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.
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
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.
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.
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.
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.
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).
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.
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.
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.’
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 :
Not to apply Article 11 to its Covered Tax Agreement entirely.
Not to apply Article 11 to its Covered Tax agreement as a similar provision already exists.
Article 10 of the OECD Model Tax Convention and United Nations Model Convention deals with the taxation of dividends. OECD and G20 in BEPS Action 6 report recommended the changes to be incorporated in dividend taxation provisions to remove the effects of tax abuse created by comprehensive tax planning.
Article 8 of Multilateral Instruments is an anti-avoidance provision that seeks to amend only Article 10(2) in those tax treaties based on the old Model Conventions.
“Provisions of a Covered Tax Agreement that exempt dividends paid by a company which is a resident of a Contracting Jurisdiction from tax or that limit the rate at which such dividends may be taxed, provided that the beneficial owner or the recipient is a company which is a resident of the other Contracting Jurisdiction and which owns, holds or controls more than a certain amount of the capital, shares, stock, voting power, voting rights or similar ownership interests of the company paying the dividends, shall apply only if the ownership conditions described in those provisions are met throughout a 365 day period that includes the day of the payment of the dividends (for the purpose of computing that period, no account shall be taken of changes of ownership that would directly result from a corporate reorganisation, such as a merger or divisive reorganisation, of the company that holds the shares or that pays the dividends).”
Article 10(2) of the OECD Model Tax Convention recommends a reduced rate of taxation by Source Country when the Subsidiary Company pays the dividend to the Holding company. Paragraph 1 of Article 8 of MLI requires a minimum shareholding period to satisfy the reduced rate of taxation on dividends by the subsidiary company.
The condition of the minimum shareholding period is added to provisions of a CTA that limit or exempt the taxation by the Source Country on dividends paid to a company that is resident of another country and holds a certain amount of capital or voting power of the dividend-paying company.
Therefore, this Article 8(1) of MLI does not affect the existing provisions of the CTA, which gives the preferential rate for dividends without the condition of holding a certain amount or voting powers of the dividend-paying company.
Paragraph 1 of Article 8 of MLI intends to add a minimum shareholding period to existing provisions of Covered Tax Agreements without modifying the other elements of such provisions, such as tax rates, ownership thresholds, and form of ownership (e.g., directly and/or indirectly).
Paragraph 2 of Article 8 of MLI
Text of Article 8(2) of MLI
“The minimum holding period provided in paragraph 1 shall apply in place of or in the absence of a minimum holding period in provisions of a Covered Tax Agreement described in paragraph 1.”
Paragraph 2 of Article 8 of MLI is a compatibility clause. It describes the interactions of Article 8(1) of MLI with the existing provisions of the Covered Tax agreements. It clarifies that the 365 days minimum shareholding period replaces the minimum shareholding periods existing in the provisions of Covered Tax Agreements. The 365 days test is to be added where such periods do not exist in the provisions of the CTA dealing with the taxation of dividends paid by the subsidiary company to the holding company, a resident of another country.
Paragraph 3 of Article 8 of MLI
Text of Article 8(3) of MLI
“A Party may reserve the right:
a) for the entirety of this Article not to apply to its Covered Tax Agreements;
b) for the entirety of this Article not to apply to its Covered Tax Agreements to the extent that the provisions described in paragraph 1 already include:
i) a minimum holding period;
ii) a minimum holding period shorter than a 365 day period; or
iii) a minimum holding period longer than a 365 day period”
Article 8 of MLI is not a minimum standard. Hence Paragraph 3 of Article 8 provides countries the option to opt-out of Article 8 in entirety vide Article 8(3)(a). The countries can choose to opt-out in other options as the existing CTA already covers the provisions guided under Article 8(1) of MLI or because they choose to have the minimum holding period of longer or shorter than 365 days.
Paragraph 4 of Article 8 of MLI
Text of Article 8(4) of MLI
“Each Party that has not made a reservation described in subparagraph a) of paragraph 3 shall notify the Depositary of whether each of its Covered Tax Agreements contains a provision described in paragraph 1 that is not subject to a reservation described in subparagraph b) of paragraph 3, 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 such a notification with respect to that provision.”
Paragraph 4 of Article 8 of MLI specifies the trigger point for notification is if no reservation is made under Paragraph 3(a) of Article 8 of MLI.
