The new OECD discussion draft concerning the application of non-discrimination article (draft)

The following post includes some draft notes on a future comment on the recently released OECD paper on Art. 24 of the OECD Model. I will be away for some days but feel free to leave your comment.

The non-discrimination article, which is designed to prohibit discriminatory taxes levied against foreign nationals or their businesses, appears in almost every tax treaty. But the principles and practice have not always been aligned. It appears that there is some reluctance and uncertainty as regards the acceptability and application of the nondiscrimination concept by tax authorities and courts. It is not surprising that a former U.S. international tax counsel involved in negotiating U.S. tax treaties, was quoted saying, "as admirable as the nondiscrimination concept sounds, the ramifications of ... [the nondiscrimination article] are probably more uncertain than those of any other article."

According to the OECD, “ the differences and complexity of modern legal arrangements and tax systems sometimes mean, however, that it is unclear whether a distinction made by a country for tax purposes constitutes a form of discrimination that violates the provisions of Art. 24 or a legitimate distinction that is not contrary to these provisions”.

These uncertainties led the OECD to issue on 3 of May 2007 a discussion draft on the interpretation and application of Art. 24 of the OECD Model. The discussion draft is a result of an initiative of OECD's working party on tax treaty issues (WP1), initiated in late 2004, to analyze technical issues concerning the application of Art. 24 and review broader policy issues. The discussion draft includes proposed amendments to the Commentaries to Art. 24. The main contents of the discussion draft are summarized below.

Overview of Article 24 of the OECD Model

The non-discrimination article has two main objectives. The first objective is to prevent discrimination of any kind by one state in taxing nationals of the treaty partner state, whether individuals or companies (paragraph 1 and 2). The second objective is to prevent discrimination, in certain cases, by one state in relation to residents of the other state.

Paragraph 1 of Article 24 of the OECD Model provides that nationals of a Contracting State shall not be subjected in the other Contracting State to any taxation or any requirement connected therewith, which is other or more burdensome than the taxation and connected requirements to which nationals of that other State in the same circumstances, in particular with respect to residence, are or may be subjected. This provision shall, notwithstanding the provisions of Article I, also apply to persons who are not residents of one or both of the Contracting States.

Paragraph 2 of Article 24 of the OECD Model extends these benefits to stateless persons who are residents of one of the Contracting States.

Paragraph 3 of Article 24 provides that a permanent establishment in a Contracting State must be treated no less favourably than a domestic enterprise carrying on the same activities. This protection does not extend to personal allowances and benefits based on civil status or family responsibilities.

Paragraph 4 of Article 24 requires that payments (of interest, royalties and other disbursements) made by an enterprise of a Contracting State to a resident of the other Contracting State be deductible under the same conditions as if they had been paid to a resident of the first-mentioned State, conditioned on treaty norms for the tax deductibility of payments between associated enterprises.

Paragraph 5 of Article 24 obligates a Contracting State not to subject an enterprise that is owned or controlled, directly or indirectly, by one or more residents of the other contracting State to more burdensome taxation and connected requirements than that imposed by other similar enterprises of the first-mentioned State.

Paragraph 6 of Article 24 applies the non-discrimination obligations to taxes of every kind and description, whether or not otherwise covered under the treaty.

General issues underlying Art. 24

Several of the existing Commentaries of the articles of the OECD Model contain preliminary remarks outlining the scope and original intention of each article. The discussion draft proposes an inclusion of general remarks before tackling each of the six paragraphs of the non-discrimination clause.

Those general remarks start by referring that tax systems incorporate legitimate distinctions (e.g. based on the liability to tax or ability to pay) and that Art. 24 envisages to balance the need to prevent unjustified discrimination with the need to take account of such legitimate distinctions.

