ELIGIBILITY OF PARTNERSHIP FIRMS FOR TAX TREATY BENEFITS - AN INDIAN PERSPECTIVE [RECENT TRENDS AND UNRESOLVED ISSUES] INTRODUCTION - With increasing global trade and investment, there is a strong need for protection of the growing number of cross border business structures from double taxation. Such activities that generate income may be carried out though various types of entities. Every developed country provides for a number of different types of entities, which feature more or less unique characteristics compared to corresponding bodies in other countries. From an international perspective, there is an almost endless variety of business vehicles and other bodies through which such activities can be conducted 1. Thus, the eligibility of partnership firms for tax treaty benefits has been a controversial area over the past few years. The conditions for eligibility of benefits under the DTAA are provided in Article 1 of the DTAA. These definitions in various DTAAs have other conditions to be fulfilled including the need for the entity to be a person and resident of the contracting states. Such conditions may not be fulfilled in certain cases and controversies arise due to the asymmetry in the manner in which partnership income is taxed in the two contracting states 2. For instance, India taxes the income of a partnership in the partnership s hands, but the Contracting State may tax such income in the hands of the partner directly, treating the partnership as fiscally transparent. In this connection, it is essential to note that the primary purpose of two countries entering into a DTAA is to avoid double taxation of same income and that should be adhered to in its interpretation. Kruthika Prakash, Advocate, Madras High Court. 1 Jesper Berenfeld, TAXATION OF CROSS BORDER PARTNERSHIPS: DOUBLE TAX RELIEF IN HYBRID AND REVERSE HYBRID SITUATIONS, IBFD, 2005. 2 http://indiacorplaw.blogspot.in/2012_08_01_archive.html Last Seen on 13th October 2016.
To deal with this type of economic double taxation, there are different mechanisms. First, the OECD mechanism provides that the source state should rely upon the characterization in the state of residence. Secondly, Indian courts have adopted a constructive approach by interpreting the DTAA to solve the issues arising out of asymmetry. Thirdly, there is an attempt to provide solutions through protocols. My attempt is to doctrinally and normatively analyse the recent trends in India and highlight the unresolved issues. The paper proceeds as follows: PART I, the introductory part, is a brief discussion on the controversy surrounding eligibility of cross-border partnership firms for treaty benefits with an analysis of hybrid and reverse hybrid situations. PART II is an overview of the OECD position on the entitlement of treaty benefits to partnerships in a cross border system. PART III is a note on the Indian approach and an attempt to analyse the unresolved issues. PART V is the concluding part. PART I CROSS BORDER TAXATION OF PARTNERSHIPS AND ECONOMIC DOUBLE TAXATION A. TAX TREATIES AND DOUBLE TAXATION Double taxation occurs when the same income is taxed more than once. 3 The main reason for double taxation may be attributed to cases of dual taxation, where both the country of residence and country of source have the right to tax. This occurs due the principles that govern taxation of income, namely, residence, source, and citizenship and the varying conception of the same. 4 This setup may result in double taxation or double non-taxation for the taxpayers. 5 The policy reason for residence taxation of income is the need for contribution towards the public services provided for them by the country where they live, on all their global income. Source taxation 3 Supra Note. 1 Pg. 48. 4 Arnold, McIntyre, International Tax Primer, (2002), p.15. 5 Roy Rohatgi, Basic International taxation, Kluwer Law International(2002).
