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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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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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Decision Tree International Tax Multilateral Instrument

Covered Tax Agreement | Article 2 Decision Tree

 

For easy understanding of the applicability of Article 2(1)(a)(ii) of MLI, we present the decision tree diagram (flow chart). It is a quick summary of Article 2 of Multilateral Instrument.

As per Article 2(1)(a)(ii) of MLI, the MLI will modify only those double tax agreements that :

  • Each Party has specifically identified and listed in a notification to the Depository
  • As well as any amending or accompanying instruments to it
  • This is determined by title, names of the parties, date of signature, and, if applicable, at the time of notification (the date of entry into force).
Decision tree for Covered Tax Agreement Provisions Article 2 of MLI
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International Tax

Everything about Triangular Cases

 

We have repeatedly discussed how corporate and multinational entities have creatively used the tax treaties to reduce their overall tax liabilities. One such measure is a typical “Triangular case” where three countries are involved, the State of residence of the entity, the State of the Source, and the State where the Permanent establishment is resident (third State).

BEPS Action 6 Report introduced an anti-abuse provision to deal with “Triangular cases,” provided through Article 10 of MLI. For better understanding the provisions suggested under Article 10, it is imperative for us to understand the present tax scenarios for the “Triangular cases.”

Introduction to  “Triangular Case”

Article 4 of the OECD Model Tax Convention covers the situation where the individual is resident of multiple countries. But no such general and consistent solution exists for the taxation problems arising from a typical triangular case, i.e., when :

Tax problems arising in the typical triangular cas

When State R taxes the profits of permanent establishment

When no DTAA exists

If there is no DTAA or tax treaty between the three states concerned, the enterprise has an unlimited tax liability. State P will tax income earned by the Permanent establishment, which includes income earned from State S. State S will withhold tax on the income earned by the Permanent establishment in its State. State R will be taxed on its total income.

The issue arising on whether and how to avoid double taxation on the profit of the P.E and income earned in the third State will be answered only through the domestic tax laws.

When DTAA exists

If each of the country in the case mentioned above has concluded a tax treaty with the other two states per the Model convention, the tax situation according to the Articles of the OECD Model Tax Convention will be as follow:

Situation of State S

State S will withhold the taxes on income (interest, dividends, and royalties) paid to the resident of State R as per the DTAA signed between State R and State S. Although the income is attributable to the permanent establishment existing in State P, the DTAA of State P – State S will not be applicable, as the P.E is not the resident of State P.

The issues arising here relate to the procedure and endorsements: whether the enterprise or the permanent establishment should claim the credit and who should endorse it?

Situation with State R

For State R, both the treaties (State R – State S and State R – State P) are applicable. DTAA between State R and State S is relevant because the income comes from State S  and goes to the resident of State R. DTAA between State R and State P is applicable because the profits of the Permanent establishment, which includes income earned in State S, earned in State P is applicable in State R.

In a triangular case, State R must grant a credit for the taxes paid in State P. The question is whether the taxes paid in State S and not credited in State P should also be taken into consideration?

The problems of procedures and endorsement mentioned for State S will also arise for State R.

Situation for State P

Under the tax treaty between State R and State P, the latter State has the right to tax the profits attributable to the business conducted in State P by the permanent establishment.  In the given case, dividends and interest income are income of the Permanent establishment and taxable in State P.

Now the question arises, Whether State P should consider a limited right of taxation of State S. As explained above, DTAA between State P and State S is not applicable; hence State P is not obliged to provide credit for taxes paid in State S. Should State P grant credit under the DTAA between State R and State P?

State R exempts the profits of the permanent establishment

This situation will arise if DTAA of State R and State P concludes exemption to the profits of the permanent establishment in State P.

Problem of double taxation

State R does not tax income earned from State S as it is attributable to the profits of the permanent establishment located in State P. It, therefore, cannot grant credit for:

  • Tax levied in State S if State P does not grant credit for tax paid in State S
  • Or any difference arising due to the amount of tax paid in State S and credit provided in State P.

When the tax is imposed on State S and State P income, only State P can eliminate double taxation. But as discussed above, State P is not obliged by the treaty to provide the credit.

Problem of tax avoidance

Some countries consider that Article 10, 11, and 12 of the treaty between State R and State S justify the exemption or relief from tax on income in State S, even when that income is not liable to tax in State R and the location the P.E. exists.

Note: The analysis and scenarios mentioned in this post are in relation to the OECD Model Tax Convention only.

Categories
International Tax Multilateral Instrument

Capital Gains from Alienation of Shares or Interests – Article 9 of MLI

 

OECD Model Tax Convention and the UN Model provide for taxation of capital gains under Article 13. Though it is an essential source of income, the DTAA does not define the term “capital gains.”.