For CTA that does not contain an existing provision and hence not notified, the phrase “in absence of” would add provisions of Article 8(1) to the relevant CTA.
For CTA that contains an existing provision, the phrase “in place of” would replace the existing provisions by Article 8(1) provided both the countries to the CTA notify existing provisions.
Impact on CTA
The United Kingdom and Australia Tax Treaty
United Kingdom – Notified reservation under Article 8(3)(a) not to apply Article 8
Australia– Notified United Kingdom under Article 8(4), as agreement contains a provision described under Article 8(1)
Hence the United Kingdom and Australia Tax Treaty are not impacted by Article 8 of the MLI.
Canada- Netherlands Tax Treaty
Canada – Notified Netherlands under Article 8(4), as agreement contains a provision described under Article 8(1) and not subject to reservation under Article 8(3)(b)
Netherlands – Notified Canada under Article 8(4), as agreement contains a provision described under Article 8(1) and not subject to reservation under Article 8(3)(b)
Article 8(1) of MLI will impact the existing provisions of dividend taxation of Article 10(2) of Canada – Netherlands Tax Treaty.
Some of us have been there, right? Tax notice from one country after paying tax in another country! How outrageous are the demands! A prestigious college in the USA invited my friend as guest speaker, the fees received was after considering the USA tax. Also, in the UK, she was expected to pay tax!
These are the real-life case of double taxation of income where a common man faces hardships. So how do we ‘avoid’ the double taxation? Here the OECD Model tax convention comes in to picture! Throughout the article 6 to 22, we have been through the allocation of the taxation rights of income among the countries. The model convention provides relief of double taxation in Article 23A and 23B, by providing the mechanism of eliminating double taxation.
To understand the relief part, we first need to understand the types of double taxation.
There exist two categories of Double Taxation :
Juridical Double Taxation: As the name suggests, this is the taxation of income of the same person in two different jurisdictions.
Economic Double Taxation: This is a bit complicated. It is the taxation of the same income between two people. It is not easy to imagine but happens in a few cases. For example, Dividends are taxable in the hands of the company and the investor.
Article 23A and 23B resolve juridical double taxation. For resolution from economic double taxation, the countries involved will have to pen down in bilateral negotiations.
International juridical double taxation arises in the following scenarios:
Both countries tax the same person on their worldwide income or capital.
Illustration: Avon, is a citizen of the USA and tax resident of Germany for the year. Germany will tax his worldwide income as a residence-based tax, and the USA will tax his global income as he is the resident.
Tax resident of one country owns capital or earns income in another State. Both State of residence and State of source tax the income and capital
Illustration: Jane Doe is a resident and citizen of Ireland. She owns a yacht in Vancouver, which she often rents for celebrity parties. Income from renting the yacht is taxable in Canada, and her global income is taxable in Ireland.
Triangular Case – A person is non-resident in the States involved in revenue-generating transactions and both the States tax the income.
Illustration: Gavin International, the owner of chain restaurants, is a resident of Taiwan. It has established the restaurant ‘Gavins Food’ in Germany, which is qualified as a permanent establishment in German law. Gavin International has acquired a commercial building in Austria to continue the expansion of ‘Gavins Food’ in Europe. German’s exchequer will tax income derived by leasing the unused portion of the commercial building in Austria.
We will take case studies in future posts to better understanding the scenarios.
What are the principal methods of eliminating double taxation?
The OECD Model Tax Convention follows two leading principles for the elimination of the double tax.
The Principle of Exemption = Look at income
Here the State of residence does not tax the income which, according to the convention, will be taxable in the State of Source or the State where the permanent establishment is situated. Its implementation has two ways
The income which is taxed in other States (State of Source or State of Permanent Establishment) is not taken into consideration when determining the tax to be imposed on the rest of the income = Full exemption method
The income, which is taxed in other States (State of Source or State of Permanent Establishment), is taken into consideration when determining the tax rate to be imposed on the rest of the income = Exemption with the progression method.
The Principle of Credit = Look at credit
Here the State of Residence will compute its tax based on taxpayer’s total income, including the income from the State of Source and State, where Permanent establishment exists. It then allows a deduction from its tax for the tax paid in the other State. It is imperative to note that the income does not include the income which is exclusively taxed in the State of Source.
