To be able to adapt treaties to include new ideas and developments, existing bilateral tax treaties are ‘updated’ by the OECD through the periodical release of new interpretive material. In particular through the release of OECD commentary on the OECD Model Tax Treaty (for more on this, see the other tax related blog posts). The use of this ‘ambulatory’ OECD commentary is controversial.

What exactly is the interpretive effect of these materials if a protocol is concluded? In other words: does a protocol ‘refresh’ a treaty for interpretive purposes so that new ideas and developments, as set out in this ‘ambulatory’ OECD commentary, are implicitly integrated into the treaty by this protocol?

The issue has come up in a number of cases I have encountered.

For instance, in a Canadian case, a 1995 protocol changed the wording of a provision of the 1975 France-Canada tax treaty. The court, when it was faced with the interpretation of this ‘new’ provision, used OECD interpretive material published in 1977 – material that was published after the conclusion of the treaty but before the date the protocol was approved.

There are also cases in which the protocol has not changed the wording of the treaty. In another case, a 2007 protocol was added to the 1980 US-Canada tax treaty. The interpretive material that was used, adopted in 2000, was in conformity with the 2007 protocol. It might be concluded that the protocol had influence on the way OECD Commentary was applied to the interpretation of the 1980 tax treaty. The Court held:

 ‘What is even more telling with (…) the Fifth Protocol Amendments is that, as the two countries are turning their minds to the wording of new provisions being drafted (…) they are content relying upon a sensible approach to the application and interpretation of the words.’

To construct this ‘sensible approach’ to interpret the treaty’s words, the court felt free to refer to the OECD materials adopted in 2000, after the conclusion of the 1980 treaty!

There are more examples from which it can be concluded that protocols can have interpretive effects. Although it cannot be said that any protocol completely ‘refreshes’ a treaty for interpretive purposes, it follows from some case law that a protocol can ‘refresh’ a treaty provision for interpretive purposes when it changes the wording of that treaty provision. Also, when a protocol is in conformity with ambulatory interpretive material adopted after the conclusion of a treaty, this interpretive material can be used to interpret the treaty.

The so-called permanent establishment is a common issue in international tax law. For example, a Dutch legal entity performs business activities in Morocco. These activities are not performed by a Moroccan legal entity, but by means of a fixed place of business through which the business of an enterprise is wholly or partly carried on. It can be compared with a Dutch supermarket that also has a shop in Belgium, without structuring by a Belgian legal entity.

The consequence of a permanent establishment is that the source state, in the example above Morocco, has the right to tax the profits which are allocable to the Moroccan part of the enterprise. However, the Netherlands wants to tax the profits of the Dutch legal entity, since that legal entity is a resident according to Dutch domestic tax laws, so the Netherlands can tax the Dutch legal entity on its worldwide income. Based on the double tax convention concluded between Morocco and the Netherlands, the Netherlands has to withdraw its taxing rights and provide for the avoidance of double taxation.

This is in short how businesses by means of permanent establishments are taxed within the international tax environment. As already mentioned in my previous blog, two model tax conventions are known. The first is prepared by the OECD, the second is developed by the UN. The commercial services industry is a large part of the global economy and important for developing countries. This is the reason why developing countries have negotiated in the UN that the source state may tax the profits derived from management and consulting services. In paragraph 9 of the commentary to Article 5 of the UN Model the following statement is written down: “Many developing countries believe that management and consulting services should be covered because the provision of those services in developing countries by enterprises of industrialized countries can generate large profits.” This resulted in a separate paragraph in Article 5 of the UN Model, i.e. that the furnishing of services of an enterprise can constitute a permanent establishment in the source country, resulting in taxing rights for the source state where the management and consulting services are furnished. And the source state is mostly the developing country.

Here, the UN Model clearly deviates from the OECD Model. The question is, what is the importance of this difference? This can be explained in just a few words. The Dutch government has endorsed the OECD Model and not the UN Model. However, the specific paragraph on the furnishing of services permanent establishment is included in not less than 15 double tax conventions that were concluded by the Netherlands. For reference purposes, the Netherlands has concluded approximately 90 double tax conventions on income and on capital in total. In specific cases and when explicitly demanded by developing countries, the Dutch government is willing to deviate from the OECD Model. It appears to me that things are never as black as they seem and that the resistance of the Dutch government to apply the UN Model could be considered as relative. Therefore, I would like to call on the government, in the current economic and financial crisis when cuts on the development aid budget are being considered, to be even more willing to apply the UN Model, following the example of the furnishing of services permanent establishment.

Tackling double non-taxation is hot. In a world where governments are increasingly looking for tax revenue, battling tax mismatches, and in particular the abuse of these mismatches, is becoming increasingly important.

An example of a mismatch is for instance the case where state A considers a payment of a company in state B to a company in state A as (exempt) dividend, whereas state B regards this payment as (deductible) interest. The result: the taxpayer is not taxed anywhere.

Algirdas Šemeta, EU Commissioner for Taxation, Customs, Anti-fraud and Audit, said: 

“Fairness must be at the heart of our tax policies. Double non-taxation undermines fair burden sharing in taxation and allows an unjust competitive advantage to companies that seek to exploit it. Tackling double non-taxation will not only deliver important revenues to Member States, but it will also ensure a stronger, fairer Single Market for all EU businesses.”

