Bulletin 2009 February/Final

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1 Bulletin_02_Final.qxp:BIT :58 Pagina i Bulletin 2009 February/Final

2 Bulletin_02_Final.qxp:BIT :58 Pagina ii Bulletin for International Taxation Formerly Bulletin for International Fiscal Documentation Editor Dr P.E. Soos, JD, LLM Editorial board Prof. W.F.G. Wijnen, meester in de rechten J.J.P. de Goede, econ. drs. Prof. Dr K.J. Holmes, B Com, M, Com, CA Correspondents At large: Charles E. McLure, Jr., Brian J. Arnold Australia: Rick Krever, Michael Dirkis Austria: Gerald Gahleitner Belgium: Luc De Broe Canada: Nathan Boidman China (People s Rep.): Jinyan Li Denmark: Bente Møll Pedersen European Union: Jonathan S. Schwarz Finland: Dr Marjaana Helminen France: Pierre Jean Douvier Germany: Peter H. Dehnen Greece: Dr George Mavraganis Hong Kong: Jefferson VanderWolk International: Richard M. Bird, Richard Vann Ireland: Charles Haccius Israel: Prof. Arye Lapidoth Italy: Prof. Augusto Fantozzi Japan: Prof. Yoshihiro Masui Liechtenstein: Dr Norbert Seeger Malaysia: Veerinderjeet Singh Mexico: Manuel E. Tron Middle East: Howard R. Hull Nepal: Rup Bahadur Khadka Netherlands: Hans Pijl, Hans van den Hurk New Zealand: Adrian J. Sawyer Poland: Matthew O Shaughnessy Portugal: Adelaide Passos Singapore: Lee Fook Hong South Africa: Ernest Mazansky Spain: Prof. Carlos Palao, Prof. Adolfo Martín Jiménez Switzerland: Markus F. Huber United Kingdom: Malcolm Gammie, D.J. Hasseldine United States: Sanford H. Goldberg Zimbabwe: D.G. Murphy Contribution of articles The editor welcomes original and previously unpublished contributions which examine an important tax development or issue of interest to an international readership of tax professionals, lawyers and scholars. The contribution should be of a scholarly nature and provide background, perspective and analysis as well as a description of the tax development or issue. Manuscripts should range from 5,000 to 12,000 words. Manuscripts accepted for publication in the Bulletin will be subject to editorial review and revision. Additional information may be obtained from the editor. ISSN / 2009 IBFD All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the written prior permission of the publisher. Applications for permission to reproduce all or part of this publication should be directed to: permissions@ibfd.org. P.O. Box HE Amsterdam The Netherlands Tel.: Fax: Disclaimer This publication has been carefully compiled by the IBFD and/or its author, but no representation is made or warranty given (either express or implied) as to the completeness or accuracy of the information it contains. The IBFD and/or the author are not liable for the information in this publication or any decision or consequence based on the use of it. The IBFD and/or the author will not be liable for any direct or consequential damages arising from the use of the information contained in this publication. However, the IBFD will be liable for damages that are the result of an intentional act (opzet) or gross negligence (grove schuld) on the IBFD s part. In no event shall the IBFD s total liability exceed the price of the ordered product. The information contained in this publication is not intended to be an advice on any particular matter. No subscriber or other reader should act on the basis of any matter contained in this publication without considering appropriate professional advice. For information about IBFD publications and activities, please visit our website at For back volumes or back issues older than two years, please go to our publishing partner PSC at

3 Bulletin_02_Final.qxp:BIT :58 Pagina 41 Contents Volume 63 Number 2 February 2009 Tax Treaty News Brian J. Arnold 42 Klaus Vogel Lecture Tax Treaties and Schrödinger s Cat Jacques Sasseville 45 The Klaus Vogel Lecture, given in the memory of Prof. Dr Klaus Vogel who passed away in December 2007, is being continued by the Institute for Austrian and International Tax Law (WU) in Vienna. This year s lecture was given by Jacques Sasseville of the OECD at the WU on 24 October Frank Engelen (University of Leiden and PricewaterhouseCoopers Netherlands) commented on the lecture. This article is the 2008 Klaus Vogel Lecture given by Jacques Sasseville, as revised for publication. United Arab Emirates: Tax Treaty Relief on International Investment Howard R. Hull 52 To date, the United Arab Emirates has concluded 47 comprehensive tax treaties, over two thirds of which are in force. This is an extensive treaty network for a jurisdiction most of whose residents do not currently pay any income tax. This article addresses some of the issues faced by UAE individuals, companies and government institutions when trying to qualify for treaty relief on income generated on their outbound investments. After discussing the sources and interpretation of UAE treaty law, the article examines the scope of bilateral treaties with regard to taxes, period in time, territory and persons. To complete the analysis, the article considers some of the anti-abuse rules in the UAE s tax treaties and in the source country s domestic law. Interpretation of Subject-to-Tax Clauses in Belgium s Tax Treaties Critical Analysis of the Exemption vaut Impôt Doctrine Prof. Luc De Broe and Niels Bammens 68 This article examines the interpretation of the subject-to-tax clauses in Belgium s tax treaties. The interpretation of these clauses gives rise to substantial difficulties in practice because of the exemption vaut impôt doctrine. The article argues that the application of this doctrine, when interpreting the treaty relief provisions containing the expression income that is taxed in the other State, leads to the same result as applying the Commentary when interpreting Art. 23 of the OECD Model, which contains the expression income which... may be taxed in the other Contracting State. Consequently, it is submitted that the application of the exemption vaut impôt doctrine should be rejected when interpreting a tax treaty containing the is taxed language. Articles Switzerland Second Corporate Tax Reform in Switzerland Dr Markus F. Huber and Lionel Noguera 74 A new set of tax measures entered into force on 1 January 2009 after the Swiss voters approved the set of measures in February The measures are designed to lower the overall tax burden for corporations, self-employed persons and small businesses in Switzerland through specific provisions affecting the income tax, stamp duty and withholding tax. Some of the measures will become effective in This article discusses the new measures, including the partial taxation of dividends, broader participation exemption, indirect tax relief from the capital tax, issuance stamp duty relief for financial reorganizations, and withholding tax exemption on the repayment of paidin capital. Nigeria Tax Relief for Business Losses of Individuals and Companies in Nigeria A Comparative Analysis Osita Aguolu 77 This article discusses the tax laws of Nigeria relating to the treatment of business losses. The article examines the provisions of the Personal Income Tax Act and the Companies Income Tax Act and analyses the differences in the provisions applicable to individuals and companies. In respect of companies, the discussion also considers the application of loss relief to companies that are subject to the minimum tax, companies that are granted pioneer status and companies engaged in petroleum operations in Nigeria. Cumulative Index 67 IBFD BULLETIN FOR INTERNATIONAL TAXATION FEBRUARY

