Global Tax Treaties, UN Model and OECD

¶ … global tax treaties, UN model and OECD model with the view of analyzing their consideration towards rights to capital and tax income. By throwing light on differences and similarities among the models, the fundamental logic of each of them is explained. The article explains the prospecting policies of consideration when tax treaties are to be signed. It is because there is strong need to enforce a flexible but more aggressive strategy. The Section 1 of the article discusses rights about tax earnings through immovable property. The Section 2 is about business profits. The Section 3 throws light upon income from investment channels like royalties, interests and dividends. The Section 4 describes the capital gains. The conclusion of the article is given in Section 5.

Right to tax income from immovable property

Because of well-known significant relationship between the country of source of the income and the source of income itself, there is similarity between UN model and OECD model. Article 6 in both models discusses that if a person generates some income from immovable assets existing and operating is some other country than the residence country of the individual, the tax will be paid in the country where the assets are located. This provision is recognition of source of income and gives the source country a right that the generated income from its immovable property can be used for its development purpose by levying taxes on it. This clause is different from the one that discusses immovable property with permanent establishment. The income generated from immovable property with permanent establishment is known as business profits. This article refers to permanent establishment as PE. This clause refers to immovable property which is not permanently established. These rules are basically formed by UN model and OECD model while a majority of the global treaties being completed in the current era do not see any reservation in following them[footnoteRef:2]. [2: Ronald B. Davies, 'Tax Treaties, Renegotiations, and Foreign Direct Investment' (2003) 33 Economic Analysis and Policy 251-273.]

2. The respective rights to tax business profits

2.1 The basic principles of allocating rights to tax business profits:

Both state of source and state of residence are interested in the income generated through business activities. The state of source levies tax on it while the state of residence balances the fiscal interests with the other state. There are three fundamental guidelines in this perspective. The first one is about independent enterprise which restricts the scope of right of tax which is in the advantage of state of source. The second principle is about profits attribution and the third one is about PE. It helps identify the source from where business profits generate. It also restricts the tax right to the state of source[footnoteRef:3]. [3: Tsilly Dagan, 'The Tax Treaties Myth' (2000) 32 New York University Journal of International Law and Policy 939-996.]

2.1.1 The PE principle

The PE principle is described in UN model and the OECD model in the similar terms. Both support the view that the state in which the business is established has the right to tax its profits. If the business enterprise is foreign and the origin of investment is in some other state yet it is operating in some other state through PE, even then the tax will be paid to the state in which the enterprise is located[footnoteRef:4]. [4: OECD, Attribution of Profit to a Permanent Establishment Involved in Electronic Commerce Transactions (OECD, 2001).]

There is, however, difference of definition of PE among the UN Model and OECD Model. OECD models have strict formal clauses defining PE. UN Model attaches more importance to the state which is importing capital from other countries. Generally, less developed countries import capital to develop their industry. Hence, it tries to relax the PE restrictions. In business practices related to PE, the common subjects of discussion are insurance related business, agent sales, services furnishing, projects duration and assembly related activities etc. There are many arguments and viewpoints related to these subjects in every business circle[footnoteRef:5]. [5: Ibid; Also see OECD Centre for Tax Policy and Administration, 2010 Report On The Attribution Of Profits To Permanent Establishments (OECD, 2010); Also see, United Nations, Model Tax Convention between Developed and Developing Countries (UN, 2001).]

Keeping in view the development stage of these countries and global relations in general, countries have many options available to them. They can follow the UN model on the grounds of its development pace and the largest size. They can adopt more flexible options by having negotiations with other states. They also have the option of increasing activities in other states through potential PEs. Keeping in view the laws of other states, the business terms may be different. For instance a project, whose duration is 9 months, when analyzed in the light of Qatar treaty, gives altogether a different perspective from that given by UN Model or OECD Model. On the other hand, a six months long project of any nature (construction, supervision, installation etc.) when analyzed in the light of Nigerian tax treaty, the applicability of concept of PE is completely different as well[footnoteRef:6]. [6: OECD Centre for Tax Policy and Administration, 2010 Report On The Attribution Of Profits To Permanent Establishments (OECD, 2010); Also see, United Nations, Model Tax Convention between Developed and Developing Countries (UN, 2001).]