Discrimination can be overt/direct or covert/indirect. National tax rules that discriminate on the basis of a criterion that is expressly prohibited, such as discrimination on grounds of nationality, will amount to overt discrimination. National rules that use different criteria to differentiate between situations, but which in practice have the effect of producing similar discrimination against the great majority of nationals in a particular category, may amount to covert discrimination (or indirect discrimination). This distinction has recently gained importance due to the fact that the ECJ has long maintained a body of jurisprudence under which European national tax systems are required to avoid any overt or covert discrimination on the basis of nationality. The OECD moves away of an all-encompassing non-discrimination clause by clarifying that the scope of Art. 24 does not cover the so-called indirect or covert discrimination.

The current Commentary only includes a reference that the nationality non-discrimination provision is subject to reciprocity. This reference has been interpreted as is preventing a third state national claiming the benefits under a most-favoured-nation clause. In this respect, the discussion draft proposes to include a reference in the general remarks that confirms such interpretation, i.e. that Art. 24 may not be interpreted as to require a most-favoured-nation treatment. This ultimately means that a more beneficial tax treatment granted by Country A under a tax treaty to a resident or national of Country B may not be extended to a resident or national of Country C under Art. 24 of the tax treaty between Country A and Country C.

As regards the central issue of comparability, the discussion draft refers that, although the wording of the various provisions of Art. 24 differs, discrimination can only arise when all factors are equal and the different treatment is solely based on the difference that is prohibited by the relevant provision.

Finally, the general remarks also include a reference that Art. 24 may not be used to justify a treatment that is better than that of a national or resident and that what is authorized by other provisions of the treaty does not constitute a violation of the provisions of Article 24.

Specific issues concerning group taxation regimes

From an economic perspective a corporate group forms an economic unit and therefore should be treated as if it were a single company. For tax purposes, most of the sophisticated tax regimes countries include a formal regime to treat a corporate group, connected through common control, as a single tax unit. Accordingly, a “group taxation regime” generally encompasses a set of rules, which enable corporate taxpayers to compute the tax liability of related companies on a consolidated or combined basis (e.g consolidation) or transfer particular tax attributes (e.g. losses) between the members of a corporate group.

It is hard to categorize the types of group taxation regimes and threshold levels to apply such regimes throughout the world. Nevertheless, on the basis of the IFA report of 2002 (Group taxation), one may distinguish:
- Organschaft system (e.g. Germany), whereby the group regime determines that members controlled by a common parent company are deemed to be “organs” of the parent company (low threshold and formal agreement necessary);
- Group contribution (e.g. Nordic countries), whereby the group regime allows income from profit making companies to be shifted throughout the group to loss making companies (high threshold);
- Group relief (e.g. UK), whereby the group regime permits losses (instead of income) to be transferred from a loss making company to a profitable company member of the same group (medium to high threshold); and
- Full consolidation or fiscal unity (e.g. Netherlands.), whereby the group taxation determines that corporate income at an individual level, neutralizing intra-group transactions and providing that the parent company remains liable for taxation on behalf of the entire group.

Quite naturally most of the group taxation regimes are restricted to domestic resident companies (Denmark, France, Italy and more recently Austria are exceptions). Policy reasons, such as revenue and administrative concerns, are generally behind the option not to include an international dimension to group taxation regimes. Another related taxation is the extension of domestic group taxation regimes to permanent establishments of non-resident companies. Also the discussion surrounding this topic has suffered from the influence of European Law, especially in the wake of the Marks & Spencer case.

From a tax treaty perspective, an issue arises since Art. 24 could be interpreted to treat the failure to allow consolidation of the earnings/losses of a host PE with the result of other group enterprises in that country as an instance of discrimination. In addition, does the recent guidance on attribution of profits reinforces the necessity to broaden the scope of the group taxation regime to the activities carried on through permanent establishments.

In this particular issue, the OECD proposes to include a reference in the Commentary that paragraph 3 does not require any extension to permanent establishments of domestic regimes for group companies which are restricted to resident companies. The technical justification given by the OECD rests on the fact that the permanent establishment non-discrimination clause only relates to the taxation on the permanent establishment itself, which excludes its application to rules that relate to groups of related companies. Nevertheless, the reasoning and further explanation on this particular point remains rather ambiguous.

