WE all have heard about the misuse of the India-Mauritius tax treaty. Serious concerns are expressed from time to time about the deleterious effects that this treaty in its implementation can have both from the revenue angle as also from the security angle. The Supreme Court of India having chosen to give its benediction to the extant practices to exploit the loopholes, the Finance Ministry has come up with some measures, which have also been well covered in the media. Today, however, we intend to discuss about another DTAA- that with Malaysia and the havoc that the interpretation of some provisions of that treaty has caused to the revenue. There has not been much coverage on this DTAA although the revenue implications can be quite large in as much as the principles laid down by the Courts in this case apply to other tax treaties as well. As the discussion below will unfold, the problems encountered in the case of this treaty relate entirely to the steadfast refusal by the Courts and the Tribunals to correct the mistake committed in the past. In fact, in some orders, the Tribunals have come out with preposterous and hair brained logic to justify the view they have taken. To be fair to the lower judiciary, however, it must also be said that some Tribunal members did try to point out the fallacy of the reasoning adopted in these cases but they were constrained to follow the precedence because of the judicial discipline.

Before coming to the case as such and the interpretation adopted by the Courts in India, a few general principles of international taxation may be noted. With the exception of a handful of countries, most countries in the world tax their residents on their worldwide income. Not doing so is a sure recipe for disaster, particularly in an interconnected world. Were foreign incomes of residents not to be taxed, at least theoretically, imagine how much more of Indian money would have been stashed abroad Besides, from a policy perspective, I do not see how India should encourage foreign investment by its residents at the cost of domestic investments whose income would be fully taxed. That's the reason why most countries tax foreign income of their residents and India is no exception. This principle of worldwide taxation of residents is contained in section 5 of the Income Tax Act. But, if a resident has to pay tax in the foreign jurisdiction as well as in India, it will lead to double taxation, which is obviously not a desirable outcome. It is precisely to overcome such an eventuality that countries enter into double taxation avoidance agreements. The rules of the game are that the residents of a country will be taxed at any rate by the home country. However, the source country gets the right to tax in respect of some items of income or at times to tax at a reduced rate. India is generally considered a source country. India also fights for greater source country taxing rights. But that does not mean that Indians will not have any foreign income. In fact, Indians have been engaged in trade and business with foreign lands from time immemorial. What happens when such Indian residents have foreign income? Well, one would have thought that considering the well-settled principle of worldwide taxation of residents, the foreign income would be charged to tax in India subject of course to the credit for the taxes paid abroad. That is how you and me and any reasonable person in India would think.

However, the lower courts and Tribunals through a curious logic have been taking a view that some foreign income of Indians could not be taxed in India wherever there is a DTAA between India and the foreign country where the income is derived. This has been going on for over three decades. No body knows what is the revenue loss arising due to such mistaken view taken by the Courts.

The genesis of the problem lies in the interpretation of the India-Malaysia Double Taxation Avoidance Agreement that was notified in April 1977. The cases related to A.Y. 1977-78 to 1979-80 and the assessees involved where HUFs and all of them were residents in India having income from Malaysia. Relying on the DTA, the taxpayers argued that their Malaysian income from rubber estates in Malaysia as also the business income of their Malaysian branch offices could not be taxed in India. Surprisingly, the Tribunals uniformly upheld this view and there was only a difference of opinion as to whether the Malaysian income should be included for rate purposes or not. The issue thus reached the Special Bench and the Special Bench also upheld the Tribunal's view by its order passed in the year 1982 (2003-TII-15-ITAT-MAD-SB-INTL).

The Special Bench held that a DTA is mainly for avoidance of double tax and that meant the income shall not be taxed in both the countries. According to the Tribunal if the DTA is interpreted to mean that both Malaysian and Indian governments still retained the power to tax at the same time the same income, it will only frustrate the object of entering into the DTA. Referring to Article 6 which delas with income from immovable properties, the Special Bench held: "Considering that the object of the agreement is avoidance of double taxation and not relief from double taxation which well-known expression, does not find a place in the preamble, the necessary interpretation should be that it is only Malaysia, that can levy the tax. If India can also levy tax, it will only frustrate the object of avoidance of double taxation with which the agreement is made. Even without the agreement, Malaysia can tax the property income which arises in Malaysia to the assessee who will be a non-resident as far as Malaysia is concerned. So, the object cannot be to confer Malaysia with power to tax which power it already possesses. The object can only be to take away or restrict the existing power of Indian Government to tax income from such properties, so that double taxation can be avoided."

Advancing similar argument in case of business income of Indian permanent establishment situated in Malaysia, the tribunal held that such income could not also be taxed in India. By the same process of reasoning the tribunal also held that interests income could also be taxed only in Malaysia and that the power of India to tax the same was taken away. The logic given by the Tribunal is ridiculous and betrays a complete lack of even the preliminary understanding of how a DTAA works.

Unfortunately, however, when the matter reached the High court in the year 1992 (2003-TII-36-HC-KAR-INTL), the High Court also agreed with this view of the Tribunal and held that when a power is specifically recognized as vesting in one, exercise of such a powers by others is to be read as not available; that such recognition of power with the Malaysian government would take away the said power from the Indian government and that the DTA does operate as a bar on the power of the Indian government in the instant case. In fact, the Court went on to say that the DTA by necessary implication takes away the power of the Indian government to levy tax on the income certain categories as per articles 6,7,8,910, 11 etc. of the agreement. In other words, as per the High Court the power to tax income from property, business, shipping, interest and dividend has been given away by the Government of India by entering into the treaty with Malaysia!