Two methods of application of the principle of credit:
The State of Residence allows the deduction of the total amount of tax paid in the Other State on income which may be taxed in that State= Full Credit
The deduction given by the State R for the tax paid in the Other State is restricted to that part of its tax, which is appropriate to the income which may be taxed in the other state= Ordinary Credit.
Growing old might have a fair share of pain and pleasure. It is a mix of joy on retirement, commencing second innings, and spending ample time on things you love. Though the person has retired, the tax department will not stop poaching. So here comes the taxation on the retirement income, i.e., the beloved pension.
Article 18 of the OECD Model Tax Convention covers the taxation on a pension. Though the Article is not complicated and capricious, it sometimes has a fair share of litigation.
Article 18 states that the pension received by the person, relating to his employment in the private sector, are taxable only in the State of Residence. The rationale for bestowing all powers of taxation to the State of residence is that the State of residence is in a better position than any other state to take the pensioner’s overall tax liability and obligations.
In case of pensions received by the person from a state or the political division and the same is not covered by Article 19(2), then it is taxable under Article 18.
But not all members of the OECD agree to this principle, and there exist multiple versions of taxation.
What is covered under pension?
Article 18 covers under the term ‘pension’ all payments received by the person or his beneficiaries directly from his former employee. For qualifying as the ‘pension,’ the amount should be obtained for the past employment service. Annuity income received by the person from his investments will not be a pension under this Article.
The Article covers periodic and non-periodic payments.
On the cessation of employment, an employee will receive various payments. To determine whether they are taxable under Article 18, the nature of the payments and facts and circumstances of the case is of importance. Article 15 covers the taxation of income received on cessation of employment.
Factors assisting identification of payment as a pension:
Whether the payment is made on or after the cessation of employment
Whether the recipient continues working
Whether the recipient has reached the normal age of retirement w.r.t his nature of employment
The status of other recipient who qualify for the same type of payment
Whether the recipient is simultaneously eligible for the other pension benefits
Note: Reimbursement of pension contributions in case of temporary employment, does not form part of Article 18.
The taxation on pay-out received by the members of the board of the company is mentioned under Article 16 of the OECD model tax convention. As the members of the board might provide services in multiple locations, identifying the taxing jurisdiction will be a difficult job. To simplify, the provisions of Article 16 give the right to taxation on the director’s remuneration to the State where the company is resident.
Director is a member of the board overseeing the operations, affairs, and welfare of the company. He often has other functions with the company as an employee, advisor, or consultant. Remuneration provided to the director for giving the services in another capacity will not be covered under Article 16.
Miss Meesha, the resident of State B, is a member of the board of Jocy Inc in State A. She spends 45 days of the financial year in State A. She is also the employee of Jocy Inc, working in State C. She receives Director Fees of 100000$ and 500000$ as salary. Assuming State A and State B have adopted OECD Model Tax, what will be taxable under Article 16?
Only Directors fees of 100000$ will be taxable under Article 16 in State A.
For the services provided to the company, a director receives the fees and other compensations. It includes the benefits in kind (e.g., stock options, free or subsidized accommodation and vehicle, health insurance, and club memberships) received by the person in his capacity as a member of the board of the company.
Salary is the payment received by a person who is fixed, regular, and includes non-monetary benefits. Remuneration consists of prerequisites like stock options, rent-free accommodation or automobiles, health or life insurance, and club memberships too.
The general rule of taxation for salary
According to Paragraph 1 of Article 15, the remuneration received by a person is taxable in the State where employment activity is undertaken.
Mr. Randolf is an employee of Global Inc in State A. He works part of the year in State B and another half in State C. As per Article 15(1) both the State B and State C have right to tax the salary received by Mr. Randolf for the period of work exercised in their respective states.
For taxing the salary, the State of the source has to prove that the person receives the salary, wages or other remunerations for the services provided in the State. It is irrespective of when that income is credited, paid, or acquired by the employee in any other means.
For better understanding, let us elaborate on a few scenarios:
Payments received by the employee/former employee
Tax Treatment as per OECD Model Tax Convention
Payment received after termination of the employment
Salary is taxable in the State where the employment activity was exercised.
Payment received for unused holidays accrued.
Salary is taxable in the State where the holidays were accrued.