The discussion draft simply proposes to include a new paragraph in the Commentary stating that the application of the PE non-discrimination principle is restricted to a comparison between the rules governing the taxation of the PE own activities and those applicable to similar business activities carried on by an independent resident enterprise. Since, group taxation rules are rules that only concern the relationship between an enterprise and other enterprises and not the PE own activities, such rules should be consider out of the scope of Art. 24(3).

In an interesting case, a Belgian company operated in Spain through a PE, which held the majority participations in Spanish subsidiaries. The Spanish PE claimed a consolidated assessment under the group taxation regime in Spain, which was dully denied by the local tax authorities based on the fact that, at that time, Spanish group taxation regime were not open to PEs of non-resident entities. The Spanish Supreme Court in a judgment of 15 July 2002 (case 4517/1997) confirmed the denial for a PE of a non-resident entity to apply for a consolidated assessment for the group. In that particular case, the Belgian company relied on the PE non-discrimination clause of the tax treaty between Spain and Belgium that followed the OECD Model. Nevertheless, the Supreme Court did not compare the Belgium PE with a Spanish company that controlled a group. The Supreme Court reasoned that to consider a violation the denial of consolidation to a PE, it would be necessary that Spanish group taxation rules would also permit the consolidation between a Belgium PE of a Spanish company and the subsidiaries attributable to that permanent establishment located in Belgium. The new position of the OECD may well justify a posteriori the Spanish Supreme Court position. It should be noted that apart of tax treaty application, this case was also controversial since the Spanish Court rejected the taxpayer request for a preliminary ruling to the ECJ on the basis of the freedom of establishment.

Two other issues have also been raised in relation to the application of Art. 24 to group of companies. In first place, the discussion draft uses the same line of reasoning used for PEs in order to clarify that that the ownership non-discrimination clause (paragraph 5) is similarly restricted to the taxation of the enterprise itself and generally excludes issues related to the taxation of the group to which the enterprise belongs. This means that the Art. 24 does not require the consolidation of two resident sister subsidiaries of a foreign parent. The OECD includes also a reference that the ownership non-discrimination clause does not seek to ensure that distributions to residents and non-residents are treated in the same way. It should be noted that the OECD leaves, however, the door open in the future to re-consider the situations where an extension of group regimes would be appropriate.

Finally, the discussion draft proposes to include an example preventing the accessibility to group taxation benefits, on the basis of the nationality non-discrimination clause, to a dual resident company subject to limited taxation in the country where it requests to benefit from the group regime. It should be noted that the example included in the Commentary does not limit the application of Paragraph 1 to resident companies subject to unlimited taxation who are simply not incorporated in that State. This principle has been for example confirmed in a German case whereby a US-incorporated company that transfered its management to Germany was allowed to become a party to a fiscal unity (Organschaft) agreement.

Issues related to the nationality non-discrimination clause (paragraph 1)
As mentioned above, the nationality non-discrimination clause prevents discrimination based on nationality but only with respect to companies “in the same circumstances, in particular with respect to residence”. Taking into account that the different treatment of residents (worldwide taxation) and non- residents (source taxation) is a crucial feature of tax systems, the discussion draft discusses to what extent does the nationality non-discrimination clause restricts the application of domestic rules that distinguish between domestic and foreign companies.

The first issue analyzed concerns the question whether paragraph 1 should apply to companies or if paragraphs 3, 4 and 5 already provide companies with sufficient protection against discrimination (French position). On this point, the OECD proposes to clarify, for the purposes of the nationality clause, that resident and non-resident companies are not in the same circumstances, except where residence is totally irrelevant for purposes of the domestic rule under scrutiny. For that purpose, four self-explanatory examples will be included in the Commentary to illustrate these conclusions.

