ON September 15, 2023, the Supreme Court of India - 2023-TII-10-SC-INTL has pronounced its first judgement on the issue of 'tax sparing' credit in the context of giving foreign tax credit by India. Before going into the facts of the case and the legal issues involved, it will be appropriate to recapitulate a little on the concept of tax sparing.

Developing countries often extend tax concessions, sometimes on their own, sometimes at the bidding of advisers, to attract foreign investments in the country in the hope that such investments will be beneficial to the domestic economy. Such incentives may take many forms from outright tax holidays for certain periods to lower or no taxes on passive incomes. It may also be that the incentives are offered to foreign investors alone. Ever since the success of China with its Special Economic Zones situated around the peripheral areas, it has become almost de rigeur for any aspiring developing country to extend such incentives. Why even the UK is establishing 'free ports. Even before spread of the Chinese model, there was the concept of export processing zones that were offered various benefits including in matters of taxation. The Kandla Export Processing zone was in fact Asia's first export processing zone and was set up way back in 1965 with the objectives of earning precious foreign exchange and to generate more employment opportunities in the industrially backward district of Kutch. Since 2000, It has now taken a new avatar in the form of a SEZ and enjoy the benefits of section 10AA.

While the efficacy of tax incentives in getting or maintaining investments and in particular foreign investments have always been questioned by economists, their allure does not seem to diminish. In the context of foreign investments, however, such incentives may produce curious results that amount to poor countries trying to attract investments ending up subsidizing the coffers of the capital exporting jurisdictions. This result follows from the general practice of countries taxing the world-wide income of their residents. Generally speaking, under the OECD Model, double taxation is avoided by the resident countries giving credit to its resident enterprises for the taxes paid in the country of source. If the source country does not tax any element of the income of the foreign enterprise, there is no source taxation and correspondingly no tax credit is available to the enterprise. However, because of worldwide taxation, the income still remains taxable in the home jurisdiction and the enterprise, instead of paying tax on its income in the source country end up paying the same in its home jurisdiction and the incentive designed to attract foreign investment, end up in the treasury of the residence country.

To overcome this effect, some capital exporting countries barring the United States, started using the tax sparing provision. Such a provision, not being part of the standard OECD template, has many variants but the essential element is that, if a developing country extends incentives or spares tax on the enterprise of a capital exporting country, then the residence country considers the tax that has been spared. i.e., the tax that would have been payable in the source country but for the incentive provision and gives credit for the same to the enterprise that has invested. In this way, the purpose of the incentive provision is preserved for the source country. Such a provision of giving credit for a tax that has not actually been paid is considered by the developed countries as part of their development assistance.

India also had tax sparing provisions in many of its tax treaties but normally such a provision is valid for a specified period and in some of Indian treaties with developed countries the provision has expired and has not been renewed, for example, in the treaty with Germany. The provision has also been given up in the treaty with Japan.

In India's tax treaties with developed countries, the liability to give such sparing credit is generally taken by the developed country concerned with no corresponding obligation on the part of India. In most of the cases, the types of incentives are also specified. For example, the treaty with Canada, has the following clarification:

""4. For the purposes of paragraph 2(a), the term "tax payable in India" shall, with respect to a company which is a resident of Canada, be deemed to include any amount which would have been payable as Indian tax but for a deduction allowed in computing the taxable income or an exemption or reduction of tax granted for that year under:

(a) sections 10(15)(iv), 10A, 32A (but not the part dealing with ships and aircraft), 80HH, 80HHD and 80-IA (but not the part dealing with ships) of the Income-tax Act, 1961, as amended, so far as they were in force on and have not been modified since the date of signature of the Agreement, or have been modified only in minor respects so as not to affect their general character.

(b) any other provision which may subsequently be made granting an exemption or reduction from tax which is agreed by the competent authorities of the Contracting State to be of a substantially similar character, if it has not been modified thereafter or has been modified only in minor respects so as not to affect its general character.

Provided that relief from Canadian tax shall not be given by virtue of this paragraph in respect of income from any source if the income relates to a period starting more than ten fiscal years after the exemption from, or reduction of, Indian tax is first granted to the resident of Canada, in respect of that source."