Article 9 of the Multilateral Instruments seeks to amend Paragraph 4 of Article 13 of the OECD model tax convention, which deals with the taxation of capital gains of alienation of shares /other interests in an entity which is primarily into the ownership of immovable property.

Capital Gains from Alienation of Shares or Interests - Article 9 of MLI

Structure of Article 9

Paragraph 1 of Article 9

Text of Article 9(1) of MLI

“Provisions of a Covered Tax Agreement providing that gains derived by a resident of a Contracting Jurisdiction from the alienation of shares or other rights of participation in an entity may be taxed in the other Contracting Jurisdiction provided that these shares or rights derived more than a certain part of their value from immovable property (real property) situated in that other Contracting Jurisdiction (or provided that more than a certain part of the property of the entity consists of such immovable property (real property)):

a) shall apply if the relevant value threshold is met at any time during the 365 days preceding the alienation; and

b) shall apply to shares or comparable interests, such as interests in a partnership or trust (to the extent that such shares or interests are not already covered) in addition to any shares or rights already covered by the provisions.”

The text of Article 13(4) of the OECD Model Tax Convention 2014 was as follow:

“ Gains derived by a resident of a Contracting State from the alienation of shares deriving more than 50 percent of their value directly or indirectly from immovable property situated in the other Contracting State may be taxed in that other state.”

Changes recommended under Article 9 of MLI are borne from the changes suggested in BEPS Action 6 Report. Paragraph 1 of Article 9 aims to :

  • Introduce a testing period of 365 days  for determining whether the condition on the value threshold is met – Article 9 (1)(a) of MLI
  • To expand the scope of interests that are comparable to shares. – Article 9 (1)(b) of MLI

The other significant changes introduced in the wordings of Article 13(4) of the OECD Model Tax Convention vide Article 9 of the MLI are as follows:

Changes in Article 9 of MLI
Changes in Article 9 of MLI
  1. The term “other rights of participation in an entity” replaces “comparable interests” to ensure Paragraph 1 of Article 9 applies to existing provisions where ownership interests are more broadly described than “comparable interests.”
  2. The term “more than a certain part” replaces “more than 50 percent” to capture the existing provisions using thresholds  not limited to percentage but to include the more generic terms “principal part,” “the greater part,” “mainly,” “wholly,” “principally” and “primarily.”
  3. The term “immovable property” now includes “real property,” and in addition, the phrase “as defined under Article 6” is removed to avoid cross-referencing with another Article.
  4. The phrase “more than a certain part of the property of the entity consists of such immovable property (real property)” has been added to address existing provisions based on Article 13(4) of the UN Model Tax Convention

The purpose of Paragraph 1 of Article 9 of MLI is solely to introduce a testing period and to ensure the provision address the interests comparable to shares. The threshold provided in existing provisions of the CTA would be preserved and continued.

Where the CTA contains exceptions to the application of the existing provisions, those exceptions would also continue to apply.

Some existing provisions of CTA might use the term “income” or “profits” in addition to or instead of “gains” in Article 13(4); such provisions would be within the scope of Paragraph 1 of Article 9 of MLI.

Paragraph 2 of Article 9

Text of Article 9(2) of MLI

“The period provided in subparagraph a) of paragraph 1 shall apply in place of or in the absence of a time period for determining whether the relevant value threshold in provisions of a Covered Tax Agreement described in paragraph 1 was met.”

Paragraph 2 of Article 9 is a compatibility clause describing the interaction between subparagraph a)of Article 9(1) of MLI with the Covered Tax Agreements. It clarifies that the 365 days testing period in Article 9(1)(a) of MLI replaces the testing period in the existing CTA. If the existing CTA does not have a testing period, the provisions of  Article 9(1)(a) of MLI will be added. 

IF the countries prefer to preserve the existing testing period reservation under paragraph 6(d) of Article 9 allows the possibility to opt-out of provisions of Article 9(1)(a) of MLI.

Since paragraph 1(b) already describes the relationship with shares or rights covered by existing provisions, paragraph 2 does not describe the compatibility of paragraph 1(b) with existing provisions.

Paragraph 3 of Article 9

Text of Article 9(3) of MLI

“A Party may also choose to apply paragraph 4 with respect to its Covered Tax Agreements.”

Paragraph 3 of Article 9 allows the countries to opt for Paragraph 4 of Article 9. Article 9(4) of MLI applies the version of Article 13(4) of the OECD Model Tax Convention, produced in the Action 6 Report, to their Covered Tax Agreements, rather than incorporating a testing period and expanding types of interest covered by existing capital gains provisions.

