In a typical scenario, the State of residence has the right to tax the resident taxpayer’s global income, and the State of the Source has the right to tax the taxpayer on the income received/derived by him from the State of the Source. Accordingly, the taxpayer is subject to taxation in both the State of the Source of income and the taxpayer’s State of residence. The purpose of the tax treaties is to grant relief regarding income tax paid in the State of Source and avoid double taxation. In our previous blog post, we have covered the methods of double taxation in detail.
Article 23A and 23B of the OECD Model tax Convention provide two methods for eliminating double taxation, i.e., Exemption Method and Credit Method. There were instances where the taxpayers exploited the exemption method in the tax treaties to achieve double non-taxation. For example, where the source state would have the right to tax the income, it may not tax, and the State of residence follows the exemption method and does not tax such income, leading to double non-taxation.
Article 5 of the MLI aims to prevent such instances by providing options for countries to eliminating double non-taxation. These options reflect a shift of preference from exemption method to Credit method. BEPS Action 6 provides an amendment to the preamble of the tax treaties, which is a minimum standard.
- Structure of Article 5 of the MLI
- Article 5(1) of MLI – Compatibility Clause
- Option A of Article 5
- Option B of Article 5
- Option C of Article 5
- Article 5(8) | Reservation Clause for Entire Article 5
- Article 5(9) | Reservation Clause to Option C of Article 5
- Article 5(10) | Notification Clause to Option C of Article 5
Structure of Article 5 of the MLI
Article 5(1) of MLI – Compatibility Clause
Text of Article 5(1)
“A Party may choose to apply either paragraphs 2 and 3 (Option A), paragraphs 4 and 5 (Option B), or paragraphs 6 and 7 (Option C), or may choose to apply none of the Options. Where each Contracting Jurisdiction to a Covered Tax Agreement chooses a different Option (or where one Contracting Jurisdiction chooses to apply an Option and the other chooses to apply none of the Options), the Option chosen by each Contracting Jurisdiction shall apply with respect to its own residents.”
Paragraph 1 of Article 5 is a compatibility clause describing a country can choose to apply any of the three options provided or choose not to apply any options. The options in Article 5(1) of the MLI derive from the recommendations of BEPS Action 2. It provides alternative ways to address problems arising from the inclusion of the exemption method in tax treaties for items of income that are not taxed in the source state. In the case of asymmetrical application (where each contracting State adopts a different method) of the elimination of double taxation, Article 5(1) clarifies that if each contracting State opts for different options under Article 5, such a chosen option will apply to the residents of each country differently.
However, it is subject to the reservation clauses given under paragraphs 8 and 9 of Article 5 of the MLI.
Option A of Article 5
Article 5(2) | Main Provision to OptionA
Text of Article 5(2)
“Provisions of a Covered Tax Agreement that would otherwise exempt income derived or capital owned by a resident of a Contracting Jurisdiction from tax in that Contracting Jurisdiction for the purpose of eliminating double taxation shall not apply where the other Contracting Jurisdiction applies the provisions of the Covered Tax Agreement to exempt such income or capital from tax or to limit the rate at which such income or capital may be taxed. In the latter case, the first-mentioned Contracting Jurisdiction shall allow as a deduction from the tax on the income or capital of that resident an amount equal to the tax paid in that other Contracting Jurisdiction. Such deduction shall not, however, exceed that part of the tax, as computed before the deduction is given, which is attributable to such items of income or capital which may be taxed in that other Contracting Jurisdiction.”
Paragraph 2 of Article 5 is based upon Article 23A(4) of the OECD Model Tax Convention. Article 5(2) of the MLI adopts Article 23A(4) of the OECD Model Tax Convention with a more general reference to the provisions for eliminating double taxation.
