By Anthony Diosdi
The major purpose of an income tax treaty is to mitigate international double taxation through tax reduction or exemptions on certain types of income derived by residents of one treaty country from sources within the other treaty country. Because tax treaties often substantially modify U.S. and foreign tax consequences, the relevant treaty must be considered in order to fully analyze the income tax consequences of any outbound or inbound transaction. The U.S. currently has income tax treaties with approximately 58 countries. This article discusses the implications of the United States- India Income Tax Treaty.
There are several basic treaty provisions, such as permanent establishment provisions and reduced withholding tax rates, that are common to most of the income tax treaties to which the United States is a party. In many cases, these provisions are patterned after or similar to the United States Model Income Tax Convention, which reflects the traditional baseline negotiating position. However, each tax treaty is separately negotiated and therefore unique. As a consequence, to determine the impact of treaty provisions in any specific situation, the applicable treaty at issue must be analyzed. The United States- India Income Tax Treaty is no different. The treaty has its own unique definitions. We will now review the key provisions of the United States-India Income Tax Treaty and the implications to individuals attempting to make use of the treaty.
Definition of Resident
The tax exemptions and reductions that treaties provide are available only to a resident of one of the treaty countries. Income derived by a partnership or other pass-through entity is treated as derived by a resident of a treaty country to the extent that, under the domestic laws of that country, the income is treated as taxable to a person that qualifies as a resident of that treaty country. Under Article 4 of the United States- India Income Tax Treaty, a resident is any person who, under a country’s internal laws, is subject to taxation by reason of domicile, residence, citizenship, place of management, place of incorporation, or other criterion of a similar nature. Because each country has its own unique definition of residency, a person may qualify as a resident in more than one country. Whether a person is a resident of the United States of India for treaty purposes is determined by reference to the internal laws of each country.
Because the United States and India have their own unique definition of residency, a person may qualify as a resident of both countries. For example, an alien who qualifies as a U.S. resident under the substantial presence test pursuant to U.S. tax law may simultaneously qualify as a resident of India under its definition of resident. To resolve this issue, the United States has included tie-breaker provisions in the United States- India Income Tax Treaty. The first test is where the individual has a permanent home. If that test is inconclusive because the individual has a permanent home available to him in both States, he will be considered to be a resident of the Contracting State where his personal and economic relations are closest, i.e., the location of his “center of vital interests.” If that test is also inconclusive, or if he does not have a permanent home available to him in either State, he will be treated as a resident of the Contracting State where he maintains an habitual abode. If he has an habitual abode in other States or in neither of them, he will be treated as a resident of his Contracting State of citizenship. If he is a citizen of both States or of neither, the matter will be considered by the competent authorities, who will attempt by mutual agreement to assign a single State of residence.
Article 4(3) of the United States- India Income Tax Treaty seeks to settle dual-residence issues for companies. A company is treated as resident in the United States if it is created or organized under the laws of the United States or a political subdivision. A corporation is treated as a resident of India if it is managed and controlled there. Dual residence, therefore, can arise if a U.S. corporation is managed in India. There are no treaty tie-breakers available for corporations.
Below, please see Illustration 1 which provides an example how a treaty-tie breaker can be analyzed and resolved for an individual under the United States- India Income Tax Treaty. .
Illustration 1.
Preyanka Chopra is a citizen and resident of India. Chopra owns Zoomtube, a company incorporated in India that is in the process of expanding to the much more lucrative U.S. market by opening a branch office in the United States. Chopra is divorced and maintains an apartment in India, where she spends every other weekend visiting her children. Chorpa’s first husband, who kept their house in their divorce, has never left India. Chopra becomes a U.S. resident alien under the substantial presence test as she operates Zoomtube’s U.S. branch. In the United States Chopra owns a luxury condominium in San Francisco where she lives with her second husband.
Because Chopra is considered a resident of both the United States and India, the treaty tie-breaker procedures must be analyzed to determine which country has primary taxing jurisdiction. With an apartment in India and a condominium in the United States, Chopra has a permanent home available in both countries. With Chopra’s children and her home office in India as opposed to the lucrative portion of his business and her new husband in the United States, Chopra does not have a center of vital interests in either country. Furthermore, because Chopra regularly spends time in both countries, she arguably has a habitual abode in both. As a result, under the treaty tie-breaker, Chopra may be considered a resident of India because he is a citizen of India.