4 Bulletin_02_Final.qxp:BIT :58 Pagina 42 Brian J. Arnold in Cooperation with the IBFD s Tax Treaty Unit Brian J. Arnold* Tax Treaty News 1. Article 2 (Taxes Covered) In the recent case of Virgin Holdings, 1 the Federal Court of Australia decided that the Australian capital gains tax was covered by the Australia Switzerland treaty despite the fact that Australia did not impose a capital gains tax at the time the treaty was concluded. The central issue in Virgin Holdings was the proper interpretation of Art. 2 of the treaty, which differs from Art. 2 of the OECD Model Tax Convention. Art. 2 of the Australia Switzerland treaty omits Arts. 2(1) and (2) of the OECD Model; it lists the existing taxes, which in the case of Australia is the Australian income tax, and includes any identical or substantially similar taxes imposed after the signature of the treaty. The issue has festered for some time in Australia. The Australian Taxation Office (ATO) issued a detailed ruling on the topic in which concluded that treaties entered into before the introduction of the Australian capital gains tax did not apply to that tax and therefore did not preclude Australia from imposing its capital gains tax on non-residents disposing of Australian assets. In several articles on the topic, commentators have taken different positions. Simplifying the facts somewhat, Virgin Holdings, a Swiss corporation, sold the shares of a related Australian corporation, Virgin Blue, as part of an initial public offering in December 2003 and realized a gain of about AUD 200 million. Virgin Holdings had acquired the shares six months earlier (in June 2003) from an affiliated company. The first issue was whether the reference to the Australian income tax in Art. 2(1) should have a static or ambulatory meaning. The reference to existing taxes would seem to suggest a meaning as of the date of signature of the treaty. Justice Edmonds sidestepped this issue by holding that, even at the time of signature of the treaty, the Australian income tax applied to capital gains because certain capital gains (for example, short-term gains) were included in income. As a result, the treaty applied to the Australian capital gains tax. This holding made it unnecessary for Justice Edmonds to consider the second issue: whether the Australian capital gains tax was substantially similar to the Australian income tax existing at the time of signature of the treaty. Because an appeal is likely, however, he analysed this issue as well, considering both the views of Klaus Vogel and the Irish Kinsella case, 3 and concluded that the comprehensive Australian capital gains tax, which was introduced in the mid-1990s, satisfied the substantially similar requirement for two reasons. First, the mechanism for taxing a capital gain including all or part of the gain in income is the same as for the income tax. Second, the income tax existing at the time of signature of the treaty included certain capital gains in income. The irony is that the provision taxing short-term capital gains was subsequently repealed. If it had not been repealed, it would have applied to the gain realized by Virgin Holdings because the company had held the shares for less than 12 months. Having concluded that the Australian tax on capital gains was covered by the treaty, the next issue was whether the treaty allocated the right to tax Virgin Holdings gain to Australia. This involved the interpretation of Art. 7 (Business profits) and Art. 13 (Alienation of property). On the basis of the Thiel case, 4 Justice Edmonds rejected the Commissioner s argument that Art. 7 only prevented Australia from taxing profits of an income or revenue nature, not capital gains. The Commissioner s argument was that nothing in the treaty precluded Australia from taxing the capital gains derived by residents of Switzerland. Art. 7 is restricted to ordinary income, and Art. 13 gives the residence country the right to tax income, not capital gains from the alienation of capital assets. The Court rejected the argument on the basis that capital gains are part of income. It should be noted that the Australia Switzerland treaty does not contain an equivalent to Art. 7(7) of the OECD Model or an other income article. An other income article along the lines of the UN Model, which gives a right to tax other income to the source country if the income is sourced there, would have given the Commissioner an argument that the treaty allowed Australia to tax. Even here, however, the Court might have held that the other income article would not have applied because the income was dealt with in either Art. 7 or 13. The troubling aspect of the decision is the absence of any reference to the intentions of the contracting states and the travaux préparatoires of the treaty. My understanding * Brian J. Arnold, Goodmans LLP, Toronto. 1. Virgin Holdings SA v. Commissioner of Taxation [2008] FCA 1503 (10 October 2008) (Federal Court of Australia). 2. ATO, Taxation Ruling TR2001/12, 19 December Kinsella v. The Revenue Commissioners, 31 July 2007 (Irish High Court), reviewed in Arnold, Brian, Tax Treaty News, Bulletin for International Taxation 7 (2008), at Thiel v. Federal Commissioner of Taxation, 171 CLR 338 (1990) (High Court of Australia). 42 BULLETIN FOR INTERNATIONAL TAXATION FEBRUARY 2009 IBFD

