The OECD Model Reconsidering the structure and operation of its distributive rules Kees van Raad 16 06 05 OECD is understandably conservative where changes to text of the OECD Model are concerned, but confusing use of the term `enterprise : Art. 5.5: ` acting in the name of an enterprise Art. 7.1: ` enterprise carried on by a resident Art. 7: Profits of an enterprise [3.1.d: carried on by a resident] of a Contracting State shall be only taxable in that State unless the enterprise carries on business : > who carries on what? 1 2 Suggested changes and additions Suggested changes and additions cont d 1. Clarify the nature of the distributive rules: do they operate by permitting (one of the states to tax) or by restricting (one of the states to tax), or does the difference not matter? 2. Take care of the currently unresolved overlaps between the distributive rules of different articles of the OECD Model (and make countries aware that they do not accidentally include overlapping distributive rules in the same treaty article) 3. Avoid the confusing use of the two different words in `shall be taxable only in v. `may be taxed in 4. Some of the distributive rules effectively solve the double taxation where other ones only provide for a first step: make all of them complete instances with a specific nexus in the `source state, to all cases where the other state may want to tax. 6. Art. 21.3 UN Model either is based on a misunderstanding of the scope of Art. 21.1 OECD as this provision was changed/clarified in 1977, or amounts to an uncontrolled expansion of the taxing rights of the `other state 3 4
1. Nature of the distributive rules: permitting or restricting? OECD Comm. Introduction: Sec. 19: ` Articles 6 to 21 determine, with regard to different classes of income, the respective rights to tax of the State of source or situs and of the State of residence. `[In respect of some] items of income and capital, an exclusive right to tax is conferred on one of the Contracting States. The other Contracting State is thereby prevented from taxing. Sec. 25.1: ` the words may be taxed in a Contracting State mean that that State is granted the right to tax the income to which the relevant provision applies and that these words do not affect the right to tax of the other Contracting State. 5 1. Nature of the distributive rules: permitting or restricting? cont d Relevance of distinction, e.g. > Confusion/mistakes in interpretation NL Supreme Court, 28 February 2001, nr. 35.557 Art. 12.1 of the 1993 NL-Mexico treaty: Royalties arising in one of the States and paid to a resident of the other State may be taxed in that other State if such resident is the beneficial owner of the royalties > Simultaneous application of two treaty rules (e.g., triangular case with payment to a dual-resident company) > What if a treaty is incomplete (e.g., missing Other Income article, incomplete Capital Gains article): 6 2. Current unresolved overlaps between distributive rules E.g., Art.s 17 ( sportspersons) and 18 (Pensions): pension of a German soccer player that moved his residence to Spain: Art. 18: exclusively taxable in the residence state: Spain Art. 17: may be taxed in the state of activity: Germany 2. Current unresolved overlaps between distributive rules cont d or even within the same article [but no blame on OECD] : Art. 13 (Capital gains) of the 1993 NL-Mexico treaty 1. [cf. 2003 Art. 13.4 OECD] Gains derived by a resident of one of the States [NL] from the alienation of shares in a company which is a resident of the other State [M] and the value of which shares is derived principally from immovable property situated in that other State [M], may be taxed in that other State [M]. 4. [from UN Model] Gains derived from the alienation of shares in a company which is a resident of one State [M] may be taxed in such State. However, the tax so charged shall not exceed 10% of the taxable gains. NL resident sells shares in a Mexican resident company that owns immovable property in Mexico: capital gain is covered by BOTH para. 1 and para. 4 para. 1: share gains based on real property may be taxed in M without restriction para. 4: share gains may be taxed in M with a maximum tax of 10% of the gain Effect on treaty application by source state (G) and residence state (Sp) 7 >> Effect on taxation by M (2 restrictions?) and NL (2x double taxation relief?) 8
3. `may be taxed v. `shall be taxable only Cf. the French (= original) version `may be taxed in = `sont imposable dans `shall be taxable only in = `ne sont imposable que dans >> Anything wrong with replacing `shall be taxable only in by : `may be taxed only in? 9 4. Transparency of the distributive rules: >> Some of the distributive rules effectively solve the double taxation where other ones only provide for a first step: make all of them complete Complete solution of double tax: Art. 18: Subject to, pensions paid to a resident of a CS shall be taxable only in that State. >> i.e. pensions may NOT be taxed in the OCS (on the basis of whatever nexus): double taxation solved Only beginning of solution of double tax: Art. 6: from immovable property situated in the OCS may be taxed in that other State. >> Remember: OECD Comm, Introduction, Sec. 25.1: ` the words may be taxed in a Contracting State mean that that State is granted the right to tax the income to which the relevant provision applies and that these words do not affect the right to tax of the other Contracting State. 