  
Japanese Income   100.00
Year 1 loss set/off  
(54.00)
Total Income

300.00

46.00
Tax on above 102.00 13.80
     
Total tax paid in both countries 199.44  

Table 3 illustrates the computation of tax payable by Indian HO as per the decision in the case of Patni Computers.

With the same facts and applying para 3.3, the position in year 1 will be same as explained in para 2.2 above. This means that taxable income in India would be Rs. 246 lakhs and there will be carry forward of loss of Rs. 54 lakhs in Japan. (This is because the assessee has chosen IT Act.)

However, in year 2, when the Japan PE earns profit of Rs. 100 lakhs, assessee will choose to be governed by DTAA. This means that profits attributable to the Japan PE will not be taxable in India as explained in para 3.1.

III) Conclusion :

Applying Patni Computer's case will lead to double dip of losses incurred in foreign country. This is because income earned in foreign country in the year 2 will not be taxable in India but losses incurred in foreign country in year 1 will be allowed to be set off against the Indian income. Tribunal has also agreed that there will be a double dip of foreign losses because of its decision. However, Tribunal has also said that this situation is permitted under the scheme of section 90 of the Indian Income Tax Act read with the High Court decisions referred above.

This issue of whether Indian DTAAs follow Credit or Exemption method for elimination of double taxation is not decided at Supreme Court level as yet. It was taken up by Supreme Court in the case of P.V.A.L. Kulandagan Chettiar (267 ITR 654). This was a case on India - Malaysia DTAA. In this case, income of the assessee was held not taxable in India by declaring him Non - Resident of India on applying tie - breaker test as per Article 4 of India - Malaysia DTAA. Therefore, the arguments by both assessee and the department on whether Indian DTAAs follow Credit or Exemption method were kept aside by the Honorable Supreme Court.

However, following the two High Court decisions and Pune Tribunal's decision it would mean that Indian DTAAs follow 'Exemption Method for Elimination of Double Taxation'. This would surely open the floodgates for scandals. This is because an Indian tax resident will establish a fixed place of business in a tax heaven (thereby not paying/paying lower tax in that country) - earn profits through that fixed place and because of the exemption method followed by Indian DTAAs as discussed above; they will not pay tax in India either. This will lead to lot of income of Indian tax residents remaining untaxed.