5 Bulletin_02_Final.qxp:BIT :58 Pagina 43 from my Australian colleagues is that the intention of the two states was to exclude capital gains from the treaty as far as Australia is concerned. The language in Art. 13(3) referring to income provides some support for this position. In other words, Australia wanted the treaty to deal only with those capital gains from the disposal of property that were included in income under Australian law at the time the treaty was signed. If this is the case, it is curious why no evidence was introduced by the Commissioner to support this position. In the absence of such evidence, the decision appears to be a correct interpretation of the provisions of the treaty. The treaty has since been renegotiated and now gives Australia the right to tax capital gains. 2. Treaty Interpretation and Reciprocity In another recent Australian case, Deutsche Asia Pacific Finance, 5 the issue was whether the provisions of the Australia United States treaty precluded the imposition of Australian withholding tax on distributions by an Australian limited partnership to a US company. Justice Edmonds, who decided Virgin Holdings, was also the judge in this case. The facts of the case are very complicated and well beyond a detailed description here. The transactions appear to be an arrangement by Deutsche Asia Pacific Finance Inc. (DAP), a US subsidiary of Deutsche Bank, to generate foreign tax credits without any underlying economic net income. DAP was a limited partner in an Australian limited partnership, Industrie LP, which was treated as a corporation under Australian law. Industrie LP was a wholly-owned subsidiary of Commonwealth Bank, one of Australia s largest banks. Under Australian tax law, the distributions by Industrie LP to DAP were deemed to be interest subject to Australian withholding tax. Under Art. 11(3)(b) of the Australia United States treaty, however, interest derived by a financial institution resident in one country from an unrelated independent person resident in the other country is exempt from any withholding tax imposed by the source country. Art. 11(5) defines interest for purposes of the treaty to mean interest from any form of indebtedness and includes income which is subjected to the same taxation treatment as income from money lent by the law of the Contracting State in which the income arises. Art. 11(9)(a) of the treaty, whose interpretation was the central issue in the case, provides that Art. 11(3) does not apply to interest that is determined by reference to the profits of the issuer and that such interest is taxable by the source country at a maximum rate of 15%. It was clear that the distributions by Industrie LP to DAP were computed by reference to Industrie LP s profits. Art. 11(9) was included in the treaty at the insistence of the United States. A similar provision is included in the US Model 6 and in most US treaties. No other Australian treaty contains such a provision. Nevertheless, the provision is not literally unilateral; it extends to the application of the treaty by both countries. The taxpayer s argument was based on a liberal purposive interpretation of the treaty. The purpose of Art. 11(9)(a) is to prevent taxpayers from taking advantage of the withholding tax exemption for portfolio interest under US domestic law. Further, Art. 11(9)(a) has no function with respect to Australian domestic law because the distributions by the Australian partnership are in substance profits and are deemed to be interest only by Australian law. Accordingly, the taxpayer argued that Art. 11(9)(a), which is intended to deal with disguised interest, should not apply to payments deemed to be interest under Australian domestic law. The taxpayer also argued that the partnership could not be considered to be the issuer within the meaning of Art. 11(9)(a). The Commissioner argued that the treaty did not make any distinction between amounts that are interest in form only and those that are interest in substance. The definition of interest in Art. 11(5) was determinative. 7 According to the judge, the underlying reason for Art. 11(9)(a), although derived from US domestic tax policy, cannot control the meaning of the provision. The text of the treaty must be given primacy in the interpretation process. However, he went on to consider the purpose of the treaty and, in particular of Art. 11(9)(a), and concluded that there was nothing in the purpose that was inconsistent with the ordinary meaning of the words in Art. 11(9)(a). He had no difficulty concluding that the interest was determined by reference to the profits of Industrie LP (indeed, it was a share of those profits) and that Industrie LP was the issuer because it was considered to be a legal entity under Australian law. As a result, Australia was entitled to impose its 10% withholding tax on the interest. The analysis and the conclusion seem to be correct. Reciprocity is a fundamental principle of tax treaties. The provisions of a treaty must apply to both countries unless the provisions are explicitly unilateral. Moreover, if a provision of a treaty gives both contracting states the right to tax an amount, each state is entitled to determine as a matter of domestic law whether to exercise that right. 8 The case also raises an interesting issue concerning the relationship between Arts. 10 and 11. Under Art. 10(6) of the Australia US treaty, the definition of dividends includes amounts deemed to be dividends payable by Australian resident corporations under Australian law. 5. Deutsche Asia Pacific Finance Inc. v. Commissioner of Taxation [2008] FCA 1570 (22 October 2008) (Federal Court of Australia). 6. United States Model Income Tax Convention (2006), Art. 11(2). 7. The Commissioner argued (inappropriately, in my view) that it was unnecessary to consider the purpose of the treaty as a whole, and of Art. 11(9) in particular, because the text of Art. 11(9) is clear and unambiguous. In my view, Art. 31(1) of the Vienna Convention on the Law of Treaties requires the purpose of the relevant provisions of the treaty to be considered in all cases. The purpose is not determinative, but it should be considered. 8. Australian practice is different from that of most countries in this regard. Under its domestic law, Australia generally taxes all Australian-source income. Moreover, Australian treaties contain a provision under which any income taxable by Australia under the treaty is considered to be income derived from a source in Australia. IBFD BULLETIN FOR INTERNATIONAL TAXATION FEBRUARY

