In this article we will discuss about the model tax conventions:- 1. Historical Background of Model Tax Conventions 2. How do Model Tax Treaties Work 3. Relief against Juridical Double Taxation 4. Benefits of the Model Tax Treaties – Some Examples 5. OECD and UN Model Conventions – Comments.
- Historical Background of Model Tax Conventions
- How do Model Tax Treaties Work
- Relief against Juridical Double Taxation
- Benefits of the Model Tax Treaties – Some Examples
- OECD and UN Model Conventions – Comments
Historical Background of Model Tax Conventions:
The first contemporary bilateral tax treaty on income and property was signed between Prussia and Austro-Hungary in 1899. After the First World War, the League of Nations took the initiative to evolve an internationally acceptable double tax treaty.
In 1921, the Finance Committee of the Council of the League of Nations commissioned four eminent economists (Bruins, Einaudi, Seligman and Stamp) to study the issue of double taxation and tax avoidance. Their 1923 Report regarded double taxation as a barrier to new foreign investment, and considered that the function of the tax treaty was to promote such investment by removing this trade barrier.
The treaty fulfilled this goal by preventing double taxation. Thus, the encouragement of foreign investment was the end and the avoidance of double taxation was just one of the means to achieve it.
The Financial Committee of the League also appointed in 1922 a group of international tax officials to study the administrative and practical aspects of international double taxation and tax evasion. Several model tax treaties drafted by them were finally presented at a General Meeting of Government Experts held in October 1928 in Geneva.
In 1929, the Council of the League of Nations appointed a permanent Fiscal Committee. This Committee issued its draft Model Convention for the Allocation of Business Income between States for the Purposes of Taxation in 1933 (revised in June 1935).
Although the 1935 Draft was never formally adopted, it was subsequently combined with the 1928 Geneva Draft to produce eventually the draft Mexico Model in 1943. This draft treaty included both the prevention of double taxation and the allocation of taxing jurisdiction among its objectives.
In March 1946, the Fiscal Committee met in London when a revised draft Model was discussed at their tenth meeting. While the Mexico Draft approved source-based taxation and favoured capital-importing countries, the London Draft gave more taxing rights to capital-exporting nations, particularly on dividends, interest, royalties, annuities and pensions.
The work of the League of Nations was taken over by the Fiscal Commission set up by the Economic and Social Council of the United Nations (ECOSOC) in October 1946. In 1951, the London Draft was abandoned in favour of the Mexico Draft.
The subsequent efforts of the Fiscal Commission were unable to reconcile the taxing interests of the capital- exporting (or developed) and capital-importing (or developing) countries and it suspended its work in 1954.
The Organisation for European Economic Co-operation (“OEEC”) took over the initiative in the late fifties. Its Fiscal Committee was requested to draft a Model treaty in 1956. From 1958 to 1961, the Committee prepared four interim Reports and finally published the first Draft Double Taxation Convention on Income and Capital (“OECD Model” or “OECD MC”) in 1963.
The Fiscal Committee (renamed the Committee on Fiscal Affairs in 1971) evolved a Model treaty draft based on the 1946 London Draft. Its recommendations were adopted by the Council of the OECD in July 1963 (“1963 Draft”). A revised MC was published in 1977 (“1977 Model”).
It was later revised in 1992 (“1992 Model”), and subsequently updated in 1994, 1995, 1997, 2000 and 2003. A further update is expected in 2005. Since 1992, the MC and its Commentaries are published by the OECD Committee on Fiscal Affairs in an ambulatory form (loose-leaf) to permit continuous future updates.
The OECD, as a group of developed countries, had similar taxing interests and tax treaty policies. Its Model treaty was intended for the use by its Member States, who had comparable tax systems and tax objectives, particularly on taxing rights of the State of residence.