In the effort to battle one of the issues of the abuse of tax mismatches, existing frameworks can be used. The OECD, as an influential participant in the world of tax, is one of the institutions that takes an active role in this respect.

The OECD has tried to tackle mismatches on the level of tax treaties. By encouraging its Member States to interpret their existing bilateral tax treaties as to include ‘inherent’ anti-abuse rules, the OECD hopes that the abuse of mismatches can be reduced. The OECD does this by periodically releasing interpretive material, in particular the OECD Commentary on the Model Tax Convention.

However, this effort does not always work out as planned as some states are skeptical about using interpretive material that is released after the conclusion of a tax treaty. For example, in a Canadian case where the issue was whether a tax treaty had to be construed as to include an ‘inherent’ anti-abuse rule, the cross-examination of an expert witness resulted in the following:

“Q. I think we both agree that trying to apply [2003] commentaries to interpret a treaty that was put in place in 1989 is nonsense. Would you agree with that?
A. That is correct.”

And in a Czech judgement, the Czech Supreme Administrative Court, when faced with interpretive material that was released in 1992 with respect to the interpretation of a 1974 treaty provision, held that it would not take into account this interpretive material. Notably, it seemed that the taxpayer was deftly making use of a mismatch.

If international consensus with respect to these interpretive issues can be established, existing tax treaty frameworks could provide a valuable tool in battling the abuse of tax mismatches. In any case, the momentum seems to be building.

During the Seventh Meeting of the United Nations Committee of Experts on International Cooperation in Tax Matters in October 2011 in Geneva, the 2011 update of the UN Model Double Taxation Convention between Developed and Developing Countries (UN Model) has been approved. This UN Model, together with the UN Manual for the Negotiation of Bilateral Tax Treaties between Developed and Developing Countries and the currently prepared UN Transfer Pricing Manual for Developing Countries, form the basic documents for developing countries to assist in their needs when negotiating and concluding tax treaties with other countries.

The OECD Member States also have agreed on a model tax treaty. However, since the OECD Model is drafted by industrialised countries, this OECD Model is not considered to be the relevant model tax treaty for developing countries.

The main difference between the UN Model and the OECD Model is a variance in the applicability of the principle of source state taxation. As the OECD is an international organisation of industrialised countries, so is the OECD Model a model tax treaty between these industrialised countries which have more or less the same (high) economic standards. In contrast, the UN Model is explicitly meant, reference is made to its full title, to provide guidance to developing countries. The fiscal knowledge of the governments of developing countries cannot be compared to the (academic) knowledge and level of education in the industrialised countries.  

In general, in the OECD Model the source state may tax the business profits derived from activities within the source state. The state in which the company is tax resident is, by means of the specific tax treaty, not allowed to tax those profits, although this resident state would tax the profits based on its domestic legislation. By means of the tax treaty, double taxation is avoided.

The UN Model provides for a larger portion of source state taxation. This means that more profits derived from activities in the source state can be taxed by that source state. In a tax treaty which is based on the UN Model the source state is in principle the developing country. Consequently, the developing country can tax a larger portion of the profits and thus earns a relatively large portion for its national budget.

I believe that the conceptual difference in applying the principle of source state taxation between the UN Model and OECD Model is necessary. As long as economical differences exist between developed and developing countries, this should be expressed in tax treaties. Periodical reviews and further development of the application of the source state taxation principle in tax treaties should improve the interpretation, application and implementation in tax treaties by developing countries. Both from an academic as well as a practical perspective.

The 2011 update to the UN Model Double Taxation Convention, launched after a meeting of the UN Committee of Experts on International Cooperation in Tax Matters on 15 March 2011, once more poses the question what the relationship is between the established OECD tax treaty model, the UN tax treaty model and some countries’ specific viewpoints with respect to these models.

The OECD Model tax treaty, an influential tax treaty model on which more than 1000 bilateral tax treaties are based, is regarded to be geared towards the interests of developed countries. Developing countries, especially the upcoming economies such as India and China, neither have nor had influence on the development of the OECD Model. The UN Model, on the other hand, can, ‘thanks to its universal membership and its legitimacy, be a catalyst for increased international cooperation in tax matters for the benefit of developed and developing countries alike’, as the Secretary-General wrote.

The UN tax treaty model, however, relies on OECD material with respect to some of the issues of double taxation it deals with. For example, with respect to the problem of transfer pricing, one of the more prominent problems of international double taxation, the Committee of Experts recommends that the OECD guidelines should be followed.

In a recent letter to the UN Financing for Development Office of the UN ECOSOC, India has expressed its doubts with respect to this practice. According to India, the Committee of Expert’s recommendation that the OECD guidelines should be followed, ‘should be ignored’. India holds that these guidelines have been developed on the basis of consensus reached by the 34 OECD states (all developed states), and not on the basis of a broader consensus that also includes non-OECD member states such as India itself.

This puts in doubt the way existing treaties between OECD countries and upcoming economies such as India have to be applied. Other internationally accepted standards are not yet available and will have to be created first. If India, clearly an important (future) trading partner to many OECD countries, questions the application of some of the basic principles set out by the OECD and relied upon by the UN, this might lead to legal insecurity with respect to tax issues relating to reciprocal trade and investor relationships. Moreover, it puts into doubt whether future OECD state treaty negotiators will be able to easily rely on these OECD principles when trying to form new tax treaty arrangements.