India-Cyprus tax treaty revised: Signals revival of trade ties between the two countries
The prolonged negotiations between India and Cyprus over the revised tax treaty have finally concluded and the two countries have signed a revised tax treaty (revised treaty) (along with a protocol) on 18 November 2016. In 2013, the Indian government declared Cyprus a ‘Notified Jurisdictional Area’ under the realms of controversial amendment made in the 2011 Budget in the Indian Income Tax Act. By declaring Cyprus as such, all transactions between India and Cyprus were subject to higher withholding taxes and various compliances need to be undertaken. This notification in a way overruled the existing India-Cyprus tax treaty and had a significant impact on investments from Cyprus.
In this context, the negotiation of the revised tax treaty had assumed a lot of significance. While the text of the revised tax treaty has not yet been published by the Indian tax authorities, it has been published by the Cyprus tax authorities. The revised tax treaty along with the protocol is expected to come into force in India from 1 April 2017 once the same is notified by both countries.
The key takeaways from the revised tax treaty are given below:
1. Capital gains – Source based taxation of gains arising on shares of an Indian company
India has obtained the taxing rights of capital gains from the alienation of shares of an Indian company acquired on or after 1 April 2017. However, protection from Indian taxation has been provided to all investments made in India by a Cyprus tax resident before 1 April 2017. Capital gains will be taxable according to the applicable tax rates in the Indian tax laws.
To elaborate, as per the existing India-Cyprus tax treaty (existing treaty), India does not have the right to tax capital gains arising to a Cyprus tax resident from the alienation of shares of an Indian company even though the source of such gains is in India. However, under the revised treaty, for shares acquired on or after 1 April 2017, the taxation of such gains will be source based (such gains would now be taxable in India). Investments up to 31 March 2017 will be protected from taxation and hence, transfers of such investments (even after 1 April 2017) will not be subject to capital gains tax in India.
2. Expansion of the scope of Permanent Establishment (PE)
The scope of PE has been expanded by way of certain insertions and amendments over the existing treaty.
- The definition of PE now specifically includes:
- a sales outlet;
- a warehouse in relation to a person providing storage facilities for others; and
- a farm, plantation or other places where agricultural, forestry, plantation or other related activities are undertaken.
- Service PE – Under the revised treaty, a service PE clause is inserted. A service PE will be created on the furnishing of services if the activities continue for period(s) aggregating to more than 90 days within a 12 month period (rolling period concept introduced).
Accordingly, the scope of an agency PE has been expanded under the revised treaty.
- The threshold for constituting a construction/installation PE has been reduced from 12 months to 6 months.
- Under the existing treaty, an agent was not considered to be independent only if the agent’s activities were wholly on behalf of the principal enterprise. Under the revised treaty, an agent will not be considered as independent if the agent’s activities are devoted wholly or almost wholly on behalf of the principal enterprise.
- Under the existing treaty, a dependent agent constituted as a PE only if the agent habitually exercised authority to conclude contracts on behalf of the foreign enterprise. However, under the revised treaty, a dependent agent would also constitute as a PE if such agent:
- Habitually maintains stock of goods from which goods are delivered on behalf of the foreign enterprise; or
- Habitually secures orders, wholly or almost wholly, for the foreign enterprise.
Scope of preparatory or auxiliary activities reduced
3. Attribution of profits to PE – scope reduced
- Maintenance of fixed place of business for delivery of goods on behalf of the foreign enterprise is no longer considered to be a part of preparatory/auxiliary activities – in line with amended agency PE provisions.
- Sole functions of advertising or supply of information or scientific research in trade or business of an enterprise would no longer be considered to be a part of preparatory/auxiliary activities. Accordingly, such activities could now result into constituting a PE, provided other conditions of a PE are met.
The existing treaty provided that in addition to the profits attributable to the activities of the PE, profits from similar activities in the country of the PE would also be attributable to the PE even if not directly connected to the PE (Force of Attraction principle). The revised treaty has removed the said Force of Attraction principle and hence only the profits attributable to the activities of the PE will be considered for taxation in the hands of the PE.
However, the revised treaty also denies deduction for expenses such as royalties, fees, commission or interest paid by the PE to its head office or other offices overseas (other than actual reimbursement of expenses). The restriction on deduction of interest paid by a PE to its head office or other offices overseas will not apply to banking enterprises. Conversely, no cognizance of income is to be taken in the hands of the PE for the amount charged to head office in respect of the aforesaid receipts.
