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International Tax Multilateral Instrument

Article 4 of MLI | Dual Resident Entities

 

Article 3 of MLI states that the critical requirement for granting treaty benefits is that the person should be a resident of the Contracting State.  Article 4 of the OECD Model Tax Convention clarifies that a person’s treaty residence depends on the domestic laws of each contracting state, resulting in a person being treated as a tax resident of both states because of the difference in residency rules of two countries.

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Article 4 of Multilateral Instruments
dual resident entities

In general, in the case of a person other than individuals, the tax residency is based on whether the person is liable to tax in a jurisdiction by its domicile, residence, place of effective management, or any other criteria. Often it leads to a person being tax resident in two or more countries. Article 4(3) of the OECD Model Tax Convention is a tie-breaker rule in dual resident entities (other than individuals). It provides that the dual resident entity shall be deemed a resident only of the state where its Place of Effective Management (POEM) is situated.

Limitation of the tie-breaker POEM rules:

The OECD recommends POEM as a tie-breaker rule for determining residency and an alternative to let the competent authorities determine the residency by mutual agreement on a case-to-case basis. Often, the entities where dual resident situations arise due to aggressive tax planning involve a low tax jurisdiction as POEM.

Some limitations of tie-breaker POEM tests are:

  1. Cannot curb tax avoidance as entities avail low tax jurisdiction as their POEM.
  2. POEM is not defined under OECD Model Tax Convention. Each contracting jurisdiction determines POEM based upon their domestic laws. There is no uniformity or clarity under the current tie-breaker test for determining the POEM of an entity.
  3. The dual resident entity may have a third country as  POEM, hence failing to determine the entity’s tax residence.

Structure of Article 4 of the MLI

Article 4 of the MLI comprises of 4 paragraphs:

  • Parapragh 1: Determining the tax residence of dual resident entities
  • Paragraph 2: Compatibility clause
  • Paragraph 3: Reservation Clause
  • Paragraph 4: Notification Clause

Article 4(1) of the MLI | Determining the tax residence of dual resident entities

Text of Article 4(1) of the MLI is as follow

Where by reason of the provisions of a Covered Tax Agreement:

  • a person other than an individual
  • is a resident of more than one Contracting Jurisdiction,
  • the competent authorities of the Contracting Jurisdictions shall endeavour to determine by mutual agreement
  • the Contracting Jurisdiction of which such person shall be deemed to be a resident for the purposes of the Covered Tax Agreement,
  • having regard to its place of effective management, the place where it is incorporated or otherwise constituted, and any other relevant factors.
  • In the absence of such agreement, such person shall not be entitled to any relief or exemption from tax provided by the Covered Tax Agreement except to the extent and in such manner as may be agreed upon by the competent authorities of the Contracting Jurisdictions.

Let us try to understand what the provision states.

Paragraph 1 of Article 4 of the MLI is a substantive provision. It reflects the measures given under BEPS Action Plan 2 and Action Plan 6, aiming to ensure that dual resident entities do not obtain the undue benefits of treaties. Article 4(1) replicates the recommendation of BEPS Action Plan 6 for Article 4(3) of the OECD Model Tax Convention.

Paragraph 1 of Article 4 of the MLI provides where a person other than the individual is a dual resident, then the competent authorities of the jurisdictions will attempt to determine the single residency for that person. It will be through mutual agreement on a case-to-case basis considering effective management(POEM), the place where it is incorporated or otherwise constituted, and any other relevant factors.

Additionally, Article 4(1) of the MLI provides that if competent authorities do not reach the agreement for determining the single residency for the dual resident entity, then in such case, the entity will not be entitled to any relief or exemption from tax under the Covered Tax Agreement except to extent and manner agreed by the competent authorities.

Article 4(2) of the MLI | Compatibility clause

Text of Article 4(2) of the MLI is as follow

Paragraph 1 shall apply

  • in place of or in the absence of provisions of a Covered Tax Agreement
  • that provide rules for determining whether a person other than an individual shall be treated as a resident of one of the Contracting Jurisdictions
  • in cases in which that person would otherwise be treated as a resident of more than one Contracting Jurisdiction.
  • Paragraph 1 shall not apply, however, to provisions of a Covered Tax Agreement specifically addressing the residence of companies participating in dual-listed company arrangements.

Article 4(2) of the MLI is the compatibility clause that interacts between Article 4(1) of the MLI and the Covered Tax Agreements provisions.

According to provisions of Article 4(2) of the MLI, Article 4(1) of the MLI is applicable (as modified by Article 4(3) of the MLI) in place of or in the absence of the relevant provisions in CTA regarding the dual resident entities.

To explain further, in case the Covered Tax Agreements already contain the provisions for determining the residency of the dual resident entities, then Article 4(1) of the MLI would be replacing such provisions.

In case the Covered Tax Agreements does not contain the provisions for determining the residency of the dual resident entities, then Article 4(1) of the MLI would be added to such a tax treaty.

Provisions of Article 4 of the MLI will replace all tie-breaker rules for the residence of persons other than individuals only. Where a single provision of a CTA provides for a tie-breaker rule for both individuals and entities, then Article 4(1) of the MLI would apply in place of that provision only to the extent that it relates to persons other than individuals.

The last part of Article 4(2) of the MLI states that Article 4(1) does not apply to Dual-listed company arrangements.

What is a dual-listed company arrangement?

Explanatory Statement to the MLI explains A dual-listed company arrangement generally refers to an arrangement, adopted by certain publicly-listed companies, that reflect a commonality of management, operations, shareholders’ rights, purpose, and mission through an agreement or a series of agreements between two parent companies, each with its stock exchange listing, together with special provisions in their respective articles of the association including in some cases, for example, the creation of special voting shares. Under these types of structures, while the participating companies retain their separate entity legal status, the position of the parent company shareholders is, as far as possible, the same as if they held shares in a single company, with the same dividend entitlement and same rights to participate in the assets of the dual-listed companies in the event of a winding-up. Arrangements of this type occur in relatively few jurisdictions, and treaty provisions addressing them are typically customized in detail to the circumstances of those jurisdictions to ensure the determination of a single Contracting Jurisdiction of residence for each participating company

Article 4(3) of the MLI | Reservation clause

Provisions of Article 4 of the MLI are not a minimum standard. Hence Paragraph 3 of Article 4 of the MLI provides for reservation clauses allowing flexibility to countries to opt-out of this provision entirely or partially.  The various alternatives for reserving the right concerning the article are as follow:

Article 4(4) of the MLI | Notification clause

Article 4(4) of the MLI is procedural, explaining the actions required and consequences in the event of reservation which are as under:

  • Suppose any country has not made a reservation on the provisions of Article 4. In that case, it should notify the depository about the provisions of its tax treaties where a similar provision described in Article 4(1) of the MLI is already present.
  • If two countries have notified the relevant provisions in their CTA, then the provision of Article 4(1) of the MLI will be replaced in the existing tax treaties
  • If both or one of the countries do not notify the provisions of the tax treaty, then to the extent that the provisions f the tax treaty is not compatible with the provisions of Article 4(1) of the MLI, Article 4(1) will supersede the tax treaty provisions.
  • If any country reserves the right not to apply Article 4 of the MLI, the provision will not apply to the concerned tax treaty.
Categories
International Tax

Article 17 | Taxation of Entertainers and Sportspersons

 

When Angelina Jolie shoots a film in Prague and Italy, where does she pay her income tax, in Prague, Italy, or the USA? Or how your favorite footballer plans taxation of the prize money of the tournament? Entertainers and sportspersons tend to travel locally and globally for performance and events. Gaining the right to tax that income requires diving into Article 17 of the OECD Model Tax Convention. The provisions of Article 17 assists in avoiding the practical difficulties arising in the taxation of entertainers and sportspersons performing in other states.