10 4. Transparency of the distributive rules cont d >> Some of the distributive rules effectively solve the double taxation where other ones only provide for a first step: make all of them complete >> In other words: under Art. 6 the recipient s residence state is not restricted from taxing as well. Solution of the double taxation is in non-mentioned Art. 23 [A and B] : 1. Where a resident of a Contracting State derives income which, in accordance with the provisions of this Convention, may be taxed in the other Contracting State, the first-mentioned [residence] State shall [provide exemption / credit] Therefore: Art. 6: Where income is derived by a resident of a CS from immovable property situated in the OCS such income may be taxed in that other State, and the first-mentioned State shall provide relief in accordance with Art. 23. 11 >> NL resident owns an apartment in Munich that he rents out to a US professor. We assume that under US domestic tax law a nonresident person who receives a rental payment from a US resident, is subject to US tax in respect of that payment Source country taxation by: Germany and US Residence country taxation by: Netherlands NL-G: art. 6: income derived by NL resident from immov prop situated in G: G may tax NL-US: art. 6: income derived by NL resident from immov prop situated in? US 12
List of the distributive articles : 6 income from immovable property 7 business profits 8 (income from) shipping, inland waterways transport and air transport 10 dividends 11 interest 12 royalties 13 capital gains 15 income from employment 16 directors fees 17 (income of) artistes and sportsmen 18 pensions 19 (income from) government service 20 (foreign support payments of) students 21 other income We should have checked which article(s) could be applicable before trying to apply Art. 6. >> Art.s 7 (Business profits) and otherwise Art. 21 (Other income) 13 Art. 7. 1. The profits of an enterprise [carried on by a resident] of a Contracting State shall be taxable only in that State (unless through PE in OCS) Art. 21. 1. Items of income of a resident of a Contracting State, wherever arising, not dealt with in the foregoing Articles of this Convention shall be taxable only in that State. >> under either rule: US may not tax 14 The use of Art.s 7 and 21 for allocating the taxing right in respect of immovable property income is a complicated way of denying a taxing right to a source state that applies a nexus for taxing immovable property income that is considered inadequate under the OECD Model. And apparently such a complicated way that also OECD Commentary gets confused; see: Sec. 1 of the OECD Comm on Art. 6: ` Article 6 deals only with income which a resident of a Contracting State derives from immovable property situated in the other Contracting State. It does not, therefore, apply to income from immovable property situated in the Contracting State of which the recipient is a resident or situated in a third State; the provisions of paragraph 1 of Article 21 shall apply to such income. Also other articles could be applicable (instead of Art. 21), notably Art. 7 (but in particular circumstances also articles, e.g., Art. 15) 15 Why does not Art. 6 take care of this? Current Art. 6: from immovable property situated in the OCS may be taxed in that other State. If no restriction as to the nexus employed by the other state: from immovable property [wherever located] shall be taxable only in that State, >> unless the property is situated in the OCS. If the property is situated in that other State, the income may be taxed in that other State. Earlier discussed update >> 16
Earlier discussed update > from immovable property [wherever located] may be taxed only in that State, >> unless the property is situated in the OCS. If the property is situated in that other State, the income may be taxed in that other State. and the first-mentioned CS shall provide relief in accordance with Art. 23. 17 Surprisingly, in a series of articles the distributive rule has a restricted reach similar to Art. 6: Art. 10: dividends: applies only where the other state wants to tax on basis of: >> residence of the dividend distributing company Art. 11: interest: applies only where the other state wants to tax on basis of: >> interest `arising in the other state: payor s residence or borne by local PE Art. 12: royalties: applies only where the other state wants to tax on basis of: >> royalties `arising Art. 16: directors fees: >> company is a resident of the other state Art. 17: entertainers and sportspersons: >> personal activities as such exercised in the other state 18 6. One consequence of the current `specific nexus scope of various distributive rules: the dual function of Art. 21.1 OECD Model and the undesirable addition of Art. 21.3 UN Model Art. 21.1 OECD: Items of income of a resident of a Contracting State, wherever arising, not dealt with in the foregoing Articles of this Convention shall be taxable only in that State OECD Comm: `The income concerned is not only income of a class not expressly dealt with but also income from sources not expressly mentioned. >> `arising : not defined: does not matter: wherever the income arises, the OCS may not tax Now look at art. 21.3 UN: 3. Notwithstanding the provisions of paragraph 1, items of income of a resident of a Contracting State not dealt with in the foregoing Articles of this Convention and arising in the other Contracting State may also be 19 taxed in that other State.