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Taxation of income from immovable property under Article 6 of model tax convention – a comparative analysis

Taxation of income from immovable property under Article 6 of model tax convention – a comparative analysis
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January 16, 2025 (MLN): The Model Tax Convention (MTC), whether under the Organization of Economic Cooperation & Development (OECD) or the United Nations (UN), assigns significant importance to Article 6, which governs the taxation of income derived from immovable property.

This provision is crucial for businesses and investors in structuring tax planning strategies and ensuring compliance.

Article 6 establishes the taxing rights for income from immovable property when the individual deriving the income is a resident of one or both of the contracting states under a Double Tax Treaty (DTT).

When both the state where the property is located (source state) and the state of residence tax the same income, juridical double taxation occurs.

To address double taxation, the MTC provides two primary solutions: either granting exclusive taxing rights to the state of residence or allowing taxing rights to the source state fully or partially with the state of residence providing relief through mechanisms outlined in Articles 23A and 23B of the OECD MTC.

In the former scenario, no double taxation arises. However, in the latter, double taxation occurs, necessitating relief measures.

The OECD commentary classifies income and capital into three categories for the allocation of taxing rights:

  1. Income and capital taxed without limitation in the source state.
  2. Income subjected to limited taxation in the source state.
  3. Income and capital not taxed in the source state.

Article 6 falls into the first category, allowing taxation in the source state without limitations.

Article 6 and Its Interpretation

According to Article 6.1 of the OECD MTC, income derived by a resident of a contracting state from immovable property (including income from agriculture or forestry) situated in another contracting state “may be taxed” in the latter.

This allocation reflects the close economic connection between the income source and the state where the property is located.

However, the phrase “may be taxed” raises questions about whether the source state’s taxing rights are exclusive or if the residence state can also impose taxes on the same income.

The OECD commentary clarifies that the phrase “may be taxed” grants the source state the right to tax the income without restricting the residence state’s taxing rights, except through double taxation elimination methods outlined in Articles 23A and 23B.

This interpretation ensures that both states can potentially tax the income, with relief mechanisms mitigating the resulting double taxation.

Domestic Taxation of Immovable Property Income

Under Pakistan’s Income Tax Ordinance, 2001 (the Ordinance), income from immovable property is classified and taxed under Sections 15 and 16.

Deductions against this income are specified in Section 15A, while withholding tax obligations are outlined in Section 155. Section 101 determines whether income is Pakistan-source or foreign-source.

Rental income is classified as Pakistan-source if it is derived from immovable property located in Pakistan, regardless of whether the property is improved.

Conversely, income from immovable property located outside Pakistan is considered foreign-source.

For non-residents owning immovable property in Pakistan, the income is treated as Pakistan-source and taxed accordingly.

Similarly, residents owning immovable property abroad are subject to tax on their foreign income in Pakistan.

In both cases, the principle of situs (location of the property) creates potential double taxation, which is addressed through DTT provisions.

Interaction Between DTTs and Domestic Law

Section 107 of the Ordinance establishes the precedence of DTTs over domestic law in matters such as providing relief, determining Pakistan-source income for non-residents, and more.

However, the Finance Act 2018 introduced an exception via Section 109, allowing the Commissioner to recharacterize income or disallow treaty benefits if the transaction lacks substantial economic effect or is part of a tax avoidance scheme.

Thus, while DTTs generally override domestic provisions, this is subject to the application of Section 109.

Application of Article 6 in Pakistan

The application of Article 6 raises the question of whether Pakistan, as the residence state, can tax income from foreign immovable property owned by its residents.

Recent rulings by the Appellate Tribunal Lahore (ATIR-LHR) and the Appellate Tribunal Islamabad (ATIR-ISL) have addressed this issue in cases involving the Pakistan-UAE DTT.

Taxpayers argued that, under Article 6.1 of the Pakistan-UAE DTT, taxing rights are reserved exclusively for the state where the property is located and is not taxable in Pakistan due to which the taxpayer had shown same as exempt under respective declarations.

The Departmental Representatives (DRs) contended that the residence state retains the right to tax such income and that tax credits can be claimed under Article 24 of the DTT.

They emphasized that the term “may be taxed” does not equate to “shall be taxed,” allowing the residence state to tax the income regardless of whether the source state exercises its taxing rights.

Divergent Tribunal Decisions

ATIR-LHR delivered two similar rulings, concluding that income from foreign immovable property cannot be taxed in Pakistan as the residence state.

The Tribunal interpreted “may” in Article 6.1 as “must,” granting exclusive taxing rights to the source state.

Consequently, even if the source state exempts the income, the residence state has no right to tax it.

The Tribunal further noted that conflating the terms “may be taxed” and “may also be taxed” would render one redundant.

Conversely, ATIR-ISL ruled that such income is taxable in Pakistan as the residence state.

It emphasized the distributive rules of the OECD MTC, which use distinct expressions (“may be taxed,” “may not be taxed,” “shall be only taxed”) to allocate taxing rights.

The Tribunal held that “may be taxed” does not preclude the residence state from taxing the income and that international law does not bar a residence state from taxing income derived from foreign immovable property.

Additionally, it clarified that the phrase “shall be taxed” would necessitate an exemption, while “may be taxed” implies that the residence state provides tax credits instead.

Conclusion

Article 6 of the Model Tax Convention plays a pivotal role in determining taxing rights for income from immovable property.

Its interpretation and application can significantly impact tax planning and compliance for individuals and businesses.

While DTTs provide mechanisms to address double taxation, the interplay between treaty provisions and domestic laws often requires judicial clarification, as evidenced by divergent tribunal decisions in Pakistan.

These rulings highlight the nuanced interpretation of treaty language and its implications for taxpayers and tax authorities alike.

However, the divergent views on this critical issue have added further complexity for taxpayers, highlighting the urgent need for resolution.

M. Muzammil Hemani is a practitioner, researcher and an author of matters pertaining to local and international taxation. He has studied International Taxation from the Chartered Institute of Taxation in the UK and is also a member of the Institute of Chartered Accountants of Pakistan (ICAP) besides being a lawyer. He can be reached at Muzammil.hemani@hbco.com.pk

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Posted on: 2025-01-16T11:57:21+05:00