Article 17 | OECD Model Tax Convention

Who is an ‘entertainer’?

There is no definition provided for the term ‘entertainer’ in the Convention. But Paragraph 1 of Article 17 corroborates the term by giving the list of entertainers such as theatre, motion picture, radio or television artist, or a musician.

The term includes stage performers, film actors, or actors in a television commercial. It may also apply to income received from the activities involving a political, social, religious, or charitable nature if an entertainment character is present. It does not extend to income earned by conference speaker, or a model performing as such(for instance, modeling or photo session) rather than as the entertainer. If the person is not an entertainer or is part of administrative and support staff (for instance, a cameraperson for a film, producers, film directors, choreographers, technical staff, roadcrew for a  pop group), then Article 17 will not be applicable.

When the person takes a dual role? As an actor and a producer?

In such a case, it is necessary to look at what the individual does in the Contracting State, where the performance takes place. If his activities are predominantly performing in nature, the Article will apply to all the resulting income he derives in that State. If the performing element is a negligible part of what he does in that State, the whole of the income falls outside the purview of Article 17.  

Who is a ‘sportsperson’?

The Article does not define the term, but we interpret in a broader sense, by including participants in athletic events, golfers, jockeys, footballers, cricketers, race drivers, and tennis players. The Article is also applicable for income from other activities that have more entertainment characters, for instance, billiards, snooker, chess, and bridge tournaments.

Income earned by the impresario is not taxable under Article 17. If he receives the revenue on behalf of the entertainer or the sportsperson, then the income is taxable.

Note:

When the income is not received by the entertainer or his impresario or agent, concerning the specific performance, but one lumpsum amount for multiple performances. In that case, according to Article 17(1), the contracting State, where the performance takes place, has the right to tax the proportion of the entertainer’s income, which corresponds to that performance.

Source State right to tax income of entertainers and sportsperson

Paragraph 1 of Article17 of the OECD model tax convention states the income received by the entertainers and the sportspersons for performance in other State, will be taxable in the Other State, i.e., State of Source. It applies to the income received by the person as an employee as well as a business. Article 17(1) is an exception to Article 7 and Article 15(2).

Principles for identifying the tax jurisdiction

Entertainers and sportspersons perform their activities in different States, making it essential to determine which income is taxable in which State. Along with the facts and circumstances, the following principles will be relevant for identifying the taxing jurisdiction:

  1. Income linked to specific activities of the entertainer or sportsperson in a State is also the income derived from the activities exercised in that State.
  2. When an entertainer or sportsperson performs as an employee, his or her remuneration is taxable, where he is physically present when performing the activities.
  3. When an entertainer or sportsperson is an employee of a team, troupe, or orchestra, and the salary covers various activities performed during a period; the payment will be taxable based upon the number of days spent in each State to perform.
  4. If the facts and circumstances provide a better link between the income received and the State of performance, then it will be precedent.

Paragraph 1 of Article 17 is applicable regardless of who pays the income.

Royalties, Sponsorship or Advertising Fees received by entertainers and sportspersons:

When entertainers or sportsperson receive other than fees for performance in the form of royalties, or sponsorship or advertising fees, other Articles will apply whenever there is no close connection between the income and the performance of activities in the country concerned.  Article 17 will apply to advertise or sponsorship income, which has a close relationship with a performance in a given State.

Principles to help identify whether the entertainer or sportspersons personal activities derive the income:

  1. Article 17 can apply to an amateur sportsperson or a one time actor too.
  2. The activities of an entertainer or sportsperson include activities conducted in the  State that links with performance.
  3. Merely reporting or commenting on an entertainment or sports event in which the reporter does not himself participate is not an activity of an entertainer or sportsperson acting as such.
  4. Preparation, such as rehearsal and training, is considered part of the normal activities of entertainers and sportspersons. If an entertainer or sportsperson is remunerated for time spent on rehearsal, exercise, or similar preparation in a State the relevant remuneration, as well as remuneration for time, spent traveling in that State for performances, rehearsal and training (or similar development), would be covered by the Article. This would apply regardless of whether or not such rehearsal, exercise, or similar preparation is related to specific public performances taking place in that State.

When the income of entertainers or sportspersons accrues to other persons?

Article 17(2) is applicable when:

  1. The income of an entertainer or sportsperson accrues to another person
  2. The State of Source does not have the right to ‘look through’ the person receiving the income

When the above conditions are satisfied, the non-taxed part of the income will is taxable in the hands of the person receiving the income. If the recipient of income carries on business activities, the tax may be applied by the State of the source even if the income is not attributable to a permanent establishment there. But it will not always be so.

There are three main situations when Article 17(2) is applicable:

  • When no legal entity is involved:

When a management company receives income for the appearance or performance of a group of entertainers or a sportspersons

  • When a legal entity receives income:

When the team, troupe, or the orchestra, legal entity in nature, receives income for performances, the tax burden will be on individual members of the group as per Article 17(1). The profit element accruing from production to the legal entity would be liable to tax under Article 17(2).

  • Tax avoidance measures

When creative tax planning for tax avoidance causes transferring the entertainer’s remuneration to another person or entity, then Article 17(2) permits the imposition of tax on the profits diverted from the income of the entertainer or sportsperson to the enterprise.

Article 17(2) allows the State of performance of activities of an entertainer or sportsperson to tax the income derived from such activities even if it accrues to another person. This is regardless of other provisions of the Convention that may otherwise be applicable.

Will Article 17(2) apply to the prize money received by the owner of the race car?

When the owner of the race car or the horse received the prize money, it is not the consideration received for the personal activities of the jockey or race car driver. In such a case, the rewards are for the activities related to the ownership, design or training, construction, and maintenance of the race car or the horse, which is not the subject matter of Article 17.

But if the money received for the personal activities of the racer or the jockey, then Article 17(1) will be applicable.

Categories
International Tax

Income from Interest| Article 11 | OECD Model Tax Convention

 

Interest is commonly known as the income earned on the movable capital. Unlike dividends, interest does not suffer the economic double taxation and is not taxed both at the hands of the debtor and the creditor. The payer of the interest gets the deduction, whereas the recipient has to discharge taxes. Article 11 of the OECD Model Tax Convention covers the taxation of interest income.

