Are you ‘liable to tax’?
A Closer look
Direct Tax
Are you ‘liable to tax’? A Closer look
The Finance Act 2021 finally attaches a new definition to the Income Tax Act, 1961 vide its newly inserted Sec 2(29A) –‘liable to tax’; a much debated topic over the years. The term holds great significance as far as cross-border taxations, Double Taxation Avoidance Agreements (DTAAs) etc are concerned. Let us closely analyse how this term was interpreted so far and how the new definition going to change the landscape going forward. The study is largely in the context of international taxation.
‘Liable to tax’ – Setting the context
Article 1 of the OECD Model Convention specifies the ‘persons’ covered by the Convention. As per 1.1, the Convention applies to persons who are ‘residents’ of one or both the Contracting States. Article 4 for the Model Convention inter alia defines the term ‘Resident of a Contracting State’ as “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 similar nature, and also includes that State and any political subdivision or local authority thereof as well as a recognised pension fund that State. The term, however does not include any person who is liable to tax in that State in respect only of income from sources in that State or capital situated therein”.
The UN Model Tax Conventions also defines the term resident almost in similar lines. The pre-condition of ‘Liable to tax’ finds a place therein as well. Most of the tax treaties that India has entered into with the other tax jurisdictions has defined the term with the element of ‘liable to tax’ as a key deciding factor in it. This key phrase has been interpreted by Courts, Tribunals and Advance Ruling Authorities in diverse manner; which added to the muddle.
As it is evident, the way the Article 4 has been framed, identification of residency of a person for the application of tax treaty is intertwined with the attribution of income and liability to tax on such income. It is not a matter of dispute that determination of residence in one of the Contracting States is a sine qua non in order to claim the benefit. Consequently, it is also important that the person is labile to tax in the one of the jurisdictions, to qualify as a resident of one of the States. This term ‘liable to tax’ however is not defined under any of the Tax Treaties in which India is a party. The domestic law – Indian Income tax Act, 1961 even though was silent on this, however after much ambiguities and litigations, brought in the definition to the statute wide Finance Act 2021 as discussed in forgoing paras.
Whilst one of the views is that the phrase ‘liable to tax’ does not contemplate actual levy or payment of tax, rather, it is sufficient enough if the Contracting State reserve its sovereign power to tax, irrespective of the actual exercise of such power or payment of tax, the contradicting view insists that, the levy and payment of tax is essential to consider a person as ‘liable to tax’.
The famous case, Union of India and Others vs Azadi Bachao Andolan and Others (MANU/SC/1219/2003) touches up on ‘liable to tax’ in order to interpret the same in context of the case. The observation, the hon’ble Court brought forth was that, “the liability to taxation is a legal situation; while payment of tax is a fiscal fact. For the purpose of application of Article 4, what is relevant is the legal situation; and not the fiscal fact”. The Court held that it is fallacious premise that the liability to tax is the same as payment of tax. If it was not the intent, the treaty would have used appropriate wording while drafting the treaty, which stresses on the payment of tax’.
The court while passing the judgement, relied on the commentary of Philp Baker in order to bring out the import of the term ‘liable to tax’ employed in Article 4 to the Treaties: “It seems clear that a person does not have to be actually paying tax to be ‘liable to tax’ – otherwise a person who had deductible losses or allowances, which reduced his tax bill to zero would have himself unable to enjoy the benefits of the Convention. It also seems clear that a person who would otherwise be subject to comprehensive taxing but who enjoys a specific exemption from tax is nevertheless liable to tax, if the exemption were repealed, or the person no longer qualified for the exemption, the person would be liable to comprehensive taxations”.
How Courts and Tribunals haver interpreted the phrase
One of the initial cases that dealt with the interpretation of ‘liable to tax’ was the take of the Advance Ruling Authorities (AAR) in the case of Mohsinally Alimohammed Rafik (MANU/AR/0002/1994) in the year 1994 – a person resident in the UAE. The Authority interpreted that the phrase ‘liable to tax’ neither mean actual liability nor payment of tax by a person. The AAR added that, to be liable, the sovereign power of the State is what matters, rather than the actual exercise of such power. It was also stated that liable to tax is followed by the words ‘by domicile, residence, place of management or any other criterion of a similar nature’ and these words cannot be ignored while interpreting the tax treaty.
However, in a subsequent decision by the Advance Ruling Authority in the year 1999 in the case of Cyril Eugene Pereira (MANU/AR0007/1999); the views of the Authority in case of Mohsinally Alimohammed Rafik was completely negated and concluded that payment of tax is a pre-requisite to satisfy the ‘liable to tax’ element of the definition. The Authority added that the treaty with UAE is applicable only to the existing taxes, and not to any potential levy of taxes.
