The fundamental principle of treaty law is that treaties are binding on the parties to them and must be adhered to in good faith. This rule is known in legal terms as pacta sunt servanda and is arguably the oldest principle of international law. This basic rule was reaffirmed in article 26 of the 1969 Vienna Convention on the Law of Treaties and thus underpins every international agreement. One of the enduring problems facing courts and tribunals both in domestic and international law contexts is the question of interpretation. Articles 31-33 of the Vienna Convention set out to a certain extent the manner of interpretation in three doctrines. These three doctrines focus on, in turn:
doctrine one ? the actual text of the agreement and the analysis of the words used;
doctrine two ? the intention of the parties adopting the agreement when resolving ambiguous provisions ? this can be termed the subjective approach as distinct from the objective approach of the previous doctrine; and
doctrine three ? the object and purpose of the treaty is considered the most important context against which the meaning of any particular treaty provision should be measured ? this third doctrine adopts a wider perspective than the other two.
The International Court noted in the Competence of the General Assembly for the Admission of a State to the United Nations case that the "first duty of a tribunal, which is called upon to interpret and apply the provisions of a treaty is to endeavour to give effect to them in their natural and ordinary meaning in the contract in which they occur".
India's position vis-à-vis double tax treaties and the Income Tax Act 1961
In CIT v Visakapatnam Port Trust it was held that: "In view of the standard OECD models, which are being used in various countries, a new area of genuine "international tax law" is now in the process of developing. Any person interpreting a tax treaty must now consider decisions and rulings worldwide relating to similar treaties (British Tax Review [1978] p394). The maintenance of uniformity in the interpretation of a rule after its international adaptation is just as important as the initial removal of divergences [1938] ALL ER 122 (CA)." Therefore, judgments rendered by courts in other countries or rulings given by other tax authorities are relevant.
A treaty, through its parliamentary mandate, has the same authority as internal law in India. It is considered a special provision. It overrides general provisions on the basis of the doctrine generalia specialibus non derogant, which means that a special provision dealing with a particular subject overrides the general provisions contained in a particular law. This rule is also established by the Central Board of Direct Taxes, Circular No 333, which states that in the case of a conflict between the treaty and the Indian Income-Tax Act 1961 (hereafter referred to as the Act), the assessing officer should give effect to the provisions of the treaty. The beneficial impact of the treaty is also established by the provisions of section 90 of the Act, which reinforces the principal that the provisions of the treaty or the Act ? whichever are more beneficial to the taxpayers ? should be applied.
The beneficial aspect of treaty provisions can be found in the functional philosophy of a tax treaty, which is to aid international trade and commerce, and which aims to provide a fiscal tool to ensure that economic double taxation of the same income is avoided, that proper credit for taxes paid is given to the taxpayer, provisions for resolving uncertainties, exchange of information, etc is established, and that each contracting state gets its fair share of tax revenues.
However, the binding nature of a treaty and the extension of the principle of benefit of interpretation supra cannot limit the sovereign power of parliament. This power thus extends not only to the enactment, but also to the termination of a treaty. A treaty is entered into pursuant to the power conferred on the government by section 90 of the Act. Subsequent legislation cannot be controlled by the treaty. This principle is well established by the Supreme Court of India in Gramaphone Co of India v Birendra B Pandey AIR 1984 SC 667: "National Courts cannot say ?yes' if Parliament has said no to a principle of international law. National Courts will endorse international law, but not if it conflicts with national law. National Courts being organs of the National State and not organs of International Law must perforce apply national law, if international law conflicts with it. But the Courts are under an obligation within legitimate limits to so interpret the Municipal Statute as to avoid confrontation with the comity of Nations or well established principles of international law. But if the conflict is inevitable, the latter must yield."
Based on the above reasoning, it is possible to analyze the provisions of article 9 of the Indian double tax treaty and sections 92-92F of the Act dealing with the transfer pricing code, with special reference to associated enterprises.