is justified by the view that the country which provides the opportunity to generate income or profits should have the right to tax it. 6 Thus, from a policy perspective it is important to note that the interests of multiple stakeholders have to be balanced when dealing with cross-border taxation. It is pertinent to note that double taxation can involve juridical as well as economic double taxation. The phenomenon of international juridical double taxation can be generally defined as the imposition of comparable taxes in two (or more) states on the same taxpayer in respect of the same subject matter and for identical periods 7. In contrast, economic double taxation takes place if assets are attributed to different persons by the domestic law of the states involved 8. This dichotomy occurs when the tax law of one state attributes the asset to its legal owner while the tax law of the other state attributes it to the person in possession or control. Asymmetrical classification of entity and income result in economic double taxation. In this context, it is relevant to look into the classification of an entity. a) The person liable to tax (the owner or the entity) b) The timing of the taxation (When earned or distribution) c) The type of income and tax (Business income or dividends) and d) The person entitled to double tax relief (the owner or the entity). 9 B. Tax Treaties and Economic Double taxation Double taxation has proven to be harmful on international trade and economic relations between countries. Thus, there have been efforts to avoid double taxation through unilateral methods and bilateral methods like credit or exemption system. The purpose of double tax treaties is to ensure settlements between two countries, which include the elimination of 6 http://www.taxjustice.net/cms/upload/pdf/source_and_residence_taxation_-_sep-2005.pdf Last Seen on 7th April 2015. 7 Organization for Economic Cooperation and Development, Report of the OECD committee on fiscal affairs, MODEL DOUBLE TAXATION CONVENTION ON INCOME AND ON CAPITAL, Supra Note 2, at Para. 3 (1977)[hereinafter cited as 1977 Report]. 8 Klaus Vogel, Double Tax treaties and their Interpretation, Berkeley Law Journal, Issue 4. 9 Supra Note.1 Pg 129.
international double taxation, promotion of exchange of goods, persons, services and investment of capital. The main reason is because the interaction of two tax systems of two different countries can result in double taxation. 10 The existing system of unilateral and bilateral efforts takes care of international juridical double taxation. An economic double taxation is not directly addressed by most tax treaties. 11 As a generally accepted principle, the purpose of a tax treaty is to prevent only juridical, but not economic double taxation. 12 To provide a mechanism of relieving this economic double taxation the OECD has prepared the The application of OECD Model Convention to Partnerships 1999 which has also lead to changes in the OECD Model Convention Commentary [ Convention ]. They show that it is well within the scope and intention of tax treaties to aim at resolving economic double taxation caused by asymmetrical tax treatment and entity classificatio n. 13 Furthermore, several jurisdictions around the world including India have recognised the need for extending treaty benefits in cases of economic double taxation. 14 Scholars like Michael Lang note that the comprehensive definition of double taxation highlights that the theoretical background of the notion is unitary, even though the causes are different. 15 In this paper, I restrict myself to economic double taxation arising out of the asymmetrical treatment of an entity in two countries. This is a hybrid structure. The term hybrid entity or partnership is referred to an entity that is treated as transparent for tax purposes in one jurisdiction and as a separate taxable person in another one. 16 Three countries may also be involved when dealing with hybrid entities: [A] The country where the income is obtained 10 Sarbapriya Ray, A Close Look into Double Taxation Avoidance Agreements with India: Some Relevant Issues in International Taxation, International Affairs and Global Strategy, Vol 2, 2011. 11 Linklaters v. ITO Para 40. 12 Para 2. OECD Model;Commentary on Article 23 (2012); para 42. 13 Example 18 of the Partnership Report (The Application of the OECD Mode Tax Convention to Partnerships, para 139. 14 Micheal Lang, et.al, The OECD-Model-Convention and its Update 2014, IBFD. 15 Id. 16 Supra Note. 1
(Source country), [B] the country of entity s incorporation (Entity country) and [C] the country where the partner/s of the entity is/are resident (Partners country). There are two types of hybrid entity treatments: i. Classic hybrid, an entity is treated as corporate in its country of organization, whilst it is transparent in the country where members are resident. ii. Reverse hybrid, this is an entity regarded as corporate in the country where the members are resident, but it considered transparent in the country of organization. In this context, it may be noted that the definition of fiscally transparent entity is as below: An entity is fiscally transparent with respect to an item of income paid to the entity if: the interest holders in the entity must include in income currently their respective shares of the item, whether or not the entity distributes the item to its interest holders; and the character and source of the item of income must be determined in the hands of the interest holders as if realized directly from the source from which realized by the entity. If, under the laws of the foreign jurisdiction where the interest holder is a resident, the interest holder is not required to separately take into account each item of income, the entity is nevertheless considered to be fiscally transparent if the interest holder is required currently to take into account income items that are not separately stated, and the interest holder s tax liability for non-separately stated items would not differ had it taken such amounts into account on a separately stated basis. 