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

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

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

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

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

Overview of Article 24 of the OECD Model

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

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

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

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

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

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

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

General issues underlying Art. 24

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

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

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

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

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

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

Specific issues concerning group taxation regimes

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Issues that require a more fundamental analysis

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

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

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

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

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

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.

Time has come for Tax Treaty Arbitration

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.

Does Cross-Border Tax Arbitrage warrants an international solution?

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?

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.