Article 9 ? associated enterprises and section 92A of the Act
Article 9 of the OECD Model Convention is identical to article 9 of the UN Model Convention (for more information go to www.oecd.org)
The OECD Model Convention commentary states that the principle behind article 9 is that it provides powers for the taxation authorities of a contracting state to rewrite the accounts of an enterprise if, due to special relations between it and the other enterprise, the true taxable profits cannot be determined. This article is more commonly referred to as providing transfer pricing rules, thus permitting adjustments to be made to determine an arm's-length price, so that a state can collect its fair share of taxes. This adjustment is called for only when the special relationship results in the associated enterprises not recording transactions according to an arm's-length standard. The commentary states that: "It is evidently appropriate that adjustment should be sanctioned in such circumstances and this paragraph calls for very little comment."
The commentary further states that the Committee on Fiscal Affairs Report on Thin Capitalization also concluded that the national rules on thin capitalization and the provisions of article 9 have to be read in harmony, as long as the goal is to set the profits of the borrower at an amount that would correspond to an arm's-length situation. The report further concluded that the article is relevant not only when determining whether the rate of interest charged is at arm's length, but also whether the principal is a loan or should be regarded as another kind of payment, eg equity contribution. Further, the goal of the rules should always be to tax profits as arm's-length profits.
The commentary states that the OECD Guidelines on Transfer Pricing and Multinational Enterprises represent internationally agreed principles and provide valid guidelines for the application of the arm's-length principle, which underlines the article.
The part of the commentary relating to domestic law says that the reversal of the burden of proof or presumptions of any kind, which are sometimes found in domestic laws, are consistent with the arm's-length principle. Thus the article by no means bars the adjustment of profits pursuant to national laws under conditions that differ from the article, and has the function of raising the arm's-length principle at treaty level. Further, the majority of member countries consider that additional information requirements, which would be more stringent than the normal requirements or even a reversal of burden of proof, would not constitute discrimination within the meaning of article 24.
Vogel's commentary and other authors have stated that the only legal basis for profit adjustments between associated enterprises is, therefore, rules set out under domestic law. Further, the treaty merely restricts, rather than generates, domestic law. Thus article 9 by itself cannot be an independent legal basis for upward income adjustments, without the necessary legislation and rules being incorporated into domestic law.
However, article 9 does not indicate how profits are to be attributed and how the subsequent adjustment amount or the profits after inclusion of the adjustment amount are to be taxed. This is left to domestic law to frame the necessary legislation and rules to determine the methodology for arriving at an arm's-length price.
The Us Treasury Department's Technical Explanation states that the internal law provisions relating to adjustments between related parties would be applicable as long as they follow the arm's-length standard set out in article 9 of the treaty.
This methodology of reverting to domestic tax law has been approved by the Indian tax courts, eg in the case of computing the profits attributable to a permanent establishment, the computation of business profit would have to be made in accordance with the provisions of the Income Tax Act 1961. Thus, the deductions available, the rate of tax and other allied matters would be as per the Income Tax Act, rules, etc.
The definition of associated enterprises in section 92A(1) of the Act is materially the same as that found in article 9 of the UN and OECD model treaties. The commentary to the model treaties makes it clear that the main element in these relationships is effective control, which is also the standard for the purposes of section 92A(1)(a) of the Act. Further, the new code contained in sections 92-92F of the Act, which deal with the transfer pricing regulations, is commensurate with the standard laid down in article 9 as regards arm's-length price. The treaty and the Act lay down the underlying principle that the associated enterprises must adhere to the arm's-length standard.
Thus, there is no dichotomy between the provisions of sections 92-92F of the Act and article 9 of the model treaties, as can be seen from the commentary and comments of authors mentioned above. The definition of associated enterprises contained in section 92A(1) of the Act and article 9 of the treaty is wide enough to cover all cases of ?control' and, hence, the deeming provisions contained in section 92A(2) of the Act are only illustrative of control and do not limit section 92A(1) of the Act.