17 As noted earlier, the controversy arises due to the asymmetry in the manner in which partnership income is taxed in the two Contracting States. The position of the OECD Commentary is that the partners would become liable to tax in the state of origin of the partnership. 18 Persons taxed by reason of domicile or residence or place of management are also included under the definition of persons under Article 4. Hence, the partners would become residents of the contracting state for the purposes of the Convention and therefore could claim benefits under the said Convention. India has a reservation to this to the extent that the same is provided in the treaty. 17 Jeff O'Donnel, Leslie Alston & Robert Rothenburg, IRS finalizes regulations on qualification for treaty benefits, International Tax Review 11 (2000): 65 18 Anish Agarwal, "Applicability of Double Taxation Avoidance Agreements to Fiscally Transparent Entities: An Indian Perspective" INTERTAX, Volume 39, Issue 11
India has DTAAs with several countries out of which many important jurisdictions, such as United Kingdom and Germany, treat partnerships as fiscally transparent entities. This asymmetrical treatment has resulted in various legal issues over the years in India with respect to non-resident Partnerships. The Hon ble ITAT (Mumbai) in the Linklaters case held that the non-resident partnership being treated as fiscally transparent in the other contracting state, can be considered to be a resident and hence would be entitled to treaty benefit. I will be analyzing the Indian cases in Part III. Before elaborating on the Indian approach I will provide a brief overview of the OECD approach. PART II - OECD APPROACH In 1992, the OECD formed a Working Group to study the application of the Model Tax Convention to partnerships, trusts, and other non-corporate entities. It was analysed that many of the problems that were brought to the attention of the Committee arose from so-called "conflicts of qualification" - cases resulting from differences in domestic law. 19 Article 1 of the Convention provides that the Convention shall apply to persons who are residents of one or both of the contracting States i.e. the States which are the parties to the Treaty. Further, Article 3 of the Convention states that the term person includes an individual, a company and any other body of persons. Therefore, for a partnership to avail the benefits of the Convention, is required to be treated as a person as defined under Article 2 of the Convention. Further, Article 4 of the Convention provides that a person is considered as a resident of a contracting state where such person is liable to tax therein by reason of his domicile, 19 The Partnership Report (The Application of the OECD Mode Tax Convention to Partnerships, page 7.
residence, place of management or any other criteria of similar nature, and includes that State and any political sub-division or local authority thereof. Hence, a fiscally transparent entity may be treated as not liable to tax in a contracting State and be denied being treated as a resident of that State. To deal with such a situation the OECD proposes a solution in Para 8.8 of OECD Model Tax Convention 2010. It states that: 8.8 Where a State disregards a partnership for tax purposes and treats it as fiscally transparent, taxing the partners on their share of the partnership income, the partnership itself is not liable to tax and may not, therefore, be considered to be a resident of that State. In such a case, since the income of the partnership flows through to the partners under the domestic law of that State, the partners are the persons who are liable to tax on that income and are thus the appropriate persons to claim the benefits of the conventions concluded by the States of which they are residents. This latter result will be achieved even if, under the domestic law of the State of source, the income is attributed to a partnership which is treated as a separate taxable entity. For States which could not agree with this interpretation of the Article, it would be possible to provide for this result in a special provision which would avoid the resulting potential double taxation where the income of the partnership is differently allocated by the two States. In 1999, OECD released a report on the Application of the OECD Model Tax Convention to Partnerships. The Partnerships Report analyses the application of the Convention to partnerships by providing eighteen examples covering various situations. Though the report has left out a few situations and clarity on a few types of entities it is yet comprehensive. The Report contains a comprehensive analysis of a wide variety of possible fact situations which may be faced in cross border taxation of partnership dealing with both bilateral and triangular situations. From a perusal of the report, it becomes clear that the report lays more burden on the source state to gather sufficient information while applying the treaty.