Payment received at the end of employment for the unused holidays and sick leaves
Where no adequate records are available: Presume the payments received on the accumulated holidays and sick leaves as a benefit for which the employee was entitled in the past 12 months of employment, and allocate the same on pro-rata basis to the State where the employment was exercised during that period. Where records of employees accrued leaves and place of employment available: Payment on unused holidays and sick leaves will be taxable in the State where the work was exercised When taxes are paid in the State of source for the holiday benefits accrued during the term of employment: The State of residence has to provide relief under the double taxation avoidance agreement for the taxes paid in the State of Source.
Payment received for the notice period; an employee is instructed not to work
Taxable as salary, as the remuneration is received by virtue of the employment and therefore constitutes remuneration ‘derived therefrom’ for the purpose of Article 15(1). It will be taxable in the State where it is reasonable to presume that the employee would have worked during the period of notice. It is generally considered to be the State, which was the last location where the employee worked for a substantial period of time before the employee was terminated. Note: the prospective employment location is not taken into consideration.
Severance payment (redundancy payment)
Severance payment is also considered to be the salary for Article 15(1). It is presumed to be the remuneration for the last 12 months of employment, allocated on a pro-rata basis to where the employment was exercised during that period.
On termination of employment due to violation of the contractual obligations, the employee receives a legal damage
The treatment under tax treaty will be based upon the damage the award seeks to compensate. For instance: a) Insufficient notice period: Taxable under Article 15(1); b) Insufficient severance payment: Taxable under Article 15(1); c) Discriminatory Treatment: Article 21; d) Injury to one’s reputation: Article 21; e) Injury due to work-related sickness: Article 21.
Payment for an obligation of not working with a competitor of ex-employer
In general: The payment is directly related to employment hence taxable under Article 15(1). It pertains to the performance of activity after the period of employment, hence taxable in the State where the recipient is resident when the payment is received. When a component of salary is set aside monthly as provision for non-compete Treatment is similar to the remuneration received during that period.
Payment on termination, made for life or medical insurance (covering a certain period after the termination of employment)
Taxable as remuneration under Article 15(1) and in the State where the employment was exercised when the obligation to pay benefits arose.
Payment of pension
Payment on termination, for non-work related sickness or where the employer is not obligated to make the payment
It is presumed to be the remuneration for the last 12 months of employment, allocated on a pro-rata basis to where the employment was exercised during that period.
Exceptions to the general rule of taxation for salary
Following are the exception to the general rule of taxation for salary mentioned under Article 15(1):
Article 15(3): Taxation of the salary of the crew of ship or aircraft in international traffic.
Article 16: Taxation of remuneration of the members of the board
Article 18: Taxation of pensions
Article 19: Remuneration and pensions with respect to Government services
Exemption under Article 15(2)
Paragraph 2 of article 15 is the general exception to Article 15(1). It covers all individuals rendering services except those covered under Article 15(3), Article 16, Article 18, and Article 19.
Let us understand the three conditions provided under Article 15(2).
Limitation of 183 day period
The first condition states that the time limitation of 183 days should not be exceeded in ANY TWELVE MONTHS commencing or ending the fiscal year concerned.
What is ‘fiscal year concerned’? What is the significance of ‘any twelve months period commencing or ending the fiscal year concerned?’
‘Fiscal year concerned’ is to be understood as the Financial year of the Contracting State, where the resident of the other contracting State has exercised his employment and during which the employment service is rendered.
For instance, the United States of America follows the fiscal year of 1st October – 30th September; the United Kingdom follows 6th April-5th April, and Germany follows the calendar year.
‘Any twelve months period commencing or ending the fiscal year concerned’ is the wordings formulated to plug the tax avoidance measures taken by the enterprises by placing the employees in a tax jurisdiction for 5 ½ months.
Minka, the tax resident of State A and employee of Mindwaves Inc, went to State B on 1st July 2018, for providing consultation services on behalf of her enterprise and returned on 31st January 2019.
State A follows calendar year as the fiscal year
State B follows 1st October to 30th September as the fiscal year.
In which fiscal year, will State B tax Minka under Article 15(1)?
No. of days
1st October 2017 – 30th September 2018
Taxable. Minka stays for more than 183 days in State B, in the 12 months commencing in the fiscal year 1st October 2017 to 30th September 2018.
1st October 2018 – 30th September 2019
Taxable. Minka stays for more than 183 days in State B, in the 12 months ending in the fiscal year 1st October 2018 to 30th September 2019.
‘Days of physical presence’ method
The period of the 183 days is computed based upon the “days of physical presence” method. The application of this method is simple, methodical, and is commonly used.