The test of association is similar, and article 9 of the model treaty is no narrower than that of section 92A(1) of the Act. The main principle is that the adjustments to be made to the accounts of the related parties must reflect the arm's-length standard, which is the common thread running through the transfer pricing provisions of the Act and the treaty. Thus, while applying the provisions of article 9, recourse should be made to the provisions contained in domestic law, ie sections 92-92F of the Act. This principle has been explained in the commentary to the model treaties and the explanation given by the IRS when explaining the provisions of the treaties signed between the USA and other countries. Further, recourse to domestic law will have to be made, as the methodology to be applied for arriving at the arm's-length standard is set out in detail by the provisions of the domestic Act, rules, etc. The requirement for adherence to the arm's-length standard is also contained in article 7 (business profit) and articles 10-12 of the treaty, ie dividends, interest and royalties.
To summarize, article 9 of the treaties authorizes the contracting states to rewrite the accounts of associated enterprises to affirm an arm's-length standard, so that each contracting state can earn its fair share of tax revenues. However, for this to take place, there should be detailed provisions in the domestic laws of the contracting states to effect such adjustment, ie transfer pricing adjustments. This is based on the principle that a tax treaty does not provide an independent legal basis for increasing a tax liability, rather it merely authorizes the legislature of each contracting state to enact legislation permitting such adjustments. This was the decision in two cases of March 12 1980 and January 21 1981 of the Bundesfinanzhof, Germany.
Further, the other principle is that tax treaties exist to relieve double taxation and do not impose a higher tax burden than exists under domestic law (German decision). But once there is a detailed framework in domestic law for making such an adjustment, then to give full meaning and a harmonious interpretation to article 9, the provisions of the law as contained in the Act should be followed to determine the true profits that are taxable in India in the hands of the associated enterprise, and the documentation and other procedures should be strictly adhered to as is the case in the US under section 482 of the Internal Revenue Code and allied rules. Further, recourse can also be made to article 3, paragraph 2 of the treaty, which states that a term not defined in the treaty shall have the meaning assigned to it in domestic law. Thus the examples of control given by section 92A(2) of the Act could become applicable.
The above interpretation may also hold true in the case of other countries where detailed provisions and rules regarding transfer pricing have been incorporated into the domestic tax law of the respective country.
Guidance is also available from the US Treasury Department's Technical Explanation to the US Model Income Tax Convention as regards transfer pricing legislation: "The Contracting States preserve their rights to apply internal law provisions relating to adjustments between related parties .... such adjustments .... are permitted even if they are different from, or go beyond those authorized by paragraph 1 of Article 9 as long as they accord with the general principles of paragraph 1, i.e. that the adjustment reflects what would have transpired had the related parties been acting at arm's length."
Thus, while the US Treasury states that it accepts an arm's-length limitation, it also states that the US regulations are consistent with the OECD guidelines.
Thus, to conclude, the Indian legislation affirms the arm's-length standard for transfer pricing adjustments as laid down in article 9 of the UN and OECD model conventions. A similar article is also to be found in all the treaties signed by India. The Indian tax code dealing with transfer pricing legislation, which is found in sections 92-92F of the Act and the rules would thus form the legal framework for the application of transfer pricing law. The requirement for adherence to the arm's-length standard is to be found in section 92(1): "Any income arising from an international transaction shall be computed having regard to the arm's length price".
Section 92F(ii) defines arm's-length price as "a price which is applied or proposed to be applied in a transaction between persons other than associated enterprises, in uncontrolled conditions".
Reference can also be made to Regulation 1.482 (1)(b)(1) of the US Internal Revenue Code: "In determining the true taxable income of a controlled taxpayer, the standard to be applied in every case is that of a taxpayer dealing at arm's length with an uncontrolled taxpayer".
The important rule to be deduced is that the domestic law of each country must have a detailed legal framework, guidelines, rules, etc for transfer pricing law. Further, these should be founded on the principle of an arm's-length standard akin to that of the OECD and UN model conventions. Then the application of domestic law provisions to the adjustments to be made to transactions between associated enterprises, ie related parties, could be said to be appropriate under the applicable treaty standard internationally.