Permanent Establishment
A central issue for any company exporting its goods or services is whether it is subject to taxation by the importing country. Most countries assert jurisdiction over all the income from sources within their borders, regardless of the citizenship or residence of the person receiving that income. Under a permanent establishment provision, the business profits of a resident of one treaty country are exempt from taxation by the other treaty country unless those profits are attributable to a permanent establishment located within the host country. A permanent establishment includes a fixed place of business, such as a place of management, a branch, an office, a factory or workshop. A permanent establishment also exists if employees or other dependent agents habitually exercise in the host country an authority to conclude sales contracts in the taxpayer’s name.
The United States- India Income Tax Treaty defines a permanent establishment as a fixed place of business through which a resident of one of the Contracting States engages in industrial or commercial activity. This includes the following: 1) a place of management; 2) a branch; 3) an office; 4) a factory; 5) a workshop; and 6) a mine, an oil or gas well, a quarry or any other place of extraction of natural resources; 7) a warehouse, in relation to a person providing storage facilities for others; 8) a farm, plantation or other place where agriculture, forestry, plantation or related activities are carried on; 9) a store or premises used as a sales outlet; 9) an installation or structure used for the exploration or exploitation of natural resources, but only if so used for a period of more than 120 days in any twelve month period; 10) a building site or construction, installation or assembly project or supervisory activities in connection therewith, where such site, project or activities (together with other such sites, projects or activities, if any) continue for a period of more than 120 days in any twelve month period; 11) the furnishing of services with a Contracting State by an enterprise through employees or other personnel, but only if: i) activities of that nature continue within that State for a period or periods aggregating more than 90 days within any twelve month period; or ii) the services are performed within that State for a related enterprise.
The treaty specifically excludes certain activities from the definition of permanent establishment. Some of these activities are: 1) the use of facilities for the purpose of storage, display, or delivery of goods or merchandise belonging to the enterprise; 2) the maintenance of a stock of goods or merchandise belonging to the resident for the purpose of storage, display, or delivery; 3) the maintenance of a stock of goods or merchandise belonging to the resident for the purpose of processing by another enterprise; 4) the maintenance of a fixed place of business solely for the purpose of purchasing goods or merchandise, or of collecting information, for the enterprise; 5) the maintenance of a fixed place of business solely for the purpose of advertising, for the supply of information, for scientific research or for other activities which have a preparatory or auxiliary character, for the enterprise.
Where a person- other than an agent of an independent status is acting in a Contracting State on behalf of an establishment, the enterprise shall be deemed to have a permanent establishment if:
1) He has habitually exercised an authority to conclude contracts on behalf of the enterprise.
2) He has no such authority but habitually maintains a stock of goods or merchandise from which he regularly delivers goods or merchandise on behalf of the enterprise.
3) He habitually secures orders for the enterprise.
Employees who limit their activities to auxiliary or preparation functions, such as collecting information about potential customers, with sales concluded in the home country, will not create a permanent establishment. To the extent that services are not considered ancillary and subsidiary to the application or enjoyment of some right, property, or information, such services shall be considered “included services.”
Below, please find two examples regarding the allocations of “includable services” for purposes of the United States- India Income Tax Treaty.
Example 1.
U.S. manufacturer grants rights to an Indian company to use manufacturing processes in which the transferor has exclusive rights by virtue of process patents or the protection otherwise extended by law to the owner of a process. As part of the contractual arrangement, the U.S. manufacturer agrees to provide certain consultancy services to the Indian company in order to improve the effectiveness of the latter’s use of the processes. Such services include, for example, the provision of information and advice on sources of supply for materials needed in the manufacturing process, and on the development of sales and services literature for the manufactured product. The payments allocable to such services do not form a substantial part of the total consideration payable under the contractual arrangement. Are the payments for these services fees for “includable services”?
The payments are fees for included services. The services described in this example are ancillary and subsidiary to the use of a manufacturing process protected by law related to the application or enjoyment of the intangible and the granting of the right to use the intangible is the clearly predominant purpose of the arrangement. Because the services are ancillary and subsidiary to the use of the manufacturing process, the fees for these services are considered fees for included services under Article 12(4)(a) (royalty and fees for included services).
