TALK TAX

See you later...

2007-09-12T16:41:00.002Z

Dear readers,

After some years writing this blog, I have to recognize that I feel accomplished because not only I enjoyed all the steps of linking my specific knowledge on the area of international and European tax law with the outside world but also I had lots of fun doing it!

Time has come to make a sabatical or extended leave of the blog to dedicate more time to the family and other professional projects.

In fact, I recently joined a major Spanish law firm in Lisbon (Garrigues) and my future plans, besides concentrating my energies in client work, include publishing more in major magazines. In that framework, I recently co-authored an article “Exploring the Boundaries of the Application of Article 10(5) of the OECD Model” with a Brazilian friend of mine, Eduardo Madeira and I have other works in the pipeline.

For me is hard to say bye bye, but ultimately I know that it is always a see you later. In any case if you wish to contact me send me do not hesitate to send a mail and I will do my best to answer promptly.

Regards,

talktaxblog@gmail.com

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

2007-05-15T23:31:00.000Z

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.

Getting closer to the finish line: The first step to revise the Commentary on Article 7 of OECD Model

2007-05-06T15:40:00.000Z

The OECD Committee on Fiscal Affairs (CFA) has issued on 10 April 2007 a highly expected discussion draft on a revised Commentary concerning Article 7 (Business profits) of the OECD Model Tax Convention. The discussion draft, which follows the release on 21 December 2006 of a revised Report on the Attribution of Profits to Permanent Establishments, is essentially designed to improve certainty on the interpretation of existing treaties based on the current text of Art. 7. This draft represents the first of the last steps of the OECD in developing an authorised OECD approach (AOA) to the attribution of profits to permanent establishments (PEs).

Historical background
The topic of attribution of profits has been in the OECD agenda already for more than 6 years and the more attentive readers may well recall that it was also one of the general topics of the 2006 IFA Congress in Amsterdam. During the Conference, Prof. Philip Baker presented the conclusions of the IFA General Report which highlighted that on the countries surveyed domestic law and treaty law are largely in conformity, but that no consensus was found as to the correct interpretation of Art. 7. Accordingly, this lack of consensus is further emphasized by the absence of guidance, and also by the abundance of disputes and attribution theories in the countries surveyed.

The First step
Taking into account the many areas covered by the PE Reports, the OECD concluded that it would perhaps not be necessary to make substantial changes to the Commentary. The idea of rewriting the existing Commentary is to provide clarification, without fundamentally altering the basic principles on which it is founded. As such, the proposed Commentary incorporates several of the conclusions of the 2006 Report that according to the CFA, “would not conflict with previous versions of the commentary”. A question remains as to whether we are faced with a major change of the Commentary disguised of clarification.

In fact, OECD member countries should follow the Commentary on the Articles of the Model Tax Convention, as modified from time to time [emphasis added], when applying and interpreting the provisions of their bilateral tax conventions that are based on these Articles. Commentaries made after a treaty is concluded may be considered not be in the same category as Commentaries in place at the time the treaty was concluded. But that is not to say that later Commentaries are to be excluded altogether from the interpretation process.

The following are arguments in favour of using later Commentaries when interpreting a treaty concluded. First, there is no rule that anything that happens after the treaty is concluded is irrelevant. Secondly, refusing to take later Commentaries into account can result in such Commentaries being frozen in time and therefore failing to adapt to changes in business or technology. Thirdly, it is common for national legislation to be interpreted to take account of later developments. There is no rule that the same should not apply in interpreting tax treaties. Finally, if later Commentaries are not used, the result could be a different interpretation of identical wording in treaties entered into at different times.

In determining the use of later Commentaries in any particular circumstances, it is important to differentiate between (substantial) changes that fill gaps in the existing Commentaries or amplify the existing Commentaries and changes that simply record a treaty practice or clarify an already existent element. It is therefore expected a period of uncertainty as to whether the courts of OECD member countries will accept that the AOA (as included in the draft) is consistent with the wording of existing articles based on Art. 7.

The step still ahead
The step still ahead consists of an alternative form of wording for Art. 7 (and commentary), which is expected to be released shortly. This option, which supports more clearly the adoption of the AOA across the board, has its disadvantages and advantages.

A problem remains that once adopted it will still be a question of years to such text (i.e. new wording of Art. 7) is incorporated into the real treaties, unless a practical solution is found.

In a recent article, Avery Jones and Philip Baker discussed the possibilities to devise a simple system for amending the wording of many tax treaties in a short period of time. In “multiple amendment of bilateral double taxation conventions” (BIFD -2006 no. 1 ; p. 19-22), the authors look at some possible solutions to the problem of the bilateral nature of tax treaties and how to overcome some constitutional limitations of the procedure of concluding tax treaties. In that regard, the authors propose that the OECD adopts multilateral framework agreements for amending existing treaties. Interestingly, the authors refer to the adoption of the AOA as a “good example of the need for a method to amend the wording of large numbers of tax treaties”. Time will tell if new developments will arise in this area.

The proposed Commentary and the interpretation of paragraph 1 of Art. 7.
It has been long acknowledged that current Commentary provides little guidance on how to interpret the term “profits of an enterprise”, beyond rejecting of the force of attraction principle. Two broad interpretations of the term “profits of an enterprise” were developed in that regard, namely the “relevant business activity” and the "functionally separate entity” approach.

In this regard, the proposed Commentary adopts the later approach by stating that Art. 7 should not be interpreted as restricting the amount of profit that can be attributed to a PE to the amount of profits of the enterprise as a whole. Under the proposed Commentary, the application of paragraph 2 may result in profits being attributed to a PE even though the enterprise as a whole has never made profits.

The proposed Commentary and the interpretation of paragraph 2 of Art. 7.
The proposed commentary indicates that in order to attribute profits to a PE it will be necessary to determine the profits that would have been realized if the PE had been a separate and distinct enterprise engaged in the same or similar conditions under the same or similar conditions and dealing wholly independently with the rest of the enterprise. This is achieved by using a two-step approach.

The first step requires a functional and factual analysis, identifying the economically significant activities carried through the PE. The second step requires to determine the remuneration for such activities by applying by analogy the transfer pricing principles with reference to the functions performed, assets used and risks assumed by the enterprise through the PE and through the rest of the enterprise [emphasis added].

The proposed commentary also points out that the same two-step approach should be used to attribute profits to a an Agency PE under Paragraph 5 of Art. 5 (this point will deserve a more detailed analysis in a future post).

The proposed Commentary and the interpretation of paragraph 3 of Art. 7.
With regards to expenses attributed to a PE, the proposed Commentary clarifies that Paragraph 3 only determines which expenses should be attributed to a PE for purposes of determining its profits. The proposed Commentary clearly refers that the issue of whether those expenses, once attributed to the PE, are deductible is a matter to be determined by domestic law of the PE State.

Interestingly, in recent days I came across an Indian ruling from the Mumbai bench of the Income Tax Appellate Tribunal (ITAT) , which determined that the deductibility of travel and entertainment expenses incurred by foreign companies which are attributable to its PE in India must be limited as per the Indian domestic law (Income-Tax Act). In Mashreqbank psc (ITA No. 2153/Mum/01), the ITAT considered that the limitations under the domestic tax laws are to be taken into account for the purposes of computing profits of a PE under Article 7(3) of the India UAE tax treaty.

The proposed Commentary and the issue of finding a consistency between paragraph 2 and 3 of Art. 7.
Paragraphs. 2 and 3 of Art. 7 provide the rules on how profits should be attributed to a PE. Art. 7(2) is the main rule which determines that the profits to be attributed to a PE are those which the PE would have made if, instead of dealing with its head office, it had dealt with an entirely separate enterprise under conditions and at prices prevailing in the ordinary market (i.e. the Arm’s length principle). Art. 7(3), on the other hand, states that, in calculating the profits of a PE, allowance is to be made for (certain) expenses incurred for the purposes of the PE.

At first glance, it seems that no major problems should exist when attributing profits to a PE on the basis of this two paragraphs. The only thing to do is to treat (for the purposes of the PE State) the PE as a subsidiary and apply the arm’s length principle. The first problems arise when one looks with more attention to the Commentary and identifies several limitations to the “deemed independence rule”, embodied in Art. 7 (2). This apparent inconsistency between 7(2) and 7(3) has created a major controversy, extensively analysed both by commentators, OECD and jurisprudence.

The proposed Commentary eliminates some of the controversial passages of the Commentary (para. 12 and following) that may be said to contain the existing exceptions to the arm's length principle. On the related issue of whether a PE may deduct its interest expense on intra-entity loans, the OECD maintains however the ban on deductions for internal debts and receivables, with the exception of financial enterprises such as banks.

Capital attribution and funding of a PE
It is acknowledged that companies require capital to support their activities and that such capital might be raised as equity capital (e.g. issue of shares) or as loan capital (e.g. issue of debt). The proposed Commentary considers that a PE would require certain amount of funding made up of "free capital" and interest bearing debt in order to support the functions performed, assets used risks assumed. The proposed Commentary accepts however that different approaches for attributing “free” capital are capable of giving an arm’s length result.

In fact, it should be mentioned that the amount of income attributable to the PE does not concern only the source jurisdiction (PE State). The attribution of profits has consequences also on the non-resident taxable base in his state of residence, namely in determining the amount double taxation relief to be granted under Art. 23 of the OECD Model.

In that regard, the proposed Commentary recognizes that the use of different capital attribution methods by the PE State and the State of Residence of the enterprise may give rise to double taxation. In that regard, the proposed Commentary refers that the OECD Member States agreed to grant double taxation relief for the amount of interest deducted (which is derived from the application of the capital attribution approach used in the PE State), if the following conditions are met:
(i) the difference in capital attribution results from conflicting domestic laws regarding the chosen capital attribution method ; and (ii)the approach used to determine the attribution of the capital is accepted in the PE state and produces a result consistent with the arm's length principle in that particular case.

The new approach does not mean, of course, that the Residence State must automatically give relief based on whatever capital attribution results the PE chooses to assign. There is always the fundamental arm’s length principle that should be complied with, in all stages of the attribution process. Nevertheless, since transfer pricing is far from being an exact science the symmetry issue may well become a future problem.

See related posts:
2007 Tax Agenda: What to expect from the usual suspects? View

Attribution of Profits to a Permanent Establishment – A brief note on the new U.S. Model View

The attribution of profits to permanent establishments during the 2006 IFA Congress View

Again Agency PEs (but this time Secret Agents) View

Attribution of Profits to an Agency PE: finding a middle ground View

Indian outsourcing activities: from finding a PE to determining its remuneration View

India: telecommunications, PE issues and attribution of profits View

The NatWest Saga continues - NatWest III View

ATO Guidelines on the Attribution of Profits to an Agency PE View

The Attribution of profits to PE - saga continues View

Trans-Atlantic European Tax Law

2007-04-28T09:18:00.000Z

Two interesting papers and a book recently published demonstrate a surge of interest across the Atlantic on the topic of European Tax Law.

EC Tax law is receiving increasing attention from the academia in the past years. The tax impact of the European Court of Justice (ECJ) judgments specially when dealing with the application of the fundamental freedoms have lead to numerous discussions, articles and books in the past years. One recent trend has been that the discussion forum has expanded geographically. A good example last year was that U.S. Law professors wrote one of the best papers on EC Tax Law (see Michael J Graetz and Warren, Alvin C "Income Tax Discrimination and the Political and Economic Integration of Europe" Yale Law Journal, Vol. 115, pp. 1186-1255, April 2006). In recent weeks I came across further contributions from the other side of the Atlantic which I must leave as suggestions.

In October 2005, a group of EU and US tax experts gathered at the University of Michigan Law School to discuss the different approaches taken by the ECJ and the U.S. Supreme Court to the question of fiscal federalism. The recent book Comparative Fiscal Federalism, Comparing the European Court of Justice and the US Supreme Court’s Tax Jurisprudence which is edited by Reuven S.Avi-Yonah, James Hines & Michael Lang will definitely further contribute to understand how those two systems or building blocs deal with different policy aspects.

In my last visit to Brazil, I came across authors interested in the tax sphere of the European economic integration, namely due to the development of the Mercosul. It is also not suprising that valuable contributions on the European topic come also from Brazil (e.g. Profs. Luís Eduardo Schoueri and Heleno Torres) and other South American countries.

Two papers provide further analysis to two sub-topics that are high in the agenda of European Tax Law. The first is the necessity and inherent difficulty to find a consistent line of the jurisprudence of the ECJ concerning the tax discrimination field. Te second paper addresses the hot topic of whether the fundamental freedoms of the EC Treaty encompass an absolute requirement on the Member States to mitigate double taxation, especially in view of the recent Kerckhaert & Morres case .

In first place Ruth Mason (University of Connecticut School of Law) has recently posted "IIn Search of Internal Consistency: Tax Discrimination in the EU“. Columbia Journal of Transnational Law, Vol. 46, 2007.

Here is the abstract:
The European Union was created to bind the countries of Europe together economically to prevent future wars. Rigorous enforcement of EU nationals' fundamental economic freedoms before the European Court of Justice (ECJ) has furthered economic integration. The fundamental freedoms prohibit tax discrimination—harsher tax treatment of cross-border economic activities than purely internal activities. Critics of the ECJ argue that the Court's broad interpretation of the EC freedoms causes it to find tax discrimination where there is none. This tendency encroaches upon the sovereignty of EU member states and hampers their ability to pursue economic policy goals. In contrast, based upon a survey of all the ECJ's tax discrimination decisions, this Article offers a more nuanced critique that shows the ECJ's errors in tax discrimination cases go in both directions. In addition to finding discrimination where there is none, the Court also sometimes fails to recognize discrimination. The Court's failure to recognize tax discrimination undermines the economic integration of Europe and abridges EU nationals' personal rights. This Article is the first to identify the Court's method of review in tax discrimination cases, the comparable internal situation test (CIST), as a principal contributor to the Court's difficulty in tax cases. Instead of CIST, the Article proposes that the ECJ borrow a method developed by the U.S. Supreme Court for tax cases arising under the Commerce Clause: the internal consistency test (ICT). Adoption of this simpler method should enable the ECJ to make more coherent tax decisions, which will promote economic efficiency and integration of the European common market.

Secondly, Georg Kofler (NYU) and Ruth Mason have jointly posted, "Double Taxation: A European 'Switch in Time'?“. Columbia Journal of European Law, Vol. 14, No. 1, 2008.

Here is the abstract:
This article considers whether the fundamental freedoms of the EC Treaty encompass an absolute requirement on the Member States to mitigate double taxation, and it concludes that such a requirement could reasonably be inferred from the goals of the fundamental freedoms and the European Court of Justice's double burden jurisprudence. Notwithstanding the reasonableness of that interpretation, in the recent Kerckhaert & Morres case, the Court of Justice found that the EC Treaty permits double juridical taxation, even though double taxation distorts the Internal Market. We review the history of the Court's relevant jurisprudence, consider alternative theories under which the Court could rule that double juridical taxation violates the EC Treaty, and compare the treatment of double state taxation in the United States by the Supreme Court under the dormant Commerce Clause.

Messages

2007-04-28T09:01:00.000Z

Dear readers,

As you notice I took some “vacation” period of blogging. There are some professional and personal circumstances that lead me to focus my attention elsewhere. In the next months I will focus on reshaping the structure of TALK TAX, a project that I started and I plan to continue (perhaps in a different format).

I will keep you posted.

Tiago

Short-term assignments, hiring-out of labour and the OECD Model

2007-03-14T01:40:00.000Z

Not so long ago, I was introduced to an expression that I came to associate with abuse, employment income and tax treaties. The expression is "international hiring-out of labour" and I have to admit it was fairly unknown to me (as many other things) before I studied in Leiden.

The use of such expression in the field of tax treaties dates back to 1985, when the OECD issued a report addressing the treaty problems of arrangements of hiring out labour. Basically those arrangements consist on a local employer wishing to use short-term foreign labour and avoid taxation of employment income in his state by recruiting the labour force through an intermediary (lessor) established abroad. The relationship is characterized by the fact that, although there is a contract of employment between the lessor and the employee and a special contract between the lessor and the lessee (local employer), no contract exists between the employee and the lessee.

In terms of tax, a problem started to arise in cases of international hiring-out of labour. Since the right of the state of the temporary employment to tax employment income was limited by the provisions and conditions of Art. 15, the tax administrations were not happy to notice that non-resident labour was easily entering their boundaries and as easily avoiding source country taxation.

As a possible contribution to solving problems of abuse, the 1985 OECD report suggested interpreting the notion of employer through a factual analysis for treaty purposes of the employment relationship. In fact, as part of the 1992 update to the OECD Model, the Commentary was amended to clarify situations covered by the exception Art. 15(2). In particular, the concept of material employer in hiring-our of labour situations and the formal criteria for a substance over form approach were inserted in paragraph 8 of the OECD Commentary.

Nevertheless, experience demonstrated that applying the criteria mentioned in paragraph 8 of the OECD Commentary only to abusive cases was a difficult task and that its practical application could easily target bona fide companies and employees. Recognizing the difficulty in certain cases of establishing which enterprise is the employer, the OECD initiated a revision of the Commentary to address this particular problems.

This introduction serves to make the bridge with the OECD most recent public discussion draft with revised changes to the Commentary on paragraph 2 of Art. 15 of the OECD Model Tax Convention. This is a very interesting report that slightly updates a previous 2004 draft version, which has been extensively discussed with the tax community. Basically, the OECD seems to be extending the cases of material employer even to situations where there are no indications of abuse (the so-called short-term assignments). For that purposes the OECD proposes, new paragraphs 8 and 8.1 to 8. 21 to the Commentary.

But to understand the issue in question is important to clarify the basic rules:

Under the general rule of paragraph 1 of the Art. 15, the residence country of the employee has the exclusive right to tax the income from employment, unless the employment is exercised in the other treaty country (i.e. country of activity). In the latter case, paragraph 2 allows the country of activity to tax the remuneration if the employee is present in the country of activity for a less than 183 days, the remuneration is paid by a resident employer or it is borne by a permanent establishment situated in the country of activity.

The purpose of the new Commentary is thereby to resolve interpretation issues concerning the concept of "employer" for purposes of paragraph 2 of Art. 15. The conflicts increasingly arise because some countries disregard the formal employment relationship in order to assess whether the income derived by short-term assignees is also taxable in the country of activity. In fact, over the last years, a body of case law and rulings from countries such as Australia, Netherlands and Belgium have proven the tendency towards a more economical employer approach.

In that regard, the draft distinguishes between countries adopting a formal approach of employer under their domestic law and countries taking the view that "employer" should be given a more material or economic emphasis (e.g. applying substance over form approaches). This material interpretation may be achieved on the basis of domestic law of the country of activity or on the basis of the object and purpose of Art 15. According to the OECD, both approaches must be applied on the basis of objective criteria.

In determining the employer, the draft attaches importance to the nature of the services rendered, in order to determine whether the services rendered by the individual constitute an integral part of the business of the enterprise to which these services are provided. In cases where the nature of the services rendered point to an employment relationship different than the one of the formal employer, the draft suggests objective criteria to determine the employer, namely:
− who has the authority to instruct the individual regarding the manner in which the work has to be performed;
− who controls and has responsibility for the place at which the work is performed;
− the remuneration of the individual is directly charged by the formal employer to the enterprise to which the services are provided;
− who puts the tools and materials necessary for the work at the individual’s disposal;
− who determines the number and qualifications of the individuals performing the work.

As a consequence, instead of being regarded as non-resident employee of a non-resident employer rendering services on a temporary basis, individuals may, if certain objective criteria are met, be deemed to be the employees of the service recipient in the other country (i.e. source country), and therefore, taxable in the source country where they are performing their services.

Since the draft includes several practical examples, lets use one of them (which by coincidence or not is also found in a ruling from the Australian Tax Authorities).

Example (form ATO ruling):
Cco is a company resident in State C. It carries on the business of filling temporary business needs for highly specialised personnel. Dco is a company resident in Australia which provides engineering services on building sites. (..) In order to complete one of its contracts in Australia, Dco needs an engineer for a period of 5 months. It contracts Cco for that purpose. Cco recruits Y, an engineer resident of State Y, and hires him under a 5 month employment contract. Under a separate contract between Cco and Dco, Cco agrees to provide the services of Y to Dco during that period. Under these contracts, Cco will pay Y's remuneration, social contributions, travel expenses and other employment benefits and charges. Dco will pay Cco this amount plus 10% for Y's services.

Possible Solution:
Y provides engineering services while Cco is in the business of filling short-term business needs. By their nature, the services rendered by Y are an integral part of the business activities of Dco, an engineering firm, but not of his formal employer. Under and could come to the conclusion that the exception of paragraph 2 of Article 15 does not apply on the basis that Dco is more in an economic employment relationship with Y than the formal employer Cco.

As a final point it is interesting to note that to the extent that the residence country (Y in the example above) acknowledges that the source country (Australia) taxed in accordance with the convention, the new proposed Commentary also provides that the resident country (Y) must grant relief for double taxation.

It is no surprise that there are critics out there, which consider that if countries would follow the new approach, the limitation of Article 15(2) would, in most cases, become meaningless. Nevertheless, not all is bad in the "wonderland" and the new commentary (which probably is now very close to its final stage) has interesting features that deserve further study and analysis.

Please hold the line, the CCCTB will be with you shortly

2007-03-09T08:18:00.000Z

The 2787th Economic and Financial Affairs (ECOFIN) Council meeting adopted a key issues paper to be submitted to the European Council on 8 and 9 March 2007, which outlines the main policy objectives relating to economy and finance. This meeting will probably stay in the annals of history not because of its round number (a think it is time they stop counting these meetings) or because what was said or discussed in terms of tax issues. The novelty is perhaps what is actually missing from the Key Issues Paper (KIP) prepared by the German Presidency, namely any reference to the ongoing project on a European-wide Common Consolidated Corporate Tax Base (CCCTB).

The draft KIP (which actually means chicken in my adopted Dutch language) originally included a heading on “tax policy in Europe – further development in the field of direct taxation”. There the actual CCTB project was apparently reaffirmed as a priority of the EU to further enhance the harmonization of direct taxation in Europe. Probably as a direct result of pressures from member states that do not favor the CCTB project (e.g. Latvia. Ireland, UK), the reference of CCTB as a key policy objective was (apparently) excluded from the final paper. An enigmatic point 3.3., under the heading “Tax policies in Europe – enhancing the internal market”, now addresses the tax issues:

National rules on taxation differ between Member States. The functioning of the internal market may be improved through co-operation on taxation among Member States and where appropriate at the European level, while respecting national competencies. The Council (Economic and Financial) has been informed of the ongoing work especially in the field of taxation and of action taken to tackle fiscal fraud and harmful tax practices.

It should be noted that the Commission's goal on the CCTB is to present a full community legislative proposal to the ECOFIN and to the European Parliament by the end of 2008. It is also public the resistance of some member states to any type of legislative proposal and the (open) possibility of the CCTB to proceed its path under the controversial enhanced cooperation procedure, which generally only requires eight member states. What is now uncertain is the consequences of an eventual setback at the level of the EU Council of the (German or Presidency) ideas to prioritize the CCTB project under the Lisbon agenda.

I have to admit that it has been difficult for various reasons to follow this project from the outset. A mixture of possibility that the project derails (as some other EU projects) and also too much information available (and no incentive to read) has made me avoid entering fully into this subject from a technical perspective. And it easy to understand why!

The CCCTB project, which the Commission officially launched in the autumn of 2004, has covered various technical meetings involving experts from all twenty seven Member States. The discussions have addressed several highly technical structural elements of the tax base, such as assets and tax depreciation, reserves, provisions and other additional elements such as group taxation, territorial scope or international aspects. Amongst the several meetings described in the EU Commision website, the following working documents have been discussed:

Working Document The mechanism for sharing the CCCTB
Working Document Related parties in the CCCTB
Working Document Issues related to business reorganisations
Working Document Personal Scope of the CCCTB
Working Document Dividends
Working Document Issues related to Group taxation
Working Document Administrative and Legal Framework
Working Document Tax treatment of Financial Institutions
Working Document Territorial Scope
Working Document International aspects in the CCCTB
Working Document Financial assets
Working Document Taxable income
Working Document Tax balance sheet
Working Document Capital Gains and Losses
Working Document Intangible Assets
Working Document Liabilities, Reserves and Provisions
Working Document General Tax Principles
Working Document Assets and Tax Depreciation

In addition to the numerous EU working documents, written contributions have been also received from third parties, with a particular reference to the very active BusinessEurope (formerly UNICE). Knowing that some member states have limited resources, I am not surprised that this project is giving some headaches to some tax officials.

In the end, even though the success of the most ambitious proposal of the Commission in the field of corporate taxation seems uncertain, I will continue to pay (as much as possible) attention to the CCTB project. Just in case…

PS: Perhaps some of you recognized, but what better than M. C. Escher to portray the dimensions and confusions of being a European?

The place of offshore financial centers in an increasingly anti-tax haven world

2007-02-25T14:23:00.000Z

This weekend I came across an interesting special report (“a place in the sun”) published on the Economist latest issue, which is dedicated to offshore financial centers. The report is a good reading for any international tax advisor because it provides some valuable insights into the policy and regulatory framework of offshore financial centers in an increasingly integrated global economy.

In the last decade, several important efforts were made to increase the scrutiny of offshore centers namely focusing on the necessity to counter money laundering, improve regulation on the financial services and reduce the (tax) advantage of using the so-called tax havens. For example, the OECD reports on Harmful Tax Competition, Towards Global Tax Co-operation and Improving Access to Bank Information for Tax Purposes were important tools because they laid down the principles of the reaction of onshore jurisdictions against those offshore centers. The aim of these initiatives was to counter distorting effects of harmful tax competition, by tackling certain practices with respect to mobile activities that (apparently) eroded the tax bases of other countries (i.e. country of the principal investor). The initiatives were also directed to find ways to improve international co-operation with respect to the exchange of information for tax purposes (which was sometimes in the possession of financial institutions).

According to the IMF definition, an offshore financial centers is a jurisdiction that (i) has a large number of financial institutions; (ii) where most transactions involve non-residents, (iii) where most institutions are controlled by non-residents, (iv) where the assets and liabilities are out of proportion to the domestic economy; and (v) where there is a very low or zero taxation, relaxed financial regulation and bank secrecy. There are multiple possible uses of OFC (i.e. offshore banking, captive insurance companies, establishing special purpose vehicles and asset management and protection) and some of them addressed in the report of the Economist.

It is interesting to note that, the OECD initially identified, in the framework of its project on harmful practices, 47 jurisdictions as tax havens. Nevertheless, 33 jurisdictions made in the meantime commitments to transparency and effective exchange of information and are now considered co-operative jurisdictions. There are only a few that remain unco-operative tax havens.

With the overwhelming increase of assets held by OFC in the 80’s and 90’s (according to the IMF cross-border assets held by OFC reached a level of US$4.6 trillion at end-June 1999) it was more than natural that other initiatives at the international level pursued the other (non-tax) elements of the OFC. For example, the Financial Action Task Force (FATF) was established to help protect financial systems from money-laundering and counter-terrorist financing systems. The FATF’s Non-Cooperative Countries and Territories process can be considered a success since the 23 jurisdictions that were listed as NCCTs in 2000 and 2001 are no longer on listed. Another initiative is the one headed by the Financial Stability Forum (FSF) which has been arguing for OFC to meet international financial markets standards and address problem areas, such as effective cross-border cooperation, information exchange and adequacy of supervisory resources.

Notwithstanding, it was visible throughout this process that there was a great variety in regulatory standards and infrastructure between the major international financial centers and other (less transparent) financial centers, where supervision was simply non-existent. As such, increased attention has been directed in the last years into reinforcing transparency and effective exchange of information for tax purposes. In that regard, the OECD Global Forum has just published a report, "Tax Co-operation: Towards a Level Playing Field – 2006 Assessment by the Global Forum on Taxation", which surveys 82 OECD and non-OECD countries and jurisdictions. This report undertakes a factual review on the legal and administrative frameworks in the areas of the existence of mechanisms for exchange of information, access to bank information and access and availability to ownership, identity and accounting information. This work is related to the wider initiative of developing a Model Agreement on Exchange of Information on Tax Matters, which is now being used by countries such as the United States (U.S.) as the basis for negotiating bilateral agreements.

For example, Article 5 (exchange of information upon request) of that Model provides that only in very few instances will the competent authority, receiving the information request, be able to circumvent the legal obligation of providing the tax-related information. The country receiving a must then provide the information, when it relates to a particular examination, inquiry or investigation in the other Country, even if the requested country does not need the information for its own tax purposes (i.e. because it has more lax rules). The rule (in connection with Art. 7) includes, nevertheless, certain safeguards (e.g. non-disclosure of trade or business secrets) as to when information requests may be refused. It is important to note that bank secrecy cannot be considered a part of public policy and therefore used as an excuse not to exchange information.

This already indicates a significant amount of pressure that can be used against the use of OFC through the conclusion of this bilateral exchange of information agreements. For example the U.S. has concluded in recent years such type of agreements with jurisdictions such as Aruba, Jersey, Isle Of Man, Guernsey, Netherlands Antilles, British Virgin Islands, Bahamas, Antigua and Barbuda and the Cayman Islands.

The recent cooperation commitments by tax havens for effective exchange of information may thus appear to constitute a “light in the end of the tunnel” for the countries that initiated the process against harmful tax measures back in 1996. As mentioned in the Economist report, the OECD prefers now to differentiate between well and poorly regulated financial centers rather than onshore or offshore and the focus has apparently shifted from (the lack of) tax to more regulatory issues. In fact, the OECD appears now to consider that “low or no taxes on their own do not constitute a harmful tax practice”.

