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 :
- Income (dividends, interest, or royalties) is derived from a State of Source (Say, State S)
- A permanent establishment receives such income in State P
- The permanent establishment depends on an enterprise resident in State R.
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.