Have You Checked the Applicability of Multi-Lateral Instrument Impacting Your Treaty Benefit Claim?

The Base Erosion and Profit Shift (“BEPS”) programme, initiated by OECD, had recommended a host of action plans, which could be implemented by making changes to the international tax treaties. . However, there are more than 3000 bilateral tax treaties entered into by contracting countries and it would have taken years to amend them. To solve this problem, over 100  jurisdictions negotiated and concluded a multi-lateral instrument (“MLI”) in November 2016. Countries that agreed to change their tax treaties were required to sign and notify the OECD Secretariat.  India was amongst the first few signatories to the MLI in 2017 and ratified   it on June 25, 2019. Thus, its network of bilateral tax treaties would be impacted by the provisions of the MLI where its treaty partner is also a signatory. It is, therefore, necessary now to read the applicable tax treaty with MLI, based on the treaty partner’s position and reservations on the provisions of the MLI.

The Indian Income Tax Act, 1961 (“IT Act”) has enacted General Anti-Avoidance Rules (“GAAR”) with effect from April 1, 2017. GAAR are anti-abuse provisions to curb aggressive tax planning resulting in impermissible tax avoidance. Therefore, commercial substance of structures and arrangements are of immense significance in the context of tax. GAAR would be attracted if the tax authorities determine that the main purpose of an ‘arrangement’ or ‘party to a transaction’ or ‘step in a transaction’ is to obtain a tax benefit and there is no commercial substance or exigency other than obtaining tax benefit (Substance Test). In such cases, the structure would be treated as an impermissible avoidance arrangement under the GAAR provisions. This could result in, multiple consequences inter alia, denial of any tax benefit offered under the applicable tax treaty, re-characterisation of debt into equity and vice versa and so on.

In view of the above, it is vital to examine the facts and commercial background of proposed transactions to assess if they would satisfy the Substance Test under GAAR, and ascertain optimum risk mitigation strategy. With the MLIs becoming effective, now there is an additional risk assessment that is necessary in respect of cross border transactions. While GAAR is applicable to both cross border and domestic transaction, MLI would be applicable in respect of  cross border transactions since its provisions change the provisions and applicability of bilateral tax treaties and will be referred to while determining taxation in cross border transactions. In this respect, one of the most critical aspects of MLI is the provision that restricts the practice of ‘treaty shopping’ and use of aggressive transaction structures such as investment through tax-saving instruments. The anti-avoidance provision of MLI requires that if one of the purposes of a transaction arrangement is to obtain tax benefit, then the arrangement fails the Principal Purpose Test (“PPT”). When PPT is not satisfied, then the benefit of the tax treaty may be denied. It is important to appreciate and note that PPT contains a stricter threshold of substance requirement as compared to GAAR. While GAAR is invoked if the ‘main purpose’ of the arrangement is to avoid tax, PPT would be attracted even when ‘one of the purposes’ of an arrangement / transaction is to obtain tax benefit.

Pursuant to the amendments to India’s tax treaties with Mauritius, Singapore and Cyprus, capital gains arising from transfer of shares of an Indian company are now taxable in India. The India-Netherlands tax treaty continues to allow an exemption from Indian capital gains tax in certain situations. However, relief under the India-Mauritius, India-Singapore, India-Cyprus treaties continues to be available for residents of these countries, in respect of capital gains from transfer of instruments other than shares in the Indian companies, such as debt instruments, or sale of shares of a foreign company, which in turn holds shares in an Indian target company, etc. Such reliefs would now be subject to satisfaction of substance requirements under the respective tax treaties (if any) as well as the rigors of GAAR and PPT rules under the domestic law and MLI, respectively.

Thus, with effect from the following dates, fund houses or investors resident in the respective countries or contemplating establishing a presence in such country for making investments into India, should consider the impact of PPT (and other provisions of the MLI) on the tax treaty between India and such country. We have summarised below the potential impact of MLI on some of the key jurisdictions through which investments into India are made.

Disclaimer: The views/content expressed in this post are for general information only. They are neither legal advice nor views that should be relied upon by anyone to base their decision in regard to the subject matter. The topic itself is an evolving one and hence specific advice must be obtained.

[1] The Entry into effect specified herein is for the purpose of income tax in India (other than for tax deduction at source) purposes. For tax deduction at source in India, the MLI shall be effective with respect to respective tax treaty, from the beginning of financial year immediately after 3 months from latest of the deposit of instrument of ratification by India or its Treaty partner.

[2] Mauritius has not notified India-Mauritius tax treaty as a covered tax treaty, hence India-Mauritius tax treaty remains unaffected by MLI.