Perhaps it is only under this stricter OFC regulatory framework, that one may understand a title in the Economist such as “Tax havens are an unavoidable part of globalisation and, ultimately, a healthy one”. Nevertheless, the issue is far from unquestionable and some of the points raised in the report deserve further reflection.

For example, the mention that “tax competition nowadays is mostly about big countries competing with each other” is an important reference. Recent years have brought increased tax competition even between jurisdictions once tagged as “high tax jurisdictions”. The difficulty today is that some traditional European jurisdictions instead of providing low corporate taxes such as Ireland (12.5%) are introducing exemptions at the level of the tax base, such as notional interest deduction in Belgium or the patent box in the Netherlands which ultimately may also have an impact in diverting of shifting certain mobile activities such as intra-group financing or licensing activities. This is one reason why in my view it is harder to frame the tax competition, when we are dealing with the so-called “big countries”. It is therefore not a surprise that the EU Code of Conduct on business taxation, which consists of a commitment not to introduce new harmful measures (standstill mechanism) and to revise existing tax measures deemed to be harmful (rollback mechanism) has lost slightly its political momentum.

Another highlight of the report is the reference to a recent study entitled Do Tax Havens Divert Economic Activity?, where economists found that tax havens boosted economic activity in nearby non-havens rather than diverting it. These references may have the benefit of re-launching the debate as to the role and place of OFC and their possible unintended or positive consequences.

In conclusion, after reading the whole report one remains with the overall impression that under the premise that tax competition may bring benefits, the role of the well run and regulated OFCs in tax evasion is perhaps being slightly dramatized. Nevertheless, one has first to listen to the interview and read the articles before taking conclusions!

Past posts on related subjects:
Corporate Tax Avoidance: The Case of Abusive Tax Shelters
Is Switzerland under enough pressure from Europe institutions to clamp tax competition?
“Benefits or evils” of Tax Competition
“Tax harmonisation is not on the agenda, nor will it be.”
Subsidy to the Celtic tiger or just healthy tax competition?

Pitfalls from cross-border services: where is the source of the income?

2007-02-18T13:32:00.000Z

The Indian case discussed below is not a tax treaty case simply because there is (until now) no tax treaty between India and Luxembourg.

The case involves a Luxembourg company, which approached the Indian Ruling Authority on the question of certain marketing and promotion payments received from an Indian Hotel. Due to the absence of a tax treaty, the issue was simply whether the payments in question were under Indian domestic law qualified as business income, royalty or fee for technical services (so as to be taxable in India) or whether they were mere reimbursement of expenses incurred by the Luxembourg company for the benefit of the Indian hotel (so as not to be taxable in India).

Although essentially a domestic case it is still an interesting decision for several reasons. The case decided by the Authority For Advance Ruling (AAR) in 27 November 2006 is then a good exercise to analyze not only the pitfalls of international transactions when no tax treaty is in place but also the problem of some domestic wide definitions of source of income.

1. The case facts

International Hotel Licensing Company, SARL (IHLC) is a Luxembourg company, which is part of the well-known Marriott group. IHLC is engaged in the business of promoting enterprises and is conducting international advertising, marketing and sales programs for the Marriott chain of hotels in order to promote them in the foreign markets.

In connection with the plans to setting up of an Indian hotel to be constructed, furnished and equipped in Uttar Pradesh, IHLC entered into an agreement with an Indian company (Unitech) whereby Unitech (the owner of the Hotel) would participate in the marketing business promotion programs and IHLC would provide, inter alia, advertising space in magazines, newspapers and other printed media and electronic media which would be conducted by it outside India.

The agreement made it clear that the IHLC would not conduct any specific marketing activity for the Unitech. Under the agreement, the consideration that Unitech would pay to the IHLC was an annual contribution equal to 1.5% of the gross revenues of the hotel by way of reimbursement of expenses that the IHLC would incur for conducting and coordinating the international marketing activities for Marriott chain of hotels. This would be later adjusted based on the final annual figures.

Pursuant to the agreement, the IHLC had also to provide certain special programs such as the Marriott Rewards Program, (Marriott's award winning guest royalty program) for which the participants including Unitech are charged 3.4% of a Marriott Rewards Program member's room charge (including taxes) during his/her stay at the applicable hotel.

2. The Issues

The question referred to the AAR was whether the said contributions of 1.5% (marketing and advertising) and 3.4% (reward program) received by IHLC from Unitech, in connection with the marketing and business promotion activities essentially conducted outside India, would be taxable in India.

The tax authorities rejected the argument that the fees paid were simply expenditures and raised the issue of whether the payment was for technical services or for the use of the Marriott brand. The tax authorities basically submitted that under the agreement, IHLC had to provide advertising but that the expenditure for these activities are aimed not for the benefit of the Indian hotel but for the Marriott group as a whole. The tax authorities noted that the advertisements carry copyright of Marriott International Inc. and the connection between it and the IHLC is not clear. The tax authorities also argued that there was no nexus between the expenditure incurred by the IHLC in rendering the services and the consideration to be received by it. Therefore, according to the authorities the proposed payment of 1.5% of the gross revenues appears to be a payment towards royalty in a disguised form for the use of the brand "Marriott" and that the expenditure incurred by the IHLC in international advertising, is for building up of the brand. The tax authorities also considered that payments based on the gross turnover of the hotel owner have no nexus with the amount of expenditure incurred by IHLC.

In alterantive, the tax authorities considered that the proposed payment would also be consideration for rendering of any managerial, technical or consultancy service, within the meaning of "fee for technical services "(FTS), which is subject to Indian withholding tax. Finally, the tax authorities submit that the income in question would anyway be deemed to accrue or arise in India.

IHLC, on the other hand, considered that the payments being in the nature of reimbursement are not taxable in India. IHLC therefore responded by firstly refuting that it had any “business connection” (similar concept to permanent establishment) in India and that even assuming that a business connection exists, no operations are carried out by the IHLC in India. Secondly, it disputed that the payments under the agreement constitute royalty or FTS, since essentially they are not for any managerial technical or consultancy services.

3. The decision

3.1. Whether the payments were mere reimbursement of expenses incurred by the IHLC for the benefit of the Unitech

As regards the first issue, the AAR analyzed in detail the agreements. The AAR first started by asserting the meaning ascribed by dictionaries to the word “reimburse”, namely "to pay back, make restoration, to repay that expended, to indemnify or make whole". Keeping that meaning in mind and after looking at the classification of the expenses under the agreement, the AAR noted that there was no direct nexus between the owners of the hotel, and the costs and expenses of providing the said advertising, marketing promotion and sales program services. The AAR mentioned that even if after adjustment the payments in the form of contributions equal to the total costs and expenses incurred by the IHLC, it would be difficult to accept that they would amount to reimbursement of costs and expenses.

The AAR also rejected the contention of IHLC that its primary object is not to make profit but to enable the owner to attract foreign tourists from all over the world as the cost of international marketing and promotion activities would be impossible for an owner of the hotel alone to incur and that in fact the IHLC is not earning any profit.

3.2. Whether the amounts in question qualified as business income, royalty or fees for technical services

The Luxemburg entity contended that the payments could not be deemed to accrue or arise in India as it had neither any “business connection” in India nor the income had any source in India, while the tax authorities submitted that the Luxemburg entity had a “business connection” as well as the source of income was located in India.

Under Indian domestic tax law, “all income accruing or arising, whether directly or indirectly, through or from any business connection in India” is deemed to accrue or arise in India. Basically, if the nonresident has a business connection in India, the non-resident is then liable to tax in India on the income earned, which is attributable to the operations carried out in India. It should be noted that the use of a dependent agent is also considered a business connection. Though not entirely defined, the term “business connection” has a wider meaning than the well-known term “permanent establishment”. For example, in the leading Indian case of CIT v. R.D. Aggarwal and Co. (1965), the Supreme Court of India held that “business connection” means something more than business.

According to the AAR, "the essential features of the business connection concept are:
(a) a real and intimate relation must exist between the trading activities carried on outside India by a non-resident and the activities within India; (b) such relation, shall contribute, directly or indirectly, to the earning of income by the non-resident in his business; (c) a course of dealing or continuity of relationship and not a mere isolated or stray nexus between the business of the non-resident outside India and the activity in India, would furnish a strong indication of 'business connection' in India."

Taking into account the above facts, the AAR considered that the first and the second requirements of business connection were satisfied. In as much as the agreement was valid for 25 years, extendable for a further 10 years, the third requirement was also satisfied. The existence of business connection was then sufficient to attract taxation to the amounts in question, especially in the absence of a tax treaty.

The AAR further considered that the question as to whether the source of income is in India is unnecessary but since both parties referred to it, the AAR decided to further analyze the issue. The Luxemburg company contended that the “source of income” was outside India, since (i) IHLC conducts international marketing and business promotion activities outside India; (ii) it has no form of presence in India nor is the owner of the hotel an agent of the IHLC; and (iii) that no activity of the owner of the hotel result in any earning of the income of the IHLC.

The issue highlighted by the AAR was that some of those advertising activities were also are carried out in India and even when they were primarily carried out from outside India, they had an extension in India as well. For example, the advertisements were not confined to magazines with circulation outside India and even samples of advertisements in Indian magazines were put forward. Further, the AAR considered that advertising on foreign TV channels is also very much accessible in India and they have the effect of advertisement in India. Therefore the AAR concluded that the payments by the owner of the Hotel for the purpose of service of advertisement has relation to the activities of the IHLC, which generate activities of the owner of hotel business. As such, the AAR held that the source of income was located in India.

The AAR further rejected the argument of the tax authorities that what was being paid by way of contributions was nothing but "royalties”. As regards whether the payments constitute fees for technical services, the AAR discussed whether the amounts paid would in fact fall within the meaning of “consideration including any lump sum consideration for the rendering of any managerial, technical or consultancy services (including the provision of services of technical or other personnel)”. In this case, the AAR concluded that the services provided by the IHLC, both within and outside India, in the form of advertising, marketing promotion, sales program and special services, would amount to rendering managerial and consultancy services.

Accordingly, the AAR held that the amounts received by IHLC from the Indian Hotel owner in connection with the marketing and business promotion activities said to be conducted outside India would be taxable in India.

4. Source of income, the taxation of services and tax treaties

In an increasing global economy, it is simpler to carry on business activities and render services, without any physical presence. In the case above, the Luxemburg service provider claimed that the services were carried out outside India, but the AAR pointed that the facts made it clear that these service activities had extension in India and, therefore, the source of income was considered in India.

At a domestic tax level, tax liability usually arises either because of a personal or substantial economic attachment to a particular jurisdiction. Such attachment typically results on: (1) unlimited tax liability - worldwide income and assets (residence taxation); or (ii) limited tax liability (source taxation). Source taxation subjects income to tax because it is considered to arise within a certain jurisdiction. It can be for example the case of a company having a permanent establishment in a particular jurisdiction or deriving a defined category of income, such as dividends, interest or royalties, from a particular jurisdiction. Nevertheless, domestic provisions generally determine the source of an item of income in several different ways. Source may for instance refer to where the tangible or intangible property is located or used; where the services are performed or even where the payer is located.

For example, in the US income from services has generally its source where the services are rendered and is deemed effectively connected with the conduct of a US trade or business and taxed by the US on a net basis. The problem is that as technology and communications progresses it is increasingly more difficult to determine the jurisdiction where the services are actually performed. In addition, this case also demonstrates that services, even if conducted or primarily performed outside a jurisdiction, they may have an economic impact or a so-called extension in the source jurisdiction. Will this be sufficient connection to tax?

It should be noted that “source” and “origin” do not always mean the same thing, as Prof. Kemmeren (Tilburg University) exposed in its work called The Principle of Origin in Tax Conventions. Prof. Kemmeren believes that the essence for the allocation of tax jurisdiction does not lie in the “physical” place where income is formally generated, but rather the place of origin of income, that is, where the intellectual element is to be found or a substantial income-producing activity is carried on.

Regardless of whether there is a need for a new configuration of the source principle (especially for certain items of income such as passive income), the current framework of tax treaties only allow for residence taxation unless the profits from services (preformed in the Source State) are attributable to a permanent establishment situated in that same Source State. Therefore in this case the services would be taxable only in the Residence State.

Some States, such as India, are naturally reluctant to adopt the principle of exclusive residence taxation of services and therefore support additional source taxation rights under a treaty with respect to services performed in their territory. Such States may secure source taxation by including an extended permanent establishment provision to cover services (Service PE) or a special provision to cover the so-called technical services.

One important premise of a service PE provision is that source taxation should not extend to services performed outside the territory of the source State. Under the treaties that allow service taxation, such as the ones following the UN Model, it is therefore not only sufficient that the relevant services be furnished to a resident of the Source State, these services must also be performed in the territory of that Source State. Pay attention to the source/territory aspect found in the Model provisions:

See the UN Model Provision:
Art. 5(3) The term “permanent establishment” also encompasses: (…)
(b) The furnishing of services, including consultancy services, by an enterprise through employees or other personnel engaged by the enterprise for such purpose, but only if activities of that nature continue (for the same or a connected project) within a Contracting State for a period or periods aggregating more than six months within any twelve-month period.

Under the UN Model, even if the Luxembourg company furnishing the services would have no fixed place of business in India (under Art.5(1)), the mere fact that the service or the consultancy is supplied for a certain period of time, means it would be deemed to have a permanent establishment, and would consequently be taxed on the income by the source country. One of the conditions is that the activity of furnishing services or consultancy is performed within the source state. Services, which are performed in the residence state of the service-performer, or in any other state besides the source country, are not within the scope of this rule.

See the new OECD Model (draft) Provision
"Notwithstanding the provisions of paragraphs 1, 2 and 3, where an enterprise of a Contracting State performs services in the other Contracting State
a) through an individual who is present in that other State during a period or periods exceeding in the aggregate 183 days in any twelve month period, and more than 50 per cent of the gross revenues attributable to active business activities of the enterprise during this period or periods are derived from the services performed in that other State through that individual, or
b) during a period or periods exceeding in the aggregate 183 days in any twelve month period, and these services are performed for the same project or for connected projects through one or more individuals who are performing such services in that other State or are present in that other State for the purpose of performing such services,
the activities carried on in that other State in performing these services shall be deemed to be carried on through a permanent establishment that the enterprise has in that other State, unless these services are limited to those mentioned in paragraph 4 which, if performed through a fixed place of business, would not make this fixed place of business a permanent establishment under the provisions of that paragraph."

Under the 2006 OECD draft, the proposed alternative provision is clear by stating it only applies to services that are performed in a State by a foreign enterprise. The example used in the draft mentions an enterprise that "provides telecommunication services to customers located in a State through a satellite located outside that State, the services performed through the satellite would not be covered by the provision because they are not performed in the State."

As mentioned above, the source state may also opt, instead of a Service PE, to have a special provision (or an extended royalty provision) to tax certain type of more technical services. The major difference with taxation of technical fees as “royalties” is that only the source of the payment is basically relevant. In this case, the assignment of tax jurisdiction is simply justified because of the payer’s location and taxation is levied on a gross basis.

The fact that under the OECD Model consideration for technical services is not to be treated as a royalty, led to the reaction by certain countries, which then concluded treaties including a technical fees provision in their own tax treaties.

Just a simple search in the IBFD database found 122 treaties, which include a fees for technical services provision. For example, in 1959 treaty (already not in place), Germany and India agreed to define "fees for technical services" as payments of any kind in consideration for services of a managerial, technical or consultancy nature, including the provision of services of technical or other personnel. Throughout the years, the definition found in treaties did not change significantly. For example, in the recently conclude treaty between Austria and Pakistan, "fees for technical services" means any services of a managerial, technical or consultancy nature. The problem lies sometimes in the fact that due to lack of further treaty definitions, it will be up to the local court to define what is a managerial, technical or consultancy service.

The final solution for this case, if there would be a treaty between India and Luxembourg that followed the OECD Model, would be that the marketing and business promotion activities would be only taxable in Luxembourg since there would be no arguments to conclude that a permanent establishment existed in India.

An additional issue is that in practice Indian treaties further deviate from the OECD model by including a provision covering “fees for technical services”. For the taxability of fees for technical services what is relevant is the place where services are utilized and not the place from where the services are rendered. Accordingly, the service income would be liable to tax (generally at rates from 10% to 15%) in India if the services would qualify as “fees for technical services”.

5. Conclusion

It is interesting to note that if we were faced with a tax treaty case, India would probably be prevented to tax (or would tax at reduced rates) the services performed outside the Indian territory. This case firstly demonstrates then the pitfalls of not having a treaty in place.

In a moment when the OECD is studying the possibility of clarifying the tax treaty treatment of services, this case also exemplifies how domestic (or treaty interpretations) may create further pressure on determining where the source of the income arises or the ill-effects of gross service taxation.

The OECD is now prepared to include in its Commentary on Art. 5 an alternative provision for States that whish to preserve source taxation rights on profits from certain services. This new draft includes a principle that taxation of services should not extend to services performed outside the territory of the source State. Nevertheless, the place were the services are performed and executed may perhaps deserve further consideration, especially for cases where services may have an “indirect” extension in the Source State.

Switzerland: the EU pressure is mounting

2007-02-14T21:50:00.000Z

Just a small note following my previous post on the Switzerland-EU relations, to mention that the European Commission has finally decided to go ahead with the case against certain favorable company tax regimes in Swiss Cantons, which are considered by the EU as a form of State aid incompatible with the 1972 Agreement between the EU and Switzerland.

Now it is a question of time to see if all EU member states agree on the "tactic" to apply in negotiations with Switzerland to put an end on tax measures, which the EU consider are resulting in a distortion of competition.

Although the 1972 agreement apparently allows the EU to take retaliatory measures, the press release indicates in its final paragraph a willingness to find a negotiated settlement with the Swiss authorities. Eventhough, note that to substantiate the decision taken against Switzerland the press release even evokes past actions against State aid taken for example against Austria in 1993 (back then EFTA country) on the basis of a corresponding provision. These cases basically involved the withdrawal of tariff concessions (retaliatory measure) but ended up being litigated in the ECJ. Let’s see the next chapters of this cat and mouse soap opera

Corporate Tax Avoidance: The Case of Abusive Tax Shelters

2007-02-11T23:25:00.000Z

‘if we could measure it, we could tax it.’
Comment of a tax official on measuring tax avoidance

In my continuous search to find interesting links and discussions to TALK TAX readers, I refer today to the discussion surrounding tax shelters. In the last few months, I have dedicated some of my available time to study issues surrounding some recent developments on corporate tax avoidance, such as the discussion on relationship between domestic anti-abuse rules and tax treaties (see for example the post on a recent Canadian Court decision), the discussion surrounding international tax arbitrage (see recent post) and the particular issue of abusive tax shelters. This short note is ultimately designed to address that the so-called tax shelters, which although predominantly a US issue are a growing concern also in other tax systems and internationally.

There is a perplexing number of tax planning techniques that even to a well-trained tax specialist are difficult to grasp. Some of them may in fact rise to the level of being qualified as tax shelters, but others are simply part of acceptable tax planning techniques, which have become a commonplace in a global economy. So the first question is what are tax shelters? and the second is were to draw the line?

Professor Michael Graetz (Yale) once amusingly defined a tax shelter as "a deal done by very smart people that, absent tax considerations, would be very stupid." This entertaining definition already provides some ideas of what is a tax shelter. Basically, one may attempt to further define a tax shelter as a transaction undertaken to secure a tax benefit that may seem, at first sight, acceptable under a literal interpretation of the law, but which the legislator did not envisages and also there is little or no business substance supporting the said transaction.

Although this definition is still far from perfect, there is in it more that meets the eye. For example, the fact that most existing tax shelters are usually “marketed” complex transactions with almost no substance, which involve an indifferent third party, already provides some additional criteria into the discussion. In fact, according to the US Internal Revenue Service, corporate tax shelters have the following characteristics: (i) lack of meaningful economic risk of loss or potential for gain; (ii) inconsistent financial and accounting treatment; (iii) presence of tax-indifferent parties; (iv) complexity; (v) unnecessary steps or novel investments; (vi) promotion or marketing; (vii) confidentiality; (viii) high transaction costs; (ix) risk reduction arrangements.

There is a lot of material available in the IRS website to understand through concrete cases what are tax shelters. For example, the listed abusive tax shelters page provides a possible start for the non-US tax lawyers attempting to enter these dangerous waters. I personally suggest another route and that is to take an example of a very complex tax shelter called Bond Linked Issue Premium Structure (BLIPS), which involves investors taking out bank loans and then shifting them to partnerships to claim tax losses. These transactions (and others) were widely discussed and even subject to an investigation by the US Senate Permanent Subcommittee on 2003, which you may recall focused on the involvement of one of the big four. Instead of reading those endless pages, I would suggest reading an interesting (and shorter) court decision on the BLIPS. In Klamath Streategic investment Fund, LLC v. United States, several interesting issues are discussed, namely: (i) the goal of the transactions; (ii) the involvement of tax advisors; (iii) the (lack of) substance issues; and (iv) the justification of the application of further penalties apart from disregarding the tax implications of the transactions. Another suggestion is listening and reading a brief description of US tax shelters.

As European, my interest is more on how fast some of these “fashions” cross the Atlantic. For example, following the US Regulations on Abusive Tax Shelters and Transactions, the UK introduced in 2004 its own disclosure rules covering tax arrangements concerning employment or certain financial products. These rules were recently (2006) widened to the whole corporate tax. Other countries are probably following with great interest the UK attempt of establishing an efficient reporting regime for tax planning arrangements. I am aware at least of (unsuccessful) attempts to introduce in France a similar regime and an ongoing discussion in Portugal. Apart from the complex regulatory and professional privilege issues that these type of rules involve, there is, I would say, a clear temptation to simply follow the American/UK model (disclose and then we see) without stopping to think what are type of transactions we want to tackle and more importantly whether there are other means more adequate to tackle them (e.g. special anti-abuse rules).

It is interesting to note that the discussion around tax shelters is also turning rather quickly into an international topic of itself. For example, the OECD Seoul Declaration of September 2006 where high ranked tax officials confronted the issue of non-compliance with the tax laws in an international context. Amongst the four areas in which the OECD Countries will intensify work we find: (i) Further developing the directory of aggressive tax planning schemes so as to identify trends and measures to counter such schemes. (ii) Examining the role of tax intermediaries (e.g. law and accounting firms, other tax advisors and financial institutions) in relation to non-compliance and the promotion of unacceptable tax minimization arrangements with a view to completing a study by the end of 2007.

This efforts already lead to the development of a Joint International Tax Shelter Information Centre (JITSIC). The JITSIC was established in 2004 by the tax administrations of four countries, Australia, Canada, the United Kingdom and the United States, to supplement the ongoing work of each of the countries in identifying and curbing abusive tax schemes.

In another front, States are also exploring additional ideas and forms to tackle the issue of tax avoidance, such as through bilateral information exchange agreements based on the OECD Model. It is important to recall that in 2002, the OECD released a model agreement for effective exchange of information in tax matters. The model agreement itself grew out of the work on curbing harmful tax practices, which identified “the lack of effective exchange of information” as one of the key criteria in determining harmful tax practices (see the OECD progress reports issued in 2000, 2001, 2004 and 2006). According to the OECD, a total of, 33 jurisdictions are committed to improve transparency and to establish effective information exchange for tax purposes. As such, it is no surprise to see the OECD congratulating Antigua and Barbuda and Australia for having signed a Tax Information and Exchange Agreement.

All these interesting developments make a life of an international tax lawyer interesting…

Don’t you agree?

Time has come for Tax Treaty Arbitration

2007-02-07T22:09:00.000Z

Following up on a previous post from April 2006, the OECD released a final report entitled “Improving the Resolution of Tax Treaty Disputes”.

The report includes in the first place a proposal to add to Art. 25 of the OECD Model Tax Convention an arbitration process to deal with unresolved issues that prevent competent authorities from reaching a mutual agreement. In addition, the report includes a revised version to the Commentary on Art. 25, ultimately designed to enhance the effectiveness of the mutual agreement procedure.

According to the report, the changes to the OECD Model were approved on 30 January 2007 by the OECD Committee on Fiscal Affairs (CFA) and will be included in the forthcoming 2008 update to the Model. The OECD countries have then finally agreed to modify the OECD Model by including the possibility of arbitration in cross-border disputes unresolved for more than two years. In that regard, the OECD will add the following new paragraph 5 to Art. 25:

“5. Where,

a) under paragraph 1, a person has presented a case to the competent authority of a Contracting State on the basis that the actions of one or both of the Contracting States have resulted for that person in taxation not in accordance with the provisions of this Convention, and

b) the competent authorities are unable to reach an agreement to resolve that case pursuant to paragraph 2 within two years from the presentation of the case to the competent authority of the other Contracting State,

any unresolved issues arising from the case shall be submitted to arbitration if the person so requests. These unresolved issues shall not, however, be submitted to arbitration if a decision on these issues has already been rendered by a court or administrative tribunal of either State. Unless a person directly affected by the case does not accept the mutual agreement that implements the arbitration decision, that decision shall be binding on both Contracting States and shall be implemented notwithstanding any time limits in the domestic laws of these States. The competent authorities of the Contracting States shall by mutual agreement settle the mode of application of this paragraph."

Although OECD also includes a detailed sample form of agreement to be used as a basis for the binding arbitration process, the OECD apparently leaves to the contracting parties the possibility to specify themselves the general approach and mechanics of the arbitration process.

For example, the OECD apparently suggests the use of the “independent opinion” approach, whereby arbitrators would be presented with the facts and arguments by the parties based on the applicable law, and would then reach their own independent decision, which would be based on a written, reasoned analysis of the facts involved and applicable legal sources. Nevertheless, the OECD also recognizes other approaches such as the "last best offer” or “final offer” approach, whereby each competent authority is required to give to the arbitral panel a proposed resolution of the issue involved and the arbitral panel would choose between the two proposals which were presented to it. This latter approach was recently included in the arbitration provision of the US-Germany protocol. Find below an extract from such provision:

“g) Each of the Contracting States will be permitted to submit, within 90 days of the appointment of the Chair of the arbitration board, a Proposed Resolution describing the proposed disposition of the specific monetary amounts of income, expense or taxation at issue in the case, and a supporting Position Paper, for consideration by the arbitration board.
(…)
h) The arbitration board will deliver a determination in writing to the Contracting States within nine months of the appointment of its Chair. The board will adopt as its determination one of the Proposed Resolutions submitted by the Contracting States. "

Last but not least, allow me to add to the previous list of 10 must read BOOKS AND ARTICLES on the subject, the winner of the 2006 Mitchell B Carroll Prize, Dr Zvi D. Altman. His thesis entitled “Dispute Resolution under Tax Treaties” is a fascinating trip into the limits of the available mechanisms for the resolution of tax treaty-related disputes and the challenges of establishing a new international organization with links to domestic judicial networks. Definitely a must read or have to any international tax library.

Tulips, Tax Planning and Rock Stars

2007-02-06T21:24:00.000Z

For any international tax lawyer it is uncommon to see some tax strategies discussed openly in a generalist newspaper. Nevertheless, we have to surrender ourselves to the transparency effect of globalization, where business and sometimes tax driven decisions are openly discussed and evaluated by the general public.

This introduction to suggest you a nice and entertaining article from the well-known New York Times suggestively entitled The Netherlands, the New Tax Shelter Hot Spot.

Does Cross-Border Tax Arbitrage warrants an international solution?

2007-01-30T23:26:00.000Z

Cross-border tax arbitrage is generally used to qualify transactions, which exploit differences in the tax systems of two (or more) countries. The subject is very current, not only due to the increasing international tax planning through complex transactions undertaken by multinational companies but also by the recent national reactions to the problem (e.g. New UK Rules on International Arbitrage).

Since the “holy grail” of international tax planners is the so-called double non-taxation, it is natural that taxpayers attempt to exploit “conflicting” tax rules in different jurisdictions so as to achieve a reduction of the total tax liability. Residence arbitrage through dual resident companies, entity characterisation through hybrid entities, hybrid financing, repos and double dip lease transactions are examples of “labelled” cross-border tax arbitrage transactions. Nevertheless, since in most cases of cross-border tax arbitrage, the taxpayer takes advantage of publicly known differences in tax regimes and technically complies with the said laws, it is difficult to say that the taxpayer is violating the law by planning in such manner. As such it is no surprise that some taxpayers maintain that the existence of cross-border tax arbitrage warrants no government action. Others consider that the problem of tax arbitrage needs an international solution.

This topic arises today because of an interesting paper entitled "Tax Competition, Tax Arbitrage, and The International Tax Regime" from the Prof. Reuven S. Avi-Yonah (University of Michigan), which brings interesting arguments to the theoretical discussion around the topic of tax arbitrage.

International tax is in fact a difficult concept to define. Traditionally, international taxation refers to treaty provisions relieving international double taxation but in broader terms, it also includes all domestic legislation with an international element (e.g. rules concerning foreign income of residents or source income of non-residents).

In "Tax Competition, Tax Arbitrage, and The International Tax Regime", Prof. Avi-Yonah argues that a "coherent international tax regime exists, embodied in both the tax treaty network and in domestic laws, forms a significant part of international law (both treaty-based and customary)". This ultimately means that countries are not free to adopt any international tax rules they please, but rather operate in the context of the so-called international tax regime.

For the purposes of defining the structure of the international tax regime, Prof. Avi-Yonah guides the reader through the content of what he calls the two basic principles that form part of such regime: (1) the single tax principle (i.e., that income should be taxed once- not more and not less) and (2) the benefits principle (i.e., that active business income should be taxed primarily at source, and passive investment income primarily at residence).

