Direct Tax Laws & International Taxation · Application and Interpretation of Tax Treaties

Taxation of Passive Income under DTAAs: Dividends, Interest, Royalties and FTS

Updated 5 October 2026 · Fact-checked

Under a DTAA, dividends, interest, royalties and fees for technical services are usually taxable in the residence state and also in the source state, but the source state's tax is capped at the treaty rate. The cap applies only to the beneficial owner. To solve a question, check treaty eligibility, classify the income, read the article, compare rates, and claim the lower of treaty or domestic tax.

Understand Taxation of Passive Income under DTAAs

A DTAA (double taxation avoidance agreement) divides taxing rights between two countries. For passive income, the split is usually shared. The residence state (where the recipient lives) may tax it. The source state (where the payer is, or where the asset or activity is) may also tax it, but only up to a rate limit. The residence state then gives credit for the source-state tax.

The four articles you must know, as numbered in the OECD and UN models, are: Article 10 (dividends), Article 11 (interest), Article 12 (royalties, and in many Indian treaties also fees for technical services, often called fees for included services or FIS) and Article 13 (capital gains). Article numbering differs in some treaties, so always read the treaty given in the question.

Two ideas decide most questions. First, the treaty rate is a ceiling, not a fixed rate. If domestic law taxes at a lower rate, you apply the domestic rate. Under section 90 of the Act, the assessee gets whichever is more beneficial. Second, the cap is available only to the beneficial owner of the income. An agent, nominee or conduit that merely passes the income on to someone else is not the beneficial owner. The treaty benefit can be denied to it. Beneficial ownership is about who has the right to use and enjoy the income, not just who receives it.

For dividends, treaties usually give a lower rate where the recipient company holds a stated minimum share of the payer's capital, and a higher rate otherwise. For interest and royalties, the rate is a single cap in most treaties. FTS is covered in the royalty article in some treaties, and in others it falls under a separate article, or under business profits if no FTS article exists. Many Indian treaties also require the services to "make available" technical knowledge for FTS to be taxable at source. Where that wording exists, ordinary services that do not transfer know-how are not FTS.

For capital gains, Article 13 gives the source state the right to tax gains on immovable property located there, on movable property forming part of a PE there, and, in many treaties, on shares of companies. The rights on share gains vary by treaty, so read the clause. Gains on other assets are generally taxable only in the residence state. Some treaties contain a most favoured nation (MFN) clause, usually in a protocol. It lets a treaty partner claim a more favourable rate or scope that India later gives to a third country. Whether it applies automatically depends on the exact wording and on notification under section 90. Do not assume it applies unless the question gives or implies the clause.

Key rules to remember

Treaty vs domestic rule: Tax in source state = lower of (domestic rate, treaty rate); Apply to each income separately. Treaty relief is available only where the recipient is a resident of the treaty partner and is eligible.
Source-state tax on dividend, interest, royalty or FTS: Tax = Gross income × applicable rate (plus surcharge and cess if the rate is the domestic one); Treaty rates are usually applied on gross income and are generally not increased by surcharge and cess. Follow the instruction given in the question.
Beneficial ownership test: Treaty cap applies only if recipient = beneficial owner; A conduit, nominee or agent with no right to use and enjoy the income does not qualify.
Dividend rate tiering: Lower rate if holding ≥ stated % of payer's capital; otherwise higher rate; The percentage and the rates are treaty-specific. Take them from the question.
Capital gains allocation (Article 13): Immovable property: source state. PE movable property: source state. Shares: as per treaty. Other assets: residence state; Immovable property is taxable where it is situated. Share gains depend on the exact treaty text.
Credit in the residence state: Credit = lower of (foreign tax paid, tax payable on that income in residence state); Links to the foreign tax credit rules under the Act. The method of relief (credit or exemption) depends on the relief article of the treaty concerned.

How to solve Taxation of Passive Income under DTAAs questions

Use the same sequence for any passive income treaty question. Write each step in the answer, because marks go to the provision, facts and conclusion.

1Check treaty eligibility. Confirm the recipient is a tax resident of the treaty country, and note whether a tax residency certificate is available.
2Classify the income correctly: dividend, interest, royalty, FTS or capital gain. Look at the treaty definition, not the label the parties used.
3Check beneficial ownership. Ask who has the right to use and enjoy the income. If the recipient is a conduit, deny the treaty cap.
4Read the relevant article for the allocation: shared right with a cap, or exclusive right to one state.
5Apply any condition: minimum shareholding, make-available clause, PE link or effectively connected test.
6Compute tax at the domestic rate and at the treaty rate. Take the lower, as the assessee may choose the more beneficial one.
7State the withholding or credit consequence: tax to be deducted by the payer, and credit in the residence state.
8Conclude in one line with the amount and the reason.

Quickest way: Five-line treaty check

When to use it: Use it for MCQs and for short written parts where the treaty rate is given in the question.

Write R (resident of treaty country?) and BO (beneficial owner?). If either fails, the domestic rate applies.
Mark the income type and the article number.
List the two rates: domestic and treaty.
Pick the lower rate and apply it on gross income.
For capital gains, ask only: immovable property, PE asset or shares? Else residence state only.

