Executive summary

On 19 March 2018, representatives of Hong Kong and India signed their first comprehensive income tax treaty (the Treaty). The Treaty will stimulate flow of investment, technology and personnel from Hong Kong to India and vice versa, prevent double taxation and provide for the exchange of information between the two countries. It will improve transparency in tax matters and help to curb tax evasion and tax avoidance.

Provisions of the Treaty are based on the Organisation for Economic Co-operation and Development Model Treaty (the OECD Model Treaty) 2017 and the United Nations Model Treaty (the UN Model Treaty) 2011, providing greater taxation rights for the source country.

Significant provisions in the Treaty are:

• Source country taxation rights on capital gains from the transfer of shares
• Beneficial rate of taxation of dividends at the rate of 5% on the gross dividend and 10% on gross interest, royalties, fees for technical services (FTS)
• Certain provisions are influenced by the OECD's Multilateral Instrument (MLI) on Base Erosion and Profit Shifting (BEPS) such as the principal purpose test (PPT), competent authority (CA) rule such as the tie-breaker test for dual resident entities, mutual agreement procedure (MAP) provisions, corresponding adjustments in transfer pricing cases, among others
• The benefit of provisions on dividends, interest, royalties, FTS, and capital gains has been made subject to the "main or one of the main purposes" test which is in addition to a general rule on the lines of the PPT of the MLI
• Authority is given to anti-avoidance provisions under the domestic laws

The Treaty will enter into force after the completion of ratification procedures by both countries. It will become effective for tax years beginning on or after 1 April following the date in which the Treaty enters into force.

This Alert summarizes the key provisions of the Treaty.

Detailed discussion

Tie-breaker test for dual residency (Article 4)

Pursuant to the OECD's Model Treaty, residency status of a person other than an individual will be determined by the MAP, based on its place of effective management, place of incorporation or constitution, and any other relevant factors. This provision follows the MLI. In the absence of the MAP, dual residents are not entitled to any relief or exemption from tax under the Treaty, except as may be agreed by the CAs.

Permanent establishment (PE) (Article 5)

• In addition to a fixed place PE, the Treaty covers other forms of PE such as Construction PE, Service PE and Agency PE. These provisions are comparable to the UN Model Treaty.
• The Treaty provides a six-month threshold for a Construction PE that includes a building site, assembly or installation project or supervisory activities.
• A Service PE is created when services, including consultancy services, are furnished for the same or a connected project for an aggregate period of more than 183 days within any 12-month period.
• The Agency PE definition covers authority to conclude contracts (except preparatory or auxiliary activities), maintaining stock of goods/merchandize for regular delivery and securing orders wholly or almost wholly for the principal or its associated enterprises. The provision does not incorporate the MLI recommended provisions on Agency PE.
• The Treaty also states that where the activities of an agent are devoted wholly and almost wholly on behalf of the enterprise, the agent will not be considered as an independent agent. Unlike the UN Model Treaty, the additional condition of satisfying an arm's-length requirement for qualifying as an independent agent, is absent in the Treaty.
• Certain activities are listed as exempt from creating a PE such as storage, display, maintenance of stock for storage, display or processing, purchasing goods or merchandize or collecting information, and other preparatory or auxiliary activities.

Business income (Article 7)

Article 7 of the Treaty provides for source taxation of business profits to the extent attributable to a PE in the source country. The provision generally follows Article 7 of the UN Model Treaty but the force of attraction rule is absent in the Treaty. Further, unlike the UN Model Treaty, the Treaty does not restrict deductibility of expenses payable to a head office in the form of royalties, fees, commission, etc. The Treaty also contains the exclusion for purchasing activity. This provision is not present in the UN or the OECD Model Treaties.

Associated Enterprises (AEs) – Corresponding adjustment related to transfer pricing provision (Article 9)

The Treaty provides that a corresponding adjustment may be made in the profits of AE in the other Contracting State:

• Where an adjustment has been made by a country to the profits of a resident, based on an arm's-length condition and taxes are levied on such adjusted profits adjusted; and
• Such profits are also taxed in the hands of the AE in the other Contracting State.

This provision relieves double taxation in the other Contracting State and is in line with India's commitment made as part of Action 14 on dispute resolution mechanism of the BEPS plan.