Article 11 | Income from Interest | OECD Model Tax Convention

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Article 11 | Taxation of Income from Interest | OECD Model Tax Convention
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Taxation of Income from Interest | Article 11 | OECD Model Tax Convention

What is interest as per Article 11?

Paragraph 3 of Article 11 defines the term ‘interest’ as:

“The term ‘interest’ as used in this Article means income from debt claims of every kind, whether or not secured by the mortgage and whether or not carrying a right to participate in the debtor's profits, and in particular, income from government securities and income from bonds or debentures, including premiums and prizes attaching to such securities, bonds or debentures. Penalty charges for late payment shall not be regarded as interest for the purpose of this Article.”

The paragraph mentioned above has provided an exhaustive and broad definition of the term ‘interest’ to reduce the ambiguity arising due to the domestic laws of the countries.

The term interest includes income from every kind of debt-claims, irrespective of whether it is secured or unsecured by a mortgage or guarantee and whether or not it provides any right to participate in the debtor’s profits. The debt claims include cash deposits and security in the form of money. Government securities, bonds, and debentures are covered explicitly as debt claims, due to their peculiar nature. Mortgage interest is treated as income from immovable property in a few countries, but for the OECD model tax convention, the same will be exclusively covered under Article 11.

The definition provided in Article 11 is exhaustive, and it is preferable not to include any subsidiary reference to the domestic laws based upon the following considerations:

  1. The definition covers all kinds of income which are regarded as interest in the various domestic laws
  2. The formula employed offers greater security from the legal point of view, and the conventions would not be affected by the future changes in the domestic law
  3. In the Model Convention, references to domestic laws should be avoided as much as possible.

Like dividends and royalty, on payment of interest tax is deducted at source.

Certain countries do not allow interest paid to be deducted for the payer’s tax unless the recipient also resides in the same State or is taxable in that State. Otherwise, they forbid the deduction. Paragraph 4 of Article 24 clarifies allowance of deduction when a resident of a Contracting State pays the interest to a non-resident.

Are interest from participating bonds be treated as interest or dividend?

Participating bonds are the bonds that are entitled to share in additional distributions of profits of the company along with its common stocks. This is over and above the interest payments received by them. Interest in participating bonds and convertible bonds will be treated as interest till they are converted to shares unless the loans effectively share the risks run by the debtor company. 

For identifying the creditor sharing risks run by the debtor company, each case has to be analyzed with its specific circumstances as follow:

  • Whether the loan very heavily outweighs any other contribution to the enterprise’s capital (or was taken out to replace a substantial proportion of capital which has been lost) and is substantially unmatched by redeemable assets;
  • Whether the creditor will share in any profits of the company
  • Whether repayment of the loan is subordinated to claims of other creditors or the payment of dividends
  • Whether the level or payment of interest would depend on the profits of the company
  • Whether the loan contract contains no fixed provisions for repayment by a definite date.

For avoiding overlap between the dividends and interest, it is to be noted that the term ‘interest’ as used in Article 11 does not include items of income which are dealt with under Article 10.

Which country has the right to tax the ‘interest’?

Paragraph 1 and 2 of Article 11 provides taxation rights on interest to both the State of residence and the State of Source.

 A formula reserving the exclusive taxation of interest to one State, either the State of residence or the State of source, could not be sure of receiving the general approval. Therefore, Article 11 provides the right to tax interest to the State of residence but leaves the right to tax interest to the  State of Source if its domestic law provides so. It is implicit that the State of Source is free to give up the right to tax the interest paid to the non-residents.

The State of Source’s right to tax interest is limited by the ceiling rate of 10% or as agreed by the Countries while agreeing.

Article 11 provides the right to tax the interest on the State of residence of the recipient. Although paragraph 2 of Article 11 bestows the State of source, the option of taxing the interest but within a limit of 10%.

State of Residence:

Paragraph 1 of Article 11, the interest paid by a resident of a contracting state to the resident of another Contracting State, may be taxed by the other State. It does not provide the exclusive right to the State of residence.

The Article deals only with interest arising in the Contracting State and does not apply to the interest arising in the third State.

State of Source:

Paragraph 2 of Article 11 bestows the limited right to tax the interest to the State of source with a ceiling of 10%. This rate is considered to be a reasonable limit as the State of Source has the right to tax profits or income produced on its territory by investments financed out of borrowed capital. The countries entering into agreement are free to choose the lower rate as a ceiling limit or an exclusive right to tax on interests to the State of residence.

Many countries believe, the State of Source’s right to tax interest forms an obstacle to international trade. The major problem that arises to the lender is the taxation of interest is on the gross amount without any deduction on the expenses incurred in order to earn such interest.  In order to avoid this burden, many creditors tend to shift the burden of tax levied by the State of Source to the debtors, which increases the cost of borrowed funds to the debtors.

Double taxation avoidance agreements many countries may consist of variation or exemption on the following points:

  • Interest paid to a State, its political subdivisions and to central banks
  • Interest paid by a State or its political subdivisions
  • Interest paid pursuant to export financing programs
  • Interest paid to financial institutions
  • Interest on sales on credit
  • Interest paid to tax-exempt entities

What is the impact of premium paid on bonds and debenture while taxing the ‘interest’?

Interest yielded on the security includes what the institution pays over and above the amount paid by the subscriber, that is, the interest accruing plus any premium paid at the redemption or issue.

If a bond or a debenture has been issued at a premium, the excess amount paid by the subscriber over that repaid to him may constitute adverse interest, which should be deducted from the stated interest in determining the taxable interest.

It is important to note that the interest does not include any profit or loss that cannot be attributed to a difference between what the issuer received and paid.

Does Article 11 applies to ‘interest rate swaps’?

The definition of interest does not apply to payments made under certain kinds of nontraditional financial instruments where there are no underlying debts. Hence for interest rate swaps, Article 11 will not apply if there are no underlying debts presumed.

Are penalty charges on late payment of interest treated as ‘interest’?

As per second part of Paragraph 3 of Article 11, penalty on late payment of interest will not be ‘interest’ for Article 11, as penalty does not form part of the income of capital but a particular form of compensation for the loss suffered by the creditor through the debtor’s delay in meeting his obligations. For considerations of legal security and practical convenience, it is advisable to place all penalty charges in whatever form they are paid on the same footing for the purpose of taxation.

Are Annuities covered under Article 11?

Annuities granted in consideration of past employment are referred to Article 18 and are subject to the rules governing pensions. Although the installments of purchased annuities include elements of interest on the purchased capital as well as the return of capital, such installments thus constituting “fruits civils” which accrue from day to day, it would be difficult for many countries to make a distinction between the element representing income from capital and the element defining a return of capital in order merely to tax the income element under the same category as income from movable capital. Hence annuities are not covered under Article 11.

How to identify the State of Source of interest?

Paragraph 5 of Article 11 states, the State of Source of interest is the State, where the payer of the interest is a resident. It provides for an exception, in case of interest-bearing loans, which have an apparent economic link with a permanent establishment owned in the other Contracting State by the payer of the interest. When loans are taken for the permanent establishment, and the said permanent establishment bears the interest, the paragraph 5 determines that the source of the interest is in the Contracting State in which the permanent establishment exists, irrespective of where the owner of the permanent establishment resides.