The second example illustrates services which are not “included services.”
Example 2.
An Indian manufacturing company produces a product that must be manufactured under sterile conditions using machinery that must be kept completely free of bacterial or other harmful deposits. A U.S. company has developed a special cleaning process for removing such deposits from that type of machinery. The U.S. company enters into a contract with the Indian company under which the former will clean the latter’s machinery on a regular basis. As part of the arrangement, the U.S. company leases to the Indian company a piece of equipment which allows the Indian company to measure the level of bacterial deposits on its machinery in order for it to know when cleaning is required. Are the payments for the services fees for included services?
In this example, the provision of cleaning services by the U.S. company and the rental of the monitoring equipment are related to each other. However, the clearly predominant purpose of the arrangement is the provision of cleaning services. Thus, although the cleaning services might be considered technical services, they are not “ancillary and subsidiary” to the rental of the monitoring equipment. Accordingly, the cleaning services are not “included services.”
Independent Personal Services
Article 15 of the United States- India Income Tax Treaty provides the rule that an individual or firm of individuals (other than a company) who is a resident of a Contracting State and who derives income from the performance of professional services or other independent activities of a similar character will be exempt from tax in respect of that income by the other Contracting State unless certain conditions are satisfied. The income may be taxed in the other Contracting State if the person has a fixed base regularly available to him in the other Contracting State for the purpose of performing his activities and the income is attributable to that fixed base or if the person stays in the other Contracting State for a period or periods amounting to or exceeding in the aggregate 90 days in the relevant taxable year.
Dependent Personal Services
Article 16 of the United States- India Income Tax Treaty discusses dependent personal services. Subject to Article 16, directors fees, income earned by entertainers and athletes, payments received by students and apprentices, payments received by professors, teachers, and research scholars, and other similar remuneration derived by a resident of a Contracting State in respect of an employment shall be taxable only in that State unless the employment is exercised in the other Contracting State.
Article 16(2) of the United States- India Income Tax Treaty provides that remuneration derived by a resident of a Contracting State in respect of an employment exercised in the other Contracting State shall be taxable only in the first-mentioned State if: 1) the recipient is present in the other State for a period or periods not exceeding in the aggregate 183 days in the relevant taxable year; 2) the remuneration is paid by, or on behalf of, an employer who is not a resident of the other State; and 3) the remuneration is not borne by a permanent establishment derived in respect of an employment exercised aboard a ship or aircraft operating in international traffic by an enterprise of a Contracting State may taxed in that State.
Income from Real Property
Tax treaties typically do not provide tax exemptions or reductions for income from real property. Consequently, both the home and host country maintain the right to tax real property. Article 6 of the United States- India Income Tax Treaty provides that income derived by an India resident from U.S. real property may be taxed in the United States and vice-versa.
Dividends, Interest, and Royalties
Like the United States, most foreign countries impose flat rate withholding taxes on dividends, interest, and royalty income derived by offshore investors from sources within the country’s borders. Tax treaties usually reduce these withholding taxes. Tax treaties usually reduce the withholding tax rate on dividends to 15 percent or less.
Article 10 of the United States- India Income Tax Treaty limits the source country’s right to tax dividends and amounts treated as dividends. The tax charged on dividends shall not exceed:
(a) 15 percent of the gross amount of the dividends if the beneficial owner is a company which owns at least 10 percent of the voting stock of the company paying the dividends;
(b) 25 percent of the gross amount of the dividends in all other cases.
The term “beneficial owner” is not defined in the treaty; it is, instead, defined by the domestic law of the United States and India. The term “dividends” for purposes of the treaty means income from shares or other rights not being debt-claims, participating in profits, income from other corporate rights which are subjected to the same taxation treatment as income from shares by the taxation laws of the State of which the company making the distribution is a resident; and income from arrangements, including debt obligations, carrying the right to participate in profits, to the extent so characterized under the laws of the Contracting State in which the income arises.
Article 11 of the United States- India Income Tax Treaty limits the source country’s right to tax interest. Article 11(2) of the United States- India Income Tax Treaty provides that the tax on the beneficial owner of interest is limited to:
(1) 10 percent of the gross amount of the interest that is paid on a loan granted by a bank carrying on a bona fide banking business or by a similar financial institution (including an insurance company); (2) 15 percent of the gross amount of the interest in all other cases.