The paragraph states that the provisions of the Covered Tax Agreement that requires the State of Residence to exempt the income derived by the taxpayer shall not apply where the State of the Source of income exempts the same income or limits the rate of tax to be charged on such income as per the Covered Tax Agreement (CTA). Article 5(2) of the MLI provides that exemption would be denied in the case mentioned above, and the State of Residence will tax the income. If the State of Source taxes an item of income at a reduced rate, the State of residence will still deny the exemption on the income but provide the tax credit for the taxes paid in the State of Source.
Article 5(3) | Compatibility Clause to Option A
Text of Article 5(3) of the MLI
“Paragraph 2 shall apply to a Covered Tax Agreement that would otherwise require a Contracting Jurisdiction to exempt income or capital described in that paragraph.”
Article 5(3) of the MLI is a compatibility clause describing the interaction between Option A and the provisions of the CTA. It provides that Option A would apply to CTAs where the State of Residence ordinarily applies exemption method to eliminate double taxation and the State of Source either taxes at a reduced rate or exempts the income from the CTA provisions.
Paragraph 3 of Option A should not be read to apply to provisions that grant exclusive taxing rights to the Contracting Jurisdiction of residence concerning specific types of income, such as provisions that exempt dividends from source taxation.
Option B of Article 5
Article 5(4) | Main Provision to Option B
Text of Article 5(4)
“Provisions of a Covered Tax Agreement that would otherwise exempt income derived by a resident of a Contracting Jurisdiction from tax in that Contracting Jurisdiction for the purpose of eliminating double taxation because such income is treated as a dividend by that Contracting Jurisdiction shall not apply where such income gives rise to a deduction for the purpose of determining the taxable profits of a resident of the other Contracting Jurisdiction under the laws of that other Contracting Jurisdiction. In such a case, the first-mentioned Contracting Jurisdiction shall allow as a deduction from the tax on the income of that resident an amount equal to the income tax paid in that other Contracting Jurisdiction. Such deduction shall not, however, exceed that part of the income tax, as computed before the deduction is given, which is attributable to such income which may be taxed in that other Contracting Jurisdiction.”
BEPS Action 2 suggests that the contracting states can add rules to their tax treaties to avoid hybrid mismatch arising due to incomes treated as dividends and are exempt in State of residence and tax-deductible in the State of Source. Option B given in Article 5(4) of the MLI allows contracting states to switch over from exemption method to credit method for deductible dividends in the payer state. The State of Residence will then deny the exemption to the tax resident for the incomes taxable as dividends in its State, which are received from the State of Source where it is deductible from taxable profits. Article 5(4) of the MLI directs the State of residence to provide credit for the taxes paid in the State of Source for such income.
Article 5(5) | Compatibility Clause to Option B
Text of Article 5(5) of the MLI
“Paragraph 4 shall apply to a Covered Tax Agreement that would otherwise require a Contracting Jurisdiction to exempt income described in that paragraph.”
Article 5(5) of the MLI is the compatibility clause, which describes the interaction between Option B and the provisions of Covered Tax Agreements. The compatibility clause indicates that Option B would apply to Covered Tax Agreements that would otherwise require the State of Residence to exempt income derived by its residents from dividends that are deductible in the Contracting Jurisdiction of the payer.
Option C of Article 5
Article 5(6) | Main Provision to Option B
Text of Article 5(6) of the MLI
- “Where a resident of a Contracting Jurisdiction derives income or owns capital which may be taxed in the other Contracting Jurisdiction in accordance with the provisions of a Covered Tax Agreement (except to the extent that these provisions allow taxation by that other Contracting Jurisdiction solely because the income is also income derived by a resident of that other Contracting Jurisdiction), the first-mentioned Contracting Jurisdiction shall allow: i) as a deduction from the tax on the income of that resident, an amount equal to the income tax paid in that other Contracting Jurisdiction; ii) as a deduction from the tax on the capital of that resident, an amount equal to the capital tax paid in that other Contracting Jurisdiction. Such deduction shall not, however, exceed that part of the income tax or capital tax, as computed before the deduction is given, which is attributable to the income or the capital which may be taxed in that other Contracting Jurisdiction.
