The Mumbai Authority for Advance Rulings (AAR) in the case of ABC, In Re AAR Nos. 1358, 1359, 1360, 1361 & 1362 OF 2012  125 Taxmann 293, denied tax treaty benefits to a fiscally transparent entity as it did not qualify as a taxable entity in the Netherlands, considering that it was not a “resident of a contracting State” as a “person” under Article 4 of the India–Netherlands tax treaty (tax treaty).
Further, investors, although tax residents of the Netherlands, making indirect investments through regulated funds, or the custodian absent a taxable or resident entity in the Netherlands, cannot claim benefits under Article 13(5) of the tax treaty.
The Applicants are investors in the Fund entities (Funds) incorporated in the Netherlands registered with the Indian capital market regulator. The Funds are established as “funds for joint account” but are not a separate legal entity under Dutch law, since it is a contractual arrangement between the fund manager, custodian and investors. The custodian is a registered tax resident in the Netherlands acting on behalf of the Funds holding legal title to such investments for the investors.
Income and gains derived by such Funds are attributed and taxed in hands of the investors in their respective proportion. Additionally, the Funds are not regarded as a taxable entity under Dutch tax law, being specifically excluded from the list of “taxable person” definition. Income of the Funds is distributed to the investors as per their participation on the date of payment or transferred collectively decided by the custodian and the investment manager of the Funds.
The Applicants of the Funds filed their tax return disclosing income distributed as capital gains at the applicable rate of 25% in the Netherlands. Considering the taxability of capital gains arising from alienation of shares, the Applicants referred the case to the AAR for evaluating whether:
- income arising to the Funds from investment in securities of the investors is a revocable transfer and if the contributions are not revocable then is income arising to the Funds assessed as representative taxpayer under Indian domestic tax law;
- the Applicants as tax residents of the Netherlands are eligible to claim capital gains tax benefit under Article 13 of the tax treaty;
- the custodian of the Funds is resident under Article 4 and eligible for tax treaty benefits acting on behalf of the Applicants to claim exemption under Article 13(5) of the tax treaty;
- the investors of the Funds are residents of the Netherlands under Article 4 of the tax treaty considering that they are taxpayers in the Netherlands.
The Applicants argued that transfer of interest under the Master Fund management and custody arrangement entitles them to terminate or reduce interests in the Funds by exchanging their participations for a selling price as revocable in nature. Applying the concept of revocable transfer, income earned by the Applicants from indirect investment in India makes it directly assessable in the hands of the Applicants.
Accordingly, the investors being Dutch tax residents holding a tax residency certificate (TRC) qualify as a tax residents of the Netherlands under Article 4 of the tax treaty and this entitles them to claim treaty benefits.
The Applicants also contended that Indian capital market regulations do not permit them to hold more than 10% interest in Indian securities, hence the Applicants are construed as Netherlands tax residents under Article 4 of the tax treaty, as eligible for capital gains tax benefit arising from transfer of the Indian company shares and regarded as taxable only in the Netherlands under Article 13(5) of the tax treaty.
Alternatively, the Applicants also argued that as the custodian as trustee of the Funds is assessable as a representative taxpayer of the Applicants’ income received on behalf of or for the benefit of the Applicants, accordingly treating income earned indirectly by the Applicants from the Funds as taxable in the hands of the custodian in the same and like manner to the extent as the Applicants qualifying for tax treaty benefit under Article 13(5) of the tax treaty.
The Applicants, arguing the above proposition, applied the rationale of the Linklaters LLP case where the Tribunal had concluded that a U.K.-based partnership firm is treated as transparent in the U.K. and treats its members as eligible for treaty benefits. Accordingly, the Applicants emphasized that the Funds, investors or custodian being taxable entities in the Netherlands, received income is taxable only in the Netherlands as per Article 13(5) of the tax treaty and is not taxable in India.
The Revenue, relying on the following premise, contested that the Applicants could not access tax treaty benefits, as:
- although they had a TRC from the Netherlands tax authorities as being resident under Article 1 of the tax treaty, are not taxable under Dutch law, hence do not satisfy the residency test under Article 4 of the tax treaty;
- the investors are not separate and distinct entities but are one and the same, making the arrangement not recognizable under trust principles to be regarded as a representative taxpayer;
- the Funds are not a taxable entity under Dutch law, hence the benefits of Article 13 under the tax treaty are not applicable.
Legal Status of the Custodian
Under Indian domestic laws the Netherlands-based custodian cannot be regarded as a trust under Indian trust law or Dutch law, to be treated as a representative taxpayer of the Applicants. Accordingly, the AAR observed that no income was accrued to the custodian and there was no issue of taxing it in the same and like manner and extent as investors. The investors are sole beneficiaries of the so-called trust arrangement and are also the settler, hence do not satisfy the essential ingredients of qualifying as an agent of the Applicants for tax treaty benefit.
Treaty Entitlement for Tax Residents
The AAR relied on Article 3(1)(e) of the tax treaty explaining the term “persons” to include an individual, a company, any other body of persons and any other entity which is treated as a taxable unit, under the tax laws. It is read with Article 4 of the tax treaty “resident of one of the States” as any person who, under the laws of a jurisdiction, is liable to tax owing to domicile, residence, place of management or any other criterion of a similar nature.
