Advanced Direct Tax Laws and Practice · Double Taxation Avoidance Agreement (DTAA)

Taxation of Income under Treaty Articles (DTAA)

Updated 11 October 2026 · Fact-checked

A DTAA divides taxing rights between the residence country and the source country, article by article. Business profits are taxed at source only through a permanent establishment. Dividend, interest and royalty usually allow limited source tax. Capital gains and other income follow their own articles. Apply the more beneficial of treaty or domestic law.

Understand Taxation of Income under Treaty Articles

A tax treaty does not create tax. It only limits or allocates the right to tax that each country already has under its own law. Each type of income has its own article, and you read the article that matches the income.

There are three broad patterns. First, exclusive right to the residence state: the income is taxed only where the person lives. Second, shared right with a cap: the source state may tax, but at a limited treaty rate, and the residence state gives credit or exemption. Third, source state taxes fully: for example, income from immovable property in that state.

Business profits (Article 7) are taxable in the source state only if the foreign enterprise has a permanent establishment (PE) there. Even then, only profits attributable to that PE are taxed. Without a PE, the profits are taxed only in the residence state.

Dividend, interest and royalty/fees for technical services are passive or service-type payments. Treaties usually let the residence state tax them and also let the source state tax at a capped rate, which varies by treaty. Often the cap applies only if the recipient is the beneficial owner. If the recipient has a PE in the source state and the payment is effectively connected with it, the article generally gives way to the business profits rules.

This matches the domestic scheme under the Income-tax Act, 2025. Section 207 applies to a non-resident (not being a company) and to a foreign company. Under section 207(1), dividend is taxed at 20%, or 10% if it is received from a unit in an International Financial Services Centre. Interest is taxed at the rates the section sets for its different kinds. Royalty and fees for technical services (FTS) are taxed at 20% under section 207(2), but only if the agreement was made after 31 March 1976 and either (a) it is approved by the Central Government, where it is with an Indian concern, or (b) where it relates to a matter in the industrial policy, it follows that policy. Income covered by section 59(1) is outside section 207(2).

Section 59 says that where the payer is the Government or an Indian concern, the agreement is with it, the assessee has an Indian PE or fixed place of profession, and the right or contract is effectively connected with it, the income is computed as business profits instead. Compare the treaty rate with the domestic rate and use the lower tax outcome, if the treaty conditions are met.

Capital gains (Article 13) follow the nature of the asset. Gains on immovable property are generally taxed where the property is. Gains on movable property of a PE are taxed at the PE's location. Gains on shares may be taxed at source or only in the residence state, depending on the treaty. Residual income falls under Other Income, usually taxable in the residence state.

Key rules to remember

Business profits rule: Source state taxes only if PE exists, and only profits attributable to the PE; No PE means taxable only in the residence state. Check the PE test first.
Capped source tax on passive income: Tax at source = lower of (domestic rate, treaty rate), where treaty conditions are satisfied; Treaty applies only if it is more beneficial. Beneficial ownership and residence status must be shown.
Domestic rates under section 207(1) and (2): Section 207(1): dividend 20%; dividend from an IFSC unit 10%. Section 207(2): royalty 20%; FTS 20%, only if the agreement is post-31 March 1976 and approved or as per industrial policy, and the income is not within section 59(1); Section 207 applies to a non-resident (not a company) or a foreign company. Plus applicable surcharge and cess where relevant.
Effectively connected income: Royalty/FTS effectively connected with an Indian PE or fixed place → computed as business income under section 59(1); All four conditions of section 59(1) must be met: payer, agreement, PE or fixed place, effective connection.
Capital gains allocation: Immovable property: where situated. PE movable property: PE location. Shares and others: as per treaty article; Treaties differ on shares. Read the specific article.
Relief in residence state: Foreign tax credit ≤ residence-state tax on that income; Credit cannot exceed the tax payable on the same income in the residence state.

How to solve Taxation of Income under Treaty Articles questions

Use this order for any written question on treaty taxation. It keeps your answer in the provision, analysis, conclusion format.

1Identify the facts: who is the recipient, where is it resident, who is the payer, what is the nature of income.
2Classify the income under the correct treaty article: business profits, dividend, interest, royalty, FTS, capital gains or other income.
3Check threshold conditions: tax residence, treaty eligibility, beneficial ownership, and whether a PE exists and the income is effectively connected with it.
4State the treaty rule: which state may tax and whether there is a cap on source tax.
5State the domestic rule, for example section 207 rates, and section 59 where a PE is involved.
6Compare and choose the more beneficial of the two. Compute the tax on the rupee amount given.
7Conclude clearly, mention the relief method in the residence state, and note compliance such as a tax residency certificate if relevant.

Quickest way: Article-first triage

When to use it: Use when time is short and the question gives a table of payments to a foreign person.

Tag each payment with its article in one word: BP, Div, Int, Roy, FTS, CG, Oth.
Ask one question for each: is there a PE and is it connected? If yes, treat as business profits.
If no PE, write the treaty cap and the domestic rate side by side.
Take the lower rate, apply it to the amount and total the tax.
Write one line on conditions: residency certificate and beneficial ownership.