PART III INDIAN POSITION, ANALYSIS, APPLICATION AND SUGGESTIONS A. INDIAN POSITION India is not a member of OECD. However, as a non-member, India has been invited to provide its views on the model tax convention on which it is unable to agree with the text of an Article or with an interpretation given in the commentary. As far as partnerships are concerned, India s position is as below: Gabon, India, Ivory Coast, Morocco and Tunisia do not agree with the interpretation put forward in paragraphs 5 and 6 of the Commentary on Article 1 (and in the case of India, the corresponding interpretation in paragraph 8.8 of the Commentary on Article 4) according to which if a partnership is denied the benefits of a tax convention, its members are entitled to the benefits of the tax conventions entered into by their State of residence. They believe that this result is only possible, to a certain extent, if provisions to that effect are included in the convention entered into with the State where the partnership is situated. Thus, India will permit treaty benefits to a partner of a fiscally transparent entity of the other contracting state, as long as India s tax treaty with that contracting state includes such a provision. Linklaters LLP v. ITO In the case of Linklaters LLP v. ITO 20, the Mumbai ITAT looked into whether the treaty benefits were available to the partners of a partnership firm which had income sourced from India. In this matter, the partnership was a fiscally transparent entity in the UK and the income from India was taxed in the hands of the partners under UK domestic tax laws. The assessee did not have a branch in India. It rendered legal services to certain clients whose operations extended to India. These services were rendered partly from the UK and at times, 20 Linklaters LLP v. ITO, [2012] 132 TTJ (Mum.).
by partners and staff visiting India. During the financial year under consideration, the assessee s partners/staff were present in India for more than 90 days. The assessee disclosed nil taxable income in Indian tax return by claiming treaty benefit and by contending that it has no PE presence (including service PE) in India. The same were rejected by the income tax officer and CIT (appeals). On appeal to the tribunal, it looked into the question of assesses entitlement to the benefits of the India-UK treaty before addressing the question of permanent establishment. The controversy revolved around the meaning of liable to tax under the definition of resident. (There was no controversy surrounding the definition of person as it was specifically provided in the India-UK tax treaty. 21 The Tribunal adopted a purposeful interpretation and held as below [Para 71] Viewed in the light of the detailed analysis above, in our considered view, it is the fact of taxability of entire income of the person in the residence State, rather than the mode of taxability there, which should govern whether or not the source country should extend treaty entitlement with the Contracting State in which that person has fiscal domicile. In effect thus, even when a partnership firm is taxable in respect of its profits not in its own right but in the hands of the partners, as long as entire income of the partnership firm is taxed in the residence country, treaty benefits cannot be declined. The in my opinion, the court has rightly applied the decision of the Supreme Court in Azadi Bachao Andolan. 22 At present, to resolve the issue at the treaty level, a protocol was introduced (presently clarified and affirmed by the CBDT by its circular in February 2016 23 ) under the India-UK tax treaty which has modified Article 4 which specifically deals with partnership firms. Under the modified Article, the tax treaty benefits will apply to income derived by a partnership firm to the extent such income is taxed in the UK in the hands of its partners. 21 Para 24. 22 Union of India & Anr. v. Azadi Bachao Andolan & Am. 263 ITR 706. 23 Circular No. 2/2016, dated 25 February 2016.
