In this article we will discuss about the interpretation of tax treaties:- 1. Interpretation under Domestic Tax Rules 2. Interpretation under the VCLT 3. Model Conventions and Commentaries 4. Other Extra-Textual Material 5. Interpretative Rule under OECD MC Article 3(2) 6. Conflicts of Qualification.
Interpretation under Domestic Tax Rules:
Treaty interpretation rules differ from domestic tax rules for several reasons. For example:
1. As international treaties, VCLT governs double tax agreements. Therefore, their interpretation is based on the rules of interpretation under customary international law. As these principles and procedures of interpretation for agreements differ from rules applied to domestic legislation, an interpretation under the domestic law as a taxing statute may be misleading and unsuitable.
2. Unlike the domestic law, which contains highly technical legislative language relevant to a specific jurisdiction, tax treaties are based on the mutual understanding among two or more Contracting States. Moreover, more than one language may be involved. They must be applied by the tax authorities and the Courts in each Contracting State in a uniform way (“common interpretation”) that may differ from the domestic laws and practices in each State.
3. Tax treaties are primarily relieving in nature and do not impose tax, while the domestic tax law seeks to impose tax in specific circumstances. A treaty specifies general taxing principles to avoid double taxation. Moreover, as the life of a treaty can be long it must be flexible enough to adapt to changes in the domestic law while continuing to reflect the original negotiated balance of obligations and concessions.
4. Tax treaties tend to be less precise and require a broad purposive “substance over form” interpretation. Therefore, they are often interpreted more liberally than domestic law in the context of their object and purpose.
On the other hand, in States that prefer a liberal, purposive interpretation of their domestic law, the interpretation of tax treaties may be stricter than under the statutes. In both cases, a neutral interpretation and common understanding requires the use of an international fiscal language, which may not be found in the domestic laws and may provide a definition quite independent from domestic laws.
5. Treaty interpretation is a subject in itself and not merely an extension of statutory interpretation despite the fact that treaties may be enforceable only when made part of domestic law under a statute in certain countries. Therefore, tax treaties should be kept as free as possible from the interpretation rules under domestic law, unless specified in the treaty itself.
The primary purpose of double tax treaties is to avoid and relieve double taxation through equitable (and acceptable) distribution of tax claims between countries. Tax treaties require a common interpretation by both Contracting States to achieve this goal.
Common interpretation also leads to an international tax language and terminology and to reliance on similar legal decisions and practices in other countries, where appropriate. Most countries accept the common interpretative principles of the VCLT under customary international law. Strictly speaking, the VCLT, and not the domestic law of the Contracting States, governs the interpretation of treaties.
Interpretation under the VCLT:
The VCLT applies to all treaties including tax treaties. Tax treaties are binding rights and obligations on the Contracting States under public international law. They are agreements between two countries and not agreements between two taxpayers or a country and a taxpayer.
As international agreements, they are governed by the VCLT, either because it applies as a law-making treaty (traite loi) between the States, or because it reflects the customary international law applicable to them generally. The Courts generally apply the VCLT as “part of the law of the land”.
The Vienna Convention on the Law of Treaties (“VCLT”) of 1969 provides the general guidelines on treaty interpretation under the VCLT Articles 31 to 33. Additional guidance is provided in the official Commentary on the preliminary draft of the VCLT, as supplementary means of interpretation under Article 32.
Article 31 provides the general rule of interpretation. Article 31(1) states: “A treaty shall be interpreted in good faith in accordance with the ordinary meaning to be given to the terms of the treaty in their context and in the light of its object and purpose” (“basic rule”).
The basic rule of interpretation refers to the following:
(a) The “Ordinary Meaning” of the Words Based on the Actual Words in the Text:
1. The interpretation should start fundamentally with the natural meaning of the words in the text, as expressed (i.e. not intended) in the context in which they occur. Therefore, the written text of the treaty is of primary importance.
2. The interpretation should follow the “ordinary meaning”, i.e. the usual and natural meaning of the words. Where there is a difference, the ordinary meaning that defines the terms in the light of the object and purpose of the treaty should prevail.
3. The ordinary meaning of terms used in the agreement can be, but is not necessarily, the everyday usage. It is the uniform legal usage (e.g. international tax language) or the specific legal usage employed by the Contracting States.
4. A tax treaty is required to be interpreted as a whole and its meaning should be consistent with the entire agreement in its context and object and purpose, and not be based on its individual provisions.
5. The treaty terms should be given their true meaning when the treaty was concluded and not what the parties subsequently believe it to be. Identical terms should be given the same meaning.