Common mistakes in Taxation of Income under Treaty Articles

Applying the treaty rate even when the domestic rate is lower
Students assume a treaty always reduces tax.
Fix: A treaty is applied only where it is more beneficial. Compare the two rates every time.
Taxing business profits without checking for a PE
Students jump to the rate and forget Article 7 gives source taxing rights only through a PE.
Fix: Make the PE test your first line in any business profits answer.
Ignoring effective connection for royalty and FTS
Students treat royalty as always taxed at the treaty cap.
Fix: If the right or contract is effectively connected with an Indian PE, the income is business profits. Section 59(1) lists four conditions.
Claiming treaty rates without beneficial ownership or residence proof
Students focus on rates and skip eligibility.
Fix: State that the recipient must be a resident of the treaty country and the beneficial owner, with a tax residency certificate.
Allowing expenses against income taxed at the flat rates under section 207
Students apply normal business computation rules.
Fix: Section 207 allows no deduction under sections 28 to 58, 60, 61 and 93 when computing the income under sub-sections (1) and (2). This covers dividend and interest as well as royalty and FTS. The gross receipts are taxed.
Treating all capital gains alike
Students remember one rule and apply it to every asset.
Fix: Classify the asset first: immovable property, PE movable property, shares or others. Then read the relevant article.

Worked examples

Example 1

A foreign company with no PE in India receives ₹50,00,000 as dividend from an Indian company. Domestic rate under section 207(1) is 20% (ignore surcharge and cess). The treaty caps source tax on dividends at 15% for beneficial owners. The company holds a tax residency certificate and is the beneficial owner. Compute the tax in India.

Show the solution

Income is dividend, so the dividend article applies.
No PE exists, so the business profits rules do not apply.
Domestic rate under section 207(1), Sl. No. 1, is 20%. The treaty cap is 15%.
The treaty is more beneficial and its conditions are met, so 15% applies.
Tax = 15% × ₹50,00,000 = ₹7,50,000.
Under domestic law it would have been 20% × ₹50,00,000 = ₹10,00,000, so the treaty saves ₹2,50,000.

Answer: Tax in India is ₹7,50,000 at the treaty rate of 15% (before surcharge and cess).

Example 2

A non-resident company with a PE in India receives ₹20,00,000 royalty from an Indian concern under an agreement. The right is effectively connected with the PE. Expenses wholly and exclusively incurred for the PE and attributable to this royalty are ₹6,00,000. Another ₹1,00,000 was paid by the PE to its head office, not as reimbursement of actual expenses. How is the royalty taxed?

Show the solution

Check section 59(1): payer is an Indian concern, there is an agreement, the company has a PE in India, and the right is effectively connected with the PE. All conditions are met.
So the royalty is computed as business profits, not under the flat rate of section 207.
Under section 59(2), no deduction is allowed for amounts paid by the PE to its head office otherwise than as reimbursement of actual expenses. The ₹1,00,000 is disallowed.
Deductible expenses are the ₹6,00,000 wholly and exclusively incurred for the PE.
Business income = ₹20,00,000 − ₹6,00,000 = ₹14,00,000.
The company must keep books of account and get them audited under section 59(4) (read with sections 62 and 63). The ₹14,00,000 is taxed under the head Profits and gains of business or profession, at the rates in force for the assessee.

Answer: The royalty is taxed as business income of ₹14,00,000 under the head Profits and gains of business or profession (section 59), at the rates in force for the assessee. The ₹1,00,000 head office payment is not deductible.

Exam tips

Begin every answer by naming the article and the income type. Examiners reward correct classification.
Always show the PE test and the effective connection test in business profits and royalty questions.
Write the domestic rate and the treaty rate side by side, then state which is applied and why.
Quote section 207 and section 59 conditions accurately. Cite them only for what the text says.
If the treaty rate is not given in the question, do not guess one. State the rule and use the rate provided.

Practice questions from Double Taxation Avoidance Agreement (DTAA)

Taxation of Income under Treaty Articles in other exams

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

Taxation of Income under Treaty Articles: frequently asked questions

Which article taxes business profits under a DTAA?

Article 7 in typical treaties. It lets the source state tax a foreign enterprise only if it has a permanent establishment there, and only on profits attributable to that PE.

Does a treaty always give a lower tax rate than Indian law?

No. The treaty applies only where it is more beneficial than domestic law. If the domestic rate is lower, the domestic rate applies.

How are royalty and fees for technical services taxed for a non-resident?

Without a PE link, section 207(2) taxes royalty and FTS at 20% where the agreement was made after 31 March 1976 and is approved by the Central Government (for an Indian concern) or is as per industrial policy. Section 207(3) removes these conditions for royalty on copyright in a book to an Indian concern or on computer software to a person resident in India. Income within section 59(1) is excluded from section 207(2), and a lower treaty rate applies if its conditions are met. If the income is effectively connected with an Indian PE, section 59 treats it as business income.

Where are capital gains taxed under a treaty?

It depends on the asset. Immovable property gains are taxed where the property is. Gains on movable property of a PE are taxed at the PE. Shares and other assets follow the specific treaty article.