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Issues of cross-border dry leases and royalty
June, 16th 2008

Surging economic growth has resulted in substantial growth in Indias 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.

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.

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.

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