Need for a Global Level - Central Authority for International Taxation

[Submitted by Mr. Bhavik Bipin Mehta,
B.Com., CA and CS student,
Mumbai, Maharashtra]

May 31, 2008

I. Introduction:

We are all aware about the litigation at the International level. We are witness to the recent court decisions on International taxation both in India and outside. Below, I have highlighted the problems/issues involved in International taxation that are yet to be resolved at the global level. I have summarised the relief mechanisms currently available with the taxpayers. I propose a better probable solution to the current litigations.

II. Mechanisms available currently:

1. Authority for Advance Rulings (AAR): Advance Rulings help a non-resident and an Indian resident to know his taxability in a particular country in advance relating to a financial transaction which has been undertaken or is proposed to be undertaken.
    
2. Advanced Pricing Arrangements (APA): It is an arrangement between a taxpayer and the tax department wherein the method of determining the transfer price for inter-company transactions are set out in advance. APA mechanism is not currently present in India.
    
3. Appeals upto Supreme Court: If a taxpayer is not satisfied with the assessment order passed by the Income-tax Officer, then he can go for appeal upto the Supreme Court stage. He has 4 levels of appeals to beg relief.
    
4. Mutual Agreement Procedure: Generally, Article 25 of the Tax treaties contain this provision that where a person considers that the actions of the domestic country or the other country shall result in taxation not in accordance with the treaty provisions, he can present his case to the competent authority in the country of residence. The authority shall verify the claims of the taxpayer whether they are justified & if the case is unable to arrive at a satisfactory solution as regards elimination of the double taxation or interpretation of tax treaty, competent authorities of both the countries shall resolve the difficulties by mutual agreement.

III. Problems in International Taxation: The below mentioned problems are a topic in itself. However, I have not elaborated much in each of them.

1. Concept of PE & E-Commerce: Permanent Establishment (PE) is defined as a fixed place of business or an agent through which the business is carried on in the other country. The non-resident's business income cannot be taxed in the domestic country in the absence of a PE. PE is a threshold for taxing business income of a non-resident/foreign company.
   In the era of E-Commerce, traditional concepts of PE are bound to fail. In today's world, businesses can be run through the globe without having any physical presence in all countries. Say, for example, an Indian company can set up a website and do business throughout the world. It does not require any fixed place of business or an agent in foreign country. Thus, PE threshold cannot be practically applied to E-Commerce transactions undertaken on phone, fax, email, websites, internet and other modern ways of communication.
    

2. Determination of PE & Attribution of Profits to PE.: Determination of PE is a fundamental question of law & fact. Sometimes, it is difficult to establish a PE. PE shall not include offices used solely for:
    
   a. Use for storage facilities or display of goods,
   b. Maintenance of stock,
   c. Purchasing activities or only collecting information,
   d. Purpose of preparatory or auxiliary character;
   e. Exempt activities, etc.
    
   After determination of PE, the issue arises as what amount of profits should be attributable to PE. The international consensus has been to attribute the profits on the basis of separate entity concept and the application of arm's length principle. Profits should be attributed having regard to the functions performed, assets used and the risks involved by respective entities. OECD has done a considerable amount of work on this issue, but still this remains a grey area.
    

3. Base Erosion: For determining jurisdiction, two connecting factors have been accepted universally: "Residence of the Assessee"; and the "Source of the Income". If one of the two Connecting factors exist, the Government has a jurisdiction to tax. Otherwise, not. These two factors constitute tax base for any country. Base erosion arises if profits that should be taxed in a particular country gets shifted to other jurisdiction. For example, an Indian company if directly does business will be taxed in India for its global income but if it does business by setting up a subsidiary in a tax heaven, then the base for Indian taxation gets shifted to the tax heaven, thereby India loses the right to tax such business income.
    
   There are also some decisions that rule that if profits arise then it will be taxable only in the foreign country and not in the residence country. But if, losses arise then they will be eligible for set-off in the residence country. Thus, the company will be able to set-off the same loss in two different jurisdictions - once in the country of residence and later in the country of source.
    

4. Categorisation of Income: Different countries tax incomes in different categories like royalty, fees for technical services (FTS), business income, sale of softwares, etc. The definition of these categories in different countries is different. This creates ample problems while interpreting a tax treaty.
    

5. Interpretation of Tax Treaties: There is a lot of litigation surrounding the Interpretation of tax treaties. There have been contradictory decisions given by all levels of judicature. Domestic laws are enacted with the background of domestic circumstances, and understanding of the domestic situation. An International Agreement like a DTA cannot take into account all the circumstances & background of the countries involved. There is difference of understanding of the DTA between two countries and difference between interpretation as per DTA and interpretation per domestic law. There are issues like- which persons are covered and which taxes are covered in the tax treaties. There are differences in interpretation of domestic law itself, changes in the domestic law after signing the DTA, change in the commentary & model after signing the DTA, change in the commentary after signing the DTA - without change in the model.
    

