By Aseem Chawla
When the Government of India opened India’s skies by deregulating the aviation sector, India was widely expected to become a dominant global player in aviation by 2020. This sector, however, which was once considered a sunrise industry, is now viewed with circumspection because of continuing inadequate infrastructure, escalating fuel prices and uncertain tax policies.
As an alternative to outright purchase of aircraft (which has the potential of adversely affecting a balance sheet), leasing has emerged as a preferred mode of meeting the requirements of increasing fleet size. The option of leasing not only leverages on operational efficiency, but also saves considerable amounts of outflows for the cash-strapped aviation sector.
The aviation industry usually adopts two mechanisms of leasing, i.e. the wet lease and the dry lease. Under a wet lease the aircraft is provided on lease along with complete crew, maintenance and insurance. Under a dry lease (also known as a ”bareboat arrangement”), aircraft are leased without any accompaniments.
Taxation of cross border leasing of civil aircraft, from a direct as well as indirect tax perspective has been a contentious affair and has multi-fold implications. This article touches upon certain indirect tax and direct tax aspects of cross border leasing and highlights matters currently being deliberated between industry stakeholders and the tax authorities.
Value Added Tax Considerations
India has not yet adopted the Goods & Service Tax Model, which is otherwise prevalent across the globe. India’s indirect tax regime is based on a Federal system wherein, goods are subject to a state levy that is Value Added Tax (VAT) is levied on transactions involving sale of goods. Services are subject to service tax which is a Central (Federal) levy. Due to the existing federal tax system, equipment leasing in India has been extremely litigious because it has been subject to double taxation in the form of VAT and service tax.
An equipment leasing transaction is considered as a sale of goods under the VAT laws and Constitution of India, if the right to use the equipment has been transferred to the lessee. However, case law and amendments of service tax laws carve out an exception under which a transaction is characterised as a “service” subject to service tax if the right to use has been transferred without control, custody and possession of the equipment.
The tax structure in India also provides that movement of goods from one state to another, pursuant to a contract of sale, or the transfer of the right to use of goods (i.e., a lease), are not subject to states’ sales tax laws and shall be taxable only under the Central Sales Tax Act, 1956, which is a federal statute.
Therefore, when the right to use an aircraft is transferred from one state to another it is characterised as an inter-state transaction. On the other hand, when there is a transfer of the right to use an aircraft outside the taxable territories of India, or vice versa, the transaction is characterised as an import/export. Given, however that Article 286(1) of the Constitution of India prohibits imposition of Central Sales Tax (CST) on the import and export of goods, it can be argued that airline leases to or from parties in another country fall outside the ambit of the CST. There is a school of thought that holds that leases qualify as import/export only if the agreement for transfer of right to use has been executed outside India. In the absence of any authoritative judicial decisions on this aspect and given high taxes and litigation costs, the aviation industry has adopted a practice of executing such contracts outside India, as a matter of abundant caution.
Service Tax Considerations
At the outset, imposition of service tax may occur where aircraft are leased without transfer of the corresponding right to use, i.e., where aircraft are leased without transfer of effective control, custody and possession.
Under the new service tax regime effective July 2012, service transactions are exigible (leviable) to service tax only if the place of provision of services is in India. In cases of service transactions, where the duration of the lease of an aircraft to be used as a means of transport does not exceed a month, the location of the service provider is considered to be the “place of provision of service.” Conversely, where the duration of the lease of an aircraft to be used as a means of transport exceeds a month, or where the aircraft is not used as a means of transport, the location of the recipient of the service shall be regarded as the “place of provision of service.”
To illustrate this legal proposition, where the lessor of an aircraft situated outside India provides the aircraft on lease to the lessee located in India for a period less than one month, for the purpose of use as means of transport, the place of lessor i.e., a country outside India, is regarded as the “place of provision” and accordingly, imposition of service tax would not arise. However, where the aircraft is being leased for a period more than one month or is being leased for purpose other than a means of transport, then the place of provision of service would be the location of lessee, i.e., India, and hence the provisions of the service tax law would be applicable.
Broadly speaking, import of aircraft is subject to customs duty at the applicable rate. However, exemptions in the applicable rate of tax have been issued from time to time by the Central Board of Excise and Customs (India’s highest indirect tax administrative body [CBEC]), in certain specified situations, such as:
- where the aircraft is imported by an operator or on behalf of an operator, for operating scheduled air transport service or scheduled air cargo service; or
- where the aircraft is imported by the Aero Club of India, New Delhi or a flying training institute approved by the competent authority, for imparting training; or
- where the aircraft is imported by an operator who has been granted approval by the competent authority in the Ministry of Civil Aviation to import aircraft for providing non-scheduled (passenger) services or non-scheduled (charter) services.
Under these scenarios there is an exemption from differential customs duty or a complete exemption depending upon the applicable scenario. Despite this, the procedural aspects and clearance formalities for aircraft are rather elaborate. The importer is required to seek various approvals from Ministry of Civil Aviation, thereby, protracting the entire process of customs clearance.