The method relies on computing the days when the individual was physically present in the country. Following days are included in the calculation:
Part of a day
Day of arrival
Day of departure
And all other days spent inside the State of activity such as Sundays, Saturdays, days of holidays, holidays before, during or after the activity, short breaks, training, strikes, lock-out, delays in supply, days of sickness and death or sickness in the family.
When the individual is unable to leave the State due to sickness, then the days are not considered as he would have received the exemption otherwise.
Days spent in traveling outside the country is excluded.
2. Remuneration should be paid by a person who is not the resident of the State of Source.
The condition states that the employer paying the remuneration should not be the resident of the State, where the employment activity is exercised.
In the case of fiscally transparent entities or arrangements, the conditions will apply at the level of the members or partners.
3. Remuneration should not be borne by the Permanent Establishment of the non-resident in the State of Source.
This condition is to prevent the source taxation on short term employment to the extent that the employment income is not allowed as deductible expenses in the State of the source as the employer is neither the resident does not have the Permanent establishment in the State of Source.
The exemption is provided to the employer if the remuneration is not borne by the permanent establishment.
Taxation of remuneration received by the crew aboard a ship or aircraft in international traffic
Paragraph 3 of Article 15, the remuneration received by a person as a member of the regular complement of a ship or aircraft, which operates in international traffic, is taxable only in the State of residence of the employee.
Comparison of taxation practices prevalent in the OECD Member countries shows the varied taxation practices adopted by states with respect to capital gains taxation.
Some countries have adopted No-taxation policy on the Capital gains, whereas some would tax only the enterprises for the capital gains; some countries tax all types of capital gains, some countries might be selective about it.
Article 13 of the OECD model tax convention is powerless against the domestic law of the contracting states. Moreover, Article 13 does not specify the list of taxes that is to be applied for capital gains as the Article will apply to all kinds of taxes levied by the Contracting States on capital gains.
Article 13 has created five scenarios when capital gains arise: movable property, immovable property, ships and aircraft, shares, and others.
In this post, we will understand the following about Article 13:
Taxation of the capital gains on the immovable property?
Paragraph 1 of Article 13 provides the taxation rights on the alienation of immovable property (Mentioned under Article 6) to the State where the immovable property is present. The rights are not exclusive. The State of Residence may also tax the gain but has to provide credit for the taxes paid in the State of the source.
Paragraph 1 of Article 13 is applicable when:
The person is a resident of one State
And the immovable property is situated in another State.
There is an alienation of the said immovable property
Paragraph 1 of Article 13 is supplemented by those of Paragraph 4, which applies to gains from the alienation of shares or comparable interests that derive more than 50% of their value from immovable property.
The term ‘alienation of immovable property’ covers the capital gains resulting from the sale, exchange of property, partial alienation, the expropriation, the transfer to a company in exchange for stocks and shares, the gift, and inheritance. It includes the gain accrued in the long term or the short term (i.e., speculative).
Some countries may choose to tax or not to tax the capital gains arising from the exchange of property or on capital appreciation and revaluation of assets not involving alienation.
Explain taxation of capital appreciation of the assets briefly.
Paragraph 2 of Article 2 of the OECD Model tax convention, has briefly touched upon the taxes mentioned in this convention will also include taxes levied on capital appreciation. Hence, when the countries agreeing have adopted the policy to tax the capital gains on the capital appreciation of the asset and the asset has not been alienated, the State of the source will have the right to impose a tax on that gain if domestic law empowers it to do so.
How to compute the capital gain for Article 13?
Article 13 is silent on the methodology of computing the capital gain; domestic tax laws will be the guiding force here. The general practice is to derive capital gains by reducing the cost from the selling price. All expenses incidental to the purchases, and all expenditure for improvements form part of the cost.
If the accounting rules are different among the Contracting state, there will be a difference in capital gains computed. Let us explain the fundamental difference that would be faced:
Major Inc of State A has acquired the corporate office building in State B at 10000$ in the year 2018.
In the books of Major Inc, the office now stands at value 8000$ after the depreciation allowance of 2000$.
Major Inc is facing a significant scandal in State B and hence chose to sell the property to Helper Inc at 12000$ in the year 2020.
Assuming State A and State B have adopted OECD model tax convention, how will State A and State B compute the capital gains?
