Understanding Fiscally Transparent Entities in International Tax Treaties

[Eshaan Singal]

Introduction

In the realm of international taxation, the concept of fiscally transparent entities (FTEs) plays a pivotal role, particularly when navigating the complexities of Double Taxation Avoidance Agreements (DTAAs). Fiscally transparent entities, such as partnerships and certain types of trusts, do not themselves pay taxes on their income. Instead, the income is passed through to their owners, who then report it on their individual tax returns. This unique characteristic raises intriguing questions and challenges when it comes to the application of DTAAs.

DTAAs are bilateral treaties designed to prevent the same income from being taxed by two different jurisdictions, thereby promoting cross-border trade and investment. However, the treatment of FTEs under these agreements can be complex and varies significantly between countries. The primary issue revolves around the determination of tax residency and the eligibility of these entities to claim treaty benefits.

This article delves into the intricacies of how FTEs are treated under DTAAs, examining key judicial precedents, the OECD Model Tax Convention, and specific provisions within various treaties. By exploring these elements, we aim to provide a comprehensive understanding of the challenges and opportunities that fiscally transparent entities face in the international tax landscape.

Judicial Precedent

In the case of GENERAL MOTORS COMPANY USA VERSUS ACIT, CIRCLE INTERNATIONAL TAXATION 1 (3) (1) , DELHI - 2024 (9) TMI 523 - ITAT DELHI, the Delhi bench of the Income-tax Appellate Tribunal (ITAT) held that a US Limited Liability Company (LLC), electing to be treated as a disregarded entity for US tax purposes, is entitled to the benefits of the India-US DTAA. The Tribunal concluded that the US LLC qualifies as a ‘person’ and meets the ‘liable to tax’ requirement under Article 4 of the India-US DTAA.

Facts of the case:

The taxpayer is a LLC incorporated in Delaware, USA. It has chosen to be treated as a disregarded entity, meaning it is not considered separate from its owner for US tax purposes.

• For the assessment years 2014-15 and 2015-16, the taxpayer earned income classified as ‘Fees for Technical Services’ or ‘Fees for Included Services.’ This income was taxed in India at 15%, as per Article 12 of the India-US DTAA.

• The taxpayer provided a Tax Residency Certificate (TRC) issued by US tax authorities, along with Form 10F, to claim benefits under the India-US DTAA.

• However, the tax officer denied the DTAA benefits, arguing that the LLC was a fiscally transparent entity and not directly subject to tax in the US. The officer then applied a 25% tax rate under section 115A of the Income-tax Act, 1961.

• The Dispute Resolution Panel supported the tax officer's decision, leading the taxpayer to appeal the case to the Delhi bench of the Tribunal.

Revenues Allegations:

Based on the taxpayer’s own admission, the Revenue argued that the taxpayer is classified as a fiscally transparent entity under US tax laws. As a result, its income is not subject to tax in the taxpayer’s own hands in the US.

The Revenue denied the benefits of the India-US DTAA to the taxpayer for two primary reasons:

• Non-qualification as a Resident under Article 4 of the India-US DTAA: The Revenue asserted that such LLCs do not meet the definition of a ‘Resident’ under Article 4 of the India-US DTAA. According to the Revenue, only persons who are ‘liable to tax’ under the laws of their country can be considered residents for the purposes of the India-US DTAA. In this case, since the income earned by the taxpayer is not directly taxed in the US, the taxpayer does not qualify as a resident of the US under the provisions of the DTAA. The Revenue's position was that liability to tax is a prerequisite for accessing treaty benefits, and the LLC’s status as a disregarded entity means it is not liable to tax in the US in its own capacity.

• Exclusion from Special Provisions for Tax Transparent Entities: The Revenue further contended that LLCs do not fall within the scope of the specific provisions in paragraph 1(b) of Article 4 of the India-US DTAA. This paragraph outlines the criteria for determining tax residency for fiscally transparent entities such as partnerships, estates, and trusts. Since LLCs are not explicitly mentioned in these provisions, the Revenue argued that the LLC cannot avail of the benefits under these special rules applicable to other tax transparent entities.

In support of its argument, the Revenue referred to paragraph 8.4 of Article 4 of the OECD commentary on the Model Tax Convention. This commentary explains that when a country treats a partnership as fiscally transparent for tax purposes, and taxes the partners on their share of the partnership's income, the partnership itself is not considered ‘liable to tax.’ Consequently, it cannot be considered a resident of that country for treaty purposes. The Revenue drew an analogy between this OECD commentary and the treatment of the taxpayer, asserting that since the taxpayer, as an LLC, is fiscally transparent, it is similarly not ‘liable to tax’ and therefore cannot be considered a resident of the US.