Common mistakes in Taxation of Passive Income under DTAAs

Applying the treaty rate even when the domestic rate is lower.
Students treat the treaty rate as the rate to be charged.
Fix: The treaty rate is a ceiling. Compare both rates and pick the lower one.
Giving treaty benefit to a recipient that only routes the income to someone else.
The question names a treaty-country company and students stop at residence.
Fix: Test beneficial ownership separately. Look for facts such as an obligation to pass the income on and no real control over it.
Treating all technical service fees as taxable under the treaty.
Students ignore the make-available condition in some treaties.
Fix: Where the treaty has this condition, check whether knowledge, skill or know-how is transferred to the payer. If not, it is not FTS under that treaty.
Assuming gains on shares are always taxable only in the residence state.
Students remember the general rule for other assets and apply it to shares.
Fix: Read the Article 13 clause for shares in the given treaty. Many give the source state a taxing right, sometimes with a holding threshold or a grandfathering rule.
Assuming the MFN clause always applies.
Students remember the idea of MFN but skip the exact wording of the protocol.
Fix: Apply MFN only if the question gives the clause or states it applies. Note that the benefit depends on the wording and on the conditions in the other treaty.
Adding surcharge and cess to a treaty rate without being told to.
Students carry over the habit from domestic rate computations.
Fix: Show the treaty rate on gross income. State your assumption on surcharge and cess clearly if the question is silent.

Worked examples

Example 1

Alpha Inc., a company resident in Country X, holds 30% of the capital of Beta Ltd., an Indian company, and is its beneficial owner. Beta pays Alpha a dividend of ₹10,00,000. The India–X treaty caps dividend tax at 10% if the recipient company holds at least 25% of the payer's capital, and at 15% otherwise. Assume the domestic withholding rate on this dividend is 20%. What tax can India levy?

Show the solution

Eligibility: Alpha is a resident of X and the beneficial owner, so the treaty cap is available.
Income type: dividend, so Article 10 applies.
Condition: Alpha holds 30%, which is at least 25%, so the 10% cap applies.
Compare rates: domestic 20% and treaty 10%. The lower rate is 10%.
Tax = ₹10,00,000 × 10% = ₹1,00,000.

Answer: India can tax the dividend at ₹1,00,000 (10%). Country X, as the residence state, may also tax it and will give relief for the Indian tax as per the treaty's relief article (usually credit).

Example 2

Gamma Co., resident in Country Y, receives interest of ₹5,00,000 from an Indian company under a loan. Gamma is a conduit that, under a back-to-back arrangement, is obliged to pay the whole interest to Delta Co. in Country Z (which has no treaty with India), and Gamma has no right to use and enjoy the income. The India–Y treaty caps interest tax at 10%. The domestic rate is 20%. Is the treaty cap available to Gamma?

Show the solution

Eligibility: Gamma is a resident of Y, so the first condition is met.
Income type: interest, so Article 11 applies.
Beneficial ownership: Gamma must pass the full amount to Delta and has no right to use and enjoy it. It is a conduit.
Consequence: the treaty cap is only for the beneficial owner. Gamma cannot claim it.
Apply the domestic rate: ₹5,00,000 × 20% = ₹1,00,000 (before any surcharge and cess).

Answer: The 10% treaty cap is not available because Gamma is not the beneficial owner. Tax applies at the domestic rate, which is ₹1,00,000 before surcharge and cess.

Exam tips

Write the four-part structure: eligibility, classification, beneficial ownership and rate comparison. Examiners reward each step.
Read the article text given in the question carefully. Conditions such as minimum holding or make-available decide the answer.
In MCQs, check first whether the recipient is the beneficial owner. A conduit fact pattern usually means no treaty benefit.
For capital gains, name the asset type first. Immovable property, PE assets and shares each have a different allocation.
State your assumption on surcharge and cess in one line if the question does not say. It protects your marks.

Practice questions from Application and Interpretation of Tax Treaties

Taxation of Passive Income under DTAAs in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

CS ProfessionalTaxation of Income under Treaty Articles

Taxation of Passive Income under DTAAs: frequently asked questions

What is beneficial ownership in a DTAA?

The beneficial owner is the person who has the right to use and enjoy the income, free of any obligation to pass it on. A nominee, agent or conduit is not one. Treaty rate limits on dividends, interest and royalties are meant for the beneficial owner.

Is the treaty rate always applied on dividends, interest and royalties?

No. The treaty rate is a maximum. If domestic law taxes at a lower rate, the lower domestic rate applies. The assessee gets the more beneficial of the two.

What is the MFN clause in Indian DTAAs?

It is a clause, usually in a protocol, that lets one treaty partner claim a more favourable rate or narrower scope given to a third country. Whether it works depends on its exact wording and on the conditions in the other treaty. Do not assume it applies unless the question says so.

How does Article 13 tax capital gains?

It gives the source state the right to tax gains on immovable property there and on movable property of a PE there. Share gains depend on the specific treaty clause. Gains from other assets are usually taxable only in the residence state.

What is the difference between royalty and fees for technical services in a treaty?

Royalty is payment for the use of, or right to use, rights such as patents, know-how and equipment as defined in the treaty. FTS is payment for managerial, technical or consultancy services. Many Indian treaties tax FTS at source only if the services make technical knowledge available.