Direct Tax Alert

BACKGROUND

In order to eliminate double taxation and facilitate efficient exchange of information, India has entered into Double Tax Avoidance Agreements (‘DTAA’ or ‘Treaty’) with several countries. Multilateral Instrument (MLI) was introduced as a swift and efficient mechanism for implementing Organisation for Economic Co-operation and Development (OECD) and the G20’s Base Erosion and Profit Shifting (BEPS) treaty-related measures across jurisdictions without the need to renegotiate Tax Treaties.

India signed MLI to implement Treaty-related measures on 7 June 2017 and ratified the MLI in 2019. Consequently, the DTAAs are to be read along with the MLI. Recently, the Supreme Court in Nestle’s decision has held that for any amendment in the DTAA, a notification needs to be issued (please click here to read our detailed alert on this decision). This raises a question regarding the automatic assimilation of such international instruments into the Indian legal framework.

Recently, the Mumbai Tax Tribunal¹ had an occasion to analyse whether the MLI provisions can be enforced into the Treaty without a separate notification under section 90(1)² of the Income-tax Act,1961 (IT Act). We, at BDO India, have summarised this ruling and provided our comments on the impact of this decision hereunder:

FACTS OF THE CASE

• The taxpayer company is a tax resident of Ireland, holding a valid Tax Residency Certificate issued by the Irish Revenue Authorities. It forms part of the TFDAC Group, an international aircraft leasing conglomerate.

• In the ordinary course of its business operations, the taxpayer entered into three separate dry operating lease agreements, each dated 1 February 2019, with InterGlobe Aviation Ltd. (‘IndiGo’).

• For FY 2021-22, the taxpayer filed its tax return declaring nil taxable income, claiming that lease rentals from the dry operating lease are not chargeable to tax in India under India-Ireland DTAA.

• The tax officer denied the Treaty benefits by invoking Articles 6 and 7 of the MLI, on the premise that the principal purpose of the taxpayer’s incorporation was to obtain the benefits of the India–Ireland DTAA.

• The Dispute Resolution Panel (DRP) upheld the tax officer’s observations. Aggrieved, the taxpayer preferred an appeal before the Mumbai Tax Tribunal. The Mumbai Tax Tribunal, while ruling in favour of the taxpayer, made the following observations:

MUMBAI TAX TRIBUNAL’S RULING

Applicability of Articles 6 and 7 of the Multilateral Convention

• Reliance was placed on the Hon’ble Supreme Court’s judgment in Nestlé³ wherein it was held that:

  • A DTAA, even when duly signed and ratified, does not itself become enforceable within the legal system, unless and until it is expressly brought into force through a notification issued under section 90(1) of the IT Act.

  • A separate notification must be issued to give effect to the impact of a subsequent DTAA on an earlier DTAA.

• The DTAA between India and Ireland was notified in the official gazette on 11 January 2002, while the MLI was notified on 9 August 2019. The India-Ireland DTAA has been designated as a Covered Tax Agreement for the purpose of MLI. Ireland, for its part, ratified the MLI with effect from 1 May 2019.

• Although both the India–Ireland DTAA and the MLI had been notified, the consequence/impact of the MLI on the India–Ireland DTAA was not expressly and separately notified.

• The synthesised text, which incorporates the MLI provisions into the covered tax agreement, is merely an expository compilation intended to facilitate understanding.

• Unless and until the MLI-based modifications themselves are separately notified, the synthesised text, however convenient for reference, cannot be treated as a source of enforceable law. Consequently, the Tax authorities cannot rely on the synthesised text to apply the provisions of the Principal Purpose Test.

• The OECD Commentary also acknowledges that a “synthesised text” is merely a non-binding explanatory aid; it does not, and cannot, substitute the requirement of a legally valid act of incorporation in each jurisdiction.

• Therefore, in the absence of a specific notification under section 90(1) of the IT Act incorporating Articles 6 and 7 of the MLI into the India–Ireland DTAA, the invocation of the MLI to deny the Treaty benefits otherwise available under the DTAA cannot be upheld.

Principal Purpose Test (PPT)

• Having regard to the guidance contained in the OECD BEPS Action Plan 6, it is evident that PPT is not triggered merely because a taxpayer derives Treaty benefits or has, in the course of its decision-making, considered the existence of a favourable Treaty.