6. Retrospective amendments by Legislature: This is the biggest drawback in the Indian tax system. Whenever, a taxpayer fights for his rights and get a ruling from Supreme Courts, Government amends the law with retrospective effect to reverse the effect of the ruling of the Supreme Court. It is a mockery of justice and equity. There is no question of the power of legislature to make retrospective amendment, but such powers should be used judiciously.
    

7. Transfer Pricing (Arm's Length Price): Determination of arm's length price and the method to be used for determination of arm's length price is a separate issue in itself. Many a times it becomes difficult to determine ALP and the method to be used.
    

8. Variable Court decisions: There have been variable court decisions like the same bench may reverse its earlier ruling. A court may reverse a ruling of an equitable court in same country. Courts of different countries give different rulings. There is no consensus among judiciary about the taxability of incomes.
    

9. No standard International Law: There are no international principles. There are no conventions. There is no international law which is common and applicable to all countries. The world is trying to develop a common consensus code that can bring around the Governments of the world into some acceptable behavior. No human entity has any authority over the Governments of any country.
    

10. Hybrid Entities: Some countries tax the income of the firm whereas some tax the income of the firm in the hands of the partners. This may give rise to conflict in classification & complication in application of treaty provisions.
     

11. Triangular Situations: There are some transactions which lead to triangular situations. Three countries may become involved and try to tax the same income. Tax treaties are bilateral i.e. between two countries. Triangular situations will involve three treaties at a same time. Say, if Mr. A and Mr. B enter into a financial transaction for transfer of an asset situated in Country C. Then, all three countries i.e. country of Mr. A, country Mr. B and country C will try to tax the same transaction on the basis of Country of Payment, Country of Residence and Country of Source respectively. No expert and no country has a perfect solution for this problem.
     

12. Treaty Shopping/Treaty Abuse: This is nothing but shopping a DTAA. A resident of a State other than contracting states of a tax treaty attempts to capitalize on benefits of the treaty by setting up a company with no economic substance. A taxpayer that has no treaty with India seeks coverage of a favorable treaty. Or a taxpayer of India treaty partner prefers the treaty of another country. Whether treaty shopping is legal/justified has been an issue! Countries have found several mechanisms of curbing treaty shopping by inclusion of a Limitation of Benefits clause (LOB), controlled foreign companies rules and thin capitalization rules.
     

13. Transfer of holding company's shares: This is most recent and the most boiling issue in International Taxation. Indian Tax Department is of the view that when the a person sells/ transfers shares of holding company (which is a non-resident company of India) that assets in India or has a subsidiary company in India, then it is also selling the assets or the shares of the Indian subsidiary along with the holding company's shares and is liable to tax in India.

IV. Need:

Sometimes, a particular country may intend to re-negotiate a treaty with other country but it cannot succeed without the assent of the other country. Thus, this may lead to a deadlock in amending a treaty.

Also, there is no central authority whose decision/orders will be applicable to both the countries. Because of this, a taxpayer is unnecessarily required to pay tax in two countries inspite of there being a treaty but both countries trying to grab their share of revenues. Both countries may not resort to mutual agreement procedure. Unnecessary the taxpayer is subjected to double taxation because both countries are interpreting the treaty for their own benefit.

Because of the above problems and looking at the mechanisms available to the taxpayer, I personally feel there is a need for a global level central authority to monitor, regulate and pronounce rulings on International taxation. This global authority shall study the laws of countries, and will function as a liasoning authority which will co-ordinate with the countries as an intermediary.

A non-resident/foreign taxpayer can reach this central authority in case he is not satisfied with the Supreme Court decision of a particular country.

V. Suggestion for a probable solution:

I propose to set-up a Central Authority for International Taxation at a global level. Currently, there are several institutions studying and researching on International tax aspects like OECD, UN, IBFD, IFA, FIT, etc. In the past, a successful Vienna Convention on the Law of Treaties was made for interpretation of tax treaties. However, the reports given by these institutions carry only a persuasive value. They are not law. These reports may or may not be accepted by Courts of different countries.

For setting up such an authority, all countries will have to come together and make an agreement/convention for incorporation of the central authority. All countries should sign an agreement together for the formation of this central authority in the same manner as the Vienna Convention was made.

The Central Authority should be managed and controlled by all countries together without being in favour of any of the developed countries. All member countries should have equal voting rights.