It is important to note that the identification of the economic link plays a pivotal role. If the economic link is absent between the loan on which interest arises and the permanent establishment, then the contracting State where the permanent establishment exists can not tax the interest.

How will the interest be taxed if the payer and the recipient are in one State and the permanent establishment for which loan is taken is in the third State?

Paragraph 5 of Article 11 is silent about the case where the recipient of the interest and the payer are residents of a contracting state, but the payers’ permanent establishment, for which loan was taken and who pays the interest, is in third State. Only the first sentence of Paragraph 5 would be applicable, and the State of Source will be the State where the payer is resident. Here interest will be taxed both in the contracting State of which payer is the resident and in the contracting State of which the beneficiary is the resident. But double taxation would not be avoided between the contracting states and the third State if the latter taxes the interest on the loan at the source when the permanent establishment in its territory bears it.

The Convention does not cover such cases, hence Contracting State of payer’s residence need not relinquish its tax at the source in favor of the third State in which is situated the permanent establishment for which the loan was effected, and interest is borne.  

Explain taxation of interest among related parties.

Paragraph 6 of Article 11 deals with the taxation of interest when related parties are involved in the transaction. It restricts the operation of the provision concerning the tax of interest in cases where, because of a special relationship between the payer and the beneficial owner or between both of them and some other person, the amount of the interest paid exceeds the Arm’s length price.

Paragraph 6 of Article 11 states that in the interest would be taxed at the arms-length price and the excess part of interest will be taxed according to the laws of the two contracting states with due regards to other provisions of the Convention.

The concept of ‘special relationship’ covers the relationship by blood or marriage and, in general, any community of interests as distinct from the legal relationship giving rise to the payment of the interest.

Categories
International Tax

OECD Model Tax Treaty: Article 1

 

Article 1 of the OECD Model Tax treaty states the persons who are covered under the convention. This forms part of scope of the treaty.

Persons covered under Article 1 of the OECD  Tax Treaty

Article 1 of the OECD Model Convention is as follow:

PERSONS COVERED

1. This Convention shall apply to persons who are residents of one
or both of the Contracting States.

2. For the purposes of this Convention, income derived by or
through an entity or arrangement that is treated as wholly or partly
fiscally transparent under the tax law of either Contracting State shall
be considered to be income of a resident of a Contracting State but
only to the extent that the income is treated, for purposes of taxation
by that State, as the income of a resident of that State.

3. This Convention shall not affect the taxation, by a Contracting
State, of its residents except with respect to the bene%ts granted under
[paragraph 3 of Article 7], paragraph 2 of Article 9 and Articles 19, 20,
23 A [23 B], 24 and 25 A [25 B] and 28.

Article 1 of the OECD Model convention

Let us approach each paragraph at a time. 

Paragraph 1 of Article 1 of OECD Model Tax Treaty states explicitly applies to the residents of either one or both the contracting states. Previously the tax treaties applied to the citizens of the countries. Article 4 of the Convention defines the term resident, and Para 1 of Article 3 establishes the person. If the person is a resident of the contracting state, he does not, by default, become beneficiary of the treaty, since the specific Articles of the Convention could deny some benefits. 

Paragraph 2 of Article 1 of the OECD Model Tax Treaty addresses the situation of the income of entities that are wholly or partially fiscally transparent. This paragraph attempts to enforce the principles laid down in the 1999 report of the Committee on

Fiscal Affairs entitled “The Application of the OECD Model Tax Convention to Partnerships.” Above mentioned paragraph 2 exclusively states that the benefit of the Convention would not be available to the fiscally transparent entities if neither of the contracting states treats the income of the fiscally transparent entities or arrangements as the income of the residents. 

Let us illustrate it. Country A and Country B have existing DTAA. Country C does not have DTAA with any countries. Mr. A makes payment of interest to a lender LQ LLC which is a resident of Country B. As per Country A law, a limited liability entity is a person. Country A withholds the tax for which Country B will provide tax relief while taxing the income. LQ LLC is a fiscally transparent entity as per Country B. Its partner, Mr. L, who is a resident of Country B and Mr. Q, who is a resident of Country C, will pay tax on their share of income from LQ LLC. Mr. L will get a tax relief due to the DTAA. But as per Para 2 of Article 1, Mr. Q will not get any tax relief from Country B as he is a resident of Country C.

Flow through entity taxation as per OECD Model Tax Treaty

The phrase “income derived by or through an entity or arrangement” has a broader meaning which covers income earned by the entity or establishment, irrespective of the Contracting state’s view. 

The phrase “fiscally transparent” refers to cases where the income is taxed at the level of the person rather than at the level of the entity. For a detailed explanation of the Fiscally transparent concept, click here. 

Paragraph 3 of Article 1 of the OECD Model Tax Treaty confirms the general principle that the Convention does not intend to restrict the right of the contracting states to tax its residents except where it is expressly intended. The below-mentioned Articles are the situations where the Contracting State may provide the treaty benefits to its own resident. 

  • Para 3 of Article 7: Adjustments on the amount of tax charged on the profits of a Permanent Establishment.
  • Para 2 of Article 9: Adjustments on amount of tax charged on the profits of the Associated Enterprise
  • Article 19: Taxation on the income of an individual
  • Article 20: Taxation on students
  • Article 23A and 23B: Relief from Double taxation
  • Article 24: Protection from discriminatory taxation
  • Article 25: Mutual Agreement Procedure
  • Article 28: Members of Diplomatic mission or Consular posts. 

Categories
BEPS International Tax

Preferential Regimes as per the OECD

 

Forum for Harmful Tax Practices has reviewed multiple regimes to identify which system is harmful to the tax base of other jurisdictions. The focus of the review was to determine the regime which provided preference for the geographically mobile business income.

How to identify Harmful Preferential Tax Regime. Tax Havens
Key Criteria for Identifying Harmful preferential tax regime

Criteria for assessing whether the preferential regime is harmful:

Key Factors

  • A regime imposing low or no effective tax rates on income from intangibles and mobile financial and other service actives is a crucial feature of the harmful tax regime. However, this does not alone determine the regime as harmful but a starting point for analysis. 
  • A preferential regime designed to be wholly or partially insulated from the domestic economy, which is known as ring-fencing, is another critical feature of the preferential tax regime. The local economy protects its jurisdiction from the harmful spillover effects of the adverse tax regime. 
  • The regime lacks transparency in financial or regulatory disclosures.
  • The regime has no active exchange of information with other jurisdictions, which hampers the effectiveness of other jurisdictions’ tax enforcement. 
  • The regime encourages operations and arrangements which do not involve substantial activities or manufacturing. 