6 Bulletin_02_Final.qxp:BIT :58 Pagina 44 As Justice Edmonds noted, under Australian law, Industrie LP is deemed to be a corporation, and distributions by it are deemed to be dividends. Under another provision of Australian law, however, dividends on non-equity shares are deemed to be interest subject to withholding tax. Consequently, it might be argued that the distributions by the partnership were both dividends within the meaning of Art. 10 and interest under Art. 11. If so, Art. 10 would have applied because the definition of interest in Art. 11 expressly excludes any amounts included in Art. 10. The better view is probably that Australian domestic law, which deems certain dividends to be interest, has the effect of taking them out of the scope of Art Arm's Length Compensation of Agent Eliminates Need for Attribution of Profits In the SET Satellite case, 9 the Indian High Court confirmed the prior ruling of the Supreme Court of India in the Morgan Stanley case 10 that the arm s length remuneration of a dependent agent eliminates the possibility of attributing any further profits to the permanent establishment. The taxpayer, SET Singapore, a Singapore company, carried on business in India through a whollyowned subsidiary, SET India, acting as its agent. Although the facts are not stated very fully in the decision, it appears that SET India solicited advertising to run on its parent company s television channels and on third-party channels. The taxpayer filed its Indian tax return claiming that it did not have a permanent establishment in India and that its agent was remunerated on an arm s length basis and paid tax on that amount in India. The Indian tax authorities rejected the taxpayer s position. At first instance, the Income Tax Appeals Tribunal decided that SET Singapore had a permanent establishment in India as a consequence of SET India s acting as its dependent agent. Further, the Tribunal held that, although SET India was subject to tax in India on its remuneration earned as SET Singapore s agent, SET Singapore was also taxable in India on the profits attributable to its permanent establishment under Art. 7 of the India Singapore treaty. Despite the ruling in Morgan Stanley, the Tribunal also held the arm s length remuneration of an agent does not extinguish the liability of a non-resident in respect of whom the agent is a permanent establishment. On appeal, the taxpayer stated the issue pejoratively as follows: Whether having taxed the agent on the fair value of the activities in India, the same could be taxed all over again in the hands of the assessee as being income attributable to the deemed permanent establishment? More fairly stated, the issue was whether the non-resident taxpayer was taxable on an amount in excess of the agent s arm s length remuneration. The agent s remuneration was not taxed all over again because it was deductible in computing the non-resident s profits attributable to the permanent establishment. It was agreed that SET India was remunerated on an arm s length basis. Under an Indian administrative tax circular, 11 a nonresident s profits from services provided through an agent are limited to the amount of profit attributable to the agent s services if certain conditions are met. Those conditions were met in this case. Under Indian law, such circulars are binding. Based on Morgan Stanley, the High Court held that if the correct arm s length price is applied and paid then nothing further would be left to be taxed in the hands of the Foreign Enterprise. The holding was based on both the circular and Art. 7 of the treaty. As concerns the treaty, the decision is clearly incorrect in principle. A non-resident enterprise doing business in a country through a dependent agent would expect to make profits in excess of the fair market value of the agent s services. This point can be seen clearly in the case of a non-resident carrying on business in a country through its employees. Although the employees receive arm s length salaries, the non-resident would certainly expect to earn a profit over and above their salaries. This principle has been expressly included in the Commentary on Art. 7 of the OECD Model as revised by the 2008 Update (Para. 26), although it is more clearly articulated in Part I of the July 2008 Report on the Attribution of Profits to Permanent Establishments, D-5, Para. 270: Issues arise as to whether there would remain any profits to be attributed to the dependent agent PE after an arm s length reward has been given to the dependent agent enterprise. In accordance with the principles outlined above... the answer is that it depends on the precise facts and circumstances as revealed by the functional and factual analysis of the dependent agent and the non-resident enterprise. However, the authorised OECD approach recognizes that it is possible in appropriate circumstances for such profits to be attributed to the dependent agent PE. 9. SET Satellite (Singapore) Pte Ltd v. Deputy Director of Income-Tax, Income Tax Appeal No. 944, 2007 (High Court Bombay, 22 August 2008). 10. DIT (International Taxation) v. Morgan Stanley and Co. Inc. (2007) 292 ITR 416 (SC). In this case, Morgan Stanley, a US resident company, was deemed to have a permanent establishment in India as a result of furnishing services in India under a provision in the India United States treaty similar to Art. 5(3)(b) of the UN Model. 11. CBDT, Circular No. 23, 23 July 1969, Para. 6(c). 44 BULLETIN FOR INTERNATIONAL TAXATION FEBRUARY 2009 IBFD

7 Bulletin_02_Final.qxp:BIT :58 Pagina 45 Jacques Sasseville* Klaus Vogel Lecture Tax Treaties and Schrödinger s Cat The Klaus Vogel Lecture, given in the memory of Prof. Dr Klaus Vogel who passed away in December 2007, is being continued by the Institute for Austrian and International Tax Law (WU) in Vienna. This year s lecture was given by Jacques Sasseville of the OECD at the WU on 24 October Frank Engelen (University of Leiden and PricewaterhouseCoopers Netherlands) commented on the lecture. This article is the 2008 Klaus Vogel Lecture given by Jacques Sasseville, as revised for publication. 1. Introduction When I agreed to give the Klaus Vogel Lecture, I expected that I would do so in Klaus presence. This was not to be; like all of you, it was with deep sadness that I learned in December 2007 that he had left us. It is a great honour for me to have been asked to give the lecture that has been instituted to celebrate his remarkable contribution to tax treaties. I was fortunate to be able to meet Klaus regularly and discuss many tax treaty issues over the years. Some of you will remember that Klaus was the first chairman of the annual IFA/OECD seminar that takes place during each IFA Congress. I had the chance to work with him on many of these seminars. It was during the preparatory meetings for them that Klaus very kindly asked me, three years in a row, to call him Klaus rather than Prof. Vogel, something that I found difficult at first, but found easier to do as I got to know him better. 