See you later...

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)

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

Trans-Atlantic European Tax Law

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

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

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

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

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?

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.