Paragraph 4 of Article 9

Text of Article 9(4) of MLI

“For purposes of a Covered Tax Agreement, gains derived by a resident of a Contracting Jurisdiction from the alienation of shares or comparable interests, such as interests in a partnership or trust, may be taxed in the other Contracting Jurisdiction if, at any time during the 365 days preceding the alienation, these shares or comparable interests derived more than 50 per cent of their value directly or indirectly from immovable property (real property) situated in that other Contracting Jurisdiction.”

Some countries prefer the version of Article 13(4) of the OECD model tax convention, provided in the BEPS Action 6 Report. It incorporates the 365 days testing period but prefers to continue with a 50 percent threshold limit and the phrase “comparable interests.”

Article 9(4) is an optional provision. Article 9(8) states that Article 9(4) of MLI will apply only if all the Contracting Jurisdictions have chosen to apply it by making a notification under Paragraph 8 of Article 9. As it is obvious, when Article 9(4) is chosen to apply, Article 9(1) will not stand in place.

To remember, if one Contracting Jurisdiction chooses to apply paragraph 4 and one or more of the other Contracting Jurisdictions do not (or neither Contracting Jurisdiction chooses to apply it), paragraph 4 would not apply to that Covered Tax Agreement, and paragraph 1 would apply.

Paragraph 5 of Article 9

Text of Article 9(5) of MLI

“Paragraph 4 shall apply in place of or in the absence of provisions of a Covered Tax Agreement providing that gains derived by a resident of a Contracting Jurisdiction from the alienation of shares or other rights of participation in an entity may be taxed in the other Contracting Jurisdiction provided that these shares or rights derived more than a certain part of their value from immovable property (real property) situated in that other Contracting Jurisdiction, or provided that more than a certain part of the property of the entity consists of such immovable property (real property).”

Paragraph 5 of Article 9 is a compatibility clause for the interaction between Article 9(4) of MLI and the existing provisions of CTA. This paragraph clarifies that the provision in paragraph 4 replaces existing provisions of Covered Tax Agreements addressing capital gains from the alienation of shares or interests in entities deriving their value principally from immovable property. It will be added where such provisions do not exist in Covered Tax Agreements.

If Parties prefer to preserve existing provisions of their Covered Tax Agreements, paragraph 6(f) allows the possibility to opt-out of paragraph 4 concerning the Covered Tax Agreements.

Paragraph 6 of Article 9

Text of Article 9(6) of MLI

“A Party may reserve the right:

a) for paragraph 1 not to apply to its Covered Tax Agreements;

b) for subparagraph a) of paragraph 1 not to apply to its Covered Tax Agreements;

c) for subparagraph b) of paragraph 1 not to apply to its Covered Tax Agreements;

d) for subparagraph a) of paragraph 1 not to apply to its Covered Tax Agreements that already contain a provision of the type described in paragraph 1 that includes a period for determining whether the relevant value threshold was met;

e) for subparagraph b) of paragraph 1 not to apply to its Covered Tax Agreements that already contain a provision of the type described in paragraph 1 that applies to the alienation of interests other than shares;

f) for paragraph 4 not to apply to its Covered Tax Agreements that already contain the provisions described in paragraph 5.”

Countries party to the MLI have six options for reservations under Article 9(6) of MLI:

  • Article 9(6)(a) – Not to apply provisions of Article 9(1) to the CTA.
  • Article 9(6)(b) – Not to apply the provision of Article 9(1)(a) to the CTA
  • Article 9(6)(c) – Not to apply provisions of Article 9(1)(b) to the CTA
  • Article 9(6)(d) – Not to apply provisions of Article 9(1)(a) to the CTA as the said CTA already has provisions of the type described under Article 9(1)(a)  that includes a period for determining whether the relevant value threshold are met.
  • Article 9(6)(e) – Not to apply provisions of Article 9(1)(b) to the CTA as the said CTA already has provisions of the type described under Article 9(1)(a)  that that applies to the alienation of interests other than shares
  • Article 9(6)(f) – Not to apply Provisions of Article 9(4) to its CTA that already contain the provisions described under Paragraph 5.

Paragraph 7 of Article 9

Text of Article 9(7) of MLI

“Each Party that has not made the reservation described in subparagraph a) of paragraph 6 shall notify the Depositary of whether each of its Covered Tax Agreements contains a provision described in paragraph 1, and if so, the article and paragraph number of each such provision. Paragraph 1 shall apply with respect to a provision of a Covered Tax Agreement only where all Contracting Jurisdictions have made a notification with respect to that provision.”