6. A special meaning should be used only if it is established that the parties so intended (Article 31 (4)).
7. One should depart from the natural or plain meaning only in cases where:
(i) A different conclusion of the treaty partners is clear beyond reasonable doubt,
(ii) The language is “ambiguous or obscure”, or
(iii) It leads to a result that is “manifestly absurd or unreasonable” (VCLT Article 32).
(b) The “Expressed Intentions” of the Parties from the Terms of the Treaty in their “Context”:
1. The expressed intentions of the parties must be ascertained from the actual treaty text and not based on presumed intentions.
2. The treaty interpretation must be the literal (and not the purposive) language of the treaty, unless the overriding intentions of the contracting parties are beyond doubt.
3. The “context” is restrictively defined to include the entire text of the treaty, its preamble and annexures (VCLT Article 31(2)). It also covers additional material included in any related agreement or instrument, such as protocols, notes, letters, explanations or memoranda of understanding, which were mutually agreed upon by all treaty partners at the time the treaty was concluded.
4. Context does not normally result in a “special meaning”. It only serves to qualify the ordinary meaning of a treaty term. It is a relative term and not an absolute term. A treaty term, phrase or provision provides context in relationship to some other treaty term.
5. Other interpretative elements that are not considered as context but treated as primary materials similar to context (VCLT Article 31(3)) comprise:
(i) Any subsequent agreements between the parties on treaty interpretations.
(ii) Subsequent practices in the application, and
(iii) Any relevant rules of international law applicable to the relations between the parties.
(c) The “Object and Purpose” of the Treaty:
1. The term “object and purpose” is one term describing one object; it is not that object and purpose have separate meanings.
2. The purpose is not the subjective purpose of the parties but the objective purpose as evidenced by the treaty itself. It refers not to the “words” but the “intentions” of the parties as reflected objectively by the treaty as a whole. Title and preamble often summarise the object and purpose.
3. The object and purpose do not provide an independent method of interpretation of the individual treaty provisions. The treaty’s objectives may be used only in the general interpretation of the treaty text.
4. The object and purpose is determined by a textual approach; the intention of the parties is only important to the extent that the intention is reflected in the text of the treaty.
5. This rule does not prevent the rejection of a literal interpretation under international law when other factors so require. The common sense or purposive meaning must be relevant to the object and purpose.
The basic rule of interpretation under VCLT Article 31 is a single rule. It adopts a holistic approach for treaty interpretation. The ordinary meaning of the terms is determined by the expressed text in (not “and”) its context and object and purpose. Context is narrowly defined to include only the rest of the treaty and certain related documents connected with the treaty.
The object and purpose is also to be established from the treaty as a whole by examining any preamble and other related provisions. To understand the meaning, one needs to examine the text at the same time as its context and object and purpose.
It would be inappropriate to start with the words and then follow up with the context, and then the object and purpose. This approach does not permit a purposive interpretation unless it follows from the words of the text.
The rule also rejects both the subjective intentions based on the negotiators and the teleological (i.e. purposive) approach that relies on the general object and purpose of the treaty.
Therefore, it does not support a purposive approach as the object and purpose is only meant to define the text, which is the true expression of the intention of the parties. The meaning is determined from the expressed text only and ignores both the intention of the treaty negotiators and any other subjective views of the meanings within the treaty.
VCLT Article 32 permits the use of other relevant material as “supplementary means of interpretation” to avoid an ambiguous, obscure, absurd or unreasonable meaning under Article 31, or to confirm the Article 31 result. Extra-textual materials are not a substitute for the study of the tax treaty itself.
They do not constitute context and may only be used to confirm, but not to contradict, or as independent support for an Article 31 interpretations. It is not mandatory that it be looked at (although most commentators support a wide examination of potentially relevant supplementary material) and it can only be used as a secondary source to confirm the meaning under Article 31 if it is unclear.
Supplementary materials refer to the circumstances of a treaty’s conclusion (the historical background) and the preparatory work of the treaty or “travaux preparatoires” (negotiating history) when it was concluded.
They include extra-textual material, such as international legal practices and other tax conventions, judicial decisions and legal writings. Unilateral material that only represents the reasons and goals of one contracting party is not regarded as a supplementary means of interpretation.
Under the VCLT Article 33, the original versions of the treaty in the language of each party, or a third language (usually English or French), are equally binding. Normally, the third language is only called upon when the two versions in the languages of the parties differ. In the case of discrepancies in meaning, the selected meaning should reconcile with both (or all) texts.
