Countering black money thru treaties

At the recent G-20 summit, it was agreed that a “tool box of measures” would be used to get countries to comply with an exchange of information to end bank secrecy, which has been a foundation of tax evasion.

K. R. Girish
Sampath Raghunathan

Speaking at the Economic Summit on November 10, the Finance Minister, Mr Pranab Mukherjee, said that he has asked the revenue department to reopen negotiations with all the countries with which India has entered into DTAAs (Double Taxation Avoidance Agreements) so that the Government can have real time exchange of information on tax evasion and tax avoidance.

The Finance Minister said that the country had agreed to accept the guidelines prescribed by the Organisation of Economic Cooperation and Development (OECD) model tax convention code, which talks about exchange of information.

This approach of the Finance Minister comes close to the recent measure of the Finance Ministry proposing to introduce a new Direct Taxes Code.

Growing tax evasion across the globe is the biggest concern before the developed and developing nations. The G-20 summit held in Brussels, in April 2009, agreed upon a “tool box of measures” that will be used to get countries to comply with an exchange of information to end bank secrecy which has been a foundation of tax evasion around the world.
The ‘tool box’

The “tool box” contains the following recommendations:

Increased disclosure requirements on the part of taxpayers and financial institutions to report transactions involving noncooperative jurisdictions;

Withholding of taxes in respect to a wide variety of payments;

Denial of deductions with respect to expense payments to payees resident in a non-cooperative jurisdiction;

Reviews of tax treaty policies;

Requiring international institutions in regional development banks to review aid if tax cooperation is not agreed;

Giving extra weight to the principle of tax transparency and information exchange while designing any bilateral aid programmes.

The OECD’s update, ‘Overview of the OECD’s work on Countering International Tax Evasion’ (November 2009), highlights the progress made in its efforts in bringing all OECD countries accepting “Exchange of Information” requirement in accordance with Article 26 of OECD Model Convention.

The overview further highlights that Hong Kong (China), Macao (China) and Singapore have agreed to bring in place necessary legislation in 2009 to comply with this. The progress reports of countries such as Austria, Belgium, Bermuda, BV Islands, Switzerland, Luxembourg, Netherlands Antilles, Cayman Islands and Bahrain are also positive in this regard.
Identifying tax havens

In 1998, OECD set out a number of factors in identifying tax havens: no or nominal tax on the incomes; lack of effective exchange of information; lack of transparency; and no substantial activities.

The progress report now released touch on the “exchange of information” and not much on the other three situations, which also equally contribute to “tax evasion”.

Transparency in international finance, cooperation among all the countries to oppose any secrecy, loopholes and distortions in tax and regulation and introduction by all the countries a tax mechanism to support a level-playing field would greatly minimise the abuses that flow from the system.

However, achieving a healthy tax compliance practice in respect of international taxation should be the consequential result of a tax Treaty and should not be the driving objective.

Perhaps, the advent of European Union (EU) since 2001 is a roll model, integrating various countries in Europe and employing practical measures among member-countries of cooperation in the field of direct and indirect taxation and assistance in the recovery of taxes, besides strengthening the internal legislation in each of the country.

At the time of integration of various countries under the EU, different taxation systems existed in different European countries. The European Parliament realised the necessity of continuing to have the coexistence of such different taxation system among the member-countries, but have built in measures around that.
EU measures

Some of the noted measures in this regard were:

Introduction of a Common Consolidated Corporate Tax Base for EU businesses (CCCTB);

Treatment of cross-border activities among the EU member-countries as similar domestic activities;

Simplification of the tax environment and creation of a level-playing field;

Application of the Home State Taxation approach;

Introduction of clear VAT rules concerning international services and financial services;

Providing of exemptions among member-countries on assertive and reciprocal basis;

Removal of cross-border tax barriers among the EU member-countries with: a system of cross-border loss relief; and

A system to manage transfer pricing; and abolition of a number of unequivocal indirect taxes, such as capital duty.

Even though to achieve these, there was a common directive in place, it was more the willingness of the member-nations for improving trade and investment in their respective countries, they have agreed to bind themselves to these common measures.

China, India’s arch rival in attracting global investments, has brought out the following measures to combat tax evasion in February 2009.

The Chinese State Administration of Taxation (SAT) has removed tax privileges afforded under various double taxation treaties to foreign investors who misuse the system of ‘special purpose vehicles’ as a means of reducing their tax liabilities or circumventing exchange controls.

Special purpose vehicle

Based on Tax Notice 81 of SAT in a number of cases, the non-resident status of such entities has been disregarded for tax purposes.

The Special Purpose Vehicle (SPV) generally allows foreign investors which set up business ventures with local partners in China, two main tax advantages: lower withholding tax (WHT) on dividends; and exemption from Chinese capital gains tax on sale of their holdings in the Chinese business companies.

China, at present, has lower tax rates with Singapore, Hong Kong, Mauritius, Barbados and Ireland. This circular of SAT enables the tax authorities to scrutinise not just the form but also the substance of the ownership structures of SPVs to satisfy themselves that the investors have bona fide residence in these countries to take advantage of the tax treaties signed by China.

This is to combat the tax evasion tactics of Chinese expatriates, who form the largest group of foreign investors, but still maintaining their nexus within China. The proposed SAT’s intervention is to remove SPV tax privileges in respect of those SPVs which are controlled by Chinese expatriates, but who are deemed to be de facto PRC resident.

India should take its lessons from the EU model. Renegotiation of the Treaties should not be with the sole objective of facilitating the exchange of information with a view to combating international tax evasion and avoidance. Such an approach would be a total disaster to promotion of investment in any country.

As pointed out by the Supreme Court in the Azadi Bacho Andolan case, the main function of a Treaty should be seen in the context of aiding commercial relations between the Treaty partners. This could be more important than perhaps the essential function of any Treaty as being the division of tax revenues between the two countries.

The apex court further pointed that while the fabric of substance of the Treaty need to maintained by both the countries, certain evils like Treaty shopping need to be tolerated in the interest of long-term development. To achieve this, there must be a mutual trust among the nations.

The following measures also must be parallelly be put in place.

Develop a standard “Treaty Model” like a typical US/UN/OECD model and define clearly the technical explanation of the same.

Any deviation in the Treaty terms with a particular country must also have a proper “technical explanation” or Protocol, explaining clearly the terms of such modified treaty.

Any terms proposed in the renegotiated treaty, which has the remotest possibility of overlapping or contradicting with the terms of the Act must be clearly brought out in the “technical explanation”.

Any amendment proposed in the Act, which has the remotest possibility of overlapping or contradicting with the terms of the treaty with any other country must be renegotiated with the respective country and a protocol of the revised terms must be in place; this would be the real nature of at par respect of an Act or Treaty. The principle of co-decision of the respective country rather than a simple notification or consultation procedure should be in place.

The legal and tax system of the respective countries must be respected. Any adverse finding on the tax of a resident of the other contracting state resulting in a higher tax in India must be capable of being properly adjusted (irrespective of the time lag in terms of the legal system of assessment of such person in the home country) to ensure that no double taxation exists.

Last, but not the least, the country’s legal system should be revamped to ensure that the:

Principle of proportionality and subsidiarity of the functionaries under the tax system are well defined — the binding nature of the decisions of the Supreme Court , High Court, Income Tax Appellate Tribunal or National Tax Tribunal on the judiciary and quasi judiciary authorities must be properly defined

Mutual respect and recognition of the decisions among various courts functioning in India and that of the international courts.

A proper quality of education of judicial persons selected in various Courts and tribunals.

(The authors are practising chartered accountant and advocate respectively.)