But there are treaties with developing countries where such tax sparing credit is to be given by both the parties and the scope also seems to be wider For example, the obligation of India to relieve double taxation in article 24 of the India- Malaysia tax treaty states:

""In case of India for taxes paid in Malaysia is as follows:

3. For the purposes of paragraph 4, the term "tax paid in Malaysia" shall be deemed to include the tax which would, under the laws of Malaysia and in accordance with this Agreement, have been payable on any income derived from sources in Malaysia had the income not been taxed at a reduced rate or exempted from Malaysian tax in accordance with the provisions of this Agreement and the special incentives under the Malaysian laws for the promotion of economic development of Malaysia which were in force at the date of signature of this Agreement or any other provisions which may subsequently be introduced in Malaysia in modification of, or in addition to, those laws so far as they are agreed by the competent authorities of the Contracting States to be of a substantially similar character."

Since the case under discussion involves the treaty with Oman, we may also note the tax credit provision of that treaty that has a different and as will be apparent from the present discussion a troubling formulation:

Article 25(2)

""2. Where a resident of India derives income which, in accordance with the provisions of this Agreement, may be taxed in the Sultanate of Oman, India shall allow as a deduction from the tax on the income of that resident an amount equal to the income-tax paid in the Sultanate of Oman, whether directly or by deduction. Such deduction shall not, however, exceed that part of the income-tax (as computed before the deduction is given) which is attributable to the income which may be taxed in the Sultanate of Oman.

Article 25(4) then states:

""The tax payable in a Contracting State mentioned in paragraph 2 and paragraph 3 of this Article shall be deemed to include the tax which would have been payable but for the tax incentives granted under the laws of the Contracting State and which are designed to promote economic development."

The important question is what are these tax incentives that are designed to promote such economic development of Oman? There is no further clarification in the treaty. With this background, we can now note the facts of the case and the arguments.

The assessment years involved were AY 2010-2011 and 2011-12 and the dispute in this case relates to the treatment of dividends received by the Krishak Bharati Cooperative Ltd (KRIBHCO) from the Oman India Fertiliser company (OMIFCO). It appears that OMIFCO was established, as an initiative of the governments of Oman and India in order to construct, own and operate a modern world scale two-train ammonia - urea fertiliser manufacturing plant at the Sur Industrial Estate in the Sultanate of Oman. OMIFCO is owned 50% by Oman Oil Company SAOC, 25% by Indian Farmers Fertiliser Cooperative Limited and 25% by Krishak Bharati Cooperative Limited. KRIBHCO has a branch in Oman, which is treated as a permanent establishment under the domestic tax law of Oman. Apparently, there is no dispute about its status as a PE under the tax treaty. However, the exact functions of the PE in Oman are not clear although the order of the ITAT and the High Court mention that the branch office was established to oversee the investments in Oman.

During the relevant year 2010-11, KRIBHCO received dividend income of INR 143.83 crores that was included in the total income. However, the taxpayer claimed a tax credit of INR 41.44 crores as relief u/s 90 of the Income Tax Act, 1961 read with Article 11, 7 and 25 of the India-Oman DTAA. The AO during the assessment proceedings examined the claim and allowed the same. However, the PCIT, invoking his powers under section 263 of the ITA, held that the order passed by the AO was erroneous and prejudicial to the interests of the revenue and accordingly set aside the order of the AO with directions to reframe the order.

Before proceeding further, we may first consider the taxation of dividends under the domestic law of Oman. It seems that changes have taken place in the Omani law. From the correspondence exchanged it appears that before 2000, under Article-8 of the Omani Tax Laws, dividends formed part of gross income chargeable to tax. As a result, investors in tax exempt companies that undertook activities considered essential for the country's economic development suffered a tax cost which had a negative impact. Therefore, the Company Income-tax Law of 1981 was amended by Royal Decree No.68/2000 by insertion of a new Article 8 (bis) that stated as follows:

""In exception to the provisions of Article 8 of this Law, tax shall not apply on the following :

1. Dividends received by the company against equity shares, portions or stocks in the capital of any other company.

2. Profits or gains realized by the Company from the sale of securities listed in Muscat Securities Market or from their disposal."

Omani income tax law has undergone further changes and the current version as available on the net is the Royal Decree No.28/2009 promulgating the Income Tax law. In terms of Article 35 of this Decree also, dividends, interests, or discount received are considered as income. Even in terms of this new law, under Chapter Five , certain incomes are exempted from income. Article 115 of this law states:

""In determining the taxable income for any tax year, the following shall be exempted from tax:

1. Dividends received by the establishment, Omani company or permanent establishment from shares, allotments or shareholding it owns in the capital of any Omani company.

