Double Taxation – India & US

Author: LegalEase Solutions 

Question Presented

What type of corporate structure would best allow the India Pvt. Ltd. to operate in the US and not be taxed twice, both by the Indian tax authorities and the US tax authorities?

Short Answer

Establishing a branch office in the US (as opposed to a subsidiary) would appear to be a better option for the Indian Company to avoid double taxation.

Discussion

The Convention between the Government of the United States of America and the Government of India for the Avoidance of Double Taxation and the Prevention of Fiscal Evasion with respect to Taxes on Income (“the US Convention”) was signed at New Delhi on September 12, 1989. It entered into force with effect from December 18, 1990.

One important term mentioned in the US Convention is the term ‘Permanent Establishment’ (“PE”). However as per US Convention, PE includes, a vide variety of arrangements i.e. a place of management, a branch, an office, a factory, a workshop or a warehouse, a mine, a quarry, an oilfield etc. According to article 5(1) of the Convention, permanent establishment means fixed place of business through which the business of the enterprise is wholly or partly carried on.

Article 5(2) defines a “permanent establishment”:

  1. The term “permanent establishment” includes especially:

(a) a place of management;

(b) a branch;

(c) an office;

(d) a factory;

(e) a workshop;

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Imposition of tax on a foreign enterprise is done only if the foreign enterprise has a PE in the contracting state. Tax is computed by treating the PE as a distinct and independent enterprise. In order to avoid double taxation it is provided that if a resident of India becomes liable to pay tax either directly or by deduction in the other country (in this example in the United States) in respect of income from any source, he shall be allowed credit against the Indian tax payable in respect of such income in an amount not exceeding the tax borne by him in the United States on that portion of the income which is taxed in the United States. The same benefit is available to the residents of the United States, on income taxed in India.

Article 25 of the US Convention provides for Avoidance of Double Taxation. It reads as follows:

  1. In accordance with the provisions and subject to the limitations of the law of the United States (as it may be amended from time to time without changing the general principle hereof), the United States shall allow to a resident or citizen of the United States as a credit against the United States tax on income:

(a) the income tax paid to India by or on behalf of such citizen or resident; and

(b) in the case of a United States company owning at least 10 percent of the voting stock of a company which is a resident of India and from which the United States company receives dividends, the income tax paid to India by or on behalf of the distributing company with respect to the profits out of which the dividends are paid.

For the purposes of this paragraph, the taxes referred to in paragraphs 1(b) and 2 of Article 2 (Taxes Covered) shall be considered income taxes.

  1. (a) Where a resident of India derives income which, in accordance with the provisions of this Convention, may be taxed in the United States, India shall allow as a deduction from the tax on the income of that resident an amount equal to the income tax paid in the United States, whether directly or by deduction. Such deduction shall not, however, exceed that part of the income tax (as computed before the deduction is given) which is attributable to the income which may be taxed in the United States.

(b) Further, where such resident is a company by which a surtax is payable in India, the deduction in respect of income tax paid in the United States shall be allowed in the first instance from income tax payable by the company in India and as to the balance, if any, from surtax payable by it in India.

  1. For the purposes of allowing relief from double taxation pursuant to this Article, income shall be deemed to arise as follows:

(a) income derived by a resident of a Contracting State which may be taxed in the other Contracting State in accordance with this Convention (other than solely by reason of citizenship in accordance with paragraph 3 of Article 1 (General Scope)) shall be deemed to arise in that other State

(b) income derived by a resident of a Contracting State which may not be taxed in the other Contracting State in accordance with the Convention shall be deemed to arise in the first mentioned State.

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Further Article 7(7) of the Treaty defines business profits. Business Profits “means income derived from any trade or business including income from the furnishing of services other than included services as defined in Article 12 (Royalties and Fees for Included Services) and including income from the rental of tangible personal property other than property described in paragraph 3(b) of Article 12 (Royalties and Fees for Included Services).”  Article 7 of the Treaty explains the nature of taxation of business profits. Article 7 reads in relevant part:  “business profits” and

Business Profits

  1. The profits of an enterprise of a Contracting State shall be taxable only in that State unless the enterprise carries on business in the other Contracting State through a permanent establishment situated therein. If the enterprise carries on business as aforesaid, the profits of the enterprise may be taxed in the other State but only so much of them as is attributable to

(a) that permanent establishment;

(b) sales in the other State of goods or merchandise of the same or similar kind as those sold through that permanent establishment; or

(c) other business activities carried on in the other State of the same or similar kind as those effected through that permanent establishment.

  1. Subject to the provisions of paragraph 3, where an enterprise of a Contracting State carries on business in the other Contracting State through a permanent establishment situated therein, there shall in each Contracting State be attributed to that permanent establishment the profits which it might be expected to make if it were a distinct and independent enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly at arm’s-length with the enterprise of which it is a permanent establishment and other enterprises controlling, controlled by or subject to the same common control as that enterprise. In any case where the correct amount of profits attributable to a permanent establishment is incapable of determination or the determination thereof presents exceptional difficulties, the profits attributable to the permanent establishment may be estimated on a reasonable basis. The estimate adopted shall, however, be such that the result shall be in accordance with the principles contained in this Article.