Sale value: 12000$
Sale value: 12000$
Cost after depreciation allowance: 8000$
Cost : 10000$
Capital Gains 4000$
Capital Gains 2000$
State B cannot consider the depreciation allowance as the books of accounts are maintained in State A and not in State B.
State A will tax the entire gain, but provide the relief for the taxes paid in the State of the source.
Such scenarios of differences will arise due to domestic laws and the rate of exchange too.
Note: Article 13 does not apply to prizes in a lottery or premiums and bonuses attaching to bonds or debentures.
Process of capital gain taxation for property owned by a Permanent establishment
When international taxation involves the scenarios of cross border investments through the mode of the permanent establishment, the gain from the alienation of movable properties of the permanent establishment will be taxable in the State of the source.
So the next obvious question, what is movable property?
The movable property would be any property other than the immovable property mentioned under Article 6. So all the intangible, know-how, and movable property of the Permanent Establishment will attract Article 13(2).
Note: Paragraph 2 of Article 13 has a broader interpretation; hence when the permanent establishment is alienated (alone or the whole enterprise), the gain will be taxable under the State of the source.
Note: Paragraph 2 of Article 13 does not follow the concept of ‘force of attraction of the permanent establishment.’ The Paragraph merely suggests that gains arising from the alienation of the movable property forming part of the business property of the permanent establishment are taxable in the State where permanent establishment exists. The gains from other movable property will be taxable only in the State of residence of the alienator, as provided by Article 13(5).
How to identify whether the property is part of the business property of the Permanent Establishment?
If ‘Economic ownership’ of the property is with the permanent establishment, then the property is said to be forming part of the business property. The economic ownership of the property means the equivalent of ownership for income tax purposes by a separate enterprise with the tax benefits and burdens. Accounting the property in the books will not be sufficient to connect the property to the permanent establishment effectively.
Taxation of the capital gains on the ships and aircraft?
Enterprises operating ships and aircraft in international traffic follow the principles of Article 8, and Paragraph 3 of Article 22 for capital gains taxation of movable property.
Paragraph 3 of Article 13 is applicable when:
The enterprise operating ships and aircraft alienates the movable property,
Note: Paragraph 3 applies to enterprise operating ships and aircraft in international traffic, whether for transportation activities or when leasing the vessel or aircraft on charter fully equipped, crewed, and supplied. But will not apply if the enterprise does not operate them.
Taxation of the capital gains on the shares and securities?
Taxation of the capital gains on the shares and securities are in the State where the immovable property exists when :
Any time during the 365 days preceding the separation
the shares or comparable interests derived
more than 50% of its value
directly or indirectly from immovable property situated in a Contracting State
How to identify the value of the shares or comparable interests?
For finding the value of shares or the comparable interests, compare the value of the particular immovable property to the amount of all the property owned by the company, entity or arrangement without taking into account of debts or liabilities. (it is irrespective of whether the immovable property was on loan).
Note: The term comparable interests pull the non-corporate entities like partnerships, trusts, and others into Article 13(4).
Mr. Richguy, the resident of State R, incorporated a wholly-owned company Rich Inc on January 1, 2019. The capital of the company is 200 shares of 100$ each. He invests 15000$ to procure a commercial space in State S on the same day, and balance is available as cash balance for future opportunities.
Mr. Richguy sold 100 shares of Rich Inc to Mr.Newguy on September 2, 2019, for 500$ each. Assuming State R and State S have adopted the OECD Model Tax Convention, which State will tax the capital gains?
According to Paragraph 4 of Article 13, State S has the right to tax the capital gains on the sale of shares from Mr.Richguy to Mr.Newguy.
What is the general rule of taxation of capital gains in case of unspecified property?
Paragraph 5 of Article 13 acts as a rule for the capital gains tax for scenarios not specified under Paragraph 1 to 4 of Article 13.
On the alienation of any property, not specified in Paragraph 1 to 4 of Article 13, the taxation rights on capital gains tax are with the State of which alienator is resident. This rule is in line with Article 22.
Are the sale of shares on liquidation of the company covered under Article 13(5)?
When the shareholder alienates the shares for:
liquidation of the company,
redemption of shares,
reduction of capital
the difference between proceeds obtained by the shareholder and the par value of the shares is, in general, a distribution of accumulated profits, not capital gains. The difference is taxable under Article 10 as dividends, mentioned in Article 10(3).