- This chapter will provides us with an understanding of the conceptual basis and operation of a Tax treaty;
- It will explain what a Double Taxation Agreement (DTA) is and why we need them;
- We will also look at the history of the development of DTAs;
- We will examine the role of a Model DTA;
- The Vienna Convention on the Law of Treaties;
- Will also distinguish between the OECD and UN Model Convention.
Tax treaties are bilateral treaties under international tax law to prevent fiscal evasion and to eliminate double juridical taxation through negotiated sharing of tax revenues based on economic and revenue interests. As already mentioned earlier, rights of legislation and enforcement are bestowed on sovereign states. However, the international tax rules are contained in tax treaties. The main importance of a tax treaty is that it helps to restraint double taxation as far as possible and this can be achieved by setting the limits on scope of domestic law and by promoting the harmonization of the international tax rules through the adoption of income tax treaties that follow the same general pattern (Arnold & McIntyre, 1995). Generally tax treaty overrides domestic law and it governs disputes between states and not taxpayers. However, it has its limitations to the fact that:
- It does not create new taxes or assessment methods;
- It cannot enlarge or initiate taxing powers; and
- The National law prevails if the treaty is more onerous.
Double Tax Treaties are enacted by an agreement between Nations and are governed by the Customary International Law. Double Tax Treaty is signed and concluded under constitutional law. A tax treaty differ from other international treaties because although it is signed by contracting states under international law it is in fact enforceable under domestic law only when it effectively becomes part of domestic law.
The VIENNA CONVENTION ON THE LAW OF TREATIES (VCLT) was enacted in 1969. It codifies existing norms of customary international law on treaties and it also contains its interpretation. It is binding on signatories and non-signatories as “part of the law of the land” and all courts must apply the VCLT to ensure compliance with international obligations. But the most important fact is that tax treaties are governed by VCLT and not domestic law.
VCLT codifies existing norms of customary law on treaties and it does not have to be included in domestic law to be enforced.
Some important articles of VCLT:
- Article 26: Every treaty must be performed in good faith
- Articles 31 – 34: Rules for treaty interpretation
- Article 60: Termination or suspension on material breach
- Article 62: Fundamental change in circumstances may not be invoked
The OECD Model Convention (OECD MC)
The first bilateral agreement was signed between Prussia and Austria in 1899. In 1909 a bilateral DTA was signed between Hungary and Austria. However, it is only after the World War I that the League of Nations began its investigation on the issue of juridical double taxation following an appeal made by the 1920 Brussels International Financial Conference. A report on Double Taxation made by eminent economists worldwide was submitted to the Economic and Financial Commission in 1923 and this very report emerged as the basis of the first draft model DTA and was published in 1928. The allocation of taxing rights to a taxpayer’s country of residence on cross border transaction was endorsed by this model treaty. But as the scope of the 1928 draft model was not very broad and it led the League of Nations to set up a Fiscal Committee to further expand its scope in 1929. The Fiscal Committee produced a draft model in 1933 but it was never adopted although it was revised in 1935.
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The Fiscal Committee of the League of Nations continued its research and finally in a regional conference in Mexico City in 1943, the representatives from North and South American countries produced another draft model. This draft model recognized that primary taxing rights remain with the source country and which was obviously advantageous for developing countries. However, this draft model was reviewed and revised in London in 1946 and it restored the original proposition where the primary taxing rights were conferred to the resident countries. It was only in 1960 that the Fiscal Committee of the Organization for European Economic Co-operation (OEEC), which was later renamed as the Organization for Economic Cooperation and Development (OECD) started gearing the developments of the double tax treaties on the international sphere. In 1963 the first OECD draft model was presented and it confirmed the interest of developed countries by allocating the taxing rights to a taxpayer’s country of residence. In 1963 a draft model was already finalized and it was only in 1977 that the model Double Taxation Convention was publicly released. The 1963 draft in fact contained an amalgamation of the four earlier drafts and it also included the 1958 draft model. This is the reason why the birth of the OECD model is usually considered to be 1 July 1958. The global economy being vibrant and prone to rapid changes, the OECD Model required constant review to address all the emerging tax issues. The Working Party No. 1 of the OECD’s Committee on Fiscal Affairs meets this need and its work results in regular changes to the Model. Updates were published in 1994, 1995, 1997, 2000, 2003, 2005, 2008, 2010 and 2014.