Accordingly, although the benefits principle is broadly accepted and reflected in both domestic rules and tax treaty network, there is a debate on whether (if one would assume that a international tax regime exists) the said regime incorporates the single tax principle. This is important when for example one has to address if the prevention of double non-taxation is an objective of the so-called international tax regime.

At the opening of the paper, Prof. Avi-Yonah asks if there is an International Tax Regime? In support of a positive answer, elements such as the existence of an extensive bilateral tax treaty network (similar in policy and language), the remarkable convergence of domestic tax systems in the recent year and the need of some degree of integration between tax systems are put forward. They play a role in arguing that a coherent international tax regime does exist.

The next question is whether such treaties and the domestic tax laws can be said to form an international tax regime that is part of customary international law. In dealing with this issue, Prof. Avi-Yonah refers the readers back to the argumentation set out in a previous paper, International Tax Law as International Law (published in Tax Law Rev. 57, no. 4, 2004), where he concluded that international tax law is part of international law, even if it differs in some of its details from generally applicable international law.

In fact, if one takes the example of tax treaties, one easily reaches the conclusion of the exceptional aspect of tax treaties (when compared with other treaties), mainly due to their profound interaction with domestic legislation, through the use of the same language and even by incorporating elements of domestic law of each party.

In support his view (that international tax law can be seen as customary international law and therefore as binding even in the absence of treaties), Prof. Avi-Yonah provides insightful examples where one can argue that international tax regime rises to the level of customary international law. These examples are the jurisdiction to tax, the non-discrimination, the arm's length standard, and the foreign tax credits. In his view, this is important step specially when dealing with a transversal issue such as tax arbitrage, whereby transactions are simply structured to take advantage of differences between tax systems and achieve double non-taxation.

The backbone of the paper is perhaps that since an international tax regime (part of customary international law) should be said to exist, a recent phenomena's such as cross-border tax arbitrage, which puts at risk the single tax principle (i.e. income should be taxed once), should be tackled under the framework of this same regime. Recent developments demonstrate, in his view, that there is an increasing consensus rejecting the ultimate result of tax arbitrage, i.e. double non-taxation and that still more can be done. In his conclusion, Prof. Avi-Yonah suggests that the OECD should take the single tax principle "more explicitly into consideration in revising its model treaty, and revise the model so that it functions better to prevent both double taxation and double non-taxation".

The problem of such view is that although one may see the non-taxation arising from tax arbitrage as the flip side of double taxation that does not mean that the tax treaties are the best equipped tool to deal with this issue. Domestic laws are inherently different and warranting a solution through treaties may well prove a difficult and frustrating exercise. In addition, domestic sudbstance over form tests may be useless in cross-border cases and international coordination fruitless, unless it is focused on the wider policy issue of tax competition.

Although I have my reservations as to whether cross-border tax arbitrage deserves an international solution, I will continue to follow the international debate around and wait for somebody to really convince me to abandon the“sceptics” club.

Further Listening
International Tax Arbitrage, A lecture by Prof. H. David Rosenbloom

Further Reading
Diane M. Ring, One Nation Among Many: Policy Implications of Cross-Border Tax Arbitrage,

2007 Tax Agenda: What to expect from the usual suspects?

2007-01-17T20:56:00.000Z

Will a new deal for a European constitution boost the possibility for further agreement concerning other EU wide-ranging tax project such as the common consolidated corporate tax base? Will the newly elected Democrat congress stall the Bush corporate tax reform projects? Will the OECD finally conclude its PE attribution project? Will the UN “wake up” in terms of international tax issues and become a larger player in the policy discussions?

Enough of open questions and let’s make a “tour de table” of some of the issues that are in the agenda and may receive fresh inputs during 2007. Personally, I have a feeling that 2007 will probably be a transitional year in terms of international and European tax issues and that more challenging and exciting times await us in 2008. But that does not mean that the developments are not expected from the prolific “usual suspects”, namely OECD, the EU Commission and the ECJ.

The OECD tax agenda
The winds and waves are always on the side of the ablest navigators.
By Edward Gibbon, The Decline and Fall of the Roman Empire

As usual, the agenda of the OECD is impressive and several topics are expected to see the green light. In the tax treaty topics, a good news is that the ongoing project on profit attribution to permanent establishments is finally close to an end. The OECD published in December 2006 the long expected new versions of Parts I, II and III of its Report on the Attribution of Profits to Permanent Establishments, along with a cover note containing an update on the status of that project. As to the announced necessary changes to the language of OECD Model Tax Convention and Commentaries, somewhere in 2007 appears to be the target of the OECD.

But the issues under discussion go well beyond profit attribution and include, dispute resolution, taxation of services, non-discrimination, collective vehicles, employment income and last but not least the place of effective management.

Dispute resolution in the framework of tax treaties (Art. 25 of the OECD Model) is one of the hot topics at the moment. The discussion draft "Proposals for Improving the Process for the Resolution of Tax Treaty Disputes", of 1 February 2006, examines the ways of improving the effectiveness of the mutual agreement procedure under Article 25 of the OECD Model, including the consideration of other dispute resolution techniques. The 2006 draft, proposes a system for the mandatory arbitration of tax disputes (new paragraph 5) between two treaty countries when the tax authorities of those countries have been unable to resolve those disputes within a two-year period. Strangely enough the recent protocol concluded between the US and Germany adopted a different arbitration approach than the one suggested by the OECD (the so-called baseball arbitration).

The application of tax treaties to services (Art. 7 of the OECD Model) is a new topic in the agenda. The recently disclosed discussion draft entitled “The Tax Treaty Treatment of Services” includes new paragraphs 42.11 to 42.45 to the Commentary on Art. 5 of the OECD Model. The new paragraphs address the appropriateness of the current provisions of the OECD Model to deal with the tax treatment of services, views (and policy reasons) of States that do not agree with the principle of exclusive residence taxation of services and finally a alternative paragraph for Art. 5 of the OECD Model that secures additional source taxation rights, in certain circumstances, with respect to services performed within the territory of the source State.

As regards, place of effective management as a tie-breaker rule (Art. 4 of the OECD Model), the discussion draft dates back already to May 2003. The OECD Model was already updated in 2005 but nothing was said about the OECD abandoning this topic. On the contrary, recent case-law from OECD countries may trigger an interest in having a fresher look at the topic (See UK Court of Appeal decision in Wood v. Holden (2006) STC 443 on the question of corporate management and control/residence). The 2003 draft develops the two alternative proposals to improve the place of effective management concept under Article 4 paragraph 3 of the Model Tax Convention. The first proposal seeks to refine the concept of “place of effective management” by expanding the Commentary explanations as to how the concept should be interpreted. The second proposal puts forward the tie-breaker rule for persons other than individuals to modify Article 4 paragraph 3 of the Model Tax Convention together with Commentary thereon. I would expect further discussion on the topic.

Another project, where a draft is available but no recent news was received on its status, is the OECD plans to revisit the scope of paragraph 2 of Article 15. The discussion draft "Proposed Clarification of the Scope of Paragraph 2 of Article 15 of the Model Tax Convention" of 5 April 2004, clarifies its application in situations when services are provided through “offshore” intermediaries by addressing the interpretation of the word “employer”, the distinction between employment and self-employment. The issue, touching upon a wide industry practice of hiring-out of labour, may have large impact and that may well explain that no further developments are available.

A release of a draft concerning the ongoing project of revising the non-discrimination article (Art. 24), may well prove to be one of the highlights of the year. Taking into account the developments in the EU and the fact that the OECD Commentaries on Art. 24 remain largely unchanged since 1977, it is expected that the project of re-examining the non-discrimination principle will probably focus on: (i) the application of Article 24 to various existing group relief concepts (e.g., consolidation, inter-corporate dividend exemptions, tax-free intra-group asset transfers); (ii) the application of Article 24 to branch level taxation; and (iii) the application of Article 24 to the thin capitalization concept, particularly its relationship to Article 9.

A far-reaching project, which recently received new impetus, is the one concerning the Taxation of Collective Investment Vehicles. After the CTPA roundtable (including tax authorities and tax specialists of the financial sector) met in Paris on 1-2 February 2006 to discuss a number of issues related to the application of tax treaties to collective investment, the OECD decided to form an informal consultative group. This group of government and private sector representatives, under the auspices of the OECD, will tackle the tax treaty issues raised by the large cross-border portfolio investments held through collective investment vehicles and global custodians. The project will examine both substantive issues and practical administrative issues related to the application of tax treaties to these investments.

But OECD is not only a synonym of work in the field of tax treaties. The OECD global tax agenda includes, amongst others, developments in the field of (i) Transfer Pricing (i.e. monitoring of the OECD Transfer Pricing Guidelines); (ii) Consumption Taxes/VAT (iii) Transparency and Information Exchange and (iv) Tax Policy. Basically it is a very wide range of issues.

The European hidden tax agenda
“Much good work is lost for the lack of a little more”
By Edward H. Harriman

The state of uncertainty in Europe is already commonplace and presidential manoeuvres in France, political changes in the UK, hard politics with Turkey and digestion problems related to the latest enlargement are probably bound to be decisive in maintaining that feeling in 2007. Europeans may expect in addition to sluggish economic growth, a new attempt to approve a new (redux) constitution, probably as an outcome of a downsizing EU summit sponsored by Germany. All this facts may have hardly any impact on the European tax agenda for 2007. Apart of the new push towards the Constitution, the development and breeding of new ideas in the tax area will continue to come from the two main players, i.e. EU Commission and from the ECJ.

As regards the first player, a special attention should be given to advances on the creation of a common consolidated corporate tax base (CCCTB) in the EU. The target is only to release a proposal is 2008, but it is expected that position making of the EU member states will become more visible during 2007. The Commission will in fact attempt to reach in 2007 a consensus agreement on a draft CCCTB project and for that will receive the additional support of the German EU presidency. The Commission will have to convince with the “carrot” some reluctant Member States (and even Commissioners such as the Irish Charlie McCreevy) that the best way forward is not to prolong tax competition amongst member states and adopt a common tax base. The “stick” to be used is the enhanced cooperation, which would allow one-third of EU Member States (9 out of 27) to adopt legislation that couldn't be passed unanimously.

However the CCCTB is hardly the remedy for the entire panacea, since there also continues to be a need for more targeted measures for short & medium term problems and for individual taxpayers. Hence, the need for better coordination of un-harmonised direct tax systems.

For this purposes, the new soft-law approach of the EU Commission is also expected to receive further developments. The end of 2006 saw the release of a set of Communications on a co-ordination of national direct tax systems, with a special emphasis on exit taxation and cross-border loss relief. The year of 2007 will probably be the year of the Commission communications ultimately directed to: (i) remove discrimination and double taxation; (ii) prevent inadvertent non-taxation and abuse; and (iii) reduce the compliance costs associated with cross-border investment.

In fact, the Commission considers a key topic that of the control of the application of specific Community tax provisions and of the Treaty freedoms. For that purposes, it plans, besides watching over the correct application of EU law by member states, to issue soft policy communications and guidelines designed to lead the member states to the desired result through coordination. This will probably be followed by benchmarks of best practices in several areas intended to pave the way for reform and alignment of domestic law with EC Tax principles. It would be no surprise if the Commission future work would focus on issues such as withholding taxes, group taxation, taxation of permanent establishments and anti-avoidance rules.

Other areas where inputs from the EU Commission are expected include, the ongoing project of the one stop shop in the area of VAT, the fight against tax fraud through the revamp of the mutual assistance directive and finally the area of environmental taxation (by means of ‘green taxes’, CO2 tax, vehicle taxes and tax incentives).

Finally, a topic where much development is expected in the near future is the area State Aid. The past year was marked in this area by new communications on the effective use of R&D tax incentives and the State Aid decision concerning the Luxembourg 1929 Holding regime. As regards 2006, the highlights will probably be the decision on the recent Dutch tax reform and the forthcoming decision of the Court of First Instance in the Gibraltar case, where the court will have the first opportunity to test the line of defence based on regional autonomy (see Azores case).

As regards the European Court of Justice, the last year has demonstrated that European Tax Law has maintained its importance. The key cases of the last year were definitely Marks & Spencer (cross-border losses), Cadbury Schweppes (CFC), Denkavit international (Outbound Dividends), Kerkhart & Morres (Relief for juridical double taxation), N case (Exit tax) Bouniach (withholding tax), Halifax (VAT Avoidance) and Banca Popolare de Cremona (IRAP). The year of 2007 will probably be the year of consolidation of the important jurisprudence issued in 2005 and 2006. It may also well be the year where the scope of the EC freedom of capital as regards third countries will be finally clarified (the non-tax case of Fidum Finanz set the grounds on 2006).

As regards the year to come, the ECJ continues to have an agenda rich of tax cases. Amongst the currently pending cases (some of them to be decided in 2007 or 2008), one may highlight the following:

(1) Meilicke (C-292/04). This case, which deals with the German corporation tax credit for foreign dividends, will give an opportunity to the Court to further develop the theory of the temporal limitation of the effects of judgments. The Advocate General suggested that the temporal effects of the judgment in Meilicke against Germany should not be limited.
(2) Thin Cap Group Litigation (C-524/04). This case deals with the UK thin cap provisions. The Advocate General already suggested that the UK thin capitalization regime is generally compatible with freedom of establishment.
(3) Skatteverket (S) v. A (C-101/05). This case deals with the Tax-neutral spin-off and the question submitted was whether a dividend distribution from a parent company, in the form of shares in its subsidiary located in a third state (with no exchange of information provision) should be tax exempt.
(4) Skatteverket (S) v. A and B (C-102/05). This case concerns the taxation of dividends distributed by close companies located in third countries, in this case Russia.
(5) Holböck (C-157/05). This case, which deals with free movement of capital and third countries, concerns an individual shareholder resident in Austria received higher taxed dividends from a corporation resident in Switzerland on which he held two thirds of the shares.
(6) Columbus Container Services BVBA (C-298/05). This case deals with the potential compatibility of a German treaty-override provision, which provides for a switch-over from the exemption method to the credit method in respect of low-taxed passive foreign permanent establishment (PE) income, with the basic freedoms under the EC Treaty.
(7) Amurta S.G.P.S. (C-379/05). This case concerns compatibility of the dividend withholding tax exemptions for non-resident companies with the EC freedom of establishment and free movement of capital (discrimination of outbound dividends) .
(8) Orange European Smallcup Fund NV (C-194/06), this case, in which no credit was given for Portuguese and German withholding taxes, deals with the question of whether the refusal to credit this tax infringed the freedom of capital movement.
(9) Cartesio (C-210/06). This case deals with on the scope of the freedom of establishment and its effect on national company laws, in particular, on the constraints imposed by this freedom on the regulation by the home and the host EU Member State of the transfer of seat of companies established under their national laws.
(10) Deutsche Shell GmbH (C-293/06). This case deals with the treatment of currency losses from the repatriation of start-up equity of PE.
(11) Heinrich Bauer Verlag (C-360/06), this case deals with different valuation of domestic and foreign participations.
(12) M+T (C-414/06). This case is one of the two pending ECJ two cases on the deductibility of losses of a foreign permanent establishment at the level of its parent which were rejected on the basis that the exemption method in the double tax treaties applied not only to positive but also to negative income. In this case, the PE was situated in Luxembourg.
(13) SEW (C-415/06). This case is the second of the two pending ECJ two cases on the deductibility of losses of a foreign permanent establishment at the level of its parent which were rejected on the basis that the exemption method in the double tax treaties applied not only to positive but also to negative income. In this case, the PE was situated in the US.
(14) Gronfeldt (C-436/06). This case deals with different thresholds for capital gains from domestic and foreign participations.
(15) Hollmann (C-443/06). This case deals with the not application to non-residents of the reduced tax base (50%) for capital gains.

Is Switzerland under enough pressure from Europe institutions to clamp tax competition?

2007-01-11T21:50:00.000Z

It is needless to say that international tax competition has become more intense as globalisation makes the world flatter. Switzerland is strategically centrally located in the hart of Europe and therefore in a privileged situation to attract foreign investment. A strong open economy, sacrosanct banking secrecy and a favourable tax system for multinationals have long made Switzerland amongst multinationals favourite headquarter locations.

As an example, the UK Times recently reported that Kraft Foods, the American multinational, recently announced that it is moving their European headquarters to Switzerland in search of efficient transport, lower taxes and an easier lifestyle.

The Swiss Federation, which includes 26 sovereign Cantons and approximately 2,900 independent municipalities, has a particular fiscally decentralised model for European standards. According to the Swiss Constitution, the Cantons have fiscal sovereignty and full right of taxation, except for particular sources that are allocated to the federal government. Basically, the Confederation (federal level) and the Cantons effectively share tax law making power for direct taxes on income and wealth.

Taking into account this decentralised model, the tax burden of a company may vary significantly depending on its Canton of residence. With a federal income tax levied at a flat rate of 8.5%, the effective income tax rate on profits for federal, cantonal, and communal taxes may be said to range between 13% and 30%, depending on the company’s place of residence. Nevertheless, at Cantonal level several tax incentives are available for example to newly established companies or holding, management and mixed companies. These incentives, which are ultimately designed to attract foreign investment, are an example of tax benefits available for multinational companies interested in locating their business in Switzerland.

The lowest corporate income tax rate in Switzerland is found in the business-friendly Cantons of Obwalden and Zug, where the effective income tax rate, including federal tax, is 13.1% and 16.44% respectively.

For much of the last decades, Switzerland has ranked amongst the wealthiest countries in Europe and recent studies have shown a boost of its international competitiveness. Low corporate tax rates, local tax incentives, favourable tax treaty network and recent access to EU free of withholding repatriation routes are amongst the main (tax) factors that explain the success of Switzerland in the international tax arena. Between international tax practitioners, Switzerland has become not only a favourable location for headquarters and holding structures, but also for finance and treasury activities (e.g. Swiss financing branches), commissioner and trading structures and last but not least a location for intellectual property and licensing activities.

The rise of Switzerland, just in the doorstep of Europe, as a favourable tax location has ignited again the tax competition debate. It is interesting to note that, both the OECD (which Switzerland is a member) and the European Union (with which Switzerland has several bilateral agreements) have been in the forefront of the discussion on tax competition.

It is important to recall that no longer than 10 years ago, OECD issued a groundbreaking report entitled, “Harmful Tax Competition: An Emerging Global Issue.” The project was based in three fronts: 1) identifying and eliminating harmful features of preferential tax regimes in OECD member countries 2) identifying “tax havens” and seeking their commitments to the principles of transparency and effective exchange of information and 3) encouraging other non-OECD economies to associate themselves with this work. As regards the first aspect, the 1998 report established a number of criteria for determining whether or not a preferential tax regime was harmful and included a commitment by the OECD Member countries to eliminate harmful tax regimes. The OECD work identified 47 preferential tax regimes as potentially harmful, out of which 19 regimes were, in the meantime, abolished, 14 amended to remove their potentially harmful features and 13 found not to be harmful on further analysis. In an annexed statement to the 1998 report, Switzerland (and Luxembourg) openly opposed the report.

In Europe, tax competition between member states has also been an issue for more than a decade now. The EU is marked by a significant diversity of company tax systems and as pointed out by the Ruding Committee report (1992), that tax differences among Member States distort foreign location decisions of multinational firms, and cause distortions in competition, especially in mobile activities. Following the OECD, the EU permissive attitude ended with the adoption on 1997 of the EU Code of Conduct for Business Taxation. On that occasion, the European Commission also made a commitment to clarify the application of state aid rules in the field of business taxation, which resulted on the 1998 Notice on the Application of State Aid Rules in the Field of Business Taxation. The EU Commission went on to defend that all 66 regimes that fell within the scope of the EU Code of Conduct for Business Taxation and were listed as harmful tax measures, were susceptible to a state aid investigation. This twin-track approach (code of conduct and state aid rules) implied a departure from the European Commission's previous policy and provided immediate success tackling tax competition within the EU borders. The problem is that outside the borders tax competition continues to increase (e.g. Singapore and Hong Kong) and only now EU Member States appear to be committed to promote the standard of the Code of Conduct with third countries.

The issue with Switzerland, from a EU perspective, stems from the fact that low cantonal tax rates and selective tax incentives may be said to contravene Art. 23 of the 1972 EU-Swiss Free Trade Agreement (FTA). Article 23 of the FTA reads as follows:

The following are incompatible with the proper functioning of the agreement in so far as they may affect trade between the Community and Switzerland:
(...)
- any public aid which distorts or threatens to distort competition by favouring certain undertakings or the production of certain goods.
Should a contracting party consider that a given practice is incompatible with this article, it may take appropriate measures under the conditions and in accordance with the procedures laid down in article 27.

Taking into account this provision, the European Commission in December 2005 launched a consultation procedure with the Swiss Authorities, stating that Cantonal tax incentives granted to holding, management and mixed companies, are incompatible with the FTA and constituted a distorting state subsidy. The EU authorities also understand that such a case against Switzerland may also be substantiated under WTO and OECD rules.

The growing importance of tax competition as a factor to attract capital and business activity, the limits of the EU bilateral path with Switzerland and its already lasting suspicion of joining the EU may have been the igniters of this new diplomatic offensive. This consultation has naturally a political backdrop, since in some member States view it is hard to accept that Switzerland, which benefits under certain bilateral agreements from a privileged access to the EU internal market, maintains an aggressive tax policy with the clear objective of attracting European mobile activities.

Nevertheless, Switzerland is not a member of the EU and State Aid, as such, is an alien and somewhat difficult concept to integrate in the existing legal order between the EU and Switzerland. Switzerland has since the rejection of the EEA agreement in 1992, adopted a different approach towards the EU, based on the conclusion of bilateral agreements. The political stakes were even raised after recently Swiss voters (narrowly) approved in November 2006 to give one billion Swiss francs (630m euros) in aid to the 10 new members of the European Union. The contribution to the European cohesion was the price agreed to pay when the EU and Switzerland agreed in 2004 a second package of bilateral treaties covering the EU-Swiss relations. On the other hand, the recent 2005 agreement between the Swiss Confederation and the European Community on the taxation of savings has even helped to reinforce the competitiveness of Switzerland tax system, by granting measures equivalent to those found in the EC Parent-Subsidiary and Interest and Royalty Directives to Swiss entities receiving or paying such items of income (see Art. 15 of the Agreement).

In this context, it is rather natural that Switzerland counter argued that the EU couldn't impose (indirectly) its State Aid rules by simply interpreting the said Art. 23 of the FTA in similar way as it interprets and applies Art. 87 of the EC treaty. In a fairly complete reply to the European Commission memorandum, the Swiss Federal Tax Administration responded by arguing:
- Firstly, that the said tax incentives do not fall within the scope of the FTA, which itself only governs the trading of certain goods, and that Art. 23 does not provide a sufficient basis for an appreciation of corporate taxation in terms of competition law;
- Secondly, that Art. 23 is not to be interpreted in the same manner as the EC treaty’s state Aid rules; and
- Thirdly, assuming that cantonal tax regulations would fall within the scope of the FTA, that the relevant incentives would not constitute a incompatible state subsidy because: (i) they take into account the (less) use of infrastructures and are justified; (ii) they are not selective; and (iii) there is no interference with the bilateral movement of goods.

The Swiss tax authorities concluded by simply rejecting any responsibility as a participant in the EU internal market and reiterated that Switzerland only "seeks to offer an attractive location for making business by providing for a package of advantageous conditions, as do all states. Corporate taxation is an important factor for choosing locations and making investment decisions – but not the only one by any means". To that effect the authorities pointed out that under the OECD parameters their system cannot be considered harmful, that in the EU one also finds a wide variety of tax levels and finally that the tax disparities in Switzerland do not arise at the federal level but instead at a Cantonal level.

The current state of play is unclear. One can argue that the fact that Switzerland is not a full EU member gives it more freedom regarding tax competition. Nevertheless, both politically and economically, Europeans should question whether Switzerland is under enough pressure from Europe institutions to clamp tax competition?

PS: this was my 201st post!

The update to the 2006 U.S. Tax Treaty Model and Technical Explanation: Is the U.S. setting or following the pace?

2007-01-03T10:53:00.000Z

You may recall a recent post on the release of the new US Model. In the meantime, I found a bit of time to prepare and share with you a Draft Article on the novelties of the new US Model.

Summary:
U.S. tax policy choices may be said to reflect not only on its tax legislation but also on the U.S. Model Income Tax Convention, which serves as a starting point in bilateral treaty negotiations.

In a 2006 testimony of before a U.S. Senate Committee, Patricia A. Brown, former International Tax Counsel to the Treasury Department reinforced the importance of the wide-ranging plan to revise and conclude tax treaties or protocols that would accordingly provide a “grater economic benefit to the United States and to U.S. taxpayers”. The recent treaties and protocols concluded with the UK , Australia , Japan , Netherlands , Denmark , Germany , Sweden , and others are a good reflection of such an effort designed to reinforce the competitiveness of U.S. multinationals in the international arena.

After a decade where the U.S. Treasury Department has revamped key treaties of its treaty network, it was therefore expected that the newly released 2006 update to the U.S. Model and Model Technical Explanation would take into account some of the tax treaty policies entrenched on those recently concluded treaties. That was the case in some instances, but surprisingly so some of the novelties were simply left out.

The following article addresses the principal changes to the 2006 U.S. Model and/or Technical Explanation, which include amongst others:
- Update of the treatment of flow-through entities, with an inclusion of specific examples addressing dividends paid to fiscally transparent and hybrid entities;
- Inclusion of a new article addressing pension funds;
- Update of the discussion on attribution of profits to a permanent establishment;
- Update of the dividend article;
- Update of interest article, including a new provision addressing "contingent interest; and
- Elimination of the independent personal services article; andRevised language of the limitation on benefits article.

http://www.savefile.com/files/385279

Christmas (tax) Reading

2006-12-23T12:26:00.000Z

The year can be closing and some people are thinking in buying last minute presents, writing their Christmas cards and gathering around their family, away, very far away from international taxation.

Then again the “usual suspects” come with large pieces of reading material for the Christmas vacation so that our attention is not focused elsewhere. The “usual suspects” suspects are the OECD and the EU Commission, which released a series of reports that for the ones that attempt to follow the international tax developments, it basically means extra tax reading and no fiction novels. Do not even think about it!

The European Commission (usual suspect n.1) adopted a Communication on a co-ordination of national direct tax systems, a Communication that invites Member States to adopt an EU-coordinated approach on exit taxation and a Communication that invites Member States to adopt an EU coordinated approach to cross-border loss relief.

The aim of the first Communication is to coordinate the national direct tax systems to ensure that they are compatible with EU law and interact coherently with each other. The second Communication provides specific guidance for the EU Member States on designing exit tax mechanisms compatible with EC law principles. Finally, the third Communication follows up the Marks & Spencer case, and invites Member States to develop a coordinated approach to cross-border loss relief that eliminates what the EU Commission says to be one of the “main obstacles to cross-border investments”! Perhaps a bit exagareted, specially if we take what the ECJ said in the M&S case.

Remeber, that the European Commission plans to issue a further Communication in early 2007 to report on progress to date in the CCCTB, which miraculously solves the problems identified on the EU communication. What a coincidence! This is called the inversed stick and carrot approach! The ECJ basically intends to beat the Member States with the soft law stick until they find the light of the CCTB! Now it’s a question to see if it lights the whole Europe or only a few brave bunch!

The OECD (usual suspect n.2) had to respond at the level of its Brussels counterpart and the new impetus to the knotty PE project was the answer. The OECD published the expected new versions of Parts I, II and III of its Report on the Attribution of Profits to Permanent Establishments, along with a cover note containing an update on the status of that project. This means that we may send the previously published discussion drafts of Parts I-III to the trash bin and start reading the new ones in a “fun” game of finding the differences!

The OECD discreetly says that the new versions of Parts I (General Considerations), II (Banks) and III (Global Trading) reflect the broad consensus of OECD member countries around an approach to attributing profits to permanent establishments which is based upon the arm’s length principle as described in the 1995 OECD Transfer Pricing Guidelines. One wonders whether the previous drafts failed that test! As to the announced necessary changes to the language of OECD Model Tax Convention and Commentaries, somewhere in 2007 appears to be the target of the OECD! The Part IV (Insurance) is still a bit behind the rest of the gang but do not stress because the OECD promises us to provide extra reading ASAP!

A special thanks for the ECJ (usual suspect n.3), which has the dignity of closing well ahead for the Christmas season!

Have a nice Christmas (reading)!

Tiago Cassiano Neves

Next post: what to expect from 2007!

OECD New "Service PE" proviso

2006-12-15T17:44:00.000Z

Did you ever noticed that some source countries are slightly reluctant to adopt the principle of exclusive residence taxation of services performed on their territory, which are not attributable to a Permanent Establishment (PE) in that source country? Believe me, there are enough countries out there supporting service PE clauses...perhaps in Asia....

The OECD did notice and therefore decided to propose (just in case) some clarification into the Commentary on Article 5, reflecting the conclusion that the current provisions of the OECD Model Tax are appropriate to deal with services (i.e. the right result for services is residence-based taxation). Just for the sake of clarity and completeness, the OECD also includes an alternative provision to be added to Art. 5 for those "rogue countries" that for one reason or another which to preserve source taxation rights on profits from certain services.

Surprised?

You shouldn't be. Just remember that the OECD is no longer an exclusive club of rich (ups..high developed) countries supporting residence-based taxation. In recent years, just as the world economy, the OECD has become more flat! (read the book the World is Flat and you will understand why!). The inclusion of a (alternative) provision on the taxation at source of certain services (even if hidden in the deepness of the Commentaries) is a sign that in an increasingly service-based economy, new challenges lie ahead on international taxation. Now countries can decide to use it or not!