In case of a drafting error, the object and purpose of the treaty guides the treaty interpretation, its context and the supplementary means of interpretation. Otherwise, the treaty is defective and the treaty provision is not applicable.
In summary, the VCLT approach is textual and the terms are interpreted in their context as well as their object and purpose.
There is a simultaneous examination of:
(i) The “ordinary meaning” of the relevant words,
(ii) Their “context”, and
(iii) The “object and purpose” of the treaty they form part of.
However, the text is the starting point and overrides other considerations. According to Vogel, “… the wording of a provision defines not only the starting point for interpretation but also its limit. Should the wording be unclear… national Courts may not replace the wording of the text with supposed intentions of the Contracting parties”.
The tax treaties are drafted by experts in international law. “It is reasonable to assume that those negotiating a tax treaty knew what they were doing, meant what they said, and said what they meant”. However, unlike domestic law, it may be given a broad (not literal) purposive interpretation, within its text and context when appropriate to make it workable.
Model Conventions and Commentaries:
Many countries use a Model Convention (“MC”) and its Commentaries for tax treaty interpretations. Generally, they use either the OECD MC or the UN MC. The OECD MC and its Commentaries reflect the views of the OECD Committee on Fiscal Affairs on the provisions and on their application to specific situations.
Similarly, the UN MC and its Commentaries represent the recommendations of the Ad Hoc Group of Experts appointed by the United Nations, and not the United Nations itself. The US Treasury applies the US MC for treaty negotiations with the United States, and many other countries have their own Model for that purpose. Both the UN MC and US MC essentially follow the form and text of the OECD MC.
The Model Conventions also provide a common format and wording as a basis for drafting bilateral tax treaties. The use of a standard form of words helps in the uniform interpretation and application of the treaties based on them.
They can be used either without any change or adapted, as appropriate, by the Contracting States. Any deviations and references are meant to reflect the intentions of the treaty negotiators at that time. Thus, they provide certain mutually agreed ground rules to eliminate elaborate analysis and discussions.
The Commentaries are an interpretation of the MC that has been adopted by OECD Member States as the primary basis for drafting and interpreting tax treaties. For non- OECD States, the Commentaries are a persuasive factor in treaty interpretation.
The Introduction to the OECD MC mentions:
“Although the Commentaries are not designed to be annexed to the Conventions signed by Member countries, which unlike the Model are legally binding international instruments, they can nevertheless be of great assistance in the application and interpretation of the Conventions and, in particular, in the settlement of any disputes”.
The use of the Commentaries is mandatory and not discretionary if it is relevant under Article 31, rather than Article 32. There are wide-ranging views among commentators. Under these views, the Commentaries may fall into any of the four qualifying categories under VCLT Article 31 or as supplementary means of interpretation under Article 32.
For example, some commentators regard the MC as part of the “context” under VCLT Article 31 of a treaty concluded by reference to it. The MC text at the time when the treaty was negotiated may also provide a special meaning intended by both parties to the negotiated agreement under VCLT Article 31 (4).
Some commentators regard the MC and the Commentaries when the treaty was concluded as a “soft obligation” on OECD Member States. The recommendations of the OECD Committee on Fiscal Affairs are deemed as an obligation on its Member States once they have been adopted by the OECD Council and approved by them, subject to their Observations and Reservations.
Therefore, in their view they should be considered as part of the context under the VCLT and not just supplementary means of interpretation. If the MC text is adopted unchanged it may be assumed that the Contracting States agreed to follow the OECD interpretation when the treaty was negotiated.
If the OECD text is not adopted literally, it may be presumed to follow the Commentaries to the extent that it is consistent with the MC. If the MC text is wholly disregarded, the Commentary may be ignored. In certain cases of treaty deviations from the MC, other treaties of the Contracting States may provide insights, but any inference should be made with caution.
The above view is not supported. Under the 1960 Statute of the OECD, its recommendations are only binding on the Member States if they are “opportune”, i.e. suitable or convenient. Hence, legally they are not binding on the governments, Courts or the taxpayers of the OECD Member States.
However, they may be treated as morally binding on the tax authorities. For non-OECD members, they are again persuasive, as a view of a group of tax experts comprising the OECD Committee on Fiscal Affairs. Despite their legal limitations, the OECD Commentaries and Reports are widely used by the Courts for treaty interpretations. In the Australian case of Thiel, the OECD Commentaries were accepted for treaty interpretation.
