Article 10 of the Multilateral Instrument deals with Anti-abuse Rule for Permanent establishments Situated in Third Jurisdictions, commonly known as PE Triangular cases. Before we dwell on it, beginners can view our exclusive post on Triangular cases to understand the concepts better.
Provisions of Article 10 of MLI only intend to cover the Triangular cases where Permanent Establishment is involved, covering three jurisdictions – Residence State, Source State, and the State where Permanent Establishment is set up.
Introduction to PE Triangular Case
A PE Triangular case involves a Multinational Enterprise (MNE) resident of a tax treaty jurisdiction that has set up a Permanent establishment (PE) in another tax jurisdiction. The PE inturn earns income from a third country.
Assuming all the three jurisdictions have tax treaties with each other, the interplay of the respective domestic tax laws and the relevant tax treaties between the following three jurisdictions involved will determine the overall taxation framework for such triangular cases:
- The Residence State – Where the MNE is set up and is a tax resident of as per the domestic laws
- The Source State- From which the MNE Earns or derived income through or from a source therein
- The PE State- where the MNE has set up a PE to carry out its business/activities.
General taxation for PE Triangular cases
Let us take a typical PE triangular case of an MNE ABC Inc, resident of State R, which has set up a PE in State P. The PE has invested through its funds in the equity of the company resident of State S. The dividend income is also received by the PE in State P. the taxability of dividend as per the tax treaties signed by State S are :
|Applicable Tax Treaty||Tax in State S limited to|
|R State – S State||5% on a gross basis|
|P State – S State||10% on a gross basis|
Taxation in State S
For an entity to claim the benefits under the tax treaty, it has to be a resident, as per the domestic laws, of one of the contracting jurisdictions to the tax treaty. In the given case, ABC Inc has to be a resident of either State R or State P to avail of the treaty benefit.
As ABC Inc is incorporated in State R, it is a tax resident of State R, and hence State R and State S treaty will be applicable. While the PE receives the income in State P, ABC Inc does not qualify as the tax resident of State P as per the domestic tax laws.
Hence, the taxation by State S on the dividend income earned by ABC Inc will be limited to 5% on a gross basis as per the tax treaty of State R and State S, although the dividend income is earned by and attributable to the PE of the MNE in the State P.
Taxation in State P
In the given PE triangular case, the dividend income is received in the State P and is also attributable to the PE; hence the dividend income will be taxable in the State P in the hands of ABC Inc.
According to Article 23, ABC Inc cannot avail credit for tax paid in State S under the State R – State S tax treaty. But as per Article 24 of the treaty between State R and State P, the taxation of the ABC Inc’s PE in State P cannot be less favorable than the taxation of a regular resident in State P from the same activities.
The regular tax resident ofo State P would have been eligible for the tax credit for taxes paid in State S on similar dividend income under State P- State S tax treaty. Thus on the same basis, ABC Inc should be eligible to claim relief for the taxes paid in State S based upon the Non-discrimination clause of Article 24 of the State P – State R tax treaty.
Taxation in State R
In this PE triangular case, ABC Inc will be subject to global income taxation in State R. The dividend income earned from State S would be subject to taxation in State R, with relief for double taxation under Article 23 for the taxes paid under the tax treaties of State S and State P.
Potential Treaty Abuse using PE Triangular Case
BEPS focuses on tax avoidance strategies of corporates and MNEs by setting up PE triangular cases to benefit from arbitrage opportunities without underlying commercial substance.
The following type of potential abuse of tax treaties may arise in PE triangular case:
- Low or non-taxation of passive income in the PE state.
- Exemption or low taxation of profits earned by PE in the MNE resident state.
- Network of treaties with the source state limiting the taxation of rights on passive income.
Anti Abuse Rules in Article 10 of MLI
BEPS Action Plan 6 recommends the anti-abuse rules for PE Triangular cases reproduced in Article 10 of MLI.
Article 10 (1) states that:
a) an enterprise of a Contracting Jurisdiction to a Covered Tax Agreement derives income from the other Contracting Jurisdiction and the first-mentioned Contracting Jurisdiction treats such income as attributable to a permanent establishment of the enterprise situated in a third jurisdiction; and
b) the profits attributable to that permanent establishment are exempt from tax in the first-mentioned Contracting Jurisdiction,
the benefits of the Covered Tax Agreement shall not apply to any item of income on which the tax in the third jurisdiction is less than 60 per cent of the tax that would be imposed in the first-mentioned Contracting Jurisdiction on that item of income if that permanent establishment were situated in the first-mentioned Contracting Jurisdiction. In such a case, any income to which the provisions of this paragraph apply shall remain taxable according to the domestic law of the other Contracting Jurisdiction, notwithstanding any other provisions of the Covered Tax Agreement.