Like with dividends, the term “beneficial owner” is not defined in the treaty; it is, instead, defined by the domestic law of the United States and India. The term “interest” includes income from debt claims of every kind, whether or not secured by a mortgage, and whether or not carrying a right to participate in the debtor’s profits, and in particular, income from government securities, and income from bonds or debentures, including premiums or prizes attaching to such securities, bonds, or debentures. Penalty charges are excluded from the term “interest.”
Article 12 of the United States- India Income Tax Treaty limits the source country’s right to tax royalties. Article 12(3) defines the term “royalties” as payment of any kind received as a consideration for the use of, or the right to use, any copyright of literary, artistic, or scientific work, including cinematographic films or work on film, tape or other means of reproduction for use in connection with radio or television broadcasting, any patent, trademark, design or model, plan, secret formula or process, or for information concerning industrial, commercial, or scientific experience. The term “information concerning industrial, commercial, or scientific experience” alludes to the concept of know-how and means information that is publicly available and that cannot be known from mere examination of a product and mere knowledge of the process of technique.
Under Article 12 of the United States- India Income Tax Treaty, royalties are generally taxed at 20 percent of the gross amount received.
Private Pensions and Annuities
Articles 19 and 20 of the United States- India Income Tax Treaty provides that pensions and similar remuneration beneficially derived by a resident of one Contracting State in consideration of past employment are taxable only in the state of residence of the recipient.
The term “pension and other similar remuneration,” as used in the treaty, means periodic payments. This provision of the treaty provides an excellent opportunity for a non-resident of the United States to utilize the United States- India Income Tax Treaty to reduce or eliminate the U.S. tax consequences associated with an Individual Retirement Account (“IRA”) or 401(k) plan distribution. For example, let’s assume that Mother Teresa is an Indian national who came to the U.S. on an E-3 Visa for a short-term assignment. While working in the United States, Teresa contributed money to an IRA. Teresa has returned to India and would like to withdraw money from his U.S. based IRA. However, Teresa is concerned about the U.S. 20% withholding tax and the 10% early withdrawal penalty.
Since Teresa is a citizen of India, a country that the U.S. has a bilateral income tax treaty, Harry may utilize the United States- India Income Tax Treaty to avoid the 20% withholding tax and the early withdrawal penalty. This is because under Articles 19 and 20, of the United States- India Income Tax Treaty, “pensions and other similar remuneration paid to an individual who is a resident of one of the Contracting States in consideration of past employment shall be taxable only in that State.” The Technical Explanations to the treaty further explains pensions derived and beneficially owned by a resident of one of the Contracting States in consideration of past employment shall be taxable only in the State [of residency].” This means that under the applicable provisions of the United States- India Income Tax Treaty, the country of residence has the sole taxing rights over pension distributions.
The terms “pensions and other remuneration” is not defined in the United States- India Income Tax treaty. However, the Organisation for Economic Co-operation and Development (“OECD”) defines the word “pension” under the ordinary meaning of the word which covers periodic and non-periodic payments. The OECD also provides that a lump-sum payment in lieu of periodic pension payments that is made on or after cessation of employment may fall within the definition of Articles 19 and 20. See OECD 2014 Commentary, Art 18. Thus, although Articles 19 and 20 of the United States- India Income Tax Treaty makes a reference to “periodic payments,” the word “periodic” does not preclude Teresa from excluding a lump sum IRA distribution from U.S. federal income tax. Even though the OECD or Articles 19 and 20 of the United States- India Income Tax Treaty does not mention the term IRA, the IRS has clarified that IRAs can be defined as pensions for articles in U.S. income tax treaties. See PLR 200209026. Since Teresa is a resident of India, she can utilize the United States- India Income Tax Treaty to avoid U.S. federal tax on the distribution from her IRA.
Limitation on Benefits
Article 24 of the United States- India Income Tax Treaty ensures that source basis tax benefits granted by a Contracting State pursuant to the treaty is limited to the intended beneficiaries.