In the Crown Forest case, the Canadian Supreme Court held that “… a Court may refer to extrinsic materials which form part of the legal context (these include accepted Model Conventions and official Commentaries thereon) without the need to first find an ambiguity before turning to such materials”.
OECD Commentaries are generally considered as supplementary means of interpretation under Article 32. They may also qualify as context under Article 31 in certain jurisdictions but only the Commentary at the time when the treaty was concluded may be considered appropriate for that purpose.
The OECD MC and the Commentaries are now “ambulatory” documents, subject to “periodic and more timely updates and amendments without waiting for a complete revision”. They are issued in a loose-leaf format to facilitate more frequent updates.
The Introduction to OECD MC suggests that the existing treaties concluded under the previous or current Model treaties should be interpreted and applied along the lines of the latest Commentaries, where applicable, except where the OECD MC has been changed in substance.
The use of subsequent amendments or additions to the Commentaries as an interpretation of previously concluded tax treaties is not universally accepted. According to Vogel, “changes in the Commentaries after the conclusion of a tax treaty can neither amend the treaty, nor retroactively determine its interpretation”.
New developments or issues may be dealt with through interpretative changes in the Commentary but only within certain limits that do not substantially change the treaty itself.
The OECD Committee on Fiscal Affairs has attempted to make substantive changes in existing negotiated treaties through additions or changes in its Commentaries in recent years. Some commentators believe that these changes overprotect the interests of the tax administration at the expense of the taxpayers.
Therefore, they pose problems in terms of taxpayers’ rights and constitutional principles, and may not be accepted by the Courts in many countries. It is felt that the loose-leaf publications of the OECD MC and Commentaries, the “bias” in the role of the Fiscal Affairs Committee and the frequent updates could make the Commentaries lose their authority.
The ambulatory approach also creates problems under the VCLT on the legal basis for the reference to subsequent Commentaries. Under the VCLT, the new Commentaries are neither context under the general meaning nor special meaning, nor are they later agreements or practices regarding older treaties.
In certain OECD countries, the Commentaries may be considered as ordinary or special meaning for the interpretation of treaty terms under the VCLT, subject to their Observations and Reservations. In such situations, the applicable Commentary would be the version in force when the treaty was concluded. The dynamic reference may not be valid as a subsequent agreement or practice mutually accepted by both parties under VCLT Article 31(3).
Thus, the MC text may be considered as only a recommended format with no legal binding force either at the international or national level. It is simply a document concluded by an international organisation. The OECD Committee on Fiscal Affairs cannot amend the contents of a negotiated tax treaty through changes in its MC or its Commentary.
Subsequent versions of the text of the Model Convention using different wording are not applicable to an existing treaty, unless it is renegotiated. The changes in the text of the Articles in the MC do not affect previous agreements.
Although there is no agreed view on the legal status of subsequent Commentaries issued after a treaty has been concluded, they are widely used by taxpayers, tax authorities and, in particular, the Courts for guidance in interpreting older treaties.
They may be considered similar to advance rulings given by the tax authorities of the countries, which have formally expressed their position on them without any Reservation or Observation. In recent years, some countries have explicitly mandated their use by a protocol to a treaty (Example: Austria).
The Courts in several countries have accepted that both the MC and the Commentaries make a significant contribution to the common application and interpretation of tax treaties. They are part of the historical context of the treaty negotiations and help either to clarify (but not change) the treaty text or to confirm alternative interpretations.
Besides treaty interpretations, subsequent Commentaries contain the current thinking of the OECD Committee on Fiscal Affairs on international tax principles and on technical issues emerging from changes in business practices or technology (e.g. electronic commerce, hybrid instruments, global trading, etc.). However, for them too to be acceptable they should not make material changes in a bilaterally negotiated treaty or its objectives.
Other Extra-Textual Material:
Other extra-textual material includes:
(i) Mutual agreement procedures:
Article 25(3) of the OECD MC permits competent authorities to “resolve by mutual agreement any difficulties or doubts arising as to the interpretation or application of the Convention”.
The mutual agreement can be either:
(i) Interpretative to avoid doubts or difficulties, or
(ii) Legislative to avoid double taxation.
As subsequent agreements, they may be treated similar to context (VCLT Article 31(3)) or at least as supplementary data (VCLT Article 32). However, these interpretation agreements among competent authorities generally do not modify a treaty and may not be binding on the Courts.
(ii) Unilateral material:
Treaty interpretations by tax authorities may be helpful as a guide to a “common interpretation”. However, such materials or practices usually tend to be unilateral (i.e. giving the views of one Contracting State only) and hence may not be binding on the other State.