The discussion draft entitled “The Tax Treaty Treatment of Services” includes new paragraphs 42.11 to 42.45 to the Commentary on Art. 5 of the OECD Model. The new paragraphs address the appropriateness of the current provisions of the OECD Model to deal with the tax treatment of services, views (and policy reasons) of States that do not agree with the principle of exclusive residence taxation of services and finally a alternative paragraph for Art. 5 of the OECD Model that secures additional source taxation rights, in certain circumstances, with respect to services performed within the territory of the source State.

For the States that wish to secure additional taxing rights on services, the OECD suggest the inclusion of a new paragraph which operates as an extension of the permanent establishment definition in conformity with the following principles:
- taxation of services should not extend to services performed outside the territory of the source State;
- taxation of services should apply only to the profits from these services rather than to the gross amount of the service fees; and
- taxation of services should involve a minimum level of presence in the source State, requiring for example a certain days of presence and a link between the revenues and the services or type of business activities performed.

The alternative OECD service PE clause included in paragraph 42.23 of the discussion draft, reads as follows:

"Notwithstanding the provisions of paragraphs 1, 2 and 3, where an enterprise of a Contracting State performs services in the other Contracting State
a) through an individual who is present in that other State during a period or periods exceeding in the aggregate 183 days in any twelve month period, and more than 50 per cent of the gross revenues attributable to active business activities of the enterprise during this period or periods are derived from the services performed in that other State through that individual, or
b) during a period or periods exceeding in the aggregate 183 days in any twelve month period, and these services are performed for the same project or for connected projects through one or more individuals who are performing such services in that other State or are present in that other State for the purpose of performing such services, the activities carried on in that other State in performing these services shall be deemed to be carried on through a permanent establishment that the enterprise has in that other State, unless these services are limited to those mentioned in paragraph 4 which, if performed through a fixed place of business, would not make this fixed place of business a permanent establishment under the provisions of that paragraph."

If the conditions of such provision are fulfilled, the service activities are therefore deemed to be carried on through a PE and the profits derived from such activities taxable in the source State pursuant to Art. 7 (business profits).

The proposed provision is different than the UN Model service PE provisio. When comparing the existing Art. 5 of the UN Model (2001) with Art. 5 of the OECD Model (2005), it can be said that under the UN Model there are more situations leading to a permanent establishment than under the OECD Model. This isthe case for example under Para. 3 (b) of Art. 5 of the UN Model, “the term "permanent establishment" also encompasses: (…) (b) the furnishing of services, including consultancy services, by an enterprise through employees or other personnel engaged by the enterprise for such purpose, but only if activities of that nature continue (for the same or a connected project) within a Contracting State for a period or periods aggregating more than six months within any twelve-month period.”.

A simple search in IBFD database retrived almost 500 real treaties with this language. This means that the OECD inclusion in the Commentary of a service PE perhaps is intended to brign the Model closer to developing nations and at the same time clarify some basic principles regarding cross-border services.

Finally, the discussion draft takes the opportunity to include additional language to paragraph 10 of the Commentary on Art. 17, allowing taxpayers to be taxed on their net income (instead of gross profits) as if they were residents.

The Tax Treaty Treatment of Services: OECD Public discussion draft on proposed Commentary changes, released on 8 December 2006

WHAT IS CLEAR AND NOT SO CLEAR FROM DENKAVIT II?

2006-12-14T17:49:00.000Z

With the exception of the Parent–Subsidiary Directive, there is no specific EC rules concerning dividend taxation. Therefore, it is reasonable to say that dividend taxation falls under the competence of each of the EU Member States, subject to the increasingly important limits under the fundamental freedoms established in the EC Treaty. As we have seen throughout the extensive case-law of the ECJ in the field of direct taxation, EC law impacts on national tax systems as a result of the combined application of the four freedoms and the prohibition of discrimination and discriminatory restrictions.

The decision of the ECJ in the Denkavit II case (C-170/05), which held that the French withholding tax on outbound dividends is incompatible with the freedom of establishment (Art. 43 of the EC Treaty), is a good example of those limits. Under certain tax systems, outbound taxation of dividends was sometimes distinguished from domestic situations, where dividends were paid and receive by resident entities. In the first case, a domestic withholding tax was levied, while in the later case no withholding tax was levied (in order to prevent for example the cascading of tax through chains of companies). This case simply says that in a EU scenario such distinction may prove to be incompatible with the treaty freedoms.

Dividend taxation under international tax law

The structure of the international income tax, drawn from the so-called international consensus, is based on the assumption that income tax is generally levied (i) on the domestic and foreign income of its residents (residence taxation) and (ii) the domestic income of non-residents (source taxation). Under such system, whilst the residence concept establishes a relationship between a particular jurisdiction and the taxpayer deriving the income, the source concept connects the income itself with a particular jurisdiction.

Under that framework, when considering the taxation of dividends it is then important to distinguish: (i) a withholding tax levied on the dividends paid by the company on behalf of the shareholder at the moment the dividends are paid out; (ii) the taxation at the level of the shareholder receiving the dividends.

Under international income tax law, dividends are usually sourced on the basis of the residence of the company paying them. As such, if a resident of one country earns dividend income from a source in another country, double taxation is likely to arise because one country will tax that income on a source basis (usually through a flat-rate final withholding tax on the gross amount of the dividends) and the other country on a residence basis (usually using a progressive income tax rate scale for individuals or a flat-rate for companies).

In this case, the internationally accepted regime is that the source country has the prior right to tax (although limited by reduced treaty rates), and the residence country is responsible for relieving any double taxation that results. Such relief is generally achieved through the exemption system (whereby the foreign income is exempted from tax in the residence country) or the foreign tax credit system (whereby the tax of the residence country on the foreign income is reduced by the amount of source country tax on the income). Under that model, this case has to be distinguished especially from the so-called economic double taxation, i.e. where two different persons are taxable in respect of the same income or capital.

The domestic withholding tax rate on outbound dividends is typically set between 20%-30%, which is then generally reduced to 5%-15% under the respective tax treaties. A usual feature found in outbound dividend taxation relates to the distinction between direct investment (an investor which has a controlling shareholding) and portfolio investment (where no controlling shareholding exists). This distinction is generally defined through an ownership percentage of the capital (for example the OECD Model uses a 25% ownership test).

It should be noted that in respect of inter-company dividends, many countries have chosen recently in their tax treaties to simply eliminate its dividend withholding tax. This situation is related with the wider trend of lowering corporate income tax rates, inclusion of domestic exemptions on certain outbound payments and the enactment of the Parent-Subsidiary Directive, which was recently extended to Switzerland. Nevertheless, at this stage one can say that withholding tax on outbound dividends is still the rule under treaties. The issue now is to see how the same issue is covered under the EC Law framework.

Outbound dividends in Europe - An (in)complete framework

The area of dividend taxation in Europe, in addition to the bilateral treaties, is fundamentally marked by the existence of a EU directive for the taxation of parent and subsidiary companies. The so-called Parent-subsidiary Directive (Council Directive 90/435/EEC) had an immediate effect on cross-border business transactions in Europe, by providing a comprehensive double tax relief throughout Europe for dividends flowing between companies from different Member States when the companies are in a parent/subsidiary relationship.

The Directive, which deals with issues that were previously the exclusive concern of tax treaties, basically requires that Member States: (i) refrain from imposing withholding taxes on distributions of profits made by subsidiary companies to their parent companies in other Member States; and (ii) to grant parent companies double taxation relief in respect of such income either by exempting it from further tax or by granting relief for the underlying company tax on the profits out of which the distribution is made.

Nevertheless, the scope of the Directive seems narrower (on the first element noted above) than the Dividend article found in tax treaties, since its application is limited to certain types of companies established in accordance with domestic law of the EU member states. Even though there have been recent extensions of its scope, there is a range of situations outside the coverage of the Parent/subsidiary Directive that may need to be assessed applying the fundamental freedoms case law.

Just imagine the treatment of EU inter-corporate dividends paid by a company that does not meet the requirements set out in Art. 2 of the Parent-Subsidiary Directive. For example it may be a dividend paid by a type of company that is not listed in the Annex. In addition, just imagine a payment of inter-company dividends that fails the 20% threshold requirements of Art. 3. On a more extreme scenario, just consider individuals, which are not covered by the Parent-Subsidiary Directive and therefore are required to incorporate their holdings, through a "listed" company, to achieve the same objectives of source taxation minimization.

What happens in these ""fringe" cases? Is the Member State authorized per se to withhold tax in those situations (or not provide relief) or do we have to read these "fringe" cases in conjunction with ECJ case-law on discrimination? But then comes along a French case on inter-corporate dividends, which fortunately covered taxable years when the Parent-Subsidiary Directive was still not in place.

The Denkavit II Decision

This case involved a dividend distribution from an (almost) fully owned French subsidiary to its Dutch parent company, Denkavit International BV. The problem derived from the fact that domestic dividends were not subject to withholding tax and were 95% exempt at the level of a French parent company, whilst, dividends distributed to a foreign parent were subject to a 25% withholding tax. This domestic withholding tax was nevertheless reduced to 5% under the French–Dutch tax treaty. Since, Denkavit International BV was unable to credit the 5% withholding tax because its dividend income was tax exempt under the Dutch participation exemption regime, it decided to claim a refund of that withholding tax on the basis that a EU parent company could not be treated less favourably than a French parent company.

The ECJ basically followed Advocate General Geelhoed opinion and held that France is precluded under EC Law to impose a withholding tax on dividends paid to a non-resident parent company if it provides an (almost full) exemption of dividend withholding tax to French resident parent companies. In addition, the ECJ held that the dividend withholding tax is prohibited, even if a tax treaty between the Source and Residence State provides for the Residence State taxation to be set off against the Source State withholding tax, if the parent company is unable to set off tax in the residence State, in the manner provided for by the tax treaty.

In taking this decision, the ECJ first pointed out that since the case related to years where the Parent-Subsidiary Directive did not apply, only the relevant provisions of the EC Treaty should be taken into account.

In a rather short decision, the ECJ arrived quickly to the conclusion that the French tax system, irrespective of the effect of the relevant tax treaty, gave rise to a difference in the tax treatment of dividends paid by a resident subsidiary (no withholding tax on domestic dividends and 25% withholding tax on outbound dividends) and that such difference constitutes in principle a prohibited restriction on the freedom of establishment.

The ECJ rejected therefore the French arguments based on the non-comparability between a domestic parent and a EU parent and the justification based on the territoriality principle (which was apparently ignored by the ECJ).

As to the controversial comparability aspect, the ECJ referred that as soon as France, either unilaterally or by way of a treaty, imposes tax on the dividend income, not only of resident shareholders, but also of non-resident shareholders, from dividends which they receive from a resident company, the situation of those non-resident shareholders (which have or not a fixed place of business in France) becomes comparable to that of resident shareholders.

The ECJ on paragraph 37 of the decision followed the preposition of the Advocate General and held that since the domestic exemption on dividends is designed to avoid economic double taxation, France is therefore required to extend such a relief (i.e. exemption) also to non-residents, to the extent that similar domestic double economic taxation results from the exercise of its tax jurisdiction over these non-residents. (1)

(1) According to the Advocate General, this follows from the principle that tax benefits granted by the source State to non-residents should equal those granted to residents in so far as the source State otherwise exercises equal tax jurisdiction over both groups.

The ECJ went on to state that the heavier tax burden on dividends paid to Netherlands parent companies (as compared to dividends paid to French parent companies) constitutes a discriminatory measure incompatible with the EC Treaty. In conclusion, France should not levy a withholding tax on outbound dividends.

The second part of the judgment concerned the equally controversial issue of the effects of tax treaties on the compatibility of domestic law with EC law. The issue here was whether a different answer should be given if a tax treaty exists between the source state and the resident state, whereby a parent company resident in the resident state may offset the withholding tax levied in the Source State, but because of the resident State tax system (i.e. participation exemption) such parent company is simply unable to set off the respective withholding tax. In fact, the Dutch participation regime simply prevented the possibility of offsetting the French withholding tax against Dutch corporate income tax, resulting in an excess tax credit of 5%.

The ECJ was again short in its argumentation and held that in such a case, the combined application of treaty and Residence State participation exemption rules does not serve to overcome the effects of the restriction on freedom of establishment and therefore constitutes incompatible discrimination against foreign parent companies. In reaching its decision, the ECJ rejected the French argumentation that under international tax law it is for the Residence State and not for the Source State, in which the taxed income has its source, to rectify the effects of double taxation.

What is (not so) clear from Denkavit II?

The Advocate General Geelhoed intellectual construction, which distinguishes between home and source State obligations, appears to have been accepted by the ECJ. This means that the obligation of the Source State only arises insofar as it exercises its tax jurisdiction over the non-residents. In this case, the source State cannot discriminate between resident and non-resident taxpayers. On Denkavit II, the ECJ appears to oblige the Source State (France) to extend a relief for economic double taxation to the non-resident (Netherlands) equivalent to the relief given in the Source State. But is this case applicable on other types of income?

The particular features of this case appear also to point out that it only applies in circumstances where the Residence State is an exemption country. This link (between the exemption method and the outcome) although not entirely clear may be extracted from paragraph 54, which refers to the combined application of the tax treaty and the relevant domestic legislation (which in that case “does not serve to overcome the effects of the restriction on freedom of establishment”). Is this sufficient to rule out a case under the credit method?

First question: Does the ECJ mean that the case is only applicable to dividend withholding tax situations such as the one found in France-Netherlands? What if the residence state operates through a credit method? What about withholding tax on other types of income?

Another problem, left untouched, is that by doing so (i.e. extending the relief), the Netherlands parent company is slightly better of than a "comparable" French resident company. This is the case, since the exemption in France covers only 95% of the dividend income, whilst the Dutch participation exemption covers the full dividend income (100%). In limit, this should not prevent France to levy a least a withholding tax on the difference (33% of 5%= 1.65).

Second question: Is France then still allowed to tax this residual amount? If yes, at which rate? Treaty rate or CIT rate?

It is needless to say that this decision will have also an impact on Member States that apply a participation exemption regime for domestic parent companies, while applying a withholding tax on outbound dividends paid to EU parent companies, namely when the conditions for exemption under the Parent-Subsidiary Directive are not met. Just imagine, as is the case in various EU member states, that that holding thresholds for the domestic participation exemption and Parent-Subsidiary Directive differ. Nevertheless, governments may easily correct this difference by simply adjusting (upwards) the domestic thresholds or (downwards) the outbound thresholds. The problem here is that experience has shown that the adjustments made as a consequence of ECJ case law have in many instances worsened the position of domestic taxpayers. For example the legislative reaction to the Lankhorst Hohorst case (C-324/00), which found the German rules on thin capitalization in violation of the Treaty, resulted in some cases on the extension of thin-cap rules to domestic creditors.

Third Question: how will governments react to Denkavit II?

Another issue will be, whether such a case would be decided in the same way for portfolio participations that fall under the scope of free movement of capital (Art. 56 EC). The existing ECJ case law seems already to indicate that the same conclusion may be drawn. And what if we are in a third-country scenario? And what if the residence state has a credit system and there is an apparent cash-flow disadvantage on having a withholding tax on the outbound dividend and only later a credit? Here the pending Amurta case (C-379/05) will probably provide an answer in that respect.(2)

(2) The Amurta case, which also focuses on the compatibility of withholding tax on intercompany dividend, deals with the specific case where a company (resident in Portugal) owning 14% of the shares of a Dutch company, receives a dividend from which 25% Dutch withholding tax was withheld. Amurta filed an objection against the levy of withholding tax and argued that such levy violated the free movement of capital as included in Art. 56 of the EC Treaty, arguing that, had the company been resident in the Netherlands, no dividend withholding tax would have been due (based upon the participation exemption rules).

Fourth Question: can we apply the same line of reasoning of Denkavit to cases falling under the free movement of capital? Again, what if the residence state is a credit country and not an exemption?

The ECJ apparently ignored or diplomatically avoided to touch upon the controversial position used by former Advocate General Geelhoed, which distinguishes between “true” and “quasi” restrictions, whereby the latter restrictions fall outside the scope of the Treaty and therefore should only be eliminated by legislative action.(3)

(3) Using the words of the former Advocate General Geelhoed, "Quasi-restrictions result directly and inevitably from the juxtaposition of systems and in particular from: (1) the existence of cumulative administrative compliance burdens for companies active cross-border; (2) the existence of disparities between national tax systems; and (3) the necessity to divide tax jurisdiction, meaning the dislocation of the base."

Fifth Question: does this mean that the distinction between “true” and “quasi” restrictions is still hanging in the air?

In the end, litigation in this area will result in the necessity of symmetry between thresholds of participation exemption. In that regard, another area now left open by this case is its impact on "fringe" cases that fall outside the directive, such as dividends paid by type of companies that are not listed in the Annex of the parent-subsidiary Directive. This discussion of course raises the issue of the relationship between primary (EC Treaty) and secondary Community law (Directives), which is far from clear. One can say, that even if a certain area has been harmonized through a Directive, this does not entail the creation of an invulnerable domain, immune from the influence of the fundamental principles set out by the EC Treaty.

Sixth Question: can we apply the same line of reasoning of Denkavit II to cases outside the subjective scope of the Parent-Subsidiary Directive?

And what about individuals? Is it another ball game altogether as some say or can we also apply the same principles? As the EU Commission rightly puts it in the communication "Dividend taxation of individuals in the Internal Market (COM (2003) 810), "a Member State cannot levy tax a withholding tax on outbound dividends and exempt domestic dividends, as it would tax outbound dividends higher than domestic dividends." Nevertheless, the Commission also alerted to the fact that in assessing the higher burden, a simple comparison of the withholding tax rates is not sufficient. In fact, the basis of comparison should be for the domestic dividends the combined effect of any domestic withholding tax rate plus the domestic income taxation and for the outbound dividend the withholding tax rate on the outbound dividend. Looking at the existing case-law of the ECJ, which has mainly focused on inbound dividends, also here some doubts start popping!

Seventh Question: what about individuals? Is it another ball game altogether?

Any other questions?

Letter from Saint Nicholas to the Tax Inspector

2006-12-05T09:57:00.000Z

Keeping up with the Dutch tradition of Sinter Klaas, which arrives in Mid-November by steamboat with his helper Zwarte Piet (Black Peter), I share a letter from Saint Nicholas to the Tax Inspector.

All credit goes of course to my colleague Dan Geddes also known as “The Satirist”. You can also read last year e-mail sent to Sinter Klaas by an egger US tax advisor.

To: Irving R. Sheen, Tax Inspector
From: Saint Nicholas of Myra, alias "Sinter Klaas", "Santa Claus"
Taxpayer ID: 000-00-0002
Date of Birth: 5 December, 343 A.D. (12-05-0343)
Occupation: Bishop Emeritus
Subject: Amended Tax Return

Dear Mr. Sheen:

I was greatly upset as I read your last FAX,
that I owed many thousands of dollars in tax,
plus penalties and interest over time that have waxed
into fines more suited to hard criminals' acts.

I have worked very hard to meet your request,
filing a second return was like taking a test.
The time spent was great. I wished to protest.
To gather my documents alone was a Quest.

My faithful assistants, a brigade of Black Petes,
searched high and low for the countless receipts,
stored long in my basement, many millions of sheets!
In order to prove I'm not someone who Cheats.

So I had to obtain rather costly advice
from a tax planning firm (they were all very nice).
They have studied my filing (and, yes, checked it twice),
and now expect from my REFUND a bountiful slice.

They found real problems in your unjust assessment,
forgetting my charity, the great sums that were spent.
And though "substantial" enough, and quite "permanent"
My steamship is really no corporate establishment.

'Twas not wise to cause us this unearned vexation.
For we too collect mountains of information,
books filled with the deeds of the men from all nations,
old scrolls dating back from the time of Creation.

Your own tax forms do not withstand close review,
your errors and omissions number more than a few,
we found that your filing contains claims quite untrue!
It is very disturbing, what we've learned about you.

Your own get-rich schemes are vast and assorted.
You're a far richer man than you've ever reported.
Your investment portfolio looks awfully contorted.
You've hid much of your wealth, or simply "off-shored it."

And your dog does not count as a fourth tax dependent.
Your wages could never buy a house so resplendent.
And where did your wife get that HUGE golden pendant?
You should really reflect on your life's path, and then mend it.

Your finances are more complex than a maze!
Our review of your deeds never ceased to amaze.
But there's one chance you have to change your foul ways.
File a new return in the next ninety days.

Sincerely,

Saint Nicholas of Myra
Bishop Emeritus

© 2006 Dan Geddes

OECD reports related to the Model Tax Convention

2006-11-30T23:45:00.000Z

The OECD Model Tax Convention on Income and on Capital is already on its sixth edition (2005), since it was first published in loose-leaf format in 1992. In order to do a through analysis of the OECD Model sometimes is necessary to rely on the background reports that were the basis of the changes to the Model. This summary is designed to provide you with an overview and respective hyperlinks to most of those reports (past and future).

Previous OECD reports related to the Model Tax Convention

1. "Transfer pricing, corresponding adjustments and the mutual agreement procedure", adopted on 24 November 1982

This report is related to Arts. 9 and 25 in the context of transfer pricing adjustments. It reviews experience gained in that field by tax administrations and multinationals and the procedures available to resolve tax disputes. The report also deals with the issues relating to mandatory corresponding adjustments subject to an arbitration procedure. Several recommendations of this report were integrated with the text of the Commentary on Arts. 9 and 25, as part of the 1992 update.

2. "The taxation of income derived from the leasing of industrial, commercial or scientific equipment", adopted on 13 September 1983

This report deals with problems arising from the inclusion of income from leasing of equipment in Art. 12 of the 1977 version of the Model. As part of the 1992 update, the reference to such equipment in Para. 2 of Art. 12 was deleted and corresponding changes were made in the Commentary on Arts. 5, 7 and 12.

3. "The taxation of income from the leasing of containers", adopted on 13 September 1983

This report is limited to problems of inclusion of income from leasing of containers (falling within the notion of industrial, commercial or scientific equipment) in Art. 12 of the 1977 version of the Model. As part of the 1992 update, the reference to industrial, commercial or scientific equipment in Para. 2 of Art. 12 was deleted and corresponding changes were made in the Commentary on Arts. 5, 7 and 12.

4. “Taxation Issues Relating to the International Hiring-out of Labour", adopted on 24 August 1984

This report addresses the problems of hiring out labour, i.e. when a local employer wishing to use short-term foreign labour and avoid taxation of employment income in his state recruits the labour force through an intermediary established abroad. As part of the 1992 update, the Commentary on Art. 15 was amended to clarify situations covered by the exception of Para. 2 of Art. 15.

5. "Thin capitalisation", adopted on 26 November 1986

This report considers the issues of financing and thin capitalization, discusses the international effects of the various national approaches and analyses to what degree unjustifiable double taxation may be relieved with the assistance of tax treaties. As part of the 1992 update, this report resulted in changes in the Commentary on Arts. 9, 10, 11, 23A and 23B, 24 and 25.

6. "Double taxation conventions and the use of base companies", adopted on 27 November 1986

This report deals with the issues of the use of so-called base companies, the counteracting domestic anti-abuse measures and their compatibility with tax treaties. The report concludes that these measures are regarded as generally consistent with the spirit of international tax treaties but that the Member countries should nevertheless relieve double taxation as long as there is no clear evidence of treaty abuse. As part of the 1992 update, changes were made in the Commentary on Arts. 1, 9, 10 and 24.

7. "Double taxation conventions and the use of conduit companies", adopted on 27 November 1986

This report considers the issues of improper use of tax treaties by use of conduit companies. The report deals with implications of the Model Tax Convention and specific treaty provisions for conduit companies. As part of the 1992 update, the recommendations of this report were incorporated in the Commentary on Arts. 1, 4,10, 11 and 12.

8. "The taxation of income derived from entertainment, artistic and sporting activities", adopted on 27 March 1987

This report describes the main problems which arise in taxing income from entertainment, artistic and sporting activities at the national and international levels and suggests ways in which these problems can be overcome. As part of the 1992 update, Art. 17 was amended to replace "athlete" with "sportsman" and the Commentary on Art. 17 was extended.

9. “Tax Treaty Override”, adopted on 2 October 1989

This report discusses treaty override by examining the rules of international and domestic law, considering the possible legal remedies to treaty overrides and discussing different practical examples. The report includes a recommendation for Member countries to avoid enacting “overriding” legislation and to address bilaterally or multilaterally problems connected with a tax treaty. No amendments to the Model Tax Convention or the Commentary were adopted.

10. "The 183 day rule: some problems of application and interpretation", adopted on 24 October 1991

This report clarifies the interpretation of Art. 15 in several respects, and in particular the calculation of the 183-day rule. As part of the 1992 update, the recommendations of the report were incorporated into the Commentary on Art. 15.

11. "The tax treatment of software", adopted on 23 July 1992

This report analyses the treatment of software rights and payments for software under domestic laws and tax treaty law, as well as the application of the OECD Model to these payments. As part of the 1992 update, the Commentary on Arts. 7, 12 and 14 was amended.

12. "Triangular cases", adopted on 23 July 1992

This report analyses the problems concerning triangular cases involving the OECD Model, analyses countries' practices in this field and discusses ways of dealing with the problem. As part of the 1992 update, the Commentary on Arts. 10, 11, 12, 23A and 23B, and 24 was amended.

13. "The tax treatment of employees’ contributions to foreign pension schemes", adopted on 23 July 1992

This report deals with the tax treatment of pension contributions made by persons who render dependent personal services to multinational enterprises, whilst they are seconded abroad, and suggests a provision to be included in bilateral tax treaties. As part of the 1992 update, changes were made to the Commentary to Art. 18.

14. "Attribution of income to permanent establishments", adopted on 26 November 1993

This report discusses the most common problems and uncertainties related to attribution of income to permanent establishments. As part of the 1994 update, the suggested modifications to the Commentary on Art. 7 were included.

15. "Tax sparing – a reconsideration", adopted on 23 October 1997

This report deals with the issues of effectiveness and necessity of tax sparing clauses as well as suggestions to minimize related abuse. As part of the 2000 update, the recommendations of the report were incorporated into the Commentary on Arts. 23A and 23B.

16. "The application of the OECD Model Tax Convention to partnerships", adopted on 20 January 1999

This report deals with the application of the provisions of the Model Tax Convention to partnerships, focusing on specific factual examples. As part of the 2000 update, an additional Para. 4 was included in the text of Art. 23A, and the Commentary on Arts. 1, 3, 4, 5, 15, 23A and 23B was amended.

17. "Issues related to Article 14 of the OECD Model Tax Convention", adopted on 27 January 2000

This report deals with a number of problems relating to the taxation of professional services and other activities of an independent character, and the application of Art. 14. As part of the 2000 update, Art. 14 was deleted and corresponding changes were made in Arts. 3, 6, 10, 11, 12, 15, 17, 21 and 22, as well as the Commentary.

18. "Improving Access to Bank Information for Tax Purposes", declassified on 24 March 2000

This report describes the current position of the OECD Member countries as to access to bank information and suggests measures to improve access for tax purposes. This report had an impact on the 2005 update, which included amendments to Art. 26 and its Commentary.

19. "Clarification on the Application of the Permanent Establishment Definition in E-Commerce: Changes to the Commentary on the Model Tax Convention on Article 5", adopted on 22 December 2000

This report deals with the application of the current definition of permanent establishment in the context of e-commerce. The suggested changes mainly reflect the consensus that human intervention is not a requirement for the existence of a permanent establishment and that a web site cannot, in itself, constitute a permanent establishment. As part of the 2002 update, changes were incorporated into the Commentary on Art. 5.

20. “Restricting the Entitlement to Treaty Benefits", adopted on 7 November 2002

This report deals with the issues of restricting the entitlement to treaty benefits for entities and income covered by measures constituting harmful tax practices. It also discusses the use of the concepts of place of effective management and permanent establishment, as well as various other types of provisions, to reduce treaty benefits, and clarifies the concept of beneficial ownership. As part of the 2002 update, the Commentary on Arts. 1, 10, 11, 12, 23A and 23B was amended.

21. “Treaty Characterisation Issues Arising from E-Commerce", adopted on 7 November 2002

This report discusses various treaty characterization issues that may arise in electronic commerce, such as delimitation of business profits, royalties and technical fees, mixed payments, and the distinction between the provision of services and transactions resulting in the acquisition of property. As part of the 2002 update, the Commentary on Art. 12 was amended. See also the Report to working party no. 1 of the CFA on Tax Treaty Characterisation Issues Arising From E-Commerce.

22. “Issues Arising under Article 5 (Permanent Establishment) of the Model Tax Convention", adopted on 7 November 2002

This report discusses problems in applying the “fixed place of business” standard, the treatment of building sites, construction or installation projects, identifying preparatory and auxiliary activities and issues related to agency permanent establishments. As part of the 2002 update, the Commentary on Arts. 5, 10, 11, and 12 was amended.

23. "Changes to Articles 25 and 26 of the Model Tax Convention", adopted on 1 June 2004

As part of the 2005 update, Art. 26 and its Commentary were amended to further extend the scope of exchange of information. The Commentary on Art. 25 was also clarified with respect to confidentiality of information obtained in the course of the mutual agreement procedure.

24. "Cross-border income tax issues arising from employee stock option plans", adopted on 16 June 2004

This report addresses a number of issues arising from the use of stock options as part of employee remuneration packages. The main critical issues relate to characterization of income, taxing rights of benefits paid after the employee no longer works in a state or changes his residence, and taxation of benefits related to employment exercised in several states. As part of the 2005 update, the Commentary on Arts. 13, 15, 16 and 23 was amended.