Other Factors

  • An artificial definition of the tax base.
  • Failure to adhere to international transfer pricing principles
  • Foreign source income exempt from residence country taxation
  • Negotiable tax rate or tax base
  • Existence of secrecy provision.
  • Access to an extensive network of tax treaties
  • Promotion of the regime as the tax minimization vehicle.
Categories
Uncategorized

Article 17 of MLI – Corresponding Adjustments

 

What is the corresponding adjustment? When the contracting jurisdiction carries out the adjustment in the price between the associated enterprises, it may lead to economic double taxation. The enterprise in a Contracting jurisdiction whose profits are revised upwards will be liable to tax on profit already taxed in the hands of its associated enterprise in the other jurisdiction. To relieve this double taxation, Article 17 of MLI provides for the corresponding adjustment.

Article 17 Corresponding Adjustment
Article 17 of MLI | Corresponding Adjustment

Action 14 Report provides that jurisdictions provide access to the mutual agreement procedure in transfer pricing cases and implement the resulting mutual agreements. The Action 14 Report noted that it would be more efficient if jurisdictions also could provide corresponding adjustments unilaterally in cases in which they find the taxpayer’s objection to being justified. Article 17 of the Convention provides a mechanism for Parties to implement this Best Practice.

Corresponding Adjustment – Article 17(1) of MLI

Article 17(1) of the MLI provides that the other contracting jurisdiction (say State B) shall make an appropriate corresponding adjustment :

  • if it finds the profits would have correctly accrued to the associate enterprises
  • and the Contracting Jurisdiction of the associate enterprise has made an upward revision
  • considering if the two entities had been independent enterprises.

It also provides that while making such corresponding adjustment, due regard shall be given to the other provisions of the CTA, and the competent authorities of the contracting jurisdiction shall if necessary consult each other in determining such adjustment.

Compatibility Clause – Article 17(2) of MLI

Paragraph 2 of Article 17 of MLI contains a compatibility clause that describes the relationship between Article 17(1) of the MLI and provisions of Covered Tax Agreements.

It provides that Article 17(1) shall apply to Covered Tax Agreements in the place or absence of a provision requiring that a Contracting Jurisdiction shall make a corresponding adjustment where the other Contracting Jurisdiction makes an adjustment that reflects the arm’s length profits of an enterprise.

Reservation Clause

Article 17(3) of MLI allows a party to reserve the right not to apply Article 17(1) of MLI only on the basis that in the absence of the provisions described in Article 17(2) in CTA, either:

  • The Party making the reservation will adjust as referred to in Article 17(1) of MLI; or,
  • Contracting Jurisdictions competent authority will try to resolve a transfer pricing case under the mutual agreement procedure provision of its tax treaty; or
  • If the Contracting Jurisdiction has expressed a reservation on Article 16(2) because it would accept an Article in its bilateral treaty negotiations by which either country will not make any adjustment after a mutually agreed period in respect of profits :
    • attributable to any enterprise or
    •  profits that would have accrued to the enterprise but did not accrue to being associated enterprises.

Notification Clause

Article 17(4) of MLI requires countries other than a country with reservations under Article 17(3) to notify the Depositary whether each of its Covered Tax Agreements contains provision for the corresponding adjustment. If such provision exists, the article and paragraph number of each such provision has to be notified.

The provisions of paragraph 1 will replace such provisions where all Contracting Jurisdictions to a Covered Tax Agreement have made such a notification. In other cases, paragraph 1 will apply to the Covered Tax Agreement but will supersede existing provisions of a Covered Tax Agreement only to the extent that those provisions are incompatible with paragraph 1.

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Article 15 of MLI | Person Closely Related to an Enterprise

 

The phrase ‘person closely related to an enterprise’ plays a critical role in applying Article 12, Article 13, and Article 14 of MLI. Article 15 of MLI defines this phrase based on the text of Article 5(6)(b) of the OECD Model Tax Convention as set out on pages 16 and 17 of the Action 7 Report.

Person closely related an enterprise

Article 15(1) of MLI – Definition

For the Covered Tax Agreements that are modified by Article 12, Article 13, or Article 14, a person is closely related to the enterprise if :

  • Based on all facts and circumstances,
  • One has control of the other, or both are under the control of the same persons or enterprises; or
  • if one possesses directly or indirectly more than 50 percent of the beneficial interest in the other person or enterprise; or
  • in the case of a company, more than 50 percent of the aggregate vote and value of the company’s shares or the beneficial equity interest in the company.

Reservation Clause

Article 15(1) of MLI intends to apply to provisions of a Covered Tax Agreement that have been modified by a provision of the MLI that uses the term “ person closely related to an enterprise” (specifically Article 12(2), Article 13(4), and Article 14(1) of the MLI). Accordingly, countries can opt out of Article 15 only if they have made the reservations described in Article 12(4), Article 13(6)(a) or (c), and Article 14(3)(a).

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Article 14 of MLI | Splitting up of Contracts

 

Splitting up of contracts is a strategy used for artificial avoidance of Permanent Establishment. Action 7 report notes that as a common strategy for avoiding PE through abuse of Article 5(3) of the OECD Model Tax Convention. Article 14 of the MLI provides to curb this abuse explicitly.

Article 14 of MLI Splitting up of Contracts

Article 14(1) of MLI – Splitting up of Contracts

Paragraph 1 of Article 14 of MLI states that:

  • Where the enterprise of a Contracting Jurisdiction carries on activities in the other Contracting Jurisdiction
  • at a place that constitutes a building site, construction project, installation project, or other specific project identified in the relevant provision of the Covered Tax Agreement, or carries on supervisory or consultancy activities in connection with such a place, in the case of a provision of a Covered Tax Agreement that refers to such activities,
  • and these activities are carried on during one or more periods, in the aggregate, exceed 30 days without exceeding the qualification period of PE referred to in the relevant provision of the Covered Tax Agreement; and
  • where connected activities are carried on in that other Contracting Jurisdiction at (or, where the relevant provision of the Covered Tax Agreement applies to supervisory or consultancy activities, in connection with) the same building site, construction or installation project, or other place identified in the relevant provision of the Covered Tax Agreement
  • during different periods, each exceeding 30 days, by one or more enterprises closely related to the first-mentioned enterprise,
  • these different periods shall be added to the aggregate period during which the first-mentioned enterprise has carried on activities at that building site, construction or installation project, or other place identified in the relevant provision of the Covered Tax Agreement.

The above provision curbs the splitting-up of contracts of construction project contracts between the related or closely related entities to avoid creating a Permanent Establishment in other contracting jurisdictions. The Contracting Jurisdiction shall aggregate such activities relating to the building site, construction, or installation and related activities at the same site/project by closely related enterprises.

Article 14(2) of MLI – Compatibility Clause

Paragraph 2 is the compatibility clause that describes the relationship between Article 14(1) of the MLI and provisions of Covered Tax Agreements. The compatibility clause provides that the splitting-up of contracts rule shall apply in place of or in the absence of provisions in Covered Tax Agreements. It applies to the extent that such provisions address the division of contracts into multiple parts to avoid applying a period about the existence of a permanent establishment for specific projects or activities.