It was based essentially on two premises:
(a) The country of residence would eliminate double taxation through the credit method or the exemption method; and
(b) The country of source, in response, would considerably restrict the scope of its jurisdiction to tax at source and reduce the rates of tax where jurisdiction was retained. Many countries felt that this approach did not address sufficiently the concerns of developing countries.
The UN Manual states in its Introduction:
“Bilateral tax treaties have been negotiated in the light of various monetary, fiscal, social and other policies important to the negotiating parties. Conclusion of a treaty between two developed countries is facilitated by their approximately similar levels of development, so that the reciprocal flows of trade and investment and hence the respective gain or loss of revenue to the parties from reducing taxes on those flows – have been relatively equal in magnitude. The presumption of equal reciprocal advantages and sacrifices underlying treaties between developed countries is not valid when the negotiating parties are at vastly different stages of economic development”.
The Fiscal Committee of the OECD also recognised as early as 1965 that its Model treaty was not appropriate for capital importing countries. Since income flows were largely from developing to industrialised countries, the revenue sacrifice was one-sided. This factor required greater allocation of taxing rights to the developing country in the various Articles of the Model.
In the mid-1960s, the United Nations took renewed interest in the problem of double taxation “as part of its action aimed at promoting the flow of foreign investment to developing countries”. In August 1967, ECOSOC decided to set up an ad hoc working group to develop an appropriate framework for tax treaties between developed and developing countries and to provide guidelines for their negotiation.
The committee called the Ad Hoc Group of Experts on Tax Treaties between Developed and Developing Countries comprising independent tax experts were appointed in 1968. The Committee’s efforts led to the UN Model treaty.
The Group was renamed as the Ad Hoc Group of Experts on International Co-operation in Tax Matters and enlarged in 1980. The enlarged Group comprises 15 members from developing and 10 members from developed countries.
The UN Model Convention between Developed and Developing Countries (“UN Model” or “UN MC”) was issued in 1980 with its own Commentaries. An updated version was adopted in January 2001.
A companion publication – Manual for the Negotiation of Bilateral Tax Treaties between Developed and Developing Countries – was also published in 1979 (revised in 2003). The term “UN Model” does not imply that it contains formal recommendations of the United Nations.
Besides the two Model Conventions, many countries also have their own “model” treaty, which they use mainly in their treaty negotiations. These “model” treaties reflect their treaty policy based on domestic tax system and negotiating objectives. Most of them are unpublished.
Some examples include:
1. The US Treasury Department published a Model Income Tax Convention in 1981, but withdrew it subsequently in 1992. A new US model treaty (“The 1996 United States Model Income Tax Convention” – US MC) was released in September 1996.
It offers insights into the US Treasury’s views on treaty interpretations, and its negotiating posture in tax treaties, particularly its right to tax its citizens and corporations on their worldwide income.
It also contains a separate section with detailed explanations (“Technical Explanation”) The US Model reflects its domestic policy, as a major net capital exporter, on anti-abuse rules such as treaty shopping, tax sparing and CFC rules. It contains a detailed Limitation on Benefits Article (Article 23). It also provides a “saving clause” to retain the taxing rights over its own residents (Article 1(4)).
2. The Netherlands Model of 1987 is similar to the OECD MC. The Dutch model allows for source tax exemption of interest and royalties, for reciprocal relief for pension contributions, and for tax arbitration and mutual assistance in collecting taxes. The Model also provides for capital gains tax on substantial participations by nonresident individuals.
The 1987 Model is provided with detailed explanations and subsequent updates. The OECD/Council of Europe Convention on Mutual Administrative Assistance in Tax Matters (1988) provides compliance assistance to tax authorities on a multilateral basis. It applies to all kinds of taxes, including social security contributions, and assists in the recovery of taxes. The Convention came into force on April 1, 1995.