25. "Employee Stock Option Plans: Impact on Transfer Pricing", adopted on 16 June 2004

This report deals with the transfer pricing issues in cases where stock options are granted to employees of an associated enterprise and discusses the impact of stock option plans on other intra-group transactions and cost attribution arrangements. No amendments to the Model Tax Convention or the Commentary were adopted.

26. "Taxation of Income from International Transport", adopted on 15 July 2005

This report deals with the concept of profit from activities directly connected or ancillary to the operation of ships or aircraft in international traffic. As part of the 2005 update, the Commentary on Arts. 3 and 8 was amended.

27. "Proposed Clarification of the Permanent Establishment Definition", adopted on 15 July 2005

This report deals with the concept of agency permanent establishment and the application of the permanent establishment concept in situations of a group company creating a permanent establishment of other group companies. As part of the 2005 update, the Commentary on Art. 5 was amended.

28. "Tax treaty issues arising from cross-border pensions", adopted on 15 July 2005

This report deals with several issues, namely characterization of pension and other social security payments, allocation of taxing rights and other issues related to foreign individual retirement schemes, pension schemes and pension funds. As part of the 2005 update, changes were made in Art 19 and Commentary on Arts. 18 and 19 were amended.

OECD discussion drafts related to the Model Tax Convention

This section lists a number of discussion drafts related to the Model Tax Convention and the Commentary thereon.

1. “Attribution of Profit to a Permanent Establishment Involved in Electronic Commerce Transactions”, discussion draft of 1 February 2001

This discussion draft provides a detailed analysis of the transfer pricing issues arising in attributing profit to a permanent establishment involved in electronic commerce activities. The paper is limited to an analysis of enterprises engaged in the retail distribution of entertainment products (“e-tailing”).

2. "Place of Effective Management Concept: Suggestions for Changes to the OECD Model Tax Convention", discussion draft of 27 May 2003

This discussion draft develops two alternative proposals to improve the place of effective management concept under Para. 3 of Art. 4 of the OECD Model. The first proposal seeks to refine the concept of “place of effective management” by expanding the Commentary explanations of how the concept should be interpreted. The second proposal puts forward a tie-breaker rule for persons other than individuals to modify Para. 3 of Art. 4 together with the Commentary thereon.

3. "Proposed Clarification of the Scope of Paragraph 2 of Article 15 of the Model Tax Convention", discussion draft of 5 April 2004

This discussion draft proposes changes to the Commentary on Para. 2 of Art. 15 to clarify its application in situations where services are provided through intermediaries. The proposed changes address the interpretation of the word “employer” and the distinction between employment and self-employment. The draft provides practical examples to illustrate the application of the rules.

4. "Attribution of Profits to Permanent Establishments", discussion draft released in parts: on 3 August 2004 (Part I General), 4 March 2003 (Part II Banks, Part III Global Trading of Financial Instruments) and 27June 2005 (Part IV Insurance)

This discussion draft aims to formulate the preferable approach to attributing profits to a permanent establishment under Art. 7. The discussion draft also examines the special considerations that need to be taken into account when profits are to be attributed to a permanent establishment of an enterprise carrying on global trading of financial instruments, banking or insurance businesses.

5. "Proposals for Improving the Process for the Resolution of Tax Treaty Disputes", discussion draft of 1 February 2006

This discussion draft examines ways of improving the effectiveness of the mutual agreement procedure under Art. 25, including the consideration of other dispute resolution techniques, which might be used to supplement the operation of the mutual agreement procedure. The proposal includes various changes to the Model Tax Convention, including a new paragraph to Art. 25.

Other OECD publications and documents related to the Model Tax Convention

This section lists a number of OECD publications and other documents related to the Model Tax Convention and the Commentary thereon.

"Transfer pricing guidelines for multinational enterprises and tax administrations", published in 1995

The OECD Transfer Pricing Guidelines maintain the arm's length principle of treating related enterprises within a multinational group and affirm traditional transaction methods as the preferred way of implementing the principle. The OECD transfer pricing guidelines are revised periodically.

"The Taxation of Global Trading of Financial Instruments", published in 1998

This publication reviews the factual background to global trading, analyses the challenges posed to traditional taxation methods and discusses a range of policy options to tackle the problems of global trading of financial instruments.

"Harmful Tax Competition, An Emerging Global Issue", adopted on 8 April 1998

This report addresses harmful tax practices in the form of tax havens and harmful preferential tax regimes in OECD Member countries and non-Member countries and their dependencies. It focuses on geographically mobile activities, such as financial and other service activities. The report defines the factors to be used in identifying harmful tax practices and goes on to make 19 wide-ranging recommendations to counteract such practices.

“OECD Model Agreement on Exchange of Information in Tax Matters”, released on 18 April 2002

This Model, developed by the Global Forum Working Group on Effective Exchange of Information, is a result of the ongoing work for eliminating harmful tax competition. The 1998 report identified the lack of the effective exchange of information as one of the key criteria in determining harmful tax practices. The Model, both in its bilateral and multilateral versions, is intended to establish the standard of what constitutes effective exchange of information.

"Guidance in Applying the 1998 Report to Preferential Tax Regimes (Consolidated Application Note)", released on 22 March 2004

The Consolidated Application Note provides guidance to assist governments in the evaluation of existing or future preferential regimes on a generic basis. It consolidates the application notes developed by the Forum on Harmful Tax Practices and provides guidance in assessing preferential regimes that apply to income from geographically mobile activities, i.e. excluding preferential regimes designed to attract investment in plant, buildings and equipment.

"Are the Current Treaty Rules for Taxing Business Profits Appropriate for E-Commerce?", released on 19 December 2005

This report presents an evaluation of the rules on taxing business profits and examines the alternatives for changes in the context of e-commerce. The report concludes that it would not be appropriate, at this stage, to embark on changing the existing treaty rules. Nevertheless, on the basis of the report several issues will continue to be monitored.

“Manual on the implementation of exchange of information provisions for tax purposes”, approved on 23 January 2006

This manual provides an overview of the operation of exchange of information provisions and some technical and practical guidance. The manual is designed to assist tax authorities in dealing with exchange of information for tax purposes, with a view to improving the efficiency of such exchanges. The manual discusses information exchange on the basis of the revised text of Art. 26, which was agreed by the OECD in June 2004.

Attribution of Profits to a Permanent Establishment – A brief note on the new U.S. Model

2006-11-26T18:07:00.000Z

This note on the issue of attribution of profits to a PE is part of a forthcoming wider analysis to the 2006 U.S. Model.

U.S. tax policy choices may be said to reflect not only on its tax legislation but also on its tax treaties. After a decade where the US Treasury Department has revamped key treaties of its treaty network, it was expected that the newly released 2006 update to the U.S. Model Income Tax Convention and Model Technical Explanation, would take into account some of the tax treaty policies well-established on the recently concluded treaties.

Taking into account that the U.S. Model and Technical Explanation are used as a starting point in bilateral treaty negotiations, it is a good window to understand certain treaty policy choices, derived form interaction of foreign legislation with domestic rules, and its recent evolution since its last update in September 1996 (See 1996 United States Model Income Tax Convention).

One of the novelties of the 2006 US Model is the addition, in line with the ongoing OECD project on attribution of profits to a PE(*), of a new language on the business profits article. In anticipation of the OECD findings, paragraph 2 of Art. 7 includes a last sentence referring that business profits to be attributed(**) to the PE shall include only the profits derived from the assets used, risks assumed and activities performed by the PE. This terminology of assets, risks and activities resembles the functional analysis approach used in the OECD PE drafts.

Paragraph 2 reads as follows: “Subject to the provisions of paragraph 3, where an enterprise of a Contracting State carries on business in the other Contracting State through a permanent establishment situated therein, there shall in each Contracting State be attributed to that permanent establishment the profits that it might be expected to make if it were a distinct and independent enterprise engaged in the same or similar activities under the same or similar conditions. For this purpose, the profits to be attributed to the permanent establishment shall include only the profits derived from the assets used, risks assumed and activities performed by the permanent establishment.”

The technical explanation was adequately expanded to take account recent developments. For example, the new technical explanation now refers that the language of paragraph 2 (combined with paragraph 3) incorporates the arm's-length standard, which is interpreted by the US in a manner consistent with the OECD Transfer Pricing Guidelines. Nevertheless, such consistency, including the application of the transfer pricing profits methods, should take into account the different economic and legal circumstances of a single legal entity (as opposed to a separate enterprise).

In addition, paragraph 3 is also amended to conform to the current OECD Model Tax Convention. The more detailed references included in the 1996 Model were simply eliminated, namely that the expenses considered to be incurred for the purposes of the PE were expenses for research and development, interest and other similar expenses.

Paragraph 3 reads as follows: “In determining the profits of a permanent establishment, there shall be allowed as deductions expenses that are incurred for the purposes of the permanent establishment, including executive and general administrative expenses so incurred, whether in the State in which the permanent establishment is situated or elsewhere.”

The new language of Paragraph 3 is coupled with an interpretative note to be included in the protocol of the US treaties to be signed. In first place, the technical explanation refers that the rule provided by the interpretative note is that internal dealings may be used to allocate income (even though U.S. domestic regulations generally do not recognize them) in cases where the dealings accurately reflect the allocation of risk within the enterprise.

Secondly, the technical explanation mentions that the principles of the OECD Transfer Pricing Guidelines are considered to apply by analogy for purposes of determining the profits attributable to a PE. In that regard, the technical explanation refers that the amount of expense allowed as a deduction is determined by applying the arm's length principle, which means that a PE may deduct payments made to its head office or another branch in compensation for services performed for the benefit of the branch. The method to be used in calculating that amount will depend on the terms of the arrangements between the branches and head office and the technical explanation includes an example of legal services performed by the head office.

The interpretative note also mentions that a PE cannot be funded entirely with debt, but must have sufficient capital to carry on its activities. As such, in determining the amount of profits, the PE shall be treated as having the same amount of capital that it would need to support its activities if it were a distinct and separate enterprise engaged in the same or similar activities. This means that an interest deduction may be denied to the extent necessary to reflect such capital attribution.

Taking into account the restrictions for capital attribution found under U.S. domestic law, the interpretative note allows a taxpayer to apply a more flexible approach. For financial institutions (excluding the insurance sector) such amount of capital may be determined by allocating the institution’s total equity between its various offices on the basis of the proportion of the financial institution’s risk-weighted assets attributable to each of them. As regards insurance companies, it is mentioned that premiums earned through the PE and the portion of the insurance company's overall investment income from reserves and surplus that supports the risks, are attributable to a PE.

Comment: It is a fact that the U.S. plays a major role in setting the pace on international tax developments and that its treaty policies, reflected on US Model and treaties, are important to understand the so-called consensus mode of a wider forum, such as the OECD. The U.S. Model, on the issue of the attribution of profits, demonstrates that the U.S. is pushing ahead with the problematic OECD project by trying perhaps to find a middle ground (between the status quo and complete revamping of Art. 7) where business and tax administrations may agree to go forward. This is an example where the U.S. model is in fact ahead of the OECD Model, but other examples could also be mentioned, such as pension fund entitlement and hybrid entities. The slight amendments to Art. 7 may prove the support of the U.S. to the OECD PE project but the cautious wording found on the technical explanation also demonstrates that work needs still to be done in areas such as capital allocation.

(*) OECD Discussion Drafts on the Attribution of Profits to Permanent Establishments: Part I: General Considerations (2001 and 2004); Part II: Banks (2001 and 2003); Part III (Enterprises Carrying on Global Trading of Financial Instruments) (2003); and Part IV (Insurance) (2005).

(**) It should be mentioned that the term "attributable to" provides an alternative to the analogous "effectively connected" term used under US section 864(c). This is an important point since the PE income determined by applying U.S. effectively connected income rules and the amount determined under Article 7 may well be different. In light of extensive litigation in US Courts, the technical explanation sets out rules for the interaction of those two results.

Prize for tax authorities: Dancing eunuchs track tax evaders

2006-11-16T14:47:00.000Z

Using dancing and singing eunuchs as a method to entice taxpayers to pay their back-taxes is curious but it is apparently paying back the investment.

See the CNN report.

US Treasury Issues New Model Income Tax Convention and Technical Explanation

2006-11-16T11:58:00.000Z

The US Treasury Department issued new versions of the Model Income Tax Convention and Model Technical Explanation, which update the 1996 Model.

The new US Model, which serves as the basis for tax treaties concluded by the US, takes into account some of the new treaty policy developments already included in recent treaties concluded by the US.

International Tax Research: Tools & techniques

2006-11-13T11:07:00.000Z

International Tax Centre - Leiden
Adv. LL.M. Program in International Taxation
Leiden, 13 November 2006

Presentation on International Tax Research: Tools & techniques

Abstract: Some people like puzzles and some don't. But to be a good (international) tax researcher you have to like (this sort of) puzzles!
When you face any legal research question or issue you have to know where to look for the answer. As we will see, electronic research can take you to sources you did not even know existed, or did not know contained possible answers. Nevertheless, you still need to know what databases to search, which are more adequate to your query. This presentation is designed to give you basic tools and then it is up to you to put it into practice!

Historical notes on the international efforts aimed at eliminating double taxation (draft)

2006-11-09T18:09:00.000Z

Note: I always had difficulty in finding my way through the maze of developments on international tax. The problem increased if I would need to go a bit backwards in time and do an historical analysis. In the information age, these historical analyses are made easier because of Internet. The text below (which started as a joke) is just a road map to finding your way in the field of tax treaties and as any unfinished work needs still some polishing! Nevertheless, I post this note because I want to use it Monday during the Lecture on research tools at the Leiden International Tax Centre. Most of the links are to free websites, while only a few direct you to the IBFD (paid) Database.

The efforts aimed at eliminating international double taxation begun with a series of model or draft model bilateral tax conventions by the League of Nations and were pursued in the Organisation for Economic Co-operation and Development (OECD) in regional forums, as well as in the United Nations

In 1921, the League of Nations, acting in response to an appeal for action aimed at eliminating double taxation, entrusted a team of four economists, Sir Josiah Stamp(UK), Professor Einaudi (Italy), Professor Bruins (Netherlands), Professor Seligman (US), with the task of preparing a study on the economic aspects of international double taxation.

The four experts expanded on the doctrine of economic allegiance, which states that the determination of the quantum of tax that an individual is required to pay to each competing jurisdiction is closely linked to ascertaining where the true economic interests of that individual are to be found. In that regard, the experts found that four factors ultimately bear some incidence on the sharing of the tax base, namely (i) the principle of production or acquisition corresponding to the place of origin of the wealth; (ii) the principle of location, that is, the situs of the wealth; (iii) the principle of legal rights assimilated to the place of enforcement of the rights to the wealth; and (iv) the principle of consumption or appropriation or disposition of wealth which is the place of residence or domicile of the ultimate owner.

The 1923 Report recommended a scheme that rested on a distinction between taxes on global income (personal taxes) and all other taxes (impersonal taxes). The former were to be levied based solely on residence, while the latter were to be divided between residence and source based on the principle of economic allegiance. The four economists determined that the most important factors for determining the international tax competence are the origin of wealth and the residence or domicile of the owner who consumes the wealth. Therefore, an equitable sharing of tax jurisdiction requires the apportioning of economic allegiance between origin (source) and domicile (residence). This principle as demonstrated in the table below turned out to be quite favourable to residence.

Category Of Wealth (Preponderant Element - Origin Vs Domicile)
I. Land (Origin)
II a. Mines, oil wells, etc. (Origin)
II b. Commercial establishments (Origin)
III a. Agricultural (Origin)
III b. Money, jewelry, furniture, etc. (Domicile)
IV. Vessels (Origin (registration))
V a. Mortgages (Origin (property taxes) - Domicile (income Tax))
V b. Corporate shares (Domicile)
V c. Corporate bonds (Domicile)
V d. Public securities (Domicile)
V e. General credits (Domicile)
VI. Professional earnings (Domicile)

In 1922, the Financial Committee of the League invited a group of high-level tax officials from several countries to study the administrative and practical aspects of international double taxation and international tax evasion. In the course of sessions held from 1923 to 1927, the group following the previous work of the four economists drafted the first bilateral Tax Conventions, the so-called 1927 Draft which included:
- Convention for the Prevention of Double Taxation in the Special Matter of Direct Taxes dealing with income and property taxes;
- Convention for the Prevention of Double Taxation in the Special Matter of Succession Duties;
- Convention on Administrative Assistance in Matters of Taxation; and
- Convention on [Judicial] Assistance in the Collection of Taxes.

The 1927 Draft Convention for the Prevention of Double Taxation contained only 14 articles, 8 of them concerning income allocation of the so-called impersonal taxes. For example:
- Income from immovable property was taxable in the State in which the property in question was situated (Art. 2);
- Income derived from investments in transferable securities other than shares was taxable in the State in which the debtors of such income were at the time resident (Art. 3);
- Income from shares or similar interests was taxable in the State in which the real centre of management of the undertaking was situated (Art.4);
- Income from any industrial, commercial or agricultural undertaking and from any other trades or professions was taxable in the State in which the persons controlling the undertaking or engaged in the trade or profession posses permanent establishments. In case, the undertaking would posses permanent establishments in both States, each of the two States would tax the portion of the income produced in its territory (Art. 5);
- The fees of managers and directors of joint-stock companies were taxable in the State in which the real centre of management of the undertaking is situated (Art. 6);
-Salaries, wages or other remuneration of any kind were taxable in the State in which the recipients carry on their employment, with the exception of officials and public employees serving abroad, which were taxable in the State which pays those salaries (Art. 7);
- Public or private pensions were taxable in the State of the debtor of such income (Art. 8); and
- Annuities or income from other claims not referred to in the previous paragraphs were taxable in the State of fiscal domicile of the creditor of such income (Art. 9).

In 1928, the League of Nations released three different models (Ia, Ib, Ic) designed to prevent double taxation in the sphere of direct impersonal or personal taxes. The first draft still drew a distinction between impersonal and personal taxes, whilst this distinction was not present in the second and third draft.

In 1929, the League of Nations appointed a permanent Fiscal Committee. The Fiscal Affairs Committee approved in 1933 a draft convention on the allocation of business profits between states for the purposes of taxation. The 1933 draft convention is substantially based on the Mitchell B. Carroll report: Taxation of National and Foreign Enterprises: Volume 4 Methods of Allocating Taxable Income. Mr. Carroll, who was a former President of the Fiscal Committee of the League of Nations and the International Fiscal Association, with the help of a grant from the Rockefeller Foundation visited 27 countries and reported on their relevant legislation. The 1933 Draft Convention was slighly revised by the Fiscal Committee in June 1935.

With the Second World War, the world started diverging and the Mexico model convention of 1943 and the London model convention of 1946 are a good example of differences in view between countries. In 1946, the Fiscal Committee of the League of Nations, noting that a difference of opinion between capital-importing and capital-exporting countries persists, published both models together with commentaries. The Committee noted that "the work done both in Mexico and in London could be usefully reviewed and developed by a balanced group of tax administrators and experts from both capital-importing and capital-exporting countries and from economically-advanced and less-advanced countries, when the League work on international tax problems is taken over by the United Nations". Notwithstanding this pledge the United Nations did not occupy itself in the first decades of its existence with the development of the Model Tax Conventions.

Taking into account the progress had already been made under the League of Nations, the Organisation for European Economic Co-operation (later OECD) adopted its first Recommendation concerning double taxation on 25 February 1955. That recommendation was followed by the establishment of the Fiscal Committee, which was instructed to prepare a draft convention for the avoidance of double taxation with respect to taxes on income and capital

From 1958 to 1961, the Fiscal Committee prepared four reports under the title “The elimination of double taxation” The suggested new articles embodied the 1963
“Draft Double Taxation Convention on Income and on Capital” followed by the 1966 “Draft Convention for the Avoidance of Double Taxation with Respect to Taxes on Estates and Inheritances".

The revision of the 1963 draft model by the renamed Committee on Fiscal Affairs led to the 1977 “Model Double Taxation Convention on Income and on Capital”. Further revisions led to the publication in 1992 of the Model Convention in a loose-leaf format. This was the first step of an ongoing revision process intended to produce periodic updates the latest of which were in 2000, 2003 and 2005. The process of updating can be tracked down through the list of OECD reports that were adopted after the publication of the 1977 Model Tax Convention and that have resulted in changes to the text of articles of the Convention or the Commentary thereon.

As regards the United Nations, it was only in 1980 that the first UN Model Double Taxation Convention between Developed and Developing countries was published. The Ad Hoc Group of Experts on International Cooperation in Tax Matters adopted in 2000 a revised version of the UN Model, which was published by the United Nations as the 2001 UN Model. The UN Model is currently under revision.

But work on double taxation has also been taken at the regional and country levels. A good example is the so-called Andean Community Model. Decision 40 sets out an agreement to avoid double taxation between Member Countries. More recently the Andean Community has enacted a new decision that sets out to avoid double taxation and prevent tax evasion in the Andean countries. In accordance with the Cartagena Agreement the current members of the Andean Community include Bolivia, Colombia, Ecuador and Peru. On April 2006 Venezuela announced its decision to depart from the Andean Community.

Another good example is the multilateral double taxation treaty in place since 1983 between the Nordic countries (Finland, Sweden and Denmark) and other members of the Nordic Council (Iceland Norway), which replaced the previous bilateral treaties between the five countries.

Other models include the 1996 United States Model Income Tax Convention and the 1987 Intra-ASEAN Model Double Taxation Convention.

UN Model on the move?

2006-11-08T11:58:00.000Z

The UN Committee of Experts on International Cooperation in Tax Matters, meeting in Geneva October 30 through November 3, discussed the possible revision of the 2001 United Nations Model Double Taxation Convention Between Developed and Developing Countries. The 2001 UN Model, which followed the previous 1980 UN Model, is still far from the development of its counterpart (the OECD Model) has had in the last decade.

The Provisional agenda and organization of work agenda included treaty abuses, mutual assistance in tax collection, definitions of permanent establishment and interest, taxation of development projects, information exchange, dispute resolution, and revisions of both the UN model income tax treaty and the Manual for the Negotiation of Bilateral Tax Treaties between Developed and Developing Countries. Read the final report.

Here is a list of the documents posted on the UN website:

1. Treaty Abuse and Treaty Shopping
2. Supplementary Note to Treaty Abuse and Treaty Shopping
3. Assistance in the collection of taxes (Article 27) and its commentary
4. Proposal for amendments to article 5 of the United Nations Model Double Taxation
5. Tax treatment of donor-financed projects
6. Revision of the wording of Article 26 of the UN Model Convention
7. Work on exchange of information and conclusion
8. Revision of the commentaries to Article 26 of the UN Model
9. Developing a Code of Conduct on Promoting Tax Compliance
10. Manual for the negotiation of tax treaties between developed and developing countries
Cover; Part1; Part 2; Part 3; Annex
11. Dispute Resolution/Arbitration in tax treaty disputes
12. Treatment of Islamic financial instruments under the UN Model Double

Click here for the documents made available for the first session held in Geneva from 5-9 December 2005.

Note: Click here for a good article by Bart Kosters (The United Nations Model Tax Convention and Its Recent Developments) on the evolution of the UN Model, namely the differences between the 2001 UN Model and the OECD Model and the UNModel of 2001 compared to the 1980 version.

Pic: the photo is taken from the strange phenomenon of the Death Valley Moving Rocks

Guardian Industries - Foreign tax credits and Group Consolidation

2006-10-29T12:52:00.000Z

I have long been trying to arrange some time to go through a recent US case (Guardian Industries) concerning the interaction of the check-the-box rules and the complex US foreign tax credit rules. But recently announced changes to the foreign tax credit rules, which can be seen as a reaction to the outcome of this case, convinced me that it would be worth wile attempting to understand the underlying issues surrounding the Guardian Industries Case (March 2005).

The issue in this case was whether Guardian was entitled to a foreign tax credit for corporate tax paid or accrued by its Luxembourg top-tier subsidiary (GIE) with respect to the taxable income of the Guardian Luxembourg Group. As they say on the London tube “mind your step” because the facts of the case involve some degree of complexity.

Basically, the facts can be summarized as follows:
- Guardian Industries, a US leading manufacturer of glass products for commercial and residential applications, conducted its manufacturing and distribution operations in a range of jurisdictions including Luxembourg;
- In Luxembourg, the Guardian group had various subsidiaries ultimately held by a US corporation. These subsidiaries were taxed under the local fiscal unity rules (i.e. consolidation), forming the so-called Guardian Luxembourg Group for Luxembourg tax purposes;
- The top tier Luxembourg company was GIE which in turn held controlling interests in the remainder Luxembourg companies;
- GIE elected under the check the box rules to be disregarded as an entity separate from its shareholder in 2001, whilst the remaining Luxembourg group companies continued to be treated as separate legal entities;
- Due to it’s check the box election and in accordance with Reg § 1.301.7701-2(a), GIE would be treated for U.S. tax purposes in the same manner as that of a branch of its US shareholder; and
- Even though it elected to be treated as a branch in the US, GIE still was in Luxembourg the top tier company of the group. In fact, GIE was responsible in 2001 for corporate income tax payments amounting approximately to Euro 3,5 million.

Apparently, in accordance with Luxembourg law, GIE was liable for, and paid or accrued the corporate income taxes for all group members (i.e. lower tier subsidiaries). On the other side of the Atlantic, the obvious happened: Guardian attempted to claim credit for all Luxembourg tax paid by GIE (its branch), but included in its US income only the income of GIE (i.e. excluding thereby income of the other Luxembourg subsidiaries).

The IRS quickly denied the claims for a direct foreign tax credit, on the basis that (1) Luxembourg law does not render GIE solely liable for the corporate tax paid or accrued with respect to the Guardian Luxembourg Group; (2) that each member of the Group becomes jointly and severally liable for the Group’s aggregate tax liability; (3) and that the US Treasury Reg. § 1.901-2(f)(3) allocate the foreign tax among them regardless of who actually remits the tax.

Guardian Group, on the other hand, held that under Luxembourg law GIE alone was legally liable for the 2001 corporate income tax, and not the other Group members. As such, Guardian US is thereby entitled to a direct foreign tax credit on the amounts paid by GIE.

Since the focus in this case was on how Luxembourg group taxation was structured, it was necessary to seek expert testimonies in order to adequately resolve this conflict. The expert testimonies from Luxembourg concluded that only the parent company is liable for the group income tax. As such, the United States Court of Federal Claims reached the decision that, since GIE was solely liable for the 2001 corporate tax payments and that there exists no joint or several liability on behalf of the members of the Group, GIE was entitled to a direct tax credit.

The Federal Claims decision was reached despite the fact that Guardian claimed a credit for the foreign taxes paid by the foreign parent without having to include the corresponding income of its subsidiaries. The tax planning scheme (probably used in European jurisdiction that provide consolidation or fiscal unity regimes) was simply vindicated on the basis of the literal interpretation of the existing rules.

The US tax authorities did not wait to long to react to this defeat and responded in the form of proposed regulations (REG-124152-06), to be applicable as of 1 January 2007. The proposed regulations establish new principles for determining who is considered a “taxpayer” for purposes of the direct and indirect foreign tax credits. The tax planning scheme explored in the Guardian case is tackled by (for example) providing that the foreign law is “considered to impose” legal liability for an income tax on the person who is required to take the underlying income into account for foreign income tax purposes.

The new rules are designed to ensure something that strangely was not previously in the law, i.e. a US foreign tax credit is only available when the income that gave rise to the tax also is subject to U.S. income tax.

The proposed regulations also set out specific rules to apply in the context of reverse hybrid entities (i.e., an entity that is a corporation for U.S. income tax purposes but is treated as a branch or pass-through entity under foreign law) and hybrid entities (i.e., an entity that is a partnership for U.S. income tax purposes but is treated as an entity under foreign law). Another ball game altogether.

Note: I first got acquainted with the issue of US foreign tax credit planning during Prof. Lokken lessons in US international Taxation in Leiden (2003). Even though coming from a tax credit country myself, the US FTC rules always astonished me not only because of their inherent complexity but also due to the degree of sophistication of the techniques for minimizing U.S. tax put in play by taxpayers. The Guardian case is perhaps a rather straightforward example of foreign tax credit planning that may be said to undermine the basic premise of the US international tax system: (i.e. taxation of worldwide income with credit for foreign income taxes) but I am sure that there is much more out there. For example to understand the underlying issues concerning the use of reverse hybrids and hybrids for FTC planning, I would perhaps suggest again the reading of Prof. Lokken, “Territorial Taxation: Why Some U.S. Multinationals May Be Less Than Enthusiastic About the Idea (and Some Ideas They Really Dislike)”.

OECD reaches out to the world: a world tax organization in the making?

2006-10-27T21:22:00.000Z

Is there a “true” intergovernmental forum on a global level to deal with questions of taxation? The answer that lawyers prefer is “it depends”! It is true that the Organisation for Economic Co-operation and Development (OECD), following the footsteps of the League of Nations, carried out pioneer work in the field of international taxation but the question remains if it is worldwide representative. Projects under the auspices of the United Nations are still pending.

The OECD is an international organisation well known to all international practitioners. This Paris-based international organization serves as think-tank for reform efforts in a number of policy areas, including international taxation.

The OECD is composed currently of thirty full members although there are plans for enlargement. According to recent plans, it may be expected that 6 to 10 countries could join by 2012, potentially raising membership to 40 countries. Chile, Israel and the six newest EU countries (Estonia, Latvia, Lithuania, Cyprus, Malta and Slovenia) are amongst the countries that are well placed to become new OECD members. This enlargement would reduce the falling threshold of global output from its members in the recent decade as regards the new rising economies. Issues concerning membership and increased cooperation with non-members will probably be discussed during the OECD 2007 ministerial meeting. The question then is if it expected also a rise in the profile of OECD, specially in terms of its influence in the tax field?