• The true enquiry is whether one of the principal purposes of entering into the relevant arrangement was to obtain that Treaty benefit, divorced from genuine commercial considerations.

• The PPT in Articles 6 and 7 of the MLI cannot be read so broadly as to imply that Treaty benefits must automatically be denied in every case where the ultimate parent entity of the taxpayer is a resident in a third country.

• Reliance was placed on the Hon’ble Bombay High Court’s ruling in Bid Services⁴ wherein it was held that SPVs globally work in the same manner, and merely because the parent company of an SPV is outside the jurisdiction of the SPV, the SPV cannot be denied the protection of the DTAA between the country of its incorporation and the source country of the investment/activity.

• The taxpayer was managed by a duly licensed management company, Apex Group Limited, which is itself based in Ireland. The directors, bankers, company secretary and legal advisors of the taxpayer were all resident in Ireland.

• The taxpayer’s investment and operational arrangement with its Irish affiliate was neither transient nor artificial.

• The records clearly establish that the Irish entity was set up and maintained to carry out substantive commercial functions, was adequately staffed with personnel, incurred genuine expenditure in the ordinary course of its business, and assumed real economic risks. These are classic indicators of a bona fide commercial enterprise, rather than a mere conduit or treaty-shopping vehicle.

• Further, a letter issued by Aircraft Leasing Ireland (ALI) evidences an institutional dialogue between ALI and the Irish regulatory and tax authorities aimed at encouraging aviation business and engaging with the aviation community to foster sectoral growth.

• The existence of a robust ecosystem and an extensive Treaty network in Ireland is, in itself, a legally and commercially sound basis for choosing Ireland as the jurisdiction for aircraft-leasing operations. Taking advantage of a country’s extensive tax-treaty network does not tantamount to taking a tax benefit in the pejorative sense.

• The taxpayer’s group has leased aircraft to jurisdictions other than India as well. This cross-border footprint underscores that the choice of Ireland was driven by the broader aviation ecosystem and Ireland’s well-known leasing infrastructure, rather than by an India-specific intention to access the India–Ireland DTAA.

Nature of lease

• The Hon’ble Supreme Court in Vodafone International Holdings BV⁵ has held that the form and structure of a genuine transaction should be respected.

• The lessee, as operator, naturally bears operational risks, such as fuel costs, crew, maintenance, and daily usage. Ownership risks such as residual value fluctuation, impairment, or inability to repossess in geopolitical crises remain with the lessor. Second, the lease is not “non-cancellable” in the absolute sense.

• Clause 21.1 of the aircraft lease agreement clearly allows termination in the event of default, which is a standard feature of operating leases.

• The mere fact that the lessee is permitted to sub-lease is not determinative of ownership. In this case, subletting is only possible with the lessor’s prior written consent. This itself reinforces that ownership remains with the lessor.

• Irish depreciation rules merely allow an Irish taxpayer to depreciate an aircraft’s cost over 8 years on a straight-line basis for tax purposes. This does not mean that the aircraft’s economic life ends in 8 years or that ownership changes. Depreciation rules are applicable only to the owner; they cannot be relied upon to determine whether a lease constitutes a finance lease in the Indian tax context.

• The lease in question meets all the essential attributes of an operating lease, and nothing in the facts or the law justifies its re-characterisation.

Existence of Permanent Establishment (PE) in India

• The Hon’ble Supreme Court in the case of Formula One World Championship⁶  held that two crucial tests for determining whether a foreign enterprise has a fixed place PE under Article 5(1) of the DTAA or not are (i) a fixed place of business and (ii) that the place of business must be at the disposal of the foreign enterprise.

• Mere ownership of an asset or the exercise of protective rights as an incident of ownership does not ipso facto satisfy this requirement. For a place to constitute a PE, the business of the foreign enterprise, as a matter of factual and functional analysis, must be conducted through that place.

• Applying these principles to the present case, the aircraft leased by the taxpayer to IndiGo were indeed present in India for extended periods.