2. Conflicts of Qualification I think that Klaus would have liked the topic I chose to address this year. It deals with a difficult issue that arises as a consequence of what he referred to as the new approach of the OECD to conflicts of qualification. In his 2003 article entitled Conflicts of Qualification: The Discussion is not Finished, 1 Klaus wrote: This article analyses why the new approach of the OECD of which this author approves in principle does not cover all cases of differing qualifications and when and why, as a consequence of such conflicts, double taxation or double non-taxation may still arise. His article went on to discuss two examples where, arguably, the conflicts of qualification were not solved by the new approach. In an article published a few months later, 2 John Avery Jones commented on the examples used by Klaus and convincingly explained that, while it was true that not all conflicts of qualification were solved by the new approach (e.g. where the residence state applies a treaty provision that does not allow it to tax), this was not the case in the examples used in Klaus article. The second example used by Klaus was the following: An independent singer who is a citizen of Austria alternates between performing in Austria and in Germany. He has a permanent contract with an opera company in Germany, committing him to a certain number of appearances each year. During the taxable year in question, he had, in addition, some separate engagements in Austria. In both states, he lived in hotels. On several occasions, he stayed part of the day in Austria and part in Germany. Therefore, the aggregate of his stays in each of the two states was more than six months. He received dividends and interest from portfolios in a third country. According to Klaus, under Austria s domestic law meaning of the term habitual abode, which appears in the tiebreaker rule of the Austria Germany treaty, the singer did not have an habitual abode in Austria and would therefore be considered to be a resident of Germany. Austria would thus apply the treaty in a way that prevented it from taxing the income derived from the third country. Under Germany s view, however, the singer had an habitual abode in both states and the singer, being a citizen of Austria, would be a resident of Austria under the treaty tie-breaker rule, with the result that Germany would also apply the treaty in a way that prevented it from taxing the income derived from the third country. The positions of both countries would therefore result in double non-taxation. John dealt with that example by taking the view that since the treaty tie-breaker rule is intended to resolve cases of dual residence, this was a case where the context required that an autonomous meaning, rather than a domestic law meaning, be given to the term habitual abode. He added that [i]f there is a conflict between the two states interpretations, it has to be resolved by the mutual agreement article. 3 * Jacques Sasseville, Head, Tax Treaty Unit, OECD/Centre for Tax Policy and Administration. The views expressed in this article are the personal views of the author and should not be attributed to the OECD or to any of its Member countries. The 2008 Klaus Vogel Lecture was sponsored by the Institute for Austrian and International Tax Law (WU) in Vienna and Pricewaterhouse- Coopers. 1. Bulletin for International Fiscal Documentation 2 (2003), at Avery Jones, John F., Conflicts of Qualification: Comment on Prof. Vogel s and Alexander Rust s Articles, Bulletin for International Fiscal Documentation 5 (2003), at Id. at 186. IBFD BULLETIN FOR INTERNATIONAL TAXATION FEBRUARY

8 Bulletin_02_Final.qxp:BIT :58 Pagina 46 As that response shows, there is a crucial difference between a conflict of qualification and a conflict of interpretation. Para of the Commentary on Art. 23 (Elimination of double taxation] of the OECD Model Tax Convention, which is referred to in a footnote to the preceding quotation, makes it clear that, under the new approach, Art. 23 will not require the residence state to eliminate double taxation where there is a conflict regarding the interpretation of the facts or the interpretation of the tax treaty provisions. Similarly, while Art. 23 A(4) may apply to prevent double non-taxation in some cases of conflicts of interpretation, it will not address all such cases and is not primarily intended to do so. Art. 23 A(4) is primarily intended to address conflicts of qualification, i.e. cases where the two states consider that the same item of income falls within different articles of the treaty because of differences in the domestic laws of the two states, but where the residence state agrees that the other state has applied the treaty correctly. The above example of the opera singer deals with a case where the two states disagree with the interpretation of the term habitual abode for the purpose of determining the treaty residence of the taxpayer; the example does not deal with the treaty classification of an item of income and is not a case where each state agrees that the other has applied the treaty correctly. In Response by Prof. Vogel, which appeared at the end of John s article, 4 Klaus admitted that the case is a little far-fetched, and I should have looked for a better one. 3. The Discussion on Conflicts of Qualification is not Finished I would like to use a different example to show that Klaus was absolutely right when he suggested, in the title of his original article, that the discussion on conflicts of qualification is not finished. Unlike Klaus example, which dealt with double nontaxation, I would like to deal with a situation of possible double taxation. As mentioned above, Art. 23 A(4), which was added when the OECD adopted the new approach, can address some cases of double non-taxation that do not arise from conflicts of qualification, and this complicates the analysis if one uses a double nontaxation example. I have already noted that Para of the Commentary on Art. 23 makes a clear distinction between, on the one hand, the situation where the two states apply different articles to the same item of income because of the correct treaty application of different domestic law meanings and, on the other hand, the situation where the two states apply different articles to the same item of income because of different interpretations of the facts or of the treaty provisions. In other words, the new approach does not force the residence state to eliminate double taxation if it does not agree with the interpretation given by the other state. Clearly, if the residence state does not agree with the interpretation given by the source state, it should not be bound to apply the treaty on the basis of that interpretation. There are different situations where this could happen. One is where the residence state does not agree that the source state has correctly determined the facts on which it based its tax assessment. For instance, the source state may have taxed the employment income of a resident of the residence state on the basis that the person was present in the source state for more than 183 days in a given 12-month period, but the residence state believes that the person was not present in the other state during all those days. In that case, the residence state would not consider that the relevant employment income has been taxed by the source state in