To be effective, the interpretation of tax treaties must be acceptable to the authorities and the Courts of both Contracting States. Similar comments apply to public and private rulings given by the tax authorities or other statutory bodies in certain countries. All the same, they can be useful as an interpretation aid for treaties and may be used with caution.
(iii) Judicial decisions:
Many countries now accept the “common interpretative principle” of legal decisions on treaty interpretation. In view of the use of Model treaties, this “common interpretation” of treaty provisions justifies the consideration of legal rulings in other countries, and references to international tax practices. The Courts or the authorities of one Contracting State may take into consideration the decisions made by the Courts or authorities of the other Contracting State (or even a third State).
(iv) Parallel treaties:
Parallel treaties are treaties on a similar subject matter concluded between third States or between one of the parties and a third State. Such treaties can provide interpretative guidance through their wording, explanatory notes and judicial decisions. For example, a similar provision may be contained, or left out, or be absent from another treaty.
Some commentators consider “parallel treaties” of limited value as an interpretation aid. As each treaty is a result of separate bilateral negotiations, the same wording in different treaties may have different meanings.
On the other hand, different wording may represent the same or different negotiating intentions. Moreover, revisions in subsequent treaties may not necessarily be applicable to earlier treaties. Despite these limitations, they often provide persuasive support when used with some caution.
Interpretative Rule under OECD MC Article 3(2):
The OECD MC provides a treaty interpretative rule under its Article 3(2). It mentions under General Definitions that “As regards the application of the Convention at any time by a Contracting State, any term not defined therein shall, unless the context otherwise requires, have the meaning that it has at that time under the law of that State for the purposes of the taxes to which the Convention applies, any meaning under the applicable tax laws of that State prevailing over a meaning given to the term under other laws of that State”.
As Article 3(2) is part of the treaty, it is also subject to the interpretation under the VCLT. The given meaning should enable the treaty provisions to be effective. Therefore, it must be performed in good faith and should not defeat the object and purpose of the treaty, i.e. to avoid double taxation and to prevent tax evasion.
The meaning need not always follow the definition under the domestic law. However, if used, the definitions under the domestic law of the taxes covered under the treaty have priority over definitions in other tax laws or in other laws.
Under Article 3(2), some of the questions that need to be answered are:
1. Does the treaty provide a definition of the term?
2. If the treaty does not provide a definition, what is the domestic meaning of the term?
3. Does the context require a meaning different from the domestic meaning?
Several terms are specifically defined in the OECD Model treaty. For example, Article 3(1) includes definitions of “person”, “company”, “enterprise”, “enterprise of a Contracting State”, “international traffic”, “competent authority”, “national” and “business”. The term “resident” is defined in Article 4(1), and “permanent establishment” in Article 5.
Additional definitions include “dividends” in Article 10(3), “interest” in Article 11(3), and “royalties” in Article 12(2), as applied to the respective Articles. These definitions, when they are present, have priority over Article 3(2). Additional definitions are also found in negotiated tax treaties under other Articles, protocols or explanations.
The tax treaty contains many other “terms” or “words”, for which there is either no given definition or the definition is partial or inconclusive, or limited to a specific Article only. Several treaty terms are either defined differently from, or not recognised in, the domestic tax law. As part of the treaty, Article 3(2) permits the use of the meaning under the domestic law in certain situations when the terms are not specifically defined under the treaty. The alternative would be to have a treaty definition for all the terms in the treaty.
Article 3(2) refers to the “meaning” of an undefined term and not its definition. A term may not be defined for purposes of a country’s tax laws but it should have an ordinary meaning. The reference to domestic law is limited to undefined “terms” and excludes legal principles or doctrine. It also does not permit a general interpretation of the treaty itself, or a use to clarify unclear treaty provisions.
As the rule applies to the terms used in the treaty, the reference to domestic law, unless they are defined in the treaty, is restricted only to those words or group of words. However, it is unclear whether the word “term” applies to both words and concepts.
The Article mentions that the domestic definition of undefined terms in the treaty should not be applied if “the context otherwise requires”. The phrase “unless the context otherwise requires” refers to the “expressed” and not the “implied” intentions of the Contracting States.
The domestic law definition will not apply if the context of the terms clearly suggests a specific definition. For example, the dictionary meaning may reflect the meaning of the treaty term in its context better than the meaning under the domestic law. This statement does not imply that the ordinary domestic definitions may be inappropriate in a tax treaty in all cases.
OECD MC Article 3(2) also leads to additional questions, such as:
(a) What is Context?