- Where in accordance with any provision of the Covered Tax Agreement income derived or capital owned by a resident of a Contracting Jurisdiction is exempt from tax in that Contracting Jurisdiction, such Contracting Jurisdiction may nevertheless, in calculating the amount of tax on the remaining income or capital of such resident, take into account the exempted income or capital.”
Article 5(6)of the MLI reflects the credit method for eliminating double taxation and replicates the language suggested in BEPS Action 6. While Option A and Option B allow a switchover from the exemption to credit method in certain situations, Option C allows a country to apply the credit method to all its tax treaties if the exemption method is applied.
The State of Residence would provide a tax credit for the lower of the following:
- Taxes paid in the State of Source by the resident
- Taxes payable on such income/capital in the State of residence.
It provides the exclusion of scenario while providing a tax credit: The State of Residence is not required to provide tax credit when the other Contracting state taxes the same income/capital SOLELY because it is also the income/capital of its residents. This scenario is included to rectify the hybrid mismatch cases mentioned under Article 3 of the MLI.
Article 5(6)(b) of the MLI enables the State of Residence to retain the right to take the amount of income /capital, which is exempt as per the State of residence, into consideration when determining the tax to be imposed on the rest of the income/capital.
Article 5(7) | Compatibility Clause to Option C
Text of Article 5(7) of the MLI
“Paragraph 6 shall apply in place of provisions of a Covered Tax Agreement that, for purposes of eliminating double taxation, require a Contracting Jurisdiction to exempt from tax in that Contracting Jurisdiction income derived or capital owned by a resident of that Contracting Jurisdiction which, in accordance with the provisions of the Covered Tax Agreement, may be taxed in the other Contracting Jurisdiction.”
Paragraph 7 of Article 5 of the MLI is a compatibility clause that describes the interaction between Option C and the provisions of the CTA. Option C would apply in place of the provisions of a CTA, which provides an exemption method for eliminating double taxation on income/capital derived from the State of Source.
Paragraph 7 should not be read to replace existing provisions intended to clarify that dividends that would be exempt from tax under the domestic law of the Contracting Jurisdiction of residence would be exempt under the Covered Tax Agreement as well.
Article 5(8) | Reservation Clause for Entire Article 5
Text of Article 5(8) of MLI
“A Party that does not choose to apply an Option under paragraph 1 may reserve the right for the entirety of this Article not to apply with respect to one or more identified Covered Tax Agreements (or with respect to all of its Covered Tax Agreements).”
Article 5 is not a minimum standard; hence Article 5(8) provides an option to countries to reserve the right for the entirety to Article 5 not to apply to selected Covered Tax Agreements.
Two countries who are Party to the CTA choose different options, or one country chooses one Option, and the other country chooses not to apply any option, then each country’s choice would apply for its residents. It is called the asymmetric application of options.
Article 5(9) | Reservation Clause to Option C of Article 5
Text of Article 5(9) of MLI
“A Party that does not choose to apply Option C may reserve the right, with respect to one or more identified Covered Tax Agreements (or with respect to all of its Covered Tax Agreements), not to permit the other Contracting Jurisdiction(s) to apply Option C.”
Article 5(9) provides that a country that does not choose to apply Option C may reserve the right for selected Covered Tax agreements or to all its Covered Tax Agreements not to permit the other country to apply Option C. Some countries may agree to apply OptionA or Option B asymmetrically but considering Option C gives effect to significant changes, countries may prefer to address the application of Option C through bilateral negotiations.
Article 5(10) | Notification Clause to Option C of Article 5
Paragraph 10 requires each Party that has chosen to apply an Option under paragraph 1 to notify the Depositary of
- its choice of Option,
- each Covered Tax Agreement containing a provision within the scope of the compatibility clause for that Option; and
- the article and paragraph number of each such provision. To ensure clarity, an Option will only apply with respect to a provision of a Covered Tax Agreement if the Party that chose to apply the Option makes such a notification with respect to that provision.