DOUBLE TAXATION AVOIDANCE AGREEMENT (DTAA),TREATY SHOPPING,HYBRID MISMATCH

There are number of tools used by MNC's to evade taxes. Few of them are discussed as below :

DOUBLE TAXATION AVOIDANCE AGREEMENT (DTAA):

• Double Taxation Avoidance Agreements (DTAA) is a treaty signed between two countries, which ensure that the taxpayer is not being taxed twice (in country of job and of residence) for the same income (earned in country of job).
• Double Taxation Avoidance Agreements (DTAA) applies in cases where a tax-payer resides in one country and earns income in another.
• Double Taxation Avoidance Agreements (DTAA) is intended to make a country an attractive investment destination by providing relief on dual taxation.
• Double Taxation Avoidance Agreements (DTAA) can provide reliefs in various arrangements like:

1. Exemption of income earned abroad from tax in the resident country
2. Provisioning of amount to the extent of taxes that have already been paid abroad.

TREATY SHOPPING:

“Treaty shopping” generally refers to a situation where resident of source country (A), earning  income from another country (B), is able to benefit from a tax treaty ie DTAA between the source country (A) and yet another country (C).  

Jurisdiction A --imposes a 25% withholding tax, 

Jurisdiction C --imposes a 5% withholding tax .

Jurisdiction A    0% treaty with Jurisdiction C.

Impact of Tax deduction on any company X belonging to country A :

01.Company X located in jurisdiction A ---Direct Investments in Jurisdiction B

Tax implications on Company X:25% withholding tax is imposed on incomes earned from Jurisdiction B.

02.If company X located in jurisdiction A ---Indirect Investments in Jurisdiction B via Jurisdiction CTax implications on Company X :

Effectively ,5 % withholding tax is imposed on incomes earned from Jurisdiction B. 

So, withholding tax payment is reduced by 20% , compared to paying them directly. 

In the above example, it is clear that Tax Treaty reduces the tax implication.

HYBRID MISMATCH :

• Hybrids mismatch arrangements (HMA) are arrangements which exploit differences in the tax treatment of various financial instruments
• Hybrids mismatch arrangements (HMA) may significantly reduce overall tax for taxpayers and therefore decrease tax revenues of countries.

Example :

• An Indian Company is having its subsidiary in US. Indian company gives a loan to its US subsidiary.  
• Interest taxed @ 15% in USA; and 30% in India. 
• Net tax cost will be 30%.

but Instead of loan,

• Indian company invests in Preference shares in its US subsidiary, redeemable at premium. 
• In USA, premium on redeemable preference shares is treated as interest and US will levy tax @ 15% on interest.
• In India, inflation adjusted capital gain on redemption of preference shares may be almost 0.
• So effective Tax  implication will be 15%.

So Tax implication is reduced from 30 % to 15 % by merely change in the nature of instrument.

ISSUES WITH TRANSEFR PRICING, CLASSIC CASE OF VODAFONE-HUTCH TRANSFER PRICING ISSUE

ISSUES WITH TRANSEFR PRICING (VODAFONE-HUTCH) :

By manipulating the income tax laws, MNC’s avoid payment of taxes. There is loss of revenues to the countries because of manipulation of the laws. Vodafone-Idea transaction is the most popular case of Transfer pricing in India. To deal with isuues with transfer Pricing ,The countries have come up with the ideas of Armed length Price (ALP), General Anti Avoidance rule (GAAR)  Advanced Price Agreement (APA), and Base erosion Profit Sharing (BEPS). Here is the brief of the case with the timeline :

February 2007:

Vodafone International Holding (Netherlands company) acquired a 100% stake in CGP Investments (Holding) Ltd (CGP), at the cost of $ 11 billion from Hutchison Telecommunications International Limited (HongKong).

• CGP Investments (Holding) Ltd (CGP) is in Cayman Islands company
• CGP holds 67% shares in an Indian company Hutchison Essar Limited ("HEL").
• Hutchison Essar Limited (HEL) has its operations in India.
• With this acquisition of CGP, Vodafone acquired control of CGP and its subsidiaries, including Hutchison Essar Limited (HEL). 

September 2007:

Indian tax authorities questioned the Vodafone Company on following grounds:

1. Why the capital gains tax had not been withheld from the HTIL purchase transaction.
2. Transaction triggers the transfer of indirect assets in India as the company Hutchison Essar Limited (HEL) has its operations in India.
3. Transaction involved purchase of assets of an Indian Company, so there is liability to be taxed in India to an amount of 12000 crores.

Response of Vodafone:

Vodafone appealed to the Bombay High regarding the jurisdiction of the tax authorities in this case.