The chronological history of the evolution of Model tax treaties over the years is as follows:
(a) League of Nations:
Bilateral Convention for the Prevention of Double Taxation in the Special Matter of Direct Taxes (1928 Draft)
Double Taxation and Tax Evasion Convention for the Allocation of Business Income between States for the Purposes of Taxation (1935 Draft)
Bilateral Convention for the Prevention of the Double Taxation of Income with Protocol (Mexico Draft)
Bilateral Convention for the Prevention of the Double Taxation of Income and Property with Protocol (London Draft)
(b) Organisation for European Economic Co-operation/Organisation for Economic Co-operation and Development:
Draft Double Taxation Convention on Income and on Capital (1963 Draft)
Model Tax Convention on Income and on Capital 1977 (1977 MC)
Model Tax Convention on Income and on Capital 1992 (1992 MC), as updated in 1994, 1995, 1997, 2000 and 2003. The next update is proposed in 2005.
(c) United Nations:
Manual for the Negotiation of Bilateral Tax Treaties between Developed and Developing Countries (1979)
United Nations Model Double Taxation Convention between Developed and Developing Countries (1980)
United Nations Model Double Taxation Convention between Developed and Developing Countries (2001)
Manual for the Negotiation of Bilateral Tax Treaties between Developed and Developing Countries (2003)
(d) United States:
United States Model Income Tax Convention (1981 with earlier Drafts in 1976 and 1977)
United States Model Income Tax Convention of September 20, 1996
How do Model Tax Treaties Work:
The main objective of the Model tax treaties is to avoid simultaneous taxation in both countries under their domestic tax laws. They are an attempt to resolve some (but not all) of the problems of overlapping tax jurisdictions through internationally accepted tax rules.
They recognise that each State is entitled to exercise its sovereign taxing rights within its fiscal jurisdiction. To avoid double taxation, the States must agree to limit their own domestic tax rules under the tax treaty.
The Model tax treaty contains classification and assignment rules (also called “distributive rules”) for income subject to taxation under the domestic law of both States. Under a schedular system, tax objects (e.g. income, profit, capital) are placed in income categories with specified treaty “source rules” to avoid source conflicts, and the taxing rights over them are then allocated through the “assignment rules” to one or both of the Contracting States.
The schedular structure of the Model treaties categories different classes of active and passive income. These income categories are further sub-divided into various types of business and investment income.
Active business income is usually allocated to the source State and passive investment income to the Residence State. The State to which the taxing rights are not assigned either exempts or taxes the income with credit for the taxes paid in the other State.
Under the treaty distributive rules, there are more than fourteen categories of income that cover the entire tax base. They comprise of standard clauses (called Articles), which may be amended in negotiations by the Contracting States.
These Articles may be grouped under:
a. Personal scope:
The treaty applies to tax residents of one or both Contracting countries under the respective domestic laws.
ii. Material scope:
The treaty includes income and capital taxes at federal, state and municipal levels, irrespective of the manner in which it is imposed.
iii. Territorial scope:
The treaty specifies the geographical area or tax jurisdiction covered under the tax agreement.
iv. Temporal scope:
Generally, the duration of the treaty is indefinite once the treaty is ratified, but it can be terminated or renegotiated as and when required.
v. Distributive rules:
The treaty provides the rules for the avoidance of double taxation on income or capital.
vi. Method of relief:
The Articles contain the recommended methods for relief in cases of double taxation between the two tax jurisdictions.
The Model treaties distinguish the income under each Article and then specify the State, which has the right to tax them under its “assignment rules”.
The “assignment rules” allocate either an exclusive or a limited taxing right to the two countries, using one or more of the following distributive principles on different income sources:
i. The exclusive right to tax is with the country of source of the object.
ii. The source country reserves the right to limited or “shared” taxation of the object.
iii. The source country may tax fully but does not have exclusive taxing rights.
iv. The exclusive right to tax is with the country of residence of the subject.
Thus, under these rules the source State bears the tax costs (i.e. loss of tax revenue), in cases where the State of residence has exclusive taxing rights. The State of residence bears the costs when the State of source has exclusive taxing rights, and when both States retain the full rights to tax.
