Introduction

The controversy relating to the eligibility of tax treaty benefits to fiscally transparent entities has come up before courts around the world.[1] This article recapitulates the evolution of the Organisation for Economic Cooperation and Development (‘OECD’) position, examines relevant case law on the issue and analyses the likely future judicial approach in India.

OECD Model and The MLI on Fiscally Transparent Entities: Tracing the Evolution

In 1999, the OECD released a report on the application of the OECD Model Tax Convention to Partnerships[2]. The Partnership Report analyses the application of the convention to partnerships by providing examples covering various situations[3].

In line with the Partnership Report, para 8.8 of the OECD Model Commentary 2010 to Article 4 provides that where a state disregards a partnership for tax purposes and treats it as fiscally transparent, taxing the partners on their share of income, the firm is not liable to tax and may not, therefore, be considered a resident of that state. In such a case, as the income of the partnership ‘flows through’ to the partners, they may claim benefits of the treaties concluded by the respective states in which they are resident. The result will be achieved even if, under the domestic law of the state of source, the income is attributed to an opaque partnership. However, the OECD left it to the contracting states (who do not agree with the above interpretation) to provide for resultant relief, keeping in mind potential double taxation.

With respect to this position, India did not agree with the interpretation in para 8.8 and required the inclusion of a special provision in the tax treaty to permit treaty benefits to partners of a fiscally transparent entity of the other contracting State.

In the 2017 update to the OECD Model, paragraph 2 to Article 1 has been added which indicates that the Convention applies to wholly or partly fiscally transparent entities under the tax law of either contracting States to the extent the income is treated for the purposes of taxation, as income of a resident of that contracting State. India reserved the right not to include para 2 of the Article with respect to treaty benefits to a fiscally transparent entity in its tax treaties.

Article 3 of the MLI, which embodies the recommendations of BEPS Action Plan 2, provides that income derived through a fiscally transparent entity (treated as such in either contracting State) shall be considered to be income of a resident of a contracting State only if the same is treated, for taxation purposes, as income of a resident of that state. This provision is similar to Article 1(2) of the OECD Model 2017.

It is pertinent to note that India has reserved the right for Article 3 of the MLI to not apply in its entirety to its Covered Tax Agreements. Instead, a treaty-by-treaty approach is advocated, which of course, is not free from doubts.

Indian Rulings on the issue of Fiscally transparent entities and Tax Treaty Entitlement—and A Recent Irish Ruling

In the case of Linklaters[4], the Mumbai ITAT examined whether the tax treaty benefits were available to the partners of a fiscally transparent UK partnership firm which had Indian sourced income. The Tribunal adopted a purposeful interpretation holding that it is not the mode of taxability but the fact of taxability of the entire income in the residence state, which should govern whether the source country should extend treaty entitlement with the other contracting State.

It is pertinent to note that the Linklaters case was decided prior to the inclusion of the amendment[5] to the India-UK tax treaty which includes a provision like Article 1(2) of the OECD Model 2017 (although varying in scope) that confers treaty benefits to fiscally transparent entities.

In AP Moller Maersk[6], the Mumbai Tribunal relied on the provisions of the OECD Model Commentary as well as the decision in the Linklaters case, to grant treaty benefits under the India-Denmark tax treaty.

On the other hand, the Authority for Advance Ruling (‘AAR’) in Shellenberg Whitmer, In Re,[7] denied tax treaty eligibility to a fiscally transparent Swiss partnership on the ground that such a partnership is not liable to tax in Switzerland. The correctness of the ruling is doubtful; we respectfully disagree with its reasoning for denial of claim, in the light of principles laid down by the Tribunal in the Linklaters case. In another recent ruling[8], the AAR observed that if a treaty intends to provide benefits to a fiscally transparent entity, it will specifically provide in treaty provisions and unintended conclusions cannot be drawn beyond the treaty. The AAR referred to the India-US tax treaty that includes an enabling provision to extend benefits to partners of fiscally transparent partnerships. It is pertinent to note that this decision provides reasons for the taxpayer’s non-qualification of the ‘resident’ requirement in the India-Netherlands tax treaty (albeit the reasons can be critiqued), unlike the AAR in Schellenberg Whitmer.

Recently, in General Motors (GM)[9], the Delhi Tribunal extended treaty benefits to a US LLC relying on paragraph 1(b) of Article 4 of the India-US tax treaty which recognizes partnership as a resident of the US for India-US tax treaty purposes to the extent that income derived by such partnership is subject to tax in the US as the income either in the hands of the partnership or in the hands of its partners or beneficiaries. In the GM case, the income was taxable fully in the hands of the members of the LLC. However, it is pertinent to note that an LLC is not a partnership under US law and to that extent reliance on Article 4(1)(b) of the India-US tax treaty does not seem correct[10].  