accordance with the provisions of the Convention and would not be forced to exempt that income, or give a credit for the tax levied by the source state, as long as there is no agreement on the facts. Another situation is where the residence state does not agree that the source state has correctly interpreted the treaty. For instance, the source state may have taxed the remuneration of a non-resident engineer on the basis that the reference, in Art. 15(2)(b), to an employer who is not a resident of the other State does not cover a situation where the non-resident engineer works under the direct control and supervision of a client who is a resident of the source state even though the engineer s formal employer is a non-resident engineering firm that seconded the engineer s services to the client for a short period of time. The residence state, however, may consider that this is not a correct interpretation of Art. 15. In that case, as in the previous case, the residence state would not consider that the relevant employment income has been taxed by the source state in accordance with the provisions of the Convention and would not be forced to exempt that income, or give a credit for the tax levied by the source state, as long as there is no agreement on how to interpret Art. 15. The disagreement between the states may, of course, involve both the interpretation of the facts and the interpretation of the treaty provisions. Assume, for instance, that a non-resident employee receives stock options during a period of employment in the source state. The source state may tax the benefits derived from the exercise of the stock options on the basis that the benefits constitute other remuneration similar to salaries and wages and are related to the services rendered in the source state. The residence state, however, may disagree with both assumptions, which involve questions relating to the facts and to the interpretation of the treaty. These examples refer to various aspects of Art. 15 on which the OECD has done some work in order to try to reduce the possibility of different interpretations. 4. Id. 46 BULLETIN FOR INTERNATIONAL TAXATION FEBRUARY 2009 IBFD

9 Bulletin_02_Final.qxp:BIT :58 Pagina 47 Indeed, changes have been made to the Commentary to clarify how to compute the 183-day period and to determine to what extent benefits derived from stock options constitute employment income and may be considered to relate to employment services performed in a country; the OECD has also worked for a long time on clarifying how Art. 15 applies to seconded employees. These clarifications, however, do not address purely factual issues (e.g. was the person really present in a state on a particular day, what were the terms under which the stock options were granted, etc.). Also, in some cases, such as the interpretation of the reference to the concepts of employment and employer in Art. 15, it has not yet been possible to agree on a single interpretation. These situations, of course, constitute an important source of possible double taxation. The mutual agreement procedure is available to address these cases but, as is well known, the mutual agreement procedure found in most treaties only requires the competent authorities to endeavour to resolve the cases that are presented to them, without any obligation to reach an agreement. This is why the recent addition to the OECD Model of Art. 25(5) providing for the mandatory arbitration of unresolved issues arising in a mutual agreement procedure case is such an important development. It is, in fact, a logical follow-up to the OECD s work on conflicts of qualifications. As much as I support arbitration, however, I realize that it will be some time before arbitration is generally applicable to resolve most cases where the two contracting states adopt different interpretations of the facts or of the treaty provisions. It is therefore important that the OECD continue its work in order to address cases where countries adopt different interpretations of the tax treaty in order to determine which interpretation should prevail. Of course, the OECD is not an arbitral body, and each country remains free to disagree with the interpretations the OECD has adopted, but unless a country does so expressly (e.g. through an observation), it should be expected to follow an interpretation to which it agreed at the OECD, and the courts of many countries will require tax administrations to do so. As long as most tax treaties do not include arbitration provisions, the cases where the OECD has not agreed on a single interpretation will continue to present important risks of double taxation. The Commentary includes only a few cases where different interpretations are put forward without any indication as to which interpretation should prevail (see, for instance, Paras. 8.5 and 8.6 of the Commentary on Art. 4). In such cases of conflicting interpretations, a residence state that adopted one interpretation would be unlikely to agree that the other state has taxed in accordance with the provisions of the treaty if it taxed on the basis of another interpretation of the treaty. This brings me to the difficult situation of applying the new approach where more than one interpretation is considered to be correct. I think we can all agree that it is possible for different people to interpret the same words in different ways. Lawyers are very good at doing this. That is different, however, from saying that the different interpretations are all correct. In a purely domestic tax context, if lawyers or academics propose two different interpretations of the same provision of a tax law, either the judicial process will ultimately decide what the highest court considers to be the correct interpretation, which will normally bind everyone retroactively, or (and this is more likely to be the case with interpretations proposed by academics!) no decision will ever be rendered as to what is the correct interpretation because the issue has no practical significance. In the tax treaty context, no judicial process will usually be available to decide what the correct interpretation is if two different interpretations are put forward by the contracting states. If the two states cannot agree on a single interpretation through the mutual agreement procedure (and arbitration, when available), each state will apply its own interpretation with possible unfortunate consequences. In these cases, the new approach will not help to eliminate double taxation because that approach deals with cases where the residence state agrees with the interpretation of the treaty provisions given by the source state. The different treaty qualification of an item of income will be the result of domestic law differences rather than different interpretations. But to what extent, if any, should the new approach apply in a case where both states agree that their interpretations of the treaty are different, but equally correct? This is where were Schrödinger s cat comes into the picture. 