The Residence State is obliged to grant treaty relief for the foreign taxes paid. In cases where both States share their taxing rights, the cost of eliminating double tax is also shared. In summary, the treaty provides a tax-sharing agreement between two Contracting States. The States either receive or give up their taxing rights on various heads of income, and then obtain a commitment from the State of residence to relieve any juridical double taxation.
Model tax treaties are relieving in nature. Most of its provisions are designed to create rights and benefits for taxpayers where none would otherwise exist. They allocate taxing rights but do not make the tax rules, which are based solely on domestic law.
They do not require that the allocated taxing rights must be exercised by a State or dictate how they must be exercised. The use of treaties is also optional since the taxpayer can choose in many countries to apply the domestic tax law if it is more beneficial. The Model treaties may reduce but normally do not increase the taxing rights under the domestic law of each State.
Conflict rules under international law determine which law applies when a transaction or event is subject to two or more legal systems. According to Vogel, tax treaties, unlike conflict rules in private international law, do not have to choose between applicable domestic and foreign law.
Each Contracting State applies its own domestic law and then limits the application of that law under the treaty. Treaties establish an independent mechanism to avoid double taxation through a restriction of tax claims in areas where overlapping tax claims are expected, or are at least theoretically possible.
Therefore, strictly speaking, there are no taxing rules under international law. Treaty rules neither allocate taxing rights, nor resolve tax conflicts, nor do they provide source rules under international tax law.
As a bilaterally negotiated treaty, a treaty only creates obligations under international law to impose certain limits on the domestic tax provisions of the Contracting States. Thus, they are an extension of domestic tax rules affecting international transactions that are binding under international rules governing treaties. A tax treaty can be regarded as a lex specialis (e.g. special case) of domestic tax law.
Relief against Juridical Double Taxation:
According to the OECD MC Introduction, the main purpose of the Model Tax Convention is to provide “a means of settling on a uniform basis the most common problems that arise in the field of international juridical double taxation”.
Tax treaties provide for the relief to be given by the Residence State for juridical double taxation. Unless the source State agrees to forego or limit its rights under a tax treaty, it exercises its rights first, as and when the taxable income arises. The country of residence is then obliged to give relief to avoid the double taxation.
There are two methods for the State of residence to relieve double taxation of income:
(a) Exemption method:
This method avoids or eliminates double taxation by exempting the income from tax in the Residence State. It may be “full exemption” or “exemption with progression”. The exemption may be conditional on the levy of tax by the source State under the treaty. However, as treaties allocate taxing rights, and not taxation, double non-taxation can arise.
(b) Credit method:
This method prevents or partly eliminates double taxation in the State of residence through the grant of credit for taxes paid in the source State.
The tax credits could be based on:
i. Ordinary or partial credit (i.e. limited to the amount of tax due on equivalent income, as computed under the domestic tax rules).
ii. Indirect credit for the underlying tax levied in the source State on dividend income.
iii. Tax sparing or matching credit for the tax not levied (i.e. “spared” by the source country) due to incentives or allowances. Tax sparing is a concession to ensure that the foreign tax incentives granted to attract foreign investment capital for particular activities are not recaptured by the Residence State.
Both exemption and credit methods of double tax relief have advantages and disadvantages. For example:
(a) Exemption method:
i. It is capital-import neutral, i.e. it treats all taxpayers in the source State on the same tax basis.
ii. It recognises fully the tax benefits granted by the source State.
iii. It is the least complex administratively.
iv. It avoids dealing with two tax authorities.
v. It eliminates actual and potential double taxation.
i. It reduces the tax revenues due to the State of residence.
ii. The source State may deny certain allowances or deductions.
iii. The losses of the permanent establishment may be disallowed by the residence State
iv. It requires detailed financial Statements if exemption is given with progression.
v. It encourages the use of low-tax countries or tax havens as source or residence States.