Within the OECD, the Committee on Fiscal Affairs is the main OECD body that drives international tax reform efforts, including revisions to the OECD model tax treaty and Commentary and the transfer pricing guidelines. The CFA brings together senior officials from all thirty-member governments who play an active role in formulating and implementing tax policies and provides a forum for exchanging views on tax policy and administrative issues. Although the OECD Secretariat and government officials generally are the main active parties, there is frequent consultation with outside institutions, including business representatives. The Centre for Tax Policy and Administration (CTPA) plays a supporting role to the CFA, namely in setting tax standards and guidelines, mutual assistance, supporting national tax reforms, resolving tax disputes, tax administration and engaging non-OECD economies.

It is interesting to note that there is an increasing cooperation of the OECD with non-OECD economies. Their input consists of participating as observers in the CFA meetings (Argentina, Chile, China, Russia and South Africa) and a dialogue with over 70 non-OECD economies for example through the OECD Multilateral Tax Centres. Apparently, the CFA mission statement requires it to encourage the integration of non-OECD countries into the world economy by adopting its standards, guidelines etc. This assistance includes also advising those countries to secure their tax bases, perhaps by using the techniques developed through the years by OECD member countries. The programme for non-OECD countries falls into 2 main categories. The first category includes core CFA topics such as tax treaties, transfer pricing and exchange of information. The second category includes three demand driven programmes with a strong development focus, such as the new partnership for African development (NEPAD), Middle East and North Africa (MENA) and South Eastern Europe (SEE).

But who better to acknowledge the OECD work in the tax field than its Secretary-General. According to Angel Gurría (OECD Secretary-General), “tax is one of the big success stories of the OECD. Our engagement with our members and key non-OECD economies has enabled us to maintain our lead role in setting the rules of the game for international taxation. Our analytical work provides governments with unparalleled information on the design and implementation of our tax systems”.

In fact in the second half of the 1990s, the OECD launched more and more ambitious and multilateral plans such as the one aimed at cracking down harmful tax practices in member states and in non-OECD jurisdictions. A good example has been the recent Global Forum on Taxation efforts on improving transparency and to establish effective exchange of information. Behind the scenes, the influence of the OECD is growing and that is demonstrated by the presence of OECD Multilateral Tax Centres in Ankara, Budapest, Seoul, Mexico City and Vienna.

So is this a world tax organization in the making?

At this stage, I would say no. One thing appears to be the OECD extending beyond its borders by for example attacking low-tax jurisdictions, attempting to set widely accepted standards and guidelines and improve mutual assistance. Another is calling the OECD a world tax organization in the making. The step (although probably in the mind of some) is still far-fetched.

I should mention that although highly applauded, an organization such as the OECD does not live without some contestation to its legitimacy. For example, the Center for Freedom and Prosperity, a Washington-based lobbying organisation, has been very critical of the role of the OECD in tax matters. Their recent attempt includes supporting the inclusion in the US spending bill of language, which would restrict OECD funding for international tax harmonization schemes!

I would say even if the OECD would probably have to pass through some difficult waters in the future, now it is time to cash in the credit for the good work done so far in the field of international tax. Although specific topics may be criticized individually by being sometimes over protectionist, the overall has been more than positive.

Let’s see the next chapters!

Credit vs Exemption: a discussion crossing the Atlantic

2006-10-20T17:59:00.000Z

Jurisdictions generally adopt two ways of reducing or eliminating the double taxation of income, namely the exemption method, whereby the income is exempted from tax altogether (although income may be taken into account for the purposes of calculation of the tax payable) or the credit method, whereby the foreign income is taxed but the foreign tax is credited against the final tax payable (1). There are jurisdictions, such as the Netherlands, that have been historically strong advocates of an exemption system in direct investment. There are other countries, such as the US, that have backed the idea of worldwide taxation (including their CFC rules) coupled with a credit system. There are several other jurisdictions that just follow the direction of the wind!

A lot of discussion in the tax community is presently coming out of a possible U.S. move from the present credit system to a territorial/exemption system, whereby income from active business operations in foreign countries, whether carried on directly or through a subsidiary would be exempt from US tax. This discussion are linked to the Advisory Panel on Federal Tax Reform recommendations released on 1 November 2005.

A recent paper by Lawrence Lokken "Territorial Taxation: Why Some U.S. Multinationals May Be Less Than Enthusiastic About the Idea (and Some Ideas They Really Dislike)" is a very interesting reading because it provokes a discussion on the current state-of-play of comparing the complex and intricate US credit system with an exemption system. This paper by Prof. Lokken (from whom I learned in Leiden the few things I know about US International Taxation) proposes very practical and plausible adjustments to the current credit system that could perhaps remove some of the existing problems and therefore pose an alternative to maintain a credit system.

But let's assume that the wind changes and the US would go ahead and move towards an exemption system. This move would likely affect or even accelerate a similar shift by other credit countries in Europe, such as the United Kingdom. One thing is granted and that is that the debate on credit/exemption has re-started. Other considerations in Europe are also placing the credit system under close scrutiny. For example, a recent opinion by the ECJ Advocate General suggested that the failure by the UK to extend tax exemption to dividends received by a UK company from a company in another EU Member State would be possibly contrary to EU law. This seems to suggest that only an exemption system of double tax relief may ultimately prove compatible with the EC Treaty. But that is another (long) story with strong crosswinds!

(1) For the ones intersted, I recall reading a UK consultation paper back in 1999 that served as a starting point for a discussion on the policy issues underpinning the systems of double taxation relief. A good reading with somewhat narrow conclusions.

Beneficial owner what?

2006-10-13T14:34:00.000Z

The concept of beneficial owner has never been clear. Long debates about the use of SPVs, some landmark cases, and a sort of tolerance, particularly in the financial sector. Something similar to the Dutch approach to coffee shops, where youngsters (and non-youngsters) get stoned before biking back home in the bike lanes and upsetting the local Dutch crowd. SPVs in the financial industry can be compared to coffee shops in the Netherlands, they are tolerated.

No one really even thought about this, it was simply something taken for granted (with more or less dubious moral/economic justification, which is: it makes cost of funding lower and therefore positive for the economy).

Then came the day that a multinational (which needed some cash) and the investment bank (which structured the deal) started quarrelling about their contract. They started arguing so vehemently that they ended up in Court!

The issue to be decided by the UK judge, competent on the basis of the agreement the two parties had signed few years before over a bottle of champagne, was the following:

(i) our contracts say that Indofood can pull out of the agreement if the 10% withholding tax levied on the interest paid to the special purpose vehicles (SPV) set up in Mauritius to get money from the market is no longer available and ‘no reasonable measure can be taken’ to reinstate the same conditions;
(ii) Indonesia, which is sick and tired of seeing Mauritius as one of its biggest inbound investors (not they do not like particularly Mauritius, but rather they only see Mauritius companies), decides to terminate the treaty;
(iii) As consequence, Indofood would have to pay 20% withholding tax;
(iv) It is not a reasonable measure to interpose another SPV in the Netherlands (by the way, a 0% withholding tax under the Dutch-Indonesia tax treaty could have been available);
(v) Why? Because the Dutch SPV is not the beneficial owner, no reasonable measure would be then available and therefore no contract (and I would stop paying this damned high interest rates, since the interest rates had gone down meanwhile).

The UK Court of Appeals looked at the treaty, at the OECD Commentary, at Prof. Philip Baker book on Double Tax Convention and said: forget about it. The Dutch SPV is not the beneficial owner. Why? Because it has no power over the interest it gets from Indofood, it simply has to pay everything to the bond holders.

This created a small tsunami in the London financial world. Advisors, lawyers, accountants, bankers, and the other guys that move the world (by the way, is it the right direction?) started wondering What? And so what about this structure, and what about this deal? And think about that? Investment funds, hedge funds, mezzanine funds, etc... It's gonna be a mess.

Back in HMRC headquarters they were simply flabbergasted. They had a weapon of mass destruction in their hands without having the trouble of litigating the issue themselves. Simply for free and even served on a silver plate.

What would you do?

Lawyers start going around saying that instability and uncertainly is the last thing the market needs, big deals are going on right now and we can’t mess everything up because of a provision that has been there for ages.

Calm down because the HRMC is gonna issue guidance to clarify everything. Let's see some pieces of that guidance:

“the decision is also likely to be of persuasive force where related issues for UK DTCs are being considered and that, where it is relevant, HMRC is obliged to follow it. Since the Court of Appeal decision is fully consistent with the UK’s existing policy HMRC does not think that, in general, the case will have a significant impact on its current practice”.

In other words, do not worry. But remember, every time they tell you do not worry, start worrying (carrot and stick approach). And here it comes:

“It is HMRC policy that, where there is treaty abuse (such as, say, “treaty shopping”), interpreting “beneficial ownership” in what the Court of Appeal called its “narrow technical” UK domestic law meaning would not give effect to the purpose and object of the DTC. It would be contrary to the object of the DTC to allow such treaty abuse. On the other hand, interpreting “beneficial ownership” in what the Court of Appeal called its “international fiscal meaning” clearly gives effect to the purpose and object of the DTC by excluding abusive cases such as “treaty shopping” from the benefits of a DTC”.

By the way, what is the UK narrow technical sense? Is it any different from the international law meaning, i.e, the meaning the context requires (by the way, is tax avoidance against the object and purpose of the treaty?). Forget about this theoretical issue for now and let's look at real life situations.

But then the carrots come:

"HMRC will also accept that there is no need to invoke the “international fiscal meaning” of beneficial ownership to deny treaty benefits where the lender receiving income directly from the SPV (the “true” beneficial owner of the interest) would, if they had been the direct recipient of the interest, have been entitled to treaty benefits as a resident of a state with which the UK has a DTC with zero withholding on interest.
HMRC will therefore accept that there is no need to invoke the “international fiscal meaning” of beneficial ownership to deny treaty benefits where the bond issued by the non-resident SPV is a Eurobond as defined in s349(4) ICTA 1988."

So far, so good. Nothing new. But the stick is ready to be used. Look at this example:

"A claim is made under the UK/Luxembourg DTA for relief from UK withholding tax in respect of a loan from a Luxembourg resident company (LuxCo) to a UK group borrower.
• LuxCo was set up (or has been maintained in the group) specifically to deal with this intra group loan and is taxed on a small “turn” for administering loans;
• the source of the loan is an affiliate in a territory with which the UK has no DTA (NoA Co)
• the NoA Co/LuxCo loan agreement shows that this interest bearing loan was predetermined to be onlent to the UK
• similarly, the interest payable by the UK on its loan from LuxCo is predetermined to be passed on to NoA Co.
The conduit company is not beneficial owner of the relevant income within the “international fiscal meaning”, because it has clear obligations to forward the interest to NoA Co. The terms and conditions of the loan agreements show that the flow of income out of the UK is predestined to be passed on to NoA Co. It is clear that one of the main purposes of the Luxembourg company is to avoid the withholding tax which would be due on payments of interest to NoA Co. The interest will not benefit from the Luxembourg/UK treaty and tax will be withheld".

In the end, if you do this from the US, no problem. There would be no withholding tax under the treaty anyway, so why bother. What about all the other cases?

It is circulating these days a memo from the London firms claiming this is not fair play, both on legal and moral grounds. They attack a draft they received in confidence from HRMC and discussed during a meeting they had. Critics are based on arguments such as foreign funds do not pay VAT on management services rendered from the UK, that's’ why they are abroad, what about the UK borrowers that for years have been paying free of withholding tax. Why did you need to insert an LOB provision in the treaty with the US then? We had even showed you the structures and you said it was ok, now you say you did not realize there was a back-to-back!

Beneficial owner what?

Ralph Red

UK Draft Guidance on Beneficial ownership

2006-10-11T16:42:00.000Z

When I commented, back in March, on the Indofood case, I was sure that a lot of water would still pass below the bridge construed by the controversial decision of the UK Court of Appeals. Some of this "water" has now came out into public, just two days ago, with the release of Draft Guidance on the UK Tax Authorities interpretation of the Indofood decision. This guidance was expected, based on the fact that the case has now became English Law, and is designed to cover the majority of situations where the controversial decision could give rise to uncertainty (e.g. every-day capital market transactions involving Special Purpose Vehicles). For me, I will read carefully the draft guidance (hopefully with critical eyes) and see what changes in the obscure world of (lack of) of beneficial ownership for tax purposes!

Index on European tax law research (revised version)

2006-10-10T12:54:00.000Z

European tax law has immense research opportunities. As Professor Pistone said recently “European tax law is picking up” and therefore keeping up to date with this new promising tax area is a challenge even for the so-called EU specialist. This overview is designed to be a short index on EC Tax Law information available through various websites of the European Union's institutions and specialized agencies in Europe and provide you a useful tool to navigate in the cyberspace in a time effective manner.

Brief Historical background (with links)

Although there is no explicit provision in the EC Treaty for the harmonisation of direct taxes, EU actions on the filed of tax have been generally based on Art. 94, which authorises "directives for the approximation of such laws, regulations or administrative provisions of Member States as directly affect the establishment or functioning of the common market".

The concrete proposals for harmonisation of corporation tax started off with the Neumark Report of 1962 and the van den Tempel Report of 1970. In 1975, an unsuccessful draft Directive proposed an alignment of rates between 45% and 55% and by 1980 a Report on the Scope for Convergence of Tax Systems by Commission was already arguing that a different approach.

The 1990 Commission report Guidelines for Company Taxation explained how the Commission decided to focus on rather targeted measures essential for completing the Single Market. As such three proposals received the approval, namely the merger directive, the parent-subsidiary directive and the arbitration procedure Convention. In a special issue of the Official Journal, the commission published the report “Removal of Tax Obstacles to the Cross-frontier Activities of Companies” (Scrivener Report), were the Commission explained the measures and presented two additional proposals regarding: losses of permanent establishments and subsidiaries situated in other Member States and a common system for interest and royalty payments.

In 1992, the Ruding Committee reported on the Community aspects of company taxation and concluded that, although there has been some degree of fiscal convergence, wide differences, remain, which could affect or distort the single market. The Committee proposed a minimum degree of harmonization and gave 21 recommendations covering three categories: elimination of double taxation of cross-border income flows, harmonization of corporation taxes, and greater transparency between Member States on other issues. The Commission reacted by not agreeing with most off the proposals (namely the corporate tax harmonization) and focus again its attention on enlarging the scope of the merger and parent/subsidiaries Directives and bringing into light the interest & royalty Directive.

A 1996 paper on "Taxation in the European Union" outlined the main challenges for taxation policy in the Union and on 1997, the Ecofin Council reached agreement on a package of proposals designed to tackle harmful tax competition. In 1999, the Code of Conduct group on business taxation (established further to the ECOFIN conclusions of 1997) submitted its final assessment report, made public in 2000. In 2003, the interest and royalty directive went ahead. The savings Directive (ensuring a minimum of effective taxation of savings income in the form of interest payments) also was finalised. another major development was the 2004 EU Savings agreement between the European Union and Switzerland, which provides for the application of the Interest and Royalties Directive and the Parent-Subsidiary Directive in the relation between the European Union and Switzerland.

As a result, of the 2001 Commission Study, Company Taxation in the Internal Market and accompanying Communication, a long term strategy was mentioned for providing companies with a consolidated corporate tax base for their EU-wide activities. This project is advancing and several reports have been in the meantime made available. Another recent development was based on the work of the EU Joint Transfer Pricing Forum, which resulted Code of Conduct on transfer pricing documentation for associated enterprises in the European Union and the Code of Conduct for the effective implementation of the Arbitration Convention

It should be noted that although network of bilateral tax treaties still lie outside the framework of Community law, the Commission is considering the possible conflicts between the EC Treaty and the bilateral double taxation treaties that Member States have concluded with each other and with third countries.

In addition to the policy and legislative developments highlighted above, the development of European tax law has a very important judicial component since the European Court of Justice has been archiving harmonisation through the application of the non-discriminatory principles of the four fundamental freedoms. This effect is evident in the Court Cases in the field of Direct Taxation since the Avoir Fiscal (1986) to the more recent N case (2006).

General Information Links

EU Legislation on Taxation (as of 1.9.2005)
- This very useful document links you to all the legislation in force in the European union in the area of taxation

Direct Taxation Directives
- This document links you to the Direct Taxation Directives: namely the Merger, Parent-subsidiary, Interest and Royalties and Savings Directives.

Indirect Taxation Directives
- This document links you to the several Indirect Taxation Directives, with a particular reference to the Sixth Directive on VAT.

Company Law Directives
- This document links you to the several Company Law Directives currently in place

Treaty establishing the European Community
- This document contains the consolidated version of the Treaty of Rome.

Other Treaties or basic legal texts of the European Union
- This document contains links to remaining treaty texts.

Specific Links of Interest

Taxation and Customs Website

Commission Staff Working Paper - Company Taxation in the Internal Market - SEC(2001) 1681 An Internal Market without company tax obstacles: achievements, ongoing initiatives and remaining challenges - COM (2003) 726

Dividend taxation of individuals in the Internal Market - COM (2003) 810

Code of Conduct on Business Taxation (Primarolo report)

OECD Harmful Tax Practices report (1998) and the 2004 Progress Report DG Competition website (in-charge for State Aid procedure)

Report on the application of the state aid rules to measures relating to direct business taxation (2004)

State Aid Register - Commission Decisions

Court Cases in the field of Direct Taxation (updated as September 2005)

Search form for Judgments, Opinions and orders of the European Court of Justice

Case-law by numerical access from (i) 1953 to 1988 and (ii) since 1989

Daily Official Journal of the European Union

ECOFIN - Economic and Financial Affairs

Latest press releases from EU EU Member States Links

Keeping up to date with the news

Financial Times - Brussels briefing

PwC EU direct tax newsalerts

E&Y EU Tax Library

KPMG European Tax Centre

Loyens & Loeff EU tax alert

Baker & McKenzie European Tax Newsletter

Reference Books (Recent publications)

§ Ben Terra & Peter Wattel, European Tax Law; 4rd edition 2004, Kluwer Law international
§ Paul Farmer and Richard Lyal, EC Tax Law, 2nd edition, Oxford, To be Published: April 2006
§ Carlo Pinto, Tax Competition and EU Law (Eucotax), Kluwer Law International, 2003
§ Pasquale Pistone, The Impact of Community Law on Tax Treaties: Issues and Solutions (Eucotax Series), (Eucotax), Kluwer Law International, 2002
§ Servaas van Thiel, Free Movement of Persons and Income Tax Law: The European Court in Search of Principles, IBFD Doctoral Series, 2002

Relevant Tax Journals

European Taxation & VAT Monitor (IBFD)
Intertax & EC Tax Review (Kluwer)
Tax Planning International European Union Focus (BNA)
EC Tax Journal (Key Haven Publications)
British Tax Review (Sweet & Maxwell)

Do not "check the insides of the box" because it is a disregarded entity

2006-10-10T10:25:00.000Z

The US Check-the-Box regulations have through the years acquired international visibility. Basically, these regulations, which are in place since 1997, serve to determine the classification of business entities (both domestic and foreign) as a corporation, partnership or disregarded entity. Under those regulations an unincorporated entity may elect (by "checking" a box on a form) the classification it wishes and that is where the name check-the-box comes from! If no election is made, the entity is classified as a corporation or partnership (or branch) according to default rules, which are basically based on the liability of and number of the members. In addition, no election can be made where an entity is deemed to be a per se corporation.

A lot has been written on the impact of these rules both from a domestic and international perspective. Recently Alice G. Abreu (Temple University) made available a paper suggestively called “Paradise Kept: A Rule-Based Approach to the Analysis of Transactions Involving Disregarded Entities”

Taking into account the recent trend in some European countries to provide some sort of check-the-box rules, perhaps this reading will bring some insights into the “unknown” world of disregarded entities.

The attribution of profits to permanent establishments during the 2006 IFA Congress

2006-10-08T19:36:00.000Z

The International Fiscal Association (IFA) held its 60th Congress in Amsterdam, the Netherlands from 17 to 22 September 2006. Following the tradition of past congresses, the IFA delegates debated two main topics, namely, the tax consequences of restructuring of indebtedness (subject I) and the attribution of profits to permanent establishments (subject II).

The two main subjects were complemented by seven specific seminars covering the following topics:
- Seminar A: Indirect tax aspects of cross-border services
- Seminar B: IFA/OECD – Do enterprises mean business?
- Seminar C: International cooperation in countering tax avoidance
- Seminar D: The effect of regional and global trade agreements on domestic tax law and bilateral tax conventions
- Seminar E: Recent developments in international tax
- Seminar F: IFA/EU: the need and scope for coordination of tax policies in the EU
- Seminar G: Tax accounting versus commercial accounting

Although it was the second main issue, the attribution of profits to a permanent establishment (PE) attracted large attention from both practitioners and academics. It is important to recall that permanent establishments were already the main topic of discussion in Vienna (1957), Stockholm (1967), Lausanne (1973) and more recently Geneva (1996).

The topic recently gained new interest with the recent OECD Discussion Drafts on the Attribution of Profits to Permanent Establishments: Part I: General Considerations (2001 and 2004); Part II: Banks (2001 and 2003); Part III (Enterprises Carrying on Global Trading of Financial Instruments) (2003); and Part IV (Insurance) (2005).

Taking into account the ongoing OECD work on this topic, now nearly approaching its completion, the first panel discussion, following the general report and the accompanying IFA branch reports, was aimed at analysing the main problem areas arising from the adoption of the so-called authorised OECD approach (AOA) to the attribution of profits to PEs. The Panel discussion also involved implementation issues and difficulties for particular countries (such as non-OECD members) in adopting the AOA.

The plenary session was complemented with a two break-out sessions specifically covering issues for financial institutions and non-discrimination issues from both the perspective of EC law and tax treaties.

General issues on the attribution of Profits to PEs (2)

The discussion of this topic took place at an important point in time, since the six-year OECD work on this same topic is now closely approaching its completion (3)

The Chair, Prof. Kees van Raad, initiated the plenary session by introducing the subject matter, namely the interpretation and application of Art. 7(1) to (4) of the OECD Model Tax Convention (the business profits provision). After briefly describing the introductory example, where an enterprise carried on by a resident of one state is operated in a host state through a PE, Prof. van Raad briefly outlined the current rules for taxing business profits under the OECD Model. This introduction was followed by an overview given Raffaele Russo on the history of the business profits provision, from the 1927 and 1928 Drafts of the League of Nations until the current 2005 OECD Model and Commentary on Art. 7.

Prof. Richard Vann discussed the current views on Art. 7. In this respect, Prof. Vann identified the two different interpretations of Art. 7(1) to (3), namely the relevant business activity approach (also called single enterprise approach) and the functionally separate enterprise approach (also called the separate enterprise approach). Prof. Vann also addressed the various approaches to the conceptualisations of the separate enterprise and focused on the potential conflict between the fiscal fiction (under which the PE is treated as a separate enterprise) and the legal facts (according to which a PE cannot own assets or bear risk separately from the remainder of the enterprise), when characterizing the so-called internal dealings.

Prof. Philip Baker (IFA General Reporter on subject II) presented the main issues and conclusions of the General Report. Prof. Baker started by highlighting that domestic law and treaty law are either largely in conformity, but that no consensus was found as to the correct interpretation of Art. 7. According to Prof. Baker, this lack of consensus is further emphasized by the absence of guidance, and also by the abundance of disputes and attribution theories in the countries surveyed. Prof. Baker also called upon the attention to the widespread use of presumptive taxation and discussed whether the attribution of profits to branches can be said to be entirely an issue for financial institutions.

The panel discussion continued with the presentation of the main issues, stemming from the future adoption Authorized OECD Approach (AOA). This was followed by an overview given by Mary Bennett of the ongoing OECD PE profit attribution project. Mary Bennett started by mentioning that the aim of the OECD project was in fact to seek to eliminate the current lack of consensus on how to hypothesize the PE as a distinct and separate enterprise, and to apply the Transfer Pricing Guidelines by analogy. Mary Bennett went on to briefly describe the AOA two-step approach and focused her additional remarks on the first step, which involves applying principles of the 1995 transfer pricing guidelines by analogy to perform a factual and functional analysis in order to analyse what is part of the PE and what is not. Mary Bennett mentioned that the first step involves addressing the question of economic ownership of assets, attributing adequate free capital to the PE in light of its risks, and attempting to identify any "dealings" between the PE and the enterprise of which it is a part. Mary Bennett explained that under the AOA risks should follow functions, the attribution of assets should follow where the people functions are performed and finally the attribution of capital should follow risks.

As regards the current state of play of the AOA, Mary Bennett announced that the OECD/CFA decided in June 2006 to publish by the end of 2006 new versions of Parts I – III of the Discussion Drafts, to finalize the Part IV draft report on insurance during the first months of 2007 and to publish during 2007 a draft implementation package, which will include the changes to the Model and Commentary. Mary Bennett also mentioned that the controversial key entrepreneurial risk-taking (functions) terminology would be retained only for specific sectors and no longer would appear in the general part. In addition, Mary Bennett stated that the symmetrical application of profit attribution methods was considered to be an issue more related to Art. 23, and that the proposed changes to the text of Art. 7 would not address the concept of symmetry.

The panel discussion continued with the presentation of five examples, which involved (i) the transfer of inventory, (ii) the transfer of an asset, (iii) debt financing (including withholding tax on notional payments), (iv) self-developed intangibles, and (v) head office expenses. Under each example, the various panel members confronted the current approach and the AOA approach, and highlighted specific issues that need to be resolved or clarified.

Following the discussion of the examples, Radhakishan Rawal addressed the extent the AOA is consistent with the UN Model Convention (2001), and whether it could be adopted by jurisdictions that follow the UN Model. Taking into account the wording of Art. 7(3), Radhakishan Rawal considered that it would not be possible to adopt AOA for treaties based on the UN Model and that such adoption would be possible only if Art. 7 of such treaties would be amended.

Meinhard Remberg presented the position of the business community on the AOA, with particular comments concerning the activities of engineering and construction companies. Meinhard Remberg noted that the integration of activities gives rise to differences regarding construction and engineering activities, and that such difference should be considered by the OECD on the preparation of Part I of the OECD PE project.

The panel continued with a discussion on the specific issue of the attribution of profits where there is an Agency PE, namely whether there may be an additional profit attributable to an Agency PE over and above the arm's length reward paid to the agent. After Prof. Van Raad outlined the issue in question, Prof. Baker highlighted several arguments in favour of the nil sum approach, while Prof. Vann exposed opposing arguments for determining a taxable profit at the level of the Agency PE. The discussion was followed by a vote by the delegates.

The final topic addressed future policy and implementation options arising from an adoption of the AOA by OECD Member States. The panellists discussed the advantages and disadvantages of adopting the AOA for all businesses, adopting the AOA only for the financial sector, not adopting the AOA but maintaining the existing wording of Art. 7 and Commentary, and finally deferred a decision and continue researching alternative solutions. As regards implementation options, the panellists discussed the advantages and disadvantages of changing only the OECD Commentary versus changing the OECD Model and Commentary.

Selected issues for financial institutions (4)

The financial industry, which usually operates through branches, is in the forefront of the debate as to how profits are attributable to a PE and the first break-out session focused on the key practical issues in determining how profits are attributed under the AOA.

The Chair, Dr Richard Collier initiated the break-out session by outlining the specific issues related to attribution of profits to PEs in the financial sector, namely key entrepreneurial risk-taking (functions), capital allocation and symmetry issues, specific issues of the insurance sector and Agency PE considerations.

Before addressing the specific issues, Angelo Digeronimo outlined the historical issues that serve as a background to the ongoing OECD work. Angelo Digeronimo started by mentioning the 1994 OECD report on the attribution income to PEs and its aim to remove uncertainty about the interpretation of Art. 7 of the OECD Model and also remove all differences between Art. 7 and Art. 9 of the OECD Model. However, due to the conservative majority opinion at that time, the report failed to address any differences between Art. 7(2) and 7(3). Although the ban on notional payments between the head office and branch was maintained, Angelo Digeronimo mentioned that the report had its merits. In addition, Angelo Digeronimo mentioned the external and internal drivers to the current OECD work, such as the adoption of the 1995 Transfer Pricing Guidelines and the OECD work on global trading. On this subject, Dr. Collier pointed out that there has been notably little controversy in the approach to the allocation of profits to financial PEs, largely due to the influential 1984 Guidance from the OECD.

Jean-Charles Balat addressed the topic of Key Entrepreneurial Risk Taking (KERT) functions in the framework of the financial industry. Jean-Charles Balat noted that KERT approach can be seen as a concrete application of the functional analysis and that such approach is positive, taking into account the goal of attributing profits to where the key profit drivers are located. Jean-Charles Balat also listed the various practical and theoretical remarks on the KERT concept and highlighted potential compliance issues for taxpayers. Jean-Charles Balat concluded that although it can be said that the KERT approach is too theoretical and has to become more flexible, it can be said that it generally improves the application of the profit split.

Peter Van Dijk commented on the KERT concept from the insurance industry perspective, where risk management is generally the key profit driver. Peter Van Dijk started by welcoming the initiative of the OECD on the attribution of profits to PEs but expressed that in a regulated industry, such as the insurance industry, it may raise more problems than solve the existing ones. Peter Van Dijk also mentioned that there is an uncertainty of what KERT means (for example for underwriting and general management functions) in the insurance business and that may probably give rise to double taxation.

Bas De Mik provided an overview of the issues of capital attribution arising from the AOA and the related issue of symmetry in the capital allocation method used by the residence state. On this topic, David Grecian highlighted that the CFA recently decided to remove the symmetry issue from the draft reports, although there is an agreement as to the inclusion of a policy statement in the draft implementation package, which will include the changes to the Model and the OECD Commentary.