The United Nations Model Convention (UN MC)
The Economic and Social Council of the United Nations in its resolution 1273 (XLIII) adopted on 4 August 1967 had mandated the Secretary-General to set up an ad hoc working committee comprising of experts and tax administrators selected by Governments, but acting in their own capacity, both from developed and developing countries and being an sufficient representation of the all the regions and tax systems, with the task of exploring, in consultation with interested international agencies, ways and means for facilitating the conclusion of tax treaties between developed and developing countries, including the formulation, as appropriate, of possible guidelines and techniques to be used in such tax treaties which would be acceptable to both groups of countries and would entirely protect their respective revenue interests. Following that resolution the committee comprising of the Group of Experts on Tax Treaties between developed and developing countries, which had on board tax officials and experts from these particular countries was set up in 1968 by the Secretary-General. The experts were appointed in their own personal capacity.
The “Group of Experts” reviewed the draft United Nations Model Convention at its Eighth Meeting, held at Geneva from 10 to 21 December 1979, and adopted the final text of the Convention and of the Commentary thereon. In 1980, the United Nations published the “United Nations Model Double Taxation Convention between Developed and Developing Countries”, which was preceded in 1979 by the “Manual for the Negotiation of Bilateral Tax Treaties between Developed and Developing Countries”. On 28 April 1980 by the resolution 1980/13 the Economic and Social Council renamed the Group of Experts as “Ad Hoc Group of Experts on International Cooperation in Tax Matters”. At present, the Group of Experts is composed of 25 members—10 from developed countries and 15 from developing countries and economies in transition. The process of revision and updating of the UN MC between developed and developing countries started in 1995 and ended in 1999 at the Ninth Meeting of the “Group of Experts” (United Nations Model Double Taxation Convention between Developed and Developing Countries).
The United Nations Model Convention (UN MC) favors capital importing countries as opposed to capital exporting countries and it was set for use between developing countries and developed countries.
Tax treaties are necessary because they provide solutions to the connecting factor conflicts. The other advantages of tax treaties can be summarized as follows:
- Provide fiscal certainty.
- Avoid and relieves double tax.
- Allocate taxing rights.
- Help in dealing with tax evasion.
- Assist in treaty negotiation and common interpretation.
Tax treaties also contain some special provisions to:
- Prevent tax discrimination;
- Permit exchange of tax information and
- Establish mutual agreement procedure for tax disputes.
The other benefits of tax treaties are:
- Provide common tax definitions;
- Define forms of taxable income;
- Set specific basic and geographical source rules;
- Define taxable presence;
- Resolve dual residence status;
- Limit domestic taxing rights;
- Provide tax incentives for investment (“tax sparing”);
- Provide additional tax benefits and
- Assist in international tax planning
Over the last few decades, the number of bilateral tax treaties has extensively increased. The United Nations Model Double Taxation Convention between Developed and Developing Countries (United Nations Model Convention) and the Organization for Economic Cooperation and Development Model Tax Convention on Income and on Capital (OECD Model Convention) provide models for countries to use in negotiating the terms of their treaties and are regularly updated (United Nations New York, 2013). These models are adapted by each and every sovereign state to suit its own needs and they are not exactly the same as the UN MC or OECD MC. Therefore, in order suit their requirements they usually add or delete and even modify articles present in model tax treaties. However, they basically follow these two model conventions. The United Nations Model Convention was most recently revised in 2011 and the OECD Model Convention in 2014.
Tax treaties have a dual nature as they are International binding agreements between sovereign states and at the same time part of domestic tax law of their respective states. A tax does not describe a tax system. However, it describes the ultimate limits to which that system may extend. For example: maximum withholding tax rate does not necessarily mean imposition of actual withholding tax. As a general rule a tax treaty does not substantiate any tax liability (or increase any taxes over national tax laws). A tax treaty involves a negotiated sharing of tax revenue by two states and is a connectionbetween two tax systems.