In conclusion, the Revenue maintained that the income earned by the taxpayer should be subject to a tax rate of 25% under section 115A of the Income-tax Act, 1961, instead of the 15% rate claimed under the DTAA.

Assessee’s Proposal:

The taxpayer argued that, under US domestic tax law, a LLC has the option to either be taxed as a corporation or be treated as a disregarded entity. When classified as a disregarded entity, the income of the LLC is attributed to its owner, and the owner is responsible for paying taxes on that income in the US. Therefore, while the LLC itself does not pay tax, its tax liability is effectively discharged by its owner in the US.

The taxpayer emphasized that the term ‘liable to tax’ is not specifically defined under the India-US DTAA and, accordingly, referenced the following interpretations:

• OECD Commentary 2017 on Article 4: The taxpayer cited the OECD's guidance, which states that a person can be considered ‘liable to tax’ under a country’s tax laws, even if the country in question does not impose an actual tax. The important factor is the individual or entity’s potential liability to comprehensive taxation, rather than the payment of taxes themselves.

• Commentary by Professor Philip Baker: The taxpayer also referenced the commentary by tax expert Professor Philip Baker, who noted that the requirement to be ‘liable to tax’ does not necessarily imply that tax has to be paid by the person or entity. Instead, it is sufficient that they are subject to tax under the jurisdiction's laws, even if no actual tax payment occurs.

Based on these interpretations, the taxpayer contended that the term ‘liable to tax’ refers to being subject to tax in a country, and whether tax is actually paid or not is irrelevant. Therefore, even though the LLC’s owner pays the tax on the income and not the LLC itself, the taxpayer should still be regarded as ‘liable to tax’ under US law.

The taxpayer also supported its position by relying on key judgments from various judicial authorities:

• Hon’ble Supreme Court of India in the case of UNION OF INDIA AND ANOTHER VERSUS AZADI BACHAO ANDOLAN AND ANOTHER - 2003 (10) TMI 5 - SUPREME COURT: The taxpayer referenced a decision by the Supreme Court of India, where the court observed that, for the purposes of applying Article 4 of a DTAA, what matters is the legal liability to taxation, not whether taxes have actually been paid. This decision reinforced the principle that the existence of a tax liability is more important than the physical payment of tax.

• Mumbai ITAT in the case of LINKLATERS LLP VERSUS ITO (INT’L TAXATION) - 2010 (7) TMI 535 - ITAT, MUMBAI: The taxpayer cited a ruling by the Mumbai bench of the Tribunal, which concluded that although the methods of taxation may vary across different jurisdictions, the important factor is whether the income is taxed in the country of residence. In a case involving a fiscally transparent UK partnership, the Tribunal held that as long as the income was taxed in the partner's home country, the benefits of the DTAA should not be denied.

Regarding the Revenue's second contention that Article 4(1)(b) of the India-US DTAA specifically addresses the residency of tax-transparent entities—covering partnerships, estates, and trusts but not LLCs—the taxpayer made the following counter-arguments:

• Historical Context of the DTAA: The taxpayer argued that when the India-US DTAA was executed in 1989, it was based on the 1981 US Model Convention. At that time, US tax law did not recognize single-member LLCs as disregarded entities for tax purposes. The concept of disregarded LLCs was only introduced in US tax law in 1996. Therefore, disregarded LLCs were not contemplated when the DTAA was signed.

• US Model Convention Technical Explanation: The taxpayer further pointed out that the technical explanation of the US Model Convention, issued by the US Internal Revenue Service (IRS), clarifies that the DTAA provisions are intended to prevent fiscally transparent entities from claiming treaty benefits when their owners are not taxed on the income in their country of residence. However, this guidance also suggests that, in general, fiscally transparent entities are eligible to be treated as residents who can claim DTAA benefits, provided their income is taxed in the hands of their owners.

• Ambulatory Approach to Treaty Interpretation: The taxpayer argued that an ambulatory approach should be applied when interpreting the India-US DTAA. This means that the interpretation should be based on the prevailing legal definitions under US tax law at the time the treaty is applied, rather than at the time the treaty was signed. Consequently, since US tax law now recognizes disregarded LLCs, a US LLC should be treated as a resident eligible to claim benefits under the India-US DTAA.

In light of these arguments, the taxpayer contended that, as a US tax resident, it should be entitled to the benefits of the India-US DTAA. Accordingly, the taxpayer should not be subject to the 25% tax rate under section 115A of the Income-tax Act, 1961, but rather to the 15% rate prescribed under the DTAA.