Many treaties feature anti-splitting rules that apply to a wide variety of activities, only some of which may be covered by the provision in Article 14 of MLI. Paragraph 2 of Article 14 of MLI intends to replace those existing rules only to the extent that they relate to the activities described in paragraph 1 and leave those rules intact concerning activities that are not within the scope of paragraph 1. For instance, the same anti-splitting rule is used for a provision relating to construction activities carried on through a fixed place of business and for a provision deeming a permanent establishment to exist in the provision of services that are not tied to a specific place of business.

Article 14(3) of MLI – Reservation Clause

Given that the provisions addressing artificial avoidance of permanent establishment status through splitting-up of contracts are not required to meet a minimum standard, paragraph 3(a) permits a Party to reserve the right for the entirety of Article 14 not to apply to its Covered Tax Agreements.

Few Covered Tax Agreements could contain anti-contract splitting rules that specifically address the exploration for or exploitation of natural resources, and these provisions are frequently carefully negotiated. Paragraph 3(b) of Article 14 of MLI allows a Party to reserve on the application of Article 14(1) only for the existence of a permanent establishment relating to the exploration for or exploitation of natural resources.

Article 14(4) of MLI – Notification Clause

Paragraph 4 of Article 14 of MLI requires each Party (other than a Party that has opted out of the entirety of the Article) to notify the Depositary of whether each of its Covered Tax Agreements contains an existing anti-contract splitting provision that is not subject to a reservation under paragraph 3(b), and if so, the article and paragraph number of each such provision.

 Paragraph 1 will replace such provisions to the extent provided in paragraph 2, where all Contracting Jurisdictions to the Covered Tax Agreement have made such a notification. In other cases, paragraph 1 will apply to the Covered Tax Agreement but will supersede the existing provisions of the Covered Tax Agreement only to the extent that those provisions are incompatible with paragraph 1.

Reference: https://www.oecd.org/tax/treaties/explanatory-statement-multilateral-convention-to-implement-tax-treaty-related-measures-to-prevent-BEPS.pdf

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International Tax Multilateral Instrument

Article 13 of MLI | Exceptions to Permanent Establishment Rule

 

Article 13 of the MLI modifies Article 5(4) of the OECD Model Tax Convention, which deals with a list of exceptions that do not constitute a Permanent Establishment. The rationale behind creating an exception list is that all activities mentioned in the list have a preparatory or auxiliary character that is not enough to establish a significant economic presence in another jurisdiction.

Article 13 of MLI - Exceptions to Permanent Establishment Rules

Article 13(1) of MLI

The opening paragraph of Article 13 of MLI provides the Contracting Jurisdictions to choose:

  • Option A  (Paragraph 2 of Article 13)
  • Option B  (Paragraph 3 of Article 13)
  • None of the above options.

Option A

Option A is a non-obstante clause. Therefore, if a Contracting jurisdiction chooses Option A, then Paragraph 2 of Article 13 of MLI will override the existing provisions of the Covered Tax Agreement defining the exceptions to the Permanent Establishment rules.

The below-mentioned activities or the overall activity of a fixed place of business is excluded from the definition of PE if it is of preparatory or auxiliary character:

  • The activities listed explicitly in the existing Covered Tax Agreement are deemed not to constitute a PE, irrespective of the activity being preparatory or auxiliary in nature.
  • The maintenance of a fixed place of business solely to carry on  for the enterprise any activity not described in subparagraph a.
  • The maintenance of a fixed place of business solely for any combination of activities mentioned in subparagraphs a and b.

The effect of applying Article 13(2) of the Convention would be to preserve the exceptions for activities described in Article 5(4)(a) through (d) of the Covered Tax Agreement but to make those activities subject to the condition that the activity is of a preparatory or auxiliary character.

Option B

Option A is a non-obstante clause. Therefore, if a Contracting jurisdiction chooses Option A, then Paragraph 3 of Article 13 of MLI will override the existing provisions of the Covered Tax Agreement defining the exceptions to the Permanent Establishment rules as follow:

  • The activities listed explicitly in the existing Covered Tax Agreement are deemed not to constitute a PE, irrespective of the activity being preparatory or auxiliary in nature. Except to the extent that the CTA provisions explicitly provide that a specific activity shall be deemed not to be a PE given that the activity is of a preparatory or auxiliary in character. – Article 13(3)(a) of MLI
  • The maintenance of a fixed place of business solely to carry on, for the enterprise, any activity not described in subparagraph a), provided it is of a preparatory or auxiliary character – Article 13(3)(b) of MLI
  • The maintenance of a fixed place of business solely for any combination of activities mentioned in subparagraphs a) and b), provided that the overall activity is a preparatory or auxiliary character. – Article 13(3)(c) of MLI

The effect of applying Article 13(3) of the Convention would be to preserve the exceptions for activities described in Article 5(4)(a) through (d) of the Covered Tax Agreement but to ensure that those exceptions will apply irrespective of whether the activity is of a preparatory or auxiliary character. It would be true whether that Contracting Jurisdiction takes the position that the exceptions in Article 5(4)(a) through (d) [OECD] of that Covered Tax Agreement are considered per se exceptions to permanent establishment status, or the position that they are already contingent on the activity being of a preparatory or auxiliary character.

An exception is provided in Article 13(3)(a) of the MLI; however, to preserve existing provisions of a Covered Tax Agreement that explicitly provide that a specific activity shall be deemed not to constitute a permanent establishment provided that the activity is of a preparatory or auxiliary character.

Anti-fragmentation – Article 13(4) of MLI

Paragraph 4 of Article 13 of MLI is based on the updated Article 5(4) of the OECD Model Tax Convention mentioned in the Action 7 Report on anti-fragmentation provisions. It addresses the issues of fragmentation of activities between closely related parties.

Paragraph 4 of Article 13 of MLI states that the provisions of a Covered Tax Agreement as modified by Article 13(2) or Article 13(3) of MLI, that lists specific activities not to constitute PE shall not apply if:

the same enterprise or a closely related enterprise carries on business activities at the same place or at another place in the same Contracting Jurisdiction AND

  • that place or other place constitutes a permanent establishment for the enterprise or the closely related enterprise under the provisions of a Covered Tax Agreement defining a permanent establishment; OR
  • the overall activity resulting from the combination of the activities carried on by the two enterprises at the same place, or by the same enterprise or closely related enterprises at the two places, is not of a preparatory or auxiliary character,

provided that the business activities carried on by the entities mentioned above constitute complementary functions that are part of a cohesive business operation.

Compatibility Clause

Article 13(2) or Article 13(3) of MLI shall apply in place of the relevant parts of provisions of a Covered Tax Agreement that list specific activities not constituting a permanent establishment.  – Article 13(5)(a) of MLI

Article 13(4) of MLI shall apply to provisions of a Covered Tax Agreement (as they may be modified by paragraph 2 or 3) that list specific activities that are deemed not to constitute a permanent establishment even if the activity is carried on through a fixed place of business (or provisions of a Covered Tax Agreement that operate in a comparable manner). – Article 13(5)(b) of MLI

Reservation Clause for Article 13 of MLI

A Party may reserve the right:

  • for the entirety of Article 13 of MLI not to apply to its Covered Tax Agreements;
  • for Article 13(2) of MLI not to apply to its Covered Tax Agreements that explicitly state that a list of specific activities shall be deemed not to constitute a permanent establishment only if each of the activities is of a preparatory or auxiliary character;
  • for paragraph Article 13(4) not to apply to its Covered Tax Agreements.

