1 Nihar Jambusaria TAXATION OF IMMOVABLE PROPERTY,CAPITAL GAINS & OTHER INCOME

Article 6 – Income from immovable property Article 13 – Capital Gains Article 21 – Other Income

ARTICLE 6 OF DTAA – Income from immovable property

 Taxability as per The Income tax Act,1961- Taxable in India if property is situated in India S.9(1)(i).  Article 6 of the OECD, U.N., and U.S. model conventions deal with income from Immovable Property.  DTAA between India-Greece is an exception, income from immovable property falls under Article 10.  The paragraphs of Article in all three conventions are similar with a minor difference.

 Income derived by a resident of a country from immovable property (including income from agriculture or forestry) situated in the other country may be taxed in that other country. The US convention uses the term ‘real property’ instead of ‘immovable property’  All three conventions grant the primary right to tax income from immovable property to the State of Source as there is a close connection between source of income and the State where the property is situated.

 The State of Source gets primary right but not the exclusive right as the para uses the words ‘may be taxed in’. The State of Residence may also tax the income and double taxation can be mitigated by granting tax credit or exemption.  Exception-Treaties between India and Bangladesh, Greece and Egypt provide that such income shall be taxable only in the country where the property is situated.

 Controversy in interpretation of the terminology ‘may be taxed in’-  The SC held in CIT v. P.V.A.L. Kulandagan Chettiar 267 ITR 654 that income from rubber estate in Malaysia was not taxable in India although Article 6 uses the words ‘may be taxed in’. Madras and MP High Courts and Chennai ITAT have taken the same view.  Notification No. 91/2008 dt clarifies that where the treaty provides ‘may be taxed in’, such income shall be included in the income of resident in India.

 Income from agriculture and forestry included as these incomes primarily concern the use of land. Ownership of immovable property exploited for agriculture not necessary.  The treaty with Armenia, Austria, France, Indonesia include this income in Article 6 whereas treaty with Australia, China, Denmark, Japan do not include this income in Article 6.  Where such income is not covered in Article 6, it shall be governed by Article 7.

 Example- Mr. A, resident of India who owns property in France has let it out to a resident of Netherlands, Mr. B. Rent received taxable under ‘Other Income’. Treaty between India and The Netherlands can not apply as the property is situated in France.  If Mr. B sublets the property to Mr. C of France, income of Mr. B will be covered by Article 6 of France Netherlands treaty.

Pays rent Mr. B of Netherland Mr. A, resident of India Immovable property in France Received rent from sub-let out Owns immovable property

 Immovable Property shall have the same meaning which it has under the law of the country in which the property is situated.  It shall include  property accessory to immovable property,  live stock and equipment used in agriculture and forestry,  rights to which the provisions of general law relating to landed property apply,  usufruct of immovable property,  Rights to variable or fixed payments as consideration for the working of mineral deposits, sources and other natural resources

 Ships, boats, aircrafts have been excluded from the scope of Article 6 as Article 8 specifically deals with such income.  Exception- India Turkey tax treaty includes fishing places of every kind within the meaning of Immovable Property.

 Income from all forms of exploitation of immovable property whether direct or indirect falls within the scope of this Article. However, income from alienation (transfer) of immovable property falls within the scope of Article 13 of the model convention.  Tax treaties of India with Finland, Kyrgyz Republic and Namibia provide that where a shareholder or owner of other rights in a company is entitled to enjoyment of immovable property held by the company, on account of direct or indirect use or letting or use of such right, it is taxable under this Article.

 Para 4 makes it clear that paragraph 1 and 3 apply to income from immovable property of industrial, commercial and other enterprises.  Article 6 takes precedence over Articles 7 and 14.

 Article 6 deals only with attribution of taxation on income from immovable property, it is silent on the modalities of determining income. In the absence of specification, the computation shall be as per the domestic law.

ARTICLE 13 OF DTAA

 Paragraph 1 preserves the right of the ‘State of Source’ to tax gains from alienation of immovable property situated in that State.  The term ‘immovable property’ means property as explained in Article 6.  It is immaterial whether the property is residential or commercial, capital asset or stock-in-trade, the state of source can levy.  The treatment of income as capital gains or business income or other income depends on the domestic law. For example in India for capital assets it is capital gain tax and for stock-in-trade it is business income.