The VCLT Article 31(2) defines the context as comprising the text, including the preamble and annexes, and any related agreement or instrument made and accepted by the parties when the treaty was concluded. Many commentators do not accept this narrow definition for tax treaty interpretation.
They adopt a broad meaning of “context” under VCLT Articles 31 and 32 based on a consideration of:
(i) The treaty policies of the Contracting States both when the treaty was negotiated and subsequently,
(ii) The domestic tax environment when the treaty was negotiated and
(iii) The political, economic and diplomatic background of the treaty.
The broad definition includes not only the OECD MC and its Commentaries but also all their grammatical (analyse the whole law), historical (identify original intent), systematical (consider the provision as part of the whole law) and teleological (contemporaneous purpose) aspects.
The OECD Commentary also gives a wide meaning to the term “context” under Article 3(2). It defines context as the intention of the Contracting States when they signed the treaty as well as the current meaning given to the term in the domestic law of the other Contracting State.
The intention when signing the treaty also implies consideration of the domestic law meaning in both States at that time. Thus, these conditions effectively disallow the use of the domestic meaning by one State without proper consideration of the past and current meaning of the term in the other State.
According to the OECD Commentary, this safeguard ensures the required “permanency of commitment” in good faith (pacta sunt servanda) under the treaty and denies any change in the domestic law, which might make the treaty “partially inoperative”. Otherwise, a change in domestic law could effectively change the context.
(b) Does the Context always Take Precedence or Only if there is an Essential Difference?
The OECD Commentary specifically mentions that under paragraph 3(2) the domestic law applies “only if the context does not require an alternative interpretation”.
There are two differing points of view, as follows:
(i) The meaning under the domestic law is authoritative and should be used always, and the context is only applicable if the context otherwise requires; and
(ii) The meaning under the domestic law should only be used in the last resort, since context takes precedence.
In the first case, all the terms, which are not defined in the treaty, initially follow the domestic law of the State applying the treaty. The meaning under the treaty must be sought as a secondary option, only if the context demands it.
In the second case, the questions of interpretation are primarily resolved by reference to the double tax treaty itself. This approach relies on the treaty’s definitions and phrasing, followed by a careful study of the context within the entire agreement.
Assuming a broad definition of “context”, as defined above, it is contended that it should be always possible to establish an autonomous meaning under the treaty acceptable to both Contracting States (i.e. common interpretation), and a domestic meaning will rarely be needed.
Any reference to domestic law would be limited to:
a. Treaty provisions referring expressly to domestic law,
b. Situations in which the context or supplementary interpretation convincingly suggests a reference to domestic law, and
c. Situations in which no convincing interpretation exists in the treaty in its context or in supplementary sources.
As a third alternative, the meaning of undefined terms may be determined by reference to all of the relevant information and all of the relevant context. To “apply” the treaty is not the same as to “interpret” it. Under this approach, both the domestic and treaty meanings are given equal significance for treaty interpretation.
(c) Is the Meaning of the Treaty Term Based on the Applicable Domestic Law when the Treaty was Concluded (“Static Approach”), or When it was Applied (“Ambulatory or Dynamic Approach”)?
As from 1995, Article 3(2) recommends the use of a dynamic approach, provided the context does not suggest otherwise. It mentions that the interpretation of terms should use the current meaning (“the meaning that it has at that time”) under the domestic law of the State applying the treaty.
Although a dynamic approach keeps pace with changes in the domestic law, a Contracting State could override the treaty unilaterally through subsequent changes in either the domestic meaning or the scope of undefined terms. If such a change affects the basic intentions of the treaty partners, it is contended that the qualification “unless the context otherwise requires” should provide a safeguard against any possible treaty abuse.
Some countries (Examples: Australia, Austria, Belgium, Canada, Germany, Norway, United Kingdom, United States) now accept the ambulatory meaning of treaty terms. Australia and Canada have ensured the use of the ambulatory approach through special domestic legislation. However, the approach is still not widely accepted by many other countries.
In several countries, the current use of the meaning under the domestic law would be deemed as a treaty override and should be avoided, unless it can be accepted as a subsequent practice under VCLT Article 31(3)(b).
Similar concern also arises in the use of subsequent Commentaries on existing treaties. Unlike domestic law, OECD Commentaries present the views of the OECD and its Committee on Fiscal Affairs and do not have the appropriate parliamentary approval.
A suggested approach is the use of an ambulatory method for changes in domestic law under Article 3(2) but a static method for post-treaty changes in the Commentaries. Thus, subsequent changes in the OECD Commentaries cannot override the text of the treaty.