The above mentioned anti-abuse rules on PE triangular case applies when:
- An enterprise of Residence State (State R) derives income from the Source state (State S);
- Such income is attributable to PE in PE State (State P);
- Such profits are attributable to PE are exempt from tax in the residence state (State R); and
- The tax in PE State is less than 60 % of the tax that would have been imposed in the Residence State (State R) if the income was earned or received in that State.
All the above four conditions should be satisfied to trigger the anti-abuse provisions.
In case the anti-abuse rules apply in the given case, the Source state (State S) would not be required to limit its taxation rights in respect of the said income under the applicable tax treaty between Residence State (State R) and the Source State (State S).
As mentioned in the illustrated case above, the Source State will generally limit its taxation rights on passive income to 5% to 10%. But when the anti-abuse rules of Article 10 of MLI are triggered, the Source state is no longer required to limit its taxation rights on such passive income, and the same would be subject to total taxation as per the domestic tax laws of the Source state.
The exception to Paragraph 1 of Article 10
Paragraph 2 of Article 10
Paragraph 1 shall not apply if the income derived from the other Contracting Jurisdiction described in paragraph 1 is derived in connection with or is incidental to the active conduct of a business carried on through the permanent establishment (other than the business of making, managing or simply holding investments for the enterprise’s own account, unless these activities are banking, insurance or securities activities carried on by a bank, insurance enterprise or registered securities dealer, respectively).
According to Paragraph 2 of Article 10 of MLI, the Anti-abuse rules on PE triangular cases will not apply to any income derived from the Source state (State S) which is in connection with or incidental to the active conduct of business carried on through the PE. The above connection is not applicable if PE is in the business of making, managing or holding investment fr the enterprise unless it is carried out as a part of banking, insurance or securities activities carried on by a banking, insurance company or registered securities dealer, respectively.
The exclusion rule will be applicable as long as there is sufficient, factual, and reasonable nexus between the income earned in the Source State (State S) and the active business activities carried out by the PE in the PE State (State P).
Competent Authorities power to address anomalies
Paragraph 3 of Article 10 of MLI
If benefits under a Covered Tax Agreement are denied pursuant to paragraph 1 with respect to an item of income derived by a resident of a Contracting Jurisdiction, the competent authority of the other Contracting Jurisdiction may, nevertheless, grant these benefits with respect to that item of income if, in response to a request by such resident, such competent authority determines that granting such benefits is justified in light of the reasons such resident did not satisfy the requirements of paragraphs 1 and 2. The competent authority of the Contracting Jurisdiction to which a request has been made under the preceding sentence by a resident of the other Contracting Jurisdiction shall consult with the competent authority of that other Contracting Jurisdiction before either granting or denying the request.
Paragraph 3 of Article 10 of MLI grants the power to Competent authorities to address the anomalies that wrongly deny the treaty benefits to the taxpayer while applying anti-abuse rules of Article 10 (1) or any other related genuine reasons. Competent authorities will review the merits of the case and provide relief to the taxpayer after consulting with the competent authorities of the other Contracting Jurisdiction.
Paragraph 4 of Article 10 of MLI
Paragraphs 1 through 3 shall apply in place of or in the absence of provisions of a Covered Tax Agreement that deny or limit benefits that would otherwise be granted to an enterprise of a Contracting Jurisdiction which derives income from the other Contracting Jurisdiction that is attributable to a permanent establishment of the enterprise situated in a third jurisdiction.
Paragraph 4 of Article 10 of MLI is a compatibility clause. It describes the interactions of Paragraphs 1 to 3 of Article 10 of MLI with the existing provisions of the Covered Tax agreements. It clarifies the anti-abuse rules on PE triangular cases, and its exceptions will replace the existing provisions of the tax treaty or be applicable in case of the absence of such provisions.
Countries signing the Multilateral Instruments are given three options for reservation under Paragraph 5 of Article 10, which is as follows.
A Party may reserve the right:
- for the entirety of this Article not to apply to its Covered Tax Agreements;
- for the entirety of this Article not to apply to its Covered Tax Agreements that already contain the provisions described in paragraph 4;
- for this Article to apply only to its Covered Tax Agreements that already contain the provisions described in paragraph 4.