 The DTAA uses the term 'alienation’. It does not use the term ‘transfer’. The term ‘alienation’ has not been defined.  The UN and OECD commentaries state that alienation includes several kinds of transactions.  It includes sale or exchange of property including a partial alienation, the expropriation, the transfer to a company in exchange for stock, the sale of a right, the gift and even passing of property on death.  Also, the meaning of any term has to be applied as per the domestic law if it is not defined in the DTAA.  Under section 2(47) of the Income-tax Act, 1961 (Act), allowing the possession of any immovable property to be taken for part performance a contract is considered a ‘transfer’  Hence, there can be capital gain on possession of property for part performance of a contract Can possession of property for part performance of contract be considered as transfer??

 Deals with gains on alienation of – movable property forming part of the business property of a PE or pertaining to a fixed base; the permanent establishment or fixed base.  Such gains may be taxed in the State where such PE or fixed base is situated i.e. the ‘State of Source’.  This clause applies only if the property sold forms part of the PE or fixed base.  This article does not apply to stock-in-trade. For stock-in- trade, Article 7 – Business Profits applies.  If there is PE in India and the assets sold are stock-in-trade then gains can be taxed in India. If there is no PE in India, then sale of stock-in-trade cannot be taxed in India.

 If PE or fixed base in India belonging to a non-resident is sold, the gains can be taxed in India.  Accordingly, the following can be taxed in India: Slump sale of undertaking; Sale of branch of a foreign bank situated in India.

 Gains on alienation of – Ships or aircraft operated in international traffic; Boats engaged in inland waterways transport; or Movable property pertaining to the operation of such ships, aircrafts or boats. Can be taxed ONLY in the Contracting State in which the place of effective management (POEM) of the enterprise is situated.  Any movable property relating to operation of ships and aircrafts in international traffic can be taxed only where the POEM is situated.  It is immaterial whether there is a PE or not or whether the asset is a part of the PE or not Article 13(3) being a specific article takes precedence over article 13(2)

 Gains on sale of shares of a company or an interest in a partnership, trust or estate, the property of which consists ‘principally’ of immovable property situated in a Contracting State be taxed by the State in which the property the situated.  This paragraph is applicable regardless of whether the company or shareholder, partnership, trust or estate is a resident of the Contracting State in which the immovable property is situated or a resident of another State.  The expression ‘principally’ in relation to ownership of immovable property has been defined to mean the value of such immovable property exceeding fifty per cent of the aggregate value of all assets owned by the company, partnership, trust or estate.

 Hence, if the property is in India and it is owned by an Indian entity or a foreign entity, on sale of shares or interest in the entity, India can tax the income.  W.e.f AY as per Explanation 5 to section 9(1)(i) of the Act if immovable property in India is held through a foreign company and the value of the share is substantially derived from the value of the immovable property then the shares will be deemed to be located in India. what is relevant is the situation of the property.

 Gains from the alienation of share of the capital stock of the company, partnership, trust or estate are to be taxed only if such an entity is engaged in the management of the said immovable properties.  This paragraph shall not apply if the immovable property is used by such entity in its business activities. ARTICLE 13(4) - EXCEPTION

 A resident of UK selling assets situated in India under the following situations: Extent of holding by the Non Resident in the Indian Company is not relevant

 All other assets – Shares of other companies  Residence country has exclusive taxation rights.  Taxability in Residence depends on domestic law, e.g. Mauritius does not tax capital gains.  The UN model of 2011 states that if “at any time during the 12 month period preceding such alienation, if the alienator directly or indirectly held at least __% of the shares”, then the same will be taxable in India. Example the shareholding prescribed in the India – Netherlands DTAA is 10%.

 Residence country exclusive taxation rights from alienation of any property other than that referred to in paragraph 1 to 5.  For example gains derived from – Movable property other than that described in paragraph 2; Know how, patents not forming part of PE Debt instruments and various financial instruments to the extent such income is not characterised as income taxable under another Artcile eg. Article 10 (dividends) or Article 11 (interest)  Taxability in Residence depends on domestic law.

