Surging economic growth has resulted in substantial growth in India’s shipping and aviation industry. The last few years have seen the mushrooming of a number of low-cost airlines and the large domestic airline companies expanding their fleets. But this growth in the aviation industry is plagued with issues such as rising cost of fuel, airport congestion, scarcity of experienced pilots, etc. Compounding these problems was the withdrawal of income tax exemption granted on lease rentals paid on aircraft leased from foreign companies, subsequent to 31 March 2007.
Manish Desai and Ketan Dalal
Of late, the issue of taxability and withholding tax has gained greater relevance, in light of an increasing number of leasing of aircraft taken on on a dry lease basis (only the aircraft is provided, without insurance, crew, maintenance, etc.) and ships on bareboat basis, that is, without a professional master or crew.
The Income-tax (I-T) Act lays down different sources of income that are deemed to accrue or arise to a foreign company in India, such as income in the nature of fees for technical services, royalties, etc. So, would lease rentals paid for aircraft or for hiring ships constitute royalties?
“Royalties” has been defined in the Act to inter alia include consideration payable towards use or right to use industrial, commercial or scientific (ICS) equipment. The I-T Appellate Tribunal in the case of West Asia Maritime Ltd vs ITO (111 ITD 155) and Poompuhar Shipping Corp. Ltd vs ITO (109 ITD 226) has held that ships are equipment. So lease rentals paid by a resident to a non-resident should be subject to tax in India at 10.5575%, and where the tax liability of the foreign company is borne by the Indian payer, the tax would need to be grossed up, resulting in an effective tax rate of 11.8037%.
Tax treaties executed by India with some countries inter alia define royalties to include “payments for the use of or right to use ICS equipment”. Hence, in the case of such tax treaties, lease rentals payable for dry lease of aircraft/bareboat charter of ships should be subject to tax to India.
(Illustration by: Malay Karmakar / Mint)
But tax treaties with countries such as Sweden, Israel, the Netherlands, Greece and Belgium do not consider payments for the use of or right to use ICS equipment as royalties. Further, the treaty executed with Ireland excludes aircraft from the definition of royalties. Accordingly, in case of such treaties, payments for the use of or right to ICS equipment should not be considered as royalties.
The tax department has sought to examine whether, in situations where dry leases are clearly not “royalties”, the lease rentals can be taxed as business income.
A key requirement for taxation of business profits is the constitution of a permanent establishment (PE) in India. The existence of a PE of the lessor in India would largely depend on the activity it carries out.
Article 5 of the tax treaty executed by India defines a PE as a fixed place of business through which business is wholly or partly carried out. The existence of a PE necessitates a certain degree of permanence.
The Organisation for Economic Co-operation and Development (OECD) in its commentary on the Model Tax Convention has inter alia stated that if an enterprise of a state lets or leases facilities, ICS equipment, buildings or intangible property to an enterprise of the other state, without maintaining for such letting or leasing activity a fixed place of business in the other state, the leased facility, ICS equipment, building or intangible property will not constitute a permanent establishment of the lessor provided the contract is limited to the mere leasing of the ICS equipment, etc. This remains the case even when, for example, the lessor supplies personnel after installation to operate the equipment, provided their responsibility is limited to the operation or maintenance of the ICS equipment under the direction, responsibility and control of the lessee.
Based on this, it could be argued that when an aircraft/ship leased to an Indian company, and the lessee is responsible for all aspects of operation, maintenance, inspection, etc., the business being carried on in India is that of the lessee, not of the lessor.
OECD has also brought out guidelines for determining the existence of PE in the host country. According to this, the existence of the PE would largely be dependent on which of the two, the lessor or lessee, is operating, servicing, inspecting and/or maintaining the equipment. If all the activities are undertaken by the lessee, mere presence of equipment should not mean a PE of the lessor.
Further, the tax treaty executed by India with Australia provides that the presence of substantial equipment itself could be translated into a PE of the lessor in India. What could be construed as substantial equipment is a contentious issue and whether an aircraft or ship could be construed to be substantial equipment is debatable. However, in the absence of such provision in other tax treaties, it may be contended that in case of such tax treaties a PE should not be constituted.
Given the above, for tax treaties that exclude payment for the use of or right to use of ICS equipment from the definition of “royalties”, a view that emerges is that such payments may not be taxable in India. But different considerations would apply if the aircraft/ships are hired on a wet lease basis, (where they come complete with crew, maintenance staff, insurance, etc.
Further, to avoid disallowance of lease rentals as a tax deduction (on account of failure to withhold taxes), it seems Indian companies in undertaking such transactions would need some risk mitigation strategies. In such cases, they could either approach the revenue authorities to obtain a nil tax withholding order or approach the Authority of Advance Ruling (AAR) to determine the tax withholding. But this carries a risk in that the AAR ruling is binding.
In sum, the shipping and aviation industries, faced with rising input costs and competition, may have some opportunities to mitigate tax risks on leasing of aircraft and ships and shore up their profitability, as explained above.
Ketan Dalal is executive director and Manish Desai is associate director, PricewaterhouseCoopers. Your comments and feedback are welcome at groundrules@livemint