The OECD also dealt with the uncertainty as to what are the relevant factors in determining whether taxpayers are in the same circumstances for purposes of the nationality clause. The Commentary explains that in the same circumstances “refers to taxpayers placed, from the point of view of the application of the ordinary taxation laws and regulations, in substantially similar circumstances both in law and fact.” On this point the OECD, although pointing out that other proposed changes may already clarify the phrase “in the same circumstances”, decided to include a reference in the Commentary that taxpayers with limited tax liability are usually not in the same circumstances as taxpayers with unlimited tax liability. This inclusion may be a reflection to the US observation to the OECD Model referring that US non-resident citizens are not in the same circumstances as other non-residents, since the United States taxes its non-resident citizens on their worldwide income.

Issues related to the permanent establishment non-discrimination clause (paragraph 3)

Assume for example that a Bank resident in Country A has a branch, involved in normal banking activities, located in a Country B and that both countries concluded a treaty following the OECD Model. Assume further that the taxpayer claims that the tax rate applicable to local companies in Country B carrying on similar businesses (i.e. banks) should be applied, instead of the higher tax rate applicable to foreign companies. For that purpose, the taxpayer relies on the non-discrimination clause of the tax treaty between those two countries.

On this particular point the OECD proposes to add a new paragraph referring that, for purposes of paragraph 3, the tax treatment in Country B of the PE of an enterprise of the Country A should be compared to that of an enterprise of Country B that has a legal structure that is similar to that of the enterprise to which the PE belongs.

According to the OECD, paragraph 3 does not use the words “in the same circumstances”, the phrase “taxation on a permanent establishment” and the reference to “enterprises, carrying on the same activities” effectively restricts the scope of the paragraph. The position of the OECD is that the permanent establishment of a foreign enterprise should be compared with a local enterprise that has a similar legal structure as that of the foreign enterprise.

The OECD further recognizes that an issue arises as to whether the reference in the PE non-discrimination clause to “taxation on the permanent establishment” extends to the treatment of the enterprise to which the permanent establishment belongs as regards the repatriation or deemed distribution of the profits of the permanent establishment. The OECD considers that since a permanent establishment, by its very nature, does not distribute dividends, the tax treatment of distributions is therefore outside the scope of paragraph 3, i.e. paragraph 3 deals with the realisation of profits and not with the decisions of the company and its shareholders after the realisation of profits concerning, for example, the distribution of these profits.

An additional issue considered was to what extent does the Art. 24 restrict the application of branch taxes, to the extent that they result in a higher rate of tax being applied to the profits of the permanent establishment than to those of a local enterprise. On this point the OECD concluded that a branch tax that is simply imposed as a supplementary rate applicable to the profits of a permanent establishment would indeed constitute a violation of paragraph 3. The Group, however, distinguished such a tax from a tax that would be imposed on amounts deducted as interest in computing the profits of a permanent establishment (e.g. “branch level interest tax”). In that case, the tax would not be levied on the permanent establishment itself but, instead, on the enterprise to which the interest is considered to be paid and would therefore be outside the scope of paragraph 3.

For the ones interested, US tax establishes a US branch level interest tax (§ 1.884–4), if the portion of the foreign company worldwide interest expense that is allocated to its US trade or business (and thus allowed as a deduction for US income tax purposes) exceeds the amount of interest actually paid by such US trade or business, the excess deductible interest is treated as if paid by a domestic subsidiary to its foreign parent and therefore is potentially subject to a 30 per cent withholding tax (unless reduced or eliminated by treaty).

The discussion draft also analyses the application of Art. 24(3) to specific domestic provisions, namely, the availability of relief for foreign tax. Paragraph 29 to 35 of the Commentary on Art. 24(3) discuss the extent to which the “special” treatment of foreign dividends received by resident companies (e.g. participation exemption) should be extended to dividends received by PEs, while paragraphs 49 to 54 discuss the extension to PEs of domestic rules granting relief of double taxation in the case of dividends, interest and royalties received from another State. As regards the revision of paragraphs 29 to 35 and 49 to 54, the OECD decided to further discuss with a view to find a consensus and, if appropriate, change the Commentary accordingly.

