Fiscally Transparent Entities - Tax Treaty Benefits
Executive Summary & Core Debates
Tax treaty entitlement to fiscally transparent entities (FTEs) has been a matter of debate in the arena of international tax. The crux of this complexity lies in the divergent principles and tax practices by various nations in relation to entity characterisation rules, i.e., tax treatment of an entity as “taxable entity” or “fiscally transparent”. This article attempts to explore and highlight few issues about claiming treaty benefits by FTE.
1. What are Fiscally Transparent Entities (FTE)?
Characterisation of any entity and how a state recognises such entity is important as it may have an impact on who pays tax on the source of income – entity or owners of the entity and eventually determine who is eligible to tax treaty benefits.
Depending upon the extent of taxation, entities can be classified under two classes:
i. Single Entities / Non-Transparent (Opaque) Entities
Entities which are taxed as separate individual bodies. Tax is levied directly at the level of the entity itself. The entity is treated as a distinct taxpayer under domestic tax law.
ii. Transparent / See-Through / Flow-Through Entities (FTE)
Entities which are taxed only at the level of owners and not at the entity level. The entity’s income flows through to its owners and is assessed directly in the hands of the owners.
Some countries tax the entity as separate entities wherein tax is levied at the level of entity, such entities are referred to as single/ non transparent/ opaque entities. Whereas fiscal transparency is a concept wherein, the entity’s income flows through to its owners and is taxed in the hands of the owners. Applicability of tax treaty benefits to a fiscally transparent entity has been a matter of debate as it is not a taxable entity. OECD issued a report in 1999, “The Application of the OECD Model Tax Convention to Partnerships” (OECD report on partnership) wherein the Committee then examined the following approach to taxation of partnerships wherein partnership is not liable to tax, instead tax payable on the income of the partnership is determined at each partner’s level.
Countries where tax laws provide that income derived by a partnership from a particular source must be computed first at the partnership level as if the partnership was a distinct taxpayer. Each partner is then allocated his share of that income which retains its character and is added to his personal income for purposes of determining his taxable income. His taxable income, including his share of the partnership’s income is then reduced by the personal allowances and deductions to which he is entitled and tax is then determined, assessed and paid at the partner’s level. Therefore, the partnership is not itself liable to tax.
The fact that an “entity” is transparent for tax purposes does not mean that it is transparent for other legal purposes. Normally the entity has legal standing in respect of making contracts. Partnerships, trusts and some other body corporates such as investment funds, real estate investment trusts, Limited Liability Corporations (LLCs) etc. may be examples of fiscally transparent entities.
Illustration: Cross-Border Conflict in Partnership Characterisation
Let us understand the tax impact of partnership firms and its partners through following illustration:
- Entity & Jurisdiction: P is a partnership established in State B.
- Partners: X and Y are P’s partners who are resident of State B.
- State B Treatment: State B treats P as a transparent entity (taxes X and Y on their shares).
- Source Income: P derives royalty income from State A that is not attributable to a permanent establishment in State A.
- State A Treatment: State A treats the partnership as a taxable (opaque) entity.
2. Where are These FTEs Prevalent?
Partnership and partnership-like structures are quite popular business forms in the United States (US). US tax laws also provide for an elective system, called “Check-the-Box” rule. Under this rule, all domestic and foreign entities, which are not stock companies, can elect to be a partnership or corporation or are treated as disregarded entity for tax purposes. They can take legal forms such as C-Corporation, S-corporations, Limited Liability Company (LLC), Partnerships, etc.
Apart from the US, other countries such as Singapore, the Netherlands, the UK, Sweden etc. consider partnerships / similar entities as fiscally transparent.
The Indian Position on Partnerships & LLPs:
In India, both partnership firms and Limited Liability Partnerships (LLPs) are treated as separate taxable entities (taxed at the entity level at flat rates), and the share of profit/income from the same is exempt in the hands of partners under Section 10(2A) of the Income-tax Act, 1961.
3. FTE – Entitled to Tax Treaty Benefits?
The legal and tax structure of an entity determines its entitlement to tax treaty benefits based on the various conditions specified in a particular tax treaty. Considering that partnership is the prominent form of FTEs globally, the focal point of this discussion is surrounded around partnerships.
Let us analyse the logical flow of the articles of the OECD Model Tax Convention on Income and on Capital, 2017 (OECD MTC). Entitlement to tax treaty benefits is dependent on whether the entity is a “person” and qualifies to be a “resident” of a contracting state as per the relevant tax treaty.
Persons Covered
Applies to persons who are residents of one or both of the Contracting States.
Taxes Covered
Specifies the taxes on income and capital to which the Convention applies.
General Definitions
“Person” includes an individual, a company and any other body of persons.
Resident Definition
Any person liable to tax by domicile, residence, place of management, or similar criterion.
Step-by-Step Treaty Eligibility Criteria:
Step A: Is a partnership a “person”?