Notification Clause for Option

Each contracting jurisdiction that chooses to apply an Option under paragraph 1 of Article 13 of MLI shall notify the Depositary of its choice of Option.

Notification Clause

Each contracting jurisdiction that does not choose an Option and makes no reservation under Article 13(6) of MLI shall notify the Depositary of whether each of its Covered Tax Agreements contains a provision described in Article 13(5)(b) and the article and paragraph number of each such provision.

Paragraph 4 shall apply to a provision of a Covered Tax Agreement only where all Contracting Jurisdictions have made a notification for that provision under this paragraph or paragraph 7.

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BEPS International Tax Multilateral Instrument

Article 12 of MLI | Avoidance of PE through Commissionnarie Arrangements

 

A country has a right to tax the income of its residents and the income of PE of non-resident MNEs. However, through a web of tax planning and corporate structures, many large corporates have artificially avoided the establishment of PE through Commissionnarie Arrangements (covered in Article 12 of MLI) and similar strategies. An OECD study Addressing Base Erosion and Profit Shifting (BEPS) finds that some multinationals use strategies that allow them to pay as little as 5% in corporate taxes when smaller businesses are paying up to 30%.

  1. Article 13 of MLI | Exceptions to PE
  2. Article 12 of MLI | Artificial Avoidance of PE through Commissionnaire Arrangements
Article 12 of MLI - PE through Commissionnarie Arrangements

PE through Commissionnarie Arrangements

“Notwithstanding the provisions of a Covered Tax Agreement that define the term “permanent establishment”, but subject to paragraph 2, where a person is acting in a Contracting Jurisdiction to a Covered Tax Agreement on behalf of an enterprise and, in doing so, habitually concludes contracts, or habitually plays the principal role leading to the conclusion of contracts that are routinely concluded without material modification by the enterprise, and these contracts are:

a) in the name of the enterprise; or

b) for the transfer of the ownership of, or for the granting of the right to use, property owned by that enterprise or that the enterprise has the right to use; or

c) for the provision of services by that enterprise,

that enterprise shall be deemed to have a permanent establishment in that Contracting Jurisdiction in respect of any activities which that person undertakes for the enterprise unless these activities, if they were exercised by the enterprise through a fixed place of business of that enterprise situated in that Contracting Jurisdiction, would not cause that fixed place of business to be deemed to constitute a permanent establishment under the definition of permanent establishment included in the Covered Tax Agreement (as it may be modified by this Convention).”

Paragraph 1 of Article 12 has a non-obstante clause. It overrides the provisions of the definition of PE term given under the CTA but is subject to exclusion from Paragraph 2 of Article 12 to the independent agents.

To curb artificial avoidance of PE through Commissionnarie Arrangements, Paragraph 1 of Article 12 deems the existence of a PE if:

  • A person is acting in a Contracting jurisdiction (State of PE) of CTA
  • On behalf of an enterprise (State of Residence of the enterprise)
  • And habitually concludes contracts or habitually plays the principal role in the conclusion of contracts without material modifications from the enterprise,
  • And these contracts are in the name of the enterprise, or for the transfer of the ownership of, or for the granting of the right to use, property owned by that enterprise or that the enterprise has the right to use; or for the provision of services by that enterprise.

When Article 12(1) of MLI is triggered, the PE is established in the Contracting Jurisdiction (State of PE) for any activities that the person mentioned above undertakes for the enterprise. An exception to this is Paragraphs 4 and 5 of Article 5 of the OECD Model Tax Convention regarding the exclusions and fixed base PE.

Paragraph 2 of Article 12 of MLI – Independent Agent

“Paragraph 1 shall not apply where the person acting in a Contracting Jurisdiction to a Covered Tax Agreement on behalf of an enterprise of the other Contracting Jurisdiction carries on business in the first-mentioned Contracting Jurisdiction as an independent agent and acts for the enterprise in the ordinary course of that business. Where, however, a person acts exclusively or almost exclusively on behalf of one or more enterprises to which it is closely related, that person shall not be considered to be an independent agent within the meaning of this paragraph with respect to any such enterprise.”

Paragraph 2 of Article 12 of MLI represents the provisions relating to independent agent exemption recommended under Final Report on BEPS Action 7. According to Paragraph 2 of Article 12 of MLI, Article 12(1) provisions will not apply to an independent agent representing the enterprise of other contracting jurisdiction in an ordinary course of business. However, when such a person works exclusively for two or more enterprises to which it is closely related, that person shall not be considered an independent agent for Paragraph 2 of Article 12 of MLI.

Paragraph 3 of Article 12 of MLI – Compatibility Clause

Paragraph 3 is a compatibility clause that describes the interaction between paragraphs 1 and 2 provisions on PE through Commissionnarie Arrangements and provisions of Covered Tax Agreements. Existing tax treaties may include a wide variety of such provisions.

Paragraph 3(a) provides that paragraph 1 of Article 12 of MLI would replace existing provisions of a Covered Tax Agreement on dependent agent permanent establishment. However, it applies only to the extent that such variations address the situation in which a person has, and habitually exercises, an authority to conclude contracts in the name of an enterprise.

Paragraph 3(b) provides that paragraph 2 of Article 12 of MLI would replace provisions of a Covered Tax Agreement that provide that an enterprise shall not be deemed to have a permanent establishment in a Contracting Jurisdiction regarding an activity which an agent of an independent status undertakes for the enterprise.

Paragraph 4 of Article 12 of MLI – Reservation Clause

Given that provisions addressing artificial avoidance of permanent establishment status through commissionnaire arrangements and similar strategies are not required to meet a minimum standard, paragraph 4 allows a Party to reserve the right not to apply the entirety of Article 12 to its Covered Tax Agreements.

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Article 11 of MLI | Country’s right to tax its residents – Savings Clause

 

Two countries enter into a tax treaty to allocate the taxation rights between them about cross-border income. It is applicable when a resident of one country derives income from another country. Most articles of the treaty regulate or limits the source-based taxation rights of the country. The domestic tax laws always regulate residence-based taxation. To emphasize that Article 11 reiterates that the tax treaty will not restrict a country’s right to tax its residents. Also commonly known as the ‘savings clause.’

Paragraph 1 of Article 11 – Savings Clause

Article 11 of MLI has sought to introduce a savings clause to preserve the right of a contracting state to tax its residents.  It is based on the recommendation of BEPS Action Plan 6, which provides –

“This Convention shall not affect the taxation, by a Contracting State, of its residents except with respect to the benefits granted under paragraph 3 of Article 7, paragraph 2 of Article 9 and Articles 19, 20, 23 A [23 B], 24 and 25 and 28.”