Internationally accepted models contain 30 (or 29) standard articles which may be grouped as follows:
- Personal Scope: Taxpayers Covered
- Material Scope: Scope of Taxes
- Territorial Scope: Area Covered
- Temporal Scope: Period Covered
- Distributive Scope: Tax Sharing
- Method of Relief: Exemption or Credit
- Commentary to Aid Interpretation
- Observations and Reservations
The model treaty comprises of standard clauses, commonly known as articles, which may be amended in negotiations by contracting states. It is governed by the Source Rules, the Assignment Rules and the Relief Rules and has got its specific structure which can be summarized as follows:
- Personal and Material Scope
Specifies to whom the convention applies and which taxes are covered– Article 1 & 2.
- The Territorial Scope – Specifies the geographical area and the tax jurisdiction covered and the General Definitions
The various terms commonly used in the various articles are defined Article 3, 4& 5
- The Assignment rights to the different classes of income – article 6 to 22
- Method of Relief
Specifies the methods for relief in cases of double taxation between two tax jurisdictions – article 23A & 23B
- Distributive Rules and Special Provisions
Provides the rules for the avoidance of double taxation on income or capital; exchange of information; assistance in collection of taxes – article 24 to 29
- The Temporal Scope
Specifies the entry into force and the duration of the treaty – Article 30 & 31
The key concept covered in this chapter were:
- International Tax treaties
- The role of Vienna Convention on the Law of Treaties
- Model Tax Treaty or Double Taxation Avoidance Agreement
- The history of DTAs and why they are necessary?
- Look at the dual nature of tax treaties; and
- The contents of a tax treaty.
Learners will be expected to have gained a detailed knowledge of the topics and be able to apply this knowledge showing an understanding of the issues involved.
- What is a tax treaty? How does it differ from other international treaties? What are the different types of tax treaties? What is a Model tax treaty?
- Explain the main functions of or reasons for a bilateral tax agreement between countries. What is the position in your country? Is there a policy of active negotiation of treaties? Are there many tax treaties in force?
- Why do we need a system of double tax treaties? What could be the results of not having treaties (think of some examples)?
- How do treaties come into existence? Who and how can they be enforced? What is the foundation in law for a tax treaty?
- What is the Vienna Convention on the Law of Treaties? What does it contain? Why is it important in tax law?
- What are the rights and obligations under a tax treaty? What is treaty override? What are its consequences?
- What are the principles of international taxation relevant to the application of tax treaties? At the public international level, does a treaty override domestic law (a) always (b) never (c) occasionally?
- Can a tax treaty impose tax (a) never (b) always (c) sometimes? Can a taxpayer claim the benefits of more than one tax treaty with the same source state (a) no (b) yes (c) only if the source State agrees?
- What is OECD? Why is it relevant in international taxation? Briefly summarise the historical development of the OECD Model treaty?
- Describe the structure of a Model treaty? What are the main benefits of the model tax treaty?
- What is the legal significance of the OECD Model treaty and commentary under domestic or international law? Does it differ from the Model treaty and commentary?
- Why do the UN and US Models differ from the OECD Model treaty? Please bullet point five specific differences between the OECD Model convention and the UN Model convention.
- How might dual residence occur for (a) an individual and (b) a company, and how do you think it might be treated form your reading and under the OECD Model? Can you define effective management in your own words?
- What are the various sources for interpretation of tax treaties? When interpreting a tax treaty, should you apply (a) the OECD Model treaty (b) the commentary, (c) the negotiated bilateral treaty, (d) domestic tax law or (e) legal decisions? In case of conflict in the domestic tax law of the two states, which state law should be applied?
- Define the term ‘permanent establishment’ used in tax treaties. Why is it important in international taxation? What factors constitute a permanent establishment? What factors are excluded from a permanent establishment? How do the rules differ between OECD and UN Models?
- If a permanent establishment exists, how are the taxing rights allocated on business profits under Article 7?
- How does a tax treaty attribute business income to ‘permanent establishments’? What is a separate entity approach? How are expenses allocated? What is the treatment of purchasing activities? How can double taxation arise?