Further Article 7(3) provides for deductions to be made in determining the profits of the PE.  In this context, it will be relevant to discuss the holding in a recent decision of the Indian Income Tax Appellate Tribunal (Chennai), India, embodied in 49 Tax Notes Int’l 1104. The parties to the proceedings were ITO(State Income Tax Department in India) v. Data Software Research Co. (P) Ltd.(a private limited company incorporated in India). The ruling of the Appellate Tribunal was released on March 21, 2008. The Appellate Tribunal in the case held that an Indian company must include the profits of its U.S. branch when computing its global income, but is eligible for a tax credit for taxes paid in the United States. Id.

In the case at issue, the profits of Indian-resident Company Data Software Research Co. (P) Ltd. for the relevant assessment year included profits earned by its branch in the United States. Id. However, the company claimed that the profits of the U.S. branch were not subject to tax in India because they had already been taxed in the United States. Id. The Company cited to Article 7 of the Treaty to contend that since it had a PE in United States in the form of the branch company and that the PE’s profits were taxable under U.S. law, it could not be taxable in India. Id. However, the State relied on article 25.2(a) of the India-U.S. income tax treaty, to contend that the wording of article 25.2(a) clearly indicates that the company’s branch profits are taxable in India, but that a tax credit will be available for the taxes paid in the United States. Id.

The tribunal agreed that two different methods exist for the elimination of double taxation — the exemption method and the tax credit method. Id. The treaty with the US provided for the tax credit method. Id. The income of the company would be computed on a global basis and then the amount of tax that the company paid in the United States would be deducted from its income. Id.

The income of all foreign branches is taxed in India as part of the Indian company’s worldwide taxable income. Similarly, the losses of all foreign branches are deductible in computing the worldwide taxable income. In computing the income or loss of a foreign branch, a deduction is generally allowed for all expenses incurred wholly and exclusively for the purpose of the business. It is evident that if the Indian Company sets up a branch in the US, the income of which is taxed in the US, India will allow a deduction of such taxes. Income of the company would be computed on a global basis and then the amount of tax that the company paid in the United States would be deducted from its income. The tax will be determined based on Article 7 but only to the extent that the profit is attributable to the PE. The PE will be treated as such where it is a distinct and independent enterprise engaged in the same or similar activities under the same or similar conditions and dealing wholly at arm’s-length with the enterprise of which it is a permanent establishment

The Treaty does not specifically include a subsidiary of a parent Indian company as a PE. However, there appears to be some evidence that a subsidiary may be treated differently than a PE. See Article 5(6) which reads as follows: “The fact that a company which is a resident of a Contracting State controls or is controlled by a company which is a resident of the other Contracting State, or which carries on business in that other State (whether through a permanent establishment or otherwise), shall not of itself constitute either company a permanent establishment of the other.” This is further supported by Article 10 which deals with Dividends. The DTAA provides source based taxation of dividends and interest. Dividends from a subsidiary to a parent corporation (i.e., which holds at least 10% shares in the subsidiary) are taxable at 15%, whereas other dividends are taxable at 25%.

Article 10(1) and (2) reads as follows:

Dividends

  1. Dividends paid by a company which is a resident of a Contracting State to a resident of the other

Contracting State may be taxed in that other State.

  1. However, such dividends may also be taxed in the Contracting State of which the company paying the dividends is a resident, and according to the laws of the State, but if the beneficial owner of the dividends is a resident of the other Contracting State, the tax so charged shall not exceed:

(a) 15 percent of the gross amount of the dividends if the beneficial owner is a company which owns at least 10 percent of the voting stock of the company paying the dividends;

(b) 25 percent of the gross amount of the dividends in all other cases.

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Article 10(4) reads as follows:

  1. The provisions of paragraphs 1 and 2 shall not apply if the beneficial owner of the dividends, being a resident of a Contracting State, carries on business in the other Contracting State, of which the company paying the dividends is a resident, through a permanent establishment situated therein, or performs in that other State independent personal services from a fixed based situated therein, and the dividends are attributable to such permanent establishment or fixed base. In such case the provisions of Article 7 (Business Profits) or Article 15 (Independent Personal Services), as the case may be, shall apply.

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Therefore, it would appear that the taxation of dividends is only applicable to a subsidiary and not a PE. Thus it may be possible for the PE to repatriate profits after paying the tax in US. It would appear that dividends of foreign subsidiary are included in the worldwide taxable income of the Indian company and no credit will be given for underlying tax paid by the foreign subsidiary. Profits not distributed by the foreign subsidiary are not taxed in the hands of the Indian company. Further Article 13 provides for each both US and India to tax capital gain in accordance with the provisions of their domestic laws.

The situations mentioned above which are applicable to subsidiaries and not for PE’s will result in double taxation and this is probably the reason why companies prefer the alternate route of setting up a company in a favorable jurisdiction and which has favorable tax treaties with both India and US. It would therefore appear that creating a branch office in the US may be a better way of avoiding double taxation as opposed to setting up a subsidiary of the Indian company.