4. Schrödinger s Cat As we are in Vienna, I suspect that many of you have heard about the Austrian physicist Erwin Schrödinger. At the end of the 1920s, Werner Heisenberg developed his famous uncertainty principle to explain why, in quantum mechanics, it was not possible to determine both the definite position and momentum of an electron in an orbit around the nucleus of an atom and why, therefore, the electron was everywhere in a probability cloud. (My superficial understanding or lack thereof of the uncertainty principle is not crucial for the rest of this article.) Albert Einstein and many others were not convinced by the uncertainty principle and thought that there was something missing in quantum theory. In 1935, Einstein co-authored a paper that attempted to challenge the uncertainty principle. In preparing that paper, he exchanged letters with Schrödinger, and they started exploring some of the strange consequences of the suggestion that an electron IBFD BULLETIN FOR INTERNATIONAL TAXATION FEBRUARY

10 Bulletin_02_Final.qxp:BIT :58 Pagina 48 could have many positions at the same time, the exact position being determined only when it was observed. In the course of the exchange, Schrödinger designed a thought experiment to show how bizarre that idea was. He may or may not have had a cat, but what may or may not have happened to the cat in the thought experiment suggests that he was a dog lover! In the thought experiment, a cat, along with a flask containing a poison gas, was placed in a sealed box together with a Geiger counter and a tiny bit of radioactive substance. The substance was small enough so that, in one hour, perhaps one of the atoms decayed, but also, with equal probability, perhaps none. If the Geiger counter detected radiation, a relay released a hammer which shattered the flask, releasing the poison which would kill the cat. Quantum mechanics suggests that, after a while, the cat was simultaneously alive and dead. Yet, when one looked into the box, he saw the cat either alive or dead, not a mixture of alive and dead. 5 I do not know what others think, but I tend to agree that if quantum mechanics resulted in a cat being both alive and dead at the same time, this would be a rather counter-intuitive result. I would like to move to transfer pricing, where it is recognized that a range of prices can all satisfy the arm s length standard. I am not suggesting that transfer pricing is governed by quantum mechanics, but it strikes me that the concept of a range of arm s length prices is somewhat similar to that of quantum superpositions, i.e. the combination of all the possible states of a system such as the combination of all the possible positions of an electron. Until there is a final agreement between the competent authorities, which would correspond, in Schrödinger s experiment, to the opening of the box that triggered the collapse of the quantum superpositions and the determination of whether the cat was dead or alive, a range of different prices constitutes a correct interpretation of the treaty words that correspond to the arm s length principle. The idea that many different interpretations of the same words may be correct at the same time also strikes me as being a counter-intuitive result. It is also a result that creates a difficult issue for the application of the new approach. This issue is whether the residence state of an enterprise that has a permanent establishment in another state is required to apply Art. 23 (Elimination of double taxation) based on the arm s length transfer price or method used by the source state even though that price or method differs from the arm s length transfer price or method used by the residence state. This issue is best illustrated by a simple example involving RCO, a company resident in State R, that has a manufacturing plant in State S which produces tables that RCO will sell to independent retailers in State R. For a given taxable period, the actual costs of producing the tables, taking into account all direct and indirect costs, are 1 million, and the tables are sold by RCO at 1.5 million. In selling the tables, RCO incurs marketing and distribution costs of 200,000, leaving profits of 300,000, as illustrated by Table 1. Table 1 sales 1,500,000 minus: cost of goods sold (1,000,000) 500,000 minus: marketing and distribution costs (200,000) profits 300,000 Art. 7 (Business profits) of the tax treaty between States R and S allocates the taxing rights on these profits. In accordance with Art. 7, State S will be allowed to tax the profits that the permanent establishment would have made if it had been a separate and independent enterprise. Quite clearly, the permanent establishment, if it had been a separate and independent enterprise, would not have sold the tables to RCO at a price of 1 million or less since this represents RCO s direct and indirect manufacturing costs for producing the tables in State S. It is also clear that RCO would not have paid more than 1.3 million if it had acquired the tables from an independent enterprise since that amount represents the maximum amount that it could pay in order to break even when it sells the tables to independent retailers. 6 In order to determine the profits that are attributable to the permanent establishment under Art. 7(2), it will therefore be necessary to determine the arm s length price at which the tables would have been sold by the permanent establishment, and acquired by the rest of RCO, if the permanent establishment had not been a part of RCO but, instead, a separate and independent enterprise. That arm s length price, which will be somewhere between 1 million and 1.3 million (this is not a suggestion of a possible arm s length range!), will determine, for purposes of the tax treaty between States R and S, which part of the profits is considered to arise in each state. This is clearly relevant for State S as Art. 7 prevents it from taxing the profits that are not attributable to the permanent establishment. It is also very relevant for State R since Art. 23 will require it either to exempt the part of the profits attributable to the permanent establishment in State S or to give a credit for the tax levied by State S on that part of the profits (which will normally mean that little or no tax will be collected in State R on that part of the profits). 5. This description is adapted from the one found at en.wikipedia.org/ wiki/schrodingers_cat. 6. For purposes of simplification, this example assumes that the circumstances do not justify predatory pricing or another loss-making strategy that either the permanent establishment or the rest of the enterprise could undertake for a limited period of time (e.g. to penetrate a new market). 48 BULLETIN FOR INTERNATIONAL TAXATION FEBRUARY 2009 IBFD

