Triangular taxation: Concept & challenges

Triangular taxation: Concept & challenges

Gaurav Taneja

COMPLEX cross-border taxation represents one among several challenges triggered by globalisation today. The vexed issue of triangular cases, in particular, has drawn considerable attention over the last two decades but remains largely unresolved.
The term ‘triangular cases’ refers to situations involving applicability of tax treaties where tax incidence on a particular stream of income is typically triggered in three countries.
Illustratively, let us assume that a company that is resident in India (ICo) establishes a branch in the UK and such branch earns income from Japan. The above situation could possibly trigger tax implications for ICo in all three countries, ie India, the UK and Japan. ICo would be taxable in India on its global income (including income earned by its UK branch), the UK would tax income accruing to the branch and Japan may levy a withholding tax on payments to the branch in the UK.
As the same income could be taxed in three countries, the related issue that needs to be addressed is how tax credit/exemption mechanisms should work to avoid triangular taxation.
As India taxes its residents on their worldwide income in the illustration above, ICo would be principally liable to tax in India on the branch income earned in the UK. However, India would grant credit for taxes paid by the branch (not exceeding the taxes payable in India on the branch income). In the instant case, if both Japan and the UK levy tax on the branch income, an incremental layer of unrecoverable taxes would be triggered, unless tax exemption or credit mechanisms are in play. The moot point therefore is how should tax treaties facilitate credit for taxes paid in Japan.
One option is that the ‘residence’ Article in the UK-Japan treaty could be amended to extend benefits of residency (and, hence, treaty access) even to a permanent establishment (PE) in the UK of a resident of a third country (India in this case) which earns income from Japan. The treaty could either provide for tax credit in India of taxes paid in Japan, or an exemption of tax in the UK on the income earned by the branch. The controversy, however, is whether a bilateral agreement between the UK and Japan can eliminate double taxation for a third country, ie India.
In view of the above, it could be provided in the India-Japan treaty that credit should be available for taxes paid by ICo overseas (including countries where PEs of ICo are situated). Alternatively, it could also be provided in the India-UK treaty that ‘taxes paid’ for credit purposes in India should include tax credits claimed in the UK (ie taxes withheld at source in Japan).
Other issues that need to be addressed include the procedure and endorsements for claim of credit by India, the UK and Japan and, also, availability of credit in India for taxes paid in Japan (especially when the UK exempts such income from taxes).
Tax courts in several developed countries have been pronouncing decisions in a triangular scenario. In a landmark EU judgment, the European Court of Justice (ECJ) observed that the refusal of Germany to grant tax concessions either by exempting tax or allowing credit for overseas taxes paid on foreign sourced dividends earned by a PE would mean differential treatment of a PE vis-a`- vis a domestic corporation and, therefore, be regarded as an infringement of the European Community tax treaty. Interestingly, in another case, the Dutch Supreme Court disallowed tax credit on royalty income earned in Japan by a Swiss PE of the Dutch Co, given that the Netherlands-Japan treaty only provided a credit for tax on income of the Dutch Co in Japan, not earned through an overseas PE.
Potential solutions to address triangular cases have been in circulation. There is a need for concrete and updated guidelines which would enable decisions on cross-border business models to be taken with more certainty. Speedy amendments to tax treaties addressing triangular cases would also be welcome.
TOUGH TASK
Triangular case refers to situations involving applicability of tax treaties where tax incidence on a particular stream of income is triggered in three countries
The related issue that needs to be addressed is how tax credit/exemption mechanisms should work to avoid triangular taxation
ECJ observed Germany’s refusal to grant concessions either by exempting tax or allowing credit for overseas taxes paid on foreign sourced dividends earned by a PE would mean differential treatment of a PE vis-a`-vis a local corporation and be regarded as an infringement of the EU tax treaty (The author is national director of tax & partner, Ernst & Young India)