As per OECD MTC Commentary on Article 3, partnerships will also be considered to be “persons” either because they fall within the definition of “company” or, where this is not the case, because they constitute other bodies of persons.
Step B: Is a partnership a “resident of a Contracting State or liable to tax”?
After the recommendation of the OECD report on partnership and post BEPS, Action 2, “Neutralising the Effects of Hybrid Mismatch Arrangements”, the OECD commentary was amended in 2017 to specifically address the issues in claiming tax treaty benefits by fiscally transparent entities. Paragraph 2 was inserted in Article 1:
“income derived by or through an entity or arrangement that is treated as wholly or partly fiscally transparent under the tax law of either Contracting State shall be considered to be an income of a resident of a Contracting State but only to the extent that the income is treated, for purposes of taxation by that State, as the income of a resident of that State”.
Further, the objective of including the requirement, ‘liable to tax’, is to ensure that only those persons who are potentially exposed to double taxation should be given treaty protection. Since, strictly speaking, a fiscally transparent entity is not ‘liable to tax’ in its own capacity and its owners are taxed, it may be argued that a fiscally transparent entity does not meet the criteria of “resident” of the contracting state. Thereby, treaty benefits would be extended to only those owners or FTEs who qualify to be resident of that state and to the extent are liable to tax on such income.
Solution to Illustration: State A can consider the entitlement to treaty benefits to X and Y, both residents of State B, who should also be considered to be the beneficial owners of such income as these are the persons liable to tax on such income in State B.
4. India’s Position on the Eligibility of Treaty Benefits to FTE
Strict Stance & MLI Reservation:
India is of the view that when a partnership is denied treaty benefit on the grounds that it is a fiscally transparent entity, the partners are also denied treaty benefits unless there is an express provision in a tax treaty to the contrary.
It may be noted that India has reserved its right for the entirety of Article 3 of the Multilateral Instrument (MLI) not to apply to its Covered Tax Agreements; thereby, it has refuted to include paragraph 2 of Article 1 of the OECD MTC in its tax treaties.
Only very few Indian tax treaties, with the US, UK, and Sweden, contain specific provisions allowing for the granting of treaty benefits to a fiscally transparent entity through Article 4. However, countries like Austria, Singapore, Switzerland, the Netherlands, etc., where partnerships are considered as FTEs, may continue to face difficulties in claiming benefits under the Double Tax Avoidance Agreement (DTAA) with India, in the absence of express provisions for granting treaty benefits.
5. Comparative Analysis of Key Indian Double Tax Avoidance Agreements
Analysis of Articles 1, 3, and 4 across Indian tax treaties with the US, UK, Singapore, and Sweden:
| Particulars | India and US | India and UK | India and Singapore | India and Sweden |
|---|---|---|---|---|
| Article 1: Persons Covered |
Convention shall apply to persons who are residents of one or both of the Contracting States, except as otherwise provided in the Convention. | Convention shall apply to persons who are residents of one or both of the Contracting States. | Agreement shall apply to persons who are residents of one or both of the Contracting States. | Convention shall apply to persons who are residents of one or both the Contracting States. |
| Article 3: Definition of Person |
The term “person” includes an individual, an estate, a trust, a partnership, a company, any other body of persons, or other taxable entity. | The term “person” includes an individual, a company, a body of persons and any other entity which is treated as a taxable unit under the taxation laws in force in the respective Contracting States. | The term “person” includes an individual, a company, a body of persons and any other entity which is treated as a taxable unit under the taxation laws in force in the respective Contracting States. | The term “person” includes an individual, a company, a body of persons and any other entity which is treated as a taxable unit under the taxation laws in force in the respective Contracting States. |
| Article 4: Definition of Resident |
The term “resident of a Contracting State” means in the case of income derived or paid by a partnership, estate, or trust, this term applies only to the extent that the income derived by such partnership, estate, or trust is subject to tax in that State as the income of a resident, either in its hands or in the hands of its partners or beneficiaries. | The term “resident of a Contracting State” means in the case of income derived or paid by a partnership, estate, or trust, this term applies only to the extent that the income derived by such partnership, estate, or trust is subject to tax in that State as the income of a resident, either in its hands or in the hands of its partners or beneficiaries. | The term “resident of a Contracting State” means any person who is a resident of a Contracting State in accordance with the taxation laws of that State. | The term “resident of a Contracting State” means - In the case of a partnership or estate, the term applies only to the extent that the income derived by such partnership or estate is subject to tax in that State as the income of a resident, either in its hands or in the hands of its partners or beneficiaries. |
| Analysis & Entitlement | Tax treaty benefits extended to FTE or owners of FTE vide Article 4(1)(b). | Tax treaty benefits extended to FTE or owners of FTE vide Article 4(1)(b). | Article 4 does not explicitly specify that tax treaty benefit will also apply to FTE or owners of FTE. | Tax treaty benefits extended to FTE or owners of FTE vide Article 4(1). |
As evident from above, as far as India is concerned, a partnership (wholly or fiscally transparent) shall be eligible (either partnership or its partners) for relief under DTAA only if Article 1 and 4 specifically prescribes such relief.