September 2010:

Bombay High -Court dismissed the Vodafone arguments and ordered Vodafone to pay the Capital Gains tax to the authorities.

Vodafone Response:

The order of Bombay High -Court was subsequently challenged in the Supreme Court of India by Vodafone.

20 January 2012:

The Supreme Court delivered its verdict on the case on 20 January 2012 with the key highlights:

• Indian authorities do not have jurisdiction on an overseas transaction as visible in this case as the tax is levied on the basis of the source and the source is the location where the sale takes and not where the product is derived or purchased from.
• Tax policy should be stable and certain as it is crucial for taxpayers (including foreign investors) to make rational economic choices in the most efficient manner.
• The demand of nearly 12,000 crore in the form  of capital gains tax, would amount to imposing capital punishment for capital investment since it lacks authority of law and therefore stands squashed.

Budget 2012 ---RESPONSE OF GOVERNMENT OF INDIA :

• In Budget 2012, the government of India proposed an Amendment to the Finance Act and changed the Supreme Court’s decision.
• As per the Finance Act, Income Tax Department can retrospectively tax such deals applicable to residents or non-residents, having business connection in India,
• Accordingly, The buyer (Vodafone in this case) will have to deduct tax at source and pay it to the government even if the deal is executed on a foreign soil.
• Finance bill 2012, also redefined the concept of indirect transfer.

As per the new definition, any asset company or entity registered or incorporated outside India shall be deemed to be situated in India, if the share or interest derives, directly or indirectly, its value substantially from the assets located in India.

• With the passage of the Finance Bill, 2012 by Parliament, the British telecom giant Vodafone might have to pay Rs 20,300 crore as tax, interest and penalty on its acquisition of Hutchison stake in Hutchison Essar in 2007. 

Response to Finance Bill 2012:

• Provisions in the finance bill 2012 were criticised by investors globally.
• This impacted the market sentiment and the flow of foreign funds to India.

Reaction of the Government:

• Because of international criticism and negative impact due to the provisions, GOI  tried to resolve the matter with Vodafone, but the Finance Ministry failed to settle the issue and in 2014, the Vodafone Group initiated arbitration against India at the Permanent Court of Arbitration at the Hague,
• When NDA government came to power in 2014, it said it would not create any fresh tax liabilities for companies using the retrospective taxation route.
• But the government did not take back route on provision in Finance Act and those provision wrt vodafone taxation remained.

Response of Vodafone :

Vodafone approached ICJ against the decision of the Indian Government and ICJ constituted Permanent Court of Arbitration (PCA).

Dec 2020:

In Dec 2020, Vodafone won arbitration against India over the retrospective tax demand of Rs 20,000 crore . The International Court of Justice (ICJ) ruled that:

1. The conduct of Indian Income-Tax department was in breach of fair and equitable treatment .
2. The imposition of tax liability on Vodafone violated the investment treaty agreement between India and the Netherlands.

TRANSFER PRICING, DYNAMICS OF TRANSFER PRICING, TRANSFER PRICING AND INDIA, INDIRECT TRANSFERS, Asset Transfer vs Share Transfer

 TRANSFER PRICING (TP):

Transfer Price is the actual price realized in an economic transaction between 2 subsidiary entities (international as well as domestic) which are part of the same MNC group. 

DYNAMICS OF TRANSFER PRICING:

• The tax rates vary from country to country. eg .In India, average Capital gains tax is 30 % while in case of Mauritius Capital Gains Tax is nil.
• So, MNC’s execute Economic transactions in such a manner that total tax implication of the MNC is minimum.
• Transfer prices are set in such a manner that less profits are booked in countries with higher tax rates to avoid tax implications.

TRANSFER PRICING AND INDIA :

• The Finance Act, 2001 inserted various provisions in IT Act 1961 for  the first time with detailed Transfer Pricing regulations in India vis-a vis international transactions.
• The transfer pricing provisions were further extended to cover Domestic Transaction with effect from Financial Year 2012-13 .
• These Transfer Pricing regulations, are intended to prevent Revenue loss arising to a country from shifting of profits from high to low tax jurisdictions in case of International Transactions,
• In case of Specified Domestic Transactions, Transfer Pricing regulations prevent shifting of expenses or income between related enterprises / inter-unit enterproses merely to reduce the tax implications.
• Transfer Pricing regulations provided for Most Appropriate Method (‘MAM’) of the 6 methods specified in section 92C of the Act to calculate the Arm’s Length Price (‘ALP’) .
• With the passage of time, various disputes arose between the taxpayer and the Indian tax authorities over the issues such as the selection of most appropriate TP methodology .
• To avoid litigation, Advance Pricing Agreement (APA) regime was introduced in 2012, followed by Safe Harbour Rules in 2013.

