Treaty shopping through bogus legal entities

Treaty shopping is a graphic expression used to describe the act of a resident of a third country taking advantage of a fiscal treaty between two states.

Several developed countries have taken suitable steps to curb abuse of tax treaties by incorporating appropriate provisions in tax conventions or by domestic legislation. The basic objective is to ensure that the benefits of a tax treaty are not available to the residents of a third country.

This issue has assumed importance because foreigners are now making large investments in India. Such investments are often routed through a third country, so as to take advantage of the tax treaty between India and that third country.

In case of investments through Mauritius, the matter was taken right up to Supreme Court (Union of India vs Azadi Bachao Andolan 263 ITR 706).

It was urged that the offshore companies have been incorporated under the laws of Mauritius only as shell companies, which carry on no business therein, and are incorporated only with the motive of taking undue advantage of the DTAC between India and Mauritius.

It was also submitted that treaty shopping is both unethical and illegal and amounts to a fraud on the treaty and that the court must be astute to interdict all attempts at treaty shopping.

The Supreme Court in its historical judgment observed: "Many developed countries tolerate or encourage treaty shopping, even if it is unintended, improper or unjustified, for other non-tax reasons, unless it leads to a significant loss of tax revenues.

"Moreover, several of them allow the use of their treaty network to attract foreign enterprises and offshore activities. Some of them favour treaty shopping for outbound investment to reduce the foreign taxes of their tax residents but dislike their own loss of tax revenues on inbound investment or trade of non-residents. In developing countries, treaty shopping is often regarded as a tax incentive to attract scarce foreign capital or technology".

The Supreme Court, thus, held that there are many principles in fiscal economy which, though at first blush might appear to be evil, are tolerated in a developing economy, in the interest of long-term development.

In the above context, it is interesting to note that the tax treaty between India and Singapore has been recently amended by way of Protocol vide notification No. 185/2005 dated 18th July, 2005, with the objective of avoiding misuse of the treaty by bogus enterprises. The amendment provides that a shell/conduit company shall not be entitled to the benefit of tax exemption from capital gains.

For the above purpose, the protocol amending the tax treaty specifically provides that a resident of a contracting state is deemed to be a shell/conduit company if its total annual expenditure on operations in that state is less than S$200,000 or Indian Rs 50 lakh in the respective contracting state, as the case may be, in the immediately preceding period of 24 months from the date the gains arise.

The protocol further provides that a resident of a contracting state is deemed not to be a shell/conduit company if it is listed on a recognised stock exchange of the contracting state.

Whereas the amendments are specific to the tax treaty between India and Singapore, it appears to be a clear indication of future legislation in India. It looks like that the days for making investment in India through bogus legal entities are over.

agar@bol.net.in