Fiscally Transparent Entities

Fiscally Transparent Entities ('FTEs') are entities wherein the owners and investors are taxed for the income earned by the entities and not the entities themselves. The income flows through to the investors and owners of the entities. These entities are considered as non-entities for tax purposes because all the burden of taxation is borne by its owners and investors. Common forms of FTEs are partnerships, Limited Partnerships and LLPs.

One of the issue that arise out of structure of these entities is the entitlement of tax treaty (Double taxation avoidance Agreements/ DTAA) benefits. Most of the tax treaties around the world are formulated in such a way that the definition of person in it doesn't recognize the existence of FTEs i.e. they fall outside the ambit of the definition of a person. Therefore, these entities try to fit themselves in the words 'any other entity which is treated as taxable'.

Article 1 of the OECD Model Tax Convention reads as 'The benefits provided under a treaty are limited to persons who are residents in at least one of the contracting States.'  The term 'person' includes an individual, a company and any other body of persons and any other entity which is treated as a taxable unit for tax purposes.

Under Article 4 of the Tax Treaties the term 'resident of a Contracting State' is defined to mean any person who, under the laws of that State, is liable to tax therein by reason of his domicile, residence, place of management or any other criterion of a similar nature, and also includes that State and any political sub-division or local authority thereof.

The issue is such fiscally transparent entities need to be 'treated as taxable' as per the laws of its residence State or as per the domestic laws of State for taking the benefit of the tax treaty. However, these entities being pass through entities are not taxable entities which bring their eligibility to benefits of treaty in question.

The issue was discussed in the case A .P. Moller TS-555-ITAT-2013 briefly discussed below:

A.P.Moller ('the Taxpayer') a partnership firm resident under the laws of Denmark. As per the Memorandum of Articles of Association of Danish companies namely, Svendborg and Dampskibsselskbet 1912 ('the Companies'), which were public limited companies incorporated and registered under Danish law. The Taxpayer was appointed as the managing owner of these two companies ('Managing Owner'). In accordance with Danish laws, the Companies appointed the Taxpayer as their Managing Owner for managing their shipping operations globally and represented them in all their matters of business over the world.

The benefits of the Tax Treaty were denied to the Taxpayer by the Indian authorities on the ground that the Taxpayer was set up under Danish laws as a partnership, which as such, is a fiscally transparent entity treated as non-taxable under Danish laws.

However, Tribunal observed that the tax payer is eligible for the benefits of the DTAA as long as its income is fully taxed in Denmark irrespective of the fact that it is being taxed from the partners. It reiterated that even though a partnership firm may be a fiscally transparent entity, as long as its profits were taxed in the hands of its partners in the resident country, benefits of the Tax Treaty could not be denied to the Partnership.

Most of the tax treaties in India do not contain specific provisions to deal with foreign entities which are fiscally transparent. A fiscally transparent foreign partnership may be considered as a separate entity in one country whereas it may be viewed as fiscally transparent by the other country. In such cases conflict is bound to arise. However, the practice upheld by this tribunal has been practiced by countries like USA and UK and it is also evident in the commentaries of OECD.

Clearly, the tax treatment of an entity in its country of organization is key to determine whether the entity, or its shareholders, partners or members, are entitled to the benefits of a treaty. The residence and beneficial owner requirements, whose meaning is not entirely free from doubt, and depends on the facts and circumstances of the particular case, call for extensive analysis of the tax classification and treatment of the entity and its owners, under the laws of their country. Under that scenario, the payer of the income must make sure that the documentation provided by the payee always establishes with sufficient certainty the payee's eligibility for treaty benefit.