Aug 31, 2023

Tax Sparing Principles in Double Taxation Avoidance Agreement

In the realm of international taxation, the primary objective of a tax treaty is avoidance of double taxation of income arising in a cross-border transaction. With the advent of changes to tax treaties brought about by the Multilateral Convention to Implement Tax Treaty Related Measures to Prevent Base Erosion and Profit Shifting (‘MLI’), this primary objective has also undergone a significant change. Tax treaties which are amended as per Article 6(1) of the MLI, are now understood to have been entered into with the primary objective of eliminating double taxation without creating opportunities for non-taxation or reduced taxation through tax evasion or avoidance.

At the same time, there are tax sparing clauses in tax treaties that are incorporated by developing countries for granting tax incentives in order to attract foreign direct investment. For example, Article 23 of the India-Thailand Double Tax Avoidance Agreement (‘DTAA’) (as it existed prior to its amendment in 2015) is recognized as a tax sparing clause, which allows an Indian resident to claim credit of tax ‘payable’ in Thailand. Recently, the Delhi High Court (‘Delhi HC’) in the case of PCIT v. Polyplex Corporation Ltd[1] (‘Polyplex Judgment’) has examined this concept of tax sparing clause contained in Article 23 of DTAA (as it existed prior to its amendment in 2015).

The issue before the Court was to examine the validity of the tax credit urged by the Polyplex Corporation in India by virtue of Article 23 of DTAA, pursuant to which credit of tax payable was being claimed by the assessee with respect to dividend income earned by it from Thailand against its tax liability in India. While no tax was paid by the assessee in Thailand owing to statutory exemption prevailing in Thailand, the Delhi HC allowed the assessee to claim credit of notional tax payable in Thailand against its income tax liability in India. The Delhi HC also acknowledged that the critics consider that tax sparing provisions lead to double non-taxation. However, the Court did not opine on such a contention, while leaving the decision regarding the fate of tax sparing principle on contracting States. The Delhi HC’s decision emphasised that the effect of the tax sparing clause was to give credit for notional tax and to boost economic activities, thereby promoting bilateral investment which acts as a tool for economic development.

The Delhi HC, in fact, has recognized the purport of tax sparing clauses previously as well.[2] However, the Income-tax authority’s appeal against the Polyplex Judgment has been heard by the Supreme Court and the final decision is awaited. Till such time, it can be concluded that tax sparing clauses are intended towards double non-taxation and that an Indian resident can claim the benefit provided thereunder, if one exists in the applicable tax treaty.

[1] PCIT v. Polyplex Corporation Ltd., [2023] 152 479 (Delhi HC).

[2] PCIT v. Krishak Bharti Cooperative Ltd., [2017] 80 326 (Delhi HC).




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