Fiscally transparent entities are the commonly used structure in cross-border investments for their tax efficiency. Fiscally transparent entities usually allow income to ‘pass through’ them; there is no taxation at the entity level. It faces hurdles when trying to access the tax treaty benefits because they often do not meet the definitions of ‘person’ and ‘resident’ in Article 1.
To mitigate the ongoing issues on taxation of income earned by the fiscally transparent entities, Article 3 of the Multilateral Convention deals with applying tax treaties to hybrid entities.
- Income derived by or through fiscally transparent entities | Article 3(1)
- Elimination of double taxation in case of fiscally transparent entities | Article 3(2)
- “Saving Clause” in relation to fiscally transparent entities | Article 3(2)
- Compatibility Clause | Article 3(4)
- Reservation Clause | Article 3(5)
Income derived by or through fiscally transparent entities | Article 3(1)
For the Covered Tax Agreements,
- Income derived by or through
- An entity or arrangement,
- That is treated as wholly or partially fiscally transparent, under the tax law of either Contracting Jurisdiction,
- Shall be considered to be the income of a resident of a Contracting jurisdiction, but,
- Only to the extent that the income is treated for taxation purposes by that Contracting jurisdiction, as the income of a resident of that contracting jurisdiction.
Paragraph 1 of Article 3 of the MLI seeks to ensure tax treaty benefit is granted only in appropriate cases and is not available when neither contracting State treats the entity’s income as that of its resident under its domestic laws.
For a detailed explanation, click here.
Elimination of double taxation in case of fiscally transparent entities | Article 3(2)
Article 3(2) states:
- Provisions of a Covered Tax Agreement that require a Contracting Jurisdiction to exempt from income tax or provide a deduction or credit equal to the income tax paid
- concerning income derived by a resident of that Contracting Jurisdiction
- which may be taxed in the other Contracting Jurisdiction according to the provisions of the CTA
- shall not apply to the extent
- that such provisions allows taxation by that other Contracting jurisdiction solely because the income is also income derived by a resident of that Other Contracting Jurisdiction.
Paragraph 2 of Article 3 of MLI intends to modify the provisions relating to eliminating double taxation concerning fiscally transparent entities. As per this provision, the State of residence is required to relieve double taxation when income is taxable in the other State as per the treaty provisions only if the income is either sourced in the other State or attributed to a permanent establishment situated in the other State.
Let us break and analyze Article 3(2)
Mr. Joy and Mr. Moy are residents of State R and have registered a partnership firm ‘JM’ in State S. ‘JM’ receive interest income from Mr. A, a resident of State A. State R treats partnership firms as taxable entities, whereas State A treats ‘JM’ as a fiscally transparent entity. State R and State S, State S and State A, and State R and State A have adopted OECD Model tax convention.
- State A has withheld tax @ 10% as per Article 11 of the OECD Model tax convention.
- State S has taxed the income of ‘JM’ as the income of the resident @ 30% (domestic tax rate)
Can Mr. Joy and Mr. Moy receive a tax credit for the interest received?
Mr. Joy and Mr. Moy will not receive a tax credit under Article 23A/B for the tax paid in State R on the interest received. State R has taxed the income as the income of its resident.
Mr. Joy and Mr. Moy will receive a tax credit under Article 23A/B for the tax paid in State S on the interest received. State S has taxed the income as the income derived in its Source.
“Saving Clause” in relation to fiscally transparent entities | Article 3(2)
Paragraph 3 of Article 3 of the MLI links Article 3 and the “saving clause” provided in Article 11 of the MLI dealing with ‘Application of tax agreements to restrict a party’s right to tax its residents. A saving clause preserves the right of a Contracting State to tax its residents. This paragraph will apply to any covered tax agreement for which one or more country has reserved the right not to use Article 11 in entirety.
Compatibility Clause | Article 3(4)
Paragraph 4 is the compatibility clause and states that paragraph 1 shall apply in place of or in the absence of similar provisions in the Covered Tax Agreements.
Reservation Clause | Article 3(5)
Article 3 is not the minimum standard, hence Paragraph 5 of Article 3 provides for reservation clause.
The various alternatives for reserving the right with respect to the article is listed below