As per the existing treaty, dividend payments are liable to withholding tax of 10% or 15%, subject to certain conditions. However, the revised treaty now provides a single rate of withholding tax of 10% for all dividend payments. Currently, in any case, dividends paid by Indian companies are exempt from tax and subject to Dividend Distribution Tax.
5. Fees for technical services and royalties
As per the existing treaty, taxation of fees for services was as given below:
Under the revised treaty, the concept of fees for included services has been removed. Accordingly, all fees for any managerial, technical or consultancy services will now be subject to the withholding tax rate of 10% irrespective of the technical knowledge, experience, skill, etc. being made available to the taxpayer.
- If treated as technical fees i.e. fees for managerial, technical or consultancy services – 10%
- If treated as fees for included services i.e. technical or consultancy services which make technical knowledge, experience, skill, etc. available to the taxpayer - 15%
Further, the definition of royalties under the revised treaty has now been brought in line with the definition of royalties under the other tax treaties of India. Furthermore, the withholding tax rate on royalties has also been reduced from 15% to 10%.
6. Independent and Dependent Personal Services
Similar to the concept of the rolling period that has been introduced in the service PE clause, the revised treaty introduces the rolling period concept even in the case of articles dealing with ‘Independent Personal Services’ and ‘Dependent Personal Services’. Accordingly, the period of stay for 183 days or more will have to be computed by checking any 12-month period commencing or ending in the concerned fiscal year.
The revised treaty has categorically stated that the article of Independent Personal Services would only apply to an individual resident of either country.
7. Other income
As per the revised treaty, the scope of taxation of other income in the source country is now restricted only to the income from lotteries, crossword puzzles, races (including horse races), card games and other games of any sort or gambling/betting of any nature in the source country. Other than these incomes, the balance other incomes will now only be taxable in the country of residence of the taxpayer.
8. Other amendments
The other significant amendments in the revised treaty are:
- The provisions with regards to granting relief from double taxation have been simplified. The double taxation will now be eliminated by granting tax credit for taxes paid in the other country. Provisions with regard to tax sparing have been removed.
- The article on ‘Exchange of Information’ categorically states that requests for information exchange cannot be denied solely because the said information is held by a bank, other financial institution, nominee or person acting in an agency or a fiduciary capacity. Further, if the information is sought by one country, then the other country cannot refuse to divulge the information on the ground that it does not need the said information for its tax purposes.
- A specific article on ‘Assistance in the Collection of Taxes’ has been inserted.
- As per the revised treaty, if the place of effective management of a person other than an individual cannot be determined for ascertaining residential status, the competent authorities shall settle the question by mutual agreement within two years of invocation of the mutual agreement procedure.
The revised India-Cyprus tax treaty was expected to be similar to the revised India-Mauritius tax treaty. While the changes in the scope of taxation of capital gains are similar in both the treaties (i.e. grandfathering of investments made prior to 1 April 2017), the benefit of 50% reduction in tax for two years which was extended to the residents of Mauritius has not been extended to the Cyprus tax residents.
However, the most surprising aspect of the revised tax treaty is that there is no Limitation Of Benefits (LOB) clause as was present in the case of the revised India-Mauritius and India-Singapore tax treaties. This could leave the benefits under the India-Cyprus tax treaty more susceptible to be challenged under the General Anti-Avoidance Rules (GAAR) which will be applicable in India from 1 April 2017. The benefit of lower withholding on interest granted to Mauritius tax residents (7.50%) has not been extended to Cyprus tax residents and the 10% withholding on interest continues.
The scope of PE has been expanded in many areas. However, the removal of the Force of Attraction principle should decrease the scope of taxable business profits in hand of the PE. The other revisions are mainly done to bring the Cyprus treaty in line with other tax treaties that India has signed/negotiated in recently.
In light of the revised tax treaty, India has retrospectively rescinded the notification made in 2013 declaring Cyprus a Notified Jurisdictional Area, except for things done or omitted to be done under the said notification. Accordingly, the requirement for higher withholding taxes and compliances will no longer apply in cases of transactions between India and Cyprus. However, any proceedings undertaken or yet to be undertaken (e.g. transfer pricing scrutiny, withholding tax proceedings, etc.) under the said notification could still be valid even after rescinding the notification.