1) Gains derived by a resident of a Contracting State from the alienation of immovable property referred to in Article 6 and situated in the other Contracting State may be taxed in that other State. 2) Gains from the alienation of movable property forming part of the business property of a permanent establishment which an enterprise of a Contracting State has in the other Contracting State, including such gains from the alienation of such a permanent establishment (alone or with the whole enterprise), may be taxed in that other State. 3) Gains from the alienation of ships or aircraft operated in international traffic, boats engaged in inland waterways transport or movable property pertaining to the operation of such ships, aircraft or boats, shall be taxable only in the Contracting State in which the place of effective management of the enterprise is situated. 4) Gains derived by a resident of a Contracting State from the alienation of shares deriving more than 50 per cent of their value directly or indirectly from immovable property situated in the other Contracting State may be taxed in that other State. 5) Gains from the alienation of any property, other than that referred to in paragraphs 1, 2, 3 and 4, shall be taxable.

1) Gains derived by a resident of a Contracting State from the alienation of immovable property referred to in Article 6 and situated in the other Contracting State may be taxed in that other State. 2) Gains from the alienation of movable property forming part of the business property of a permanent establishment which an enterprise of a Contracting State has in the other Contracting State or of movable property pertaining to a fixed base available to a resident of a Contracting State in the other Contracting State for the purpose of performing independent personal services, including such gains from the alienation of such a permanent establishment (alone or with the whole enterprise) or of such fixed base, may be taxed in that other State. 3) Gains from the alienation of ships or aircraft operated in international traffic, boats engaged in inland waterways transport or movable property pertaining to the operation of such ships, aircraft or boats, shall be taxable only in the Contracting State in which the place of effective management of the enterprise is situated.

4 ) Gains from the alienation of shares of the capital stock of a company, or of an interest in a partnership, trust or estate, the property of which consists directly or indirectly principally of immovable property situated in a Contracting State may be taxed in that State. In particular: (a) Nothing contained in this paragraph shall apply to a company, partnership, trust or estate, other than a company, partnership, trust or estate engaged in the business of management of immovable properties, the property of which consists directly or indirectly principally of immovable property used by such company, partnership, trust or estate in its business activities. (b) For the purposes of this paragraph, “principally” in relation to ownership of immovable property means the value of such immovable property exceeding 50 per cent of the aggregate value of all assets owned by the company, partnership, trust or estate.

5) Gains, other than those to which paragraph 4 applies, derived by a resident of a Contracting State from the alienation of shares of a company which is a resident of the other Contracting State, may be taxed in that other State if the alienator, at any time during the 12-month period preceding such alienation, held directly or indirectly at least ___ per cent (the percentage is to be established through bilateral negotiations) of the capital of that company. 6) Gains from the alienation of any property other than that referred to in paragraphs 1, 2, 3, 4 and 5 shall be taxable only in the Contracting State of which the alienator is a resident.

OTHER ISSUES

 No distinction between Long Term and Short Term Capital Gain as per DTAA: any kind of capital gain is covered by this article.  No distinction between Capital Gain and Speculation Gain: except if it is business income, it is taxable under article 7, and if it is a sale of asset not forming part of the business, it is taxable under article 13.  Appreciation of an asset: is not taxable as capital gain: However, some countries tax the appreciation, as if there is a transfer. For example Australia, Canada and now USA have an exit tax.

 Conversion of capital asset into stock-in-trade : normally not considered as capital gain. In India however, it is considered as deemed capital gains u/s 45(2) of the Act.  “Personal effect” : not considered as capital asset under the Act. W.e.f. AY 08-09, under the Act over and above jewellery, on transfer of the following assets there can be capital gain:  archaeological collections,  drawings,  paintings,  sculptures and  any work of art DTAA covers the taxing rights of capital gains. The manner of taxations is as per the domestic law.

 Situation where there is no article for Capital Gains in a DTAA:  Article 21(other income) which says that ONLY Country of Residence has the right to tax and Country of Source does not have the right to tax.  Some Indian DTAAs provide that if the income arises in Country of Source, then income can be taxed in Country of Source. (DTAA with India and Malaysia)  Situation where neither other income article nor capital gain article there:  In such a case each country can tax the Capital Gain as per its own law, as there is no restriction provided in the DTAA. Example DTAA between India and Libya.

ARTICLE 21 OF DTAA – Other Income

 Article 21 – ‘Other Income’ deals with the Income which are not specifically covered under any other Article of the Tax Treaty.  In some of the Tax Treaties (those with Australia, Singapore etc.) this Article is referred to as ‘Income not expressly mentioned’  However, both the terms used in the tax treaties covey the same meaning.