6. Key Judicial Precedents: Global Rulings & Indian Jurisprudence
1. Anson (formerly Swift) v HMRC [2015] UKSC 44 (United Kingdom Supreme Court)
The case concerns an individual member, Mr. Anson, of a Delaware LLC. The issue was whether he was entitled to double tax relief for US tax paid on the profits of the LLC. He was taxed personally on his share of the LLC profits in the US as the US viewed the company as a transparent entity. However, HMRC in the UK viewed the LLC as a corporate entity, which had merely paid the member the equivalent of a dividend. Therefore, from the UK perspective he had not personally been taxed on the same income and so did not qualify for double tax relief. However, the UK Supreme Court allowed the treaty relief to Mr. Anson since the profits of LLC were directly taxed in his hands and LLC was treated as transparent in the US.
2. Japanese Taxation of Delaware Limited Partnership (Supreme Court of Japan, 2013 (Gyo-Hi) No. 166 – July 2015)
Taxpayers invested in a business managed by a Delaware LP which leased and ran apartments in the US. On the point whether Delaware LP was, for Japanese tax law, a separate entity or was fiscally transparent so that its income was taxable directly in the hands of the investors, the Supreme Court of Japan set out two clear criteria:
- First Test: Determine whether or not it was clear (beyond doubt) under the laws of the foreign country that the entity had a legal status equivalent to a corporation under Japanese law.
- Second Test: If unable to decide, examine the attributes of the entity to consider whether it possessed separate rights and obligations.
Contrast with Anson: In Anson, the UK Supreme Court purely relied on entity classification made in the US (country of residence), whereas the Supreme Court of Japan based its determination on entity classification in Japan (country of source).
3. Calcutta High Court in P&O Nedlloyd Ltd & Others v ADIT (WP Nos. 457 and 458 of 2005)
The taxpayer was a UK partnership between P&O Containers Ltd of the UK and Nedlloyd Lines BV of the Netherlands, operating ships in international traffic including India. Although income derived from India was taxable on non-residents under Indian domestic law, the partnership claimed exemption under Article 9 of the 1993 India-UK treaty. Tax authorities asserted that the partnership was not entitled to treaty benefits because it was not liable to UK tax. However, Article 3(2) of the 1993 treaty includes a partnership as a person if treated as a taxable entity under the Indian Income-tax Act, 1961. The Calcutta High Court regarded the partnership as a person entitled to treaty benefits under Article 9, although the decision did not address the Article 4(1) requirement of being liable to UK tax.
4. Mumbai ITAT in Linklaters LLP v ITO [2010] 40 SOT 51 (Mum)
Examined whether treaty benefits under the India-UK treaty were available to the partners of a partnership firm which had income sourced from India. The Tribunal adopted an objective approach in granting treaty benefits, ruling that benefits cannot be denied as long as the profits are taxed in the UK.
5 & 6. Statutory Resolution in India-UK Treaty & CBDT Circular No. 2/2016
With effect from 27.12.2013, the India-UK treaty addressed this problem through Article 4(1)(b), specifically granting treaty benefits to income derived by a partnership to the extent that it is taxed in the partner’s hands in the UK. Furthermore, Indian Income-tax authorities issued Circular No. 2/2016 (dated 25.02.2016) clarifying that the India-UK DTAA applies to a partnership resident in either India or the UK, to the extent that income derived by the partnership is taxed in the UK in the hands of its partners.
7. Mumbai ITAT in A.P. Møller–Mærsk (2015) 235 Taxmann 513
The Mumbai Tribunal held that the “taxability of the income” in the resident State should govern eligibility for treaty benefits. Therefore, even though a partnership firm may be a fiscally transparent entity, as long as its profits are taxed in the hands of its partners in the resident country, benefits of the tax treaty cannot be denied to the partnership.
8. Authority for Advance Rulings (AAR) in Schellenberg Wittmer
The AAR examined whether Swiss partnerships are treated as residents of Switzerland under the India-Switzerland DTAA. The AAR held that since the partnership is not a taxable entity in Switzerland, it does not qualify to be a ‘person’ as per Article 3 of the treaty. Rebutting the Applicant’s reliance on the OECD MTC, the AAR observed that since India is not a member of the OECD, any recommendation of the OECD could be relevant to India tax treaties only if such provision is agreed to be included by both contracting states.
7. Conclusion & Unresolved Cross-Border Landscape
The OECD partnership report, OECD MTC, tax practices in each state and principles emanating out of judicial precedents have developed numerous divergent tax rules when it comes to the taxation of FTEs.
While the adoption of Article 3 of MLI – Transparent entities may resolve few issues for countries who have agreed to apply Article 1(2) of the OECD MTC, the same remains unresolved as far as India is concerned, as India has refrained from applying the same to its tax treaties. ■■■