2.1.2 The profits attribution principle

As mentioned earlier, the state of source has the right to levy taxes on the income generated from its immovable property with PE. It is important to mention here that this right is limited to the extent of the income that is generated through PE property. If some income is generated through immovable property which is not PE, the source state does not have any right to levy tax on the income. In this case, the state of residence will levy tax on the business enterprise. There are two distinguished manners in which profits can be attributed to PE. In OECD model, profits are attributed to PE in the light of economic relationship. It strictly states that only that income is taxable by the source country which is generated through PE activities. On the other hand, the UN Model gives the country of residence a leverage to levy taxes on the profits of the enterprise. It states that if the business is operated in some other state through PE, the country of state is liable to levy taxes[footnoteRef:7]. It broadens the scope of PE. To throw further light upon the UN model of profit attribution, it is mentioned that the profit generated through PE is taxable by the country of source and the profit which is generated through trade of commodities which are similar to those as in PE, is also taxable by the country of source. Yet another point is that the income which is generated through practices and activities similar to the ones carried out in PE are also taxable by the country of source[footnoteRef:8]. It is the recognition of taxable activities by the country of source that is important, even if the enterprise carries out these activities using other platforms than PE, but the activities and traded commodities are the same. Thus UN Model is based on attraction principle which attributes the similar activities and conditions to the taxable income. If the enterprise adopts different activities or practices, the income will not be taxable by the country of source[footnoteRef:9]. [7: The general force of attraction principle gives the state of source an unrestricted right to tax the source income, regardless of its economic connection with a PE. Bin Yang, A Comparative Study on the Rules and Administration of the International Taxation System (China Tax Publishing House, 2003).] [8: Paragraph 1, Article 7 of the UN model] [9: Klaus Vogel, Klaus Vogel on Double Taxation Conventions (Kluwer Law International, 1997) 421-422; Also see, OECD, Model Tax Convention on Income and on Capital (OECD, 2010).]

The principle of economic relationship with PE is a more feasible option for the countries to promote their relations with other countries. This is so because it is lenient as compared to the attraction principle; it also eases tax administration and boosts economic efficiency. There are, however, certain cases where attraction principle is deliberately introduced. It is when the enterprises try to avoid taxes by disguised separation of activities from PE. For instance, according to the tax treaty enforced between Philippines and Germany, if it is proved that the enterprise is avoiding taxes though the activities are similar to those carried out at PE, the regulation allows the country of source to levy taxes on the total income generated by the enterprise. The tax treaties enforced with Germany by many countries like Mexico, Papua New Guinea, Indonesia, Pakistan, India and Turkey etc. have the same clauses in them.

2.1.3 The independent enterprise principle and the arm's length principle

PE is part of the enterprise that is operating business in some other country. The activities and profits both belong to the enterprise hence it is evident that it is not an independent activity. But, keeping in view the tax jurisdiction and the related principles, it is mandatory to view PE as a separate entity. PE must calculate its business returns separately and independently so that taxable income can be determined accurately. In this perspective only, the UN Model and OECD Model consider PE an in independent enterprise. Therefore, it becomes mandatory in the business practices that PE is considered part of enterprise and its relationships with the enterprise itself and the other parts are preserved but for tax purposes, the state of source considers it the other way around.

The countries that are not the members of OECD or UN have the right to deviate from few of their clauses and implications. For instance, it states in the 2010 OECD Model that it has full regard for the concept of enterprise which considers PE as an independent entity, but keeping in view its capacity of tax administration, it can refer back to the old version of the model. It is also at the liberty to adopt simple methods for profit calculation related to PE.

2.2 On the calculation of the business profits of a PE

2.2.1 The rules of deduction of expenses between a PE and the enterprise

In legal terms, PE is not just similar to an independent enterprise. There is a principle known as arm's length principle which must be considered in the operations of business. The important questions are accrued expenses related to head office such as interest, loans, commissions, royalties etc.

In Article 7(3) of UN Model, it is explicitly stated that the expenses related to permanent establishment should be deducted in the accounts of permanent establishment. It is because these expenses are incurred for the business of permanent establishment and not for any other purpose. The counting of these expenses in the books of permanent establishment is necessary irrespective of the state where it takes place. If the organization (PE) pays the dues to the main office or any other sub-offices, in terms of royalty, fee or any related payments against the patents and copyright, no deduction can be made, otherwise the whole repayment of the actual expense is made. In the same way, if the commission is paid for particular services, rendered for the management deduction will not be allowed, except in the shape of interest at the borrowed amount is paid by the entity.