(b) Credit method:
i. It is capital-export neutral, i.e. it treats all taxpayers in the residence State on the same tax basis.
ii. It allows the deduction of foreign losses of permanent establishment in the home country.
iii. It discourages the transfer of assets or income to low-tax countries or tax havens.
iv. It is easy to apply since the tax authority giving the tax credit computes the amount under its own laws and does not have to consider the foreign tax system.
i. The taxpayer always pays the greater of foreign and domestic taxes.
ii. It could lead to excess foreign tax credits that may not be useable.
iii. It eliminates the tax relief and incentives given in the source State, unless the residence State spares the tax.
iv. It makes the export of capital less attractive.
v. It is complicated and can be time-consuming.
The choice often depends on the national policy on capital export neutrality or capital import neutrality. Many developed countries prefer the credit system since it is capital- export neutral and treats both domestic and foreign investors fiscally on par. The exemption method is capital-import neutral. Unlike the credit method, tax exemption eliminates both factual and potential double tax.
Tax treaties restrict the taxation in one or both Contracting States but may not eliminate double taxation in all cases. For example:
a. Tax conflicts could arise because of differing definitions of terms, under the treaty and the domestic law. This problem may become an issue when there is no autonomous or treaty definition and the domestic laws of the two States do not have a common or clear definition of the terms used in the tax treaty. As a result, the same income may be categorized or classified under two differing treaty provisions.
b. The Contracting States may interpret the same treaty provision differently and arrive at differing conclusions on its applicability. As a result, the residence State may not provide relief for source taxes leading to double taxation.
c. The two Contracting States may apply different treaty rules on the same income due to differing treaty interpretations arising from overlaps in the treaty rules or unclear provisions.
d. Double taxation could also arise under the credit system, despite the treaty relief. For example, since the credit is based on the equivalent tax in the residence State under its domestic tax rules, the differences in how the tax is computed could lead to disallowed tax credits for the foreign taxes suffered.
e. Tax treaties normally do not relieve economic double taxation.
Benefits of the Model Tax Treaties – Some Examples:
The benefits of the Model tax treaties include:
a. They facilitate international trade and investment by eliminating tax impediments under the domestic tax laws of countries on cross-border income flows. They assist global taxpayers chiefly, but not exclusively, to avoid double taxation through provisions that restrict the domestic taxing rights of each Contracting State, and provide tax relief when it arises.
b. They provide an internationally accepted format for drafting and negotiating bilateral agreements affecting income taxes. The treaty text classifies the income by type of income and source and provides the rules to assign or distribute them between the Contracting States. In the case of juridical double taxation, it specifies the method of relief that can be used for eliminating them. The treaty applies to all income taxes, including taxes imposed by provincial or state, local and sub-national bodies.
c. They provide for a negotiated division of taxing rights over foreign source income of residents under an internationally accepted agreement governed by customary international law. In particular, they set out the ultimate limits of the taxing powers under the domestic laws of the two States involved. Although the allocation of taxing rights remains a primary consideration in all treaties, it cannot be done unilaterally.
d. They provide certainty over source rules. These rules avoid conflict with domestic source rules, if they are different, and ensure relief from double taxation in the residence State. As an internationally accepted agreement, they also restrict the rights of the tax authorities and thereby avoid ad hoc decisions taken by them.
e. They provide certainty over time for taxpayers and assure international investors of a stable tax system. On average, the tax treaties of OECD countries remain unchanged for 15 years after they are signed or after a protocol is concluded, unless they are terminated, renegotiated or overridden.
In most countries, changes in domestic tax laws are made every year. Since treaties generally override domestic law, the treaty guarantees the taxpayers that future increases in taxes over the treaty limits will be restricted.
f. They eliminate discriminatory taxation of foreign nationals (including stateless persons) and nonresidents and provide a mechanism to resolve tax disputes through mutual consultations. They also help the tax authorities in the prevention of tax evasion through the exchange of tax-related information. A recent addition to the treaty (Article 27) also permits them to request assistance in the collection of taxes.
g. They avoid excessive taxation in source States. The treaty provisions require the source State to grant selective tax benefits (e.g. reduced withholding taxes) and tax exemptions, based on negotiations, to the Residence State. Moreover, as treaties are primarily relieving in nature, they do not impose tax. Generally, tax treaties cannot make the taxpayer worse- off than he would be under the domestic tax law.
h. They assist global tax planning on cross-border transactions.
i. Tax treaties are needed because national tax laws of various countries differ.