Angelo Digeronimo commented on the status and major points of the draft report on insurance (Part IV) and mentioned that a public release is expected during the beginning of 2007. Peter Van Dijk commented on the specific problems arising from the insurance sector that need to be addressed in the forthcoming draft report.

The break-out session also addressed specific issues concerning Agency PE in the framework of the financial sector. Richard Collier, after providing an overview of the issues, questioned whether the KERT approach, which s focused on Art. 7(2), has an indicative or determinative influence when considering the existence of an Agency PE under Art. 5(5). On this issue, David Grecian started by describing the OECD approach on Agency PE under the AOA and highlighted that the AOA does not make any distinction between different types of PE. David Grecian mentioned that although the OECD did not originally see the Agency PE considerations as a controversial issue, it has became one of the more controversial issues of the AOA. In that regard, David Grecian outlined some of the concerns raised by the business sector and highlighted the importance of the principle that an Agency PE can receive an arm's length reward above the remuneration paid to the dependent agent. Finally, David Grecian concluded that KERT approach hypothesizes the PE and serves to allocate the financial assets and its attached risks to identify a PE, and that such analysis is different than the set of tests under Art. 5(5) and (6). Bas De Mik suggested that the are two hurdles to overcome regarding the Agency PE. The first is the text of Art. 5(5) and the second is the lack of symmetry on capital attribution.

As a conclusion, each of the panel members offered a final comment on important issues coming out of this session. Peter Van Dijk started by mentioning that as long as PEs are not treated as subsidiaries the problems will continue and therefore recommended further study of the issue. David Grecian, considered that the OECD project brought the treatment of the PEs further and will help to achieve greater consistency between the approaches currently in place in the OECD member countries. Anuschka Bakker noted that the regulatory issues of the insurance industry should be further addressed. Richard Collier stressed that further work should be done on Art. 5(5), as a financial sector imperative. Angelo Digeronimo mentioned that the implementation of the AOA introduces the functional analysis, and that with the AOA, we are moving closer to not having differences between Art. 7 and Art. 9. Bas De Mik highlighted symmetry as an important point to reach a solution. Finally, Jean-Charles Balat suggested that the OECD changes the text of Art. 7, so that Anglo-Saxon countries give up the practice of non-recognition of intra-group branch transactions.

EC law and non-discrimination issues(5)

Since most tax treaties contain a non-discrimination article, it is important that any approach to the attribution of profits to PEs is consistent both with the provisions of the Art. 24(3) and its Commentary.

In addition, the current member states of the EU are also subject to the constraints of Community law, which may also impact their position on the attribution of profits to PEs. In fact, although several decisions of the European Court of Justice (ECJ) have dealt already with the taxation of PEs, several EC law aspects still need to be resolved, such as exit taxes, notional income and capital allocation. In that regard, the second break-out session discussed in detail the non-discrimination implications of the OECD Discussion Drafts on the attribution of profits to a PE.

The Chair, Prof. Lang, initiated the session by introducing the subject matter, i.e. non-discrimination issues in respect of the proposed authorized OECD Approach (AOA) arising from the EU fundamental freedoms and Art. 24 of the OECD Model. The session covered five case studies, concerning a head office in State A with a PE in State B.

The first case study dealt with the issues of transfer of assets from the head office to the PE and issues of exit taxation. Prof. Kroppen outlined the main facts and issues, i.e. whether or not the resident state is allowed to tax the transfer of assets from a head office to a PE and whether or not the source state is required to provide a step-up in value when the assets are transferred to the source state.

Prof. Pistone started by exploring the fundamental freedoms, relevant for direct taxation purposes and the four steps that the ECJ uses when applying them to judicial cases. Starting from the state of residence, Prof. Pistone analysed which fundamental freedoms would apply (the freedom of establishment or the free movement of capital) and whether or not that would raise any difference, such as in situations involving third countries. With regard to the correct comparison to determine whether or not discrimination exists, Prof. Pistone submitted the scenario of a head office and a PE in the state of residence. Assuming a difference in treatment exists, Prof. Pistone addressed possible justifications, i.e. territoriality and internal market tax cohesion. From the perspective of the state of source, Prof. Pistone referred to the conclusions of the ECJ in the "N" case (C-470/04) and stated that it may be relevant to determine if the state of source also grants a step-up for EU resident subsidiaries or takes into account if the source state taxes (with deferral) outgoing transfers.

Prof. Gutmann raised additional questions as to whether or not there is a problem under EC law. In doing so, Prof. Gutmann first questioned, from the perspective of the state of residence, if a transfer of assets would be covered by the freedom of establishment. Second, Prof. Gutmann questioned if there would be discrimination, as it is not clear if the residence state has to treat the foreign PE as a foreign subsidiary. Prof. Gutmann also discussed whether or not the EC law solution depends on the features of the domestic tax system of the resident state, e.g. the territorial system. With regard to the state of source, Prof. Gutmann remarked that if no step-up is given in a situation of a domestic head office and PE, why would it be required to do so in this case? Prof. Kroppen drew attention to an ongoing discussion in Germany as to whether or not a discrimination and/or infringement can be justified on the grounds that the EU systems for exchange of information do not work in practice.

Prof. Lang addressed tax treaty law issues by determining the right term of comparison under Art. 24 (3). Taking into account that a step-up in the PE state could raise a double deduction issue, Prof. Lang said that such double dips would not, in principle, be a problem, as Art. 24 only deals with the state of source. Prof. Garcia Pratz also defended the position that there is no problem for the residence state. With regard to the state of source, Prof. Garcia Pratz said that, depending on the comparable enterprise treatment, Art. 24(3) could be said to force (under the traditional and AOA approach) this state to give a step-up to PE in order to avoid discrimination treatment.

The second case study dealt with a scenario involving a notional royalty income from a PE to the head office. Prof. Pistone outlined the main facts and issues, i.e. whether or not a notional royalty payment should be deductible in the source state, what is the right comparison and whether or not a withholding tax levied only at the level of a subsidiary affects the outcome of the case.

Prof. Garcia Pratz, who dealt with the source state EC law issues, said that this case would fall under freedom of establishment. As to the right comparison, and as ECJ case law offers many valid possibilities, it could be possible to compare the present case with the situation of a parent company in the residence state and a subsidiary in the source state. Nevertheless, Prof. Garcia Pratz pointed out that it is important to determine if the notional payment and the real payment would be in a comparable situation. With regard to a possible justification to non-deductibility, Prof. Garcia Pratz stated that, following ECJ case law, the compensation with other advantages, such as the withholding tax levied on subsidiaries, would probably not be allowed as a justification. Prof. Lang dealt with the residence state issues and said that, if the outcome of this case would result in the residence state being precluded to tax such a notional royalty, this could again result in a double benefit. In this regard, Prof. Lang pointed out the recent tendency of the ECJ to look together at both source and residence and the use of the fundamental freedoms to a certain extent as a policy tool.

Prof. Kroppen said that, from a tax treaty law perspective, the right comparator under Art. 24(3) could be a subsidiary of the source state. Accordingly, the fact that a subsidiary would be granted a deduction, whilst no deduction would be available to a PE, amounted to a breach of Art. 24(3). Prof. Kroppen also highlighted that only under the AOA notional payments would be deductible and, therefore, a PE and subsidiary would be treated equally. David Rosenbloom, who offered the US perspective on the non-discrimination article, considered that the correct comparison under Art. 24(3) should be a standalone company and not a subsidiary. In addition, David Rosenbloom said that the concept of intra-entity notional royalty is not recognized, which makes the comparison more difficult. Finally, David Rosenbloom stated that the issue of deduction of development costs could be resolved under Art. 7 and possibly Art. 24(3).

The third case study dealt with a scenario involving a supply of services between head office and PE. Prof. Lang outlined the main facts and issues, i.e. whether or not an equal treatment of a foreign PE and a foreign subsidiary would remove possible problems under Art. 24(3) and EC law.

Prof. Kroppen, considering the residence state EC law issues, stated that the correct comparison would be with a head office and a PE in the residence state. A difference in treatment could amount to discrimination under the freedom of establishment, but in such case possible justifications would need to be evaluated. Prof. Garcia Pratz, considering the source state EC law issues, said that the correct comparison could be with a parent company in the residence state and a subsidiary in the source state. With regard to the outcome of the case, Prof. Garcia Pratz submitted that, provided that domestic law allows deduction of the expense, the current approach and the AOA would not raise EC compatibility issues.
From a tax treaty perspective, Prof. Gutmann considered that a discrimination issue can be raised under the current OECD approach, whilst under the AOA it would cease to exist. David Rosenbloom pointed out that the application of the US transfer pricing rules would result in the arm's length remuneration most likely being the cost for these services. David Rosenbloom stated that this case is similar to the notional royalty case, i.e. no discrimination, with the only difference that in this case there is no timing mismatch.

The fourth case study dealt with the issue of capital allocation to a PE under the AOA. Prof. Lang outlined the main facts and issues, i.e. how much capital is needed to cover the assets and support the risks assumed by the PE and how to deal with the situation when the amount of capital attributed to the PE is higher than the minimum amount attributed to a local subsidiary.

Prof. Gutmann started by pointing out that there is an EC Law issue if a PE in the source state is worse off than a domestic subsidiary. In this regard, three sub-issues need to be resolved. First, whether minimum legal capital is relevant for tax purposes in cases where the PE free capital is higher. Second, what happens in cases where no thin capitalization rule exists in the PE state or transfer pricing rules apply? Third, what happens where free capital is also required for a PE and there is a thin capitalization rule for subsidiaries? Prof Garcia Pratz, defending the point that no EC law problems are raised, stated that the correct comparability depends largely on which "capital allocation model" is followed.
Prof. Pistone, addressing the treaty law issues, said that the comparability of a PE with a subsidiary is strengthened by the AOA. Prof. Pistone also said that, in cases where thin capitalization rules do not exist, the AOA may lead to discrimination. David Rosenbloom commented from a US perspective and referred that no discriminatory treatment should be found. In this regard, David Rosenbloom offered four possible scenarios for comparison under Art. 24(3).

Finally, the fifth and last case study dealt with documentation requirements for a PE of a third country national. Prof. Gutmann outlined the main facts and issues, i.e. the application of EU freedom of capital in a scenario involving third countries instead of intra-EU, the legitimacy to impose more burdensome requirements on a PE and whether or not the assessment of procedural and substantive rules differs.

Prof. Pistone, started by determining the scope of free movement of capital and payments in relation with non-EU countries by referring to a recent ECJ Advocate General's opinion in the Fidum Finanz case. Prof. Pistone also said that, from an EU perspective, procedural obstacles are obstacles and may create EU problems. With regard to the correct comparison, Prof. Pistone referred to a head office in a third country with a profit-making PE in the source state. Prof. Pistone also pointed out that different standards for justifications and proportionality may be envisaged in third country situations. Prof. Kroppen, questioning if there is an EC law problem, said that a restriction (instead of discrimination) could be found, as such a rule could deter the formation of PEs. Since the mutual assistance directive would not apply, Prof. Kroppen discussed the issue of if there would be a practical difference under a tax treaty exchange of information clause.

David Rosenbloom questioned if Art. 24 would apply to procedural restrictions and said that the key enquiry in this case would be if the source state applied a similar rule as to where the accounting takes place as regards a resident company. Finally, Prof. Lang followed the approach that both substantive and procedural rules may affect Art. 24. With regard to the correct comparison, if the comparable situation in this case would be with an enterprise carrying out activity in the source state, Prof. Lang submitted that there would be no discrimination.

Final Comment

There have been during this past years several calls of scepticism, namely of the extension of the already complex and difficult transfer pricing rules to the situation of the branch or to an Agency PE. Critics mentioned, amongst others that the practical application of this process of applying transfer pricing rules by analogy raises a number of difficult issues, which in the end will not make life easier to taxpayers. The increased pressure in the Agency PEs side is perhaps a visible element of those difficult issues. Nevertheless, the OECD has demonstrated its resilience and (as announced during the IFA Congress) will apparently bring this project to an end by 2007/2008. The implementation package announced by the OECD, the discard of the KERT terminology (at least for general PEs) and the postponement of the debate on the symmetry issue were the most recent OECD news announced during the IFA Congress. The question remains as to whether “calm seas” lie ahead or some of the voiced concerns during the Congress will bring some "turbulence" into the project. One thing appears more certain, the attribution of profits project will set anchor in 2007 and we expect changes into the OECD Model (and not only to the Commentary).

Endnotes

(1) The IFA, which is headquartered in the Netherlands, is the leading non-governmental international organisation dealing with tax matters and comprises more than 11,000 members worldwide. The objects of IFA are the study and advancement of international and comparative tax law through specific research, holding of congresses and publications. In 2007, the Annual Congress will be held in Kyoto (Japan). For further details, visit www.ifa.nl

(2) The plenary panel was composed by Prof. Kees van Raad (Netherlands) as the chair, Prof. Philip Baker Q.C. (United Kingdom) as the General Reporter and: Mary Bennett (OECD), Radhakishan Rawal (India), Meinhard Remberg (Germany) and Prof. Richard Vann (Australia) as panel members. Raffaele Russo (Italy) served as secretary.

(3) OECD Discussion Draft on the Attribution of Profits to Permanent Establishments: Part I: General Considerations (2001 and 2004); Part II: Banks (2001 and 2003); Part III (Enterprises Carrying on Global Trading of Financial Instruments) (2003); and Part IV (Insurance) (2005).

(4) The panel of the first break-out session was composed by Dr Richard Collier (United Kingdom) as the Chair and Jean-Charles Balat (France), Bas De Mik (Netherlands), Angelo Digeronimo (Switzerland, OECD – WP6), David Grecian (OECD – WP6) and Peter Van Dijk (Canada) as members. Anuschka Bakker (Netherlands) served as secretary.

(5) The panel of the second break-out session was composed by Prof. Dr Michael Lang (Austria) as the Chair and Prof. Alfredo Garcia Pratz (Spain), Prof. Daniel Gutmann (France), Prof. Dr Heinz-Klaus Kroppen (Germany), Prof. Dr Pasquale Pistone (Italy) and David Rosenbloom (United States) as panel members. Patrick Plansky (Austria) served as secretary.

NOTE: This summary is based on a three seperate TNS reports made for the IBFD in connection with the IFA Congress

Regional selectivity: A fine day of sun for the European “true” autonomies

2006-09-10T18:51:00.000Z

It is not every day (on the contrary) that Portugal is on the spotlight of the European Court of Justice (ECJ). In the first day after its summer vacations, the European Court of Justice issued a decision concerning the action brought by the Portuguese Republic seeking the annulment of Commission Decision 2003/442/EC which classified as state aid the reductions on the rate of income tax for natural and legal persons having their tax residence in the Portuguese Autonomous Region of the Azores (case C-88/03).(1)

(1) A region is the layer of government directly below the national level. The term is used, especially, in relation to regions with some sort of historical claim or idiosyncrasy in relation to the remaining territory. Examples may include for instance: (i) Scotland, Wales and Northern Ireland, in the UK; (ii) The island-regions of Sardinia and Sicily in Italy; (iii) the Basque country in Spain; or (iv) the Finnish province of Åland. Many other regions exist, with different degrees of decentralisation.

One interesting point is that the Azores case may be of great assistance to other autonomous jurisdictions within the European Union, such as Gibraltar and the Spanish Basque region, in their efforts to reform their tax systems and deviate from their central government tax system. In that regard, it should be mentioned that there is case currently pending in the European Court of First Instance (CFI) contesting the Commission decision regarding to the Government of Gibraltar’s’ plans for corporate tax reform.

The Azores tax benefits

The facts of the case are quite long and for persons not fully involved in state aid maters, this subject may seam a bit wearisome. But for sake of completeness allow me to very briefly explain what is state aid in plain tax terms and why is it important in the framework of the European Union internal market.

In 2000, the Portuguese authorities notified (as required by EC Law) the European Commission of a scheme adapting the national tax system to the specific characteristics of the Autonomous Region of the Azores (2).

(2) The Azores, an archipelago of nine Portuguese islands in the middle of the Atlantic Ocean (1,500 km from Lisbon and 3,900 km from North America), is one of the two Portuguese autonomous regions (the other being Madeira), which possesses its own political and administrative statute and has its own regional government and legislative parliament (elected by universal suffrage).

The measures, approved by the legislative body of the Azores Region, included, in particular, a reduction in the rate of personal income tax of 20 % (15 % for 1999) and a reduction in the rate of corporation tax of 30 % for taxpayers in the region.

In the context of the EU internal market (one of the main goals of the EU), state aid rules are aimed at reducing distortions of competition. Since restrictions on competition are not a “monopoly” of companies, governments when granting public aid to businesses should be assessed in a similar fashion. As such, the Treaty of Rome (Article 87) considers incompatible with the EU internal market any aid (including forgone tax revenue) granted by a Member State, which distorts or competition and affects trade between Member States. In order for a specific measure to be considered incompatible state aid (in the form of forgone tax revenue) it is generally necessary for such measure to: (i) give rise to a selective advantage (e.g. favouring certain undertakings or the production of certain goods); (ii) involve state resources; (iii) affect intra-community trade or competition; and (iv) not be justified by the nature of the tax system (3).

(3) For more details on the application of those rules in tax matters, please see the 1998 Commission notice on the application of the State aid rules to measures relating to direct business taxation and the 2004 Report on the implementation of the Commission notice on the application of the State aid rules to measures relating to direct business taxation.

Taking into account the state aid rules, the EU Commission responded to the Portuguese notification by initiating an investigation procedure, specifically with regard to that part of the scheme concerning reductions in the rates of income and corporate tax.

This investigation was crystallized the Commission Decision 2003/442/EC, which classified as state aid the tax reductions for residents of the Azores. After examining the scheme, in light of the guidelines on national regional aid, the Commission, however, considered that such aid meet the conditions for being considered as being compatible with the Common Market, under the derogations of Art. 87(3)(a) of the EC Treaty, i.e. "aid to promote the economic development of areas where the standard of living is abnormally low or where there is serious under-employment". National regional aid in Azores was, in this case, justified due to its contribution to regional development and the fact that it was proportional to the additional costs they were intended to offset.

Nevertheless, the Commission decision included a caveat. Accordingly, a distinction was made between the financial and the non-financial sectors. In fact, in respect of financial sector firms, the Commission stated that such corporation tax reductions were "not justified by their contribution to regional development" and, therefore, the tax reductions did not qualify as permitted national regional aid under Art. 87(3)(a) (i.e. regional aid) or any other derogation provided for in the EC Treaty. The reasoning was that the existence of real regional handicaps counts for very little for mobile activities, such as financial services and firms of the ‘intra-group services’ or ‘coordination centre’ type of activities.

Accordingly, Portugal was ordered to recover the aid made available to firms carrying on financial or intra-group service activities. Since the Portuguese law did not establish any intra-group service regime, the impact of the decision was primarily on the financial institutions benefiting from the reduced rates.

The Portuguese Counter-attack

Even though the Commission decision impacted only in financial firms having their activities in Azores, it could be said that that the argument as concerns regional selectivity limited future plans for future divergence between the tax system of mainland Portugal and the tax regime in place in the two autonomies, namely Azores and Madeira.

Portugal therefore reverted to the ECJ and attacked the Commission decision on 3 grounds, being the first ground the important issue for the discussion today. Under the first ground, the Portuguese Government submitted that the reduced rates were not selective but general measures, since the reference framework should have been the region and not the whole Portuguese territory.

The United Kingdom and Spain, which intervened in support of the Portugal, mentioned that due regard should be made to the degree of autonomy of the regional or local authority before classifying regional tax rates (which are lower than the national tax rate) as State aid. The Commission, on the other hand, submitted that the selectivity of a measure was to be determined by reference to the national framework and that the degree of autonomy of the Autonomous Region of the Azores was in fact limited.

At this point, it is important to note that, tax measures which are open to all economic agents operating within a Member State are in principle general measures. In that respect, it is commonly said that only measures whose scope extends to the entire territory of the State escape the specificity criterion. But if that assertion would be the case for all situations, then prima facie all national tax variations limited to a geographic subsection of a Member State qualify as ‘geographically’ selective! So an answer is needed as to which should be the point of comparison (tacking into account different degrees of autonomy found in the various member states) in considering whether a geographically limited national tax rate variation “favours certain undertakings or the production of certain goods”.

It should be noted that the Commission, in the 2004 report on applying the State aid rules to direct business taxation, had adopted a rather limitative position with regard to fiscal autonomy. As such, clarification in this regard was “desperately” needed.

The Principles set out by Advocate General Geelhoed

Advocate General Geelhoed, the same advocate which is actively involved in some of the high profile pending tax cases (such as ACT Group Litigation, FII Group Litigation and Denkavit II), delivered its opinion on 20 October 2005. The AG pointed out that since the ECJ has never answered this specific question, it was for the Court to set out the applicable principles. For this purposes, the AG distinguished three different scenarios, depending on the decentralization model adopted by a particular state:

- In a first situation, if a central government of a EU Member State unilaterally decides that the national tax rate should be reduced within a defined geographic area, the AG considers that such a measure should be clearly viewed as selective;

- Secondly, if a local or regional authority has autonomous powers to set the tax rate for their geographical jurisdiction, whether with or without reference to a "national" tax rate, the AG considers the measure to be non-selective within the meaning of the state aid provisions; and

- In a third situation, where a tax rate lower than the national tax rate is decided on by a local authority and applicable only within the territory of that local authority, the AG considers that the selective nature of the measure depends on whether or not the lower tax rate results from a decision taken by a local authority that is "truly" autonomous (i.e. institutionally, procedurally and economically autonomous) from the central government of the EU Member State.

This begs the question as to whether the distinction between an autonomous infra-State body and a not “truly” autonomous infra-State body is a rather straightforward distinction, i.e. easy to apply in practice.

By “truly” autonomous, the AG referred to three different parameters of a state autonomy, namely the institution, the procedural and the economic autonomy. By institutionally autonomous, the AG was referring to infra-State bodies with its own constitutional, political and administrative status separate from that of the central government. By procedurally autonomous, the AG was referring to the independence of infra-State body in the procedure of setting the tax rate and without any obligation on the part of the local authority to take the interest of the central State into account. Finally, by economically autonomous, the AG was referring to the situation of whether the forgone tax revenue (through a tax reduction) is cross subsidised or financed by the central government, so that the economic consequences of such tax reductions are not ultimately borne by the region itself.

The AG concluded that when a local authority decides to institute a tax rate lower than the national rate and it exercises its (tax) autonomy institutionally, procedurally and economically, such decision cannot be qualified as ‘selective’ for State Aid purposes.

The ECJ decision on regional selectivity

As regards the selectivity criterion, the ECJ started by mentioning that it is possible that an infra-State body enjoys a legal and factual autonomy, to the extent that it will be the area in which such infra-State body exercises its powers, and not the country as a whole, the so-called reference framework for the purposes of assessing whether a particular measure is selective.

For the purposes of examining a measure adopted by an infra-State body in the exercise of powers sufficiently autonomous vis-à-vis the central power, the ECJ referred back to AG Geelhoeds’ three different scenarios, set out in his opinion.

In a more polished way (but without deviating from Geelhoeds’principles), the ECJ considered that the exercise of sufficiently autonomous powers requires constitutional autonomy (i.e. separate political and administrative status), procedural autonomy (i.e. no directly intervention by the central government) and financial autonomy (i.e. the cost of tax reductions is borne by the autonomy and not offset by aid or subsidies).

The difference between the AG opinion and the final decision of the court rests in the issue of procedural autonomy. The ECJ made no reference to an “obligation on the part of the local authority to take the interest of the central State into account in setting the tax rate” and that missing element may play an important role in evaluating autonomies, whereby the power to legislate is limited by national interest parameters.

This forth parameter could in fact jeopardize or make the analysis more intricate, as regards cases where the freedom of the infra-body to legislate is limited constitutionally by principles of solidarity, maximum or minimum tax burdens or similar restrictions.

In applying the set of principles, laid down by the AG, to the present case, the ECJ started by noting that the Azores have been designated an "autonomous region" and that this region has the power, in certain circumstances, to exercise their own fiscal competence and the right to adapt national fiscal provisions to regional specificities.

Nevertheless, the ECJ noted that the reduction in tax revenue, resulting form the lower rates, is offset by a financing mechanism, in the form of compensatory financial transfers from the central State. In this regard, the ECJ considered that the decision of the government of the Autonomous Region of the Azores to exercise its power to reduce the rates was not economically autonomous, in view of the budgetary transfers managed by central government.

In conclusion, the ECJ considered that the relevant legal framework for determining the selectivity of the reduced rates was the whole of Portuguese territory and that such reductions were not justified by the nature or the overall structure of the Portuguese tax system.

The Gibraltar Case

As mentioned above, the decision of the ECJ on the Azores case may have a wider impact and eventually influence the currently pending Gibraltar case (Gibraltar is a UK overseas territory which is part of the European Union). On 30 March 2004 the European Commission “pushed the breaks” on the proposed reforms to Gibraltar’s corporate tax system, which were intended to take effect from 1 July 2004, by concluding that they were incompatible with the EU rules on State aid.

According to the planned reform, which could be said to deviate from other EU benchmark tax systems), companies domiciled in Gibraltar would be subject to a yearly payroll tax (per employee) and to a business property occupation tax. As such, every employer in Gibraltar would be required to pay payroll tax for the total number of its full-time and part-time employees who are employed in Gibraltar plus a business property occupation tax at a rate equivalent to a percentage of their liability to the general rates charged on property in Gibraltar. One interesting (and controversial) point of the reform would be that the liability to payroll tax together with business property occupation tax would be capped at 15 % of profits (that would probably mean that an offshore company without any physical presence in Gibraltar would pay no tax at all). The project included other features, such as a registration fee applicable to all Gibraltar companies and an additional top-up or penalty tax on profits generated by certain designated activities.

In its scrutiny of the reform plans, the Commission considered that a number of features of the reform proposals would be liable to confer an advantage on Gibraltar companies. At the top of the list (i.e. the first ground of dispute) was the regional selectivity, which would mean that the proposed system would grant an advantage to Gibraltar companies compared with UK companies. Basically, the corporate tax rate tax in Gibraltar would be set at 15%, rather than the United Kingdom’s 30% statutory corporate tax rate.

The essence of the Commission's view on the regional selectivity of the Gibraltar tax reform proposals, is that they provide, in general, for a lower level of taxation than that applicable in the United Kingdom and that this difference amounts to a selective advantage for companies active in Gibraltar. According to the Commission, a distinction based solely on the body that decides the measure would remove all effectiveness from Article 87 of the Treaty, which seeks to cover the measures concerned exclusively according to their effects on competition and Community trade.

The Commission, in making its point on regional selectivity, even referred to the controversial position of AG Saggio opinion on the cases involving the Basque region (it should be noted there was no final ruling in these cases, as the proceedings were later suspended). According to Saggio, “the fact that the measures [are] adopted by regional authorities with exclusive competence under national law is (...) merely a matter of form, which is not sufficient to justify the preferential treatment reserved to companies which fall under the provincial laws. If this were not the case, the State could easily avoid the application, in part of its own territory, of provisions of Community law on State aid simply by making changes to the internal allocation of competence on certain matters, thus raising the general nature, for that territory, of the measure in question”.

In addition, the Commission pointed out that the use of a purely institutional criterion to differentiate ‘aid’ from ‘general measures’ would inevitably lead to differences in treatment in the application of the rules on aid to Member States, according to whether they had adopted a centralised or decentralised model of allocating tax competence.

Gibraltar counter-attacked by bringing an action to annul the disputed Commission decision, before the Court of First Instance of the European Communities. On the point of regional selectivity, Gibraltar submited that the Commission's regional selectivity principle cannot apply to Gibraltar, since we are dealing with two tax jurisdictions, which are entirely separate and mutually exclusive so that Gibraltar's tax laws cannot be treated as derogations from tax law in the United Kingdom.

It is expected that the acceptance by the ECJ of new parameters to determine regional selectivity in the Azores case may play a considerable role in the forthcoming discussions of this case. Nevertheless, the negative assessment of Gibraltar corporate tax reform plans by the commission also focused on other issues such as material selectivity.

The case of the Spanish Basque regions

Another region where the parameters set out by the ECJ will deserve future attention is in the Basque Country. The Basque territory is an autonomous community with the status of historical region within Spain and its institutional and economic autonomy, may be said, in many ways, the highest standard of autonomy found in EU member states.

The Spanish constitution outlines a quasi-federal system where three levels of government coexist: central, regional, and local. In general, the autonomous area of the Basque Country benefits from a special tax regime, within the framework of the national laws of Spain. Under such special regime, the parliaments of the different regions comprising the Basque Country (Alava, Guipuzcoa and Bizkaia) are authorized to adopt and modify certain taxes within certain prescribed limits. The recognition by the Spanish Constitution of historic rights of the Basque Country resulted in a need to agree on the details of the functioning of the financial and tax system and the Economic Agreement between the Basque country and Spain (Concierto Económico) served that purpose. The Economic Agreement embodies the Spanish fiscal decentralization model, which entails a maximum level of tax autonomy. Conversely, these regions must contribute to the central government by means of the so-called “cupo” (quota), which is linked to the general expenses that the central government makes on their behalf (4).

(4) In the case of the Basque Country, the authority on taxation matters is exercised by the governing bodies (Diputaciones forales) of the three foral provinces: Álava, Bizkaia and Guipuzcoa. Their treasuries regulate, levy and administer all the (conceded) Basque Country’s taxes.

In summary, under the Economic Agreement the Basque Country is given right to have its own tax systems, which include most of the powers to regulate and administer the main taxes, including personal and corporate taxes (VAT is for example excluded). The agreement includes, notwithstanding, a set of provisions that aim to guarantee an adequate level of harmonization between regional system and the common territory system.