The OECD MC Article 3(2) and its Commentary support the ambulatory interpretation provided the meaning of the terms of the original treaty as originally negotiated between the Contracting States is not seriously altered.
The subsequent Commentaries are supposed to reflect a common view as to what the meaning is and always has been and not to a new meaning, i.e. an elaboration rather than a change. Often, a study of the changes in the Commentary over time may be necessary to understand a treaty provision.
(d) Should the Domestic Interpretation of Terms in one Contracting State be Legally Binding on the Other Contracting State?
The reference to the domestic laws of both Contracting States could lead to either double taxation or double non-taxation, if they have conflicting meanings under their respective laws. The Pierre Boulez case highlighted this problem when the US tax authorities disagreed with the German tax authorities.
The payments to Boulez were treated as “royalties” in Germany, but the US IRS held that they were “compensation for personal services” in the United States. The case led to double taxation since the tax authorities in the USA and Germany were unable to agree on a common definition.
Article 3(2) mentions that “As regards the application of the Convention… any term not defined therein shall, unless the context otherwise requires, have the meaning that it has at that time under the law of that State…” The phrase “application of the Convention” under this Article refers to any decision by tax authorities or Courts concerning tax matters where the treaty is or is likely to be considered.
Hence, both States can claim to apply the treaty. While the treaty restricts the taxing rights of the source State under the classification and distribution rules it also requires the Residence State to grant treaty relief by tax exemption or credit. The words in Article 3(2) require both States to apply their own domestic law.
Some commentators take a narrow meaning that describes the situation as one where one State “applies” the treaty to restrict its taxing rights while the other State merely “reads” the treaty. In their view, only the source State applies the treaty since it alone is restricted under the treaty provisions from applying its own domestic tax laws.
The Residence State only reads the treaty to determine whether the source State has correctly applied the Convention before giving the relief for double taxation. It only “applies” the treaty in accordance with the law of the source State. Therefore, the definition under the domestic law of the source State should apply and the residence State should accept this definition if the meaning under the two countries differs.
The OECD Commentary Update 2000 has adopted the latter view and suggested that the “qualification” conflicts should be avoided by obliging the residence State to accept the categorisation of the source State.
According to Vogel, the treaty’s special rules of interpretation should take precedence over Article 3(2). Neither the use of the domestic law in interpreting tax treaties nor the use of domestic definitions of terms is justified if they are not applicable under the treaty provisions.
Conflicts of Qualification:
Under the MC, Article 3(2) is the treaty interpretation rule. This Article allows a State to use its domestic law meaning when a term is not defined in the treaty, unless the context otherwise requires. The rule provides a choice between the meaning under the domestic law and an autonomous or independent meaning.
Although an autonomous meaning under the context to achieve a common interpretation is preferable, it may not be always feasible. Moreover, often States prefer their domestic meaning (“lex fori”), when applying the treaty, for convenience and ease of use. They may also prefer it since it avoids the waiver of their sovereign taxing rights under the treaty from what is mentioned in their domestic law.
One of the reasons for double taxation (or double non-taxation) when domestic laws are used is differing qualification, i.e. characterisation (also called classification or categorisation), of the same income in the two States. The treaty uses terms derived from the domestic laws but the terms have different meaning.
These undefined terms in the treaty can then be interpreted to have the meaning in either of the two States or even a third interpretation. The problem that arises when the two Contracting States apply different distributive rules on the same income and taxpayer due to different meanings of treaty terms in the two Contracting States is called a “conflict of qualification” in international tax law. Similar problems also arise under a “conflict of attribution” when both Contracting States apply the same distributive rules but to different taxpayers.
Some commentators had suggested in the early nineties that the qualification according to the source State should be adopted in such cases. Under this rule, the Residence State should accept the categorisation of the source State and grant treaty relief even if it would have characterised the income differently under its own domestic law.
This approach was further developed in the OECD Partnership Report 1999 and recommended by the OECD Committee on Fiscal Affairs in their Commentary Update 2000.
The new approach is contained in the OECD Commentary on Article 23 under “Conflicts of Qualification”. It provides that the phrase “in accordance with the provision of the Convention may be taxed”, as used in the Article, be given another interpretation.
In the case of qualification conflicts arising from differences in the domestic law of the Contracting States, the source State would have taxed in accordance with its provisions when, following Article 3 (2), if it applies its domestic law to determine whether the treaty permitted it to tax.
