No retrospective interpretation on amendments made to tax treaties
Amendment made to Article 7(3) of the Indo-UAE tax treaty to be applied prospectively
The Mumbai bench of the Income Tax Appellate Tribunal (“Tribunal”) recently held, in the case of Abu Dhabi Commercial Bank v. ADIT1 that the amendment made to Article 7(3) of the India-UAE tax treaty (“Treaty”), by way of protocol that deductions of a Permanent Establishment (“PE”) would be in accordance with the provisions of and subject to the limitations of the tax laws of each country, was applicable only with effect from April 1, 2008, and cannot be given retrospective interpretation. Additionally, the Tribunal upheld that restrictions under domestic tax law cannot be impliedly read into Article 7(3) of the treaty unless there is express wording to that extent.
Abu Dhabi Commercial Bank Ltd. (“the taxpayer”) is a banking company incorporated in UAE, conducting banking operations in India through two branches. The business profits earned by the taxpayer in relation to its Indian offices were to be computed under Article 7 of the treaty, dealing with income from business profits. While computing the taxable income, taking into consideration the wording of Article 7(3) of the treaty, the taxpayer claimed deduction of all the expenses incurred relating to the PE and took the stance that the restriction on allowability of head office expenditure provided under Section 44C of the Income Tax Act, 1961 (“the Act”) did not apply to it. Section 44C of the Act limited the head office expenses to the lesser of 5% of the total income of the PE (nonresident) or the actual expenses incurred by such PE.
The tax authorities relied on a circular issued by the Central Board of Direct Taxes (“CBDT”)2 and held that restrictions under Section 44C of the Act need to be read into Article 7 of the Treaty so as to bring the correct profit to tax as provided by the OECD and UN Model conventions. On appeal, the Commissioner of Income Tax (Appeals) held that although Article 7(3) of the treaty in itself did not allow the applicability of restrictions under domestic law, Article 25(1) of the treaty dealing with elimination of double taxation states that laws in force of the Contracting States shall continue to govern the taxation of income and therefore, limitation under section 44C would apply. Aggrieved by such order, the taxpayer preferred an appeal to the Tribunal.
Arguments and Ruling
Contentions of the Taxpayer
The taxpayer contended that there was nothing in the language of Article 7(3) of the treaty to limit the deductions as per domestic law at the time when the taxpayer claimed such deductions and therefore, such limitations cannot be retrospectively applied by implication. The taxpayer claimed that since the amendment to Article 7(3) of the treaty expressly including such restrictions was introduced only with effect from April 1, 2008, such restrictions could not be applied to prior years. The taxpayer also contended that Article 25(1) of the treaty only provided credit for taxes according to domestic law in case of double taxation and it did not apply to Article 7(3) of the treaty. The taxpayer relied on the Special Bench decision of the Tribunal in M/s Sumitomo Mitsui Banking Corporation v. DDIT (IT)3 in support of this contention. Moreover, the Taxpayer also relied on the decision of the Ahmedabad bench of the Tribunal in ADIT (IT) v. M/s Dalma Energy LLC4 to contend that the amendment made to Article 7(3) of the treaty is prospective in application.
Contentions of the Revenue
The tax authorities contended that the issue in dispute in the instant case was squarely covered by the decision of the Tribunal in Mashreqbank Psc. v. DDIT (IT)5 and contended that the restriction under Section 44C of the Act was impliedly read into Article 7(3) of the treaty on account of the wording of Article 25(1) of the treaty. Moreover, the tax authorities also contended that the amendment made to Article 7 with effect from April 1, 2008 was merely clarificatory in nature and thus, has retrospective operation.
Ruling of the Tribunal
The Tribunal, after a perusal of all contentions put forward by both parties, observed that the decision of the Tribunal in Mashreqbank Psc.6 was overruled by the Special Bench decision in Sumitomo Mitsui Banking Corporation7. Thus, it held that the application of Article 7(3) of the treaty was not limited by Article 25(1) of the treaty since Article 25(1) of the treaty provided for the elimination for double taxation through the provision of credit under domestic law and did not in any way affect the applicability of Article 7. The Tribunal further reasoned this finding based on the fact that the express inclusion of an amendment proved that there was no such implication prior to its introduction. The Tribunal, therefore, agreed with the Special bench where it followed Union of India v. Azadi Bachao Andolan8 and held that Section 90(2) of the Act implied that the treaty would override provisions of the Act whenever there was a conflict. Thus, it ruled that Section 44C of the Act was overruled by full allowability of deductions under Article 7(3) of the treaty prior to the amendment.
With respect to the question of applicability of the amendment, the Tribunal followed the ruling in Dalma Energy9 and held that Section 44C of the Act would be applicable to deductions under Article 7 of the treaty prospectively, that is, with effect from April 1, 2008. Owing to the previous finding of the Tribunal with respect to Article 25(1) of the treaty, the Tribunal also arrived at the conclusion that the amendment made to Article 7 is not clarificatory in nature. Thus, the Tribunal held that the amendment does not have retrospective operation.
The ruling given by the Tribunal will have widespread ramifications on foreign corporations operating through a PE in India. A ruling to the contrary would have meant that every tax treaty provision is restricted by domestic law provisions owing to the application of Article 25. Such a ruling could have had serious implications on the interpretation of Indian tax treaties and one can breathe a sigh of relief that this was not the case. As per the decision, unless the tax treaty entered into by India with another country has a specific provision in Article 7 itself that deductions for a PE would be in accordance with the provisions of and subject to the limitations of the tax laws of each country, the limitation under Section 44C of the Act would not apply.
This ruling again emphasizes the position that if the treaty is more beneficial than the Act, then the treaty would apply as held in Azadi Bachao Andolan and section 90(2) of the Act.
Interestingly, India’s treaties with Mauritius and Japan do not have such a clause in Article 7 to limit the deductions of PE as per domestic law. This means, the entire expenses of the PE, including the expenses incurred out of India, could be claimed by such PEs against its taxable income in India.
*Special assistance from Sriram Govind