Taxation of dividends (Article 10), interest (Article 11), royalties (Article 12), and FTS (Article 13)

Passive streams of income like dividends, interest, royalties and FTS are generally taxable in the resident country. Such income may also be taxed in the source country at a tax rate of 5% on dividends and 10% on interest, royalties and FTS on a gross basis.¹ If such incomes is effectively connected to a PE in the source country, Article 7 will govern the taxation on the net basis.

The beneficial tax rates will not be available, however, if the main purpose or one of the main purposes of any person concerned with the creation or assignment of shares or other rights or debt or royalty rights or performance of services is to take advantage of these Articles by means of such arrangement. This is similar to the PPT in the MLI.

Definitions of royalty and FTS are similar to those in the UN and the OECD Model Treaties. However, the Treaty does not include a condition of "make available" with respect to FTS, accordingly, its scope is much broader compared to other treaties with such condition.

Capital gains (Article 14)

• Capital gains arising from the sale of immovable property and from the sale of shares of a company which derives more than 50% of its asset value directly or indirectly from immovable property will be taxed in the country where the immovable property is situated.
• The source country where the company is a resident retains a taxing right on capital gains from sale of other shares in a company.
• Each country will determine taxability of any other property in accordance with the provisions of its domestic laws.

Similar to other passive income streams, benefits under this Article are also subject to the "main purpose or one of the main purposes" test.

Elimination of double taxation (Article 23)

To eliminate the double taxation on a person, both countries allow a foreign tax credit for the taxes paid in the other country.²

MAP (Article 25)

The Treaty provides for MAP similar to the MLI provision. Among other things, it states that a taxpayer may present its case to a CA in its resident country within three years from the first notification of the action resulting in taxation. The CA would work together to resolve the case by a mutual agreement to be implemented notwithstanding any time limits in the domestic laws.

Anti-avoidance provisions (Article 28)

The provisions of the Treaty will not prevent a country from the application of its domestic law and measures concerning tax avoidance or evasion.

Treaty benefits will not be granted if the main purpose or one of the main purposes of any persons is non-taxation or reduced taxation through tax evasion or avoidance, including through treaty-shopping arrangements. This provision is comparable to the PPT rule as well as the language of the Preamble to the BEPS Action 6 in the MLI.

Cases of legal entities not having bona fide business activities will also be covered under the provisions.

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ENDNOTES

¹ Under Hong Kong's domestic law, an Indian resident is not subject to withholding tax on dividends, interest or FTS in Hong Kong, while royalties are subject to a 4.95% Hong Kong withholding tax.

² Under Hong Kong's domestic law, the amount of tax credit is limited to the Hong Kong profits tax payable in respect of the same income.

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CONTACTS

For additional information with respect to this Alert, please contact the following:

Ernst & Young LLP, Indian Tax Desk, New York

• Riad Joseph
  riad.joseph1@ey.com
• Sameep Uchil
  sameep.uchil@ey.com

Ernst & Young LLP, Hong Kong Tax Desk, New York

• Charlotte Wong
  charlotte.wong1@ey.com

Ernst & Young LLP, Indian Tax Desk, Chicago

• Roshan Samuel
  roshan.samuel1@ey.com

Ernst & Young LLP, Indian Tax Desk, San Jose

• Archit Shah
  archit.shah@ey.com

Ernst & Young LLP, Indian Tax Desk, Dallas

• Monika Wadhwa
  monika.wadhwa1@ey.com

Ernst & Young Solutions LLP, Indian Tax Desk, Singapore

• Gagan Malik
  gagan.malik@sg.ey.com

Ernst & Young LLP (United Kingdom), Indian Tax Desk, London

• Amit B Jain
  amit.b.jain1@uk.ey.com

Ernst & Young Tax Services Limited, Hong Kong

• Tracy Ho
  tracy.ho@hk.ey.com
• Florence Chan, Financial Services
  florence.chan@hk.ey.com

Ernst & Young LLP, Asia Pacific Business Group, New York

• Chris Finnerty
  chris.finnerty@ey.com
• Kaz Parsch
  kazuyo.parsch@ey.com
• Bee-Khun Yap
  bee-khun.yap@ey.com

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ATTACHMENT

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