 The Article does not apply to those income which is not covered by Article 2 of the tax treaty Eg Indirect Taxes.  Also, if any income which is not subject to tax under any Article, it should not lead to taxable under this Article – DCIT v/s Andaman Sea Food Pvt. Ltd [ITA No 1412/KOL/2011]

Inclusions Lottery Winnings Prize Money Gambling income Guarantee fees Punitive damages Social security payments Non compete fees etc Exclusions: × Items of Income which are specifically covered under any other Article of the treaty

ParaOECD ModelUN Model 21(1)Income of a Resident of a contracting state, wherever arising, not covered under any other article of the tax treaty shall be taxable only in the state of residence. Identical to OECD Model. ‘Other Income’ – Under OECD Model and UN Model

 Under both the Models, the ‘State of Residence’ has the exclusive right to tax the other Income.  Some of the tax treaties entered into by India where there is exclusive right of taxation to the ‘State of Residence’ (eg with Korea, Philippines)  However, under India-Namibia Treaty, the exclusive right to tax the other income is given to the ‘State of Source’ Article 21(1)

 Also, under the India-Singapore Treaty, other income is taxable in accordance with the domestic law of the respective contracting state  Article 21 uses the term ‘wherever arising’ which widens up the scope of the Article ‘Other Income’ irrespective of whether such income has arisen in the Source State or any Third State.  Under OECD Model, income from Third State can be taxed only in the ‘State of Residence’.

Para OECD ModelUN Model 21(2) The provisions of Paragraph 1 shall not apply to income, other than income from immovable property as defined in Paragraph 2 of Article 6, if the recipient of such income, being a resident of a Contracting State, carries on business in the other Contracting State through a permanent establishment situated therein and the right or property in respect of which the income is paid is effectively connected with such permanent establishment. In such case the provisions of Article 7 shall apply. The provisions of Paragraph 1 shall not apply to income, other than income from immovable property as defined in Paragraph 2 of Article 6, if the recipient of such income, being a resident of a Contracting State, carries on business in the other Contracting State through a permanent establishment situated therein, or performs in that other State independent personal services from a fixed base situated therein, and the right or property in respect of which the income is paid is effectively connected with such permanent establishment or fixed base. In such case the provisions of Article 7 or Article 14, as the case may be, shall apply. Article 21(2) – Exclusions to 21(1)

44 Yes No Yes

 However, even if the tax treaty does not contain para 2 under this Article, still the Income could be taxable as per the para 1.  Few eg with which India has entered treaty which do not contain paragraph 2 are Italy, Korea, New Zealand, Thailand, South Africa etc.

Para OECD ModelUN Model 21(3)MissingNotwithstanding the provisions of Paragraphs 1 and 2, items of income of a resident of a Contracting State not dealt with in the foregoing Articles of this Convention and arising in the other Contracting State may also be taxed in that other State. Article 21(3)

 By virtue of Para 3, it gives a co-relative right to tax the income arising in such other state i.e. the ‘State of Source’.  This leads to double taxation and the provisions of Article 23 pertaining to tax credit will come into effect  India adopts UN Model and hence in majority of the Treaties which India has entered into, the article contains the above para. Exceptions are treaties with Korea, Nepal, Philippines etc.

 OECD has inserted in its commentary, the Arm’s Length principle in the case of Other Income for the transactions between the parties having special relationship.  Few articles (Interest, Royalty) under treaty covers only Arm’s Length amount. If any excessive amount due to special relationship does not get covered in any of the foregoing Articles, such excessive amount will fall under ‘Other Income’  Such excess amount will be taxable according to the laws of each Contracting State  Special relationship includes relationships by blood or marriage or any community of interest other than which give rise to payment due to legal relationship.

OTHER ISSUES

 If a particular tax treaty do not contain ‘Fees for technical services’ Article, the same could be treated under ‘Business Income’ Article – AAR ruling in case of Tekniskil (Sendirian) Berhad (88 taxman 435)  However, another view was also ruled by AAR that in the absence of Fees for technical services’ Article, the same could be treated under ‘Other Income’ Article – XYZ. In re (20 taxman.com 88)  There is an ambiguity in this matter and the approach would depend upon facts to facts and matter to matter.

 Few Tax Treaties which India has entered into do not have ‘Other Income’ Article (eg: Netherlands, Libya etc)  In such a scenario, both the contracting States may tax in accordance with their domestic laws.