OECD and UN Model Conventions – Comments:
What differentiates the UN MC from the OECD MC is the primary objective of each Model. The OECD MC mentions in its Commentary that “the principal purpose of double taxation conventions is to promote, by eliminating international double taxation, exchanges of goods and services, and the movement of capital and persons. It is also a purpose of tax conventions to prevent tax avoidance and evasion”.
The UN MC takes a broader view of taxation as a means to promote the flow of foreign investment to developing countries. It mentions in its Introduction: “there is a need for international and regional organisations to provide guidelines to facilitate conclusion of tax treaties with a view to promote trade liberalisation and expansion as well as socio-economic growth”. It is a tool for economic growth and not just an agreement for the sharing of taxing rights.
Developing countries using the UN MC often (but not always) mention the promotion of mutual economic relations, trade and investment as one of the objectives of their tax treaties.
This objective gives the treaty a wider perspective than just avoidance of double taxation. It justifies double non-taxation when countries give up their taxing rights, in cases such as tax sparing. It also permits tax treaties with countries that do not levy direct taxes on some or all of its residents.
The wider objectives of the UN MC also permit intended treaty shopping to meet non- fiscal goals through tax treaties. Like tax sparing, this could provide tax benefits to the foreign investor when as a source country it is prepared to give up its taxing rights for other non-fiscal benefits.
According to a recent Indian Supreme Court decision, treaties “are negotiated and entered into at a political level and have several considerations as their bases”. The latter may be political, social or economic in nature. In case of treaty abuse due to unintended use of a tax treaty, the Court held that this should be dealt with through specific Limitation on Benefits clause in the treaty.
The drafters of the OECD Model assumed that the countries have more or less the same tax bases and the same tax systems. The UN Model is meant for treaties between countries with unequal economic status. While the OECD MC presents the views of developed countries and advocates CEN and residence taxation, the developing countries as net capital importers generally prefer CIN neutrality and more source taxation.
They also prefer the UN MC for its wider treaty policy objective than just taxation and tax sharing, i.e. to promote social and economic growth. For developing countries, treaties are a means to an end and not an end in itself.
Model tax treaties deal with direct taxation only. The treaty objectives are also affected by the different policy on direct taxation of developing countries when compared with developed countries.
Moreover, direct taxation often does not constitute the main source of government revenue and is considered both less significant and more cumbersome and costly to collect. As many developing countries rely more on indirect taxation, they can justify low or nil direct taxes under the domestic law and/or tax treaties for wider policy reasons.
The UN MC is widely used by developing countries as a treaty policy document that favours source-based taxation and non-fiscal objectives. Its provisions are also found in many treaties concluded by transition countries in Eastern Europe. The UN MC has also influenced the tax treaty policy of several OECD Member States.
Nevertheless, the reputation of the OECD Committee on Fiscal Affairs and its research on international tax issues is recognised. The developing countries often rely on the OECD MC and its Commentaries for guidance on issues involving treaty interpretation, where necessary, to supplement the UN MC Commentaries.
Tax treaty policy of countries is influenced by their political, economic and social needs. While OECD Committee on Fiscal Affairs performs an excellent role as an international “think tank” on tax-related technical issues, its views on tax treaty policy understandably favour its Member States.
To be a legitimate international body, the OECD should take into consideration and meet the expectations of both developed and developing countries and act, as well as be seen to act, in their overall interest. Moreover, it should involve all of them in the formulation of its views. Only a truly world tax organisation can fulfil such an ideal goal.