In the same way, permanent establishment will not come under the account of calculating its profits for the indicted amount if it has paid to the main office or any sub-offices in terms of royalty, fee or any other shape of payment against the usage of patents and similar rights. (If not, then the repayment of the authentic expense amount is to be made). The same would be the case if the payment has been made for the services presented for the management or, excluding the case study of a lending organization, the interest on the loans to the main or any other office of the enterprise[footnoteRef:10]. [10: Paragraph 2, Article 7 of both the UN model and the OECD model. The corresponding provisions do not comprise formal provisions of the OECD model; rather they are to be found in its commentaries]

OECD changed its model in the year 2010 and announced modifications in Article 7 by application of a lengthy principle to determine the corporate profit of a personal establishment. In the new version of article 7, the personal establishment is taken as a detached and self-governing business entity. Hence, acknowledgement of the profits to a personal establishment will be made by calculating profits/losses of other activities and deals with other parts of the entity[footnoteRef:11]. [11: Ibid]

The latest version provides comprehensive insight about the PE and its dealing with its main office and other activities like franchises, patents, loans and service delivery and many more. In this regard, this principle discusses the amount of the applicable expenses that can be subject to deduction and how the income has to be determined. The earlier model presented by OECD was pretty similar to United Nations model, where no provisional clauses and restrictions exist primarily. While, the model presented by OECD has parallel but more explicit views on the subject in its explanation[footnoteRef:12]. [12: Commentaries on Paragraph 3, Article 7 of the OECD model]

2.2.2 The calculation of profits of mere purchase by a PE

PE is not and should not be considered as an entity to be exclusively limited for the purchase activities. In this regard, if the PE gets involved in the purchase activities along with other corporate activities, there are quite a few divergent views on whether the acquisition profits will go to PE or not. In this regard, the United Nations model is pretty clear stating that a capable body of Contracting States will resolve the matter in a mutually agreeable manner[footnoteRef:13]. [13: OECD Centre for Tax Policy and Administration, 2010 Report On The Attribution Of Profits To Permanent Establishments (OECD, 2010).]

However, in the OECD 2010 model, the provision stating that PE cannot be attributed profits by any reason, if it involves in purchasing of goods and services for the venture has been removed, because of its inconsistency with the net set standards and principles. The arm's length principle explicitly indicates that every activity of PE including purchasing will be kept in mind while calculating profits. Moreover, while calculating the profits for PE all the expenses born by the PE have to be taken into the consideration due to the fact that the tax exception for the entity is subject to the expenses. However, this might lead to an administrative dilemma[footnoteRef:14]. [14: Ibid]

2.2.3 Special methods for calculation of profits of a PE

The best approach to deal with the determination and attribution of the profits is to research the accounting record of the PE on the grounds of logic presented in new arm's length principle. However, if the record has not been maintained or it's not trustworthy, then there are a variety of methods to calculate the proportions of the profits for PE as well as enterprise.

In the previous OECD model and United Nation's model, it was clearly stated that this had been a tradition that Contracting States decided about the determination and attribution of the profits for PE on the grounds of distribution of profits among an enterprise and its different parts. In this regard, paragraph 2 doesn't stop Contracting States from deciding and determining taxable profits in a traditional division. Hence, the distribution of the profit will be therefore, determined in line with the standards explained in the clause. Unless there is another good reason to determine from other criteria, year to year comparison is used for attribution of income[footnoteRef:15]. [15: Ibid]

The income distribution methods have been deleted from the OECD 2010 codes because it became essential to remove due to the incomparable usage of the provisional application. Moreover, sometimes it looked hard to make sure that the application of the code would be in line with the arm's length principle. As applying it for quite different methods is not permitted, the OECD model doesn't accept the requirement of such restriction[footnoteRef:16]. [16: Ibid]

2.4 An exception to the PE principle-international transportation

Usually, several countries are involved in air transportation and international shipping. A business activity might involve various countries with many branches of a business enterprise in different countries. Thus, profits of business enterprises have to be taxed in several countries as required by the PE principle. Not only the determination of the profit apportionment to various countries (and the PEs) is hard, but also the overall tax burden born by the business enterprise might become too much and in some scenarios, might increase above the accounting profits. It is reasonable to tackle the international transport industry taxes, which under the rules of the PE principle would be heavy, in a unique or innovative manner for its development, because of the common knowledge that international transport industry earns relatively low profit margins[footnoteRef:17]. [17: Tsilly Dagan, 'The Tax Treaties Myth' (2000) 32 New York University Journal of International Law and Policy 939-996.]

