International Tax Updates

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Direct Tax – International Tax Updates

Canada SC: Guarantee fees are not treaty interest

In this case, the taxpayer is a company resident in Canada that obtained a business loan from a Canadian bank. To secure the loan, a non-resident German bank provided a legal guarantee to the Canadian bank on behalf of the taxpayer. In consideration for this credit guarantee, the taxpayer paid a guarantee fee to the German bank. The German bank did not have a Permanent Establishment (‘PE’) in Canada.

The Canadian Revenue Authority subsequently sought to recover withholding tax on the guarantee fees remitted to the German bank. The Revenue Authority argued that following an amendment to Canada’s domestic Income Tax Act in 1974, any consideration paid to a non-resident for guaranteeing a Canadian resident’s obligation is legally “deemed to be a payment of interest” for withholding tax purposes. Consequently, they contended that the fees were subject to domestic withholding tax.

The taxpayer argued that domestic amendments cannot unilaterally override an existing international tax treaty. They relied on Section 3 of the Canada-Germany Income Tax Agreement Act, 1956, which explicitly mandates that the provisions of the treaty prevail in the event of any inconsistency with domestic law.

Furthermore, the taxpayer contended that under Canadian law at the time the treaty was signed (i.e., in 1956), “interest” strictly meant compensation paid by a borrower to a lender for the use of capital. Because a guarantee fee paid to a third-party guarantor is a commercial fee rather than interest, it constitutes “industrial or commercial profits”. Under Article III(1) of the treaty, such profits are completely exempt from Canadian tax if the foreign enterprise does not have a PE in Canada.

The Supreme Court of Canada dismissed the revenue’s appeal and held that:

• The Canada-Germany Income Tax Agreement Act, 1956 overrides domestic tax laws in the event of an inconsistency.
• Domestic legislation cannot unilaterally amend treaty provisions unless Parliament expressly amends the 1956 Treaty Act which was not done in 1974.
• Guarantee fees are commercial profits, not interest. Since the German bank did not have a PE in Canada, Canada lacked the authority to levy withholding tax.

Delhi HC: Secondment reimbursement taxable as FTS

Ernst & Young U.S. LLP (“EY US”) seconded its employees to various EY India entities under secondment arrangements. The Indian entities reimbursed EY US, on a cost-to-cost basis, for salary and related employment costs of the secondees. The Revenue treated such reimbursements as FTS under section 9(1)(vii) of the Income-tax Act, 1961 (‘ITA’) and Article 12 of the India-US DTAA, whereas the Income Tax Appellate Tribunal (‘ITAT’) had held the reimbursements to be non-taxable.

The issue before the Delhi High Court was whether reimbursement of salary costs paid by the Indian entities to EY US under secondment arrangements constitutes taxable FTS under the ITA and the India-US DTAA, and whether the “make available” condition under the DTAA is satisfied.

The Delhi High Court reversed the ITAT’s decision and held that:

• The seconded personnel continued to remain employees of EY US, as EY US retained an overarching employer-employee relationship and lien over the employees during the secondment period.
• The secondees transferred technical knowledge, expertise, processes and EY global standards to the Indian entities, thereby satisfying the “make available” test under Article 12(4)(b) of the India-US DTAA.
• The absence of any mark-up on reimbursement does not alter the character of the payment.
• The arrangement was akin to a deputation by EY US for rendering technical and consultancy services to the Indian entities.
• The Court relied on the principles laid down in an earlier ruling in the case of Centrica India Offshore Pvt. Ltd., observing that reimbursement of secondment costs may still constitute taxable FTS where the overseas entity continues to retain control over the secondees.
• The Court also held that the ITAT had failed to adequately examine the distinction between receipts claimed as exempt professional services and those taxable as FTS.

The decision reinforces the substance of a secondment arrangement, rather than its contractual form or cost-to-cost reimbursement mechanism. Where the foreign employer retains control over seconded employees and the arrangement results in transfer of technical knowledge or know-how to the Indian entity, the reimbursement may be characterized as FTS taxable in India, notwithstanding that salary is taxed in the hands of the employees.

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