The department could have resorted to clarificatory amendment at that stage; however, it chose not to do so and waited for the outcome of its appeal before the Supreme Court which was finally decided in the year 2004 by the Supreme Court in famous case of P.V. Kulandayan Chettiar's case (2004-TII-01-SC-INTL). In this case, based on OECD commentaries and other authorities the department tried to argue that whenever the expression “may be taxed” has been used in a treaty, the country of residence retains the rights of tax subject to providing necessary relief from double taxation. The Supreme court, however, went off a tangent and held that the immoveable property being situated in Malaysia, the income out of rubber plantations could not be taxed in India because of the closer economic relations between the assessee and Malaysia in which the property is located and where the permanent establishment has been set up will determine the physical domicile.

One would not have expected such muddled thinking on the part of the highest court. An example:

“…it has also been held as a matter of fact that there is no permanent establishment in India in regard to carrying on the business of rubber plantations in Malaysia out of which income is derived and that finding of fact has been recorded by all the authorities and affirmed by the High Court. We, therefore, do not propose to re-examine the question whether the finding is correct or not.”

How can an Indian entity doing business in Malaysia through a permanent establishment in Malaysia have a permanent establishment in India? Or for that matter, where is the question of an Indian assessee having any permanent establishment in India. Moreover, how can the place where the PE has been set up determine the fiscal domicile of the entity?

When relying on the OECD and other commentaries, the department tried to argue that wherever the expression ‘may be taxed' has been used in a treaty, the country of residence has a right to tax, the Supreme Court held as follows:

“We need not enter into an exercise in semantics as to whether the expression “may be” will mean allocation of power to tax or is only one of the options and it only grants power to tax in that state and unless tax is imposed and paid, no relief can be sought. Reading the treaty in question as a whole, when it is intended that even though it is possible for a resident in India to be taxed in terms of Sections 4 and 5, if he is deemed to be a resident of a contracting state where his personal and economic relations are closer, then his residence in India will become irrelevant, the treaty will have to be interpreted as such and prevails over Sections 4 and 5 of the Act . Therefore, we are of the view that the High court is justified in reaching in its conclusion, though for different reasons from those stated by the High Court.”

The Supreme Court applied the tiebreaker rule of the tax treaty to determine residence. But, tiebreaker rule is applied when both the countries claim the taxpayer to be its resident. That is not the case here. Here it is undisputed that the taxpayer was resident in India. Even when all these deficiencies were pointed out, the Supreme Court refused to review its order. It had occasion to correct itself in a subsequent case in Dy. CIT Vs. Turquoise Investment and Finance Ltd (2008-TII-02-SC-INTL) but it chose to follow its own flawed logic. Nobody knows how much of revenue was lost in the process.

Meanwhile, by the Finance Act, 2003 an amendment was made in Section 90 by inserting a sub-section (3) that stated that any term used but not defined in the Act or in the DTA will have taken as assigned to it in a notification issued by the Central Government. Five years thereafter, a notification was finally issued in 2008 which states as follows:-

“In exercise of the powers conferred by sub-Section (3) of Section 90 of the Income Tax Act, 1961, the Central Government hereby notifies that where an agreement entered into by the Central Government with the Government of any country outside India for granting relief the tax or as the case may be, avoidance of double taxation, provides that any income of a resident 'may be taxed' in the other country, such income shall be included in his total income chargeable to tax in India in accordance that the provisions of Income Tax Act, 1961 and relief shall be granted in accordance with the method for elimination or avoidance of double taxation provided in such agreement.”

Even after the aforesaid notification making the intention clear, it is gathered that some taxpayers were taking the plea that this clarification would apply only in respect of agreement notified after 2008. It is obvious that as a result of the peculiar interpretation given by the courts, no income from business of any Indian branch abroad could be taxed in India. Taking advantage of the same, some companies are reported to have opened branches in some countries like the UAE where there is no income tax. In the process, all income of such branches would be entirely tax-free. No tax would be paid in UAE since it does not levy any tax. No tax would be payable in India by virtue of the Supreme Court judgement. Therefore, in order to avoid the further leakage of revenue, the Finance Bill 2012 has added a further explanation (iii) w.e.f. 1.10.2009 which states as follows:-

“For the removal of duties, it is hereby declared that whether any term is used in any agreement entered into sub-section (1) and not defined under the said agreement or the Act but is assigned a meaning to it in the notification issued under sub-section (3) of the notification issued thereunder being in force, then, the meaning assigned to such term shall be deemed to have affect from the date on which the said agreement came into force.”

The effect of this amendment is that expressions like ‘may be taxed' which are not defined in the tax treaty will have the meaning as given in the notification. The implication is that the foreign income of Indian residents will be taxed in India subject to giving appropriate relief. Outrage has been expressed again in the Press about the retrospective effects of these explanations. If the courts and tribunals are ignorant about the working of the double taxation avoidance agreement and how the same are negotiated and put in place, it is but obvious that the Government is left with no choice but to clarify the issues so that the precious revenue of the government are not lost due to some bogus concern for double taxation.

And since this was always the intention of the treaty negotiators, it is but normal that effect should be given to the meaning of such expressions right from the date that the treaty has come into force. Those who choose to oppose the retrospective amendment should realize that in this case, the government had absolutely no alternative. In fact, the government waited for almost thirty years, exhausted all the appellate channels and only thereafter acted. If at all, the government can be held guilty of not acting earlier to settle the issue.