Article 24(1) of the United States- India Income Tax Treaty provides a two-part test, the so-called ownership and base erosion tests, both of which must be met by a person (other than an individual) if that person is to be entitled to benefits under the treaty. If a person fails to qualify under Article 24(a), benefits may still be granted if the person qualifies under the provisions of Article 24(2) through (4). Under Article 24(1), benefits will be granted to a resident of a Contracting State, such as a corporation, partnership, or trust, if both:
1) More than 50 percent of the beneficial interest in the person (or in the case of a corporation, more than 50 percent of each class of its shares) is owned, directly, or indirectly, by individuals who are subject to tax in one of the Contracting States on worldwide income, or by one of the Contracting States, its political subdivisions or local authorities, and
2) The person’s income is not used in substantial part, directly, or indirectly, to meet liabilities (including liabilities for interest or royalties) in the form of deductible payments to persons, other than persons who are residents of a Contracting State, U.S. citizens, or a contracting State, political subdivision, or local authority. The first test would be satisfied if a corporation claiming benefits is owned by another corporation which itself is owned (either directly or through additional tiers) by individual residents of a Contracting State.
Article 24(2) of the United States- India Income Tax Treaty provides for eligibility for benefits which looks not solely at objective characteristics of the person deriving the income and that activity. Under this test, a resident of either the United States or India deriving income from the other country is entitled to benefits, regardless of the income recipient’s ownership, if the recipient is engaged in an active trade or business in its State of residence, and the item of income in question is derived in connection with, or is incident to, that trade or business. For example, if an Indian parent corporation derives income from a U.S. subsidiary, and the income is derived in connection with activities in India carried on by an Indian subsidiary of the parent, the business connection would be deemed to be present. Income which is derived in connection with, or is incidental to, the business of making or managing investments will not qualify for benefits under this provision, unless the business is a bank or insurance company engaged in banking or insurance activities.
Article 24(3) of the United States- India Income Tax Treaty, a corporation is a resident of a Contracting State is entitled to treaty benefits from the other Contracting State if there is substantial and regular trading in the corporation’s principal class of shares on-a recognized stock exchange. The term “recognized stock exchange” is defined in Article 24(3) to mean, in the United States, the NASDAQ System and any stock exchange which is registered as a national securities exchange with Securities and Exchange Commission, and, in India, any stock exchange which is recognized by the Central Government under the Securities Contracts Regulation Act, 1956.
Article 24(4) of the United States- India Income Tax Treaty provides that a resident of a Contracting State that derives income from the other Contracting State and is not entitled to the benefits of the treaty under other provisions of the treaty may, nevertheless, be granted at the discretion of the competent authority of the Contracting State in which the income arises. Article 24(4) provides no guidance to competent authorities or taxpayers as to how the discretionary authority is to be exercised.
Disclosure of Treaty-Based Return Positions
Any taxpayer that claims the benefits of a treaty by taking a tax return position that is in conflict with the Internal Revenue Code must disclose the position. See IRC Section 6114. A tax return position is considered to be in conflict with the Internal Revenue Code, and therefore treaty-based, if the U.S. tax liability under the treaty is different from the tax liability that would have to be reported in the absence of a treaty. A taxpayer reports treaty-based positions either by attaching a statement to its return or by using Form 8833. If a taxpayer fails to report a treaty-based return position, each such failure is subject to a penalty of $1,000, or a penalty of $10,000 in the case of a corporation. See IRC Section 6712.
The Income Tax Regulations describe the items to be disclosed on a Form 8833. The disclosure statement typically requires six items:
1. The name and employer identification number of both the recipient and payor of the income at issue;
2. The type of treaty benefited item and its amount;
3. The facts and an explanation supporting the return position taken;
4. The specific treaty provisions on which the taxpayer bases its claims;
5. The Internal Revenue Code provision exempted or reduced; and
6. An explanation of any applicable limitations on benefits provisions.
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. As a domestic tax attorney and international tax attorney, Anthony Diosdi provides international tax advice to individuals, closely held entities, and publicly traded corporations. Diosdi Ching & Liu, LLP has offices in San Francisco, California, Pleasanton, California and Fort Lauderdale, Florida. Anthony Diosdi advises clients in international tax matters throughout the United States. Anthony Diosdi may be reached at (415) 318-3990 or by email: adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.