Similarly in case of Abdula Razak Meman [2005] 146 Taxman 115 (AAR), the Advance Ruling Authority held that treaty benefit wouldn’t be available to an assesee who has not paid any tax in the UAE. The Authority while referring to the case of Cyril Eugene Pereira case, went into a detailed analysis in line with Article 32 of the VCLT of taking recourse to supplementary means of interpretation like preparatory work of the treaty and circumstances of entering into such a convention etc in order to interpret the meaning, where meaning is ambiguous or obscure or leading to results which is absurd or unreasonable on application of the principles laid down under Article 31. The Authority further went into the power bestowed on the UAE Government as per their Constitution, to tax the income and their understanding about the Governments ongoing plans in codifying tax laws for the individual of the state, which however did materialize till date. This supported the Authority’s contentions of the usage of the expression and the intended definition of ‘resident contracting state’ in the treaty. The AAR thus concluded that the treaty benefit cannot be availed since the assesee cannot be considered as the resident of the state for treaty purpose.
Subsequently in Green Emirates Shipping & Travel [2006] 100 ITD 203 (Mumbai)/[2006] the Mumbai Tribunal while in concurrence with the observations by the AAR in the case of Cyril Eugene Pereira, followed of the principles and ruling upheld by the hon’ble Supreme Court in case of Azadi Bachao Andolan and concluded that payment of tax is not a prerequisite to claim the tax treaty benefit. The Tribunal further added that a tax treaty not only prevents current but potential double taxation and thus endorsed the sovereign power of a State to tax its residents.
It is interesting indeed to note that, subsequent to all the diverse interpretations, discussions, deliberations, contradictions and views, with regard to the residential status emphasising on the phrase ‘liable to tax’, Article 4 to the treaty between UAE and India was amended in the year 2007. Clause 1(b) to the Article was replaced with the following vide the Notification No. SO 2001(E), dated 28-11-2007:
“in the case of UAE, an individual who is present in the UAE for a period or periods totally in the aggregate at least 183 days in a calendar year is concerned, and a company which is incorporated in the UAE and which is managed and controlled whole in UAE”.
The definition of ‘resident’ of UAE finally got limited to mere number of days of stayed in the UAE in contrast of the earlier definition where ‘the liability to tax’ was a requirement in order to gain residency in the state for the treaty purpose. However, the requirement of those who are in India continues to be the same which is covered under clause 1(a) to the Article, where ‘liable to tax; is still valid and tested.
Introduction of ‘Liable to tax’ by Finance Act 2021
In anticipation to put end to all the confusions and varied interpretations on the what ‘liable to tax’ meant, Finance Act 2021 inserted Sec 2(29A) to define ‘liable to tax’. As per the Memorandum to Union Budget 2021, the insertion not only aims to clarify the positions impacting the domestic provisions, but also targets to the interpretation issues within the agreements entered into under Section 90 & 90A of the Income Tax Act. As per Section 2(29A) brought in vide Finance Act, 2021, ‘liable to tax in relation to a person with reference to a country means that there is an income tax liability on such person under the law of that country for the time being in force and shall include a person who has subsequently been exempted from such liability under the law of that country’.
While the former part of the definition starts with ‘means’, the latter part is rather inclusive. The definition underlines that liability is under the law of the country for the time being in force; and covers the cases where such taxes are levied, but got subsequently exempted under the law of that country. The definitions stresses on the existence of taxation levy in the contracting state even though the net payment of tax is not stipulated.
The introduction of new definition raises valid questions like; – does the change brought in vide the Finance Ac 2021 has a any bearing on the DTAAs then existed? Can India unilaterally define a term in domestic law that has bearing on the treaty? etc. While attempting to answer these questions, the intention of the legislature would play an important role. While Article 3(2) to the Treaty becomes relevant which allows adoption of the definitions as per the domestic laws of the contracting states in case of terms that are not defined in treaty, Sec 90(3) of the Act along with the explanations 3 and 4 even though restrictive allows India to define terms in the domestic law. However, in line with the principles of interpretation laid down by VCLT under Article 26 – a treaty is binding on the parties and expected to be performed in good faith; and hence a unilateral amendment cannot be considered is in compliance with this. Moreover, as per Article 27, state cannot use domestic law as an excuse for its failure to perform treaty.
It is arguable that if the newly inserted definition of liable to tax in the Act can be adopted while interpreting the treaty provisions considering the VCLT principles. It is also pertinent to note that while ‘liable to tax’ does not actually meant payment of tax, after series of contradicting rulings where India & UAE were parties, the countries finally decided to change the concerned Article of the Treaty, rather than clarifying the stand. Even at this step taken by the Government to clarify what the ‘liable to tax’ actually meant, it’s worth a wait to see how it pans out in the arena of international taxation.
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