Except for countries with a reservation under Article 9(6)(a), every other country shall notify whether each of its CTA contains an existing provision described under Article 9(1). Paragraph 1 would apply with respect to a provision of a Covered Tax Agreement only where all Contracting Jurisdictions have made such a notification with respect to the existing provision.

Paragraph 8 of Article 9

Text of Article 9(8) of MLI

“Each Party that chooses to apply paragraph 4 shall notify the Depositary of its choice. Paragraph 4 shall apply to a Covered Tax Agreement only where all Contracting Jurisdictions have made such a notification. In such case, paragraph 1 shall not apply with respect to that Covered Tax Agreement. In the case of a Party that has not made the reservation described in subparagraph f) of paragraph 6 and has made the reservation described in subparagraph a) of paragraph 6, such notification shall also include the list of its Covered Tax Agreements which contain a provision described in paragraph 5, as well as the article and paragraph number of each such provision. Where all Contracting Jurisdictions have made a notification with respect to a provision of a Covered Tax Agreement under this paragraph or paragraph 7, that provision shall be replaced by the provisions of paragraph 4. In other cases, paragraph 4 shall supersede the provisions of the Covered Tax Agreement only to the extent that those provisions are incompatible with paragraph 4.”

Article 9(8) requires each party choosing to apply Paragraph 4 to notify its choice.

A Party that has not reserved the right under paragraph 6(a) for paragraph 1 not to apply to its Covered Tax Agreements will have included in its notifications under paragraph 7 a list of Covered Tax Agreements containing a relevant existing provision. However, a Party that has made such a reservation will be required to include a list under paragraph 8, except where such Party has reserved the right under paragraph 6(f) to preserve existing provisions. It then describes the relationship between paragraph 4 and paragraph 1.

While all Contracting Jurisdictions have chosen to apply paragraph 4 by making a notification under this paragraph, paragraph 1 would not apply with respect to that Covered Tax Agreement. Instead, paragraph 4 would apply.

An existing provision of a Covered Tax Agreement would be replaced by paragraph 4, where all Contracting Jurisdictions have made a notification under paragraph 7 or 8 with respect to the existing provision.

In other cases, paragraph 4 would supersede the provisions of the Covered Tax Agreement only to the extent that those provisions are incompatible with paragraph 4.

Categories
International Tax Multilateral Instrument

Everything about Article 7 of MLI | Treaty Abuse

 

Multilateral Instrument (MLI) is an instrument that implements tax treaty-related measures of BEPS. Article 7 of MLI is made by the recommendations of OECD and G20 in the BEPS Action 6 Report. 

Article 7 of Multilateral Instruments

Structure of Article 7 of MLI

Paragraph 1 of Article 7

Paragraph 1 of Article 7 covers the principal purpose test, where the treaty benefits will be granted only if the arrangements are not made with the sole purpose of obtaining the treaty benefits. As the Principal Purpose Test (PPT) requires a detailed post on its own, the same can be read here.

Paragraph 2 of Article 7

Paragraph 2 is a compatibility clause that describes the interaction between Article7(1) and provisions of Covered Tax Agreements. This paragraph states that the PPT in paragraph 1 replaces existing provisions of Covered Tax Agreements that deny all or part of the benefits otherwise provided when the transaction fails PPT.

Paragraph 3 of Article 7

Paragraph 3 permits countries opting for PPT under Article 15(a) to include the additional provision in Covered Tax Agreements.

Paragraph 4 of Article 7

Paragraph 4 reflects the additional provision with minor changes (to conform terminology and avoid cross-references to a particular article by number). Paragraph 4 is an optional provision and will apply to a Covered Tax Agreement only where all Contracting Jurisdictions have chosen to apply it by making a notification.

Paragraph 5 of Article 7

Paragraph 5 is a compatibility clause that describes the interaction between paragraph 4 and provisions of Covered Tax Agreements. When both the parties to the CTA opt to apply Article7(4), it will be applicable to the PPT of a CTA. An existing PPT will be modified by paragraph 1, and paragraph 4 will apply in conjunction with paragraph 1.

Paragraph 6 of Article 7

Paragraph 6 allows Parties to choose to apply the simplified LOB provision contained in paragraphs 8 through 13 (the “Simplified Limitation on Benefits Provision”) as a supplement to the PPT in paragraph 1 by making the notification

Paragraph 7 of Article 7

Where one Party chooses to apply the SLOB Provision under Article7(6) and the other does not, the SLOB Provision would not apply, and the PPT in paragraph 1 would apply symmetrically.

