Article 3(1) of MLI – Taxation of income derived by or through fiscally transparent entities


Article 3(1) is the primary provision of Article 3. It reflects BEPS Action Plan 2 measure that addresses income earned through fiscally transparent entities.

Paragraph 1 of Article 3 of Multilateral convention

To understand this provision’s genesis, we need to look into the issues of fiscally transparent entities while availing the treaty benefits.

Whether treaty applies to a Fiscally transparent entity?

Article 1 of the OECD model tax convention, a treaty applies to persons who are residents of one or both contracting states. The definition in the Model Tax Convention did not specifically cover the fiscally transparent entities.

Article 4 of the OECD Model tax convention defines ‘resident of a contracting state’ to mean any person who, under the laws of that State, is liable to tax therein because of his domicile, residence, place of management, or any other criteria of a similar nature including that State or any political subdivision or local authority thereof.

When you read both these provisions, it concludes that a fiscally transparent entity may not itself be liable to tax under the State’s laws where it is formed. Thus, the application of the treaty to such an entity could be denied.

Article 3(1) of Multilateral Convention

For the purpose of 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. 

Application of Article 3(1) of Multilateral Convention

AYC is a partnership firm registered in State A, with Mr. A (resident of State A) and Mr. Y (resident of State B).  AYC has given a loan of 1 million euros to Candy Inc, registered in State C. Candy Inc pays an interest of 3000 euros per day to AYC, which is treated as a transparent entity under State C’s domestic tax laws.

Tax rates on interest income in State C is 30%. State A and State C have adopted the OECD model tax convention, and tax rates of interest under Article 11 are 10%. How much will State C withhold as tax?

Illustration for Article 3 Paragraph 1 of Multilateral convention

Candy Inc pays 3000 Euros per day to AYC Inc, which is equally owned by Mr. A and Mr. Y.

Hence 1500 Euros will be treated as interest income in the hands of Mr. A and Mr. Y each.

As Mr. A is a resident of State A, which has a tax treaty with State C, as per Article 3(1) of the MLI, the interest income will be taxable under Article 11 of the OECD Model Tax Convention. Hence State C will withhold the tax @10% on 1500 Euros paid towards Mr. A’s share.

Mr. Y is a State B resident, which does not have any tax treaty with State C; hence State C will tax the interest income as per the domestic law tax rate of State C @ 30% on 1500 Euros.

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