Tribunal’s Decision:

The Tribunal carefully examined the taxpayer's reliance on Publication No. 3402 issued by the US Department of Treasury, Internal Revenue Service (IRS), which outlines the tax treatment of a LLC with a single member that is classified as a disregarded entity. According to this publication, the income of such an LLC is reported on the income tax return of its owner, making the income earned by the LLC liable to tax in the United States. Thus, even though the LLC itself does not file a separate tax return, its income is still subject to taxation through its owner.

Additionally, the Tribunal noted that the taxpayer had submitted a TRC issued by the IRS to support its claim for benefits under the India-US DTAA. The taxpayer further referred to the instructions for Form 8802 (which is used to apply for the TRC), which clarify that fiscally transparent entities, such as LLCs, that do not have any US partners, owners, or beneficiaries are not entitled to receive a TRC. The fact that the IRS issued a TRC in this case demonstrates that the LLC was recognized as meeting the requirements for tax residency.

The Tribunal highlighted a significant point regarding the TRC. When the IRS issues such a certificate, it verifies that a fiscally transparent entity (such as an LLC) has complied with the requirement to file an information return, and that its partners, members, owners, or beneficiaries have reported their income on their tax returns as US residents. This issuance of the TRC by the IRS in the present case provided strong evidence that the taxpayer was eligible to claim DTAA benefits.

The Tribunal also addressed the LLC’s ability to elect its tax classification—either as a corporation or as a disregarded entity. This flexibility in classification was seen as additional support for the taxpayer’s position that the LLC is ‘liable to tax’ in the US. When an LLC chooses to be treated as a disregarded entity, it remains ‘liable to tax’; however, the tax is imposed on its owner, as the LLC’s income is attributed to the owner, who is responsible for paying the tax.

In its final analysis, the Tribunal determined that the Revenue had erred on two key points:

• Regarding the LLC's status as a person liable to tax in the US: The Tribunal rejected the Revenue’s assertion that the taxpayer was not liable to tax, even though the Revenue had acknowledged the LLC’s status as a fiscally transparent entity. The Tribunal ruled that the Revenue had failed to recognize that the taxpayer qualified as a US resident under Article 4 of the India-US DTAA.

• On the application of Article 4(1)(b) of the India-US DTAA: The Tribunal disagreed with the Revenue’s conclusion that the LLC was excluded from the special provisions governing the taxation of fiscally transparent entities under Article 4(1)(b). The Tribunal pointed out that this clause provides specific guidance on tax transparency for entities such as partnerships, but the LLC was wrongly excluded from consideration under these provisions.

The Tribunal concluded that the TRC issued by the IRS effectively demonstrated that the taxpayer met the criteria to be considered a US resident under Article 4 of the India-US DTAA. The fact that the LLC’s income was included in the tax return of its owner, who discharged the tax obligation, meant that the LLC was ‘liable to tax’ in the US. This tax liability, attributed to the owner, satisfied the requirements of the DTAA.

Furthermore, the Tribunal emphasized that the intent of the India-US DTAA should take precedence, particularly regarding the recognition of fiscally transparent entities as being ‘liable to tax.’ The Tribunal referenced Article 4(1)(b), which excludes certain partnership income from DTAA benefits if the income is not ‘subject to tax’ in the US (either in the hands of the partnership or the partners). However, the Tribunal clarified that an exclusion provision can only exclude something if it was initially included. This reasoning led to the conclusion that fiscally transparent entities, such as the LLC in this case, were inherently considered ‘liable to tax’ under the India-US DTAA.

Based on this reasoning, the Tribunal concluded that the disregarded US LLC was eligible to claim the benefits of the India-US DTAA, as it qualified as a person ‘liable to tax’ in the US. Therefore, the LLC should be regarded as a resident of the US and entitled to the benefits under the DTAA.

Conclusion

This ruling marks a pivotal moment for US LLCs and other fiscally transparent entities operating in India. By affirming their eligibility for benefits under the India-US Double Taxation Avoidance Agreement (DTAA), the ITAT has broadened the interpretation of tax treaties, paving the way for greater inclusivity. This decision is likely to influence future litigation and shape tax planning strategies for cross-border businesses, allowing them to utilize treaty benefits even when classified as fiscally transparent.

In a global landscape where tax authorities increasingly emphasize transparency and compliance, this judgment reflects a growing trend toward recognizing substance over form. It highlights the shift toward fair taxation of international businesses, prioritizing the true nature of taxation over legal technicalities. Moving forward, multinational corporations must reassess their structures to ensure they are positioned to take advantage of favorable treaty provisions, regardless of technical classifications.