INDIRECT TRANSFERS :

• Indirect transfers occur when foreign entities own assets in India  and the shares of the such foreign entities are owned by its subsidiary headquartered abroad.
• In Indirect Transfer, substantial shares holdings in India are transferred only rather than any transfer of actual assets.
• The Hutch-Voda CASE  was the classical example of indirect transfer.

Asset Transfer vs Share Transfer : 

• In an asset transfer, the buyer chooses the assets rather than purchasing all the assets and the process of such buying is referred to as “cherry picking”.
• In most of asset transfer cases, pre-existing liabilities of the business are not transferred as the buyer do not want to bear the liabilities.
• Liabilities will normally remain with the seller unless specifically transferred to the buyer .
• In a share transfer, ownership of the company transfers from the seller to the buyer, but the underlying business and assets remain owned by the company.
• The buyer cannot cherry pick the assets and liabilities.
• The buyer will acquire the shares in the company and will inherit all of the company’s assets and liabilities.

TAX HAVENS, SHELL COMPANY, ROUND TRIPPING

 

TAX HAVENS:

• Tax havens, or offshore financial centers, are generally countries or locations with low or no corporate taxes enabling outsiders to set up businesses there.
• Information is not easily provided by Tax Haven countries about these financial transactions and hence they are also be referred to as secrecy jurisdictions. 
• Examples of Tax Havens are countries like Panama, the Netherlands and  Maurititus etc. 
• Business is being executed in these tax havens through the legal entities ie shell company. 

                         

HOW TAX HAVENS EARN INCOME:

• Tax havens charge a lower tax rate than other countries and usually charge high customs or import duties to cover the losses in tax revenues. 
• Tax havens mostly charge a fee for new registration of companies, and individuals have to pay renewal charges every year which is the source of earning for these countries .
• By attracting foreign individuals or businesses, even if they pay a nominal tax rate, the nation may earn substantially more in tax revenues than it would otherwise. 
• The country also benefits from corporate investments in business operations as they offer jobs to the country's residents.
• In 2016, a report by Citizen for Tax Justice-a US-based think-tank , stated that more than 370 companies out of Fortune 500 operate subsidiaries in such countries.

• Obama in 2009 says Tax Haven is the largest tax scam in the world. 
• Topmost countries acting as tax havens are Bermuda, Netherlands, Luxembourg ,Cayman Islands ,Singapore and Switzerland etc.
•  Top cos. Benefitted from tax havens are apple, Nike and Goldman Sachs etc.

SHELL COMPANY /OFFSHORE COMPANY/ SPECIAL PURPOSE ENTITY:

• A shell company is a legal entity created in a tax haven. 
• Shell company typically exist only on paper, with no full-time employees, and no office. 
• The single most objective of shell companies is to avoid taxes by manipulating the tax laws.

ROUND TRIPPING: 

• Round tripping of FDI refers to the capital belonging to a country, leaves the country to the TAX HAVEN and then is reinvested in the parent company in the form of FDI.
• This money in most of the cases is used for share market manipulations.
• There can be multiple forms of Round Tripping like an entity transferring money to another entity only to receive it back later to create a false impression of sales or revenue.
• For instance, Company A can transfer $100,000 to Company B, which then returns the same amount to Company A. Company A can then record this as $100,000 in sales even though no goods or services were exchanged.
• Round-tripping can also be used to hide financial losses or debt by creating the impression of cash flow.
• For instance, a company can transfer money to an offshore account, which then transfers it back to create the impression of incoming revenue.

TAX AVOIDANCE vs TAX EVASION, Income-tax Act and Tax Evasion ,BLACK MONEY

 

TAX AVOIDANCE:

• Tax avoidance is the use of legal methods to minimize the amount of income tax to be paid by an individual or a business. 
• This is generally accomplished by claiming as many deductions /manipulating the law and credits as is allowable under the law. 
• As it is not illegal so this method is used by individuals to manipulate the tax payments  without any legal implications
• As per law, it is not illegal so Governments across the world are planning to adopt legal provisions to check this. 
• GOI has institutionalized General Anti Avoidance Rule (GAAR) to check Tax Evasion. 
• At global level , countries are adopting Base Erosion Profit sharing (BEPS) to tackle Tax Evasion.

