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Non-discrimination tax debate
October, 16th 2008

In a significant decision by the Pune Tribunal, it has been held that a non-resident foreign company could not avail relief under the Non-discrimination clause of the tax treaty, unless the alleged discrimination in taxation is unreasonable and unfounded.

Non-discrimination clause in tax treaties

Article 24 of the Model tax Convention provides relief to non-resident taxpayers on account of discrimination (in taxation) in the source country. The basic principle underlying such relief is that a national or a resident of a foreign country shall not be subjected (in the source state) to a less favorable taxation regime or any onerous requirement which is more burdensome than that applicable to nationals of the source country, under same circumstances.

For illustration, if a branch of US resident company operates in India, it shall not be subject to any less favourable tax treatment than those applicable to Indian companies under similar circumstances. Article 24 however, limits the extent of such relief by stating that non-discrimination clause does not, in any manner, make it obligatory for the source state to grant to such non-resident any relief in taxation on account of civil status or family responsibilities, which are otherwise granted to residents of the source country. Hence, non-discrimination applies subject to limits laid down in the treaties.

Facts of the case

The taxpayer, a US resident company, was engaged (through its branch office) in the business of export of computer software. For years under consideration, the company claimed deduction for profits generated in foreign exchange in relation to export of software. In the course of assessment, the Assessing Office (AO) denied such deduction holding that such relief is specifically available only to an Indian company under the domestic Indian tax law. Under section 80HHE the Indian law allows such holiday to resident Indian companies. Interestingly, the company withdrew its claim for deduction during the course of assessment based on a legal opinion obtained from its tax counsel.

In appeal before Commissioner, Appeals (CIT (A)) the assessee re-instated its claim for deduction on the ground that denial of deduction would result in discrimination under the US- India tax treaty. The CIT(A) rejected such claim on account of the question of law involved as such claim was firstly withdrawn and on the merits itself. The CIT(A) argued that deduction was available only to an Indian company by reason of its civil status and hence there was no case of discrimination. The CIT(A) relied on an Advance Authority ruling wherein it was held that a higher rate of tax (applicable to a foreign company) cannot be covered by the non-discrimination provisions under the French-India tax treaty.

Tribunal ruling

The Tribunal held that in order to establish discrimination, not only does the taxpayer has to demonstrate discriminating tax treatment but also that the ground of such differentiation is unreasonable, arbitrary or irrelevant. With respect to the question of applicability of OECD commentary, the Tribunal held that in construing the provisions of the India-US treaty, the OECD commentary would not be relevant where provisions are specifically explained in the technical explanation to the US Model Convention. The Tribunal further observed that in view of the Technical Explanation to the US Model Convention, it would be crucial to examine dissimilarity, if any, in position of the US company in this case vis--vis an Indian company and test the reasonableness of limitation on incentive deduction.

Tax holiday for export of services whether a case of unreasonable differentiation.

The Tribunal held that eligibility for incentive deduction or tax holiday is clearly related to the residential status of the taxpayer; that the legislature was clear in its intent of not granting such incentive to a company, other than an Indian company. The Tribunal observed that one of the significant motives underlying incentive deduction was to encourage foreign exchange earnings and augment countrys foreign exchange reserves.

It was reasonable to assume that the earnings by resident tax payers are more likely to be retained in the country than in a situation where profits are derived by a non-resident. Therefore, there is a rational relation between differentiation and the objective of an incentive deduction; to that extent the test of reasonableness in differential treatment for the US Company is prima facie satisfied in the instant case.

Important principle of law

Indian tax treaties have specific non-discrimination clauses pertaining to deductibility of expenses (despite limitation under domestic laws), differential rates of tax, rates not to exceed specified limit etc. The reliance of lower authorities on Advance Authority Ruling position with respect to rate of tax in my view is incorrect. Having said that, if the argument of non-discrimination is carried to encompass equal treatment to residents and non residents, this would in my view, be stretching it too far. Several countries honour the non discrimination clause subject to inbuilt limits laid down in the domestic law. The domestic law otherwise would be rendered meaningless and redundant.

I feel the tribunal has set the correct principle and intent of the non-discrimination clause. Hence, incentive provision applicable to resident tax payers under the domestic law shall not apply to non residents. It is also a principle (unless reversed by the courts) which would guard foreign companies from stretching the argument of non-discrimination.

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