2. Profits or gains from the disposal of securities listed in the Muscat Securities Market."

The position that emerges from the above is that dividends are includible in the total income of the taxpayer in Oman but is specifically excluded by virtue of a special provision in the law. In terms of Article 25(4) read with article 25(2) of the India-Oman tax treaty , India is obliged to grant a credit in respect of the tax that would have been payable but for the tax incentives granted under the laws of Oman and which are designed to promote economic development of Oman.

We may note that the India-Oman tax treaty came into force on 1996. The domestic tax law of Oman was changed in 2000.

The Principal CIT took the view that the tax sparing clause is applicable only if the income concerned was excluded as part of the tax incentives designed for the development of Oman. The question was whether the exemption of the dividend was part of a tax incentive, a term that is not defined in the treaty. Therefore, the PCIT reasoned that in terms of Art 3(2) of the tax treaty, its meaning can be ascertained from the domestic law of India. But the term is not defined even under the Income Tax Act.

The PCIT took the view that the tax incentive refers to income which would otherwise be taxable but has not been taxed with a view to promote economic activity in certain sectors or in the economy as a whole. He was of the opinion that any income which is not taxed at all as per the tax laws cannot be construed as an incentive; that the Omani Companies Income Tax Law vide Article 8(bis) exempts dividend income from taxation in Oman and this cannot be interpreted as an incentive as it exists across the board with no exceptions in Oman. It is simply a feature of Oman's Tax Law that does not tax dividend income. Hence, according to the PCIT, it cannot be construed as an incentive granted under Oman's tax laws.

The PCIT held that the Royal Decree 28/2009, which came into force w.e.f. 01-01-2010 makes the position very clear and reiterates the position of exemption of dividend income provided for in the Article 8 of old Royal Decree 68/2000. The Royal Decree of 2009 also provides for incentive only for a period of five years and that in the case of the taxpayer that period has elapsed long back.

The taxpayer objected to the show cause notice given by the PCIT both on the ground that the issue was examined by the AO after going through all the legal and factual provisions and hence the recourse to section 263 was not justified.

The PCIT also noticed some discrepancy in the accounting of the dividend in the books that need not detain us here.

He noticed that article 118 of the Royal decree No 28 of 2009 states as follows:

""Income that accrues to an establishment or Omani company from the following activities carried on as their main business, except management contracts and project execution contracts, shall be exempted from tax:

1. Industry in accordance with the aforementioned Law for Unified Industrial Organization of Gulf Cooperation Council Countries.

2. Mining in accordance with the aforementioned Law of Mining. 48 Income Tax Law

3. The export of locally manufactured or processed products.

4. The operation of hotels and tourist villages.

5. Farming and processing of farm products including animals and the processing or manufacturing of animal products and agricultural industries.

6. Fishing and fish processing, farming and breeding.

7. University education, college or higher institutes, private schools, nurseries or training colleges and institutes.

8. Medical care by establishing private hospitals. Exemption from tax shall be for a period of five years beginning from the date of commencement of production or of the business, as the case may be. The exemption may be renewed, if necessary, for a further period not exceeding five years, provided that the renewal shall be made by a decision issued by the Minister in accordance with the regulations decided by the Financial Affairs and Energy Resources Council.".

The PCIT took the position that this provision in the law is the one that should be construed as the one meant for promoting the economic development of Oman and not the general exemption given to dividends of all companies/establishments. Therefore, his direction to the AO was that the share of profit of KRIBHCO other than dividends should be included in its income but tax sparing credit should be given in respect of income, if any as mentioned in the said article 118.

On appeal by the taxpayer against the order of the PCIT u/s 263, the Tribunal found that the AO has in earlier years and even for the current year had called for all the details and after examining the relevant laws specifically granted the tax sparing credit. Considering umpteen number of case laws, the tribunal held that the order of the PCIT could not be upheld on procedural grounds alone. Besides, even if the proposition that res judicata is not applicable in tax cases is accepted, the principle of consistency had to be followed and since the tax officer had consistently held that the taxpayer had a PE in Oman with which the dividends were effectively connected, the taxpayer was rightly given the benefit of tax sparing in terms of Article 25(4) of the tax treaty.

The Tribunal could have given the relief on that ground alone. For the sake of completeness however, the tribunal also considered the issue on merits as well and went into an analysis of the treaty provisions and their interpretation.