Operating profits of airplanes or ships in global traffic will be taxable only in Contracting State where the place of effective enterprise management is situated, as per OECD model. Furthermore, according to the OECD model, the management shall be considered to be situated in Contracting State where the home harbor is located or in case of no home harbor, in which the ship's operator is a resident, when the place of efficient management of the shipping enterprise is aboard the boat or ship[footnoteRef:18]. [18: Ibid]

The UN model has provided two alternatives in a single article: Article 8. The first alternative is the same as OECD model. But the second one, with its peculiar rules, specifies that only in the Contracting State will the operating profits of ships or boats in the international trade be taxed. The State in which the effective management's place is situated will only be of significance if the transportation activities emanating from such operations are anything further than casual. The profits will be taxable in the other State if the activities are more than casual. In the other state, the profits to be taxed are calculated depending on the appropriate allocation of all the net profits gained from shipping operations by the company. The tax thus computed on the basis of such appropriate allocation will be decreased by a large percent (this actual percentage amount is usually decided upon through timely negotiations)[footnoteRef:19]. [19: Bin Yang, International Taxation (Fudan University Press, 2004).]

Many other rules are also adopted despite of conferring by most of the global tax treaties to the right of tax to the state of residence. An example may be, the taxing right in treaties between Qatar and China, Laos and Venezuela are conferred to the head-office's place, while in Algeria, Morocco and Tunisia treaties the taxing rights are conferred to the effective management's place. A relatively special tax treaty is that between China and Indonesia. According to this treaty, profits that are from the sources within the Contracting State made by a business of the other Contracting State from international traffic operation of ships or boats might be taxable in the first-mentioned state. Nonetheless, the tax will be decreased by 50%[footnoteRef:20]. [20: OECD Centre for Tax Policy and Administration, 2010 Report On The Attribution Of Profits To Permanent Establishments (OECD, 2010).]

3. Rights to tax investment income

In the taxation of investment income, two methods are employed. Firstly, a withholding income can be levied in the source state. According to the income's total amount, it is taxable to a flat rate of income tax, whereby the beneficiary owner is the payer of tax and the payer is the withholding agent. The credits available on taxes are received in the final settlement of the residents that is why it is called withholding tax. The second one is the tax imposed on business profits. If a resident of a contracting State carries out business in some other contracting State, he is liable to receive investment income via a PE situated in there. This investment income will be treated as business profit and is taxed consequently. Even the same treatment is undergone with any rights and properties in other contracting states due to which payments are received. Source of investment income is fixed in order to solve the double taxation issues. There are rules recognized to guarantee that the tax is allocated to one source, in case of overlapping income sources. The rights to receive tax go to the state of source or the state of residence[footnoteRef:21]. [21: Ibid]

3.1 The basic principles of allocating rights to tax investment income

There are exceptional provisions available for interest, dividend and royalties, in both OECD and UN model. As per UN model, tax should be deducted from the source country as well as in the Residency State; even no exception is given to royalties. The laws in favor of both the states clearly signify that, it does not matter from which country the franchising income is generated, it will be taxed in the source country as well as in the State of Residence. This is because of the fact that although the franchising income is generated from the source country but the expenditure for the development of copy rights took place in the state of residence, therefore making the state eligible to have a contribution of tax is fair and logical. In practice, this franchising income is regarded as being generated from the state of residence because of the patents and technical know-how developed in the State of residence, which call for a large investment over a long span of time. As per the OECD model, tax on royalties is payable in the state of residence; the source country's authorities are completely deprived of the right to tax[footnoteRef:22]. [22: Ronald B. Davies, 'Tax Treaties, Renegotiations, and Foreign Direct Investment' (2003) 33 Economic Analysis and Policy 251-273.]

A sensible solution is to have sharing of tax; it is the first right of the source country to avail tax but at a lower rate, while the state of residence can also obtain a share to add in its revenues. Due to the priority of tax given to the source country, the country is encouraged to make investment in its technologies and thus gaining macro directive on its economic growth. In addition to this, the source authorities are even able to tackle the tax avoidance more successfully. The state of residence bears the risk and even makes efforts for the development of patents and other rights; therefore it would be unfair to deny them of their rights to tax. UN definition of royalty is being followed by quite a few developed countries that are adamant to gain the right of tax in the source country[footnoteRef:23]. [23: Ibid]