Accordingly, the (regional) tax system shall nevertheless be in accordance with the (i) constitutional principle of solidarity; (ii) the general structure of the Spanish tax system; (iii) the coordination, fiscal harmonisation and cooperation with the Spanish State; and (iv) international agreements signed by the Spanish State (i.e. double tax treaties and European Union).

In addition, when drafting tax legislation the infra-state bodies are required: (i) respect the general tax law in matters of terminology and concepts; (ii) maintain an overall effective fiscal pressure equivalent to that in force in the rest of the State; (iii) respect and guarantee fundamental freedoms throughout the territory of Spain, without giving rise to discrimination or a lessening of the possibilities of commercial competition or to distortion in the allocation of resources; and (iv) use the same system (as the common territory) for classifying (...) industrial, commercial (...) activities.

Taking into account this degree of autonomy it is expected that the Basque region competency to regulate tax would fulfil the three principles set out by AG Geelhoed and accepted by the ECJ in the Azores case.

Final comments

Tacking into account the parameters set out by the ECJ in the Azores case, it appears that the issue of regional selectivity under EU state aid rules is close to become settled. Interpretation issues may still arise as to whether a specific region fulfils the criteria of being institutionally, procedurally and economically autonomous and a clarification/update by the EU commission on this field is also welcomed.

Although it is understandable that the Commission is worried with allowing infra-state bodies to make changes to the general tax system and in that way circumvent EU state aid rules, namely the strict limits set out for regional aid, such worries should not be made at the expense of the process of EU fiscal decentralization, a model adopted by certain EU states to preserve and guarantee the unity of their own territories.

Fiscal autonomy has been and will continue to be (perhaps even more) present in the political and social landscape of some of the most important European regions and state aid rules may have a limited role in tackling such fiscal autonomy. Perhaps the outcome on the regional selectivity may reinforce the necessity to develop additional measures to curb (potential) tax competition by infra-state bodies (under the so-called “shadow” of fiscal autonomy). Nevertheless, the outcome on the Azores case may be said to have been fine day of sun for the European “true” autonomies!

Treaty Shopping and GAAR: To be or not to be

2006-08-28T16:05:00.000Z

In late 2004, Canada extended the application of Canada’s general antiavoidance rule (GAAR) to Canada’s tax treaties. Basically, section 245, which contains the GAAR rule, was retroactively amended to make explicit reference to tax treaties Taking into account the uncertainty surrounding the application and compatibility of GAAR in the field of tax treaties, any case-law in this area is helpful, not only to discuss this issues, but also to determine whether GAAR is an effective tool to counter abusive tax Treaty transactions.

In a very recent case decided by the Tax Court of Canada (MIL (Investments) S A v. The Queen), a Luxemburg company was able to claim for an exemption under the previous Canada-Luxembourg income tax treaty on capital gains derived from the sale of shares, notwithstanding the Canadian tax authorities claim that the Canada's GAAR or even an "inherent anti-abuse rule" in the Treaty denied the benefits of the said exemption.

The facts of the case involve a series of (rather complex) transactions, namely (i) the acquisition by a Cayman Islands incorporated company (MIL) of shares of a Canadian company (DFR), (ii) exchange of DFR shares for shares of another Canadian public company (INCO) by MIL reducing the shareholding of MIL in DFR to just less than 10%; (iii) the transfer of the place of effective management of MIL from Cayman to Luxemburg; and (iv) the sale to INCO by MIL of DFR shares, amounting to a sale of shares representing less than 10 percent.

According to Paragraph 4 of Article 13 of the Canada-Luxembourg income tax treaty, capital gains derived by a resident of Luxemburg (MIL) from the alienation of shares (other than shares listed on an approved stock exchange in the other Contracting State) forming part of a substantial interest (i.e. 10% or more) in a Canadian company may be taxed in Canada. Nevertheless, in this case the sale of shares was just below the 10% threshold. As such, paragraph 5 of the same article was applicable, determining that capital gains from the alienation of shares were taxable only in Luxemburg, namely the country where the alienator is a tax resident.

In first place the Canadian tax authorities attempted to apply the Canada's GAAR (i.e. Section 245) in order to deny the treaty exemption. In that regard, the Tax Court made a number of interesting findings in the course of deciding that the GAAR did not apply to deny the treaty exemption.

According to the Court, the application of the Canadian GAAR involves three steps. The first step is to determine whether it is a 'tax benefit' arising from a 'transaction'. The second step is to determine whether the transaction is an avoidance transaction, in the sense of not being 'arranged primarily for bona fide purposes other than to obtain the tax benefit. The third step is to determine whether the avoidance transaction is abusive. All three requirements must be fulfilled before GAAR can be applied to deny a tax benefit.

In this case there was no discussion as to whether the treaty exemption afforded the Luxemburg company a “tax benefit”, but instead whether the transactions taken by the taxpayer qualified as an “avoidance transaction”.

In that regard, the court noted that if there are both tax and non-tax purposes to a transaction, it must be determined whether it was reasonable to conclude that the non-tax purpose was primary. If so, the GAAR cannot be applied to deny the tax benefit. In this case and after careful and long examination, MIL was said to have a bona fide commercial reason for selling the shares.

As to the transfer of place of effective management to Luxemburg, The Court considered that MIL continuance into Luxembourg was commercially justified because it was a better jurisdiction than the Cayman Islands from which to carry on a mining business in Africa and that there was sufficient business presence in Luxemburg to demonstrate that fact.

Having considered that both the sale and underlying transactions were not avoidance transactions, the issue whether any of those transactions was abusive was no longer necessary. Nevertheless, the Tax Court considered whether the tax treaty exemptions relied upon by MIL were abusive in the context of the GAAR.

As regards the choice of Luxemburg as the (new) place of residence of the holding, the court noted that here is nothing inherently proper or improper with selecting one foreign regime over another. The Court stated that, although the selection of a low tax jurisdiction may speak persuasively as evidence of a tax purpose for an alleged avoidance transaction, the shopping or selection of a treaty to minimize tax on its own cannot be viewed as being abusive.

The Court further noted that one must examine the treaty in question and in this case the general rule, contained in Art. 13(5) of the Treaty, is that capital gains on the sale of shares are taxable only in the country in which the taxpayer is resident (i.e. Luxembourg). An exception is only made (allowing Canada also to tax) for capital gain on the sale of shares amounting to a substantial interest (10% or more).

The Court noted that the reliance by MIL (Luxemburg resident company) on the treaty provision agreed upon by both Canada and Luxembourg couldn’t be viewed as being a misuse or abuse. In fact, if Canada concern was directed to the use of preferable tax rates by any of its treaty partners, the Court recommended the (more difficult) option of renegotiate the treaty, instead of attempting to apply the GAAR provision!

The tax authorities presented an alternative line of argumentation that even if the GAAR would not apply to deny the treaty benefit, it is still possible to deny the treaty benefits based on the anti-abuse rule inherent within the Tax Treaty itself. For that purpose, the Canadian Tax Authorities relied on an expert from Luxembourg, namely Prof. Dr. Alain Steichen.

Accordingly, inherent anti-abuse test considers that that a specific Treaty benefit may be denied in situations where both domestic anti-avoidance rules (i.e. Canada and Luxembourg) would deny that benefit. As such, it would be important also to consider the "reversed scenario" in which MIL continued into Canada from the Cayman Islands in order to use the Treaty. In order to establish the inherent anti-abuse rule, reference was made to international legal principles, namely the Vienna Convention on the Law Treaties and the OECD Commentaries.

The expert mentioned that neither Art. 13 nor any other article appears to be providing for a specific anti-treaty shopping provision eventually explicitly authorizing Luxembourg under the reversed scenario to deny the Treaty Benefits under Article 13(5). Only the preamble, which refers to the prevention of fiscal evasion, could be relied upon. Nevertheless, the expert considered that such reference does not constitute an anti-treaty shopping provision on which Luxembourg could rely upon in order to deny Treaty benefits.

When considering the proper Treaty interpretation, the expert mentioned that only in case of ambiguity under the Treaty, one should refer to other principles in international public law to confer the proper meaning of the Treaty. Accordingly, the expert considered that silence in a Treaty equals ambiguity and such ambiguity could be avoided by writing in the Treaty that local GAAR cannot affect the validity of the application of the Treaty. The expert noted that such inclusion would be a clear statement, in which case one would not have to argue about whether that implicit anti-abuse provision exists or not. Furthermore, the tax authorities presented the 2003 revisions to the OECD commentary as support for the existence of an inherent anti-abuse rule in tax treaties.

As regards the inherent anti-abuse rule, the tax court considered the expert’s opinion unconvincing, in light of the OECD commentary and the decision not to include an explicit reference to anti-avoidance rules in the said Treaty. The Tax Court relied on "ordinary meaning" of the Treaty and found no ambiguity in the Treaty permitting it to be construed as containing an inherent anti-abuse rule. In conclusion, the claim of MIL for capital gains exemption under Art. 13(5) of the Canada-Luxembourg Tax Treaty was allowed.

Note
Following the 2003 revisions to the OECD commentary, this case is perhaps one of the first in a series of expected cases (in countries which apply a GAAR or substance-over-form rules) dealing with issue of tax treaties and domestic anti-abuse rules.

It is widely discussed by scholars (without sometimes reaching any meaningful conclusion) whether tax treaties preclude the application of domestic anti-abuse or substance-over-form rules. This problem was further emphasized by 2003 revisions to the OECD Commentaries that support the tax authorities view on the subject. Accordingly, Para. 9.2 of the Commentary on Art. 1 of the OECD Model Tax Convention. states that “(...) the answer to that second question [i.e. whether the provisions of tax conventions may prevent the application of the anti-abuse provisions of domestic law], is that to the extent these anti-avoidance rules are part of the basic domestic rules set by domestic tax laws for determining which facts give rise to a tax liability, they are not addressed in tax treaties and are therefore not affected by them.”

Albeit the victory of the taxpayer, this case demonstrates the willingness of tax authorities to push the boundaries of domestic anti-abuse provisions into the sphere of the tax treaties. Now the question is whether Treaty Shopping and GAAR is to stay or not to stay!

Further (recent) reading
(1) Weeghel, S. van, Boer, R. de, Anti-abuse measures and the application of tax treaties in the Netherlands, Bulletin for international taxation, Vol. 60 (2006), no. 8/9 ; p. 358-364

(2) Arnold, B.J., Weeghel, S. van The relationship between tax treaties and domestic anti-abuse measures, In: Tax treaties and domestic law, IBFD, 2006 ; p. 81-120

(3) Matteotti, R., Interpretation of tax treaties and domestic general anti-avoidance rules - a sceptical look at the 2003 update to the OECD commentary, Intertax, Vol. 33 (2005), no. 8/9 ; p. 336-350

(4) Obermair, C. Weninger, P.J. Treaty shopping and domestic GAARs in the light of a recent Austrian decision on Irish IFS companies, Intertax, Vol. 33 (2005), no. 10 ; p. 466-473

(5)Bernstein, J., GAAR and treaty shopping: an international perspective, Tax notes international, 2005, no. 12 ; p. 1107-1110

(6) Arnold, Brian J., “Tax Treaties and Tax Avoidance: The 2003 Revisions to the Commentary to the OECD Model”, 58 Bulletin for International Fiscal Documentation (2004) no. 6, p. 249-252.

(7) Zimmer, F., “Domestic Anti-Avoidance Rules and Tax Treaties – Comment on Brian Arnold’s Article”, 59 Bulletin for International Fiscal Documentation 1 (2005), no. 1, p. 25.

(8) Martín Jiménez, A.J., Domestic anti-abuse rules and double taxation treaties : a Spanish perspective - part I and 2, Bulletin for international fiscal documentation (2002), no. 11 /12; p. 542-553

IFA 2006: what to expect from this year IFA

2006-08-24T16:33:00.000Z

With less than one month to the annual meeting of IFA (a congregation of international tax fanatics), which this year is in my adopted town of Amsterdam (relieving me of big trips), it is time to make an overview of the various topics that will be discussed between 17-22 September 2006.

As usual the congress evolves around two plenary sessions (tax consequences of restructuring of indebtedness and attribution of profits to permanent establishments), which are coupled with break out-sessions (related to such topics) and additional seminars on other pre-selected topics.

The first topic is tax consequences of restructuring of indebtedness. This topic, which explores several debt restructuring scenarios originating from situations of corporate distress analyses the tax treatment of different types of work-outs from a comparative perspective. The first session will focus on tax consequences to unrelated creditors and debtors of debt restructurings, while a special breakout session will analyse the situation where debtor and creditor are related parties.

The second topic addresses the already controversial topic of attribution of profits to permanent establishments (PEs) under the OECD Model Tax Convention. In the wake of delays as to the conclusion of the OECD project on attribution of profits to PE’s, the work of IFA gains more importance since from the branch reports it is already visible differences in the approaches and potential implementation issues and difficulties of the so-called authorised OECD Approach. The same topic is followed up in two breakout sessions, one dealing with specific issues concerning the financial service industry and the other focusing on EU/non-discrimination issues.

With respect to the seminars, it should be mentioned that:
- Seminar A will focus on Indirect tax aspects of cross-border services;
- Seminar B will focus on the concepts of “enterprise” and “business” which are used throughout the OECD Model Tax Convention;
- Seminar C will address international cooperation in countering tax avoidance from a policy and administration perspective;
- Seminar D will focus on the effect of regional and global trade agreements on domestic tax law and bilateral tax conventions;
- Seminar E that normally address recent developments in international tax will focus this year on Chinese incentives and the US fight against inversions;
- Seminar F will discuss the need and scope for coordination of tax policies in the EU; and
- Seminar G will address the increasingly important issue of the relationship between tax accounting and commercial accounting.

But this year the IFA is not only two plenary sessions and seminars but also about the launch of the young IFA network (YIN). Having been actively involved in the launch of this idea, I hope this year will be a YIN year for IFA!

For a more complete overview of the congress activities visit the website of the IFA congress.

Prize for the best piece of tax legislation

2006-08-22T12:32:00.000Z

According to a CNN report, US Republican Sen. Charles Grassley of Iowa is hoping to stamp out the sex trade by taxing pimps and prostitutes, then jailing them when they don't pay.

No wonder Jon Stewart's Daily Show mocked perfectly this genuine piece of tax proposal!

Again Agency PEs (but this time Secret Agents)

2006-08-21T15:35:00.000Z

I am back from vacation (more detail in some days). Meanwhile, in the eve of the 2006 IFA Congress in Amsterdam, where the topic of the Attribution of Profits to a Permanent Establishment will be thoroughly discussed, the highly recognized Richard J. Vann made available a paper on the (secret) topic of agency permanent establishment (PE) under tax treaties. As you may have noticed (by the old enteries) this topic is dear to me and it is with pleasure that I post the link to the paper at the same time I will print it for the first time and read it! Probably the readers of Talk Tax will expect a comment on the paper in the coming week and I will do the utmost to fulfil such expectation.

In the meantime, here is the abstract to the paper Tax Treaties: The Secret Agent's Secrets also published in the last number of the British Tax Review (No. 3, p. 345, 2006)

Abstract:
Recently two apparent paradoxes have been revealed about an agency permanent establishment (PE) under tax treaties, first that it is possible to avoid an agency PE by exploiting a difference between civil law and common law on agency (often referred to as commissionnaire structures) and secondly that if the agent is rewarded with a market-value fee there will be no profits to attribute to an agency PE. This article demonstrates that these problems have been present since the origin of tax treaties, and that they stem from a form-over-substance approach to PE tests which relegates the independence test in defining PEs to a secondary role, from the use of a different indeterminate independence test in transfer-pricing rules and from the definition of the firm in terms of common ownership. Underlying the problems have been inconsistent views on how value is generated within a firm. The solution is to settle on a workable theory of value, to apply substance over form, and to realise the significance of independence in defining the boundary of the firm. Under current treaty law, the second asserted paradox is not correct if treaties are interpreted in a sensible manner.

LOB: When Tax Treaty Derivative Benefits Provisions Don't Apply

2006-07-22T08:50:00.000Z

You find in Article 22 of the US 1996 Model Treaty of most tax treaties entered into by the United States a limitation on benefits clause (LOB). This clause, which has the purpose to prevent the application of the benefits of the treaties to treaty shopping structures, added a certain degree of complexity to the application of treaties in intricate corporate structures. It is interesting to note that the 2003 changes in the OECD Commentaries on Art. 1 of the OECD Model include already a number of similar clauses to those provided under the US Model. Therefore it can be said that the interest of any analysis of the practical issues arising from the application of the LOB clause goes well beyond the treaties signed with the US.

In that regard, I would like to call upon the attention of Ruth Mason (Associate Professor of Law of Connecticut Law School) recent article When Tax Treaty Derivative Benefits Provisions Don't Apply. Here is an abstract:

The U.S.-U.K tax treaty¸ like several other recent treaties, has a limitations on benefits (LOB) clause that contains a derivative benefits provision. Under derivative benefits, a company that qualifies as a resident under Article 4 of the Treaty - but fails to qualify under the LOB clause due to its foreign ownership - may nevertheless be entitled to treaty benefits if the foreign owner is an “equivalent beneficiary.”
An equivalent beneficiary is a beneficial owner that is resident in a third country with which the United States also has a tax treaty. However, for certain items of income, a beneficial owner does not automatically qualify as an equivalent beneficiary simply because its country has a tax treaty with the United States. For those items of income (dividends, interest and royalties), the third country’s treaty must offer withholding rates “at least as low” as the rate available under the claimed treaty.
What happens when the equivalent beneficiary’s treaty with the United States provides higher withholding rates than does the claimed treaty? What withholding rate applies? There are two choices. The United States could apply: (1) the higher of the two treaty withholding rates or (2) the statutory withholding rate. This article describes the derivative benefits problem in detail and considers which rate should apply.

Comment:
According to the author there seems to be disagreement about the correct withholding tax rate to be applied in cases where a company fails the third test of a derivative benefits provision (LOB clause). The author seems to defend, instead of the domestic withholding tax (30% in the case of US), the application of the rate under the equivalent beneficiary’s treaty (5% in the example given). This result is said to be the “right” result, as a matter of policy and from an interpretive perspective. Nevertheless, the author acknowledges that the issue is far from clear and assert that the US Treasury should clarify, which of the withholding taxes apply.

Allow me to make a side comment. First of all, taking into account that tax treaties are bilateral by nature it is difficult from the outset to conceive a fallback to a rate included in a third treaty when a particular treaty provision is said to be non-applicable. Tax treaties restrict domestic law and therefore if for any reason they are inapplicable (such as by the application of the LOB clause), domestic law should apply (irrespective of the final result).

Secondly, it is also difficult to conceive the application of a rate included in a third treaty, in a situation when you even fail to have a resident under Art. 1 of such treaty. In the given example, the UK company (even though controlled by French shareholders) cannot be said to be a resident of France for the purposes of the treaty between US and France and therefore the treaty (and rates therein) do not apply.

Finally, I would like to recall the (recently changed) US position in cases of dual resident companies and make an analogy with the issue at stake. Ignoring for now specific rules contained in the US-UK treaty for dual resident companies, according to Rev. Ruling 2004-76, a dual resident company, resident for example both in the UK and France under the domestic laws of those countries, is not entitled to claim benefits under the U.S. treaty with the UK, if under the tie-breaker rule of the UK-France treaty it is treated as a resident of France and not of UK.

The US tax authorities arrived to such result by (restrictively) construing the term “liable to tax by reason of residence” of Art. 4(1), as excluding the possibility of a dual resident company to gain access to the treaty network of the “loser” state (in this case UK). Although this interpretation may be criticised (*), in the case under discussion (LOB) it reinforces the argument that unless the UK company is a also considered a resident of France (for example by having there the place of effective management) the rate included in the treaty between US and France should not apply.

In the end, I agree that 1the result of applying the domestic rate when derivative benefits provisions don’t apply is quite harsh. Nevertheless, such “inadequate” result should be corrected by amending the provision itself and not by any interpretative construction.

(*) Interesting to note that the same result (as regards dual resident companies) was achieved by the Supreme Court of the Netherlands (BNB 2001/295)

Who said tax was not funny?

2006-07-15T19:50:00.000Z

The term “tax humor” is no doubt an oxymoron to many people; to the more cynical, it is an apt description of the entire tax code. (by John F. Iekel)

See below some examples of funny tax language (taken from the US Tax code)!

Section 509(a)
For purposes of paragraph (3), an organization described in paragraph (2) shall be deemed to include an organization described in section 501(c)(4), (5), or (6) which would be described in paragraph (2) if it were an organization described in section 501(c)(3).

Section 168(i)(2)(B)
(B) COMPUTER OR PERIPHERAL EQUIPMENT DEFINED. -- For purposes of this paragraph--
(i) IN GENERAL. -- The term "computer or peripheral equipment" means--
(I) any computer, and
(II) any related peripheral equipment.

For more examples see http://nersp.nerdc.ufl.edu/~acadian/humor.htm

ECJ Annual report 2005 made available

2006-07-15T14:55:00.000Z

The 2005 Annual Report of the ECJ can already be downloaded here. The document titled “The Court of Justice in 2005: changes and proceedings”, prepared by Vassilios Skouris (President of the Court of Justice) mentions 3 tax cases amongst the most relevant cases of 2005. The referred cases are the unavoidable Marks & Spencer (UK), the non-less controversial D case (Netherlands) and the less-known Schemp case (Germany). This reference to 3 cases dealing with tax matters demonstrates ultimatly the impact of these 3 tax cases on the overall “development” of the jurisprudence of the ECJ.

Not a while ago, the whispers in the corridors of conferences was that ECJ jurisprudence was leading to some sort of tax harmonization through the backdoor, by forcing member states to adjust their direct tax systems. But these rumours have recently vanished and were even substituted with claims of a “change of hart” by the ECJ on direct tax issues. These claims are apparently supported by recent victories of tax authorities on landmark cases such as Marks & Spencer and the D case. No wonder that the joke is “please remain seated until this area of turbulence has passed”!

The choice of those 3 cases to appear in the Annual Report does not seem to be coincidence. If the denial of the MFN concept in the "D case" took some tax advisors by surprise, the outcome of the Marks & Spencer case can be said to lay a shadow on future cases. The significance of Marks & Spencer case is said to rest on the use of a new justification, which apparently is already being used by Member States to defend other infringements of EU Law. Below I summarize very briefly the cases mentioned by the ECJ report.

Case C-446/03 Marks & Spencer
In the Marks & Spencer case the ECJ had to deal with a claim by M&S to the UK tax authorities for group tax relief in respect of the losses incurred by its German, Belgian and French subsidiaries. The problem lied in the fact that UK tax legislation, which allowed, under certain circumstances, the parent company of a group to effectively offset profits and losses incurred by its subsidiaries, denied that same group relief to subsidiaries not resident or trading in the UK (foreign subsidiaries). The ECJ surprisingly held that the UK legislation constitutes a restriction on freedom of establishment since it applied a different treatment for tax purposes to losses incurred by a resident subsidiary and losses incurred by a non-resident subsidiary. Nevertheless, the story was far from the end and the ECJ acknowledged that such a restriction may be justified. In that regard, the Court set out objective criteria that demonstrate that such legislation pursues legitimate objectives that are compatible with the EC Treaty. The ECJ considered that the fact that the UK legislation (I) protects the balanced allocation of the power to impose taxation between the various Member States; (ii) provides for avoidance of the risk of double use of losses; and (iii) limits the risk of tax avoidance, results in such legislation being compatible with the EC Treaty. But the ECJ was still not truly satisfied in complicating the mater (with the above 3 justifications) and further added that UK legislation did not comply with the principle of proportionality if there would be no more possibility for the foreign subsidiary’s losses to be taken into account in its State of residence. This means that only if M&S would demonstrate to the UK tax authorities that all possibilities to take into account the losses in Germany, Belgium and France were exhausted then the loss would be taken into account! But this, as you imagine, is very difficult to prove… In my humble opinion this mess could have been simply avoided by saying that since UK does not tax the non-resident company such losses should not be taken into account by the parent company (i.e. there is no difference in treatment or restriction if the first place).

Case C-376/03 D case
In the D case the ECJ scrutinized the Dutch wealth-tax regime, which only granted an allowance to non-residents if at least 90% of the non-residents wealth was in the Netherlands. But the central issue in this case was not the domestic rule but a provision in the tax treaty between the Netherlands and Belgium, which extended to Belgian nationals the said allowance, whatever the proportion of their net assets located in the Netherlands. The ECJ was called to answer whether the difference in treatment created between Belgian nationals and nationals of other Member States (arising from the said allowance included in a tax treaty) was consistent with Articles 56 and 58 of the EC Treaty. This was basically the Most Favored Nation (MFN) argument in EC Law. Again in a controversial decision, the ECJ simply preferred to refer that Member States are at liberty, in the framework of tax treaties, to determine the connecting factors for the purposes of allocating powers of taxation and that it has accepted that a difference in treatment between nationals of the two contracting States that results from that allocation cannot constitute discrimination contrary to Article 39 EC. The ECJ hided behind the reciprocity element of tax treaties to state that the fact that reciprocal rights and obligations laid down by the Tax Treaty apply only to persons resident in one of the two contracting Member States is specifically an inherent consequence of tax treaties. I found particularly unsatisfactory the fact that this allowance (included in the tax treaty) can be said to be ultimately an incentive to invest in the Netherlands given to Belgium nationals and the fact that such provision, instead of being placed in the domestic tax code, is agreed in the framework of tax treaties “cures” this evident difference in treatment!

Case C-403/03 Schempp
In the Schempp case the issue in question concerned the deductibility for tax purposes of maintenance paid to a recipient resident in another Member State. In Germany, income tax legislation provides that maintenance payments to a divorced spouse are deductible but in case of non-resident recipients the deductibility is linked to the effective taxation of the recipient’s maintenance payments in the other Member State, proved by a certificate from the foreign tax authorities. In this case, since the former spouse was resident in Austria (where such maintenance payments are exempt at the level of the recipient) the German national was refused the deduction of its maintenance payments. In this case the ECJ observed that the unfavorable treatment simply derived from the difference between the German and Austrian tax systems with regard to the taxing of maintenance payments. The ECJ Court that the ECJ treaty offers no guarantee to a citizen of the Union that transferring his activities (or the transfer of his former spouse’s residence) to a Member State other than that in which he previously resided will be neutral as regards taxation.
Although this was not a case on one of the fundamental freedoms, it cannot be minimized the effect that the Court considered that the EC treaty does not guarantee a EU-citizen that a transfer of his activity to a Member State other than the one in which previously resided will be neutral for tax purposes.

Aren’t we all part of the same (EU) boat!

2006-07-15T13:45:00.000Z

Hungary applies a registration tax on motor vehicles on their first entry into circulation in Hungary whether they are new or second-hand, purchased in Hungary or imported and/or brought in from another EU Member State *apparently this rule was changed or will be in the near future). The amount of the tax depends on the engine capacity, type of fuel used and emission standards. Nevertheless, the Hungarian registration tax does not take account of the depreciation undergone by the second-hand vehicle imported from another EU Member State. According to the recently issued opinion of Advocate General Sharpston (recently nominated to replace the former Advocate General Francis Jacobs, who retired at the end of December), it is clear from the Court’s case-law [that such treatment] is in principle contrary to the first paragraph of Article 90 EC (see point 62 of AG opinion on Case C-290/05).

But what grabbed my attention in this judgment was the part concerning the issue of limitation of the temporal effects. It is important to recall that this issue is central to two landmark cases still to be decided, the German Meilicke case and the Italian IRAP case. In the Meilicke the problem concerns the lack of tax credit in Germany for dividends received from foreign companies. In that case the Advocate General suggested that the ECJ put a temporal limitation to the application of its judgment to claims for reimbursement of unduly paid taxes. In the IRAP case regarding the incompatibility of the Italian Regional Tax (IRAP) with the EU VAT Sixth Directive the Advocate General also suggested a date for temporal limitation, namely the date of release of the conclusions of Advocate Jacobs (i.e. March 17, 2005). The reason for the use of that that was based on the fact that on that date the Italian Government learnt with a degree of certainty that IRAP was incompatible with the Sixth Directive. This has major impacts because if the ECJ follows such recommendation the decision would have effects only on claims raised before March 17, 2005.

In this case concerning the Hungarian registration tax the Advocate General does not consider that the existence of a risk of serious economic repercussions for Hungary has been proved, and therefore recommends the Court not to limit the temporal effect of its decision. In this case and rather surprisingly it was Poland and not Hungary that requested that, if the registration tax was to be found incompatible with EC Law, the Court should limit the temporal effect of that judgment (the spilling effects of other pending cases). Hungary simply got the message and raised the issue in the oral hearing! But the Advocate General did not close the book without mentioning that it would be undesirable if such a limitation were to be granted at the sole request of a different Member State!

Why should other EU states (in similar circumstances) be restricted to raise arguments on cases that may indirectly impact their revenue? After all aren’t we all part of the same (EU) boat! The conditions for budgetary instability, which can result from an ECJ decision cannot be said to affect only the State that is addressed in a particular case (in this case Hungary). Court cases in the area of tax have demonstrated in several instances that their consequences may easily spillover to other EU countries (e.g. Manninen). In addition, while Member States of the euro-zone are bound to the stability and growth pact (EMU) other States outside the euro-zone, are making an enormous effort to meet in the future those goals. Therefore, I see no problem in other countries (such as Poland) raising the issue of serious budgetary impact. The Advocate General simply needs to address whether there is serious budgetary impact or not.

Tax Treaty Moot Court

2006-07-10T19:38:00.000Z

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.

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

2006-07-07T16:08:00.000Z

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!