According to the Tribunal, the crucial issue to be examined is whether the dividend income was granted exemption in Oman with the purpose of promoting economic development. It noted that the exemption was granted under Article 8(bis) of the Omani Tax Laws that has been clarified and explained vide letter dated 11.12.2000 issued by the Sultanate of Oman, Ministry of Finance, Secretariat General for Taxation, Muscat, the main points of the same were:

(a) Under Article-8 of the Omani Tax Laws, dividend forms part of gross income chargeable to tax.

(b) As a result, investors in tax exempt companies that undertake activities considered essential for the country's economic development suffered a tax cost which had the negative impact.

(c) The Company Income-tax Law of 1981 was therefore amended by Royal Decree No.68/2000 by insertion of a new Article 8 (bis).

(d) Thereby the Government of Oman would achieve its main objective of promoting economic development by attracting investments.

(e) Tax would be payable on dividend income if not for the tax exemption provided under Article 8(bis).

(f) As the introduction of Article 8(bis) is to promote economic developments in Oman, the Indian investors should be able to obtain relief in India under Article 25(4) of the Agreement for Avoidance of Double Taxation.

According to the ITAT, the interpretation of Omani Tax Laws can be clarified only by the highest tax authorities of Oman and such interpretation given by them must be adopted in India. Further, in the tax assessments made in Oman in respect of the PE of the assessee-society it is clearly mentioned that the dividend income which is included in the gross total income is, however, exempt in accordance with Article 8(bis) and such exemption is granted with the objective of promoting economic developments within Oman by attracting investments. Therefore, on merits also the assessee-society was entitled to tax credit in respect of deemed dividend tax which would have been payable in Oman.

The order of the Tribunal has now been endorsed both by the High Court and also the Supreme Court. The High Court has observed that if the tax department had any doubts, it could have approached for clarification from Oman. The SC has observed that having accepted that the taxpayer had a PE and was getting the benefit of art 25(4) for a number of years, there is no reason that a different view should be taken now.

The result of the arrangement adopted by the taxpayer and now endorsed by the courts is that the taxpayer earns crores of dividends from a foreign company. It does not pay any income tax on the said dividends in Oman. But by claiming that the dividend received in Oman is effectively connected with a PE, the taxpayer managed to claim a tax sparing credit to the extent the tax is alleged to have been spared by Oman. It is true that the Omani authorities had issued a certificate to the effect that the dividend was included in the total income of the PE in Oman and then excluded from its total income. But It has also not categorically given a finding that the dividend was effectively connected with the PE although it did say that the taxpayer could claim the benefit of article 25(4).

The Tribunal and the higher courts were right in pointing out that the CIT could not have invoked the provisions of section 263 since there was application of mind by the AO after calling for and considering the clarifications given by the taxpayer, but it would have been better not to deliberate on the substantial aspect of tax sparing credit.

Besides, nobody seems to have noticed that in order for the dividends to be effectively connected to business, there must be some business activity by the PE. The PCIT has indeed pointed out that the alleged PE has only one employee and its activities were auxiliary in nature.

The ITAT did not consider (nor was it effectively argued before the tribunal or the higher fora) that various abuses involving the sparing credit and also involving the use of permanent establishments for merely managing investments have been noticed and that some specific observations have been made both in the OECD and the UN Model Commentaries in this regard. In particular, we may note the following observation in regard to article 10(4) by virtue of which dividend is considered effectively connected with a PE and hence suffers the normal rate of tax on business rather than the lower rate albeit on the gross basis on the dividends declared:

""32. It has been suggested that the paragraph could give rise to abuses through the transfer of shares to permanent establishments set up solely for that purpose in countries that offer preferential treatment to dividend income. Apart from the fact that the provisions of Article 29 (and, in particular, paragraph 8 of that Article) and the principles put forward in the section on ""Improper use of the Convention" in the Commentary on Article 1 will typically prevent such abusive transactions, it must be recognised that a particular location can only constitute a permanent establishment if a business is carried on therein and, (…), that the requirement that a shareholding be ""effectively connected" to such a location requires more than merely recording the shareholding in the books of the permanent establishment for accounting purposes." (Paragraph 21 of the UN Model Commentary (2021) on article 10(4), quoting from paragraph 32 of the OECD Model, 2017)

Oman obviously offers preferential treatment to dividend income in that no tax is charged at all and the alleged PE's function in Muscat as discussed by the PCIT being negligible, the abovesaid observation should have been considered. One therefore only hopes that this case is not used a precedence in other cases.