Filling the gaps and fixing what’s broken: issues in Interpretation of income tax treaties

Revista Nº 180 Nov.-Dic. 2013

Patricia A. Brown 

Director, Graduate Program in Taxation 

University of Miami School of Law 

Treaty negotiators have the best international tax jobs in the world. Everyone loves a new tax treaty —it arrives promising reductions in withholding tax at source, clear thresholds that must be met before taxes can be imposed, and a procedure by which tax authorities will resolve any “difficulties or doubts” arising under the treaty. The treaty negotiator is like Santa Claus— after delivering the shiny new packages, he disappears.

The competent authorities are left with a much tougher job —they are the ones who clean up after the excitement is over, who fix the toys when they get broken, or who find a way to make the thing work when there is a missing piece. Whether or not the tax treaty will achieve its goals depends on the willingness of the competent authorities to make it work— to interpret the treaty in a consistent way that reflects the agreement reached by the negotiators. This process tends to go relatively smoothly when both sides were relatively happy with the agreement that was reached. If they are not, the unhappiness with the deal tends to resurface in connection with the interpretation of the agreement.

Many issues of tax treaty interpretation involve relatively technical questions that are resolved easily because they do not affect the fundamental economic interests of the Contracting States. On the other hand, there are several broad categories of issues that encompass most of the intractable or recurring problems of tax treaty interpretation. It may be difficult to achieve a lasting resolution of these issues because they frequently arise from differences in the economic circumstances of the two Contracting States, or to political sensitivities.

This phenomenon is reflected in the many tax treaty issues that involve the allocation of tax revenue arising from the use of intangible property. These are not limited to transfer pricing issues, but include difficult questions regarding the dividing lines between “royalties” and other types of income, such as payments for services and other types of business profits. A transfer of technology generally is required in order for a payment to be considered a royalty under the OECD Model Tax Convention. In many cases, a provider of a service possesses high-value intangibles that it will use in providing services or generating business profits. It will not, however, transfer those intangibles to the customer. Nevertheless, the price for the service or goods reflects the value of the intangibles. It is not unusual for the source country to try to tax the value of the intangible by arguing that the payment constitutes a royalty or by broadening the definition of royalties in its treaties to include “technical services” or “technical assistance”. Other issues involve the source of such payments. Because the OECD Model does not provide for taxation of royalties at source, it does not include a source rule. While the rule in the UN Model, based on the residence of the payor, is relatively straightforward, some countries instead use a “place of use” test. Identifying where an intangible is used has proved tricky in practice. Finally, the creeping expansion of the permanent establishment concept (and of calls to scrap the permanent establishment concept in the context of the “digital economy”) is due largely to the importance of high-value intangibles and services and the difficulty of pinning them down to a particular location.

Another, equally enduring, set of issues revolves around differences in the treatment of entities. Civil law or other countries where trusts are uncommon or unknown have been known to question whether a trust is entitled to treaty benefits, either because the source state does not view the trust as a person or as the beneficial owner of the income it receives, even if it is viewed as a resident of a Contracting State. The Commentary to Article 4 of the OECD Model Tax Convention leaves open the question of whether charities and other tax-exempt entities are to be considered residents of the States in which they are organized, creating uncertainty for intermediaries and withholding agents around the world. The 2009 OECD Report on the Granting of Treaty Benefits with Respect to the Income of Collective Investment Vehicles addressed a number of interpretive issues relating to these important retail investment vehicles, but left many issues to be resolved by the competent authorities.

Even very common entities such as partnerships and companies continue to create problems. The 1999 Report on the Application of the OECD Model Tax Convention to Partnerships established the principle that a tax treaty can and should be interpreted in such a way as to prevent unintended double non-taxation. It is not clear, however, that the principles set out in the report are always applied in practice, particularly to hedge funds and private equity funds, which are viewed with suspicion by many tax authorities. In addition, the use of hybrid entities within multinational groups has been identified as one of the practices to be addressed by the Action Plan on Base Erosion and Profit Shifting, raising the issue of how much can be achieved through interpretation of existing provisions, and whether new treaty provisions are required.

Similar issues arise in connection with hybrid instruments. If a payment is treated as interest in the source State, but as a dividend that qualifies for the participation exemption in the residence State, may the source State deny treaty benefits? On the other hand, could the residence State deny the participation exemption on the grounds that a deduction was allowed in the source State? What happens if both States decide to apply an anti-arbitrage rule? If, as noted by the Action Plan, it is “difficult to determine which country has in fact lost tax revenue”, how will they decide which country gets to keep the tax revenue? What rules of interpretation will provide taxpayers with the certainty they need to move forward with investments while protecting the legitimate interests of governments? General anti-abuse rules, targeted anti-abuse rules, economic substance, or something else? And how consistent are such rules with tax treaties as they are currently written?

The world economy is not static. Capital importing countries become capital exporting countries. Countries that import services begin exporting services. Treaty provisions, and interpretations, that are too extreme may end up hurting the very countries they were meant to benefit. As the OECD, with the backing of the G-20, pursues its Action Plan, finding the moderate middle ground will be key to supporting cross-border trade and investment, but is also likely to be much more difficult.