Pre-Linklaters Prior to the decision of the Mumbai ITAT in Linklaters, there were several other related controversies before ITAT and AAR especially on the scope of liable to tax. In an initial decision in Mohsinally Alimohammed Rafik 24, the claimant resided in Dubai and claimed the benefit of the UAE convention of April 29 1992 even though there was no personal income tax in Dubai to which he might be subject to tax. The AAR concluded that he was entrusted to the benefits of the convention. The authority subsequently reversed this position in the case of Cyril Eugene Pereira 25, holding that an individual could not be a resident of a state where he was not subject to taxation. It concluded that an individual who is not liable to pay tax under the UAE law cannot claim any relief from the only tax on income which is payable in India under the agreement and that the provisions of the Double Taxation Avoidance Agreement do not apply to any case where the same income is not liable to be taxed twice by the existing laws on both the Contracting States. Dr. Philip Baker notes that the ruling in Cyril Eugene Pereria is clearly beyond the international practice 26. He notes that there is a clear distinction between liable to tax and subject tax, which was clearly ignored by the Indian AAR ruling. It seems clear that a person does not have to be actually paying tax to be liable to tax, otherwise a person who had deductible losses or allowances which reduced his tax bill to zero, would find himself unable to enjoy the benefits of the convention 27. 24 Mohsinally Alimohammed Rafik, In re [1995] 213 ITR 3171. 25 Cyril Eugene Pereria, In re [1999] 239 ITR 6501. 26 Philip Baker QC, DOUBLE TAX CONVENTIONS at 4B.06. 27 Id. 4B.05.
In ADIT v. Green Emirates Shipping & Travels 28, the question was entitlement of the India UAE tax treaty benefits to UAE resident who do not have to pay income tax but are liable to tax. The Tribunal held that actual payment of tax in one of the contracting States is not a condition precedent to avail the benefits of DTAA in the other Contracting States because the tax treaty prevents not only 'current' taxation but also potential' double taxation. Thus, this clearly highlighted that there is a difference between liable to tax and subject to tax. Post Linklaters Divergent Decisions In Asst. DIT v. M/s Chiron Bhering GmbH & Co 29, the Bombay High Court in the case of held that treaty benefit under India and Germany tax treaty cannot be denied to the limited partnership which pays trade tax under the tax treaty and is a taxable unit under the laws of Germany. The court held that the OECD commentary does not govern the applicability of a tax treaty and the provisions of the treaty. In DIT v. AP Moller Maersk 30, the Bombay Tribunal relied on provisions of the OECD Commentary on Double Taxation Avoidance Agreements as well as the decision Linklaters, to hold that it was the taxability of the income in the resident State, rather than the mode of taxability, which should govern eligibility to treaty benefits. Therefore, even though a partnership firm may be a fiscally transparent entity, as long as its profits were taxed in the hands of its partners in the resident country, benefits of the tax treaty could not be denied to the partnership. 28 ADIT v. Green Emirates Shipping & Travels (100 ITD 203). 29 DIT(IT) v. Chiron Bearing Gmbh & Co. (2013) 351 ITR 115. 30 (2015) 235 Taxmann 513.
On the other hand, the Authority for Advanced Ruling in Schellenberg Wittmer 31 held that a Swiss partnership firm which was engaged by an Indian party was not entitled to invoke the India-Switzerland DTAA, because it is not a Person. The definition of "Person" in the Swiss treaty is as below The definition of person in the India-Swiss treaty is: (d) the term person includes an individual, a company, a body of persons, or any other entity which is taxable under the laws in force in either Contracting State; The AAR held that a partnership, which was treated as transparent under Swiss domestic law, is not a person because it is not taxable under the laws in force in either Contracting State (Switzerland). This decision of the AAR as some writers point is clearly not consistent with the approach of the court in linklaters to liable to tax. B. UNRESOLVED PROBLEMS i. LINKLATER S SOLUTION WOULD NOT BE USEFUL IN A CERTAIN SITUATION The decision in Linklater s case raises questions regarding India s approach to the interpretation of the term liable to tax in tax treaties with other countries where the latter treats the partnership firm as a fiscally transparent entity. The solution provided in Linklaters would fail in a situation, where its partners are not residents of the same country as the partnership and where the partnership is in itself fiscally transparent. In such a case, the taxation of the entire income of the fiscally transparent partnership firm is not taxed in the country of its organisation. Further, since the partners of the partnership are not taxed in that country as residents, it would be difficult to conclude that the test of fiscal 31 Schellenberg Wittmer, In re [2012] 24 taxmann.com 299.
