Tax Treaty Moot Court

As I mentioned in my earlier post, the first IBFD Tax Day consisted of a moot court hearing before a distinguished panel of judges – Justice Arijit Pasayat (Indian Supreme Court), Philippe Martin (Franch Supreme Court) and John Avery Jones (UK Special Commissioner). The case before the court was a dispute between two states concerning the interaction between treaties and domestic law, the scope of the royalties article in treaties and timing issues and at the end of the day, the honourable judges delivered a very balanced judgment.

(a) Interaction between treaties and domestic law and the eventual treaty override issue

The first issue was basically whether the Circular issued and applied by the tax authorities of Appalaria goes beyond mere interpretation of the Treaty by unjustifiably broadening the concept of know-how and amounts to treaty override.

In their submission, the Applicant stated that Appalaria abused its discretion of developing domestic terminology for tax purposes by artificially construing a term (which is not even found in their domestic law) with the aim and effect of altering the equitable distribution of tax revenue. By this action, the applicant contended that Appalaria failed to perform the Treaty in good faith.

The applicant did not dispute whether Appalaria could have issue a definition of a term used in Section 111 but whether such changes was compatible with the context of the treaty. In the applicant’s view it was clear from the case, that the end result of the circular was the qualify items of income under Art 12 which would otherwise fall under Art 13 (technical services article) or art. 7 (business profits). By doing so, the applicant contended that Appalaria was simply draining out any purpose of Art. 13 of the treaty.

The applicant, enquiring why Appalaria acted in such a manner, alerted to the fact that the Circular was published in the same year (2002) when Pearonia signed a treaty with the Tangerine Republic. In that treaty, Peronia had relinquished source taxation on technical services and due to the MFN clause included in the Treaty between Appalaria and Pearonia, the reduced rate on royalties and the elimination of withholding tax on technical fees were to be extended to Pearonian residents investing in Appalaria.

The Applicant therefore submitted that by indirectly extending the domestic scope of know-how, Appalaria not only ignored the context of the treaty but also attempted to minimise the effects of the MFN clause. This is well demonstrated in the test case of Securobits.

Unanimously, the judges decided that a circular such as that in this case, which represented a mere opinion of the tax administration, could not as such constitute treaty override.

The question of the potential binding nature of the Circular was relevant to the outcome on this point. The facts of the case were deficient on this point and the Court naturally felt the necessity to clarify this issue. As such, considering that that the Circular did not qualify as Appalaria Law(*) and therefore was not defensible under a Court of Law, the treaty override issue did not arise.

(b) Application and interpretation of the Treaty to the case of Securobits

In addition to the treaty Override issue, this was also a case about the correct interpretation of the treaty, as well demonstrated in the matter of Securobits. In fact, the issue was whether in the matter of Securobits, the correct interpretation of the treaty should determine that: (i) the payments for the lists of potential customers qualify as business profits under the Treaty; (ii) the payments for the training (including the troubleshooting support services) qualify as technical services under the Treaty; (iii) the payments for assistance with the marketing campaign qualify as technical services under the Treaty.

In the first place, the issue required to decide if Art. 3(2) of the treaty applied, with the Applicant arguing for the context otherwise requiring (referring to the OECD Commentaries), while the respondent argued for internal legislation to apply.

The Court started by referring that the "payment for information concerning industrial, commercial or scientific experience" contained in Art. 12(2) of the treaty are not defined in the treaty. The judges started by looking to the provisions on both royalties and technical fees in the domestic law of Appalaria but realised that domestic law was not of great assistance to resolve the case since, expect to the demised Circular, there was no more guidance on how to interpret the term “information concerning industrial, commercial or scientific experience”. Taking into account the Circular was not law (see point above), the Court reverted to the OECD Commentaries to assert the context of the term in question.

The Applicant submitted that the Commentaries indicate that the term “information concerning industrial, commercial or scientific experience” included in the royalty definition of Art. 12 of the Treaty refer to the concept of know-how and that such Commentaries should provide valuable assistance in resolving this interpretative question. The Applicant emphasised that the essential element of know-how is the impart-principle. Imparting, which means more than mere communication, involves that the know-how provider introduces the other party to the special, undivulged knowledge/experience it has for the purpose of allowing that other party to use the know-how for its own account independently from the provider.

Using a dynamic interpretation, the applicant submitted that imparting necessarily implies a transfer of right to use the know-how and that the correct interpretation of that definition the term “use, or right to use” has to be understood to pertain to the second half of the definition, that is to “information concerning industrial, commercial or scientific experience”.

The Court on this point did not go so far as reading the words "use or right to use" in the case of payments for know-how, but nevertheless recognized that there is perhaps a distinction to be made between information made available to someone and the use or the right to use such information.

After deciding the question of principle, the Court addressed, with referance to the OECD Commentaries, each of the payments in question, recognizing thereby that the appropriate qualification of the payments should be determined by using a “break down” method.

(i) Customer list. Based on the facts, the Court did not fully agree on the characterization of the payment for the handing over of the customer list. Although one judge considered that the payment for the customer list should constitute a royalty payment insofar as the list was prepared using the knowledge and experience of the supplier and handed over in secrecy to the client, the Court considered that the payment for the customer list did not constitute royalties or fees for technical services, but business profit. The third judge considered the payment for the customer list to constitute technical fees because of the cooperation between the two companies.

(ii) Marketing campaign. The Court considered that the payment for the marketing campaign constituted technical fees because: (i) the assistance in the marketing campaign was not experience handed over but merely cooperation; (ii) the supplier kept tight control over the marketing campaign; and (iii) as a "comforting" argument, the remuneration was a lump-sum payment. A dissenting judge considered the payment for the marketing campaign should fall under the royalty article.

(iii) Training. The majority of the judges held the provision of training to constitute a service. However, a distinction was perhaps to be made (based on the facts) between the two types of training in the case; i.e. for ordinary staff and for high-level technical staff. In respect of training for high-level technical staff (who were being trained to build, operate and maintain a complex computer system), the distinction between royalties and technical fees was harder to make. The decision was taken on the grounds that the supplier did not reveal any specific secret to the client, and because the payment was based on the number of employees trained, rather than the value of any information revealed during the training. A dissenting judge considered the such payments should fall under the royalty article.

(c) Application of MFN clause

This issue of the MFN clause was less controversial and the judges held unanimously, that, 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 by the MFN clause.

The Court pointed out that as a general principle, negotiators could choose reciprocity or non-reciprocity in respect of the application of an MFN clause contained in a treaty. However, if the drafting of the MFN clause remains unclear, the MFN clause should be considered to be reciprocal, especially considering that, in the case in question, the treaty contained reciprocal ceilings in respect of withholding taxes.

The judges held that in respect to the timing issue, payments made in 2004 for services rendered in 2003 were subject to the rates applicable in 2004 (after the MFN clause in the case was activated) because Appalarian domestic law imposes withholding tax at the time of payment.

(*) It is important to recall that besides executive decrees and regulations, most tax administrations in continental European countries issue administrative commentaries, instructions and circular letters. Such administrative commentaries or instructions are, in some cases, binding only within the tax administration, and the interpretation contained therein is not binding externally, either on judges or on taxpayers. They are not binding on the taxpayers or the courts. For example, in France the instructions and circular letters issued by the tax administration are binding on it. In other countries, such as the UK, statements of revenue practice may be of great importance for the practical administration of the tax system, although they do not have the force of law.