• The taxpayer’s business is that of dry leasing aircraft, an activity carried out entirely from Ireland, with negotiations, contract execution, and management undertaken outside India. However, operational control over the aircraft, including deployment, routing, scheduling, and crewing, is vested exclusively with IndiGo.

• The rights retained by the taxpayer, such as periodic inspection, ensuring compliance with maintenance standards, and repossession in default, are standard lessor protections safeguarding the value of the asset, not indicative of the asset being at the lessor’s disposal for carrying on business in the source State.

• In the case of Hyatt International Southwest Asia Ltd.⁷ the Supreme Court emphasised that a foreign enterprise’s business must actually be conducted through the alleged PE.

• In the present case, the aircraft, though valuable business assets, did not serve as a “place” through which the taxpayer’s leasing business was carried on in India.

• The aircraft could not be accessed or used by the taxpayer at will for its business. Every entry to airside/hangar areas required IndiGo’s operational consent and regulatory clearances, and inspections were episodic, noticed, and ancillary to ownership protection.

• The aircraft were never placed at the disposal of the taxpayer in India to conduct its business. They were placed at the disposal of the lessee, which operated them for its own commercial purposes.

Applicability of Article 8(1) of India-Ireland DTAA

• Article 8(1) of the India-Ireland treaty provides that―Profits derived by an enterprise of a Contracting State from the operation or rental of ships or aircraft in international traffic and the rental of containers and related equipment which is incidental to the operation of ships or aircraft in international traffic shall be taxable only in that Contracting State.

• The taxpayer’s leased aircraft formed part of IndiGo’s integrated fleet and were deployed interchangeably on domestic and international routes, and such integration necessarily brought them within the scope of “international traffic” as defined in Article 3(1)(g) of the DTAA.

• That definition excludes only those cases where the ship or aircraft is “operated solely between places in the other Contracting State”. IndiGo is an international carrier with scheduled flights to multiple foreign destinations, and the aircraft type and configurations leased were suitable and certified for such operations.

• Once it is shown that the leased aircraft formed part of a fleet used on both domestic and international sectors, the rental income falls within the protective ambit of Article 8(1) of the Treaty.

• The allocation rule in Article 8(1) is a specific provision which prevails over the general rule for business profits as provided in Article 7 of the treaty. Even if the taxpayer were considered to have a PE in India, Article 8(1) would nonetheless require the profits from such rental to be taxed only in the State of residence, i.e. Ireland.

• Further, a careful reading of Articles 8 and 12 of the India–Ireland DTAA shows that the Treaty consciously departs from the OECD and UN Model Conventions in so far as it limits the source country’s taxing rights in respect of aircraft-leasing income. This represents a deliberate and considered policy choice of the two contracting states. The taxpayer’s submission that the very object and purpose of the treaty is to exclude aircraft-leasing income from source-based taxation is tenable.

• Articles 8 and 12 of the India–Ireland DTAA are specifically designed to remove aircraft-leasing income from the ambit of source-country taxation. A taxpayer claiming such Treaty relief is not seeking to subvert the Treaty, but merely availing a benefit that the Treaty itself was designed to confer.

• Accordingly, even without the finding regarding the non-applicability of PPT due to the absence of notification under section 90(1) of the IT Act, the taxpayer would in any event be entitled to the Treaty protection.

BDO INDIA COMMENTS

This ruling reinforces the principle laid down by the Hon’ble Supreme Court in Nestle that Treaty benefits do not cascade automatically by reason of external developments such as OECD membership or subsequent bilateral arrangements. Only a deliberate, notified act of incorporation can elevate such benefits into enforceable domestic law. Each DTAA is a self-contained instrument, the interpretation of which must remain tethered to its own text, structure and definitional scope; it cannot be expanded by implication merely because similar expressions appear in another DTAA or because a party has subsequently joined a multilateral organisation.

Further, this ruling restricts invoking MLI-based PPT provisions and reinforces that MLI cannot be construed as a self-executing document. It also takes into account the taxpayer’s cross-border footprint and the industrial and economic advantages in Ireland’s ecosystem while analysing the PPT, thereby emphasising the commercial nature of the transaction. This ruling, being the first on this subject, could have far-reaching implications. The taxpayers who are applying provisions of the MLI may need to consider the impact of this decision on their transactions.