Any country collects income tax on the basis of source rule as well as on the basis of residence rule. As per the source rule, a country taxes the income which has arisen in that country. On the other hand, on the resident based taxation, the country taxes the income earned by a resident of that country irrespective of the fact whether the income is earned in that country or in any other country.
In India, the source rule of taxation is applied in respect of income earned by non-residents in India, and residence taxation is applied in respect of persons resident in India. As a result of this, various type of incomes may be taxed in India as well as outside India. The Government took note of this fact and in section 90 of the Income-tax Act provided that the central Government may enter into agreement with government of other countries to grant relief in respect of incomes on which tax has been paid in India as well as outside India. The object of this provision is to avoid double taxation of the same income and also to ensure that the tax is collected by that country which is entitled to collect such tax.
In exercise of the power granted under section 90 of the IT.Act, the central Government has entered into Double Taxation Avoidance Agreement (DTAA) with government of various other countries. These agreements have been made in line with the object, i.e. to avoid double taxation of income or to grant relief in respect of income which has been doubly taxed.
However, over the number of years, DTAAs have often been used in such a manner that no taxes are at all paid in any country. For example, in case of India-Mauritius DTAA, it is provided that the capital gains earned by a resident of Mauritius shall be taxable in Mauritius only. There is nil tax in Mauritius in respect of capital gains. Therefore, no taxes are effectively levied on a resident of Mauritius in respect of capital gains. Considering the aforesaid provision, in most of the cases, the foreign enterprises desirous of making investment in India started routing their investment through Mauritius. Accordingly no taxes are paid in India on the capital gains. In other words, a circuitous route is followed by the foreign investors to save taxes. This practice is popularly called as “treaty shopping” resulting in abuse of treaty provisions.
It is important to note that Supreme Court in the case of Azadi Bachao Andolan, 263 ITR 706 (SC) held treaty shopping as valid in the absence of any limitation of benefit clause in Indo- Mauritius Treaty. It was held that an assessee has the right to arrange its affairs in any legitimate manner within the framework of law, to mitigate the impact of tax.
Although, the Hon’ble Supreme Court had held that treaty shopping is valid, however, the policy of Indian Government seems to discourage such treaty shopping. Therefore, the Government of India has been in negotiation with the government of other countries to provide for “limitation of benefit clause” in their respective DTAAs. Limitation of benefit clause is basically an anti-abuse provision to avoid undesirable treaty shopping.
In the above context, the Government of India has signed a protocol with the government of United Kingdom on October 30, 2012. In the said protocol, the Government of India has amended the Indo-UK DTAA and has provided vide Article 28C that benefit of the Indo-UK Treaty would not be available where the main purpose or one of the main purposes of creation or existence of residence or any transaction undertaken by the assessee is to obtain treaty benefits.
However, to ensure that “limitation of benefit” clause is not misapplied by tax authorities, it has been provided that before applying this provision, if the resident of a contracting state is denied benefits in the source country, the competent authority of source country shall notify the corresponding competent authority in the country of residence of the tax payer.
This provision is to safeguard the taxpayers from arbitrary application of the limitation of benefit clause by tax officers.