Each member country should have right to appoint its 20 judges/ representatives in the Central Authority. These judges/ representatives should be experts in the field of International Taxation. They can either be tax experts or the Commissioners of the Income-tax department who are well versed with their domestic law and good knowledge of tax treaties. They should have a minimum of 20 years of experience in the field of International Taxation. A 3-tier departmental hierarchy can be set-up to handle cases involving tax amounts varying from Rs. 1 crore to any amount as given in the following example:

The Central Authority should have the power to regulate its own procedure. The decisions/ orders made by this authority will be binding on the respective countries and the taxpayers.

There should be defined method of working/procedure of this authority. Only orders passed by the AAR/ Supreme Court of any particular country should be allowed to be appealed against. Respective countries will be required to bring out an amendment in their domestic laws for compulsory acceptance/binding nature of the orders passed by this Central Authority.

There can be a two level appeal in the Central Authority. Even the orders passed by a smaller bench can be appealed against and can be handled by the larger bench of the Central Authority.

Even income tax department of respective countries aggrieved by the order of Supreme Court in their respective countries or of the orders of Central Authority should be allowed to go for appeal. The order passed by the higher bench should be final. Numbers of judges sitting in these benches should be decided.

The judges of the litigating countries should not be allowed to try a case pertaining to their country. For example, if a Taxpayer of India and Income-tax department of U.K. are the appellants and respondents of the appeal, then judges of India and U.K. should not be allowed to try such cases. The reason behind is independence of the judges giving the decision. The judges of a particular bench not belonging to the litigating countries should call for a report on tax law/provisions of litigating countries from the representative of the litigating countries. The judges shall study the law of the litigating countries, tax treaty between them and finally decide on the case. The judges should interpret the treaties in line with the global principles and pronounce rulings. These rulings pronounced will have superiority over the decisions passed by courts of litigating countries.

The Central Authority should not apply the concept of PE in cross border E-Commerce transactions. PE should be applied on non E-Commerce transactions only.

The Central Authority should come out with a Common Trilateral treaty that will be applicable to countries in case of triangular situations. This triangular treaty shall override the Double tax avoidance treaty signed between litigating countries. Also, the Central Authority will be the final authority in case of determination of PE and the profits attributable to operations of PE in different countries based on the level of operations undertaken in that country.

The Central Authority may order a particular country to enter into a double tax avoidance and prevention of avoidance of tax agreement with another country if there is none.

In case a particular country does not agree to amend the treaty provisions because the existing treaty provisions are in its favour, then the other aggrieved country (country whose tax base is eroded) should be allowed to file an appeal with the Central Authority. If the Central Authority feels that the appellant is justified in its claim, then the Central Authority will pass an order for immediate amendment of particular treaty.

The Central Authority should come out with common categories of income. The Central Authority will pass necessary orders to amend the domestic law of member countries to categorise a particular transaction in the manner specified by the Central Authority.

The member countries shall not be allowed to pass any retrospective amendments in domestic law to override a particular decision of Central Authority.

The Central Authority can also pronounce Advance Rulings regarding taxability/ arm's length price of a particular transaction.

The Central Authority will decide where its offices should be located in the world for convenience of all countries and the mode of filing the appeals. The countries or taxpayers should be allowed to file appeals online. The Central Authority should have adequate powers of stay, setting aside orders, power of revision, power to attach properties, power to award costs, etc.

There should be proper arbitration rules. There should be a research department in the authority that will take into account the existing laws of countries, international tax concepts and principles and will help countries to sign or re-negotiate DTAAs. The Central Authority should conduct courses, organize seminars and conferences on International Taxation. The Central Authority should be open to any suggestions/views given by the representatives of member countries and should include the same in its future agenda.

The formation of this Central Authority is an urgent requirement for the solution to the current international tax issues. It is high time that Finance Ministry or CBDTs of some country take the lead/initiative in forming the Central Authority for International Taxation.

VI. Benefits of formation of a Central Authority:

1. Solution to the current problems in International Taxation.
    

2. Non-resident taxpayers will be given just and equitable treatment in appeal proceedings since the decisions will be given by independent judges.
    

3. The orders passed by the Central Authority will be in line with global internationally accepted standards, concepts and principles.
    

4. The different jurisdictions will come closer to each other and there will be common interpretations of tax treaties and aligning of the tax system with the global system.

VII. Problems in formation of Central Authority:

1. Countries may not be willing to come together. It will be very difficult to bring all countries together and take a signoff from each country to accept the proposal of formation of Central Authority.
    

2. Countries might be skeptical of giving such huge powers to the Central Authority whose orders will override the orders passed by the Supreme Courts of respective countries.
    

3. Setting-up of a Central Authority means shifting of control from the member countries to the Central Authority.
    

4. The member countries may not buy views of the Central Authority.
    

5. The orders passed by the Central Authority may not be in tandem with the developments prospects of the country.

The above proposal of formation of a Central Authority for International Taxation is a milestone away. It will take years convincing each country to accept the proposal. It is just a proposal that if implemented will help in resolving current issues in International Taxation.

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