The entitlement of partnerships to the benefits of a double taxation avoidance agreement [“DTAA”] is a contentious issue. The main reason is asymmetry in the manner in which partnership income is taxed in the two Contracting States – India, for example, in certain circumstances taxes the income of a partnership in the partnership’s hands, but the Contracting State with which it has a DTAA (for example the UK) may tax such income in the hands of the partner directly, treating the partnership as “fiscally transparent”. In such cases, it is possible that the entity assessed in the UK does not qualify as a “person” or a “resident” under (typically) articles 3 and 4 of the DTAA. A consequence of this is that the income of a partnership from the same transaction may be taxed in the United Kingdom (in the hands of its partners) and in India (in the hands of the partnership), India taking the view that those “liable to tax” in the UK are not assessed in India, and those who are assessed in India are not liable to tax in the UK.
The question whether a partnership firm is a “resident” is a more complex issue than whether it is a “person”. In general, there are two approaches to this problem. The OECD’s view is that a partnership is not a resident under article 4 if it is treated as transparent in the State of residence, but that the source State (India, in our example) must extend the benefit of the treaty to the individual partners, in respect of their share of the partnership income. In the leading Indian decision on the point, Linklaters v ITO, this solution has been rejected. In an elaborate judgment that repays study on a number of important questions of international tax law, Pramod Kumar, AM gave two reasons for the conclusion that the partnership firm is itself entitled to the benefit of the treaty. The first was that it is the fact of taxation that is significant, and not its mode, and that if the “entire income” of the firm is taxed in the hands of its partners, the firm is itself a “resident” under article 4. The second was that India defines “liable to tax” more widely than does the OECD, which (virtually) makes fiscal transparency a non-issue. This, of course, is because the Supreme Court, in Azadi Bachao Andolan, held that the words “liable to tax” “by reason of domicile…” refer to the right of a State to tax a person on those yardsticks (as Pramod Kumar, AM, has put it in a subsequent case, a “locality-related attachment”). Whether the State exercises the right or not is irrelevant, as is the fact that the assessee is not even a taxable entity in the other Contracting State. While the view the AAR took in Cyril Eugene Pereira was incorrect, the Supreme Court’s approach goes further than the generally accepted international view (see, for example, Mr Baker QC’s Commentary at ¶4B.06). In Linklaters, the Tribunal held that the UK partnership, on this view of “liable to tax”, was a UK resident and entitled to the benefit of the treaty.
Significantly, the question whether a partnership is a “person” for the purposes of a treaty did not arise in Linklaters, because of specific provisions in the India-UK treaty. In a ruling given earlier this week in Schellenberg Wittmer, the Authority for Advance Rulings has held that a Swiss partnership firm which was engaged by an Indian party in relation to a foreign arbitration was not entitled to invoke the India-Switzerland DTAA, because it is not a “person”. The definition of “person” in the 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)”. Unfortunately, the AAR, with respect, appears to have overlooked one point: that the words “which is taxable under the laws in force…” qualify the words “or any other entity” but not the words “individual, company, a body of persons”. There are two reasons in support of this construction: (i) that there is no “comma” after the words “other entity”, and the word “which” is used to describe the class to which the following words were intended to apply; and (ii) the words “other entity” imply that "individual, company, a body of persons” are deemed to be entities, perhaps on the assumption that these entities are taxable under the laws in force in the Contracting States. If this were not the case, the treaty would not use the word “other”, and there is no room for applying an independent taxability analysis to the three designated entities.
The AAR also rejected the alternative argument (based on the OECD Model) that the partners are entitled to invoke the Swiss treaty if a “partnership” is not considered a “person”, for the reason that India has entered a reservation, and because what India seeks to tax is not the income the partner derives from the partnership, but the income the partnership derives from India. With respect, the second reason does not appear to be correct, because the rationale for the OECD’s view is that the source State must take into account the residence State’s characterisation of a partnership – if the partnership is transparent, there is no distinction between the income of the firm and the income derived by the partners from the firm. The AAR would also have had to consider whether this reasoning is consistent with the Supreme Court’s approach to “liable to tax”, since there was a finding in this case that the individual partners were also residents of Switzerland.
Ultimately, two questions arise when any court or tribunal asked to decide whether a partnership is entitled to the benefit of a DTAA is this:
- Is the definition of “person” in the treaty in question qualified by a residence taxability condition as to both “body of persons” and the residuary class? If the answer is in the negative, the partnership is a “person”.
- Is the partnership “liable to tax” under article 4? The answer, applying Azadi Bachao Andolan, is that it always is (as the Tribunal points out in Linklaters, though it may be that the Supreme Court perhaps did not envisage this consequence of its “liable to tax” analysis when it decided Azadi). If Azadi is distinguished on this ground, the question is whether the treaty applies to the partnership because of the fact/mode analysis, or to the individual partners.