How would a hypothetical International Taxation Court decide on a tax treaty issue?

This question would need a hypothetical case to arrive to such International Taxation Court. The IBFD tax day was the occasion and the result (in terms of academical exercise) exceeded the expectations of many of the participants.

Imagine a hypothetical dispute arising out of country responsibilities over the material breach a double taxation agreement. This hypothetical discussion was examined by an actual court dispute during the IBFD Tax Day, the first moot court on tax treaty application (which we expect in the future to be extended to universities).

Facts: Imagine that two countries (Appalaria and Pearonia) concluded a treaty. The Appalaria and Pearonia Treaty, which entered into force in 1997, generally follows the OECD Model Tax Convention. The following official statement accompanied the publishing of the Treaty in Pearonia:

“The treaty contains separate articles applying to royalties and technical service fees (Arts. 12 and 13, respectively), which allow taxation in the source state of up to 15% on royalties and 10% on technical service fees. After some discussion it was agreed to follow the definition of royalties suggested in the OECD Model Convention and to follow the definition of technical service fees that has been used in some earlier conventions signed by both countries.”

In 2002, Appalaria issued an administrative guidance, under the form of a circular letter, interpreting, inter alia, the concept of royalties (without having a definition itself in their domestic law). According to the preamble of the Circular, such guidance was aimed at clarifying uncertainties arising from several tax disputes in Appalaria, concerning the interpretation of the certain types of income subject to the withholding of tax, namely royalties.

The application of the Circular resulted in additional source taxation in Appalaria and consequently increased requests for foreign tax credits in Pearonia.

The Treaty included a most-favoured nation (MFN) clause covering amongst others royalties and fees for technical services. Accordingly, if Pearonia concludes a more beneficial treaty with another OECD member the same rate or scope as provided for in that more beneficial treaty shall also apply under the Treaty. The MFN clause is automatically activated as from the date on which the relevant Pearonia Convention or Agreement enters into force.

In 2002 Pearonia concluded a treaty with the Tangerine Republic (an OECD member), which disallows source state taxation of technical service fees, and limits source taxation of royalties to 5 %. This treaty was ratified in 2003 and entered into force on 1 January 2004.

The matter of Securobits, in which the two countries were unable to reach a mutual agreement, was selected as the test case of this dispute.

CompuTV (company resident in Appalaria) concluded a five-year agreement with Securobits (company resident in Pearonia) concerning security systems to be incorporated into the sound systems and televisions manufactured by CompuTV. According to the agreement, Securobits was required to supply various types of hardware, including hardware and software for a central control unit designed to collect and analyse customer information. In addition, Securobits was required to train CompuTV staff in several areas, namely in the installation of the control unit,
security systems and proper use by customers of the systems. Securobits was also required to assist CompuTV on a five-year marketing campaign in Appalaria and supply CompuTV with lists of potential customers. Finally, the agreement includes a license of Securobits logo, to be used in CompuTV products incorporating Securobits technology. The contract provides that payment for all goods and services supplied to CompuTV in a calendar year is to be paid within three months of the end of the year.

In March 2004, when CompuTV paid Securobits, tax was withheld at 5% from the payments for use of the Securobits brand name and logo.

Appalarian tax authorities later reassessed CompuTV and required tax to be at 15% on all the payments except for the payments for the chips, sensors software and other security apparatus.
Securobits requested Pearonia to initiate a mutual agreement procedure with Appalaria to resolve the issue of double taxation, but the two tax authorities failed to reach an agreement. Pearonia submitted a claim against Appalaria in the International Taxation Court to resolve the dispute.

Pearonia requested that the International Taxation Court to decide:
i) Whether the Circular issued and applied by the tax authorities of Appalaria goes beyond mere interpretation of the Treaty and amounts to treaty override;
ii) Whether in the matter of Securobits, the correct interpretation of the treaty should determine that:
- the payments for the lists of potential customers qualify as business profits under the Treaty;
- the payments for the training (including the troubleshooting support services) qualify as technical services under the Treaty;
- the payments for assistance with the marketing campaign qualify as technical services under the Treaty.
ii) Whether Appalaria is acting manifestly in breach of the Treaty by requiring that tax be withheld from the amounts paid to Securobits at the rate applicable in 2003 and not at the rate applicable in 2004, under the Treaty as modified from 1 January 2004.

I plan in the comming days (if time allows) to report on the almost full victory on Pearonia, (which lost only on the issue of treaty override!). In the meantime, you can read through more detailed case facts or go immediately for the winning pleadings of Pearonia!