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India's reservation on OECD tax convention
September, 09th 2008

The Organisation for Economic Co-operation and Development (OECD) is an international economic research organisation. The vast majority of its 30 members are economically developed nations. India is not a member, but was granted an observer status in 2006, and is now engaged in enhanced dialogue. Observer status nations, particularly BRIC economies, have been playing an important role in influencing OECDs fiscal policies.

The OECD mandate covers economic, environmental, fiscal and social issues. It is a forum which through the medium of discussion and debate, develops policies and implements soft law non-binding instruments that occasionally lead to binding treaties between member countries. One such important fiscal policy document is the Model Tax Convention (MTC), which serves as a template for bilateral negotiations for coordination and cooperation and the commentary thereon (the Commentary). An updated MTC and Commentary was recently released by the OECD. For the first time , the draft MTC incorporates Indias views and reservations. While commenting on the draft MTC, the Indian policy makers have understandably taken an approach aimed at maximising the rights of the source state to tax income of non-residents arising out of activities in India. The initial response to Indias reservations from tax experts within the OECD nations has been that of resentment!

The UN Model Tax Convention has naturally found favour with the developing nations given that in such emerging economies, the balance of trade and investment is tilted in favour of inbound investments and maximising source state taxation rights enables augmentation of tax revenues. The OECD member countries naturally support the concept of residence based taxation i.e. the right to tax vesting not with country where income is earned, but with the country whose resident earns the income.

Key reservations E-Commerce Contrary to the OECD interpretation of the MTC, India is of the view that a website itself may constitute a Permanent Establishment (PE) in certain circumstances and that depending on the facts of case, an enterprise can be considered to have a place of business by virtue of hosting its website on a server located in India.

Business Meetings Similarly, India disagrees with OECD approach that mere attending or participating in negotiations (by an agent) should not give rise to a PE, but considers that mere presence in meetings where negotiations are taking place is sufficient to conclude that the person has exercised authority to conclude contracts and thus, a PE of the foreign enterprise is constituted.

Leasing With respect to lease transactions, whether of tangible or intangible property, the Indian approach suggests that a mere dry lease (without presence of people) may constitute a PE of the lessor in certain circumstances. India disagrees with OECD approach that no PE is constituted unless the non-resident enterprise has a fixed place of business in the source state

Services While the MTC does not include a specific rule relating to creation of a PE merely on account of furnishing of services, most Indian tax treaties contain such a rule. Further, India disagrees with OECDs conclusion that taxation should not extend to services performed outside the source state; and only to the profits derived from such services rather than to the entire consideration.

Force of attraction rule Similarly, while the commentary to the MTC rejects the force of attraction rule, Indias tax treaties contain such imputation. Such rules provide that profits derived by an enterprise from business activities independent of its PE in the source state would also be deemed to be attributable to that PE provided such business activities are same or similar in nature.

Resolving Transfer pricing disputes India has emerged on top of the TP dispute league. The alternate dispute resolution mechanism prescribed under the MTC is now blocked given Indias reservation. Disputes involving countries such as Germany, Singapore and others will certainly be impacted.

Pitfalls of our Approach A Tax everything approach may perhaps not auger well. Our source based rules and interpretation have generated enough anxiety in the minds of tax payers, not to forget the mounting cost of tax compliances in India. Given that , the moot point is whether OECD nations (via OECD) would exert pressure to adopt the model tax convention and commentary to aid interpretation. For India to make transition towards a highly developed economy, numerous sectors need a liberal dose of investment which cannot purely be funded from domestic sources.

Further, given that the balance of trade would gradually tilt in Indias favour and the Indian economy would emerge as a net exporter/investor of goods and capital, the preference for a source based taxation could come to haunt us. Not to forget that a strict source based rule could invite provocation by tax administrators of nations where Indian companies decide to invest.

Indias decision to be an observer nation is understandable. It would be interesting to observe Indias response to OECDs overtures for becoming a member, not that India has expressed any reservations to be part of the OECD club.

My closing comment on MTC would be for India to unite with other non-OECD nations and align its reservations. Otherwise, India could find itself isolated! We should bear in mind that we export more capital than import and this requires a taxation shift in our tax treaty negotiations and interpretation.

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