TAX EVASION:

• Tax evasion is an illegal activity in which an individual or organization deliberately avoids paying a true tax liability. 
• It is a criminal activity for which the assesse is subject to punishment under the law of the land. 
• It involves acts like deliberate misrepresentation of material /income, Hiding important documents, Not maintaining complete records of all the Economic transactions, Making false statements to hide economic transactions, Smuggling and Using fake documents to claim exemption. 
• Tax Evasion leads to generation of Black Money.

Income-tax Act, 1961 and Tax Evasion:

The Act defines certain activities as illegal which can attract hefty penalties and even land you in jail. Following activities under IT act are said to be illegal :

• Not filing Income tax return, 
• Not providing PAN or quoting wrong PAN ,
• Not paying taxes as per self assessment and 
• Concealing income to avoid paying of taxes.

BLACK MONEY:

• The money that is hidden from tax authorities which can be either money earned from illegal activity or unaccounted/unreported money from legal activity. 
• Black money may be generated either by illegitimately drug trade, terrorism, corruption, or legitimate failure to pay the taxes to the government. 
• Different terms are used for black money in an economy like unaccounted income, underground income, black wealth, or in economy terms it is known as parallel economy, black economy, shadow economy and unofficial economy.

Seigniorage ,All about currency notes and coins , Time/Demand Deposit,Currency in circulation vs Currency with Public

 

Seigniorage: 

• Seigniorage is the difference between the face value of currency/money and the cost of producing it. 
• Seigniorage is essentially the profit earned by the Government   by printing currency. 
• If the cost of printing a Rs 500 note in India is Rs 2, then Rs 498 is the profit made on the production of the note and it is Seigniorage.

Seigniorage Formula: 

Face value of currency/money -Cost of producing Currency 

Issue of currency Notes:

• In India, monetary authority is RBI .
• All the currency notes except One Rupee Note  are issued by the Reserve Bank of India (RBI),under Section 22  of RBI Act 1934.

Issue of Coins and One Rupee currency Note:

• The Government of India is responsible for the designing and minting of coins in various denominations as per the Coinage Act, 2011.
• One Rupee Note are signed by Finance Secretary, GOI.
• The role of RBI is limited to distribution of coins that are supplied by Government of India. 
• Coins and one rupee note are the liability of GOI. 

Currency Chests: 

• Currency chests are storehouses where bank notes and rupee coins are stocked on behalf of the Reserve Bank. 
• Deposits into the currency chest are treated as reserves with the Reserve Bank and are included in the Cash Reserve Ratio.

Different type of deposits:

●        Demand deposit

●        Time deposits

Demand deposits: 

Deposits in the form of saving accounts are called demand deposits as they are available on demand of the account holder and the bank is mandated to pay it as and when demanded by the depositor.

Time Deposits:

• Deposits which are having a fixed period to maturity are referred to as time deposits. 
• Deposits like fixed deposits are examples of Time Deposits.

Money in circulation:

In a modern economy money in circulation comprises mainly of currency notes and coins issued by the monetary authority of the country. In India, term money includes

●        Notes and Coins,

●        Balance in savings, current  and demand  deposits

Currency in circulation vs Currency with Public: 

• Currency with Public is the money in the hands of public exclusively and is the most liquid in the economy as it is at the disposal of the individual.
• Currency in circulation comprises of currency notes and coins with the public and cash in hand with banks or DD. 
• Currency in circulation is more than currency with public. 
• Currency in circulation is a major liability component of a central bank’s balance sheet. 

Proportional Reserve System, Minimum Reserve system, fractional reserve banking system

RESERVE SYSTEMS:

These are the mechanisms and policies that regulate the money supply in the banking system and hence liquidity in the economy.

Proportional Reserve System:

• This system was prevalent before 1956 .
• RBI has to maintain certain amount in the form of reserves as proportional reserve against the issued currency .
• This reserve consist of not less than 2/5th of the Gold or sterling securities, and the value of  Gold was not less than Rs. 40 Crores in value.
• Remaining 3/5th of the assets might be rupee coins. 

Minimum Reserve system:

• In 1956, Proportional Reserve System was replaced and Minimum Reserve system was adopted by RBI.
• In Minimum Reserve system, RBI is supposed to maintain a Gold and Foreign Exchange Reserves of Rs. 200 Crore of which at least Rs. 115 Crore should be in Gold.
• It simply means that issuance of currency is not backed by any asset.
• This system continues till date.

The fractional reserve banking system:

• Banking method in which only a fraction of the deposits are kept as reserves by the banks as a mandatory requirement.
• Rest of the amount is given to the people as loans.
• Disbursement of the loans expand the money supply and facilitate economic growth.
• Fractional Reserve system results in Money Multiplier