Therefore, the Residence State is obliged to grant relief from double taxation under Article 23, regardless of its own different qualification. An autonomous meaning under Article 3(2) would only be required when the source State did not have a domestic meaning or it was required by the context.
The recommended approach, however, contains several limitations, such as:
(a) The approach avoids qualification issues only when different provisions of the treaty are used by the Contracting States in determining the treaty category of income due to differences in their domestic laws. Moreover, the Residence State is obliged to give treaty relief for source taxation only if it is satisfied that the source State has correctly applied its domestic law.
There is no obligation to give relief if double taxation is due to either:
(i) Differing interpretation of the facts or
(ii) Different interpretations of the treaty provisions.
In such situations, double taxation must be avoided under the mutual agreement procedure (Article 25).
(b) The approach does not avoid conflicts of qualification involving treaty provisions other than Article 23. This relieving Article applies when the treaty provides for “may be taxed” (“open”) rights to the source State with subsequent tax relief to be given by the Residence State.
The Article does not apply when the distributive rules provide for “shall be taxable” (“complete”) rights to one of the two States. In addition, it may not resolve conflicts due to non-distributive provisions in a treaty.
(c) The approach does not prevent double non-taxation if the Residence State provides relief under the exemption method. The source State may apply a provision of the treaty that either limits (e.g. Articles 10 and 11) or excludes its right to tax, while the Residence State takes the view that the taxing right belongs to the source State and it must give an exemption.
Unlike double taxation, double non-taxation cannot be avoided through the mutual agreement procedure (Article 25).
To avoid this double non-taxation, the Commentary makes certain additional recommendations, such as:
(i) If the double non-taxation is solely the result of differences in domestic laws of the two States, it must be granted since it is not the result of applying the treaty. However, if it arises as a result of the interaction of the domestic tax rules with the provisions of the treaty, then the residence State is not obliged to exempt the income under Article 23 A( 1).
It may presume that the source State has not taxed the income in accordance with the provisions of the treaty.
(ii) If the double non-taxation arises due to different interpretations of the facts or treaty provisions, the new paragraph 23A (4) should be added to the treaty text and applied to permit the Residence State to deny (“shall not apply”) the exemption relief under the treaty to the taxpayer.
The suggestions above of the OECD Committee on Fiscal Affairs assume that the avoidance of double non-taxation is one of the treaty objectives. For this purpose, it relies on the object and purpose of a treaty to avoid double taxation and then takes the view that double non-taxation should be avoided.
The new approach has several critics and few countries have used it so far.
Some of the concerns expressed are as follows:
a. The new approach requires the residence State to accept the characterization under the domestic law of the source State. This acceptance may affect the allocation of taxing rights of the Contracting States, as negotiated by them. Moreover, the new approach could lead to treaty abuse by the source State through subsequent changes in the meaning of a term under the domestic law.
b. The new approach is an attempt by the OECD Committee on Fiscal Affairs to modify the Model treaty through subsequent changes in its Commentary. It is, therefore, unlikely to be accepted under VCLT by the Courts (and taxpayers) in many countries.
In any case, the Commentary can only clarify and provide guidance on treaty interpretation and not make radical changes that affect the context. Moreover, the change cannot be applied on treaties concluded prior to the Commentary Update 2000 since a dynamic interpretation will be unacceptable in such cases.
c. Although some countries regard double non-taxation as undesirable, very few countries consider it as a treaty objective or accept the “single taxation principle” that require that all income be taxed in at least one State. Double non-taxation may be intended or unintended but does not constitute tax evasion.
Double non-taxation is considered a problem only if it is inappropriate or abusive. If double non-taxation is unintended or unlawful and abusive, the treaty should be modified. Moreover, any “subject to tax” provisions should be included in the treaty itself and not inferred from the Commentary.
d. There may be situations where either the State’s internal law is not applicable or a State does not have an appropriate domestic meaning, or it contains more than one meaning. In such cases, a meaning, using the interpretation rule under the VCLT, may be necessary to achieve a common interpretation of the treaty.
Despite these limitations, many supporters of the new approach believe that it does provide a practical solution in case of most qualification conflicts. Moreover, in their view the interpretation can also be justified under the VCLT.
Some of them, however, agree that as the dynamic interpretation of the Commentary may not be acceptable, the new provisions can only apply to treaties concluded after the issue of the Commentary Update 2000.
Ideally, an autonomous meaning acceptable to both treaty partners should be sought. If the autonomous meaning in the two States differs, any disagreement may then be resolved through the mutual agreement procedure under Article 25(3).