The savings clause of Article 11 carves out the exception where the right of a contracting state to tax its residents would be restricted. The following benefit granting provisions of the tax treaty shall override the provision of Article 11 –

  • Granting an enterprise a correlative or corresponding adjustment following the initial adjustment made by the other State following the tax treaty on the profits of  PE of the enterprise or an associated enterprise;
  • Taxation of its resident individual which derives income in respect of services rendered to the other Contracting State or political subdivisions or a local authority thereof;
  • Taxation of its residents individual who is a student, business apprentice, or trainer or teacher, professor, lecturer, instructor, researcher or research scholar who meets the conditions of the tax treaty;
  • Provision of tax credit or tax exemption to its resident for the income that the other contracting State may tax per the tax treaty  (including profits are attributable to PE situated in another contracting state in accordance to tax treaty)
  • Protection of its residents against certain discriminatory taxation practices (Non-discrimination clause);
  • Allowance of its residents to request the competent authority of its State or other states to consider cases of taxation under a tax treaty (Mutual Agreement Procedure);
  • Taxation of its resident who is a member of a diplomatic mission, government mission, or consular post of the other State;
  • Provision of taxation of pension or other payments made under the social security legislation of other contracting State shall be taxable only in other contracting State;
  • Provision of taxation of pension and similar payments, annuities, alimony payments, or other maintenance payments arising in other contracting State shall be taxable only in other contracting State; or
  • Any other provision which expressly limits a contracting state’s rights to tax its residents or exclusively allocates taxing rights of an item of income to a contracting state.

Paragraph 2 of Article 11 – Compatibility Clause

Paragraph 2 is a compatibility clause that describes the interaction between the savings clause mentioned in paragraph 1 and provisions of Covered Tax Agreements. This paragraph clarifies that the provision in paragraph 1 replaces existing provisions of Covered Tax Agreements stating that the Covered Tax Agreements would not affect the taxation by a Contracting Jurisdiction of its residents. Article 11(2) adds the savings clause in paragraph 1 of Article 11, where such provisions do not exist in Covered Tax Agreements.

Paragraph 3 of Article 11 – Reservation Clause

Paragraph 3 of Article 11 is a reservations clause where the country is given the option to either :

  1. Not to apply Article 11 to its Covered Tax Agreement entirely.
  2. Not to apply Article 11 to its Covered Tax agreement as a similar provision already exists.
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International Tax Multilateral Instrument

Article 10 of MLI – PE Triangular Case

 

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.

Anti abuse rules on PE Triangular case Article 10
Anti abuse rules on PE Triangular case Article 10

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 TreatyTax in State S limited to
R State – S State5% on a gross basis
P State – S State10% 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:

Where:

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.

Compatibility clause

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.  

Reservation Clause

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.
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Decision Tree Multilateral Instrument

Summary of changes to Preamble | Article 6 | MLI

 

Article 6 of MLI introduces changes in the Preamble of the Covered Tax Agreements. It is a minimum standard as recommended under BEPS Action 6 report.

We have discussed in detail the preamble stated under Article 6 of MLI in our previous post. Click here to read it.

MLI preamble will be in place of or in the absence of the existing preamble language of a CTA, which expresses an intent to eliminate double taxation. However, a Party is permitted to make a reservation for those CTAs which already satisfy the minimum standard and contain the requisite preamble language. In such case reservation by one of the Treaty Partners to a CTA, the preamble of that CTA will remain unchanged.

Paragraph 5 of Article 6 requires Signatories to notify the Depository which of its CTAs (not covered by the reservation) contain a preamble language referring to intent to eliminate double taxation. Both the Treaty Partners have made such notification, the preamble of such CTA stands replaced by the MLI Preamble. If one or both of the Treaty Partners remain silent on such notification and none of them have made a reservation, then the existing preamble shall include the MLI Preamble.

For the applicability of Article 6(1) to the existing CTA, refer to the decision tree below.

Applicability of Preamble under Article 6(1) of Multilateral Instruments

For the applicability of Article 6(3) to the existing CTA, refer to the decision tree below.

Applicability of Preamble under Article 6(3) of Multilateral Instruments
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Decision Tree Multilateral Instrument

Elimination of double taxation – Article 5 of MLI

 

Article 5 of the MLI contains provisions that provide three options for the elimination of double taxation. Countries may choose to address cases of double non-taxation that may where countries use the exemption method to prevent double taxation of income that is not taxed in the State of the source. OECD model convention provides two methods for the elimination of double taxation.

Typically, treaties either adopt the exemption method or the credit method to ensure that the same item of income is not taxed twice in the same person’s hands in two different jurisdictions. In the exemption method, an income taxable in another State is generally exempted from taxation in its State. Whereas under the credit method generally, a tax credit is given equivalent or proportionate to the amount of tax paid in the other State, which can be set off against tax payable in its resident State.

However, double non-taxation may arise due to disagreements between the State of residence and the State of source on the facts of a case or the interpretation of the provisions of a bilateral tax treaty. To cap such an instance, Article 5 of MLI introduces the methods for the elimination of double taxation.

Alternatively, while the income could be liable to tax in the other state/source state, it is not subject to tax. In such a situation, the use of the exemption method may result in an obligation on the State of residence to exempt such income, and therefore double non-taxation. To prevent such instances of double non-taxation, the MLI has provided the following options for countries to choose from. Overall, these options show a marked shift or preference towards tax credit mechanisms over the exemption method.

To read the detailed explanation on Article 5 of MLI – Click here.

For an easy understanding of the impact of Article 5 of MLI on the CTA, refer to the below flowchart.

Flowchart on Methods of elimination of double taxation as per Article 5 of MLI

The summary of three option provided under Article 5 of MLI are as follow:

Option A (paragraph 2 of Article 5 of the MLI) is based on Article 23A(4) of the OECD Model Convention and provides that if an item of income is taxed in the source state, the residence state will not be completely exempt it. Instead, the State of residence shall deduct an amount equal to the tax paid in the State of source against tax payable against the same income in the State of residence. Option A is not intended to apply in situations where the provisions of a Covered Tax Agreement grant exclusive taxing rights to the contracting jurisdiction of residence for specific types of income.

Option B (paragraph 4) allows contracting states to not apply the exemption method to dividends that are deductible in the contracting jurisdiction of the payer (State of source).

Option C reflects the credit method for the elimination of double taxation and is based on Article 23B of the OECD Model Tax Convention.

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Decision Tree International Tax Multilateral Instrument

Dual Resident Entities | Article 4 | Complete flowchart

 

Article 4 of MLI provides a tie-breaker rule for the dual resident entities for determining their tax residence.

A company is easily considered tax resident in two different states simultaneously when it registers under one state’s laws but has the place of effective management in another. It is generally understood that a place of effective management is where key management and commercial decisions necessary for the conduct of the enterprise’s business are made. However, of course, states are free to attach a different meaning to the concept. A conflict like this results in dual residence for the company.

Bilateral tax treaties include specific tie-breaker rules to decide where the company should be considered resident and which state can, therefore, tax the company’s worldwide income.

For a detailed analysis of Article 4 click here.

Dual Resident Entities Decision Tree Chart
Dual Resident Entities| Article 4 of MLI
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