domicile is met in that country. The solution under Linklaters will not apply in triangular situations. 32 ii. INDIAN CONSTRUCTIVE APPROACH FAILS IN CERTAIN SITUATIONS In some cases the constructive approach adopted by the Indian judiciary in cases like Linklaters will fail and treaty benefit will have to be denied due the language of the treaty. For instance, when we look at the definition of Person in the various DTAAs entered by India, it becomes clear that the wordings are slightly different. For example: India-Austria DTAA - the term "person" has been defined to include an individual, a company and any other entity which is treated as a taxable unit under the taxation laws in force in the respective Contracting States; India-Swiss Treaty - the term "person" has been defined to include an individual, a company, a body of persons, or any other entity which is taxable under the laws in force in either Contracting State It may be observed that the former (India-Austria) does not include the terms Body of persons. Thus, the argument that partnership would fall under the head body of persons (if raised by the assessee) would fail in the case of India-Austria DTAA. The constructive interpretation of the Indian courts will not be sufficient to deal with such situations. There is a need for a change at the treaty negotiation level. iii. OECD approach is more stable INDIAN JUDICIAL APPROACH CAN LEAD TO INTERPRETATION ERRORS AND DIVERGENT RESULTS. 32 http://www.nishithdesai.com/fileadmin/user_upload/pdfs/research%20articles/cross%20border%20taxation %20of%20Partnerships.pdf Last seen on 13 th October 2016.
In attempting to solve economic double taxation, the Indian judiciary has used a constructive approach. This approach can lead to interpretational errors and divergent results. For instance, in Shellenberg whitmer the AAR in my opinion erred in trying to reconcile the definition of person under the India Swiss DTAA vis-à-vis the domestic laws of India and Switzerland, having read Article 3(1)(d) together with Article 4(1) of the said DTAA. In a DTAA to be applicable, a person has to be a resident of one of the Contracting States which are parties to the DTAA. The definition of person under Article 3(1)(d) of the India- Swiss treaty required the entity to be taxable in either Contracting State 33. Being a partnership, the firm is a taxable entity under Section 2(31)(iv) of the (Indian) Income Tax Act, hence it will be covered under the ambit of the term person under the India Swiss DTAA. Therefore, the finding of the AAR that the firm was not a taxable entity under Swiss domestic law is an interpretational error. PART IV - CONCLUSION It should be recalled that the commentaries to the OECD MTC expressly establish that the convention is designed to deal with the elimination of international juridical but not economic double taxation 34. The objective of my paper was to elucidate the underlying reasons for the potential difficulties arising in asymmetrical situations from a theoretical perspective. The question whether double taxation in asymmetrical situations is in fact relieved will depend on the details of the individual double tax convention or the domestic laws. There is a strategic need for providing treaty benefit to avoid double taxation. Thus, it is established that treaties have to interpreted so as to prevent double taxation. Constructive approach aims at removing double taxation 35. However, when such an interpretation is not possible due to strict treaty 33 http://www.taxsutra.com/experts/column?sid=77 Last Seen on 13 th October 2016. 34 M Lang, THE APPLICATION OF THE OECD MODEL TAX CONVENTION TO PARTNERSHIPS, (2000), p.29. 35 Hindalco Industries Ltd vs ACIT (94 ITD 242).
provisions the only alternative would be to enter into negotiations with the countries for necessary changes in the treaty. Thus, only the combined efforts of the judiciary and the policy makers would provide solutions to resolve economic double tax controversies.