The AAR acknowledged that treaty interpretation follows the general rule of explicit language under tax treaties and can be referred to the model commentaries only in case of ambiguity, by relying on the Canada Supreme Court case of R. v. Crown Forest Industries Ltd. to confirm that the language and the intention of the taxpayers is construed on a plain reading of the treaty provision consistent with the goals and purposes of the treaty, and external reference to the model commentaries to apply rule of interpretation is made only in case of ambiguity in the language.
The AAR recognized that Indian jurisprudence interprets the law according to the letter and spirit of the law, and recognizes the importance of international commentaries in interpreting the provisions of tax treaties. In order to recognize tax treaty principles, the AAR considered that if a tax treaty intends to grant benefits then it would specifically prescribe such entities in the provisions.
Consequently, the AAR, relying on the Supreme Court cases of P. V. A. L. Kulandagan Chettiar and Azadi Bachao Andolan, confirmed that if a tax treaty provides specific provisions being unambiguous in nature, no reference may be made to the international materials, and commentaries for interpretation and model commentaries can be referred to for interpreting similar terms occurring under the domestic laws.
In the present case, the Applicants are tax resident of the Netherlands who indirectly invested in India through the Funds and this entitles them to treaty benefits only if the conditions contained in the tax treaty are satisfied. The Funds are not regarded as a taxable unit under the Netherlands tax laws, hence neither person nor resident of the Netherlands in terms of the tax treaty, thus making the Applicants not admissible for tax treaty benefits.
Taxability of a Fiscally Transparent Entity in India
On a reading of the OECD Model Commentary with the Indian position on Article 1, it was clear that where a partnership is denied tax treaty benefits its members may be entitled to treaty benefits entered by their state of residence subject to such enabling provisions as are explicitly prescribed in the tax treaty. A similar position is mutually agreed between countries like the Netherlands and U.S., Norway, U.K., Denmark, Sweden, Canada, Germany and Indonesia with India to expressly grant treaty benefits to tax transparent entities.
India has reserved its position on the OECD Model Commentary to prescribe that there is a need for an enabling provision to expressly allow treaty benefits to the beneficiaries of transparent entities, similar to Article 4 of the India-U.S. tax treaty that permits benefits to partnership firms or trusts if partners or beneficial owners are taxed on the same income, where a similar enabling provision is missing under the tax treaty. Hence, on a conjoint reading of Articles 1, 3 and 4 of the tax treaty, benefit is not available to the fiscally transparent entity since it is not regarded as a taxable entity in the Netherlands.
The AAR analyzed the Mumbai Tribunal cases of Linklaters LLP and NNIP Bewaar Maatschappij I BV, where tax transparent entities were held to be a person for tax treaty purposes, but rejected their applicability in the instant case as the Applicants were not a person or even a partnership firm within the meaning of Article 3(1)(e) of the tax treaty. Accordingly, the AAR concluded that income arising to the Applicants from indirect investment made in Indian securities is assessable in the hands of the Funds without granting any benefit attributable under Article 13(5) of the tax treaty.
The AAR further rejected the alternative claim of the Applicants to treat the transfer as revocable in nature, since it was already held that the treaty benefit is not admissible to the Fund or investors or the custodian, considering that they are clubbing provisions enacted to counter the design by the Applicants to reduce their tax liability by parting their property in such a way that the income should no longer be received by them but at the same time retaining certain powers over property/income. In the present case there was no such arrangement where the custodian can transfer income of the Applicant to some other person.
Accordingly, the Funds being registered with the Indian capital market regulator, income deriving from investments in India has accrued to them in India and is taxable under the Indian domestic tax laws without claiming any benefit under Article 13 of the tax treaty.
The taxability of capital gains of tax transparent entities is a contentious subject disputed before the Indian courts, ideally being resolved and settled based on the literal language and clauses of the applicable tax treaty. It is relevant to note that the AAR verdict carries persuasive importance for relying on the cases, and is not binding but merely acts as guidance for other taxpayers dealing with cases having identical facts.
Importantly, the AAR agreed with the OECD Model Commentary to observe that reference for interpretation can be made only in situations of ambiguity in the literal language of the treaty as manifested by the recent Supreme Court decision of Engineering Analysis Centre of Excellence Private Limited which stated that the OECD Model commentary shall merely have persuasive value for interpretation of tax treaties. Further reference can also be made to the Indian Finance Act, 2021 that now defines the term “liable to tax” in domestic direct tax law, providing that, if a taxpayer is unable to establish that it is “liable to tax” in the resident jurisdiction, it will not qualify to be a resident of that state, thus dis-entitling such taxpayers from claiming tax treaty benefits.
Separately, it is worth referring to the OECD Action Plan 2 that introduced the concept of neutralizing the effects of hybrid mismatch arrangements considering the illustration of transparent intermediaries like trusts and partnerships establishment jurisdictions, that restricts such intermediary as a taxpayer in its own right from claiming tax treaty benefits but rather it can be recognized through its underlying partners or beneficiaries. In such cases, where the establishment jurisdiction tax makes payments on an ordinary basis it should not give rise to a deduction or no income outcome under the reverse hybrid rules and can qualify for tax treaty benefits. Importantly, in the present case, as the ultimate investors were taxpayers in their residence jurisdiction, applying the analogy of the OECD Action Plan 2 at least the investors of such Funds ought to be eligible for tax treaty benefits.
As an alternative remedy, India can explore a competent authority agreement with the Netherlands to permit treaty benefits to such transparent entity.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Shailendra Sharma is a Chartered Accountant associated with a multinational financial services firm, India.