Issues related to the deduction non-discrimination clause (paragraph 4)

In respect of the deduction non-discrimination clause, the OECD analyzed the interesting aspect of the application of Art. 24(4) in the context of domestic rules that may generally allow deductions when expenses are accrued but allow non-residents such deductions only when the respective payment is made. As regards such deferral of deductions, the OECD seems to indicate that different rules between residents and non-resident as to when expenses may be deducted may be in violation of Art. 24(4).

It is interesting to note that a similar problem was raised recently in a US Court in the framework of the US rules that restricted the possibility to deduct interest in case of interest accruing to foreign persons. The US Tax Law apparently allows a taxpayer to take a deduction on all interest paid or accrued within a taxable year on indebtedness, with certain provisions of the code determining which of these two alternatives apply. Differently than in a general situation of interest payable to a US taxpayer, the applicable US Treasury Regulation (1.267(a)-3) provides for the cash method of accounting when claiming interest deductions for payments to a related foreign person. In that case, the taxpayer argued to the US Tax Court (2002) and later to the Seventh Circuit Court of Appeals (13 February 2006) against the denial to take the mentioned deductions for interest payments to its French parent company violated the non-discrimination clause contained in the 1967 Tax Treaty between the US and France. The Courts rejected the appeals (read previous post).

In addition to the issues above, the OECD also proposes to include a new paragraph in order to clarify that Art. 24(4) does not prohibit additional information requirements with respect to payments made to non-residents, since such requirements are only intended to ensure similar levels of compliance between payments to residents and non-residents.

Issues related to the ownership non-discrimination clause (paragraph 5)

The discussion draft also analyses the relationship between Art. 24, Art. 9 and thin capitalisation rules. In this respect, the OECD states that Art. 24(5) would generally not be relevant (i.e. outside the scope) for most thin capitalisation rules because the direct focus of such rules is not the relationship between an enterprise and the persons who own its capital (i.e. company-shareholder relationship) but, instead, the payment of interest from a resident enterprise to a non-resident related creditor (debtor-creditor relationship).

In addition, the discussion draft proposes to clarify that even in cases where thin capitalisation rules apply only to enterprises owned or controlled by non-residents, these rules do not violate Art. 24(5) to the extent that they result in adjustments to profits that are made in accordance with Art. 9(1) and 11(6) of the OECD Model.

This developments are interesting because they essentially follow two decisions of 30 December 2003 of the French Supreme Administrative Court, which held that France's thin capitalization rules, limiting the deduction of interest paid to German parent companies but not to French ones, were incompatible with Art. 24(5) of the France-Austria tax treaty (Decision No. 233894, SA Andritz) and also freedom of establishment - Art. 43 of the EC Treaty (Decision No. 249047, SARL Coréal Gestion).

Issues that require a more fundamental analysis

The OECD recognized that there are some issues that require a more fundamental analysis, namely:
1. Whether the Art. 24 should be amended or expanded to cover forms of discrimination
not currently covered;.
2. Application of non-tax agreements (e.g. WTO and GATS) to taxation and relationship with Art. 24;
3. Analysis of the impact on European Community Law on the interpretation of the non-discrimination provisions of tax treaties in EU Member States;
4. Application of Art. 24(1) to persons who are not residents of either States and the relevancy of the use of Art. 24(2);
5. Application of Art. 24(1) to transparent entities;
6. Meaning of "other or more burdensome taxation or any requirement connected therewith";
7. Group Regime issues related to Art. 24(5);
8. Treaty exemption that depends on VAT liability; and
9. Dispute resolution of issues related to Art. 24.

The Working Party is expected to initiate consultations on the second stage of its work in the forthcoming months.