Direct Tax Considerations
Cross border leasing of aircraft also enjoys a special exemption under Section 10(15A) of the Income Tax Act, 1961 (ITA). However, a sunset clause was introduced by the Finance Act, 2005, to provide that the exemption shall not be available for agreements entered after April 1, 2007.
In the aftermath of the withdrawal of the exemption, direct tax is largely governed by the ITA or bilateral tax treaties entered into by India and various countries. The extent to which a direct tax liability arises depends on the nature of the lease agreement. The foremost consideration is whether a non-resident lessor has a taxable presence in India by way of a Permanent Establishment (PE) as defined by Article 5 of those tax treaties. Where a PE is found to exist under Article 5, the profits that are attributable to such PE are chargeable to tax in India as defined in Article 7 (business profits).
Generally speaking, mere leasing of an aircraft which is located in India ought not to result in finding the existence of a PE. The Organisation for Economic Development and Cooperation has expressly stated that where an enterprise leases equipment in another contracting state without maintaining a fixed place of business in that other state, the leased equipment shall not constitute a PE in that other state. This should also be so where the lessor supplies personnel to operate the equipment, as long as its responsibility is limited solely to the operation and maintenance of the equipment under the direction, control and responsibility of the lessee.
A departure from this general principle is contained in the India-Australia tax treaty, the peculiar provisions of which stipulate that presence of equipment in the other state may lead to a finding of the existence of a PE in that other state. A detailed examination of the facts of each case is essential to evaluate whether a PE will be found to exist on the basis of leasing activities.
There are other considerations regarding the characterisation of lease income. Depending on the nature of the lease arrangement, i.e., whether the lease is an operating lease or finance lease, the lease rentals accruing to the lessor may also be characterised as “royalty” or “interest.”
The definition of royalty under the ITA and certain tax treaties, includes consideration for the use or right to use any commercial, scientific and industrial equipment. Aircraft do arguably fall within this category of equipment (although the equally opposite argument is also made) and therefore, the corresponding lease rentals may be characterised as royalty. However, certain tax treaties which India has, notably with Ireland and Singapore, have explicitly excluded aircraft from the scope of this provision. While under the ITA royalty attracts a withholding tax rate of 25 percent (subject to surcharges where income exceeds INR 10 million to INR 1 billion), the tax payer may be entitled to the beneficial provisions of the tax treaty which requires a tax ranging from 10-to-20 percent.
The characterisation of lease rentals as royalty may be appropriate only where the lease arrangement is of the nature of an operating lease. Moreover, it is essential that the lessor be in “control” and “possession” of the aircraft, which is usual for a dry lease.
In contrast, a finance lease arrangement has certain characteristics of a loan for purchase of an asset, rather than mere use of an asset. The consideration in a finance lease comprises the selling price along with an embedded interest component. Under the ITA, this interest element is taxable at the rate of 20 percent (subject to the same surcharge as a royalty). However, the tax treaties entered into by India do prescribe a beneficial rate of tax for interest, which ranges from 10-to-15 percent.
Most of the tax treaties entered into by India incorporate a separate provision (Article 8) on profits from shipping and air transport. Although, in broader terms, this Article deals with allocation of taxing rights on profits from operations of ships and aircraft in international traffic, certain tax treaties, also include within the ambit of this provision, rental of ships and aircraft. For instance, under the tax treaty with Ireland, profits derived by an enterprise of a contracting state from rentals of aircraft are taxable “only” in such country.
Another aspect is the entitlement tax depreciation on leased aircrafts. The issue of eligibility of tax depreciation is often contentious, especially with finance lease arrangements. However, the Supreme Court of India has held that the claim of depreciation in the case of a finance lease lies with the lessor, because the lessor fulfils the twin test of “ownership” and
“usage for the purpose of business.”
The debate is far from settled. First, the Direct Tax Code, 2010 (which will replace the ITA but whose effective date has not yet been announced), grants tax depreciation to the lessee, rather than the lessor. Second, the Central Board of Direct Taxes— the apex direct tax administrative body—recently rolled out draft “Tax Accounting Standards” (TAS) and invited public comment. Among other things the draft TAS provides that in a finance lease transaction, the lessor shall be eligible to receive the benefit of tax depreciation. It remains to be seen whether these draft provisions will withstand future judicial scrutiny. Transactions involving the sale and lease of fixed assets have always been viewed with circumspection.
Lease Versus Purchase
In light of the prevailing legal, tax and regulatory environment in India and the recent head winds being faced by the aviation industry, the efficacy of importing aircraft is a matter of doubt. This is especially due to the fact that outright importing of aircraft does have a considerable impact on the financial position and liquidity of an enterprise. However, given the lack of clarity surrounding the tax treatment of transactions involving cross border leasing of aircraft—including consequential tax and litigation costs—the cost/ benefit of a leasing transaction has to some extent withered away.
Aseem Chawla is the founding partner of MPC Legal in New Delhi and leads the firm’s tax practice group. He is currently Vice Chair of India Committee of ABA Section of International Law & is Co-editor of India Law News. He can be reached at email@example.com. The author wishes to acknowledge the contributions of Anuj Mathur and Shashank Goel, senior associates in the tax practice group at MPC Legal.