11 Bulletin_02_Final.qxp:BIT :58 Pagina 49 Both states therefore have a direct interest in making sure that the arm s length standard is properly applied in determining the profits attributable to the permanent establishment situated in State S. In determining the transfer price of the tables transferred from the permanent establishment in State S to the rest of the enterprise in State R, RCO may have an interest in choosing either a high transfer price that will maximize the share of profits allocated to State S or a low transfer price that will maximize the share of profits allocated to State R. This will depend on the tax rates and various other tax factors (e.g. loss utilization) in each state and, if all the tax factors are relatively equal, RCO may have no interest at all in determining the transfer price of the tables. States S and R, however, will both be interested in what the transfer price is, but their interests will go in opposite directions: State S will want to make sure that the price is not too low to deprive it of tax revenues; conversely, State R will want to make sure that the price is not too high to reduce the amount of profits on which State R has exclusive taxing rights. It will therefore not be surprising if the three parties who are required to determine the transfer price of the tables (i.e. the taxpayer RCO, the tax administration of State S and the tax administration of State R) end up with different amounts. Ultimately, any difference between the taxpayer and the tax administration of one of the states may be resolved through the judicial process in that state. In other words, both the taxpayer and the tax administration may have correctly applied the treaty as both chose a transfer price that is in the range of acceptable arm s length prices, but a final determination by the courts of that state will produce, in quantum mechanics parlance, a collapse of the quantum superpositions of correct transfer prices and the observation of a single correct transfer price. To paraphrase Schrödinger, the judge will open the box and find out whether the cat is dead or alive. A difference between the tax administrations of the two states, however, is more problematic. If the tax administrations end up with different transfer prices for the tables and both prices satisfy the arm s length requirement of Art. 7(2), what will happen? If the result is double taxation, one can easily imagine that the taxpayer will consider the mutual agreement procedure in Art. 25 of the treaty. Art. 25(1) indicates that a person may initiate a mutual agreement procedure if he considers that the actions of one or both of the Contracting States result or will result for him in taxation not in accordance with the provisions of... [the] Convention. If, however, both tax administrations used a correct transfer price in applying Art. 7(2), can it be said that there is taxation not in accordance with the provisions of... [the] Convention? If we conclude that this is not the case, the weaker form of mutual agreement procedure provided by Art. 25(3) would, of course, still be available. The problem, however, is that the arbitration provision in new Art. 25(5) is not available in the case of a mutual agreement procedure that falls within Art. 25(3). This is where the possible application of the new approach comes into play. If one were to consider that the different prices used by the two tax administrations result in a conflict of qualification, the result would be that State R, in applying Art. 23, would have to agree that State S has taxed in accordance with the provisions of the treaty and would have to eliminate double taxation accordingly. If State R did not agree, its failure to comply with the obligation imposed by Art. 23 would allow the taxpayer to go to court in State R and would also mean that taxation by State R was not in accordance with the treaty, thereby allowing the taxpayer to present its case under Art. 25(1). The big question, however, is whether the different arm s length prices used by the tax administrations can be viewed as producing a conflict of qualification. This issue was discussed extensively during the drafting of new Art. 7, which was released in July 2008 as a discussion draft. 7 Draft new Art. 7(3) and Paras. 40 to 69 of the proposed Commentary on draft new Art. 7, which are included in the discussion draft, discuss extensively what happens where the taxpayer and the two contracting states use transfer prices or methods that are different, but that equally satisfy the arm s length requirement of Art. 7(2). The main purpose of these paragraphs is to explain how Art. 23 will apply in such cases. Draft new Art. 7(3) deals with one specific situation, i.e. where the domestic law rules of the contracting states require the use of different acceptable approaches to attribute an arm s length amount of free capital to the permanent establishment. As explained in Para. 44 of the proposed Commentary: Paragraph 3 deals with this issue, which is especially problematic for financial institutions. It provides that a Contracting State must accept, for the purposes of determining the amount of interest deduction that will be used in computing double taxation relief, the attribution of free capital derived from the application of the approach used by the other State in which the permanent establishment of an enterprise of the first State is located if the following two conditions are met. First, the difference in capital attribution between the two States must result from conflicting domestic law choices of capital attribution methods. Second, the States must agree that the State in which the permanent establishment is located has used an authorised approach to the attribution of capital and that that approach produces a result consistent with the arm s length principle in the particular case. Draft new Art. 7(3) basically achieves the same function as Para. 45 of the current Commentary on Art. 7 (added through the 2008 Update), which is to deal with the difficulties created by the recognition that there is more than one acceptable method of allocating free capital to a permanent establishment. These difficulties were particularly acute for banks, which have many foreign branches to which free capital must be allocated; this led the OECD to deal expressly with the issue. 7. Available at IBFD BULLETIN FOR INTERNATIONAL TAXATION FEBRUARY

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