In an interesting case before the High Court of Ireland[11], the question was whether the treaty benefit of non-discrimination would be available to a US LLC to claim group loss relief. The Court held that the US LLC was not a resident of the US (as it was not liable to tax) and hence cannot claim treaty benefits. The Court relied on paragraph 8.8 of the 2010 OECD Model adopting a static interpretation approach.

Analysis and Conclusion

It is our view that the OECD Model 2010 deviates from the OECD Model 2017 as the latter includes a provision (paragraph 2 of Article 1) for extending treaty benefits to a fiscally transparent entity unlike the interpretation in the former commentary which extends treaty benefits to the extent the partners are taxed on that income (without requiring a special provision unless a contracting State disagrees with the interpretation).

As a generally accepted principle, the purpose of a tax treaty is to prevent juridical and not economic double taxation, although the OECD Model digresses from this principle in some situations[12]. The OECD Model Commentary 2010 interpretation can be classified as one such case of digression. In our view, the interpretation in the Linklaters case is correct as it interprets ‘liable to tax’ to provide tax treaty benefits in line with the object and purpose of the treaty. Further, the interpretation is in line with principles under Article 31(1) of the Vienna Convention of Law of Treaties, 1969.

However, in view of the OECD Model 2017 and the decision in the GM case (although the Court in GM case relied on the Linklaters case ratio subjecting it to the presence of Article 4(1)(b) of the India-US tax treaty), there is a possibility that Indian courts could extend treaty benefits to fiscally transparent entities only when a provision similar to Article 1(2) of the OECD Model 2017 exists (for instance India’s tax treaties with Norway, Sweden, US, UK and China[13]). An example is the 2021 AAR decision in ABC, In Re (discussed above).[14]

Furthermore, it is pertinent to note that India has committed to resolving the issue of fiscally transparent entities[15] with its treaty partners through protocols and not through MAP[16], although, in the author’s view, such an executive position is not binding on courts and appears to be inconsistent with good faith principle.[17] Since a MAP outcome is specific to a case, a legislative change or some form of administrative guidance would have been a preferred method to resolve the debate given the contentious nature of the issue at hand.

In this context, it’s worth noting that in 2021, India defined the phrase ‘liable to tax’ in the Indian Income-tax Act.[18] One of the aims of the amendment was to qualify exempt entities within the scope of ‘liable to tax’. It is pertinent to note that the phrase ‘subject to tax’ requires actual taxation of income unlike the concept ‘liable to tax’, which encompasses within its ambit exempt entities as they are fiscal residents though not being ‘subject to tax’. Although, it is interesting to note that the amendment requires liability (including any subsequent exemption) under the law of the resident country. While the words ‘liable to tax’ and ‘by reason of domicile…’ (as interpreted in the seminal decision of Azadi Bachao Andolan[19]) refer to the right of a State to tax a person on those yardsticks and whether the State exercises the right or not is irrelevant.[20] Nevertheless, to the extent the amendment extends benefits to a legally exempt entities, it doesn’t diverge from the internationally accepted difference[21] between ‘subject to tax’ and ‘liable to tax’.

Furthermore, the 2021 amendment does not specifically clarify the issue of treaty relief to fiscally transparent entities and the same is left to be determined from the language of the relevant tax treaties. Below is a table with tax treaties that extend treaty benefits to fiscally transparent entities by qualifying them as ‘residents’ subject to the condition that the income is taxed in the hands of the residents of that state.

All the above treaties (except India-China tax treaty) extend treaty benefits to fiscally transparent entities, subject to the condition of the income being ‘subject to tax’ in the hands of partners or beneficiaries. This could affect exempt entities from treaty entitlement. A generally accepted international view is that reference to the term ‘subject to tax’ has its limitations where a trust comes under the definition of a “resident” to the extent that the income or capital gains (of the trust) are taxed in the hands of the trust or of the beneficiaries[22].  Thus, even in treaties with specific provisions extending benefits to fiscally transparent entities, there could be controversies and treaty entitlement may warrant a case-by-case analysis.  

Reverting to the issue of treaties that do not house a specific provision to extend treaty benefits to fiscally transparent entities, it would be interesting to see if the seminal Linklater’s interpretation, would stand the test in future cases or if the courts insist on the need for specific provisions in the tax treaties.