Aircraft Lease Payments Under the India-UAE DTAA: Royalty or Business Income?

Aircraft Lease Payments Under the India-UAE DTAA: Royalty or Business Income?

Classification of income is the cornerstone of international tax planning. For multinational enterprises engaged in the aviation sector, determining whether lease payments constitute "Royalties" or "Business Profits" creates a significant difference in tax liability. This distinction is particularly critical under the India-UAE Double Taxation Avoidance Agreement (DTAA), where specific treaty wording diverges from standard international models.

This article explores how aircraft lease payments are treated under the India-UAE DTAA, analyzing the conflict between source-based taxation (India) and residence-based taxation (UAE).

1. The Core Conflict: Business Profits vs. Royalties

The classification of income determines which country has the right to tax.

• Business Profits (Article 7): Generally, business profits are taxable in the source state (India) only if the foreign enterprise has a Permanent Establishment (PE) there. If no PE exists, the income is taxable only in the state of residence (UAE).
• Royalties (Article 12): Royalties allow the source state to levy a withholding tax on the gross amount of payment, regardless of whether a PE exists.

The critical issue for the aviation industry is whether an aircraft is considered "equipment." If leasing an aircraft is treated as the "use of commercial equipment," the payments shift from being tax-free Business Profits (assuming no PE) to taxable Royalties.

The OECD vs. UN Model Distinction

To understand the India-UAE position, one must look at the global models:

• The OECD Model: In 1992, the OECD removed "industrial, commercial or scientific equipment" from the definition of royalties. Consequently, under OECD-based treaties, aircraft leasing income is generally treated as business profits (Article 7) or international traffic profits (Article 8), taxable only in the residence state.
• The UN Model: The UN Model retains the "equipment" clause in the royalty definition. This allows source countries (like India) to tax payments for the lease of equipment as royalties.

2. Analyzing the India-UAE DTAA

The India-UAE DTAA deviates from the OECD Model and aligns with the UN Model regarding royalties.

The "Equipment Royalty" Clause

Article 12(3) of the India-UAE treaty defines royalties to include payments for the "use of, or the right to use, industrial, commercial or scientific equipment". The term "equipment" in this context is broad and, outside of a consumer context, includes ships, aircraft, cars, and containers.

Because the treaty explicitly includes the "use of equipment" in the royalty definition, payments made by Indian lessees to UAE lessors for the use of aircraft (a dry lease) are characterized as Royalties. This grants India the right to tax these payments at source.

The Exclusion of Aircraft from Article 8

Usually, profits from operating aircraft in international traffic are exempt from source taxation under Article 8 (Shipping and Air Transport). However, as established in the treaty text, Article 8 of the India-UAE DTAA is restricted specifically to "Shipping" and does not cover aircraft. This exclusion is significant. Without the protection of Article 8 (which allocates taxing rights solely to the residence state for international traffic), aircraft income falls into the general "Business Profits" or "Royalties" bucket. Since the "equipment royalty" definition applies, the income is captured under Article 12 rather than Article 7.

3. Operational Distinctions: Wet Lease vs. Dry Lease

The tax treatment often depends on the nature of the lease arrangement.

Dry Lease (Bareboat Charter)

A dry lease involves leasing the aircraft without crew, maintenance, or insurance. The lessor provides the asset, but the lessee operates it.

• Tax Treatment: Under the India-UAE DTAA, this is a classic case of paying for the "use of commercial equipment." Consequently, dry lease payments are treated as Royalties subject to withholding tax in India.
• India's Reservation: India has consistently reserved the right to apply Article 12 (Royalties) rather than Article 8 to profits from leasing ships or aircraft on a bareboat basis.

Wet Lease (Time/Voyage Charter)

A wet lease involves providing the aircraft with crew, fuel, and supplies. The lessor retains control over the navigation and management of the aircraft.

• Tax Treatment: International commentary generally regards wet leases as the provision of a transportation service rather than a mere rental of assets. Profits from a wet lease are typically treated as profits from the operation of aircraft.
• The Conflict: While wet leases are conceptually "business profits" or "shipping/air transport profits," the specific exclusion of aircraft from Article 8 in the India-UAE treaty complicates this. If the arrangement is viewed as a service, it might fall under Article 7 (Business Profits). However, if Indian authorities view the substantial element of the contract as the "use of equipment," they may still attempt to characterize portions of the payment as Royalty, particularly given their reservation to tax equipment leasing.

4. Key Takeaways for Lessors and Lessees

1. Withholding Tax Risk: UAE lessors entering into dry leases with Indian operators must anticipate Indian withholding tax. The "equipment royalty" clause in Article 12(3) acts as a catch-all for leasing income.
2. No Article 8 Protection: Unlike many other treaties, the India-UAE DTAA's Shipping Article does not cover aircraft. Lessors cannot claim the standard exemption for "operation of aircraft in international traffic" under this specific treaty article.
3. Permanent Establishment Exposure: If the lease is not classified as a royalty, it falls under Article 7. In this scenario, taxation depends on the existence of a PE. However, Indian domestic law (Section 9 of the Income Tax Act) and treaty practice have a broad concept of PE and "Business Connection".
4. Priority of Articles: Article 12 (Royalties) operates as lex specialis (specific law) to Article 7 (General Business Profits). If a payment fits the definition of Royalty, the Royalty article takes precedence over the Business Profits article.

Conclusion

Under the India-UAE DTAA, the leasing of aircraft—specifically dry leasing—is generally classified as Royalty income, not Business Income. This is due to the specific inclusion of "commercial equipment" in the treaty's royalty definition and the exclusion of aircraft from the Shipping article. This structure preserves India's right to tax lease payments at the source, a position consistent with India's broader tax treaty policy regarding equipment leasing.