Article7(7) provides two optional ways for Parties that do not choose to apply the SLOB to remove the risk that this interaction would result in Article 7 not applying for a given bilateral relationship.

Option 1: Article 7(7)(a)

A country that has chosen only PPT agrees to apply SLOB provisions symmetrically for the purpose of granting the treaty benefits if the other Party to the CTA has chosen SLOB provisions.

Option 2: Article 7(7)(b)

A country that has chosen only PPT agrees to apply SLOB provisions asymmetrically for the purpose of granting the treaty benefits if the other Party to the CTA has chosen SLOB provisions.

Paragraph 8 to 13 of Article 7

Paragraph 8 to 13 of Article 7 covers the provisions for Simplified Limitation of benefits rules. An in-depth analysis of the provisions can be read here.

Paragraph 14 of Article 7

Paragraph 14 is a compatibility clause that describes the interaction between the SLOB and provisions of CTA. The SLOB Provision would replace existing provisions of Covered Tax Agreements that limit the benefits of the Covered Tax Agreements only to a qualifying resident who qualifies as per its categorical tests. It intends to apply in place of or in the absence of existing LOB provisions. It does not intend to restrict the scope or application of other types of anti-abuse rules in Covered Tax Agreements

Paragraph 15 of Article 7

Paragraph 15 defines the reservations that are permitted from Article 7.

A country has three options for reservations:

Option 1: Article 7(15)(a)

A country may reserve the right not to apply Paragraph 1 of Article 7 to its CTA, as it intends to adopt a combination of Detailed limitation of benefits provisions and address the rules to address either conduit financing structures or principal purpose test. Such countries shall try to reach a mutually satisfactory solution to meet the minimum standards provided under BEPS Action 6 Report.

Option 2: Article 7(15)(b)

A country may reserve the right not to apply Paragraph 1 (and Paragraph 4) of Article 7 to its CTA, if it already contains the Principal Purpose test. This would apply in case of a preexisting comprehensive PPT in the CTA and not limited to specific articles.

Option 3: Article 7(15)(c)

A country may reserve the right not to apply for the SLOB Provision not to apply to its Covered Tax Agreements that already contain the provisions of Article 7(14).

Paragraph 16 of Article 7

Where one country to a Covered Tax Agreement prefers to apply the PPT in paragraph 1 alone, and the other prefers to apply the PPT combined with the SLOB Provision, the SLOB Provision would not apply. In such cases, Parties that prefer to apply the SLOB may prefer to apply nothing under Article 7 and leave the issue to bilateral negotiations.

Where the country has chosen SLOB under Article 7(6) and not opted for either option under Article 7(7), they may reserve the right for the SLOB provisions not to be applicable when other parties CTA has opted out of SLOB.  

Paragraph 17 of Article 7

Paragraph 17 describes notifications that are required in order to ensure clarity as to the application of Article 7.

Article 7(17)(a)

Requires Parties that have not opted out of the application of Article 7(1) under Article 7(15)(a) to notify the Depositary of each of its Covered Tax Agreements that is not subject to a reservation under paragraph 15(b). And that contains an existing PPT, along with the article and paragraph number of each such provision.

Article 7(17)(b)

Each Party that chooses to apply Article 7(4) shall notify the Depositary of its choice. Paragraph 4 shall apply to a Covered Tax Agreement only where all Contracting Jurisdictions have made such a notification.

An existing provision of a Covered Tax Agreement would be replaced by the provisions of paragraph 1 (and paragraph 4, where applicable) where all Contracting Jurisdictions to that Covered Tax Agreement have made such a notification with respect to the existing provision. In other cases, paragraph 1 (and paragraph 4, where applicable) would apply to the Covered Tax Agreement, but would supersede the existing provisions of the Covered Tax Agreement only to the extent that those provisions are incompatible with paragraph 1 (and where applicable, paragraph 4).

Article 7(17)(c)

Each Party that chooses to apply the Simplified Limitation on Benefits Provision under Article7(6) shall notify the Depositary of its choice.

Article 7(17)(d)

Each Party that does not choose to apply the Simplified Limitation on Benefits Provision under Article7(6) but chooses to apply either subparagraph a) or b) of Article7(7) shall notify the Depositary of its choice of subparagraph.

Article 7(17)(e)

Where all Contracting Jurisdictions have made a notification under Article 7(17)(c) or Article 7(17)(d) to a provision of a Covered Tax Agreement, that provision shall be replaced by the Simplified Limitation on Benefits Provision. In other cases, the Simplified Limitation on Benefits Provision shall supersede the provisions of the Covered Tax Agreement only to the extent that those provisions are incompatible with the Simplified Limitation on Benefits Provision.

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